INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

S
IM
M
N
 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

S
IM
Edited by:
Dr. Barnabas Varghese Nattuvathuckal
NMIMS Centre for Distance and Online Education
M
N

iSBn:
978-93-5464-556-3
978-93-5464-552-5 (ebk)

NMIMS Centre for Distance and Online Education

Address: V. L. Mehta Road, Vile Parle (W), Mumbai – 400 056, India. NMIMS Centre
 C O N T E N T S

CHAPTER NO. CHAPTER NAME PAGE NO.

1 Investment – Instruments and Markets 1

2 Classifications of Markets 19

3 Index 37

Case Studies 1 to 3 53

4 Return 57

5 Risk 69

6 Portfolio Theory 85

Case Studies 4–5 and 6 107

7 Asset Pricing Models: Capital Asset Pricing Model 111

8 Asset Pricing Models – Arbitrage Pricing Theory 133

9 Mutual Fund Investments 145

Case Studies 7 to 9 171

10 Performance Evaluation of Mutual Funds 177

11 Macro-Economic Factors Impacting Investments 197

12 Financial Planning 225

13 Wealth Management and Estate Planning 251

Case Studies 10 to 13 273

 INVESTMENT ANALYSIS AND
PORTFOLIO MANAGEMENT

C U R R I C U L U M

Investment Analysis and Portfolio Management

Investment – Instruments and Markets: Introduction, Motives of Investment, Investment Assets, Financial
Assets, Functions of Financial/Capital Markets
Classifications of Markets: Over-the-Counter (OTC) Markets, Primary Market, Private Placement and
Preferential Allotment, Secondary Markets
Index: Introduction, Constructing Index, Uses of Indices, Impact Cost, Managing Changes in Index, Total
Return Index
Return: Introduction, Return, Historical and Expected Return, Expected Return
Risk: Risk, Measuring Expected Return and Risk from Historical Data, Expected Returns and Risk Under
Uncertainty, Normal Distribution
Portfolio Theory: Introduction, Portfolio Return, Covariance and Correlation, Two-Asset Portfolio,
The Optimum Portfolio, Portfolio Construction, Understanding Diversification and Risk
Asset Pricing Models: Capital Asset Pricing Model: Introduction, Systematic and Unsystematic Risk,
Asset Pricing and Risk, Assumptions of Capital Asset Pricing Model, Separation Theorem, Pricing a
Financial Asset – Capital Asset Pricing Model (CAPM), Interpretation of CAPM, Measuring Beta, Portfolio
Theory and CAPM, Capital Market Line (CML) and Security Market Line (SML), Limitations of CAPM,
Sharpe’s Single Index model (The Total Risk Concept)
Asset Pricing Models – Arbitrage Pricing Theory: Introduction, How APT Works, Process of Arbitrage,
Diversification Under APT, Assumptions of CAPM and APT, Limitations of APT
Mutual Fund Investments: Introduction, Concept of Mutual Fund, Structure of Mutual Fund, Regulation of
Mutual Fund, Returns and Taxation, Types of Mutual Funds, Exchange-Traded Funds, Index Fund, Tracking
Error, Advantages of Investing in Mutual Funds, Limitations of Investing in Mutual Funds, Performance
Evaluation of Mutual Funds
Performance Evaluation of Mutual Funds: Performance Evaluation of Mutual Fund, Net Asset Value,
Measure of Return and Risk of Portfolio, Risk Adjusted Returns, Lower vs Higher NAVs
Macro-Economic Factors Impacting Investments: Introduction, Assessing of the Economy, The Stock
Market and the Economy, Understanding the Stock Market, Making Market Forecasts
Financial Planning: What is Financial Planning?, Life Cycle Concept of Financial Planning, Financial Planning
Process – A Six-Step Approach, Asset Allocation and Goal Analysis, Asset Allocation and Financial Goals,
Optimum Asset Allocation, Risk Aversion, Creating Personal Financial Plan, Retirement Planning
Wealth Management and Estate Planning: Wealth Management, Essential Features of Wealth Management, Asset
Allocation, Strategies for Asset Allocation, Importance of Wealth Management, Process of Wealth Management,
Advantages of Wealth Management, Role of Professional Wealth Manager in Wealth Management Process,
Wealth Management and Tax Planning, Estate Planning
 C H A
1 P T E R

INVESTMENT – INSTRUMENTS AND MARKETS

CONTENTS

1.1 Introduction
Self-Assessment Question
1.2 Motives of Investment
Self-Assessment Question
1.3 Investment Assets
1.3.1 Real Assets versus Financial Assets
1.3.2 Marketable Versus Non-Marketable Securities
1.3.3 Nature of Claim – Fixed Versus Variable
1.3.4 Secured Versus Unsecured Assets
1.3.5 Maturity of Investment
1.3.6 Individual versus Collective
Self-Assessment Questions
Activity
1.4 Financial Assets
Self-Assessment Questions
Activity
1.5 Functions of Financial/Capital Markets
1.5.1 Continuity of Capital
1.5.2 Price Discovery
1.5.3 Market-Based Resource Allocation
1.5.4 Promote Savings
1.5.5 Forcing Management Efficiency and Performance
Activity
1.6 Summary
Key Words
1.7 Descriptive Questions
1.8 Answer Keys
Self-Assessment Questions
1.9 Suggested Reading and E-References
2 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

INTRODUCTORY CASELET

From 1994 onwards the trading on the exchanges has become screen-
based with terminals available with the members of the exchange all
over India. Prior to 1994 it was an open-outcry system that prevailed.
Screen-based automated trading has its own advantages. It speeds up
the execution of orders, increases transparency of prices, and facilitates
real-time updating of relevant market information of prices and vol-
umes. These features of screen-based trading increase the confidence
of investors and helps them make well-informed and timely decisions.
The structural efficiency of the market has increased manifold since the
advent of screen-based automated trading.

QUESTIONS

1. How has the trading on exchanges changed post 1994?

2. Mention the advantage of screen-based automated trading.
 INVESTMENT – INSTRUMENTS AND MARKETS 3

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Explain the motives of investment
> Describe investment assets
> Understand various kinds of financial assets
> Understand the functioning of financial markets

1.1 INTRODUCTION
Investment is a word and an activity that has universal appeal and pursued
by almost all in some form or the other. Irrespective of one’s financial stand-
ing, any person who earns money is faced with two broad alternatives: to
spend it now to fulfil consumption needs or attempt to save it today for ful-
filling the future needs by deferring the current consumption. Each person is
guided by own circumstances, his approach towards life, present and future
needs, etc. while deciding the proportion of income to be saved or consumed,
and the avenues where saving would be deployed.
Over the period of time, financial innovation has grown resulting into host
of different investment products to meet varying needs of investors. Some
of these investment products have become increasingly complex to confuse
naïve investors causing them to keep away from such products. However,
innovations continue unabated and complexities keep getting added. It is
one of the objectives of this book to explain complexities of the various finan-
cial products, and highlight few common principles on which these product
innovations are devised.
Till about a century ago the common form of investment used to be park-
ing money in bank deposits or real assets like gold or real estate. With lim-
ited savings there was perhaps no need to expand the investment landscape
and innovate newer products. This led to increased search for more invest-
ment avenues and development of newer products. Today we hear terms
like stocks, bonds, futures, options, mutual funds, convertible securities, etc.
that are becoming increasingly popular vehicles of investment. The menu of ! IMPORTANT CONCEPT
products and complexity of markets has really confounded many. The aim
The subject of investment
of this subject is to resolve the dilemma of investment by studying different management is concerned
investment products and their features, understand market structures along with (a) choice of investment
with the investment attributes of the investors. avenues available in the
The subject of investment management is concerned with (a) choice of form of different financial
investment avenues available in the form of different financial instruments, instruments, (b) distinguishing
(b) distinguishing features of each instrument, (c) suitability or desirability features of each instrument,
of investment instruments to different classes of investors, and (d) relative (c) suitability or desirability
merits and demerits of each instrument. By addressing the above ques- of investment instruments to
tions it is hoped that investors would become more knowledgeable and different classes of investors,
and (d) relative merits and
would be in a better position to take a well-informed decision regarding
demerits of each instrument.
their investments.
4 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

SELF-ASSESSMENT
1. The subject of investment management is not concerned with:
QUESTION
a. Choice of investment avenues available in the form of different
financial instruments
b. Similar features of each instrument
c. Suitability of investment instruments to different classes of
investors
d. Relative merits and demerits of each instrument

1.2 MOTIVES OF INVESTMENT

Investment is a need for all individuals and firms alike. Most firms are actually
borrowers and face an investment decision referred to as capital budgeting
decision. This is investment in real assets to increase the earning potential
of the firms. There are only a handful of firms that are cash surplus and face
investment decisions in financial assets/products. Mostly investment deci-
sion is faced by individual investors who need to deploy relatively small part
of their income into financial products. However, the motives of investment
may vary from investor to investor. Because future is uncertain, one needs to
protect it by saving from the present income.
These savings are used for investment in financial products with broadly the
following two purposes:
1. Enhancing and Securing Future Income: Most of us have greater
consumption needs than the resources we possess. This consumption
needs comprise present and planned consumption needs for future. We
need to save for the rainy days, post-retirement sustenance, planning
for future needs like housing, education, health, etc. Some investors
invest to supplement their present income or earn income from
investment when the other sources of income dry up. For example,
an individual in the job may retire in future when he would earn no/
paltry income. When this happens, the individual has to supplement
the income from the investment made earlier in life. This investment
income comes in the form of interest or dividend which is the reward
for the investment.
2. Increasing Wealth: Most individuals consume first and save the
remaining. However, some individuals − called “rich” − save first and
consume the remainder. They save to multiply the wealth rather than
to provide for future consumption. The investment considerations
for such individuals may be entirely different from those in the first
category. The reward for making the investment comes in the form
of increased wealth through capital appreciation of the investment.
Irrespective of the primary motives of investment, two features of any
investment that remain constant with all instruments are returns and
risks. These two aspects of investment occupy most space in the subject
of investment and portfolio management. Most research and studies in
the subject are focussed on portfolio return and risk.
 INVESTMENT – INSTRUMENTS AND MARKETS 5

SELF-ASSESSMENT
2. Consider the following statements.
QUESTION
1. Most individuals consume first and save the remaining.
2. They save to multiply the wealth rather than to provide for future
consumption.
Which of the statement/s given above is correct?
a. Only 1
b. Only 2
c. Both 1 and 2
d. None of the above

1.3 INVESTMENT ASSETS

The menu of investment products has become too large to be classified along
single dimension. There are too many features available in various invest-
ment assets. The types of investment avenues available can be classified
along several attributes such as nature of products, security, sources, mar-
kets, trading practices and methods, purposes. Different kinds of classifica-
tion are presented here with the hope to cover the entire ambit of investment
and highlight distinguishing features of various investment assets. Yet one
can never be sure that whether these classifications would cover the entire
spectrum of investment products or not because of continuing financial inno-
vations and development of financial markets.

1.3.1 REAL ASSETS VERSUS FINANCIAL ASSETS

First major classification of investment is whether the savings are used as
investment in the real assets such as gold, stones, commodities, land, etc. or
in financial assets such as stocks, bonds, fixed deposits, etc. The difference
between real asset and financial asset is that former exists as tangible while
latter is a financial claim on another party. Financial assets create a liability
on the counterparty while real asset do not have a corresponding liability.
Real assets provide the investor with a sense of security with assets in hand
in physical form, while financial assets remain clouded with uncertainty
being claims on another party, mostly on the future cash flows. As such real
assets are considered more secure than financial assets.
Most common and popular form of investment is stock of the firm. It is a
claim on the future cash flows of the firm issuing stocks. Financial assets are
created on the real assets.

1.3.2 MARKETABLE VERSUS NON-MARKETABLE SECURITIES

An interesting and useful feature of financial asset is the ease of transferabil-
ity of financial claim from one investor to another. While land and automo-
bile too are transferable, the process is extremely cumbersome, lengthy, and
! IMPORTANT CONCEPT

perhaps very costly. In contrast, the transferability of financial claim made Most financial assets are
on real asset is easy, rather instantaneous and involves negligible cost. Most transferable by endorsement
and delivery. These are also
financial assets are transferable by endorsement and delivery. These are also
called negotiable instruments.
called negotiable instruments.
 6 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Another description for these assets is whether they are tradable or non-
tradable. Tradability implies that prices of these assets is available in public
domain, therefore investor always knows the worth of investment at all points
of time. Though prices of few real assets such as gold and other metals too
are available in public domain on continuous basis, it is not always the case.
Financial assets are easily traded in the markets with large number of buyers
and sellers always available, making the valuation of the financial asset more
market-driven, competitive, and fair.

! IMPORTANT CONCEPT
Marketability of the financial claims essentially involves existence of the
efficient markets where these financial claims can be traded. Since claims
Marketability of the financial are transferable readily and instantaneously, the price at which this would
claims essentially involves happen gains prominence, as valuation changes with time depending upon
existence of the efficient the value of the real asset on which such financial claim was issued. If there
markets where these financial exists a market, the price would be available in the public domain and would
claims can be traded. enthuse buyers and sellers alike to trade depending upon what value they
perceive. In contrast, markets for real assets are constrained by limited
number of participants who have to negotiate the price with little informa-
tion. The process by which easily transferable claims are created over real or
illiquid assets is called securitisation.
The scope of this book is concentrated on the securitised marketable securities.

1.3.3 NATURE OF CLAIM – FIXED VERSUS VARIABLE

As stated, the financial assets are claims on the cash flows of the counterparty
normally called the issuer. This nature of claim can be broadly of two types:
1. Fixed amount of cash payable periodically at specified dates, called
fixed income securities. These securities when issued by government
are called government bonds (G-Sec). When issued by a firm, they are
called corporate bonds.
2. Variable amount with no certainty of timing of financial claims on the
free cash flows of the firm, if and when they occur. These include stocks/
shares.

! IMPORTANT CONCEPT
Another class of investment which has gained popularity is called derivatives.
A derivative is an instrument which can be defined as a claim over a claim.
A derivative can have But this is not the definition accepted by most. A derivative is defined as an
bond, share, or perhaps a instrument that derives its value from some other underlying asset. A deriv-
hypothetical asset such as ative can have bond, share, or perhaps a hypothetical asset such as index,
index, interest rate that do interest rate that do not have any physical shape, etc. as underlying asset.
not have any physical shape, Some of these assets are deliverable and some are non-deliverable. But the
etc. as underlying asset. aspect of deliverability does not come in the way of trading and transferabil-
ity. Most popular derivatives instruments are futures and options.
Besides fixed-income securities, equity, and derivatives, there can be vast
number of instruments that are a combination of two/three instruments. These
include preference shares, convertible debentures, warrants, etc. that com-
bine properties of more basic financial instruments such as stocks and bonds.

1.3.4 SECURED VERSUS UNSECURED ASSETS

In case of real asset the investor always has a real asset to support the invest-
ment. As stated earlier, financial assets create a financial liability/obligation
 INVESTMENT – INSTRUMENTS AND MARKETS 7

on the counterparty rather than conferring the real asset. The counterparty
while issuing a claim would have created either a real or financial asset from
the funds so received. What recourse does the holder has against the coun-
terparty if it fails to honour the liability? If the holder of the financial asset
can have an access to any other asset (financial or real) in case of default then
the instrument is called secured. If no such recourse to some real or financial
asset is available, the instrument would be termed as unsecured.
Availability of security to back the claim in case of default has implications on
returns, risk, and marketability of a financial instrument. A secured instrument
should have lesser return, lesser risk and should be more easily marketable as
compared to the unsecured instrument. An unsecured financial instrument
necessarily has to offer increased returns to induce investors to subscribe due
to greater inherent risks associated with possession of such instruments.

1.3.5 MATURITY OF INVESTMENT

One of most important dimension of investment is the tenor of investment,
that is, the time when original investment is returned. Investment implies
deferent of present consumption to future. The investor would like to disin-
vest at some point of time in future when the consumption can be no more
deferred. All investors have an investment horizon in mind while initiating an
investment. Hence financial markets offer variety of instruments with vary-
ing maturities to match the investment needs of investors. This is referred as
tenor of the instruments.
Instruments can be classified in terms of tenure or maturity of instruments.
There are bonds that normally have fixed maturity though these are bonds
with maturity as large as 50 or 100 years. On the other hand, we have instru-
ments of investment that can have maturity as low as 7 days like a bank fixed
deposit or a money-market instrument. Also investment can be made in equi-
ties which have no fixed maturity and are perpetual in nature. Derivatives are
instruments which more often than not have maturity over few months only.
Maturity of investment too has implications on the returns and risk. Though
not always true, investor may seek higher returns for longer term of invest- ! IMPORTANT CONCEPT
ment. Further risk multiplies with time, and therefore higher returns need to Instruments with longer term
be offered for instrument with longer tenure. The tenor of the instrument also would have to be listed and
has implication on trading. Instruments with longer term would have to be traded in the market place
listed and traded in the market place so as to provide an exit route to the inves- so as to provide an exit route
tor at all points of time. Failure to provide an alternate exit may constrain the to the investor at all points
marketability of the instruments with long tenor. Further listing of the instru- of time.
ments creates the confidence in the minds of investors that it is fairly priced.

1.3.6 INDIVIDUAL VERSUS COLLECTIVE

Most investments mentioned above are held by investors in their individ-
ual capacities. These investments are constrained by the limited amount of
savings available to naïve individuals forcing them to invest in fewer securi-
ties which has its own disadvantages such as inability to take well-informed
investment with too little income and too much of risk. A new financial inno-
vation created a product called mutual fund where small savings from large
number of investors are pooled together to have large resources invested by
professional managers doing adequate due-diligence with the objective of
sharing the income therefrom proportionately.
8 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Investing through mutual funds has gained in popularity for several reasons.
Increased levels of income have increased the scope of larger investment.
Investors, while becoming wealthier, spend more time in enhancing income,
leaving little time for every other activity. At the same time, product inno-
vations in the investment world demand increased levels of financial liter-
acy on part of investor for which neither time nor inclination is available.
Therefore, investors have to hire the necessary financial expertise to guide
the investment. Constraints of time and knowledge have opened up the ave-
nues for development of mutual fund industry.
Another dimension that has led to the growth of mutual funds industry is
the need for asset allocation and diversification. With many classes of assets
available and many instruments in each class of asset, the investment world
has indeed become complex. The choice of investment has increased man-
ifolds with varying risk−return profiles. No single investment can perhaps
meet the needs of the investors. With limited availability of funds, adequate
diversification is perhaps difficult to achieve. Collective investment can over-
come the obstacles in diversification.
Figure 1.1 attempts to cover the spectrum of investment and defines the
scope of the subject to (a) stocks, (b) bonds, and (c) derivatives. These instru-
ments would be described in detail with respect to their risk and return char-
acteristics. There can be many other instruments combining the features of
these three instruments. Mutual funds would be nothing but a collection of
these instruments.

Investment

Financial assets Real assets

Non marketable Marketable

Equity Bond Derivative

Figure 1.1 Spectrum of Investment Alternatives.

Table 1.1 attempts to describe few popular investment alternatives in terms

of some of the distinguishing features described above.

TABLE 1.1 DISTINGUISHING FEATURES OF DIFFERENT

INVESTMENT ALTERNATIVES
Instrument Features
Public provident Financial Non Marketable Unsecured Long term
fund
Equity share Financial Marketable Unsecured Perpetual
Government bond Financial Marketable Unsecured –
Gold Real Marketable – –
Futures Financial Marketable Unsecured Short term
Mutual fund Financial Marketable Unsecured –
 INVESTMENT – INSTRUMENTS AND MARKETS 9

SELF-ASSESSMENT
3. Which of the statements given below is not correct?
QUESTIONS
a. The difference between real asset and financial asset is that
former exists as tangible while latter is a financial claim on
another party.
b. Financial assets create a liability on the counterparty while real
asset do not have a corresponding liability.
c. Real assets do not provide the investor with a sense of security
with assets in hand in physical form.
d. Most common and popular form of investment is stock of the firm.
4. Most financial assets that are transferable by endorsement and
delivery are also called:
a. Negotiable instruments
b. Non-negotiable instruments
c. Tangible instruments
d. Variables
5. An instrument which can be defined as a claim over a claim is also
known as:
a. Bond
b. Fixed variables
c. Derivatives
d. None of the above

1. ‘Mutual Funds are subject to market risks.’ You must have heard ACTIVITY 1
it several times on television. Research using the internet, find out
what kind of risks are associated with a mutual fund investment and
the measures to overcome these risks.

1.4 FINANCIAL ASSETS

As described above there is a wide array of financial instruments with sev-
eral distinguishing features. It is perhaps not possible to describe each one of
them but few of the popular and common investment alternatives are briefly
described below:
1. Stocks: Shares or stock are the most popular instruments of investment.
A stock is issued by firms to mobilise capital for business purposes
from general public called shareholders or equity holders with
implicit understanding that profits earned from the business would
be shared proportionately among shareholders. However, there is no
explicit promise that certain level of profit or cash would be generated.
Even when there is cash generation or profit, all of it may or may not
be distributed; some may be retained in business. Subscribers to the
shares are also the owners of business and have the right to manage
its affairs. Besides shareholders there are other stakeholders in
the business such as suppliers, customers, employees, lenders, society,
government, etc. Each of these stakeholders has a claim on the cash
flow of the firm. It must be noted that the claim of the shareholder on
 10 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

the cash flows of the firm is residual, that is, only after satisfying the
claims of all other stakeholders, the remainder, if any, belongs to the
shareholders. This makes investment in shares very risky. Since this
claim is perpetual in nature, there is no fixed maturity to investment.
More often than not, shares are listed on the stock exchanges and are
transferable instruments so as to provide an exit route to those wanting
to relinquish their claim as well as entry point to those wanting to
accept the claim.
2. Bonds: Besides mobilising capital from shareholders, the other major
! IMPORTANT CONCEPT source of funds is borrowing. Business enterprises borrow from other
Bonds promise a fixed rate firms, financial institutions, banks, and general public with explicit
of return on periodic basis conditions of payment of interest on sums borrowed and repayment
as well as return of original obligations. Such debt is issued in the form of bonds. Unlike stocks,
amount supposedly from the subscribers to bonds do not have right to manage the business of the
cash to be generated from issuing firm. Like shares they too can be listed and are transferable.
the project. But all debts such as bank borrowing are non-transferable. Bonds
promise a fixed rate of return on periodic basis as well as return of
original amount supposedly from the cash to be generated from the
project. The promise to pay the interest and principal is not linked with
the fortunes of the firm. It remains fixed irrespective of profitability or
growth of the firm. These instruments may be secured or unsecured,
though most firms issue secured instrument.
3. Government Securities (G-Sec): Like bonds are issued by firms to
augment the resource base, government too needs finance for various
purposes. They need to fund the government expenses by borrowing
from public promising certain returns and repayment of principal at
maturity. They have same features as that of bonds except that the
issuer is government. Also these securities issued by government are
unsecured while most bonds issued by firms are secured. Despite being
unsecured, government securities are regarded as risk-free and often
serve as best proxy for risk-free rate of return. They are considered
safer than the secured bonds issued by different firms. It is due to the
reason that public does not expect the government to default on its
financial commitments due to its unique ability to print the money
when required. They are the safest financial instruments of investment.
Like bonds they too are transferable and are traded on the exchanges.
4. Money Market Instruments: Normally debt instruments are classified
! IMPORTANT CONCEPT according the term of maturity. If repayment is very short (typically
Money market instruments less than 90 days or one year), they are termed as money market
include treasury bills instruments. Money market instruments include treasury bills issued
issued by the government, by the government, commercial papers issued by highly rated firms,
commercial papers issued and certificates of deposits issued by banks in lieu of deposits made
by highly rated firms, and with them. Investment in money market instruments is large and for
certificates of deposits issued short term. It suits large investors such as commercial banks, financial
by banks in lieu of deposits institutions, insurance companies, etc. with huge funds available for
made with them. short term. Investment in money market instruments is guided by legal
environment and liquidity considerations.
5. Post Office Deposits, Public Provident Funds: Large proportions
of savings of individual investors are parked in the form Post Office
deposits, in employee provident funds and public provident funds.
 INVESTMENT – INSTRUMENTS AND MARKETS 11

These savings or investments are unsecured and non-marketable, but

are backed by government for interest payment and redemption of
principal. Therefore these investments are considered extremely safe.
They become even more attractive in terms of returns when tax rebates
are attached with them.
6. Mutual Funds: Mutual funds are collective investment where large
number of investors pool their savings to form a corpus and invested in
accordance with the investment objectives of the fund. They can invest
the corpus in shares, bonds, or any other financial instruments in the
proportions as specified by the investment objectives. It is a form of
indirect investment as funds operate on behalf of investors collectively.
It is usually managed by professional managers. Rather than issuing
shares or bonds, a mutual fund issues units to collect the corpus. The
market value of units, called Net Asset Value (NAV), is available in
public domain on daily basis. These mutual funds may be listed and
traded (close-ended) or may be unlisted (open-ended). For close-ended
funds, the investor can exit through the market while open-ended funds
can be redeemed by the mutual funds. These funds periodically declare
dividends and offer choice to investors for reinvestment of dividend.
Rise/fall in NAVs would provide capital gains/losses.
7. Derivatives: Derivatives are financial instruments that derive their value
from some underlying asset. These underlying assets can be prices of ! IMPORTANT CONCEPT
stocks, bonds, currencies, etc. or hypothetical assets such as indices, Arbitrage helps the process
interest rates, etc. These instruments can be used as speculation by of price discovery making
taking a directional view of the change of value of the underlying assets markets efficient, competitive,
or may be used as hedging tool to contain the price risk. As prices of and transparent.
derivatives are dictated by prices of the underlying assets, they can also
offer arbitrage opportunities in case of mispricing. Arbitrage helps the
process of price discovery making markets efficient, competitive, and
transparent. Common derivative products are futures and options that
are tradable on an exchange though there can be other products too
that are traded over-the-counter. For common investors they normally
serve the purpose of hedging.
8. Real Assets: ‘Real assets’ is another class of assets where investors
like to invest. These include commodities like gold and silver, precious
stones, land and housing. These are non-negotiable instruments that
are not traded on exchange. However, over-the-counter markets exist
for each of the asset where assets can be bought and sold and ownership
transferred. Transfer of ownership in these assets is rather slow, costly,
and cumbersome. They are tangible assets and not financial assets.
To the investor, real assets provide a comfort of some tangible asset in
hand. However, financial assets on real assets can exist in the form of
derivatives.
9. Bank/Company Fixed Deposits: Most commonly understood and
favoured instrument of investment is a bank deposit. Surplus funds are
parked in the bank that offer fixed rate of interest and with varying
maturities ranging from 7 days to several years. They are unsecured,
non-transferable instruments of savings issued by commercial banks.
Few non-banking finance companies and firms, both public and private
sectors, too issue fixed deposits for specific tenor promising fixed rate
 12 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

of return. Fixed deposits of firms offer greater return than the deposits
by banks because they are supposed to be more risky.
10. Insurance Policies: Life insurance and other policies also occupy a
! IMPORTANT CONCEPT place in the investment portfolio of individuals. The motive for having
The motive for having insurance policies is often not guided by return considerations because
insurance policies is often they serve an altogether purpose. They mostly cover event risk where
not guided by return the payoff is given upon happening of some adverse event. Decision
considerations because they to have an insurance policy is driven by security. Insurance policies
serve an altogether purpose. provide very nominal returns. Since insurance policies are devoid of
They mostly cover event risk return considerations, they are often not a part of investment decision.
where the payoff is given They are illiquid, non-transferable, and long term in nature. However,
upon happening of some payment of premium for insurance policy constraints the availability of
adverse event. funds for investment purposes.
Besides the instruments described above, there are other investment ave-
nues such a preference shares, convertible debentures, etc. that combine
features of different instruments and expand the menu of investments.
Table 1.2 shows the changes in the household savings for the period 2010−11
to 2015−16. It shows overwhelming preference of individual investors to
park savings in bank deposits though there is a continuous rise in the shares
and debentures.

TABLE 1.2 CHANGES IN COMPOSITION OF

HOUSEHOLD SAVINGS IN INDIA (RS IN CRORES)
Year 2010−11 2011−12 2012−13 2013−14 2014−15 2015−16
Currency 137131 106242 111521 99520 134110 200552
Bank deposits 548299 525970 57508 648137 593296 615890
Non-banking 5099 10021 27911 21707 33257 40349
deposits
Life insurance 210102 195673 179949 183960 248161 272538
fund
Provident and 141139 95680 156479 190175 204992 211139
pension fund
Claims on 29545 −21889 −7109 8438 975 53556
government
Shares & 1729 16522 17027 42503 53272 91763
debentures
1079867 932728 1064041 1199278 1272240 1489853
Source: RBI Annual Report, Handbook on Statistics on Indian Economy, 2016.

SELF-ASSESSMENT
6. Which of the statement/s given below is correct?
QUESTIONS
a. A stock is issued by firms to mobilise capital for business purposes
from general public called shareholders or equity holders.
b. G-secs are considered safer than the secured bonds issued by
different firms.
c. All debts such as bank borrowing are non-transferable.
d. All of the above
 INVESTMENT – INSTRUMENTS AND MARKETS 13

7. Which of the statement/s given below is not correct in context of

mutual funds?
a. Mutual funds are collective investment where large number of
investors pool their savings to form a corpus.
b. They can invest the corpus in shares, bonds, or any other finan-
cial instruments in the proportions as specified by the invest-
ment objectives.
c. It is a form of indirect investment as funds operate on behalf of
investors collectively.
d. It is usually not managed by professional managers.

1. Research using the internet which are the top mutual funds that ACTIVITY 2
hold a strong place in the Indian economy and are popular among
masses.
2. Find out the different types of mutual funds in India. Also, using the
internet, give an example of each of these.

1.5 FUNCTIONS OF FINANCIAL/CAPITAL

MARKETS
One of the most important features of the investment instruments is tradabil-
ity of these instruments in the market. Most financial instruments are issued
as financial claims by firms that need financial resources to execute projects
that promise a future cash flow generation.

1.5.1 CONTINUITY OF CAPITAL

The most primary function of secondary markets at national and macro-eco-
nomic level is to maintain the continuity of capital for projects. As we know,
capital is scarce and projects requiring large outlay of capital would neces-
sitate mobilisation of capital for the project, which is contributed by large
number of small investors. These investors would need to withdraw capital
for their personal needs at different points of time. Withdrawing capital from
the project would imply abandonment of project and jeopardising the inter-
est of other investors who need to remain invested.

1.5.2 PRICE DISCOVERY

While markets provide ease of entry and exit at any point of time, the con-
sideration for entry and exit must be settled. A platform for large number
of buyers and sellers for exchanging the fair price needs to be established.
These large numbers of buyers and sellers continuously offer bid and ask
prices, thus helping discover the true value of the investment purely guided
by commercial considerations. The freer these markets are, the more effi-
cient the price discovery would be. In case of mispricing, there would be
investors willing to take positions so as to result in profit and therefore
price would tend to be equal to fair value. With continuous flow of informa-
tion the adjustment to the price too would be continuous and quick. It is
 14 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

assumed that in the market there are investors who estimate the true value
of the asset.

1.5.3 MARKET-BASED RESOURCE ALLOCATION

In an economy there is always the question of allocation of financial resources
in various sectors, which are constrained especially in developing nations.
Allocation of capital to various sectors of economy is often done on several
considerations such as balanced regional development, balanced sectoral
growth, equal employment generation, poverty reduction, even distribution
of wealth, etc. All these are desirable social objectives and are met with cap-
ital allocation based on subjective judgement of the policy makers. In such a
subjective process, commercial consideration and efficiency of capital in var-
ious sectors is often sacrificed. From the point of view of efficiency of capital
such resource allocation is sub-optimal. Capital chases higher returns and
flows from low return avenues to high return avenues. Markets assumed to be
free, perform the function of price discovery. Investments are driven by com-
mercial considerations alone. Software industry providing excellent returns
implies capital shortage in the sector. Therefore, returns are indicative of
needs of capital in particular sector. In free markets, the savings would auto-
matically get channelised to sectors where they are needed most. Therefore,
efficient capital markets would ensure optimum allocation of scarce capital.

1.5.4 PROMOTE SAVINGS

When savings can earn handsome returns with no sacrifice of the efficiency
of capital the households cultivate habit of savings to earn higher returns.
Savers of capital know that capital can be allocated in most efficient ways by
efficient and free markets. The charm of attractive returns induces people
to save more. For all developing nations increasing saving rate is always a
desirable national objective, as it reduces fiscal obligations of government
spending by boosting private investment. The extent to which projects are
funded by private capital, the onus of public spending on part of government
helps reduction in taxes.

1.5.5 FORCING MANAGEMENT EFFICIENCY

AND PERFORMANCE
Since capital is scarce, there is a competition among those needing capital to
attract investment in a specific venture. With continuous process of price dis-
covery in the market, managements of firms attempt to maximise the traded
price. It becomes the yardstick of the measurement of performance of the proj-
ect. Therefore, all firms in the sector competing for funds from same investors
!Efficient
IMPORTANT CONCEPT
functioning of strive for optimisation of value and concentrate on prices in the markets. This
markets provides liquidity causes healthy competition among management of different firms attempting
to investors for ease of entry to outperform one another. This healthy competition among managers of dif-
and exit as well as quick ferent firms ensures maximum efficiency of all productive resources, besides
and efficient dissemination capital. Desire for increased returns by investor creates continuous pressure
of information at lower on managers to perform better and better, making them increasingly transpar-
costs. Efficient markets also ent, and adopt highest standards of corporate governance.
encourage increased financial
Thus, at macro-level, the markets are extremely important for economic
literacy.
development and therefore its efficient functioning must be encouraged by
 INVESTMENT – INSTRUMENTS AND MARKETS 15

policy makers. Efficient functioning of markets provides liquidity to inves-

tors for ease of entry and exit as well as quick and efficient dissemination of
information at lower costs. Efficient markets also encourage increased finan-
cial literacy.
Due to wide array of investment instruments with widely divergent features,
the market for these securities are many. They can be classified in several
ways, some of which are discussed here.

SELF-ASSESSMENT
8. Which of the following is a function of financial market?
QUESTIONS
a. Continuity of capital
b. Price discovery
c. Promote savings
d. All of the above
9. Consider the following statements.
1. In free markets, the savings would automatically get channelised
to sectors where they are needed most.
2. Therefore, efficient capital markets would ensure optimum
allocation of scarce capital.
Which of the statement/s given above is correct?
a. Only 1
b. Only 2
c. Both 1 and 2
d. None of the above
10. The most primary function of secondary markets at national and
macro-economic level is to maintain:
a. Continuity of capital for projects
b. Find cheap labor
c. Location
d. All of the above

1. Using the internet, find out the reasons why markets at macro-level ACTIVITY 3
play a significant role in economic development. According to you,
what steps can be taken to make the functioning of markets more
efficient?

1.6 SUMMARY
‰ The two most important considerations in choosing the investment are
return and risk. Besides these, there can be many more features desired
in an investment.
‰ The subject of investment is confined to the investment in financial
assets. Financial assets, as distinct from real assets, are those that create
a financial liability on the counterparty referred to as the issuer.
16 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

‰ Tradability implies that prices of the assets is available in public domain,

therefore investor always knows the worth of investment at all points of
time.
‰ Marketability of the financial claims essentially involves existence of the
efficient markets where these financial claims can be traded.
‰ If the holder of the financial asset can have an access to any other asset
(financial or real) in case of default then the instrument is called secured.
If no such recourse to some real or financial asset is available, the instru-
ment would be termed as unsecured.
‰ Shares or stock are the most popular instruments of investment.
‰ A stock is issued by firms to mobilise capital for business purposes from
general public called shareholders or equity holders with implicit under-
standing that profits earned from the business would be shared propor-
tionately among shareholders.
‰ Besides mobilising capital from shareholders, the other major source of
funds is borrowing. Business enterprises borrow from other firms, finan-
cial institutions, banks, and general public with explicit conditions of
payment of interest on sums borrowed and repayment obligations. Such
debt is issued in the form of bonds.

KEY WORDS 1. Stock is the most common and popular form of investment in any firm.
It is a claim on the future cash flows of the firm issuing those stocks.
2. Securitisation is the process by which easily transferable claims are
created over real or illiquid assets.
3. A fixed income security is a fixed amount of cash payable periodically
at specified dates. These securities when issued by government are
called government bonds (G-Sec). When issued by a firm, they are
called corporate bonds.
4. A derivative is defined as an instrument that derives its value from
underlying asset. A derivative can have bond, share, or perhaps a
hypothetical asset such as index, interest rate that do not have any
physical shape, etc. as underlying asset.
5. Mutual funds are collective investment where large number
of investors pool their savings to form a corpus and invested in
accordance with the investment objectives of the fund.
6. Real assets include commodities like gold and silver, precious stones,
land and housing. These are non-negotiable instruments that are not
traded on exchange.
7. Issuer is the firm that needs the capital for funding its projects and
makes an offer. It issues securities such as shares, bonds, etc.
8. Prospectus is a document which contains all information about the
company, details of the project, background of promoters, capital
structure, profit potential of the project, risk factors, terms and
conditions, financial position, etc.
 INVESTMENT – INSTRUMENTS AND MARKETS 17

1.7 DESCRIPITIVE QUESTIONS

1. Why do people save and invest in financial instruments?
2. What are the reasons for investment through mutual funds?
3. List out the differences between Derivatives and Bonds.
4. Describe various kinds of financial assets in terms of nature of income,
security, marketability.
5. Differentiate between real assets and financial assets.

1.8 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS
Topics Q. No. Answers
Introduction 1. b. Similar features of each instrument
Motives of Investment 2. c. Both 1 and 2
Investment Assets 3. c. Real assets do not provide the investor
with a sense of security with assets in
hand in physical form.
4. a. Negotiable instruments
5. c. Derivatives
Financial Assets 6. d. All of the above
7. d. It is usually not managed by profes-
sional managers.
Functions of Financial/ 8. d. All of the above
Capital Markets
9. c. Both 1 and 2
10. a. Continuity of capital for projects

1.9 SUGGESTED READING

AND E-REFERENCES

SUGGESTED READINGS
‰ Srivastava, Rajiv. 2017. Investment Management. New Delhi: Wiley.
‰ Elton, J Edwin, Martin J Gruber, William N. Goetzmann and Stephen
J Brown. 2013. Modern Portfolio Theory and Investment Analysis.
New Delhi: Wiley.

E-REFERENCES
‰ Brooke, P. and Penrice, D., A Vision for Venture Capital – Realizing the
Promise of Global Venture Capital and Private Equity (New Ventures), 2009.
‰ Capital Dynamics, The Definitive Guide to Risk Management in Private
Equity (PEI Media), 2010.
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A., Private Equity:
History, Governance and Operations (John Wiley & Sons), 2008.
 C H A
2 P T E R

CLASSIFICATIONS OF MARKETS

CONTENTS

2.1 Over-the-Counter (OTC) Markets

Self-Assessment Questions
2.2 Primary Market
Activity
2.2.1 Book Building
2.2.2 Proportionate Allotment
2.2.3 Rights Issue
Self-Assessment Questions
2.3 Private Placement and Preferential Allotment
Self-Assessment Question
2.4 Secondary Markets
Activity
2.4.1 Orders for Trading Settlement
2.4.2 Containment of Settlement Risk
2.4.3 Market Efficiency
Self-Assessment Questions
2.5 Summary
Key Words
2.6 Descriptive Questions
2.7 Answer Keys
Self-Assessment Questions
2.8 Suggested Reading and E-References
20 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

INTRODUCTORY CASELET

NSE prescribes conditions for listing of shares which include stipula-

tions regarding minimum size of paid-up capital of Rs 10 crores with
minimum market capitalisation of Rs 25 crores, good track record of
profitability and promoter holding of more than 20%. Under the listing
agreement, the firms have many obligations to fulfil. Listing require-
ments include timely submission of financial statements, conduct of
board meeting within stipulated time, notifying exchanges of price-
sensitive information, etc. Failure to meet listing requirement would
attract fines, suspension of trading, freezing of promoters’ holding, etc.

QUESTIONS

1. What are firms obliged to do under a listing agreement?

2. What actions are taken by the NSE if a firm fails to meet listing
requirement?
 CLASSIFICATIONS OF MARKETS 21

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Describing various kinds of financial assets
> Describing government securities and their importance
> Explain functioning of secondary markets and their role in the eco-
nomic development
> Differentiate between primary market and secondary market
> Explain the process of issues of new securities, different parties
involved therein and their roles

2.1 OVER-THE-COUNTER (OTC) MARKETS ! IMPORTANT CONCEPT

One way of categorising the markets is by the way the securities are traded in OTC markets mean that
the markets. There are two ways – over-the-counter (OTC) and on exchanges. buyers and sellers find one
OTC markets mean that buyers and sellers find one another to transfer own- another to transfer ownership,
ership, and include trading of real assets, insurance policies, bank deposits, and include trading of real
etc. Most financial assets such as stocks, bonds, mutual funds, derivatives, assets, insurance policies,
etc. are normally exchange traded. It implies that buyers and sellers bid their bank deposits, etc.
prices and quantities on the platform provided by the exchange. It does not
imply that exchange-traded assets cannot be traded OTC. The route of OTC
is always open for all. In OTC markets, the terms and conditions of the con-
tract are mutually decided by buyer and seller including the price. The infor-
mation relating to the contract may or may not be made public and is the
prerogative of the parties concerned. When assets are exchange-traded, the
price and other information is available in public domain. The prospective
buyers and sellers can use this information for negotiating price.

SELF-ASSESSMENT
1. A market where buyers and sellers find one another to transfer
QUESTIONS
ownership and trade in real assets, insurance policies, bank deposits
etc., is called:
a. Primary market
b. Secondary market
c. International market
d. Over-the-counter market
2. Consider the following statements.
1. OTC implies that buyers and sellers bid their prices and quantities
on the platform provided by the exchange.
2. It does not imply that exchange-traded assets cannot be traded
OTC.
Which of the statement/s given above is correct?
a. Only 1
b. Only 2
c. Both 1 and 2
d. None of the above
 22 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

2.2 PRIMARY MARKET

Another classification of the market is primary versus secondary. When a
security is marketed for the first time (e.g. a public issue of shares or bonds)
by the issuing firm, it is called the primary market. It is a direct relation-
ship between the issuing firm and prospective investors. Once the public
issue is marketed, the securities are listed on the exchange for future trading
among investors. Subsequent buying or selling of the securities is done on
the exchange. The exchanges are referred as secondary markets.
There are many parties involved in the primary market as briefly described
below:
1. Issuer: The firm that needs the capital for funding its projects and
makes an offer is called issuer of securities such as shares, bonds, etc.

! IMPORTANT CONCEPT 2. Lead Managers and Merchant Bankers: The issue made by issuer
needs to be managed for marketing of securities offered. This is done
The issue made by issuer through a document called prospectus which contains all information
needs to be managed for about the company, details of the project, background of promoters,
marketing of securities capital structure, profit potential of the project, risk factors, terms
offered. This is done through and conditions, financial position, etc. The prospectus is vetted by an
a document called prospectus independent party called lead manager for correctness and fullness of
which contains all information the information required to be disclosed to the public. The guidelines for
about the company, details issue of new securities are framed by a regulator, called Securities and
of the project, background of Exchange Board of India (SEBI). If information is correct and complete,
promoters, capital structure, SEBI approves the issuance of securities to the prospective investors.
profit potential of the project,
risk factors, terms and 3. Underwriters: Underwriters to the issue give commitment to meet the
conditions, financial shortfall of funds in the issue if not fully subscribed. This is required
position, etc. to protect the interest of those who have subscribed to the issue, but
the issuer is unable to get the adequate funds for the project, thereby
jeopardising the interest of investors who have subscribed. In such a case
! IMPORTANT CONCEPT of shortfall of the funds, the money committed by those investing would
have to be refunded. This would imply abandonment of the proposed
Underwriters provide the project, which too is not desirable. However, another alternative is
assurance of meeting the that the shortfall is made good so that the project can be executed on
shortfall if such a need arises. expected lines and not shelved for want of funds. Underwriters provide
They in turn provide the the assurance of meeting the shortfall if such a need arises. They in turn
comfort level to issuer as provide the comfort level to issuer as well as to the prospective investors.
well as to the prospective For underwriting they charge a fee. Mostly bankers and financial
investors. institutions act as underwriters lending credibility to the issue.
4. Registrars: Registrar to the issue collects the applications from
investors, makes allotment in consultation with the lead manager, and
issues securities to successful applicants.
Besides the above-mentioned participants there are several others like bank-
ers, brokers, advertisers, etc. helping the marketing of issue and discharging
! IMPORTANT CONCEPT other responsibilities.
In the primary market, the
prospective investors have to 2.2.1 BOOK BUILDING
estimate the true potential The major difference between the primary and secondary market is the pric-
of the assets using different
ing of the asset. In the primary market, the prospective investors have to
methods.
estimate the true potential of the assets using different methods. While issuer
 CLASSIFICATIONS OF MARKETS 23

would want maximum price, the subscribers like to pay the least. The offers
of shares and debentures are required to mention an indicative price of the
issue. The issuer has been given freedom to fix the offer price. This is often
done in consultation with the lead managers to the issue, and is based on
prevailing market conditions including the perception of demand and supply
affecting the marketability of the issue. When the price is not pre-decided
then the offer can be made on the basis of demand and supply and an indic-
ative price. Interested investors are asked to submit their bids in terms of
quantity and price. The lead manager compiles the demand at various prices
by different bidders, and then the allocation of shares is made in order of
price. However, all successful investors are charged the same price irrespec-
! IMPORTANT CONCEPT
tive of the price quoted by them. Such a method of allocation of shares is Book-building process shifts
called book-building process. Book-building process shifts the onus of deter- the onus of determination of
mination of the acceptable price on the market and investors, rather than on the acceptable price on the
market and investors, rather
the issuer. The issuing firm has the advantage that it gets the maximum price
than on the issuer.
for the offer.
Despite free pricing, the primary markets are regulated by various bodies
supposedly protecting the interest of investors. This protection is provided
in terms of disclosure requirements before a firm can offer securities in the
primary markets. The disclosures are made to enable prospective investors
take well-informed decision whether to subscribe or not.
In India, Securities and Exchange Board of India (SEBI) regulates the public
issues providing guidelines and rules for (a) issuance of securities, (b) the
pricing of instruments, (c) purpose of issue, (d) transparency of procedures,
(e) processing, and rationale and procedures of allotment, (f ) end-use of
funds so mobilised, (g) risk factors that can affect the performance of the
securities, etc. The public issue is marketed through a prospectus that con-
tains all the details which are prepared and verified by merchant bankers or
lead managers. Merchant bankers are required to conduct the due-diligence
exercise for the prospectus, which is approved by SEBI before its contents
are made public and issue opens for subscription by investors.
Public offers are normally made for equity shares or bonds (debentures)
though some combinations such as preference shares, convertible deben-
tures, warrants, etc. too can be offered. These offers can be made to public,
to existing shareholders (rights), or on preferential basis. These may also be
sold to investors on private placement basis.

2.2.2 PROPORTIONATE ALLOTMENT

When securities are offered to public and demand exceeds the size of the
issue, all investors cannot be allotted the desired quantity. In such a case the
allotment is on proportionate basis. For example, for 10 crore shares if inves-
tors submit bids for 20 crore shares then each applicant would be offered only
half as much as demanded by an individual investor. Proportionate allotment
is done for each category of investors. Normally in the public issue, reserva-
tions are made for various kinds of investors such as institutions, employees,
and retail investors. Institutional investors include private bodies, banks,
mutual funds, etc. The demand in each category is compared with the res-
ervations made for the category. If the demand is less than reserved quan-
tity, full allotment is made in each category. Only when demand exceeds the
quantity reserved in that category the proportionate allotment is made.
 24 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

2.2.3 RIGHTS ISSUE

! IMPORTANT CONCEPT
When a firm intends to mobilise capital from its existing shareholders/debt
Rights issue gives a chance
holders and not from public at large, such offers are called rights. Rights
to the existing shareholders
issue gives a chance to the existing shareholders to contribute capital for the
to contribute capital
firms so that the beneficial interest of existing shareholders/ stakeholders is
for the firms so that the
not diluted by participation of others or new shareholders. Such issues are
beneficial interest of existing
shareholders/ stakeholders is made on pro-rata basis, that is new shares are issued in proportion to the
not diluted by participation of existing holding of existing shareholders to retain proportionate interest
others or new shareholders. in the prospects of company. Shareholders may opt to exercise their rights
to subscribe to the fresh capital or decline. Further they can also renounce
their rights in favour of another investor if they so wish. The pricing of
the issue is normally at discount to the prevailing price of the shares in
the market.

SELF-ASSESSMENT
3. What does SEBI stand for?
QUESTIONS
a. Securities and Efficiency Board of India
b. Securities and Exchange Board of India
c. Secondary Exchange Board of India
d. Social and Economic Board of India
4. SEBI regulates the public issues providing guidelines and rules for:
a. Issuance of securities
b. The pricing of instruments
c. Transparency of procedures
d. All of the above

ACTIVITY 1 1. The Securities and Exchange Board of India is the regulatory body
for securities and commodity market in India. Using the internet,
make a list of its counterparts in various nations.

2.3 PRIVATE PLACEMENT AND PREFERENTIAL

ALLOTMENT
Besides public or rights issue, other modes of offering securities are pref-
erential allotment and private placement. Mobilising capital through public
issue is extremely onerous task in terms of preparation, costs, approvals, and
disclosures. Public issue is extremely time consuming and expensive. For
speedier mobilisation of capital with least paperwork, fresh capital can be
issued through private placement. When an unlisted firm mobilises capital
from select group of investors it is referred as private placement. A private
placement by a listed firm offering fresh capital to select group of individ-
uals is called preferential allotment. These select individuals/entities are
mostly promoters of the company. They may include private equity suppliers
as well as venture capitalists who are not existing shareholders of the firm.
Such a route is often adopted by firms to increase promoter stake, ward-off
 CLASSIFICATIONS OF MARKETS 25

takeover threats, bring institutional investors, etc. The routes of private

placement and preferential allotment are adopted by firms because they ! IMPORTANT CONCEPT
believe that they can mobilise capital at higher issue price (therefore lower The routes of private
cost of capital) from select financially literate interested investors rather placement and preferential
than face the uncertainty of price and capital through a public issue. There is allotment are adopted by
a maximum limit on the number of persons/institutions who can be offered firms because they believe
shares in such a manner. that they can mobilise
capital at higher issue
Below Table 2.1 gives the growth of initial public offers (IPOs) made by pri- price (therefore lower
vate companies in India from 2010−11 onwards. cost of capital) from select
financially literate interested
investors rather than face
TABLE 2.1 GROWTH OF INITIAL PUBLIC OFFERS (IPOS) OVER YEARS the uncertainty of price and
Public issues by Non-Govt. Public Ltd. companies (Rs in Crores) capital through a public issue.
Ordinary Shares Debentures Total
No. of No. of No. of
Year Issues Amount Issues Amount Issues Amount
2010−11 70 24830 6 2630 76 27460
2011−12 49 8152 14 7530 63 15682
2012−13 48 13885 6 2215 54 16100
2013−14 53 5812 17 5869 70 11681
2014−15 63 9315 23 7741 86 17056
2015−16 87 24002 9 2714 96 26716
Source: RBI Annual Report, Handbook on Statistics on Indian Economy, 2016.

SELF-ASSESSMENT
5. Consider the following statements.
QUESTION
1. When an unlisted firm mobilises capital from select group of
investors it is referred to as private placement.
2. A private placement by a listed firm offering fresh capital to select
group of individuals is called preferential allotment.
Which of the statement/s given above is correct?
a. Only 1
b. Only 2
c. Both 1 and 2
d. None of the above

2.4 SECONDARY MARKETS

Once the issue is marketed with initial subscribers, the securities are listed on
the secondary markets, that is on the stock exchanges. Listing is permission
by the exchanges that the securities can be traded in the stock exchanges/
secondary markets after they comply with the requirements. The listing con-
tinues if firms follow disclosure requirements of the exchanges.
 26 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

ACTIVITY 2 1. Make a table to distinguish between a Primary market and a

Secondary market on the basis of:
i. Purchase type
ii. Frequency of Selling
iii. Purpose
iv. Beneficiary
v. Parties involved
vi. Investment
vii. Rules and regulations
viii. Type of product
ix. Location
x. Stability

LISTING
Listing of securities on the stock exchanges is permission by the exchange
to allow trading of securities for investors. The exchange provides a plat-
form for traders to place orders for buying and selling of securities. Besides
providing platform to facilitate trade, the exchange performs many other
functions such as settlement of trade, information dissemination pertaining
to the demand and supply, trade statistics and historical trends, corporate
announcements, publication of financial results, and other data of trade.
Therefore, listing provides visibility to the issuer.
NSE prescribes conditions for listing of shares which include (a) stipulations
regarding minimum size of paid-up capital of Rs 10 crores with (b) minimum
market capitalisation of Rs 25 crores, (c) good track record of profitability
and promoter holding of more than 20%.

! IMPORTANT CONCEPT Under the listing agreement, the firms have many obligations to fulfil. Listing
requirements include timely submission of financial statements, conduct of
Listing requirements include board meeting within stipulated time, notifying exchanges of price-sensitive
timely submission of financial information, etc. Failure to meet listing requirement would attract fines, sus-
statements, conduct of board pension of trading, freezing of promoters’ holding, etc.
meeting within stipulated
time, notifying exchanges of For stocks and other securities there are two major exchanges in India –
price-sensitive information, National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).
etc. Besides these, there are many regional stock exchanges but they are mostly
non-functional and instead have become members of BSE. Table 2.2 indi-
cates the dominance of NSE and BSE in the capital markets of India.
The dominance has been achieved due to their highly automated trading
systems with speedier and transparent execution of orders, and nation-
wide distribution networks through large number of brokers facilitating
investors. These members (brokers) have trading terminals making stock
exchanges virtual. Table 2.3 reflects the values of indices of BSE and NSE.
 CLASSIFICATIONS OF MARKETS 27

TABLE 2.2 SHARE OF BSE AND NSE IN INDIAN SECURITIES MARKETS

2010−11 2011−12 2012−13 2013−14 2014−15 Apr 15−Dec 15
Quantity of shares, lacs
BSE 9,90,776 6,54,137 5,67,220 4,79,951 8,56,755 5,73,100
NSE 18,24,515 16,16,978 16,59,160 15,33,716 23,61,779 16,11,313
Total all exchanges 28,16,069 22,72,796 22,28,173 20,15,659 32,18,534 21,84,605
Proportion of BSE and NSE 99.97% 99.93% 99.92% 99.90% 100.00% 99.99%
Value of shares, Rs crore
BSE 3,02,126 1,81,560 1,68,490 1,80,243 2,99,836 1,86,265
NSE 9,78,015 7,84,407 7,96,784 8,22,446 24,22,737 9,58,821
Total all exchanges 12,81,441 9,69,086 9,68,355 10,03,227 27,22,573 11,45,137
Proportion of BSE and NSE 99.90% 99.68% 99.68% 99.95% 100.00% 100.00%
Source: Handbook of Statistics on Indian Securities Market 2015, SEBI.

TABLE 2.3 ANNUAL AVERAGES OF MAJOR INDICES

AND THEIR MARKET CAPITALISATION
Market Capitalisation
( `crore)
Year/Month S&P BSE Sensex Nifty 50 BSE NSE
2010−11 18605 5584 68,39,084 67,02,616
2011−12 17423 5243 62,14,941 60,96,518
2012−13 18202 5257 53,48,645 52,32,273
2013−14 20120 6010 74,15,296 72,77,720
2014−15 26557 7967 1,01,49,290 99,30,122
CAGR (2010−15) 7.38% 7.37% 8.22% 8.18%
Source: Handbook of Statistics on Indian Securities Market 2015, SEBI.

The capital markets are divided in three broad segments – equity, debt,
and derivatives. Equity market deals with stocks while debt market deals
with corporate debt as well as government securities. Derivatives have
many underlying assets including stocks, indices, currencies, and interest
rates.
The equity derivatives market turnover on the Indian exchanges increased
from Rs 474.308 lac crore in FY 2014 to Rs 759.692 lac crore in FY 2015.
Currency derivatives trading in India was started in August 2008 at NSE
with currency futures on the underlying USD-INR exchange rate, followed
by future trading in currency pairs such as GBP-INR, EURO-INR, and JPY-
INR. Later, in October 2010, currency options trading were allowed on USD-
INR. The currency derivatives trading turnover (Rs 56.345 lac crore) in India
declined by 19% in 2014–2015 as compared to a year ago. Derivative trading
with respect to various products is given in Table 2.4.
 28 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

TABLE 2.4 TURNOVER OF EQUITY DERIVATIVES IN BSE AND NSE (RS IN CRORES)
Index Options Stock Options
Year Index Futures Stock Futures Call Put Call Put Total
BSE
2010−11 154 0 0 0 0 0 154
2011−12 1,78,449 10,216 2,00,090 4,18,253 1,277 192 8,08,476
2012−13 1,22,374 3,418 32,30,232 37,97,249 5,186 5,060 71,63,519
2013−14 63,494 54,609 57,05,317 33,49,884 22,186 23,945 92,19,434
2014−15 48,632 9,794 1,01,12,605 1,00,16,621 93,854 81,233 2,03,62,741
Apr−Dec 15 11,409 1,293 23,13,043 17,52,765 29,028 39,535 41,47,072
NSE
2010−11 43,56,755 54,95,757 90,90,702 92,74,664 7,77,109 2,53,235 2,92,48,221
2011−12 35,77,998 40,74,671 1,15,54,301 1,11,65,731 6,71,770 3,05,261 3,13,49,732
2012−13 25,27,131 42,23,872 1,15,81,485 1,12,00,089 13,02,779 6,97,648 3,15,33,004
2013−14 30,85,297 49,49,282 1,38,23,059 1,39,44,282 15,43,894 8,65,594 3,82,11,408
2014−15 41,09,472 82,91,766 2,07,71,439 1,91,51,224 22,43,382 10,39,170 5,56,06,453
Apr−Dec 15 33,76,452 57,98,145 1,84,05,777 1,63,85,396 16,55,566 8,21,993 4,64,43,328
Source: Handbook of Statistics on Indian Securities Market 2015, SEBI.

2.4.1 ORDERS FOR TRADING SETTLEMENT

In the secondary market the prices are determined by the demand and
supply for the securities. Most financial assets like shares, bonds, govern-
ment securities, etc. are traded in secondary markets.
From 1994 onwards, the trading on the exchanges has become screen-based
with terminals available with the members of the exchange all over India.
Prior to 1994 it was an open-outcry system that prevailed. Screen-based
automated trading has its own advantages. It speeds up the execution of
orders, increases transparency of prices, and facilitates real-time updating
of relevant market information of prices and volumes. This feature of screen-
based trading increases the confidence of investors and helps them make
well-informed and timely decisions. The structural efficiency of the market
has increased manifolds since the advent of screen-based automated trading.

! IMPORTANT CONCEPT
The orders of investors are entered in Electronic Limit Order Book (ELOB)
which enables feeding of buy and sell orders in terms of quantity and price.
The orders of investors are Buyers can specify quantity to buy and the maximum price to buy, and sellers
entered in Electronic Limit can enter sell orders with quantity to sell and the minimum selling price. Such
Order Book (ELOB) which orders that mention the price for the trades are called limit orders. Till the
enables feeding of buy specified limit price is breached the order is not executed, that is, buy order
and sell orders in terms of gets activated when price falls to the limit price and sell order is executed only
quantity and price. when price goes above the limit price. With limit orders the investors can trade
at the desired price in mind with the objective of maximising their returns.
For example, for an investor wanting to buy a share at Rs 100 that is trading
at Rs 110, a limit order would not get executed till the price falls to Rs 100.
Similarly, an investor wanting to sell at Rs 120 for a share trading at Rs 110 the
limit order would not get executed till the price rises to Rs 120.
 CLASSIFICATIONS OF MARKETS 29

The buy and sell orders without the specific limit on the price are deemed
to be placed at prevailing market price and are called open orders or market ! IMPORTANT CONCEPT
orders. Open/market orders would be executed instantaneously at the pre- The buy and sell orders
vailing market price while limit orders would wait for the limit price to be without the specific limit on
reached. the price are deemed to be
placed at prevailing market
BLOCK DEALS AND BULK DEALS price and are called open
orders or market orders.
Besides regular deals done on the screen-based trading platform of the
exchanges, there are facilities to transact high volume/high value trading
business separately on the exchange, without feeding orders in the system.
In an automated trading there is no control over choosing the counterparty
to the trade. Buyers cannot choose sellers and vice-versa. While feeding
orders on the window of exchange, it becomes open for all. If orders of large
quantities/value of trade are fed, it may lead to distortion in the price for
common and retail investors.
At times, there are negotiated deals that are finalised between two parties.
These are classified as block deals and bulk deals, which happen regularly
on stock exchanges. They are more in the nature of over-the-counter but
such deals are notified to the exchange with identities of parties, price, and
quantity transacted revealed.
A bulk deal refers to transaction of more than 0.5% of a company’s equity
shares by a single buyer or a seller. However, the counterparties can be many.
A bulk deal can be done any time within the trading hours. Therefore, price
of bulk deals are market-driven. The broker, who facilitates the trade, has to
provide details of the trade to the stock exchanges whenever it happens.
A block deal happens when two parties agree to buy or sell shares at an
agreed price among themselves for a single transaction of a minimum quan-
tity of 500,000 shares or a minimum value of Rs 5 crore, whichever is lower.
Block deal is done on a separate window provided by stock exchanges. This
window is open for only 35 minutes prior to the time of opening of the mar-
kets for public. SEBI rules prescribe that the price for block deal has to be
within ±1% of the previous day’s closing or the current market price.
Retail investors cannot participate in such transactions. Only institutional
investors such as mutual funds, financial institutions, insurance companies,
banks and foreign institutional investors, venture capitalist, private equity
suppliers, etc. participate in block deals. Promoters also use this window to
deal with issues related to cross-holding.
Retail investors often take the clue about pricing from bulk deals and block
deals. In the order book the buy orders are stacked in the descending order
of price (orders with higher buy price get priority over buy orders with
lower price) and sell orders are stacked in the ascending order (sell orders
with lower price get priority over sell orders of higher price). At NSE top
five orders on buy and sell sides with respective quantities are available for
public viewing. When the limit price is achieved, the orders are released
according to the time they were entered. The orders with same limit price
are released from limit order book and executed using the practice of First-
In-First-Out (FIFO).
30 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Figure 2.1 displays the details of shares including the current price, volumes,
and order book at any point of time that are available for public viewing.

Figure 2.1 Screen Shot of Trading Details of Shares at NSE.

STOP-LOSS ORDER
An additional feature of the order book is the facility to enter a price to con-
tain the loss, that is, stop-loss price. A stop-loss order is designed to limit an
investor’s loss on a position in a security. For example, an investor has pur-
chased a share at Rs 200. Immediately thereafter one can enter a stop-loss
order for selling at Rs 180 if the loss is to be contained at 10%. This order
means that if the stock falls below Rs 180 the shares will be sold preventing
losses beyond 10%. The advantage of a stop order is that it eliminates the
need for monitoring of price on continuous basis. The disadvantage is that
the stop-loss price could be activated by a short-term temporary fluctuation
in a stock’s price making investor lose, only to realise later that the loss could
have been reduced if only he/she held the security with greater patience.

TIME CONDITIONS ON ORDERS

Also as a matter of convenience the exchanges for orders are valid for the
day (GTD, Good Till Day) and order till cancelled (GTC, Good Till Cancelled).
These orders too are given at a desired price and eliminate continuous mon-
itoring by the investors for the desired price to be reached. These are called
time condition orders which remain valid till the time desired by the investor.
GTD order if remains unexecuted till the end of the day, would go out of the
order book while GTC order would continue till executed.

SETTLEMENT
Once the trade is executed, it needs to be settled by (a) seller giving the
delivery of the shares and (b) buyer making the payment thereof. The onus
 CLASSIFICATIONS OF MARKETS 31

of settlement is assumed by the exchange on which the trade took place.

The delivery is in the electronic mode, that is, in the dematerialised form.
Buyers and sellers both must have account in the dematerialised form called
DEMAT account with a depository. DEMAT account is like a bank account
with the difference that instead of money it holds the shares of firms in the
account. The account of the buyer is credited with the shares bought and
that of seller is debited with the shares sold. Exchanges carry out the settle-
ment through the broker of buyers and sellers. Similarly the value of trade is
settled through bank accounts.

DAY-TRADERS
The settlement of trades is done daily on net basis. It implies that obligations
of deliveries and payments are netted on daily basis. For example, if one sold
1000 shares and bought 1000 shares of the same firm the same day there
would be no delivery of shares involvedly-traders add volumes to trading and
help in more efficient price discovery because they play on price differential
during the day rather than taking delivery-based positions. Delivery-based
positions require rather large monetary involvement, while day-traders need
to provide for anticipated loss enabling them take highly magnified positions.
. However, the difference of price of buying and selling would have to be paid
or received, as the case may be to settle both the trades. Investors who buy/
sell first and sell/buy later on the same day to cancel the delivery obligations
are called day-traders.

ROLLING SETTLEMENT
For investors who buy or sell, shares are settled on rolling basis where com-
mitments of each day are settled. Delivery and fund position of a day need to ! IMPORTANT CONCEPT
be cleared on daily basis and cannot be netted with position on the next day. Delivery and fund position
This is called rolling settlement. With electronic trading and dematerialised of a day need to be cleared
form of shares it has become possible to settle the trades on T+2 basis in on daily basis and cannot be
India, that is, trades are settled with delivery and cash in two business days netted with position on the
after the trade has taken place. In a rolling settlement, for all trades executed next day. This is called rolling
on trading day (i.e. T-day), the obligations are determined on the T+1 day, settlement.
and settlement is done on T+2 basis, that is, on the 2nd working day follow-
ing the trade date.

2.4.2 CONTAINMENT OF SETTLEMENT RISK

The onus of settlement in the secondary markets is on the exchanges, that
is, they guarantee the delivery by seller and payment to the buyer. Since
in the financial markets commitments by investors are made on the basis
of anticipation of fulfilment of previous contracts, a default can lead to sev-
eral defaults and make the entire financial system fragile. Therefore, any
default has to be prevented and exchanges need to take safeguards. These
safeguards are at several levels.

INTRA-DAY TURNOVER AND EXPOSURE LIMITS

The business on exchanges is conducted by its members (brokers) who exe-
cute orders for their client. The volume of trade conducted by each member
must be within the means of his/her financial standing. Therefore, trading
 32 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

levels of each member are monitored on continuous/daily basis. Based on the

financial standing (base capita) of the member, a limit on the (a) daily gross
turnover and (b) gross exposure is prescribed. These limits curb the specula-
tive tendencies and prohibit members to trade within their financial means.
Such measure keeps the prices of securities within manageable limits.

AUCTION
Another tool to prevent default is the right of the exchanges to auction. When
any seller fails to deliver or makes a faulty delivery, the exchange has the right to
obtain the securities from the market by calling an auction where others mem-
bers may be ready to deliver the shortfall of the quantity for a price. Exchange
obtains the delivery of security through auction mechanism at a price quoted by
another member. The shortfall in delivery is made good by obtaining the securi-
ties with the differential of price chargeable to the original seller. The exchange
meets the delivery commitment to the buyer and thus prevents default.

MARGINS
The most effective tool to prevent default as well as discipline the members
! IMPORTANT CONCEPT to keep them within their financial means is the system of margins. There are
MTM margin covers the loss three levels of margins – initial margin, mark-to-market (MTM) margin, and
already made while initial extreme loss margin. While initiating a trade the exchange asks for a deposit
margin is supposed to cover (% of the value of trade) with them that is supposed to cover the potential
potential loss. loss on the trade. Both buyer and seller deposit this margin, which is based
on the volatility of the prices of the asset being traded. This is called initial
margin. Thereafter till the trade is settled the exchange calculates the profit/
loss on the open position on daily basis. This process is called marking to the
market. The loss has to be made good on daily basis while the profit is cred-
ited to the margin account. This is called MTM margin. MTM margin covers
the loss already made while initial margin is supposed to cover potential loss.
Another margin supposed to take care of extreme situations which are not
captured under initial margin is called extreme loss margin.

2.4.3 MARKET EFFICIENCY

Market efficiency is judged by (a) speed of execution of order, (b) time elapsed
for communication of trade and confirmation to the ultimate investors, (c)
speed of settlement of trades with delivery and payment, and (d) level of
transaction costs.
With screen-based trading the Indian markets have indeed become very
efficient structurally as well as informationally. Market orders are executed
instantaneously if the shares are liquid. The confirmation of order and its
price are also available almost instantaneously. In an open-outcry system,
there was substantial delay in confirmation of order execution as well as its
prices. Under rolling settlement the trades have to be settled on T+2 basis.
Transaction costs, mainly comprising brokerage, too have come down sub-
stantially from levels of 2% in 1980s and 1990s to about 0.5% now for retail
investors. Large investors can have orders executed at lower costs.

TRANSACTION COSTS
While transacting in the stock market, both buyers and sellers are required
to bear certain expenses because there are several agencies involved that
 CLASSIFICATIONS OF MARKETS 33

facilitate the trade among investors. These agencies levy certain charges that
investors have to bear. Collectively they represent the transaction cost.
1. Brokerage: The trading at exchanges are conducted through a member
of the exchange commonly referred to as broker. The brokers charge
certain fee from buyers and sellers in terms of percent of the trade
value. The amount of brokerage is negotiable between the client and
the broker. More commonly these are of the order of 0.05% to 0.50%.
This is payable both at the time of buying and selling.
2. Securities Transaction Tax (STT): The STT is levied by government
for the trades done of exchange. Introduced in 2004 by Government of
India, it stands at 0.10%. Therefore, for a trade value of Rs 10,000 and
brokerage of Rs 50 the STT changed is Rs 10.05.
3. SEBI Fee: SEBI collects a fee from broker which stands at very nominal
Rs 2 per 10,000.
4. Exchange Transaction Fee: Like SEBI, a stock exchange too charges a
fee for providing the platform. BSE charges Rs 2.75 per one lac of value.
5. Stamp Duty: The contract note attracts stamp duty payable to state
government and is governed by the state.
6. Service Tax: Service tax including cess is payable on the service charge
of the broker. It is of the order of 15%. It is not payable on the value of
trade but only on the brokerage.

SELF-ASSESSMENT
6. According to the NSE, the conditions for listing of shares include:
QUESTIONS
a. Stipulations regarding minimum size of paid-up capital of Rs 10
crores
b. Minimum market capitalisation of Rs 25 crores
c. Good track record of profitability and promoter holding of more
than 20%
d. All of the above
7. For stocks and other securities there are two major exchanges in
India. They are:
a. National Supply Exchange (NSE) and Bombay Supply Exchange
(BSE)
b. National Stock Exchange (NSE) and Bombay Supply Exchange
(BSE)
c. National Supply Exchange (NSE) and Bombay Stock Exchange
(BSE)
d. National Stock Exhibition (NSE) and Bombay Stock Exchange
(BSE)
8. The buy and sell orders without the specific limit on the price are
deemed to be placed at prevailing market price and are called:
a. Open orders
b. Surplus orders
c. Virtual orders
d. Online orders
34 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

9. Which the following statement/s is correct regarding brokerage?

a. The trading at exchanges are conducted through a member of
the exchange commonly referred to as broker.
b. The brokers charge certain fee from buyers and sellers in terms
of percent of the trade value.
c. The amount of brokerage is negotiable between the client and
the broker.
d. All of the above
10. The efficiency of a market is not judged by:
a. Speed of execution of order
b. Time elapsed for communication of trade and confirmation to
the ultimate investors
c. Speed of settlement of trades with delivery and payment
d. Level of labor costs

2.5 SUMMARY
‰ Buyers can specify quantity to buy and the maximum price to buy, and
sellers can enter sell orders with quantity to sell and the minimum selling
price. Such orders that mention the price for the trades are called limit
orders.
‰ In the secondary market prices are determined by the demand and
supply for the securities.
‰ Most financial assets like shares, bonds, government securities, etc. are
traded in secondary markets.
‰ Listing requirements include timely submission of financial statements,
conduct of board meeting within stipulated time, notifying exchanges of
price-sensitive information, etc.
‰ For stocks and other securities there are two major exchanges in India –
National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).
‰ Registrar to the issue collects the applications from investors, makes
allotment in consultation with the lead manager, and issues securities to
successful applicants.
‰ Buyers and sellers both must have account in the dematerialised form
called DEMAT account with a depository. DEMAT account is like a bank
account with the difference that instead of money it holds the shares of
firms in the account.
‰ Since prices of securities in the primary market are not available, first-
time issue of security is done through a process called book-building,
where investors bid their demand and price that benefits both investors
and issuers by letting the price to be based on supply and demand.
‰ Environment of primary market is regulated by SEBI.
 CLASSIFICATIONS OF MARKETS 35

‰ Markets can be categorised as primary or secondary. When securities are

issued for the first time, it is called primary market.
‰ There are many participants involved in the process of issue of securities
such as lead managers, underwriters, registrars, etc. who have different
roles to play in marketing of the issue.

1. Over-the-Counter (OTC) markets mean that buyers and sellers KEY WORDS
find one another to transfer ownership, and include trading of real
assets, insurance policies, bank deposits, etc.
2. Issuer is the firm that needs the capital for funding its projects and
makes an offer is called issuer of securities such as shares, bonds,
etc.
3. Registrar to the issue collects the applications from investors,
makes allotment in consultation with the lead manager, and issues
securities to successful applicants.
4. Private placement is when an unlisted firm mobilises capital from
select group of investors.
5. Preferential allotment refers to private placement by a listed firm
offering fresh capital to select group of individuals.
6. Book-building process is a method of allocation of shares to all
successful investors by charging the same price irrespective of the
price quoted by them is called book-building process
7. Private placement means when an unlisted firm mobilises capital
from select group of investors
8. Preferential allotment means offering fresh capital to select group
of individuals by a listed firm.
9. Electronic Limit Order Book (ELOB) enables feeding of buy
and sell orders in terms of quantity and price. Buyers can specify
quantity to buy and the maximum price to buy, and sellers can enter
sell orders with quantity to sell and the minimum selling price.
10. A bulk deal refers to transaction of more than 0.5% of a company’s
equity shares by a single buyer or a seller.
11. A block deal happens when two parties agree to buy or sell shares
at an agreed price among themselves for a single transaction of a
minimum quantity of 500,000 shares or a minimum value of Rs 5
crore, whichever is lower.

2.6 DESCRIPTIVE QUESTIONS

1. Write a short note on book-building process highlighting its advantages
to issuers and investors.
2. What is the rationale for rights issue?
3. Make a list of the functions of SEBI.
36 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

4. What is a DEMAT account? Why is it important for both buyers and

sellers?
5. Differentiate between a bulk deal and a block deal.

2.7 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS
Topics Q. No. Answers
Over-the-Counter (OTC) Markets 1. d. Over-the-Counter (OTC)
Markets
2. c. Both 1 and 2
Primary market 3. b. Securities and Exchange
Board of India
4. d. All of the above
Private Placement and Preferential 5. c. Both 1 and 2
Allotment
Secondary Markets 6. d. All of the above
7. c. National Stock Exchange
(NSE) and Bombay Stock
Exchange (BSE)
8. a. Open orders
9. d. All of the above
10. d. Level of labor costs

2.8 SUGGESTED READING

AND E-REFERENCES

SUGGESTED READINGS
‰ Srivastava, Rajiv. 2017. Investment Management. New Delhi: Wiley.
‰ Elton, J Edwin, Martin J Gruber, William N. Goetzmann and Stephen
J Brown. 2013. Modern Portfolio Theory and Investment Analysis.
New Delhi: Wiley.

E-REFERENCES
‰ Brooke, P. and Penrice, D., A Vision for Venture Capital – Realizing the
Promise of Global Venture Capital and Private Equity (New Ventures), 2009.
‰ Capital Dynamics, The Definitive Guide to Risk Management in Private
Equity (PEI Media), 2010.
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A., Private Equity:
History, Governance and Operations (John Wiley & Sons), 2008.
 C H A
3 P T E R

INDEX

CONTENTS

3.1 Introduction
Self-Assessment Questions
Activity
3.2 Constructing Index
3.2.1 Types of Indices
Self-Assessment Question
3.2.2 Market Capitalisation and Free Float
Self-Assessment Questions
3.3 Uses of Indices
Self-Assessment Question
Activity
3.4 Impact Cost
3.5 Managing Changes in Index
3.5.1 Corporate Actions
Self-assessment Question
3.6 Total Return Index
Self-Assessment Question
3.7 Summary
Key Words
3.8 Descriptive Questions
3.9 Answer Keys
Self-Assessment Questions
3.10 Suggested Readings and E-References
38 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

INTRODUCTORY CASELET

In India the most popular indices are NIFTY consisting of 50 stocks at

National Stock Exchange (NSE) and SENSEX consisting of 30 stocks
traded at Bombay Stock Exchange (BSE). The stocks that are included
in the index must necessarily represent significant proportion of the
value as measured by its market capitalisation, comprise significant pro-
portion of trading activity as may be measured by volume by value, and
be extremely liquid. Every economy has several indices that are com-
piled and constructed by respective stock exchanges.

QUESTIONS

1. How many stocks does NIFTY consist of?

2. What do stocks included in the index represent?
 INDEX 39

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Explain an index and its purposes
> Explain the methodology of construction of index
> Conceptualise liquidity and its measurement
> Incorporate changes in the index for changes in the economy and
various corporate actions

3.1 INTRODUCTION ! IMPORTANT CONCEPT

All of us have heard about terms like SENSEX and NIFTY and wonder In India, the most popular
what they mean and what purposes do they serve. There are a huge number indices are NIFTY consisting
of shares listed on the stock exchanges and changes in price of each of the of 50 stocks at National Stock
stock will indicate changes in the performance of the firm the stock rep- Exchange (NSE) and SENSEX
resents. Therefore, aggregate changes in the prices of all the stock should consisting of 30 stocks traded at
ideally represent aggregate corporate performance, that is, national econ- Bombay Stock Exchange (BSE).
omy. In India, the most popular indices are NIFTY consisting of 50 stocks
at National Stock Exchange (NSE) and SENSEX consisting of 30 stocks
traded at Bombay Stock Exchange (BSE). Measuring changes in the values
of all securities traded on an exchange is somewhat impractical, tedious,
! IMPORTANT CONCEPT
and time consuming. Therefore, an adequate sample from huge number of An adequate sample from
stocks should serve the purpose of measurement of economic activity. This huge number of stocks
sample is called an index. should serve the purpose of
measurement of economic
Indices are devised by respective stock exchanges to measure the day-to- activity. This sample is called
day activity of the movement of prices of stocks. Indices are developed to an index.
have a bird’s eye view of the state of the economy and the financial markets.
Like consumer price index or wholesale price index consists of representa-
tive sample of all products we consume and the changes in them reflect the
rate of inflation, the changes in the value of indices on the stocks measure the ! IMPORTANT CONCEPT
state of economy and the financial markets at any given point of time. Stock Stock indices are regarded
indices are regarded as barometer of state of the economy in general. Index as barometer of state of the
is an aggregate single measure that reflects the mood and sentiments of the economy in general.
stock markets and serves as proxy for the state of the economy. Change in the
value of index is more important than its absolute value.
If an index has to serve as a suitable proxy for the economic activity (which
most broad-based indices are), it must:
a. comprise stocks that roughly resemble the composition of GDP of an
economy,
b. represent significant proportion of total market capitalisation and
volume,
c. be dynamic enough to change periodically as the structure of economy
changes over time, and
d. exhibit substantial investor’s interest as may be gauged by a number of
financial products devised on it and trading volumes thereof.
 40 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Since prices of securities are supposed to be discounting the future, investors

! IMPORTANT CONCEPT often use changes in index value not only as measure of past and present state
The perception of investors of the economy but also as predictor of future economic outlook. The per-
about the present health of ception of investors about the present health of the economy and its future
the economy and its future course becomes extremely important for global investors and attracts foreign
course becomes extremely investment. Perhaps the biggest feature of the index is that its value is com-
important for global puted on real-time basis. As the value of index continuously changes with
investors and attracts foreign incessant flow of information from across the globe, the impact of any eco-
investment. nomic policy change can be gauged instantaneously without loss of time. This
is because stock prices are supposed to act in advance, that is, at the time of
flow of news rather than wait for actual outcome.
Index is a useful tool for planning at national level. The stocks included in
the index are supposed to reflect the relative performance of various sectors
of an economy, and therefore can serve as guide to most efficient allocation
of resources. Being determined by market forces, it perhaps indicates the
relative strengths of various sectors. Besides broad-based indices, there are
several other indices available depending upon the objective. These include
small cap index/mid cap index comprising small and medium sized firms, IT
or banking index concentrating of specific sectors of an economy, etc. These
size- or sector-specific indices serve similar purpose as the broad-based index.

SELF-ASSESSMENT
1. In India, the most popular indices are:
QUESTIONS
a. NIFTY b. SENSEX
c. Both a and b d. None of the above
2. How many stocks at National Stock Exchange (NSE) does NIFTY
consist of?
a. 40 b. 45
c. 50 d. 30
3. How many stocks does SENSEX consist of at Bombay Stock
Exchange (BSE)?
a. 17 b. 30
c. 40 d. 55
4. Consider the following statements:
1. The stocks included in the index are supposed to reflect the relative
performance of various sectors of an economy, and therefore can
serve as guide to most efficient allocation of resources.
2. Being determined by market forces, it perhaps indicates the
relative strengths of various sectors.
Which of the statement/s given above is correct?
a. Only 1 b. Only 2
c. Both 1 and 2 d. None of the above

ACTIVITY 1 1. Research using the internet how many countries in the world have
their own stock exchanges. Of these, list the top 10 stock exchanges.
 INDEX 41

3.2 CONSTRUCTING INDEX

Construction of an index depends upon its objective. A broad-based index
must satisfy the properties mentioned under “Introduction”. The stocks that
are included in the index must necessarily:
a. represent significant proportion of the value as measured by its market
capitalisation,
b. comprise significant proportion of trading activity as may be measured
by volume by value, and
c. be extremely liquid.
Every economy has several indices that are compiled and constructed by
respective stock exchanges. In India, the most popular indices are NIFTY
consisting of 50 stocks at National Stock Exchange (NSE) and SENSEX con-
sisting of 30 stocks traded at Bombay Stock Exchange (BSE).

3.2.1 TYPES OF INDICES

Indices are normally either price based, or market capitalisation based. In
a price-based index, only prices form the basis of initial value of index, and ! IMPORTANT CONCEPT
further changes in prices of constituent stocks alone cause the change in In a price-based index, only
the value of the index. Market capitalisation is the product of price and out- prices form the basis of
standing number of shares. In market-capitalisation-based index, the market initial value of index, and
value of stock forms the basis of its inclusion in the index and changes in further changes in prices
market capitalisation are periodically reflected in the value of the index. For of constituent stocks alone
example, consider a small index consisting of five shares: A, B, C, D, and E. cause the change in the value
The number of outstanding shares and their prices on a base date, say 1 Jan of the index.
20X0, are given in the below Table 3.1.

TABLE 3.1 CONSTRUCTION OF INDEX, BASE VALUE, AND CURRENT VALUE

Outstanding Base Price Current Price Base Value Current Value
Stock Shares (millions) (Rs) (Rs) (Rs millions) (Rs millions)
A 500 120 200 60,000 100,000
B 800 150 400 120,000 320,000
C 600 110 150 66,000 90,000
D 700 90 120 63,000 84,000
E 300 130 300 39,000 90,000
Total 600 1,170 348,000 684,000
Index value Price based Market capitalisation based
1,000 1,950.00 1,000 1,965.52

In a price-based index, the prices as on base date would be added and

indexed to say 1000. The prices of five stocks add to Rs 600 which is indexed
to 1000. On a current date, say three years later on 1 Jan 20X3, the prices of
the index stocks add to Rs 1170. The value of price-based index as on 1 Jan
20X3 would be
42 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Total of prices on base date

Value of price based index   1,000
Total of prices on current date
1,170
  1,000  1,950.00
600
For market-capitalisation-based index, the market value of stocks on base
date would be added and indexed to say 1000. On any subsequent date, the
market capitalisation of the index stocks would be compared with that on
base date and value of index computed as below:

Total of market cap on base date

Value of market cap based index   1,000
Total of market cap on current date
684,000
  1,000  1,965.52
348,000

SELF-ASSESSMENT
5. The stocks that are included in the index must necessarily:
QUESTION
a. Represent significant proportion of the value as measured by its
market capitalisation
b. Comprise significant proportion of trading activity as may be
measured by volume by value
c. Be extremely liquid
d. All of the above

3.2.2 MARKET CAPITALISATION AND FREE FLOAT

While finding the value of index based on market capitalisation, the value of
the firm being included in the index was reckoned as current market price
multiplied by total number of shares outstanding. Larger the market capital-
isation, greater is the weight of the security in the index. For some this value
of market capitalisation is not true because all shares of the firm are not avail-
able for trading under normal course. Shares held by promoters are seldom
sold by them. They hold on to the shares for the purpose of controlling the
firm. Should the shares not expected to be traded be included in the market
capitalisation? It is generally believed this must be excluded from the market
capitalisation of the firm while assigning weight in the index. Excluding the
shares not expected to be traded in the market from the market capitalisation
is called free float. Calculating index based on free float reduces influence of
large promoter/strategic holding. Free-float methodology in index calcula-
tion aids both active and passive investment strategies. Active managers are
able to compare their portfolio return vis-à-vis the investable index and at
the same time passive fund managers are able to offer low tracking error by
introducing passive funds such as index funds, exchange traded funds linked
to indices calculated based on free-float methodology.
Higher free float suggests greater number of shares held by the retail inves-
tors. Free float for each firm in the index is determined based on the public
shareholding. The shares are held by:
a. promoters and promoter group/associates directly or through ADRs/GDRs,
b. Government in the capacity of strategic investor,
 INDEX 43

c. strategic investors,
d. bodies that fall in FDI category,
e. Employee Welfare Trusts, and
f. under lock-in category, do not form the part of free float.
If market capitalisation of the firm is Rs 10,000 crores and 30% of the shares are
in the categories described above, then under free-float methodology the weight
of the firm in the index would be Rs 7,000 crores and not Rs 10,000 crores.

SELF-ASSESSMENT
6. Excluding the shares not expected to be traded in the market from
QUESTIONS
the market capitalisation is called:
a. Strategic holding b. Free float
c. Restricted holding d. Spontaneous float
7. Free float for each firm in the index is determined based on the
public shareholding. The shares are held by:
a. Government in the capacity of strategic investor
b. Strategic investors
c. Bodies that fall in FDI category
d. All of the above

3.3 USES OF INDICES ! IMPORTANT CONCEPT

Because index comprises stocks from diverse industries it is regarded as The changes in the index
suitable proxy for the market as a whole, often called the market portfolio. value measure the capital
The changes in the index value measure the capital gains or losses on the gains or losses on the market
market portfolio. portfolio.
Besides measuring capital gains, the index serves as a benchmark value for
measurement of portfolio performance. Many investors and organisations
such as mutual funds, brokerage houses managing client’s portfolio measure
the returns of their portfolios against index gains to see if they have been
able to outperform the market. Index returns serve as benchmark for com-
parative performance of various investment schemes.
While broad-based index serves as proxy to overall markets and can be used
for benchmarking performance of the broad-based portfolios, they are not
appropriate for measuring performance of portfolios that have investment
objectives different than market-wide diversification. There are investors who
! IMPORTANT CONCEPT
work on certain themes, sectors, sizes of firms, etc. to achieve their investment While broad-based index
objective. For example, some investors may believe that mid-cap firms would serves as proxy to overall
outperform the large cap and therefore may include only mid cap firms in markets and can be used for
their portfolios. Similarly, some investors may believe that pharmaceutical or benchmarking performance
banking sector firms would deliver better returns than most other industries of the broad-based portfolios,
and hence form a portfolio accordingly. Yet some risk-conscious investors may they are not appropriate
like to sacrifice some returns for safer investment in public sector companies. for measuring performance
While one may not challenge the investment objective with regard to its desir- of portfolios that have
investment objectives
ability as it is matter of individual choice, but measuring performance of such
different than market-wide
portfolios is a common concern. The performance of these portfolios though
diversification.
can be measured against the broad-based index, but it would not be providing
44 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

evaluation along the investment objectives of the portfolio. A comparative per-

formance within the investment objective is desired. To do so a narrower index
is required. With this objective in mind exchanges may develop narrower
indices to provide a benchmark for performance evaluation of portfolios with
common investment objectives. NSE has developed a range of indices for dif-
ferent investment objectives. Few of them are as follows:
1. Sectoral Indices: Aimed at specific sectors, these indices are designed
to provide a benchmark for the aggregate performance of a number of
companies representing a group/particular sector of the economy.
2. Thematic Indices: Thematic indices are constructed to provide a
benchmark for measuring performance of portfolios designed with a
specific theme.
3. Fixed Income Indices: Fixed income index is used to measure
performance of the bond market. The fixed income indices are useful
for measuring and comparing performance of bond portfolios.

PRACTICAL PERSPECTIVE
Bond Index

For measuring performance of portfolio of fixed income securities, a bond index

is identified as the benchmark. Bond index is not calculated in the same way as
an index on shares. Like there are several kinds of indices for portfolios of shares,
there are several indices in the bonds too. Primary consideration in a bond portfolio
is the term to maturity. Therefore, indices based on bonds are designed with bonds/
securities with respect to maturity.
Following is the methodology adopted by NSE in calculating an index named
NIFTY 4–8 year G-Sec Index which represents Government of India bonds having
residual maturity between 4 and 8 years:
‰ Top 3 liquid securities based on turnover during previous month are eligible to
be part of the index.
‰ The outstanding amount of the bond should be more than Rs 5,000 crores.
‰ Each bond is assigned weight based on turnover (in previous month period)
and outstanding amount (latest).
‰ Turnover of the bond contributes 40% and outstanding amount contributes 60%
in weight calculation of each bond.
‰ Weights of the bonds are determined at beginning of the month and remain
constant during the entire month.
‰ The index is computed using the total returns methodology.
‰ Accrued interest is calculated using 30/360 day count convention.
‰ Index is reviewed on monthly basis.
‰ Index has a base date value of 1000 and base date of Jan 03, 2011.
Index Review: The index is reviewed on a monthly basis. Bonds not forming part
of top 3 based on turnover shall be eligible for replacement. A new bond shall be
included if it meets the replacement criteria, that is
‰ Residual maturity should be more than 4.5 years.
‰ Should have traded for more than 10 days during the month.
 INDEX 45

‰ Average daily turnover in a month should be 2 times of the existing bond in the
index.
‰ Number of trades in the month should be 2 times of the existing bond in the
index.
‰ If no bond is available for replacement then existing bond shall continue.
‰ If the residual maturity of a bond forming part of the index falls below 4 years,
then it shall be excluded from the index.
‰ The prices are sourced from the CCIL and FIMMDA.
In case of bonds, the index must change by the amount of return each day.
Compiled from NSE website www.nseindia.com

SELF-ASSESSMENT
8. Indices that are constructed to provide a benchmark for measuring
QUESTION
performance of portfolios designed with a specific theme are called:
a. Sectoral indices
b. Thematic indices
c. Fixed income indices
d. Fractional indices

1. NSE has developed a range of indices for different investment ACTIVITY 2

objectives. Research about each of these objectives and explain with
an example.

3.4 IMPACT COST

Besides market capitalisation of the index, the other most crucial factor for
inclusion in the index is the liquidity, that is, how easy and cost effective is
to trade in the stock. We need to develop an objective or numeric measure of
liquidity along which liquidity of various companies/stocks can be compared.
One such measure is bid-ask spread. Bid price is the price at which we have
willing buyers and ask price is the price asked for by the seller. For example,
the demand−supply conditions in the market may show willing buyers at
Rs 29.50 while sellers are demanding Rs 30.30. If one needs to trade in the
market, he/she would have to buy at Rs 30.30 and sell immediately at Rs 29.50
making him/her lose Rs 0.80 per share. The bid-ask spread of Rs 0.80 is the
amount of loss the trader incurs in a round trip transaction. If there is large
demand and supply for the share, the spread would fall down. Lower the bid-
ask spread, better is the liquidity.
Further, the bid-ask spread is also a function of quantity traded. With increas-
ing quantity of trading, the bid-ask spread would go up. Impact cost is a
practical and realistic measure of market liquidity; it is closer to the true cost
of execution faced by a trader in comparison to the bid-ask spread. Impact
cost represents the cost of executing a transaction in a given stock, for a spe-
cific predefined order size, at any given point of time.
46 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

3.5 MANAGING CHANGES IN INDEX

One of the properties of an index is that it must be dynamic enough to reflect
the changes that take place in the economy and corporate sector. For an index
to reflect the true character of an economy, its composition must undergo
changes. New firms gain prominence while stocks of some firms included in
the index may lose their importance, necessitating reconstruction of index,
that is, replacing less important stocks with more important ones.
For example, consider that Stock F, not part of the index, has achieved a
market capitalisation of Rs 88 billion exceeding the market capitalisation
of Stock D included in the index, valued at Rs 84 billion (refer Table 3.1).
Therefore, index may be reconstituted to replace Stock D with Stock F.
Assume that it is decided to affect the change on 2 Jan 20X3 (ex-date). The
market capitalisation of index stocks on 1 Jan 20X3 (cum-date) stood at Rs
684 billion corresponding to index value of 1965.52. On the ex-date, when F
replaces D the market capitalisation of newly constituted index would sud-
denly increase by Rs 4 billion to Rs 688 billion corresponding to index value
of 1977.01. This overnight change from cum-date to ex-date would be mis-
leading because no such capital gain from 1965.52 to 1977.01 has actually
taken place. The change has resulted not due to market conditions, but due
to change in composition of index.
Indeed the market capitalisation of the stocks included in the index has
changed, warranting a change in the index value. However, we need to keep
the value of the index unchanged so as to prevent the miscommunication
of gains/losses on the portfolio. To keep the index value unchanged and yet
incorporate the changed composition the alternative is to change the base
value, that is Rs 384 billion, which corresponded to index value of 1000 when
the index was devised. The base value would stand revised from Rs 348 bil-
lion to Rs 350.04 billion as follows:

Market capitalisation on ex-date

Revised base value   1,000
Index value on cum-date
688
  1,000  Rs 350.04 billion
1,965.52

The revised value of the base now would be used to compute the index value
on all dates subsequent to the ex-date of 2 Jan 20X3 till another change in the
base value is warranted.

3.5.1 CORPORATE ACTIONS

Market capitalisation or price of the stock changes continuously due to
market forces. However, sometimes the change in the market capitalisation
occurs because of several corporate actions such as rights issue, bonus/stock
split, share buyback, conversion of debt into equity, mergers and acquisition,
etc. that either change the outstanding number of shares or price or both.
These changes in market capitalisation are not caused by market-driven
prices but instead result due to corporate actions. These changes are treated
in the same way as reconstituting of index, that is, to keep the index value
unchanged from cum-date to ex-date, modify the base value. Some of the
corporate actions are discussed in Example 3.1 below.
 INDEX 47

Index Value and Corporate Actions EXAMPLE 1

Assume an index of five stocks A, B, C, D, and E has a value of 1965.52 on
1 Jan 20X3, details of which are shown in Table 3.1. Analyse the impact
on the index of the following corporate actions, separately taking affect
on 2 Jan 20X3:
a. Firm B becomes ex-dividend after dividend of Rs 10 with its price
falling from Rs 400 to Rs 390.
b. Firm A becomes ex-rights after 1:5 rights issue made at Rs 150 per
share.
c. Firm B becomes ex-bonus after 1:1 bonus issue.
d. Firm C splits shares in the ratio of 1:5 with ex-date of 2 Jan 20X3.
e. Convertible debt of Rs 800 million for Firm C is converted into 8
million equity shares.
f. Firm B acquires a firm for cash of Rs 16 billion and issue of 50
million new shares.
g. Firm A acquires Firm D by issue of 7 shares of A for every 10 of Firm
D. To maintain 5 stocks in the index another stock F with market
price of Rs 140 and 500 million outstanding shares is added.
Solution:
a. Declaration of dividend would decrease the price by equivalent
amount. The index value would change but no adjustment to the
base value would be made on the principle that value of stock rose by
the amount of dividend gradually and was incorporated in the price
of the stock. Changes in the index value therefore only reflect capital
gains and not the dividend yield. For comparing total returns on the
portfolio, we need to have another index called Total Return Index.
b. Upon full subscription of rights issue, the number of outstanding
shares of Firm A would rise by 100 million and market capitalisation
and hence the index would increase by 100 × 150 = Rs 15000 million.
Therefore, the revised base would be Rs 355.63 billion as follows:
Market capitalisation on ex-date
Revised base value   1,000
Index value on cum-date
684  15
  1,000  Rs 355.63 billion
1,965.52
c. Firm B issuing a bonus share in the ratio of 1:1 would increase the
number of outstanding shares to double and reduce the price to
half, keeping the market capitalisation of the stock same. Hence
no change in the base value of index is required.
d. Firm C splitting the shares to 5 would increase the outstanding
stock fivefold with price falling to 1/5th again keeping the market
capitalisation unchanged. Therefore no change in the base value
would be made.
e. Firm C had a convertible debt of Rs 800 million which was
converted to 8 million shares. With 8 million new shares added,
48 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

the market capitalisation increased by Rs 1200 million (8 million ×

Rs 150). The base value would be modified to Rs 348.46 billion as
Market capitalisation on ex-date
Revised base value   1,000
Index value on cum-date
684  1.2
  1,000  Rs 348.61 billion
1,965.52
f. Firm B acquired a firm cash of Rs 16 billion and issue of 50 million
new shares. The consideration paid in cash would have no impact
on the index. Due to issue of new shares, the market capitalisation
of Firm B would increase by Rs 20 billion (50 million × Rs 400). The
base value of index would be revised to
Market capitalisation on ex-date
Revised base value   1,000
Index value on cum-date
684  20
  1,000  Rs 358.17 billion
1,965.52

g. Firm A acquiring Firm D by issue of 7 shares of A for every 10 of

Firm D results in increase of 490 million (7 × 700 million/10) shares
of Firm A increasing its market capitalisation by Rs 98 billion (490
million × Rs 200), and extinguishment of 700 million shares resulting
in decrease of market capitalisation by Rs 84 billion. Another stock
F with market price of Rs 140 and 500 million outstanding shares
adds Rs 7.5 billion (500 million × Rs 130) to the market capitalisation.
The new market capitalisation is increased by Rs 21.5 billion
(98 - 84 + 7.5). The revised base would be
Market capitalisation on ex-date
Revised base value   1,000
Index value on cum-date
684  21.5
  1,000  Rs 358.94 billion
1,965.52

SELF-ASSESSMENT
9. Consider the following statements:
QUESTION
1. Market capitalisation or price of the stock changes continuously
due to market forces.
2. The changes in market capitalisation are caused by market-
driven prices but instead result due to corporate actions.
Which of the statement/s given above is/are not correct?
a. Only 1 b. Only 2
c. Both 1 and 2 d. Both are correct

3.6 TOTAL RETURN INDEX

Indices based on market capitalisation are calculated on the basis of cur-
rent market prices of the constituent securities. The prices are continuously
adjusted for all the events. One such event is the dividend of the firm. The
 INDEX 49

price on the ex-dividend falls by the amount of dividend declared. Since price
indices are calculated on real-time basis with the prices prevailing at the
time the amount of dividend is not accounted for in the calculation of index.
The price index hence reflects the returns that one would earn if investment
is made in the index portfolio. It represents only the capital gain and does not
consider the returns arising from dividend receipts. Therefore, to get a true
picture of returns, the dividends received from the constituent stocks also
need to be factored in the index values. Such an index, which includes the
dividends received, is called the Total Returns Index.
Total Returns Index reflects the returns on the index arising from (a) stock
price movements, and (b) dividend receipts. ! IMPORTANT CONCEPT
To find the total return, we need the following: Total Returns Index reflects
the returns on the index
1. Price index returns. arising from (a) stock price
2. Dividend pay-out in rupees. movements, and (b) dividend
receipts.
3. Index base capitalisation on ex-dividend date.
4. Dividend pay-outs as they occur are indexed on ex-date.
Indexed dividend is found in percent terms by the following equation:
Total Dividend
Indexed Dividend, % =
Base market capitalisation of index
Indexed dividends are then presumed

Total Return Index

  Price Index today  Indexed Dividend 
 Index value the previous day 1    1 
  Previous days Price Index 

An investor in index stocks should benchmark his/her investments against

the total returns index instead of the price index to determine the actual
returns vis-à-vis that of index.

SELF-ASSESSMENT
10. Which of the following is required to find the total return?
QUESTION
a. Price index returns
b. Dividend pay-out in rupees
c. Index base capitalisation on ex-dividend date
d. All of the above

3.7 SUMMARY
‰ An index is a sample drawn from large number of securities traded in the
market.
‰ Index provides a bird’s eye view of state of capital markets and economic
development. The change in value of index is more important than the
absolute value of the index.
‰ Since markets act in anticipation, a change in index is reflective of policy
changes envisaged by the government.
50 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

‰ The index can be price based or market capitalisation based. Most indi-
ces are calculated on the basis of market capitalisation of the constitu-
ent shares in the index. Larger the market capitalisation, greater is the
weightage of the firm in the index.
‰ Few indices in the world are based on price only and not market
capitalisation.
‰ Market capitalisation is calculated on the basis of free float eliminating
the shares that are not expected to be part of trading. In India, indices are
computed based on free float.
‰ The most prominent and popular use of an index is that it serves as a
benchmark for evaluation of performance of a portfolio.
‰ Since portfolios are designed with different investment objectives, there
are many varieties of indices available such as sectoral, thematic, fixed
income, etc. to serve as suitable benchmark.
‰ Besides market capitalisation, the other consideration for a stock to be
included in the index is liquidity.
‰ Liquidity is measured by impact cost. Impact cost is the difference in
price caused due to size of the order. Lower the impact cost, higher is the
liquidity of the stock.
‰ Since environment is dynamic, the market capitalisation keeps chang-
ing. Therefore, index needs to be reconstructed if market capitalisation
of stock in the index decreases sufficiently and that of a stock not in the
index increases substantially.
‰ Index is balanced periodically with the changes so as to reflect latest
position and changing complexion of economy.
‰ Index also needs to be adjusted for various corporate actions such as
rights, conversion of debt into equity, fresh issue of shares, mergers, etc.
It is done by changing the base capitalisation so as to keep the value of
index same pre- and post-adjustment of corporate actions.
‰ Changes in the index capture only capital gains and ignore dividend
yield. To reflect true return, one must include dividend yield. The indices
that incorporate dividend yield are called total return indices.

KEY WORDS 1. NIFTY consists of 50 stocks at National Stock Exchange (NSE)

2. SENSEX consists of 30 stocks traded at Bombay Stock Exchange
(BSE).
3. Market capitalisation is the product of price and outstanding
number of shares.
4. Free float is excluding the shares not expected to be traded in the
market from the market capitalisation.
5. Sectoral Indices are aimed at specific sectors, these indices are
designed to provide a benchmark for the aggregate performance of
a number of companies representing a group/particular sector of the
economy.
 INDEX 51

6. Thematic Indices are constructed to provide a benchmark for

measuring performance of portfolios designed with a specific theme.
7. Fixed Income index is used to measure performance of the bond
market.
8. Total Returns Index includes the dividends received.

3.8 DESCRIPTIVE QUESTIONS

1. What is an index in capital market and what useful purposes its serves
for a nation besides providing a bird’s eye view of capital markets?
2. Explain briefly the steps involved in construction of an index
incorporating the desired properties of it.
3. Differentiate between:
a. Price-based index and market-capitalisation-based index
b. Market capitalisation and free float
c. Broad-based and sectoral indices
4. What do you understand by impact cost? Illustrate with an example
how to calculate it.
5. Why does the base capitalisation of the index undergo a change while
managing the index for various corporate actions?

3.9 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS
Topics Q. No. Answers
Introduction 1. c. Both a and b
2. c. 50
3. b. 30
4. c. Both 1 and 2
Constructing Index 5. d. All of the above
Market Capitalisation and Free Float 6. b. Free float
7. d. All of the above
Uses of Indices 8. b. Thematic indices
Corporate Actions 9. b. Only 2
Total Return Index 10. d. All of the above
52 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

3.10 SUGGESTED READINGS

AND E-REFERENCES

SUGGESTED READINGS
‰ Srivastava, Rajiv. 2017. Investment Management. New Delhi: Wiley.
‰ Elton, J Edwin, Martin J Gruber, William N. Goetzmann and Stephen
J Brown. 2013. Modern Portfolio Theory and Investment Analysis.
New Delhi: Wiley.

E-REFERENCES
‰ Brooke, P. and Penrice, D., A Vision for Venture Capital – Realizing the
Promise of Global Venture Capital and Private Equity (New Ventures), 2009.
‰ Capital Dynamics, The Definitive Guide to Risk Management in Private
Equity (PEI Media), 2010.
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A., Private Equity:
History, Governance and Operations (John Wiley & Sons), 2008.
 CASE STUDIES
1 TO 3

CONTENTS

Case Study 1 Investment – Instruments and Markets

Case Study 2 Classification of Markets
Case Study 3 Index
54 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

CASE STUDY CHAPTER – 1

INVESTMENT – INSTRUMENTS AND MARKETS

The Fixed Income Money Market and Derivatives Association of India

(FIMMDA) is an association of Scheduled Commercial Banks, Public
Financial Institutions, Primary Dealers, and Insurance Companies.
Incorporated as a company in June 1998, FIMMDA is a voluntary market
body for the bond, money, and derivatives markets. All major financial
institutions are its members. FIMMDA represents market participants
and aids the development of the bond, money, and derivatives markets.
It acts as an interface with the regulators on various issues that impact
the functioning of these markets. It also undertakes developmental
activities, such as introduction of benchmark rates and new derivatives
instruments, etc. FIMMDA releases rates of various government securities
that are used by market participants for valuation purposes. FIMMDA
also plays a constructive role in the evolution of best market practices
by its members so that the market as a whole operates transparently as
well as efficiently.

QUESTIONS

1. What does FIMMDA stand for?

2. When was FIMMDA incorporated as a company? Also describe
its purpose.
3. Mention at least three responsibilities of FIMMDA.
4. What role does FIMMDA play in the evolution of best market
practices?
 CASE STUDY 55

CASE STUDY CHAPTER – 2

CLASSIFICATIONS OF MARKETS

Besides regular deals done on the screen-based trading platform of

the exchanges, there are facilities to transact high volume/high value
trading business separately on the exchange, without feeding orders in
the system. In an automated trading there is no control over choosing the
counterparty to the trade. Buyers cannot choose sellers and vice-versa.
While feeding orders on the window of exchange, it becomes open for
all. If orders of large quantities/value of trade are fed, it may lead to
distortion in the price for common and retail investors. At times, there
are negotiated deals that are finalised between two parties. These are
classified as block deals and bulk deals, which happen regularly on stock
exchanges. They are more in the nature of over-the-counter but such
deals are notified to the exchange with identities of parties, price, and
quantity transacted revealed. A bulk deal refers to transaction of more
than 0.5% of a company’s equity shares by a single buyer or a seller.
However, the counterparties can be many. A bulk deal can be done any
time within the trading hours. Therefore price of bulk deals are market-
driven. The broker, who facilitates the trade, has to provide details of the
trade to the stock exchanges whenever it happens.
A block deal happens when two parties agree to buy or sell shares at an
agreed price among themselves for a single transaction of a minimum
quantity of 500,000 shares or a minimum value of Rs 5 crore, whichever
is lower. Block deal is done on a separate window provided by stock
exchanges. This window is open for only 35 minutes prior to the time of
opening of the markets for public. SEBI rules prescribe that the price
for block deal has to be within ±1% of the previous day’s closing or the
current market price. Retail investors cannot participate in such trans-
actions. Only institutional investors such as mutual funds, financial
institutions, insurance companies, banks and foreign institutional
investors, venture capitalist, private equity suppliers, etc. participate in
block deals. Promoters also use this window to deal with issues related
to cross-holding. Retail investors often take the clue about pricing from
bulk deals and block deals.

QUESTIONS

1. What are the characteristics of automated trading?

2. What do you understand by block deal?
3. How is a bulk deal different from block deal?
4. Can you explain SEBI’s rule for block deals?
56 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

CASE STUDY CHAPTER – 3

INDEX

NSE uses impact cost as a measure of liquidity. Impact cost is the

difference in price due to change of order size. It does not include and
must not be confused with transaction cost that includes brokerage,
depository charges, taxes, etc. While small quantity of the buy/sell
orders can be executed at current price, the large quantities of the
orders (in value terms) tend to influence the bid and ask prices.
The change in the price for execution of buy/sell orders from the
ideal price is called impact cost. Greater the impact cost, lower is
the liquidity. If a stock is more liquid, the size of the order becomes
less and less relevant. Generally, large sell orders would be executed
at lower than the prevailing price while large buy orders would be
executed at higher than the prevailing price.
NSE uses Electronic Limit Order Book (ELOB) as source of providing
a measure of liquidity and measurement of impact cost. ELOB does
away with market makers and allows bids and ask on the electronic
platform.
Liquidity may be gauged by the outstanding pending orders of either
side of order book, representing intentions to buy or sell a particular
quantity at the indicated price. Upon matching of price, the transaction
can be presumed to take place for lower of the quantity on either side
of the order book. Impact cost is determined by computing the ideal
price taken as average of the best bid and best ask. This is based on
the assumption that best bid and best ask would converge to execute
a small order. Impact cost is a function of order size, that is, as order
becomes larger and larger, the deviation from the ideal price becomes
greater. Thereafter actual price paid/realised for a predetermined
order size for buying and selling can be computed. The difference
between the actual price and the ideal price would be the impact cost
for a predetermined order size.

QUESTIONS

1. For what purpose NSE uses Electronic Limit Order Book (ELOB)?
2. What do you understand by impact cost?
3. How can you define the impact cost for a predetermined order size?
4. Explain how impact cost is related to liquidity.
5. How is the impact cost determined?
 C H A
4 P T E R

RETURN

CONTENTS

4.1 Introduction
Self-Assessment Questions
4.2 Return
Self-Assessment Questions
Activity
4.3 Historical and Expected Return
4.3.1 Arithmetic Mean (Average)
4.3.2 Geometric Mean
4.3.3 Arithmetic Mean Versus Geometric Mean
4.3.4 Internal Rate of Return (IRR)
Self-Assessment Question
4.4 Expected Return
4.5 Summary
Key Words
4.6 Descriptive Questions
4.7 Answer Keys
Self-Assessment Questions
4.8 Suggested Readings and E-References
 58 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Understand the concept of return
> Differentiate between historical and expected return
> Measure return and risk
> Differentiate between arithmetic and geometric averages and IRR

4.1 INTRODUCTION
Individuals and firms have diverse motives while making investment deci-
sions. These motives include desire for control, expansion or growth, beating
competition, gaining greater market share, increased customer satisfaction,
improved customer service, etc. Similarly, we have several motives while
making investment in our personal capacity. These motives range from plan-
ning for retirement, speculation, to simply becoming richer. In a nutshell,
everybody is looking for some returns, tangible or intangible, for the invest-
ment made. For example, a stamp collector makes an investment in stamps
with the possible motive of becoming a well-known person. Irrespective of
the motives, the common thread that binds all the different motives is the
expectation of a return, sometimes easily quantifiable and sometimes not.
For individuals and firms alike, though desire for return is a dominant factor
in determining the desirability, it cannot be the sole motive for investment.
Because these returns are subject to change from one period to another, most
businesses want to diversify their businesses not only to grow but to follow
a common adage of not to put all eggs in one basket. Similarly, seldom do we
! IMPORTANT CONCEPT find investors putting all their eggs in one basket. If returns were the sole
This variability of expected criteria, we would find individuals and firms making investment in assets
return is called risk. Therefore, that yield maximum return. In practice this is rarely the case and we find
returns and risks are businesses expand beyond a single product and line. Similarly, individuals
interdependent with the invest in several assets. Why such practices are adopted by individuals is not
unfailing rule that higher risk far to seek. As common sense would reveal, multiple businesses or multi-
demands higher returns. ple investments protect returns of one from another. This is because returns
from all assets do not react in the same manner for a given impetus. While
returns determine the desirability of investment, they fructify only in future
! IMPORTANT CONCEPT and therefore are uncertain. We always deal with expected return assuming
certain conditions would prevail. Whether these conditions would actually
Risk-neutral investors are those fructify would determine the variability of expected return. This variability
whose investment decision of expected return is called risk. Therefore, returns and risks are interdepen-
is purely guided by expected dent with the unfailing rule that higher risk demands higher returns. The
return. Risk-averse investors concept of return and risk needs to be understood simultaneously. Not all
are those who detest risk and investors have same trade-off for risk and return. Risk-neutral investors are
want greater compensation of those whose investment decision is purely guided by expected return. Risk-
increased return for nominal averse investors are those who detest risk and want greater compensation
rise in risk. Investors who of increased return for nominal rise in risk. Investors who undertake great
undertake great risk for rather risk for rather small increase in return are called risk seekers. The measure-
small increase in return are
ment of return and risk is a complex issue because whether a return is good
called risk seekers.
or not good is the subjective opinion of the investors. Similarly, risk would
 RETURN 59

be viewed as acceptable or unacceptable would depend upon whether the

investor is risk seeker, risk neutral, or risk averse. Therefore, measuring risk
and return from individual’s investor point of view would not hold univer-
sally. Fortunately, we have abundant data available for measuring return and
risk. The past data available is considered an authentic source as millions
of investors exchange trades at prices that are rather independently deter-
mined among them. These prices, and hence returns, reflect the collective
wisdom of millions of investors.

SELF-ASSESSMENT
1. Which of the statements given below is correct?
QUESTIONS
a. Risk-neutral investors are those whose investment decision is
purely guided by expected return.
b. Risk-averse investors are those who detest risk and want greater
compensation of increased return for nominal rise in risk.
c. Investors who undertake great risk for rather small increase in
return are called risk seekers.
d. All of the above
2. Investors who undertake great risk for rather small increase in
return are called:
a. Risk investors b. Risk seekers
c. Risk-averse investors d. Risk-neutral investors
3. Investors whose investment decision is purely guided by expected
return are called:
a. Risk investors b. Risk seekers
c. Risk-averse investors d. Risk-neutral investors
4. Investors who detest risk and want greater compensation of increased
return for nominal rise in risk are known as:
a. Risk investors
b. Risk seekers
c. Risk-averse investors
d. Risk-neutral investors

4.2 RETURN
Measurement of return is normally based on past prices, though future
estimates of returns based on judgment too can be used. The difference of
prices over a period provides return. These prices are obtained from stock
market, which is considered authentic source for measuring returns because
(a) stock prices represent collective wisdom of millions of investors which no
individual’s merit can substitute, and (b) the prices are unbiased as individ-
ual’s estimates are affected by his opinion.
Having appreciated the importance and suitability of data of financial assets
provided by the capital markets, we now turn our attention on how to use the
data for measurement of returns. Consider an initial investment in the stock
of Infosys currently selling at a price of Rs 1000. An investor buys 100 shares
making an initial investment of Rs 1,00,000. Assume that this investment
 60 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

is made for a period of one year. How do we calculate the returns of the
investor? The investor would earn return in two forms:
1. The reward the investor gets by owning the share over the holding
period taken as one year here, that Infosys would give as his share of
profit referred as dividend yield, and
2. The profit or loss made after the holding period by disowning the asset,
! IMPORTANT CONCEPT depending upon the price at the end of holding period, referred to as
The profit or loss made capital gains.
after the holding period Assume that Infosys declares a dividend of Rs 20 during the year and after
by disowning the asset,
one year the price became Rs 1200 per share. We assume that dividend pay-
depending upon the price
ment takes place exactly after a year. We make this assumption to eliminate
at the end of holding period,
the impact of time value of money. The funds received by the investor after
referred to as capital gains.
one year are:
Dividend received + Amount realised by divestment = 100 × 20 + 100 × 1200
= 2,000 + 1,20,000 = Rs 1,22,000
The absolute return of the investor would be
Amount realised - Amount invested = 1,22,000 - 1,00,000 = Rs 22,000
We normally measure return in term of percent per annum rather than in
absolute terms so that different investment can be compared straightaway.
The absolute return of Rs 22,000 over one year over an investment of Rs
1,00,000 translates to 22% that can be broken in two components as below:
1. Dividend yield: The return obtained by holding the asset, and
2. Capital gains: The return obtained by disowning the asset.
Investor received Rs 2,000 as dividend over investment of Rs 1,00,000 which
amounts to 2%. This is referred as dividend yield calculated as below:
Dividend Received 2,000
Dividend Yield, %   100   100  2%
Inital Investment 1,00,000

The return of 20% is referred as capital gains, that is, the return obtained
by disowning the asset. Note that it is not essential for investor to sell the
asset after one year. Even though the investor does not sell the share, the
conclusion about measurement of return would still hold for the purpose of
measurement of return. If indeed the investor sells the shares, the return
would be called as realised, and if investor continues to hold, the return
would be classified as unrealised. In both the cases, the measurement of
return as differential of price at the beginning and end of the investment
horizon remains valid.

Value Realised  Amount Invested

% Return   100
Amount Invested
1,20,000  1,00,000
  100  20%
1,00,000

With capital gains and dividend of Rs 2,000 (100 × 20) the aggregate return
is 22%.
 RETURN 61

Total Return = (Dividend Earned + Capital Gain)/Investment amount

= (2,000 + 20,000)/1,00,000 = 0.22 ≡ 22%
In mathematical terms assuming P0 as the initial price, D1 is the dividend
received in the Period 1, and P1 as the price at the end of Period 1, we have

Dividend  Capital Gain

Total Percentage Return 
Initial Investment
D1  ( P1  P0 )

P0
D1 P1  P0
 
P0 P0

In the above analysis we have (a) ignored the time value of money, as nor-
mally the periodic return is mostly calculated for a period of one year and
as ratio of price in the previous period; (b) made no adjustment for inflation
and the returns calculated are in nominal terms, because considering infla-
tion would only change the absolute values but judgment of relative values
remains unaffected, and (c) not provided for taxes that may be payable on
dividend and capital gains.

SELF-ASSESSMENT
5. The reward the investor gets by owning the share over the holding QUESTIONS
period taken as one year is referred as:
a. Dividend yield b. Risk yield
c. Investor yield d. None of these
6. The profit or loss made after the holding period by disowning the
asset, depending upon the price at the end of holding period, is
referred as:
a. Risk gain b. Capital gain
c. Investor gain d. Profit margin

1. Assume you bought a share at Rs 500 and after four years you ACTIVITY 1
sold the stock at Rs 550. With no dividend paid by the stock your
returns were 50% over a period of four years. Calculate your return
percentage. Also give reasons why you think your decision to invest
in the stock was correct.

4.3 HISTORICAL AND EXPECTED RETURN

There are several ways one can estimate the expected price or return. One
of the ways is to directly address the question to the investor about what
price they expect in future. However, this would be too subjective and biased
with individual’s opinion. The personality characteristics of individual inves-
tors would play a dominant role in such a projection. Another approach is to
develop and adopt a valuation model and forecast the price using the model.
Capital asset pricing model and arbitrage pricing model attempt to forecast
62 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

returns. However, a very simple approach is to find expected return based on

historical returns.

4.3.1 ARITHMETIC MEAN (AVERAGE)

Historical returns are measured from past prices. Let us assume the price
and dividend data of a share for the last six years denoted as 0 to 5 in reverse
order as given in Table 4.1.

TABLE 4.1 HISTORICAL PRICE AND DIVIDEND DATA FOR A STOCK

Stock Dividend during
Price, Rs the Year, Rs Capital Gains Dividend Yield Rate of
Year Pt Dt (Pt − Pt−1)/Pt−1 Dt/Pt−1 Return
0 120 – – –
1 130 10 8.33% 8.33% 16.67%
2 135 11 3.85% 8.46% 12.31%
3 90 11 -33.33% 8.15% -25.19%
4 110 12 22.22% 13.33% 35.56%
5 120 12 9.09% 10.91% 20.00%

From the historical data of the returns on the stock, we can estimate the
average rate of return the stock has offered over a period of time. Rate of
return is total of capital gains and dividend yield as shown in last column
of Table 4.1.
The average rate of return is the simple arithmetic mean of the return. If n
is the number of years and Rn is the rate of return in the nth year, the simple
–
arithmetic average R mathematically is represented by
1 1 n
Arithmetic Average Return R  ( R1  R2  R3    Rn )   Rn
n n 1
For the data in Table 4.1 the arithmetic mean of returns works out to 11.87%:
1
Arithmetic Average Return, R  (16.67  12.31  25.19  35.56  20.00)
5
 11.87%

4.3.2 GEOMETRIC MEAN

Another statistic that is very popular measure of return is the geometric
mean. Let us consider an example to demonstrate how the geometric mean
is different from the arithmetic mean.
For holding period return we consider geometric mean. More generally,
holding period return over n-period investment is given by geometric mean.
If each period returns are R1, R2, …, Rn for periods till n, respectively, the geo-
metric mean can be written as Eq. (4.1).

(1  Rg ) n  (1  R1 )(1  R2 )(1  R3 )(1  R4 )(1  Rn )

(4.1)
 Rg  n (1  R1 )(1  R2 )(1  R3 )(1  R4 )(1  Rn )  1
 RETURN 63

The geometric mean takes compounding into account. If we take Rg to be

the annual rate of return in a holding period of two years in this case (more
generally that is different than a year), and first year and second year returns
are 100% and –50%, respectively, we can write as below:

(1  Rg )2  (1  1)  (1  0.5)  2  0.5  1
 Rg  1  1  0

The relationship between the geometric mean and arithmetic mean is

approximated by Eq. (4.2) where Rg is geometric mean and Ra is the arith-
metic mean, and s is the standard deviation (discussed next) of the returns.
1
Rg  Ra   2 (4.2)
2
Geometric mean is always less than arithmetic mean. Relationship of geo-
metric mean and arithmetic mean as given by Eq. (4.2) is exact when returns
follow normal distribution.

4.3.3 ARITHMETIC MEAN VERSUS GEOMETRIC MEAN

Preceding discussion on arithmetic and geometric means raises a doubt as
! IMPORTANT CONCEPT
to which of them is the correct measure of return. The answer depends upon Preceding discussion on
the purpose. If the objective is to know holding period, the geometric mean is arithmetic and geometric
means raises a doubt as to
the appropriate measure. However, if we plan investment in future, the judg-
which of them is the correct
ment must be based on arithmetic average because that correctly depicts the
measure of return.
potential of investment.

4.3.4 INTERNAL RATE OF RETURN (IRR)

Another related issue while measuring returns arises if the investor changes
the value of investment from period to period. Consider the following simple
scenario:

Period Action
0 Invest Rs 100 by purchase of one share selling at Rs 100
1 Invest Rs 110 to buy second share when trading at Rs 110
Receive Rs 5 as dividend from owning one share
2 Receive Rs 12 as dividend for two shares owned,
Sell 2 shares and receive Rs 240 @ Rs 120 per share.

How do we measure the return for the investor in such a case where there
is a change in the value of the investment in each period? Arithmetic
mean would assume constant investment and geometric mean assumes
no interim investment over the holding period. The best way to find out
the return earned is to set up the cash flows for each period and use the
discounted cash flow approach. The return r can be found from the below
equation:

110  5 240  12
100   0
1 r (1  r)2
64 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

By a procedure of hit-and-trial and after a few iterations one can find r

that satisfies the above equation. The solution to the above equation can
be easily found using an EXCEL worksheet and the IRR function as shown
in EXCEL APPLICATION. IRR and average return are also computed in
Table 4.2.

TABLE 4.2 FINDING RETURN USING EXCEL AND IRR FUNCTION

Cash Inflow Cash Outflow Net Cash
Period (Rs.) (Rs.) Flow (Rs.)
0 0.00 100.00 -100.00
1 5.00 110.00 -105.00
2 252.00 252.00
Rate of return 14.70% =irr(d5:d7,0.1)
Computation of Average Return on Investment
Dividend Capital Dividend Total
Period Price (Rs.) (Rs./Share) Gain (%) Yield (%) Return (%)
0 100
1 110 5 10.00% 5.00% 15.00%
2 120 6 9.09% 5.45% 14.55%
Average return 14.77%

EXCEL APPLICATION Finding Internal Rate of Return (IRR)

EXCEL provides the fastest and easiest way to find internal rate of return
(IRR) of a cash flow. To find IRR, feed cash flow in successive rows (or
columns). Ensure that there is at least one change of sign of cash flow.
Then in the last row follow Insert >> Formulas >> Financial >> IRR.
The dialog box as in the screen exhibited below would appear.
Values = Feed range of cells containing the cash flow
Guess = Feed an arbitrary value of your estimate of return in percent.
IRR would be displayed in the result in decimal form.
 RETURN 65

The IRR, which measures the performance of the investment, is 14.70%. In

contrast, the average rate of return offered by the share is 14.77% computed
on the basis of data available in each period.

SELF-ASSESSMENT
7. What does IRR stand for?
QUESTION
a. Internal Rate of Return b. Interest Rate of Return
c. Internal Rule of Return d. Internal Rate of Refund

4.4 EXPECTED RETURN

Basing investment decision on arithmetic mean implies that past performance
would be repeated in future and therefore expected return would be identi-
cal to historical average. There was another implicit assumption that all the
past observations were equally likely as average was computed by dividing
the sum with the number of observations. In practice, all outcomes are not
always equally likely. Some outcomes are more probable than others. This
lends uncertainty to returns and therefore we deal with expected returns. To
know expected returns, we need frequency distribution of return that exhibits
how often each outcome (return) occurs. In arithmetic average, all outcomes
were assumed evenly distributed with probability of 1/number of observations.
A graphical plot of the values on the horizontal axis and the frequency of
occurrence on the vertical axis is referred to as frequency distribution. ! IMPORTANT CONCEPT
Consider the data of returns for 200 observations on the returns of a security A graphical plot of the values
as given in Table 4.3: on the horizontal axis and the
frequency of occurrence on
TABLE 4.3 RETURNS ON SECURITY the vertical axis is referred to
Frequency of occurrence 22 46 64 40 16 12 as frequency distribution.
Return in % 10 15 20 25 30 35
Probability of occurrence 0.11 0.23 0.32 0.20 0.08 0.06
Probability × Return 1.10 3.45 6.40 5.00 2.40 2.10
Expected return, % 20.45

A total of 200 observations are made of which maximum observations of 64

relate to a return of 20%. This corresponds to a relative frequency of 32%.
Likewise probability of the occurrence of each value is given in row 3 of
Table 4.3. Frequency distribution is plotted in Figure 4.1.
70 64
Expected value = 20.45%
60

50 46
Frequency

40
40

30
22
20 16
12
10

0
10 15 20 25 30 35
Return, %

Figure 4.1 Frequency Distribution.

66 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

The average of returns where they are not equally likely, the expected value
is the product of probability and the value of the variable. The expected value
E can be calculated as sum of product of probabilities and values as given in
Eq. (4.3):
n
E( R)   pi Ri (4.3)
i 1

where pi = probability of occurrence of i+ outcome; Ri = return for the ith out-

come; n = number of possible outcomes.
Using Eq. (4.3) and data from Table 4.1 we find the expected value of return
as 20.45%.
n
E( R)   pi Ri  0.11  10  0.23  15  0.32  20  0.20  25  0.08  30  0.06
6  35
i 1

 20.45%

4.5 SUMMARY
‰ The two key determinants of any investment decision are return and
risk associated, and they cannot be studied in isolation as both are very
closely interlinked and affect each other.
‰ Data of trading in financial securities is ideal to make assessment of
return and risk because they reflect collective wisdom and expectations
of investors and are unbiased indicators.
‰ Return of financial assets comprises dividend yield and capital gains.
‰ Dividend yield is the reward of ownership that accrues due to holding of
the asset and capital gains arise when investors disown the asset.
‰ Arithmetic mean and geometric mean are the two common measures of
expected return. While arithmetic mean is useful for making investment
decision, the geometric mean provides holding period return.
‰ Internal rate of return (IRR) too is also a measure of realised return over
holding period that is based on cash flows.
‰ Arithmetic mean makes an implicit assumption that during the interim
periods the investment remains constant period after period.

KEY WORDS 1. Risk-neutral investors are those whose investment decision is

purely guided by expected return.
2. Risk-averse investors are those who detest risk and want greater
compensation of increased return for nominal rise in risk.
3. Risk seekers are investors who undertake great risk for rather small
increase in return.
4. Capital gains is the profit or loss made after the holding period by
disowning the asset, depending upon the price at the end of holding
period.
5. Dividend yield is the return obtained by holding the asset.
 RETURN 67

6. Frequency distribution is the graphical plot of the values on the

horizontal axis and the frequency of occurrence on the vertical axis.
7. Variance is the sum of squared deviations multiplied by respective
probabilities.
8. Gaussian distribution is normal distribution that is symmetrical
around its mean and is bell-shaped.
9. Standard normal distribution is normal distribution with mean as
zero and standard deviation as one.

4.6 DESCRIPTIVE QUESTIONS

1. What do you understand by return and risk? Explain with examples.
2. Which of the two − arithmetic mean or geometric mean − is superior
measure of return and why?
3. What is IRR? Give examples.
4. What do you understand by probability density function and normal
distribution?
5. What is the relationship between normal distribution and standard
normal distribution?

4.7 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS
Topics Q. No. Answers
Introduction 1. d. All of the above
2. b. Risk seekers
3. d. Risk-neutral investors
4. c. Risk-averse investors
Return 5. a. Dividend yield
6. b. Capital gain
Historical and Expected Return 7. a. Internal Rate of Return

4.8 SUGGESTED READINGS

AND E-REFERENCES

SUGGESTED READINGS
‰ Srivastava, Rajiv. 2017. Investment Management. New Delhi: Wiley.
‰ Elton, J Edwin, Martin J Gruber, William N. Goetzmann and Stephen
J Brown. 2013. Modern Portfolio Theory and Investment Analysis.
New Delhi: Wiley.
68 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

E-REFERENCES
‰ Brooke, P. and Penrice, D., A Vision for Venture Capital – Realizing the
Promise of Global Venture Capital and Private Equity (New Ventures), 2009.
‰ Capital Dynamics, The Definitive Guide to Risk Management in Private
Equity (PEI Media), 2010.
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A., Private Equity:
History, Governance and Operations (John Wiley & Sons), 2008.
 C H A
5 P T E R

RISK

CONTENTS

5.1 Risk
5.1.1 Measures of Risk
Self-Assessment Questions
5.2 Measuring Expected Return and Risk from Historical Data
5.2.1 Variance and Semi-Variance
5.2.2 Coefficient of Variation
Self-Assessment Questions
Activity
5.3 Expected Returns and Risk Under Uncertainty
5.4 Normal Distribution
5.4.1 Standard Normal Distribution
Self-Assessment Questions
5.5 Summary
Key Words
5.6 Descriptive Questions
5.7 Answer Keys
Self-Assessment Questions
5.8 Suggested Readings and E-References
 70 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Understand the concept of risk
> Measure risk
> Learn about the different measures of risk
> Understand variance and standard deviation
> Learn about the normal distribution and standard normal distribution
> Understand and apply the standard normal distribution to real-life
data

5.1 RISK
The expected return of 20.45% arrived above is the most likely value of return.
It implies that it may or may not take place and actual return may differ
from its expected value. This is referred to as risk. In the simplest sense, risk
may be viewed as the possibility that the actual outcome will differ from the
expected outcome. If one is certain that a particular outcome will occur then

! IMPORTANT CONCEPT
there is no risk involved. Risk refers to the chances that the actual outcome
will be different than the expected outcome. Therefore, risk is an inseparable
Risk refers to the chances that part of return when scenario is probabilistic.
the actual outcome will be
In the real world, risk is perceived in different ways by different investors.
different than the expected
Some of the expressions of risk may be like:
outcome. Therefore, risk is
an inseparable part of return 1. The maximum loss that I can incur is 20%.
when scenario is probabilistic.
2. The chances that I will not make a profit are 50%.
3. It is a risky investment because the chances that price will exceed the
current level are only 20%.
Though the above statements may be expressions of risk and each has some
measure of quantification but essentially they remain subjective. There is no
objective and consistency of measurement of risk. Whether or not a particular
level of risk is considered safe is dependent upon the subjective interpretation
and perception of the investor. What is risky for one may be safe for another and
what is safe for one may be risky for another. We need to eliminate the subjectiv-
ity by having a common measure of risk and leaving the judgement whether a
venture is risky or otherwise to the individuals. A person losing 20% on an invest-
ment may consider the happening as extremely risky while another person after
losing even 40% may not feel desperate. Risk is a state of mind. However, we
! IMPORTANT CONCEPT need measurement of risk to be objective and unambiguous.
The difference between the 5.1.1 MEASURES OF RISK
maximum and minimum
values of return can be one Risk can be measured or quantified in many ways. We discuss few of the pop-
measure of risk. Larger the ular measures of risk here.
difference between maximum
and minimum values, larger is RANGE
the range and hence greater
The difference between the maximum and minimum values of return can be
is the risk.
one measure of risk. Larger the difference between maximum and minimum
 RISK 71

values, larger is the range and hence greater is the risk. Defined as a range,
it can be stated as Equation below:
Range = Maximum Value - Minimum Value
To illustrate, consider Stock A selling at Rs 100 today. It is estimated that price
can go as high as Rs 200 if good conditions prevail, or fall as low as Rs 50 under
depressed conditions. There is another stock (Stock B), also selling currently
at Rs 100, whose estimated maximum and minimum values can be Rs 300 and
Rs 25, respectively. On the basis of the difference in the extreme values of the
stocks, Stock B may be regarded as more risky having a larger possible varia-
tion of Rs 275 (300 – 25) compared to Rs 150 (200 – 50) for Stock A.
The drawback with range as a measure of risk is that it ignores the probabil-
ity of happening of extreme values. If in the above case the likelihood of price
of Stock A falling to Rs 50 is 50%, while for Stock B it is only 10%, the per-
ception of risk perhaps may change. To have a clear view of risk one has to
not only consider the range of values that the price/return can take but also
the probabilities of the different values. Hence, the range cannot be regarded
as an appropriate measure of risk even though most investors remain con-
cerned about the maximum and minimum values a stock has taken. Perhaps
realising the concern of the investors, most financial dailies show 52-week
high and 52-week low of stock prices while reporting daily data.

AVERAGE DEVIATION
Another measure of risk can be average value of deviation of actual value from
expected value. As highlighted in discussion on range as measure of risk, the
value of deviation and its probability are equally important. We decide not to
ignore probability another time. Therefore, deviations from expected value
may be modulated by their respective probabilities. Hence, we multiply each
deviation with its probability. These values may be added to provide a measure
of risk. Using the method, we measure risk by deviations weighted by proba-
bilities as computed in Table 5.1 for returns and respective probabilities given
in first two columns. Expected value of return is 25.50% and deviations and
probability weighted of deviations are shown in last two columns.

TABLE 5.1 AVERAGE DEVIATION

Probability Return % Deviation
p r p×r r − E(r) p × {(r − E(r)}
0.1 10 1.00 -15.50 -1.55
0.2 20 4.00 -5.50 -1.10
0.3 25 7.50 -0.50 -0.15
0.2 30 6.00 4.50 0.90
0.2 35 7.00 9.50 1.90
Expected return, E(r) 25.50
Sum of deviations (as measure of risk) 0

As we can observe in Table 5.1, the sum of deviations weighted by respec-

tive probabilities as measure of risk comes to zero. Does this mean that
 72 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

returns would always equal expected value of 25.5% implying no risk?

From the data in first two columns of Table 5.1, we can say that it is cer-
tainly not so. Then why the measure of risk suggests no uncertainty? The
reason is not far to seek. The positive deviations cancel out negative devia-
tions. Therefore, average deviation cannot be a measure of risk as it would
always underestimate risk due to offsetting effect of positive and negative
deviations.

VARIANCE AND STANDARD DEVIATION

One possible way of overcoming the offsetting effect of positives and nega-
tives is to eliminate the direction of deviations. This can be done by taking
square of deviations before multiplying them with respective probabilities.
Finally, we can add these values. The sum of squared deviations multiplied
by respective probabilities is known as variance and can provide an objective
estimate of risk.
The measurement of risk through variance will have the unit of per cent
squared. In order to be consistent with the unit of measurement of expected
! IMPORTANT CONCEPT return, one can take the square root of the variance, called standard devia-
In order to be consistent with tion, as a measure of risk. By repeating the data shown in Table 5.1 we find
the unit of measurement of that the variance is 52.25 and standard deviation of the returns is 7.23% as
expected return, one can shown in Table 5.2.
take the square root of the
variance, called standard TABLE 5.2 VARIANCE AND STANDARD DEVIATION
deviation, as a measure of risk.
Probability Return % Deviation Deviation2
p R p×r r – E(r) [r – E(r)]2 p × [r − E(r)]2
0.1 10 1.00 -15.50 240.25 24.03
0.2 20 4.00 -5.50 30.25 6.05
0.3 25 7.50 -0.50 0.25 0.08
0.2 30 6.00 4.50 20.25 4.05
0.2 35 7.00 9.50 90.25 18.05
Expected return, E(r) 25.50
Variance (as measure of risk) 52.25
Standard deviation (as measure of risk), % 7.23

Mathematically, variance and standard deviation are given by Eqs. (5.1) and
(5.2), respectively:
n
Variance  2   pi * {( ri  E( r)}2 (5.1)
1

n
Standard deviation    p * {(r  E(r)}
1
i i
2
(5.2)

where pi = probability of ith value of return, ri = value of ith return, E(r) =

expected value of return, n = number of possible values of returns.
 RISK 73

SELF-ASSESSMENT
1. Consider the following statements.
QUESTIONS
1. Risk may be viewed as the possibility that the actual outcome will
differ from the expected outcome.
2. If one is certain that a particular outcome will occur then there is
no risk involved.
Which of the statement/s given above is/are correct?
a. Only 1
b. Only 2
c. Both 1 and 2
d. None of the above
2. Consider the following statements.
1. The difference between the maximum and minimum values of
return cannot be one measure of risk.
2. Larger the difference between maximum and minimum values,
larger is the range and hence greater is the risk.
Which of the statement/s given above is/are correct?
a. Only 1 b. Only 2
c. Both 1 and 2 d. None of the above
3. Consider the following statements.
1. Risk refers to the chances that the actual outcome will be different
than the expected outcome.
2. Risk is an inseparable part of return when scenario is probabilistic.
Which of the statements given above is correct?
a. Only 1 b. Only 2
c. Both 1 and 2 d. None of the above
4. What are the various measures to measure Risk?
a. Range b. Average Deviation
c. Standard Deviation d. All of the above
5. The sum of squared deviations multiplied by respective probabilities
is known as:
a. Risk b. Variance
c. Total deviation d. Range

5.2 MEASURING EXPECTED RETURN AND

RISK FROM HISTORICAL DATA
Normally, historical data of the prices of securities provide a useful guide
for the expected return and risk on the premise that future cannot be much
different from the past. Using past price data, we illustrate the process of
finding the expected return and the risk associated through an example:
Consider the price data of a stock as shown in first two columns of Table 5.3.
Starting with the price of Rs 79.55 in week 1 the closing prices for next 25
weeks is shown. At the end of week 2 the price became Rs 76.00 thereby pro-
viding a return of −4.46% in week 2. This is the first observation of return.
The return for each week is arrived by dividing the difference of price during
74 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

the week by the opening price assuming no dividend. The per cent return for
any period may be found by using Equation as:

Pn  Pn 1 76.00  79.55
% return for period n; rn   100   100  4.46%
Pn 1 79.55

Proceeding in the same manner, the weekly returns for next 25 weeks are
shown in column 3 of Table 5.3.

TABLE 5.3 MEASURING THE AVERAGE RETURN AND STANDARD

DEVIATION FROM HISTORICAL DATA
Close Price, Weekly Deviation from
Week Rs Return, % Mean Deviations2
1 79.55
2 76.00 -4.46 -5.74 32.92
3 79.00 3.95 2.67 7.14
4 79.60 0.76 -0.52 0.27
5 84.40 6.03 4.76 22.61
6 82.60 -2.13 -3.41 11.61
7 75.60 -8.47 -9.75 95.05
8 71.85 -4.96 -6.24 38.88
9 72.00 0.21 -1.07 1.14
10 68.55 -4.79 -6.07 36.80
11 70.00 2.12 0.84 0.71
12 64.85 -7.36 -8.63 74.51
13 68.50 5.63 4.35 18.95
14 70.25 2.55 1.28 1.64
15 83.15 18.36 17.09 292.00
16 83.90 0.90 -0.37 0.14
17 87.00 3.69 2.42 5.86
18 84.40 -2.99 -4.26 18.18
19 84.90 0.59 -0.68 0.47
20 92.00 8.36 7.09 50.24
21 103.15 12.12 10.84 117.61
22 98.65 -4.36 -5.64 31.78
23 91.70 -7.05 -8.32 69.22
24 89.80 -2.07 -3.35 11.20
25 86.90 -3.23 -4.50 20.29
26 102.95 18.47 17.19 295.66
Mean average weekly return, % 1.27
Sum of squared deviations 1254.86
Variance = Sum of squared deviations/24 1
50.19
Standard deviations of weekly returns, % 7.08
 RISK 75

The mean value is calculated by dividing the sum of all values by the number
of observations, which are 26. The average weekly return works out to 1.27%:
25

R i
31.87
Average Return R  1
  1.27%
n 25
Risk as measured by standard deviation is calculated by dividing the sum of
squared deviation by (n - 1). Using the formula as given below the standard
deviation of the mean is 1.96%.
1 n 1254.86
Variance,  2   (ri  r)2  24  50.19
n1 1
Standard deviation,   Variance  50.19  7.08%
From the above analysis average return of 1.27% per week in the past can
be taken as expected return in coming weeks. Similarly, as measure of risk,
standard deviation of return in the past can be used to assess the volatility
expected in near future.

5.2.1 VARIANCE AND SEMI-VARIANCE

One possible doubt lingers in the minds of people that why variance or stan-
dard deviation as measures of risk should include positive as well as nega-
tive deviations from an expected return. Most people believe that a return
in excess of expected return (the positive deviation) is in fact not a risk but
instead is a desirable outcome. Therefore, it will be appropriate to include
only the negative deviations, that is, the returns lesser than expected return
while measuring risk. The objection is apparently valid.
If one considers only the negative deviations and ignores the positive ones, the
measure will be called semi-variance. However, if probability distribution of ! IMPORTANT CONCEPT
returns is symmetrically distributed around its mean value, that is, the positive If one considers only the
and negative sides around the central point of mean are mirror images of one negative deviations and
another (which apparently is the case for returns on the individual stocks and ignores the positive ones,
portfolios), then semi-variance will be half the variance. Therefore, using vari- the measure will be called
ance or semi-variance would make no difference in the analysis when returns semi-variance.
are symmetrical around the mean except that one is half/double of another.
Though numerically different, it does not affect the comparative study of
alternative investment as long as variance is used as measure of risk. Since
variance is well-tabulated figure, analysts tend to use it rather than using
! IMPORTANT CONCEPT
semi-variance. In case the returns are non-symmetrical, then neither variance Since variance is well-
nor semi-variance would be an appropriate measure of risk. Instead, an addi- tabulated figure, analysts tend
tional parameter called skewness needs to be considered. to use it rather than using
semi-variance. In case the
The justification of variance by including positive outcomes as a measure of returns are non-symmetrical,
risk is as follows: then neither variance nor
1. Historically, the returns on stocks are observed to have symmetrical semi-variance would be
distribution. The probability distribution of returns is usually a bell- an appropriate measure of
risk. Instead, an additional
shaped curve known as normal distribution, which is described
parameter called skewness
completely by its mean and standard deviation.
needs to be considered.
2. The utility of money for investors is also a quadratic function of risk
and, therefore, variance as a measure of risk is apt as it reflects the
tendency of risk aversion of investors.
 76 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

5.2.2 COEFFICIENT OF VARIATION

Standard deviation or variance is an absolute measure of risk. It does not
give a complete comprehension of risk, nor does it indicate desirability or
otherwise of an investment proposition. As stated earlier, risk cannot be seen
in isolation and needs to be seen as in conjunction with return. For example,
returns for stock A and B may exhibit the standard deviation of 20% each.
However, the expected returns of the two may be 15% and 20%, respectively.
Although in absolute terms both the shares carry identical risk, in relative
terms the risk of stock B is lower because of its higher expected return. The
standard deviation when compared with the expected returns is known as
the coefficient of variation. It links return and risk. It is defined as the ratio of
standard deviation to the expected value and computed as follows:
Standard Deviation 
Coefficient of Variation  
Expected Value E( r)

! IMPORTANT CONCEPT Coefficient of variation gives risk per unit of return and gives a better under-
standing of two investment propositions of almost similar risk−return profiles.
Coefficient of variation gives Some investors would prefer choosing investment alternative with lower coeffi-
risk per unit of return and cient of variation. However, for lower values of mean the coefficient of variation
gives a better understanding tends to overstate risk. As an extreme case if expected value is zero the coefficient
of two investment of variation would be infinite, which is a value difficult to interpret. Similarly, for
propositions of almost similar
a higher expected value, the risk tends to be understated. Therefore, coefficient
risk−return profiles.
of variation must be used cautiously as a measure of risk.

SELF-ASSESSMENT 6. The measure of consideration of only the negative deviations and

QUESTIONS ignorance of the positive ones is called:
a. Semi-variance b. Variance
c. Deviation d. Risk free measure
7. What is standard deviation when compared with the expected
returns is known as?
a. Coefficient of change b. Coefficient of variation
c. Variable risk d. None of the above

ACTIVITY 1 1. There is investment X, which has a 20% probability of giving a 15%

return on investment, a 50% probability of generating a 10% return,
and a 30% probability of resulting in a 5% loss. Assume that it
generated a 15% return on investment during two of those 10 years,
a 10% return for five of the 10 years, and suffered a 5% loss for three
of the 10 years. Keeping all these in consideration, calculate the
expected return on investment X.

5.3 EXPECTED RETURNS AND RISK UNDER

UNCERTAINTY
Historical returns and risks as measured from past price data may hold good for
stock that grow at steady rate offering cash flows that are perhaps predictable
fairly accurately based on past data. Certain old companies in conventional
 RISK 77

sectors that operate in matured phase of product life cycle do fall in this cat-
egory. However, most companies have growing cash flows or are susceptible
to competition and their future is rather uncertain. The cash flows of past
and hence the past prices of stock bear no relationship with future prospects.
Under such circumstances, investors prefer to rely on their own perception
and estimates of future rather than use past prices of stock. When analysts and
investors use their own estimates of performance, they have countless way of
doing it. One very common way is to link the performance of the firms with the
overall economic environment. Under such a case analysts tend to:
a. project likely business scenarios,
b. attach a possibility of each the scenario, and
c. estimate returns under each scenario.

5.4 NORMAL DISTRIBUTION

In actual practice the probabilities to each scenario are assigned, and the
returns estimated. Such a distribution of returns is called a discrete distribution. ! IMPORTANT CONCEPT
However, when the number of scenarios become too large, the exercise of In actual practice the
assigning probabilities and estimating returns for each of them becomes probabilities to each scenario
too tedious and time-consuming. In such a case the frequency distribution are assigned, and the returns
becomes continuous where probability of a particular return is trivial but estimated. Such a distribution
instead a range of return becomes important. For instance, under continuous of returns is called a discrete
distribution, the question of finding returns exactly equal to 10% is irrelevant. distribution.
Instead, it is more appropriate to find the possibility of return between 8% and
10%. Fortunately for investment analysis it has been observed that returns
follow a continuous probability distribution pattern, called normal distribution.
Normal distribution is a probability distribution that is symmetrical around its
mean and is bell-shaped as depicted in Figure 5.1. It is also referred to as the
! IMPORTANT CONCEPT

Gaussian distribution. This is the most frequently occurring probability distri- Normal distribution is a
probability distribution that is
bution and it is assumed that the returns on the stocks and portfolios exhibit
symmetrical around its mean
return characteristics that are similar to that of normal distribution.
and is bell-shaped.

x ± 1.s = 68.3%

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
Expected return

Figure 5.1 Normal Distribution.

The probability of occurrence of any value x is given by p(x, m, s) for a distri-

bution that has mean of m and standard deviation of s:
( x   )2
1 
p(x,  ,  )  e 2 2
(5.3)
2 
 78 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

where m is mean and s is standard deviation. Equation (5.3) is also called the
normal density function. Normal distribution is symmetrical around mean
and is completely defined with two parameters, that is, mean (m) and stan-
dard deviation (s). Figure 5.1 depicts a normal distribution with mean of 20%
and standard deviation of 10%.
In continuous distribution probabilities are not assigned to specific values of
return but instead a range of values is used, that is, what is probability that
expected return would be less than 25%, or returns would lie between 18%
! IMPORTANT CONCEPT and 22%. The area under the normal distribution curve to the left of desired
return gives the probability of return less than desired value and is called
The area under the normal cumulative density function.
distribution curve to the left
of desired return gives the Values of probability density function and cumulative density function for
probability of return less than any value of return x can be found using EXCEL, given the expected value
desired value and is called and standard deviation. For value of x = 25% with the expected value of 20%
cumulative density function. and a standard deviation of 10%, cumulative density function can be found
easily using Insert – Function – NORM.DIST, where x represents the chosen
stock return. Refer to EXCEL Application.

EXCEL APPLICATION Normal Distribution

Area under the normal distribution curve represents the probability of
values falling between two points. EXCEL can give the probability of
returns below the specified value. To find the probability of returns less
than 25% for a normal distribution with mean return of 20% and stan-
dard deviation of 10% go to Insert >> Formulas >> Statistical >> NORM.
DIST. The screen exhibited below would appear.
X = Feed desired return
Mean = Feed mean value of the distribution of returns
Standard_dev = Feed standard deviation of expected returns
Cumulative = Feed TRUE
The probability that return would be less than 25% is 69.15% as shown.
 RISK 79

Probability that the returns would be less than 25% is 69.15, which also
implies that the probability that the returns would exceed 25% is 30.85:

p(x > 0.25) = 1 - p(x ≤ 0.25) (5.4)

The probability of certain ranges of value is used very often and it is handy
to remember these values. Following are the probabilities of returns of
specific ranges of values mentioned in terms of mean and standard devi-
ations:
X ± 1s = 20 ± 10 = Between +10% and +30% : 68.3%
X ± 2s = 20 ± 20 = Between 0% and +40% : 95.4%
X ± 1s = 20 ± 30 = Between -10% and +50% : 99.7%

5.4.1 STANDARD NORMAL DISTRIBUTION

For a mean value (m) of zero and standard deviation (s) of one the distribu-
tion is called standard normal distribution. Any normal distribution can be
converted to standard normal distribution and the corresponding value of x
becomes z given as follows:
x
z

It is always better to use the standard normal distribution because we can
convert all normal distributions with any value of mean or standard devia-
tion into an equivalent standard normal distribution. The areas under the
curve for particular values of z can also be found using EXCEL exactly in
the same manner as described for normal distribution except that one has
to choose NORMSDIST function instead of NORMDIST. This is shown in
EXCEL Application.

Standard Normal Distribution EXCEL APPLICATION

Area under the standard normal distribution curve represents the prob-
ability of values falling between two points. EXCEL can give the prob-
ability of returns below the specified value. To find the probability of
returns less than 22% for a normal distribution with mean return of 20%
and standard deviation of 10%, first convert the distribution to standard
normal distribution as shown in cells C62 to C65. Then go to Insert >>
Formulas >> Statistical >> NORM.S.DIST. The screen exhibited below
would appear.
Z = Feed desired return in terms of standard normal distribution
Cumulative = Feed TRUE
The probability that return would be less than 22% is 57.93 % as shown.
80 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

With the help of normal or standard normal distribution we can find proba-
bility of returns for a given range using
p(z1 ≤ z ≤ z2) = N(z2) - N(z1) (5.5)
For example, if we wish to know what is the probability of returns falling between
15% and 25% we can convert each value to an equivalent z-value and find cumu-
lative normal distribution using Excel function NORM.S.DIST. For returns to
fall between 15% and 25%, the z-values are -0.50 and +0.50, respectively, and we
can find the probability of returns between 15% and 25% as 38.29%:
p(-0.50 ≤ z ≤ 0.50) = NORM.S.DIST (0.50) - NORM.S.DIST (-0.50)
= 0.6914 - 0.3085 = 0.3819 ≡ 38.29%
While Excel denotes the standard normal distribution by z, commonly we
denote the same figure by d. Some of the properties of normal distribution
that are worth remembering are:
1. The area under the curve between two points on the horizontal axis
represents the probability of occurrence of values between those two points.
2. The distribution is symmetrical around its mean with equal area on
either side.
3. Three measures of central tendency, that is, mean, mode and median,
are at the same point for normal distribution.
4. 50% of the area is covered under X ± 0.67s.
5. Normal distribution with mean as zero and standard deviation as one is
known as standard normal distribution and the values of the area under
the curve are tabulated.
For small holding periods, the mean and variance of the holding period
returns are proportional to those of annually compounded rates and the time
 RISK 81

interval measured in years. Accordingly, variance and standard deviation are

given by
Variance (r) = Variance (ř t) = t × Variance (ř )
Standard deviation for holding period t, st = s × t (5.6)
If standard deviations of annual, monthly, and daily returns are denoted as
sa, sm, and sd, respectively, then
Standard deviation of monthly returns, sm = sa/ 12
Standard deviation of daily returns, sd = sa/ 250
If standard deviation of weekly returns is 2% then it is equivalent to annual
standard deviation of st = s × t = 2 × 52 = 14.42%.

8. Which of the statements given below is not correct? SELF-ASSESSMENT

QUESTIONS
a. Normal distribution is a probability distribution that is symmet-
rical around its mean and is bell-shaped.
b. It is also referred to as the Gaussian distribution.
c. The past prices of stock bear relationship with future prospects.
d. All are correct
9. The area under the normal distribution curve to the left of desired return
gives the probability of return less than desired value and is called:
a. Cumulative density function
b. Gaussian distribution
c. Coefficient of change
d. Deviation
10. Consider the following statements.
1. Normal distribution with mean as zero and standard deviation as
one is known as standard normal distribution.
2. For small holding periods, the mean and variance of the holding
period returns are proportional to those of annually compounded
rates and the time interval measured in years.
Which of the statements given above is correct?
a. Only 1
b. Only 2
c. Both 1 and 2
d. None of the above

5.5 SUMMARY
‰ The two key determinants of any investment decision are return and
risk associated, and they cannot be studied in isolation as both are very
closely interlinked and affect each other.
‰ Data of trading in financial securities is ideal to make assessment of
return and risk because they reflect collective wisdom and expectations
of investors and are unbiased indicators.
82 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

‰ Internal rate of return (IRR) too is also a measure of realised return over
holding period that is based on cash flows.
‰ Arithmetic mean makes an implicit assumption that during the interim
periods the investment remains constant period after period.
‰ Risk is denoted by the magnitude and likelihood of not realising the
expected return.
‰ Though risk has several measures like range, deviation, variance, etc. but
standard deviation is considered the most apt measure.
‰ For most financial assets the returns are deemed to resemble a bell-
shaped curve called normal distribution that is completely defined by the
parameters of average and standard deviation.
‰ The area under the curve of normal distribution at a point gives the prob-
ability of finding returns lesser than that point.
‰ Standard normal distribution is a special case of normal distribution with
a mean equal to zero and standard deviation of one.

KEY WORDS 1. Risk-neutral investors are those whose investment decision is

purely guided by expected return.
2. Risk-averse investors are those who detest risk and want greater
compensation of increased return for nominal rise in risk.
3. Risk seekers are investors who undertake great risk for rather small
increase in return.
4. Capital gains is the profit or loss made after the holding period by
disowning the asset, depending upon the price at the end of holding
period.
5. Dividend yield is the return obtained by holding the asset.
6. Frequency distribution is the graphical plot of the values on the
horizontal axis and the frequency of occurrence on the vertical axis.
7. Variance is the sum of squared deviations multiplied by respective
probabilities.
8. Gaussian distribution is normal distribution that is symmetrical
around its mean and is bell-shaped.
9. Standard normal distribution is normal distribution with mean as
zero and standard deviation as one.

5.6 DESCRIPTIVE QUESTIONS

1. What do you understand by coefficient of variation? Explain with
examples.
2. Distinguish between Variance and Standard Deviation.
3. What is understood by risk and what are the different measures of risk?
 RISK 83

4. What do you understand by probability density function and normal

distribution?
5. What is the relationship between normal distribution and standard
normal distribution?

5.7 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS
Topics Q. No. Answers
Risk 1. c. Both 1 and 2
2. b. Only 2
3. c. Both 1 and 2
4. d. All of the above
5. b. Variance
Measuring Expected Return 6. a. Semi-variance
and Risk from Historical Data
7. b. Coefficient of variation
Normal Distribution 8. c. The past prices of stock bear
relationship with future prospects.
9. a. Cumulative density function
10. c. Both 1 and 2

5.8 SUGGESTED READINGS

AND E-REFERENCES

SUGGESTED READINGS
‰ Srivastava, Rajiv. 2017. Investment Management. New Delhi: Wiley.
‰ Elton, J Edwin, Martin J Gruber, William N. Goetzmann and Stephen
J Brown. 2013. Modern Portfolio Theory and Investment Analysis.
New Delhi: Wiley.

E-REFERENCES
‰ Brooke, P. and Penrice, D., A Vision for Venture Capital – Realizing the
Promise of Global Venture Capital and Private Equity (New Ventures), 2009.
‰ Capital Dynamics, The Definitive Guide to Risk Management in Private
Equity (PEI Media), 2010.
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A., Private Equity:
History, Governance and Operations (John Wiley & Sons), 2008.
 C H A
6 P T E R

PORTFOLIO THEORY

CONTENTS

6.1 Introduction
Self-Assessment Question
6.2 Portfolio Return
Self-Assessment Question
6.3 Covariance and Correlation
6.4 Two-Asset Portfolio
6.4.1 Risk Return Profile of 2-Asset Portfolio
6.4.2 The Efficient Portfolios and Efficient Frontier
6.4.3 Feasible Portfolios and Efficient Frontier
Self-Assessment Questions
6.5 The Optimum Portfolio
6.6 Portfolio Construction
6.7 Understanding Diversification and Risk
6.7.1 Portfolio Risk and Return
Activity
Self-Assessment Questions
6.8 Summary
Key Words
6.9 Descriptive Questions
6.10 Answer Keys
Self-Assessment Questions
6.11 Suggested Readings and e-References
86 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

INTRODUCTORY CASELET

When I consider the plethora of books, articles, consultants, and

conferences on risk in today’s world, my friend’s aphorism has never
seemed more appropriate. Are we never going to nail risk down and bring
it under control? How much more can anyone reveal to us beyond what
we have already been told? In a very real sense, this flood of material
about risk is inherently risky. Sorting out the pieces and searching for
main themes has become an escalating challenge. The root of the matter
gets lost in the shuffle while we are analyzing all the elegant advances in
risk measurement and the impressive broadening of the kinds of risks
we seek to manage.
More is said than is done, or what is done loses touch with what has
been said. If we go back to first principles for a moment, perhaps we
can put the multifarious individual pieces into some kind of a larger
framework and optimize the choices among the masses of information
we are attempting to master.
Remember always: Risk is not about uncertainty but about the unknown,
the inescapable darkness of the future. If more things can happen than
will happen, and if we are denied precise knowledge of the range of
possible outcomes, some decisions we make are going to be wrong.
How many, how often, how seriously?
The beginning of wisdom in life is in accepting the inevitability of being
wrong on occasion. Or, to turn that phrase around, the greatest risks we
take are those where we are certain of the outcome—as masses of people
are at classic market bottoms and tops. My investment philosophy has
always been that victory in the long-run accrues to the humble rather
than to the bold.
Now we can break down the problem of risk into what appear to me to
be its three primary constituent parts. First, what is the balance between
the consequences of being wrong and the probability of being wrong?
Many mistakes do not matter. Other mistakes can be fatal. No matter
how small the probability you will be hit by a car when you cross against
the lights, the consequences of being hit deserve the greater weight
in the decision. This line of questioning is the beginning, and in some
ways the end, of risk management.
All decisions must pass through this sieve. It is the end if you decide not
to take the risk, but it is also the end in the sense that distinguishing
between consequences and probabilities is what risk management is
all about.
Second, expect the unexpected. That sounds like an empty cliché, but
it has profound meaning for risk management. It is easy to prepare for
the risks you know— earnings fail to meet expectations, clients depart,
bonds go sour, and a valued associate goes to a competitor.
Insurance and hedging strategies cover other kinds of risks lying in wait
out there, from price volatility to premature death. But preparation
 PORTFOLIO THEORY 87

for the unexpected is a matter of the decision-making structure, and

nothing else. Who is in charge here? That is the critical question in any
organization. And if it is just you there when the unexpected strikes,
then you should prepare in advance for where you will turn for help
when matters seem to be running out of control.
Finally, note that word “control.” With an exit strategy—when decisions
are easily reversible—control over outcomes can be a secondary matter.
But with decisions such as launching a new product or getting married,
the costs of reversibility are so high that you should not enter into
them unless you have some control over the outcome if things turn out
differently from what you expect. Gambling is fun because your bet
is irreversible, and you have no control over the outcome. But real life
is not a gambling casino. These three elements are what risky decisions
are all about—consequences versus probabilities, preparation for
dealing with unexpected outcomes, and the distinction between revers-
ibility and control. These are where things get done, not said.

QUESTION

1. Describe the three elements about taking Risky decisions and

how can one overcome them?
88 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

LEARNING OBJECTIVES

The objectives of this chapter include the following:

+ Describe a portfolio and measure its return and risk.
+ Differentiate between variance, covariance, and coefficient of
correlation.
+ Distinguish between feasible and infeasible portfolios and efficient
and inefficient frontier.
+ Compute portfolio variance and standard deviation.
+ Describe utility of money as a function of returns and risk.

6.1 INTRODUCTION
We explained the concepts of risk and returns as two inseparable
dimensions of investments that are interlinked with each other. We studied
these concepts of risk and return in respect of an individual asset.
In this chapter, we will study the return and risk in the context of many
securities held together as investment, called a portfolio. The simplest
definition of portfolio is holding two or more assets. The study of risk
and return profile of individual assets guides the formation of a portfolio.
However, the portfolio characteristics exhibit different behavior than
simple aggregation of return and risk of individual assets comprising the
portfolio. The study of individual financial asset is not as important as
the study of portfolio because most investors make investment in several
securities and hold portfolio of many financial assets rather than a single
asset. We attempt to examine the question as to how the risk and return
of the portfolio consisting of individual securities are different than
the aggregate sum of the risk and returns of the securities consisting
the portfolio.
In the context of the study of the portfolio it is pertinent to understand
that focus of study is on asset classes rather than on individual securities.
There are thousands or perhaps millions of securities but they can be
divided in limited number of asset classes. For example, millions of equity
stocks can be clubbed together as one asset class; thousands of bonds can
be another asset class; while commodities can be another assets class.
In each asset class there can be several securities. Portfolio consists of
diverse types of asset classes. Each asset class serves a different purpose.
Besides investments directly in the financial assets and markets, most
people do have savings canalized in various other assets like insurance
policies, provident funds, fixed deposits, etc. Each of the investment
appeals to different sets of people and meets different objectives, financial
or otherwise. Investors construct these portfolios to have offsetting effect
on the return of one asset on another. For example, an insurance policy
against theft of a car protects the loss in value of the asset, that is, the
car. These assets (i.e. the car) and the theft insurance policy form a
portfolio whose return and risk complement each other so as to provide
a stabilizing effect.
 PORTFOLIO THEORY 89

Insurance policies in general are hedges against event risks, attempting to

protect the loss in value of the asset against particular type of event. Idea of a ! IMPORTANT CONCEPT
portfolio comes from different needs that individuals need to fulfil. In doing so, Insurance policies in general
they inadvertently construct a portfolio. Different asset classes in the portfolio are hedges against event
provide an offsetting effect. Due to offsetting effects in a portfolio the return risks, attempting to protect
and risk characteristics – the two most important dimensions of investment the loss in value of the
management − are substantially different than those of individual security asset against particular
and asset class comprising it. They need to be studied separately. type of event.

1. Which among the following statements are correct? SELF-ASSESSMENT

QUESTION
a. the study of risk and return profile of individual assets
guides the formation of a portfolio. However, the portfolio
characteristics exhibit different behavior than simple
aggregation of return and risk of individual assets comprising
the portfolio.
b. the study of individual financial asset is not as important as the
study of portfolio because most investors make investment in
several securities and hold portfolio of many financial assets
rather than a single asset.
c. both a) and b)
d. none of the above

6.2 PORTFOLIO RETURN

If we construct a portfolio comprising two assets A and B then the expected
returns of the portfolio should be the average of the expected returns on
Asset A and Asset B. If the expected return on Asset A is 10% and on Asset B
is 20% and we make equal investment in each of them, then the expected
return of the portfolio would be 15%. As we increase the proportion of
investment in Asset B our return would tend to follow more of Asset B and
increase beyond 15%. Conversely, if we invest more in Asset A, portfolio
characteristics should follow Asset A and portfolio return should be lower
than 15%. When portfolio consists of several assets, the return on the
portfolio is given by weighted average of the returns of individual assets
consisting the portfolio. This is represented as follows:
n
R p = w1R 1 + w2 R 2 + w3 R 3 +  = ∑ wi Ri
1

where wi is the weight of the asset ‘i’ in the portfolio and Ri is the expected
return on asset ‘i’. Under uncertainty returns get replaced by expected ! IMPORTANT CONCEPT
return. The expected return on any asset is given by probability weighed The expected return on any
average of its returns over all scenarios. If there are three scenarios possible, asset is given by probability
that is, good growth, normal growth, and poor growth with equal probabil- weighed average of its returns
ities and the share is expected to provide returns of 28%, 22%, and 13%, over all scenarios.
respectively, then the expected return of this share is weighted average of
three scenarios, that is
1
(28 + 22 + 13) = 21%
3
 90 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

SELF-ASSESSMENT 2. Each individual asset’s weight in the portfolio is found by:

QUESTION
a. dividing the asset’s standard deviation by its expected value.
b. calculating the percentage of the asset’s value to the total
portfolio value.
c. calculating the return of the asset as a percent of total portfolio
return.
d. dividing the asset’s expected value by its standard deviation.

6.3 COVARIANCE AND CORRELATION

How do returns co-vary with one other is defined as covariance. For variance
we multiply the deviation from its mean as follows:
n
Var, s p2 = ∑ p (R - R )
1
i
2

Covariance of two securities is determined by product of deviation of one

security and deviation of another security i.e.
n
Cov(R1 , R2 ) = ∑ pi ( R1 - R1 )( R2 - R2 )
1

Covariance of the two securities indicates the direction and extent of

! IMPORTANT CONCEPT linkage of behavior of variations of returns of two securities. Positive
Positive covariance implies covariance implies that the deviations of returns from the expected values
that the deviations of returns of the two securities are in same direction while negative covariance
from the expected values means that the deviations are in opposite directions. The extent of
of the two securities are in relationship is reflected in the magnitude of the covariance.
same direction while negative
covariance means that the An indicator of how much two random variables fluctuate together is
deviations are in opposite called covariance. Correlation reveals the relationship between the
directions. variables.
Covariance provides the extent of relationship of two securities in absolute
terms. To facilitate comparison, we need a relative measure. This measure
is called coefficient of correlation. If we normalize the covariance with
! IMPORTANT CONCEPT another absolute measure of risk, that is, standard deviation, we would
Covariance provides the get the relationship in relative terms. Coefficient of correlation, denoted
extent of relationship of two as ρ (rho) is defined as covariance divided by product of the standard
securities in absolute terms. deviations:
Cov(R 1 , R 2 )
Coefficient of Correlation, ρ =
s 1s 2
Coefficient of correlation can range from –1.00 to +1.00. Negative sign
indicates an inverse relationship between the two securities, that is, the
returns of the two securities would move in opposite directions. If returns
of one increases, the other decreases. A positive value signifies movement
in the same direction. The magnitude of coefficient of correlation indicates
how strong the relationship is. The values of coefficient of correlation of
+1.00 and –1.00 denote perfect positive and perfect negative correlation
implying complete offsetting of positive and negative values.
 PORTFOLIO THEORY 91

6.4 TWO-ASSET PORTFOLIO

Let us examine another aspect of designing a portfolio. Besides selection
of assets to be included in the portfolio, another factor is to be chosen
by investor, that is, what proportion of wealth should be invested in
each asset. The proportion of wealth in each asset can alter the risk−
return characteristics of the portfolio substantially. Again, we keep our
illustration simple by deciding to form a portfolio consisting of only two
assets. Let these two assets be Bollywood and Tollywood, which have
following characteristics:

Bollywood Tollywood
Expected return, % 15.50 14.70
Standard deviation, % 3.50 2.10
Covariance −7.35
Coefficient of correlation −1.00

By changing the proportion of wealth in Bollywood and Tollywood we can

form numerous portfolios. A portfolio with 10% of wealth in Bollywood and
90% in Tollywood is different from the portfolio with 90% in Bollywood
and 10% in Tollywood. The expected returns as well as risk of these two
portfolios are different from one another only because proportions of
wealth invested are different despite the fact that shares included in both
portfolios are same. The returns of the portfolio is the weighted average of
returns of securities in the portfolio. However, the variance of the portfolio
is not. When two assets with variances of s 12 and s 22 are combined to form
a portfolio, the variance of the portfolio is given by:
Variance of the portfolio, s p2 = w12s 12 + w22s 22 + 2w1 w2Cov( R1 , R2 )
where w1, w2 are the proportions of wealth in asset 1 and 2, respectively, and
w1 + w2 = 1. Variance of the portfolio can be stated in terms of coefficient of
correlation as given by
Variance of the portfolio, s p2 = w12s 12 + w22s 22 + 2w1 w2 ρs 1s 2
Expected return and variance of the portfolio with equal investment in
Bollywood and Tollywood, that is, w1 = w2 = 1/2, respectively, are 15.10%
and 0.49 equivalent to standard deviation of 0.70%.
n
Rp =w1 R1 + w2 R2 + w3 R3 +  =∑ wi Ri =
1
0.5 × 15.50 + 0.5 × 14.70 =
15.10%

Variance of the portfolio, s p = 0.5 × 3.52 + 0.52 × 2.12 + 2 × 0.5 × 0.5 × (-7.35) =
2 2
0.49

or sp = 0.70%

It is revealing to note that the portfolio risk as measured by standard deviation

is merely 0.70% as against the standard deviations of 3.50% for Bollywood
and 2.1% for Tollywood. Importantly, portfolio risk is lower than the least of
the risk of securities forming it. How can the risk be lesser than either of the
constituents of the portfolio is hard to digest? Normally we would expect
the portfolio risk to lie between the risks of two constituents of the portfolio,
that is, between 2.10% and 3.50%, just as we expected for the portfolio return
92 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

to be between the returns of its two constituents. The answer to this question
lies in the negative correlation of returns of Bollywood and Tollywood.
Reduction in risk was possible because negative impact on portfolio return
caused by Bollywood/Tollywood was fully or partially offset by Tollywood/
Bollywood. When returns from one asset in the portfolio declined, the
returns from second increased, and when returns from second deteriorated,
the first asset compensated the loss. This rendered stability to the returns of
the portfolio, making it safer than either of the asset comprising it.

6.4.1 RISK RETURN PROFILE OF 2-ASSET PORTFOLIO

In order to generalize the observation made in the portfolio of Bollywood
and Tollywood we need to study the portfolio in greater detail.
The observation that portfolio risk can indeed be lesser than the least
of the risk of its constituents is valid only under specific circumstances.
We can only guess that it happened because of the negative covariance
between the returns of the two assets. In order to quantify the reduction
in risk we need to study the portfolio further. While the characteristics of
return and risk of individual assets remain same and cannot be altered,
but as portfolio manager we can (a) choose assets in the portfolio and
(b) change the proportions of investment in each of the asset. We choose
Security 1 and Security 2 with expected returns R1 and R2 at 15% and
30% respectively, and standard deviation σ1 and σ2 of 10% and 20%,
respectively. The relationship of Security 1 and Security 2 is defined
as covariance between the two. The relative measure of relationship is
defined by coefficient of correlation r which can take any value from
−1.00 to +1.00. We examine two extreme cases of perfect negative and
perfect positive correlation, that is, ρ = −1.00 and ρ = +1.00.
Case I: With perfect positive correlation between Security 1 and Security 2
(ρ = +1.00)
When there exists perfect positive correlation among the securities of
Firm 1 and Firm 2 the portfolio return and risk are given respectively:
Portfolio Return, R p = w1R 1 + w2 R 2

Portfolio Risk, s p 2 = w12s 12 + w2 2s 22 + w1w2 ρs 1s 2

s p 2 = w12s 12 + w2 2s 22 + w1w2s 1s 2 , with ρ =
1
= (w1s 1 + w2s 2 ) 2

⇒
s p = (w 1s 1 + w 2s 2 )
Note that in case of perfect positive correlation the standard deviation of
the portfolio is also the weighted average of the standard deviations of the
individual securities consisting the portfolio, as is the case with portfolio
return. Now we analyze the portfolio return and portfolio risk with changing
proportions of money in two securities. When 100% of the money is invested
in Firm 1, the return and standard deviation of the portfolio would be equal
to those of Firm 1, that is, a portfolio return of 15% and standard deviation of
10%. As we change the composition of the portfolio by replacing the Firm 1
by Firm 2 in the portfolio, its characteristics would move towards those of
 PORTFOLIO THEORY 93

Firm 2. Depending upon the proportion of money in Firm 1 and Firm 2,

the return and standard deviation of the portfolio would change respectively.
For various select proportions of wealth the return and risk are computed in
Table 6.1. When all money is invested in Firm 2, the portfolio risk and return
would be identical to those of Firm 2.

TABLE 6.1 PORTFOLIO RETURN AND RISK (ρ = +1.00)

w1 100.00 75.00 50.00 25.00 0.00
w2 0.00 25.00 50.00 75.00 100.00
Rp 15.00 18.75 22.50 26.25 30.00
σp 10.00 12.50 15.00 17.50 20.00

With different proportions of wealth in Firm 1 and Firm 2 the locus of

portfolio return and risk is depicted graphically in Figure 6.1 by bold black
dashed line when coefficient of correlation ρ = +1.
Case II: With perfect negative correlation between two securities (ρ = –1.00)
The second extreme case is when returns of the two securities are perfectly
negatively correlated, that is, ρ = −1.00. While portfolio return continues
to be determined for portfolio risk, we modify substituting ρ = −1.00 and
get portfolio risk as

Portfolio Risk, s p 2 = w12s 12 + w22s 22 + w1w2 ρs 1s 2

s p 2 = w12s 12 + w22s 22 - w1w2s 1s 2 (with ρ =
-1)
= (w1s 1 - w2s 2 )2

⇒ s p = (w1s 1 - w2s 2 )

Return, %
30 x Security 2

 = +1.00

 = –1.00
–1.00 <  < 1.00

15 x Security 1

10 20
Standard deviation, %

Figure 6.1 Portfolio Return and Risk and Coefficient of Correlation.

94 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Note that while return of the portfolio remains equal to the weighted
average of the returns of the individual securities consisting the portfolio,
the risk of the portfolio throws up some interesting results. When 100%
of the money is invested in Firm 1, the return and standard deviation
of the portfolio would be equal to those of Firm 1. As we change the
composition of the portfolio by replacing Firm 1 by Firm 2 the portfolio
return and risk move towards those of Firm 2. With perfect negative
correlation between two securities, while initially the return increases
(returns of Firm 2 being higher than those of Firm 1), the risk declines
due to offsetting effect of the two securities. With different proportions in
Firm 1 and Firm 2 different profiles of the return and risk of the portfolio
are shown in Table 6.2.

TABLE 6.2 PORTFOLIO RETURN AND RISK ( ρ = −1.00)

w1 100.00 75.00 50.00 25.00 0.00
w2 0.00 25.00 50.00 75.00 100.00
Rp 15.00 18.75 22.50 26.25 30.00
σp 10.00 2.50 5.00 12.50 20.00

With different proportions of wealth in Firm 1 and Firm 2 the locus of portfolio
return and risk is depicted graphically in Figure 6.1 by bold grey dashed line
when coefficient of correlation ρ = −1. A look at Table 6.2 and Figure 6.1
would reveal that as we decrease the proportion of investment in Security 1
from 75% to 50%, the portfolio risk moves from 2.50% to 5.00%. Intuitively
we can say that in between the two, the risk must fall before rising and
perhaps there is a point at which risk can become zero. This can be solved
mathematically by putting the portfolio risk to zero.
w1 s 2
s p = (w1s 1 - w2s 2 ) =0 ⇒ =
w2 s 1
s s
or =w1 = 2
and w2 1
s1 + s2 s1 + s2
We may find one such combination of Firm 1 and Firm 2. The portfolio
that gives zero risk would have
s2 20 2 s1 10 1
=w1 = = =
and w2 = =
s 1 + s 2 10 + 20 3 s 1 + s 2 10 + 20 3
With two-third in Firm 1 and remaining one-third in Firm 2 we can achieve
the portfolio risk as zero and portfolio return of 20%.
2 1
Portfolio Return, R p = w1R 1 + w2 R 2 = × 15 + × 30 = 20%
3 3
Case III: With correlation coefficient between +1 and –1
With coefficient of correlation between ±1.00 the portfolio returns are given
for different proportions of wealth while portfolio risks are computed, for
special cases of ρ = ±1.00. Under such circumstances the locus of return
and risk would not be linear but instead be curvilinear. As we move the
coefficient of correlation from +1.00 to −1.00, the locus shifts and becomes
 PORTFOLIO THEORY 95

more and more convex towards origin. This can be seen from the set of three
bold black lines in Figure 6.1.

6.4.2 THE EFFICIENT PORTFOLIOS AND EFFICIENT FRONTIER

An efficient portfolio, additionally known as an ‘most reliable portfolio’, is
one that gives that pleasant, predicted go back on a given level of chance,
or as an alternative, the minimum hazard for a given predicted return.
A portfolio is a selection of investment products.
If, given a selected degree of hazard, the predicted returns are not met, or
if the hazard required to obtain that anticipated degree of return is simply
too high, it is called an ‘inefficient portfolio’.
American economist Harry Max Markowitz (born 1927), a recipient of the
1990 Nobel Memorial Prize in economic Sciences, who delivered the current
Portfolio concept in 1952, said that the holder of an efficient portfolio
cannot diversify any similarly to growth the expected rate of return without
accepting a higher level of chance.
An efficient frontier is a set of funding portfolios which might be expected
to offer the best returns at a given level of chance. A portfolio is said to be
efficient if there’s no other portfolio that gives better returns for a decrease
or equal quantity of danger.
The efficient frontier is a curved line. There’s a diminishing marginal
return to danger, and it outcomes in a curvature. Diversifying the assets
to your portfolio results in increased returns and reduced dangers, which
ends up in a portfolio that is placed on the efficient frontier. Therefore,
diversification can create an efficient portfolio that is positioned on a
curved line.
Example: Through the help of diagram which showcases the efficient and
non-efficient portfolios, In the Figure 6.1, depicts the locus of return and
risk of portfolios with various coefficients of correlation. A closer look at
the locus of special case of perfect negative coefficient of correlation reveals
two linear segments, XY and YZ shown in Figure 6.2, as we move from
increasing proportions of Security 2 in the portfolio.
As we increase the proportion of Security 2 we move along the segment XY
where (a) the portfolio risk decreases due to its negative relationship with
returns of Security 1 and (b) the portfolio return increases due to greater
returns of Security 2. This is reflected in the first segment, XY of dotted
line in Figure 6.2. After a certain point Y, though the return continues to
increase with increased proportions of Security 2 the risk too increases as
we move along the segment YZ, the bold line in Figure 6.2.
Most financial assets have positive correlation or at best can be said to
have no correlation (coefficient of correlation very close to zero). Under
such conditions, the possible portfolios would lie on the curved paths as in
Figure 6.2.
The portfolios formed with lower of negative correlation as represented by
bold curve in Figure 6.3 outperform other portfolios.
96 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Efficient portfolios
Return, %
30 x Security 2Z

Inefficient
Y portfolios
 = –1.00

15 x Security 1X

10 20
Standard deviation, %

Figure 6.2 Efficient and Inefficient Portfolios.

Return, % Efficient frontier

30 x Security 2Z

Inefficient
frontier

A B

15 x Security 1X

10 20
Standard deviation, %

Figure 6.3 Efficient Frontier and Inefficient Frontier.

6.4.3 FEASIBLE PORTFOLIOS AND EFFICIENT FRONTIER

When only two risky assets are combined to form a portfolio the possible
combinations on the return risk space are represented by a curved line as
shown in Figures 6.3. When more than two assets are combined in the portfolio
the combination of portfolios that are feasible by changing proportions of
money occupy an area on the return risk space rather than a line. Figure 6.4
shows the space for feasible portfolios and efficient frontier for four securities
 PORTFOLIO THEORY 97

Efficient 1
Return frontier

Set of inefficient 2
but feasible
portfolios
3

Risk

Figure 6.4 Feasible Portfolios and Efficient Frontier.

having different return and risk profiles. The area bounded by the curve
represents the set of feasible portfolios meaning that any combination of
return and risk that lies in the area can be attained by having securities 1–4
in some proportion. The dark line represents the efficient frontier implying
the superiority of the portfolios falling on it in terms of either maximum
return for given risk or least risk for given return.

3. The major difference between the correlation coefficient and the SELF-ASSESSMENT
covariance is that the correlation coefficient: QUESTIONS
a. can be positive, negative, or zero, whereas the covariance is
always positive.
b. measures the relationship between securities, whereas the
covariance measures the relationship between a security and
the market.
c. is a relative measure showing association between security
returns, whereas the covariance is an absolute measure showing
association between security returns.
d. none of the above
4. Which of the following statements regarding portfolio risk and
number of stocks is generally true?
a. adding more stocks increases risk.
b. adding more stocks decreases risk but does not eliminate it.
c. adding more stocks has no effect on risk.
d. adding more stocks decreases only systematic risk.
5. When returns are perfectly positively correlated, the risk of the
portfolio is:
a. zero.
b. the weighted average of the individual security’s risk.
c. equal to the correlation coefficient between the securities.
d. infinite.
98 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

6. When the covariance is positive, the correlation will be:

a. positive.
b. negative.
c. zero.
d. impossible to determine.
7. When only two risky assets are combined to form a portfolio the
possible combinations on the return risk space are represented
by a _________.
a. curved line
b. straight line
c. steep line
d. none of the above

6.5 THE OPTIMUM PORTFOLIO

For investment decision an investor would have to consider (a) return on
the asset, (b) its risk, and (c) what utility of that investment. Out of millions
of portfolios we have eliminated most of them as inefficient and only those
that fall on efficient frontier are worth considering in terms of return and
risk. Among those on the efficient frontier the investor would like to invest
in the portfolio that maximizes the utility. Such a portfolio would be the
optimum portfolio. Therefore, the optimum portfolio desired must satisfy
the following conditions:
1. It must lie on the efficient frontier and
2. It must maximize utility for the investor. We explain the process of
finding the optimum portfolio graphically. Consider Figure 6.5.

Return, %

Increasing utility

U=5

U=4
B
O Efficient
RO
U=3 frontier

U=2
A
U=1

O Standard deviation, %

Figure 6.5 Finding Optimum Portfolio.

 PORTFOLIO THEORY 99

Black solid lines depict rising iso-utility curves for an investor, while grey
line is the efficient frontier. A portfolio on the efficient frontier implies that
for given return there is no portfolio with lesser risk or for given risk there
is no portfolio with higher return. The investor would choose the portfolio
that lies on efficient frontier as well as on any of the utility curve, that is, the
intersection of the two. Observe two portfolios A and B that lie on efficient
frontier and iso-utility curve U = 2. Both these portfolios are indeed efficient
being on the efficient frontier but are not suitable/desirable for the investor
because there could be other portfolios that can potentially increase utility.
Scanning upwards on the iso-utility curves we find another portfolio O that
is efficient but has a greater utility of 3.00. Moving beyond iso-utility curve of
U = 3 is not possible because space is beyond the efficient frontier.

6.6 PORTFOLIO CONSTRUCTION

The central issue in portfolio theory is the selection of assets to be included in
the portfolio. Out of the millions of investment avenues available, it is indeed
difficult to form a desired portfolio straightaway. A better approach to portfolio
selection would be to first categorize investments into different classes so as
to club the investment of similar kind in terms of broad parameters. One such
asset classification can be bonds, real assets, and stocks. Bonds would
comprise government securities like T-Bills, Treasury Bonds, and other
government securities offering nominal returns with minimal risk. Real assets
would perhaps consist of gold and commodities that offer mediocre returns
with mediocre risk. Stocks would comprise equity shares that bear greater
risk with commensurate returns. These are the most risky assets.
Indifference curve is also known as Iso-Utility curve: it means a set of
products that produce equal utility i.e. satisfaction that a consumer gets
from the provided service.

6.7 UNDERSTANDING DIVERSIFICATION

AND RISK
Diversification reduces danger by making an investment in categories that
span unique monetary units, industries, and different classes. Unsystematic
risk can be mitigated through diversification while systematic or market
chance is usually unavoidable.
Diversification helps in reducing risk. The general expression of portfolio
risk which is weighed average of covariance of the portfolio of n securities
and is reproduced below
n n
s p 2 = ∑∑ wi w j Cov(R i , R j )
=j 1=i 1

So, basically Diversification is a strategy by which the investors mange Risks.

It comprises spreading money across various modes like assets and
industries.
Thus, Risk Diversification is practiced by investors quite commonly and is
widely opted by investors globally.
100 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Since we know that all investments do carry some sort of risks, thus the
best way to mitigate those risks would be to spread them out as those risks
cannot be completely neglected. Thus, we can achieve Diversification of
risks in the following ways:
1. Balanced Stocks and Bonds
2. Inclusion of Bond and Cash Investments
3. Diversification in stocks
So, if we have to conclude the topic of Risk and Diversification through
an example.
The best to put it out would be: that instead of putting all your cookies in one
single box, divide it amongst 2–3 boxes rather than assembling all in one.
Thus, remember always to balance your portfolio in such a manner which
drastically reduces your risk for losses but also at the same time doesn’t
affect your potential profits.
The portfolio risk stands reduced to the following expression, the firm
specific risk of the securities consisting of the portfolio:
1 2 s
=s p2 = s or s p
n n

6.7.1 PORTFOLIO RISK AND RETURN

Example: Let’s assume that the returns(R) on two assets are B1 and B2.
Also let’s assume that the weights of the two assets are D1 and D2.
Note: sum of the weights of the assets in the portfolio’s should be 1. Thus,
the return on the portfolio will be the average weighted returns from the
two assets.

R = D1B1 + D2B2.

ACTIVITY 1 Note: The historical return of a financial asset – such as a stock, bond, index,
security, or fund – is its past rate of performance and return. Historical
data is commonly used in financial analysis to find out the future returns
or determine what variables may impact future returns and the extent
to which the variables may impact the returns. The historical returns
of a financial asset are usually recorded from the beginning of a year
(i.e., January 1st) to the end of the year (i.e., December 31st) to determine
the annual return of a particular year.

Example 1

CALCULATING HISTORICAL RETURNS

The data below provides the historical performance of a hypothetical index
named MYBY.
‰ December 31, 2012: 2,105
‰ December 31, 2013: 2,540
 PORTFOLIO THEORY 101

So, in order to start calculating the historical returns, the difference between
the most recent rate and the past rate needs to be calculated and then
divided by the past rate multiplied by 100 to get the result as a percentage.
The calculation can be made iteratively to cater for longer time periods –
e.g., 5 years & more.
Hence, the historical return for MYBY based on the data provided is
calculated as:

Historical Return(s) = [(2,540 – 2,105)/2,105] × 100 = 0.20665 × 100

Historical Return(s) = 20.7%

CALCULATING EXPECTED RETURN FOR A SECURITY

To describe the single most likely outcome from a particular probability
distribution, it is necessary to calculate its expected value. The expected
value of a probability distribution is the weighted average of all possible
outcomes, where each outcome is weighted by its respective probability
of occurrence. Since investors are interested in returns, we will call this
expected value the expected return(ex-ante return), and for any security,
it is calculated as
m
E( R) = ∑ Ripri (6.1)
i-1

where
E(R) = the expected return on a security
Ri = the ith possible return
pri = the probability of the ith return Ri
m = the number of possible returns

CALCULATING RISK FOR A SECURITY

Investors must be able to quantify and measure risk. To calculate the
total (stand-alone) risk associated with the expected return, the variance
or standard deviation is used. The variance and its square root, standard
deviation, are measures of the spread or dispersion in the probability distri-
bution; that is, they measure the dispersion of a random variable around
its mean. The larger this dispersion, the larger the variance or standard
deviation.
‰ The tighter the probability distribution of expected returns, the smaller
the standard deviation, and the smaller the risk.
Example 2
Based on your analysis, you think that next year’s return for General Foods
will range from 1 to 15 percent as described earlier. The expected value
of the probability distribution for General Foods returns is calculated in
the first three columns of Table. We call this expected value the expected
return.
102 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

CALCULATING THE STANDARD DEVIATION USING EXPECTED DATA

(1)
Possible (2) (3) (4) (5) (6)
Return (%) Probability (1) × (2) Ri − E(R) (Ri − E(R))2 (Ri − E(R))2pri
1 0.2 0.2 −7.0 49.0 9.8
7 0.2 1.4 −1.0 1.0 0.2
8 0.3 2.4 0.0 0.0 0.0
10 0.1 1.0 2.0 4.0 0.4
15 0.2 3.0 7.0 49.0 9.8
1.0 8.0 = E(R) 20.2
σ = (20.2)1/2 = 4.49%

To calculate the variance or standard deviation from the probability

distribution, first calculate the expected return of the distribution using
Equation 6.1. Now the way we calculate risk applies here, but now the proba-
bilities associated with the outcomes must be included, as in Equation 6.2:
m

∑[R - E(R)] pri

2
= s=
Variance of returns 2
i
(6.2)
i=1
and
Standard deviation of returns= s= (s 2 )1/ 2 (6.3)

where all terms are as defined previously.

Note that the standard deviation is simply a weighted average of the
deviations from the expected value. As such, it provides a measure of
how far the actual value may differ from the expected value, either above
or below. With a normal probability distribution, the actual return on a
security will be within ±1 standard deviation of the expected return
approximately 68 percent of the time, and within ±2 standard deviations
approximately 95 percent of the time.

INDIVIDUAL STOCK RISK & RETURN

We can understand that risk and returns vary when we invest in an individual
stock and while it is invested under the portfolio stocks.

¯k = ∑ni = 1Piki
¯k = P1k1 + P2k2 + … + Pnkn

Where: ¯k represents the expected return of the stock

Pi represents the probability of the ith possible outcome (state of
nature)
ki represents the return under the ith outcome (state of nature)
Pn represents the probability of the nth possible outcome (state of
nature)
kn represents the return under the nth outcome (state of nature)
Assume a stock has 3 possible outcomes for the next year under the different
scenarios. The first possibility is the economy enters a recession causing
 PORTFOLIO THEORY 103

the stock to have a return of –15%. The probability of this occurring is

20%. The second possibility is that the economy goes smoothly, but does
not experience rapid growth causing the stock to rise and offer a 10%
return. The probability of this occurring is 50%. The third possibility is
that the economy booms, causing the stock to provide a 35% rate of return.
The probability of the economy booming is 30%.
The Expected return on the above stock considering all the risks under
different scenarios can be calculated as follows;

¯k = (.20)(−15%) + (.50)(10%) + (.30)(35%)

¯k = −3% + 5% + 10.5%k¯ = −3% + 5% + 10.5%
¯k = 12.5%
It is clear that the above stock will have 12.5% positive returns.

PORTFOLIO RISK & RETURNS

Let us now understand how the risk and returns are changed when we
invest in portfolio stocks.
We can calculate this using the portfolio variance. The portfolio variance
represents the value of weighted combination of the individual variances of
each of the assets adjusted by their covariances. This means that the overall
portfolio variance is lower than a simple weighted average of the individual
variances of the stocks in the portfolio. The formula for portfolio variance in
a two-asset portfolio is as follows:
‰ Portfolio variance = w12σ12 + w22σ22 + 2w1w2Cov1,2
Where: w1 = the portfolio weight of the first asset
w2 = the portfolio weight of the second asset
σ1= the standard deviation of the first asset
σ2 = the standard deviation of the second asset
Cov1,2 = the covariance of the two assets, which can thus be expressed
as p(1,2)σ1σ2, where p(1,2) is the correlation coefficient between
the two assets
The portfolio variance is equivalent to the portfolio
For example, assume there is a portfolio that consists of two stocks. Stock A
is worth $50,000 and has a standard deviation of 20%. Stock B is worth
$100,000 and has a standard deviation of 10%. The correlation between
the two stocks is 0.85. Given this, the portfolio weight of Stock A is 33.3%
and 66.7% for Stock B. Plugging in this information into the formula, the
variance is calculated to be:
‰ Variance = (33.3%^2 × 20%^2) + (66.7%^2 × 10%^2)
+ (2 × 33.3% × 20% × 66.7% × 10% × 0.85)
= 1.64%
Variance is not a particularly easy statistic to interpret on its own, so most
analysts calculate the standard deviation, which is simply the square root
of variance. In this example, the square root of 1.64% is 12.81%.
104 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

SELF-ASSESSMENT 8. Indifference curve is also known as Iso-Utility curve.

QUESTIONS
a. true
b. false
9. Unsystematic risk can be mitigated through diversification while
systematic or market chance is usually unavoidable.
a. true
b. false
10. Mickey invested 70,000 INR in asset 1 which produced 20% returns
and 30,000 INR in asset 2 which produced 12% returns. The weights
of the two assets are 60% and 40%. So, what will be the portfolio
return?
a. 0.60% × 20% + 0.40% × 12% = 16.8%
b. 0.40% × 20% + 0.40% × 12% = 16.8%
c. 0.60% × 20% – 0.40% × 12% = 16.8%
d. 0.60% × 20% + 0.40% × 20% = 16.8%

6.8 SUMMARY
‰ A portfolio is a combination of two or more than two assets, the study
of which is important because in real life people hold multiple assets
knowingly or unknowingly.
‰ People hold different assets because they serve diverse purposes and
meet needs of investors. Portfolios are more stable than individual
assets.
‰ The interesting aspect of portfolio is that assets forming the portfolio
behave differently in terms of risk and return just in the same manner as
individuals behave differently when part of a group than alone.
‰ While portfolio return is weighted average of the returns of the individual
assets consisting it, the risk is not because of the offsetting effect one
security has on another.
‰ Portfolio risk depends upon how the returns of one security co-vary
with other assets in the portfolio called covariance. While covariance
measures the deviations of returns of one asset with another in
absolute terms, coefficient of correlation gives the relationship of two
assets in relative terms. Study of coefficient of correlation is the crux
of portfolio theory.
‰ Coefficient of correlation is between ±1.00 with value of −1.00
signifying perfect negative correlation and complete offsetting while
a value of +1.00 implies perfect positive correlation and identical
effect on returns. With coefficient of correlation of +1.00, the risk of
the portfolio would also be weighted average of individual risks just
as portfolio returns are.
 PORTFOLIO THEORY 105

‰ With coefficient of correlation at −1.00, it is possible to reduce portfolio

risk to zero by combining the two by investing wealth inversely propor-
tional to standard deviation of the two.
‰ All portfolios lying on the locus are feasible portfolios while those not on
it are not feasible.
‰ Efficient portfolios satisfy the condition of (a) maximum returns for given
risk or (b) minimum risk for given return. Investors, being rationale,
necessarily choose efficient portfolios. Locus of efficient portfolios
is called efficient frontier. It is necessary for all investors to choose
portfolios that lie on efficient frontier.
‰ Investors neither maximize return nor minimize risk but instead opt
for a trade-off between risk and return that provides maximum utility.
There are many combinations of assets with different returns and risks
capable of giving same utility to the investor represented by iso-utility
curves.
‰ Investors are risk-averse implying that increasing returns increases
utility but increasing risk decreases utility.

Efficient Portfolio – A portfolio with the highest level of expected return KEY WORDS
for a given level of risk or the lowest risk for a given level of expected
return.
Asset Allocation Decision – The allocation of a portfolio’s funds to classes
of assets, such as real estate, cash equivalents, bonds, and equities.
Expected Return – The ex ante return expected by investors over some
future holding period.
Portfolio Weights – Percentages of portfolio funds invested in each
security.
Correlation Coefficient – A statistical measure of the extent to which two
variables are associated.

6.9 DESCRIPTIVE QUESTIONS

1. Any portfolio comprising two perfectly negative correlations would
always yield portfolio risk lesser than lower of the standard deviation of
the two assets. Do you agree?
2. Efficient frontier would always start from portfolio of least risk.
Comment.
3. To what extent diversification can reduce risk?
4. What does the below statement “don’t put all your eggs in one basket”
means in terms of Diversification and Risk?
106 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

6.10 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS
Topic Q. No. Answers
Introduction 1 c. Both a) and b)
Portfolio Return 2 b. calculating the percentage of the asset’s
value to the total portfolio value.
Two-Asset Portfolio 3 c. is a relative measure showing
association between security returns,
whereas the covariance is an absolute
measure showing association between
security returns.
4 b. Adding more stocks decreases risk, but
does not eliminate it
5 b. the weighted average of the individual
security’s risk
6 a. positive
7 a. curved line
Portfolio Construction 8 a. True
Understanding 9 a. True
Diversification and Risk
Portfolio Risk and Return 10 a. 0.60% × 20% + 0.40% × 12% = 16.8%

6.11 SUGGESTED READINGS AND

E-REFERENCES
‰ Srivastava, Rajiv (2017), Investment Management, Wiley
‰ Elton J Edwin, Brown J Stephen (2013), Modern Portfolio Theory and
Investment Analysis, Wiley
‰ Brooke, P., and Penrice, D. (2009) A Vision for Venture Capital –
Realizing the Promise of Global Venture Capital and Private Equity
(New Ventures)
‰ Capital Dynamics (2010) The Definitive Guide to Risk Management in
Private Equity (PEI Media)
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A. (2008) Private
Equity: History, Governance and Operations (John Wiley & Sons)
 CASE STUDIES
4–5 AND 6

CONTENTS

Case Study 4–5 Return and Risk

Case Study 6 Portfolio Theory
108 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

CASE STUDY CHAPTER – 4–5

CLOSING CASE

Jia is an entrepreneur of B&B Cosmetics. She asked her financial advisor

to share the progress report of her firm including audit data and profits/
loss if any. After a week, the advisor was ready.
So, in the meeting, Jia was shocked to know that the firm’s holding period
return was in negatives compared to last year which was 0%.
Further, after the meeting was over, her advisor came up with possible
recommendation to improve the situation. He had a detailed discussion
with Jia about estimated Returns and Volatility in the next financial
year. He was able to provide data supporting the probability of achieving
specific returns.

QUESTION

1. What does it mean that the Holding period return is in negatives?

2. What does the statement holding period 0% mean also what
could be the possible reasons for the same?
 CASE STUDY 109

CASE STUDY CHAPTER – 6

CASE STUDY

CLOSING CASE

DYG Limited is an investment company located in Bangalore. Recently,

they had a huge client for investment. The employees worked hard
and finally all this resulted in getting huge profits for their clientele.
They incorporated various techniques in order to get the desired results
and achieving profits at the end. They discussed about what will be
estimated returns along with volatility. Then they discussed about diver-
sification of their Portfolio with respect to the risks involved. Questions
like what the outcomes on the minimum returns will be were put up
and discussed well internally. Thus, the investors were pretty impressed
with DYG.

QUESTION

1. What according to you did DYG used as a Portfolio approach for

their clientele?: Reducing risk/minimizing risk or eliminating
the risk.
 C H A
7 P T E R

ASSET PRICING MODELS: CAPITAL

ASSET PRICING MODEL

CONTENTS

7.1 Introduction
7.2 Systematic and Unsystematic Risk
Self-Assessment Questions
7.3 Asset Pricing and Risk
7.4 Assumptions of Capital Asset Pricing Model
Self-Assessment Questions
7.5 Separation Theorem
7.6 Pricing a Financial Asset – Capital Asset Pricing Model (CAPM)
7.7 Interpretation of CAPM
7.7.1 Benchmark Values
Self-Assessment Questions
7.8 Measuring Beta
Self-Assessment Question
7.9 Portfolio Theory and CAPM
7.9.1 Portfolio Design
7.9.2 Portfolio Revision
7.10 Capital Market Line (CML) and Security Market Line (SML)
7.10.1 Portfolio Beta
Self-Assessment Questions
7.11 Limitations of CAPM
7.11.1 Single Factor Model
7.11.2 Single Period Model
7.11.3 Homogeneous Expectations
7.11.4 Identical Lending and Borrowing Rates
7.11.5 Ignores Transaction Cost Constancy of Beta
7.11.6 Incomplete and Expanding Universe of Assets
7.11.7 Benchmark Errors
112 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

7.12 Sharpe’s Single Index model (The Total Risk Concept)

Self-Assessment Question
7.13 Summary
Key Words
7.14 Descriptive Questions
7.15 Answer Keys
Self-Assessment Questions
7.16 Suggested Readings and e-References
 ASSET PRICING MODELS: CAPITAL ASSET PRICING MODEL 113

INTRODUCTORY CASELET

Rahul is a 26-year-old employee working at BCY Constructions.

He wants to start saving by investing money. So, after an extensive
research and consulting few of his friends who are from the commerce
background, he finally made his mind to start investing. Therefore,
he makes investment decisions based on Risk and Return. If we go
by the CAPM model i.e. Capital Asset Pricing Model (it’s a model that
establishes the formal relationship between risk and return), he will
have two areas to consider while investing; one would be regarding
the use of beta (As per definition it is measured in terms of returns
in relation with the chosen market index) and other would be using
both beta and variance of return (proportion of chance/risk in putting/
investing into a solitary asset or portfolio).

QUESTION

1. Considering yourself as a Financial Analyst; guide Rahul as to

what will be best option for him.
Should he use only Beta or Both i.e., Beta and Variance of Return?
114 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

LEARNING OBJECTIVES

The objective of this chapter is to

+ Explain how risk of an asset becomes different when it is part of
the portfolio.
+ Describe the bifurcation of risk into systematic and unsystematic
risk.
+ Explain the assumptions of Capital Asset Pricing Model (CAPM)
and its derivation.
+ Differentiate between Capital Market Line and Security Market
Line.
+ Explain CAPM and its implications on portfolio management.
+ Find out relationship of total, systematic, and unsystematic risk.
+ Understand limitations of CAPM.

7.1 INTRODUCTION
Holding a portfolio instead of an individual security is beneficial as
portfolios enable risk reduction. If investors behave rationally, as suggested
by Markowitz, and capital markets are efficient then the returns offered by
individual assets must follow some rule that must fully and truly reflect
the investors’ choice and state of the capital markets. Besides, the pricing
of the assets must be commensurate with the risk it entails. If portfolios
enable risk reduction, does it have any impact on the pricing of assets is
the question. Since risk has bearing on pricing of assets, would pricing of
assets differ under two circumstances − when considered alone or when
considered as part of a portfolio? To examine this issue, we need to further
elaborate on the risk.

7.2 SYSTEMATIC AND UNSYSTEMATIC RISK

Risk of an individual asset is measured by standard deviation. But when we
include the asset as part of a portfolio, the variance (standard deviation) of
the asset becomes rather insignificant part of portfolio risk. The covariance
rather than the variance dominates the portfolio risk. This can be illustrated
with a simple analogy. In a group test comprising subjects English and
Mathematics, it is better to construct a team of two individuals – one with
expertise in English and the other in Mathematics, rather than choosing two
participants with both having expertise in either English or Mathematics.
In a group, the members have to complement each other compensating
for the shortcomings of each other. Portfolio too is a group of securities
that complement each other so as to render stability to the performance
of the portfolio, as well as outperform the individual security. The analysis
has important implication for portfolio construction. While constructing
a portfolio the emphasis should be placed on the behavior of returns of a
security with respect to the returns of other securities in the portfolio rather
 ASSET PRICING MODELS: CAPITAL ASSET PRICING MODEL 115

Total Risk
Variability of returns
due to all factors

Systematic Risk Unsystematic Risk

Variability of returns Variability of returns due
due to broad, uncontrollable to firm-specific factors
factors

Figure 7.1 Classification of Risk.

than on the variance or standard deviation of its own returns, σ. The mathe-
matical model of Harry Markowitz quantifies the amount of risk reduction.
Investment in a single security carries the return and risk associated with
particular firm. With addition of another security, the chances are that when
the first firm does poorly, the second firm may perform better, and while
second does not do well, the first may come out with better than expected
performance. As we keep adding securities to the portfolio, the chances of
achieving compensating effect improve and returns become more and more
stable. Therefore, diversification helps eliminate the firm specific risks.
To understand whether the compensating effect is partial or full, we need
to understand the sources of risk in greater detail. The variability of returns
can arise from two sources, as discussed below and depicted in Figure 7.1:
1. Factors specific to a firm: Factors specific to a firm such as level of
earnings, nature of business, the prospects, quality of management,
quality of products, technology adopted, riskiness of the cash flows,
capital expenditure plans, growth prospects, etc. affect the returns a
security provides. These factors are unique to the firm and the change
in expected returns due to these factors is referred as unique risk or
unsystematic risk.
2. Factors common to all firms (market): Factors common to all firms
(market) such as economic growth, industry growth, government
expenditures, levels of taxes, political environment, weather conditions,
international issues, budget deficit, balance of payment, threats of war,
internal strife, sentiments of the market, etc. also affect returns. Since
these factors are market wide, the risk emanating from these factors is
referred as market risk or systematic risk.
While firm-specific factors that cause returns to vary are not same for all firms,
we can perhaps eliminate the negative impact on returns of one security by ! IMPORTANT CONCEPT
positive impact on returns of another security. As we add more securities The direction of change in the
to the portfolio the compensating effect would be better. Therefore, unique returns of securities due to
risk is also referred as diversifiable risk. However, the same cannot be said market wide factors is more
about the market-specific factors. The direction of change in the returns of likely to be same rather than
securities due to market wide factors is more likely to be same rather than opposite.
opposite. By adding more and more securities the market wide risk cannot
be eliminated no matter how large the portfolio becomes. Market risk
 116 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Portfolio
risk,  p

Total risk

Unique
risk

Market
risk

Number of securities, n
Figure 7.2 Diversification and Portfolio Risk.

therefore is also called non-diversifiable risk. Another name for market

risk is systematic risk. As we add securities to the portfolio, the unique risk
starts diminishing. However, the reduction in risk is by smaller and smaller
amount as we progress, as shown in Figure 7.2.

SELF-ASSESSMENT 1. ____________ model provides important clue to selection of securities

QUESTIONS for the portfolio.
a. marco
b. markowitz
c. goldratch
d. none of the above
2. Which factors are common to all firms (market)?
a. economic growth, industry growth
b. government expenditures
c. levels of taxes, political environment
d. all of the above

7.3 ASSET PRICING AND RISK

! IMPORTANT CONCEPT
Returns and risks are two inseparable aspects of an investment and are
inter-dependent. They need to be studied together. With the bifurcation of
Returns and risks are two risk as systematic and unsystematic, a natural question arises as to which of
inseparable aspects of an the two or the aggregate of the two would determine returns. In an efficient
investment and are inter- market should an investor get rewarded for carrying unsystematic risk when
dependent. it is easily diversifiable? The overwhelming opinion is that it should not.
The risk about which investor cannot do anything should only get rewarded
in an efficient capital market. Given the same framework as that of portfolio
theory, we now examine the capital market theory dealing with the aspect
of how the individual assets would be priced in the capital markets. Capital
asset pricing model (CAPM) is one such model that establishes the formal
 ASSET PRICING MODELS: CAPITAL ASSET PRICING MODEL 117

relationship between risk and return. Most of the research in capital market
is directed towards better understanding of the risk and returns of financial ! IMPORTANT CONCEPT
assets. CAPM seeks a relationship between risk and return that must exist CAPM dominates the
in the capital markets. modern financial literature
the most because of its wide
CAPM dominates the modern financial literature the most because of its array of applications. The
wide array of applications. The understanding of CAPM helps investors understanding of CAPM
identify assets to invest based on two parameters of return and risk. helps investors identify
assets to invest based on two
parameters of return and risk.
7.4 ASSUMPTIONS OF CAPITAL ASSET
PRICING MODEL
For pricing of financial assets, we need to make certain assumptions. It is
considered appropriate to list them at one place for easier comprehension of
the idea presented by the CAPM as follows:
1. CAPM assumes that the only two parameters of the asset, the expected
return and the risk form, the basis of investment decisions.
2. All investors have homogeneous expectations implying no ambiguity
about the measurement of expected return and expected risk.
3. All investors are rational in their decision-making. Though each
investor may exhibit a different appetite for risk but all of them are
risk-averse, seeking lower risk for same return and higher return for
same risk. They could differ only in their initial wealth.
4. All investors have identical holding periods implying identical
time horizon and what happens after the holding period becomes
redundant.
5. The conditions of perfect capital markets prevail such as (a) Free and
instantaneous flow of information implying no information asymmetry.
(b) No transaction cost implying that change of portfolio comes free of
cost. (c) No investor is large enough to influence the price.
6. There exist no taxes or uniform taxes implying no difference in the
form of return.
7. The investor can lend and borrow as much as is required at the same
and risk-free rate.

3. Which of the following is a correct Assumption of Capital Asset SELF-ASSESSMENT

Pricing Model? QUESTIONS
a. CAPM assumes that the only two parameters of the asset, the
expected return and the risk form, the basis of investment
decisions.
b. all investors have heterogeneous expectations implying no
ambiguity about the measurement of expected return and
expected risk.
c. both a) and b)
d. only (a)
118 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

4. State the correct answers.

The conditions of perfect capital markets prevail such as:
a. free and instantaneous flow of information implying no
information asymmetry.
b. no transaction cost implying that change of portfolio comes free
of cost.
c. no investor is large enough to influence the price.
d. all of the above

7.5 SEPARATION THEOREM

Investment choices are made with two interrelated decisions:
1. Which of the securities to invest in, called investment decision.
2. How much to invest in each selected securities, called financing
decision.
The first decision, that is the investment decision, is already made for all
investors. It implies that all investors must hold the two assets, F and M.
The next decision, that is, the financing decision, would vary from investor
to investor. How much to lend or borrow is governed by the desired return
or the risk appetite of the investor. By the above analysis it is clear that
investment decision and financing decision can be taken independent of
each other. This is referred to as separation theorem.

7.6 PRICING A FINANCIAL ASSET – CAPITAL

ASSET PRICING MODEL (CAPM)
The Capital Resource Estimating Model (CAPM) depicts the connection
between the general risks of effective money management, and anticipated
return for resources, especially stocks.
CAPM was developed as a method for estimating the systemic risk. It is
broadly involved all through finance for estimating risky securities and
producing anticipated returns for resources, given the risks of those
resources and cost of capital.
The CAPM comprises of three components, namely, Risk Free Rate, Risk
Premium and Beta. The risk-free rate is equivalent to the time value of
money. It is a value assigned to zero-risk returns expected in the future by
an investor. Beta represents a stock’s volatility. The risk added to a portfolio
due to an investment is that potential investment’s beta. Thirdly, whatever
return is expected from a risky portfolio above the risk-free rate is the market
risk premium.
Take an investor who is considering a $200 valued share of a stock.
Compared with the market, its beta is of 1.5, making it riskier. Take the
risk-free rate as 5% and the investor expects a 10% rise in value in market
per year.
 ASSET PRICING MODELS: CAPITAL ASSET PRICING MODEL 119

CAPM is used to calculate expected returns on the security/assets.

The CAPM formula is:
Tp is expected Return on security
Trf is Risk free rate
Bp is Beta of the security
Tm is Expected return of the market
Note: Risk Premium = (Tm – Trf)
Tp = Trf + [Bp × (Tm – Trf)]
Input of values will give us the expected return, which is 12.5%:
5% + 1.5 × (10% – 5%) = 12.5%
Knowing whether a stock is fairly valued is an important part of
investment. The CAPM is a tool for evaluating if the time value and risk
involved in the stock are justified or fair when you compare them with
the stock’s expected returns.

7.7 INTERPRETATION OF CAPM

CAPM model or Capital Asset Pricing Model is a unique model which is used
in the financial sector to calculate the expected returns for a security. Also,
this can be compared with the addition of beta and risk-free returns.
In order to fully understand this CAPM model, it’s essential to know the
unsystematic and systematic risk.
Systematic Risks are basically the dangers which are general in nature like
occurring of inflation, recession, or wars.
Unsystematic risks are unique risks of the firm. Eg- Management Issue,
Union Strike.
Thus, CAPM focuses on the systematic risks in securities and help in
prediction of investments failure.
Capital Asset Pricing Model (CAPM) can be interpreted as follows:
‰ Risk Free Rate of Return
The risk-free rate of return is the interest rate which an investor can expect
to receive on its investment without any risk or we can say at zero risk.
In other words, this is the rate which is fixed for a particular instrument and
investor is certain to receive it. Practically, risk free rate is represented by
the interest paid on government Treasury Bill which is supposed to be the
safest investment.
(Risk free rate of return) RF = (1+ government bond rate)/
(1 + inflation rate) – 1
This relates to long-tern bonds of the government which are inflation-
adjusted. The time period is of importance in its calculation. If it is up to
120 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

1 year, Treasury Bills become government security that can be compared.

Between 1-10 years means the use of Treasure Note.
‰ Market Risk Premium
We can say that the “difference between expected return on an investment
in the market minus the risk-free rate” represents the “market risk
premium”. The Market Risk Premium is the component that an investor
expects as the additional return over and above the risk-free rate of interest.
This is like a premium to invest in investing in a riskier asset class so as to
compensate for the risk, an investor is willing to take.
‰ The beta, measures the stock price’s sensitivity with respect to the
change in market price. It can be useful for measuring systemic risks
involved in an investment. This financial metric has two ways of
discovery. The variance-covariance method, and the standard deviation
and correlation method, both give us the beta.
The variance-covariance method:
Beta = Market and Security covariance/Variance of the Security
The standard deviation and correlation method:
Beta = (Market & Securities Returns correlation) × (Standard deviation of
return of securities/Standard deviation of the benchmark returns)

7.7.1 BENCHMARK VALUES

For estimating returns of any security, we need three inputs – risk-free rate of
return, market returns, and relative measure of risk (beta). Beta is security
specific. All in all,
‰ A stock, asset, or portfolio with a beta above 1 historically has boosted
the market as a whole (positive or negative). If the stock or asset has a
beta of 2, for instance, it will move twice as much for every 1% change in
the return of the market portfolio.
‰ Stocks, assets, or portfolios with a beta of 0 are indifferent to systematic
risk. This stock’s return will match the risk-free rate of return in this
situation.
‰ A negative beta means that shocks to the market return caused by
systematic risk will cause the stock return to move in the opposite way.

SELF-ASSESSMENT
5. Which of the followoing statements are correct:
QUESTIONS
a. CAPM model is used to determine the expected returns for
a security.
b. CAPM establishes a linear relationship between price of an
assets and its risk – with price being directly proportional
to risk.
c. CAPM suggests that all investors would hold two assets – the
risk-free asset and market portfolio.
d. all of the above
 ASSET PRICING MODELS: CAPITAL ASSET PRICING MODEL 121

6. Which of the following statements are correct?

a. the yield on T-Bills (ST Govt. Security) is assumed as risk-free
b. the yields on the T-Bills would add the risk-free rate
c. market returns are taken as benchmark for RM.
d. all of the above

7.8 MEASURING BETA

Third and most crucial input of CAPM for determining the expected
return is the beta of the security. Beta as per definition is measured
in terms of returns in relation with the chosen market index. If the
relationship of the security with the market indicates greater sensitivity
the β value would be greater than one. If it is less sensitive than market,
its beta would be less than one. For securities that exhibit same risk and
returns move in exact tandem with those of the market, the beta would
be 1.00. Beta is defined as follows:
Covariance of stock returns with market returns Cov(S, M )
Beta of Stock =
Variance of market returns s M2
Numerical : Consider a scenario in which a portfolio manager wishes
to estimate the beta for ABC Inc. and incorporate it in its portfolio.
He chooses to compare it to the S&P 500, which serves as its benchmark.
According to data from the previous year, the correlation between
ABC Inc. and S&P is 0.032, and the variance of S&P is 0.015. Calculate
the beta.

7. Beta of Stock = SELF-ASSESSMENT

a. covariance of stock returns with market returns/variance of QUESTION
market returns
b. covariance of stock returns with market returns + variance of
market returns
c. covariance of stock returns with market returns – variance of
market returns
d. none of the above

7.9 PORTFOLIO THEORY AND CAPM ! IMPORTANT CONCEPT

CAPM has several notable and important implications for portfolio selection, For designing of portfolio,
management, and performance measurement. we need to choose some
securities out of many. As per
CAPM, the selection of the
7.9.1 PORTFOLIO DESIGN securities must be based on
For designing of portfolio, we need to choose some securities out of many. amount of risk as measured
As per CAPM, the selection of the securities must be based on amount of from beta and not standard
deviation. Unsystematic risk is
risk as measured from beta and not standard deviation. Unsystematic risk
diversifiable .
is diversifiable. It is assumed that while designing a portfolio, the unsys-
tematic risk would be eliminated either by choice or inadvertently. Investors
122 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

must only be concerned with the risk that cannot be diversified away.
The second important implication of CAPM is that passive investment
is efficient as all choose market portfolio and risk-free asset. Only the
proportions of investment vary from individual to individual. CAPM
suggests that passive management of portfolio is low-risk and low-cost
alternative to active portfolio management. CAPM talks about the expected
returns and not the risk.

7.9.2 PORTFOLIO REVISION

For remaining alive to environmental changes, one needs to rebalance
the portfolio periodically under active portfolio management strategies.
For portfolio balancing, CAPM suggests a strategy of adjusting beta according
to the market sentiments. In rising markets, the portfolio manager can
shift the portfolio in favor of high beta stocks, while in falling markets, the
orientation may change to having low beta stocks. By doing so the portfolio
is expected to outperform the market by registering a larger-than-market
return in bullish conditions and incurring a lesser loss than the market in
bearish conditions.

7.10 CAPITAL MARKET LINE (CML) AND

SECURITY MARKET LINE (SML)
Capital Market Line established a relationship between the risk-free asset
and market portfolio and dictated the allocation of funds for investment in
two assets. It gave a relationship of the returns and the risk measured by
standard deviation of the portfolios as was shown in Figure 7.3.
Security Market Line (SML) is the relationship of expected return and
beta of the security. Here the measure of risk changes from standard
deviation to beta. The market portfolio by definition has beta of one, while

Feasible CALs
Return, %
Capital market line

X
D
Y

B Z
M
RM
C
Efficient
A frontier

M Standard deviation, %
Figure 7.3 Capital Market Line.
 ASSET PRICING MODELS: CAPITAL ASSET PRICING MODEL 123

Returns Underpriced security

Market portfolio
RM SML

RF Overpriced
security

1.00 Beta
Figure 7.4 Security Market Line (SML).

the risk-free asset has beta of zero. SML is depicted in Figure 7.4 and helps
identification of securities in terms of their pricing. The relationship of
the expected returns of the security and its risk is measured by beta. If the
market values, the securities as per CAPM they all would lie exactly on the
SML as per CAPM. Also, if market follows CAPM the returns of any security
could be predicted if its beta is known. In reality, prices of securities may,
however, differ from the theoretical CAPM. The portfolio manager may
seek to identify securities that are currently underpriced or overpriced.
If not on SML, the market would correct the pricing so that assets are
priced as per CAPM. Overpriced securities which would lie below the SML
are sold and underpriced securities that lie above the SML are bought.
These are also shown in Figure 7.4.
The difference of CML and SML is significant even though Figure 7.3
for CML and Figure 7.5 for SML look alike. CML is actually a locus of

6.00
y = 1.3287x + 0.0855
R2 = 0.4318
4.00
Regression line

2.00
Maruti returns, %

–3.00 –2.00 –1.00 0.00 1.00 2.00 3.00

–2.00

–4.00

–6.00

–8.00
Nifty returns, %

Figure 7.5 Finding Beta of Stock.

124 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

portfolios that is composed of risky portfolio M and risk-free asset. Along

the CML the proportion in the risky and risk-free assets would differ.
The measure of risk in CML is standard deviation. SML, on the other
hand, represents relationship between expected return to beta. SML
substitutes the total risk σ with the systematic risk β on the horizontal
axis. Here, the measure of risk is beta assuming the security forms the
part of a diversified portfolio.

7.10.1 PORTFOLIO BETA

If many securities are combined to form a portfolio with fi as proportion of
the investment in security fi, the portfolio’s return and risk are also given
by CAPM. In terms of regression equation described earlier, portfolio
returns can be represented as
n n
Rp = ∑ fi × Ri =
1
∑f
1
i × (α i + β i Rm + ei )

n n n
Rp = Ri = ∑f
1
i × α i + RM ∑ fi × β i + ∑ fi ei
1 1

A closer look and its comparison with CAPM would reveal that beta of the
portfolio is the weighted average of the betas of securities consisting the
portfolio, that is
n
βP
Beta of the portfolio,= ∑f
1
i × βi

CAPM and SML apply equally well to portfolio. In fact, it should apply
better because portfolio returns would be more governed than those of
individual security.
For example, consider risk-free rate of 6% and market risk premium of 12%.
Then the returns of two securities A and B with beta coefficients of 1.5 and
0.8, respectively, will be
Security A: Ra = 6% + 1.5 × 12% = 24.0%
Security B: Rb = 6% + 0.8 × 12% = 15.6%
If we form a portfolio C consisting equally of A and B, the expected return
of C would be
Rc = 0.50 × Ra + 0.50 × Rb = 0.50 × 24.0% + 0.50 × 15.6% = 19.8%
The beta of the portfolio C would be weighted average of betas of A and B.
The beta of portfolio C is
βc = 0.5 × βa + 0.5 × βb = 0.5 × 1.5 + 0.5 × 0.8 = 1.15
We confirm the CAPM return of portfolio C with beta of 1.15. As per CAPM
Rc = RF + βc × (RM - RF ) = 6 + 1.15 × 12 = 19.8%
Example: James has to decide to invest in either Stock ML or Stock DC
using the CAPM model. James has to decide to invest in Stock ML or Stock
DC with the given information available to him. ML – Return 9.6%, Beta
0.95. DC – Return 8.7%, Beta 1.2. As measured by the return on government
stock, a risk-free return in the market is 5.6%.
 ASSET PRICING MODELS: CAPITAL ASSET PRICING MODEL 125

The expected rate of return of the stock ML will be calculated below.

Expected return = Risk free return (5.60%) + Beta (95.00)
× Market risk premium (9.60% – 5.60%)
Expected Rate of Return = 9.40%
The expected rate of return of the stock DC will be calculated as below.
Expected return = Risk free return (5.6%) + Beta (1.2)
× Market risk premium (8.7% – 5.6%)
Expected Rate of Return = 9.32%
Thus, the investor should invest in Stock ML.

8. Security Market Line (SML) is the relationship of expected return SELF-ASSESSMENT

and __________. Here the measure of risk changes from standard QUESTIONS
deviation to beta.
a. beta of the security
b. beta of the stock
c. co-variance
d. none of the above
9. Capital Market Line established a relationship between the risk-free
asset and market portfolio and dictated the allocation of funds for
investment in __________.
a. one asset
b. two assets
c. three assets
d. four assets

7.11 LIMITATIONS OF CAPM

The limitations of CAPM lie in the assumptions made by the model. However,
despite the limitations CAPM remains a very robust model. It helps us
understand the pricing of assets in the real world. CAPM is not the only way
to forecast consensus expected returns but it is arguably the best.

7.11.1 SINGLE FACTOR MODEL

Consider a scenario where a factor model only includes one component,
which represents a distinct aspect of the systematic risk influencing the
return on an asset. The model will thereafter be referred to as a single-
factor model.
Using this model, the required return on an asset: Ri = α + βiF + εi
The expected return therefore: E(Ri) = α + βiF
Here, the variables α, βi and F stand for the constant independent return,
sensitivity of the returns to a change in the factor, and market premium,
respectively.
 126 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

CAPM constrains the risk to just one factor, which is the covariance with the
market portfolio. This makes it a single index model. The CAPM solely takes
into account of only systemic or market risk, not the inherent or systemic
risk of the investment. This factor removes the ambiguity around the risk of
a specific securities, leaving only the more certain overall market risk as the
main variable. The model assumes that the investor has a diversified portfolio,
thus between the stock holdings, there is no longer any unsystematic risk.

7.11.2 SINGLE PERIOD MODEL

CAPM applies as single period model where returns and risks are
! IMPORTANT CONCEPT considered for one investment horizon which is assumed identical for
CAPM applies as single period all investors. It may not be so. While one investor plans investment for
model where returns and one year, another may take a long-term view of 5 years. If the planning
risks are considered for one periods for different investors were different, the CMLs and SMLs faced
investment horizon which by each investor would be somewhat different.
is assumed identical for
all investors. 7.11.3 HOMOGENEOUS EXPECTATIONS
In Harry Markowitz’s Modern Portfolio Theory (MPT), the idea that all investors
have the same expectations and make the same decisions in a particular
situation is known as “homogeneous expectations.” If investors are presented
with many investment plans with various returns at a specific risk, they will,
in accordance with homogenous expectations, select the plan with the highest
return. In contrast, if investors are presented plans with various risks and the
same potential profits, they will pick the plan with the lowest risk.

7.11.4 IDENTICAL LENDING AND BORROWING RATES

Another assumption that is objected is regarding the unlimited lending and
borrowing at the same risk-free rate. The assumption is unrealistic because
in the real world borrowing is done at a higher rate than the lending rate.
Further the amount of borrowing and interest rates are often linked – as
borrowing amount increases rates also increase. It does not change the
outcome of the CAPM materially. The variation can easily be incorporated
in the CAPM in as much as the borrowing segment of the CML would have
a different slope than the lending giving two CMLs. The existence of two
different rates makes the definition of market portfolio somewhat vague as
all investors do not hold the same market portfolio.

7.11.5 IGNORES TRANSACTION COST CONSTANCY OF BETA

Like any other theoretical model, market distortions are assumed to be absent
in CAPM. However, such distortions do not invalidate the broad outcome of
any theory. CAPM too holds despite presence of transaction costs. The idea
of pricing of asset remains intact except the fact that portfolio changes by
way of buying and selling of assets would not take place till the benefits of
such change outweigh the cost of changes.

CONSTANCY OF BETA
Beta is central to the idea of CAPM and it is derived parameter rather
than an observable statistic. Though the most common way of finding
 ASSET PRICING MODELS: CAPITAL ASSET PRICING MODEL 127

beta is to conduct a regression analysis of past return data with that of

the market, it can be challenged for its future validity. Betas of the firms
are subject to change though it has been observed that they change very
slowly. Therefore, till they change substantially the asset pricing as per
CAPM must hold.

7.11.6 INCOMPLETE AND EXPANDING UNIVERSE OF ASSETS

Most investment gurus challenge the assumption that unsystematic risk
of the firm is immaterial. As per CAPM, the market would not reward
unsystematic risk if an investor chooses assets with high unsystematic
risk. Universe of stock changes over time. Some stocks vanish, some are
added, and yet some merge. Whenever the universe of stock changes, which
unfortunately happens all the time, the unsystematic risk would be high for
the incoming/outgoing assets. In any case, for new assets the measure of
systematic risk would not be available. The assumption that market portfolio
contains only the stocks of going concerns limits the usage of CAPM and
SML to only going concerns. Further, to many analysts and researchers
the universe of asset should include all assets – financial and real, tradable
as well as non-tradable. CAPM confines itself to universe of tradable stocks
alone. The tradable assets of stocks and bonds do not embody all the assets
in the universe in which investors invest their wealth.

7.11.7 BENCHMARK ERRORS

In pricing of the asset we have substituted the risk-free rate and market
return with the yields on T-Bills and return on the index respectively.
Therefore, returns of the security were benchmarked against these assets.
In case the benchmark itself is faulty the pricing of the asset too would
be error-prone. Do the benchmarking problems invalidate the CAPM?
Benchmarking only highlights the measurement problem but really does
not invalidate the CAPM as normative model. It only emphasizes the need
for using a wider and more diversified index while testing the model,
assessing the sensitivity and systematic risk, and evaluating the portfolio
performance.

7.12 SHARPE’S SINGLE INDEX MODEL

(THE TOTAL RISK CONCEPT)
As we understand that the Modern Portfolio Theory developed by Harry
Markowitz in 1950 is a mean variance criterion for selecting optimum
portfolios for an investor. The application of this model requires large
number of input data for calculations. For instance, if there are n securities
in a portfolio, the Markowitz Model requires n expected returns, n variance
terms, and n(n–1)/2 covariance terms. Then we need to reduce the inputs
necessary for Markowitz Portfolio Optimization for making the theory
operational. Markowitz suggested that an index to which securities are
related may be used for generating covariance terms.
To improve upon and also to simplify the Markowitz model and reducing
the covariance estimates, William Sharpe developed a simple and elegant
128 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

model called as Single Index Model or Market Model. Before going through
the Sharpe’s Single Index Model, it is important to understand the concept
of Systematic and Unsystematic Risk. The portfolio theory perceives the
investment risk from a different perspective where total risk could be
divided as under;
Total Risk = Market Risk + Unique Risk, or (TR = MR + UR)
Total Risk = Systematic Risk + Unsystematic Risk OR
Statistically Total risk is;

σ2/p = β2/P σ2/M + σ2/eP

It can be further explained as under;

Market Risk or Systematic Risk
As we know that systematic risk comprises the proportion of total risk that
occurs on account of external factors. The systematic risk arises due to
fluctuations in the market and therefore it is called as market risk. This kid
of risk is unpredictable, and it is inbuilt in the system that cannot avoided.
The systematic risk that exists in the total risk cannot be eliminated even
through the diversification of the portfolio. Therefore, this risk is observed
in well-diversified portfolio. The risk factors comprise of systematic risk
include, equity risk, interest rate risk, currency risk and commodity risk.
Any investment is subject to one or all risk components. In the above
model, the systematic risk component of the total risk (variance) that
occurs due to external environment factors and represented by (β2/P σ2/M).
It is measured through beta (β) and continues to exist despite the diversi-
fication of the portfolio and σ is the excess of return after adjustment of
market volatility.
Unsystematic Risk
On the other, the unsystematic risk arises on account of internal operational
and administrative deficiencies of an organization. This kind of risks are
firm specific and therefore they are also known as unique risk. This risk
primarily affects the specific business entity and not all the firms in general
and therefore they could be controlled and diversified. The examples of such
risks could be administrative and operational inefficiencies in the organi-
zation, competitors, regulatory norms impacting the business, misman-
agement etc. In a well-diversified portfolio, the unsystematic risk in majority
of stocks tends to cancel each other resulting in minimum non market risk.
In the above model, the non-systematic component of the total portfolio
risk (variance) that is attributable to firm specific factors is represented
through (σ2/eP). Further, with an increased diversification in portfolio, the
total portfolio risk (variance) approaches the systematic risk which is the
square of portfolio sensitivity coefficient (β2/P) multiplied by market portfolio
variance (σ2/M).
Single Index Model & CAPM
The alpha of a portfolio is the average of the alphas of the individual
securities. For a large portfolio the average will be zero, since some stocks
 ASSET PRICING MODELS: CAPITAL ASSET PRICING MODEL 129

will have positive alpha whereas others will have negative alpha. Hence, the
alpha for a market index will be zero.
Likewise, the average of firm-specific risk (aka residual risk) diminishes
toward zero as the number of securities in the portfolio is increased. This, of
course, is the result of diversification, which can reduce firm-specific risk,
but not market risk, to zero.
Hence, the alpha component and the residual risk tends toward zero as the
number of securities are increased, which reduces the single-index model
equation to the market return multiplied by the risky portfolio’s beta, which
is what the Capital Asset Pricing Model predicts.
Sharpe Model and Markowitz Model
William Sharpe tried to simplify the Markowitz method of diversification
of portfolios. Sharpe’s Index Model simplifies the process of Markowitz
model by reducing the data in a substantive manner. He assumed that the
securities not only have individual relationship, but they are related to each
other through some indexes represented by business activity.
Sharpe has improved the method of Markowitz but in addition he has also
put in some additional inputs. He made estimates of the expected return
and variance of indexes which may be one or more and are related to
economic activity. Sharpe’s index showed that the return of each security
is correlated by some securities markets in the U.S.A. It is generally the
Dow Jones Industrial Average or the Standard and Poor’s 500 stock index.
In India, it is Dalal Street Index which may be applied. Sharpe’s index
takes into consideration 3N + 2 kinds of information which is different
to the Markowitz assumption of N(N + 3)/2. According to Markowitz,
a portfolio of 100 securities would require the following bits of information:
100 (100 + 3)/2 = 5150, and Markowitz covariance shows that 100 securities
would require (N2 – N)/2 = (1002 – 100)/2 = 9900/2 or 4950 covariance.
Sharpe first made a single index model.
This was compared to multiple index models for conducting reliability
test in finding out the full variance efficient frontier of Markowitz. Many
researchers have taken into consideration the Sharpe Index Models.
They have preferred the stock price index to the economic indexes in finding
out the full covariance frontier of Markowitz for stake of simplicity.
Example
Find return on the stock when:
(a) Expected Index I = 30%
(b) Alpha (α) = 9.00
(c) Beta (β) = 0.05
Expected Return on Security:
Ri = 9.00 – 0.05 (30%)
= 9.00 – .015
= 8.985
130 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

SELF-ASSESSMENT 10. Which of the following statements are wrong?

QUESTION
a. William Sharpe tried to simplify the Markowitz method of diver-
sification of portfolios.
b. Sharpe’s Index Model simplifies the process of Markowitz
model by reducing the data in a substantive manner.
c. both a) and b)
d. none of the above

7.13 SUMMARY
‰ Comprehension of risk can be far simpler if we group the factors that
impact security’s returns. One such grouping is systematic factors and
unsystematic factors.
‰ The risk of an asset changes its nature when the asset becomes part of
the portfolio than when it is held individually as single asset, just as in
the same manner individual behavior is different when alone and when
as a member of a group.
‰ The changed behavior of risk in a portfolio as compared to a stand-alone
investment is because unsystematic risk of a stock is diversifiable while
systematic risk is not.
‰ A portfolio of about 15−20 assets is considered a well-diversified
portfolio as most reduction in risk is achieved by doing so. There
need not be any conscious effort to identify stocks for the purpose of
risk reduction.
‰ CAPM establishes a linear relationship between price of an assets and
its risk – with price being directly proportional to risk where risk is
measured by beta and not standard deviation.
‰ CAPM suggests that all investors would hold two assets – the risk-free
asset and market portfolio. Different investors would allocate different
proportions in these two assets according to their risk−return profile.
Market portfolio is defined as a portfolio of all assets with investment in
each asset proportional to its market capitalization.
‰ According to CAPM all investors hold some proportion of market
portfolio and some of risk-free asset. Market portfolio is essentially mean
variance efficient.
‰ Contribution of risk of an individual asset to the aggregate risk of the
portfolio is proportional to (a) fraction of money invested and (b) its
covariance with all the other assets in the portfolio.
‰ Mispricing of an asset would be corrected by equating the incremental
risk premium and incremental return of different securities. Incremental
risk premium of an asset would be equal to the product of risk as
measured by beta and market risk premium.
 ASSET PRICING MODELS: CAPITAL ASSET PRICING MODEL 131

‰ There are several ways of determining beta but regression of security’s

return with market return is the most popular and acceptable. Slope of
the regression line is the value of beta.
‰ According to CAPM, passive portfolio management strategy is efficient
and portfolio balancing if needed can be done on the basis of betas of
security.
‰ Beta of a portfolio of assets is weighted average of betas of assets
consisting it.
‰ CAPM is criticized for its simplistic formulation of consolidating all risks
in a single parameter called beta. But for the same reason of its simplicity,
it is extremely popular and acceptable.

Capital Market Line (CML) – It is the relationship of returns of security KEY WORDS
with its risk measured by standard deviation while Security Market Line
(SML) is the relationship of returns with risk measured by beta. SML
helps in identifying mispriced and correctly priced assets.
Beta – It measures systematic risk of the asset with respect to market and
is the sensitivity of its returns.
Standard deviation – It measures the total risk of an asset without
attributing the source of risk. According to CAPM, only systematic risk is
relevant for price determination.
Capital Asset Pricing Model (CAPM) – It is the most popular, acceptable,
and robust model that attempts pricing of asset based on the risk it carries
and concentrates of only systematic risk.
Slope of CML – It is the price of risk in an efficient market and for efficient
portfolios.
Systematic factors – These are those sources of risk that impact several
securities and unsystematic factors are stock specific that cause deviations
in the returns of single security.

7.14 DESCRIPTIVE QUESTIONS

1. According to CAPM the relevant risk is systematic risk. Do you agree
with the statement?
2. Differentiate between capital market line and security market line.
3. How would you measure beta in variance-covariance method?
4. What are the assumptions made by capital asset pricing model and
their implication if they are not actually true?
5. How would you identify the securities for selection to achieve adequate
diversification?
132 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

7.15 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS
Topics Q. No. Answers
Systematic and Unsystematic Risk 1 b. Markowitz
2 d. All of the above
Assumptions of Capital Asset 3 d. Only a)
Pricing Model
4 d. All of the above
Interpretation of CAPM 5 d. all of the above
6 d. All of the above
Measuring Beta 7 a. Covariance of stock returns
with market returns /
variance of market returns
Capital Market Line (CML) and 8 a. Beta of the security
Security Market Line (SML)
9 b. Two assets
Sharpe’s Index Model of 10 d. None of the above
Optimization

7.16 SUGGESTED READINGS AND

E-REFERENCES
‰ Srivastava, Rajiv (2017), Investment Management, Wiley

‰ Elton J Edwin, Brown J Stephen (2013), Modern Portfolio Theory and

Investment Analysis, Wiley
‰ Brooke, P., and Penrice, D. (2009) A Vision for Venture Capital –
Realizing the Promise of Global Venture Capital and Private Equity
(New Ventures)
‰ Capital Dynamics (2010) The Definitive Guide to Risk Management in
Private Equity (PEI Media)
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A. (2008) Private
Equity: History, Governance and Operations (John Wiley & Sons)
 C H
8
A P T E R

ASSET PRICING MODELS – ARBITRAGE

PRICING THEORY

CONTENTS

8.1 Introduction
Self-Assessment Questions
8.2 How APT Works
Self-Assessment Question
8.3 Process of Arbitrage
8.4 Diversification Under APT
Self-Assessment Questions
8.5 Assumptions of CAPM and APT
Self-Assessment Questions
8.6 Limitations of APT
Self-Assessment Questions
8.7 Summary
Key Words
8.8 Descriptive Questions
8.9 Answer Keys
Self-Assessment Questions
8.10 Suggested Readings and e-References
134 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

INTRODUCTORY CASELET

James is a prudent investor who does his due diligence before investing,
and analyses all aspects of a stock purchase or sale. Apart from keeping
up with the developments in the stock market, checking stock recom-
mendations and subscribing to newsletters, James understands that
there can always be risk when investing in the stock market. Knowing
whether an asset is overpriced or undervalued is a crucial piece
of information. This is where he utilizes a pricing model for assets.
This model works using the relationship between risk and the returns
an asset is expected to have. It is the Arbitrage Pricing Theory (APT)
that allows James to know the expected returns of assets which he can
the compare and know if they are priced fairly or not. Based on this, he
can take advantage of any pricing incongruency. He once came across
a stock which was trading at $80. Using the arbitrage pricing theory, he
concluded that its fair price was $90. He saw the profitable opportunity
and purchased the stock and waited for the price correction which
would eventually happen. He used the same pricing theory for a
stock which was trading at an overvalued $50. Since its fair price was
concluded to be $35, he borrowed the stock, sold it and returned it
later when it was less expensive. This way he profited from shorting,
all because of an efficient pricing model which considers many factors
of macro-economic risk.

QUESTIONS

1. The Arbitrage Pricing Theory uses the relationship between

which two elements?
2. How did James utilize the APT to profit from an undervalued
asset?
 ASSET PRICING MODELS – ARBITRAGE PRICING THEORY 135

LEARNING OBJECTIVES

The objective of this chapter is to:

+ Describe an alternate model of price based on Arbitrage Pricing
Theory (APT).
+ Explain how process of arbitrage works.
+ Compare advantages, disadvantages, and limitations of CAPM
and APT.

8.1 INTRODUCTION
One of the serious criticisms of CAPM was that it consolidated all risks
in a single parameter called beta, a relative measurement with respect
to market portfolio. Various studies have shown that risk adjusted (beta
adjusted) returns of various portfolios vary implying perhaps that single
factor model is not adequate to capture all risks. The various tests have
emphasized the need to consider some additional variables in the risk.
This led further to search for finding some alternative asset pricing models
to include some more parameters for inclusion in risk. While consolidating
all the environmental risks in a single measure, that is market, and capturing
the sensitivity of returns in the beta we assumed that all securities respond to
changes in the macro-economic environment in similar fashion. Relatively
low values of R-squared indicated that all risk is not captured in single
index. This emphasized the need to have multi-factor model to explain
behavior of the price of the security. A better assessment of asset pricing
can be there if multiple macro-economic factors are incorporated in the
model. Arbitrage Pricing Theory (APT) recognizes that returns of the
security respond differently to different economic factors and having
varying sensitivities to such economic factors.
Further, the response of different individual securities is different for the
same economic factor. It neither assumes normal distribution of returns nor
does it use quadratic utility function. It only assumes efficient markets and
investors’ preference for more wealth. It assumes that the correlation between
securities results when the securities respond to the same economic factor or
factors in varying degrees. APT assumes that returns of each security depend
upon its sensitivities to the unanticipated changes in various economic
factors. APT makes the expected return a function of multiple systematic
factors rather than single factor captured by market as a whole represented
by index. The general APT model as formulated by Roll and Ross is given.
Like CAPM the APT also states that each stock’s return depends linearly on
macroeconomic factors and partly on noise (events unique to the firm):
APT Expected Returns for a security, R
= 0 +  1 1 +  2 2 +  3 3 +  4  4 + Noise (e )
Where (beta 1) β1 and (beta 2) β 2 are the sensitivities of the returns with respect
to factor 1, 2, …. These can be taken as beta factors in the CAPM parlance.
λ 1, λ2, etc. are the risk premiums of the factor 1, 2, …, and λ0 is the expected
 136 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

return with zero systematic risk, that is the risk-free rate of return. The noise
is the unsystematic risk not related to any of the chosen factors. ‘e’ referred
as noise is the return attributable to the firm-specific factors. Factors that are
relevant for the particular security in determining the expected returns can be
different for different securities. For example, Tata Steel may have important
linkage with spending on infrastructure and may be sensitive for spending on
infrastructure, while a software firm like Infosys may be influenced more by
technological advancement and adoption. APT neither states which factors
to include in the analysis nor specifies the number of such factors that are
relevant. The selection is left at the discretion of the analyst.

SELF-ASSESSMENT 1. Which of the following statements are correct?

QUESTIONS
a. APT recognizes that returns of the security respond differently
to different economic factors and having varying sensitivities to
such economic factors.
b. APT assumes that returns of each security depend upon its
sensitivities to the unanticipated changes in various economic
factors.
c. APT makes the expected return a function of multiple systematic
factors rather than single factor captured by market as a whole
represented by index.
d. both a), b) and c)
2. The general APT model was formulated by __________.
a. Rolls and Royce
b. Roll and Ross
c. Roll and Davidson
d. Roll and Deming

8.2 HOW APT WORKS

! IMPORTANT CONCEPT The process of pricing of asset under APT is to find an equilibrium
relationship among all factors that influence returns based on arbitrage
The process of pricing of
process using law of one price. If there is any in-equilibrium the arbitrages
asset under APT is to find
an equilibrium relationship process sets in to buy the undervalued and sell the overvalued so as to restore
among all factors that the equilibrium of returns. Though Arbitrage Pricing Model is a multi-factor
influence returns based on model we illustrate the process of price discovery and adjustment assuming
arbitrage process using law that single factor APT. Single factor APT is taken for the sake of simplicity
of one price. and convenience, and to draw distinction with CAPM in the process of estab-
lishing equilibrium price/returns. Assume that returns of the security with
single factor APT are governed by the following equation:
APT Returns R = 0 +  1 1
where λ 0 is the return on the asset with no systematic risk, λ 1 is the risk
premium associated with risk factor 1 (say unanticipated changes in
the GDP growth rate), and (beta 1) β1 represents the responsiveness of the
financial asset to the risk factor 1. The basic premise of APT is that if
two portfolios are constructed and have dependence only on one factor,
 ASSET PRICING MODELS – ARBITRAGE PRICING THEORY 137

then the process of arbitrage will derive the price of the portfolios to
converge with respect to that factor. Assuming the values of λ 0 and λ 1 as
2% and 10%, respectively, APT implies that with 1% change in estimate
of GDP growth rate will cause returns to change by 10% (same as beta is
sensitivity with respect to market risk premium). With no unanticipated
change in the GDP growth, the returns on the security would be 2%.

3. In the formulae: SELF-ASSESSMENT

QUESTION
APT Returns R = 0 +  1 1

What does Beta represent?

a. return on the asset
b. the risk premium associated with risk factor 1
c. responsiveness of the financial asset to the risk factor 1
d. none of the above

8.3 PROCESS OF ARBITRAGE

We may define arbitrage as a process in which no investment is made, and
no risk is assumed and yet one makes profit. It is the risk-less profit without
! IMPORTANT CONCEPT
making an investment which implies that return on investment is infinite. Arbitrage as a process in
which no investment is
Former Wharton School of Business professor and economist Stephen made, and no risk is assumed
Ross created the APT for the first time in 1976. In place of the Capital and yet one makes profit. It
Asset Pricing Model, he created the idea. is the risk-less profit without
making an investment
According to APT, an investor can leverage deviations in returns from the
which implies that return on
linear pattern through arbitrage strategy. Arbitrage is a process where
investment is infinite.
simultaneous purchase and sale of stocks take place thereby an investor can
have advantage of slight pricing discrepancies to lock in a risk-free profit
for the trade. However, an arbitrage is not a risk-free operation under the
APT though it offers greater probability of success. The APT mode is helpful
in determining the theoretical fair market value of an asset. This helps the
trader to have deviations from the fair market price, and take a position
accordingly. The following are the features of APT.
Arbitrage Pricing Theory (APT) is used to assess and anticipate the returns
of assets and portfolios.
‰ APT is a model that shows the relationship between an asset’s expected
risk and the return.
‰ The APT model shows how the changes in macroeconomic factors
affect an asset’s returns. These variables are inflation, interest rates,
exchange rates, etc.
‰ APT is an alternative model to the Capital Asset Pricing Model (CAPM).
Although, both the theories represent the relationship between risk
and expected risk, the arbitrage pricing theory is harder to gauge and
implement.
138 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

‰ Arbitrage is the process of buying an asset at a lower price and then

selling it at a higher price. In theory, arbitrage offers the investors a high
chance of success.
This can be explained through an example. Let us suppose that the fair
market value of stock A is $13 per share according to APT model, but assume
if the market price of the stock drops to $11, this will help the investor to
decide to buy the stock under the perception that the price of the stock
will be back to $13 once market picks up.
The Arbitrage Pricing Theory can be expressed as a mathematical model:

E(x) = Rf + β1 × RP1 + β2 × RP2 + … + βn × RPn

Where: ER(x) – Expected return on asset

Rf – Riskless rate of return
βn (Beta) – The asset’s price sensitivity to factor
RPn – The risk premium associated with factor
Example
Let us assume that asset as a commodity stock called GOLD 123. The stock
has two risk factors associated with it – inflation and the price of the
U.S Dollar currency.
Rf (risk free rate) = 2%
Inflation – Risk premium = 2%, Beta = 0.2
U.S Dollar – Risk Premium = 10%, Beta = 0.5
Expected Return will be;

E(x) = Rf + β1 × (factor 1) + β2 × (factor 2) + … + βn × (factor n)

E(x) = 0.02 + 0.2 × (0.02) + 0.5 × (0.10)
= 0.02 + 0.004 + 0.05
= 0.074, or 7.4%

In this arbitrage pricing theory example, the expected return of GOLD 123
is equivalent to 7.4%.
Elements of Risk
In practice. The investors are exposed to critical risk factors that will affect
asset’s sensitivity or exposure to risk components. The following are the
examples of such risk elements.
‰ Changes in inflation
‰ Gross Domestic Product (GDP)
‰ Changes in interest rates
‰ Yield curve changes
‰ Market sentiments
‰ Exchange rates
 ASSET PRICING MODELS – ARBITRAGE PRICING THEORY 139

8.4 DIVERSIFICATION UNDER APT

Sensitivity analysis: With the APT, we can model the outcomes of various
monetary scenarios on the investment portfolio. As soon as element betas
are estimated, we are able to describe the expected alternate in security
returns with respect to changes in that issue. How will my portfolio carry
out in a recession? Am I exposed to shifts within the yield curve? These are
the standard questions addressed by using APT evaluation.
Constructing portfolios: The APT is a useful tool for building portfolios
tailored to specific wishes. As an instance, suppose a first-rate oil agency
desired to create a pension fund portfolio that was insulated in opposition
to shock to oil charges. The APT allows the manager to pick out a diverse
portfolio of shares that has low publicity to inflation shocks (oil charges
are correlated to inflation). If the CAPM is a “one length fits all” model of
investing, the APT is a “tailored made.” With the APT world, humans can
and do have distinctive tastes and care extra or much less about particular
elements.
Locating factors: How will we follow the APT? One problem with the
model it’s far generality. We’ve left the easy world of the CAPM. We no
longer know exactly what assets of systematic danger people surely care
about. However, reading the monetary section of the newspaper we are
able to get idea. The wall street journal for example, often reviews on
surprises in hobby rates, surprises in GNP (Gross National Product),
surprises in inflation and changes within the stock marketplace indices.
All of those are applicants for APT elements. Indeed, we won’t really
need to pick out the economic system’s hazard elements. We only want
to find a series of things that collectively are right proxies for them. After
the theoretical development of the APT, Chen, Roll and Ross set out on a
quest for the elements. They located that a set of 4 or 5 macro-financial
series’ that defined security returns pretty properly. Those factors turned
out to be surprises in inflation, surprises in GNP, surprises in investor
confidence (measured with the aid of the company bond top rate) and
shifts in the yield curve. Because the apt remains utilized in practice, other
variables are probable to be used. Once factors are selected, most effective
the unanticipated part of the factor is used for estimating the apt model.
As with the CAPM, we typically regress ancient security returns at the
factor to estimate ß’s. These ß’s are used in a model of expected returns to
estimate the discount rate.
Application of APT
The following is the process of applying the APT.
Finding Factors: For the use of APT, it is important to understand the
systematic risk which includes changes in the interest rates, changes in
GNP, changes in inflation and changes in the stock market indices. All these
are the important factors for APT as it works on these factors. As an investor
one needs to find a collection of things that together are good proxies for
them. These factors turned out to be surprises in inflation, Surprises in GNP,
surprises in investor confidence (measured by the corporate bond premium)
and shifts in the yield curve. As the APT continues to be used in practice,
 140 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

other variables are likely to be used. Once factors are chosen, only the
unanticipated portion of the factor is used for estimating the APT model.
Building portfolios: The APT is a useful tool for building portfolios adapted
to particular needs. For example, suppose a major oil company wanted to
create a pension fund portfolio that was insulated against shock to oil prices.
The APT allows the manager to select a diversified portfolio of stocks that
has low exposure to inflation shocks (oil prices are correlated to inflation).
If the CAPM is a “one size fits all” model of investing, the APT is a “tailor-
made suit.” In the APT world, people can and do have different tastes and
care more or less about specific factors.
Sensitivity analysis: With the APT we can model the effects of different
economic scenarios on the investment portfolio. Once factor betas are
estimated, we can describe the expected change in security returns with
respect to changes in that factor. How will my portfolio perform in a
recession? Am I exposed to shifts in the yield curve? These are typical
questions addressed by APT analysis.

SELF-ASSESSMENT 4. What is GNP?

QUESTIONS
a. gross domestic product
b. gross national product
c. gross net product
d. none of the above
5. Former Wharton School of Business’s professor and economist ______
created the APT time in _______.
a. Stephen Ross, 1976
b. Stephen King, 1976
c. Geoffrey Ross, 1976
d. none of the above
6. The APT allows the manager to pick out a diverse portfolio of shares
that has low publicity to inflation shocks (oil charges are correlated
to inflation).
a. true
b. false

8.5 ASSUMPTIONS OF CAPM AND APT

As compared to CAPM, the APT makes fewer assumptions. CAPM makes
few assumptions that are not required by APT. These are as follows:
1. CAPM stipulates market portfolio as a prerequisite and is an asset
! IMPORTANT CONCEPT that is mean variance efficient. On the contrary, APT does not require
CAPM stipulates market construction of market portfolio to determine pricing of the assets.
portfolio as a prerequisite Instead, it requires identification of factors that impacts the price and
and is an asset that is mean measure sensitivities of returns (the beta factors) in respect of each
variance efficient. identified factor. The condition of mean variance efficiency is irrelevant
for APT.
 ASSET PRICING MODELS – ARBITRAGE PRICING THEORY 141

2. APT is a multifactor model and CAPM is a single-factor model.

3. APT assumes efficient markets and investors’ preference for more
wealth. It assumes that the correlation between securities results
when the securities respond to the same economic factor or factors in
varying degrees.
4. APT assumes that returns of each security depend upon its sensitivities
to the unanticipated changes in various economic factors.
5. Also dispensed are the assumptions related to lending and borrowing at
a risk-free rate. No investment is made and no risk is assumed and yet
one makes profit. It is the risk-less profit without making an investment
which implies that return on investment is infinite.
6. Since APT is based on identifying arbitrage opportunities it is not
necessary for markets to be efficient.
Few large investors are enough to correct the pricing of assets through
arbitrage. Under CAPM one critical assumption was that markets are efficient.
The assumptions that are common to both APT and CAPM are as follows:
1. Investors prefer more wealth to less wealth.
2. Investors are risk-averse
3. All investors have homogeneous expectations.
4. Conditions of perfect capital market exists.
The additional assumption made by APT is that the short selling is allowed
that permits setting up of arbitrage opportunity.
Suppose the following information about a stock is known: It trades on the
NYSE and its operations are based in the United States. Its yield on a U.S.
10-year treasury is 2.5%. The average excess historical annual return for
U.S. stocks is 7.5%, The beta of the stock is 1.25
The expected return of the security using the CAPM formula?

Expected return = Risk Free Rate + [Beta × Market Return Premium]

Expected return = 2.5% + [1.25 × 7.5%]
Expected return = 11.9%
In an arbitrage pricing theory example, let’s take our asset as a commodity
stock called ABC 123. The stock has two risk factors associated with it –
inflation and the price of the U.S Dollar currency.

Rf (risk free rate) = 2%

Inflation – Risk premium = 2%, Beta = 0.2
U.S Dollar – Risk Premium =10%, Beta = 0.5

E(x) = Rf + β1 × (factor 1) + β2 × (factor 2) + … + βn × (factor n)

E(x) = 0.02 + 0.2 × (0.02) + 0.5 × (0.10)
= 0.02 + 0.004 + 0.05
= 0.074, or 7.4%
Therefore, the expected return of ABC 123 is equivalent to 7.4%.
 142 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

SELF-ASSESSMENT 7. APT is _________ and CAPM is _________ model.

QUESTIONS
a. multifactor model, single-factor
b. single-factor, multifactor model
c. multifactor model, multifactor model
d. single-factor, single-factor
8. The assumptions that are common to both APT and CAPM are:
a. investors prefer more wealth to less wealth.
b. investors are not risk-averse
c. all investors have heterogeneous expectations.
d. both a) and b)

8.6 LIMITATIONS OF APT

The construction of APT model is open-ended as it leaves the selection
! IMPORTANT CONCEPT of price determinant factors and sensitivities of returns purely at the
The construction of APT discretion of investor. The sensitivities of returns, the beta factors
model is open-ended as it (in CAPM parlance), are difficult to determine due to inadequacy of data
leaves the selection of price with respect to each economic variable. The idea of APT seems appealing
determinant factors and but the implementation is subjective and open for challenges by different
sensitivities of returns purely investors. This leads to controversies and conflicts among theorists that do
at the discretion of investor. not let the model become popular. However, it is acceptable because it is the
divergence of ideas that makes markets efficient rather than convergence
of ideas. CAPM assumes consolidation of all macro factors into a single
factor, that is, return on market portfolio and does not leave price-deter-
mining factors at the discretion of investors. This makes application and
measurement easy.
The validity of CAPM rests on its assumptions, some of which are challenged.
At the same time these assumptions have been relaxed to examine the adapt-
ability of the CAPM.
The ability of CAPM to cope with assumptions has been good and therefore
! IMPORTANT CONCEPT it helps develop a consensus estimate of return among analysts. APT due
The ability of CAPM to cope of open-ended questions of which factors and how many factors to
with assumptions has been consider leaves interpretations of returns seem subjective. The efforts for
good and therefore it helps reconciliation among the analysts are likely to be futile due to divergence
develop a consensus estimate of factors to be included in the model and measurement of the sensitivity
of return among analysts. of returns to the each of the factor. One of the by-products of CAPM is
a procedure for determining consensus expected return. Consensus
expected returns are valuable because they give us a benchmark for
comparison. Flexibility of APT may be seen as advantage or disad-
vantage depending upon the orientation of investors. It can neither be
said to be inferior or superior to CAPM. At best it must be regarded as an
alternative to CAPM in pricing of assets.
 ASSET PRICING MODELS – ARBITRAGE PRICING THEORY 143

9. Which statements are correct? SELF-ASSESSMENT

QUESTIONS
a. CAPM assumes consolidation of all macro factors into a single
factor, that is, return on market portfolio and does not leave
price-determining factors at the discretion of investors.
b. CAPM is a method for determining expected return
c. the validity of CAPM rests on its assumptions, some of which are
challenged.
d. all of the above
10. Which of the following is not an assumption under the APT?
a. the return-generating process can have more than one common
factor.
b. short sales are allowed, and the proceeds are available to the
short sellers.
c. security returns are generated by a linear factor model.
d. investors are risk averse.

8.7 SUMMARY
‰ Arbitrage pricing theory (APT) is another way of pricing assets. Returns
of an asset are determined by several economic variables with varying
sensitivities of each variable.
‰ APT is based on arbitrage process of taking investment-free and risk-free
positions in case of mispricing of assets and then earn profit assuming
mispricing corrects over time.
‰ APT makes fewer assumptions than CAPM and is dependent upon
process of arbitrage rather than assumption of efficient markets.

Arbitrage Pricing Theory (APT) – It is another way of pricing assets. KEY WORDS
Returns of an asset are determined by several economic variables with
varying sensitivities of each variable.
Arbitrage – It is a process in which no investment is made, and no risk is
assumed and yet one makes profit. It is the risk-less profit without making
an investment which implies that return on investment is infinite.
CAPM – Its consolidated risks in a single parameter called beta, a relative
measurement with respect to market portfolio.

8.8 DESCRIPTIVE QUESTIONS

1. Describe arbitrage pricing theory with its assumptions.
2. What are the similarities and dissimilarities of CAPM and Arbitrage
Pricing Theory?
144 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

3. What is the criticism behind risk being confined to a single parameter

called beta?
4. The claim made by CAPM that all investors necessarily hold risk-free
assets and market portfolio is wrong because there are millions of
investors who invest all their money either in stocks or all their money
in bank deposits alone. Comment.

8.9 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS
Topics Q. No. Answers
Introduction 1 d. both a), b) and c)
2 b. Roll and Ross
How APT Works 3 c. Responsiveness of the financial
asset to the risk factor 1
Diversification Under APT 4 b. Gross National Product
Process of Arbitrage 5 a. Stephen Ross, 1976
Diversification Under APT 6 a. True
Assumptions of CAPM and APT 7 a. Multifactor model, single-factor
8 a. Investors prefer more wealth to
less wealth
Limitations of APT 9 d. All of the above
10 d. investors are risk averse.

8.10 SUGGESTED READINGS AND

E-REFERENCES
‰ Srivastava, Rajiv (2017), Investment Management, Wiley
‰ Elton J Edwin, Brown J Stephen (2013), Modern Portfolio Theory and
Investment Analysis, Wiley
‰ Brooke, P., and Penrice, D. (2009) A Vision for Venture Capital –
Realizing the Promise of Global Venture Capital and Private Equity
(New Ventures)
‰ Capital Dynamics (2010) The Definitive Guide to Risk Management in
Private Equity (PEI Media)
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A. (2008) Private
Equity: History, Governance and Operations (John Wiley & Sons)
 C H A
9 P T E R

MUTUAL FUND INVESTMENTS

CONTENTS

9.1 Introduction
9.2 Concept of Mutual Fund
9.3 Structure of Mutual Fund
9.4 Regulation of Mutual Fund
Self-Assessment Questions
9.5 Returns and Taxation
9.5.1 Calculating Net Asset Value
9.5.2 Investment Options
Self-Assessment Questions
9.6 Types of Mutual Funds
9.6.1 Classification by Investment
Self-Assessment Questions
9.7 Exchange-Traded Funds
9.8 Index Fund
9.9 Tracking Error
9.9.1 Calculating Tracking Error
9.9.2 Reasons for Tracking Error
9.9.3 Managing Tracking Error
Self-Assessment Question
9.10 Advantages of Investing in Mutual Funds
9.10.1 Small Yet Diversified Investment
9.10.2 Professional Management
9.10.3 Cost Effectiveness
9.10.4 Entry, Exit, and Liquidity
9.10.5 Protection, Transparency, and Safety
Self-Assessment Question
9.11 Limitations of Investing in Mutual Funds
9.11.1 Over-diversification
9.11.2 Entry and Exit Load
9.11.3 Dilution
146 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

9.11.4 Idle Cash Reserves

9.11.5 Inability to Enter and Exit during the Day for Open-Ended Funds
Self-Assessment Questions
9.12 Performance Evaluation of Mutual Funds
9.13 Summary
Key Words
9.14 Descriptive Questions
9.15 Answer Keys
Self-Assessment Questions
9.16 Suggested Readings and e-References
 MUTUAL FUND INVESTMENTS 147

INTRODUCTORY CASELET

Brett is a young employee working at DIY Solutions. He lives with his

family of four which includes his dad, mother, him and his brother.
His dad is retired, and mother is a housewife. His younger brother,
Will is still studying. The only source of income for the family is Brett.
On Sunday, the family was having a discussion where Brett was seen
talking about the rising expenses and his plan to start saving. He was
searching on internet about Mutual Funds and thus decided to consult
his friend, David who is a financial advisor. David has a thorough
knowledge of the market and the risks associated with Mutual Fund.
So, he meets Brett at a café and then they both have a long discussion
about the investment idea.
He lets Brett know that one of the strongest investing instruments for
diversification is mutual funds. Mutual fund investments are followed up
by additional investments in the asset class specified by the programme.
As a result of portfolio diversification, risks are greatly decreased.

QUESTION

1. You must advise Brett about investing in Mutual Funds

which could be a beneficial idea from David’s point of view by
explaining in detail.
148 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

LEARNING OBJECTIVES

The chapter is aimed at

+ Explaining what a mutual fund and the relevant concept of collective
investment is, its advantages and limitations.
+ Describing the roles and responsibilities of different participants in
a mutual fund.
+ Describing the legal environment governing the mutual funds in
India, especially taxation.
+ Differentiating between different kinds of mutual fund schemes
along investment objectives and structures.
+ Differentiating between mutual fund and exchange-traded fund.
+ Distinguishing features of an index fund, its advantages.
+ Explaining what is tracking error and ways of reducing it.
+ Measuring performance of mutual funds.

9.1 INTRODUCTION
Mutual funds are becoming a way of life because of their unique
advantages to large number of investors, particularly small investors
whose money finds a way in diversified investment. One of the reasons
that mutual fund investing has become popular is the simplicity with
which the investment can be made. Earlier, small savings were either
put in bank deposits or in stocks. Bank deposits, though considered safe
form of investment, suffers from the disadvantage of low returns barely
compensating the investor of the inflation. There was no enrichment
of investors in real terms. Instead, if small savings were invested in the
stocks, it offered scope of obtaining handsome return, but the risk was
perhaps too large for the limited risk appetite of the small investors.
Of course, the risk could be reduced through adequate diversification,
but that would require rather large investment which is beyond the
scope of small investor.

9.2 CONCEPT OF MUTUAL FUND

The concept of mutual fund is about (a) pooling of savings from investors
who have common investment objective in the form of a trust, (b) appointing
a professional manager for identifying and investing the pooled resources
in market securities, (c) with the objective of making investment grow and
finally, (d) sharing the gains among the investors in the proportion of savings,
as depicted in Figure 9.1.
The savings by each investor are converted in equivalent number of units
thus specifying the entire pool of money into units. The returns obtained by
an investor is proportional number of units an investor holds. Mutual fund
investment is also referred as collective investment. Here investors are not
managers taking investment decision, and those who decide investment
and design portfolios are not investors.
 MUTUAL FUND INVESTMENTS 149

Investors Pool in their

Pressed to
Back money

How Mutual
Returns Funds Work?

Generate Invest in
securities
Security

Figure 9.1 Concept of Mutual Fund.

9.3 STRUCTURE OF MUTUAL FUND

The pool of money of investors is managed by a third party and not by the
investors themselves just as a company is run by professional employees
who normally are not the owners. Vast majority of owners, that is, retail
shareholders, do not manage the firms. However, promoters who hold the
controlling stakes do manage the firms. The management of investment
places onus of performance, transparency, legal adherence, etc., on the
mutual fund body as a whole. This body of mutual fund consists of following
players with diverse responsibilities:
Sponsor: Just as there is/are promoter(s) of firm, there are sponsors to a
mutual fund. The sponsor is required to start the pool with their own capital
and fulfil all legal obligations as prescribed in the law. The basic legal
framework for management of mutual fund is given by SEBI (Mutual Fund)
Regulations 1996 as amended from time to time.
Trust and Trustees: The interest of the investors of mutual fund, called
unitholders, is safeguarded by the trust. The trustees of the mutual fund hold
its property for the benefit of the unitholders. The trust deed executed by
sponsor must be registered under Indian Registration Act 1908. The trust
must have independent board of trustees. To reduce the influence of
sponsor, majority of the trustees must be independent and not associated
with sponsors in any manner. The trustees are responsible for – inter alia –
ensuring that the AMC (see below) has all its systems in place, all key
personnel, auditors, registrars, etc., have been appointed prior to the launch
of any scheme. It is also the responsibility of the trustees to ensure that the
AMC does not act contrary to the interest of the unitholders.
Asset Management Company (AMC): The investment and portfolio decision
of the fund is taken by AMC, who is the investment manager. It is a separate
company appointed by trustees to manage the investment of the fund.
150 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

AMC must be staffed by knowledgeable persons conversant with financial

markets. The staff includes a Chief Investment Officer supported by portfolio
managers. AMC charges fee, subject to a ceiling prescribed by SEBI for its
professional services.
Custodian: Custodian of the mutual fund holds the securities of the funds in
his custody, keeping record of dividend earned from the securities held.
Registrar and Transfer Agent: Registrar and Transfer Agent handle the
requests of investors for buying and selling (redemption), holding statement,
providing facts sheets, etc.

9.4 REGULATION OF MUTUAL FUND

The legal environment for mutual fund is governed by SEBI. SEBI notified
regulations in 1993 initially that were revised in 1996. The regulations are
named as SEBI (Mutual Funds) Regulations 1996, as amended from time to
time. Mutual funds, either promoted by public or by private sector entities,
are required to adhere to these regulations concerning the formation and
management of mutual funds in India. Some of the salient features of the
regulations are as follows:
1. The sponsor is required, under the provisions of the Mutual Fund
Regulations, to have a reputation of fairness and integrity in all his
business transactions. Sponsor
a. should have been in the business of financial services for not less
than 5 years;
b. must have positive net worth in preceding 5 years; and
c. must have earned profit after depreciation, interest, and taxes in 3 of
the last 5 years. Additionally, the sponsor should contribute at least
40% to the net worth of the AMC. If any person holds 40% or more of
the net worth of an AMC, he shall be deemed to be a sponsor.
2. The mutual fund is required to have an independent Board of Trustees,
that is, two-thirds of the trustees should be independent persons who
are not associated with the sponsors in any manner whatsoever.
An AMC or any of its officers or employees are not eligible to act as a
trustee of any mutual fund. In case a company is appointed as a trustee,
then its directors can act as trustees of any other trust provided that the
object of such other trust is not in conflict with the object of the mutual
fund. Additionally, no person who is appointed as a trustee of a mutual
fund can be appointed as a trustee of any other mutual fund unless he
is an independent trustee.
3. AMC must satisfy following conditions:
a. The sponsor must have at least 40% stake in the AMC.
b. the directors of the AMC should be persons having adequate profes-
sional experience in finance and financial services-related field and
not found guilty of moral turpitude or convicted of any economic
offence or violation of any securities laws;
c. the AMC should have and must at all times maintain a minimum net
worth of Rs. 100 million;
 MUTUAL FUND INVESTMENTS 151

d. the board of directors of such AMC has at least 50% directors, who
are not associate of, or associated in any manner with, the sponsor
or any of its subsidiaries or the trustees;
e. Chairman of the AMC is not a trustee of any mutual fund.
4. Under the Mutual Fund Regulations, a mutual fund is allowed to float
different schemes. Each scheme has to be approved by the trustees
and the offer document is required to be filed with the SEBI. The offer
document should contain disclosures which are adequate enough to
enable the investors to make informed investment decision.
5. Close-ended schemes are required to be listed on a recognized stock
exchange within 6 months from the closure of the subscription. This is
not mandatory if the scheme provides for periodic repurchase facility
to all the unit holders.
The units of close-ended scheme may be converted into open-ended
scheme if the offer document discloses the option or if the unit holders
are provided with an option to redeem their units in full. A close-ended
scheme is required to be fully redeemed at the end of the maturity
period. It may be allowed to be rolled over if the purpose, period, and
other terms of the rollover and all other material details of the scheme
are disclosed to the unit holders. The rollover cannot be enforced, and
investor unwilling of rollover may be given an option to redeem in full
at latest net asset value (NAV).
6. The SEBI has restricted a mutual fund from giving guaranteed
returns in a scheme unless such returns are fully guaranteed by
the sponsor or the AMC or a statement indicating the name of the
person who will guarantee the return is made in the offer document
or the manner in which the guarantee to be met has been stated in
the offer document.
7 The moneys collected under any scheme of a mutual fund shall be
invested only in transferable securities in the money market or in
the capital market or in privately placed debentures or securitized
debts. However, in the case of securitized debts, such fund may
invest in asset-backed securities and mortgaged-backed securities.
Furthermore, the mutual fund having an aggregate of securities
which are worth Rs.100 million or more shall be required to settle
their transactions through dematerialized securities.
8. Mutual funds are not permitted to borrow money from the market
except to meet temporary liquidity needs of the mutual funds for the
purpose of repurchase, redemption of units or payment of interest or
dividend to the unitholders.
Borrowing cannot exceed 20% of the net asset of a scheme and
6 months maturity. A mutual fund is not permitted to advance any
loans for any purpose. A mutual fund is permitted to lend securities in
accordance with the Stock Lending Scheme of SEBI.
9. The funds of a scheme are prohibited from being used in option trading
or in short selling or carry forward transactions. However, SEBI has
permitted mutual funds to enter into derivative transactions on a
152 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

recognized stock exchange for the purpose of hedging and portfolio

balancing.
10. The AMC can charge the mutual fund with investment and advisory
fees subject to the following restrictions:
a. 1.25% of weekly average net assets outstanding in each accounting
year for the scheme (where net assets do not exceed Rs 1 billion) and
b. 1% excess over Rs 1 billion, where net assets so calculated exceed
Rs 1 billion. For schemes launched on a no-load basis, the AMC
can collect an additional management fee not exceeding 1% of the
weekly average of net assets outstanding in each financial year. AMC
may charge the mutual fund with the initial expenses of launching
the schemes and recurring expenses such as marketing and selling.
There is a cap of 6% on initial expenses.

SELF-ASSESSMENT 1. Which of the following is not correct about NAV of Mutual fund?
QUESTIONS
a. NAV is calculated each day based on the closing price of the
assets invested
b. NAV represents net returns on Mutual fund investment
c. The Net Asset value considers the payables by Mutual fund
d. The Net Assets are divided by number of outstanding units
2. The SEBI has restricted a ________ from giving guaranteed returns
in a scheme unless such returns are fully guaranteed by the sponsor
or the AMC or a statement indicating the name of the person who
will guarantee the return is made in the offer document or the
manner in which the guarantee to be met has been stated in the offer
document.
a. mutual fund
b. net Present Value
c. net Asset Value
d. solvency

9.5 RETURNS AND TAXATION

Like returns from stock, returns from mutual fund are also of two types:
a. periodic dividends and
b. capital appreciation.
Dividends are declared out of the profits earned by the mutual fund.
There is no predetermined periodicity of distribution of dividend.

9.5.1 CALCULATING NET ASSET VALUE

Capital gains are measured with the change in NAV, just as we measure
returns on stock by changes in the price of the stock. NAV is the value of
the assets net of liabilities that each unitholder has. Mutual funds mobilize
money from investors and make a portfolio by investing in financial
 MUTUAL FUND INVESTMENTS 153

securities. The value of the portfolios grows (may fall too) with time, and
each investor has proportionated share of the increased value.
As a simple example, consider a mutual fund has mobilized Rs 100 crore
at initial value of Rs 10 issuing 10 crore units. After a year, if the initial
value of Rs 100 crore grows to Rs 120 crore due to rise in prices of the
securities, NAV after a year would be Rs 12 (Rs 120 crore/10 crore). If an
investor holds 1,00,000 units, the value of his holding after a year would
be Rs 12,00,000. Therefore, NAV is the value of portfolio per unit at which
investors can enter and exit the fund. Because performance of mutual
funds depends upon the prices of the financial securities, NAV is declared
on daily basis at close of business, in case of open-ended mutual funds.
Besides the market value of the portfolio, in practice the computation of
NAV would consider
a. expenses like brokerage, custodian fee, audit fee, salary, etc.
b. cash reserves maintained for redemption.
c. amount borrowing if any; and
d. dividend distributed during the period, etc. NAV is given as:
NAV = (Assets – Debts)/(Number of Outstanding units)
where
Assets = Market value of mutual fund investments
+ Receivables + Accrued Income
Debts = Liabilities + Expenses (accrued)
From the NAV, the returns for the investors can be computed. The returns
of the investors is sum of
a. dividends distributed,
b. realized capital gains during the period, and
c. unrealized capital gains. This can be expressed as:
Distributed capital gains + Dividend distributed + (NAVt - NAVt -1 )
Returns, r =
NAVt -1

NAV is an indicator of the market value of the fund’s units. It helps track
the performance of the mutual fund. The change in NAV over time is the
capital gain. Therefore, changes in NAV over time establishes track record
of performance. A caveat is in order here.
Many investors while deciding to invest assume that putting money in
mutual funds with a lower NAV may offer them better scope compared
to a mutual fund with a higher NAV. This is a misconception and on the
contrary reverse may be true. Low NAV of a mutual fund may suggest that
the fund was either floated recently or has performed poorly. High NAV
can be accumulated over time and with good performance. Therefore, low
or high, NAV does not impact the return on investment from the mutual
fund. Better way to invest in mutual funds is to study the comparative
trends of NAVs of mutual funds with same investment objectives/themes/
portfolios.
154 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

9.5.2 INVESTMENT OPTIONS

While the investment is made in financial securities according to the
investment theme to earn returns, mutual funds offer the following three
different investment options to the investors about how these gains would
be distributed/reinvested:
Dividend Option: Under dividend option, the investor gets periodic dividend
as regular income akin to the fixed deposit in a bank withdrawing the
interest periodically while leaving the principal amount intact. This option
is normally preferred by investors who need regular cash flows. Dividend
is paid by selling the part of the portfolio. However, neither the amount of
dividend nor its timing can be predetermined because prices of securities
are extremely volatile.
Dividend Reinvestment Option: Under dividend reinvestment option, the
dividend is declared but not disbursed. It is reinvested in the portfolio by
buying fresh units at the new value. This option is akin to fixed deposit in a
bank where the interest is reinvested only to be disbursed upon maturity.
Growth Option: Under growth option, the dividend is neither announced
nor paid. The entire amount remains invested in the portfolio and allowed
to grow in value. Whenever an investor needs cash flow, he can choose to
withdraw from the fund by placing the redemption request.
With these options, there would be two NAVs of the same fund, that is, one
for the growth option, that is, NAV (growth) and the other for the dividend
option, that is, NAV (div). The difference in the NAVs of the two options
is the amount of dividend paid. There is no separate NAV for dividend
reinvestment option. In terms of returns, all options are equivalent when
there are no taxes. Investment options are merely the choices given to
investors how they want the return to be bifurcated in dividend and capital
gains. Dividend reinvestment option as compared to dividend option is
operationally smoother and more efficient. Under dividend option, an
investor would first receive the dividend and then reinvest involving time
gap between disbursal and reinvestment. Under dividend reinvestment, the
dividend is reinvested instantly. Under both the options, the units would
be purchased at NAV (div). Dividend option is for investors who prefer to
consume cash rather than reinvest.
Most mutual funds permit change in the investment options recognizing
the fact that investment needs do not remain static with time. Dividend
reinvestment and growth options are identical and equivalent to each other.
However, tax considerations make one superior to another. When dividends
are taxed more than the capital gains, growth option becomes more
beneficial. When capital gains are taxed more than the dividend, dividend
reinvestment becomes superior to growth option.

SELF-ASSESSMENT 3. The change in NAV over time is the ______.

QUESTIONS
a. solvency ratio
b. capital gain
 MUTUAL FUND INVESTMENTS 155

c. dividend gain
d. bonus
4. Under dividend reinvestment option, the dividend is _________ but
not________.
a. declared, disbursed
b. disbursed, declared
c. reimbursed, disbursed
d. none of the above

9.6 TYPES OF MUTUAL FUNDS

Enormous interest of investors and massive competition in the industry has
caused the innovation and development of several products in the mutual
fund. From the days of UTI when the mutual fund used to be a plain vanilla
product, the menu has become too large that often confuses the investors
where and how to choose investment in mutual fund. Mutual funds can be
categorized in several ways:
1. Based on structure and
2. Based on investment objective
By structure, there are two types of mutual funds, that is, open-ended and
closed-ended.
Open-Ended Schemes: Open-ended mutual funds issue and redeem their
units at any time without having restriction on the target corpus to be built.
They offer units for sale without specifying any duration for redemption.
If demand is high enough, the fund will continue to issue units. Open-ended
funds also redeem when investors withdraw investment.
Investors can conveniently buy and sell units of open-ended funds directly
from the fund house at the prevalent NAV prices. One of the key features
of open-ended schemes is the liquidity that these funds offer to investors.
Open-ended funds are more popular and in demand, and therefore most of
the funds are open-ended. Buying and selling of units is done at NAV which
is disclosed at the end of each business day. To do so, the fund is required
to maintain certain cash balance. While issuing fresh units or redeeming
the existing units, most open-ended funds charge an entry load (from those
wanting to buy) and exit load (from those wanting to redeem). This is to
compensate the fund for the liquidity that it keeps and to cover the adminis-
trative expenses. With effect from August 2009, no entry load can be charged
by mutual funds as per SEBI guidelines.
Close-Ended Schemes: Close-ended mutual funds issue a fixed number of
units with a pre-announced target corpus size. Close-ended funds raise a
fixed amount of capital through a new fund offer (NFO). The fund is then
structured, listed, and traded like a stock on a stock exchange. Unlike
open-ended funds, new units are not created or redeemed by the fund
managers to adjust demand from investors. Investors wanting to enter the
156 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

fund have to buy them from secondary markets and likewise those wanting
to divest must sell in the secondary market. Naturally, there would be no
entry/exit load in such schemes.
The price per unit (share) is determined by the market and is usually
different from the underlying value or NAV. The price of the unit can
be different from NAV. The price is said to be at a discount or premium
to the NAV when it is below or above the NAV, respectively. A premium
might be due to the market’s confidence in the investment manager’s
ability to produce above-market returns. A discount might reflect the
charges to be deducted from the fund in future by the fund managers.
Some close-ended funds give an option of selling back the units to the
mutual fund through periodic repurchase at NAV-related prices. Such
funds fall under interval schemes where repurchase option is open for
limited time. SEBI regulations stipulate that at least one of the two exit
routes is provided to the investor, that is, either repurchase facility or
through listing on stock exchanges.

9.6.1 CLASSIFICATION BY INVESTMENT

Each mutual fund has a clearly defined investment theme, that is, the nature
of securities that the fund would invest in. They are named based on what
asset classes they invest in. Some of these popular names are as follows:

Fund Name and/or Objective Asset Class/Securities of Investment

Equity (Growth) In stocks of companies
Debt In fixed-income securities such as
government bonds and corporate bonds
Money markets Short-term money market of government
securities, commercial papers
Balanced Partly in stocks and partly in fixed-income
securities

Equity funds can be further broken down in terms of their narrower

investment themes.
Based on Market Capitalization: One way of choosing the stocks to invest
in is based on the market capitalization theme related to level of market
capitalization. One investment philosophy is that risk is inversely propor-
tional to the size of the firm. Larger firms are considered less risky, and
smaller firms are viewed as bearing greater risk. The size is measured by
the extent of market capitalization of the firm, that is, number of shares
multiplied by market price. Stocks are normally classified as large-cap,
mid-cap, and small-cap.
There cannot be a universal definition of these terms, but conventionally
large-cap stock are taken as firms that have market capitalization in
excess of Rs 20,000 crore. Market capitalization between Rs 5,000 crore
and 20,000 crore is considered as mid-cap, while market capitalization
below Rs 5,000 crore is regarded as small-cap. Large-cap stocks are
considered less risky and therefore must offer lower returns as compared
 MUTUAL FUND INVESTMENTS 157

to small-cap stocks that are supposed to offer larger than normal returns
because they bear more risk.
Accordingly, they are sub-classified as follows:
1. Large-cap funds: These funds invest in companies from different
sectors but only in large-cap stocks.
2. Mid-cap funds: Again, these funds invest in companies from different
sectors like large-cap. However, they would invest only in equity of
the firms that have relatively lower market capitalization, that is, they
invest largely in BSE of NSE mid-cap stocks.
3. Small-cap funds: These funds typically invest in any company that has
small market capitalization.
Based on Sector: Some funds believe that certain sectors would outperform
the economic growth of the country. For example, some of us may believe
that software export would grow faster than the economic growth of India,
say 7%. Therefore, making investment in software firms would yield better
performance in term of risk reward ratio. Therefore, risk-adjusted returns
in case of portfolio of software companies may be higher than that of the
diversified portfolio. Based on this philosophy, it is common to see fund-
focused banking, infrastructure, FMCG, pharmaceuticals, etc.
Thematic: These schemes invest in various sectors but restrict themselves to
a particular theme, for example, blue-chip, services, exports, consumerism,
infrastructure, etc.
Based on Tax Benefits [(Tax-savings funds (ELSS)]: Investments in these
funds are exempt from income tax at the time of investment, up to a limit of
Rs 1.50 lakh.
Debt-oriented Funds are also called income funds and are aimed at
providing reasonable but assured appreciation by investing in fixed-
income or money market securities. The performance of these funds is
highly dependent upon interest rates in the economy. If interest rate falls,
the prices fixed-income securities go up and therefore the NAV of debt
funds would rise. However, the upside potential in investment in such
securities is limited but most assured. They too can be classified as money
market or liquid funds, that is, those funds who invest in safer short-term
instruments, such as treasury bills, certificates of deposits, commercial
papers, etc. Gilt funds are those who invest only in government securities.
Balanced Funds attempt to combine the benefits of equity and debt funds.
Equity-oriented funds have greater risk, but they offer higher return. Debt
funds have little risk with relatively lower returns. A balance between risk
and return may be found by allocating different proportions on the fund in
equity and debt depending upon the risk-return profile desired.
Funds that part allocate the funds between stocks and fixed-income
securities are called balanced funds. Typically, balanced fund allocates
60% or more in stocks so as to remain classified as equity-oriented fund
under Income Tax Act to derive home the tax advantages available to
equity-oriented schemes.
158 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Depending on its investment goal, a scheme may alternatively be categorised

as a growth scheme, income scheme, or balanced scheme. These plans could
be either the above specified close-ended or open-ended plans-
‰ Growth/Equity Oriented Scheme: Growth funds are designed to offer
capital growth over the medium to long term. Such programmes typically
invest a sizable portion of their corpus in equities. These investments
have comparatively significant risks.
‰ Income/Debt Oriented Scheme: Investors’ regular and steady income
is the goal of income funds. These types of investments typically
involve fixed income securities including bonds, corporate debentures,
government securities, and money market instruments. These funds
carry less risk.
‰ Balanced/Hybrid Scheme: As they invest in both equities and fixed
income assets in the ratio specified in their offer documents, balanced
schemes seek to provide both growth and consistent income. Investors
searching for moderate growth should choose these.
‰ Money Market or Liquid Schemes: These plans, which are also income
plans, seek to offer simple liquidity, capital preservation, and moderate
income. These programmes invest only in short-term securities such
Treasury Bills, commercial paper, interbank call money, and government
bonds, among others. In comparison to other funds, returns on these
plans fluctuate substantially less.
‰ Gilt Funds: These funds only make government securities investments.
There is no default risk with government securities. As with income or
debt focused schemes, the NAVs of these schemes fluctuate in response
to changes in interest rates and other economic factors.
‰ Index Funds: Index funds mimic the holdings of a specific index. These
programmes invest in the same weighted securities that make up an
index. NAVs for such schemes would fluctuate in line with changes in
the index.
From January 1, 2013, mutual funds must compel the launch of a direct
plan for direct investments, or investments that are not routed through a
distributor. A commission is not to be paid from such distinct plans, and
they have a lower expense ratio when distribution costs, commissions,
etc. are excluded. Additionally, the plan has a unique NAV. Mutual fund
plans that are purchased through an intermediary are known as regular
plans. Brokers, consultants, and distributors are some examples of these
middlemen. When marketing their mutual funds, the intermediaries are
paid a specific commission by the fund house. The expense ratio is often
how the AMCs get this fee back. Regular mutual funds have a somewhat
higher expense ratio than direct mutual funds.
The expense ratio indicates how much, in percentage terms, you pay a
fund each year to manage your money. It is an efficiency ratio that assesses
the proportion of total assets invested in a mutual fund that goes toward
management costs. Investors in mutual funds have a choice between the
Direct plan and Regular plan, two different types of plans. As a result, there
 MUTUAL FUND INVESTMENTS 159

are two different sorts of expense ratios for these plans. With the aid of an
intermediary, such as a distributor, counsellor, broker, etc., we invest in the
Regular Plan. They charge us fees for this service in exchange for making
investment recommendations and periodically monitoring our portfolio.
Investors in Direct Plans manage their own portfolios using their own
knowledge and judgement, without the assistance of a third party. He doesn’t
have to pay any additional money because of this. As a result, the expense
ratio in the Regular Plan is larger than it is in the Direct Plan. As a result, the
Regular Plan’s expense ratio is larger than the Direct Plan’s.

5. ________ regulations stipulate that at least one of the two exit routes SELF-ASSESSMENT
is provided to the investor, that is, either repurchase facility or QUESTIONS
through listing on stock exchanges.
a. RBI
b. SEBI
c. GDP
d. none of the above
6. These funds invest in companies from different sectors like
large-cap. However, they would invest only in equity of the firms
that have relatively lower market capitalization, that is, they
invest largely in BSE of NSE mid-cap stocks, which type of fund
is being described here?
a. mid-cap fund
b. low-cap fund
c. large-cap fund
d. mutual fund

9.7 EXCHANGE-TRADED FUNDS

An exchange traded fund (ETF) is a basket of securities, that is, a portfolio
that is traded on an exchange just as individual securities do. ! IMPORTANT CONCEPT
An exchange traded fund
A pooled investment security called an exchange-traded fund (ETF) functions
(ETF) is a basket of securities,
very similarly to a mutual fund. ETFs often follow a certain sector, index,
that is, a portfolio that is
commodity, or other asset, but unlike mutual funds, they can be bought or traded on an exchange just as
sold on a stock exchange just like normal stocks can. Anything from the individual securities do. It is
price of a single commodity to a sizable and varied group of securities can a hybrid of open-ended and
be tracked by an ETF. ETFs may even be designed to follow particular close-ended mutual fund.
investment strategies.
The SPDR S&P 500 ETF (SPY), which replicates the S&P 500 Index and is
still an actively traded ETF today, was the first ETF.
Because it is exchanged on an exchange like stocks are, an ETF is also
known as an exchange-traded fund. As shares of an ETF are purchased
and sold on the market throughout the trading day, the price of the shares
will fluctuate. Contrary to mutual funds, which only trade once daily after
the markets close and are not traded on an exchange, this is the case.
In comparison to mutual funds, ETFs are typically cheaper and more
160 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

liquid. Unlike stocks, which only hold one underlying asset, ETFs hold a
variety of underlying assets. ETFs are frequently used for diversification
because they contain a variety of assets. Thus, a variety of investments,
including stocks, commodities, bonds, or a combination of investments,
can be found in ETFs.
Investors have access to a variety of ETFs that can be used to manage risk
in their portfolios, generate income, engage in speculation and price appre-
ciation, and generate income:
‰ Passive and Active ETFs: ETFs can generally be classified as either
passively managed or actively managed. The goal of passive ETFs
is to mimic the performance of a larger index, whether it be a more
specialised sector or trend or a more diversified index like the S&P 500.
Typically, actively managed ETFs do not aim to track an index of assets
but rather have portfolio managers choose which securities to hold.
Despite being more expensive for investors, these have advantages
over passive ETFs.
‰ Bond ETFs: Bond ETFs are designed to give investors consistent
income. Their income distribution is based on how well the underlying
bonds perform. Government bonds, corporate bonds, and municipal
bonds—also known as state and local bonds—might be among them.
Bond ETFs lack a maturity date like their underlying assets do. They
typically trade above or below the price of the underlying bond.
‰ Stock ETFs: Stock (equity) ETFs are a collection of stocks that track a
certain sector or industry. A stock ETF, for instance, might follow equities
in the automobile industry or overseas. The goal is to give a single industry
with both strong performers and new entrants with growth potential a
varied exposure. Stock ETFs feature lower costs than stock mutual funds
and don’t require actual ownership of any securities.
‰ Industry/Sector ETFs: Sector or industry ETFs are investments that
concentrate on a certain industry or sector. For instance, an ETF for the
energy sector will include businesses engaged in that industry. Industry
ETFs are designed to give investors exposure to an industry’s potential
growth by monitoring the activity of its constituent companies.
‰ Commodity ETFs: Invest in commodities like gold or crude oil.
The advantages of commodity ETFs are numerous. They first diversify
a portfolio, which makes it simpler to hedging downturns.
‰ Currency ETFs: The performance of currency pairings, which include
both domestic and foreign currencies, is tracked through currency
exchange-traded funds (ETFs). ETFs that invest in currencies have
many uses.
‰ Inverse ETFs: By shorting stocks, inverse ETFs try to profit from
stock falls. Shorting is the practise of selling a stock in anticipation of
a decrease in value and buying it back at a loss. Derivatives are used
by an inverse ETF to short a stock. In essence, they are wagers against
the market.
 MUTUAL FUND INVESTMENTS 161

‰ Leveraged ETFs: A leveraged ETF aims to return a number of times

(such as two or three times) the return of the underlying investments.

9.8 INDEX FUND

The investment objective of index funds is to provide returns to the investors
equal to that of an index. For example, a fund may have an investment
objective to provide returns equal to NIFTY 50 or SENSEX. Normally
market returns are measured by the changes in the values of a broad-based
index. In such funds, the portfolio is already decided and known, that is,
invest in stocks included in the index in the same proportion as in the
index. They attempt to replicate the index in the physical form in the
hope that portfolio so constituted would provide returns equal to market.
The concept of index fund revolves around the belief that it is difficult to
beat the market on consistent basis.
For a mutual fund that outperformed the market in a year or last few years,
it is not necessary that it repeats the performance in future too. However,
one can assure a market-based return over long term if the portfolio
replicates the index. The strategy of index mutual fund is passive one as no
action is required on part of the mutual fund unless the index undergoes
a change in its composition. Even when the index is changed (which is
infrequent), the action to be taken by the fund manager is known requiring
no research.
The fund manager simply has to buy the stock that is included in the index
and sell the stock that is excluded from the index. Index fund has the
following advantages:
1. Because of the known portfolio, and infrequent portfolio balancing, the
expense ratio of the index fund is very low as it incurs very nominal
research cost and transaction costs. Index funds do not have to hire several
portfolio managers to devise a portfolio that must beat the market.
2. Since the index fund mimics the broad-based index and is well
diversified, the unsystematic risk too is almost zero. Index funds carry
the systematic risk only.
3. Index fund are also free from the biases of investment/fund manager.
The portfolio of the mutual fund would be affected by the nature of the
individuals managing it and their risk appetite.

9.9 TRACKING ERROR

Index funds are supposed to provide returns equal to the target index
by replicating it in the physical form. The return of the fund would be ! IMPORTANT CONCEPT
measured by the changes in its NAV. If fund tracks NIFTY 50, the returns Index funds are supposed to
of the fund should be equal to that of the returns offered by the market. provide returns equal to the
However, while tracking the index in the physical form, the return offered target index by replicating it
normally are less than that of the index. This is referred as tracking error. in the physical form.
Tracking error is defined as annualized standard deviation of the difference
between the index fund and its target.
162 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

9.9.1 CALCULATING TRACKING ERROR

The tracking error quantifies the error committed by fund in providing returns
equal to the index being tracked by it. It may be found out as follows:
1. Find the NAV of the fund and the total return index for every day (Note
that changes in the index indicate only the capital gains, while total
return index includes the dividend yield too).
2. Calculate the per cent change in the value each day, that is, each day
return of fund and the index.
3. Find the difference between the per cent returns of fund and total
return index.
4. Find out the standard deviation difference, s daily.
5. Convert the daily standard deviation to annualized by using the formula
s daily × √Nos. of days p.a.

Day NAV TR Index Return in NAV Return in TR Index Difference

(A) (B) (C) (D) (E) (F)
1 NAV1 TRI1
2 NAV2 TRI2 100 × (NAV2 - 100 × (TRI2 - TRI1)/ (E - D)
NAV1)/NAV1 TRI1
.. ….. …… ………. ……… …..
.. ….. …… ………. ……… …..
.. ….. …… ………. ……… …..

Let’s explore the calculation of the tracking error with the help of an example,
take mutual fund X, which is tracking the oil and gas index. It is calculated
by the difference in the return of the two variables.
Tracking Error calculation = Ra – Ro&G
Ra = Return from the portfolio
Ro&g = return from the oil and gas index
Suppose the return from the portfolio is 10%, and the return from the
benchmark is 9%. In this case, after the calculation, the tracking errors for
the portfolio will be 1%.
Tracking error is the standard deviation of the difference between the returns of
an investment and its benchmark. Given a sequence of returns for an investment
or portfolio and its benchmark, tracking error is calculated as follows:
Tracking Error = Standard Deviation of (P – B)
‰ Where P is portfolio return and B is benchmark return.
Example of a Tracking Error
For example, assume that there is a large-cap mutual fund benchmarked
to the S&P 500 index. Next, assume that the mutual fund and the index
realized the following returns over a given five-year period:
‰ Mutual Fund: 11%, 3%, 12%, 14% and 8%.
 MUTUAL FUND INVESTMENTS 163

‰ S&P 500 index: 12%, 5%, 13%, 9% and 7%.

Given this data, the series of differences is then (11% – 12%), (3% – 5%),
(12% – 13%), (14% – 9%) and (8% – 7%). These differences equal –1%, –2%,
–1%, 5%, and 1%. The standard deviation of this series of differences,
the tracking error, is 2.50%.

9.9.2 REASONS FOR TRACKING ERROR

Inability of the fund to provide same returns as that of the index being
tracked is because of several reasons as follows:
Fund Expenses: An index is a hypothetical asset and while replicating it in
the physical form, one would have to incur transaction costs to construct
the portfolio of the index. These expenses would be charged to the corpus of
the fund and reduce the return.
Cash Reserves: Open-ended funds provide entry and exit to investors all
the time. When the investor redeems his units, he has to be paid in cash
immediately. For the purpose of redemption, every mutual fund keeps cash
reserve that reduces the investible funds. Therefore, to match the returns
of the index being tracked, the fund would have to earn extra returns to
compensate for the idle funds.
Time Gap in Rebalancing: Corporate action, such as bonus, dividend, rights,
debt conversion, etc., are reflected in the index instantaneously. The fund
would take time in replicating the index and therefore would lag the returns
of the index. For example, dividends while adjusted in the index instanta-
neously are distributed later and cannot be invested till received. There would
be a mismatch in the timing of index adjustment and actual rebalancing of the
portfolio by the fund. Another example would be changes in the construction
of index. The fund has to sell the stock that is going out of index and buy the
one being included in the index. This would imply mismatch of timing as well
as incurring of transaction costs bringing down the returns.
Rounding Off: Though a rather insignificant amount but exact replication is
practically not possible as funds tend to round off the quantity of stock being
purchased.

9.9.3 MANAGING TRACKING ERROR

There are a number of ways in which tracking error can be reduced.
Some of the strategies are (a) using index futures to enable the fund earn
extra returns with least investment and much lower transactions cost in
derivatives, (b) invest in high dividend stocks to earn a little more because
usually stocks included in the index have low dividend yield, (c) invest in
fixed-income securities rather than keeping cash to earn some returns on
the reserves kept for redemption purposes.
Proper management and application of tracking error is useful for
calculating and evaluating a portfolio’s performance in relation to the
relevant benchmark or index. Tracking error explains how higher
returns consistently occur and it can also be used by portfolio managers
to gauge how closely a portfolio resembles its benchmark. Investors can
164 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

assess the effectiveness of a portfolio manager’s investing strategy using

a tracking error.
However, tracking error has its own limitation. A fund’s outperformance
or underperformance compared to its benchmark can be determined using
tracking error. In the event of an out-performance by the fund, investors
frequently favour a high tracking error. In the event of recurrent under-
performance, a low tracking error is better. Tracking inaccuracy, however,
is unable to assist in rapidly differentiating between the two.

SELF-ASSESSMENT 7. Inability of the fund to provide same returns as that of the index
QUESTION being tracked is because of several reasons, which are:
a. rounding off
b. time gap in rebalancing
c. cash reserves
d. all of the above

9.10 ADVANTAGES OF INVESTING

IN MUTUAL FUNDS
9.10.1 SMALL YET DIVERSIFIED INVESTMENT
The concept of mutual fund is mobilization of small savings from large number
of investors so as to have a large enough corpus to provide adequate diversi-
fication. This is perhaps the foremost advantage of investing in mutual fund.
Small investors are not able to achieve risk reduction due to limited amount
of investment made in limited number of securities. Universal objective of
small investors is risk reduction. With investment limited to small number of
securities, the investor is exposed to unsystematic risk as well as systematic
risk. Mutual funds with larger corpus are able to diversify adequately so as
to almost completely eliminate the unsystematic risk. Most funds must make
investment in different asset classes spread across various industries subject
to the constraints of investment objective, set beforehand and is known to
the investors. If the investor agrees with the investment objective, he invests.
Due to exposure in different asset classes across different industries, most
mutual funds carry only the market risk specified by its beta.

9.10.2 PROFESSIONAL MANAGEMENT

Mutual funds are managed by professionals who invest on behalf of millions
of small investors. These investors in their own individual capacity neither
have the ability to understand the nuances of stock markets, nor are literate
enough to analyze financial statements. Further, they also do not have access
to information that may be critical for making an informed decision to invest.
The professional managers (a) are literate enough to comprehend the financial
statements, (b) have domain expertise to analyze the competitive position of
firms, (c) are skilled enough and capable of forecasting the prospects, and
(d) have access to information that is desired for making intelligent investment.
These professional managers therefore devise portfolios consistent with the
investment objective of the mutual fund.
 MUTUAL FUND INVESTMENTS 165

9.10.3 COST EFFECTIVENESS

! IMPORTANT CONCEPT
As stated earlier, professional managers who manage the mutual fund are
Professional managers who
compensated handsomely for their services and knowledge. They also incur
manage the mutual fund are
other expenses associated with research. These costs are borne by investors
compensated handsomely for
only and therefore bring down the returns, which investors could have their services and knowledge.
earned. However, these expenses, even though substantial, get spread over
millions of investors, the adverse impact on returns in nominal. The benefits
of investment in mutual funds far outweigh the cost. Investing in mutual
funds perhaps is the most cost-effective way of investment.

9.10.4 ENTRY, EXIT, AND LIQUIDITY

Entry and exit to mutual funds is rather easy and prompt. The question
of finding a counterparty is irrelevant. Therefore, investors enjoy
competing liquidity with full benefits of diversification.
A financial emergency may force an investor to sell their holdings quickly.
If the assets have been damaged at the wrong time, the results could be
severe. As a result of their diversification, mutual funds’ value swings
are generally less erratic than stocks. Beware of any selling-related fees,
such as back-end load fees, which are percentages subtracted from your
proceeds when you sell the fund. Be aware that after determining the fund’s
net asset value, mutual funds only trade once per day, unlike equities and
exchange-traded funds.
You can select your desired investing strategy when using mutual funds in
India, which is an additional benefit. A lump contribution can be put into a
fund, or you can start with Systematic Investment Plans. With SIP, you can
invest money at regular intervals—weekly, monthly, quarterly, etc.—for as
little as INR 100 per installment.

9.10.5 PROTECTION, TRANSPARENCY, AND SAFETY

Since mutual funds are managed by persons who are not stakeholders
or owners of fund, there is always an apprehension regarding safety and
transparency of investment. SEBI prescribes rules about the constitution/
structure of mutual funds, quality of management, control of expenses and
of disclosure requirement, etc., ensuring that there is no misuse of funds or
deviations from objectives of investment. Information to investors is made
available through fact sheets, offer documents, annual reports, declaration
of NAV, and disclosures of portfolios help investors gather knowledge about
monitoring their investments.

8. The professional managers:

a. devise portfolios consistent with the investment objective of the
mutual fund
SELF-ASSESSMENT
b. are literate enough to comprehend the financial statements QUESTION
c. have domain expertise to analyze the competitive position
of firms
d. all of the above
 166 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

9.11 LIMITATIONS OF INVESTING

IN MUTUAL FUNDS
It is indeed difficult to comprehend any limitations of investing in mutual
fund. However, some analysts point out the following:

9.11.1 OVER-DIVERSIFICATION
While diversification is a standard strategy of risk reduction, the extent of
diversification is debatable. Most experts believe that investment in 20 to
30 different stocks is a reasonable diversification. Any further addition of
financial securities to the portfolio is not cost-efficient, because the risk
reduction thereafter is not commensurate with the equity research cost
one incurs. Yet we find mutual fund investing in hundreds of stocks and
investors investing in multiple mutual funds with the reasoning of achieving
adequate diversification. Overenthusiasm for diversification has disad-
vantage of increased equity research cost, and increased management and
monitoring cost.

9.11.2 ENTRY AND EXIT LOAD

Mutual funds are best for the long term since they provide a larger
return with little risk. This is mainly because the fund diversifies the
total portfolio by investing in a combination of debt and equity. On your
behalf, trained fund managers invest in mutual funds and provide you
recurring messages. But everything has a price. Each and every asset
management company (AMC) charges the investors a specific amount
to cover their operating expenses, distribution costs, and other transac-
tional fees. Therefore, there will be costs involved anytime you purchase
a mutual fund or decide to withdraw from a certain programme.
The entry load and the exit load are the two primary charges. In some
mutual funds, there may be additional fees beyond the expense ratio
for entry and exit. The total returns that the investor receives may be
impacted by these fees.

9.11.3 DILUTION
! IMPORTANT CONCEPT Some analysts provide a view contrary to the very essence of diver-
A diversified portfolio would sification. A diversified portfolio would see some stock providing
see some stock providing more than average returns, while some other stock would not do as
more than average returns, well. Comparatively investment in blue-chip or high-growth stocks
while some other stock would could outperform the mutual fund. For an investor with a short-term
not do as well. view, inability of mutual fund to capture full returns has severe
limitation because investment in such security would be a fraction of
total corpus.

! IMPORTANT CONCEPT
9.11.4 IDLE CASH RESERVES
Large cash reserves
maintained for sudden and Large cash reserves maintained for sudden and large withdrawal reduce
large withdrawal reduce the the amount of investible surplus. If a mutual fund keeps 1% of the corpus
amount of investible surplus. as reserves for redemption, it implies that out of Rs 100 only Rs 99 has
 MUTUAL FUND INVESTMENTS 167

been invested. This brings down the return for the mutual fund investor
as compared to the one who invests of his own. However, one must keep
in mind that even investors opting to invest on their own to maintain some
cash for precautionary motive.

9.11.5 INABILITY TO ENTER AND EXIT DURING THE DAY FOR

OPEN-ENDED FUNDS
For open-ended mutual funds, the redemption can be made only at the
end-of-the-day NAV. There is no possibility to exit at market-oriented
prices during the day. Though not a serious limitation, but some very active
investors may feel deprived of exit possibility when market peaks during the
day. For passive investors, it indeed is insignificant.

9. Which among the following is not a limitation of Investing in SELF-ASSESSMENT

Mutual Funds: QUESTIONS
a. non-dilution
b. idle cash reserves
c. entry and exit load
d. over-diversification
10. Overenthusiasm for diversification has disadvantage of _____ equity
research cost, and __________ management and monitoring cost.
a. increased, increased
b. increased, decreased
c. decreased, increased
d. decreased, decreased

9.12 PERFORMANCE EVALUATION

OF MUTUAL FUNDS
The performance of mutual funds is normally evaluated from changes in NAV
that indicate the capital gains from the investment. This would be applicable ! IMPORTANT CONCEPT
for the investment with growth options where no dividend is distributed. The performance of mutual
For investment with dividend options, the returns would be measured by funds is normally evaluated
adding the dividend distributed and capital gains as measured from changes from changes in NAV that
in NAV. Note that change in NAV would be different than in case of investment indicate the capital gains from
with growth option. Under investment option of dividend reinvestment, the the investment.
number of units grows with each dividend announcement, because dividends
are deemed to be reinvested at NAV prevailing at the time of dividend.
The change in total value of investment at the end divided by value of
investment at beginning would give per cent returns. While the above
measures provide the absolute return, they are silent on comparative
returns. In a competitive industry, comparative performances are more
meaningful for investors to make investment decision. As per regulations, it
is mandatory to compare the performance of every scheme against a suitable
index. For example, a mutual fund scheme with the objective of investing
168 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

in pharmaceutical stock must be compared against an appropriate index

representing pharmaceutical industry rather than a broad-based index.
The effectiveness of a mutual fund is also measured with the expense ratio.
These expenses can be regarded as cost of managing the fund. Lower the
cost, more efficient is the fund from the perspective of the investor.
Large mutual funds would normally have low expense ratio as expenses
get distributed over large sum, while those with smaller corpus would have
larger expense ratio.

9.13 SUMMARY
‰ Investment through mutual fund has become the most common form
of investment in recent years for small investors because of its many
advantages.
‰ First mutual fund in India was pioneered by Unit Trust of India (UTI)
in 1986 with the objective of attracting small investors to the investment
in equities. It gained popularity only after 2001 when it was regulated
by SEBI in 1996.
‰ It gained popularity only after 2001 when it was regulated by SEBI in 1996.
‰ A mutual fund pools small money from large number of investors to
form a large corpus and invests according to the investment objectives
laid out in advance.
‰ The returns on the investment are shared in proportion of investments
made.
‰ In a mutual fund, there are many participants with different role
assigned to each of them. Sponsors initiate the fund inviting subscription
from general investors called unitholders. Sponsors are required to
contribute substantial part of the corpus. A fund manager is appointed
who identifies investment, monitors it, and rebalances the portfolio as
and when required. The fund is managed by professional managers.
‰ Mutual fund industry in India is regulated by SEBI imposing several
conditions on sponsors, managers and their fee, trust and disclosure
requirements to make investment transparent.
‰ As per the regulations, all mutual funds are required to disclose their
NAV on daily basis. NAV is simply the value of one unit obtained by
value of the portfolio divided by number of units.
‰ Mutual funds offer three options to investors: (a) dividend option,
(b) dividend reinvestment option, and (c) growth option. In dividend
option, the periodic dividend is distributed. Dividend reinvestment and
growth option are same where dividend is reinvested.
‰ Mutual funds can be open-ended or close-ended. Open-ended mutual
funds are those where investment can be redeemed at any time at the
prevailing NAV. Close-ended mutual funds are required to be listed and
traded just as shares do. Investors can enter or exit through secondary
market at market prices, which, too, are related to NAV.
 MUTUAL FUND INVESTMENTS 169

‰ In between the close-ended and open-ended mutual fund, lies the ETFs.
‰ Growth funds invest major part of corpus in equities while debt funds
deploy a major part in debt securities. Balanced funds invest both in
equities and debt securities. Those concerned with liquidity invest in
money market mutual funds.
‰ Investment objectives can be further subdivided as per extent of market
capitalization, sectoral, or thematic.
‰ Another popular passive but efficient strategy is to invest in index fund
which replicate an index as investment strategy to provide market-related
returns to investors. The advantages of index fund are elimination of
research cost and reduction of transaction cost.
‰ Tracking error relates to the inability of the index funds to replicate the
returns provided by index. This is due to (a) transaction cost, (b) corporate
actions, (c) necessity to maintain cash for redemption purposes, and
(d) expenses of the fund, etc.
‰ The advantages of investment through mutual fund include (a) diversi-
fication with low capital outlay, (b) professional management, (c) cost-
effectiveness, and (d) ease of entry/exit and liquidity.
‰ Limitations of investment through mutual fund include enthusiasm for
over-diversification, levy of entry, and exit loads, and idle cash reserves
impacting returns adversely.
‰ Benchmarking of performance of every mutual fund is mandatory as
per the law.
‰ Mutual funds can be categorized in many ways. But two ways of classifi-
cation are most common – based on structure and based on investment
objective.
‰ According to investment objectives, the mutual funds are classified in
four ways – growth, debt, money market, and balanced.
‰ Growth funds invest in equities and are suitable for young and earning
population. Debt funds provide regular income and invest in fixed-
income securities. Balanced funds find balance between equity and
debt instruments. Money market focuses on liquidity and invests in
short-term instruments.

Idle Cash Reserves – Idle cash is, as the word implies, cash which is idle KEY WORDS
or isn’t being utilized in a way that can boom the fee of a commercial
enterprise. It means that the cash aren’t generating any interest incomes
from sitting in financial savings or a checking account, and isn’t always
generating profit inside the form of asset purchases or investments.
Tracking error – It is defined as annualized standard deviation of the
difference between the index fund and its target.
Balanced Funds – It attempts to combine the benefits of equity and debt
funds. Equity-oriented funds have greater risk, but they offer higher return.
170 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Debt-oriented Funds – These are also called income funds and are aimed
at providing reasonable but assured appreciation by investing in fixed-
income or money market securities.
Net Asset Value – It is the total value of an investment fund’s assets after
removing the liabilities further dividing it by the number of outstanding
shares.

9.14 DESCRIPTIVE QUESTIONS

1. What are the advantages and disadvantages in investing in mutual funds?
2. Why do you think benchmarking is important in the evaluation of
performance of a mutual fund?

9.15 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS
Topics Q. No. Answers
Regulation of Mutual Fund d. NAV represents net
1 returns on Mutual
fund investment
2 a. Mutual fund
Calculating Net Asset Value 3 b. Capital gain
Investment Options 4 a. Declared, Disbursed
Types of Mutual Funds 5 b. SEBI
Classification by Investment 6 a. Mid-cap Fund
Reasons for Tracking Error 7 d. All of the above
Professional Management 8 d. All of the above
Limitations of Investing in Mutual Funds 9 a. Non-dilution
10 a. Increased, increased

9.16 SUGGESTED READINGS AND

E-REFERENCES
‰ Srivastava, Rajiv (2017), Investment Management, Wiley
‰ Elton J Edwin, Brown J Stephen (2013), Modern Portfolio Theory and
Investment Analysis, Wiley
‰ Brooke, P., and Penrice, D. (2009) A Vision for Venture Capital –
Realizing the Promise of Global Venture Capital and Private Equity
(New Ventures)
‰ Capital Dynamics (2010) The Definitive Guide to Risk Management in
Private Equity (PEI Media)
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A. (2008) Private
Equity: History, Governance and Operations (John Wiley & Sons)
 CASE STUDIES
7 TO 9

CONTENTS

Case Study 7 Asset Pricing Models: Capital Asset Pricing Model

Case Study 8 Asset Pricing Models – Arbitrage Pricing Theory
Case Study 9 Mutual Fund Investments
172 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

CASE STUDY CHAPTER –7

CLOSING CASE

Market Risk and Returns Further to your study of five stocks, that
is, Infosys, Maruti, Hindustan Unilever, Tata Steel, and Sun Pharma,
you recognized that consideration of aggregate risk as measured by
standard deviation is irrelevant to portfolio consideration because
what can be diversified away does not get rewarded. What cannot
be diversified away would only get rewarded in an efficient capital
market. You strongly believe that Indian stock markets are efficient.
Therefore, you decided to concentrate only on the systematic risk as
measured by beta of the stocks, and ignore the aggregate risk
measure of standard deviation. Rather than attempting to find beta
of the five chosen stocks from the historical returns you chose to
rely on the published information of few of the large and respected
research houses, who regularly make public their estimates of beta
of the prominent stocks. Assuming that historical returns would
continue for the next one year and markets would correct thereafter
to provide CAPM based returns, you decided to buy undervalued
stocks and sell overvalued stock. The expected returns and measures
of risk are condensed in the table below:

Risk and Returns of Five Stocks

Infosys Maruti HUL Tata Steel Sun Pharma
Standard deviation, 13.58 8.99 6.71 10.24 11.61
% monthly
Standard deviation, 47.05 31.15 23.25 35.46 40.23
% annualised
Annualised 20.63 17.25 11.03 17.22 19.12
expected return, %
Beta is available 1.4 1.2 0.9 1.3 1.5
from published
sources

As per the estimates of most analysts the market return for next year is
15% while risk-free rate of return based on the yields of 365-day T-bill
currently at 5% is expected to continue. As an investment strategy you
were inclined to form an equally weighted portfolio of five stocks. Your
manager, Mr Vith Pradhan, believes it to be too naïve and instead wants to
improve risk-adjusted returns. His strategy is to increase the proportion
of investment in undervalued stocks by 5% for each 0.5% extra return,
and decrease the proportion of investment in overvalued stock by 5% for
each 0.5% shortfall in return. However he decides not to sell any of the
overvalued stock short, but to invest/borrow remaining proportion in the
risk-free assets of T-bills. However one of your colleague Mr Tej Bahadur
replicates the investment strategy of your manger Mr. Vith Pradhan but
is more adventurous. Rather than 5% increase/decrease from equally
 CASE STUDY 173

weighted portfolio, he allocates 10% increase/decrease in undervalued/

overvalued stocks for each 0.5% excess/short returns. Unlike your
manager he is willing to short-sell the overvalued stocks and borrow if
the need arises.

QUESTION

1. Based on the above consideration, compare the risk-adjusted

returns of your strategy with those of your manager Mr. Vith
Pradhan and your colleague Mr. Tej Bahudur.
174 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

CASE STUDY CHAPTER – 8

CLOSING CASE

ARBITRAGE PRICING – TWO FACTORS

Assume that two factors are considered in the APT model and following
model works:
Expected Returns, R =λ 0 + β 1λ 1 + β 2 λ 2
Assume λ 0 = 6% and the risk premiums for Factor 1 and Factor 2 are 4%
and 5%, respectively.
Three portfolios with following characteristics are in equilibrium with
respect to the two macroeconomic
variables:

Portfolio Beta (Factor 1) Beta (Factor 2)

A 0.5 1.2
B 1.5 1.0
C 2.5 0.6

QUESTIONS

1. Find out the expected returns of the three portfolios A, B, and C.

2. There exists a Portfolio D with betas of 0.6 and 0.8 with respect to
Factor 1 and Factor 2, respectively, but provides a return of 10%.
How will you take advantage of mispricing of Portfolio D?
3. What profit can you generate?
 CASE STUDY 175

CASE STUDY CHAPTER – 9

CASE STUDY

CLOSING CASE

MUTUAL FUND ANALYSIS

With many large investors to whom you render portfolio management
services, your firm decided to tap the large segment of the investors
with small savings. These investors primarily invested in bank’s fixed
deposits only because of their non-familiarity with stock markets.
They considered that stock market investment was meant only for
literate, resourceful, and for less risk-averse investors.
In order to develop equity cult among small investors, government came
out with an incentive scheme for financial consulting and brokerage
firms, where financial incentives were offered for mobilising funds
from small investors. Realizing the inhibitions of small investors, you
thought that closest substitute to the investment in bank deposit was
the investment in mutual fund. A mutual fund unit’s owner or investor
receives a share which is comparable to the fund’s gains, losses,
revenue, and expenses. A sort of equity mutual fund called an equity
linked savings scheme (ELSS) gives its owner tax advantages. On the
dividend received from the mutual funds, investors are not required to
pay any taxes. The amount that can be claimed as tax-exempt under
this heading has no upper limit as well. Besides, investment in mutual
funds offered the benefits of diversification with small capital. Investors
in mutual funds need not worry about how to construct or rebalance the
portfolio. Mutual fund managers would do it for them for a very nominal
fee. Highlighting these advantages of mutual fund, you approached
large number of small investors through distribution of flyers educating
people of the advantages of mutual fund.

QUESTION

1. List the benefits of mutual funds that you would pitch to the
small investors.
 C H
10 A P T E R

PERFORMANCE EVALUATION OF MUTUAL FUNDS

CONTENTS

10.1 Performance Evaluation of Mutual Fund

Self-Assessment Questions
10.2 Net Asset Value
Self-Assessment Questions
10.3 Measure of Return and Risk of Portfolio
10.3.1 Risk
10.3.2 Beta: Measure of Systematic Risk
Self-Assessment Questions
10.4 Risk Adjusted Returns
10.4.1 Sharpe’s Ratio
10.4.2 Treynor’s Ratio
10.4.3 Jensen’s Alpha
Self-Assessment Question
10.5 Lower vs Higher NAVs
10.5.1 Criteria for Investment in Mutual Fund Schemes
10.5.2 Systematic Investment Plan (SIP)
Self-Assessment Questions
10.6 Summary
Key Words
10.7 Descriptive Questions
10.8 Answer Keys
Self-Assessment Questions
10.9 Suggested Readings and E-References
178 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

INTRODUCTORY CASELET

Mutual Fund entities being financial intermediaries are engaged in

facilitating small savings of the investors through pooling them and
deploy these funds into various financial instruments for dividend and
interest earnings as well capital appreciation. Once these funds start
paying income and capital appreciation, the mutual fund distributes
them among the investors. In the last two decades the mutual funds
have emerged enormously and small investors have been participating
enthusiastically. Mutual funds are supposed to be the most preferred
investments as they are cost effective as well pay comparatively better
returns over other investments. However, the larger segment of small
investors are not aware about how to choose a good mutual fund based
on its past performance and what are the essential components of
evaluating a good mutual fund. The investors are also not aware of the
risk, returns and financial performance ratios.
Some of the investors compare the risks and expected yields post tax
on various instruments while taking investment decisions. A few of
the investors evaluate the portfolio along with the market volatility.
However, a general perception is that majority of domestic investors lack
market-moving influence. There are measures like Net Asset Value, Beta
measurement, Relative Performance Index, Treynor’s ratio, Sharpe’s
etc. that are used for performance evaluation of mutual funds. As an
innovative investor one should know about the performance indicators of
mutual funds before taking investment decisions. There have been good
number of research studies that reveal that more purposeful investment
decision can be taken by investor with the help of a study on mutual
Funds special performance. One can find based on analysis of mutual
funds that yield on mutual funds do differ to a larger extent.

QUESTIONS

1. What are the different types of performance evaluators of

Mutual Funds?
2. What are the prerequisites to mutual fund investments which an
innovative investor should keep in mind?
 PERFORMANCE EVALUATION OF MUTUAL FUNDS 179

LEARNING OBJECTIVES

After going through this chapter, you will be able to understand the
following:
+ Need for evaluating the performance of mutual funds
+ The concept of Net Asset Value and its significance
+ Inter-comparison of Mutual Fund performance
+ The calculation of different types of returns
+ The concept of Beta and its significance
+ Treynor’s Ratio analysis to evaluate mutual fund performance
+ Sharpe Ratio and Mutual Fund performance
+ Assessment of Systematic Investment Plan of a mutual fund

10.1 PERFORMANCE EVALUATION

OF MUTUAL FUND
We often watch and observe from various advertisements of mutual fund
envisaging that past performance does not indicate the future performance
of a fund. It simply denotes that one cannot expect guaranteed returns on
the investments based on the past performance. Therefore, it is essential
to evaluate beyond the previous years’ returns while assessing and taking
investment decisions in mutual funds. One is required to monitor
the investments that will help to take decisions in mutual funds based on
informed decisions and thus realize higher returns. The essential features
of the capital market across the globe are that this keeps fluctuating with
changes in the overall economic environment and other social and political
developments. All this very much impacts the asset allocation of the portfolio
like an original allocation which an investor proposes 50:50 in equity and
debt securities may change to 70:30 considering the market rally and other
developments. It may increase the risk profile of the fund beyond your
requirements. Mutual fund performance evaluation also helps to compare
the performance of investment as compared to other similar funds. Further,
the fund manager may change fundamental attributes which might also
have an added advantage and add to mutual fund performance. Therefore,
a continuous review, monitoring and rebalancing is very much required to
maintain the risk profile intact.
The market is subject to fluctuations with high or low volatility. An individual
cannot evaluate the portfolio each day but nevertheless, it is important to
evaluate the portfolio at frequent intervals. As per SEBI guidelines, the
mutual funds are required to inform the details of their portfolio with all ! IMPORTANT CONCEPT
details every month. The investor can have a look and watch the performance. The market is subject to
It is equally important to watch the performance of other mutual funds fluctuations with high or
with similar schemes to have an idea which of the funds have performed low volatility. An individual
well. An investor must understand that evaluating the performance of cannot evaluate the portfolio
funds in a shorter time period may not provide a very realistic picture of each day but nevertheless, it
the performance of investments under the portfolio. As qualified interme- is important to evaluate the
diaries, mutual funds now have plans and schemes where one can invest in portfolio at frequent intervals.
180 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

funds based on financial goals and risk profile. One of the suggested ways to
analyze performance of mutual fund is to analyze the fund fact sheet which
shows the performance of all the schemes managed the Asset Management
Company (AMC). Different financial ratios could be analyzed and compared
to understand the performance and yield on investments.
The following table represents the performance of individual mutual funds
and the Indexed funds.

TABLE 10.1 PERFORMANCE OF FUNDS UNDER INDEXED

FUNDS (AS OF 30-AUG-2022)
Scheme Name Benchmark Risk NAV NAV Return Return Return
Date Regular 1 Year 3 Year 5 Year
Aditya Birla Sun NIFTY 100 Very 2022– 346.57 3.44 17.65 10.45
Life Frontline Total Return High 08–30
Equity Fund Index
Axis Bluechip S&P BSE 100 Very 2022– 44.60 –3.61 15.29 13.42
Fund Total Return High 08–30
Index
Bank of India NIFTY 100 Very 2022– 10.67 –2.73
Bluechip Fund Total Return High 08–30
Index
Baroda BNP NIFTY 100 Very 2022– 142.29 3.23 16.83 11.78
Paribas Large Cap Total Return High 08–30
Fund Index
Canara Robeco S&P BSE 100 Very 2022– 41.53 0.53 19.74 13.85
Bluechip Equity Total Return High 08–30
Fund Index
DSP Top 100 S&P BSE 100 Very 2022– 291.15 –2.72 14.28 8.24
Equity Fund Total Return High 08–30
Index
Edelweiss Large NIFTY 100 Very 2022– 55.06 1.47 16.71 12.25
Cap Fund Total Return High 08–30
Index
Franklin India NIFTY 100 Very 2022– 696.80 0.75 17.90 9.86
Bluechip Fund Total Return High 08–30
Index
HDFC Top 100 NIFTY 100 Very 2022– 730.92 10.50 16.38 11.15
Fund Total Return High 08–30
Index
HSBC Large Cap NIFTY 100 Very 2022– 320.85 2.11 15.84 10.71
Equity Fund Total Return High 08–30
Index
ICICI Prudential NIFTY 100 Very 2022– 67.46 7.08 18.65 12.33
Bluechip Fund Total Return High 08–30
Index
IDBI India Top NIFTY 100 Very 2022– 40.27 4.98 19.85 10.93
100 Equity Total Return High 08–30
Index

(Continued)
 PERFORMANCE EVALUATION OF MUTUAL FUNDS 181

TABLE 10.1 PERFORMANCE OF FUNDS UNDER INDEXED

FUNDS (AS OF 30-AUG-2022)—CONTINUED
Scheme Name Benchmark Risk NAV NAV Return Return Return
Date Regular 1 Year 3 Year 5 Year
IDFC Large Cap S&P BSE 100 Very 2022– 50.04 2.25 17.49 10.77
Fund Total Return High 08–30
Index
Indiabulls NIFTY 100 Very 2022– 29.32 2.70 13.06 8.97
Bluechip Total Return High 08–30
Index
Invesco India NIFTY 100 Very 2022– 44.23 2.12 16.96 11.51
Largecap Fund Total Return High 08–30
Index
ITI Large Cap NIFTY 100 Very 2022– 11.95 –0.73
Fund Total Return High 08–30
Index
JM Large Cap S&P BSE 100 Very 2022– 99.41 4.62 14.97 9.78
Fund Total Return High 08–30
Index
Kotak Bluechip NIFTY 100 Very 2022– 379.31 2.51 19.02 12.44
Fund Total Return High 08–30
Index
LIC MF Large NIFTY 100 Very 2022– 40.52 0.28 15.77 10.85
Cap Fund Total Return High 08–30
Index
L&T India Large S&P BSE 100 Very 2022– 41.21 2.21 15.97 10.64
Cap Fund Total Return High 08–30
Index
Mahindra NIFTY 100 Very 2022– 15.72 3.31 17.23
Manulife Large Total Return High 08–30
Cap Pragati Index
Yojana
Mirae Asset Large NIFTY 100 Very 2022– 78.93 2.23 17.02 12.12
Cap Fund Total Return High 08–30
Index
Nippon India S&P BSE 100 Very 2022– 53.65 11.16 19.20 12.17
Large Cap Fund Total Return High 08–30
Index
PGIM India Large NIFTY 100 Very 2022– 241.97 –2.61 14.02 9.39
Cap Fund Total Return High 08–30
Index
SBI Bluechip S&P BSE 100 Very 2022– 62.66 5.13 18.29 11.38
Fund Total Return High 08–30
Index
Sundaram Large NIFTY 100 Very 2022– 15.00 1.77 15.97 11.85
Cap Fund Total Return High 08–30
Index
Tata Large Cap NIFTY 100 Very 2022– 335.00 3.17 16.54 10.88
Fund Total Return High 08–30
Index
(Continued)
 182 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

TABLE 10.1 PERFORMANCE OF FUNDS UNDER INDEXED

FUNDS (AS OF 30-AUG-2022)—CONTINUED
Scheme Name Benchmark Risk NAV NAV Return Return Return
Date Regular 1 Year 3 Year 5 Year
Taurus Largecap S&P BSE 100 Very 2022– 109.71 8.05 15.52 8.70
Equity Fund Total Return High 08–30
Index
Union Largecap S&P BSE 100 Very 2022– 16.60 2.41 16.96 10.30
Fund Total Return High 08–30
Index
UTI Mastershare S&P BSE 100 Very 2022– 194.80 1.80 18.33 12.63
Fund Total Return High 08–30
Index
Source: https://www.amfiindia.com/research-information/other-data/mf-scheme-performance-details

From the above data it may be observed that performance of mutual funds
does differ to a large extent under the same scheme. Therefore, an investor
must be more careful while investing in mutual funds and it is necessary to
evaluate the performance.

SELF-ASSESSMENT 1. As per SEBI guidelines, the mutual funds are required to inform the
QUESTION details of their portfolio with all details every month.
a. true
b. false

10.2 NET ASSET VALUE

This is perhaps the most important term to know with respect to mutual
! IMPORTANT CONCEPT funds. Net Asset Value (NAV) is important to understand the performance
The NAV can be more of a particular scheme of a mutual fund. As an investor, when savings
or less than the face are invested in mutual fund, the mutual funds’ issue units. The investors
value depending on the become unit holders. This could be treated as if the investors are
market value of the assets holding the stocks of the company. The NAV is a concept that indicates
(investments made by the the per unit value of investment at a given point of time. Usually, the
mutual funds). face value of a unit is Rs 10. The NAV can be more or less than the face
value depending on the market value of the assets (investments made by
the mutual funds).
The NAV depends on the present market value of the investments
after the adjustments of receivables and payables. The NAV of a unit
may change daily as the market value of the investment’s changes on
daily basis. This is an indication for investors to know the value of their
investments and it is the price at which the units could be bought or sold
under a particular mutual fund scheme.
NAV is calculated by dividing the value of total net assets by the total
number of units issued. A total net asset is the market value of all the
assets a mutual fund holds, subtracting any liabilities and adding up the
 PERFORMANCE EVALUATION OF MUTUAL FUNDS 183

value of receivables which have become due but not yet received at a
given point of time.
Current Market Value of Assets + Receivables
Formula of NAV =
number of outstanding Units under the scheme

Here, Current Market Value of assets is arrived based on the current

movement of the stock market. The NAV of a mutual fund is calculated at
the end of the market day based on the closing prices of the equity where
mutual fund has invested. This is because the market value of securities
changes daily. Therefore, the NAV of a mutual fund also changes daily.
Receivables are the receipts which has become due but mutual fund is yet
to receive like dividend declared or interest which has become due.
Payables are the expenses which mutual fund must pay like, brokerage,
commission, fee etc.
The major criteria for measuring the performance of mutual funds are its
NAV which reflects the very performance of mutual funds on day-to-day
basis, weekly basis. As per SEBI guidelines, the NAVs of mutual fund
schemes are required to be disclosed and are also published in newspapers.
The mutual funds are also required to upload NAV of individual schemes on
the websites by individual mutual funds. The NAV is required to be displayed
on the website of the Association of Mutual Funds in India (AMFI).
In addition to the disclosure of NAVs, the mutual funds are also required
to publish their periodical performance in different time horizons like,
half-yearly results, which also include their returns over a period such as
last six months, last 1 year, last 3 years, last 5 years, and since inception
of schemes. This helps the investor to have a look and analyze other data
and information like percentage of expenses to the total, trends in return on
investments, etc. It is mandatory for all the mutual funds to submit annual
report or abridged annual report to all the investors, SEBI, Stock Exchanges,
and other stakeholders.
Various studies on mutual fund schemes including yields of different
schemes are being published by the financial newspapers on a weekly basis.
Apart from these, many research agencies also publish research reports on
performance of mutual funds including the ranking of various schemes in
terms of their performance. The investors are guided by such study reports
and keep updated about the performance of various schemes of different
mutual funds. While taking investment decisions, the investors can compare
the performance of different schemes of various mutual funds and arrive at
the appropriate investment decision on the type of mutual funds.

2. The _________ is the market value of the securities that mutual funds SELF-ASSESSMENT
have purchased minus any liabilities per unit. QUESTIONS
a. net asset value
b. book value
c. gross asset value
d. net worth value
184 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

3. Which of the statement is correct?

a. NAV informs you about the present value of Rupees
b. NAV gives you information about the Unit price of the equity
growth scheme if you have invested in equities through some
mutual funds
c. both a and b
d. none of the above

10.3 MEASURE OF RETURN AND RISK

OF PORTFOLIO
Let’s look at a few cases to understand the return on mutual fund investments.

ABSOLUTE RETURNS
Absolute or point to point returns are the returns calculated based on
the initial investment and ending value of the investment based on NAV.
The duration of investment does not have any relevance. Suppose an
investor has investments in a mutual fund scheme, where initial NAV was
Rs 10 and after 2 years the NAV becomes Rs 16. In this case, point to point or
absolute return will be 60 per cent. We can say,
Absolute returns = (Current NAV – Initial NAV)/Initial NAV × 100

ANNUALIZED RETURNS
At times, the investor is interested in knowing the annualized returns when
the holding period is less than a year. In that case, the annualized returns
can be calculated as under:
((1 + Absolute Rate of Return) ^ (365/number of days)) – 1
We can further understand it through a small example.
Suppose NAV of a mutual fund scheme rises from Rs 20 to Rs 25 in
the holding period of 7 months. The 7 months calculated on days basis
comprises of 210 days. We may calculate the absolute returns in this case
as follows:
First, calculate absolute returns on this scheme which comes to 25 per cent
(25 – 20/20) = 0.25
Based on absolute returns, we can calculate annualized returns
Absolute Returns = ((1 + 0.25) ^ (365/210)) – 1 = 0.4738
= 47.38 per cent

COMPOUNDED ANNUAL GROWTH RATE (CAGR)

Often an investor is more interested in knowing the compounded annual
growth (CAGR) on the investments over a period of time in case the
investor is interested in long term or medium term investments. This can
be calculated based on the initial NAV and ending NAV and the number of
 PERFORMANCE EVALUATION OF MUTUAL FUNDS 185

months in consideration. The following formula can be used to calculate

the CAGR:
CAGR = [(Ending Value/Beginning Value) ^ (1/n)] – 1

Example:
Suppose your investment starts off at Rs. 15,000 and ends up costing
Rs. 25,000 after three years (N = 3).
Based on absolute returns, we can calculate Annualized Returns,
Annualized Returns = CAGR = (25,000/15,000)^(1/3) – 1
Absolute return is the indicator of performance for your overall investment,
whereas annualised return measures how an investment performed over
the course of a year. The term “return” refers to the yield produced by
an investment over a predetermined amount of time. Basically, this is the
amount by which the investment’s value increased or decreased over the
specified period of time. The performance of the specified investment is
shown, independent of the amount of time spent. Either INR or a percentage
can be used to express the metric. However, because percentages combine
the components of the initial investment and the return into a single number,
they are thought to be far more effective. One would need the initial and
end Net Asset Values to calculate absolute return (NAV). Here, the time is
unimportant.
The annualised return, as its name suggests, establishes the investor’s returns
per year. A percentage figure can be used to compute an annualised rate of
return. The term compound annual growth rate (CAGR) is frequently used to
describe how returns compound over time. It provides investors with a summary
of the outcomes of their investment. But it is unable to foresee instability.
While annualised return shows how longer-term investments with varied
return rates build value annually, absolute return measures the performance
of an investment in terms of how much money you’ve generated from the
first day.

RETURNS ON SYSTEMATIC INVESTMENT PLAN

In a systematic investment plan (SIP) of a mutual fund, the investor invests
a fixed amount regularly on monthly basis(can be as per the person’s choice)
for a long period of time. This amount is invested by the mutual fund on long
term securities. On maturity, the investor receives the total amount based on
the NAV as at the day of maturity. Since the NAV of the scheme gets changed
with the accumulated amount and performance of investments, it is difficult
to calculate the NAV under the SIP in a routine manner. On the day the
investor exits the scheme by redeeming units, the maturity amount is paid
based on the NAV of that day.

10.3.1 RISK
One of the most popular indicators used by traders and analysts to evaluate
the volatility and relative risk of possible investments is standard deviation.
The mean is first subtracted from each number to get the variance, which
186 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

is then squared, added, and averaged to determine the standard deviation.

Squaring the individual differences allows the variance, which is a helpful
indicator of range and volatility in and of itself, to be reported in a standardised
unit of measurement rather than the units used in the original data set.
The riskier the investment, the bigger the standard deviation. The fundamental
presumption when using standard deviation to assess risk in the stock market
is that the vast majority of price movement adheres to a normal distribution.
The standard deviation of a mutual fund’s return compared to projected
returns based on its past performance is what we learn about mutual funds.
For instance, it may be inferred with 95% certainty that the next closing
price in a stock with a mean price of $45 and a standard deviation of $5 will
remain between $40 and $50. However, 5% of the time the price rises or
falls outside of this range. A stable blue-chip stock often has a low standard
deviation compared to a stock with a high standard deviation.

10.3.2 BETA: MEASURE OF SYSTEMATIC RISK

The volatility that impacts the entire stock market across a variety of sectors,
stocks, and asset classes is known as systematic risk, sometimes known as
total market risk. Because it has an impact on the entire market, systematic
risk is challenging to forecast and insure against.
The systematic risk of a mutual fund can be measured through Beta of the
mutual fund scheme in the following manner;
rp = α + β × rm + ep
Where, rp is the return on the mutual fund scheme, rm is the return on
the market, α is the intercept, β is the slope or the beta coefficient, ep is the
error term.
The higher values of β indicate a high sensitivity of a fund returns as
compared to market returns and the lower value indicates low sensitivity.
Obviously, higher β values are desired for the mutual funds during bull
phase of the market and lower β values are suitable during the bear phase
to obtain better results.
The market has a beta of 1.0 by definition. Values of individual securities and
portfolios are evaluated based on how far they depart from the market. The price
of the investment will move in lockstep with the market if the beta value is 1.0.
An investment will likely be less volatile than the market if its beta value is less
than 1.0. Accordingly, a beta value greater than 1.0 denotes that the price of
the investment will fluctuate more than the market. The market is 20% more
volatile than, for instance, a fund portfolio with a beta of 1.2.

SELF-ASSESSMENT 4. What do CAGR stands for?

QUESTIONS
a. compounded annual growth rate
b. conceptual annual growth rate
c. covariance in annual growth rate
d. convenient annual growth rate
 PERFORMANCE EVALUATION OF MUTUAL FUNDS 187

5. When calculating absolute returns, what duration of investment is

taken into account?
a. 2 years
b. duration of investment does not matter
c. 5 years
d. duration given by business partner
6. Systemic risk is also known as _______
a. zero risk
b. complete risk
c. total market risk
d. complete market risk

10.4 RISK ADJUSTED RETURNS

The returns and risk of the portfolio must both be taken into account
when evaluating portfolio performance. The Treynor’s ratio, Jensen
alpha, and Sharpe’s ratio are the three often used risk indicators.
The risk-adjusted return calculates your investment’s profit in relation
to the risk it entailed over the course of a certain amount of time.
The investment with the lowest risk will have a higher risk-adjusted
return if two or more investments produced the same return over a
specific period of time.

10.4.1 SHARPE’S RATIO

The Sharpe ratio calculates the benefit of an investment per unit of standard
deviation that is higher than the risk-free rate. It is computed by taking the
investment’s return, deducting the risk-free rate, and dividing the outcome
by the standard deviation of the investment.
In all other respects, a greater Sharpe ratio is preferable. Greater standard
deviations indicate larger returns, whereas narrower standard deviations
suggest more concentrated returns. The standard deviation illustrates the
volatility of an investment’s returns relative to its average return. The yield
on a risk-free investment, like a Treasury bond (T-bond), for the applicable
time period is the risk-free rate.
Say, for instance, that Mutual Fund B returns 10% and has a standard
deviation of 7%, while Mutual Fund X returns 12% over the last year and has
a standard deviation of 10%, and that the risk-free rate for the period was
3%. Following are the steps for calculating the Sharpe ratios:
‰ Mutual Fund X: (12% – 3%)/10% = 0.9
‰ Mutual Fund B: (10% – 3%)/7% = 1
Even though Mutual Fund X had a higher return, Mutual Fund B had a
higher risk-adjusted return, meaning that it gained more per unit of total
risk than Mutual Fund X.
188 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

10.4.2 TREYNOR’S RATIO

The Treynor ratio is calculated the same way as the Sharpe ratio, but uses
the investment’s beta in the denominator. As is the case with the Sharpe,
a higher Treynor ratio is better. The ratio describes the systematic risk.
It has been assumed here that an investor could overcome unsystematic
risk by holding a diversified portfolio, therefore systematic risk assumes
significance. The performance measure is denoted as Tp that represents the
excess returns over the risk-free rate per unit of systematic risk. We can also
say that it represents risk premium per unit of systematic risk. This can be
described as under:
Risk Premium r - rf
=Tp = p
Systematic Risk Index βp
where Tp = Treynor’s Ratio, rp = portfolio return, rf = risk free return, and
βp = Beta.
Using the previous fund example, and assuming that each of the funds has a
beta of 0.75, the calculations are as follows:
‰ Mutual Fund X: (12% – 3%)/0.75 = 0.12
‰ Mutual Fund B: (10% – 3%)/0.75 = 0.09
Here, Mutual Fund X has a higher Treynor ratio, meaning that the fund is
earning more return per unit of systematic risk than Fund B.

10.4.3 JENSEN’S ALPHA

Jensen’s measure finds the excess return on risk-adjusted basis.
Sharpe’s measure and Treynor’s measure are the portfolio performance
in relative terms with respect to risk, while Jensen’s measure is focused
on absolute excess of returns on risk-adjusted basis. As we know that
Capital Asset Pricing Model (CAPM) suggests that portfolios must earn
returns proportional to the portfolio risk measured by beta, that is, βP.
The CAPM-based returns are measured in excess of risk-free rate of
return. Since beta of the market portfolio is one the excess returns of
the market portfolio is (rM – rF), where rM is the returns on the market.
Portfolio return rP in excess of risk-free return must be proportional to
its beta. In terms of CAPM, excess returns of the portfolio (rP – rF) are
given as,
rP - rF = β P × (rM - rF )
For example, for a portfolio with beta of 1.5, market return of 16% and
risk-free rate of 5%, the portfolio should earn a return in excess of risk-free
rate of 1.5 × 11 = 16.5%. The return of the portfolio, therefore, must
be 16.5 + 5.0 = 21.5%. With respect to performance, if the actual return
of the portfolio happens to be more than 21.5%, it has outperformed the
market on risk-adjusted basis. On the other hand, if the portfolio’s actual
return is less than 21.5%, it has underperformed the market on risk-
adjusted basis.
 PERFORMANCE EVALUATION OF MUTUAL FUNDS 189

7. Which of the following the Sharpe and Treynor ratio measures? SELF-ASSESSMENT
QUESTION
a. standard deviation
b. risk adjusted returns
c. beta
d. alpha Factor

10.5 LOWER vs HIGHER NAVs

It has been observed that investors at large tend to opt for a scheme which
is available at the lower NAV as compared to higher NAV. At times, investors
prefer a new scheme which is being issued at Rs 10 per unit. As per the
practices followed by the investors in the selection of mutual fund schemes,
the following is suggested:
a. In case of mutual funds schemes, lower or higher NAVs in similar nature
of schemes in different mutual funds have not much significance.
b. Fundamentally, the investors should prefer a scheme after analyzing
the merits of each scheme, based on performance track record of the
concerned mutual fund.
c. The quality-of-service standards and kind of professional management
available with the mutual fund also assume significance.
We can further understand this through an example. Let us assume that
scheme P of a mutual fund is available at a NAV of Rs 12 and another
scheme R at Rs 72. Let us further assume that both the schemes are
equity oriented and diversified schemes. We assume that the investor has
invested Rs 10800 under each of the two schemes. Under the scheme P
the investor would receive 900 units (10800/12) and under the scheme R,
the investor would receive 150 units (10800/72). Suppose the markets
go up by 20 per cent and both the schemes perform equally good.
This will be reflected in the NAV of both the schemes. Accordingly, NAV
of the scheme P will rise to Rs 14.40 and for the scheme R to Rs 86.40.
The following will be the market value of investments:
Value under scheme P = Rs 12960 (900 × 14.40)
Value under scheme R = Rs 12960 (150 × 86.40)
Therefore, the investor will receive the same return of 20 per cent under
both the schemes. We can understand from the above that lower or
higher NAV of the schemes has no significance while making investments
decisions in mutual fund schemes. Similarly, there is no relevance in
making investment decisions in a newly launched scheme at par value of
Rs 10 per unit and an existing scheme which have NAV of Rs 100. This is
also true with the income or debt-oriented schemes of mutual funds.
Another important aspect is efficiency in the management of schemes by the
mutual fund. The better managed funds may provide better returns and,
therefore, higher NAV as compared to schemes available at lower NAV with
inefficient management. Similar is the case of fall in NAVs. Efficiently managed
scheme at higher NAV may not fall as much as inefficiently managed scheme
190 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

with lower NAV. Therefore, the investor should give more importance to the
professional management of a scheme instead of lower NAV of any scheme.
He may get a much higher number of units at lower NAV, but the scheme may
not give higher returns if it is not managed efficiently.

10.5.1 CRITERIA FOR INVESTMENT IN MUTUAL FUND SCHEMES

As a retail investor, one usually goes through the offer document issued
by different mutual funds. This document provides all the details of the
scheme that is being launched. Depending on the convenience, terms
of the scheme and suitability to individual investors, the decision about
investing in the scheme can be arrived. Once the investment decision is
taken, the past performance of the mutual funds must be seen to get a
view on the past track of return on investment. Investors may also keep
in view the past track record of the scheme or other schemes of the same
mutual fund. This will help the investors to make a comparison about the
performance of the mutual funds in question with other schemes having
similar investment features. This should be kept in view that the past
performance of a scheme cannot be taken as a true indicator of its future
performance. However, given the market conditions, this gives a direction
about the trend of performance of different mutual funds.

10.5.2 SYSTEMATIC INVESTMENT PLAN (SIP)

A Systematic Investment Plan, or SIP, promotes regular saving habits and a
disciplined approach to investing. At the conclusion of a specific period, we
observed that every rupee saved added up to a greater sum. We can rarely
forecast with any degree of accuracy when a particular stock will move up or
where the interest rates are headed in developing nations like India where
stock markets may be extremely volatile and it is rare to be able to timing the
market & predict the future.
When you consistently invest the same amount in a fund, you purchase
more units when the price is lower and fewer units when the price is higher.
As a result, you would gradually lower your average cost per unit. “Rupee
cost averaging” is the name given to this tactic. This is particularly valid
for equity investments. This method can smooth out the market’s ups and
downs and lower the dangers of investing in erratic markets by using a
prudent and long-term investment approach. SIP turns the volatility to our
advantage. A fixed monthly investment buys more units when the price is
low and fewer units when the price is higher. As a result, regardless of how
the market changes or rises or falls, the average unit cost will always be
lower than the average sales price per unit.
Rupee Cost Averaging enables investors to maximize the return on their
capital. It helps lower their investing costs by making purchases in both rising
and falling markets. In times of declining markets, it offers the investor extra
units for the same price. Rupee cost averaging eliminates the benefit of daily
market monitoring. The benefit of rupee cost averaging is that investments
are made gradually, assisting in avoiding the dangers of market volatility.
It is a technique that offers improved chances for generating cash.
 PERFORMANCE EVALUATION OF MUTUAL FUNDS 191

SYSTEMATIC INVESTMENT PLAN (SIP)

SIP is a unique investment plan offered by mutual funds to inculcate a
regular investment of a fixed amount of money at pre-defined intervals.
This is a significant option for the investors who want to invest in frequent
intervals instead of investing the whole amount at once. It gives flexibility
to the investor to invest in installments. It is not restricted to mutual funds
and is also used as an investing strategy in the stock market and investing
schemes. The following are the features of this plan.
1. Safe Investment: Even if one does not know about stocks and shares,
a Mutual fund is an opportunity or an exposure to the equity market
with minimal risk. Besides, the money is invested periodically, making it
convenient for the investor and deducting directly from the bank. It is a safe
investment because the money is invested in the mutual fund scheme that
the investor decides.
2. Regular & Organized Plan: Systematic Investment Plan (SIP) makes
the process more disciplined and organized. Once the SIP is put in place,
it becomes more flexible to invest in it either weekly, monthly, or quarterly
basis depending on the scheme. This ensures the investor is not drained on
a financial basis and makes investing much more convenient and flexible.
The basic fundamental of mutual funds is a systematic or organized order
of using money and distributing it with interest. SIP works in order and in a
disciplined manner to comply with the convenience of the investor. Although
this is not limited to mutual funds, there is a small difference in the stocks
market where SIP helps in investing though the market is fluctuating. When
the stock market hits rock-bottom, SIP allocates the investor more units and
allocates lesser units when the market prices are high.
3. Facility of Small Payments: Most of the investments need the investor
to invest huge amounts to get better and higher results. Besides, a few
investments are so high that it would not be possible for most investors to
invest in them. So, where does this huge number of people invest in? Mutual
funds are the option. Mutual funds SIP option allows investors to invest as
low as Rs.500, which is affordable for the greater audience.
4. Convenience: Unlike most investments, Investors who invest in SIP
mutual funds can find it convenient to invest because it is a hassle-free
process. Once the mutual fund is applied, all the investor needs to do is ask
the bank to enable auto-debits. The monthly, weekly, or quarterly SIP is
deducted directly from the bank without any manual process. This is a great
option for the investors who are busy earning money and let the process be
automated. Apply and receive the interest in a timely manner.
5. Power of Compounding: Compounding is when the interest earned is
invested back in the mutual fund for higher returns. Besides, the primary
conduct needs to stay invested for a longer time to ensure higher profits and
invest in the early stages.
The compounding effect magnifies the returns earned through SIP and
invests for a longer term. It ensures that the interest is earned on the
principal amount and the interest over a long period. This is highly beneficial
for investors who want to earn more in the longer run.
192 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

6. Own more stocks in smaller quantities: Investors might want to invest

in multiple stocks to diversify the portfolio, and buying individual stocks
might want the investor to have a large surplus. This is not possible for all
the investors, but when the investors invest in mutual funds, they can own
multiple stocks in small quantities and at a lesser price.
7. SIP can be stopped or skipped: One of the SIP benefits is it can be stopped
anytime by opting out of the SIP plan. This is one of the biggest benefits over
recurring deposits, which fine when the investment is stopped. Once the SIP
is stopped, either the investor can return to the amount or continue to invest
in the mutual fund. Besides, SIP offers an option to skip the payment. If the
investor has no balance in the account for SIP investment for a particular
month, he/she can continue with the SIP in the next period without any
problems or fines.

HOW RUPEE COST AVERAGING WORKS?

When you invest the same amount in a fund at regular intervals over time,
you buy more units when the price is lower and buy less when the price
is higher. Thus, you would reduce your average cost per unit over time.
This strategy is termed as ‘Rupee cost averaging’. This is especially true for
investments in equity. With a sensible and long term investment approach,
this strategy can smooth out the market’s ups and downs and reduce the
risks of investing in volatile markets.
SIP makes the volatility work in our favor. As a constant amount invested
every month ends up buying more units at low prices & fewer units when
the price is up. Thereby the average unit cost will always be less than the
average sales price per unit, irrespective of the market rising, falling, or
fluctuating.
For better understanding refer the table below as an example

AMOUNT RISING FALLING VOLATILE

MONTH
INVESTED MARKET MARKET MARKET
Units Units Unit
NAV NAV NAV
Allotted Allotted Allotted
1 1000 100 10 100 10 100 10
2 1000 120 8.33 80 12.5 120 8.33
3 1000 140 7.14 60 16.67 80 12.5
4 1000 160 6.25 40 25 100 10
Total 4000 520 31.72 280 64.17 400 40.83
Average Purchase Price 130 70 100
Average Cost Per Unit 126.10 62.33 97.96

In the above table, we can see both average purchase price and the average
cost per unit are different.
(Average cost per unit = Actual average acquisition cost under SIP)
< Average purchase price
 PERFORMANCE EVALUATION OF MUTUAL FUNDS 193

Benefits of Rupee Cost Averaging

‰ Rupee Cost Averaging helps investors to get the maximum benefit on
their investments.
‰ It helps an investor to average out their investment cost by purchase in
both falling & rising markets.
‰ It gives the investor more units for the same amount at the time of falling
markets.
‰ Rupee cost averaging negates the aspect of tracking the market on a
daily basis.
‰ Rupee cost averaging gives the benefit of gradual investments which
help in avoiding the pitfalls of market volatility.
‰ It is a method that provides better prospects for wealth creation.

8. What does SIP stand for? SELF-ASSESSMENT

QUESTIONS
a. systemic investment plan
b. systematic investment plan
c. sizeable investment plan
d. systematic investment programme
9. In a SIP of a mutual fund, the investor invests a fixed amount
regularly on ______ basis for a long period of time.
a. monthly
b. yearly
c. quarterly
d. as per choice
10. Rupee Cost Averaging helps investors
a. maximize returns on their capital
b. minimize returns on their capital
c. achieve diversification
d. none of the above

10.6 SUMMARY
‰ The mutual fund investments are primarily meant for small investors
who has no time to watch and monitor the market and also, they are not
regular players in the market.
‰ Mutual fund performance evaluation also helps to compare the
performance of investment as compared to other similar funds. Further,
the fund manager may change fundamental attributes which might
also have an added advantage and add to mutual fund performance.
Therefore, a continuous review, monitoring and rebalancing is very
much required to maintain the risk profile intact.
194 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

‰ Net Asset Value (NAV) is important to understand the performance of a

particular scheme of a mutual fund. The NAV depends on the present
market value of the investments after the adjustments of receivables and
payables.
‰ The riskier the investment, the bigger the standard deviation.
The fundamental presumption when using standard deviation to assess
risk in the stock market is that the vast majority of price movement
adheres to a normal distribution.
‰ The systematic risk of a mutual fund can be measured through Beta of
the mutual fund scheme.
‰ The risk-adjusted return calculates your investment’s profit in relation
to the risk it entailed over the course of a certain amount of time.
‰ Rupee Cost Averaging enables investors to maximize the return on
their capital. It helps lower their investing costs by making purchases
in both rising and falling markets.

KEY WORDS Annualized rate of return – The average annual return over a period of
years, taking into account the effect of compounding. Annualized rate of
return also can be called compound growth rate.
Beta – A measurement of volatility where 1 is neutral; above 1 is more
volatile; and less than 1 is less volatile.
Capital gain – The difference between a security’s purchase price and its
selling price, when the difference is positive.
Net Asset Value (NAV) – The current market price of one unit of
Mutual Fund.
Portfolio allocation – Amount of assets in a portfolio specifically
designated for a certain type of investment.
Sharpe Ratio – A risk-adjusted measure that measures reward per unit
of risk. The higher the sharpe ratio, the better. The numerator is the
difference between the Fund’s annualized return and the annualized
return of the risk-free instrument.
Systematic investment plan – A service option that allows investors to
buy mutual fund shares on a regular schedule, usually through bank
account deductions.

10.7 DESCRIPTIVE QUESTIONS

1. Why it is important to evaluate the performance of Mutual fund
schemes?
2. What are the important factors that contribute to the good performance
of a Mutual Fund?
3. Explain Sharpe, Treynor and Jensen’s Alpha.
 PERFORMANCE EVALUATION OF MUTUAL FUNDS 195

10.8 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS
Topics Q. No. Answers
Performance Evaluation of 1 a. True
Mutual Fund
Net Asset Value 2 a. Net Asset Value
3 c. both a and b
Measure of Return and Risk 4 a. Compounded Annual Growth Rate
of Portfolio
5 b. Duration of investment does not
matter
6 c. Total market risk
Risk Adjusted Returns 7 b. risk adjusted returns
Lower vs Higher NAVs 8 b. Systematic Investment Plan
9 d. As per choice
10 a. Maximize returns on their capital

10.9 SUGGESTED READINGS AND

E-REFERENCES
‰ Srivastava, Rajiv (2017), Investment Management, Wiley
‰ Elton J Edwin, Brown J Stephen (2013), Modern Portfolio Theory and
Investment Analysis, Wiley
‰ Brooke, P., and Penrice, D. (2009) A Vision for Venture Capital –
Realizing the Promise of Global Venture Capital and Private Equity
(New Ventures)
‰ Capital Dynamics (2010) The Definitive Guide to Risk Management in
Private Equity (PEI Media)
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A. (2008) Private
Equity: History, Governance and Operations (John Wiley & Sons)
‰ https://www.amfiindia.com/research-information/other-data/mf-scheme-
performance-details
 C H
11 A P T E R

MACRO-ECONOMIC FACTORS
IMPACTING INVESTMENTS

CONTENTS

11.1 Introduction
Self-Assessment Questions
11.2 Assessing of the Economy
11.2.1 The Business Cycle
11.2.2 Forecasts of the Economy
Self-Assessment Questions
11.3 The Stock Market and the Economy
11.3.1 The Economy and the Stock Market Booms
11.3.2 Economic Slowdowns and Bear Markets
11.4 Understanding the Stock Market
11.5 Making Market Forecasts
11.5.1 Forecasting Stock Market Returns
11.5.2 Business Cycle to Make Market Forecasts
Self-Assessment Questions
11.6 Summary
Key Words
11.7 Descriptive Questions
11.8 Answer Keys
Self-Assessment Question
11.9 Suggested Readings and E-References
198 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

INTRODUCTORY CASELET

The first week of June, 2022 saw the opening of markets on a flat
note. Indian benchmark indices ended with volatile trading session
on a negative note amid worsening geopolitical situation in Europe.
Additionally, rising bond yields in the debt market also dampened
investors’ sentiment. The BSE Sensex index fell 185 points, or 0.33%,
to end at 55,381 levels, while the NSE Nifty 50 index shut shop at 16,523,
down 62 points or 0.37%. Both the indices had touched intra-day lows
of 55,091 and 16,439, respectively. In the broader markets, the BSE
MidCap index slipped 0.1%, while the BSE SmallCap index added
0.62%. Sectoral wise, the Nifty IT index slipped over 1%, while the
PSU Bank index added 0.9%.
Despite mixed global cues Indian share markets saw positive trading
activity and ended higher. As buying returned in heavyweight
stocks, benchmark indices witnessed extended gains as the session
progressed. The second week of June saw the Indian share markets
under the trap of the bear-grip throughout the day with the markets
ending on a negative note. This was possibly due to the worries of
high inflation along with the expected follow-up of Reserve Bank of
India’s unscheduled rate hike in May. The third week of June saw
the Indian share markets facing further losses due to investors’ fear
of a looming recession as Wall Street hit a bear market milestone.
Benchmark indices ended the volatile session on a weaker note while
investors were spooked by Wall Street hitting a bear market milestone
on fears of a looming recession.
The final week of June started as a glimmer of hope with Indian
markets ending strongly as investors’ sentiments were uplifted due
to firm global market cues. June finally ended with the Indian share
markets ending on a flat note. Benchmark indices fell into red after
giving up early gains due to weakness in auto and IT stocks.
This is the case that shows how the inflation, interest and international
markets impact the volatility in the capital markets.
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 199

LEARNING OBJECTIVES

After going through this chapter, you will be able to understand;

+ The Business Cycle
+ Assessing the Economy
+ Forecasts of the economy
+ The Stock Market and The Economy
+ The Economy and The Stock Market Booms
+ Economic Slowdowns and Bear Markets
+ Making Market Forecasts
+ Forecasting Stock Market Returns
+ Using the Business Cycle to Make Market Forecasts

11.1 INTRODUCTION
A sound financial system is the barometer of the economic growth and
social development of a country. The economic and social development is
mainly measured in terms of GDP growth of a country and in turn, the per
capita income. The pace of GDP growth among others depends on the
nature and depth of capital investments and thereby the quality and type
of infrastructure developed in the economy to further boost the output.
The investments are financial and physical resources that are deployed to
build a strong foundation of an economy. The financial system can be defined
as a mechanism of mobilizing surplus resources from various segments of
the economy and deploy such resources for the capital formation in the
country. Capital formation can be defined as process of transfer of savings
from savers to users of capital. In other words, the capital formation can
be explained in terms of creating infrastructure and other facilities that
will accelerate the production process in a systematic manner. The capital
formation basically involves three components viz. savings, financing and
investments. This is done through financial intermediation involving financial
institutions, financial markets and financial instruments. Therefore, we can
say that there are three core pillars of a strong financial system in any of the
economies. These are:
1. Financial Institutions
2. Financial Markets
3. Financial Instruments
The depth and width of the above three pillars is an indicator of the
strength of the financial system of a country. The three pillars are very
closely inter-related. The financial intermediation is a process to facilitate
transfer of surplus resources from different savers and investing them for
productive purposes. There are two essential elements in this process.
One, the savers need an institutionalized system to park their surplus
resources without much of risk and faster liquidity while on the other,
200 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

the investors to whom these resources are lent require cost effective
borrowings for various purposes. The financial intermediary agency
performs both the tasks. Broadly we can mention the role of financial
intermediation as under;
a. Mobilizing huge available surplus resources from housed hold, private
and the government sectors by designing and developing tailor made
products.
b. Provide faster liquidity of funds from one segment to another.
c. Attaining cost efficiencies account of economies of scale and transfer
benefits to savers and investors both.
d. Providing risk shelter to savers on one side while guiding and directing
on risk control measures to investors on the other.
e. Maintaining adequate balance on mismatch of maturities of assets and
liabilities.
f. Provides an efficient mechanism for healthy growth of financial markets
of the country.
g. Extension of credit to various needy segments of the society.
h. Facilitating in minimizing the gaps between rich and poor and thereby
economic inequalities in the society.
i. Playing a significant role in wealth maximization.
j. Accelerating the pace of transfer and payments related services.
We can say that the investments facilitate the process of economic growth
since a strong infrastructure is created through infusing capital to attract
and motivate the investments under various segments of the economy.
The investments and savings are directly affected by the macro economic
factors like, GDP growth, inflation, interest rates, availability of financial
institutions and depth of the financial markets in an economy. The financial
markets comprise of capital and money markets to meet long terms and
short term financial requirements. The investors get motivated by efficient
functioning if the capital markets in general and the stock markets in
particular.

SELF-ASSESSMENT 1. The ________ can be defined as a mechanism of mobilizing surplus

QUESTIONS resources from various segments of the economy and deploy such
resources for the capital formation in the country.
a. financial system
b. capital formation
c. GDP
d. none of the above
2. ________ can be defined as process of transfer of savings from savers
to users of capital.
a. capital formation
b. GDP
c. financial system
d. none of the above
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 201

3. Three core pillars of a strong financial system in any of the economies.

These are:
1. financial institutions
2. financial markets
3. financial instruments
Which statement is correct?
a. only 1
b. only 2
c. all 1, 2 and 3
d. none of them

11.2 ASSESSMENT OF THE ECONOMY

The economic development is an ongoing process that changes over a period
of time. There are different criteria to assess the economic development of
a country. These parameters differ in terms of qualitative and quanti-
tative assessment. This also depends on the nature of the economy
whether it is developed or developing economy and accordingly the growth
parameters do change. There are different possible measures to assess the
economic development of a country like, income per head, the extent of
available resources utilized, capital per head, per capita savings, amount
of social capital, human development index etc. However, when we talk in
terms of economic growth, an increase in national income, per capita real
income, comparative concept, standard of living and economic welfare of
the society at large are the key indicators of economic development of a
country. Let us understand these parameters in brief.

A. NATIONAL INCOME
The National Income of a country is supposed to be as one of the important
criteria to determine the degree of economic growth of a country. For this
measurement, capatilize Initial’s like Net National Product (NNP) is preferred to
Gross National Product (GNP) as it provides a better insight about the economic
growth of a country. According to Prof. Meier and Baldwin, “If an increase in
per capita income is taken as the measure of economic development, we would
be in the awkward position of having to say that a country has not developed if
its real national income, had increased but its population had also increased
at the same time same rate.” A higher real national income is generally a
pre-requisite for an increase in real per capita income and therefore a higher
national income is an indicator of economic development. Of course, there are
difference of opinion among the section of economists but overall it is recognized
as one of the crucial factor to measure the economic development of a country.
There are two approaches for calculating the GDP of a country.
Expenditure Approach: This approach considers the amount of money
everyone in the economy spent during a certain period. This can be
calculated using the following formula.

C + G + I + NX = GDP
202 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Here;
C = Consumer Spending
G = Government Expenditure
I = Investment in the country
NX = Net Exports
Income Approach: Under this approach, the total income the goods and
services earned are considered. The GDP can be calculated using the
following formula.

Total national income + sales taxes + depreciation

+ net foreign factor income = GDP

B. PER CAPITA REAL INCOME

The economic growth is meaningful if it can improve the living standards of
common people in the society. Therefore, the economic development has to
focus on increased aggregate output. The economic development can be
termed as a process that contributes to an increase in per capita real income
over a long period time. The UNO experts in their report on ‘Measures of
Economic Development of Under-developed Countries’ have also accepted
this measurement of development. The very objective of development is to
facilitate better and qualitative living standard of the people to help increase
the consumption level. This can be well measured through per capita income
rather than national income. In the developed economies, per capita
income has been on continuous increase because the growth rate of national
income is greater than the growth rate of population. This can be well stated
in case of India where per capita national income was Rs.86.65 thousand in
financial year 2015 that increased to more than 150 per thousand in 2021–22.
This shows that the economy of the country has been progressing.

C. ECONOMIC WELFARE AS AN INDICATOR OF

ECONOMIC DEVELOPMENT:
The equal distribution of national income across the segments of the society
contributes to increase economic welfare. This increases the purchasing
power of money and this leads to an increase in the level of economic
welfare. The economic welfare also facilitates price stability. This also helps
in increasing the economic welfare.

D. HUMAN DEVELOPMENT INDEX

The Human Development Index (HDI) is a measure to indicate economic
development and economic welfare of the people of a country. The HDI
measures three important criteria of economic development viz. life
expectancy, education and income levels. This is used to create an overall
score between 0 and 1 where 1 indicates a high level of economic development
and 0 a very low level.

E. OCCUPATIONAL PATTERN
The distribution of working population in different occupations is also
regarded as a criteria for the measurement of economic development.
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 203

The changes in composition of occupational structure can be used as an

important parameter to assess the nature of economic development.
There are basically three sectors i.e. Primary sector that includes agriculture,
fisheries, forestry, mining etc. the secondary sector consisting of manufac-
turing, trade, construction and third, the tertiary sector comprising of
services like banking, transport, etc. A shift in occupational distribution of
population from primary sector to secondary and territory sectors shows the
movement towards economic development when a country makes economic
progress, its working population begins to shift from primary sector to
secondary and tertiary sectors.

F. SAVINGS AND INVESTMENTS

Another measurement id the pattern of savings and investments in the
country. This shows the level of increased income among the population
and extent of amount available as savings. Higher the savings with
the people, it will add to higher growth of investments and increased
production and consumption level. The efficiency of economic growth
and development is primarily assessed by the pace of savings and
investments by different segments of the society viz. individuals, business
sector and the government sector as the savings are the surplus resources
available with household sector, private sector and the government sector.
The surplus can be further explained in terms of disposable income which
remains available with various segments after meeting their necessities.
These savings are mobilized and pooled to create investments in the
economy. The savers get advantage of interest in the savings being offered
by various financial intermediaries. The savings are also required to
meet various financial requirements in future. The savings are deployed
as short term or long term investments. Therefore, the savings can be
withdrawn and utilize as and when desired. Therefore, to pool the savings
from different segments we need an institutional system comprising of
financial institutions, capital markets and money markets.
In case of India, the financial savings of household sector stood at 10.8 percent
of GDP during financial year 2022 as compared to 15.9 per cent in financial
year 2021. The decline in savings was on account of Pandemic of COVID 19.
In the three previous fiscal years, it was 12 per cent. Among other components,
the pace of savings and investment by the household sector depends on
efficient capital markets. In India, an increased savings rate in the recent
past had been possible on account of healthy growth of capital and stock
markets. Once the savings are mobilized, the next question arises as how to
make optimum utilization of these savings.
The investment function can be explained in terms of deployment of surplus
resources into productive purposes which is also known as capital formation.
The growth of infrastructure in terms of roads, railways, airports, flyovers,
machinery, equipment etc. is better for economic growth. Therefore, we can
say that investment functions have basically the following features:-
‰ Investment contributes to economic growth at macro level.
‰ Investment helps further production process by infusing additional
capital in the plant, machine and equipment.
204 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Investment

Capital Formation

Additional/Increased
Output

Increased Revenue

Increased Income

Increased Savings

Increased Investment

Figure 11.1 Investment Cycle.

‰ Investment is also helpful in increasing employment opportunities.

‰ Investment also helps in increase GDP growth.
‰ Investment also help in boosting individual incomes and there by savings.
The savings in term are circulated in form of further investments and
thus this cycle goes on.
If we assess an economy in terms of importance and contribution of financial
system, it is measured in many ways in terms of economic development, social
growth and living standards of people at large. As discussed the integration
of financial intermediaries, financial markets and financial instruments
contribute significantly for healthy growth of a financial system in a country.
The efficient functioning of efficient financial markets contributes to the
growth of savings and investment as follows;
‰ The strong financial markets contribute effectively for the economic
development and growth of the country.
‰ It promotes the process of capital formation that helps in long term
investments in creating and developing strong infrastructure, an
important phenomenon for economic growth.
‰ It establishes a links between the savers and investors through an
effective financial intermediation.
‰ It is accelerates the process of transforming savings into investments.
In a nutshell, the width and depth of financial markets provides variety of
options to the investors and savers in terms of avenues to deploy surplus
resources by way of savings and wider choices to investors to raise resources
from different sources matching with cost and efficiency.
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 205

11.2.1 THE BUSINESS CYCLE

The business cycle is an inbuilt process whose presence increases and
decreases, a country’s real GDP over a period of time. In view of various
changes and developments in macro-economic environment, the economy
of a country fluctuates and faces expansion and contraction and accordingly
it impacts the business scenario and entities since the conditions of market
demand and supply do change. However, these changes are in the short
term and causes expansion or recession. However, in the long run the
economy may go towards the growth to increase its potential level of output
over time. There are mainly four phases of the business cycle viz.
a. Expansion: A stage where real GDP increases and it causes decrease in
unemployment.
b. Peak: The peal level is a turning point when output stops increasing
and it starts declining.
c. Recession: At this stage, the output gets decreasing and thereby
unemployment rising.
d. Trough: It is again a turning point where recession ends and output
starts rising again.
Therefore, a country monitors the business cycle so as to have a
required track and ensure that the economy is on the growth path. Also,
to ensure that the unemployment rate declines, and the inflation remains in
control.

THE BUSINESS CYCLE & OUTPUT GAPS

The output gap can be expressed as a difference between actual output and
potential output in the business cycle. The Potential output can be explained
as the optimum output a country can gain assuming that all its resources
have been used efficiently. Under the business cycle model, a country’s s
potential output at any given time is represented as the long-run growth
trend. The output gaps occur whenever the current amount of output
a country produces is more or less than the expected potential output.
Accordingly, when the business cycle curve is above the potential growth,
it indicates that the country has a positive output gap. On the other hand,
when business cycle curve is below the growth trend, it is a sign of a negative
output gap.
Similarly, if actual output is more than the potential output, it implies that
aggregate demand has grown more than the aggregate supply and it causes
to overheat the economy. The concept of overheating signifies that output is
taking place a higher level and in that case the unemployment rate is lower
than the regular rate of unemployment. Consequently, the business cycle in
such a case will reach a peak and then turn to a recession stage.
Further, if actual output is lower than the potential output, it indicates
that aggregate demand or aggregate supply have started falling and this
causes a decline in the employment and output both. Whenever, there is a
negative output gap, this will add to higher unemployment rate. In such
a situation, the business cycle will reach a trough before entering into
recovery and expansion.
206 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

POTENTIAL OUTPUT AND BUSINESS CYCLE

The Potential output is also known as the full-employment output where
all available resources are used effectively and efficiently to produce and
contribute to real GDP. I this situation, the labor is used efficiently and it
will result where actual rate of unemployment will be equal to the natural
rate of unemployment. We should be clear that the actual unemployment
rate is different than the natural rate of unemployment at different stages
of the business cycle. The cyclical unemployment changes according to the
business cycle. The cyclical unemployment also increases on account of
lower output during recessions, and it decreases when output is increased
as the output expands.
It is a crucial task to predict the business cycle phases and it is a challenge
for the policymakers and governments. But it is also very significant to
predict the business cycles to effectively deal with deflation and inflation.
The following are some f the limitations of the business cycle.
i. Scarcity of information and data: The business cycle analysis is based
on research and it poses challenges to the policy makers to have access
to accurate and to obtain complete data and information required for
the analysis.
ii. Two contrasting Models: The Keynesian theories consider money
supply to be the important factor behind fluctuations. But the Real
Business Cycle theory opposes this concept and proposes that market
imperfection is the important factor behind fluctuations.
iii. Human Errors: Economic researchers are humans; they are the ones
who study trade cycle trends and present economic indicators that
cause the trend. Thus, this analysis is prone to human errors.

11.2.2 FORECASTS OF THE ECONOMY

The economic forecasting is the process of prediction future direction of
different elements of economic activity in an economy. This forecasting
helps the government to understand the likely macro-economic conditions
that may impact the future economic growth. Therefore, it establishes a
base for the future planning. A systematic economic forecasting is generally
undertaken by the experts based on well-established economic forecasting
models. These theories are developed as how the economy works. There is
an assumption that changes in the supply of money determine the rate of
growth. Further, the government has also crucial role in making investment
in new facilities such as. housing, industrial plants, highways, and so forth.
The forecasting models that a forecaster uses assumes significance in the
forecasting process.
The different forecasting models and also the economic theories are
helpful in taking up the forecasting but individual judgment also plays
an important role in purposeful forecasting. The present circumstances.
other macro-economic developments and government policies for the
growth and development also impact the forecasting results to a greater
extent. This is the responsibility of the forecaster to decide that the circum-
stances of the moment are unique and that a forecast produced by the usual
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 207

statistical methods should be modified to take account of special current

circumstances. This is more pertinent if any of the event occurs or likely to
occur specifically and it may have impact and influence on the economic
development and growth. For example, in India, the present government is
pro economic growth and focuses on long term growth and in this direction,
it has been initiating all the required strategies in terms of investments,
infrastructure development and these changes will certainly impact the long
term economic growth of the country. This is where, the forecaster’s own
judgement will work more.

FORECASTING & GNP

Gross National Product (GNP), is the total value of the goods and services
produced in a nation and it is supposed to be a comprehensive measure for
measuring changes in general economic conditions. A forecast of the GNP
also provides a useful framework for more detailed forecasts of specific
industries. The GNP is a composition of three major components: spending
by government, private investment spending, and spending by consumers.
We have seen above that Net exports are also included in the GNP.
Government spending is determined with a fair degree of accuracy since
they have budgetary allocations. The government programs introduced also
impact the government spending.
However, private investment are complex and difficult to forecasting as it
reflects number of individuals and corporate entities and many of them are
not recorded publicly besides they are changed frequently. Nevertheless.
a perfect and more accurate forecast of investment spending is necessary for
assessment of overall economic situation.

FORECASTING TECHNIQUES

There are many techniques and methods to forecast the economic indicators.
Some of the generally accepted are discussed hereunder.

1. SURVEYS
The survey is short-term forecasting method which basically depends
approximation, beliefs, intentions and future budgetary plans of the
government. However. It broadly provides a direction of the future course
of happenings and developments in the economy. This surveys are mainly
undertaken to through personal contact to record opinions and views one’s
intention to invest money by type of product, and by type of industry in
future, and make analysis of it. A representative sample is a pre-requisite
in the survey to obtain the required information and data.

2. INDICATORS
The indicators are like a barometer that provides an indication of the economic
growth process through cyclical timings. This project is a method of getting
indications of the future related to the likely developments of growth, slow
down or consistency in the economy. This method helps in finding out the
leading, lagging and coincidental indicators of economic activity. One cannot
expect a very accurate estimate under this approach but it provides the likely
direction of the economy and level of economic activities in near future.
208 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

3. DIFFUSION INDEXES
This method is a combination of different indicators into one total measure
and it gives weaknesses and strengths of a particular time series of data.
The diffusion index is also known as a census or a composite index.
This method is generally used for assessing and understanding the economic
indicators for the future. It considers the leading, the coincidental and the
lagging factors as a combination and summarize them to arrive at and draw
out a particular composite solution to the indicators.

4. ECONOMIC MODEL
Economic Model Building is a mathematical and statistical application to
forecast the future trend of the economy. This technique can be used by
the experienced and professionals to find out relationships between two
or more variables. The technique is to make one independent variable and
dependent variable and to draw out a relationship between these variables.
The answer of drawing up these relationships is to get a forecast of direction
as well as magnitude. This is a process technique as it specifies a particular
system and calculates the results through the simultaneous equations
taking both endogenous variables and exogenous variables. The endogenous
variables are usually predetermined and one equation is usually needed to
find out the forecast value of the endogenous variables.

5. OPPORTUNISTIC MODEL BUILDING

This method is a very common and widely accepted economic model
of forecasting. This is also known as sectoral analysis of GNP Model
Building. Under this method. the national accounting data is used to
forecast for future indicators in the short-term period. It is a flexible and
reliable method of forecasting. The method of forecasting is to find out
the total income and the total demand for the forecast period. Besides,
environment conditions of political stability, economic and fiscal policies
of the government, policies relating to tax and interest rates are also added
to this. This must be added to Gross domestic investment, government
purchases of goods in services, consumption expenses and net exports.
The gross private domestic investment is to be calculated by adding the
business expenses for plan, construction and equipment changes in the
level of business. The third sector which is to be taken is the consumption
sector relating to the personal consumption factor.

SELF-ASSESSMENT 4. Which among the following is not a criterion to assess the economic
QUESTIONS development of a country?
a. national income
b. expenditure approach
c. economic welfare
d. none of the above
5. HDI Stands for
a. human development index
b. house development index
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 209

c. human death index

d. none of the above
6. The HDI measures three important criteria of economic development
viz.________, ________ and ________. This is used to create an overall
score between 0 and 1 where 1 indicates a high level of economic
development and 0 a very low level.
a. life expectancy, education and income levels
b. death expectancy, education and income levels
c. life expectancy, food and income levels
d. none of the above
7. ________, is the total value of the goods and services produced in
a nation and it is supposed to be a comprehensive measure for
measuring changes in general economic conditions.
a. Gross National Product (GNP)
b. Gross Domestic Product (GDP)
c. Business Process Technology (BPT)
d. none of the above

11.3 THE STOCK MARKET & THE ECONOMY

The stock market represents a place where the buying and selling of stocks
are undertaken. There are both types of investors to buy and sell the
securities with other intermediaries who facilitate the process of trading and
settlement. The different types of stock index indicate the performance of
the stock markets and their movements from time to time. We have in India
SENSE, NIFTY in India and S&P 500 in U.S. The stock markets are the
barometers indicating the performance the corporate sectors and business
activities in a country. The economy of a country represents overall activities
of the country that helps in making and spending money within a region or
country. The economy of a country is measured by the GDP, employment
levels, the housing sector, consumer satisfaction and spending. This shows
the strength of an economy. Though stock markets and economy have the
objectives of growth but they do not have a consistent relationship. This is
on account of the following reasons.
The Investors and traders have a close watch and scan the economic
data to understand the movements of the stock market prices to follow.
Many of the investors keep a track of the market indices to get the
signals about the state of the economy. The question arise now, whether
markets and economy move in one direction? In case the stock prices
truly reflects the direction of growth of our economy then forecasting of
future of markets should not be a mean task. Generally, the stock market
and the economy move in tandem with each other but this is not true all
the times. As we know that stock markets are very volatile as they are
influenced by the volatility of international stock markets, there may be
a situation when the stock prices tend to fall even in upbeat economic
210 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

situations and vice versa. If the GDP is rising and the economy looks
upward, the same sentiment is likely to be reflected in the stock market
prices as well, but not necessarily in the short term. The stock markets
react promptly to the events or happenings that may have little bearing
in the long run. Therefore, we can say that the stock markets do not
always reflect the true state of the economy. There are also instances
where the traders and investors grumble that the markets are “overre-
acting” or “the markets did not factor in a particular move” in the right
proportion. According to the experts, even though the stock markets and
the economy are supposed to move in the same direction but markets can
change the direction any time due to external factors.

11.3.1 THE ECONOMY & STOCK MARKET BOOMS

The focus of the stock markets and the economy are different where stock
market is forward looking. The stock prices and growth of stocks are
influenced as how much an investor is willing to pay for a stock at present
in the expectation of future returns. The performance of the economy is
measured by the past performance in terms of achievements on different
social segments. The forward-looking nature of the stock market tends to
mean it often leads the economic cycle, as seen in the chart below.

The stock market and the economy: How the two cycles are related

At this point in the

At the start the
TOP OF cycle, the economy is
cycle, exuberance
STOCK PEAK OF in a recession.
makes investors
MARKET ECONOMIC
want to buy CYCLE CYCLE
more stocks at
high prices Stock market recovery
begins while economy is
Many investors
STOCK MARKET still in recession and
hesitate to invest
CYCLE media headlines are
even as the market
negative.
begins to recover.
ECONOMIC Worry pushes
CYCLE investors to sell their
stocks when values
drop, rather than buy
more and ride out the
market bottom. BOTTOM OF STOCK
TROUGH OF
MARKET CYCLE
ECONOMIC
CYCLE

Time

Source: RBC GAM. For illustrative purposes only.

Figure 11. 2 The Stock Market and the Economy.

1. Cyclical and Counter Cyclical Sectors: Further, there are cyclical and
counter cyclical sectors that impact the stock markets. Cyclical sectors
move in the same direction with the economy. For example, in an economy
with good performance, consumer do spend money this helps in rising
the stock prices. On the other when economy is not performing well the
value of stock prices decreases. In case of counter cyclical sectors, this
covers essential items and people consume these items even when the
market prices are rising. In that case, stock of such companies perform
well even though the economy may not be performing well.
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 211

2. The Economic News and Investors sentiments: The economic news

and market information have greater influence on the investors’
sentiments. When news are positive about development and growth
of various sectors of the economy, the investors become optimist.
The increased consumer activities are also received well by the
investors since it derives the economic activity. The positive and pro
industry growth policy decisions of the government and monetary
authorities also impact the stock markets activities.

11.3.2 ECONOMIC SLOWDOWN & BEAR MARKETS

A bear market represents that stock markets have a trend to go towards
south and might further decline. The outcome of bear market is that
investors get negative sentiments. In the situation, when investors lose
confident about corporate performances and visualize that returns on the
stocks might go down, they start selling the stock holdings rather than
buying. We can also infer that investors in this situation feel that the stocks
are overvalued and the prices are too high in the current scenario. It so
happens when larger investors begin offloading. The spirit of pessimism
spreads and due to the negative feedback, other investors follow suit.
This leads to a decline in the market indices. Generally, a 20% decline in the
indices from the recent highs is termed a bear market. In other words, when
the markets register a fall of 20% from their recent highs, we can say that we
have entered a bear market phase.
In the US, indices like- S&P 500, or Dow Jones are commonly used to
measure this decline. In India, we use Nifty, Sensex, and the likes.
For example, it was on September 26, 2022 that Dow Jones (US market
index) registered a 20% (close at 29,260) from its record high of 36,585
points on 4th January 2022. It implies that Dow has entered a bearish
phase and this decline would also be considered a part of the bear markets.
The reasons for such a fall may vary from country to country. In general,
the stock market shows such a bearish trend based on declining macro-
economic parameters like, low production, increasing unemployment,
decreasing corporate profits, fall in disposable incomes, etc.
A market correction is a stage to indicate a decline in the value of market
indices or individual stocks of at least 10% from the recent highs. It can last for
some days or months. Markets often experience various correction phases in a
year but are short-lived in comparison to the bear market cycle. For example,
in the last 30 years, there have been 19 corrections in NIFTY, and in July 2022
it registered a 14% fall from its recent high. Market corrections are common
phenomena and it is a part of the volatility in the stock markets. Investors
should not worry about them. Instead, they should see them as an opportunity
to increase their investments, if possible when markets correct

11.4 UNDERSTANDING THE STOCK MARKETS

Stock Exchange is an organized form of financial markets that provides
common platform for stock brokers, investors and traders to trade
company stocks and other securities as per the pre decided certain rules
212 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

and regulations. According to the Securities Contracts (Regulation) Act 1956,

the term ‘stock exchange’ is defined as ‘’An association, organization or body
of individuals, whether incorporated or not, established for the purpose of
assisting, regulating and controlling of business in buying, selling and dealing
in securities.” The basic function of a stock exchange is the creation of a
continuous market where securities are bought and sold. It gives investors
the chance to disinvest and reinvest. This provides both liquidity and easy
marketability to already existing securities in the market.
There are two terms the stock markets and stock exchange. Let us clearly
understand these terms. Stock Market is a place where the trading of stocks
issued by the companies takes place. The stocks in such a case include
both, the shares issued by the listed and unlisted companies. It very much
different from stock exchange since it includes all the securities being
traded in all the national stock exchanges of the country. In this direction
we often say “the stock market was up or down today” or “the stock market
crashes” etc. On the other hand, the stock exchange is a well organized
platform with set rules and regulations for trading in securities. They have
a different entity and managed by a professional body.
The participants in the stock exchanges are the investors, brokers and all
other entities related to facilitating trade transactions. The members of
stock exchange may act either as agents for their customers, or as principals
for their own accounts. Stock exchanges facilitate delivery and settlement of
transactions held at the exchange. They are also instrumental in the issue
and redemption of securities and other financial instruments including the
payment of income and dividends. There are number of stock exchanges
operating in India at the national and regional level. However, all trade
transactions are centralized in the modern stick exchanges due to comput-
erized mechanism of stock market operations. All the trade transactions on
an exchange are held through authorized agents.
The stock exchange plays significant roles in the economic development
and growth of an economy. In fact, the trends and conditions prevailing in
the stock market are indicators of the growth of an economy. The growth
of stock market operations certainly depends on the increased role of stock
exchanges. We can explain the role of stock exchanges through the following
components.
a. Promote Business Capital – Stock exchange enables the companies
to raise capital through selling shares by way of IPO and then the
listing of IPO on attractive prices enthuses the investing public
to contribute more by way of investments in securities and thus
promote business capital.
b. Mobilization of Savings – Stock exchange is an organized market
place that helps the public to mobilize their savings by investing in
shares of higher yielding sectors to accelerate capital.
c. Safety to Investors funds – To ensure the investors’ safety, Government
has established the SEBI and independent boards for stock exchanges.
All the trading transactions are monitored and controlled by these
boards. The stock exchange provides security and safety to the investor
through the strict enforcement of their rules and regulations. This helps
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 213

in prohibiting the scams and minimize the risk of investor. The malprac-
tices and unhealthy practices of the broker are punishable with heavy
penalty, suspension of their membership and even imprisonment etc.
This keeps every one aware and cautious about investors’ interest and
safeguarding their interests.
d. Creating Investment Opportunities for Small Investors – Since the
shares of the companies are available in different price ranges,
it facilitates the small investors to invest in the large companies
through purchasing small number of shares.
e. Promotes capital formation – The increased stock market operations
enthuse and motivate the number of investors to subscribe more and
more for the public issues and also trade in the secondary markets.
The increased participation in the capital market operations
promotes more investment and thereby increased amount of capital
formation.
f. Indicator for Industrial Development – Stock exchanges are vital for
the existence and smooth functioning of the industry. It acts as an
indicator of industrial development of the country. If the share prices
of the company tend to rise or remain stable, it shows the financial
stability, efficiency, productivity of that particular company. Thus,
Stock exchanges measure the growth of the companies from diverse
industries.
g. Proper Channelization of Funds – Stock exchange serves as a motivator
for investors to persuade them to channelize their savings into
productive sectors yielding good returns. The funds are collected
through investment are redirected in the growth and development of
several economic sectors as trade, industry, agriculture, manufacturing
and production etc. Thus, it ensure the proper channelization of saving
into investment and optimum utilization of financial resources leads
to economic development of the country and higher productivity.
h. Raising Government Fund for Development Purpose – Stock Exchange
empowers the government to raise the capital through the issue of bonds
for financing the infrastructure projects like power projects, sewage,
shipping, railways, telecommunication, dams and roads constructions
etc. Stock exchanges provide liquidity, marketability, price continuity
and constant evaluation of government securities.
i. Listing of Securities – whenever a company raises funds through
the public offer for the first time, it is mandatory to get the shares
listed in the stock exchange to facilitate trading of the share so
subscribed. The listing of share on the stock exchange binds the
concern company to adhere certain listing requirements with certain
guidelines for protecting the interests of investors. These guidelines
mainly framed to ensure fair activities and practices to be followed
by the company related on the trading of shares. On the other hand,
if companies do not comply with the rules and regulations of the
exchange, the shares of a company can be delisted. Therefore, the
company manages its affairs more cautiously and effectively to avoid
any consequences at a later date. The requirements include among
others the publication of audited annual financial statements of
214 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

the company, submission of annual reports to the stock exchange,

keep the stock exchange aware of important affairs of the company,
declaration of dividends etc.
j. Performance indicator of national Economy – Stock exchange is taken
as a Barometer of the economy of a country. Each economy is econom-
ically symbolized by its most significant stock exchange. At both
national and international level these stock exchanges represent the
progress and conditions of their economies. They maintain the stock
indexes which are the indicators of the general trend in the economy.
They also regulate the stock price fluctuations.
k. Reliable Guider – It helps the investors to make sound investment
decisions by providing the accurate information about the prevailing
prices of the securities and the financial position of the industry. It also
provides information of the various types of securities from which
the investors can choose according to requirement. Thus it promotes
efficiency of investors.
l. Provide Employment Opportunity – It provides employment opportu-
nities to the jobbers and other members of the stock exchange. Besides
direct employment, there is huge population remain engaged on
account of active stock exchange operations throughout the country at
various forums.
m. Easy Liquidity of Investment – Stock exchange provides faster liquidity
of investment to investors as the shares traded in the stock exchange
are cash settled. They can be converted into cash at any time delay.
n. Instrumental for mergers and acquisitions – The companies view the
stock market operations as an opportunity from the mergers and acqui-
sitions point of view. The valuation of the company’s acquisition very
much depends on the share price traded in the market. This provides
wider opportunities for acquisitions to expand product lines, increase
distribution channels, hedge against volatility, increase its market
share etc. In practice, a takeover bid or a merger agreement through
the stock market is one of the simplest and most common ways for a
company going for merger or acquisition.

11.5 MAKING MARKET FORECASTS

It is a well- known and established fact that stock markets are volatile,
dynamic, and nonlinear. Accurate stock price prediction is extremely
challenging because of multiple (macro and micro) factors, such as politics,
global economic conditions, unexpected events, a company’s financial
performance, and so on. The stock market forecast is a process where the
movements of stock prices in the near future could be predicted. However,
this requires a lot of data to find patterns using various techniques and
statistical tools. Therefore, the financial analysts, researchers and data
scientists remain busy in exploring analytics techniques to detect stock
market trends. Of course, the movements of the stock market in future
cannot be exactly predicted but it certainly provides the direction of
future trends based on the fundamental and technical analysis and using
other techniques.
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 215

11.5.1 FORECASTING STOCK MARKET RETURNS

There are various methods to forecast stock market returns that requires
advanced calculation and technical analysis. In this section, we cover the
common methods used by the investors while making investment decisions.

1. EXPECTED RETURNS
Expected returns = Starting Dividend Yield + Earnings Growth rate
(nominal, annualized + Percentage change (annualized) in the P/E multiple.
over the next 10 years)
Predicted Returns = Starting dividend yield + Earnings growth
+ %age change in P/E
How this model works?
Company XYZ has a P/E ratio of 9, a projected earnings growth rate of 15%
for the next year, and a dividend yield of 4.5%. Using these numbers, we
arrive at the following PEGY ratio:
The PEGY ratio = 9/15 + 4.50 = 0.46
A PEGY ratio below 1.0 is considered low and represents a potential
investment opportunity as it indicates the stock has high dividend yields or
potential growth and is currently selling at a bargain price.

2. ESTIMATING EARNINGS GROWTH RATE

There are two approaches to estimate the earnings growth rate using
geometric and arithmetic mean. Geometric mean is the average rate of return
of a given set of values calculated using the products of the terms. It takes
into account several values and multiplies them together and sets them to
the 1/nth power. This can be explained thorough a small example. Assume
there are only two numbers 2 and 8. In case, 2 and 8 is multiplied and then
square root is taken (the ½ power since there are only 2 numbers), this will
give a figure of 4. Geometric mean is a commonly used tool for calculating
portfolio performance since it considers the effects of compounding.
The arithmetic mean is arrived by adding all values and dividing by the
number of values. If we need to find out the arithmetic mean of the numbers
of 3, 5, 8, –1, and 10, this will be; s.
3 + 5 + 8 + –1 + 10 = 25/5 = 5
However, it does not consider the compounding effect and therefore, the
average returns do not provide more accurate returns. This could be
understood through the following example.
Assume, an investor invests $100 and receives the following returns:
Year 1: 3%, year 2: 5%, Year 3: 8%, Year 4: –1%, Year 5: 10%
The $100 grew each year as follows:
Year 1: $100 × 1.03 = $103.00
Year 2: $103 × 1.05 = $108.15
Year 3: $108.15 × 1.08 = $116.80
216 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Year 4: $116.80 × 0.99 = $115.63

Year 5: $115.63 × 1.10 = $127.20
The geometric mean is: [(1.03 × 1.05 × 1.08 × .99 × 1.10)^(1/5 or .2)]–1
= 4.93%.
The average return per year is 4.93%.

3. ESTIMATING THE P/E MULTIPLE

The price-to-earnings ratio (P/E) is widely used by the investors and financial
analysts to assess the value of stock. This also shows whether a company’s
stock price is overvalued or undervalued. The P/E ratio reflects a stock of the
company compares with the industry P/E. It helps to measure the market
value of a stock as given the company’s earnings. This ratio also indicates as
what investor are willing to pay as current price of a stock based on its past
or future earnings. In general, a high P/E ratio signifies that a stock’s price
is high relative to earnings and possibly overvalued. On the other, a low P/E
ratio is an indication of low stock price as compared to its earnings.
Investors not only use the P/E ratio to determine a stock’s market value
but also in determining future earnings growth. For example, if earnings
are expected to rise, investors might expect the company to increase its
dividends as a result. Higher earnings and rising dividends typically lead to
a higher stock price.

HOW TO CALCULATE P/E RATIO

The P/E ratio can be calculated by dividing the current market price per
share by the company’s earnings per share. The earnings per share denoted
the amount of a company’s profit distributed to company’s common stock
holders. This indicates the company’s financial performance. This can be said
as earnings per share if all the earnings are distributed to shareholders.

HOW TO ANALYZE P/E RATIO?

To measure whether a stock is overvalued or undervalued, we should compare
with other stocks in the same industry group. As matter of fact, the industry
segment is benefited by the different business cycles within which it operates.
A good number of investors concentrate on an industry segment when business
cycle is up. The P/E is a measure of expected earnings. When business cycle is up,
some of the industries perform well. The consumer cyclical stocks usually have
higher earnings because consumers may be more willing to purchase on credit
when rates are low. There are instances where the P/E of stocks is expected
to rise. An investor could look for stocks within an industry that is expected to
benefit from the economic cycle and select the stocks of the companies with the
lowest P/E to understand as which stock is undervalued.

THE CAPITAL ASSET PRICING MODEL (CAPM)

The CAPM is commonly used for pricing the stocks as it describes the
relationship between systematic risk, the risk of investment on account of
external factors, and expected return for assets. This model is based on the
relationship between a particular stock’s beta, the risk-free rate and the
equity risk premium minus the risk-free rate. Therefore, CAPM is primarily
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 217

a tool to measure the systematic risk. It is mainly used for pricing risky
securities and calculating expected returns for assets considering the risk of
particular assets and cost of capital.
The CAPM model helps in calculating the expected rate of return for a stock
or nay other investment. This is undertaken using the expected return on
both the risks i.e. market and a risk-free asset, and the stock’s sensitivity to
the market risk as measured through beta. Of course, the model has certain
limitations as it assumes some unrealistic assumptions and rely on a linear
interpretation of risk vs. return. Nevertheless, the CAPM is widely used for
comparison of various investment options.

CAPM FORMULA
The following is the formula of CAPM;
ERi = Rf + βi (ERm − Rf)
Where
ERi = expected return of investment
Rf = risk-free rate
βi = beta of the investment
(ERm − Rf )= market risk premium
Every investor expects to be rewarded for the expected risk and also requires
the time value of money. Under the CAPM, the risk-free rate denotes for
the time value of money. The very objective of the CAPM is to evaluate
whether a stock is fairly valued taking into account the risk and the time
value of money when compared with its expected return. We can also say
that components of CAPM helps in measurement if the current price of a
stock is in consistent with expected return.

THE EXAMPLES
The following are the examples to understand whether the stocks are under
or over-valued.

EXAMPLE 1
The beta of McGrow Co. is 1.2. The risk-free rate is 3.5 percent and the
expected return on the market is 10 percent. What is the stock’s required
return?
E(R) = k = rf + β × (Rm – Rf)
= 0.035 + 1.2 × (0.10 – 0.035) = 0.080
= 8.0%
Therefore, this stock is undervalued as the required return is 10%.

EXAMPLE 2
Lisa, an equity analyst is considering investment in a stock that a beta of
1.2 and an estimated return of 10 percent. The risk-free return is 3.0 percent
and the market return of 12.0 percent. By referring to the Security Market
Line (SML), Lisa would conclude that the stock is:
E(R) = 3 + 1.2 × (12 – 3) = 13.8%
218 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

The required return of 13.8% is greater than the estimated return of 10%.
It indicates that stock is over-valued.

BOND YIELD
Bonds are essentially a debt instruments for the issuing company. The investors
earn interest on a bond during the life of the bond and also get back the face
value of the bond on the maturity. The bond purchase price in the market
either ta the premium or at the discount impacts the bond yield. The bonds
are rated by the credit rating agencies and the higher the ratings, the bond
will be issued at a lower interest rate since the investors prefer investment at
the lower risks. For calculating the bond yield, the interest payment is divided
by the face value of the bond. This is known as the coupon rate.
Coupon Rate = Annual Coupon Payment/Bond Face Value
Suppose a bond has a face value of $1,000 and if coupon payments (interest)
of $100 per year, then its coupon rate is 10% ($100/$1,000 = 10%).
The current yield is:
Current Yield = Current Bond Price/Annual Coupon Payment

THE BOND YIELD AND BOND PRICE

As we know that Price of bond and yield are inversely related as the price
of a bond goes up, its yield declines and vice versa. We can understand it
through an example.
If an investor buys a bond with a face value of $100 that matures in five
years with a 10% annual interest rate, the bond pays $10 as annual interest.
If interest rates in the market goes up above 10 %, the price of this bond
will fall as there will be lesser number of buyers of this bond in the market.
Any investor invests in the market will get higher rate of interest. Therefore
this bond will sell in the market at discount, below the face value.

YIELD TO MATURITY
A bond’s yield to maturity (YTM) is equal to the interest rate that makes
the present value of all a future cash flows equal to its current price. These
cash flows include all the interest payments and maturity value. The YTM
can be calculated as follows.
[Annual Interest + {(FV-Price)/Maturity}]
Yield to Maturity =
[(FV + Price)/2]
In the above example, a bond with a $100 face value, five years to maturity,
and $10 annual coupon payments is worth $92.79 to match a new YTM of
12%. The five coupon payments plus the $ 100 maturity value are the bond’s
six cash flows.

11.5.2 BUSINESS CYCLE AND MARKET FORECAST

It is important to understand as how the state of the economy and how
recessions impact investors sentiments and investment decisions. For this,
we should first understand the business cycle. The business cycle refers to
the fluctuations in economic activity that an economy experiences over a
period of time. At the peak of the business cycle, the economy is healthy
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 219

and growing; stock prices for companies often reach all-time highs. During
the recession phase of the business cycle, income and employment decline;
stock prices fall as companies struggle to sustain profitability. A sign that the
economy has entered the trough phase of the business cycle is when stock
prices increase after a significant decline. Let us understand how different
stages of business cycle impact the stock markets and investment decisions.
There are mainly four stages of the business cycle in an economy.

1. PEAK
When the economy is at the peak, it is supposed to run at full steam. In such a
situation, the employment is at or near maximum levels, real gross domestic
product (GDP) is growing at a higher rate and income levels start rising. All these
positive economic outlook is very well reflected in stock prices, with share prices
for many companies and industries rising to all-time highs. To encourage and
motivate the shareholders for their enthusiastic participation and continued
support and investment, some of the companies decide to increase dividend
payouts. Less encouragingly, prices tend to be rising due to inflation. Even so,
most businesses, workers, and investors are enjoying the boom times.

2. RECESSION
Recession is a stage when income and employment begin to decline due to
any number of internal and external factors causes. It could be an external
event that triggers the downturn, such as an invasion or a supply shock,
a sudden correction in overheated asset prices, or a drop in consumer
spending due to inflation, which in turn can lead firms to lay off employees.
During a recession, stock prices significantly plummet. The markets can be
volatile with share prices experiencing wild swings. Investors react quickly
to any hint of news—either good or bad—and the flight to safety can cause
some investors to pull their money out of the stock market entirely.

3. TROUGH
This is a stage when output and employment bottom out before they begin
to rise again. At this point, spending and investment have cooled down
significantly, pushing down prices and wages. Troughs can be challenging to
pinpoint while they are happening, but they are recognizable in hindsight.
Troughs are the point where business activity moves from contraction to
recovery. A sign that the trough has occurred—or is about to occur—is
when stock prices begin to rally after a significant decline. This rebalancing
of the economy makes new purchases attractive to consumers and new
investments—in labor and assets—attractive to firms.

4. RECOVERY AND EXPANSION

Inn the stage of recovery “expansion,” the economy begins to grow again.
As consumers spend more, firms increase their production, leading them to
hire more workers. Competition for labor emerges, pushing up wages and
putting more money in the pockets of workers and consumers. That allows
firms to charge more for products, sparking inflation that starts low and
slow but may eventually bring growth to a halt and start the cycle over again
if it rises too high. Over the long-term, however, most economies tend to
grow, with each peak reaching a higher high than the last.
220 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Peak

REAL GDP

ion

Re

y
r
ve
ns

ce

co
pa

ssi

Re
Ex

on
Trough
Time
‰ The bold line indicates the business cycle
‰ Thin line indicates the stock market movements
Figure 11.3 Business Cycle Stages and Stock Market Movements.

We can show the business cycle stages and stock market movements through
the following chart.

SELF-ASSESSMENT 8. The ________ is an inbuilt process of fluctuations in the GDP along

QUESTIONS it’s long-term natural growth.
a. loop cycle
b. boom cycle
c. business cycle
d. none of the above
9. Which statement is correct?
1. recession: at this stage, the output gets decreasing and thereby
unemployment rising.
2. trough: it is again a turning point where recession ends, and
output starts rising again.
a. only 1
b. only 2
c. both 1 and 2
d. none of them
10. The output gap can be expressed as a difference between actual
output and maximum potential output of the economy during the
business cycle. The ______ can be explained as the optimum output
a country can gain assuming that all its resources have been used
efficiently.
a. potential output
b. potential input
c. reverse output
d. reverse input
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 221

11.6 SUMMARY
‰ The macro economic factors have direct and great influence on GNP of
a country and in turn the per capita income.
‰ The extent of income influence the savings of the people and extent of
savings have direct impact on investments.
‰ In this chapter, we have explained in detail as how the GDP and other
components impact the savings and investments.
‰ Further, the likely developments in the economy, policy decisions and
directions of industrial growth directly impact the investments.
‰ The investors are willing to invest in the expectation that the economy
will grow in the near future and in long run. This boosts the confidence
of investors. In the process of investments, the stock markets plays an
important role in accumulating investments into the financial system.
‰ The direction of growth of an economy has direct influence on the stock
trading activities. The demand and supply conditions depends on the
growth of the economy impacting the stock markets. Therefore, this
chapter provides a detailed view on Forecasting techniques and how
this impacts the investment scenario.
‰ Finally, the chapter provides knowledge about general methods of
evaluating the returns on the stocks since it also greatly impact the
investments. Even, investment in treasury bonds and other bonds
depends on the expected and current yield.

Bond – A bond acts like a loan issued by a corporation, municipality or KEY WORDS
the government. The issuer promises to repay the full amount of the loan
on a specific date and pay a specified rate of return for the use of the
money to the investor at specific time intervals.
Bear market – A bear market is a prolonged period of falling stock prices.
EPS – The portion of a company’s profit allocated to each outstanding
share of common stock. EPS serves as an indicator of a company’s
profitability.
Market price – The current market price of an asset.
Price-to-earnings (P/E) Ratio – A stock’s price divided by its earnings per
share, which indicates how much investors are paying for a company’s
earning power.
Short-term investment – Asset purchased with an investment life of less
than a year.
Stock – A long-term, growth-oriented investment representing ownership
in a company; also known as ‘equity.
Valuation – An estimate of the value or worth of a company; the price
investors assign to an individual stock
222 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Yield to maturity – Concept used to determine the rate of return an

investor will receive if a long-term, interest-bearing investment, such as a
bond, is held to its maturity date.

11.7 DESCRIPTIVE QUESTIONS

1. What are the important macro-economic factors that impact the
investments in an economy?
2. How do you calculate the GDP of a country?
3. What do you understand by forecasting of an economy and how does it
impact the investments flow in an economy?
4. Describe some of the important forecasting techniques used in
forecasting of an economy?
5. Explain the concept of forecasting of Market returns?
6. What is the significance of stock markets in boosting the investments
into an economy?
7. Describe main advantages of the stock exchanges in an economy.
8. How does price-earning ratio impact the investment decisions?
9. The Bond Price and bond yield have inverse relationship, explain
through an example.

11.8 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS
Topics Q. No. Answers
Introduction 1 a. financial system
2 a. Capital formation
3 c. All 1, 2 and 3
Assessment of the Economy 4 d. None of the above
5 a. Human Development Index
6 a. life expectancy, education and
income levels
7 a. Gross National Product (GNP)
Making Market Forecasts 8 c. Business cycle
9 c. Both 1 and 2
10 a. Potential output
 MACRO-ECONOMIC FACTORS IMPACTING INVESTMENTS 223

11.9 SUGGESTED READINGS AND

E-REFERENCES
‰ Srivastava, Rajiv (2017), Investment Management, Wiley
‰ Elton J Edwin, Brown J Stephen (2013), Modern Portfolio Theory and
Investment Analysis, Wiley
‰ Brooke, P., and Penrice, D. (2009) A Vision for Venture Capital –
Realizing the Promise of Global Venture Capital and Private Equity
(New Ventures)
‰ Capital Dynamics (2010) The Definitive Guide to Risk Management in
Private Equity (PEI Media)
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A. (2008) Private
Equity: History, Governance and Operations (John Wiley & Sons)
 C H
12 A P T E R

FINANCIAL PLANNING

CONTENTS

12.1 What is Financial Planning?

Self-Assessment Questions
12.2 Life Cycle Concept of Financial Planning
12.2.1 Income and Asset Accumulation
12.2.2 Wealth and Life Protection – Dependents Stage
12.2.3 Growth Stage
12.2.4 Retirement Distribution
Self-Assessment Questions
12.3 Financial Planning Process - A Six-Step Approach
Self-Assessment Questions
12.4 Asset Allocation and Goal Analysis
Self-Assessment Questions
Activity
12.5 Asset Allocation and Financial Goals
12.6 Optimum Asset Allocation
Activity
12.7 Risk Aversion
12.7.1 Risk Averter and Utility Function
Activity
12.8 Creating Personal Financial Plan
12.8.1 Important Steps to Create a Financial Plan
Self-Assessment Questions
Activity
12.9 Retirement Planning
12.9.1 Features of Pension Plans
12.9.2 Types of Retirement Plans
12.9.3 Importance of Retirement Planning
Activity
12.10 Summary
Key Words
12.11 Descriptive Questions
12.12 Answer Keys
Self-Assessment Questions
12.13 Suggested Reading and E-References
226 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

INTRODUCTORY CASELET

After completing his Masters in Finance, Robert joined a leading bank

in the United States as manager recently. He was very particular about
leading a happy lifestyle without worries on the financial front and more
particularly to enjoy a high level of financial satisfaction. He approached
a professional financial planning adviser and described his financial goals
to be achieved in the short term (say 2 to 5 years), medium-term goals (6
to 10 years) and then the long-term goals and sought advice as how he
should plan to achieve his goals to avoid last moment hassle and inconve-
niences. The financial planner after understanding the financial needs
and goals also attracted his attention to retirement planning. The adviser
asked him about his expected salary growth cycle over a period of time.
After a detailed analysis, the adviser categorized the entire financial
planning profile into the following broad categories:
a. Cash flow planning
b. Tax planning
c. Investment planning
d. Insurance planning
e. Retirement planning
f. Debt planning and management
The adviser also suggested to him to plan for emergency require-
ments to meet any unforeseen circumstances and maintain a particular
amount as liquid money. After three rounds of detailed interactions, Mr.
Robert understood well that the money received every month as salary
does not guarantee the lifestyle one wishes to maintain through life
since the circumstances and needs keep changing. The present strong
and sound financial position does not guarantee a very strong financial
future. Therefore, inadequate and unsystematic financial planning can
cause serious problems. Also, there are various phases of the life cycle
one has to pass through that involve family responsibility, social obliga-
tions, meeting aspirations of family members, savings for the future etc.
Therefore, a systematic financial planning exercise helps to save, invest,
and earn the required return as well as ensure the timely availability of
money required to meet the expected and unexpected financial needs.
Mr. Robert advised the financial adviser to go ahead with formulation of
a financial plan considering all the financial goals and suggest to him the
pattern of savings. Finally, Mr. Robert thanked the professional adviser
for making him feel relaxed and confident that with systematic savings
and investments, he will be able to meet all his financial goals in time
and this will make him and his future generations financially secure.

QUESTIONS

1. What are the components of a financial planning profile?

2. What was Mr. Robert’s takeaway from his discussion with the
financial adviser?
 FINANCIAL PLANNING 227

LEARNING OBJECTIVES

After going through this chapter, you will able to

> Understand the concept and essence of personal financial planning
> Describe important steps in financial planning
> Decide on asset allocation and analyze financial goal
> Understand risk tolerance levels
> Describe risk aversion and utility function
> Develop a personal financial plan
> Plan for post-job retirement life

12.1 WHAT IS FINANCIAL PLANNING?

The importance of financial planning has increased enormously, especially
in the recent two decades in India, even though financial planning concepts
and their application received focus in developed countries much earlier.
Financial planning per se has different dimensions as it is applicable to differ-
ent segments like business, institutions, individuals, etc. where each segment
has different types of financial goals and plans to achieve. Nevertheless, each
segment requires proper financial planning to achieve the desired financial
goals. Even though the goals may differ, the process of financial planning
is almost similar for each segment. Under financial planning, one needs to
manage current income (current earnings) and the money required to meet
future needs and goals according to life cycle requirements. In essence,
financial planning facilitates the achievement of financial freedom to meet
all lifestyle goals of an individual.
Financial planning is a process that promotes the habit of financial saving
and facilitates channelizing such savings into different kinds of investments
to meet future financial needs during the various phases of life cycle in an
easy way. Financial planning includes current income, expenses and savings,
assets and liabilities, future goals, investment pattern, returns on invest-
ments and direction of future cash flows. The following are the important
constituents of financial planning:
1. Current income and expected pattern of income in future, i.e.,
incremental cash flow over a longer period of time.
2. Current expenditure and likely increase in the expenses over a period
of time considering all the requirements.
3. The pattern of current savings and expected savings in future, keeping
in view the increased income and expenditure. This will help to plan
the investment pattern.
4. Investment decisions and risk aptitude of the investor.
5. Short term, medium term and long-term financial goals and needs.
6. Emergency funds requirements for contingencies.
228 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

7. Insurance plans and health insurance.

8. Planning for retirement.
9. Wealth management.

SELF-ASSESSMENT
QUESTIONS
1. Financial planning is a process which leads to:
a. Financial savings
b. Investment decisions
c. Share trading
d. Both a. and b.

12.2 LIFE CYCLE CONCEPT OF FINANCIAL

PLANNING
There are various stages of human life cycle and all stages have different
kinds of needs and aspirations. Accordingly, financial planning life cycle also
operates along with an individual’s life cycle span. Financial planning life
cycle involves four major stages where financial planning is required based
on the needs and requirements at that stage. The ultimate objective of finan-
cial planning is to budget and plan for generating savings, investing them
for pre-determined goals, securing, protecting assets through insurance,
managing debt, and finally managing the wealth. Even though all these
are important, their utility and significance differ in different stages of life
cycle. Therefore, they are categorized based on the life cycle stages to focus
accordingly.

12.2.1 INCOME AND ASSET ACCUMULATION

When an individual starts earning, budgeting becomes an essential aspect.
Budgeting requires financial discipline. One must understand and develop
a suitable budget for income and expenditure in such a way that savings
become an integral part of the budget. This is the initial stage of financial
planning cycle when an individual starts accumulating assets immediately
after earnings start by virtue of a job, profession, or business. This begins
with accumulating assets either through savings or investments in a phased
manner. In the initial stages, the financial planning goals of an individual
may comprise acquiring vehicle, home and getting married. At this stage one
would like to establish the family and household needs, and therefore, plan
for savings and investments accordingly. The savings help to a larger extent
in meeting the utilities and also serve as a contribution margin for mortgaged
loans. Here, one attempts to have forced savings. This may be the period
starting from the age of 25 years to nearly 35 years - an individual accumu-
lates the necessary assets required to lead a satisfactory lifestyle. People even
start savings and investments for children’s education.

12.2.2 WEALTH AND LIFE PROTECTION – DEPENDENTS STAGE

Once the assets are accumulated, the next stage in financial planning is
wealth protection. In this phase one takes care of the safety of the assets
accumulated during the first phase including the safety of one’s own life.
 FINANCIAL PLANNING 229

Further, the individual or family wealth begins to grow, and therefore, pro-
tection from risks receive priority during this phase. Maintaining a proper
level of insurance can help ensure that a household is not exposed to common
risks. For example, a medical insurance policy will keep catastrophic med-
ical expenses from destroying a family’s nest egg. Additionally, those who
have dependents will want to purchase a life insurance policy to make sure
that their family is taken care of should they die unexpectedly. As many as
10 years of income is an appropriate level of life insurance to hold. This is
the crucial stage where various elements of financial planning need to be
serviced including repayment of debt obligations. Term insurance becomes
a necessity at this stage to protect life risk at minimum cost. Following the
budgeted income and expenditure becomes very significant at this stage.
The budget requires better fine-tuning periodically to reflect your income
and need for savings. Advice from professional and financial planners play
an important role at this stage. This is the period when one attains the age
between 36 to 50 years.

12.2.3 GROWTH STAGE

This is one of the important phases where savings and investments accu-
mulated over different phases start paying the required returns and wealth
gets accumulated. Income starts yielding high returns with upward growth
trends. Expenses get stabilized since many of the household responsibil-
ities are met by this time. However, investments are to be managed effi-
ciently during this period. This phase is significant since the focus now
should be on retirement planning and extra savings need to be deployed
accordingly. Debt obligations need to be reduced. Investments should be
growth oriented with moderate risk. This happens during the age span of
51 to 60 years.

12.2.4 RETIREMENT DISTRIBUTION

This is again a significant phase where a person reaches a stage when regu-
lar source of income is not available, and the person and dependents have to
rely on pension or on the earnings through investments. The priority must
be to control undesirable expenses and live within the available income.
The available corpus is to be invested in risk-free securities to earn moder-
ate returns that could beat the expected inflation. Further, adequate health
insurance and meeting medical expenses become a crucial issue at this stage.
As one approaches retirement, it is vital to simplify finances by reducing mul-
tiple accounts and investments, arranging documents, updating details, and
consolidating investments. Once a person hits retirement age, he or she will
enter the retirement distribution phase of life. While distributing the invest-
ments, one should also consider the taxation aspects to avail the existing
benefits. Another important area is transfer of wealth and estates to avoid
further complications after death. Necessary legal documents like will, nom-
ination, trust etc. should be completed.
It can be well understood that the financial planning life cycle coincides
with the personal life cycle where preferences and priorities towards sav-
ings, investments, risk etc. change accordingly. It is important for a person to
understand the financial life cycle to take wise decisions at each stage.
230 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

SELF-ASSESSMENT
2. Which of the following legal documents is required for distribution
QUESTIONS
of wealth?
a. Will b. Estate
c. Security d. Voter-Id

12.3 FINANCIAL PLANNING PROCESS - A

SIX-STEP APPROACH
Everyone wants to save and invest for future needs. When there are various
options available, the question is how to plan systematically so that our finan-
cial goals are achieved in time in a planned way. Experts have suggested a
six-step approach to financial planning that will help investors significantly.
Appropriate savings and investment strategy will help to determine financial
goals as well as achieve them. Financial planning professionals and advisers
follow these steps. Let us understand them.
1. Assessment of Current Financial Position
The first step in the financial planning process is to make a detailed analysis
and assessment of the current as well as the likely financial position of the
person opting for personal financial planning. This includes current income
from all sources, mandatory deductions, debt obligations, consumption needs,
and amount available for savings and investments. This depends on the per-
son’s lifestyle, family size, and other family and social commitments. Ultimately,
what is important is the net savings available at his disposal. It is important to
evaluate and assess the following financial commitments in the near future:
‰ Immediate requirement of a vehicle
‰ Plan for wedding
‰ Plan to own a house
‰ Emergency funds requirements
‰ Any other financial commitments to be met with
‰ Risk aptitude of the person
The purpose of this exercise is to understand the fundamental financial
requirements of the person and net surplus amount available that could
be considered for savings or investments. The short-term goals will help to
assess short-term financial requirements of a person.
2. Determination of Financial Goals
Determination of financial goals is the basic requirement of any type of finan-
cial planning, which is made to achieve pre-determined goals. These goals
can be further divided as short, medium and long-term goals. For example,
marriage and buying a car may be a short-term goal whereas plan for higher
education of children could be a long-term goal. Obviously, these goals are to
be achieved in different financial life cycles as discussed earlier. Broadly, the
common financial goals could be:
‰ Buying a car and in that case, the type of car and its probable cost
‰ Getting married and expected expenditure required for the purpose
 FINANCIAL PLANNING 231

‰ Purchase of household utilities

‰ Buying a house
‰ Term insurance and health insurance plans
‰ Children’s education and plan for higher education
‰ Pension plans for retirement
‰ Emergency funds requirements
‰ Any other financial goals to be achieved
It can be well understood that the above financial goals can be categorized into
short, medium and long-term goals. Based on the requirements for funds to
achieve a financial goal and the time available to achieve such a goal, the finan-
cial planner will assess the funds allocation requirements for each goal. For
example, suppose Rs.20 lac is required for children’s higher education after 16
years. The financial planner will advise how much investment per month/year
is required that will have cumulative value of Rs.20 lac after 16 years.
3. Analysis of Alternatives for Investment
Once the financial goals, requirements and amount of investments are eval-
uated, the next step is to analyze the different types of investment opportu-
nities and instruments. Considering the short, medium and long-term goals,
an integrated investment strategy to match and meet the financial goals and
requirements is suggested. Here, one evaluates the returns available on var-
ious investments, tax benefits, risk factors, liquidity, payment before matu-
rity, etc. The very purpose is to analyze various investment opportunities
and whether the maturity amount would be sufficient to meet the particular
requirement. In this, the investor analyzes various investments and savings
instruments from different angles to take a decision on what could be the
best option for investment. In practice, the professional financial planner
would present before the investor a holistic view of all the investment oppor-
tunities along with returns on investments, risk factors, liquidity, tax benefits
or tax implications, etc. for consideration. This helps the investor to decide
rationally on the type of investments.
4. Evaluate Alternatives
There may be situations where an investor may not understand the implica-
tions and hidden risks of an investment instrument. In that case, the financial
planner provides counselling and clarifies all the doubts in face-to-face meet-
ings with detailed evaluation and assessment of various options, and thus,
helps to choose the ideal one. Here, we must understand that risk aptitude
of different investors differs to a large extent, and therefore, the decision to
invest in a particular instrument also varies. If any of the investors have con-
cerns regarding the financial planner’s suggestions and recommendations,
a clarification can be sought for and plans could be revised. The alterna-
tive analysis helps a lot to arrive at a wise investment decision. An in-depth
analysis of the risks associated with different instruments is very crucial and
professional advice plays a significant role.
5. Financial Plan Implementation Process
After the finalization of the investment options and instruments, the next step
is to proceed with the investment options chosen after a detailed analysis.
232 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

The investments are to be carried out as planned and cash flows are to be
remitted as required under the particular scheme. This could be an exercise
to initiate the financial planning process to achieve short, medium or long-
term goals. An important aspect in this regard is to implement the chosen
investment plans as early as possible since delay in implementation will lead
to non-achievement of targeted plans and goals. Further, it is also import-
ant that all payments for different types of investments are to be made as
planned. Non-payment in time or breaks of the payments will add to further
delay. The compound impact of non-adherence of scheduled payments will
result in penalty, reduced ROI and delay in maturity payment.
6. Monitoring and Review of the Investments
We must understand that financial planning is an on-going and dynamic pro-
cess. Since the financial market conditions remain dynamic, one must keep
a close watch on the latest market movements. It is very much desirable
that one assesses the investment portfolio position to ascertain that growth
of investments is in appropriate direction. As the investment portfolio pro-
gresses, it passes through different phases which impact the financial needs
and goals and it calls for required changes from time to time. Monitoring of
financial investments and returns also help to prioritize investment decisions.

SELF-ASSESSMENT
3. The number of steps in financial planning are:
QUESTIONS
a. Six b. Two
c. Four d. Ten
4. Financial planning is defined as:
a. The process of meeting one’s life goals through proper manage-
ment of personal finance
b. The process of meeting one’s life goals
c. The proper management of personal finances
d. None of the above
5. The first step in the financial planning process is:
a. Assessment of current financial position
b. Asset allocation
c. Management of finances
d. Monitoring the financial plan

12.4 ASSET ALLOCATION AND GOAL ANALYSIS

Asset allocation is a process of allocating your investments into various
financial assets, such as securities, bonds, mutual funds, and other finan-
cial instruments. This is done to meet the expected returns with minimum
risk for a particular time period matching the financial planning goals. This
strategy involves investing the requited amount across the asset classes in
different proportions. The investment portfolio may comprise alternative
assets, such as financial assets, real estate, commodities, derivatives, and so
on. We know that each asset class has a different level of risk and return and
it is apportioned by its behavior over time. While allocating different types
of assets, the focus needs to be on reducing the concentration of risk in the
overall portfolio and at the same time ensuring to earn considerably balanced
 FINANCIAL PLANNING 233

returns. Since the risk and returns on the assets have a positive correlation,
a balanced approach in asset allocation is important. There are possibilities
of one asset class getting reduced in value while another asset class compen-
sating it. In the short term, asset allocation requires more diversification in a
portfolio. In the long term, asset allocation enables you to accumulate wealth
and achieve your financial goals easily.
Asset allocation also depends on the time to achieve a financial goal. For meet-
ing the short-term financial goals, investment in short-term instruments is
required, while for the long-term goals, investment in long-term securities will
be needed. Suppose, the financial goal is to buy a new car within one year’s
time, allocating funds in short-term instruments like certificate deposits or
money market instruments will be preferred. Different types of assets are:
‰ Cash: Cash or cash equivalents like savings bank deposits, certificates
of deposit (CD), and money market instruments. Money market mutual
funds, etc. are the least risky assets but returns too are very low.
‰ Bonds: Bonds or fixed-income securities provide assured returns, but
they offer lower returns as compared to equity investments. Further,
there are different kinds of bonds, such as secured, unsecured, fixed
interest, floating interest, compound interest, convertible bonds, etc. The
investor needs to understand the features of each bond before invest-
ment. There are even government bonds with tax savings. Depending on
the time horizon available to meet a particular financial planning goal,
the investment decision can be made.
‰ Stocks: Stocks or equities are the riskiest type of assets but also offer the
highest returns. This investment fetches a higher return over the longer
period and greatly helps to meet the financial goals including meeting
inflation cost. Investment in equities can be segregated into small, mid and
large-cap listed companies for a rational diversification. Generally, you
can invest a higher proportion in equities during the initial years of your
earnings taking rational risk. An optimum portfolio comprising combina-
tion of stocks and bonds can provide attractive returns with moderate risk.
In addition to the above securities and assets, there are other alternative
investments one can choose according to the determined financial goals.
‰ Real estate and real estate funds
‰ Mutual funds
‰ Commodities such as gold, oil, etc.
‰ Pension and retirement funds

SELF-ASSESSMENT
6. Which one of the following is an investment option for asset
QUESTION
allocation?
a. Cash b. Will
c. Mutual funds d. Return

Write a case to study and analyze the risk involved, expected returns on ACTIVITY 1
investments, impact of stock market developments and time horizon of
investments under the mutual funds, equity and retirement plans.
234 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

12.5 ASSET ALLOCATION AND FINANCIAL

GOALS
Let us now understand how asset allocation works to meet financial goals.
Firstly, the focus of an investor must be to achieve the amount required to
meet a particular financial goal after a pre-determined time period irrespec-
tive of market movements during the period. This could be well explained
through an example. Let us assume an investor has Rs 10 lacs for investment
and plans to invest into equity, bonds, and cash. Let us further assume that
the investor is a risk taker and has 10 years left for superannuation. The
investor decides to invest 60% in equities with a combination of large cap and
small-cap companies for appropriate diversification comprising 40 % under
indexed funds and 20% in large-cap companies and another 20% in index
funds of small-cap companies. Further, 35% of total investments are invested
in bonds and other fixed-income securities and the remaining 5% in cash or
cash equivalents.
In the above scenario, we must understand that in case the market witnesses
an upswing, the investor will be benefitted from the equity shareholdings. On
the other, if the market falls, the investor will be cushioned through bonds
and other secured investments. It implies that when assets are placed in
diversified portfolio, one may get higher returns which help to achieve the
desired goals.
The asset allocation process directly depends on the financial planning goals.
Therefore, whatever one plans or set a goal to achieve through financial plan-
ning like owning a car, home, marriage expenses, child’s education, retire-
ment corpus, etc. the financial investment allocation will depend on them.
The financial planning goals, investment horizon, and risk capacity are the
major components that influence the asset allocation decision.
Financial planning goals and asset allocation require a proper mapping. This
can be explained through the following table.

TABLE 12.1 MAPPING OF FINANCIAL GOALS AND

ASSET ALLOCATION
Financial Expected duration Term of Risk toler- Suggested
planning goal to achieve the goal the goal ance level investment
buying a car 2 years Short Risk neutral Mutual funds
term or short-term
instrument
Getting mar- 4 years Short Risk neutral Mutual fund
ried term
Buying a home 6 years Medium Risk loving Equity funds
Children’s 15 years Long Risk loving Equity and
higher term balanced
education funds
Retirement 25 years Long Risk neutral Equity and
planning term mutual funds,
pension plans
 FINANCIAL PLANNING 235

Investment goals such as buying a house, sponsoring the education or mar-

riage of a child, retirement planning, etc. must be mapped with your asset
allocation. Further, the period of investment and your risk tolerance has a
considerable impact on your asset allocation. For instance, if you are 58 years
old and nearing your retirement in another few years, your investment hori-
zon is small, and your risk tolerance is not very high. Hence, the ideal asset
allocation would be to buy more bonds and create a conservative portfolio
with an aim for capital preservation rather than growth.
Alternatively, if you are a young investor in your early 30s and wish to save
and invest to buy a house, it could help to opt for a more aggressive asset
allocation. You can easily put 60% or more of your funds in equity and bal-
ance the rest with bonds and cash equivalents or alternative assets like com-
modities or real estate. As per experts, you can also follow the rule of 100 to
determine the percentage of stocks you should hold. You can divide your
present age by 100 and the answer would be the share of your funds that
ideally should be invested in stocks.
That said, for any financial goals that require money in a year, the asset allo-
cation should primarily be cash because if invested, a significant portion of
your principal might be lost before you need it. However, for money that you
might need in two years or a short time, consider placing it in income-pro-
ducing assets such as CDs, treasury bills, and bonds.

12.6 OPTIMUM ASSET ALLOCATION

According to experts, there cannot be a perfect or standard asset allocation.
Asset allocation is highly influenced by an individual’s personal attributes
and choices, such as age, risk aptitude, and financial goals. Further, the phase
of one’s life span also impacts the financial planning decisions. The decision
on asset differs if one is a bachelor, married or with kids. Accordingly, one’s
future plans, aspirations, and expectations also impact the asset allocation.
Additionally, the attitude and aptitude of individuals during adverse market
conditions also impact the same. Some of the practical tips for asset alloca-
tion are:
‰ Choosing the right asset allocation is extremely crucial for a portfolio’s
success and also for achieving the pre-determined financial goals.
‰ Alternative asset allocation for goal-based investment shall be target date
funds, i.e., a mutual fund which invests across multiple asset classes.
‰ Target date funds can manage required asset allocation where investor
need not monitor or rebalance the portfolio.
‰ Target date funds facilitates best investment practices since they are
optimally diversified across different asset classes as per your age and
financial goal.
‰ Target date funds neither consider risk tolerance capacity of the investor
nor are influenced by changing life situations.
‰ The investors should preferably change asset allocation and make it
more conservative when one reaches the retirement phase.
‰ It is important to create a comprehensive and foolproof financial plan
236 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

according to the financial goals and distribute assets to meet the pre-de-
termined goals well in time.
‰ A well-managed and balanced asset portfolio focused on financial goals with
maximizing returns and minimizing investment risks should be preferred.
‰ One should create an optimum mix of assets according to one’s goals,
expected returns and risk tolerance.

ACTIVITY 2 Assume Mr. Arun has recently graduated and joined an IT company at a
handsome salary. His current age is 25 years. He is smart and has aspira-
tions to lead a happy married life as well as take adequate care for the chil-
dren. Consider yourself in his place and chalk out the expected financial
goals in the short, medium, and long term.

12.7 RISK AVERSION

The fundamental principle of utility function is to maximize the utility, more
so under the theory of consumer behavior. But this works in situations when
there is no risk and uncertainty. This is simple - the consumer consumes
given the bundle of choices to gain maximum utility from the combination
of various available commodities within the bundle. But the question is
how does a consumer maximize its utility when there are conditions of risk
and uncertainty? In this case, attitude towards risk is the main criterion.
Therefore, attitude can be assumed as a single commodity that represents
income from the investments. An individual’s monetary income represents
the market basket of goods that could be bought. Let us assume that that the
individual is also aware of the probabilities of gaining the expected income
under different market conditions. However, the payoffs are measured in
terms of utility rather than money value (rupees).
In most of the cases, investors’ preferences towards risk vary to a large extent.
Most of the people generally prefer less risky situations, i.e., less variability in
the expected returns. We can say that majority of investors opt for minimum
risk and therefore they are known as risk averse. Nevertheless, some inves-
tors prefer risk and are therefore called risk lovers. Then there are investors
with indifferent attitude towards risk and they are known as risk neutral.
Now, given the situations, it is important to understand that different prefer-
ences towards risk depend on whether marginal utility of money diminishes,
increases, or remains constant for an individual. The below study shows that
for a risk averse investor, marginal utility of money diminishes as he has
more money, while for a risk seeker, marginal utility of money increases as
money with him increases. In case of a risk neutral individual, marginal util-
ity of money remains constant as he has more money. This is explained in the
following sections.

12.7.1 RISK AVERTER AND UTILITY FUNCTION

Figure 12.1 A shows curve OU indicating the utility function of money income
of an investor who is risk averse. It can be observed from the figure that the
slope of the total utility function decreases as the monetary income of the
individual increases. The money income is measured on the X-axis and util-
 FINANCIAL PLANNING 237

ity on the Y-axis. It explains when money income of the investor increases
from 10 to 20 thousand rupees, the total utility increases from 45 to 65 units
and when money increases from 20 thousand to 30 thousand rupees, the total
utility increases from 65 to 75 units.

Figure 12.1 A
It may be observed that the concave utility function indicates marginal utility
of money of an investor and shows that it decreases with the decrease in the
money income. This implies the case of an individual who is risk averse.
We can understand this with another example of a person who earns Rs.15,000
as salary at present but is looking for a job to earn Rs.30,000. However, the
probability of getting the new job is 50-50. He can either earn Rs.30,000 or
Rs.10,000. In this uncertainty, an individual remains indecisive. The expected
utility can be calculated as under based on the given probabilities. Whether
the person will prefer a new job with risk or continue at the present job can
be evaluated by comparing the expected utility from the new risky job as
against the utility of the current job.
It is observed from the utility function curve OU in Figure 12.1 A that the
utility of money income of Rs.15,000 is 55. On the other hand, if in the new
risky job, he proves himself as a successful salesman, the income increases
to Rs.30,000 and utility to 75. But in case of failure as a good salesman, the
income falls to Rs. 10,000, and utility to 45. (In the new risky job, the expected
income is Rs.20,000 which is given by E(X) = 0.5 x 10,000 + 0.5 x 30,000 = Rs.
20,000). Given that the probability of success or failure as a salesman is 0.5,
the expected utility of the new job is given by:
E (U) = 0.5 U (10,000) + 0.5 U (30,000)
= 0.5 × 45 + 0.5 × 75
= 22.5 + 37.5
= 60.0
It is found that in the current job with a fixed salary of Rs.15,000 with no
uncertainty, the utility is 55 whereas the expected utility of the new job is
60. The person is risk averse by the nature of the utility function of money
income, but since the expected utility of the risky job is greater than the util-
ity of the present job with a certain income, he will choose the risky job.
238 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Thus, the utility function can be calculated in a similar manner for risk neu-
tral and risk seekers as well. Figure 12.1 B shows the utility function of a risk
seeker. A person will be risk neutral if his marginal utility of money income
remains constant with the increase in his money. The total utility function
of a risk-neutral person is shown in Figure 12.1 C. It shows that the utility of
income of Rs. 20,000 is 80. Now, in a risky job when the income increases to
Rs. 30,000 (if he proves to be a successful salesman), the utility of Rs. 30,000 is
120 units.

Figure 12.1 B

Figure 12.1 C
In case the person fails to succeed, the income goes down to Rs.10,000 with
utility to the individual as 40 units. It is presumed that there is equal prob-
ability of high and low income in the new risky job. The expected value of
income in the new job with an uncertain income is 20,000 as (0.5 × 10,000 +
0.5 (30,000) = 20,000. The expected utility of the new risky job can be arrived
at as under:
E (U) = 0.5 U (10,000) + 0.5 U (30,000)
= 0.5 (40) + 0.5 (120)
= 20 + 60
= 80
 FINANCIAL PLANNING 239

It is evident that in case of a risk-neutral person, the expected utility of an

uncertain income with the same expected value is equal to utility of a certain
income. This implies that a risk neutral person is indifferent towards both.

You are engaged in a job but it is not to your satisfaction. Your present ACTIVITY 3
earning is Rs.60,000 per month. You have a new job offer but it is really
challenging and tough. The probability of success is 50%. If you suc-
ceed, you may earn Rs.1,20,000 but if you fail to achieve the business
targets, the earnings will fall to Rs.75,000. What will be the marginal
utility assuming that you are risk averse?

12.8 CREATING PERSONAL FINANCIAL PLAN

When we choose to create a personal financial plan, it is important to set
goals as explained earlier for its success. It is not sufficient to set personal
financial goals but we must ensure that the goals set are achieved as planned.
This calls for establishing a perfect plan to achieve the goals. Planning and
implementation play a crucial role in this direction. Our goals may be far
from the present but our planning must be in present. It is even more import-
ant in case of long-term goals. We need to understand that meeting education
expenses or buying a new car, or taking a home loan, all these do not happen
in a short time but takes a long time to plan and execute. As discussed ear-
lier, the six basic steps are essential for creating a personal financial plan.
These steps are:
1. Determine your current financial situation.
2. Develop your financial goals.
3. Identify alternative courses of action.
4. Evaluate alternatives.
5. Create and implement your financial action plan.
6. Review and revise the financial plan.
It is never too early to begin planning. In fact, the earlier you begin planning
for your financial future, the sooner you will reach your goals. The concept
of compounding interest assumes much significance and investments have
immense value in the long run with greater benefits. The longer you invest
for, the greater their growth will be.
What is required is a systematic approach to create the financial plan con-
sidering your short term or long-term goals. For each of the financial goals,
a template must be created covering the target amount needed to meet the
specific goal, time period available for meeting the goal and investment
required considering the maturity value of the investments. This will help to
understand how much money is required as savings and investment to meet
the goal, assessment of different investment opportunities and total invest-
ment value at the end of the term period including interest.
There are two important statements to be prepared - cash flow statement and
net worth statement. The cash flow statement explains the net surplus cash
available for investment. The net worth statement represents the position of
240 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

assets, liabilities, and net worth. A hypothetical example of cash flow state-
ment is presented in the following table.

TABLE 12.2
income annual amount percent amount
Family Income (Before-Tax) $100.000 $24, 169
Income Taxes & Source 100% 24%
Deductions
Family Income (After-Tax) $75,831 76%

expenses annual amount percent amount

Housing $17,700 36%
Auto $5,500 11%
Food/Clothing $9,000 18%
Health Care $2,400 5%
Investments $4,600 9%
Loans $1,200 2%
Other $9,000 18%
Total Expenses $49,400 100%
NET INCOME $26,431 26%*
* Net income as a percentage of Family Income (Before-Tax)

In Table 12.2, the net income available for savings is 26% and this could be
invested for meeting various goals according to preferences. The investor
now can allocate the amount available for investment to achieve the desired
financial goals.

TABLE 12.3 REPRESENTS THE FORMAT OF

CALCULATING THE NET WORTH.
Current Estimated Net Worth
Assets
Personal Residence (Estimated Full Value)
Vehicles
Savings Accounts
Stocks/Bonds/Mutual Funds/ETF’s
Total Short Term Savings in 24 months
Other Assets
Other Assets
Other Assets
Total Assets
Liabilities
Mortgage Loan Balance
Vehicle Loan Balance
Student Loans
 FINANCIAL PLANNING 241

TABLE 12.3 REPRESENTS THE FORMAT OF

CALCULATING THE NET WORTH.
Credit Card Balance
Personal Loans
Medical Debt
Other Liabilities
Other Liabilities
Other Liabilities
Total Liabilities
Net Worth (Assets - Liabilities)

From the above table an investor can clearly understand and assess the posi-
tion of different assets and liabilities including savings, investments, other
assets and liabilities. The net worth is the combination of what one owns (the
assets) and what one owes (the liabilities). It is important to know your net
worth to understand the current financial position. The net worth also indi-
cates a reference point to assess progress to achieve one’s financial goals. It
is advisable to continue to earn and save, and thus, grow the net worth. If the
net worth is low or negative, it is a note of caution to be watchful on savings
and control the expenses.

12.8.1 IMPORTANT STEPS TO CREATE A FINANCIAL PLAN

The following are some of the suggested steps that help to create an ideal
financial plan.
1. Need to track spending: One needs to assess and evaluate the financial
planning process by monitoring the cash flows to assess expenses and
earnings. Negative cash flow indicates more spending and may lead to
more debt burden.
2. Determine SMART financial goals: SMART signifies Specific,
Measurable, Achievable, Relevant, and Time-bound, and it is a key
to achieve financial goals. This helps to invest savings in a more
purposeful manner to achieve future goals. It also helps to segregate
the extensive financial planning process into workable points. Further,
the process of setting concrete goals is a self-motivated process and
makes one accountable, and therefore, one spends cautiously to stick
to the budget. The monetary goals also facilitate to arrive at smarter
short-term decisions to invest in long-term goals.
3. Constant follow-up of budget: Developing a budget helps to determine
and create a financial plan and achieve long-term financial goals.
It helps in understanding one’s affordability to spend and savings
strategies. Here, people commonly follow the 50:30:20 rule of Senator
Elizabeth Warren. According to this rule, the after-tax income should
be segregated as Essentials (50%), Wants (30%) and Savings (20%). This
thumb rule is a significant way to achieve your financial goals and track
the budget.
4. Savings for emergency: One must understand that it is always better
to plan in good times for the unforeseen circumstances. Emergency
242 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

never comes with prior intimation and one needs to be prepared for
such unexpected monetary challenges. When one starts the financial
planning process, one must mandatorily plan for emergency finances.
It is necessary to have adequate financial backup to manage an
unexpected financial crisis.
5. Liquidate the debt: The debt does not have only the burden of interest
payment, but also the extent of interest payment goes up much higher
if it is not paid in time or paid over a longer period. The payments of
debts in advance can reduce interest burden substantially and one gets
relieved of the debt obligation soon. Irrespective of the debt repayment
option opted for, the success lies in prompt repayment or advanced
repayment. One needs to adjust the budget accordingly.
6. Need for organizing investments: If one understands the basics of
savings and investments, it is easy to grow savings and wealth passively
over a period of time. The investment may be started with small amount
also and one should not wait for larger savings and investments plan.
Just like the saying “little drops make the ocean,” little savings would
add up to something substantial. Following this philosophy, no matter
how much you are able to save you must develop a habit of saving, it
may be Rs.50 or Rs.5000 both contribute to savings. One must plan to
set aside certain amount each month for investments. The investments
need to be organized according to the financial goals.
7. Retirement planning: When one makes a financial plan, it is important
to consider the future goals including retirement planning. It is always
better to start saving for retirement from an early stage. Longer period
for retirement investments has two advantages. Firstly, one can save
and invest small amounts and secondly, the long-term investments
fetch higher returns due to the compounding factor.
8. Estate planning: Estate planning is an integral part of financial
planning since the wealth accumulated over the life span should be
in right hands and used for right purpose after one’s demise. Estate
planning also reduces disputes among the family members as the
deceased had already planned for the allocation of wealth among them.
For creating an estate plan, all the assets are to be listed to transfer the
ownership through different modes.
9. Insurance plans: Under financial planning, insurance of health, life,
unforeseen circumstances, and assets are important. Accordingly, one
must plan for different types of insurance schemes.
10. Planning for taxes: Planning for taxes implies that one should
understand the different provisions and complications of various
tax rules and regulations. It is not to evade tax but to avail optimum
advantage of various tax rules and invest accordingly to pay the
minimum taxes after availing various tax incentives. It will help in
reducing the taxable income.
11. Review and monitoring of financial plans: It is extremely important
to re-evaluate financial and investment plans periodically and adjust
financial goals to achieve them successfully. Financial goals also
change with the life span as individuals go through various stages and
 FINANCIAL PLANNING 243

modify the plans. Interest rates also may change from time to time and
newer investment opportunities may emerge. Therefore, one must
keep a vigil and remain updated on all the aspects and monitor the
financial plans.

SELF-ASSESSMENT
7. Which of the following is/are plans to achieve financial goals?
QUESTIONS
a. Liability and insurance planning
b. Asset acquisition planning
c. Employee benefit planning
d. All of the above
8. Budgets:
a. Allow you to monitor and control spending
b. Are based on expected income and expenses
c. Are forward looking
d. All of the above
9. In preparation of personal financial statements, which one of the
following cannot be classified in the category of investments in
balance sheet?
a. Residential house property
b. Pension fund
c. Shares
d. Bonds
10. Which of the following statements is/are true?
a. Long-term goals are set first followed by a series of corre-
sponding short term and intermediate goals.
b. Financial goals are more effective when set with goal dates.
c. Goal dates are target points in the future when you expect to
achieve or complete certain financial objectives.
d. All of the above.

Mr. Shyam has ambitious plans for himself and his family. His cur- ACTIVITY 4
rent earning is Rs. 2.50 lacs per month and his expenses are met with
Rs.50,000. He wants to lead a comfortable life and is keen to own a flat
in a posh area in Delhi, an SUV, provide good education to his chil-
dren including higher education at a premiere institute. Considering
the present and expected costs, prepare a financial plan for Mr. Shyam
and suggest how should he invest.

12.9 RETIREMENT PLANNING

Retirement plans are investment plans to facilitate save money for future
on a long-term basis. An individual starts to accumulate savings through
these plans systematically. One needs to invest a certain sum of money to
a plan periodically up to the age when one retires. By this, a considerable
corpus gets accumulated. Retirement plans provide the benefits of wealth
244 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

accumulation as well as insurance cover. In fact, a majority of the people

have a misconception about retirement planning and plan for it at a very
late stage and lose out on the benefit of compounding and tax incentives.
They also find it difficult to invest a large sum at that stage. Therefore,
retirement planning should be a priority in the early stage when one
starts earning. Retirement planning requires careful analysis of the funds
needed after retirement to meet consumption and other needs related
to old age. The following steps may be helpful to arrive at the financial
requirements:
1. Assessment of current and expected future income considering
investment income
2. Calculation of current expenses and estimated cash outflows during
retirement
3. Amount required at the time of retirement – 1 minus 2

12.9.1 FEATURES OF PENSION PLANS

The features of pension plans are as follows:
1. Accumulation phase: One can opt either to pay a lump sum amount
or contribute at periodic intervals. In both the cases, the money
contributed will grow over a period of time to accumulate into a good
corpus. This is known as the accumulation phase of the retirement
plan. This period may vary since the time to choose retirement savings
plan also vary from person to person. Longer the period, the amount
will be sizeable as compared to shorter period of investment.
2. Power of compounding: The investors’ money in the pension plans
is further invested by the pension funds to generate optimal risk-
adjusted returns. Therefore, it is suggested to go for retirement plan
at an early stage to get the potential returns based on the power of
compounding.
3. Vesting age: This is the age from when one starts receiving pension,
i.e., 60 years.
4. Payment period: This is the period for which one receives pension
payments post-retirement. Suppose a person survives up to 80 years,
the pension will be payable for 20 years after 60 years of age. This is
also called the annuity phase. However, depending on the plan chosen,
one may receive partial or full withdrawal in the accumulation phase as
well.

12.9.2 TYPES OF RETIREMENT PLANS

Generally, the following types of annuity plans are available.
1. Annuity plans: Under this pension plan a guaranteed income is
provided during the retirement period either for the whole life or for a
stipulated time period as chosen by the person at the time of availing
the plan. An annuity plan can be used to accumulate retirement corpus
and from this corpus, a regular income, known as annuity or pension is
paid to the beneficiary. This plan protects from outliving savings as it
 FINANCIAL PLANNING 245

guarantees a certain income. Further, the payout is certain for life and
reinvestment risk is not involved.
2. Immediate annuity: Under immediate annuity, one starts getting
pension within one year of paying the premium amount. This implies
that one becomes eligible to receive annuity immediately after the
initial investment. Under this plan, a lump sum amount is invested
and annuity starts for a particular time period. This annuity plan is
appropriate for them who are close to retirement.
3. Deferred annuity: Under deferred annuity, one can choose to opt for
the timeframe over which annuity can be received. This plan is suitable
for persons working and have few years left for their retirement.
4. Unit linked insurance plan: This plan provides dual benefits - risk
cover during the tenure of plan and returns at the end of the plan. One
can choose the investment plan depending on risk profile and return
requirements. It is more beneficial in the long run and fetches long-
term returns while providing the advantage of insurance protection.
5. National pension scheme: This is a voluntary retirement scheme where
one accumulates the available retirement corpus of their choice. It is
available to all Indian citizens between the age of 18 and 65 years. You
can start an NPS even at the age of 60 and continue to contribute till
you reach 70 years. On completion of 60 years, 60% can be withdrawn
and the balance amount is payable as annuity.

12.9.3 IMPORTANCE OF RETIREMENT PLANNING

1. According to a United Nations report, the share of population in India over
the age of 60 is projected to increase from 8% to nearly 20% in 2050. One
need not worry if adequate funds are accumulated by the time one retires.
2. Post retirement, expenses on health as well as cost of living increases
due to inflation. Under such circumstances, one cannot sustain or lead
a satisfactory life without adequate financial support.
3. The system of joint families has slowly vanished and senior citizens
lack adequate support from the family. Moreover, people prefer to be
independent in their old age.
4. In India, there are no social security schemes for senior citizens similar
to developed countries.
5. Retirement plans make one self-sufficient and allow people to live their
life according to their interests and preferences.
Therefore, retirement planning is a necessity in the present context.

Mr. Narayan is a 35-year-old software engineer. He wants to opt for ACTIVITY 5

superannuation at the age of 55. The lifestyle he maintains requires
Rs.50,000 per month. He aspires to have the same life- style after super-
annuation. How much corpus should he accumulate at the age of 55 that
could provide him a return of Rs.2 lac per month so that he could meet
all the living expenses comfortably? Also suggest, how much should he
invest into retirement plans from now?
246 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

12.10 SUMMARY
‰ Financial planning per se and personal financial planning in particular
have assumed a lot of significance nowadays since the economic con-
ditions, social connect, and family aspirations have undergone drastic
changes especially in the last two decades.
‰ Personal financial planning is a process whereby an individual sets finan-
cial goals over a life span and invests money in phased manner to achieve
such goals in time without much difficulties.
‰ The goals are set based on their priorities and time available to achieve
them. The six- step approach is of much significance and helps to a great
extent in setting financial goals in a systematic manner.
‰ Once the goals are set, the next step is how to achieve them. For this,
savings and investments are decided to achieve each goal and assets in
which such investment is to be made are identified considering the risk
factors and returns available over a time period.
‰ Once the investment is made in different financial assets, it becomes very
important to review and monitor them and replace in case of need to
fetch better returns.
‰ In financial planning, risk assumes much significance and it differs from
person to person as there are people with different risk perception and
risk attributes.
‰ The returns on investments are directly related to risk. Therefore, a
person must be very cautious in taking the risk while considering invest-
ments. One cannot be either totally risk averse or a risk lover. Therefore,
a balanced approach is suggested.
‰ While taking decisions over risk, the marginal utility function will be a
guiding factor.
‰ One of the important components of personal financial planning is the
retirement planning which has gained immense significance in recent
times. This requires proper planning right from the early stage so that
one can accumulate adequate corpus till the time of retirement.
‰ Retirement planning is a long-term investment and a person should
invest in pension funds available in the market with minimum risk and
moderate returns.

KEY WORDS 1. Annuity: A contract with an insurance company where

the issuer agrees to make regular payments to someone
for life or for a fixed time period in exchange for a lump
sum or periodic deposits.
2. Asset: Anything of value (e.g., securities, property) that you own
that increases your net worth.
3. Asset allocation: The placement of certain amount of one’s
investment capital in different types of asset classes (e.g., 50%
stock, 30% bonds, and 20% cash).
 FINANCIAL PLANNING 247

4. Cash flow: The relationship between household income and

expenses, for example, households that spend more than they
earn have negative cash flow.
5. Compound interest: Interest credited daily, monthly, quarterly,
semi-annually, or annually on both principal and previously
credited interest.
6. Estate planning: The process of organizing your assets for use
during your lifetime and distribution after death in accordance
with prevailing state and federal laws.
7. Financial planning: The process of establishing financial goals
and developing an action plan to achieve them.
8. Growth fund: A mutual fund that invests in stock with an objective
of capital appreciation.
9. Mortgage: A loan used to purchase a home with the real estate
used as collateral to secure the loan.
10. Mutual fund: An investment company that pools deposits from
many shareholders and invests in the stock, bonds, or cash assets
of many companies in order to achieve the specific objectives of
the fund.
11. Net worth: A snapshot of your financial situation calculated by
subtracting debts (liabilities) from assets.
12. Portfolio rebalancing: Periodically adjusting the holdings in an
investment portfolio to maintain a certain asset allocation.
13. Retirement planning: The process of planning one’s finances
and making lifestyle decisions for later part of life, typically for the
period after paid employment ceases.
14. Return: Investment gain or loss - average annual return on
investments.
15. Risk: Exposure to investment loss.
16. Risk tolerance: A person’s capacity to emotionally and financially
handle the risks associated with investing.

12.11 DESCRIPTIVE QUESTIONS

1. Explain the life cycle concept of personal financial planning with
suitable examples.
2. Explain the six-step approach to financial planning.
3. What are the important considerations while determining the financial
goals?
4. What is asset allocation? What are the important points you will suggest
while allocating assets for investments?
5. Differentiate among bond, equity, and mutual fund securities.
6. How do you explain risk tolerance capacity of investors and what is its
significance?
248 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

7. Explain with a suitable example the law of marginal utility in investment

decisions.
8. Describe the important contents in a cash flow statement.
9. What is net worth? How significant is it for considering financial
decisions?
10. Mention the important points you will consider while creating a
financial plan for an individual.
11. Why is it important to plan for retirement?
12. Explain the salient features of different pension plans.

12.12 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS

Topic Q. No. Answer

What is Financial Planning? 1. d. Both a. and b.
Life Cycle Concept of Financial 2. a. Will
Planning
Financial Planning Process - A 3. a. Six
Six-Step Approach
4. a. The process of meeting one’s
life goals through the prop-
er management of personal
finances

5. a. Assessment of current finan-

cial position
Asset Allocation and Goal Analysis 6. c. Mutual funds

Creating Personal Financial Plan 7. d. All of the above

8. d. All of the above
9. a. Residential house property
10. d. All of the above

12.13 SUGGESTED READING AND

E-REFERENCES

SUGGESTED READINGS
‰ Srivastava, Rajiv. 2017. Investment Management. New Delhi: Wiley.
‰ Elton, J Edwin, Martin J Gruber, William N. Goetzmann and Stephen
J Brown. 2013. Modern Portfolio Theory and Investment Analysis. New
Delhi: Wiley.
 FINANCIAL PLANNING 249

E-REFERENCES
‰ Brooke, P. and Penrice, D., A Vision for Venture Capital – Realizing the
Promise of Global Venture Capital and Private Equity (New Ventures),
2009.
‰ Capital Dynamics, The Definitive Guide to Risk Management in Private
Equity (PEI Media), 2010.
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A., Private Equity:
History, Governance and Operations (John Wiley & Sons), 2008.
 C H
13 A P T E R

WEALTH MANAGEMENT AND ESTATE PLANNING

CONTENTS

13.1 Wealth Management

13.2 Essential Features of Wealth Management
Self-Assessment Questions
13.3 Asset Allocation
Activity
13.4 Strategies for Asset Allocation
Self-Assessment Questions
13.5 Importance of Wealth Management
13.6 Process of Wealth Management
Activity
13.7 Advantages of Wealth Management
Self-Assessment Questions
13.8 Role of Professional Wealth Manager in Wealth Management Process
13.8.1 Professional Skills of Wealth Manager
13.9 Wealth Management and Tax Planning
13.9.1 Objectives of Tax Planning
13.9.2 Methods of Tax Planning
13.9.3 Tax Saving Strategies
Self-Assessment Questions
Activity
13.10 Estate Planning
13.10.1 Objectives of Estate Planning
13.10.2 Benefits of Estate Planning
13.10.3 Methods of Estate Planning
Activity
13.11 Summary
Key Words
13.12 Descriptive Questions
13.13 Answer Keys
Self-Assessment Questions
13.14 Suggested Reading and E-References
252 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

INTRODUCTORY CASELET

Mr. Anuj Sharma had been quite active, cautious, and systematic in
financial planning right from the early days of his career. He had set
the financial planning goals considering all the necessary requirements
of his family and children, including retirement planning and health
insurance. He had acquired enough knowledge about the financial mar-
kets and investment analysis. Based on his own judgement, he created
his own portfolio and monitored continuously and changed the portfo-
lio mix depending on market movements. He had invested systemati-
cally under all types of securities and accumulated considerable corpus
by the time he got superannuated from his job. When he was on the
verge of retirement, he checked the corpus available for investment in
the post-retirement period. He realized that the corpus available was
not adequate to lead a lifestyle post-retirement similar to what he had
been leading till now. The reason being he did not consider the infla-
tion factor while planning for investments in the retirement investment
plans. Otherwise, he had accumulated a good amount of wealth includ-
ing a small farmhouse, three flats at different locations in posh areas,
fixed deposits in banks and a hefty investment in equity and debt secu-
rities. He also had enough life insurance plans for himself and his family
members including term plan. However, he had not made any invest-
ment in pension plans.
Further, he was very optimistic about living a long life as he enjoyed
good health all through. He did not consider about estate planning and
assets accumulated over the life span remained in his name. Even his
family members were not aware of the physical and financial assets he
had accumulated over time. Unfortunately, he passed away suddenly. His
family members looked for documents and had to struggle a lot in getting
the ownership rights transferred in their name. Property dispute among
family members cropped up and they entered into litigation. It took years
to settle the dispute through legal process and a huge amount of money
was spent in the litigation. The family dispute resulted in strained rela-
tionship among the family members. From this, it can be well understood
that even though Mr. Anuj was very cautious in all respects, he lacked
knowledge about proper wealth management and estate planning, His
family had to struggle the way they never thought of.
 WEALTH MANAGEMENT AND ESTATE PLANNING 253

LEARNING OBJECTIVES

After going through this chapter, you will be able to:

> Understand the concept of wealth management in personal finan-
cial planning
> List the objectives of wealth management
> Explain the process of wealth management
> Summarize the advantages of wealth management
> Analyze the tax implications of wealth management
> Understand the significance of estate planning
> List the objectives estate planning
> Explain the methods of estate planning

13.1 WEALTH MANAGEMENT

In the present working environment with the concept of working 24X7,
most of the young and new class of affluent population are hard pressed for
time. They do not find enough time to educate themselves about savings and
investments. Though they have aspirations and dreams as well as adequate
savings to fulfill those, they find it difficult to take effective investment deci-
sions. Even wealth management process and practices are outside their pur-
view. These investors mainly depend on seeking useful advice and guidance
for investment decisions and wealth management to reap adequate returns
with least risk on their investments. Wealth management is a comprehensive
area that includes financial planning, investment decisions, asset allocation,
portfolio re-balancing, estate planning, tax structuring, and international
investing. This calls for a professional approach and expertise. Wealth
management is a process of wealth creation involving a team of experts to
evaluate the financial requirements and needs of the investors and suggest
appropriate financial asset allocation. The scope of wealth management is
enormous and has long-term wealth creation as its prime objective. Wealth
management process and practices also help in the creation of income from
the asset base. The very objective of the wealth management practices is to
help the investors in efficient asset allocation, management, and rebalancing.

13.2 ESSENTIAL FEATURES OF WEALTH

MANAGEMENT
Wealth management facilitates direct and dynamic counselling and advice
to the investors to help make better investment decisions in terms of asset
allocation management, tactical management, and diversified management.
The following are the features of wealth management:
‰ Asset Allocation Management
Asset allocation is a process, whereby according to the wealth management
practices the available asset is allocated into an optimum portfolio that will
ultimately yield increased returns and capital appreciation. Further, the
asset allocation is matched with the financial goals of the investors. It also
254 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

aims to balance the risk of investments by rebalancing the securities within

the portfolio.
‰ Suggest Alternative Investment Strategies
The financial markets are very dynamic as well as volatile. Therefore, wealth
management practices and efficient management help in selecting appro-
priate ways to achieve financial goals by choosing the best alternatives and
strategies.
‰ A Process of Diversified Management
A diversified management team helps its clients by providing a flexible model
which helps in meeting the need of the client.

SELF-ASSESSMENT
QUESTIONS
1. The goal of wealth management is to sustain and grow wealth in the
_____________,
a. Long term b. Short term
c. Mid term d. Low time
2. A wealth manager should act as an______________ and not as a
salesman.
a. Suggestion b. Advisor
c. Reporter d. Auditor

13.3 ASSET ALLOCATION

Asset allocation is a process of distribution of wealth in different types of
asset classes, such as debt, equity, mutual funds, real estate, etc. for achieving
short term, medium term and long-term financial goals of an investor. Under
this strategy, an investor allocates investment portfolios among different
diverse asset classes to minimize investment returns with optimum risk. The
allocation of assets under different categories depends on the risk aptitude
of an investor. The financial planning advisers advice the investors to reduce
the level of volatility of portfolios and diversify investments into various asset
classes. The rationale behind asset allocation is that different assets have dif-
ferent types of risks and returns which help in balancing the asset portfolio.
Investors will have a shield to safeguard their risk and returns and protect
their investments. The process of asset allocation can be well understood
through the following example.
Assume Mr. A is considering to create a financial plan for his retirement. He
is thinking to invest Rs. 5 lacs for a time horizon of five years. He approaches
a financial planning adviser who advises A to diversify his portfolio into three
major categories of assets, viz., a mix of 50:40:10 consisting of stocks, bonds,
and cash. Therefore, the portfolio will have the following combination:
‰ Stocks
‰ Small-cap growth stocks – 25%
‰ Large-cap value stocks – 15%
‰ International stocks – 10%
 WEALTH MANAGEMENT AND ESTATE PLANNING 255

‰ Bonds
‰ Government bonds – 15%
‰ High-yield bonds – 25%
‰ Cash
‰ Money market – 10%
Accordingly, the asset portfolio distribution of investments will be Rs.2,50,000
in equity, Rs.2,00,000 in bonds and Rs.50,000 in money market instruments.

Create a hypothetical portfolio with a combination of equity, debt, and ACTIVITY 1

mutual funds with assumed returns. Further assume that stock market
becomes volatile and returns fall by 4%, whereas returns on debt instru-
ment remains the same. Change the portfolio structure by rebalancing
10% equity to bonds and analyze the impact on annual returns.

13.4 STRATEGIES FOR ASSET ALLOCATION

Asset allocation strategies depend on many factors. Some of the important
considerations are described hereunder.
1. Asset Allocation Based on Age
Age is a highly significant factor on investment decisions since it is directly
related to the risk tolerance capacity, time available for investments, and life
expectancy of the investor. Therefore, it is suggested to the investors to make
the stock investment decision based on a deduction of their age from a base
value of 100. This figure also depends on the life expectancy of the investor.
The higher the life expectancy, the higher the portion of investments com-
mitted to riskier arenas, such as the stock market. This could be understood
with the following example. Suppose the present age of A is 50 years and
he is planning to get superannuated at 60 years of age. According to the
age-based investment fundamentals, he can invest in stocks approximately
50% of the investments and remaining in other assets. This explains that one
should subtract present age (50) from a base value of 100.
2. Asset Allocation and Life Cycle
In life cycle funds allocation, investors maximize their return on invest-
ment (ROI) based on factors, such as investment goals, risk tolerance capac-
ity, and age. This kind of portfolio mix is slightly complex on account of
standardization approach. Let us assume that A has an original investment
mix of 50:50. After a time span of five years, the risk tolerance for equity
investment may increase to 20%. In this situation A can offload 20% stake
in debt securities and reinvest in equity. Therefore, the changed mix of the
portfolio will be 80:20. This ratio may further change over a period of time
depending on investment goals, risk tolerance, and age.
There are few other strategies for asset allocation.
(a) Constant-Weight Asset Allocation
The constant-weight asset allocation strategy is based on the buy-and-hold
policy. It means, if a stock loses value, investors buy more of it. However, if
256 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

it increases in price, they sell a bigger proportion. The goal is to ensure the
proportions never deviate by more than 5% of the original mix.
(b) Tactical Asset Allocation
The tactical asset allocation strategy addresses the challenges that result
from strategic asset allocation relating to the long-run investment policies.
Therefore, tactical asset allocation aims at maximizing short-term invest-
ment strategies. As a result, it adds more flexibility in coping with the market
dynamics so that the investors invest in high-returning assets.
(c) Insured Asset Allocation
For investors averse to risk, the insured asset allocation is the ideal strat-
egy to adopt. It involves setting a base asset value from which the portfolio
should not drop. If it drops, the investor takes the necessary action to avert
the risk. Otherwise, as long as they can get a value slightly higher than the
base asset value, they can comfortably buy, hold, or even sell.
(d) Dynamic Asset Allocation
The dynamic asset allocation is the most popular type of investment strategy.
It enables investors to adjust their investment proportion based on the highs
and lows of the market and the gains and losses in the economy.

SELF-ASSESSMENT
QUESTIONS 3. Which of the following is/are growth asset/s?
a. Neither gold nor real estate
b. Equity
c. Equity and real estate
d. Real estate
4. Dynamic asset allocation is a/an:
a. Negotiation strategy b. Selling strategy
c. Investment strategy d. Purchasing strategy
5. The financial planner’s fundamental role is to ensure that the
client has adequate ________ to meet various financial goals.
a. Property b. Gold
c. Money d. Cash

13.5 IMPORTANCE OF WEALTH MANAGEMENT

Wealth management has emerged as one of the attractive areas catching
attention of investors since an effective asset management provides better
returns on investments over a period of time. Majority of the investors invest
a sizeable amount of their savings to accumulate capital with the objective to
provide financial security to their family. Investing all the savings unsystem-
atically will not provide the required returns and will increase risk exposure.
It is equally important to make proper strategies and understand and imple-
ment the strategies where savings and investments can be optimally utilized.
Wealth management experts and professionals offer guidance and proper
direction to investors where to invest and how to build an efficient portfo-
 WEALTH MANAGEMENT AND ESTATE PLANNING 257

lio. The wealth management practices also assist in creating a financial plan
through which one can utilize and allocate assets in a manner to achieve the
required financial objectives and goals. Wealth management also emphasizes
on the compounding aspect for higher returns over a long tenure. Taxation,
an important aspect in wealth management, is also covered under the ser-
vices of wealth management.
It may not be possible to achieve the financial goals in the absence of efficient
wealth management practices and strategies. It is also important to identify
and understand the financial strengths and challenges before making finan-
cial strategies as they facilitate in building the strengths and overcoming
adverse movements in the financial markets. The expert engaged in wealth
management plays the role of an intermediary implementing the plan into
action and also monitoring its progress periodically.

13.6 PROCESS OF WEALTH MANAGEMENT

The process of wealth management involves the following steps:
1. Collection of Information and Data
The wealth management process takes a fresh look at investors’ present
financial position. The following information about the investors are col-
lected and analyzed:
‰ Value of assets at fair market price
‰ Total liabilities
‰ Monthly cash expenditures required
‰ Income tax payment obligation
‰ Wills and trusts
‰ Insurance contracts
‰ Retirement assets
After collecting all the above information and other necessary detail, a com-
prehensive plan is prepared based on financial position, available savings,
and investment goals.
2. Determination of Objectives
Under the wealth management process, a detailed study based on personal
interactions with the investors is made to understand the financial needs and
goals. They are not based on assumptions. Generally, the following financial
goals are determined:
‰ Investment Planning
‰ Determining investment temperament and risk tolerance
‰ Setting investment goals
‰ Selecting investment variables
‰ Monitoring investment portfolio
258 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

‰ Retirement Planning
‰ Targeting retirement age
‰ Retirement plan selection and design
‰ Targeting income needs at retirement
‰ Distribution alternatives & IRA rollover options
‰ Design of deferred compensation plans
‰ Cash Flow Analysis
‰ Identifying income sources
‰ Projecting living expenses
‰ Implementing methods to improve cash flow
‰ Income Tax Planning
‰ Methods of reducing tax
‰ Tax deferral techniques
‰ Income shifting techniques
‰ Insurance Planning
‰ Determining life insurance needs
‰ Determining disability insurance needs
‰ Determining long-term care insurance needs
‰ Selecting insurance products
‰ Business Planning
‰ Selecting a business entity
‰ Techniques for transferring ownership
‰ Employee benefit plans
‰ Education Planning
‰ Targeting cash needs for education
‰ Selecting methods for funding education
3. Processing and Analyzing Information
After identifying the objectives in the above manner, all the financial infor-
mation available is analyzed to develop strategies matching with financial
goals. This leads to preparation of financial plans. The priorities of financial
goals are kept in view while preparing the financial plans.
4. Suggesting Strategies
Once the information is analyzed and financial goals are determined, the
next stage is recommending required strategies. This helps in proper asset
allocation and design of the right plan. The strategies are developed based on
the time available for the particular financial goal, risk aptitude of the inves-
tor, and current and likely future scenario of the financial markets. All the
strategies are reviewed and changed if needed. This is step by step planning
so that the particular financial goal could be achieved in time.
 WEALTH MANAGEMENT AND ESTATE PLANNING 259

5. Plan Implementation
Even the best plan can fail if it is not properly implemented. Therefore,
implementation is a critical step to put the plan into necessary action. This
helps in putting the strategy to action and ultimately turning the financial
goals into a reality.
6. Monitoring the Plan
The wealth management process does not end with the implementation of the
plan. Continuous monitoring of the progress and bringing required changes
from time to time depending on market movements is integral to wealth man-
agement. Changes in the initial plan are made to rebalance the assets.

While preparing a financial plan for higher education of children, exam- ACTIVITY 2
ine two situations wherein one child aspires to earn a foreign degree
and the other one an MBA from a premiere institute in India. How will
you forecast the expected budget for both the children? How would you
suggest the investment strategies?

13.7 ADVANTAGES OF WEALTH MANAGEMENT

Wealth management helps in effective financial planning to achieve financial
goals in a systematic manner with optimum yield and minimum risk. Right
determination of financial goals, appropriate asset allocation, continuous
monitoring and follow up are essential to make it happen. The following are
the advantages of wealth management:
1. A Process of Systematic Financial Plan
Through wealth management services, it is possible for investors to create
the ideal and effective financial plan to achieve the desired financial goals.
It also enables the investors to accumulate assets and create capital in an
efficient manner. Wealth management professionals help in creating finan-
cial strategies and they devote sufficient time and effort to understand the
proper needs of the investors and provide appropriate direction for meeting
their financial goals as required.
2. It Relieves Financial Stress
Wealth management practices and professional services help investors in
understanding the financial uncertainties. Wealth management experts pro-
vides guidance to make critical financial decisions whenever the need arises.
They also help in managing the finances during volatile and unforeseen
market conditions and reduce the financial stress during abnormal times.
Wealth management also minimizes financial stress and prioritizes financial
decisions based on a timeframe. The wealth management process consid-
ers related financial aspects while creating the goals that ultimately help in
rebalancing the portfolio from time to time.
3. Customized Services
Nowadays, a good number of professional experts and financial advisors
have entered the market extending professional services related to wealth
management. Based on their experience and expertise, professional wealth
260 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

management experts provide customized services to investors according to

one’s requirements. The wealth manager designs financial strategies keep-
ing in mind the personal needs of the clients. He acts as a financial counselor
cum advisor. The investors can seek advice from the professionals any time
and can discuss matters related to their financial planning and goals. The
wealth managers create various strategies in asset allocation, portfolio bal-
ancing, and monitoring.
4. Wealth Management - a Flexible Investment Approach
Wealth management practices and processes keep in mind the investors’
welfare and priorities and whenever the need arises, the investment pro-
cess is made flexible to suit the present requirements. Wealth management
professionals do consider both the market categories and market conditions.
Through effective and efficient wealth management practices, it is possible to
modify the financial plans and strategies during times of financial trouble for
better investment decisions. This is a flexible investment approach through
which the financial strategies can be modified involving new approaches and
perceptions according to changed market conditions.
5. Other Advantages
The following are the additional advantages of wealth management pro-
cesses and practices:
‰ Wealth management plans are matched with investors’ specific needs.
The financial products are combined to effectively reach the financial
goals of the investor.
‰ The professional wealth management and advisory services facilitate effi-
cient investor services and updated information including sensitive issues.
Professional advisors also maintain the confidentiality of information
obtained during the course of financial planning and advisory services.
‰ A wealth management professional follows diverse financial disciplines,
such as finance, accounting and tax services, investment advice, legal or
estate planning, and retirement planning to manage an affluent inves-
tor’s wealth.
‰ Wealth management practices and the corresponding services may differ
from one location to another, depending on the state of the economy, per
capita income, and saving habits of the people.
‰ Wealth management is different from investment advice. The former is
a more holistic approach in which a single manager coordinates all the
services needed to manage the money and plan for the client’s needs,
including the current and future needs of the client’s family.
‰ While most wealth managers provide services in any financial field, cer-
tain wealth managers specialize in specific areas of finance. The special-
ization would be based on the area of expertise of the wealth manager.
‰ Wealth management services are usually appropriate for wealthy individ-
uals who have a broad array of diverse needs. The advisors are high-level
professionals and experts.
‰ Wealth managers may work individually or as part of a small-scale busi-
ness or as part of a large firm. Based on the nature of the business, wealth
 WEALTH MANAGEMENT AND ESTATE PLANNING 261

managers may function under different titles, which include financial

consultant or financial adviser. An investor may receive services from a
single designated wealth manager or may have access to the members of
a specified wealth management team.
Wealth management processes and practices provide all-inclusive services
and research-based advisory guidance duly customized to investor require-
ment. Wealth management services offer an incomparable product base that
covers debt, equity, mutual funds, insurance, derivatives, commodities, and
funds. Before offering the wealth management services, the experts have
in view the investors’ goals and requirements and understand the types of
financial planning and management. Wealth management services include
planning and protection of fiscal matters, business plan, and retirement
needs, which help in building up the investors’ present and future finances.
Wealth management combines a dogged business approach with an easy
mark of customized attention and dedicated customer care.

6. If interest rates in the market were to decrease, fixed rate debt SELF-ASSESSMENT
instruments issued earlier will lose value because of the poor QUESTIONS
sentiment.
a. False b. True
7. An investor has a 60:40 equity:debt allocation in his portfolio. If he
is following fixed asset allocation, what will be his likely behavior
if equity market goes down 25% and he has nothing new to invest.
a. Switch 15% of revised equity portfolio to debt
b. Switch all equity to debt
c. Do nothing
d. Switch 15% of original debt portfolio to equity
8. Distribution based on risk profile is called:
a. Flexible asset allocation
b. Fixed asset allocation
c. Tactical asset allocation
d. Strategic asset allocation
9. Goal-based financial planning gets complex in the case of
_______________.
a. Changes in inflation
b. Market volatility
c. Multiple goals
d. Sudden wealth gain

13.8 ROLE OF PROFESSIONAL WEALTH

MANAGER IN WEALTH MANAGEMENT
PROCESS
A wealth manager plays a crucial role in building strong relationships with
the clients and helping them in taking better decisions. A wealth manager is
an expert offering integrated services that include financial and investment
262 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

advice, tax planning services, and also real estate planning. He acts as a
broker on behalf of clients to buy and sell stocks and has an in-depth knowl-
edge of investment business and finances which help them in managing cli-
ents’ finances effectively. However, there are certain criteria that a wealth
manager is required to meet before offering services to clients.

13.8.1 PROFESSIONAL SKILLS OF WEALTH MANAGER

The qualification required for a wealth manager varies from organization
to organization. Before joining as a wealth manager, it is necessary to take
an employer-based training. The person must possess a degree and knowl-
edge in various fields like finance, economics, and management. Adequate
experience in financial services can be another route to become a wealth
manager. He should complete a sanctioned qualification from the Financial
Conduct Authority (FCA) Appropriate Qualification list. Once qualified he
is required to continue with trainings and keep himself updated on any
changes in regulations or procedures and take further courses to enhance
knowledge. As a wealth management professional, one should have the fol-
lowing skill sets:
‰ Great organizing skills
‰ Capable of handling complex situations
‰ Strong interactive skills
‰ Knowledge and expertise in different fields
‰ IT capabilities
‰ Good administrator
‰ Able to make good judgement
‰ Analyze the risks involved in different investments
‰ Better interpersonal skills and trustworthiness

13.9 WEALTH MANAGEMENT AND TAX

PLANNING
Tax planning has an important role in wealth management processes and
practices as one needs to pay taxes on annual earnings. Tax planning implies
a legitimate way of minimizing tax liabilities considering various tax incen-
tives in a particular financial year. It helps in optimum utilization of the tax
exemptions, deductions, and benefits offered by the tax authorities in the
best possible way to reduce tax liability. Tax planning can be defined as an
assessment of one’s taxable income from the tax efficiency point of view.

13.9.1 OBJECTIVES OF TAX PLANNING

Tax planning is an integral component of financial planning and wealth man-
agement. It ensures savings on taxes while simultaneously conforming to the
legal obligations and requirements of the Income Tax Act, 1961. The primary
concept of tax planning is to save money and mitigate one’s tax burden and
not evading the tax liability. The following are the advantages of tax planning:
 WEALTH MANAGEMENT AND ESTATE PLANNING 263

‰ Overcoming litigation issues: To litigate is to resolve tax disputes with

local, federal, state, or foreign tax authorities. There is often friction
between tax collectors and taxpayers as the former attempts to extract
the maximum amount possible while the latter desires to keep their tax
liability to a minimum. Minimizing litigation saves the taxpayer from
legal liabilities.
‰ Minimizing tax liabilities: Every taxpayer wishes to reduce their tax
burden and save money for their future. You can reduce your payable tax
by arranging your investments within the various benefits offered under
the Income Tax Act, 1961. The Act offers many tax planning investment
schemes that can significantly reduce your tax liability.
‰ Adding to economic stability: Taxpayers’ money is utilized for the bet-
terment of the country. Effective tax planning and management provides
a healthy inflow of white money that results in the sound progress of the
economy. This benefits both the citizens and the economy.
‰ Leveraging productivity: One of the core tax planning objectives is
channelizing funds from taxable sources to different income-generating
plans. This ensures optimal utilization of funds for productive issues.

13.9.2 METHODS OF TAX PLANNING

Tax planning is not only meant for reducing the tax liability but also invest-
ing in the right securities at the right time to achieve your financial goals.
Some of the important methods of tax planning are:
‰ Short-range tax planning: Tax planning is thought of and executed at
the end of the fiscal year. Investors resort to this planning in an attempt
to search for ways to limit their tax liability legally when the financial
year comes to an end. This method does not partake long-term commit-
ments. However, it can still promote substantial tax savings.
‰ Long-term tax planning: In this case, the plan is chalked out at the
beginning of the fiscal year and the taxpayer follows this plan throughout
the year. Unlike short-range tax planning, you might not be offered with
immediate tax benefits but it can prove useful in the long run.
‰ Permissive tax planning: This method involves planning under vari-
ous provisions of the Indian taxation laws. Tax planning in India offers
several provisions, such as deductions, exemptions, contributions, and
incentives. For instance, Section 80C of the Income Tax Act, 1961, offers
several types of deductions on various tax-saving instruments.
‰ Purposive tax planning: It involves using tax-saver instruments with a
specific purpose in mind. This ensures that you obtain optimal benefits
from your investments. This includes accurately selecting the appropri-
ate investments, creating an apt agenda to replace assets (if required),
and diversification of business and income assets based on your residen-
tial status.

13.9.3 TAX SAVING STRATEGIES

Taxpayers are provided with several options to reduce their tax liabili-
ties. Various sections of the Indian income tax law offer tax deductions and
264 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

exemptions of which Section 80C is the most popular tax-saving avenue. For
example, deposits in Public Provident Fund, Five-Year Bank Deposits, National
Savings Certificate, Investment in ELSS schemes.
The best and the most optimum way to save taxes is by laying out a financial
plan whenever there is a revision in your income, and then sticking to it.
Also, it is a good habit to make tax-saving investments at the beginning of
the year rather than making hasty and often incorrect investment decisions
at the last moment. To do this, it is crucial to be aware of all the exemptions
and deductions available to you.

TAX SAVING OPTIONS UNDER SECTION 80C

Section 80C, one of the most prevalent sections in the Income Tax Act, 1961,
provides provisions to save up to Rs.46,800 (assuming the highest slab of
income tax, i.e., @30% plus education cess 4%) on tax liabilities each year.
One of the best tax-saving avenues under Section 80C is investing in an equi-
ty-linked savings scheme, more commonly known as ELSS. Such tax plan-
ning mutual funds offer the dual benefit of potential capital appreciation and
tax saving. Apart from ELSS funds, you can choose to invest in government
schemes, such as National Savings Certificate (NSC), Public Provident Fund
(PPF), tax-saving FDs, etc. Cumulative investments under these securities
can offer deductions up to Rs.1.5 lac.

TAX SAVING OPTIONS UNDER SECTION 80D

Under this Section, taxpayers are offered deductions on the premium paid
towards health insurance policies. Under Section 80D, a taxpayer can claim
the following amounts as deductions:
1. Avail up to Rs.25,000 on the premium paid towards health insurance for
self, children, or spouse.
2. Avail up to Rs.50,000 if your parents are also covered under your health
insurance plan.
3. If either of your parents belongs to the senior citizen bracket, then a
maximum deduction of Rs.75,000 is allowed.

TAX SAVING OPTIONS UNDER SECTION 80E

Section 80E offers tax deductions on the interest paid for an education loan.
These deductions can be claimed for eight years starting from the date of
repayment. There is no upper limit on the deductible amount. This means
that an assessee can claim the entire amount paid as interest from the tax-
able income.

CLAIMING HRA EXEMPTION

Under HRA, taxpayers can avail exemption on the cost incurred to stay
in a rented accommodation. The taxpayer is mandated to furnish the rent
receipts provided by the landlord. The deduction available is the least of the
following amounts:
 WEALTH MANAGEMENT AND ESTATE PLANNING 265

1. Actual HRA received; or

2. 50% of basic salary + DA (dearness allowance) for taxpayers living in
metro cities; 40% of (basic salary + DA) for taxpayers residing in non-
metro cities; or
3. Total rent paid less 10% of basic salary + DA

OTHER EXEMPTIONS AND DEDUCTIONS

Apart from the deductions and the exemptions mentioned above, you can
save taxes in several other ways. Donations towards charities and qualified
organizations are also eligible for tax exemptions.
Under the new tax regime announced in the Union Budget 2020, individuals
can opt to pay taxes at reduced rates and redefined income tax slabs by for-
going the various deductions and exemptions.
Income tax planning, if performed under the framework defined by the
respective authorities, is an entirely legal and a smart decision. However,
you might land yourself in trouble for adopting unlawful techniques to save
taxes. It is the duty and responsibility of every citizen to carry out prudent
tax planning. Based on your tax slab, personal choices, and social liabilities,
you can choose from distinct tax saver mutual funds and investment avenues
offered to you.

SELF-ASSESSMENT
10. Medical Insurance premium provide tax exemption under QUESTIONS
Section___________ of Income Tax Act.
a. 80A b. 80B
c. 80C d. 80D

Prepare a consolidated list of all the tax incentives available for an ACTIVITY 3
Individual. Calculate the maximum exemption one can get as tax bene-
fits assuming that the person has investments or expenses under all the
heads and is eligible to get tax benefits up to the maximum limit under
each category.

13.10 ESTATE PLANNING

Estate planning is a systematic process to facilitate arranging and planning
succession and financial affairs. Estate planning services ensures the man-
agement of estate during and after the lifetime, and thus, plan one’s legacy.
It is an approach to preparing for the transfer of a person’s wealth and assets
after his or her death. Assets, life insurance, pensions, real estate, cars, per-
sonal belongings, and debts are all part of one’s estate. Estate plans must be
written, signed, and notarized by the person who owns the estate. An estate
comprises the total property and assets including real and personal possessed
by an individual prior to the distribution of trust or will. The distribution of
both the real and personal property among its prospective heirs is covered
under the process of estate planning. The very objective of estate planning
266 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

is to preserve the maximum amount of wealth for the intended beneficiaries

keeping in view the sudden demise of an individual. Estate planning is one
of the very essential financial obligations to protect, distribute, and preserve
the wealth created during one’s lifetime.
Who does not want their loved ones to remain financially secure even after
one’s death? To make this possible, implementation of estate planning is nec-
essary. All the existing legal questions related to one’s financial status are
resolved by the professionals. It is important to understand that the right
estate planning option turns out to be absolutely feasible in resolving com-
plex financial problems.
Estate planning involves determining how an individual’s assets will be pre-
served, managed, and distributed after death. It also considers the management
of an individual’s properties and financial obligations in the event a person
become incapacitated. Assets that could make up an individual’s estate include
houses, cars, stocks, artwork, life insurance, pensions, and debt. Individuals
have various reasons for planning an estate, such as preserving family wealth,
providing for a surviving spouse and children, funding children’s or grandchil-
dren’s education, or leaving their legacy behind to a charitable cause.

13.10.1 OBJECTIVES OF ESTATE PLANNING

The objectives of estate planning are stated below.
‰ Distribution of assets among the loved ones: The accumulated wealth
can be transferred among the family members, legal heirs, loved ones
according to the will and wishes of the person who accumulated the
wealth. This could be done during the lifetime or a person can plan during
the lifetime but distribution could be after the death as per the will.
‰ Reduced tax burden: One of the objectives of estate planning is to trans-
fer maximum wealth and payment with minimum taxes.
‰ Incapacitation: Estate planning sometimes is resorted to in case of inca-
pacitation as well. This avoids court-controlled guardianship and the
sole control remains within the family itself. Also, this reduces the cost of
third-party engagement by a court.
‰ Appropriate succession plan: Estate planning includes writing a will as
a part of financial planning. This helps in identifying the assets’ disposal
cum succession plan of an individual after his death.
‰ Wealth distribution schedule: Estate planning helps in preparing a well-
designated will to distribute the wealth of the deceased individual among
his beneficiaries. Sometimes a will clearly stipulates that a particular
family member becomes the owner of any personal effects till his minor
child becomes an adult or a minor would become the owner of a particu-
lar asset when he reaches a particular age.

13.10.2 BENEFITS OF ESTATE PLANNING

There are many benefits of estate planning since it is helpful for distribution
of wealth and assets according to ones will and wish and avoids many legal
complications and litigations after the death of a person. The following are
some of the important benefits:
 WEALTH MANAGEMENT AND ESTATE PLANNING 267

‰ Property transfer and ownership distribution takes place as per the will
of the person after his death.
‰ It helps in reducing taxes and other transfer costs and saves legal expenses.
‰ The family’s finances are well taken care of.
‰ Sufficient liquidity remains to pay debts, taxes, and other costs at the
death of the client.
‰ It avoids the process of probate which may be time-consuming and
expensive.
‰ It avoids litigation problems that may arise in the absence of proper
estate planning.
‰ It also helps to maintain good family and social relationship as no dis-
putes take place regarding asset distribution of the person who accumu-
lated the wealth.

13.10.3 METHODS OF ESTATE PLANNING

Immovable assets, such as land, building, and infrastructure assets and mov-
able assets, such as car, cash, jewelry, shares and stocks, insurance policies,
debts, loans and even the financial obligations become an important part of
estate planning for individuals. Estate plans are taken care of by attorneys
who have experience in estate laws. In practice, the below methods are fol-
lowed in estate planning.
1. Through execution of the will
According to Section 2(h) of The Indian Succession Act, 1925, a “Will” means
the legal declaration of the intention of a testator with respect to his property
which he desires to be carried into effect after his death. A will is a legal doc-
ument which is prepared during the lifetime of the person (known as a tes-
tator) but comes into existence after his demise. A will declares the testator’s
wishes regarding distribution of his assets and possessions after his demise. A
will should be made by the testator in a sound mind and without any coercion
or undue influence from any person. The registration of a will is not manda-
tory under law; however, getting a will registered increases its genuineness
and authenticity as compared to a will which is unregistered. Once a will is
registered, it is recorded in the register of the sub registrar, and hence, the
chances of it being stolen, mutilated, or tampered are minimized. At any time,
a certified copy of the original will can also be obtained by the legal heirs of
the testator after his demise. It can be executed in the following manner.
(a) Appointing an executor under the will
A person writing a will should be extremely cautious of the fact as to who will
be the executor of his will - this being a position of trust and responsibility.
An executor is regarded as a representative of the testator, who takes charge
of the estate of the deceased and ensures that the assets are distributed as
enumerated in the will.
(b) Creation of trust
A trust is created to transfer property by the owner to another for the benefit
of a third person along with or without himself or a declaration by the owner,
268 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

to hold the property not for himself and another. A trust is hence an arrange-
ment between the author of the trust and the trustees to transfer the legal
ownership of assets to the trustee with an obligation that the same should be
held for the benefit of the beneficiaries as specified in the trust deed. One of
the major advantages of a trust is that if the person goes bankrupt or faces
other financial crisis, then the lender cannot touch the assets which are held
within the trust. For the purpose of estate planning, a private trust can be
created, i.e., when the purpose of the trust is to benefit an individual or a
group of individuals or his or their descendants or any person and who is
capable of holding the property, it is a private trust.
(c) Forming a limited liability company (LLC)
One of the emerging modes of estate planning is forming a limited lia-
bility company (LLC). It can be a useful legal structure as the assets will
be under your control during the lifetime and at the same time it can be
passed down to your loved ones while avoiding or minimizing estate and
gift taxes. A family LLC allows your heirs to become shareholders who can
then benefit from the assets held by the LLC, while you retain manage-
ment control.
(d) Distribution of assets during the lifetime/gifts
According to Section 122 of The Transfer of Property Act 1882, a “Gift” is the
transfer of certain existing moveable or immoveable property made volun-
tarily and without consideration, by one person, called the donor, to another,
called the donee, and accepted by or on behalf of the donee. Such acceptance
must be made during the lifetime of the donor and while he is still capable
of giving. If the donee dies before acceptance, the gift is void. A lifetime gift
is a gratuitous transfer of ownership of any property between living persons
which is not made in expectation of death. On the contrary, gifts made in
expectation of death may qualify as deathbed gifts. A valid gift is “without
any consideration.” A lifetime gift may be made by:
‰ A gift deed or other instrument in writing
‰ Through delivery in cases where the subject of the gift is capable of delivery
‰ Through creation of trust
Estate planning is an ongoing process that should take place when an individ-
ual starts accumulating wealth and assets. The estate plan can be amended
with changes in life journey. It is advisable that a person seek advice of pro-
fessionals and legal experts for estate planning. This will avoid legal compli-
cations at a later date.

ACTIVITY 4 Assume A is 56 years old and he has a good amount of savings and assets.
He plans to allocate some of the assets to his family members and with
50% of his wealth with a corpus of Rs.5 crore, he wants to create a trust
for social welfare of the people. Suggest ways to create a trust. How will
the transfer of wealth take place to the trust?
 WEALTH MANAGEMENT AND ESTATE PLANNING 269

13.11 SUMMARY
‰ Wealth management has emerged as an area of much interest in the
present context due to increased awareness among investors about the
benefits and advantages of professional management of savings and
investments.
‰ The financial market developments are hard to predict in view of the
global developments and an individual cannot keep a track on various
developments. More importantly, the lifestyle of young generation has
become quite hectic due to increased work pressure and the working
environment of the corporate sector.
‰ However, majority of the people have become savings conscious right
from the beginning of their career or income generation.
‰ A systematic wealth management approach contributes in many ways,
viz., better returns on investments, higher accumulation of wealth, achiev-
ing various financial goals, balancing the portfolio, risk mitigation, etc.
‰ It is a comprehensive approach that helps investors to balance their finan-
cial position and create adequate assets and wealth over the life span.
‰ Retirement planning, life insurance, health insurance, minimizing tax
burden are also integral parts of wealth management. It has received
much attention in the developed countries and has provided wider scope
for professionals and experts for advisory and consultancy services.
‰ Estate planning hitherto neglected by the common man has started
receiving much attention now since a good number of investors has
started accumulating assets and wealth.
‰ Accumulation of wealth without proper distribution among family mem-
bers and loved ones leaves much scope for disputes and litigations.
Therefore, estate planning which is a process of transfer of ownership
before the death of a person assumes much significance.
‰ It is suggested that investors and in particular those who have accumu-
lated good amount of wealth must understand estate planning and exe-
cute the will during the life time.

1. Wealth management: A process of wealth creation involving a KEY WORDS

team of experts to evaluate the financial requirements and needs
of the investors and suggest appropriate financial asset allocation.
2. Asset allocation: The apportionment of a portfolio’s assets among
asset classes and/or markets.
3. Credit risk: The risk that a bond issuer will default on their
contractual obligation to make interest payment to investors.
4. Developed markets: Countries that tend to be industrialized and
have a high gross domestic product.
5. Wealth manager: An expert offering integrated services that
include financial and investment advice, tax planning services,
and also real estate planning.
270 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

6. Tax planning: An assessment of one’s taxable income from the tax

efficiency point of view.
7. Estate planning: A systematic process to facilitate arranging and
planning succession and financial affairs.
8. Will: The legal declaration of the intention of a testator with
respect to his property which he desires to be carried into effect
after his death.
9. Fixed income: Refers to securities such as bonds which carry a
predetermined and fixed rate of interest (coupon).
10. Market risk: The possibility that the value of an investment will
fall due to a general decline in the financial markets.
11. Risk: The chance of incurring a loss from an investment.
12. Volatility: A statistical measure of the fluctuations of a security’s
price.

13.12 DESCRIPTIVE QUESTIONS

1. What is wealth management? Explain its salient features.
2. In what way does asset allocation strategy help in wealth management?
3. Differentiate between tactical and dynamic asset allocation strategies.
4. Explain the process of wealth management
5. What are the advantages of wealth management?
6. What are the tax incentives available for wealth management?
7. Explain how efficient wealth management help in retirement planning.
8. What is estate planning? Describe its objectives.
9. What are the benefits of estate planning?
10. Explain the different methods of estate planning with examples.

13.13 ANSWER KEYS

SELF-ASSESSMENT QUESTIONS

Topic Q. No. Answer

Wealth Management 1. a. Long term
Essential Features of Wealth 2. b. Advisor
Management
Strategies for Asset Allocation 3. d. Real estate
4. c. Investment strategy
5. c. Money
 WEALTH MANAGEMENT AND ESTATE PLANNING 271

Topic Q. No. Answer

Advantages of Wealth Manage- 6. b. True
ment
7. a. Switch 15% of revised equity
portfolio to debt
8. d. Strategic asset allocation
9. c. Multiple goals
Wealth Management and Tax 10. d. 80D
Planning

13.14 SUGGESTED READING AND E-REFERENCES

SUGGESTED READINGS
‰ Srivastava, Rajiv. 2017. Investment Management. New Delhi: Wiley.
‰ Elton, J Edwin, Martin J Gruber, William N. Goetzmann and Stephen
J Brown. 2013. Modern Portfolio Theory and Investment Analysis. New
Delhi: Wiley.

E-REFERENCES
‰ Brooke, P. and Penrice, D., A Vision for Venture Capital – Realizing the
Promise of Global Venture Capital and Private Equity (New Ventures),
2009.
‰ Capital Dynamics, The Definitive Guide to Risk Management in Private
Equity (PEI Media), 2010.
‰ Cendrowski, H., Martin, J., Petro, L., and Wadecki, A., Private Equity:
History, Governance and Operations (John Wiley & Sons), 2008.
 CASE STUDIES
10 TO 13

CONTENTS

Case Study 10 Performance Evaluation of Mutual Funds

Case Study 11 Macro-Economic Factors Impacting Investments
Case Study 12 The Financial Planning
Case Study 13 Wealth Management and Estate Planning
274 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

CASE STUDY CHAPTER – 10

CLOSING CASE

Two friends, Rima and Lakshmi were discussing their newfound

interest in investments. Being beginners, both were wary of making
risky investments and wanted a safe way of entering the world of
investments. Together they had decided on mutual fund investment.
Lakshmi planned on using a significant saving already in her possession
while Rima, who did not have the same bulk of savings, decided to
invest using her regular income.
They approached their friend Amal for advice, who had good knowledge
of investing. Amal gave them both a separate method of investing. Rima
and Lakshmi could invest in mutual funds through lump sum payment
or through SIP. The main difference in both these ways is the frequency
of making the investments. Lump sum investment consists of making a
bulk investment at a specified time in a particular scheme. The amount
would be relatively higher. Since Lakshmi had her savings, she possessed
more risk tolerance. Amal suggested that lump sum investment would
be more beneficial for Lakshmi. Now Rima on the other, could not afford
to invest a large amount in the beginning itself. Amal suggested she
invest through SIP. SIP would let Rima invest relatively lower amount
money at more frequent intervals. Since she had a steady income, SIP
would keep her from making emotional decisions and also lower her
average cost of the total investment. Moreover, Rupee Cost Averaging
is an approach with which she can invest a fixed amount at regular
intervals. It would allow her to purchase more units of a particular
mutual fund when its prices are low and similarly limit her purchases
to lesser units when the price was high. The bull and bear run of the
market would ultimately, in the longer run, be beneficial for her.

QUESTION

1. List the two approaches to mutual fund investment.

2. Discuss why in comparison with lump sum investment SIP is
more suited to Rima’s situation.
 CASE STUDY 275

CASE STUDY CHAPTER – 11

CASE STUDY

CLOSING CASE

COVID 19 PANDEMIC & STOCK MARKETS IN INDIA

The Covid 19 has had the set back on financial markets all across the
globe and especially the stock markets that saw a higher down fall After
the outbreak of the COVID-19, the stock market came under shock as
BSE Sensex and NSE Nifty chop down by 38%. It leads to a 27.31%
loss of the total stock market capitalization from the beginning of 2020
but after that market recovered rapidly thanks to nice corporate results,
high vaccination, high FDI investments (as US fed pumped lots of dollar
in the economy) etc. This paper will analysis the pre and post covid
position of Indian stock markets i.e. NSE and BSE. According to the
reports and experts opinion, the Covid-19 crisis has so far failed to spark
a deep stock selloff like that seen last year, and some asset managers
point to less stringent curbs on activity as one factor at least for now.
Even as the nation reports more than 300,000 confirmed infections
and over 4,000 deaths a day, India’s benchmark equity index has been
moving in line with regional peers. The S&P BSE Sensex index has
declined 6.6% from a mid-February peak, about as much as the MSCI AC
Asia Pacific index. That compares with a 23% tumble in the Sensex in
March last year when the coronavirus pandemic started to rage globally.
The surprisingly muted stock market reaction to India’s virus disaster
can also be seen in net outflows of foreign investors, which totaled about
$1.5 billion in April versus $8.4 billion during the height of the rout
last March. They turned net buyers of Indian equities this week after
four straight weeks of outflows. More limited and regional lockdown
measures being implemented by state governments have prevented a
slide in economic activity like last year, but the risk is that the outbreak
may prompt a sharp escalation in restrictions again.
The reports state that steep fall in stocks though would provide an
opportunity to allocate more to that asset class, as equity valuations
have grown expensive over the course of the last year, Companies are
better equipped to continue operating as they know the procedures to
operate in a lockdown, have cut costs, streamlined operations, and in
many cases have raised capital. “The current approach India is taking
to curb the virus – staggered, state-level restrictions on non-essential
services rather than a blanket nationwide lockdown – suggests the
impact is likely to be limited relative to last year,” said Abhishek Gupta,
Bloomberg’s India Economist, in a note.
Expectations that Asia’s third-largest economy won’t take as big of a hit
as last year have also been reflected in the rupee, which has recouped
most of last month’s decline. Benchmark government bond yields have
eased about 11 basis points in the last month after the Reserve Bank of
India announced its version of quantitative easing in April.
276 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Indian shares are moving more in line with global peers, which despite
this week’s stumble have been on a bullish trajectory overall. The average
monthly correlation between returns on India’s Nifty 50 and the S&P 500
rose to about 85% in the last year, compared with a 70% correlation over
the longer term, according to Gaurav Patankar, an analyst at Bloomberg
Intelligence.

QUESTION

1. Why there was sudden fall in the index of BSE & NSE, analyze
the reasons.
2. Did the foreign portfolio investments impact the stock market
rise or fall?
3. How does stock markets movements impact the government
bond yield?
 CASE STUDY 277

CASE STUDY CHAPTER – 12

CASE STUDY

FINANCIAL PLANNING

Abhishek is single and stays with his parents in his father’s house in
Delhi. He has an elder brother who works abroad. Abhishek remembers
that at an early age he got a first-hand experience on savings when his
parents encouraged both the brothers to open a children’s bank account
which was being operated from the school premises. Both brothers
started saving Rs. 5 per month and this money was utilized in the next
academic year to purchase some books, stationery, etc. His father used
to work in an engineering firm while his mother was a teacher. When
he was in the first standard, his father’s company faced lockout and for
nearly two years the family survived on his mother’s income. Later, his
father got an opportunity to work in a Gulf country and for some time
the family’s finances were on track.
However, again tragedy struck when his mother had to give up her job
due to health reasons. After working for a couple of years abroad, his
father’s firm closed down and he had to come back. His mother started
taking tuitions at home to make ends meet. Since the convent school
where the siblings were studying were aided by the government, they
did not have to pay any fees for their secondary school education.
Abhishek’s mother ensured that every expense was monitored and
followed a strict budget. Both the brothers understood the family’s
grim financial situation and consciously suppressed their desires for
story books/toys, etc. The difficult financial situation made the brothers
realize that having a good education and qualification was the only
way to get a good job and ensure financial stability. With the generous
help from charitable donors, Abhishek and his brother got interest-free
loans to complete their higher education. Abhishek completed his BE in
automobile engineering while his brother studied hotel management.
During his first few years of college, Abhishek had started earning by
giving tuitions. Part of this money was deposited in his bank and the rest
was given to his mother to manage the family’s expenses. Abhishek has
had a very good rise in his career in the last 9 years since he has been
working and currently, he is in a very good position with a well-known
general insurance company. Since he has been only exposed to traditional
investment options like insurance, post office and FD schemes, Abhishek
started his investment journey with these products from 2007. To save
tax he purchased traditional insurance policies and invested the rest in
fixed deposits. Even then he has been able to create a good investment
basket because he has kept his expenses to the minimum and tried to
save as much as he could.
Last year he booked an under construction flat worth Rs.62 lacs for
which he paid the down-payment of 10% from his own savings. He is
expected to get possession of the flat by December 2018. So far, he has
taken a loan of Rs. 18.50 lacs and he intends to pay as much as he can
from his own sources in the next two years before possession.
278 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

HABIT OF SAVING
In almost all cases with a few exceptions, our parents introduce us to
the world of savings and investments. Abhishek too understood the
importance of savings from his parents who encouraged him right from
his school days. He had never looked back ever since. Most of us lose our
way once we get caught up in our work and other family responsibilities.
Abhishek continues this habit till today and now saving has become an
integral part of his responsibilities. He only needs guidance on how/
where to invest the savings.

INSURANCE AS AN INVESTMENT
Most people buy insurance as an investment product or rather it is
sold that way to make it attractive for the buyer. Investment-oriented
insurance policies are of two types – traditional and unit linked.
Traditional policies typically invest in government bonds, approved
securities and instruments which provide fixed income while unit linked
policies invest in instruments varying from government bonds to equities
as per the fund chosen by the investor.
Traditional insurance policies typically do not provide more than 5-6%
returns over the long term while equity-oriented funds in unit linked
policies can fare better than traditional policies in the long run. Therefore,
traditional insurance policies do not serve as a good investment for the
long term. How can a product which cannot beat inflation help you to
reach your long-term goals? Abhishek made an early start but due to
lack of knowledge and with a view of saving tax, he invested in traditional
insurance policies, allocating a good amount of premium.

SOURCE OF INCOME
Source Category Per month
Abhishek Salary 90000
Total Monthly Income 90000
Total Annual Income 1080000

Basic Numbers
Monthly Income: Rs 90000

Expenses Per month Annual

Household 10000 120000
Home Loan EMI 19500 234000
Personal Expenses 10000 120000
Insurance Premium 17978 215740
Total 57478 689740

Monthly Surplus: Rs. 32522

 CASE STUDY 279

NET WORTH STATEMENT

Assets Rs. Liabilities Rs
Savings Account 105000 Home loan 1850000
Fixed Deposits 800000
EPF 532000
Insurance Cash Value 454758
Equity Mutual Funds 1070000
Shares 476000
Under Construction Property 2500000
Total 5937758 1850000
Net Worth 4087758

QUESTIONS

1. Decide the financial planning goals of Abhishek.

2. Offer your suggestions and recommendations on each financial
goal.
3. How do you recommend investment plans?
4. Prepare assets Break-up after your investment recommendations.
280 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

CASE STUDY CHAPTER – 13

WEALTH MANAGEMENT AND ESTATE PLANNING

The following data is of different classes of assets over a period of 15

years (2006 to 2020) in different stock exchanges. The yield shown in the
columns can be converted into percentage. The negative sign shows a
negative yield in a particular year on the specific Index.

Asset Class Index Used

Domestic Equities NIFTY 50 Index
International Equities NASDAQ 100 Index
Debt (Bonds) S&P BSE India 10 Year Sovereign
Bond Index
Gold Price of Gold

Year NIFTY 50 Nasdaq 100 10Y Bond Gold

2006 0.32 0.03 0.04 0.2
2007 0.15 0.19 0.07 0.29
2008 −0.52 −0.42 0.17 0.16
2009 0.76 0.53 −0.04 0.16
2010 0.18 0.19 0.05 0.28
2011 −0.25 0.03 0.04 0.43
2012 0.28 0.17 0.14 18
2013 0.07 0.35 −0.02 −0.05
2014 0.31 0.18 0.14 −0.05
2015 −0.04 0.08 0.05 −0.06
2016 0.03 0.06 0.14 0.09
2017 0.29 0.31 −0.01 0.04
2018 0.03 −0.01 0.07 0.06
2019 0.12 0.38 0.1 0.12
2020 0.15 0.48 0.1 0.48
(Source https://www.etmoney.com/blog/what-is-asset-allocation-and-how-to-do-it-right/)

QUESTIONS

1. What will be the CAGR during the period on individual indexes?

2. In 2009, NIFTY showed 72 per cent returns. Analyze its reasons.
3. Which is the index that provides higher yield and why?