SECURITY

ANALYSIS AND
PORTFOLIO
MANAGEMENT
Shivam Popat
T N Rao College Management
Studies, Rajkot.
Nature Of Investment
 Return
 Risk
 Safety
 Liquidity
Investment Process
Investment Alternatives
 Non-Marketable Financial Assets:
 Bank Deposits
 Post Office Deposits
 Company Deposits
 Provident Fund Deposits
Investment Alternatives
 Equity Shares
 Blue Chip Shares
 Growth Shares
 Income Shares
 Cyclical Shares
 Speculative Shares
Investment Alternatives
 Money Market Instruments
 Treasury Bills
 Commercial Papers
 Certificate of Deposit
Investment Alternatives
 Mutual Funds
 EquitySchemes
 Debt Schemes
 Balanced Schemes
Investment Alternatives
 Life Insurance
 Endowment Assurance Policy
 Money Back Policy
 Whole Life policy
 Term Assurance Policy
Investment Alternatives
 Real Estate
 Housing
 Commercial property
 Semi Urban Land
 Agricultural Land
Investment Alternatives
 Precious Objects
 Gold
 Silver
 PreciousStones
 Art Objects
Investment Alternatives
 Financial Derivatives
 Forward
 Futures
 Options
 Swaps
Stock Trading
 Participants
 Stock Exchanges.
 Traders (Members).
 Investors.
Stock Trading
Open Outcry System Screen Based Trading
Margins (Stock Trading)
 Initial or Percentage Margin
Equity in Account
PM =
Value of Stock

 Maintenance Margin or Margin Call

Price of Equity – Loan from Broker
MM =
Price of Equity
Stock Trading
 TYPES OF MARKETS
 Primary Markets
 IPO
 Private Placement
 Secondary Market
 National Stock Exchanges
 The OTC Market
 Direct trading between two parties
Stock Trading
 Major Stock Exchanges
 BSE
 NSE
 OTCEI
Stock Trading (Process)
Activity Day
Trading Rolling Settlement Trading T
Clearing Custodial Confirmation T+1
Delivery Generation T+1
Settlement Securities and funds pay in T+2
Securities and funds pay out T+2
Stock Trading (Orders)
Limit Orders
Price Below Price Above
Limit Limit

Buy

Sell
How Do Investors Measure Risk and
Return for Alternative Investments ?
 Historicalrates of return
 Average rates over time
 Average rate of a portfolio
 Variance and standard deviation
 Expected rates of return
 Measures of uncertainty
Measures of
Historical Rates of Return
1.1
Holding Period Return

Ending Value of Investment

HPR 
Beginning Value of Investment
$220
  1.10
$200
Measures of
Historical Rates of Return
1.2

Holding Period Yield

HPY = HPR - 1
1.10 - 1 = 0.10 = 10%
Measures of
Historical Rates of Return

Annual Holding Period Return

 Annual HPR = HPR 1/n 1.3

 where n = number of years investment is held

Annual Holding Period Yield

 Annual HPY = Annual HPR - 1
Measures of
Historical Rates of Return
Arithmetic Mean 1.4
AM   HPY/n
where :

 HPY  the sum of annual

holdingperiod yields
Measures of
Historical Rates of Return
1.5
Geometric Mean
1
GM   HP R n 1
where :

  the product of the annual

holdingperiod returns as follows :

 HP R1    HP R2    HP Rn 
Measures of
Historical Rates of Return
Arithmetic mean return over time
Geometric mean will be lower than arithmetic mean
if returns vary over time
Y Begin End HPR HPY
R

1 50 100 2.00 1.00

2 100 50 0.50 -0.50

Arithmetic mean = 0.25

Geometric mean = 0.00
Portfolio of Investments
 Weighted average of HPYs for the individual
investments in the portfolio is the mean historical
rate of return (HPY) for a portfolio
 Computation of Holding
Period Yield for a Portfolio
# Begin Beginning Ending Ending Market Wtd.
Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY
A 100,000 $ 10 $ 1,000,000 $ 12 $ 1,200,000 1.20 20% 0.05 0.010
B 200,000 $ 20 $ 4,000,000 $ 21 $ 4,200,000 1.05 5% 0.20 0.010
C 500,000 $ 30 $ 15,000,000 $ 33 $ 16,500,000 1.10 10% 0.75 0.075
Total $ 20,000,000 $ 21,900,000 0.095

$ 21,900,000
HPR = = 1.095
$ 20,000,000

HPY = 1.095 -1 = 0.095

= 9.5%
Expected Rates of
Return
 Risk is uncertainty of return
 Point estimates are most likely expected return
 Range of possible returns
 Probabilities of various possible returns
Expected Rates of Return
Expected Return  E(R i ) 1.6
n
 ( P robability of Return)  (P ossibleReturn)
i 1

[(P1 )(R 1 )  (P 2 )(R 2 )  ....  (P n R n )

n
 (Pi )(R i )
i 1
Probability Distributions
Figure 1.1

Risk-free Investment
1.00
0.80
0.60
0.40
0.20
0.00
-5% 0% 5% 10% 15%
Probability Distributions Figure 1.2

Risky Investment with 3 Possible Returns

1.00
0.80
0.60
0.40
0.20
0.00
-30% -10% 10% 30%
Probability Distributions Figure 1.3
Risky investment with ten possible rates of return

1.00
0.80
0.60
0.40
0.20
0.00
-40% -20% 0% 20% 40%
Measuring the Risk of
Expected Rates of Return
1.7

Variance ( 2) 
n 2
 (Probability)  (PossibleReturn - Expected Return)
i 1

n 2
 (Pi )[R i  E(R i )]
i 1
Measuring the Risk of 1.8

Expected Rates of Return

Standard Deviation
square root of the variance

=
 Measuring the Risk of
Expected Rates of Return
Coefficient of variation (CV) measures risk relative to expected
return:
1.9

i
Standard Deviation of Returns

Expected Rate of Returns E(R)
 Measuring the Risk of
Historical Rates of Return
2 n 2/n 1.10
   [HPYi  E(HPY)]
i 1
2 
variance of the series
HPYi  holding period yield during period I
E(HPY)  expected value of the HPY that is equal to the arithmetic mean
of the series
n  the number of observations
Determinants of Required Rates of
Return
 Time value of money
 Expected rate of inflation
 Risk involved
 Promised Yields on Alternative
Bonds

Type of Bond 1992 1993 1994 1995 1996 1997 1998

U.S. Govt. 3-Month T-bills 3.43% 3.00% 4.25% 5.49% 5.01% 5.06% 4.78%
U.S. Govt. long-term bonds 7.52% 6.59% 7.41% 6.93% 6.80% 6.67% 5.69%
Aaa corporate bonds 8.14% 7.77% 7.97% 7.59% 7.37% 7.27% 6.53%
Baa corporate bonds 8.98% 7.93% 8.63% 7.83% 8.05% 7.87% 7.22%
Source: Federal Reserve Bulletin , various iss ues
Time Value of Money
The real risk-free rate (RFR)
 Assumes no inflation.
 Assumes no uncertainty about future cash flows.
 Is the price charged for exchanging current
goods and future goods.
Nominal Risk-Free Rate

Dependent upon
 Expectedrate of inflation
 Monetary environment
Adjusting For Inflation
1.11
Nominal RFR = (1+Real RFR) x (1+Expected Rate of
Inflation) - 1
 Adjusting For Inflation
1.12

Real RFR =
 (1  Nominal RFR) 
  1
 (1  Rate of Inflation) 
 Three-Month T-Bill Yields
and Rates of Inflation
Table 1.3 Three-Month Treasury Bill Yields and Rates of Inflation

3-Month Rate of 3-Month Rate of

Year T-Bills Inflation Year T-Bills Inflation
1978 7.19% 7.70% 1989 8.11% 4.65%
1979 10.07% 11.30% 1990 7.50% 6.11%
1980 11.43% 7.70% 1991 5.38% 3.06%
1981 14.03% 10.40% 1992 3.43% 2.90%
1982 10.61% 6.10% 1993 3.33% 2.75%
1983 8.61% 3.20% 1994 4.25% 2.67%
1984 9.52% 4.00% 1995 5.49% 2.54%
1985 7.48% 3.80% 1996 5.01% 3.32%
1986 5.98% 1.10% 1997 5.06% 1.70%
1987 5.78% 4.40% 1998 4.78% 1.60%
1988 6.67% 4.42%
Risk Premium and Fundamental Risk
 Business risk
 Financial risk
 Liquidity risk
 Exchange rate risk
 Country risk
 Business Risk
 Uncertainty of income flows caused by the nature of a firm’s
business affect income flows to an investor.
 Investors demand a risk premium based on the uncertainty
caused by the basic business of the firm.
 Financial Risk
 Uncertainty is introduced by the method by which the firm
finances its investments.
 Borrowing requires fixed payments which must be paid ahead
of payments to stockholders.
 The use of debt increases uncertainty of stockholder income
and causes an increase in the stock’s risk premium.
 Liquidity Risk
 Uncertainty is introduced by the secondary market for an
investment.
 How long will it take to convert an investment into cash?
 How certain is the price that will be received?
 Investors increase their required rate of return to compensate
for liquidity risk.
 Exchange Rate Risk
 Uncertainty of return is introduced by acquiring
securities denominated in a currency different from
your own.
 Changes in exchange rates affect the investors return
when converting an investment back into the “home”
currency.
 Country Risk
 Political risk is the uncertainty of returns caused by the
possibility of a major change in the political or economic
environment in a country.
 Individuals who invest in countries that have unstable
political-economic systems must include a country risk-
premium when determining their required rate of return
Total Risk
Risk Premium is a function of
 Business Risk,
 Financial Risk
 Liquidity Risk
 Exchange Rate Risk
 Country Risk
 Risk Premium and Portfolio
Theory
 Systematic risk relates the variance of the
investment to the variance of the market
 Beta measures this systematic risk of an asset
 Fundamental Risk
versus Systematic Risk
Risk Premium = f (Business Risk, Financial Risk, Liquidity Risk,
Exchange Rate Risk, Country Risk)
or
f (Systematic Market Risk)
 Measures of Risk
 Variance of rates of return
 Standard deviation of rates of return
 Coefficient of variation of rates of return (standard
deviation/means)
 Covariation of returns with the market portfolio
(beta)
Sources of Risk
 Business Risk
 Financial Risk
 Liquidity Risk
 Exchange Rate Risk
 Country Risk
Systematic v/s Unsystematic Risk
Index Calculation
Share Outstanding Shares Base Price Current Price
A1 500,000 120 200
A2 800,000 150 900
A3 600,000 110 150
Market Value Weighted Method
Share Outstanding Base Base Value Current Current
Shares Price Price Value
A1 500,000 120 60,000,000 200 100,000,000
A2 800,000 150 120,000,000 900 720,000,000
A3 600,000 110 66,000,000 150 90,000,000
Total 246,000,000 910,000,000
Price Weighted Method
Share Base Price Current Price
A1 120 200
A2 150 900
A3 110 150
Total 380 1,250
Equal Weight Method
Share Percentage Change In Weight Weighted
Share Average
A1 66.67 1/3 22.22
A2 500 1/3 166.67
A3 36.36 1/3 12.12
Total 201.01
Indian Indices