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INVESTMENT MANAGEMENT

Objective:

1. To enable develop skills in analyzing various types of securities.

2. To develop necessary skills in students to design and revise a portfolio of securities

Unit 1: lNTR0DTtON TO INVESTMENT MANAGEMENT

Investment management, nature and scope, investment avenues, types of financial assets and real assets,
Security return and risk - Systematic and unsystematic risk - sources of risk, Measurement of risk and return,
sources of investment information, Fixed income - securities - bonds, preference shares - sources of risk,
valuation, duration of bonds -
theory of interest rates - yield curve, Bond innovations and their valuation.

UNIT 2: SECURITY ANALYSIS

Analysis of variable income securities, fundamental analysis - analysis of economy, Industry analysis, company
analysis - financial and non - financial, Equity valuation models, Options, futures, forwards, warrants, and their
valuations, Technical analysis - Dow’s theory, charts - Efficient market hypothesis and its implications Tax
aspects of investment, Securities trading procedure. A Critical Survey of software packages for
security analysis.

UNIT 3: PORTFOLIO MANAGEMENT

Meaning of portfolio management, portfolio analysis, why portfolios? Portfolio objectives, portfolio
management process, selection of securities. Portfolio theory, Markowitz Model, Sharpe’s single index model.
Efficient frontier with Lending and borrowing, optimal portfolio capital Asset pricing model, Arbitrage pricing
theory two factor and multi
factor models.

UNIT 4: PORTFOLIO MANAGEMENT STRATEGIES

Bond Portfolio Management strategies, Equity portfolio management strategies, strategies using derivatives,
hedging. Portfolio revision - rebalancing plans, portfolio evaluation, Sharpe’s index, Treynor’s measure and
Jenson’s measure.

UNIT 5: MUTUAL FUNDS

Mutual funds, Investors life cycle, personal investment, Personal Finance, Portfolio Management of funds in
banks, insurance companies, pension funds, International investing, international funds management,
emerging opportunities. A brief survey of software packages for Portfolio Management.

CHAPTER-1 INTRODUCTION TO IN VESTMENT MANAGEMENT


CHAPTER-2 SECURITY ANALYSIS

CHAPTER-3 PORTFOLIO MANAGEMENT

CHAPTER-4 PORTFOLIO MANAGEMENT STRATEGIES

CHAPTER—5 MUTUAL FUNDS


1. INTRODUCTION TO INVSTMENT
MANAGEMENT
Learning Objectives
After reading this chapter, you will be able to:

. Understand the concept oF investment

. Identify the classification of securities

. UnderstafldC5tmt strategies

. Evaluate the risk and uncertainty associated with investments.

. Identify different investment avenues

Investment is employment of funds with aim of or growth in value. It’s a long term commitment, where
essential quality is waiting fora reward.

It can also be defined as “The act of committing money or capital to an endeavor wills ¡lie expectation of
obtaining an additional income or profit.

Investment in financial sense:

Investment s parting with one’s fund to be used by another party for productive activity. Investment is a
conversion of money or cash into a monetary asset on a claim on future money for a return.

Real investments generally involve some kind of tangible asset, such as land, machinery, factories, etc. Financial
investments involve
contracts in paper or electronic form such as stocks, bonds, etc.

There are two types of investors:

. Individual investors

. Institutional investors.

Individual investors are individuals who are investing on their own. Sometimes individual investors are called
retail investors. Institutional investors are entities such as investment companies commercial banks, insurance
companies, pension funds and other financial institutions

Direct versus Indirect Investing

Direct investing is reliazed using financial markets and indirect investing involves financial intermediaries. Buy
and sell financial assets and manage individual investment portfolio themselves. Consequently, investing
directly through financial market investorts take all the risk and their successful investing depends on their
understanding of financial market.
Using indirect type of investing investors are buying or selling financial markets and hold portfolios. Indirect
investing relieves investors from making decision about their portfolio.
Speculation

Investment and speculation are somewhat different and yet similar because speculation requires an investment
and investments are at least somewhat speculative.
Speculation is short term objective. Investment, a well grounded and carefully planned speculation.

The speculator’S motive is to achieve profits through price change, that


is, capital gains are more important than the direct income from an investment. Thus, speculation is associated
with buying low and selling high with the hope of making large capital gains. Investors arc careful while
selecting securities trading.

Based on the above discussion, the following differences can be identified


between Investment and specula1ion.

Gamb1ing

Gambling is a High risk venture, where the investor plays for high stakes. Reckless venture to look Profits the
short term. Gambling is based upon tips, rumours, its un planned unscientific, and without the knowledge of
the exact nature of risk.

Characteristics of gambling

. It is typical, chronic and repetitive experience

. Gambling Absorb all other interests

. Displays persistent optimism without winning

. Never stops while winning

• Risks more than what can be afforded

• Enjoys a strange thrill, a combination of pleasure and Pain.

Gambling involves high risk not only for high returns but also for the associated excitement. Gambling is
unplanned and unscientific, without knowledge of the nature of risk involved, it is surrounded by uncertainty
And a gambling decision is taken on unfounded market tips and rumours. Investment is an attempt to evaluate,
and allocate funds to various investment outlets that offer safety of principal and expected returns over a long
period of time.

Characteristics of Investment

The features of economic and financial investments can be summarised as return, risk, safety, and liquidity.

1. Return: All investments are characterised by the expectation of a return.

2. Risk: Risk is inherent ¡n any investment. Risk may relate to loss of capital, delay in repayment of capital, non-
payment of interest, or variability of returns.

3. Safety: The safety of investment is identified with the certainty of return of capital without loss of money or
time.

4. Liquidity: An investment that is easily saleable or marketable without loss of money and without loss of time
is said to possess the characteristic of liquidity.

Investment Objectives
The options for in vesting savings are continually increasing, yet every single investment vehicle can be easily
categorized according to three fundamental characteristics - safety, income and growth - which also correspond
to types of investor objectives.

The following are the primary objectives of investment:

1. Safe

Perhaps there is truth to the axiom that there is no such thing as a cornplete1y secure investment. Yet we can
get close to ultimate safety for our investment funds through the purchase of government-issued securities in
stb1e economic systems, or through the purchase of the highest quailitycorporate bonds issued by the
economy’s top companies.

The safest investments are usually found in the money market, which include such securities as Treasury bills
(T-bills), certificates of deposit (CD), commercial paper or bankers acceptance slips, or in the fixed income
(bond) market in the form of municipal and other government bonds, and in corporate bonds.

2. Income

The safest investments are also the ones that are likely to have the lowest rate of income return or yield.
Investors must inevitably sacrifice a degree of safety if they want to increase their yields.

3. Growth Of capital

This discussion has thus far been concerned only with safety and yield as investing objectives, and not
considered the potential of other assets to provide a rate of return from an increase in value, often referred to
as a capital gain.

Growth of capital is most closely associated with the purchase of common stock, particularly growth securities,
which offer low yields but considerable opportunity for increase in value.

Secondary Objectives of Investment


1. A Tax Minimization

An investor may pursue certain investments in order to adopt tax minimization as part of his or her investment
strategy.
Marketing contributions to an IRA or other tax.she1 retirement plane such as a 401(k), can be an effective tax
minimization strategy.

2. Marketability / Liquidity
Many of the investments we have discussed are reasonably liquid, which means they cannot be immediately
sold and easily converted into cash. Achieving a degree, of liquidity, however, requires the sacrifice of a certain
level of income or potential for capital gains.

Investment Process
Investment process ¡s the process of managing money or funds. The investment process describe how an
investor should go about making decisions Investment Process can be disclosed by five step procedure,
which includes following stages:

1. Setting of investment policy.

2. Analysis and evaluation of investment vehicles

3. Formation of diversified investment portfolio

4. Portfolio revision

5. Measurement and evaluation of portfolio performance.

1. Setting of investment policy is the first d very important step in investment management process.
Investment policy includes setting of investment objectives. The investment policy should have the specific
objectives regarding the investment return requirement and risk tolerance of the investor

2. Analysis and evaluation of investment vehicles. When the investment policy is set up, investor’s objectives
defined and, the potential categories of financial assets for inclusion in the investment portfolio identified, the
available investment types can be analyzed.

3. Formation of diversified in investment portfolio is the next step in investment management process.
Investment portfolio is the set of investment vehicles, formed by the investor seeking to realize its’ defined
investment objectives. In the stage of portfolio formation the issues of
selectivity, timing and diversification need to be addressed by the investor, Selectivity refers to micro
forecasting and focuses on forecasting price movements of individual assets. Timing involves macro forecasting
of price movements of particular type of financial asset relative to fixed-income securities in general.
Diversification involves forming the investor’s portfolio for decreasing
1. Limiting risk of investment.
2. Techniques of diversification.

. Random diversification, when several available financial assets arc put to the portfolio at random.

. Objective diversification when financial assets are selected to the portfolio following investment objectives
and using appropriate techniques for analysis and evaluation of each financial asset.

4. Portfolio revision. This step of the investment management process concerns the periodic revision of the
three previous stages. This is necessary, because over time investor with long-term investment horizon may
change his/her investment objectives and this, in turn means that
currently held investor’s portfolio may no longer he optimal and even contradict with the new settled
investment objectives.
5. Measurement and evaluation of portfolio performance. This the last step in investment management
process involves determining periodically how the portfolio performed, in terms of not only the return earned,
but also the risk of the portfolio. For evaluation of portfolio performance appropriate measures of return and
risk and benchmarks are needed.

Real Assets and Financial Assets


Conducive economic environment attracts investment, which in turn influences the development of the
economy. One of the essential criteria for the assessment of economic development is the quality and quantity
of assets in a nation at a specific time. There are two broad types of assets: (1) real assets, (2) financial assets.
Real assets comprise the physical
and intangible items available to a society.

CLASSIFICATION OF SECURITIES
Financia1 claims or financial assets like shares debentures etc dealt in a financial market are referred to as
financial instruments or securities. Securities refer to claims of periodical payments of certain sum of money by
way of payment of principal, interest or dividend. The payments relating to financial securities depending on
the nature of financial instruments held. For instance, in the case of bonds, debentures or bank deposits, the
investor receives regular interest and the principal repayment at the end of a specified maturity period.

Types of Securities

Securities can be broadly classified in to

(a) Money market instrument! Securities

(b) Capital market Securities/instruments.

(a) Money Market Securities! Instruments

The most liquid, short-term debt obligati01S that arc traded in the money market are called money market
instruments. Some of these Instruments arc briefly described below:

1. Treasury Bills (T-Bills): Treasury Bills, one of the safest money market instruments, are short term borrowing
instruments of the Central Government of the Country issued through the Central Bank (RBI in India). They arc
zero risk instruments, and hence the returns are not so attractive. It is available both in primary market as well
as secondary market. It is a promise to pay a said sum after a specified period. T-bills are short-term securities
that mature in one year or less from their issue date. They are issued with three-month, six-month and one-
year maturity periods.

2 Commercial Papers: Commercial paper is a low-cost alternative lo bank loans. 1t is a short term unsecured
promissory note issued by corporate and financial institutions at a discounted value on face value.

3 Certificate of Deposit: It is a Short term borrowing more like a bank term deposit account. It is a promissory
note issued by a bank in form of a certificate entitling the bearer to receive Interest. The certificate
bears the maturity date, the fixed rate of interest and the value.

4 Repo/Re verse Repo: Repo: Reproductive transactions called Repo or Reverse Repo are transactions or short
term loans in which two parties agree to sell and repurchase the same security. They are usually used for
Overnight borrowing. Repo/Reverse Repo transactions can be done only between the parties approved by RBI
and in RBI approved securities viz. GOI and State Govt Securities, T-Bills, PSU Bonds, FI Bonds, Corporate Bonds
etc.

5. Call Money: Call money is mainly used by the banks to meet their temporary requirement of cash. They
borrow and lend money [rom each other normally on a daily basis. It is repayable on demand and its maturity
period varies in between one day to a fortnight. The rate of interest
paid on call money loan is known as call rate.

• Call Money Money lent for one day

• Notice Money Money lent for a period exceeding one day

• Term Money Money lend for 15 days or more in Inter—bank market.

(b) Capital Market Securities? Instruments

Sonic of the important securities of capital market arc

1. Equity Shares

Equity shares, commonly referred to as ordinary share also represents the form of fractional ownership in
which a shareholder, as a fractional owner, undertakes the maximum entrepreneurial risk associated with a
business venture. The holder of such shares is the member of the company and has voting rights. Equity
shares, other than non-voting shares, have voting rights at all general meetings of the company.

ji1wIerence share capital

2. Preference Shares

It is an unique type of long term financing instrument which combines some of the characteristics of equity
shares as well as debentures. It is similar Lo debenture because it carries fixed dividend. It is ranked higher than
equity on the basis of claim and it does not have any Voting rights.

3. Debentures/Bonds

Section 2(12) of the Companies Act, 1956 defines debentures as “Debenture includes debenture stock, bonds
and any other Securities of a Company, whether constituting a charge on the assets of the company or not.”
Debenture is a document evidencing the debt of an organization. It is issued by a company as a certificate of
indebtedness and it usually indicates the date of redemption and also provides for the repayment of principal
and payment of interest at specified date or dates.

Debentures are issued in the following forms:

. Naked or unsecured debentures.

. Secured debentures.

. Redeemable debentures.

. Irredeemable/ Perpetual debentures.

. Non-convertible/ Fully convertible! Partly convertible debentures

. Bearer debentures.

. Registered debentures.
. Zero interest debentures/bonds (ZIB):

. Deep discount bonds:

• Secured premium notes:

• Floating rate bonds:

4. DR/GDR

An American depositary receipt (ADR) or global depositary receipt (GDR) is a simple way for investors to
invest in companies whose shares are listed abroad. The ADR or GDR is essentially a certificate issued by a bank
that gives the owner rights over a foreign share. It can be listed on a stock exchange and bought and sold just
like a normal share. The holder of an ADR or GDR is entitled to all benefits such as dividends and rights issues
from the underlying shares. They are sometimes — hut not always — able (Ø vote. As you might expect from
the name, an ADR is listed in the US. A GDR is typically listed in London or Luxembourg. A depositary receipt
where the issuing hank is EurøpC1fl will sometimes he called a European
Depositary Receipt (EDR), although this term is less common.

5. Foreign Currency Convertible Bonds (FCCBs)

A Foreign Currency Convertible Bond(FCCB) is a quasi debt instrument which is issued by any corporate entity,
international agency or sovereign state to the investors all over the world. They are denominated in any freely
convertible foreign currency. Euro Convertible Bonds are usually issued as unsecured obligation of the
borrowers.

6. Term Loan

Term Loan is a method of debt financing by banks or financial institutions with maturity period of over one year
to about 10 years. It provides for a fixed and often large amount of loan required either for setting up a new
Unit for financing the expansion / diversification modernization of a project in terms of land, building plant and
machinery or permanent addition to current assets. Hence, term loan ¡s also called Project Financing. Term
loan carries floating rate of interest.

7. External Commercial Borrowing

An external commercial borrowing (ECB) is an instrument used in India to facilitate the access to foreign money
by Indian companies ECBs include commercial bank loans, buyers’ credit, suppliers’ credit, securitised
instruments such as floating rate notes and fixed rate bonds etc. It also includes credit from official export
credit agencies and commercial borrowings from the private sector window of multilateral financial Institutions
such as International Finance Corporation (Washington), ADB, AFIC, CDC, etc. ECBs cannot be used for
investment in stock market or speculation in real estate.

RETURN AND RISK


Investors have many motives for investing. Some investors invest in order to gain a sense of power or prestige.
The control of corporate empires, thus, is an important motive. For most investors, however, the prime interest
in investments is largely to earn a return on their money.
Investors not only like return, they dislike risk.

To facilitate our job of analysing securities and portfolios within a return-risk context, we must begin with a
clear understanding of what risk and return are, what creates them, and how these should be measured. In
fact, we find the answer to the following two questions while
taking investment decisions: (I) what securities should be held, and (2) how many rupees should be allocated to
each.
Return
People want to maximize expected returns subject to their tolerance for risk. Return is me principal reward in
the investment process and it provides the basis to investors in comparing alternative investments. Measuring
historical returns allows investors to assess how well they have done, and it plays a part in the estimation of
future, unknown returns. We often use two terms regarding return from investments, realized return and
expected return. Realize return is after the fact return that was earned (or could have been earned).

Components of return

Return on a financial asset, generally, consists of two components. The principal component of return is the
periodic income on the investment, either in the form of interest or dividends. The second component is the
change in the price of the asset— commonly called the capital gain or loss.

The capital gain or loss must also be considered.

Note that either component of return can be zero fora given security over any given period. A bond purchased
for ₹.800 and held to maturity provides both type of income: interest payments and a price change.

Total return is defined as

Average Returns
The total return is an acceptable measure of return for a specified period of time. The arithmetic average,
customarily designed by the symbol
or the sum of each of the values being considered divided by the total number of values

Example: The return of stock A for four quarters is as follows:

Quarter-l = 10%; Quarter-11 8%; Quarter-11l -4%; and Quarter 1V20%. The average return is

Risk
Risk is generally associated with the possibility that realizcd returns of securities will be less than the returns
that wee expected. The source of such risk is the failure of dividends (interest) and/or the security’s price to
materialize as expected.

There are numerous forces that Contribute to variations in return price or dividend (interest). These forces are
termed as elements of risk. Some factors are external to the firm and cannot be controlled. These factors affect
large numbers of securities. In investments, those forces that are uncontrollable, external, and broad in their
effect are called of systematic risk. Other forces are internal to the firm and are controllable to a large degree.
The controllable internal factors somewhat peculiar Lo industries and/or firms are referred to as sources of
unsystematic risk.

Sources of Systematic Risk


As discussed, the main constituents of systematic risk include- market risk, interest rate risk and purchasing
power risk.

A. Market risk: The price of a stock may fluctuate widely within a short span of time even though earnings
remain unchanged. The causes of this phenomenon are varied. But it is main1y due to a change in investors’
attitudes towards equities in general, or toward certain types or groups of securities in particular.

B. Interest-rate risk: The risk of variations in future market values and the size of income, caused by
fluctuations in the general level of interest rates is referred to as interest-rate risk. The basic cause of interest-
rate risk lies in the fact that, as the rate of interest paid on Indian
government securities rises or falls, (he rates of return demanded on alternative investment vehicles, such as
stocks and bonds issued in the private sector, rise or fall. In other words, as the cost of money changes for risk-
free securities, the Cost of money to risk-prone issuers will
also change.

C. Purchasing power risk: Purchasing-power risk refers to the uncertainty of the purchasing power of the
money to be received. In simple terms, purchasing-power risk is the impact of inflation or deflation on an
investment. When we think of investment as the postponement of consumption, we can sec that when a
person purchases a stock, he has foregone the opportunity to buy some goods 0r service for as long as he owns
the stock.

Sources of Unsystematic Risk


Market, purchasing powers and interest-rate risks are the principal sources of systematic risk in securities; but
we should also consider another important category of security risks, unsystematic risks. The portion of total
risk that is unique or peculiar to a firm or an industry, above and beyond that affecting securities markets in
general is called unsystematic risk.

A Business risk: Business risk relates to the variability of the sales, income, profits, etc., which in turn depend
on the market conditions for the product mix, input supplies, strength or competitors etc. The business risk is
sometimes external to the company due to changes in government policy or strategies of competitors or
unforeseen market conditions.

B Financial Risk: This relates to (he method of financing, adopted by the company; high leverage leading to
larger debt servicing problems or short-term liquidity problems due to bad debts, delayed receivables and fall
in current assets or rise in current liabilities.

C Default or insolvency risk: The borrower or issuer of securities may become insolvent or may default, or
delay the payments clue, such as interest instalments or principal repayments. The borrower’s credit rating
might have fallen suddenly and he became default prone and in its extreme form it may lead to insolvency or
bankruptcies.

D Other Risks: Besides the above described risks, there are many more risks, which can be listed, but in actual
practice, they may vary in form, size and effect. Some of such identification risks are the Political Risks,
Management Risks and Liquidity Risks etc.

Risk Measurement
Understanding the nature and types of risk is not adequate unless the investor or analyst is capable of
measuring it in some quantitative terms. The quantitative expression of the risk of a stock would make it
comparable with other stocks. However, the risk measurements cannot be considered fully accurate as it is
caused by multiplicity of factors such as social, political, economic and managerial aspects.

Risk is measured by the variability of returns. The statistical tool often used to measure risk is the standard
deviation.

Investment Avenues
There are a large number of investment instruments available today. To make our lives easier we would classify
or group them. In India, numbers of investment avenues are available for the investors. Some of them are
marketable and liquid while others are non-marketable and some of them also highly risky while others are
almost risk les. The people has to choose
Proper Avenue among them, depending on his specific need, risk preference, and return expected Investment
avenues can broadly categories under the following heads.

Debt:
Debt is a route that most people will know and have the necessary experience of. There is a widerange of debt
instruments that arc present from bank fixed deposits to company fixed deposits. Debt is simple as the investor
ill earn at a fixed percentage of the investment, which will then be returned to the investor at the time of
maturity or redemption of the investment

Mutual Funds:
This is an emerging area for investment and there is a large variety of schemes in the market to suit the
requirements of a large number of people.
Corporate Debenture:
Corporate debentures are normally hacked by the reputation and general credit worthiness of the issuing
company. It is a type of debt instrument that is not covered by the security of physical assets or collateral.

Company Fixed Deposit:


Company fixed deposit is the deposit placed by investors with companies for a fixed term carrying a prescribed
rate of interest. Company FDs are primarily meant for conservative investors who don’t wish to take the risk of
vagaries of the stock market.

Fixed Deposits:
Fixed Deposits with Banks are also referred to as term deposits. Minimum investment period for bank FDs is 30
days. Deposits in banks are v safe because of the regulations of RBI and the guarantee 1ovded by the deposit
insurance corporation.

Post Office Savings:


Post Office Monthly Income Scheme is a low risk saving instrument, which can be availed through any Post
Office The interest rate on deposits is slightly higher than banks. The interest is calculated half yearly and paid
yearly

Life Insurance Policies:


Insurance companies offer many investment schemes to investors. These schemes promote saving and
additionally provide insurance cover. L1Cis the largest life insurance company in India. Some of its schemes
include -

- Life policies,

- Convertible whole life assurance policy,

- Endowment assurance policy,

- Jeevan Saathi,

- Money back policy

— Unit linked plan

- Term assurance

- Immediate annuity

- Deferred annuity

- Riders etc

Public Provident Fund (PPF):


Along term savings instrument with a maturity of 15 years. A PPF account can be opened through a
nationalized bank al anytime during the year and is open all through the year for depositing money. Tax
benefits can be availed for the amount invested and interest accrued tax-free. A withdrawal is permissible
every year from the seventh financial year of the date of opening of the account.

Real Estate:
Investment in real estate also made when the expected returns are very attractive. Buying property is an
equally strenuous investment decisions. Real estate investment is often link with the future development plans
of the location.

Fixed Income Securities


The important fixed income securities include Bonds and Preference shares.

Debentures/Bonds

Debentures/bond is a debt instrument indicating that a company has borrowed certain sum of money and
promises to repay if future under clearly defined terms. Debenture holder are the long term creditors of the
organization and are eligible to get stipulated amount of interest and re-payment on the maturity. Usually it is
termed as Bond if it is issued by Government
authorities and as debentures if it is issued by private companies. Many cases names are interchangeably used.

Features:

a) Interest:- Debentures carries a fixed rate of interest, which is a contractual payment by the company.
Interest is allowed as deduction for tax purpose

b) Maturity:- debentures have fixed maturity Usually 7— 10 years. They are redeemable after the maturity
period.

c) Redemption:- After the maturity debentures are redeemed. They may be redeemed at par or at premium.

d) Sinking fund:- A Sinking fund si created by the Company for the purpose of redemption of the bond. Every
year a fixed Sui is transferred to the fund and that money will be used to redeem the debentures

e) Buy back/Call provision: Company may exercise call option, there by can redeem the debentures before (he
maturity wherever buy back is done the company has to redeem at a premium

f) Trust:- When the debentures is issued by (lie company a trust is created. It includes trustees drawn from
company’s directors, investors bankers etc. i is the duty of the trust to protect the interest of the investors.

g) Security: Debentures arc either secured or unsecured. If it is secured the debenture holders can exercise lien
on company’s assets.

h) Yield:- Debentures are listed in the stock exchange there will be a market value of debentures. Yield on the
debenture is related with its market value.

i) Claims on asset and income:- Before payment of dividend to shareholders interest on debentures are paid
same way. Before payment of capital to shareholders, capital he paid to debenture holders, therefore
debentures holders are having preferential claim over shareholders.

j) Compulsory credit rating:- The company issuing debentures need to take


compulsory credit rating from approved agencies.

Types of Debentures
i) Non convertible debentures: There are the debentures, which will not converted in to equity shares by the
company.

ii) Fully convertible debentures:- These are the debentures which will be fully converted into equity shares as
per the terms of issue. The conversion will be made at the end of stipulated period.

iii) Partly convertible debentures:- Here only a part of debenture will be converted into equity shares at the
end of the period and remaining part will be redeemed by the company.

iv) Innovative debt instruments


I) Zero interest debentures/bonds(ZIB):
Zero interest bonds, do not carry any explicit interest. They are sold at discount, the difference between face
value and acquisition price is the return/gain on the bond.
For e.g.:-Rs.100 face value bond may he issued at Rs.50 for period of 6 years.
The investor pays Rs.50 on the bond at the time of issue and gets RS.100 on maturity.

2) Deep discount bonds:


It is similar to ZIB. In case of deep discount bond, it carries a marginal rate of interest and issued at discount
and redeemed as par.
Example:-Rs.100 face value bond issued at Rs.70, 6 years and redeemed at
Rs.100 over 6 years period it carries a interest of 3 years.
Organization like IDBI, SIDBI have issued this type of debentures.

3) Secured premium notes:


It is a secured debenture which is redeemable at premium in different installments. It carries no interest in
lock-in period. TISCO has issued in 1992.
Example:-Rs. 100 face value instrument is issued at par, for 3 years there will be no interest from 4 th year
onwards till the 8th year it will be redeemed at RS.35 per annual.

4) Floating rate bonds:


Interest rate on these bonds are not fixed. Interest is linked to market rate of interest. Interest is payable on the
benchmark rates like bank rate, maximum interest on term deposits etc.

Advantages of Debentures
a) Less costly:- as compared to equity shares
b) Tax deduction:- Interest payable on debentures is allowed as deduction for tax purpose.
c) No Ownership dilution: As the debenture holders does not car any interest payment.
d) Fixed interest:_ Interest rate does not increases with increase in profits of organization
e) Reduced real obligation:- Although interest payable is fixed, with the change in inflation rate. The real
obligation the part of the company reduces.

Limitations of debentures:
i) Obi6igatorv Payment: lithe company fails to pay the interest on debentures the investors can ask for
the declaring company as bankrupt. Interest payment on debenture is obligatory.
ii) Financial risk associated with debenture is higher than shares.
iii) Cash out flow on maturity is very high.
iv) The investors may put various restrictions/covenants while investing in the debentures.

Bond Return
There are several ways of describing a rate of return on bond. Some of them are:
1. Holding period return
2. The current yield
3. Yield to maturity

1. Holding Period Return


It is a return in which an investor buys a bond and liquidates it in the market after holding it for a definite
period of time. The formula for calculating holding period of return is as follows:

It can be calculated on a daily monthly or annual basis

2. The Current Yield


It is a measure through which the investors can easily figure out the rate of cash flow on the investments made
by them every year. It is calculated as:

3. Yield to maturity
It is the single discount factor that makes the present value of future cashflows from bond equivalent to the
current price of the bond.

The following assumptions are used to calculate yield to maturity:


• There should not be any default.
• The interest payments are reinvested at yield to maturity.
• The investor has to hold the bond till its maturity.
• It is calculated as:

Preference Share Capital


It is an unique type of long term financing which combines some of the characteristics of equity shares as well
as debentures.

It is similar to equity capital because:

a) Dividend to equity capital because:


b) Not obligatory to pay dividend
C) Irredeemable type does not have any maturity.

It is similar to debenture because:

a) It carries fixed dividend


b) It is ranked higher than equity on the basis of claim
c) It does not have any voting rights normally
d) It does not have any share in residual earnings.

Features of Preference Shares


1) Prior claim on income asset:- Prior claim arises as compared to equity shares.
2) Cumulative dividend:- Dividends get accumulated and must be paid before paying dividend to equity
shareholders.
3) Redeemability:- At the end of maturity period the preference shares need to be redeemed.
4) Fixed divided:- Preference shares carries fixed of dividend.
5) Convertibility:- Preference shares can be converted into equity shares at the end of maturity period.

W here
g = annual expected growth in earnings, dividends and price

e = most recent earnings per share

d/e = dividend pay out

r = required rate of return

P/E = price-earnings ratio

N = holding period in years

Constant Growth Model

The basic assumption of this model is that the dividends are expected to grow at the same rate. It is calculated
as:
¡t is calculated as:

Where
P0 = Present value of the stock
r = Required rate of return
g = Growth rate
D1 = Next year’s dividend

Valuation through Price-Earnings Ratio

P/E ratio indicates price per rupee of share earnings. The advantages of price earnings ratio are that it helps in
comparing the stock prices that have different earnings per share and it helps in estimating the stocks of those
companies that do not pay the dividends.

The formula for calculating P/E ratio is as:


Preferred Stock Valuation

Preferred stocks are those stocks that provide a steady rate of return. ? Preferred stocks can be calculated with
the help of the following formula:

Where D = dividend paid


R = required rate of return

EXAMPLE PROBLEMS ON RISK AND RETURN

P- Probability of Individual stock

R- Return on individual stock

Risk which is measured by Standard deviation

Standard deviation is a square root of variance

Illustration

Calculate the expected rate of return from the following information relating to B Ltd.

Solution
Illustration

An investor would like to find the expected return on the share of Golden Ltd. The following data have been
available:

Calculate the expected return from the share.

Solution

Illustration

Given below are the likely returns in case of shares of VCC Ltd. and LCC Ltd. in the various economic conditions.
Both the shares are presently quoted at Rs.100 per share,

Which of the two companies are risky investments?

Solution
VCC Ltd.
LCC Ltd.

Comment:

L The risk in LCC is more than VCC Ltd.


2. The choice of an Investor totally depends upon the risk return profile of the Investor

An Investor, who is willing to take risk, would invest in LCC, since the return is highest. An investor who is willing
to lake less risk, will Invest in VCC Ltd.

REVIEW QUESTIONS

Section A
1. Define Investment.
2. What is a return?
3. Differentiate between historical return and expected return.
4. What is Risk?
5. What is Interest rate risk?
6. What are the components of returns?

Section B
1. What is Gambling? What arc its characteristics?
2. What are the characteristics of Investment?
3. What are the important characteristics of securities?
4. Discuss the capital market instruments.
5. What are the money market instruments?
6. What are the investment objectives?

Section C
1. Differentiate between investment and speculation.
2. Discuss the Investment avenues available for an Investor.
3. What are the systematic and unsystematic risks?
4. Discuss in detail investment process.

PRACTICAL QUESTIONS
1. The shares of Sumit Ltd. were purchased for ₹50 on January 1. The stock paid dividends totalling ₹2
during ensuing year. At year-end, the stock was sold for ₹45. What was the total return on Sumit stock
for the year?
2. A stock costing ₹100 pays no dividends. The possible prices that the stock might sell for at year-end
and the probability of each are:
a. What is the expected return on the stock?
b. What is the standard deviation of the expected return?

3. Ms. Kiran has analysed a stock for a one-year holding period. The stock is currently selling for ₹10 but
pays no dividends and there is a fifty-fifty chance that the stock will sell for ether ₹10 or ₹12 by year-
end. What is the expected return and risk if 250 shares are acquired with 80 per cent margin? Assume
the cost of borrowed funds is 10 per cent. (Ignore commissions and taxes).

4. Stocks A and B do not pay dividends. Stock A currently sells for ₹50 and B for ₹100.
At the end of the year ahead there is a fifty-fifty chance that A
will sell for either ₹61 or ₹57 and B for either ₹117 or ₹ 113. Which
stock, A or B, would you prefer to purchase flow? Why?

5. Torrent and company estimates the probability and the expected returns as returns for the five
observations as follows:

What are the expected values of return and standard deviation?

6. Stock A has the following probability distribution of expected


returns:

What is Stock A’s expected rate of return and standard deviation?


2. SECURITY ANALYSIS
Learning Objectives

After reading this chapter, you will be able to:


 Understand the concept of security analysis
 Identify Macro economic factors influencing the security analysis
 Understand Industry and company analysis
 Evaluate the DOW theory
 Identity different charting techniques
 Differentiate between fundamental and technical analysis
 Understand tax aspects of investments.
Active portfolio managers undertake a variety of different types of analysis in order to attempt to select
outperforming equities for the portfolios they manage.

Fundamental Analysis

Security analysis is the basis for rational investment decisions. If a security’s estimated value is above its market
price, the security analyst will recommend buying the stock. If the estimated value is below the market price,
the security should he sold before its price drops. However the values of the securities are continuously
changing as news about the securities becomes known.

Fundamental analysis is primarily concerned with determining the intrinsic value or the true value of a security.
If the market price is substantia11y greater than the intrinsic value the security is said to be overpriced. If the
market price is substantially less than the intrinsic value, the security is said to be under priced.

However, Fundamental Analysis Comprises

1. Economic Analysis
2. Industry Analysis
3. Company Analysis

ECON0MIC ANALYSIS
For the security analyst or investor, the anticipated economic environment, and therefore the economic
forecast, is important for making decisions concerning both the timings of an investment and the relative
investment desirability among the various industries in the economy. That is, the success of the economy will
ultimately include the success of the overall market. For studying the Economic Analysis, the Macro Economic
Factors and the Forecasting Techniques are studied in following paragraphs.

MACRO ECONOMIC FACTORS


The macro economy is the study of all the firms operates in economic environment. The key variables to
describe the state of economy are explained as below:

1. Growth rate of Gross Domestic Product (GDP): GDP is a measure of the total production of final
goods and services in the economy during a year. It is indicator of economic growth. It consists of
personal consumption expenditure, gross private domestic investment, government expenditure on
goods and services and net export of goods and services.
2. Savings and investment: Growth of an economy requires proper amount of investments which in
turn is dependent upon amount of domestic savings. The amount of savings is favourably related to
investment in a country.
3. Industry Growth rate: The GDP growth rate represents the average of the growth rate of
agricultural sector, industrial sector and the service sector. Publicly listed company p1aying a major
role in the industrial sector.
4. Price level and Inflation: If the inflation rate increases, then the growth rate would be very little.
The increasingly inflation rate significantly affect the demand of consumer product industry. The
inflation rate in the Indian economy has been around 7 percent till 1990s. In recent years, the
inflation rate has fallen significantly.

5. Agriculture and monsoons: Agriculture is directly and indirectly linked with the industries. Hence
increase or decrease in agricultural production has a significant impact on the industrial production
and corporate performance.

6. Interest Rate: Interest rates vary with maturity, default risk, inflation rate, productivity of capital etc.
The interest rate on money market instruments like Treasury Bills are low, long dated government
securities carry slightly higher interest rate and interest rate on corporate debenture is still higher.

7. Government budget and deficit: Government plays an important role in the growth of any
economy. The government prepares a central budget which provides complete information on
revenue, expenditure and deficit of the government for a given period.

8. The tax structure: The business community eagerly awaits the government announcements
regarding the tax policy in March every year.

9. Balance of payment, forex reserves and exchange rate: Balance of payment is the record of all the
receipts and payment of a country with the rest of the world. This difference in receipt and
payment may be surplus or deficit. Balance of payment is a measure of strength of rupee on
external account.

10. Infrastructural facilities and arrangements: Infrastructure


facilities and arrangements play an important role in growth of
industry and agriculture sector.

11. Demographic factors: The demographic data details about the


population by age occupation, literacy and geographic location.

12. Sentiments: The sentiments of consumers and business can have an important

ECONOMIC FORECASTING TECHNIQUES

To estimate the stock price changes, an analyst has to analyze the macro economic environment. All the
economic activities affect the corporate profits, investor’s attitudes and share price. For the purpose of
economic analysis and in order to decide the right time to invest in securities some techniques are used.

INDUSTRY ANALYSIS

The mediocre firm in the growth industry usually out performs the best stocks in a stagnant industry.
Therefore, it is worthwhile for a security analyst to pinpoint growth industry, which has good investment
prospects. The past performance of an industry is not a good predictor of the future- if one look very far into
the future. Therefore, it is important to study industry analysis. For an industry analyst-industry life Cycle
analysis, Characteristics and classification of industry is important. All these aspects are enlightened in
following sections:

INDUSTRY LIFE CYCLE ANALYSIS


Many industrial economists believe that the development of almost every industry may be analyzed in terms
of following stages.
1. Pioneering stage: During this stage, the technology and product is relatively new. The prospective
demand for the product is promising in this industry. The demand for the product attracts many
producers to produce the particular product. This lead to severe competition and only fittest
companies survive in this stage. The producers try to develop brand name, differentiate the product
and create a product image. This would lead to non-price competition too. The severe competition
often leads to change of position of the firms in terms of market share and profit.

2. Rapid growth stage: This stage starts with the appearance of surviving firms from the pioneering
stage. The companies that beat the competition grow strongly in sales, market share and financial
performance. The improved technology of production leads to low cost and good quality of products.
Companies with rapid growth in this stage, declare dividends during this stage. It is always adisable to
invest in these companies.

3. Maturity and stabilization stage: After enjoying above-average growth, the industry now enters in
maturity and stabilization stage. The symptoms of technology obsolescence may appear. To keep
going, technological innovation in the production process should be introduced. A close monitoring at
industries events are necessary at this stage.

4. Decline stage: The industry enters the growth stage with satiation of demand, encroachment of
new products, and change in consumer preferences. At this stage the earnings of the industry are
started declining. In this stage the growth of industry is low even in boom period and decline at a
higher rate during recession. It is always advisable not to invest in the share of low growth industry.

CLASSIFICATION OF INDUSTRY

Industry means a group of productive or profit making enterprises or organizations that have a similar
technically goods, services or source of income.

1. Growth Industries: These industries have special features of high rate of earnings and growth in
expansion, independent of the business cycle.

2. Cyclical Industries: The growth and profitability of the industry move along with the business cycle.
These are those industries which are most likely to benefit from a period of economic prosperity and
most likely to suffer from a period of economic recession.

3. Defensive Industries: Defensive industries are those, such as the food processing industry, which
hurt least in the period of economic downswing. For example—the industries selling necessities of
consumers withstands recession and depression.

4. Cyclical-growth Industries: These possess characteristics of both a cyclical industry and a growth
industry. For example the automobile industry experiences period of stagnation decline but they grow
tremendously. The change in technology and introduction of new models
help the automobile Industry to resume their growing path.

PROFIT POTENTIAL OF INDUSTRIES: PORTER MODEL


Michael Porter has argued that the profit potential of an industry depends on the combined
strength of the following live components as explained below. Following Figure depicts the forces that
drive competition and determine industry profit potential. These are:

1. Threat of New Entrants: New entrants add capacity, inflate cost, push prices down and reduce
profitability. Hence, if an industry face threat of new entrants, its profit potential would be
limited. The threat from new entrants is low if the entry barriers confer an advantage on existing
firms and deter new entrants. Entry barriers are high when:
 The new entrants have to invest substantial resources to enter the industry.
 Economics of scale arc enjoyed by the industry.
 The government policy limits or even prevents new entrants.
 Existing firms control the distribution channels, benefit from product differentiation in the
form of brand image and customer loyalty, and enjoy some kind of proprietary experience
curve.

Factors Driving Industry Competition

2. Rivalry among the Existing Firms: Firms in an industry compete on the basis of price, quality,
promotion service, warranties etc. If the rivalry between the firms in an industry is strong,
competitive moves and countermoves dampen the average profitability of the industry. The
intensity of rivalry in an industry tends to be high when:

 The number of competitors in the industry is large.


 At least a few firms arc relatively balanced and capable of engaging in a sustained
competitive battle.
 The industry growth is sluggish, providing firms to strive for a higher market share.
 The industry confronts high exit barriers.
 The industry’s product is regarded as a commodity or near commodity, stimulating strong
price and service competition.

3. Pressure from Substitute Products: All the firms in an industry face competition from industries
producing substitute products. The substitute goods may limit the profit potential of the industry by
imposing a ceiling on the prices that can be charged by the firms in the industry. The threat from
substitute products is high when:

 The price-performance trade off offered by the substitute products is attractive.


 The switching costs for prospective buyers are minimal.
 The substitute products are being produced by industries earning superior profits.

4. Bargaining Power of Buyers: Buyer is a competitive force. They can bargain for price cut, ask for
superior quality and better services and induce rivalry among competitors. If they are powerful, they
can depress the profitability of the supplier industry. The bargaining power of a buyer group is high
when:

 Its purchases are large relative to the sales of the seller.


 Its switching costs are low.
 It poses a strong threat of backward integration.

5. Bargaining Power of Suppliers: Suppliers, like buyers, can exert a competitive force in an industry as
they ca raise prices, lower quality and curtail the range of free services they provide. Powerful
suppliers can hurt the profitability of the buyer industry. Suppliers have strong bargaining power
when:

 Few Suppliers dominate and the Supplier group is more concentrated than the buyer
group.
 There are hardly any viable substitutes for the products supplied.
 The switching costs for the buyers are high.
 Suppliers do present a real threat of forward integration.

COMPANY ANALYSIS
Fundamental analysis is the method of analyzing companies based on factors that affect their
intrinsic value. There are two sides to this method: the quantitative and the qualitative. The
quantitative side involves looking at factors that can be measured numerically, such as the company’s
assets, liabilities, cash flow, revenue and priceto-earnings ratio. The limilatio1i of quantitative analysis,
however, is that it does not capture the company’s aspects or risks
Unmeasurable by a number - things like the value of an executive or the risks a company faces with
legal issues.

Factors Affecting Present and Future value of Stocks

1) Competitive Edge: Many industries in India are composed of hundreds of individuals companies.
The large companies are successful in meeting the competition and some companies rise to the
position of eminence and dominance.
a) Market share: The market share of the company helps to determine a company’s relative position with
in the industry.

b) Growth of annual sales: Investor generally prefers to study the growth in sales because the larger size
companies may be able to withstand the business cycle rather than the company of smaller size.

c) Stability of annual sales: If a firm has stable sales revenue, other things being remaining constant, will
have more stable earnings.

2) Earrings: The earning of the company should also be analyzed along with the sales level. The income of the
company is generated through the operating (in service industry like banks- interest on loans and investment)
and non-operating income (ant company rentals from lease, dividends from securities).

 Change in sales.
 Change ¡n costs.
 Depreciation method adopted.
 Inventory accounting method.
 Wages, salaries and fringe benefits.
 Income tax and other taxes.

3) Capital Structure: Capital structure is combination of owned capital and debt capital which enables to
maximize the value of the firm.

a) Preference shares: Preference shares are those shares which have preferential rights regarding the
payment of dividend and repayment of capital over the equity shareholders. At present many
companies resort to preference shares. The preference shares induct some degree of leverage in
finance.
b) Debt: It is an important source of finance as it has the specific benefit of low cost capital because
interest is tax deductible.

4) Management: The basic objective of the company is to attain the stated objectives of the company for the
good of the equity holders, the public and employees. If the objectives of the company are achieved, investor
will have a profit.

5) Operating Efficiency: The operating efficiency of the company directly affects the earnings capacity of a
company. Raw materials, labour and management would lead to more income from sales. This leads to
internal fund generation for the expansion of the firm.

6) Financial Performance:

a) Balance Sheet: The level, trends, and stability of earnings are powerful forces in the determination of
security prices. Balance sheet shows the assets, liabilities and owner’s equity in a company.
b) Profit and Loss account: It is also called as income statement. It expresses the results of financial
operations during an accounting year i.e. with the help of this statement we can find out how much
profit or loss has taken place from the operation of the business during a period of time.

COMPANY ANALYSIS: THE STUDY OF FINANCIAL STATEMENTS


Financial statement means a statement or document which explains necessary financial information. Financial
statements express the financial position of a business at the end of accounting period (Balance Sheet) and
result of its operations performed during the year (Profit and Loss Account). The main techniques of financial
analysis are:

1. Comparative Financial Statements


2. Trend Analysis
3. Common Size Statement
4. Fund Flow Statement
5. Cash Flow Statement
6. Ratio Analysis Account

1) Comparative Financial Statements: In comparative financial statement‚ the financial statements of two
periods arc kept by side so that they can be compared.

2) Trend Analysis: In order to compare the financial statements of various years trend percentages are
significant. Trend analysis helps in future forecast of various items on the basis of the data of previous years.

3) Common Size Statement: Common size financial Statements are such statements in which items of the
financial Statements arc Converted in percentage on the basis of common base.

4) Fund Flow Statement: Income statement or Profit or Loss Account helps in


ascertainment of profit or loss for a fixed period. Balance Sheet shows the financial position of business on a
particular date at the close of year. Income Statement does not fully explain funds from Operations of business
because various non-fund items are shown in Profit or Loss Account. Balance Sheet shows only static financial
Position of business and financial changes occurred during a year can’t the known from the financial Statement
of a particular date.

5) Cash Flow Statement: The investor is interested in knowing the cash inflow and outflow of the enterprise.
The cash flow Statement expresses the reasons of change in cash balances of company between two dates.
6) Ratio Analysis: Ratio is a relationship between two figures expressed mathematically. It is quantitative
relationship between LW0 items for the purpose of comparison. Ratio analysis is a technique of analyzing
financial statements.

It summaries the data for easy understandings comparison and interpretation. The ratios are divided in the
following group:

a) Liquidity Ratios

b) Turnover Ratios

c) Profit Margin Ratio

FORECASTING EARNINGS
There is strong evidence that earnings have a direct and powerful effect upon dividends and share prices.
These ratios are generally known as ‘Return on Investment Ratios’. These ratio help in evaluating the whether
business is earning adequate return on the capital invested or not. With the help of the following ratios the
performance of the business can be measured. The earning forecasting ratios are:

Return on Total Assets: The Return on Total Assets is calculated as follows:

. Return on Assets = Net Income (EBIT)/ Total Assets

Return on Equity: This ratio is calculated to evaluate the profitability of the business from the point of view the
ordinary shareholders. It is calculated as follows

Return on Equity = Net profit/ Net Worth Or

Return on Equity = Equity Earnings /Equity

Valuation Ratios
(a) Book value per share = Paid up Equity share capital + Reserves & Surplus/Total number of equity shares
0utstanding

b) Earnings per share (EPS) = Equity Earnings or EAT/number of equity shares outstanding

(e) Dividend per Share (DPS) = Profits distributed to Equity shareholders/ Number of Equity shares

Fundamental Analysis: An Overview

STRENGTHS OF FUNDAMENTAL ANALYSIS


Long-term Trends

Fundamental analysis is good for long term investments based on long-term trends. The ability to identify and
predict long-term economic, demographic, technological or consumer trends can benefit investors and helps in
picking (he right industry groups or companies.

Value Spotting
Sound fundamental analysis vi1l help identify companies (hat represent a good value. Some of the most
legendary investors think for long-term and value. Fundamental analysis can help uncover the companies with
valuable assets, a strong balance sheet, stable earnings, and staying power.

Business Acumen

One of the most obvious, but less tangible rewards of fundamental analysis is the development of a thorough
understanding of the business. After such painstaking research and analysis, an investor will be familiar with
the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers
of equity prices. A good understanding can help investors avoid companies that are prone to shortfalls and
identify those that continue to deliver.

Value Drivers

In addition to understanding the business, fundamental analysis allows investors to develop an understanding
of the key value drivers within the company. A stock’s price is heavily influenced by the industry group. By
studying these groups, investors can better position themselves to identify opportunities that are high-risk
(tech), low-risk (utilities), growth oriented (computer), value driven (oil), non-cyclical (consumer staples),
cyclical (transportation) etc.

Knowing Who is Who

Stocks move as a group. Knowing a company’s business, investors can better categorize stocks within their
relevant industry group that can make a huge difference in relative valuations. The primary motive of buying a
share is to sell it subsequently at a higher price. In many cases, dividends are also to be expected. Thus,
dividends and price changes constitute the return from investing in shares. Consequently an investor would be
interested to know the dividend to be paid on the share in the future as also the future price of the share.
These values can only be estimated and not predicted with certainty. These values are primarily determined by
the
performance of the company which in win is influenced by the performance of the industry to which the
company belongs and the general economic and socio-political scenario of the country.

TECHNICAL ANALYSIS
Technical analysis is frequently used as a supplement to fundamental analysis rather than as substitute to it.
According to technical analysis, the price of stock depends on demand and supply in the market place.

Technical analysts study the technical characteristics which may be expected at market turning points and their
objectives assessment.

Technical analysis is directed towards predicting the price of a security. The price at which a buyer and seller
settle a deal is considered to be the one precise figure which synthesis, weighs and finally expresses all factors,
rational and irrational quantifiable and non—quantifiable and is the only figure that counts.

ASSUMPTIONS OF TECHNICAL ANALYSIS

. The market value of a security is solely determined by the interaction of demand and supply factors operating
in the market.

. The demand and supply factors of a security are surrounded by numerous factors; these factors arc both
rational as well as irrational.

. The security prices move in trends or waves which can be both upward or downward depending upon the
sentiments, psychology and emotions of operators or traders.
. The present trends are influenced by the past trends and the projection of future trends is possible by an
analysis of past price trends

. Except minor variations, stock prices tend to move in which continue to persist for an appreciable length of
time.

. Changes in trends in stock prices are caused whenever there is a shift in the demand and supply factors.

. Shifts in demand and supply, no matter when and why they occur, can be detected through charts prepared
specially to show market action.

. Some chart trends tend to repeat themselves. Patterns which arc projected by charts record price movements
and these Patterns are used by technically analysis for making forecasts about the future patterns.

TOOLS AND TECHNIQUES OF TECHNICAL ANALYSIS

There are numerous tools and techniques for doing technical analysis. Basically this analysis is done from the
following four important points of view:-

1) Prices: Whenever there ¡S change in prices of securities it is reflected in the changes in investor attitude and
demand and supply of securities

2) Time: The degree of movement in price is a function of time. The longer it takes for a reversal in trend,
greater will be the price change that follows.

3) Volume: The intensity of price changes is reflected in the volume of transactions that accompany the
change. If an increase in price is accompanied by u small change in transactions, it implies that the change is
not strong enough.

4) Width: The quality of price change is measured by determining whether a change in trend spreads across
most sectors and industries or is concentrated in few securities only. Study of the width of the market indicates
the extent to which price changes have taken place in the market in accordance with a certain overall trends.

Dow Theory

Originally proposed in the late nineteenth century by Charles H Dow, the editor of Wall Street Journal, the Dow
theory is perhaps the oldest and best-known theory of technical analysis. Dow developed this theory on the
basis of certain hypothesis, which are as follows:

a. No single individual or buyer or buyer can influence the major trends in the market. However, an individual
investor can affect the daily price movement by buying or selling huge quantum of particular scrip.

b. The market discounts everything. Even natural calamities such as earth quake, plague and fire also get
quickly discounted in the market. The world trade center blast affected the share market for a short while and
then the market returned back to normalcy.

e. The theory is not infallible and it is not a tool to beat the market but provides a way to understand the
market.

Explanation of the Theory


Dow describes stock prices as moving in trends analogous to the movement of water. He postulated three
types of price movements over time: (1) major trends that are like tide in ocean, (2) intermediate trends that
resemble waves, and (3) short run movements that are like ripples.
Followers of the Dow theory hope to detect the direction of the major price trend (tide) known as primary
trend, recognizing the intermediate movements (waves) or secondary trends that may occasionally move in the
opposite direction.

Primary Trend
The price trend may be either increasing or decreasing. When the market exhibits the increasing trend, it is
called bull market. The bull market shows three clear-cut peaks. Each peak is higher than the previous peak and
this price rise is accompanied by heavy trading volume.

Secondary Trend
The secondary trend moves against the main trends and leads to the correction.

Efficient-Market Hypothesis (EMH)


In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”,
or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information. The
efficient-market hypothesis states that it is impossible to outperform the market by using any information that
the marketalready knows, except through luck. Information or news in the EMH is defined as anything that may
affect prices that is unknowable in the present and thus appears randomly in the future.
Weak-form Efficiency
Excess returns cannot be earned by using investment strategies based on historical share prices. Technical
analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental
analysis may still provide excess returns.

Semi-Strong-form Efficiency
Semi-Strong-form efficiency implies that share Prices adjust to publicly available new information very rapidly
and in an unbiased fashion, such that no excess returns can be earned by trading on that information.

Strong-form Efficiency
Share prices reflect all information, public and private, and no one can earn excess return. If there are legal
barriers to private information becoming public, as with insider trading laws strong-form efficiency is
impossible, except in the case where the laws are universally ignored.
To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess
returns over a long period of time.

REVIEW QUESTIONS
Section A

1. What is fundamental analysis?

2. Define economic analysis.

3. What is company analysis?

4. List out the techniques of financial analysis.

5. What is primary trend?

6. What is a moving average?

7. What is Relative Strength Analysis?

Section B

1. Discuss macro economic factors

2. What are the economic forecastj0 techniques?

3. Discuss about classification of Industry

4. What are the assumptions of technical analysis?

5. What arc the tools and techniques of technical analysis?

6. Discuss the concept of suppo1.1 and resistance level.

Section C
1. Differentiate between Fundamental analysis and technical analysis.

2. In detail discuss the concept of Industry analysis.

3. Explain the porter model.

4. Explain DOW theory.

5. Explain different chart patterns?

6. Discuss the tax aspects of investment in equity shares.

7. Explain Efficient-Market Hypothesis (EMH).


3. PORTFOLIO MNAGEMENT
Portfolio is a combination of securities such as stocks, bonds and money market instruments. The process of
blending together the broad asset classes so as to obtain optimum return with minimum risk is called portfolio
construction. Individual securities have risk return characteristics of their own.
Diversification of investment helps to spread risk over many assets. A diversification of securities gives the
assurance of obtaining the anticipated return on the portfolio. In a diversified portfolio, some securities may
not perform as expected, but others may exceed the expectation and making the actual return of the portfolio
reasonably close to the anticipated one.

Approaches ¡n Portfolio Construction


Commonly, there are two approaches in the construction of the portfolio of securities viz. traditional approach
and Markowitz efficient frontier approach (modern approach). In the traditional approach, investors needs in
terms of income and capital appreciation are evaluated and appropriate securities are selected to meet the
needs of the investor.

Traditional Approach
The traditional approach basically deals with two major decisions. They are:

(a) Determining the objectives of the portfolio.

(b) Selection of securities to be included in the portfolio.

The investor has to assess the major risk categories that he or she is trying to minimise. Compromise on risk
and non-risk factors has to be carried out. Finally relative portfolio weights are assigned co securities like
bonds, stocks and debentures and then diversification is carried out. The flow chart below shows the steps in
traditional approach

1. Analysis of Constraints
The constraints normally discussed are: income needs, liquidity, time horizon, safety, tax
considerations and the temperament.
2. Determination of Objectives
Portfolios have the common objective of financing present and future expenditures from a
large pool of assets. The return that the investor requires and the degree of risk he is willing to
take depend upon the constraints. The objectives of portfolio range from income to capital
appreciation. The common objectives are stated below:

 Current income
 Growth in income
 Capital appreciation
 Preservation of capital
The investor in general would like to achieve all the four objectives, nobody would like to
lose his investment.

Markowitz Model (HM Model)


Harry Markowitz put forward this model in ¡952. It assists in the selection of the most
efficient by analysing various possible portfolios of the given securities. By choosing securities
that do not ‘move’ exactly together, the HM model shows investors how to reduce their risk.
The HM model is also called Mean-Variance Model due to the fact that it is based on expected
returns (mean) and the standard/deviation (variance) of the various portfolios. Harry Markowitz
made the following assumptions while developing the HM model

1. Risk of a portfolio is based on the variability of returns from the said portfolio.
2. An investor ¡s risk averse.
3. An investor prefers to increase consumption.
4. The investor’s utility function is concave and increasing, due to his risk aversion and consumption
preference.
5. Analysis is based on single period model of investment.
6. An investor either maximizes his portfolio return for a given level of risk or maximizes his return
for the minimum risk.
7. An investor is rational in nature
To choose the best portfolio from a number of possible portfolios, each with different return and risk,
two separate decisions are to be made:
1. Determination of a set of efficient portfolios.
2. Selection of the best portfolio out of the efficient set.

Determining the Efficient Set


A portfolio that gives maximum return for a given risk, or minimum risk for given return ¡s an
efficient portfolio. Thus, portfolios are selected as follows:
(a) From the portfolios that have the same return, the investor will prefer the portfolio with lower
risk, and
(b) From the portfolios that have the same risk level, an investor will prefer the portfolio with higher
rate of return.

Choosing the Best Portfolio


For selection of the optimal portfolio or the best portfolio, the risk-return preferences are analysed. An investor
who is highly risk averse will hold a portfolio on the lower left hand of the frontier, and an investor who isn’t
too risk averse will choose a portfolio on the Upper portion of
the frontier.
Figure 2 shows the risk-return indifference curve for the investors. Indifference curves C1, C2 and C3 are
shown. Each of the different points on a particular indifference curve shows a different combination of risk and
return, which provide the same satisfaction to the investors. Each curve to the left represents higher utility or
satisfaction. The goal of the investor would be to maximize his satisfaction by moving to a Curve that is higher.
An investor might have satisfaction represented by C2, but if his satisfaction/utility increases, he/she then
moves lo curve C3 Thus,
at any point of time, an investor will be indifferent between combinations S 1 and S2, or S3, and S6.

Demerits of the Markowitz Model

1. Unless positivity constraints are assigned, the Markowitz solution can easily find highly leveraged
portfolios (large long positions in a subset of investable assets financed by large short positions in
another subset of assets), but given their leveraged nature the returns from such a portfolio are
extremely sensitive to small changes in the returns of the constituent assets and can therefore be
extremely ‘dangerous’. Positivity constraints are easy to enforce and fix this problem, but if the user
wants to ‘believe’ in the robustness of the Markowitz approach, it would be nice if better-behaved
solutions (at the very least, positive weights) were obtained if an unconstrained manner when the set
of investment assets is close to the available investment opportunities (the market portfolio) — but
this is often not the case.
2. Practically more vexing, small changes in inputs can give rise to large changes in the portfolio. Mean-
variance optimization has been dubbed an ‘error maximization’ device ‘an algorithm that takes point
estimates (of returns and covariance’s) as inputs and treats them as if they were known with certainty
will react to tiny return differences that are well measurement error’. In the real world, this degree of
instability will lead, to begin with, to large transaction costs, but it is also likely to shake the confidence
of the portfolio manager in the model.
3. The amount of information (the covariance matrix, specifically, or a complete joint probability
distribution among assets in the market portfolio) needed to compute a mean-variance optimal
portfolio is often intractable and certainly has no room for subjective measurements (‘views’ about
the returns of portfolios of subsets of
investable assets).

Sharpe’s Single Index Model

This simplified model proposes that the relationship between each pair
of securities can indirectly be measured by comparing each security to a common factor ‘market performance
index’ that is shared amongst all the securities. As a result, the model can reduce the burden of large input
requirements and difficult calculations in Markowitz’s mean variance settings (Sharpe,1963). This model
requires only (3n+2) data inputs i.e. estimates of alpha and beta for each security, estimate of unsystamic risk
for each security, estimates for expected return on market index and estimates of variance of return on). Due
to this simplicity, sharpe’s single index model has gained its popularity to a great extent in the arena of
investment finance as compared to Markowitz’s model.

Assumptions Made
The Sharpe’s Single Index Model is based on the following assumptions:
1. All investors have homogeneous expectations.
2. A uniform holding period is used in estimating risk and return for
each security.
3. The price movements of a security in relation to another do not
depend primarily upon the nature of those two securities alone.
They could reflect a greater influence that might have cropped up
as a result of general business and economic conditions.
4. The relation between securities occurs only through their
individual influences along with some indices of business and
economic activities.
5. The indices, to which the returns of each security are correlated,
are likely to be some securities’ market proxy.

Stock prices are related to the market index and this relationship could used to estimate the return of
stock.
The Capital Asset Pricing Model (CAPM)
The capital asset Pricing model (CAPM) Was introduced by Jack Treynor(1961) while parallel work was also
performed by Will lam Sharp(1964) and Lintner(1965). In 1990, Sharp received the Nobel Memorial Prize in
Economics with Harry Markowitz and Merton Miller in the field of financial economics.

The Capital Asset Pricing Model ¡s an economic model which is used for valuing the securities ties, stocks and
assets by relating risk and expected rate of return.
The CAPM help us to calculate investment risk and what is the return on the investment.

This investment contains two types of risk.

• Systematic Risk

• Unsystematic Risk

Systematic Risk: Systematic risks are market risks that cannot be diversified away. For example, wars and
interest rates are good examples of the systematic risk.

Unsystematic Risk: Unsystematic risk is specific to each individual stocks and it can be diversified away as the
investor increases the number of stocks in portfolio. It is also known as “specific risk”.

Assumption of Asset pricing Model (CAPM)


The capital asset pricing model (CAPM) is valid within a special set of assumption.

These assumptions are

. All investors have 0mgcnOUS expectations about the assets.

. Investor may borrow and lend unlimited amount of risk free asset.

. The risk free borrowing and lending rates are equal.

. The quantity of assets is fixed

. Perfectly efficient capital markets

. No market imperfections such like taxes and regulation and no change in the level of interest rate exists.

. There are no arbitrage opportunities.

. There is a separation of production and financial stocks.

. Returns (assets) are distributed by normal distribution.

The equation for CAPM is


Security Market Line (SML)
When the Capital Asset Pricing Model is drawn graphically we get the S.M.L., which is shown in the chart
below. If the investor wants to decide on investment with an expected return he would know the level of risk
he has to take or alternatively given the level of risk, he has preferred to take, he would know the expected
return from this chart.
Arbitrage Pricing Theory (APT)
In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds that the expected return
of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical
market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.

The arbitrage pricing theory (APT) describes the price where a mispriced asset is expected to be. It is often
viewed as an alternative to the capital asset Pricing model (CAPM) since the APT has more flexible assumption
requirements.

The general idea behind APT is that two things can explain the expected return on financial asset:

(1) macroeconomic/security-specific influences and

(2) the asset’s sensitivity to those influences. This relationship takes the form of the linear regression formula
above.
REVIEW QUESTIONS
Section A

1. What is a portfolio?

2. What are the benefits associated with investing in a portfolio of securities instead of investing in a security?

3. What is Beta?

4. How to calculate a portfolio’s beta?

5. What is a Systematic Risk?

Section B

1. What are the assumptions associated with Markowitz model?

2. What are the demerits of Markowitz Model?

3. What are the assumptions associated with Sharpe’s Single Index Model?

4. Explain the concept of SML and CML.

5. Differentiate between SML and CML.

Section C

1. Discuss the traditional approach of portfolio construction.

2. Explain the Markowitz model.

3; Explain Sharpe’s Single Index Model.

4. What are the assumptions of CA PM?


PRACTICALQUESTIONS
1. Stock A has a beta of I .2 Stock B has a beta of 0.6, the expected rate of return on an average stock is 12
percent, and the risk-free rate of return is 7 percent. By how much does the required return on the riskier stock
exceed the required return on the less risky stock?

2. Consider the following information for the ABC Retirement Fund, with a total investment of ₹.4 million.

3. You are given the following distribution of returns:

4. Suppose the rate of return of the market has an expected value 14% and a Standard deviation of 15%, let the
risk free rate be 10%. Using the capital asset pricing model formula calculate an expected rate of return.

5. Consider that you have ₹.30,000 in the following 4 stocks


The risk free rate is 4% and the expected return on the market portfolio is 15%. Using the capital asset pricing
market, what ¡s the expected return on above portfolio?

6. Two Securities P and Q are considered for investment. Compute the risk and return of the portfolio assuming
the two securities, whose correlation coefficient of returns is -0.84, are combined iii the following proportions
in the portfolio: (a) 0: 100, (b) 10: 90, (c) 20: 80, (d) 50: 50,
(e) 80: 20, (f) 90: 10, (g) 100: 0.

The historical risk-return of the two securities is as follows:

Computation of portfolio return:

7. Compute the risk return characteristic of an equally weighted portfolio of three securities whose individual
risk and return are given in the following table. The correlation between Security A and B s -0.43 and the
correlation between security B and C is 0.21 and the correlation coefficient between security A and C is -0.62.

8. From the two securities available for investment opportunity, find the proportion or investment in each
security that will minimise the risk for the investor. The correlation coefficient between the two securities is
-0.65. Determine portfolio risk.

9. The following securities are available for investment for an investor. Select the optimal portfolio using the
Sharpe’s Single Index Portfolio Selection method. Assume the risk free rate of return as 5 per cent and the
standard deviation of the market return as 25 per cent.

1O. Gopal holds portfolio of two companies A and B with the following details.
11. Compute the risk and return of a portfolio of these securities. Assume equal weights.

12. Give the minimum risk portfolio from the combination of the following securities.

13. Select suitable portfolios for an investor who falls in the risk bracket of 40 per cent

14.
Use
the

Sharp Index Model to select the best combination of securities for a portfolio. The risk free rate is 5% and
market standard deviation is 20%.

15. Compute the beta for thefollowing security:


4. PORTFOLIO MANAGEMENT
STRATEGIES
Learning Objectives
. Understand the concept of portfolio evaluation and management

. Identify methods involved in portfolio evaluation adn portfolio revision

. Understand Sharpe, Treyner and Jensen measure of portfolio evaluation.

Portfolio Management
It is necessary to understand the concept of portfolio management before understanding the concept of
portfolio evaluation. Portfolio management ¡S a process en-compassing many activities of investment in assets
and securities. It is a dynamic and flexible concept and involves continuous and systematic analysis, judgment
and operations. The objective of this service is to help the novices and uninitiated investors with the expertise
of professionals in portfolio management.

Elements of Portfolio Management


1. Identification of the investors’ objectives, constraints and preferences, which will help formulate the
investment policy.

2. Strategies arc to be developed and implemented in tune with the investment policy formulated. This vil1
help the selection of asset classes and securities in each class depending upon their risk—return attributes.

3. Review and monitoring of the performance of the portfolio by continuous overview of the market
conditions, companies’ performance and investors’ circumstances.

4. Finally the evaluation of the portfolio for the results to compare with the targets and needed adjustments
have to be made in the portfolio to the emerging conditions and to make up for any shortfalls in achievement
vis-a-vis targets.

Evaluation of Portfolio Performance


Investment analysts and Portfolio Managers continuously monitor and evaluate the results of their
performance. The revision of portfolio investments is conducted on the basis of such monitoring and
evaluation. The ability of Managers to our perform the market depends on their expertise and experience.

Criteria for Evaluation of Portfolio

Portfolio managers and inVest0 who manage their own portfolios continuously monitor and review the
performance of the portfolio. The evaluation of each portfolio, followed by revision and reconstruction are all
steps in the portfolio ‘wish ¡o know how they performed in their investment strategies in terms of return per
unit risk, both in absolute terms and relative terms relative to overall market performance.
Diversification in terms of Markowitz model or Sharpe’s Single Index Model will reduce the market related risk
and maximise the returns for a given level of risk. Market returns being related positively to risk, evaluation has
to take into account:

1. Rate of returns, or excess return over risk free rate.

2. Level of Risk both Systematic (Beta) and Unsystematic and residual risks through proper diversification.

PortfoI1o Management Strategies


Portfolio Management Strategies refer to the approaches that are applied for the efficient portfolio
management in order to generate the highest possible returns at lowest possible risks. There are two basic
approaches for pofo1io management Strategy and Passive Portfolio Management Strategy.

Active Portfolio Management Strategy


The Active portfolio manage111 relies on the fact that particular style of analysis or management can generate
returns that can beat the market.

Passive Portfolio Management Strategy


Passive asset management relics on the fact that markets are efficient and it is not possible to beat the market
returns regularly over time and best returns are obtained from the low cost investments kept for the long term

Efficient market theory: This theory relies on the fact that the information that affects the markets is
immediately available and processed by alt investors. Thus, such information is always considered in evaluation
of the market prices. The portfolio managers who follows this theory, firmly believes that market averages
cannot be beaten consistently.

Indexing: According to this theory, the index funds are used for taking the advantages of efficient market
theory and for creating a portfolio that impersonate a Specific index. The index funds can offer benefits over
the actively managed hinds because they have lower than average expense ratios and transaction costs.

Apart from Active and Passive portfolio Management Strategies, there are three more kinds of portfolios
including Patient Portfolio, Aggressive Portfolio and Conservative Portfolio

Patient Portfolio: This type of portfolio involves making investments in well-known stocks. The investors buy
and hold stocks for longer periods. In this portfolio, the majority of the stocks represent companies that have
classic growth and those expected to generate higher earnings on a regular basis irrespective of financial
conditions.

Aggressive Portfolio: This type of portfolio involves making investments in “expensive stocks” that provide
good returns and big rewards along with carrying big risks. This portfolio is a collection of stocks of companies
of different sizes that are rapidly growing and expected to generate rapid annual earnings growth over the next
few years.

Conservative portfolio: This type of portfolio involves (lie collection of stocks after carefully observing the
market returns, earnings growth and consistent dividend history.

Bond portfolio Management Strategies


Bond portfolio management strategies can be broadly classified into passive management, semi active
management and active management. The basis of classification of bond management strategies ¡s the nature
of inputs required. Passive management is an approach which does not rely too much on forecasts about
future whereas active management relies too much on forecasting. The frequency of forecasts and the number
of variables that are forecasted are high in case of active management. Semi-active management tI1s in
between these two approaches.

Passive management Strategy: Passive management places less emphasis on


expectations. That, is most of the key Inputs are known at the of investment analysis itself. Three widely used
strategies of passive management are buy-and-hold, bond laddering and indexing.

(a)Buy-and-Hold Strategy: ‘One of the simple investment strategies is to identify a security with the desired
characters and hold it till maturity or redemption and reinvest the proceeds in similar securities. This strategy is
known as buy-and-hold strategy. Buy-and-gold investors do not trade actively with the objective of increasing
their returns. They buy the bond with a maturity or duration close to their investment horizon to reduce price
and reinvestment risk. When a security is held till maturity, price risk is eliminated and the return on the
security is controlled by the coupon payments and reinvestment rate. Therefore, cash flows over life of the
security arc determined by the coupon payments received and reinvested. An important thing is buy-and-hold
approach is identifying bonds with attractive yield and maturity profiles. The investors has to choose carefully
from the available bonds based on the analysis of quality, coupon level, term to maturity and important
indenture provisions such as call, sinking fund features, etc. Though management of the portfolio is passive,
bonds are selected based on a careful analysis. Buy-and-hold strategy is suitable to income maximising
investors such as pensioners, bond mutual funds, endowment funds, insurance companies, etc. The objective
of these investors s to maximise yield over the investment horizon, in some cases, followi1g active bond
management strategies may be difficult because of the market impact of large cash flows of large funds.
Another feature of buy-and-hold approach is its low level risk. As we are already seen the main source of risk
for bonds, interest rate risk, can be limited to
investment risk. Price risk is eliminated under buy-and-hold strategy because the security is

d till maturity and price realized would be the same as expected. This also makes the buy
d-hold strategy attractive to risk adverse investors. Therefore, buy-and-hold strategy will be

¡table to investors with the objective ofmaximiSiflg inCome with minimum risk.

(b) Bond Ladder Strategy: Another form of buy-and-hold passive strategy of bond portfolio management is
bond laddering. Bond laddering involves investing in bonds with several maturity dates instead of a single time
horizon as in the case of simple buy-and-hold strategy. This process of bond managCmc1t is called laddering
because of the various rungs of investment established over the maturity ladder.

(c) Indexing Strategy: Another form of passive management is indexing strategy. Under this strategy, a bond
portfolio is formed with the objective of replicating the performance of selected index. Performance is
measured in terms of total return realized over the investment horizon. Sources of total return over the
investment horizon arc change in portfolio value, coupon interest received and reinVCstm1t income. Once it is
decided to pursue an indexing strategy, the next step is to select a bond index to replicate. There are a number
of bond indexes to choose from. Various factors such as investor’s risk tolerance, investor’s objectives, and
constraints imposed by regLllat0 guide the decision on appropriate benchmark index. If the investors risk
tolerance is low, then the index should include more of government securities do not have credit risk. The
objective of the investor has a major influence on selecting an appropriate index. If the objective is to maximise
variability of total returns, he
may be biased towards choosing an index with a lower variability. On the other hand, if the investor has strong
expectations about the directions of interest rate, selection of index may biased towards an index, which 3 is
expected to yield maximum returns. If the objective of the investor is to meet certain future liability, then
choosing an index with the duration of the liability may be prudent.

Active Management Strategies: When investing to enhance the total return from the bond portfolio, the
objective is to maximise the total value in each period, given the investor’s risk—tolerance. Because total
return includes price appreciation coupon income, and reinvestment returns, accomplishing this objective may
force the investor to trade—off one form of return for another in the hope that the total return will be
increased. Different types of strategies that seem well suited for this objective arc (i) portfolio shifts in
anticipation of changes in the overall structure of interest rates. (ii) Valuation analysis, (iii) credit analysis and
(iv) bond swaps, which attempt to exploit temporary aberrations in the price/yield structure. Because all types
of strategies entail a great deal of time, investors seeking Lo increase total return can expect to be actively
involved in the management of their bond portfolio. (1) Interest Rate Anticipation Interest rate anticipation is
perhaps the riskiest strategy for managing bonds. With interest rate anticipation, you, as an investor, make a
forecast of the direction and quantum of change. Your risk is two-fold. First, you are making an estimate and
YOU might be wrong and it could have disastrous consequences for your overall return position. Second, if you
currently own a portfolio, rebalancing will change its duration, which in turn, will alter your risk/expected-
return position.
Decision With Respect to Maturity Because interest rate sensitivity is related to bond duration, the general rule
for interest rate anticipation is to increase your investment in long duration bonds (i.e., long maturity’ and low-
coupon bonds) when interest rates are expected to decline. This enhances the opportunity to increase total
return in the short run through price appreciation. Alternatively, if interest rates are expected to rise, moving
into shorter-duration bonds (i.e. short maturity and high-coupon bonds) aids in preserving capital, which, in
turn, can stabilize or increase the total return in a market with falling prices.

Equity Portfolio Management Strategies


The equity portfolio rctUr1 profiles can be modified by the use of different investment management strategies.
To achieve the desired investment objective a portfolio manager has to take necessary steps with respect to his
decision on asset allocation, risk diversification, benchmarking, monitoring, forecasting the future economic
performance as well as the market

-‚ ,r,iprI1CC aSSeSSITt and finallY the return generatio

Portfolio Revision
A portfolio constructed will not and cannot remain as it is for ever. Due to changes in the economy and
financial markets the risk return characteristics of security keep changing. A security looked attractive once may
loose that attraction and vice versa. There is a need to change the composition of the portfolio to ensure that
the performance does not get affected due to changes in the financial market.

Need for Portfolio revision:

. The risk bearing characteristics of investor may change during course of time.

. Additional funds may be available.

. Investors need to withdraw funds

. Changes may happen in Economy, industry and company

Strategies for Portfolio Revision

• Active revision strategies

• Passive revision strategies

Formula plans for Revision

1. CONSTANT RUPEE VALUE PLAN

Portfolio consists of Defensive and aggressive stocks. This plan specifies that rupee value of stocks in both
portfolio will remain constant. i.e., when value raises — sell some and when value falls—buy some stocks.
Portfolio will remain constant in money value. But, excessive transaction cost and cannot claim full benefit of
price movements.

2. CONSTANT RATIO PLAN

Portfolio COflSl5tS of Defensive and aggressive stocks. This plan specifies that RATIO of stocks in both portfolio
will remain constant. i.e., when value raises— sell SO- and when value falls— buy some stocks. Portfolio will
remain constant in terms of ratio. But, excessive transaction cost and cannot claim full benefit of price
movements ‘excessive transaction

3. VARIAVLE RATIO PLAN

Steadily increase aggressive stock portion and decrease defensive stock. Buy more of a stock group when price
falls and Sell more of a stock group when price raises.

Portfolio Evaluation Measures

The important measures of performance of portfolio are derived independently by Sharp Jensen and Treynor.
All these three ratios are based on the the assumption that

(1) all investors are averse to risk, and are single period expected utility of terminal wealth maximizers

(2) all investors have identical decision horizons and homogeneous expectations regarding investment
opportunities
(3) all investors are able to choose among portfolios solely on the basis of expected returns and variance of
returns,

(4) all trans-actions costs and taxes are zero, and

(5) all assets are infinitely divisible.

Sharpe Ratio
A ratio developed by Nobel Laureate William F. Sharpe to measure risk-adjusted performance. It is calculated
by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the standard
deviation of the portfolio returns. The sharp ratio tells us whether the returns of a portfolio are due to smart
investment decisions or a result of excess risk.

Here, Rp is the rate of return of a portfolio, Rf is the risk-free rate, σp the standard deviation of a portfolio. The
Sharpe ratio is used to characterize how well the return of an asset compensates the investor for the risk taken.

Treynor Ratio
A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been
earned on a riskless investment per each unit of market risk. The Treynor ratio is a measurement of the returns
earned on a riskless investment (i.e. Treasury Bill) (per each unit of market risk assumed)

Treynor ratio (Tr) does not quantify the value added, if any, of active portfolio mana11t. It is a ranking criterion
only. A ranking of portfolios based on the Treynor Ratio is only useful if the portfolios under considerati0n sub-
portfolios of a border, fully diversified portfolio.

Jensen Ratio: Like the previous measures discussed, the Jensen measure
is also based on CAPM. Named alter its creator, Michael C. Jensen. The Jensen measure is also suitable for
evaluating a portfolio’s performance in combination with other portfolios because it is based on systematic risk
rather than total risk. The Jensen measure or alpha is usually very
close to zero.

Alpha is a coefficient that is proportional to the excess return of a portfolio over its required return, or its
expected return, for its expected risk as measured by its beta.
Solved Example

Solved Example
Solved Example

Solved example
Solution
DERIVATIVES
Meaning and Definition

In finance, a derivative is a financial instrument derived from some other asset; rather than trade or exchange
the asset itself market participants enter into an agreement to exchange cash, assets or some other value at
some future date based on the underlying asset.

The term derivatives indicates that it has no independent value i.e., its value is entirely derived from value of
underlying asset. The underlying asset can be securities, commodities bullion, currency, indices, live stock, etc.
Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration,
linked for the purpose of contract fulfilment to the value of a specified real or financial asset or to an index of
securities.

BASIC FEATURES OF DERIVATIVES


1. As derivatives are not physical assets, transactions are settled by offsetting/squaring transactions. The
difference in value of derivative is cash settled.

2. There is no limit on number of units transacted in derivative market because there is no physical asset to be
transacted.

3. Derivative markets are usually the screen based /computerised.

4. Derivatives are secondary market securities and cannot help raising funds to a firm.

5. Derivative market is quiet liquid and transactions can be effected easily.

6. Derivative provides a hedging against different risk.

REVIEW QUESTION
Section A

1. What is a portfolio management?

2. What is portfolio building?

3. What is portfolio rcvision?

4. How to compute Treynor’s ratio?

5. What is an option?
Section B

1. Discuss the elements of portfolio management.

2. Discuss the criteria for evaluation of a portfolio.

3. What are the assumptions relating to portfolio evaluation measures?

4. Difference between forward and future.

5. Explain equity portfolio management strategies.

Section C

1. Explain the Sharp’s measure of portfolio evaluation.

2. Discuss in detail the Treyner and Jensen’s measure of portfolio evaluation.

3. What is derivatives? What are the types of derivatives?

4. Explain bond portfolio management strategies.

PRACTICAL QUESTIONS

1. Assume that we have the following data for three hinds namely, AI3C, DEF and GHI with their rate of return
and beta. The risk free rate is 12%. The risk for market (M) is 1 .0 and the rate of return for the market (M) is I
8%.

Now by using the Treynor index equation, we can calculate the value Of each manager.

2. Rate of return and standard deviation for three portfolios are free rate is O. I 2. the systematic risk for the
market (M) is 1.0 and the rate of return for market (M) is 18%.
5. MUTUAL FUNDS
At one time investing in the stock market was confined to high net worth Individuals. Ordinary person with
little income had no access to the stock market. With development of economy over the years through Five
Year plans, purchasing power of the people increased. Savings has raised to 28% of the earnings of the
economy.

MEANING AND SCOPE OF MUTUAL FUND


The “Fund” is constituted under statutes for the mutual benefit of unknown small investors. The organisation
which floats the Fund, pools the small savings of general public, manages the pooled funds by investing in
quality Securities and pays return to investors and pays back the principal after the lapse of stipulated time
period stated in Fund Certificate It cannot be said that return will be constant on investment of savers. It
depends upon the movement and behaviour of stock market.

Simply put, money pooled by large number of investors is what makes up a mutual fund. This money is then
managed by a professional fund manager, who uses his management skills to invest it in various financial
instruments.

Mutual Fund is defined by Securities and Exchange Board of India (Mutual Funds) Regulations, 1993 as “a fund
established in the form of a trust by a sponsor, to raise monies by the trustees through the sale of units to the
Public, under one or more schemes for investing in securities in accordance with these regulations “Thus, a
Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal.

Scope
MFs cover wide range of activities. They being the managers of public funds, that too of small investors, by and
large, Cannot operate arbitrarily. Though they provide for development of the economy, they cannot stretch
their operations beyond unmanageable limits. They should maintain strict financial discipline.

FEATURES OF MUTUAL FUNDS


Mobilisation of Savings

Mutual funds mobilizes funds by selling its shares popularly known as units. This in turn encourages the
household savings and investment.

Provides Investment Avenue

Mutual funds provides investment avenues for small and retail investors who does not have the expertise of
investing in equity market.

Diversification in Investment

Mutual funds invest the funds collected from retail investors’ ¡n securities of different industries. This
diversification leads to reduction in the risk associated with investment.

Professional Management
Panel of experts who possesses professional knowledge manages mutual funds. This leads to professional and
profitable management of mutual funds.

Reduces Risk

Mutual funds reduces the risk associated with investment by going for better liquidity of units, professional
management and diversification.

Better Liquidity

Mutual fund units can be sold/liquidated easily as they possess ready market.

Provides Tax Benefits

Investing in many schemes of Mutual funds provides tax exemptions under section 80C of Income tax act

STRUCTURE/INSTITUTIONAL FRAMEWORK OF MUTUAL FUND


A mutual fund is set up in the form of a trust, which has sponsor trustees, asset management company
(“AMC”) and a Custodian. The trust is established by a sponsor or more than one sponsor who is like a
promoter of a company. The trustees of the mutual fund hold its property for the benefit of the unit-holders.
The AMC, approved by SEBI, manages the funds by making investments in various types of securities. The
custodian, who is registered with SEBI, holds the securities of various schemes of the fund in its custody. The
trustee are vested with the general power of superintendence and direction over AMC. They monitor the
performance and
compliance of SEBI Regulations by the mutual fund.

1 Sponsor

Sponsor of a mutual fund is akin to the promoter of a company as he gets the fund registered with SEBI. Under
SEBI regulations, Sponsor is defined as any person who acting alone or in combination with another body
corporate establishes the mutual fund. Sponsor can be Indian companies, banks or financial institutions,
foreign entities or a joint venture between two entities. As Reliance mutual fund has been sponsored fully by
an Indian entity. Whereas, funds like Fidelity mutual fund and J P Morgan mutual fund are sponsored fully by
foreign entities. IC1CI Prudential mutual fund has been set up as a joint venture between ICICI Bank and
Prudential plc. Both sponsors have contributed to the capital of the Asset Management Company of ICICI
Prudential.

SEBI has laid down the eligibility criteria for Sponsor as it should have a sound track record and at least five
years experience in the financial services industry. SEBI ensures that sponsor should have professional
competence financial Soundness and general reputation of

MUTUAL FUND SCHEMES/ CLASSIFICATION OF MUTUAL FUNDS/ TYPES OF MUTUAL FUNDS

Types of Mutual Funds Schemes in India


1. Classification on the basis of Operations/ Structure

(a) Open ended Scheme: In an open-ended mutual fund there are no limits on the total size of the
corpus (Fund raised). Investors are permitted to enter (Buy) and exit (Sell) the open—ended mutual
fund at any point of time at net asset value (NAV). These schemes are opened throughout the year
with no definite closing period.

Characteristics

1. Accepts funds from investors on continuous basis.

2. Repurchase facility available.

3. No listing in stock exchange.

4. Better liquidity due to continuous repurchase.

5. Sale and purchase based on NAV of the units.

(b) C1ose ended Schemes: Here the duration and amount to be raised from the funds is pre- fixed schemes are
opened for specific time period. Once the subscription reaches the pre-determined level, the entry of investors
is closed. Alter the expiry of the fixed period, the entire corpus is disinvested and the proceeds are distributed
to the various unit holders in proportion to their holding. Investors can transact (buy or sell) the units of the
scheme on the stock exchanges where they are listed. The market price at the stock exchanges could vary from
the net asset value (NAV) of the scheme on account of demand and supply situation, expectations of unit
holder and other market factors. Canara Robeco Equity Tax Saver-93, DSP Merrill Lynch Tax Saver Fund, Tata Life
Sciences and Technology Fund, JM Arbitrage Advantage Fund, Kotak Gold ETF are some of the close ended
funds in India.

Characteristics

1. Schemes are opened only for short duration.


2. Corpus normally does not change, throughout the year.
3. Normally these schemes are listed in stock exchanges.
4. Liquidity is available to investors at the time of redemption.
5. Market price may be below or above par.
(b) Interval Schemes: Basically it is a close ended scheme with a peculiar feature that every year
for a specified period (interval) it is made open. Prior to and after such interval the schemes operates
as closed ended schemes. During the said period, mutual fund is ready to buy or sell the units
directly from or to the investor. Reliance interval fund, Taurus quarterly interval fund-series, ICICI-
Pru’s Interval Fund II are some of the intervals funds in India.

2. Classification by Investment Objectives

(a)Income Schemes: To maximize the current income is the objective of this scheme. Periodical
income distribution is the feature. Investment in low risk securities is made in these schemes.

(b)Growth Schemes: To achieve capital appreciation is the objective of this scheme. Investment is
made in growth oriented securities like equity shares.

(c)Balanced Schemes: To provide current income as well as capital appreciation is the objective.

3. Classification by Nature of Investment


(a)Equity fund:
These funds invest a maximum part of their corpus into equities holdings. The structure of the fund may vary
different for different schemes and the fund manager’s outlook on different stocks. The Equity Funds are sub-
classified depending upon their investment objective, as follows:
1. Diversified Equity Fund
2. Mid-Cap Funds
3. Sector Specific Funds
4. Tax Savings Funds (ELSS)

(b) Debt funds:


The objective of these Funds is to invest in debt papers. Government authorities, private companies, bank and
financial institutions are some of the major issuers of debt papers. By investing in debt instruments, these
funds ensure low risk and provide stable income to the investors. Debt funds are further classified as:

. Gilt Funds: Invest their corpus in securities issued by Government, popularly known as Government of India
debt papers. These Funds carry zero Default risk but are associated with Interest Rate risk. These schemes are
safer as they invest in papers backed by Government.

. Income Funds: Invest a major portion into various debt instruments such as bonds, corporate debentures and
Government securities.

. MIPs: Invests maximum of their total corpus in debt instruments while they take minimum exposure in
equities. It gets benefit of both equity and debt market. These scheme ranks slightly high on the risk-return
matrix when compared with other debt schemes.

Short Term Plans (STPS). Meant for investment horizon for three to six months. These funds primarily invest in
short term papers like Certificate of Deposits (CDs) and Commercial Papers (CPs). Some Portion of the corpus is
also invested in corporate debentures

Liquid Funds: Also known as Money Market Schemes, These funds provides easy
liquidity and preservation of capital. These schemes invest in short-term instruments like Treasury Bills,
interbank call money market, CPs and CDs. These funds are meant for short-term cash management of
corporate houses and are meant for an investment horizon of 1 day to 3 months. These schemes rank low on
risk-return matrix and are considered to be the safest amongst all categories of mutual funds.

4. Classification hy Geography
(a) Domestic Mutual Fund Schemes: Schemes launched with a view to mobilize savings of the citizens of the
country.

(b)Off Shore Schemes: Mutual fund schemes launched with a view to mobilize the savings of the foreign
countries for the investments in local markets. The aim is normally long-term capital growth by investing in
local equities.

SEBI REGULATIONS ON MUTUAL FUNDS


The securities and Exchange Board of India (SEBI) as the regulator of Indian capital market had come out with
its first mutual fund regulations in 1993. The need for creation and compliance mechanism for mechanism for
mutual fund industry was expressed by SEBI in these guidelines.

1. Legal character of mutual funds in India

It is useful to understand the legal composition of a mutual fund. A mutual fund is a legal entity. In India it is
organized in form of a trust. The SEBI (Mutual Fund) Regulations, define a mutual fund as a fund established in
the form of a trust by a sponsor, to raise monies by the trustees, through the sale of units to the public under
one or more schemes for investing in securities in accordance with these regulations.

2. The Structure
The SEBI Mutual Fund Regulations have defined the structure of a mutual fund and segregated the various
constituents into separate legal entities

3. Independent Custodian
Regulation 25 of the SEBI (MF) Regulations requires that mutual funds should have a custodian is not in any
way associated with the AMC.

4. Registration of mutual funds


All mutual funds are required to register with the Securities and Exchange Board of India. Registration is
intended to provide adequate and accurate disclosure of material facts concerning the mutual fund.

5. Governance of mutual funds


Mutual fund schemes are repositories of trust and investor’s hard earned money. The task of providing
protection to them is a difficult one. Mutual funds arc unique in a way as that they are organized and operated
by people whose primary loyalty and pecuniary interest lies outside the enterprise.

6. Operations of mutual funds


This section will show the regulatory provisions pertaining to the operations of the mutual fund and their
implications on unit holders protection.

FACTORS CONTRIBUTING FOR THE GROWTH OF MUTUAL FUNPS IN INDIA


A slew of factors have contributed for the growth of mutual fund industry in India during the past two decades.

1. Better Returns
The first and foremost reason is delivering of substantial returns by equity and debt-oriented funds.

2. Changes in Investment environment


Significant changes in the investment environment such as increased competition, ongoing reforms which
allow mutual funds to invest abroad as well as in derivative instruments helped for growth of the industry.

3. Competition and Efficiency


Unlike monopoly of UTI in the past, mutual fund industry now-a-days has been backed by FIIs and domestic
market. Early in the reforms process, it is recognized that greater competition and innovation would be
required so that the public received better financial services.
4. Transparency
The transparency in operations and disclosure practices related to the NAV, stock selection strategies, portfolio
churning costs, rationale for expense charges and investment related risks also fuelled the growth of the
industry.

5. Regulation
Stringent regulatory environment of the SEBI, investor awareness programmes offered by the AMFI, entry of
foreign players with strong financial and research capabilities,potential entry of employee pension and
provident funds and a slew of innovative schemes to cater to the different needs have attracted the investors.

6. Standardization of operations
Mutual fund operations like maintenance of investment accounts and the scheme accounts by outsourcing is
restricted.

7. Technology
Majority of the mutual funds have their own websites providing basic information relating to the schemes and
enable purchase and redemption of units online for clients in select locations.

8. Product Innovation
The tailor-made innovative schemes launched by the mutual fund houses have given investors option to
choose funds which choose his investment needs.

ADVANTAGES OF MUTUAL FUNDS

The advantages of investing in a Mutual Fund are:

. Diversification: The best mutual funds design their portfolios so individual investments will react differently to
the same economic conditions. For example, economic conditions like a rise in interest rates may cause certain
securities in a diversified portfolio to decrease in value.

• Professional Management: Most mutual funds pay topflight professionals to manage their investments.
These managers decide what securities the fund will buy and sell, when to buy or sell etc.

• Performs as Substitute for Initial Public Offerings (IPOs): As MFs are assured certain percent of allotment in
IPOS, small investors who are unable to apply for IPOS can enjoy the benefit of IPO through MF.

• Marketing cost of new shares can be reduced by MFs.

• MFs keep money market active by investing money on the money market instruments and strengthen money
market operations. Thus MFs provide stability to share prices, safety to investors and resources to business.

Supports Capital Market: MFs channelize private funds to the capital market and make this market active
through sustained supply of funds. They also provide valuable liquidity to capital market and make the market
stable.

. Regulatory oversight: Mutual funds are subject to many government regulations that protect investors from
fraud.

. Liquidity: It’s easy to get your money out of a mutual fund. Write a cheque, make a call, and you’ve got the
cash.

. Convenience: You can usually buy mutual fund shares by mail, phone, or over the Internet.
. Low cost: Mutual fund expenses are often no more than 1.5 per cent of your investment. Expenses for Index
Funds are less than that, because index funds are not actively managed. Instead, they automatically buy stock
in companies that are listed on a specific index.

. Transparency: There is very little scope for malpractice as it is regulated by SEBI.

• Flexibility: The funds can be easily shifted to different categories or from one MF to another.

• Choice of Schemes: Each MF company will have number of products. Most of the funds provide variety of
schemes depending on the individual requirement of the investors.

• Tax benefits: Most of the MFs have tax saver schemes covered by IT Act.

. Well regulated: Security Exchange Board of India (SEBI) fully controls MF


operations through its regulations.

DRAWBACKS OF MUTUAL FUNDS

• No Guarantees: No investment is risk free. If the entire stock market declines in value, the value of mutual
fund shares will go down as well, no matter how balanced the portfolio. Investors encounter fewer risks when
they invest in mutual funds than when they buy and sell stocks on their own. However, anyone who invests
through a mutual fund runs the risk of losing money.
• Fees and Commissions: All funds charge administrative fees to cover their day-to day expenses.

. Taxes: During a typical year most actively mutual fund, sell anywhere from 20 to 70 percent of the securities
in their portfolios.

. Management Of Risk: When investment is done in a mutual fund, investor depend on the fund’s manager to
make the right decisions regarding the fund’s portfolio.

Net Asset Value (NAV)


Net Asset Value is the market value of assets of the scheme minus its liabi1ities. Per unit NAV is the net asset
value of the scheme divided by the number of units outstanding on the Valuation Date8. For calculating the
mutual fund’s NAV, Value of the total assets of the mutual fund is subtracted by its liabilities, and then this
amount is divided by the total number of units in the mutual fund. i.e.

Mutual Fund’s NAV = (Total Assets-Liabilities)/Total number of units

Personal Financial Planning Process


The key component of personal finance is financial planning, which is a dynamic process that requires regular
monitoring and re-evaluation. In general, it involves five steps

1. Assessment: A person’s financial situation is assessed by compiling simplified versions of financial


statements including balance sheets and income statements. A personal balance sheet lists the values
of personal assets (e.g., Car, house Clothes, stocks, bank account), along with personal liabilities (e.g.,
credit card debt, bank loan, mortgage). A personal income statement lists personal income and
expenses.
2. Goal setting: Having multiple goals is common, including a mix of short-and long-term goals. For
example, a long-term goal would be to “retire at age 60 with a personal net worth of ₹1,00,O0,O0O”
while a short-term goal would be to “save up fora new computer in the next month.” Setting financial
goals helps t0 direct financial Planning. Goal setting is done with an objective to meet specific financial
requirements.
3. Plan creation: The financial plan details how to accomplish the goals. It could include, for example,
reducing unnecessary expenses, increasing the employment income, or investing in the stock market.
4. Execution: Execution of a financial plan often requires discipline and perseverance. Many people
obtain assistance from professionals such as accountants, financial planners, investment advisers, and
lawyers.
5. Monitoring and reassessment: As time passes, the financial plan is monitored for possible
adjustments or reassessments.

Typical goals that most adults and young adults have are paying off credit card/student loan/housing/car
loan debt, investing for retirement, investing for college costs for children, paying medical expenses.

Objectives of Portfolio Management

There are three main objectives of portfolio management which a wise bank follows: liquidity, safety and
income. The three objectives are opposed to each other. To achieve on the bank will have to sacrifice the
other objectives. For example, if the banks seek high profit, it may have to sacrifice some safety and
liquidity. If it seeks more safety and liquidity it may have to give up some income.

1. Liquidity:
A commercial bank needs a higher degree of liquidity in its assets. The liquidity of assets refers to the ease
and certainty with which it can be turned into cash.

2. Safety:
A commercial bank always operates under conditions of uncertainty and risk. It is uncertain about the
amount and cost of funds it can acquire and about its income in the future. Moreover, it face two types of
risks.

3. Profitability:
One of the principle objectives of a bank is to earn more profit. It is essential for the purpose of paying
interest to depositors, wage to the staff, dividend to shareholders and meeting other expenses.
Review Questions
Section A

1. Define mutual fund.


2. What is personal finance?
3. Define Gilt Fund.
Section B
1. Explain the need for mutual funds
2. What are salient features of mutual funds?
3. What are the advantages and limitations of mutual funds?
4. Explain personal investment process.

Section C
1. Explain the different types of mutual fund schemes.
2. Explain the factors contributing to the development of Mutual Funds in India.
3. Explain the marketing aspects of mutual funds.
4. What are the SEBI guidelines on Mutual Funds?
5. Explain portfolio management in banks.

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