INTRODUCTION TO

SECURITY ANALYSIS
INDTRODUCTION

»OVERVIEW
»INVESTMENT – BASIC CONCEPTS
»INVESTMENT ALTERNATIVES
»SECURITIES MARKET

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INVESTMENT

»Investment is a sacrifice of current money or

other resources for future benefits
»In finance, investment is putting money into
an asset with the expectation of
capital appreciation, usually over the long-
term future.
» Most or all forms of investment involve some
form of risk, such as investment in equities,
property, and even fixed interest securities
which are subject, inter alia, to inflation risk

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Investment alternatives

Non marketable
Financial Equity Shares . Bonds .
Assets .

Mutual fund
Real estate .
Schemes .

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Investment alternatives

Life
Money Precious
insurance
market . Objects.
Policies .

Financial Preference
Derivatives. shares

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Non – marketable Financial Assets

1. Bank Deposits
2. Post office Deposits
3. Company Deposits
4. Provident fund Deposits .

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EQUITY SHARES

»Equity shares are most common investment.

»Equity shares represent ownership in a
business.
»Traded on Stock Exchanges.
»Equity is one of the principal asset classes.
»The equity shareholders have residual claim
on assets of the company.

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BONDS

»A debt investment in which an investor loans

money to an entity (corporate or
governmental) that borrows the funds for a
defined period of time at a fixed interest rate.
»Bonds are commonly referred to as fixed-
income securities and are one of the three
main asset classes, along with stocks and
cash equivalents.

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 Mutual Funds

»Indirect way of investing into Assets classes.

»Mutual Funds are run by professional
managers.
»Benefit of diversification .

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Real Estate

»Can be purchased from borrowed money

» Capital appreciation of 5-10%
»Rent owned Property
»Real estate Mutual Funds are available .

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Money market Instruments
»The money market is used by participants as a
means for borrowing and lending in the short
term, from several days to just under a year.
»These are debt instruments
» Important money market instruments are :
»Treasury bills
»Commercial paper
»Certificate of deposits
»Repos .
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 Life Insurance

» Life insurance is a contract between an insured and

an insurer , where the insurer promises to pay
a beneficiary a sum of money (the "benefits") upon
the death of the insured person.
»Life-based contracts tend to fall into two major
categories:
»Protection policies
»Investment policies .

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Precious Objects

»Precious objects are items that are generally

small in size but highly valuable in monetary
terms
1. Gold and silver
2. Art objects
3. Precious stones
4. Gold ETF’s are available .

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Financial Derivatives
» A derivative is a financial instrument or a
financial contract, whose value is derived
from one or more underlying assets.
»The most common underlying assets include
stocks , bonds , commodities , currencies ,
interest rates and market Indexes
» Most important financial derivatives from the
point of view of investors are :
»Options
»Futures .
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Types of investors

»Individuals
»Institutions
» (a) Mutual Funds
» (b) Pension Funds
» (c ) Endowment funds (used by nonprofits org)
» (d) Insurance Companies
» (e) Banks

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Criteria for Evaluation

»For evaluating an investment avenue , the

following criteria are relevant
»Rate of return.
»Risk .
»Marketability/ Liquidity .
»Taxation .
»Investment horizons .

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 Rate of return

»The rate of return on an investment for a period (

which is usually a year ) is defined as follows

Rate of Return =
Annual income + ( Ending price – Beginning price)
Beginning Price
.

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Example
» Consider the following information about a certain
equity share :
» Price at the beginning of the year Rs 85
» Dividend paid towards the end of the year Rs 4.00
» Price at the end of the year Rs 98
» The rate of return on this share is calculated as follows
:
» 4.00 + ( 98- 85)
85

= 17/85 = 20%

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Risk

»The rate of return from investments like equity

shares , real estate silver and gold can vary
rather widely.
»The risk of an investment refers to the
variability of its rate of return.
»How much do individual outcomes deviate
from the expected value ?
»Measure used commonly in finance are as
follows

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»Variance : the is the mean of square deviations
of individual returns around their average value
»Standard deviation : this is square root of
variance
»Beta : this is how volatile is the return from an
investment relative to market swings.

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Marketability

»A measure of the ability of a security to be bought

and sold. If there is an active marketplace for a
security, it has good marketability.
»Share/stock, bond, etc that is listed on
an exchange and can be readily bought or sold.
»The ability and ease of an asset to be converted
into cash and vice versa.
»Securities that can be converted into cash quickly
at a reasonable price are called highly liquid or
marketable.
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»Adequate liquidity is usually characterized by
high levels of trading activity.
»High demand and supply of the security would
generally result in low costs of trading and
reduce liquidity risk .

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Taxation

»The investment decision is also affected by the

taxation laws of the land.
»Investors are always concerned with the net and
not gross returns and therefore tax-free
investments or investments subject to lower tax
rate may trade at a premium as compared to
investments with taxable returns.
» The following example will give a better
understanding of the concept:

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Taxation
Asset Type Expected Net Return
Return

10% taxable bonds (30% tax) 10% 10%*(1-0.3) = 7%

A

B 8% tax-free bonds 8% 8%

Although asset A carries a higher coupon rate, the net return for the
investors would be higher for asset B and hence asset B would trade at a
premium as compared to asset A.
In some cases taxation benefits on certain types of income are available
on specific investments. Such taxation benefits should also be
considered before deciding the investment portfolio.

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 TAXATION OF SECURITIES- INDV
Dividends CAPITAL GAINS
SHORT TERM LONG TERM DDT
EQUITY EXEMPT 15 .45% EXEMPT 15% DDT
applies on
dividends
MUTUAL
FUNDS
-Equity EXEMPT 15.45% EXEMPT NA
oriented
-Other than EXEMPT AS PER 10% without indexation or DDT
equity NORMAL RATES 20% with indexation which applies
ever is lower + 3% Cess
GOLD ETF EXEMPT AS PER 10% without indexation or DDT
NORMAL RATES 20% with indexation which applies
ever is lower + 3% Cess

FMP’s NA AS PER 10% without indexation or NA

NORMAL RATES 20% with indexation which 25
Investment horizon
» Length of time for which an investor expects
to remain invested in a particular security or
portfolio.
» The investment horizon is the deciding factor
for security selection .
» Investors with shorter investment horizons
should prefer assets with low risk, like fixed-
income securities,
» Longer investment horizons investors look at
riskier assets like equities .

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MUTUAL FUNDS
What is a Mutual Fund?

»It is a trust that pools the savings of several

investors
»Invests these into different kinds of securities
(shares, debentures, money market
instruments, or a combination of these) .
»Income thus generated and the capital
appreciation is distributed among unit holders
in proportion to the number of units held by
them.

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3
 Benefits of Mutual funds
Which Stock should I invest In ? Mutual Funds are run by
professional Managers who have
necessary skills for stock selection

How many shares can I really buy To achieve diversification : lets say
with Rs 1000 there 1000 investors who invest
INR 1000 with a fund, the total
amount with fund will be INR
10,00,000 they can now achieve
the diversification by purchasing
no of shares across various
sectors

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Lets say they buy 3 stocks
Company No of Cost per share Total Amount Rs
shares (Rs)
HDFC Bank 500 800 500* 800 = 4,00,000
RIL 225 1000 225*1000 = 2,25,000
TCS 250 1500 250* 1500= 3,75,000
TOTAL 10,00,000

How much of this you hold on pro-rata basis ?

Company Shares worth Rs shares you own
HDFC Bank 400 400/800 = .50
RIL 225 225/1000 = .225
TCS 375 375/1500= .25
1000
You could not have achieved this on your own as you would
have buy minimum 1 share in each case
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STRUCTURE

Regulator : Frames the rules and regulates the industry . Mutual Fund
are a highly regulated as they have been set up for small investors.
SEBI has strict regulation on fees , reporting standards and audits
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STURCTURE OF MUTUAL FUND
»SPONSORS : Sponsor is basically the promoter
of the fund.
»ASSEST MANAGEMENT COMPANY : A set of
Financial professionals who manage the fund
»TRUSTEES : Professionals who supervise the
activities of AMC.
»CUSTODIAN : keeps safe custody of
Investments and benefits Interest &dividends
»TRANSFER AGENTS : maintains record of unit
holders & provide services like purchase ,
transfer and redemption
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Structure of a mutual fund

SPONSOR Asset Management Company

AMC
The sponsor
initiates the idea AMC raises money from
to set up a mutual Investors and invest in
fund group of assets

Asset Management Company

SPONSOR AMC
`

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How do Fund raise money ?

»Mutual funds raise money by selling

units or shares of the fund to the public
, much as any other type of company
can sell shares of itself to the public.
»They then invest this money in various
investment vehicles such stocks ,
Bonds and Money market instruments

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What do Mutual Funds Invest In ?

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Net Asset Value ( NAV)

»The price of each unit is known as “ net asset

value” of the fund
»NAV on any day reflects the value of the
funds investment divided by number of units
issued by the fund
»Customer’s purchase and sale price per unit
is based on this amount

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 MF NAV Calculation

»NAV is thus combination of market value of all

investments in the portfolio including cash
and accrued income minus accrued expense

Market value of funds investment + Income accrued - Expenses accrued

NAV = No of units outstanding

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MF NAV Calculation
» XYZ Investments launches a Equity Fund.
» It raises Rs 150 crore by issuing 15 crore units of
funds at Rs 10 each.
» Post issue, investors can buy and sell from the fund.
» Suppose on a particular day, the number of units
outstanding were 15.5 crore, the market value all the
investments ( including cash) was Rs 178.25 crore ,
the dividend income accrued was Rs 1.5 crore and
expenses accrued totaled Rs 3.25 crore

»What is the NAV of each unit ?

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 NAV EXAMPLE

»Using the formula given below

Market value of funds investment + Income accrued - Expenses accrued

NAV = No of units outstanding

NAV = 178.25 + 1.5 -3.25

15.5

NAV = Rs 11.387

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Loads and commissions

»Entry load and front end load : Entry load or

front end load is the commission paid by the
investor while buy into the fund.
» Exit or back end load : Exit or back end load
is the commission paid while redeeming the
units (exiting ) from the fund
»Trail Commission : Distributor also receives a
Trail commission from AMC. This is paid on
the basis of net assets of the investors during
the period

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MUTUAL FUNDS IN INDIA

»Lets understand the types of mutual funds that

are available in India
»Mutual funds in India can be classified in india
based on

Mutual finds
in India

Investment Investment
Structure
Objective Plan

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»Mutual fund can be broadly classified on the
basis of structure into two categories as shown
below.
Based on
Structure

Open
ended fund

Close
ended fund

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OPEN ENDED FUNDS

»An open-ended fund or scheme is one that

remain open all the time. Investors can buy or
sell into the fund any time .
» These schemes do not have a fixed maturity
period. Fund corpus is not fixed
» Investors can conveniently buy and sell units
at Net Asset Value (NAV) related prices which
are declared on a daily basis.
»The key feature of open-end schemes is
liquidity.
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Open ended funds

»These funds cannot invest 100% of the funds

because of the need to maintain cash
reserves to provide for shareholder
redemptions in uncertain amounts
»The portfolio manager needs to be dynamic ,
he needs to strike a balance on two things.
»(a) Should he keep cash for redemptions ? or
»(b) Should he invest cash to generate returns
for the unit holders ?

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»The retail investors tend to behave in an
irrational behavior i .e they buy when the
markets are high and sell when the markets
are low
»The fund manager has to do the same thing
as well, to generate cash when you are
selling and invest when you are buying .
»This means he will buy when the markets are
high and sell when the markets are low but he
would ideally like to do the opposite

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CLOSE ENDED FUND

»The fund is open for subscription only once

and the corpus is fixed once the issue closes .
»Thereafter they can buy or sell the units of the
scheme on the stock exchanges where the
units are listed
»A close-ended fund are non redeemable ie
investors cannot buy or sell into the fund .
They have a stipulated maturity period.
»Investors cannot transact daily.

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»In order to provide an exit route to the
investors, some close-ended funds give an
option of selling back the units to the mutual
fund through periodic repurchase at NAV
related prices.
»SEBI Regulations stipulate that at least one of
the two exit routes is provided to the investor
ie either repurchase facility or through listing
on stock exchanges.
»These mutual funds schemes disclose NAV
generally on weekly basis.
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»FIXED CORPUS : As the corpus is fixed , the
fund manager is not subject to the vagaries
like in open ended fund.
»The fund manager knows exactly the cash he
has any time he can decide when to hold
cash and when to invest thereby using his
skills to maximize the returns for the unit
holders

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Classification on the basis of Investment

Growth/Equity oriented schemes

Income/Debt oriented scheme

Balanced Fund

Money Market or Liquid fund

Special Schemes, like Gilt , index

etc

Fixed Maturity Plans

INVESTMENT OBJECTIVE

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Growth/Equity oriented schemes
»These funds Invest a major part of their corpus in
equities.
»Such funds have comparatively high risks
»One should invest them for long to medium term
for capital appreciation.
HDFC equity
»Example Scheme- open
ended growth
scheme

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»Growth schemes can further be classified on the
based on the companies they invest in.

Large Cap / Mid Cap / Small Cap Funds

»These are classified on the basis market

capitalization of the individual stocks
» Big/large caps are companies which have a
market cap over 1000 crore.

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» Sectoral Funds these funds are at the highest end
of the risk spectrum as they mainly invest in one
sector. This could be in FMCG , telecom etc
»Example : SBI FMCG
Open ended equity
scheme

COMPANY ALLOCATION
ITC 44%
Hindustan lever 8%
Untied spirits 7%
Titan industries 3%
Others 38%
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Income/Debt oriented scheme

»The aim of income funds is to provide regular

and steady income to investors.
»Such schemes generally invest in fixed
income securities such as bonds: Corporate
debentures, Government securities and
money market instruments.
»Such funds are less risky compared to equity
schemes.
»These funds are not affected because of
fluctuations in equity markets.
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»However, opportunities of capital appreciation
are also limited in such funds.
» The NAVs of such funds are affected because
of change in interest rates in the country
» If the interest rates fall, NAVs of such funds
are likely to increase in the short run and vice
versa.
»However, long term investors may not bother
about these fluctuations

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»Income funds can be classified based on
tenor and nature of debt securities they invest
in.
Based on Tenor

Short /medium /long term

Dynamic/flexible

Example :Birla sunlife Dynamic Bond .open ended income fund

ICICI PRU long term , open ended income fund

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 Based on Debt
security

Gilt Funds : Invest only in Govt securities

Regular Funds : Invest in Corporate and Govt

securities

»Gilt Funds
»Kotak Gilt Inv Regular

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Example : Regular Fund

»Regular Fund : Baroda Pioneer Income fund

others
10%

G Sec G Sec
money market
43%
18% Corporate
money market
others

Corporate
29%

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Balanced /Hybrid schemes
»These schemes invest both in equities and fixed
income securities in a certain stable proportion .
» These will carry a higher risk as compared to
income funds but lower than growth fund .
»They generally invest 40-60 per cent in equity
and debt instruments.
» These funds are also affected because of
fluctuations in share prices in the stock markets.
»However, NAVs of such funds are likely to be less
volatile compared to pure equity funds.
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Example : Balanced Fund
»HDFC Balanced Fund , Open ended scheme
Cash and
cash equv, , 0
Debt, 5%
25.00% Equity
Debt
Cash and cash equv

Equity,
70.00%

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Money Market or Liquid fund

»These funds are at lowest end of risk spectrum.

»These schemes invest in very safer short-term
instruments such as T bills, CD’s issued by banks
, CP’s ( corporate) and inter-bank call money,
overnight call money market .
»These funds are also income funds and their aim
is to provide easy liquidity, preservation of capital
and moderate income.
»Returns on these schemes fluctuate much less
compared to other funds.
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»These funds are appropriate for corporate and
individual investors as a means to park their
surplus funds for short periods.
»UTI Money Market Fund
cash and short term
cash eqv deposit short term deposit
7% 8%
Certificate of
Certificate deposit
commercial of deposit commercial paper
paper 42%
43%

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Index Funds

»These are the funds that invests in shares

comprising of a benchmark index or sectoral
index .
»Their performance will almost mirror the
performance of the respective index
» NAVs of such schemes would rise or fall in
accordance with the rise or fall in the index,

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 Example : Index Fund

Franklin India BSE Sensex Fund : Open ended equity scheme

RETURNS
Fund Return % Sensex %
As of 17 Jul 2013

1-week 3.03 3.39

1-month 3.25 3.22
3-month 6.88 6.5
1-year 16.66 16.62
2-year 3.73 3.65
3-year 3.75 3.56

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Principal protected / Capital Guaranteed

»The investor is assured that he will at least

get his initial investment amount back at the
time of maturity of the scheme.
»The funds' investments are structured in such
a way that this protection is assured
»These funds invest a portion of the portfolio
in debt securities (usually secured) that
mature to the principal value of the fund.
»The balance is invested in the equity markets.

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»The money is allocated between debt and
equity in such a way that the principal amount
is recoupable and does not get eroded in case
of negative market swings

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Example : Capital Guaranteed

Amount Invested in Return

Invest Rs 700 in 5 year The amounted invested

in high rated corporate in bonds will generate
bonds at 9% and hold a return of Rs 315 .
them till maturity Which recoups the
principal amount
Rs 1000
The balance Rs 300 is Even if the equity
invested in Equity to shares do not perform
generate better returns and go to Zero , still
the principal is
protected to Rs 1000

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Fixed Maturity Plans

»Simply put, fixed maturity plans (FMPs) are

the mutual fund industry’s version of fixed
deposits (FDs).
»Over time, they have established a place in
the portfolios of debt fund investors.
»Savvy investors sometimes do away with FDs
and replace them with FMPs.
» So what is it about FMPs that makes it so
appealing to investors and how do they differ
from FDs?
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»FMPs are close-ended debt funds.
» Investments can be made in them only during
the new fund offer period.
» FMPs invest in debt instruments issued by
corporate and their investments have a
maturity that coincides with the maturity of
the FMP.
»Hence the name - fixed maturity plans.

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Taxation of FMP’s

» Taxation: FMPs also differ from FDs in tax

treatment of income.
»In FDs, the interest income is added to the
investor’s income and is taxable at the
applicable tax slab, also known as the
marginal rate of tax.
»FMP Returns are treated as capital gains
(short-term or long-term depending on the
investment tenure).

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»long-term capital gains (if investments are
held for more than 365 days), the tax liability
is determined based on the lower of with
indexation (charged at 20% plus surcharge)
and without indexation (charged at 10% plus
surcharge).
»With the indexation benefit, FMPs end up
delivering more tax efficient returns than FDs.

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TYPES OF MUTUAL FUND : INVESTMENT PLAN

»The classification based on Investment plan is

as follows
1. Growth Plan
2. Dividend Plan
3. Systematic Investment Plan

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Growth Plans

»These are the plans where the fund

automatically reinvests the returns made by
you into the Fund.
»This is good for those investors who have a
long term horizon and not interested in
regular income .
»Example : Birla sunlife Top 100-G…open ended
scheme

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Dividend Plan

»These are the plans where the returns are

distributed in the form of dividend back to the
investor at regular intervals.
»This is good for those investors who want
regular income . Thus is a better investment
at time of retirement or if you want to
supplement your income.
»Example : Axis Equity-Dividend ..open ended
scheme

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Systematic Investment Plan ( SIP)

»Under a SIP money is invested by the investor

in committed installments over a certain
period.
»For example Rs 2500/- every month over next
12 months
»SIP helps one to cover both ups and downs
across the period .
»It also helps in getting better weighted
average cost to the investors

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EXCHANGE TRADED FUNDS (ETF’S)

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»A security that tracks an index, a
commodity or a basket of assets like
an index fund, but trades like a stock
on an exchange.
» ETFs experience price changes
throughout the day as they are bought
and sold.

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»Exchange Traded Funds (ETFs) represent a
basket of securities that is traded on an
exchange, similar to a stock.
» Hence, unlike conventional mutual funds, ETFs
are listed on a recognised stock exchange and
their units are directly traded on stock exchange
during the trading hours.
» In ETFs, since the trading is largely done over
stock exchange, there is minimal interaction
between investors and the fund house.

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54
55
56
»ETFs are either actively or passively managed.
Actively managed ETFs try to outperform the
benchmark index, whereas passively-managed
ETFs attempt to replicate the performance of a
designated benchmark index.

57
BONDS BASICS
BONDS
» A bond is a fixed income security (debt instrument)
that typically carries
1. A specific rate of interest called coupon rate that
the bond issuer agrees to pay to the bond holder
2. And the promise to repay the principal at maturity
It as a loan taken by the issuer of the bond. The
bond certificate is the proof of borrowing or a
promise to repay

Bonds are traded in India are primarily OTC ( over the counter)
There are bonds traded on the stock exchange also to
encourage retail participation

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 COUPON RATE

» A Coupon is the payment that is paid to the

bond holder during the time between when
the bond is issued and when it matures.
»It is the rate of interest which is promised by
the issuer while floating the bonds in the
primary market.
» The bond issuer pays the bond holder at
certain frequency. Normally the coupon is
paid semi-annually or annually.
Example : XYZ ltd issued Rs 100 face value, 9% annual coupon 5 year bonds on
15th July 2013. Here the bond holder will keep getting a constant amount Rs 9/- annually
till 2018 irrespective of the market Price of the bond. The payment contracted
at the time of issuing bond is called the coupon
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Types of Coupon

• They have a constant

Fixed rate coupon rate throughout the
life of the bond

• They have coupon rates that vary

Floating based on market interest rate or
specific index (we call it reference
rate rate) over the life of the bond

• They do not have periodic interest.

Zero The issuer simply pays the par value
at the maturity. The zero-coupon
Coupon bonds are sold at a substantial
discount to par value.

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Yield

»A Yield is a rate that shows the return you get on

a bond in the secondary market.
»The basic yield formula is:
»Yield = coupon amount / price.

At the time when the bonds are issued in the primary market,
the return to the investor is the coupon rate…i.e. the percentage
Of face value.
Thereafter the bond is traded in the secondary market , the
Investor pays price different from the face value. hence his return
at that time is : Coupon amount / price
The return will be different from the coupon rate as he has
invested different amount than the face value

5
»Market price of the bond keeps varying, the yield
in the market also keep varying

The coupon of the bond

remains the same through
out's life but the yield
keeps changing based on
the prevailing market price

Let me explain this through an example .

You buy a 1 Year bond that gives a coupon of
9% annually at a face value of Rs 100 . What
is your return or yield ? …9% So , coupon
and yield are the same when the bond is issued

6
»Now let’s say the 1 year interest rate in market
falls to 7% what does this mean ?
»This means that if a fresh bond is issued , it
can be issued at only at 7%
»So now we have 2 bonds , one with a coupon
of 9% and another with 7%.
»Which bond will command higher price in the
market – Of course the 9% bond , as it gives
you a fixed annual cash flow of Rs 9 as
opposed to 7% bond
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»Every one think the same way, and want to
buy the 9% bond will then go up , but by how
much ? The price will go up in such a way
that the return (yield) on this bond will also be
7% .
»Therefore , the price has to now increase such
that coupon of Rs 9 gives a return of 7%on
this price.
»That price will be Rs 128.5 ( 9/128.5 = 7%)

8
»This shows two things
»All 1 year bonds will now yield of 7%
irrespective of coupon as this is the prevailing
market interest rate for 1 year
»As prevailing market interest rate (yield) goes
down the bond prices goes up and vice –
versa . Hence bond price and yield have an
inverse relationship

9
Yield to maturity (YTM)

»YTM measures the annual return earned of an

investor if he holds this bond until maturity, it
is essentially the IRR.
»If the investor buys a bond today at market
price and he holds the bond until maturity,
assuming all the coupons and principal will
be received as scheduled, he will receive a
rate of return equal to the YTM (or the IRR).
Put very simply, if one were to buy the bond at the market price
and hold it to maturity , the total return on your investment
considering all returns is YTM .

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»The following equation will help us
understand the YTM as it relates to the market
price of a bond.
»Note that the final cash flow should include both
the principal and the coupon.

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»If the YTM is less (greater) than the bond’s
coupon rate, the market price is greater (lesser)
than the par value, and we say the bond is
selling at a premium (at a discount).
»If YTM is more than the coupon rate, we say the
bond is selling at a discount. If the YTM is equal
to the coupon rate, the bond is trading at its par
value (selling at par).

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SELF CHECK

»Consider a 10 year bond with 10% coupon ,

which has a yield of 8% . If the market interest
rate rises by 100 basis points , what will happen
to the price of the bond ? Click the correct option
from those given below
»(a) lower
»(b) will remain the same
» (c ) Higher
»(d) None of the above

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SELF CHECK

»Consider a 10 year bond with 10% coupon ,

which has a yield of 8% . If the market interest
rate rises by 100 basis points , what will happen
to the price of the bond ? Click the correct option
from those given below
»(a) lower
»(b) will remain the same
» (c ) Higher
»(d) None of the above

14
YIELD CURVE

»If we were to plot the market yield for a bond

for each tenor 1 year , 2 years , 3 years , 5
years , 10 years at any point in a graph , we
get a graph called yield curve
»A yield curve gives the relationship between
interest rate and term to maturity , at a
specified time

Slope of the yield curve

is a reliable predictor of future
real economic activity

15
POSITIVE YIELD CURVE
A positive yield curve is a curve where interest rate for
shorter maturities are lower than the rates for longer
maturities

Y
I
E
L
D

A normal yield curve is upward-sloping and shows

higher yieldTENOR
for longer maturity due to the risks
associated with the passage of time. ( liquidity premium for
a longer holding period). 16
NEGATIVE YIELD CURVE
A negative yield curve is a curve where interest rate for
shorter maturities are higher than the rates for longer
maturities

Y
I
E
L
D

However,
TENORthe yield curve can be inverted and
downward-sloping if the economy is expected to slow
or a recession is imminent. 17
FLAT YIELD CURVE
A Flat yield curve is a curve where interest rates are the
same across maturities

Y
I
E
L
D

It may reflect widespread uncertainty about the future of

TENOR
Interest rate and economy as a whole
18
SELF CHECK

»What does the current shape of the yield

curve imply about the market's expectation
for economic growth?
» When the economy is good, the yield curve is
increasing upward. However, the yield curve is
inverted when the economy is bad.

Yield Curve:
Economy Good = Increasing Upward
Economy Bad = Inverted

19
SELF CHECK

»A yield curve depicts the relationship between

yield and:
»a. Safety
»b. Maturity date
» c. Risk
»d. Coupon rate
»e. Price

20
SELF CHECK

»A yield curve depicts the relationship between

yield and:
»a. Safety
»b. Maturity date
» c. Risk
»d. Coupon rate
»e. Price

21
Self Check

»The Yield to Maturity of a bond is,

»(a) same as coupon if the bond at the face value
»(b) the interest payable on the bond
»(c ) Return on the bond in the secondary market
»(d) a & c

22
Self Check

»The Yield to Maturity of a bond is,

»(a) same as coupon if the bond at the face value
»(b) the interest payable on the bond
»(c ) Return on the bond in the secondary market
»(d) a & c

23
CREDIT RATING
Government of India wants to issue a 10 year bond to borrow money .
The current 10 year yield on government bond is 8% .
The coupon on the new bond , will be around 8%

Now if any company say Tata Motors comes to the market to issue
A 10 year Bond …..At what rate can they raise money

At more than 8% , as the risk a investor faces when he buys Tata

Motor;s bond is higher than investing in Government bond. Let’s
Say 9 %

Now DLF comes to the market and issues a 10 year bond . At what
Can it issue the bond ? It will depend on credit rating of DLF

24
CREDIT RATING AGENCIES

»There are crediting rating agencies who rate the

companies on the basis of risk. They are experts
in evaluating the credit default risk.
»AAA is the highest rating for long term bonds
followed by AA+ , AA , A , B , BB , BBB so on
»Some of the Indian and international rating
agencies are as follows :
CREDIT RATING AGENCIES
Moody’s ICRA
Standard and Poor's CARE
Fitch CRISIL
DBRS SMERA
25
»Hence If Tata Motors is AAA rated and DLF
BB, then we know which carries more risk
and thereby by higher coupon.
»It is now mandatory for companies to get their
issue rated before they come to the market

26
BOND MARKET

27
Classification of Bonds

»Bonds can be classified based :

(a ) Type of issuer
(b) The bond characteristics
BONDS

Bond
Types of issuer
characteristics

Government Callable/Puttable Convertible

Corporate bonds
bonds bonds Bonds

28
BY ISSUER : GOVERNMENT BONDS
»These bonds are issued by the government of a
country , to fund their fiscal deficit. These bonds
are called by different names in different countries
»In India they are called G- secs or Gilts. They are
very safe investments as they are backed by the
Government
»G-secs are available for maturities as high as 30
years . These bonds require high investment and
the market is therefore limited to Institutional
players . Individuals therefore invest through
mutual funds
29
BY ISSUER : CORPORATE BONDS

»Companies issue bonds to finance operations

and expansion plans .
»They are comparatively cheaper than to raise
money through borrowing from banks
»These bonds must be rated by a rating agency
before they issue, 'AAA', which is the highest
grade, to 'C' ("junk"), which is the lowest
grade. They rate the bond issuer’s ability ,
based on risk factors , to make timely
repayment of Principal and interest.

30
»They are traded primarily OTC like G-secs ,
though a few are listed on the stock exchange

31
BONDS CHARACTERSICS
CALLABLE BOND

»Bonds can also be based on their characteristics

»Lets say L & T ltd issues a 5year bond. It has a
feature by which , the company can buy back the
bond from the investor , any time after 3 years
and return the money
»Now why would a company have such a feature ?
In case the company is expecting interest rates to decline in the
Future , they want the option to repay the bonds that carry a high
Coupon They can then issue fresh bonds at a lower coupon ( at
The prevailing market rate)

32
BONDS CHARACTERSICS
PUTAABLE BOND

»Puttable bond gives the right to the investor to

sell the bond back to the issuer prior to maturity
»When this will happen ?

When the market yield is higher than the coupon , the investor
Will sell the lower coupon bonds held by him and use the money to
Buy bonds in the market at the prevailing yield

33
Convertible Bonds

»A bond that can be converted into a

predetermined amount of the company's
equity at certain times during its life, usually
at the discretion of the bondholder.The
conversion ratio and price are defined in the
initial contract terms at issuance.
»These are popular as the give the investor the
opportunity to convert to common stock if the
company is doing well , or to retain the
instrument as bond with a fixed coupon

34
»Convertible bonds carry a lower coupon
because of the obvious benefit to the
investors.
»In India , Corporate bonds tend to be
mandatorily convertible after a period.

35
SELF CHECK

»Reliance issues a 10 year Callable ( after 5

years) Bond at 8% coupon in 2008 . The
estimated market yields are given below
»According to you when the company should call
back the bonds ? what will be the gain ?

1 2 3 4 5 6 7 8

YEAR 2008 2009 2010 2011 2012 2013 2014 2015

YIELD 8% 8.5% 9% 9.5% 9% 8% 6.5% 7%

36
SELF CHECK

»Reliance issues a 10 year Callable ( after 5

years) Bond at 8% coupon in 2008 . The
estimated market yields are given below
»According to you when the company should call
back the bonds ? what will be the gain ?

YEAR 2008 2009 2010 2011 2012 2013 2014 2015

YIELD 8% 8.5% 9% 9.5% 9% 8% 6.5% 7%

In the year 2014 it will result in saving of 1.5%

37
Models of Risk and
Return

Parvesh Aghi
CONCEPT

• Higher Expected Returns Require Taking

Higher Risk
• Most investors are comfortable with the
notion that taking higher levels of risk is
necessary to expect to earn higher returns.
• There are two important models that have
been developed to make this relationship
precise. They are
1. CAPITAL ASSET PRICING MODEL
2. ARBITRAGE PRICING MODEL

2
CAPITAL PRICING ASSET MODEL

A model that describes the relationship

between risk and expected return and
that is used in the pricing of risky
securities.
In this model, a security’s expected
(required) return is the risk-free rate
plus a premium based on the systematic
risk of the security

3
CAPM MODEL

Rs = Rf + bs(Rm - Rf)

Rs = Expected return of stock S

Rf = Risk free return
bs = Beta relative to market portfolio

4
As per CAPM the investors needs to be
compensated in two ways: time value of
money and risk

The time value of money is represented by

the risk-free (Rf ) rate in the formula and
compensates the investors for placing money
in any investment over a period of time

5
The other half of the formula represents risk
and calculates the amount of compensation
the investor needs for taking on additional
risk.
This is calculated by taking a risk measure
(beta) that compares the returns of
the asset to the market over a period
of time and to the market premium (Rm-Rf ).

6
The CAPM says that the expected return of a
security or a portfolio equals the rate on a
risk-free security plus a risk premium.

If this expected return does not meet or beat

the required return, then the investment
should not be undertaken.
The security market line plots the results of
the CAPM for all different risks (betas).

7
Security Market line

8
CAPM ASSUMPTIONS

1.Capital markets are efficient.

2. All investor are rational, risk averse and broadly diversified
across a range of investments. They cannot influence prices.
Trade without transaction or taxation costs.
3. Risk-free asset return is certain.
4.Market portfolio contains only systematic risk
5. Assume all information is available at the same time to all
investors.
6. Investors have no access to private information
( allowing them to find undervalued or valued stock)

9
Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk is the variability of return on stocks or

portfolios associated with changes in return on the
market as a whole.

Unsystematic Risk is the variability of return

on stocks or portfolios not explained by
general market movements.
It is avoidable through diversification

10
UNSYSTEMATIC RISK

11
SYSTEMATIC RISK

12
What is BETA ?

Beta is used in the capital asset pricing model

(CAPM), a model that calculates the expected return of
an asset based on its beta and expected market returns

Rs = Rf + bs(Rm - Rf)

A measure of the volatility, or systematic risk, of a

Security or a portfolio in comparison to the market as
a whole

13
Beta is calculated using regression analysis,
and you can think of beta as the tendency
of a security's returns to respond to swings
in the market.
It measures the sensitivity of a stock’s returns to
changes in returns on the market portfolio

The beta for a portfolio is simply a weighted

Average of the individual stock betas in the
portfolio.
14
A beta of 1 indicates that the security's price
will move with the market.
A beta of less than 1 means that the security
will be less volatile than the market.
A beta of greater than 1 indicates that the
security's price will be more volatile than
the market.
For example, if a stock's beta
is 1.2, it's theoretically 20% more volatile than
the market.

15
BETA FORMULA

Beta : It is the ratio of covariance between

the market return and the security’s
return to the market return variance .

16
 Calculating “Beta”
YEARS MARKET RETURN XYZ LTD RETURNS

Rm (%) Rx (%)

1 20 25

2 -18 -32

3 40 55

4 -8 -13

5 36 45
 ESTIMATION OF BETA
YEA MARKET XYZ LTD Market Stock
RS RETURN Rx % Deviation deviation (4) X (5) (Rm-Rm )²
% Rm-Rm Rx -Rx

(1) ( 2) (3) (4) (5) (6) (7)

1 20 25 6 9 54 36

2 -18 -32 -32 -48 1536 1024

3 40 55 26 39 1014 676

4 -8 -13 -22 -29 638 484

5 36 45 22 29 638 484

Rm=14 Rx=16 Sum= Sum=

Mean Mean 3880 2704
Beta Calculation

Multiply deviations of the market returns and

deviations of XYZ Ltd (column 6).
Take the sum and divide by 5 (no of observations) to
get covariance
COV m x = 3880/5 = 776

Calculate the squared deviations of the market returns

(column 7) Take the sum and divide by 5 to find the
variation of market return.
= 2704/5 = 540.8

Divide the covariance of the market and XYZ Ltd by the

Market variance to get beta
Beta = β = 776/ 540.8= 1.434 .
19
INTERCEPT

The intercept term is given by the following formula

α = Rx – βxX Rm
Rx= expected return on security x
Rm= is the expected market return
α = return on security on account of unsystematic risk

α = 16 – 1.434 X 14
= 16 – 20.076
= - 4.076 % is the return from unsystematic risk
Thus the characteristic line of XYZ Ltd is :
Rx = -4.076 + 1.434 Rm

20
We can plot the observed returns on market and
XYZ ltd and fit A regression line as shown in the
figure . The fitted line is as per the equation A ,
the regression line as per the market model is called
The characteristics line

Security characteristic line (SCL) is a regression line,

plotting performance of a particular security or
portfolio against that of the market portfolio at every
point in time .The SCL is plotted on a graph where the
Y-axis is the return and the X-axis is the
return of the market in general.

21
Security Characteristic line

XYZ LTD RETURN

Rx = -4.076 + 1.434 Rm

Characteristic line

Slope = beta

MARKET RETURN

Characteristic Line
Security Characteristic line

The slope of the line is the security's beta, which is a

measure of systematic risk, determines the
risk-return tradeoff.

According to this metric, the more risk you take on

-as measured by variability in returns - the higher the
returns you can expect to earn.

23
The Market Model

There is another proceedure for calculating Beta is the

use of the Market or Index model
In the market model, we regress returns on a security
against returns of the market index

The market model is given by following equation

Where Rx is the expected return on security x , Rm is
the market return. α is intercept , beta is the slope and
e is the error.
R   b R e
x x m x

Return = Unsystematic Risk (α) + Systematic risk (β )

24
 Rx    b x Rm  ex
Equation A

Rx= expected return on security x

Rm= is the expected market return
α = is intercept ,
β= slope of regression or beta
ex = is the error term

α Is indicates the return on the security when the

market return is zero . It could be interpreted as
return on security on account of unsystematic risk

25
The value of β and α in the regression are given
by the following equations

Beta = β = N ∑XY – (∑X) ( ∑Y)

N ∑X² - ( ∑ X)²

26
 MARKET STOCK
Year RETURN RETURN X Y XY X² Y²
1 20 25 6.00 9.00 54 36 81
2 -18 -32 -32.00 -48.00 1536 1024 2304
3 40 55 26.00 39.00 1014 676 1521
4 -8 -13 -22.00 -29.00 638 484 841
5 36 45 22.00 29.00 638 484 841
14.00 16.00
0 0 3880 2704 5588

∑X=0 ∑y=0 ∑XY=3880 ∑X²=2704

∑X²=0 N∑XY= 19400

= 19400- 0 = 19400 = 1.43

5X 2704 13520
27
Risk free returns = Rf

A risk-free asset is one where the investor knows

The expected return with certainty.
Therefore an asset is risk free whose actual returns
be equal to the expected return …..

In valuation, the time horizon is generally infinite,

leading to the conclusion that a long-term riskfree
rate will always be preferable to a short term rate, if
you have to pick one.

Ten year G-secs can be considered as Risk free

asset for CAPM

28
Risk Premium = (Rm-Rf)

The risk premium in the capital asset pricing model

measures the extra return that would be demanded by
investors for shifting their money from a riskless
investment to an average risk investment
The difference between the expected return on a
market portfolio and the risk-free rate.

Risk premium is the minimum amount of money by

which the expected return on a risky asset must
exceed the known return on a risk-free asset, or the
expected return on a less risky asset, in order to
induce an individual to hold the risky asset rather
than the risk-free asset .
29
APT

Arbitrage Pricing Theory

1976, Economist Stephen Ross

assume:
several factors affect E(R)
does not specify factors

30
MACRO ECONOMIC FACTORS

Implications
E(R) is a function of several Macro
Economic factors, F each with its
own b .
E( R )  R f  b1F1  b2 F2  b3F3  ....  bN FN

31
APT vs. CAPM

APT is more general

many factors
unspecified factors
CAPM is a special case of the APT
•1 factor
•factor is market risk premium
•It captures an assets exposure
to all market risk in one number ..Beta but at
the cost of making restrictive assumptions
•APM relaxes these assumptions.
•It allows for multiple sources of market risk
and asset to have different beta to source of
Market risk

32
CONCLUSION

The CAPM, with its inherent simplicity, linking

market covariance risk to expected returns.

Its simplicity helps to build intuition around the

concept of modelling return as a function of risk.

The CAPM’s simplicity is also its greatest

shortcoming, as the underlying assumptions limit its
ability to explain and predict actual returns.

APM expands the capabilities of the model by adding

company specific risk factors - These factors in
concert explain most of the returns due to risk expos

33
Arbitrage pricing theory (APT)

APT is a general theory of asset pricing that holds

that the expected return of a financial asset can be
modelled as a linear function of various
macro-economic factors , where sensitivity to changes
in each factor is represented by a factor-specific
beta coefficient.

The model-derived rate of return will then be used to

price the asset correctly - the asset price should
equal the expected end of period price discounted
at the rate implied by the model. If the price
diverges, arbitrage should bring it back into line .

34
Sensex market return 2002-13 = 15%

35
10 year Govt Bond ( 2002-13) = 8%

36
»Market risk premium= Rm-Rf = 15% -8% =7%

»-

37
PORT FOLIO
THEORY

Parvesh Aghi
If you were to craft the perfect investment, you would
probably want its attributes to include high returns
coupled with low risk. The reality, of course, is that this
kind of investment is next to impossible to find.
Not surprisingly, people spend a lot of time developing
methods and strategies that come close to the
"perfect investment".

But none is as popular, or as compelling, as modern

portfolio theory (MPT). Here we look at the basic ideas
behind MPT, the pros and cons of the theory, and
how MPT affects the management of your portfolio

2
MODERN PORTFOLIO THEORY (MPT)

MPT was originally developed by Dr Harry Markowitz in 1952

Further developed by others including Dr William Sharpe & Dr Merton
Miller. The three were awarded the noble prize in Financial Economics

MPT created a standard framework for evaluating risk and return.

Has become the foundation for modern day professional management

MPT is a theory and it relies on assumptions that are not always

realistic

It is not used for making precise predictions . It is used to establish

range of reasonable expectations

3
MODERN PORTFOLIO THEORY (MPT)

MPT is a framework for evaluating risk and return. A theory on how

risk-averse investors can construct portfolios to optimize or maximize
expected return based on a given level of market risk, emphasizing
that risk is an inherent part of higher reward.

It assumes that large samples of data will form a normal distribution

and exhibit central tendency.

For any normal distribution data is disbursed around mean in a certain

way and mean is the most common value

The dispersion can be measured by Standard Deviation , which

represents uncertainty , volatility or risk

4
NORMAL DISTRIBUTION

Central Tendency theory : As a sample of data increase in size , the

Observations will increasingly concentrate around a central value

5
NORMAL DISTRIBUTION

6
NORMAL DISTRIBUTION

7
MODERN PORTFOLIO THEORY (MPT)

»The portfolio
A portfolio theory
is a bundle provides
or a combination a normative
of individual assets
or securities to investors to make decisions to invest
approach
their wealth in assets or securities under risk.
The portfolio theory provides a normative approach to investors
to make decisions to invest their wealth in assets or securities
under risk.

It is based on the assumption that investors are risk-averse.

The second assumption of the portfolio theory is that the
returns of assets are normally distributed

8
MODERN PORTFOLIO THEORY (MPT)

Very broadly , the investment process consists of two tasks .

The first task is security analysis which focuses on assessing the
risk and return characteristics of the available instruments.

The second task is portfolio selection which involves choosing

the best possible portfolio from the set of feasible portfolios.

Now we will discuss how investors can construct the best

possible risky portfolio with the help of efficient diversification

9
Diversification and portfolio risk

Let us understand intuitively how diversification influences risk.

Suppose you have Rs 1,00,000/- and you want to invest it equally

in stock A and stock B

For simplicity sake lets assume five states of economy are

equi-probable

10
Probability distribution of returns
State of Probability Return of Stock Return of Stock
economy A B

1 .2 15% -5%

2 .2 -5% 15%

3 .2 5 25

4 .2 35 5

5 .2 25 35

11
 EXPECTED RETURN OF PORTFOLIO
State of Probability Return of Return of Return of
economy Stock A Stock B Portfolio

1 .2 15% -5% 5%

2 .2 -5% 15% 5%

3 .2 5 25 15%

4 .2 35 5 20%

5 .2 25 35 30%

How the return of portfolio has been computed :

50% X 15% + 50% X -5% = 5% , 50% X -5%+ .50%X15% = 5% and so on

The return of a portfolio is equal to the weighted average of the returns of

individual assets (or securities) in the portfolio with weights being equal to the
proportion of investment value in each asset. 12
 Expected Return of the Portfolio
State of Probability Return of Return Return of Expected
economy Stock A of Portfolio return of port
Stock folio
2 B 5
(2X5)
1 .2 15% -5% 5% 1

2 .2 -5% 15% 5% 1

3 .2 5 25 15% 3

4 .2 35 5 20% 4

5 .2 25 35 30% 6

EXPECTED RETURN OF PORTFOLIO 15%

13
 Expected Return and Standard Deviation

Expected Return
Stock A .2 (15%)+.2 (-5%)+.2(5%)+.2(35%)+.2(25%)= 15%
Stock B .2 (-5%)+.2 (15%)+.2(25%)+.2(5%)+.2(35%)= 15%

Portfolio of A an B .2 (5%)+.2 (5%)+.2(15%)+.2(20%)+.2(30%)= 15%

Standard Deviation
Stock A .2( 15-15)2+ .2(-5-15)+.2(5-15)+.2(35-15)+.2(25-15)=200
A
(200 )½ 14.14%
A
Stock B .2( -5-15)+.2(5-15)+.2(15-15)+.2(20-15)+.2(30-15)=200
(200 )½= 14.14%
Portfolio (A+B) .2(5-15)+.2(5-15)+.2(15-15)+.2(20-15)+.2(30-15)= 90
(90 )½= 9.49%
14
Last slide shows that if you invest only in stock A , the expected
Return is 15% and the standard deviation is 14.4%.
Like wise if you invest only in stock B , the expected return is
15% and standard deviation is 14.4%

What happens if you invest in a port folio consisting of stock A

and Stock B in equal proportions ? While the expected return
remains 15% , the same as that of either stock individually ,
the standard deviation of the port folio returns 9.49% , is lower
Than that of each stock individually .
Thus diversification reduces risk

15
In General , if returns on securities do not move in perfect
lockstep , diversification reduces risk.

In technical terms , diversification reduces risk if returns are

not perfectly positively correlated The relation ship between
diversification and risk is shown graphically in the next slide.

As more and more securities are added , the portfolio risk

decreases , but at a decreasing rate and reaches a limit

16
Relationship between diversification & Risk

Firm specific risk

Market risk

17
Market risk versus Unique risk
Notice that the portfolio risk does not fall below a certain level ,
irrespective of how wide the diversification is.

To understand this we must know that when we invest in securities

we assume two kinds of risk
Total risk= Unique risk + Market risk

The Unique risk of a security represents that portion of its total

risk which stems from the firm specific factors like the development
of a new product , a labour strike, or the emergence of a new
competitor . Events of this nature primarily affect the specific firm
and not all firms in general

18
Market risk versus Unique risk
Hence , the unique risk of a stock can be washed away by combining
it other stocks. In a diversified portfolio unique risks of different stocks
tend to cancel each other favorable development in one firm may
offset an adverse happening in another and vice versa . Unique risk
is also referred to as diversifiable risk or unsystematic risk

The market risk of a stock represents that portion of its risk which is
attributable to economy wide factors like the growth rate of GDP
, the level of government spending , money supply, interest rate s
tructure and inflation rate

Since these factors affect all firms to a greater or lesser degree , investors
cannot avoid the risk arising from them , however diversified their
portfolios may be . Hence it is also referred to as systematic
risk or non diversifiable risk

19
Portfolio return and risk

Portfolio Expected Return : the expected return on a portfolio

is simply the weighted average of the expected returns on the
individual securities in the portfolio.

Example A portfolio consists of four securities A,B, C and D

with expected returns of 12%, 15% 18% and 20% respectively.
The proportions of portfolio value invested in these securities
are .20, .30, .30, and .20 respectively

The expected return on the portfolio is :

ER = .20(12%)+.30(15%)+ .30(18%)+ .20(20%)=16.3%

20
Portfolio Risk Just as the risk of an individual security is
measured by the variance (or Standard deviation) of its return,
the risk of a portfolio too is measured by the variance or
standard deviation of its return.

Although the expected return on a portfolio is the weighted

average of the expected returns on the individual securities in
the portfolio , port folio risk is not the weighted average of the
risks of the individual securities in the portfolio

Thanks to this inequality , investors can achieve the benefit

of risk reduction through diversification

21
What Does Covariance Mean?
A measure of the degree to which returns on two risky assets move in
tandem.

A positive covariance means that asset returns move together.

A negative covariance means returns move inversely.

One method of calculating covariance is by looking at return

Surprises (deviations from expected return in each scenario.
Another method is to multiply the correlation between the two
variables by the standard deviation of each variable.

22
Possessing financial assets that provide returns and have a high
covariance with each other will not provide very much diversification.

For example, if stock A's return is high whenever stock B's return
is high and the same can be said for low returns, then these stocks
are said to have a positive covariance.
If an investor wants a portfolio whose assets have diversified
earnings, he or she should pick financial assets that have low
covariance to each other.

23
What Does Correlation Coefficient Mean?
A measure that determines the degree to which two variable's
movements are associated.

The correlation coefficient is calculated as:

Correlation Coefficient
The correlation coefficient will vary from -1 to +1. A -1
indicates perfect negative correlation, and +1 indicates
perfect positive correlation

24
25
Types of correleationships

26
Total Risk of A & B DOES NOT EQUAL to ( Risk of A )+ (Risk of B)

Total Risk of A & B = (Risk of A )+ (Risk of B) + (Correlation of A & B)

27
Portfolio Risk: Two-Asset Case
» The portfolio variance or standard deviation depends
on the co-movement of returns on two assets.
Covariance of returns on two assets measures their
co-movement.
» The formula for calculating covariance of returns of
the two securities X and Y is as follows:
» Covariance XY = Standard deviation X ´ Standard
deviation Y ´ Correlation XY
» The variance of two-security portfolio is given by the
following equation:
 p2   x2 wx2   y2 wy2  2wx wy Co varxy
  x2 wx2   y2 wy2  2wx wy x y Corxy
» P = Variance of the portfolio
Wx and Wy are the weights of securities

29
Efficient frontier

»Different combinations of securities produce

different levels of return.
»The efficient frontier represents the best of
these securities combinations -- those that
produce the maximum expected return for a
given level of risk.
» Every point on the efficient frontier, there is at
least one portfolio that can be constructed from
all available investments that has the expected
risk and return corresponding to that point.

30
Efficiency frontier

Suppose an investor is evaluating two securities A and B

Coefficient
Expected Standard of
Return deviation correlation

Security A 12% 20% -0.2

Security B 20% 40%

31
The investor can combine securities A and B in a portfolio in a number of ways by
simply changing the proportions of funds allocated to them
Standard
PROPORTION PROPORTION Expected Deviation
PORTFOLIO A B return

1(A) 1 0 12.00% 20.00%

2 0.9 0.1 12.80% 17.64%

3 0.759 0.241 13.93% 16.27%

4 0.5 0.5 16.00% 20.49%

5 0.25 0.75 18.00% 29.41%

6(B) 0 1 20.00% 40.00%

32
 Efficiency Frontier
0.25

0.2 B
5

4
0.15
Return

A
0.1 2

0.05

0
0.00% 10.00% 20.00% 30.00% 40.00% 50.00%
Risk ( STANDARD DEVIATION )

33
»The six options described are plotted graphically
A few important points about this graph may be
noted.
1. The benefits of diversification arises when the
correlation between the two securities is less
than 1. Because the correlation between the
securities is -.20 , the effect of diversification
can been seen by comparing the curved line
between points A and B
2. Portfolio 3 represents the minimum variance
portfolio
34
3. The investor considering a portfolio of A and B
faces an opportunity set or feasible set
represented by the curve AB . By choosing an
appropriate mix between the securities , the
investor can achieve any point on the curve .
4 the curve bends backward between points A and
3 ( the minimum variance portfolio) . This
means that for a portion of the feasible set ,
standard deviation decreases although the
expected return increases.

35
»5. Although the entire curve from A and B is
feasible , investors would consider only the
segment fro 3 to B . This is called the efficency
set or the efficiency frontier. Points lying along
the efficient frontier are called efficient portfolio.

36
Risk Reduction Through Diversification

When the securities are perfectly positively

correlated ( p= 1), diversification does not
reduce risk.
By the same logic when the securities are
perfectly negatively correlated ( p= -1),
diversification results in maximum risk
reduction
In fact in this case risk can be reduced to zero ,
by choosing the weights suitably

37
Risk Reduction Through Diversification

Y
Expected return

r = -0.5

r = -1 r = +1
B A
r = 0.5
Z
r=0
C X
Std. dev.
Introducing Borrowing and Lending : Risk Free Asset

Stage 2 of the investment process : You are now allowed

to borrow and lend at the risk free rate r while still
investing in any SINGLE ‘risky bundle’ on the
efficient frontier

For each SINGLE risky bundle, this gives a new set of

risk return combination known as the
‘transformation line’.

Rather remarkably the risk-return combination you are

faced with is a straight line (for each single risky
bundle) - transformation line.

39
Bundle of Risky Assets + Risk free Rate

Returns
T Bill Equity
(safe) (Risky)

Mean 10% 22.5%

SD 0% 24.87%

Coefficient of correlation 0

40
New Portfolio with Risk

Share of wealth Portfolio

in
X= risky bundle
(1-X) X ERp σp
1 1 0 10% 0%
2 0.5 0.5 16.25% 12.44%
3 0 1 22.5% 24.87%
4 -0.5 1.5 28.75% 37.31%

41
Example : Transformation Line

35
30
R 0.5 lending +
e 25 0.5 in 1 risky bundle
t 20
u
r 15 No borrowing/
no lending
n 10
-0.5 borrowing +
5 All lending 1.5 in 1 risky bundle
0
0 5 10 15 20 25 30 35 40

Standard deviation (Risk)

Transformation Line

Expected Return, N
Borrowing/
leverage
Z
Lending
X all wealth in risky asset
L
Q
r
all wealth in
risk-free asset

X Standard Deviation, N
The CML – Best Transformation Line
(CML) is the tangent line drawn from the point of the risk-free
asset to the feasible region for risky assets

Transformation line 3
– best possible one
ERp Portfolio M
Transformation line 2
Transformation line 1
rf
Portfolio A

p
The Capital Market Line (CML)

Maximum Sharpe Ratio (MSR) portfolio.

Highest total returns per unit of risk
Expected return CML
Market Portfolio

Risk Premium / Equity Premium

(ERm – rf)

rf

20 Std. dev., i
 The Security Market Line (SML)

Treynor introduced the concept of the security market line

Expected return SML

Market Portfolio

Risk Premium / Equity Premium

(ERi – rf)

rf

0.5 1 1.2 Beta, bi

The larger is bi, the larger is ERi

Risk Adjusted Rate of Return Measures

we have three sets of performance measurement tools

to assist us with our portfolio evaluations.

Sharpe Ratio : SRi = (ERi – rf) / i

Treynor Ratio : TRi = (ERi – rf) / bi

Jensen’s Alpha = Portfolio Return – Benchmark Portfolio Return

Where:
Benchmark Return (CAPM) = Risk-Free Rate of Return +
Beta (Return of Market – Risk-Free Rate of Return)

Objective :
Maximise Sharpe ratio (or Treynor ratio, or
Jensen’s alpha)
47
CAPITAL MARKET LINE

48
In Exhibit 1, the risk-free rate is assumed to
be 5%, and a tangent line—called the
capital market line— has been drawn to the
efficient frontier passing through the
risk-free rate.
The point of tangency corresponds to a
portfolio on the efficient frontier.
That portfolio is called the super-efficient
portfolio.

49
Using the risk-free asset, investors who hold
the super-efficient portfolio may:

leverage their position by shorting the

risk-free asset and investing the proceeds in
additional holdings in the super-efficient
portfolio, or de-leverage their position by
selling some of their holdings in the
super-efficient portfolio and investing the
proceeds in the risk-free asset

50
The resulting portfolios have risk-reward
profiles which all fall on the capital market
line.
Accordingly, portfolios which combine the
risk free asset with the super-efficient
portfolio are superior from a risk-reward
standpoint to the portfolios on the
efficient frontier.

51
Tobin concluded that portfolio construction
should be a two-step process.

First, investors should determine the

super-efficient portfolio.
This should comprise the risky portion of
their portfolio.
Next, they should leverage or de-leverage
the super-efficient portfolio to achieve
whatever level of risk they desire.

52
Significantly, the composition of the
super-efficient portfolio is independent of
the investor's appetite for risk.
The two decisions:
(A)the composition of the risky portion of the
investor's portfolio, and
(A)the amount of leverage to use,
are entirely independent of one another.
One decision has no effect on the other.
This is called Tobin's separation theorem

53
William Sharpe's (1964)
capital asset pricing model (CAPM)
demonstrates that, given strong simplifying
assumptions, the super-efficient portfolio
must be the market portfolio.
From this standpoint, all investors should
hold the market portfolio leveraged or
de-leveraged to achieve whatever level of
risk they desire.

54
'Efficient Market Hypothesis - EMH'

An investment theory that states it is impossible to

"beat the market" because stock market efficiency
causes existing share prices to always incorporate
and reflect all relevant information.
According to the EMH, stocks always trade at their
fair value on stock exchanges, making it impossible
for investors to either purchase undervalued stocks
or sell stocks for inflated prices. As such, it should
be impossible to outperform the overall market
through expert stock selection or market timing, and
that the only way an investor can possibly obtain
higher returns is by purchasing riskier investments.

55
Although it is a cornerstone of modern financial
theory, the EMH is highly controversial and often
disputed.
Believers argue it is pointless to search for
undervalued stocks or to try to predict trends in the
market through either fundamental or technical
analysis.

56
Meanwhile, while academics point to a large body of
evidence in support of EMH, an equal amount of
dissension also exists.
For example, investors, such as Warren Buffett
have consistently beaten the market over long
periods of time, which by definition is impossible
according to the EMH. Detractors of the EMH also
point to events, such as the 1987 stock market
crash when the Dow Jones Industrial Average
(DJIA) fell by over 20% in a single day, as evidence
that stock prices can seriously deviate from their
fair values.

57
Random Walk Theory'

The theory that stock price changes have the same

distribution and are independent of each other, so the
past movement or trend of a stock price or market
cannot be used to predict its future movement.

In short, this is the idea that stocks take a random

and unpredictable path.

A follower of the random walk theory believes

it's impossible to outperform the market without
assuming additional risk.
.

58
Random Walk Theory

Critics of the theory, however, contend that

stocks do maintain price trends over time –
in other words, that it is possible to
outperform the market by carefully selecting
entry and exit points for equity investments.

This theory raised a lot of eyebrows in 1973

when author Burton Malkiel wrote "A
Random Walk Down Wall Street", which
remains on the top-seller list for finance
books
59
INTERNATIONAL PORTFOLIO INVESTMENT

1 THE BENEFITS OF INTERNATIONAL

EQUITY INVESTING
A. Advantages
1. Offers more opportunities
than a domestic portfolio
only
2. Larger firms often are
overseas

60
THE BENEFITS OF INTERNATIONAL EQUITY
INVESTING

B. International Diversification

1. Risk-return tradeoff: may be greater

basic rule- the broader the
diversification , more stable the
returns and the more diffuse the
risk.

61
INTERNATIONAL PORTFOLIO INVESTMENT

2. International diversification and

systematic risk
a. Diversifying across nations with
different economic cycles.
b. While there is systematic risk
within a nation, it may be
nonsystematic and diversifiable
outside the country.

62
INTERNATIONAL PORTFOLIO INVESTMENT

Past empirical evidence suggests

international diversification reduces
portfolio risk.

63
INTERNATIONAL PORTFOLIO INVESTMENT

3 .Recent History
a. National stock markets
have wide differences in returns
and risk.
b. Emerging markets have higher risk
and return than developed markets.
c. Cross-market correlations have
been relatively low.

64
Thank you

65
Fundamental Analysis

Parvesh Aghi
The methods used to analyze securities
and make investment decisions fall into
two very broad categories:

(a) FUNDAMENTAL ANALYSIS AND

(b) TECHNICAL ANALYSIS.

2
Fundamental analysis involves analyzing the characteristics of a
company in order to estimate its value.

Technical analysis takes a completely different approach;

it doesn't care one bit about the "value" of a company or a
commodity. Technicians (sometimes called chartists) are only
interested in the price movements in the market

Technical analysis studies supply and demand in a market in an

attempt to determine what direction, or trend, will continue in
the future. In other words, technical analysis attempts to
understand the emotions in the market by studying the market
itself, as opposed to its components.

3
FUNDAMENTAL ANALYSIS
A method of evaluating a security that entails attempting to
measure its intrinsic value by examining related economic,
financial and other qualitative and quantitative factors.

Fundamental analysts attempt to study everything that can affect

the security's value, including macroeconomic factors
(like the overall economy and industry conditions) and
company-specific factors (like financial condition and management).

The end goal of performing fundamental analysis is to produce a

value that an investor can compare with the security's current
price, with the aim of figuring out what sort of position to take with
that security (underpriced = buy, overpriced = sell or short).

4
Fundamental stock analysis requires , among other things ,
a close examination of the financial statements for the company
to determine Its current financial strength , future growth and
profitability prospects and current management skills . In order
to estimate whether the stock price is undervalued or overvalued.

A good deal of reliance is placed on annual and quarterly

earning reports, the economic , political and competitive
environment facing the company , as well as any current
news item or rumors relating the company’s operations

Simply put , Fundamental analysis concerns itself

with basic of business in assessing the worth of the stock

5
Numerous ratios derived from balance sheet and income statement
data are used In fundamental analysis including such widely used
ratios as Working Capital Ratio Debt-equity Ratio Return on
Equity Ratio Earnings per Share etc

Fundamental analysis may be the preferred method to use for

mid to longer term investors. However it is not suitable for use
by day traders because of the amount of research required and
the fact that trades are entered into and exited within a very
short time frame.

6
The Concept of Intrinsic Value
One of the primary assumptions of fundamental analysis is that
the price on the stock market does not fully reflect a stock’s “real”
value.

After all, why would you be doing price analysis if the stock market
were always correct? In financial jargon, this true value is known
as the intrinsic value.

For example, let’s say that a company’s stock was trading at Rs200.
After doing extensive homework on the company, you determine
that it really is worth Rs 300.

7
 In other words, you determine the intrinsic value of the firm to be
Rs 300.
This is clearly relevant because an investor wants to buy stocks
that are trading at prices significantly below their estimated
intrinsic value.

This leads us to one of the second major assumptions of

fundamental analysis: in the long run, the stock market will reflect
the fundamentals . There is no point in buying a stock based on
intrinsic value if the price never reflected that value.

8
»
This is what fundamental analysis is all about. By focusing on
a particular business, an investor can estimate the intrinsic value
of a firm and thus find opportunities where he or she can buy at
a discount

If all goes well, the investment will pay off over time as the
Market catches up to the fundamentals.

9
Fundamental analysis serves to answer questions,
such as:
Is the company’s revenue growing?
Is it actually making a profit?
Is it in a strong-enough position to beat out its
competitors in the future?
Is it able to repay its debts?
Is management trying to "cook the books"?

10
Even though there is no one clear-cut method a breakdown is
presented below in the order an investor might proceed.

This method employs a top-down approach that starts with the

overall economy and then works down from industry groups to
specific companies

As part of the analysis process it is important to remember that all

information is relative. Industry groups are compared against other
industry groups and companies against other companies.

Usually companies are compared with others in the same group.

For example a telecom operator (Bharti Airtel) would be compared
to another telecom operator (Vodafone ) not to an IT company
(Infosys).

11
Economic Forecast

First and foremost in a top-down approach would be an overall

evaluation of the general economy. The economy is like the tide
and the various industry groups and individual
companies are like boats. When the economy expands most
industry groups and companies benefit and grow .When the
economy declines most sectors and companies usually suffer.

Many economists link economic expansion and contraction to

the level of interest rates. Interest rates are seen as a leading
indicator for the stock market as well.

12
Group Selection

if the prognosis is for an expanding economy then certain groups are

likely to benefit more than others. An investor can narrow the field to
those groups that are best suited to benefit from the current or future
economic environment.

If most companies are expected to benefit from an expansion then

risk in equities would be relatively low and an aggressive
growth-oriented strategy might be advisable. A growth strategy
might involve the purchase of technology ,biotech and
cyclical stocks.
If the economy is forecast to contract an investor may opt for a
more conservative strategy and seek out stable income-oriented
companies. A defensive strategy might involve the purchase of
consumer staples utilities and energy-related stocks.

13
To assess a industry groups potential an investor would want
to consider the overall growth rate ,market size and importance
to the economy.

While the individual company is still important its Industry group

is likely to exert just as much or more influence on the stock price.

When stocks move they usually move as groups there are very
few lone guns out there.

Many times it is more important to be in the right industry than

in the right stock

14
Narrow Within the Group

Once the industry group is chosen an investor would need to

narrow the list of companies before proceeding to a more
detailed analysis.

Investors are usually interested in finding the leaders and the

innovators within a group. The first task is to identify the
current business and competitive environment within a group as
well as the future trends.

How do the companies rank according to market share ,product

position and competitive advantage ? Who is the current leader and
how will changes within the sector affect the current balance of
power ? What are the barriers to entry ?success depends on an
edge ,be it marketing, technology ,market share or innovation

15
A comparative analysis of the competition within a sector
will help identify those companies with an edge and those
most likely to keep it.

16
Company Analysis

With a shortlist of companies an investor might

analyze the resources and capabilities within
each company to identify those companies that are
capable of creating and maintaining a competitive
advantage.
The analysis could focus on selecting
companies with a sensible business plan solid
management and sound financials.

17
Business Model
Even before an investor looks at a company's financial
statements or does any research, one of the most
important questions that should be asked is:
What exactly does the company do? This is referred
to as a company's business model – it's how a
company makes money. You can get a good
overview of a company's business model by
checking out its website

Sometimes business models are easy to understand.

Take McDonalds, for instance, which sells hamburgers,
fries, soft drinks, salads and whatever other new
special they are promoting at the time. It's a simple
model, easy enough for anybody to understand.
18
Competitive Advantage

Another business consideration for investors is

competitive advantage.
A company's long-term success is driven largely
by its ability to maintain a competitive advantage
- and keep it.

Powerful competitive advantages, such as

Coca Cola's brand name and Microsoft's domination
of the personal computer operating system,
create a moat around a business allowing
it to keep competitors at bay and enjoy growth
and profits

19
Operational effectiveness means a company is better
than rivals at similar activities while competitive
advantage means a company is performing better than
rivals by doing different activities or performing similar
activities in different ways.

Investors should know that few companies are able

to compete successfully for long if they are doing
the same things as their competitors.

20
Business Plan

The business plan model or concept forms the

bedrock upon which all else is built.

If the plan model or concepts stink there is little

hope for the business

For a new business the questions may be these :

Does its business make sense? Is it feasible ? Is there
a market ?. Can a profit be made ? For an established
business the questions may be : Is the company’s
direction clearly defined ? Is the company a leader
in the market ? Can the company maintain leadership?

21
Management

Just as an army needs a general to lead it to victory,

a company relies upon management to steer it
towards financial success.

Some believe that management is the most important

aspect for investing in a company

It makes sense - even the best business model is

doomed if the leaders of the company fail to properly
execute the plan.

22
In order to execute a business plan a company
requires top-quality management. Investors might
look at management to assess their capabilities
strengths and weaknesses
Some of the questions to ask might include How
talented is the management team? Do they have a track
record ?How long have they worked together? Can
management deliver on its promises? If management
is a problem it is sometimes best to move on.
Even the best-laid plans in the most dynamic industries can go to
waste with bad management (JK synthetics in Nylon 6). Alternatively
even strong management can make for extraordinary success in
a mature industry (Bharti Airtel in telcom or SRF in Nylon 6).
23
Corporate Governance
Has the company set systems, processes and
principles which ensure that a company is
governed in the best interest of all stakeholders
The purpose of corporate governance policies is to ensure
that proper checks and balances are in place, making it
more difficult for anyone to conduct unethical and illegal activities

It has to ensure that :

Adequate disclosures and effective decision making to
achieve corporate objectives
Transparency in business transactions
Statutory and legal compliances
Protection of shareholder interests
Commitment to values and ethical conduct of business.
24
Customers

Some companies serve only a handful of customers,

while others serve millions.

In general, it's a red flag (a negative) if a business

relies on a small number of customers for a large
portion of its sales because the loss of each
customer could dramatically affect revenues.

For example, think of a military supplier who has 100%

of its sales with the U.S. government. One change in
government policy could potentially wipe out all of
its sales.

25
Market Share
Understanding a company's present market share can
tell volumes about the company's business

The fact that a company possesses an 75% market share

tells you that it is the largest player in its market by far.

Furthermore, this could also suggest that the company possesses

some sort of "economic moat," in other words, a competitive
barrier serving to protect its current and future earnings,
along with its market share.

Market share is important because of economies of scale.

When the firm is bigger than the rest of its rivals, it is
in a better position to absorb the high fixed costs of a
capital-intensive industry.

26
Industry Growth

One way of examining a company's growth potential is to first

examine whether the amount of customers in the overall market
will grow. This is crucial because without new customers,
a company has to steal market share in order to grow.

In some markets, there is zero or negative growth, a factor

demanding careful consideration. For example, a manufacturing
company dedicated solely to creating audio compact cassettes
might have been very successful in the '70s, '80s and early '90s.
However, that same company would probably have a rough time
now due to the advent of newer technologies, such as CDs and
MP3s. The current market for audio compact cassettes is only a
fraction of what it was during the peak of its popularity.

27
Competition

Simply looking at the number of competitors goes a long way in

understanding the competitive landscape for a company.
Industries that have limited barriers to entry and a large number of
competing firms create a difficult operating environment for firms.

One of the biggest risks within a highly competitive industry is

pricing power. This refers to the ability of a supplier to increase
prices and pass those costs on to customers. Companies operating
in industries with few alternatives have the ability to pass on costs
to their customers. A great example of this is Wal-Mart.
They are so dominant in the retailing business, that
Wal-Mart practically sets the price for any of the
suppliers wanting to do business with them. If you want
to sell to Wal-Mart, you have little, if any, pricing power

28
Regulation

Certain industries are heavily regulated due to the importance

or severity of the industry's products and/or services.
As important as some of these regulations are to the public,
they can drastically affect the attractiveness of a
company for investment purposes.

In industries where one or two companies represent the

entire industry for a region (such as utility companies),
Governments usually specify how much profit each company
can make. In these instances, while there is the potential for
sizable profits, they are limited due to regulation.

29
All in all, investors should always be on the lookout for
regulations that could potentially have
a material impact upon a business' bottom line.
Investors should keep these regulatory costs in mind as
they assess the potential risks and rewards of investing.

30
»For example, value investors that follow
fundamental analysis look at both qualitative
(business model, governance, target market
factors etc.) and quantitative (ratios, financial
statement analysis, etc.) aspects of a business to
see if the business is currently out of favor with
the market and is really worth much more than its
current valuation.
»Competitive land scape, Competitive advantage,
business plan

31
FINANCIAL MARKETS

Parvesh Aghi
Financial Markets

Any marketplace where

Financial buyers and sellers participate in
the trade of assets such as
Markets equities, bonds, currencies
and derivatives

Money Capital Markets

Markets Long term & riskier
Short term & Low risk

T -Bills
Equity Debt
CPs, CDs,

2
Financial markets can mainly be classified into money
markets and capital markets.

Instruments in the money markets include mainly

short-term, marketable, liquid, low-risk debt securities.

Capital markets, in contrast, include longer-term and

riskier securities, which include bonds and equities.

There is also a wide range of derivatives instruments

that are traded in the capital markets.

3
Both bond market and money market instruments
are fixed-income securities but bond market instruments
are generally of longer maturity period as compared
to money market instruments.
Money market instruments are of very short maturity
period.
The financial markets can be further classified into the
primary and the secondary market.

Derivative market instruments are mainly futures,

forwards and options on the underlying instruments,
usually equities and bonds.

4
PRIMARY AND SECONDARY MARKETS

5
A primary market is that segment of the capital market,
which deals with the raising of capital from investors
via issuance of new securities

New stocks/bonds are sold by the issuer to the public

in the primary market.

When a particular security is offered to the public for

the first time, it is called an Initial Public Offering (IPO).

6
When an issuer wants to issue more securities of a
category that is already in existence in the market it is
referred to as Follow-up Offerings.

Example: Idea Cellular Ltd.’s offer in 2007 was an

IPO because it was for the first time that Idea
Cellular Ltd offered securities to the public.
Whereas, Tata Steel’s public offer in 2011 was a
Follow-up Offering as Tata Steel shares were already
issued to the public before 2011 and were available
in the secondary market.

7
It is generally easier to price a security during a
Follow-up Offering since the market price of the security
is actually available before the company
comes up with the offer, whereas in the case of an IPO
it is very difficult to price the offer since there is no
prevailing market for the security.
It is in the interest of the company to estimate the
correct price of the offer, since there is a risk of failure
of the issue in case of non-subscription if the offer
is overpriced.
If the issue is underpriced, the company stands to
lose notionally since the securities will be sold at a price
lower than its intrinsic value, resulting in lower realizations

8
The secondary market (also known as ‘aftermarket’) is
the financial market where securities, which have been
issued before are traded.

The secondary market helps in bringing potential buyers

sellers for a particular security together and helps
in facilitating the transfer of the security between the
parties.
Unlike in the primary market where the funds move from
the hands of the investors to the issuer (company/ Government,
etc.), in case of the secondary market, funds and the
securities are transferred from the hands of one investor
to the hands of another.

9
Thus the primary market facilitates capital formation
in the economy and secondary market provides liquidity
to the securities.
There is another market place, which is widely referred
to as the third market in the investment world. It is
called the over-the-counter market or OTC market.

The OTC market refers to all transactions in securities

that are not undertaken on an Exchange. Securities
traded on an OTC market may or may not be traded
on a recognized stock exchange

10
Trading in the OTC market is generally open to all
Registered broker-dealers. There may be regulatory
restrictions on trading some products in the OTC
markets.

For example, in India equity derivatives is one of the

Products which is regulatory not allowed to be traded
in the OTC markets.
In addition to these three, direct transactions
between institutional investors, undertaken primarily
with transaction costs in mind, are referred to as
the fourth market.

11
Money Market

The money market is a subset of the fixed-income

market.

In the money market, participants borrow or lend for

short period of time, usually up to a period
of one year.

These instruments are generally traded by the

Government, financial institutions and large
corporate houses

12
These securities are of very large denominations,
very liquid, very safe but offer relatively low interest
rates.

The cost of trading in the money market (bid-ask spread)

is relatively small due to the high liquidity
and large size of the market

Since money market instruments are of high

denominations they are generally beyond the reach
of individual investors. However, individual investors
can invest in the money markets through
money-market mutual funds
13
We take a quick look at the various products available
for trading in the money markets

T-Bills or treasury bills are largely risk-free.

(guaranteed by the Government and hence carry
only sovereign risk) short-term very liquid instruments
that are issued by the central bank of a country.
They are issued as Zero Coupon Bonds i.e, the coupon
Is implicit, and the bonds are issued at discount to
face value
The maturity period for T-bills ranges from 3-12 months.

14
 T-bills are circulated both in primary as well as
in secondary markets.

T-bills are usually issued at a discount to the face value

and the investor gets the face value upon maturity.

The issue price (and thus rate of interest) of T-bills

is generally decided at an auction, which individuals
can also access. Once issued, T-bills are also traded in
the secondary markets

15
In India, T-bills are issued by the Reserve Bank of India
for maturities of 91-days, 182 days and 364 days.
They are issued weekly (91-days maturity) and
fortnightly (182-days and 364- days maturity).

16
Commercial Paper

Commercial paper is an unsecured money market

instrument Issued by corporate to raise money

It was introduced to enable highly rated corporate

borrowers to diversify their sources of short term
borrowings, and provide additional instrument
to investors

As market interest rates decline , corporate can obtain

cheaper funding through CP market, below the
Prime Lending Rate (PLR) /Base Rate of Banks

17
Commercial paper Features

CPs are issued at discount to face value i.e, they are

zero coupon instruments

They have to be mandatorily rated by one of the credit

rating agencies only corporates who get the required
rating can issue CPs

The issuers shall ensure at the time of issuance of CP

that are rating so obtained is current and has not fallen
due for review.
The maturity date of the CP should not go beyond the
date up to which The credit rating of the issuer is valid

18
CPs can be issued in denominations of rs 5 lakh or
multiples thereof They can be issued for a maturity
of 15 days and a maximum of one year from the date
of issue

These instruments are very popular as there is a ready,

liquid market for CPs among Money Market Mutual
Funds. However , during the Global credit crises in
2008 , the CP market just dried up , as these
Instruments were unsecured and carried high risk
of default

19
Certificates of Deposit

CDs are issued by banks to raise funds.

CDs are issued in demat form or as a Promissory Notes.
Can be issued to individuals, corporations, trusts &funds

•Interest either on maturity or periodically

•Tradable on secondary market
•Interest rate higher than T- Bills , as they carry higher
default risk
•Rate depends on the credit rating of the issuer and
the market liquidity

20
Repos and Reverse Repos

Repos (or Repurchase agreements) are a very popular

mode of short-term (usually overnight) borrowing
and lending, used mainly by investors dealing in
Government securities.

The arrangement involves selling of a tranche of

Government securities by the seller (a borrower of funds)
to the buyer (the lender of funds), backed by an
agreement that the borrower will repurchase the same
at a future date (usually the next day) at an agreed price

21
The difference between the sale price and the
repurchase price represents the yield to the buyer
(lender of funds) for the period.

Repos allow a borrower to use a financial security as

collateral for a cash loan at a fixed rate of interest.

Since Repo arrangements have T-bills as collaterals

and are for a short maturity period, they virtually
eliminate the credit risk

22
Reverse repo is the mirror image of a repo, i.e., a repo
for the borrower is a reverse repo for the lender

Here the buyer (the lender of funds) buys Government

securities from the seller (a borrower of funds)
agreeing to sell them at a specified higher price at
a future date.

23
 Repurchase Agreement (repos)

An instrument or transaction common in the money

markets are called Forward transactions or “Repos”
.Repos comes from Repurchase Agreements

Let us illustrate the transaction with example :

I want I am ready
Rs 100 Crore To lend at
for one day 3.5% p.a
ICICI BANK Standard
for the one
Chartered Bank
day loan

24
 I have got Rs 100 crore If you give me collateral
G-secs with me. I will lend you at
I will that to you as 3%
Collateral

Standard
ICICI BANK Chartered Bank

A repo is therefore a secured borrowing

But why it is called Repo or Repurchase Agreement ?
Incase ICICI defaults , SCB can sell the G-secs
For SCB to sell the G-Secs they must own it first
So, the ownership has to move first from ICICI to SCB 25
»s
ICICI Banks will actually sell Rs 100 crore Government securities to SCB
At Prevailing market (dirty price) price
The transaction between both the banks will be structured as follows

Sells G-secs for 100 crore today

Pays 100croes on the the same day

Repurchase the G-secs at

Rs 100.00821 after one day

SCB makes a profit of Rs 0.821 lakh . Which is the equivalent of 3%

Interest per annum for one day

26
Thank You

27
Technical Analysis

Parvesh Aghi
The methods used to analyze securities
and make investment decisions fall into
two categories:

(a) FUNDAMENTAL ANALYSIS AND

(b) TECHNICAL ANALYSIS.

2
Fundamental analysis involves analyzing the economic, financial
and other qualitative and quantitative factors characteristics of a
company in order to estimate its value.

Technical analysis takes a completely different approach;

it doesn't care about the "value" of a company .
Technicians are only interested in the price movements in
the market
Technical analysis studies supply and demand in a market in an
attempt to determine what direction, or trend, will continue in
the future. In other words, technical analysis attempts to
understand the emotions in the market by studying the market
itself. It uses little or no information about the actual business
behind the stock.

3
TECHNICAL ANALYSIS

•PRICE ACTION

•SUPPLY AND DEMAND

•DETERMINE THE TREND

•EMOTIONS OF THE MARKET PLAYERS

4
Technical Analysis meaning

Technical analysis is the study of a stock, or the market

as a whole, strictly by using the price and volume
history of a stock. It analyses the data generated by
market activity, such as past prices and volume to
predict the future
Technical analysts do not try to measure a
security's intrinsic value, but instead use charts and
»other tools to identify patterns that can predict future
activity.
Technical analysis looks at the price movement of a
security and uses this data to predict its future price
movements.

5
Difference between the two

At the basic level, a technical analyst approaches

a security from the charts, while a fundamental analysis
involves delving into the financial statements.
»
By looking at the balance sheet, cash flow
statement and income statement, a fundamental analyst
tries to determine a company's real value.

In financial terms, an analyst attempts to measure a

company's intrinsic value. In this approach, investment
decisions are made on the basis of current price .
if the price of a stock trades below its intrinsic value,
it's a good investment.
6
Technical traders, on the other hand, believe there
is no reason to analyze a company's fundamentals
because these are all accounted for in the security's price .

Technicians are of the opinion that all the information

they need about a stock can be found in its charts.

Technical analysts firmly beleive that the historical

performance of stocks and markets are
indications of future performance.
»
In contrast to fundamental analysts ,Technical analysts are not
concerned whether a stock is undervalued - the only thing that
matters is a security's past trading data and what information this
data can provide about where the security might move in
the future.
7
Technical Analysis is built on some fundamental
assumptions in regards to the fashion in which
a market operates :

1. Price discounts everything.

2. Prices usually always move in trends .
3. History repeats itself over time!

8
Price discounts everything
A criticism of technical analysis is that it only
considers price movement, ignoring the fundamental
factors of the company.
The chartists believe that the prices of the market
reflect all the possible causes such as fundamental,
political, psychological etc. Therefore the study of
prices and volume is all that is required.

This only leaves the analysis of price movement, which

technical theory views as a product of the supply and
demand for a particular stock in the market.
The shift in demand and supply causes the price to
change. If demand exceeds supply, prices will rise
and vice versa.
9
Prices usually always move in trends

In technical analysis, price movements are believed

to follow trends. The whole purpose of charting the
prices of a market is to identify the trend in the early
stages of its formation.
This means that after a trend has been established,
the future price movement is more likely to be in the
same direction as the trend , than to be against it.

One can also say it is similar to Newton’s first law of

motion “a trend in motion is more likely to continue
than to reverse”.
Most technical trading strategies are based on this assumption.

10
History repeats itself over time!
Another important idea in technical analysis is that
history tends to repeat itself, mainly in terms of price movement.

The repetitive nature of price movements is attributed to

market psychology; in other words, market
participants tend to provide a consistent reaction
to similar market stimuli over time.

Most of the technical analysts believe that the study of market

action has a lot to do with the study of human psychology.
Chart patterns for example, have been identified
and characterized over the past hundred years to reflect
certain pictures. These pictures appear on the price charts
and reveal bullish or bearish psychology of the market. Since
these patterns have worked well in the past it is assumed to work
well in the future as well. Future is just the repetition of the past.

11
PRICE CHART

12
TECHNICAL CONCEPTS

1. TREND
2. SUPPORT & RESISTANCE
3. VOLUME
4. CHARTS & CHART PATTERNS
5. MOVING AVERAGES

13
TREND

One of the most important concepts in technical

analysis is that of trend

A trend is really nothing more than the general direction

in which a security or market is headed.

Take a look at the chart

14
Types of Trend

There are three types of trend:

1. Uptrend
2. Downtrend
3. Sideways/Range bound Trend
As the names imply, when each successive peak and
trough is higher, it's referred to as an upward trend.
If the peaks and troughs are getting lower, it's a
downtrend.

15
It isn't hard to see that the trend in Figure is up.
However, it's not always this easy to see a trend:
16
There are lots of ups and downs in this chart, but there
isn't a clear indication of which direction this security is headed.

17
»For example, an uptrend is indicated by
higher highs and higher lows. By connecting
the lows together, we get an upward sloping
trend line. When the trend line is sloping
upwards, we have an uptrend.

18
»A downtrend is indicated by lower highs and
lower lows. By connecting these points
together, we can draw a downward sloping
trend line. And when the trend line is sloping
downwards, we have a downtrend.

19
The Importance of Trend

It is important to be able to understand and identify

trends so that you can trade with rather than against
them.
Two important sayings in technical analysis are
"the trend is your friend" and "don't buck the trend,"
illustrating how important trend analysis is for
technical traders.

Trends tell us validity of chart patterns, overall price

action and give us an idea of support & resistance

20
SUPPORT AND RESISTANCE

Support : The price level of a particular

instrument where there is enough demand
should price reach that level to keep prices
from falling further.
Resistance : The price level of a particular
Instrument where there is not enough demand
should price reach that level to keep prices
rising further.
Knowing this, it only makes sense to buy at support
and sell at resistance!

21
» As you can see in Figure , support is the price level through which a stock or
market seldom falls (illustrated by the green line). Resistance, on the other hand,
is the price level that a stock or market seldom surpasses (illustrated by the red
line).

22
Role Reversal

Once a resistance or support level is broken,

its role is reversed. If the price falls below a support
level, that level will become resistance in future.
If the price rises above a resistance level, it will often
become support in future.

As the price moves past a level of support or resistance,

it is thought that supply and demand has shifted,
causing the breached level to reverse its role

For a true reversal to occur, however, it is important

that the price make a strong move through either the
support or resistance.

23
» If the price goes up through resistance by a good
way, then that resistance level becomes a support
level when the price comes back down. Here’s an
illustration of that.

24
»And in the same way, when you have a
downtrend, often the support which gets
penetrated becomes a resistance next time
the price rises, as you can see here.

25
Volume
To this point, we've only discussed the price of a security.
While price is the primary item of concern in
technical analysis, volume is also extremely important.

What is Volume?
Volume is simply the number of shares or contracts
that trade over a given period of time, usually a day.
The higher the volume, the more active the security.

To determine the movement of the volume

(up or down), chartists look at the volume bars that can
usually be found at the bottom of any chart.
Volume bars illustrate how many shares have
traded per period and show trends in the same way that prices do.

26
27
Why Volume is Important
Volume is an important aspect of technical analysis because
it is used to confirm trends and chart patterns.

Any price movement up or down with relatively high

volume is seen as a stronger, more relevant move than a
similar move with weak volume.
Therefore, if you are looking at a large price movement,
you should also examine the volume to see whether it tells
the same story.

Say, for example, that a stock jumps 5% in one trading day

after being in a long downtrend. Is this a sign of a trend reversal?
This is where volume helps traders.

28
If volume is high during the day relative to the average
daily volume, it is a sign that the reversal is probably for real.

On the other hand, if the volume is below average,

there may not be enough conviction to support a true trend
reversal.
Volume should move with the trend. If prices are moving
in an upward trend, volume should increase (and vice versa).

If the previous relationship between volume and price

movements starts to deteriorate, it is usually a sign of
weakness in the trend

29
Volume should move with the trend. If prices are
moving in an upward trend, volume should increase
(and vice versa).

For example, if the stock is in an uptrend but the up trading

days are marked with lower volume, it is a sign that the trend
is starting to lose its legs and may soon end.

When volume tells a different story, it is a case of divergence,

which refers to a contradiction between two different indicators.
The simplest example of divergence is a clear upward trend
on declining volume.

30
What is a Moving Average ?

•Primarily a trend following indicator

•Constructed in several ways

-Simple and Exponential

•Advantage : Smooth data series , making

data easier to use

•Disadvantage : Lag price because of the

smoothing effect

31
MOVING AVERAGES
Moving averages smooth the price data to form a trend
following indicator. They do not predict price direction,
but rather define the current direction with a lag.

Moving averages lag because they are based on past

prices. Despite this lag, moving averages help smooth
price action and filter out the noise.
The two most popular types of moving averages are the
Simple Moving Average (SMA) and the Exponential
Moving Average (EMA). These moving averages can be
used to identify the direction of the trend or define
potential support and resistance levels.

32
Simple Moving Average
A simple moving average is formed by computing the average
price of a security over a specific number of periods.

Most moving averages are based on closing prices.

A 5-day simple moving average is the five day sum of closing
prices divided by five.

As its name implies, a moving average is an average that moves.

old data is dropped as new data comes available.
This causes the average to move along the time scale.

33
SMA CALCULATION
Example of a 5-day moving average evolving over
three days.

Daily Closing Prices : 10 ,11,12, 13, 14, 15 , 16

First Day of 5 Day SMA : (10 + 11+ 12 +13 +14 ) / 5= 12

Second Day of 5 day SMA : ( 11+12+13+14+15) / 5 = 13

Third Day of 5 day SMA : (12+13+14+15+16) / 5 = 14

The first day of the moving average simply covers the last five
days. The second day of the moving average drops the first data
point (10) and adds the new data point (15). The third day of the
moving average continues by dropping the first data point (11)
and adding the new data point (16).

34
Simple Moving Average Example

The above chart shows 3 examples of simple moving averages.

Obviously, the closer the time span gets to 0 days, the closer
it represents the actual price chart, and the faster it responds to
price trends. The opposite is also true, the greater the number
of days used to calculate the SMA the less quickly it responds
to the current price trend.
35
Many individuals argue that the usefulness of this type of average
is limited because each point in the data series has the same
impact on the result regardless of where it occurs in the
sequence.

The critics argue that the most recent data is more

important and, therefore, it should also have a higher weighting.

This type of criticism has been one of the main factors

leading to the invention of other forms of moving averages.

36
Exponential Moving Average

With simple averages the calculation is, well, simple. The simplicity
of the calculation can sometimes cause a bit of a flaw to the SMA.
The flaw is due to spikes in the price of a security.

For example, if you were to calculate the 4 day SMA of stock ABC
where its closing prices were, 2.75, 2.90, 3.00 and 2.95 the
SMA would work just fine and smooth the price out to 2.90.
Great, that sounds and looks normal.
In comes trouble, in our second example stock ABC has a huge news
event on day 2. Its closing prices over this 4 day span are 2.75, 5.05,
3.40, 3.20 See the large spike on day 2? That would cause the 4 day
SMA to average the price out to 3.60, which is a bit high.
The exponential moving average to the rescue! With the EMA the
calculation is a bit more complex in that it weighs the different
closing prices within the moving average range.

37
The EMA gives more weight to prices near the end of the range and less to those
prices in the beginning of the range. This gives more influence to the current
market activities of the stock. Which as you know, what is happening now in
the market is what is most important to pay attention to.

As you can see , a 30-period EMA rises and falls faster than a 30-period SMA.
This slight difference doesn’t seem like much, but it is an important factor to be aware of
since it can affect returns.

38
Major Uses of Moving Averages

Moving averages are used to identify current trends

and trend reversals as well as to set up support and resistance
levels
Moving averages can be used to quickly identify whether a
security is moving in an uptrend or a downtrend
depending on the direction of the moving average.

When a moving average is heading upward and the price is

above it, the security is in an uptrend. Conversely, a downward
sloping moving average with the price below can be used to
signal a downtrend.

39
Another method of determining momentum is to look at
the order of a pair of moving averages. When a
short-term average is above a longer-term average,
the trend is up.
On the other hand, a long-term average above a
shorter-term average signals a downward movement in
the trend.
Moving average trend reversals are formed in two
main ways: when the price moves through a moving
average and when it moves through moving
average crossovers

40
The first common signal is when the price moves
through an important moving average. For example,
when the price of a security that was in an uptrend
falls below a 50-period moving average

The other signal of a trend reversal is when one

moving average crosses through another

For example, as you can see in Figure , if the 10-day

moving average crosses above the 50-day moving
average, it is a positive sign that the price will start to
increase.

41
Notice the short term average crossing
above the long term average signals
beginning of an uptrend

42
Trend reverses once the price breaks above
The 30 DMA

43
If the periods used in the calculation are relatively short,
for example 10 and 30, this could signal a short-term trend reversal.

On the other hand, when two averages with relatively long

time frames cross over (50 and 200, for example),
this is used to suggest a long-term shift in trend.

Another major way moving averages are used is to identify

support and resistance levels

It is not uncommon to see a stock that has been falling stop its
decline and reverse direction once it hits the support of a
major moving average. A move through a major moving
average is often used as a signal by technical traders that
the trend is reversing.

44
For example, if the price breaks through the 200-day
moving average in a downward direction, it is a signal
that the uptrend is reversing.

Moving averages are a powerful tool for analyzing

the trend in a security.

They provide useful support and resistance points

and are very easy to use.

45
The most common time frames that are used when
Creating moving averages are the 200-day, 100-day,
50-day, 20-day and 10-day.

The 200-day average is thought to be a good measure

of a trading year, a 100-day average of a half a year,
a 50-day average of a quarter of a year, a 20-day
average of a month and 10-day average of two weeks

Moving averages help technical traders smooth out

some of the noise that is found in day-to-day
price movements, giving traders a clearer view of
the price trend.

46
The Big question

Is the Market trending or Trading ?

47
Market movements can be characterized by two
distinct types of phases

In one phase , the market shows trending movements

either up or down

Trending movements have a direction bias over a

period of time.

In the second phase , the market shows no consistent

directional bias and moves between two levels

48
These two different phases of the market require the
use of different types of technical indicators :

Trending Markets need the use of trend following

indicators , such as the Moving averages , MACD
(Moving Average Convergence Divergence ) etc.

Trading range markets , on the other hand need the

use of oscillators like the RSI ,stochastic etc. which
decide the methodology a trader need to follow

49
VALUATION

-Parvesh Aghi
VALUATION

Valuation means the intrinsic worth of the company.

There are various methods through which one can
measure the intrinsic worth of a company.

Valuation means how much a company is worth of.

Talking about equity investments, one should have an
understanding of valuation.

This section is aimed at providing a basic

understanding of these methods of valuation.

2
Equity Discounted Cash flow Models

We can value the equity in a business and value the

entire business.

The models that value the equity are :

1 DIVIDEND DISCOUNT MODELS
-Gordon Growth Model (Constant Growth rate)
-Multiple Stage Growth
2 FCFE DISCOUNT MODELS
3 WALTER’S MODEL

3
Common Share Valuation using DDM

Security analysts that use these model are called

FUNDAMENTAL ANALYSTS because they base the
estimate of inherent worth on the economic
fundamentals of the stock

Once they have estimated the inherent worth, they

compare their estimate with the actual stock price in
the market to determine whether the stock is
UNDER, OVER, or FAIRLY valued.

4
Constant Growth Dividend Discount Model

The DDM says the intrinsic value of the stock is equal

to the sum of the present value of all future dividends
to be received

D1 D2 Dn
P0    ... 
(1  kc ) (1  kc )
1 2
(1  kc ) n

Problems:
Companies that do not pay dividends.
The formula assumes that the growth rate will remain the same
in period 1 through infinity.

5
Gordon Growth Model
The DDM is most suitable when:
the company is dividend-paying
the board of directors has a dividend policy that
has an understandable relationship to profitability
the investor has a non-control perspective.

Gordon Growth Model : PV of dividend stream is:

D0 (1  g )1 D0 (1  g ) 2 D0 (1  g )
P0    ... 
(1  kc )1
(1  kc ) 2
(1  kc )

P0 = Share Price
D0 = current dividend D0 (1  g ) D1
g = Growth P0  
Kc = Cost of Equity kc  g kc  g
D1 = Dividend next year
6
Example

Super limited recently paid a dividend of Rs 85 per

share , continuing its tradition of raising the dividend
by 12% every year . If the investors in similar firm
expects a 16% return , at what price should the shares
be selling

Po = 85(1.12)
16%-12%

P0 = 95.2 / 4% = Rs 2380/-

7
Two-stage DDM

The two- stage growth model allows for two stages of

growth – initial Phase where the growth rate is not stable
and a Subsequent steady state where the growth rate
is stable and is expected To remain so for the long term

Value of the stock = PV of dividends during the

Extraordinary phase + PV of terminal price

gs = growth period
gL = growth stable period
P0

8
Assume the following values
D0 is Rs 1.00
gS is 30%
Supernormal growth continues for 6 years
gL is 6%
The required rate of return is 12%
Present Values
Time Value Calculation Dt or Vt Dt/(1.12)t or Vt/(1.12)t
1 D1 1.00(1.30) 1.30 1.161
2 D2 1.00(1.30)2 1.69 1.347
3 D3 1.00(1.30)3 2.197 1.564
4 D4 1.00(1.30)4 2.856 1.815
5 D5 1.00(1.30)5 3.713 2.107
6 D6 1.00(1.30)6 4.827 2.445
6 V6 1.00(1.30)6(1.06) / (0.12 – 0.06) 85.273 43.202
Total 53.641

9
WALTER’S MODEL

Walter's 's model of share valuation mixes dividend policy

with investment policy of the firm. The model assumes that
retained earnings are the only source of financing
investments in the firm . Walter put forth the following
model for valuation of shares
P0 = DIV + r/k(EPS – DIV)
k

P0 = market price per share

DIV = Dividend per share
EPS = Earnings per share
EPS – DIV = Retained earnings per share
r = Firm’s average rate of return
k = firm’s cost o capital

10
From the following information , determine the market value of the
equity share of a company as per Walter’s Model :
-Earning of the Company =Rs. 30 Lakh
-Dividend paid = Rs. 10 Lakh
-No. of shares outstanding = 2,00,000
-Ke= 10%
-Rate of return on Investment =12%

Rs
Earning of the company 30,00,000 EPS = 15
Dividend paid 10,00,000 Dividend = 5
No. of shares outstanding 2,00,000
Cost of Equity Ke= 10%
Rate of return on Investment 12%
P0 = DIV + r/k(EPS – DIV) 5+ .12 /.10 (15-5)
k .10
= Rs 170
11
The following information is available for
ABC Ltd.
Earnings per share : Rs. 4
Rate of return on investments : 18 percent
Rate of return required by shareholders : 15 %
What will be the price per share as per the
walter model if the payout
Ratio is 40 percent? 50 percent? 60 percent?

12
Given E = Rs 4, r = 0.18 ,and k = 0.15, the value of P
for the three different payout ratios is as follow:

Payout ratio D=EPS * Cost of capital

40 percent 1.6 + (2.40) 0.18/0.15
0.15 = Rs 29.87

50 percent 2.00 + (2.00) 0.18/0.15

.0.15 = Rs29.33

60 percent 2.40 + (1.60) 0.18/0.15

0.15 = Rs28.80

13
Company Valuation Methods

• Net Asset Value or Book Value

• Liquidation Value
• Discounted Cash Flow Method
• Relative Valuation
• Option Valuation Method

14
 Net Asset Value / Book value
Book value is the per share rupee value that would be
received if the assets were liquated for the values
at which the assets are kept on books minus the
monies that must be paid to liquidate the liabilities
and preferred stock.
Book value is also called net worth or net assets value.

Historical balance sheet values are not consistent

with the true value of the company ‘s assets .

Use of book value is to provide a floor value with the true

value of the company being some amount higher .
Sales prices of companies can be expressed as multiples
of book value.
If firms in the industry are priced at a certain average
value , such as selling at six times the book value ,
and a firm in question is selling for only two times the
book value , this might be an indicator of an
undervalued situation

It is preliminary indicator that takeover artists use to

find undervalued firm.
Historical cost valuation : All assets are taken at
historical book value. Value of goodwill is added to this
above figure to arrive at the valuation.
VALUE = ASSETS - LIABILITIES

16
LIQUIDATION VALUE

Liquidation value is another benchmark of the

company's floor value.

It is a measure of the per share value that would be

derived if the firm’s assets were liquidated and all
liabilities and preferred stock as well liquidation costs
were paid

It is more realistic measure than book value.

Liquidation value does not directly measure the earning

power of the firm’s assets

17
Current cost valuation
All assets are taken at current value and summed to
arrive at value This includes tangible assets, intangible
assets, investments, stock, receivables

VALUE = ASSETS - LIABILITIES

18
DISCOUNTED CASH FLOW METHOD

One of the important valuation methods and a strong

tool because it measures the cash generation potential
of the business

Future cash flows of the company are discounted with

the weighted average cost of capital used in the
business

In simple terms, discounted cash flow tries to work out

the value of a company today, based on projections of
how much money it's going to make in the future.

19
DCF analysis says that a company is worth all of the
cash that it could make available to investors in the
future

A business is worth the present value of the expected

future cash flows of the business.

Discounted cash flow (DCF) analysis uses future free

cash flow projections and discounts them to arrive at
a present value, which is used to evaluate the
potential for investment. If the value arrived at through
DCF analysis is higher than the current cost of the
investment, the opportunity may be a good one.

20
STEPS
Merits of the DCF

STRENGTHS:
•It produces closest thing to an intrinsic stock value
•Scientific
•Widely used
•Based on cash flow

WEAKNESSES:
•Almost always results in overvaluation.
•Can we ever predict the future?
•Based on many assumptions
•Which assumptions are the most critical?
•5 years vs. 10 years estimation

22
Calculating Business Value

The value of the business is calculated by discounting

the free cash flows projected over the projection
period and the terminal value calculated at the end
of the projection period to their present values using
the chosen discount rate (WACC).
BV = FCF1 + FCF2 + +FCFn + TV
(1+r)1 (1+r)2 (1+r)n (1+r)n

Terminal Value =
FCFn(1+ Growth Rate)
(Discount Rate –Growth Rate)

23
A publicly traded firm potentially has an infinite life.
The value is therefore the present value of cash
flows forever.

Since we cannot estimate cash flows forever, we

Estimate cash flows for a “growth period” and then
estimate a terminal value, to capture the value at the
end of the period:
t = N CF
Value =  t  Terminal Value
t (1 + r)
N
t = 1 (1 + r)

24
The value of the firm is obtained by discounting
expected cash flows to the firm, i.e., the residual
cash flows after meeting all operating expenses and
taxes, but prior to debt payments, at the weighted
average cost of capital, which is the cost of the
different components of financing used by the firm,
weighted by their market value proportions.

Free cash flows are those cash flows , that are available
to capital providers, both equity holders as well as
debt holders, after necessary deductions have been
made for capital expenditures that are needed to
maintain the continuity of the cash flow stream in future

25
Working capital investments and taxes paid are also
deducted

Firm value = FCFF discounted at WACC

Equity value= FCFE discounted at the required return

on equity

Equity value = Firm value – Market value of debt

26
 CASH REVENUES

Working capital
Investment Cash operating
expenses
Including taxes but
Fixed capital excluding interest
investment

FCFF
Interest payment to
bond holders

FCFE Net Borrowing

from bondholders
 FREE CASH FLOWS OF FIRM V/S EQUITY
FREE CASH FLOW FOR ALL INVESTORS FREE CASH FLOW FOR EQUITY
SHARE HOLDERS

EBIT (1-T) = NOPAT PAT

+ Depreciation and non cash charges + Depreciation and non cash charges

- Net Capital Expenditures - Net Capital Expenditures

- Increase in Working Capital - Increase in Working Capital

– Repayment of Debt

+ Proceeds from debt issues

28
Calculating FCFF from net income

FCFF = NI + NCC + INT (1-Tax rate) –FCInv – WCInv

NI : Net Income
NCC : Non Cash Charges (Deprecation)
INT : Interest
FCInv : Capital expenditure – proceeds from long
term assets
WCInv : Working Capital Investment

29
Calculating FCFE from net income

FCFE = NI + NCC - FCInv – WCInv + Net Borrowings

NI : Net Income
NCC : Non Cash Charges (Deprecation)
FCInv : Capital expenditure – proceeds from long
term assets
WCInv : Working Capital Investment
Net Borrowings : Long & Short term debt issues
– long & short term debt payments

30
Calculating FCFF from EBIT

FCFF = EBIT (1-Tax) + Dep –FCInv – WCInv

EBIT : Earning before interest & tax

Dep : Depreciation

FCInv : Capital expenditure – proceeds from long

term assets
WCInv : Working Capital Investment

31
Estimating Cash Flows

Estimates of cash flows are a key element in investment

evaluation

The cash flow of a firm from the point of view of all

investors is the cash flow available to all investors
after paying taxes and meeting investment needs of
the firm, if any . it is estimated as follows :

Cash flow to all investors= EBIT(1-T) + Depreciation

and non cash charges – Capital Expenditure
– Change in net Working Capital

32
The cash flow of a firm from the point of view of equity
share holders is the cash flow available
to equity share holders after paying taxes , meeting
investments needs , and fulfilling debt related
commitments. It is estimated as follows
Cash flow to equity share holders = Profit after Tax
+ Depreciation and other non cash charges
–Capital Expenditures – Changes in Working capital
– Repayment of Debt + Proceeds from debt issues

33
 What are Free cash flows and determine the free cash flows
of XYZ Limited from following projected figures ( in Lakhs

YEAR 2011 2012 2013 2014 2015

Rs lakhs

EBIDT 350 400 470 525 600

Depreciation 100 135 145 110 90

Interest 55 56 58 62 77

Capital Expenditure 250 100 75 20 55

Inc in Working Capital 35 38 42 45 52

Repayment of debt 50 450

Proceeds from Debt issue 500

Tax 35%

34
 FREE CASH FLOW OF XYZ LTD

FREE CASH FLOW OF THE FIRM

2011 2012 2013 2014 2015

EBIDT 350 400 470 525 600

Depreciation 100 135 145 110 90

EBIT 250 265 325 415 510

EBIT(1--T) 162.5 172.25 211.25 269.75 331.5

Depreciation 100 135 145 110 90

Capital Expenditure 250 100 75 20 55

Inc in Working Capital 35 38 42 45 52

FREE CASH FLOW OF A

FIRM -22.5 169.25 239.25 314.75 314.5

35
 FREE CASH FLOW FOR EQUITY
FREE CASH
2011
FLOW
2012
FOR2013
EQUITY
2014 2015
EBIDT 350 400 470 525 600
Depreciation 100 135 145 110 90
Interest 55 56 58 62 77
EBT 195 209 267 353 433
Tax 68.25 73.15 93.45 123.55 151.55
PAT 126.75 135.85 173.6 229.45 281.45
Depreciation 100 135 145 110 90
Capital
Expenditure 250 100 75 20 55
Inc in Working
Capital 35 38 42 45 52
Repayment of
debt 50 450
Proceeds from
Debt issue 500

FREE CASH FLOW

FOR EQUITY 441.75 132.85 201.6 224.45 -185.55
36
Adjustments to DCF Enterprise Value

While calculating EV we consider only those assets

which contribute to the generation of cash flows.

Those assets which have positive market value but do

not contribute to cash flow generation have to be
added to EV computed using DCF

An example is real estate assets that are not involved

in operation of business

37
Estimating – Sustainable Growth

Sustainable growth can be estimated using the following equation:

g  b  ROE

Where: b= the firm’s earnings retention ratio

= (1 – firm’s dividend payout ratio)
ROE = firm’s return on common equity
= net profit/common equity

Clearly, the value of the firm will rise if the firm retains and
reinvests its profits at a rate of return (ROE) greater than kc
Under such conditions, g increases more than kc

38
Estimating Growth

g  b  ROE

Net income Sales Total Assets

ROE   
Sales Total Assets Equity
 Net Profit Margin  Turnover Ratio  Leverage Ratio

Decomposing ROE using the DuPont system allows managers to

see how they can increase the value of the firm:
increase the profit margin on sales
Increase the turnover rate on sales
Leverage the firm using less equity and more debt
(although use of more debt implies higher risk and the benefits may
be offset by a higher kc)

39
Estimating Inputs: Discount Rates

Critical ingredient in discounted cashflow valuation.

Errors in estimating the discount rate or mismatching

cash flows and discount rates can lead to serious
errors in valuation

At an intuitive level, the discount rate used should be

consistent with both the riskiness and the type of cash
flow being discounted.

40
Estimating Inputs: Discount Rates

The riskier the investment , the higher the

discount rate , the lower the PV of the
projected cash flows.
Equity versus Firm: If the cash flows being
discounted are cash flows to equity, the
appropriate discount rate is a cost of equity.

If the cash flows are cash flows to the firm, the

appropriate discount rate is the cost of capital.

41
Estimating Inputs: Discount Rates

We can select cost of capital ( WACC) as discount rate

A calculation of a firm's cost of capital in which each

category of capital is proportionately weighted.

All capital sources - common stock, preferred

stock, bonds and any other long-term debt - are
included in a WACC calculation.

42
COST OF EQUITY

The cost of equity should be higher for riskier

investments and lower for safer investments

Expected Return = E(R) = Rf +  (Rm- Rf)

Inputs Needed
1. Risk free rate
2. Beta relative to market portfolio
3. Market risk premium

43
Estimating the Cost of Debt

The Cost of Debt is the effective rate of a company's

current debt. Taking taxes into consideration the
cost of debt could be much less due to interest payments
being tax deductible. The cost of debt after factoring in
the tax benefits is called the After-Tax Cost-of-Debt.

The cost of debt is the rate at which you can borrow

at currently, It will reflect not only your default risk
but also the level of interest rates in the market

44
Weights for the Cost of Capital Computation

The weights used to compute the cost of capital should

be the market value weights for debt and equity.

The WACC equation is the cost of each capital

component multiplied by its proportional weight and
then summing:
WACC = wEKE + wDKD(1-T)

All else equal, the WACC of a firm increases as the beta

and rate of return on equity increases, as an increase in
WACC notes a decrease in valuation and a higher risk.

45
EXAMPLE

FCF grows information

Following at a constantisrate of 6%inyear
available 4 of XYZ ltd .
respect
Cost
You of
arecapital 13%
required to calculate the value of the Firm.
Rs lakhs

FCF grows at a constant rate of 6% after year 4

Cost of capital 13%

46
COMPUTATION OF FREE CASH FLOW
Year EBIT TAX NOPAT Depreciation CAPEX Inc FREE CASH
WC FLOW

1 600 180 420 100 100 20 400

2 720 216 504 120 200 24 400

3 840 252 588 150 60 38 640

4 1200 360 840 180 40 40 940

47
PV OF FREE CASH FLOW
Year FREE W ACC @ Present value
CASH 13%
FLOW

1 400 .885 354

2 400 .783 313.2

3 640 .693 443.52

4 940 .613 576.22

Terminal 940(1.06) 14234.29 .613 8725.61

value 13%-6%
Enterprise 10412.56
value

48
EXAMPLE

Calculate the value of share from the following information :

Profit of the Company Rs 290 crore
Equity Capital of the Company Rs 1300 crore
Par value of share Rs 40 each
Debt ratio of Company 27
Long run growth rate of the company 8%
Beta 0.1 Risk free rate 8.7%
Market return 10.3%
Capital Expenditure per share Rs 47
Depreciation per share Rs 39
Change in working Capital Rs 3.45 per share

49
Solution

Equity Capital = Rs 1300 crore

Par value = Rs 40 crore
No of shares issued = 32.5 crore
PAT = 290 crore
Depreciation = Rs ( 39X 32.5)= 1267.5 crore
Capex = Rs ( 47X 32.5) = 1527.5
Change in WC = Rs 3.45X 32.5)= 112.125 crore

Target debt ratio(DR) = 27/100 = .27

FCFE= PAT – ( 1-DR)(FCInv-Dep) –(1-DR)WC inv)

FCFE = 290 – (1-.27) (1527.5-1267.5) – (1-.27)( 112.125)= 18.35
Cost of Equity = Rf + Beta( Rm- Rf) = 8.7%+.1 ( 10.3%-8.7%)= 8.86%
Using DDM 18.35(1+g)/Ke-g 18.35(1.08)/ 8.86%-8%= Rs 2304.26
Value of Equity = Rs 2304.26 / 32.5 = Rs 70.90 per share

50
Relative Valuation

6-51
What is relative valuation?

In relative valuation, the value of an asset is compared

to the values assessed by the market for similar or
comparable assets .

Finding comparable assets

We need to identify comparable assets and obtain
market values for these assets

Scaling the market prices to a common variable

Convert these market values into standardized values,
since the absolute prices cannot be compared
This process of standardizing creates price multiples.

52
Adjusting for differences across assets

Compare the standardized value or multiple for the

asset being analyzed to the standardized values
for comparable asset, controlling for any differences
between the firms that might affect the multiple, to
judge whether the asset is under or over valued

53
Relative valuation is pervasive…

Most valuations are relative valuations.

Almost 85% of equity research reports are based
upon a multiple and comparables.
More than 50% of all acquisition valuations are
based upon multiples
While there are more discounted cash flow
valuations in consulting and corporate finance,
they are often relative valuations disguised as
discounted cash flow valuations

54
Comparable multiples
Comparable multiples are regularly used to value
businesses.
They are quick and easy method to come up with a
value for a company.
There are two basic steps in using comparable
multiple analysis :
1.Selecting the correct multiple and then
2.Applying it to the relevant earning base

Reasons for popularity :

Use of comparable is less time and resource intensive
It is easier to sell
It is easier to defend
Market imperative:Measures relative and not intrinsic value
55
Comparable multiples/Relative valuation

Relative valuation approaches estimate the value

of common shares by comparing market prices
of similar companies, relative to some variable such as:

1.PE Ratios
2.Enterprise value / EBITDA
3.EV/EBIT
4.EV/Sales
5.EV/ Free Cash flows
6.Equity Value/ Book value

56
PE Ratio

It is the ratio of a company stock price divided by its

earning per share.
PE Ratio = MPS P0  Estimated EPS  Justified P/E ratio
EPS P0
MPS : Market value per Share  EPS 
E1
EPS : Earning price per Share

When we multiply the a derived P/E ratio by a target

company ‘s estimated EPS , we get an estimated stock price.

For example let us say that we have analyzed 10 comparable

companies have found that the average P/E ratio is 17.
We then multiply this value by the target company’s estimated EPS
, which we assume in this example is Rs 3/- Po = 17 X3= Rs 51

57
Enterprise value / EBITDA

A ratio used to determine the value of a company. The enterprise

multiple looks at a firm as a potential acquirer would, because
it takes debt into account - an item which other multiples like
the P/E ratio do not include.

Enterprise multiple is calculated as:

Enterprise Value
EBIDTA

The multiple can be computed even for firms that are

reporting net losses, since earnings before interest, taxes and
depreciation are usually positive. For firms in certain industries,
such as cellular, which require a substantial investment in
infrastructure and long gestation periods, this multiple seems to be
more appropriate than the price/earnings ratio.

58
 Exercise in Valuation

Plantation Co. Garden Co. Park Co.

Enterprise market value/sales 1.4 1.1 1.1
Enterprise market value/EBITDA 17.0 15.0 19.0
Enterprise market value/free cash flows 20 26 26

Application to Meadows Co.

Sales Rs. 200 crores
EBIDTA Rs. 14 crores
Free cash flow Rs. 10 crores

59
 Value estimated

Plantation Co. Garden Co. Park Co. Average

Enterprise market value/sales 1.4 1.1 1.1 1.2
Enterprise market value/EBITDA 17.0 15.0 19.0 17.0
Enterprise market value/free cash flows 20.0 26.0 26.0 24.0

Application to Meadows Co. Average Value

Sales Rs. 200 crores 1.2 Rs. 240 crores
EBIDTA Rs. 14 crores 17.0 Rs. 238 crores
Free cash flow Rs. 10 crores 24.0 Rs. 240 crores

60
STOCK EXCHANGES, INDICES,
DEPOSITORY SYSTEM &
MARKET REGULATORS

-Parvesh Aghi
CONTENTS

•STOCK EXCHANGES
•TRADING MECHANISM
•MARKET INDEXES
•MARKET REGULATION
•DEPOSITORY SYSTEM
•TRADING IN SECONDARY MARKETS

2
STOCK EXCHANGES

Most of the trading in the Indian stock market takes

place on its two stock exchanges: the Bombay Stock
Exchange (BSE) and the National Stock Exchange
(NSE)

The BSE has been in existence since 1875. The NSE,

on the other hand, was founded in 1992 and started
trading in 1994.

However, both exchanges follow the same trading

mechanism, trading hours, settlement process, etc.

3
Almost all the significant firms of India are listed on
both the exchanges.

NSE enjoys a dominant share in spot trading, with

about 70% of the market share, and almost a
complete monopoly in derivatives trading.

4
Trading Mechanism

Trading at both the exchanges takes place through

an open electronic limit order book, in which order
matching is done by the trading computer.

The entire process is order-driven, which means that

market orders placed by investors are automatically
matched with the best limit orders. As a result,
buyers and sellers remain anonymous.
The advantage of an order driven market is that it
brings more transparency, by displaying all buy and
sell orders in the trading system.

5
All orders in the trading system need to be placed
through brokers, many of which provide online trading
facility to retail customers.

Institutional investors can also take advantage of the

direct market access (DMA) option, in which they use
trading terminals provided by brokers for placing
orders directly into the stock market trading system

6
Settlement Cycle and Trading Hours

Equity spot markets follow a T+2 rolling settlement.

This means that any trade taking place on Monday,
gets settled by Wednesday.

All trading on stock exchanges takes place between

9:00 am and 3:30 pm, Monday through Friday.

Delivery of shares must be made in dematerialized

form, and each exchange has its own clearing house,
which assumes all settlement risk, by serving as a
central counterparty.

7
Market Indexes

The two prominent Indian market indexes are Sensex

and Nifty. Sensex is the oldest market index for
equities; it Includes shares of 30 firms listed on the
BSE, which represent about 45% of the index's
free-float market capitalization. It was created in 1986
and provides time series data from April 1979, onward.

Another index is the S&P CNX Nifty; it includes 50

shares listed on the NSE, which represent about 62%
of its free-float market capitalization.
It was created in 1996 and provides time series data
from July 1990, onward.

8
Market Regulation

The overall responsibility of development, regulation

and supervision of the stock market rests with the
Securities & Exchange Board of India (SEBI),
which was formed in 1992 as an independent authority

Since then, SEBI has consistently tried to lay down

market rules in line with the best market practices.
It enjoys vast powers of imposing penalties on market
participants, in case of a breach.

9
DEPOSITORY SYSTEM

Although India had a vibrant capital market which is

more than century old , the paper based settlement
of trades caused substantial problems like bad
delivery and delayed transfer of title till recently. The
enactment Depositories Act in August 1996 paved
the way for establishment of NSDL, the first depository
in India .

A depository is an organisation which holds securities

(like shares, debentures, bonds, government
securities, mutual fund units etc.) of investors in
electronic form at the request of the investors through
a registered Depository Participant.

10
It also provides services related to transactions in
securities. At present two Depositories viz. National
Securities Depository Limited (NSDL) and Central
Depository Services (India) Limited (CDSL)
are registered with SEBI.

A Depository Participant (DP) is an agent of

the depository through which it interfaces with the
investor and provides depository services.

11
Public financial institutions, scheduled commercial
banks, foreign banks operating in India with the
approval of the Reserve Bank of India, state financial
corporations, custodians, stock-brokers, clearing
corporations ,clearing houses, NBFCs and Registrar
to an Issue or Share Transfer Agent complying with
the requirements prescribed by SEBI can be
registered as DP.

Banking services can be availed through a branch

whereas depository services can be availed through
a DP.

12
Legal framework for a Depository

A depository system is governed by the following

Acts

1. Securities & Exchange Board of India Act 1992

2. The SEBI(Depositories and Participants)Reg 1996

3. Bye –laws of depository
4. Business rules of depository
5. The Companies Act 1956

13
Constituents of a Depository System

1. Depository
2. Depository Participant (DP)
3. Securities, Issuers and Registrars
4. Share Transfer Agents
5. Stock Exchanges and Stock Brokers
6. Clearing Corporation/ Clearing House
7. Clearing Members
8. Banking system
9. Investors

14
Facilities offered by Depository System

• Opening of depository system (Demat)

• Dematerialization
• Rematerialization
• Settlement of trades in dematerialized
securities
• Account transfer
• Transfer ,transmission and transposition
• Pledge and hypothecation
• Redemption or repurchase
• Stock lending and borrowing

15
Dematerialisation

Dematerialisation : It means conversion of the

physical certificates into dematerialised
holdings at the request of the investor

Only shares registered in the name of the

account holder are accepted for
dematerialisation at the depository

16
Dematerialization Procedure
First open a Demat account with any Depository of
investor’s choice
Obtain account number from his Depository
Participant
A dematerialisation request form (DRF) to be submitted
to the DP who intimates depository of the request

DP then submits the certificate along with the DRF to

the registrar who confirms the Demat request
Registrar validates the request, updates records ,
destroys the certificates and informs depository who in
turn credits the DP a/c
Depository participant updates the investor a/c and
informs the investor
17
Rematerialisation

It means conversion of Demat holdings back into

certificates
If the investors wish to get the securities in physical
form ,all he has to do is to request DP for remat
Investor must fill up a remat request form (RRF)

The DP will forward the request to depository after

verifying that the shareholder has the necessary
balances
Depository will in turn intimate the registrar
RTA (registrar & transfer agent) will print the certificates
And dispatch the same to the investor

18
Trading in Secondary Markets

Trading in secondary market happens through

placing of orders by the investors and their matching
with a counter order in the trading system.

Orders refer to instructions provided by a customer

to a brokerage firm, for buying or selling a security
with specific conditions.

These conditions may be related to the price of the

security (limit order or market order or stop loss
orders) or related to time (a day order or immediate
or cancel order).

19
Advances in technology have led to most secondary
markets of the world becoming electronic exchanges.

Disaggregated traders across regions simply log in

the exchange, and use their trading terminals to key
in orders for transaction in securities.

Some of the most popular orders are:

• Limit Price/Order
•Market Price/Order
•Stop Loss (SL) Price/Order

20
Types of Orders

Limit Price/Order: In these orders, the price for

the order has to be specified while entering
the order into the system

The order gets executed only at the quoted price or at

a better price (a price lower than the limit price in case
of a purchase order and a price higher than the
limit price in case of a sale order).

21
Market Price/Order: Here the constraint is the
time of execution and not the price.

It gets executed at the best price obtainable at the

time of entering the order. The system immediately
executes the order, if there is a pending order of the
opposite type against which the order can match.

The matching is done automatically at the best available

price (which is called as the market price).

22
If it is a sale order, the order is matched against the
best bid (buy) price and if it is a purchase order, the
order is matched against the best ask (sell) price.
The best bid price is the order with the highest buy
price and the best ask price is the order with the lowest
sell price.

Stop Loss (SL) Price/Order: Stop-loss orders which are

entered into the trading system, get activated only
when the market price of the relevant security reaches
a threshold price. An order placed with a broker to sell a security
when it reaches a certain price. A stop-loss order is designed to
limit an investor's loss on a security position.

23
When the market reaches the threshold or
pre-determined price, the stop loss order is triggered
and enters into the system as a market/limit order
and is executed at the market price / limit order price
or better price.

Until the threshold price is reached in the market the

Stop loss order does not enter the market and
continues to remain in the order book. A sell order in
the stop loss book gets triggered when the last traded
price in the normal market reaches or falls below the
trigger price of the order

24
A buy order in the stop loss book gets triggered when
the last traded price in the normal market reaches or
exceeds the trigger price of the order.
The trigger price should be less than the limit price
in case of a purchase order and vice versa.

25
Examples-Trigger price – sell order

“A” buys TCS at Rs 1290 in expectation that the price

will rise .
However , in the event the price falls “A “ would like
to limit his losses .
A may place a limit sell order specifying the trigger
price of Rs 1270 and a limit price of Rs 1265.
The trigger price has to be between the limit price and
the last traded price at time of placing the order.

Once the last traded price touches or crosses Rs 1270

, the order gets converted into a limit sell order
at Rs 1265

26
Examples-Trigger price – Buy order

“A” short sells TCS at Rs 1300 in expectation that the

price will fall .
However , in the event the price rises “A “ would like
to limit his losses .
A may place a limit buy order specifying the trigger
price of Rs 1325 and a limit price of Rs 1330.
The trigger price has to be between the last traded
price and the buy limit price.

Once the market price of TCS breaches the trigger

Price i.e. Rs 1325 the order gets converted to a limit
Buy order at Rs 1330

27
Rolling Settlement

Before the Rolling Settlement was introduced in

year 2000, the normal settlement period was 5 days
and it used to take about 15-20 days to get the
sale proceeds of the shares.

Rolling Settlement system the trades completed on

a particular day are settled after given no's of business
days.

At present NSE and BSE it is after 2 days and hence

called T+2 settlement.

28
Rolling Settlement ( Cont)

Trade day, will be settled by exchange of money

and securities on the second business day
(excluding Saturday, Sundays, Bank and Exchange
Trading Holidays).
E.g.- Trade completed on Monday are settled on
Wednesday.

PAY IN .
Pay in day is the day when the brokers shall make
Payment or delivery of securities to the exchange.
PAY OUT
Pay out day is the day when the exchange makes
payment or delivery of securities to the broker

29
 Example
Transaction Sale Value Purchase Settlement PAY OUT
on MONDAY Value on
Wednesday
PAY IN
Sold 40 Rs.9430
shares of XYZ
Co. At Rs.
235.75 per
share
Bought 75 Rs.17,325
shares of XYZ
Co of Rs.231
per share
Gross basis 40 shares of 75 shares of
XYZ Co. and XYZ Co.
Rs.7,895
Net basis Rs.7,895 35 shares of
XYZ co.
 UPDATE
Update
• Receives the • NSDL
share from the Demat Account • CDSL
stock exchange or if in physical
on behalf of his form send it to
client Registrar and
Transfer Agent Electronic
Brokers Database
Maintenance

Central Depository Services Limit)

National Securities Depository Limited
 NSCCL Transfer
NSE
BOISL Securities and
BSE Funds
(Clearing House)

Transfer to
investors through Brokers
Clearing Bank
 REASONS

» Reduces the market risk to a

considerable extent
» The investors trading on a particular
day are treated differently from the
investors trading on the preceding
or succeeding day.
» Reduces market volatility.
» It limits the outstanding positions
and reduces settlement risk.
» Made trading cycle uniform.
WHAT IS PAY-IN AND PAY-OUT ?

»Pay-in day is the day when the securities sold

are delivered to the exchange by the sellers
and funds for the securities purchased are
made available to the exchange by the buyers.
»Pay-out day is the day the securities
purchased are delivered to the buyers and the
funds for the securities sold are given to the
sellers by the exchange.
» At present, the pay-in and pay-out happens on the 2nd working day
after the trade is executed on the exchange, that is settlement cycle is
on T+2 rolling settlement.

34
Depository system

Before introduction of Depository system, the problems

faced by investors and corporate in handling large
volume of paper were as follows:
Bad deliveries
Fake certificates
Loss of certificates in transit
Mutilation of certificates
Delays in transfer
Long settlement cycles
Mismatch of signatures
Delay in refund and remission of dividend etc.

35
Thank You
Models of Risk and
Return
CONCEPT

• Higher Expected Returns Require Taking

Higher Risk
• Most investors are comfortable with the
notion that taking higher levels of risk is
necessary to expect to earn higher returns.
• There are two important models that have
been developed to make this relationship
precise. They are
1. CAPITAL ASSET PRICING MODEL
2. ARBITRAGE PRICING MODEL

2
CAPITAL PRICING ASSET MODEL

A model that describes the relationship

between risk and expected return and
that is used in the pricing of risky
securities.
In this model, a security’s expected
(required) return is the risk-free rate
plus a premium based on the systematic
risk of the security

3
CAPM MODEL

Rs = Rf + bs(Rm - Rf)

Rs = Expected return of stock S

Rf = Risk free return
bs = Beta relative to market portfolio

4
As per CAPM the investors needs to be
compensated in two ways: time value of
money and risk

The time value of money is represented by

the risk-free (Rf ) rate in the formula and
compensates the investors for placing money
in any investment over a period of time

5
The other half of the formula represents risk
and calculates the amount of compensation
the investor needs for taking on additional
risk.
This is calculated by taking a risk measure
(beta) that compares the returns of
the asset to the market over a period
of time and to the market premium (Rm-Rf ).

6
The CAPM says that the expected return of a
security or a portfolio equals the rate on a
risk-free security plus a risk premium.

If this expected return does not meet or beat

the required return, then the investment
should not be undertaken.
The security market line plots the results of
the CAPM for all different risks (betas).

7
Security Market line

8
CAPM ASSUMPTIONS

1.Capital markets are efficient.

2. All investor are rational, risk averse and broadly diversified
across a range of investments. They cannot influence prices.
Trade without transaction or taxation costs.
3. Risk-free asset return is certain.
4.Market portfolio contains only systematic risk
5. Assume all information is available at the same time to all
investors.
6. Investors have no access to private information
( allowing them to find undervalued or valued stock)

9
Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk is the variability of return on stocks or

portfolios associated with changes in return on the
market as a whole.

Unsystematic Risk is the variability of return

on stocks or portfolios not explained by
general market movements.
It is avoidable through diversification

10
UNSYSTEMATIC RISK

11
SYSTEMATIC RISK

12
What is BETA ?

Beta is used in the capital asset pricing model

(CAPM), a model that calculates the expected return of
an asset based on its beta and expected market returns

Rs = Rf + bs(Rm - Rf)

A measure of the volatility, or systematic risk, of a

Security or a portfolio in comparison to the market as
a whole

13
Beta is calculated using regression analysis,
and you can think of beta as the tendency
of a security's returns to respond to swings
in the market.
It measures the sensitivity of a stock’s returns to
changes in returns on the market portfolio

The beta for a portfolio is simply a weighted

Average of the individual stock betas in the
portfolio.
14
A beta of 1 indicates that the security's price
will move with the market.
A beta of less than 1 means that the security
will be less volatile than the market.
A beta of greater than 1 indicates that the
security's price will be more volatile than
the market.
For example, if a stock's beta
is 1.2, it's theoretically 20% more volatile than
the market.

15
BETA FORMULA

Beta : It is the ratio of covariance between

the market return and the security’s
return to the market return variance .

16
 Calculating “Beta”
YEARS MARKET RETURN XYZ LTD RETURNS

Rm (%) Rx (%)

1 20 25

2 -18 -32

3 40 55

4 -8 -13

5 36 45
 ESTIMATION OF BETA
YEA MARKET XYZ LTD Market Stock
RS RETURN Rx % Deviation deviation (4) X (5) (Rm-Rm )²
% Rm-Rm Rx -Rx

(1) ( 2) (3) (4) (5) (6) (7)

1 20 25 6 9 54 36

2 -18 -32 -32 -48 1536 1024

3 40 55 26 39 1014 676

4 -8 -13 -22 -29 638 484

5 36 45 22 29 638 484

Rm=14 Rx=16 Sum= Sum=

Mean Mean 3880 2704
Beta Calculation

Multiply deviations of the market returns and

deviations of XYZ Ltd (column 6).
Take the sum and divide by 5 (no of observations) to
get covariance
COV m x = 3880/5 = 776

Calculate the squared deviations of the market returns

(column 7) Take the sum and divide by 5 to find the
variation of market return.
= 2704/5 = 540.8

Divide the covariance of the market and XYZ Ltd by the

Market variance to get beta
Beta = β = 776/ 540.8= 1.434 .
19
INTERCEPT

The intercept term is given by the following formula

α = Rx – βxX Rm
Rx= expected return on security x
Rm= is the expected market return
α = return on security on account of unsystematic risk

α = 16 – 1.434 X 14
= 16 – 20.076
= - 4.076 % is the return from unsystematic risk
Thus the characteristic line of XYZ Ltd is :
Rx = -4.076 + 1.434 Rm

20
We can plot the observed returns on market and
XYZ ltd and fit A regression line as shown in the
figure . The fitted line is as per the equation A ,
the regression line as per the market model is called
The characteristics line

Security characteristic line (SCL) is a regression line,

plotting performance of a particular security or
portfolio against that of the market portfolio at every
point in time .The SCL is plotted on a graph where the
Y-axis is the return and the X-axis is the
return of the market in general.

21
Security Characteristic line

XYZ LTD RETURN

Rx = -4.076 + 1.434 Rm

Characteristic line

Slope = beta

MARKET RETURN

Characteristic Line
Security Characteristic line

The slope of the line is the security's beta, which is a

measure of systematic risk, determines the
risk-return tradeoff.

According to this metric, the more risk you take on

-as measured by variability in returns - the higher the
returns you can expect to earn.

23
The Market Model

There is another proceedure for calculating Beta is the

use of the Market or Index model
In the market model, we regress returns on a security
against returns of the market index

The market model is given by following equation

Where Rx is the expected return on security x , Rm is
the market return. α is intercept , beta is the slope and
e is the error.
R   b R e
x x m x

Return = Unsystematic Risk (α) + Systematic risk (β )

24
 Rx    b x Rm  ex
Equation A

Rx= expected return on security x

Rm= is the expected market return
α = is intercept ,
β= slope of regression or beta
ex = is the error term

α Is indicates the return on the security when the

market return is zero . It could be interpreted as
return on security on account of unsystematic risk

25
The value of β and α in the regression are given
by the following equations

Beta = β = N ∑XY – (∑X) ( ∑Y)

N ∑X² - ( ∑ X)²

26
 MARKET STOCK
Year RETURN RETURN X Y XY X² Y²
1 20 25 6.00 9.00 54 36 81
2 -18 -32 -32.00 -48.00 1536 1024 2304
3 40 55 26.00 39.00 1014 676 1521
4 -8 -13 -22.00 -29.00 638 484 841
5 36 45 22.00 29.00 638 484 841
14.00 16.00
0 0 3880 2704 5588

∑X=0 ∑y=0 ∑XY=3880 ∑X²=2704

∑X²=0 N∑XY= 19400

= 19400- 0 = 19400 = 1.43

5X 2704 13520
27
Risk free returns = Rf

A risk-free asset is one where the investor knows

The expected return with certainty.
Therefore an asset is risk free whose actual returns
be equal to the expected return …..

In valuation, the time horizon is generally infinite,

leading to the conclusion that a long-term riskfree
rate will always be preferable to a short term rate, if
you have to pick one.

Ten year G-secs can be considered as Risk free

asset for CAPM

28
Risk Premium = (Rm-Rf)

The risk premium in the capital asset pricing model

measures the extra return that would be demanded by
investors for shifting their money from a riskless
investment to an average risk investment
The difference between the expected return on a
market portfolio and the risk-free rate.

Risk premium is the minimum amount of money by

which the expected return on a risky asset must
exceed the known return on a risk-free asset, or the
expected return on a less risky asset, in order to
induce an individual to hold the risky asset rather
than the risk-free asset .
29
APT

Arbitrage Pricing Theory

1976, Economist Stephen Ross

assume:
several factors affect E(R)
does not specify factors

30
MACRO ECONOMIC FACTORS

Implications
E(R) is a function of several Macro
Economic factors, F each with its
own b .
E( R )  R f  b1F1  b2 F2  b3F3  ....  bN FN

31
APT vs. CAPM

APT is more general

many factors
unspecified factors
CAPM is a special case of the APT
•1 factor
•factor is market risk premium
•It captures an assets exposure
to all market risk in one number ..Beta but at
the cost of making restrictive assumptions
•APM relaxes these assumptions.
•It allows for multiple sources of market risk
and asset to have different beta to source of
Market risk

32
CONCLUSION

The CAPM, with its inherent simplicity, linking

market covariance risk to expected returns.

Its simplicity helps to build intuition around the

concept of modelling return as a function of risk.

The CAPM’s simplicity is also its greatest

shortcoming, as the underlying assumptions limit its
ability to explain and predict actual returns.

APM expands the capabilities of the model by adding

company specific risk factors - These factors in
concert explain most of the returns due to risk expos

33
Arbitrage pricing theory (APT)

APT is a general theory of asset pricing that holds

that the expected return of a financial asset can be
modelled as a linear function of various
macro-economic factors , where sensitivity to changes
in each factor is represented by a factor-specific
beta coefficient.

The model-derived rate of return will then be used to

price the asset correctly - the asset price should
equal the expected end of period price discounted
at the rate implied by the model. If the price
diverges, arbitrage should bring it back into line .

34
»Thanks

35
PORTFOLIO
MANAGEMENT
FRAMEWORK
Introduction

• Activities of Portfolio Management

- Formation of an optimal portfolio
•Investment objective and constraints
• Phases of portfolio management
- SECURITY ANALYSIS
- PORTFOLIO ANAYSIS
- PORTFOLIO SELECTION
- PORTFOLIO REVISION
- PORTFOLIO EVALUATION

2
Formation of an optimal portfolio

Formation of an Optimal Portfolio requires following

activities for any Investor

• Choosing appropriate Securities

• Making a portfolio with the help of the selected
securities
• Choosing appropriate weights or proportion of
securities so as to form the optimal portfolio
• The choice of the securities and their respective
proportion will depend on the risk appetite of the
investor

3
Investment objective and constraints

Objectives and Constraints :

1. Return requirements
2. Risk tolerance
3. Safety and security of principal
4. Investment horizon
5. Taxes
6. Liquidity & Marketability
7. Diversification

4
Objectives

Income : to provide a steady stream of income

through regular interest and dividends
payment

Growth : to increase the value of the principal

amount through capital appreciation

Stability : To protect the principal amount

invested from the risk of loss

5
Constraints

Liquidity :lt refers to the marketability of the asset, i.e.,

the ability and ease of an asset to be converted into
cash and vice versa.
Investment Horizon : it refers to the length of time for
which an investor expects to remain invested in a
particular security or portfolio, before realizing the
returns
Taxes : Investors are always concerned with the net
and not gross returns and therefore tax-free
investments or investments subject to lower tax rate
may trade at a premium as compared to investments
with taxable returns.

6
PHASES OF PORTFOLIO MANAGEMENT

7
SECURITY ANALYSIS

Security analysis is the analysis of trade able

financial instruments called securities
These can be classified into debt securities,
equities, or some hybrid of the two.

Security analysis is typically divided into

fundamental analysis, which relies upon the
examination of fundamental business factors
auch as financial statements, and technical
analysis which focuses upon price trends
and momentum
8
PORTFOLIO ANALYSIS

A process used to assess the suitability of a

portfolio of securities relative to its expected
investment return and its correlation to the risk
tolerance of an investor seeking the optimal
trade-off between risk and return.
An analysis conducted at regular intervals
enables the investor to make the necessary
adjustments in the portfolio's allocation of
different investment classes according to
changing market conditions or changes in his
own circumstances.
9
PORTFOLIO SELECTION

A study of how people should invest their wealth

optimally

Although there are some general rules for portfolio

selection that apply to virtually everyone, there is
no single portfolio or portfolio strategy that is best
for everyone.
A process of trading off risk and expected return
to find the best portfolio of assets and liabilities

10
Modern portfolio theory (MPT) :is a theory
that attempts to maximize portfolio
expected return for a given amount
of portfolio risk, or equivalently minimize
risk for a given level of expected return, by
carefully choosing the proportions of
various assets

11
PORTFOLIO REVISION

The art of changing the mix of securities in a

portfolio is called as portfolio revision

The process of addition of more assets in an

existing portfolio or changing the ratio of
funds invested is called as portfolio revision.

The sale and purchase of assets in an existing

portfolio over a certain period of time to
maximize returns and minimize risk is called
as portfolio revision.
12
PORTFOLIO REVISION

An individual at certain point of time might feel

the need to invest more.
The need for portfolio revision arises when
an individual has some additional money to
invest.
Change in investment goal also gives rise to
revision in portfolio. Depending on the cash
flow, an individual can modify his financial
goal, eventually giving rise to changes in the
portfolio i.e. portfolio revision.

13
PORTFOLIO REVISION

Financial market is subject to risks and

uncertainty.
An individual might sell off some of his assets
owing to fluctuations in the financial market.

14
PORTFOLIO EVALUATION

Performance Measurement involves the

calculation of the return realized by a portfolio
manager over some time interval called
the evaluation period.

Performance Evaluation is an appraisal of

how well a managed portfolio has done over
the evaluation period.

15
THANK YOU

16