Final Module

Table of Content
COURSE DESCRIPTION ............................................................................................................................ 4

COURSE OBJECTIVES .............................................................................................................................. 4
CHAPTER ONE: INVESTMENT PROCESS ............................................................................................. 5
INTRODUCTION ........................................................................................................................................ 5
1.1 MEANING OF INVESTMENT: ................................................................................................................... 6
1.2 INVESTMENT ALTERNATIVES/FORMS ..................................................................................................... 7
1.3 OBJECTIVES OF INVESTMENT................................................................................................................ 15
1.4 CHARACTERISTICS OF INVESTMENT ..................................................................................................... 17
1.5 INVESTMENT AND SPECULATION ......................................................................................................... 17
1.6 TYPES OF SECURITIES ............................................................................................................................ 19
1.7 MAJOR INVESTOR IN SECURITIES .......................................................................................................... 21
1.8 THE INVESTMENT PROCESS .................................................................................................................. 22
CHAPTER TWO: SECURITY ANALYSIS AND VALUATION ............................................................ 24
2.1 SECURITY ANALYSIS ................................................................................................................. 24
2.2 FUNDAMENTAL ANALYSIS ...................................................................................................... 25
2.2.1 Fundamental Analysis - Economic Analysis ............................................................................. 29
2.2.2 Fundamental Analysis: Qualitative Factors - The Industry ....................................................... 33
2.2.3 Fundamental Analysis: Qualitative Factors - The Company ..................................................... 34
2.3 TECHNICAL ANALYSIS ............................................................................................................. 36
2.4 FUNDAMENTAL VS TECHNICAL ANALYSIS ....................................................................... 45
2.5 VALUATION OF SECURITIES .................................................................................................. 45
2.5.1 Basic Valuation Model............................................................................................................... 48
CHAPTER THREE: RISK AND RETURN OF SINGLE SECURITY ..................................................... 67
3.1 INTRODUCTIONS ........................................................................................................................ 67
3.1.1 Key term Definitions .......................................................................................................... 67
3.1.2 General over view of securities ......................................................................................... 69
3.2 CONCEPTS AND MEASUREMENT OF EXPECTED RETURN OF INDIVIDUAL SECURITY .............. 74
3.2.1 Investment returns ............................................................................................................... 75
3.2.2 Stand-alone risk................................................................................................................... 77
3.2.3 Probability distributions ...................................................................................................... 77
3.2.4 Expected rate of return ........................................................................................................ 79
3.3 CONCEPTS AND MEASUREMENT OF STAND-ALONE RISK......................................................... 81
AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

3.4 FACTORS THAT AFFECT RISK AND RETURN ............................................................................... 87
3.4.1 The real risk-free rate (RRFR) ............................................................................................. 88
3.4.2 Factors influencing the nominal risk-free rate (NRFR) ...................................................... 89
3.4.3 Risk premium ...................................................................................................................... 92
3.5 SYSTEMATIC AND UNSYSTEMATIC RISK .................................................................................... 95
CHAPTER FOUR: PORTFOLIO ANALYSIS AND MODERN PORTFOLIO THEORY ...................... 97
4.1 INTRODUCTION..................................................................................................................... 97
4.1.1 What is portfolio ........................................................................................................................ 97
4.1.2 What is portfolio management? ................................................................................................. 98
4.1.3 The key elements of portfolio management ..................................................................... 98
4.1.4 Need for portfolio management ........................................................................................ 99
4.1.5 Types of portfolio management ...................................................................................... 100
4.1.6 Who is a portfolio manager? ........................................................................................... 100
4.2 PORTFOLIO ANALYSIS ..................................................................................................... 100
4.2.1 What is portfolio analysis? ................................................................................................ 100
4.2.2 What is involved in portfolio analysis? ............................................................................. 102
4.3 MEASURING EXPECTED PORTIFOLIO RETURN AND RISK .................................. 102
4.3.1 Measuring expected portfolio return ........................................................................................ 103
4.3.2 Measuring portfolio risk........................................................................................................... 104
4.3.3 Variance and standard Deviation as a measure of risk............................................................. 106
4.4 PORTFOLIO RISK-RETURN ANALYSIS OF TWO SECURITIES .............................. 108
4.5 PORTFOLIO RISK-RETURN ANALYSIS of N SECURITIES ....................................... 118
4.6 DIVERSIFICATION AND PORTFOLIO RISK....................................................................... 119
4.7 PORTFOLIO SELECTION MODELS ................................................................................ 120
4.7.1 Markowitz portfolio selection model ................................................................................ 121
4.7.2 Single index model............................................................................................................ 124
4.7.3 Multi-factor model ............................................................................................................ 127
4.7.4 Capital ASSET PRICING MODEL–CAPM .................................................................... 128
CHAPTER FIVE: PORTFOLIO REVISION AND EVALUATION ........................................................................ 132
INTRODUCTION............................................................................................................................... 132
5.1 MEANING AND NEED OF PORTFOLIO REVISION ..................................................... 132
5.1.1 Meaning of portfolio Revision ................................................................................................. 132
5.1.2 Need for Portfolio Revision .............................................................................................. 133
5.2 PORTFOLIO EVALUATION............................................................................................... 134
5.2.1 Constraints in portfolio revision .............................................................................................. 134
5.3 PORTFOLIO REVISION STRATEGIES ................................................................................. 134

5.3.1 Active Portfolio revision strategy ..................................................................................... 135
5.3.2 Passive Portfolio revision strategy .................................................................................... 135
5.3.3 Meaning of Portfolio Evaluation....................................................................................... 140
5.3.4 Need for Portfolio Evaluation ........................................................................................... 140
5.4 PORTFOLIO PERFORMANCE EVALUATION MODELS .................................................. 142
5.4.1 Sharpe Ratio ...................................................................................................................... 143
5.4.2 Treynor Ratio .................................................................................................................... 144
5.4.3 Jensen Ratio ...................................................................................................................... 145
5.5 CONCLUSION ............................................................................................................................. 147
REFERENCE ...................................................................................................................................... 149

COURSE DESCRIPTION
To become a successful investor, investment advisor and portfolio manager, or security analyst as
well as security broker and dealer, learners must grasp the necessary knowledge of financial market
as well as a wide variety of qualitative and quantitative skills in the area of Investment Analysis.
Thus, this course is designed to provide students with necessary knowledge and skill of making
sound Investment decision by understanding Stock exchange and trading system, Analyzing risk
and return, Constructing and Analyzing stock index, Conducting security analysis and finally
Applying theory of portfolio Selection and performance evaluation.
COURSE OBJECTIVES
After completion of the course, the student should be able to:

 Develop a sound investment background.
 Understand the function of stock exchange markets
 Understand stock trading system, stock listing requirement and efficient capital
markets
 Construct and analyze security market index.
 Conduct economy, industry and company analysis to identify potential
investment areas
 Analyze the relationship between risk and return
 Apply the theory of portfolio selection and performance evaluation.

CHAPTER ONE: INVESTMENT PROCESS
INTRODUCTION
For most of the investors throughout their life, they will be earning and spending money. Rarely,
investor’s current money income exactly balances with their consumption desires. Sometimes,
investors may have more money than they want to spend; at other times, they may want to purchase
more than they can afford. These imbalances will lead investors either to borrow or to save to
maximize the long-run benefits from their income. When current income exceeds current
consumption desires, people tend to save the excess. They can do any of several things with these
savings. One possibility is to put the money under a mattress or bury it in the backyard until some
future time when consumption desires exceed current income. When they retrieve their savings
from the mattress or backyard, they have the same amount they saved. Another possibility is that
they can give up the immediate possession of these savings for a future larger amount of money
that will be available for future consumption. This tradeoff of present consumption for a higher
level of future consumption is the reason for saving. What investor does with the savings to make
them increase over time is investment. In contrast, when current income is less than current
consumption desires, people borrow to make up the difference. Those who give up immediate
possession of savings (that is, defer consumption) expect to receive in the future a greater amount
than they gave up. Conversely, those who consume more than their current income (that is,
borrowed) must be willing to pay back in the future more than they borrowed. The rate of exchange
between future consumption (future Birr) and current consumption (current Birr) is the pure rate
of interest. Both people’s willingness to pay this difference for borrowed funds and their desire to
receive a surplus on their savings give rise to an interest rate referred to as the pure time value of
money. This interest rate is established in the capital market by a comparison of the supply of
excess income available (savings) to be invested and the demand for excess consumption
(borrowing) at a given time.
An investment is the current commitment of birr for a period of time in order to derive future
payments that will compensate the investor for (1) The time the funds are committed, (2) The
expected rate of inflation, and (3) The uncertainty of the future payments. The “Investor” can be
an individual, a government, a pension fund, or a corporation. Similarly, this definition includes
all types of investments, including investments by corporations in plant and equipment and
investments by individuals in stocks, bonds, commodities, or real estate. In all cases, the investor
is trading a known birr amount today for some expected future stream of payments that will be
greater than the current outlay. Definition of Individual investor: “An individual who purchases
small amounts of securities for themselves, as opposed to an institutional investor, also called as
Retail Investor or Small Investor.” They invest to earn a return from savings due to their deferred
consumption. They want a rate of return that compensates them for the time, the expected rate of
inflation, and the uncertainty of the return. In today’s world everybody is running for money and
it is considered as a root of happiness. For secure life and for bright future people start investing.
Every time investors are confused with investment avenues and their risk return profile.
1.1 MEANING OF INVESTMENT:

Investment is the employment of funds with the aim of getting return on it. In general terms,
investment means the use of money in the hope of making more money. Specifically, an
investment is the current commitment of dollars for a period of time in order to derive future
payments that will compensate the investor for (1) the time the funds are committed, (2) the
expected rate of inflation during this time period, and (3) the uncertainty of the future payments.
The “investor” can be an individual, a government, a pension fund, or a corporation. Similarly,
this definition includes all types of investments, including investments by corporations in plant
and equipment and investments by individuals in stocks, bonds, commodities, or real estate. This
text emphasizes investments by individual investors. In all cases, the investor is trading a known
dollar amount today for some expected future stream of payments that will be greater than the
current dollar amount today.
At this point, we have answered the questions about why people invest and what they want from
their investments. They invest to earn a return from savings due to their deferred consumption.
They want a rate of return that compensates them for the time period of the investment, the
expected rate of inflation, and the uncertainty of the future cash flows.
In finance, investment means the purchase of a financial product or other item of value with an
expectation of favorable future returns. Investment of hard earned money is a crucial activity of
every human being. Investment is the commitment of funds which have been saved from current
consumption with the hope that some benefits will be received in future. Thus, it is a reward for
waiting for money. Savings of the people are invested in assets depending on their risk and return
demands. Investment refers to the concept of deferred consumption, which involves purchasing an
asset, giving a loan or keeping funds in a bank account with the aim of generating future returns.
Various investment options are available, offering differing risk-reward tradeoffs. An
understanding of the core concepts and a thorough analysis of the options can help an investor
create a portfolio that maximizes returns while minimizing risk exposure. There are two concepts

of Investment: 1) Economic Investment: The concept of economic investment means addition to
the capital stock of the society. The capital stock of the society is the goods which are used in the
production of other goods. The term investment implies the formation of new and productive
capital in the form of new construction and produces durable instrument such as plant and
machinery. Inventories and human capital are also included in this concept. Thus, an investment,
in economic terms, means an increase in building, equipment, and inventory. 2) Financial
Investment: This is an allocation of monetary resources to assets that are expected to yield some
gain or return over a given period of time. It means an exchange of financial claims such as shares
and bonds, real estate, etc. Financial investment involves contrasts written on pieces of paper such
as shares and debentures. People invest their funds in shares, debentures, fixed deposits, national
saving certificates, life insurance policies, provident fund etc. in their view investment is a
commitment of funds to derive future income in the form of interest, dividends, rent, premiums,
pension benefits and the appreciation of the value of their principal capital. In primitive economies
most investments are of the real variety whereas in a modern economy much investment is of the
financial variety. The economic and financial concepts of investment are related to each other
because investment is a part of the savings of individuals which flow into the capital market either
directly or through institutions. Thus, investment decisions and financial decisions interact with
each other. Financial decisions are primarily concerned with the sources of money where as
investment decisions are traditionally concerned with uses or budgeting of money.
1.2 INVESTMENT ALTERNATIVES/FORMS

Wide varieties of investment avenues are now available in Ethiopia. An investor can himself select
the best avenue after studying the merits and demerits of different avenues. Even financial
advertisements, newspaper supplements on financial matters and investment journals offer
guidance to investors in the selection of suitable investment avenues. Investment avenues are the
outlets of funds. A bewildering range of investment alternatives are available, they fall into two
broad categories, viz, financial assets and real assets. Financial assets are paper (or electronic)
claim on some issuer such as the government or a corporate body. The important financial assets
are equity shares, corporate debentures, government securities, deposit with banks, post office
schemes, mutual fund shares, insurance policies, and derivative instruments. Real assets are
represented by tangible assets like residential house, commercial property, agricultural farm, gold,
precious stones, and art object. As the economy advances, the relative importance of financial
assets tends to increase. Of course, by and large the two forms of investments are complementary
and not competitive. Investors are free to select any one or more alternative avenues depending

upon their needs. All categories of investors are equally interested in safety, liquidity and
reasonable return on the funds invested by them. In Ethiopia, investment alternatives are
continuously increasing along with new developments in the economy. Investment is now possible
in corporate securities, government bond etc. Thus, wide varieties of investment avenues are now
available to the investors. However, the investors should be very careful about their hard earned
money. An investor can select the best avenue after studying the merits and demerits of the
following investment alternatives:
1. Shares
2. Debentures and Bonds
3. Bank Deposits
4. Post Office Savings
5. Money Market Instruments
6. Mutual Fund Schemes
7. Life Insurance Schemes
8. Real Estates
9. Gold-Silver
10. Derivative Instruments
11. Commodity Market (commodities)
For sensible investing, investors should be familiar with the characteristics and features of various
investment alternatives. These are the various investment avenues; where individual and
institutional investors can invest their hard earn money. The following investment avenues are
popular and used extensively in the world:
1) SHARES: ‘Share means a share in the share capital of a company. A company is a business
organization. The shares which are issued by companies are of two types i.e. Equity shares and
Preference shares. Every company has share capital. The share capital of a company is divided
into number of equal parts and each of such part is known as a 'share'. A public limited company
has to complete three stages. The first is registration. The second is raising capital and the third is
commencement of business. A public limited company issues shares to the public for raising
capital. The first public issue is known as Initial Public Offerings (IPO). The shares can be issued
at par, premium or discount. Each share has a face value of birr 100, or 1000. In order to issue
shares a prospectus is prepared and it is got approved from concerned government body. These
shares are listed with the stock exchange so that the shareholders can sale these shares in the
market. The company has to make an application to the stock exchange for listing of shares. The
shares are also called as "stock". Investment in shares is more risky because the share prices go
on changing day by day. Today, the market is more 'volatile' means more fluctuating. The share
prices may go up or go down. If the stock market falls the share prices will go down and the
investor will lose money in the investment However, the return on investment in shares is higher.
The return on investment in shares is in the form of regular dividend, capital appreciation, bonus
and rights. There is also liquidity in this kind of investment. The shares can be sold in stock market
and money can be collected within 3 to 4 days. Investment in shares is not a tax saving investment.’
Companies (Private and Public) need capital either to increase their productivity or to increase
their market reach or to diversify or to purchase latest modern equipment. Companies go in for
IPO and if they have already gone for IPO then they go for FPO. The only thing they do in either
IPO or FPO is to sell the shares or debentures to investors (the term investor here represents retail
investors, financial institutions, government, high net worth individuals, banks etc). Shares
constitute the ownership securities and are popular among the investing class. Investment in shares
is risky as well as profitable. Transactions in shares take place in the primary and secondary
markets. Large majority of investors (particularly small investors) prefer to purchase shares
through brokers and other dealers operating on commission basis. Purchasing of shares is now
easy and quick due to the extensive use of computers and screen based trading system (SBTs).
Orders can be registered on computers. The purpose of a stock exchange is to facilitate the trading
of securities between buyers and sellers, thus providing a marketplace. Investing in equities is
riskier and definitely demands more time than other investments. There are two ways in which
investment in equities can be made: i. through the primary market (by applying for shares that are
offered to the public) ii. Through the secondary market (by buying shares that are listed on the
stock exchanges)
2) DEBENTURES AND BONDS: A debenture is a document issued by a company as an

evidence of a debt. It is a certificate issued by a company under its seal, acknowledging a debt due
by it to its holders. The term debenture includes debenture stock, bonds and any other securities
issued by a company. A company can raise loans from the public by issue of debentures. The
debenture holder becomes the creditor of the company. The debenture holder gets interest on the
debenture which is fixed at the time of issue. The debentures are also issued to the public just like
issue of shares. However, there is a need for credit rating before issue of debentures or Bonds.
Bonds are issued by Government companies and the debentures are issued by the Private sector
companies. Therefore, bonds may be tax saving but debentures are not tax saving investment. The
companies use owned capital as well as borrowed capital in their capital structure as compared to
equity shares because debenture holders have no say in the management of the company and
interest on debentures is allowed as a business expense for tax purposes. The debentures are
considered as secured loan. There is no much risk in the investment in debentures as compared to
shares. The return on debentures is also reasonable and stable. The debentures are also listed with
the stock exchanges and can be traded in the stock market. However, the prices of debentures are
not much volatile. The debenture, being a loan, is redeemable at a certain period or maturity,
otherwise it can be irredeemable. The debentures can be convertible or nonconvertible. If a
debenture is convertible into shares at maturity, it is called convertible. The convertible debentures
may be partly convertible or fully convertible. Convertible debentures became popular in the last
decade. The method of raising long term funds through debentures is not popular in Ethiopia.
Bonds refer to debt instruments bearing interest on maturity. In simple terms, organizations may
borrow funds by issuing debt securities named bonds, having a fixed maturity period (more than
one year) and pay a specified rate of interest (coupon rate) on the principal amount to the holders.
Bonds have a maturity period of more than one year which differentiates it from other debt
securities like commercial papers, treasury bills and other money market instruments. Debt
instrument represents a contract whereby one party lends money to another on pre-determined
terms with regards to rate and periodicity of interest, repayment of principal amount by the
borrower to the lender. Most of the time, the term ‘bond’ is used for debt instruments issued by
the governments and public sector organizations and the term ‘debenture’ is used for instruments
issued by private corporate sector.
3) BANK DEPOSITS: Investment of surplus money in bank deposits is quite popular among
the investors (Particularly among salaried people). Banks (Co-operative and Commercial) collect
working capital for their business through deposits called bank deposits. The deposits are given by
the customers for specific period and the bank pays interest on them. In Ethiopia, all types of banks
accept deposits by offering interest. The deposits can be accepted from individuals, institutions
and even business enterprises, the business and profitability of banks depend on deposit collection.
For depositing money in the bank, an investor/depositor has to open an account in a bank. Different
types of deposit accounts are: 1. Current Account 2. Savings Bank Account 3. Fixed Deposit
Account, and 4. Special Saving account. The rate of interest for Fixed Deposits (FD) differs from
bank to bank. Usually a bank FD is paid in lump sum on the date of maturity. However, some
banks have facility to pay interest at the end of every quarter. If one desires to get interest paid
every month, then the interest paid will be at a discounted rate. The Interest payable on Fixed
Deposit can also be transferred to Savings Bank or Current Account of the customer. This indicates
the use of bank deposit as an avenue of investment by investors.

4) POST OFFICE SAVINGS: Post office operates as a financial institution. It collects small
savings of the people through savings bank accounts facility. In addition, time deposits and
government loans are also collected through post offices. Postal savings bank schemes were
popular in most countries for a long period as banking facilities were limited and were available
mainly in the urban areas. The popularity of postal savings schemes is now reducing due to the
growth of banking and other investment facilities throughout the world. However, even at present,
small investors use postal savings facilities for investing their savings/ surplus money for short
term/long term due to certain benefits like stable return, security and safety of investment and loan
facility against postal deposits. Even tax benefit is one attraction for investment in post office.
Investment in postal schemes is as good as giving money to the government for economic
development along with reasonable return and tax benefits. The interest rates on time deposits
vary from time to time but it is higher than other deposits due to long maturity period. Thus, post
office provides various schemes for safe investment of surplus funds. However, the return on
investment is rather low.
5) MONEY MARKET INSTRUMENTS: Money market is a centre in which financial

institutions join together for the purpose of dealing in financial or monetary assets, which may be
of short term maturity. The short term generally means a period up to one year and the term near
substitutes to money denotes any financial asset which may be quickly converted into money with
minimum transaction cost. Thus, money market is a market for short term financial instruments,
maturity period of which is less than a year. The deals are over the counter. The numbers of players
in the market are limited. It is regulated by National Bank of Ethiopia. Money Market Instruments
where Investors can invest are Treasury bills, Certificate of Deposit, Commercial Paper,
Repurchase Options (Repo), Money Market Mutual Funds (MMMFs).
6) MUTUAL FUNDS: Mutual fund is a financial intermediary which collects savings of the
people for secured and profitable investment. The main function of mutual fund is to mobilize the
savings of the general public and invest them in stock market securities. The entire income of
mutual fund is distributed among the investors in proportion to their investments- Expenses for
managing the fund are charged to the fund. These funds are managed by financial and professional
experts. The savings collected from small investors are invested in a safe, secured and profitable
manner. Therefore, it is said that mutual fund is a boon to the small investors. A mutual fund is
formed by the coming together of a number of investors who hand over their surplus funds to a
professional organization to manage their funds. The main function of mutual fund is to mobilize

the savings of the general public and invest them in stock market securities. At present, there is
diversion of savings of the middle class investors from banks to mutual funds.
Mutual funds have introduced many schemes for attracting investors and also for collecting their
savings. Such schemes include open ended schemes which are open to the investors for all the
time. They can buy or sell the units whenever they desire. Such schemes are Regular Income
Schemes, Recurring Income Schemes, Cumulative Growth Schemes, etc. There are close-ended
schemes in which there is a lock in period of three to five years and investors cannot buy or sell
the investment during that period. Basically, there are four schemes by which mutual funds collect
money from the investors such as (1) Growth Schemes (2) Income Schemes (3)Balanced Schemes
(4) Tax Saving Schemes. In case of growth schemes the investment grows according to the time
and in case of income schemes the investors get regular income from the investments. Balanced
schemes are the combination of both these schemes. Tax saving scheme is designed to save income
tax while investing in the market. There are different types of investors and their objectives are
also different. Therefore, mutual funds have started different schemes in order to suit the objectives
of these investors. Mutual funds are popular investments because of low risk and high returns.
There is liquidity in case of open-ended schemes and some of the schemes provide tax savings.
There are income schemes which provide regular income to the investors. Investors prefer to give
their savings to mutual funds for the safety of their funds and also for securing the benefits of
diversified investment. These funds take appropriate investment decisions and handover the
benefits of profitable investment to the investors.
7) LIFE INSURANCE POLICIES: Nothing is more important to a person than the feeling that
their family is financially secure - at all times. “Life insurance is a contract whereby the insurer,
in consideration of a premium paid either in a lump sum or in periodical installments undertakes
to pay an annuity or certain sum of money either on the death of the insured or on the expiry of a
certain number of years, whichever is earlier.” The distribution system for life insurance products
involves various intermediaries between the insurer and the insured. The different distribution
channels used by insurance companies are, Agents, Brokers, Corporate Agents, Banc assurance.
Private insurance companies have been exploring the various distribution channels available
instead of concentrating on individual agents. Life insurance is a kind of Investment Avenue
provides family protection to the investor as well as return on investment in the form of yearly
bonus on the policy. The return on investment is reasonably low because of risk coverage and tax
incentives. Though, the maturity period is longer the insurance policy can be surrendered or loan
can be availed on the policy, therefore there is some sort of liquidity in this investment. Thus,

investment in life insurance is a profitable investment and there is no risk in this investment. Life
insurance covers the risk that exists in one's life. These risks may arise due to accident, illness or
natural causes like fire, flood, and earthquake. Life insurance aims to protect the family of the life
insured so that they may not suffer from financial consequences on the death or disability of the
insured person.
8) INVESTMENT IN REAL ESTATES: Investment in real estate includes properties like

building, industrial land, plantations, farm houses, agricultural land near cities and flats or houses.
Such properties attract the attention of affluent investors. It is an attractive, as well as profitable
investment avenue today. A residential building represents the most attractive real estate property
for majority of investors. The prices of real estate are increasing day by day. The land is limited
on the earth but the population has been increasing. As the demand increases but the supply of
land is limited, the prices tend to increase. Therefore, it is attractive investment which generates
higher return during a short period of time. Types of properties are Residential property,
Commercial property, and Agricultural land. Ownership of a residential house provides owned
accommodation to the family and gives satisfaction to the family members. It acts as one useful
family asset with saleable value. It is a long term investment. Investment in real estate provides
capital appreciation of residential buildings, urban land and flats. It gives reasonable return on
investment. There is a low risk but there is no liquidity. There are chances of capital appreciation
also. The property can also be used as security for raising loans. There is a quick appreciation in
the value of assets. There is a low liquidity in case of investment in real estates. The risk in the
investment is also more as compared to investment in banks and mutual funds. The amount of
investment is huge and therefore the benefits of diversification of investment are not available. In
real estate profitability is available at the cost of liquidity.
9) INVESTMENT IN GOLD AND SILVER: Gold and silver are the precious objects.
Everybody likes gold and hence requires gold or silver. These two precious metals are used for
making ornaments and also for investment of surplus funds over a long period of time. Some
people buy these metals as an investment. The prices of gold and silver are also increasing
continuously. The prices also depend upon demand and supply of gold. The supply has been
increasing at low speed. However, the demand has been increasing very fast. Therefore, the prices
also go on increasing. People use gold and silver at the time of marriages and other festivals. Apart
from gold and silver, precious stones such as diamonds, rubies and pearls are also appealing for
long term investment particularly among rich people. Gold and silver are useful as a store of
wealth. They act as secret assets. The investment is highly liquid, which can be sold at any time.

The market prices are continuously increasing. Therefore, the return on investment is also
increasing. The investment is also safe and secured. There is a high degree of prestige value for
gold and silver in the society. The benefit of capital appreciation is also available. The investment
in gold and silver is risky due to the chances of theft. It may also cause an injury to the life of the
investor. It is a long term investment. Regular income from the investment is not available. This
investment is not available for capital formation and economic growth of the country. There is no
tax saving on this investment. Gold and silver, the two most widely held precious metals, appeal
to almost all kinds of investors for the following reasons. i. Historically, they have been good
hedges against inflation. ii. They are highly liquid with very low trading commissions. iii. They
are aesthetically attractive. iv. Returns on gold, in general, have been negatively correlated with
returns on stocks. So, gold provides a good diversification opportunity. v. They process a high
degree of ‘moneyness’. According to jack clark francis: “ A substance possesses moneyness when
it is (1) a store of value, (2) durable, (3) easy to own anonymously, (4) easy to subdivide into small
pieces that are also valuable, (5) easy to authenticate, and (6) interchangeable, that is,
homogeneous or fungible." As against these advantages, investment in gold and silver has the
following disadvantages: i. They do not provide regular current income. ii. There is no tax
advantage associated with them, iii. There may be a possibility of being cheated. Investment in
gold and silver can be in physical or nonphysical forms. The physical form includes bullion, coins,
and jewellery. Gold or silver bars, called bullion, come in a wide range of sizes. Jewellery made
of gold or silver may provide aesthetic satisfaction but is not a good form of investment because
of high making charges which may not be recovered. The nonphysical form includes futures
contracts, units of gold exchange-traded funds, and shares of gold mining companies. Investors
can buy futures contracts in gold and silver—such contracts tend to be highly leveraged
investments. The units of gold exchange—traded funds (ETFs) are listed on a secondary market
and investors can buy such units easily. Finally, investors can buy shares of common stock of a
company that mines gold or silver as an indirect way of investing in these metals.
10) DERIVATIVE INSTRUMENTS: A derivative is a product whose value is derived from the
value of an underlying asset, index or reference rate. The underlying asset can be equity, forex,
commodity or any other asset. For example, if the settlement price of a derivative is based on the
stock price of a stock for e.g. Facebook which frequently changes on a daily basis, then the
derivative risks are also changing on a daily basis. This means that derivative risks and positions
must be monitored constantly. A derivative security can be defined as a security whose value
depends on the values of other underlying variables. Very often, the variables underlying the
derivative securities are the prices of traded securities. Derivatives are of four types, (1) Forward
(2) Futures (3) Options and (4) Swaps. From the point of view of investors and portfolio managers,
futures and options are the two most important financial derivatives. They are used for hedging
and speculation. The difference between a share and derivative is that shares/securities are an asset
while derivative instrument is a contract.
11) COMMODITIES: A commodity may be defined as a product or material or any physical

substance like food grains, processed products and agro-based products, metals or currencies,
which investors can trade in the commodity market. One of the characteristics of a commodity is
that its price is determined as a function of its market as a whole. Well-established physical
commodities are actively traded in spot and derivative commodity market. Commodities actually
offer immense potential to become a separate asset class for market-savvy investors, arbitragers
and speculators. Retail investors, who claim to understand the equity market, may find commodity
market quite tricky. But commodities are easy to understand as far as fundamentals of demand and
supply are concerned. Retail investors should understand the risks and advantages of trading in
commodity market before taking a leap. Historically, prices of commodities have remained
extremely volatile. The gradual evolution of commodity market in Ethiopia has been of great
significance for the country's economic prosperity. A commodity market is a market where various
commodities and derivatives products are traded. Most commodity market across the world trade
in agricultural products and other raw materials (like wheat, barley, sugar, maize, cotton, cocoa,
coffee, milk products, pork bellies, oil, metals, etc.) and contracts based on them. These contracts
can include spot prices, forwards, futures and options on futures. Other sophisticated products may
include interest rates, environmental instruments, swaps, or ocean freight contracts. The sale and
purchase of commodities is usually carried out through futures contracts on exchanges that
standardize the quantity and minimum quality of the commodity being traded. Commodities
exchanges usually trade futures contracts on commodities, such as trading contracts to receive a
particular commodity in physical form. Speculators and investors also buy and sell the futures
contracts at commodity exchanges to make a profit and provide liquidity to the system. The
Ethiopian commodity market offers a variety of products like Coffee, wheat, and many more.
1.3 OBJECTIVES OF INVESTMENT

Investing is a wide spread practice and many have made their fortunes in the process. The starting
point in this process is to determine the characteristics of the various investments and then
matching them with the individuals need and preferences. All personal investing is designed in
order to achieve certain objectives. These objectives may be tangible such as buying a car, house
etc. and intangible objectives such as social status, security etc. similarly; these objectives may be
classified as financial or personal objectives. Financial objectives are safety, profitability, and
liquidity. Personal or individual objectives may be related to personal characteristics of individuals
such as family commitments, status, dependents, educational requirements, income, consumption
and provision for retirement etc. The objectives can be classified on the basis of the investors
approach as follows:
a) Short term high priority objectives: Investors have a high priority towards achieving certain
objectives in a short time. For example, a young couple will give high priority to buy a house.
Thus, investors will go for high priority objectives and invest their money accordingly.
b) Long term high priority objectives: Some investors look forward and invest on the basis of
objectives of long term needs. They want to achieve financial independence in long period. For
example, investing for post-retirement period or education of a child etc. investors, usually prefer
a diversified approach while selecting different types of investments.
c) Low priority objectives: These objectives have low priority in investing. These objectives are
not painful. After investing in high priority assets, investors can invest in these low priority assets.
For example, provision for tour, domestic appliances etc.
d) Money making objectives: Investors put their surplus money in these kinds of investment. Their
objective is to maximize wealth. Usually, the investors invest in shares of companies which
provide capital appreciation apart from regular income from dividend. Every investor has common
objectives with regard to the investment of their capital. The importance of each objective varies
from investor to investor and depends upon the age and the amount of capital they have. These
objectives are broadly defined as follows.
i. Lifestyle – Investors want to ensure that their assets can meet their financial needs over
their lifetimes.
ii. Financial security – Investors want to protect their financial needs against financial risks
at all times.
iii. Return – Investors want a balance of risk and return that is suitable to their personal risk
preferences.
iv. Value for money – Investors want to minimize the costs of managing their assets and their
financial needs.
v. Peace of mind – Investors do not want to worry about the day to day movements of markets
and their present and future financial security.

Achieving the sum of these objectives depends very much on the investor having all their assets
and needs managed centrally, with portfolios planned to meet lifetime needs, with one overall
investment strategy ensuring that the disposition of assets will match individual needs and risk
preferences.
1.4 CHARACTERISTICS OF INVESTMENT

The characteristics of investment can be understood in terms of as - return, risk, safety, liquidity
etc.
Return: All investments are characterized by the expectation of a return. In fact, investments are
made with the primary objective of deriving return. The expectation of a return may be from
income (yield) as well as through capital appreciation. Capital appreciation is the difference
between the sale price and the purchase price. The expectation of return from an investment
depends upon the nature of investment, maturity period, and market demand and so on.
Risk: Risk is inherent in any investment. Risk may relate to loss of capital, delay in repayment of
capital, nonpayment of return or variability of returns. The risk of an investment is determined by
the investments, maturity period, repayment capacity, nature of return commitment and so on.
Risk and expected return of an investment are related. Theoretically, the higher the risk, higher is
the expected returned. The higher return is a compensation expected by investors for their
willingness to bear the higher risk.
Safety: The safety of investment is identified with the certainty of return of capital without loss of
time or money. Safety is another feature that an investor desires from investments. Every investor
expects to get back the initial capital on maturity without loss and without delay.
Liquidity: An investment that is easily saleable without loss of money or time is said to be liquid.
A well-developed secondary market for security increase the liquidity of the investment. An
investor tends to prefer maximization of expected return, minimization of risk, safety of funds and
liquidity of investment.
1.5 INVESTMENT AND SPECULATION

Often investment is understood as a synonym of speculation. Investment and speculation are
somewhat different and yet similar because speculation requires an investment and investment are
at least somewhat speculative. Probably the best way to make a distinction between investment
and speculation is by considering the role of expectation. Investments are usually made with the
expectation that a certain stream of income or a certain price that has existed will not change in
the future. Whereas speculation are usually based on the expectation that some change will occur
in future, there by resulting a return.
Thus an expected change is the basis for speculation but not for investment. An investment also
can be distinguished from speculation by the time horizon of the investor and often by the risk
return characteristic of investment. A true investor is interested in a good and consistent rate of
return for a long period of time. In contrast, the speculator seeks opportunities promising very
large return earned within a short period of time due to changing environment. Speculation
involves a higher level of risk and a more uncertain expectation of returns, which is not necessarily
the case with investment.
Basis Investment Speculation

Type of contract Creditor Ownership
Basis of acquisition Usually by outright purchase Often- on-margin
Length of commitment Comparatively long term For a short time only
Source of income Earnings of enterprise Change in market price
Quantity of risk Small Large
Stability of income Very stable Uncertain and erratic
Psychological attitude of Cautious and conservative Daring and careless
Participants
Reasons for purchase Scientific analysis of Hunches, tips, “inside dope”,
intrinsic worth etc.
The identification of these distinctions helps to define the role of the investor and the speculator
in the market. The investor can be said to be interested in a good rate of return of a consistent basis
over a relatively longer duration. For this purpose the investor computes the real worth of the
security before investing in it. The speculator seeks very large returns from the market quickly.
For a speculator, market expectations and price movements are the main factors influencing a buy
or sell decision. Speculation, thus, is more risky than investment.
In any stock exchange, there are two main categories of speculators called the bulls and bears. A
bull buys shares in the expectation of selling them at a higher price. When there is a bullish
tendency in the market, share prices tend to go up since the demand for the shares is high. A bear
sells shares in the expectation of a fall in price with the intention of buying the shares at a lower
price at a future date. These bearish tendencies result in a fall in the price of shares.

A share market needs both investment and speculative activities. Speculative activity adds to the
market liquidity. A wider distribution of shareholders makes it necessary for a market to exist.
Difference between Investor and Speculator
a) Investor Speculator planninghorizon: An investor has a relatively longer planning horizon.

His/Her holding period is usually at least 1 year. A speculator has a Very short planning
horizon. His holding period may be a few days to a few months.
b) Risk disposition: An investor is normally not willing to assume more than moderate risk.
Rarely does he/she knowingly assume high risk. A speculator is ordinarily willing to
assume high risk.
c) Return expectation: An investor usually seeks a modest rate of return which is
commensurate with the limited risk assumed by him/her. A speculator looks for a high rate
of return in exchange for the high risk borne by him/her.
d) Basis for decisions: An investor attaches greater significance to Fundamental factors and
attempt a careful evaluation of the prospects of the firm. A speculator relies more on
hearsay, tips, technical charts and market psychology.
e) Leverage: Typically an investor uses his own funds and eschews borrowed funds. A
speculator normally resorts to borrowings, which can be very substantial, to supplement
his personal resources.
1.6 TYPES OF SECURITIES

There are many different securities that you can invest your money in. They're usually divided into
two categories. Equity securities grant you partial ownership of a company. Debt securities are
considered loans to companies or entities of the government. Here's some of the most popular
security investments.
Stocks
Stocks are the best known equity security. You're purchasing an ownership interest in a company
when you buy stock. You're entitled to a portion of company profits and sometimes shareholder
voting rights.
Stock prices can fluctuate greatly. Investors try to buy stock when the price is low and sell it when
the price is high. Stock has a higher investment risk than most other securities. There's no guarantee
that you won't lose money. However, stock usually has the potential for the greatest returns.

Most stock is considered common stock. Preferred stock normally offers dividends but not
voting rights. Common stockholders also have greater potential for higher returns.
Corporate Bonds
A corporate bond is a debt instrument issued by a company. It's a loan to the company when you
invest in a bond. You're entitled to receive interest each year on the loan until it's paid off.Bonds
are safer and more stable than stocks. You're guaranteed a steady income from bonds. However,
bondholders aren't entitled to dividends or voting rights. In addition, stockholders have potential
for greater returns in the long run.
Government Bonds
Government bonds are issued by the federal government. The most common are the great
renaissance bonds issued by the federal government of Ethiopia. Generally government bonds aree
issued to help finance the national debt.Government bonds have very low investment risk. In fact,
they're virtually risk-free since they're guaranteed by the government. However, the potential
return is lower than stocks and corporate bonds.
Municipal Bonds
Municipal bonds are debt securities from states and local government entities. These local entities
include counties, cities, towns and school districts. The interest income you earn on the municipal
bonds is usually exempt from federal income taxes. It may also be exempt from state and local
income taxes if you live where the bonds are issued. However, the interest rate is usually lower
than corporate bonds.
Mutual Funds
A mutual fund is made up of a variety of securities. It may focus on stocks, bonds or a collection
of both. Your money is usually pooled with other investors. An investment company chooses the
securities and manages the mutual fund. This diversity helps decrease investment risk.
Stock Options
A stock option is the right to buy or sell a stock at a certain price for a period of time. A call is
the right to buy the stock. A put is the right to sell the stock. Stock options can be used to help
reduce your investment risk.
Futures Options

A futures contract is an agreement to sell a specific commodity at a future date for an agreed
upon price. A futures option is the right to buy or sell a futures contract at a certain price for a
specific period of time. Many investors use futures options to help reduce investment risk.
1.7 MAJOR INVESTOR IN SECURITIES

They are generally classified in to two: Individual investors and Institutional investors
I. Individual Investor: “An individual who purchases small amounts of securities for
themselves, as opposed to an institutional investor, also called as Retail Investor or Small
Investor.” Individuals invest to earn a return from savings due to their deferred
consumption. They want a rate of return that compensates them for the time, the expected
rate of inflation, and the uncertainty of the return.
In today’s world everybody is running for money and it is considered as a root of happiness.
For secure life and for bright future people start investing. Every time investors are
confused with investment avenues and their risk return profile.
Individual investors are characterized by large in number, investible resources are smaller,
lacks extensive evaluation & analysis
II. Institutional investors: An institutional investor is an organization, rather than an

individual, that invests on behalf of the organization's members. They are a large
organization, such as a bank, pension fund, labor union, or insurance company, which
makes substantial investments on the stock exchange. Organization with surplus fund who
engage in investment activities. In contrast to the individual investors institutional investors
are fewer in numbers, their investible resources are much larger, and use professional
approach in the investment decision making process.
Institutional investors are the biggest component of the so-called "smart money" group.
There are generally six types of institutional investors: pension funds, endowment funds,
insurance companies, commercial banks, mutual funds and hedge funds.
Most institutional investors in the U.S. are regulated by the Securities and Exchange
Commission (SEC). Institutional investors must file a Form 13F with the SEC to report their
quarterly holdings; they must also file a Form 13G if they own more than 5% of a
company's stock. Retail investors can use these public filings to peek into what institutions
are buying or selling each quarter.

Institutional investors have the resources to do extensive research on wide-
ranging investment options, and due to their specialized knowledge, they generally have an
edge over retail investors. Portfolio managers often meet personally with company
executives, study entire industries, and evaluate companies in depth before making specific
investment decisions.
Institutions are usually the largest force behind supply and demand in securities markets,
thus they have a major influence of the prices of many securities. The vast majority of the
trading on major exchanges is done by institutions and it's important to note that because
of the size of their portfolios, institutional buying and selling may greatly influence the
price of a security.
1.8 THE INVESTMENT PROCESS

The investment process is description of the steps that an investor should take to construct and
manage their portfolio. These proceed from the initial task of identifying investment objectives
through to the continuing revision of the portfolio in order to best attain those objectives. The steps
in this process are:
1. Determine Objectives. Investment policy has to be guided by a set of objectives. Before

investment can be undertaken, a clear idea of the purpose of the investment must be obtained. The
purpose will vary between investors. Some may be concerned only with preserving their current
wealth. Others may see investment as a means of enhancing wealth. What primarily drives
objectives is the attitude towards taking on risk. Some investors may wish to eliminate risk as
much as is possible, while others may be focused almost entirely on return and be willing to accept
significant risks.
2. Choose Value: The second decision concerns the amount to be invested. This decision can be
considered a separate one or it can be subsumed in the allocation decision between assets (what is
not invested must either be held in some other form which, by definition, is an investment in its
own right or else it must be consumed).
3. Conduct Security Analysis. Security analysis is the study of the returns and risks of securities.
This is undertaken to determine in which classes of assets investments will be placed and to
determine which particular securities should be purchased within a class. Many investors find it
simpler to remain with the more basic assets such as stocks and fixed income securities rather than
venture into complex instruments such as derivatives. Once the class of assets has been
determined, the next step is to analyze the chosen set of securities to identify relevant
characteristics of the assets such as their expected returns and risks. This information will be
required for any informed attempt at portfolio construction. Another reason for analyzing securities
is to attempt to find those that are currently mispriced. For example, a security that is underpriced
for the returns it seems to offer is an attractive asset to purchase. Similarly, one that is overpriced
should be sold. Whether there are any assets are underpriced depends on the degree of efficiency
of the market. More is said on this issue later. Such analysis can be undertaken using two
alternative approaches:
 Technical analysis: This is the examination of past prices for predictable trends. Technical
analysis employs a variety of methods in an attempt to find patterns of price behavior that
repeat through time. If there is such repetition (and this is a disputed issue), then the most
beneficial times to buy or sell can be identified.
 Fundamental analysis: The basis of fundamental analysis is that the true value of a
security has to be based on the future returns it will yield. The analysis allows for temporary
movements away from this relationship but requires it to hold in the long-rum.
Fundamental analysts study the details of company activities to makes predictions of future
profitability since this determines dividends and hence returns.
4. Portfolio Construction. Portfolio construction follows from security analysis. It is the

determination of the precise quantity to purchase of each of the chosen securities. A factor that is
important to consider is the extent of diversification. Diversifying a portfolio across many assets
may reduce risk but it involves increased transactions costs and increases the effort required to
manage the portfolio.
5. Evaluation. Portfolio evaluation involves the assessment of the performance of the chosen
portfolio. To do this it is necessary to have some yardstick for comparison since a meaningful
comparison is only achieved by comparing the return on the portfolio with that on other portfolios
with similar risk characteristics.
6. Revision. Portfolio revision involves the application of all the previous steps. Objectives may
change, as may the level of funds available for investment. Further analysis of assets may alter the
assessment of risks and returns and new assets may become available. Portfolio revision is
therefore the continuing reapplication of the steps in the investment process.
SUMMERY
Investment is a financial activity that involves risk. It is the commitment of funds for a return
expected to be realized in the future. Investments may be made in financial assets or physical
assets. In either case there is the possibility that the actual return may vary from the expected
return. That possibility is the risk involved in the investment.
Risk and Return are the two most important characteristics of any investment. Safety and liquidity
are also important for an investor. The objective of an investor is specified as maximization of
return and minimization of risk. Investment is generally distinguished from speculation in terms
of three factors, namely risk, capital gains and time period. Gambling is the extreme form of
speculation. Investors may be individuals or institutions. Both types of investors combine to make
investment activity dynamic and profitable. The investors in the financial market have different
attitudes towards risk and varying levels of risk bearing capacity. Some investors are risk averse,
while some may have an affinity to risk. The risk bearing capacity of an investor, on the other
hand, is a function of his income. A person with higher income is assumed to have a higher risk
bearing capacity. Each investor tries to maximize his welfare by choosing the optimum
combination of risk and return in accordance with his preference and capacity.
CHAPTER TWO: SECURITY ANALYSIS AND VALUATION
2.1 SECURITY ANALYSIS
Security analysis is one vital part of investment decision process involving the analysis and
valuation of individual securities. 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. More broadly, futures contracts and trade-able credit derivatives are sometimes
included. Security analysis is typically divided into fundamental analysis, which relies upon the
examination of fundamental business factors such as financial statements, and technical analysis,
which focuses upon price trends and momentum. Quantitative analysis may use indicators from
both areas.

When the objective of the analysis is to determine what stock to buy and at what price, there are
two basic methodologies investors rely upon:
 Fundamental analysis: maintains that markets may misprice a security in the short run
but that the "correct" price will eventually be reached. Profits can be made by purchasing
the mispriced security and then waiting for the market to recognize its "mistake" and re-
price the security.
 Technical analysis: maintains that all information is reflected already in the price of a
security. Technical analysts analyze trends and believe that sentiment changes predate and
predict trend changes. Investors' emotional responses to price movements lead to
recognizable price chart patterns. Technical analysts also analyze historical trends to
predict future price movement.
2.2 FUNDAMENTAL ANALYSIS

Fundamental analysis is the analysis of a business's financial statements (usually to analyze the
business's assets, liabilities, and earnings); health; and its competitors and markets. When applied to
futures and forex, it focuses on the overall state of the economy, and considers factors including
interest rates, production, earnings, employment, GDP, housing, manufacturing and management.
When analyzing a stock, futures contract, or currency using fundamental analysis there are two
basic approaches one can use: bottom up analysis and top down analysis. The terms are used to
distinguish such analysis from other types of investment analysis, such as quantitative and technical.
Fundamental analysis is the cornerstone of investing. In fact, some would say that you aren't really
investing if you aren't performing fundamental analysis. Because the subject is so broad, however,
it's tough to know where to start. There are an endless number of investment strategies that are
very different from each other, yet almost all use the fundamentals.
The biggest part of fundamental analysis involves delving into the financial statements. Also
known as quantitative analysis, this involves looking at revenue, expenses, assets, liabilities and
all the other financial aspects of a company. Fundamental analysts look at this information to gain
insight on a company's future performance.
But there is more than just number crunching when it comes to analyzing a company. This is where
qualitative analysis comes in - the breakdown of all the intangible, difficult-to-measure aspects of
a company.

Fundamental analysis is performed on historical and present data, but with the goal of making
financial forecasts. There are several possible objectives:
 To conduct a company stock valuation and predict its probable price evolution;
 To make a projection on its business performance;
 To evaluate its management and make internal business decisions;
 And/or to calculate its credit risk.
 To find out the intrinsic value of the share.
Investors can use one or both of these different but complementary methods for stock picking. For
example, many fundamental investors use technical for deciding entry and exit points. Similarly,
many technical investors use fundamentals to limit their universe of possible stock to 'good'
companies.
The choice of stock analysis is determined by the investor's belief in the different paradigms for
"how the stock market works”
Fundamental analysis includes:
1. Economic analysis
2. Industry analysis
3. Company analysis
Phase Nature of Analysis Purpose Tools and techniques

FIRST Economic Analysis To access the general Economic indicators
economic situation of
the nation.
SECOND Industry Analysis To assess the Industry life cycle analysis,
prospects of various Competitive analysis of industries
industry groupings etc.
THIRD Company Analysis To analyze the Analysis of Financial aspects:
Financial and Non- Sales, Profitability, EPS etc.
financial aspects of a Analysis of Non-financial aspects:
company to determine management, corporate image,
whether to buy, sell or product quality etc.

hold the shares of a
company.
The intrinsic value of the shares is determined based upon these three analyses. This value is
considered the true value of the share. If the intrinsic value is higher than the market price, it is
recommended to buy the share. If it is equal to market price, it is recommended to hold the share;
if it is less than the market price, then one should sell the shares.
Investors using fundamental analysis can use either a top-down or bottom-up approach.
 The top-down investor starts their analysis with global economics, including both
international and national economic indicators; such as GDP growth rates, inflation, interest
rates, exchange rates, productivity, and energy prices. They subsequently narrow their search
to regional/industry analysis of total sales, price levels, the effects of competing products,
foreign competition, and entry or exit from the industry. Only then do they refine their
search to the best business in the area being studied.
 The bottom-up investor starts with specific businesses, regardless of their industry/region,
and proceeds in reverse of the top-down approach.
Fundamental analysis is a technique that attempts to determine a security's value by focusing on

underlying factors that affect a company's actual business and its future prospects. On a broader
scope, you can perform fundamental analysis on industries or the economy as a whole. The term
simply refers to the analysis of the economic well-being of a financial entity as opposed to only its
price movements.
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"?
Of course, these are very involved questions, and there are literally hundreds of others you might
have about a company. It all really boils down to one question: Is the company's stock a good
investment? Think of fundamental analysis as a toolbox to help you answer this question.
Note: The term fundamental analysis is used most often in the context of stocks, but you can
perform fundamental analysis on any security, from a bond to a derivative. As long as you look at
the economic fundamentals, you are doing fundamental analysis. For the purpose of this course,
fundamental analysis always is referred to in the context of stocks.
The various fundamental factors can be grouped into two categories: quantitative and qualitative.
The financial meaning of these terms isn't all that different from their regular definitions. Here is
how they are defined in different literature:
 Quantitative – capable of being measured or expressed in numerical terms.
 Qualitative – related to or based on the quality or character of something, often as opposed

to its size or quantity.
Quantitative fundamentals are numeric, measurable characteristics about a business. It's easy to
see how the biggest source of quantitative data is the financial statements. You can measure
revenue, profit, assets and more with great precision. Turning to qualitative fundamentals, these
are the less tangible factors surrounding a business - things such as the quality of a company's
board members and key executives, its brand-name recognition, patents or proprietary technology.
Neither qualitative nor quantitative analysis is inherently better than the other. Instead, many
analysts consider qualitative factors in conjunction with the hard, quantitative factors. Take the
Coca-Cola Company, for example. When examining its stock, an analyst might look at the stock's
annual dividend payout, earnings per share, P/E ratio and many other quantitative factors.
However, no analysis of Coca-Cola would be complete without taking into account its brand
recognition. Anybody can start a company that sells sugar and water, but few companies on earth
are recognized by billions of people. It's tough to put your finger on exactly what the Coke brand
is worth, but you can be sure that it's an essential ingredient contributing to the company's success.
The concept of Intrinsic Value
Before we get any further, we have to address the subject 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 $20. After doing extensive homework on the
company, you determine that it really is worth $25. In other words, you determine the intrinsic

value of the firm to be $25. 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. Nobody knows how long "the long run" really is. It
could be days or years. 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.
The big unknowns are:
 You don't know if your estimate of intrinsic value is correct; and
 You don't know how long it will take for the intrinsic value to be reflected in the marketplace.
2.2.1 Fundamental Analysis - Economic Analysis

The economy is studied to determine if overall conditions are good for the stock market. Is inflation
a concern? Are interest rates likely to rise or fall? Are consumers spending? Is the trade balance
favorable? Is the money supply expanding or contracting? These are just some of the questions
that the fundamental analyst would ask to determine if economic conditions are right for the stock
market. For studying the Economic Analysis, the Macro Economic Factors are considered.
The macro economic factors that significantly affects the firms and describe the state of economy
in any economic environment includes the followings:
 Growth rate of Gross Domestic Product (GDP):
An economy's overall economic activity is summarized by a measure of aggregate output. As the

production or output of goods and services generates income, any aggregate output measure is
closely associated with an aggregate income measure. The GDP is a measure of all currently
produced goods and services valued at market prices. One should notice several features of the
GDP measure. First, only currently produced goods (produced during the relevant year) are
included. This implies that if you buy a 150-year old classic residential house, it does not count
towards the GDP; but the service rendered by your real estate agent in the process of buying the
house does. Secondly, only final goods and services are counted. In order to avoid double counting,
intermediate goods—goods used in the production of other goods and services—do not enter the
GDP. For example, steel used in the production of automobiles is not valued separately. Finally,
all goods and services included in the GDP are evaluated at market prices. Thus, these prices reflect
the prices consumers pay at the retail level, including indirect taxes such as local sales taxes.
Growth in the country’s GDP have positive effect in the price of stock.
 Savings and investment:
Growth of an economy requires proper amount of investments which in turn is dependent upon
amount of domestic savings. The amount of savings is favorably related to investment in a country.
The level of investment in the economy and the proportion of investment in capital market is major
area of concern for investment analysts. The level of investment in the economy is equal to:
Domestic savings + inflow of foreign capital - investment made abroad. Stock market is an
important channel to mobilize savings, from the individuals who have excess of it, to the individual
or corporate, who have deficit of it. Savings are distributed over various assets like equity shares,
bonds, small savings schemes, bank deposits, mutual fund units, real estates, etc. The demand for
corporate securities has an important bearing on stock prices movements. Greater the allocation of
equity in investment, favorable impact it have on stock prices.
 Industry Growth rate:
The GDP growth rate represents the average of the growth rate of agricultural sector, industrial
sector and the service sector. The current contribution of industry sector in GDP in the year 2015-
16 is 12.5 percent approximately. Publicly listed company play a major role in the industrial sector.
The stock market analysts focus on the overall growth of different industries contributing in
economic development. The higher the growth rate of the industrial sector, other things being
equal, the more favorable it is for the stock market.
 Price level and Inflation:
The inflation rate is defined as the rate of change in the price level. Most economies face positive
rates of inflation year after year. The price level, in turn, is measured by a price index, which
measures the level of prices of goods and services at given time. The numbers of items included
in a price index vary depending on the objective of the index. Usually three kinds of price indexes,
having particular advantages and uses are periodically reported by government sources. The first
index is called the consumer price index (CPI), which measures the average retail prices paid by
consumers for goods and services bought by them. A couple of thousand items, typically bought
by an average household, are included in this index.

A second price index used to measure the inflation rate is called the producer price index (PPI). It
is a much broader measure than the consumer price index. The third and broadest measure of
inflation is the called the implicit GDP price deflator. This index measures the prices of all goods
and services included in the calculation of the current output of goods and services in the economy,
the GDP.
The three measures of the inflation rate are most likely to move in the same direction, even though
not to the same extent. Differences can arise due to the differing number of goods and services
included for the purpose of compiling the three indexes. In general, if one hears about the inflation
rate number in the popular media, it is most likely to be the number based on the CPI.
 Agriculture and monsoons:
Agriculture is directly and indirectly linked with the industries. Hence increase or decrease in
agricultural production has a significant impact on the industrial production and corporate
performance. Companies using agricultural raw materials as inputs or supplying inputs to
agriculture are directly affected by change in agriculture production.
 Interest Rate:
The interest rate is invariably quoted in nominal terms—that is, it is not adjusted for inflation.
Thus, the commonly followed interest rate is actually the nominal interest rate. Nevertheless, there
are literally many nominal interest rates. Examples include: savings account rate, six-month
certificate of deposit rate, 15-year mortgage rate, variable mortgage rate, 90 days Treasury bill
rate, and commercial bank prime lending rate. One can see from these examples that the nominal
interest rate has two key attributes—the duration of lending/borrowing involved and the identity
of the borrower.
One should note that the nominal interest rate does not represent the real cost of borrowing or the
real return on lending. To understand the real cost or return, one must consider the inflation-
adjusted nominal rate, called the real interest rate. Tax and other considerations also influence the
real cost or return. Nevertheless, the real interest rate is a very important concept in understanding
the main incentives behind borrowing or lending.
 Government budget and deficit:
Government plays an important role in the growth of any economy. The government prepares a
central budget which provides complete information on revenue, expenditure and deficit of the
government for a given period. Government revenue come from various direct and indirect taxes
and government made expenditure on various developmental activities. The excess of expenditure
over revenue leads to budget deficit. For financing the deficit the government goes for external
and internal borrowings. Thus, the deficit budget may lead to high rate of inflation and adversely
affects the cost of production and surplus budget may results in deflation. Hence, balanced budget
is highly favorable to the stock market.
 The tax structure:
The business community eagerly awaits the government announcements regarding the tax policy.
The type of tax exemption has impact on the profitability of the industries. Concession and
incentives given to certain industry encourages investment in that industry and have favorable
impact on stock market.
 Balance of payment, forex reserves and exchange rate:
Balance of payment is the record of all the receipts and payment of a country with the rest of the
world. This difference in receipt and payment may be surplus or deficit. Balance of payment is a
measure of strength of Birr on external account. The surplus balance of payment augments forex
reserves of the country and has a favorable impact on the exchange rates; on the other hand if
deficit increases, the forex reserve depletes and has an adverse impact on the exchange rates. The
industries involved in export and import are considerably affected by changes in foreign exchange
rates. The volatility in foreign exchange rates affects the investment of foreign institutional
investors in Ethiopian economy. Thus, favorable balance of payment renders favorable impact on
stock market.
 Infrastructural facilities and arrangements:
Infrastructure facilities and arrangements play an important role in growth of industry and
agriculture sector. A wide network of communication system, regular supply or power, a well-
developed transportation system (railways, transportation, road network, inland waterways, port
facilities, air links and telecommunication system) boost the industrial production and improves
the growth of the economy. Banking and financial sector should be sound enough to provide
adequate support to industry and agriculture. The government has liberalized its policy except the
communication, Air transport, financial sectors and power sector for foreign investment. Thus,
good infrastructure facilities affect the stock market favorable.

2.2.2 Fundamental Analysis: Qualitative Factors - The Industry
Each industry has differences in terms of its customer base, market share among firms, industry-
wide growth, competition, regulation and business cycles. Learning about how the industry works
will give an investor a deeper understanding of a company's financial health.
 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.
 Market Share
Understanding a company's present market share can tell volumes about the company's business.
The fact that a company possesses an 85% 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.
 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.
 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 Ethio-Telecom. They are so dominant in the telephone business, that Ethio-
Telecom practically sets the price for any of the suppliers wanting to do business with them. If you
want to buy telephone and internet service from Ethio-Telecom, you have little, if any, pricing
power.
 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.
In other industries, regulation can play a less direct role in affecting industry pricing. For example,
the drug industry is one of most regulated industries. And for good reason - no one wants an
ineffective drug that causes deaths to reach the market. As a result, the Ethiopian. Food and Drug
Administration Agency (FDAA) requires that new drugs must pass a series of clinical trials before
they can be sold and distributed to the general public.
However, the consequence of all this testing is that it usually takes several years and millions of
Birr before a drug is approved. Keep in mind that all these costs are above and beyond the millions
that the drug company has spent on research and development.
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.
2.2.3 Fundamental Analysis: Qualitative Factors - The Company

Fundamental analysis seeks to determine the intrinsic value of a company's stock. But since
qualitative factors, by definition, represent aspects of a company's business that are difficult or
impossible to quantify, incorporating that kind of information into a pricing evaluation can be quite
difficult.
On the flip side, as we've demonstrated, you can't ignore the less tangible characteristics of a
company. Some of the company-specific qualitative factors that you should be aware of are:
 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 or read company profile.
Sometimes business models are easy to understand. Take WOW, 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.
 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. When a company can achieve competitive
advantage, its shareholders can be well rewarded for decades.
 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. So how does an average investor go about evaluating
the management of a company?
This is one of the areas in which individuals are truly at a disadvantage compared to professional
investors. You can't set up a meeting with management if you want to invest a few thousand
dollars. On the other hand, if you are a fund manager interested in investing millions of Birr, there
is a good chance you can schedule a face-to-face meeting with the upper brass of the firm.
Every public company has a corporate information section on its website or company profile
document. Usually there will be a quick biography on each executive with their employment
history, educational background and any applicable achievements. Don't expect to find anything
useful here. Let's be honest: We're looking for dirt, and no company is going to put negative
information on its corporate website or company profile document.
 Corporate Governance
Corporate governance describes the policies in place within an organization denoting the
relationships and responsibilities between management, directors and stakeholders. These policies
are defined and determined in the company charter and its bylaws, along with corporate laws and
regulations. 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.
Good corporate governance is a situation in which a company complies with all of its governance
policies and applicable government regulations in order to look out for the interests of the
company's investors and other stakeholders.
Although, there are companies and organizations that attempt to quantitatively assess companies
on how well their corporate governance policies serve stakeholders, most of these reports are quite
expensive for the average investor to purchase.
Fortunately, corporate governance policies typically cover a few general areas: structure of the
board of directors, stakeholder rights and financial and information transparency. With a little
research and the right questions in mind, investors can get a good idea about a company's corporate
governance.
2.3 TECHNICAL ANALYSIS

Fundamental analysis and Technical analysis are the two main approaches to security analysis.
Technical analysis is frequently used as a supplement to fundamental analysis rather than as a
substitute to it. According to technical analysis, the price of stock depends on demand and supply
in the market place. It has little correlation with the intrinsic value. All financial data and market
information of a given stock is already reflected in its market price.
Technical analysts have developed tools and techniques to study past patterns and predict future
price. Technical analysis is basically the study of the markets only. Technical analysts study the
technical characteristics which may be expected at market turning points and their objective
assessment. The previous turning points are studied with a view to develop some characteristics
that would help in identification of major market tops and bottoms. Human reactions are, by and
large consistent in similar though not identical reaction; with his various tools, the technician
attempts to correctly catch changes in trend and take advantage of them.
Technical analysis is directed towards predicting the price of a security. The price at which a buyer
and seller settle a deal is considered to be the one precise figure which synthesis, weighs and finally
expresses all factors, rational and irrational, quantifiable and non-quantifiable and is the only figure
that counts.
Thus, the technical analysis provides a simplified and comprehensive picture of what is happening
to the price of a security. Like a shadow or reflection it shows the broad outline of the whole
situation and it actually works in practice.
Assumptions of technical analysis
 The market value of a security is solely determined by the interaction of demand and supply
factors operating in the market.
 The demand and supply factors of a security are surrounded by numerous factors; these
factors are both rational as well as irrational.
 The security prices move in trends or waves which can be both upward or downward
depending upon the sentiments, psychology and emotions of operators or traders.
 The present trends are influenced by the past trends and the projection of future trends is
possible by an analysis of past price trends.
 Except minor variations, stock prices tend to move in trends which continue to persist for
an appreciable length of time.
 Changes in trends in stock prices are caused whenever there is a shift in the demand and
supply factors.
 Shifts in demand and supply, no matter when and why they occur, can be detected through
charts prepared specially to show market action.
 Some chart trends tend to repeat themselves. Patterns which are projected by charts record
price movements and these patterns are used by technical analysis for making forecasts
about the future patterns.

Advantages of Technical Analysis
According to technical analysts, it is important to recognize that the fundamental analysts can
experience superior returns only if they obtain new information before other investors and process
it correctly and quickly. Technical analysts do not believe the vast majority of investors can
consistently get new information before other investors and consistently process it correctly and
quickly.
In addition, technical analysts claim that a major advantage of their method is that it is not heavily
dependent on financial accounting statements—the major source of information about the past
performance of a firm or industry. The technician points out several major problems with
accounting statements:
1. They lack a great deal of information needed by security analysts, such as information related
to sales, earnings, and capital utilized by product line and customers.
2. According to GAAP (generally accepted accounting principles), corporations may choose
among several procedures for reporting expenses, assets, or liabilities. Notably, these alternative
procedures can produce vastly different values for expenses, income, return on assets, and return
on equity. As a result, an investor can have trouble comparing the statements of two firms in the
same industry, much less firms in different industries.
3. Many psychological factors and other non-quantifiable variables do not appear in financial
statements. Examples include employee training and loyalty, customer goodwill, and general
investor attitude toward an industry. Investor attitudes could be important when investors become
concerned about the risk from restrictions or taxes on products such as tobacco or alcohol or when
firms do business in countries that have significant political risk.
Therefore, because technicians are suspicious of financial statements, they consider it
advantageous not to depend on them. As we will show, most of the data used by technicians, such
as security prices, volume of trading, and other trading information, is derived from the stock
market itself.
Also, a fundamental analyst must process new information correctly and quickly to derive anew
intrinsic value for the stock or bond before the other investors can. Technicians, on the other hand,
only need to quickly recognize a movement to a new equilibrium value for whatever reason—that
is, they do not need to know about an event and determine the effect of the event on the value of
the firm and its stock.
Challenges to Technical Analysis

Those who doubt the value of technical analysis for investment decisions question the usefulness
of this technique in two areas. First, they challenge some of its basic assumptions. Second, they
challenge some specific technical trading rules and their long-run usefulness.
Challenges to Technical Analysis Assumptions
The major challenge to technical analysis is based on the results of empirical tests of the efficient
market hypothesis (EMH). For technical trading rules to generate superior risk-adjusted returns
after taking account of transactions costs, the market would have to be slow to adjust prices to the
arrival of new information, that is, it would have to be inefficient. (This is referred to as the weak-
form efficient market hypothesis.) The two sets of tests of the weak-form EMH are: (1) the
statistical analysis of prices to determine if prices moved in trends or were a random walk, and (2)
the analysis of specific trading rules to determine if their use could beat a buy-and-hold policy
after considering transactions costs and risk. Almost all the studies testing the weak-form EMH
using statistical analysis have found that prices do not move in trends based on statistical tests of
autocorrelation and runs. These results support the EMH.
Challenges to Technical Trading Rules

An obvious challenge to technical analysis is that the past price patterns or relationships between
specific market variables and stock prices may not be repeated. As a result, a technique that
previously worked might miss subsequent market turns. This possibility leads most technicians to
follow several trading rules and to seek a consensus of all of them to predict the future market
pattern.
Other critics contend that many price patterns become self-fulfilling prophecies. For example,
assume that many analysts expect a stock selling at $40 a share to go to $50 or more if it should
rise above its current pattern and “breakthrough” its channel at $45. As soon as it reaches $45,
enough technicians will buy to cause the price to rise to $50, exactly as predicted. In fact, some
technicians may place a limit order to buy the stock at such a breakout point. Under such
conditions, the increase will probably be only temporary and the price will return to its true
equilibrium.
Another problem with technical analysis is that the success of a particular trading rule will
encourage many investors to adopt it. It is contended that this popularity and the resulting
competition will eventually neutralize the technique. If numerous investors focus on a specific
technical trading rule, some of them will attempt to anticipate the price pattern and either ruin the
expected historical price pattern or eliminate profits for most traders by causing the price to change
faster than expected.
Tools and Techniques of Technical Analysis
There are numerous tools and techniques for doing technical analysis. Basically this analysis is
done from the following four important points of view:-
1) Prices: Whenever there is change in prices of securities, it is reflected in the changes in

investor attitude and demand and supply of securities.
2) Time: The degree of movement in price is a function of time. The longer it takes for a
reversal in trend, greater will be the price change that follows.
3) Volume: The intensity of price changes is reflected in the volume of transactions that
accompany the change. If an increase in price is accompanied by a small change in
transactions, it implies that the change is not strong enough.
4) Width: The quality of price change is measured by determining whether a change in trend
spreads across most sectors and industries or is concentrated in few securities only. Study
of the width of the market indicates the extent to which price changes have taken place in
the market in accordance with a certain overall trends.
The followings are some of the technical analysis methods:
I. DOW THEORY
The Dow Theory, originally proposed by Charles Dow in 1900 is one of the oldest technical
methods still widely followed. The basic principles of technical analysis originate from this theory.
According to Charles Dow “The market is always considered as having three movements, all
going at the same time. The first is the narrow movement from day to day. The second is the
short swing, running from two weeks to a month or more and the third is the main movement,
covering at least four years in its duration”.
The Theory advocates that stock behavior is 90% psychological and 10% logical. It is the mood
of the Crowd which determines the way in which prices move and the move can be gauged by
analyzing the price and volume of transactions.
The Dow Theory only describes the direction of market trends and does not attempt to forecast
future movements or estimate either the duration or the size of such market trends. The theory uses

the behavior of the stock market as a barometer of business conditions rather than as a basis for
forecasting stock prices themselves. It is assumed that most of the stocks follow the underlying
market trend, most of the times.
A trend should be assumed to continue in effect until such time as its reversal has been definitely
signaled. According to this theory the market movement/behavior is classified as bull market, and
bear market and. The end of a bull market is signaled when a secondary reaction of decline carries
prices lower than the level recorded during the earlier reaction and the subsequent advance fails to
carry prices above the top level of the preceding recovery. The end of a bear market is signaled
when an intermediate recovery carries prices to a level higher than the one registered in the
previous advance and the subsequent decline halts above the level recorded in the earlier reaction.
II. CHARTING
Charting is the basic tool in technical analysis, which provides visual assistance in defecting
changing pattern of price behavior. The technical analyst is sometimes called the Chartist because
of importance of this tool. The Chartists believe that stock prices move in fairly persistent trends.
There is an inbuilt inertia, the price movement continues along a certain path (up, down or
sideways) until it meets an opposing force due to demand-supply changes. Chartists also believe
that generally volume and trend go hand in hand. When a major ‘up’ trend begins, the volume of
trading increases and also the price and vice-versa.
The essence of Chartism is the belief that share prices trace out patterns over time. These are a
reflection of investor behavior and it can be assumed that history tends to repeat itself in the stock
market. A certain pattern of activity that in the past produced certain results is likely to give rise
to the same outcome should it reappear in the future. The various types of commonly used charts
are Line Chart, Bar Chart and Point and figure Chart.
Line Charts: The simplest form of chart is a line chart. Line charts are simple graphs drawn by
plotting the closing price of the stock on a given day and connecting the points thus plotted over a
period of time. Line charts take no notice of the highs and lows of stock prices for each period.
Bar Charts: It is a simple charting technique. In this chart, prices are indicated on the vertical axis
and the time on horizontal axis. The market or price movement for a given session (usually a day)
is represented on one line. The vertical part of the line shows the high and low prices at which the
stock traded or the market moved. A short horizontal tick on the vertical line indicates the price or
level at which the stock or market closed.

Point and Figure Chart (PFC): Though the point and figure chart is not as commonly used as
the other two charts, it differs from the others in concept and construction. In PFC there is no time
scale and only price movements are plotted. As a share price rises, a vertical column of crosses is
plotted. When it falls, a circle is plotted in the next column and this is continued downward while
the price continues to fall. When it rises again, a new vertical line of crosses is plotted in the next
column and so on. A point and figure chart that changes column on every price reversal is
cumbersome and many show a reversal only for price changes of three units or more.
III. TRENDS
A trend can be defined as the direction in which the market is moving. Up trend is the upward
movement and downtrend is the downward movement of stock prices or of the market as measured
by an average or index over a period of time, usually longer than six months. Trend lines are lines
that are drawn to identify such trends and extend them into the future. These lines typically connect
the peaks of advances and bottoms of declines. Sometimes, an intermediate trend that extends
horizontally is seen.
IV. MOVING AVERAGE ANALYSIS
The statistical method of moving averages is also used by technical analysts for forecasting the
prices of shares. While trends in share prices can be studied for possible patterns, sometimes it
may so happen that the prices appear to move rather haphazardly and be very volatile. Moving
average analysis can help under such circumstances. A moving average is a smoothed presentation
of underlying historical data. It is a summary measure of price movement whichreduces the
distortions to a minimum by evening out the fluctuations in share prices. The underlying trend
in prices is clearly disclosed when moving averages are used.
To construct a moving average the time span of the average has to be determined. A 10 day moving
average measures the average over the previous 10 trading days, a 20 day moving average
measures the average values over the previous 20 days and so on. Regardless of the time period
used, each day a new observation is included in the calculation and the oldest is dropped, so a
constant number of points are always being averaged.
The moving averages are worked out in respect of securities studied and depicted on the graph.
Whenever the moving average price line cuts the actual price line of the security or of the market
index from the bottom it is a signal for the investors to sell the shares. Conversely, when the
moving average price line cuts the actual price line from above, it is the right time to buy shares.

The moving average analysis is quite a useful method in finding out the trends in security prices
when it is based on long-term approach. However, a point of caution is in order. Moving average
analysis always invariably provide signal to buy or sell, after the trend reversal has begun. These
are neither lead indicators nor juncture points for change in trends. The moving averages should
therefore, be used only with other indicators, otherwise these may provide true, but mathematically
inaccurate information. The technical analysts can use three types of moving averages -simple,
weighted or exponential.
V. RELATIVE STRENGTH
The empirical evidence shows that certain securities perform better than other securities in a given
market environment and this behavior remains constant over time. Relative strength is the
technical name given to such securities by the technical analysts because these securities have
stability and are able to withstand both depression and peak periods. Investors should invest in
such securities, because these have constant strength in the market. The relative strength analysis
may be applied to individual securities or to whole industries or portfolios consisting of stock and
bonds. The relative strength can be calculated by:
i. Measuring the rate of return of securities
ii. Classifying securities
iii. Finding out the high average return of securities
iv. Using the technique of ratio analysis to find out the strength of an individual security.
Technical analysts measure relative strength as an indication for finding out the return of securities.
They have observed that those securities displaying greatest relative strength in good markets
(bull) also show the greatest weakness in bad markets (bear). These securities will rise and fall
faster than the market.
Technical analysts explain relative strength as a relationship between risk and return of a security
following the trends in the economy. After preparing charts from different securities over a length
of time, the technician would select certain securities which showed relative strength to be the
most promising investment opportunities.
Evaluation of Technical Analysis

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

conjunction with fundamental analysis to guide investment decision-making, as it is
supplementary to fundamental analysis rather than substitute for it.
2.4 FUNDAMENTAL VS TECHNICAL ANALYSIS

The basic differences are:-
1. While the fundamental analysis believes that the market is 90 percent logical and 10percent
psychological, the technical analysis assumes that the market is 90 percent psychological and 10
percent logical.
2. Like fundamental analysis, technical analysis does not evaluate the large number of fundamental
factors relating to the company, the industry and the economy but in it, the internal market data is
analyzed with the help of charts and graphs.
3. Technical analysis mainly seeks to predict short-term price movement appealing the short-term
traders where fundamental analysis tries to establish long-term values. Hence, it appeals to long
tern investors.
4. The technical analysis is based on the premise that the history repeats itself. Therefore, the
technical analysis answers the question “What had happened in the market” while on the basis of
potentialities of market fundamental analysis answers the question, “What will happen in the
market”.
2.5 VALUATION OF SECURITIES

Investment process invariability requires the valuation of securities in which the investments are
proposed. The value of a security may be compared with the price of the security to get an idea as
to whether a particular security is overpriced, underpriced or correctly priced. A number of
concepts of valuation have been used in the literature. Some of these are:
1) Book Value (BV). BV of an asset is an accounting concept based on the historical data
given in the balance sheet of the firm. BV of an asset may either be given in the balance
sheet or can be ascertained on the basis of figures contained in the balance sheet. For
example, the BV of a debenture is the face value itself and is stated in the balance sheet.
The BV of an equity share can be ascertained by dividing the net worth of the firm by the
number of equity shares.
2) Market Value (MV). MV of an asset is defined as the price for which the asset can be
sold. MV of a financial asset refers to the price prevailing at the stock exchange. In case a
security is not listed, then its MV may not be available.

3) Going Concern Value (GV). GV refers to the value of the business as an operating,
performing and running business unit. This is the value which a prospective buyer of a
business may be ready to pay. GV is not necessarily the MV or BV of the entire asset taken
together. GV may be less than or more than the MV/BV of the total business. Rather, GV
depends upon the ability to generate sales and profit in future. If the GV is higher than the
MV, then the difference between the two represents the synergies of the combined assets.
4) Liquidation Value (LV). LV refers to the net difference between the realizable value of
all assets and the sum total of the external liabilities. This net difference belongs to the
owners/shareholders and is known a LV. The LV is a factor of realizable value of an asset
and therefore, is uncertain. The LV may be zero also and in such a case, the
owners/shareholders do not get anything if the firm is dissolved.
5) Intrinsic Value or Capitalized Value (CV). The Intrinsic Value of a financial asset is
defined as the sum of present value of cash flows from an asset discounted at the required
rate of return. In order to find out the Intrinsic Value, the future expected benefits are
discounted for time value of money. In the valuation of financial assets, the Intrinsic Value
is most relevant concept of valuation and has been used in this module.
Required Rate of Return. (RRR)
In order to find out the intrinsic value of security, what is required is the determination of the
required rate of return of the investor for the specific security being valued. This required rate of
return is used as the discount rate to find out the present value. The required rate of return refers
to the yield which the investor wants to earn by making investment. It is consisting of two elements
– the risk free rate of return and the risk premium. These two elements have been presented in the
figure below

The level of risk associated with a given cash flow can significantly affect its value. In terms of
present value, greater risk is incorporated by using a higher discount rate/rate of return. Above
figure shows that as the risk increases, the required rate of return also increases and the increase
occurs because of the increase in risk premium. The risk-free rate, Ip remains the same for all levels
of risk, and the risk premium, rp, goes on increasing with the increase in risk. Thus, it may be said
that the required rate of return is a factor of the following:
1. The risk free rate Ipn
2. The risk perception/attitude of the investors, and
3. The risk premium, rp, i.e. compensation required for bearing the risk.
Required rate of return, k, may be defined as:
kd= rf + rp
Where:
rf=the risk free rate
rp =The risk premium,,

Kd= Required rate of return,
2.5.1 Basic Valuation Model

Value of a security is a fundamental variable and depends on its promised return, risk and the
discount rate. You may recall the basic understanding of present value concept, with the mention
of fundamental factors like returns and discount rate. In fact the basic valuation model is none else
than present value procedure.
Basically, the valuation model can be presented in terms of the cash flows, their timings and the
required rate of return. The value of a security is determined by discounting the expressed cash
flows to their present value at a discount rate commensurate with the risk-return prospective of the
investor. So utilizing the present value technique, the value of financial asset can be expressed as
follows:
V0 = [cf1/(1+k)1] + [cf2/(1+k)2] + [cf3/(1+k)n ]
Where:
v0 = value of the security
cf = cash flows expected at the end of year i
k = appropriate discount rate and
n = expected life of the asset
Thus the value of a security is the sum of discounted values of expected future cash inflows. For
example, an investment is expected to provide an annual cash flow of Birr.5000 per year. for the
next 5 years and the appropriate discount rate for the risk associated with the investment is 15%
the valve of the investment may be found as follows:
V0= Σni=1 5000/(1+.15)i
After going through the basic valuation model, the next step is to understand the valuation of two
basic financial assets, i.e. the bonds and the shares.
The valuation process of securities
Investment process requires the valuation of securities in which the investments are proposed. The
value of a security may be compared with the price of the security to get an idea as to whether a

particular security is overpriced, underpriced or correctly priced. Hence, the valuation is the key
concept for investment decisions. No buy-sell action will take place without values.
The basic valuation is constant exercise rationality with cost, benefits, and uncertainty as important
variables. The valuation process will be examined in view of the performance of a firm in relation
to the performance of industry to which it belongs; and the industry performance in turn, is linked
to performance of the economy and the market in general.
We apply the time value concept to find out the value of different types of securities. Different
types of securities that will be covered are
 Debentures(Bonds)
 Preference Shares
 Equity shares
Generally, a financial security will have the potential to generate some additional return above
face value in the future. Thus we can say that the value of a security is the “present value of the
future benefits” associated with it.
1. BOND VALUATION
A bond or debenture is a debt security issued by a borrower and subscribed/purchased by a

lender/investor. Bond is a usual form of long-term financing used by the firms, which upon issuing
a bond, promise to make certain cash flows in future (in the form of interest and/or repayment)
under clearly defined terms and conditions.
Bond valuation is relatively easy because the size and time pattern of cash flows from the bond
over its life are known. A bond typically promises;
a. Interest payments every six months equal to one-half the coupon rate times the face value
of the bond
b. The payment of the principal on the bond’s maturity date
In corporate finance, the term is used for a medium-to-long-term debt instrument used by large
companies to borrow money. In some countries the term is used interchangeably with bond, loan
stock or note.
In order to understand the valuation of bonds, the understanding of the following basic terms is
required:
1. Par value. The par value (also called the face value or nominal value) of a bond is the
principal amount of a bond and is stated on the face value of the bond is stated on the face
of the bond security. The par value of a bond can be or amount. The issue price, however,
may be less than, equal to or more than the par value.
2. Coupon rate.This is the rate at which interest on the par value of the bond is payable as per
the payment schedule. The interest may be paid annually or even monthly. The coupon rate
is usually described as % rate and is applied to the par value to find out the periodic interest
amount.
3. Maturity date.The maturity date of a bond refers to the period from the date of issue, after
the expiry of which the redemption repayment will be made to the investor by the borrower
firm.
4. The intrinsic value of a bond (PV) is equal to the present value of its expected cash flows.
If the coupon interest payments and principal payments are known and the present value is
determined by discounting these future payments from the issuer at an appropriate discount
rate or market yield.
Debenture valuation model
An investor of debenture is entitled to get the following two things.
 Interest at a fixed rate till maturity
 Principal amount of the debenture on its maturity date
The value of a bond may be defined as the sum of the present values of the future interest payments
plus the present value of the redemption repayment. The appropriate discount rate to find out the
present value would be the required rate if the return kd, which depends upon the prevailing risk-
free interest rate and the risk premium. The valuation model may be modified to find out the value
of a bond as follows:
C FV

n
PV = 
t 1
(1  r n
(1  r ) n
Where:
PV = Present value of the bond today
C = Coupon rate of interest
FV = face value repayable

r = Appropriate discount rate or market yield
n = Number of years to maturity
For example, in 2010, birr 10,000 bond due in 2025 with a 10% coupon will pay birr 500 every
six months for its 15-year life. In addition, the bond issuer promises to pay the birr 10,000 principal
at maturity in 2025. Therefore, assuming the bond issuer does not default, the investor knows what
payments (cash flows) will be made and when they will be made.
Applying the valuation theory which states that the value of any asset is the present value of its
cash flows the value of the bond is the present value of the interest payments and the present value
of the principal repayment. The only unknown for this asset (assuming the borrower does not
default) is the required return that should be used to discount the expected stream of returns (cash
flows). If the prevailing nominal risk-free rate is 7% and the investor requires a 3% default risk
premium on this bond, the required return would be 10%. The present value of the semi-annual
interest payments is an annuity for 30 periods (15 years every six months) at one-half the required
return (5%).
birr 500 * 15.3725 = birr 7,686
(Present Value of Interest Payments at 10%)
The present value of the principal is likewise discounted at 5% for 30 periods:
birr 10,000 *0.2314 = birr 2,314
(Present Value of the Principal Payment at 10%)
This can be summarized as follows:
Present Value of Interest Payments birr 500 * 15.3725 = birr 7,686
Present Value of Principal Payment birr 10,000 * 0.2314 = birr 2,314
Total Present Value of Bond at 10% = birr 10,000
This is the price that an investor should be willing to pay for this bond, assuming that the required
return on a bond of this risk class is 10%. If the bond’s market price is more than birr 10,000, the
investor should not buy it because the promised yield to maturity at this higher price will be less
than the investor’s required return.
Alternatively, assuming an investor requires a 12% return on this bond, its value would be:

Present Value of Interest Payments birr 500 * 13.7648 = birr 6,882
Present Value of Principal Payment birr 10,000 * 0.1741 = birr 1,741
Total Present Value of Bond at 12% = birr 8,623
This example shows that if you want a higher return, you will not pay as much for the bond; that
is, a given stream of cash flows has a lower value to you. It is this characteristic that leads to the
often-used phrase that the prices of bonds move in an opposite direction of yields.
Example 2
A bond of birr.1000 bearing a coupon rate 12% is redeemable at par in 10 years. Find out the value
of the bond if:
i. Required rate of return is 12% or 10% or 14%
ii. Required rate of return is 12% and redeemable at birr 950 or birr1050 after 10 years.
Solution to the value of the bond can be ascertained by the equation
Pv = ppmt[ 1  (1] k+)  n FV

k (1  k ) n
Now the value of the bond under different situations can be ascertained as follows:
i. Basic information
Coupon rate 12%, Redeemable at par, Maturity 10 years.
a. If required rate of return is 12%
PV = 120(5.650) + 1000(0.322)
= 678 + 322
= birr.1000
b. If required rate of return is 10%
PV = 120(6.145) + 1000(0.386)
= 737.4 + 386
= birr.1123.40
c. If required rate of return is 14%

PV = 120(5.216) + 1000(0.270)
= 625.92 + 270
= birr.895.92
Bond valuation Behavior
On the basis of the above calculation, certain conclusions regarding the behavior of the valuation
of bond can be arrived as follows:
i. Relating to the required rate of return:
k=c sold at par
k<c sold at premium
k>c sold at discount
ii. Relating to maturity period:
Whenever the required rate of return is different from the coupon rate and assumed constant until
maturity the time to maturity also affects the value of the bond. Further, the longer the time to
maturity of bond, the greater its value changes in response to a given change in the required rate
of return.
Semiannual interest rate and valuation of the bond
This is the case when the interest is payable semiannually (twice in a year)
To calculate the value of the bond
 Divide the coupon rate ,c, by 2
 Divide the required rate of return, k, by two.
 Multiply the maturity period by 2
 Do the calculations as before for the annual compounding
Valuation of deep discount bonds (DDB’s)
In recent years, some financial institutions have issued a debt instrument known as DDB. These
DDB’s have an issue price and a par value or a face value which is payable to the holder of DDB.
 No interest or any other type of Payment is available to the holder before maturity.

 Since there is no intermediate payment between the date of issue and the maturity date,
these DDB’s may also be called the zero coupon bonds.
The valuation of DDB’s can be made on the same lines as the ordinary bonds are valued. As DDB
generates only one future cash flow at the time of maturity, the value of the DDB may be taken as
equal to the present value of this future cash flow discounted at the required rate of return of the
investor for the number of years of the life of DDB’s.
The value of DDB can be calculated with equation
PV (DDB) = FV/ (1+r) n
Where:
PV (DDB) = present value of the DDB
FV= face value of DDB payable at maturity
r= the required rate of return
n= life of the DDB
Example
A DDB is issued for maturity period of 10 years and having a par value of birr 25,000. Find out
the value of the DDB given that the required rate of return is 15%
Applying the equation above the value of the DDB is:
PV (DDB) = 25,000/ (1+0.15)10
= 25,000*0.247
= birr 6,175
Valuation of perpetual debenture
Perpetual debenture is:
 A debenture that never matures
 Rarely found in practice
Vdp=ppmt/kd
Vdp=Annual interest payment/required rate of return

Example
A debenture holder is to receive an annual interest @ 10% for perpetuity. The face value of the
debenture is birr 1000. Calculate the value of the debenture if the required rate of return is:
 if kd = 15%
PV= Birr 667
 if kd = 8%
PV= Birr 1250
 if kd = 10%
PV= Birr 1000
2. VALUATION OF PREFERENCE SHARES
Preference share is a share which entitles the shareholder to receive
i. a dividend at a fixed rate for a given period
ii. a redemption amount at the time of preference share ( in case of redeemable preference
share) OR a dividend at the fixed rate perpetually till the liquidation of the company
(in case of irredeemable preference share)
Preference shares are hybrid security. They have some features of bonds and some of equity shares.
Theoretically, preference shares are considered a perpetual security but there are convertible,
callable, redeemable and other similar features, which enable issuers to terminate them within the
finite time horizon.
Preference dividends are specified like bonds. This has to be done because they rank prior to equity
shares for dividends. However, specifications doesn’t imply obligation, failure to comply with
which may amount to default several preference issues are cumulative where dividends accumulate
over a period of time and equity dividends require clearance of preference arrears first.
Preference shares are less risky than equity because their dividends are fixed and all arrears must
be paid before equity holders get their dividends. They are however, more risky than bonds because
the latter enjoy priority in repayment and in liquidation. Bonds are scurried also and enjoy
protections of principal which is ordinarily not available to preference shares. Investor’s required
returns on preference shares are more than those on bonds but less than on equity shares.

Assumptions;Two assumptions are relevant while ascertaining the value of preference shares are
as follows:
a. The dividend on preference share are received once a year and that the first dividend
is received at the end of one year from the date of acquisition / purchase
b. The company always intends to pay the preference dividend so that the stream of
preference dividend is concerned to be known with certainty.
Since dividends from preference shares are assumed to be perpetual payments, the intrinsic value
of such shares will be estimated from the following equations.
Vp = C_ + C__ + Cn__
(1 + k) (1 + k)2 ( 1 + k)n
Where:
Vp = Value of perpetual today
C = Constant dividends received
K = Required rate of return appropriate
𝑫
Therefore, 𝐕𝐩𝐬 =
𝑲𝒑
i. Redeemable preferences share.
The value of redeemable preference share may be defined as the present value of the cash flows
expected from the company. The future cash flows associated with a redeemable preference share
are
 The stream of future dividends at a fixed rate of dividend
 The maturity payment at the time of redemption.
These future cash flows are discounted at an appropriate rate to find out the value of the redeemable
preference shares as follows:
P0 = [d1/(1+kp)1] + [d2/(1+kp)2]+ ….+ [dn/(1+kp)n+ [RV/(1+kp)n
P0 =PVIFA*Annual dividend Payment + PVIF*Amount payable at Maturity
Where:

P0 = value of preference share
Di = annual fixed dividend
RV = redemption value of preference share
Example
A Preference share of birr 1000 carries a dividend rate of 10%. The current market interest rate is
15%. The preference share becomes due for redemption in 10 years. Find the value of the
preference share?
Solution
PO =Annual dividend Payment * PVIFA + PVIF*Amount payable at Maturity
= Birr 748.90
ii. Irredeemable preference share.
The value of irredeemable preference share may be defined as the present value of the perpetuity
of the fixed, dividend on the preference shares.
Irredeemable preference shares Have Single component Annual dividend cash inflow
Value (PO) = Annual dividend cash inflow/Current yield
Example
Face value of preference share=birr 100, Dividend rate @10%, Current yield on the preference
share=15%
Vps=10%(100)/0.15
= Birr 67
Yield on the preference share can be calculated on the same patterns as calculated for the
Debentures.
3. valuation of common stock
An investor buys or acquires an equity share in expectation of (i) a stream of future dividends from
the company, and (ii) resale price of the equity share after some time when he is no longer
interested in holding the share. The owner of share receives the shares as a compensation for
investing the firm. So, as long as the firm is operating profitably and the investor holds the shares,
he would be expecting to receive a dividend from the company. So, the dividend plays a crucial
and important role in determining the value of equity share. Though there is no legal compulsion
to pay dividend on equity shares, still most companies prefer to pay dividends to satisfy the
exception s of their shareholders.
Assumption: Valuation of equity share based on dividends requires the following equation:
1. The dividends are paid manually
2. The first dividend is paid after one year from the date of acquisition/purchase.
3. Sale of the equity share, if any, occurs only at the end of a year and at the ex-dividend
terms.
The value of an equity share applying the basic valuation model may be defined as equal to the
present value of all future benefits which the share is expected to provide in the form of dividend
over the infinite period. The future capital gain/loss on sale, if any, is ignored because theoretically
speaking, what is sold is the right to all future subsequent dividends. So, from valuation point of
view only the infinite stream of dividends is relevant.
The value of equity share is the sum of the present values of future cash flows (in the form of
dividends) discounted at the required rate of return of the investors. The valuation of equity shares
may be ascertained with the help of the following equation.
P0 = [d1/(1+ke)1] + [d2/(1+ke)2] ……. [dn/(1+ke)n
Where:
Po = value of the equity share
Di = expected dividend over the year
ke = required rate of return of the equity investors
In case of equity shares, the future stream of earnings or benefits pose two problems. One, it is
neither specified nor perfectly known in advance as an obligation. Resulting this, future benefits
and their timing have both to be estimated in a probabilistic frame work. Two, there are at least
three are three elements which are positioned as alternative measures of such benefits namely
dividends, cash flows and earnings.
The valuation of common stock has two methods.
1. No growth in dividends
a. Single period approach
b. Multiple period approach
2. Growth in dividends
a. Constant growth on year to year basis
b. Variable growth in dividends on year to year basis
1. Zero growth (No growth) model
This is the simplest type of dividend pattern in which the dividend amount remains constant over
years. The dividend stream, therefore, is a long term annuity, or almost perpetuity. Under this the
assumption is the growth of dividend is zero or constant. Symbolically,
Vc = D/ K
Where:
Vc = Value of common stock
D = Dividend paid
K = The required rate of return
a. Single period approach
The investor is presumed to hold the share for one year only. In such case the cash inflow for the
investor are Dividend that will come after one year and The price of the share that he/she may get
after one year
Present value of the share
PV of the dividend + PV of the market price of share after one year
Po=Do/(1+k)1 +P1/(1+k)1
Example
Mr. A holds an equity share giving him an annual dividend of birr 20.He is expected to sell the
share at birr180 after one year. Calculate the value of share at present. The required rate of return
(discount rate) is 12%.

Solution
P = 20/(1+0.12) + 180/(1+ 0.12)
= birr 178.57
b. Multiple period approach
The investor is presumed to hold the share beyond one year for an unspecified no of years Equity
shares don’t have any maturity period One can expect the dividend cash inflow for infinite period
This kind of cash flow is similar to the cash flow of a perpetual debenture (one with no Maturity)
So valuation can be done in similar way.
Po=Expected Annual dividend/Discount rate
Po=D/k
Example
A company is paying an annual dividend of birr40 per share. The company is expected not to
deviate from this dividend amount in the future. Current discount rate is 15%.Calculate the present
value of the share?
Solution
Po= D/k
= 40/.15
= Birr267
2. Growth model
The assumption of constant dividend without any growth is unrealistic as companies grow over
time. So, growth in dividends needs to be incorporated. The model changes if the growth in
dividends also taken care of.
a. Constant Growth Model
The dividend payable to common stock holders will grow at a uniform rate is future. The
assumption is that the dividends will grow constantly at a rate, g, and every year. If a firm pays a
dividend of Do at present then dividend at the end of year 1 will be D 1, i.e., Do (1+g) and dividend
at the end of year 2 will be D2 = Do (1+g) 2 ,and so on. Therefore, dividend payable in any future
year can be ascertained with help of following:
Po=D1/(k-g)
Where:
D1= Dividend at the end of second year
k= discount rate
g=growth rate of dividends (in %)
The above formula can also be written as
Po=Do(1+g)/(k-g)
The value of an equity share is positively correlated with growth rate and negatively correlated
with the required rate of return. Suppose a firm is expected to pay a dividend of Re.1 which is
expected to grow at growth rate g annually. The value of the share under different growth rates
and different required rates of return have been summarized in the following table 1.
Table 1
Growth Rate Required Rate of Return

10% 12% 14% 16%
2% 12.50 10.00 8.33 7.14
4% 16.67 12.50 10 8.13
6% 25.00 16.67 12.50 10.00
8% 50.00 25.00 16.67 12.50
The value given in table 1 reflects the sensitivity of the growth rate and required rate of return. The
higher the growth rate, higher will be the value for a given required rate of return. Further, the
higher the required rate of return, lesser will be value for a given growth rate. The constant growth
model is an extremely useful theoretical model to value the equity shares.
Example
ABC limited is expected to pay dividend of birr 40 per share.. The dividends are expected to grow
at a rate of 10%. The capitalization rate is 15%. Find the value of share?
Solution
D1= Birr 40

g = 10%, k =15%
Po= D1/k-g
= 40/.15-.10
= 40/.05
= 800 birr.
b. Variable Growth
The zero growth rate and constant growth rate assumptions of dividend patterns are extreme
assumptions. In a practical situation, the dividend from a company may show one growth rate for
few years, followed by another growth rate for next few years and then yet another growth rate for
next few years, and so on. For example, for five years the growth rate in dividends may be 2%
then it may be 3% for next 5 years then it may stick to 4% growth rate in infinitely. This means
that the dividends will grow at 2% annually for years 1 to 5 at 3% annually for years 6 to 10 and
at 4% annually from the year 11onwards.
The dividends on the Company share may not grow at a constant rate.
Two stage dividend growth model
 Companies have years of super-normal growth where the dividend grow at a very high
rate
 After this super-normal growth period the dividend s grow at a lower rate.
Such growth situations to find out the value of the equity shares;
Po = Σi=1n [d0 (1+g1)i/ (1+ke)i] +nΣi=55 [d6 (1+g2)i-5/ (1+ke)i-5] +Σi=10n[d10 (1+g3)i-10/
(1+ke)i-10]
Where:
Po = value of equity share,
g1, g2 and g3 = different growth rates for different periods, and
ke = required rate of return of equity investors
To find out the value of equity shares under varying growth rates the following procedure may be
adopted:

Step1. Find the value of cash dividend at the end of each year during the period over which the
growth rate is changing. In the above eg., the growth rate is changing over 10 years ( 2% growth
rate for 1st five years & 3% growth rate for next 5 years).
Step2. Find out the present values of these cash dividends for different years by discounting at the
required rate of return, ke . For this purpose, the cash dividend is to be multiplied by the respective
discounting factor to find out the present value. Add up all these present values.
Step3. Find out the value of the equity share at the end of the last year of the varying growth
period, i.e., the 10th year as follows:
P10 = D11 / ke – g3
This value P10 represents the present value of all expected dividends from year 10 onwards at a
constant growth rate in dividends, g3. Find out the present value of this year by discounting to
period 0.
Step4. Sum of the figures arrived in steps no.2& 3 is the value of the equity share. If there are
more breaks in the growth rates, then the similar procedure may be adopted.
A firm is paying a dividend of birr. 1.50 per share. The rate of dividend is expected to grow at 10%
for next 3 years and 5% thereafter infinitely. Find out the value of the share given that the required
rate of return of the investor is 15%.
Solution
For this situation following information is available:
ke = 15% Do = Rs.1.53
= 10%(for 3 years) g2 = 5%(infinitely)
Now, the value may be calculated as follows:
End of Year Dividend Amount PVF((15%,n) PV

1 1.65 0.87 1.44
2 1.82 0.756 1.38
3 2.00 0.658 1.32
Total 4.14

birr.4.14 is the present value of dividends expected from the company for the first 3 years. The
value of equity shares at the end of year 3 will be as follows:
P3 = D3(1+g)/ke-g
P3 = 2(1.05)/15-0.05
= birr 21
The value of the share at the end of the 3 years will be birr. 21. Present value of birr. 21 is
= 21*(PVF15%, 3y)
= 21 * (0.658
= birr 13.82
The value of the share at present is birr 4.14 + 13.82 i.e. birr. 17.96
Valuation of share
Currently not paying dividends there may be numerous cases where the firm is not able to pay any
dividend on equity shares because of insufficient profits during early years or gestation period or
otherwise. Sum of the form may not like to pay early dividends because they require funds for
growth purposes. The dividend models discussed above can take care of this type of situations
also. For example, a firm is not expected to pay any dividend for 1st 3 years but thereafter will be
paying a dividend of birr. 2 growing at 10% p.a. forever. The value of the share, given the required
rate of return can be calculated as follows:
As per the constant growth rate model, the value of the share at the end of year 3 will be:
P3 = D4/ke-g
= 2/15-10
= birr. 40
Now, this is the value of the share at the end of year 3. This value should now be discounted at
15% to find out the present value.
P0 = P3 * (PVF15%*3y)
= birr.40 (0.658)
= birr 26.32
So, the value of the share is birr.26.32
Valuation of equity shares based on earnings
Some firms have extensive growth opportunities and require funds to take up new projects. So
these firms may retain profits (wholly or partially).This reduce the amount of dividends to the
shareholders. The retained earnings are reinvested internally to generate higher profits in future.
Investors are willing to forego cash dividends today in exchange for higher earnings and
expectation of higher dividends in future. The value of an equity share in such a case may be
determined on the basis of the earnings of the firm. The earnings of the firm may be expressed as
earnings as per share (EPS) which is ascertained from the accounting information of the firm.
There are different approaches to find out the value of the equity share on the basis of the earnings
of the firm. These include Gordon valuation model, Walter’s Model, the P/E ratio approach and
the explicit resale price model.
A. The Gordon’s Model.
This valuation model presupposes that earnings of the firm are either distributed among the
shareholders or are reinvested within the business. The growth in dividends in future would
therefore depend upon the profits retained and the rate of return on these retained profits. The
golden valuation model can be represented as follows:
P0 = EPS1 (1-b)/ ke – br
Where:
Po = price of a share
EPS1 = EPS at the end of year 1
‘b = retention rate, i.e., % of earnings being retained
r = rate of return on reinvestments, i.e., ROI
ke = required rate of return of the equity investors.
B. Walter’s Model
The Walter’s model supports the view that the market price of a share is the sum of
i. present value of an infinite stream of dividends, and

ii. Present value of an infinite stream of returns from retained earnings.
The investors will evaluate the retention of earnings resulting in lesser dividends, in the light of
a. The rate of return, r, earned by the company on these retained earnings, and
b. The opportunity cost of equity investors, ke .
Depending upon the relationship between r and ke, the investors will value the expected capital
gains and will thus value the share. The Walter’s Model can be presented as follows:
P = [D/ ke] + (ke/r)(E-D)/ ke
C. Price earnings ratio(P/E ratio)
The P/E ratio is the most common earnings valuations Model. The P/E ratio between the price of
a share & it is EPS. For eg., if a share whose EPS is birr. 10 is having market price of birr.250,
then its P/E ratio is 250/10 =25. it means that the mp of the share is 25 times that of the EPS. As
per P/E ratio approach the value of the share is expressed as;
Value = EPS * P/E ratio
But there is a question as to how to estimate / forecast the P/E ratio? One method is to estimate the
P/E ratio of the similar type of a company or the industry as a whole. Then those estimates may be
further adjusted in the light of characteristics and features of the particular firm and its share. The
P/E ratio before being applied to a particular case, to find out the value of the share may be
analyzed for the risk involved in the firm, in the share, growth prospects of the firm stability of
earnings of the firm, etc. the higher the growth prospects of the firm and stability of a dividend,
larger would be the P/e ratio. Similarly, higher the risk of firm, lower would be P/E ratio.
The P/E ratio as the basis of valuation of share has been quite common and is often used in business
dailies and generals. The share quotations are often supplemented with the P/E ratios. It may be
observed that some companies have very high P/E ratios while others have a low P/E ratio. The
share price at any particular point of time reflects investor’s expectation of future operating and
investment performance of the firm. The shares of the growing firm shall act very high P/E ratio
because investors are willing to pay a higher price now for expected higher returns in future.

CHAPTER THREE: RISK AND RETURN OF SINGLE SECURITY
3.1 INTRODUCTIONS
3.1.1 Key term Definitions

Investment is defined as an activity that commits funds in any financial/physical form of asset
with an expectation of receiving some return in the future.
Securities: can be defined in different form some of them are listed as follows:
 A security is a financial instrument that represents an ownership position in

a publicly-traded corporation (stock), a creditor relationship with governmental
body or a corporation (bond), or rights to ownership as represented by an option. A
security is a fungible, negotiable financial instrument that represents some type of
financial value. The company or entity that issues the security is known as the
issuer.
 A transferable instrument representing an ownership interest in a corporation
(equity security or stock) or the debt of a corporation, municipality or sovereign.
Other forms of debt, such as mortgages, can be converted into securities. Certain
derivatives on securities (for example, options on equity securities) are also
considered securities for the purposes of certain securities laws.
 A security is a tradable financial asset. The term commonly refers to any form
of financial instrument, but its legal definition varies by jurisdiction. In some
jurisdictions the term specifically excludes financial instruments other
than equities and fixed income instruments. In some jurisdictions it includes some
instruments that are close to equities and fixed income, e.g. equity warrants. In
some countries and/or languages the term "security" is commonly used in day-to-
day parlance to mean any form of financial instrument, even though the underlying
legal and regulatory regime may not have such a broad definition.
 Financing or investment instruments (some negotiable, others not) bought and sold
in financial markets, such as bonds, debentures, notes, options, shares (stocks), and
warrants.
 A simple definition of a security is any proof of ownership or debt that has been
assigned a value and may be sold. (Today, evidence of ownership is likely to be a
computer file, while once it was a written piece of paper.) For the holder, a security
represents an investment as an owner, creditor or rights to ownership on which the
person hopes to gain profit. Examples are stocks, bonds and options.
Risk
Whenever you make a financing or investment decision, there is some uncertainty about the
outcome. Uncertainty means not knowing exactly what will happen in the future. There is
uncertainty in most everything we do as financial managers/investor, because no one knows
precisely what changes will occur in such things as tax laws, consumer demand, the economy, or
interest rates.
Though the terms “risk” and “uncertainty” are often used to mean the same thing, there is a
distinction between them. Uncertainty does not know what’s going to happen. Risk is how we
characterize how much uncertainty exists: The greater the uncertainty, the greater the risk. Risk is
the degree of uncertainty.
Return
Whether investors are willing to make an investment, and the price they are willing to pay, depends
on the return they expect. A return, the benefit an investor receives from an investment, can be in
the form of:
 a change in the value of the asset - it’s appreciation or depreciation,
 a cash flow from the investment, such as a dividend or an interest payment, or
 Both a cash flow and a change in value.
General definition of return is the benefit associated with an investment. In most cases the investor
can estimate his/ her historical return precisely.
Expected return is the difference between potential benefits and potential costs.
Portfolio is group of assets/securities where investment is made.
If management has some idea of the uncertainty associated with a project’s future cash flows /its
possible outcomes/ and the probabilities associated with these outcomes, then there is some
measure of the risk of the project. But this is the project’s risk in isolation from the company’s
other projects. This is the risk of the project ignoring the effects of diversification and is referred
to as the project’s total risk or stand-alone risk.
Because most firms have many assets, the stand-alone risk of a project under consideration may
not be the relevant risk for analyzing the project. A firm is a portfolio of assets, and the returns of
these different assets are not perfectly positively correlated with one another. We are therefore not
concerned about the stand-alone risk of a project, but rather how the addition of the project to the
firm’s portfolio of assets changes the risk of the firm’s portfolio.

How do we assess the risk of a project? We begin by recognizing that the assets of a firm are the
result of its prior investment decisions. Therefore, a firm is really a collection or portfolio of
projects. So when the firm adds another project to its portfolio, should we be concerned only about
the risk of that additional project? Or should we be concerned about the risk of the entire portfolio
when the new project is included in it? To answer this question, you should look at the different
dimensions of risk of a project. i.e standalone risk versus market risk, measurement return and risk
as well.
3.1.2 General over view of securities

The objective of any financial decision, whether it is a financing or investment decision, should be
to maximize owners’ wealth. For a corporation this translates into maximizing the market value of
the ownership interest—the value of the stock. So a financial manager’s decisions must be made
with an eye on the value of the firm’s stock and the markets in which the stock is traded.
If a firm needs funds, should it issue stock or borrow? If it issues new stock, will present investors
lose? If it borrows, what interest rates will its lenders?/the investors in its bonds/require? How
soon could the loan be paid off? How soon should it be paid off? If a firm has funds to invest,
should financial managers invest it until it is needed? In what kind of financial instrument? What
characteristics must the investment vehicle have? What types of risk must they take on with their
investment? Financial managers must understand the risk and return of single security.
This section provides an overview of return and risk of single security. Its purpose is twofold. First,
we acquaint you with the terms and definitions we use in this section. Then, we give you an idea
how markets for securities function.
Securities
A security is a document that gives the owner a claim on future cash flows. A security may
represent an ownership claim on an asset (such as a share of stock) or a claim on the repayment of
borrowed funds, with interest (such as a bond). The document may be a piece of paper (such as a
stock certificate or a bond) or an entry in a register (which may, in turn, be a computer record).
A securities market is an arrangement for buying and selling securities. It may be a physical
location or simply a computer or telephone network.
Based on their maturity and the source of their value securities are classified into three groups:
money market securities, capital market securities, and derivative securities. The word
“maturity” is often used loosely to refer to the length of time before repayment of a debt. Other
terms using the word “maturity” are more specific. The maturity date of a security is the preset
date on which the amount borrowed (called the face value, the par value, the principal, or the

maturity value) is repaid. The security is said to mature on its maturity date. The original maturity
is the time between the date a security is issued and its maturity date.
Money Market Securities

Money market securities are short-term indebtedness. By “short term” we usually imply an original
maturity of one year or less. The most common money market securities are Treasury bills,
commercial paper, negotiable certificates of deposit, and bankers’ acceptances.
 Treasury bills (T-bills) - are short-term securities issued by the U.S. government; they have
original maturities of either four weeks, three months, or six months. Unlike other money
market securities, T-bills carry no stated interest rate. Instead, they are sold on a discounted
basis: Investors obtain a return on their investment by buying these securities for less than
their face value and then receiving the face value at maturity. T-Bills are sold in $10,000
denominations; that is, the T- Bill has a face value of $10,000.
 Commercial paper - is a promissory note—a written promise to pay—issued by a large,
creditworthy corporation. These securities have original maturities ranging from one day
to 270 days and usually trade in units of $100,000. Most commercial paper is backed by
bank lines of credit, which means that a bank is standing by ready to pay the obligation if
the issuer is unable to. Commercial paper may be either interest bearing or sold on a
discounted basis.
 Certificates of deposit (CDs) - are written promises by a bank to pay a depositor.

Nowadays they have original maturities from six months to three years. Negotiable
certificates of deposit are CDs issued by large commercial banks that can be bought and
sold among investors. Negotiable CDs typically have original maturities between one
month and one year and are sold in denominations of $100,000 or more. Negotiable
certificates of deposit are sold to investors at their face value and carry a fixed interest rate.
On the maturity date, the investor is repaid the amount borrowed, plus interest.
 Eurodollar certificates of deposit -are CDs issued by foreign branches of U.S. banks, and
Yankee certificates of deposit are CDs issued by foreign banks located in the United States.
Both Eurodollar CDs and Yankee CDs are denominated in U.S. dollars. In other words,
interest payments and the repayment of principal are both in U.S. dollars.
 Bankers’ acceptances - are short-term loans, usually to importers and exporters, made by
banks to finance specific transactions. An acceptance is created when a draft (a promise to
pay) is written by a bank’s customer and the bank “accepts” it, promising to pay. The

bank’s acceptance of the draft is a promise to pay the face amount of the draft to whomever
presents it for payment. The bank’s customer then uses the draft to finance a transaction,
giving this draft to the supplier in exchange for goods. Since acceptances arise from
specific transactions, they are available in a wide variety of principal amounts. Typically,
bankers’ acceptances have maturities of less than 180 days. Bankers’ acceptances are sold
at a discount from their face value, and the face value is paid at maturity. Since acceptances
are backed by both the issuing bank and the purchaser of goods, the likelihood of default
is very small.
Money market securities are backed solely by the issuer’s ability to pay. With money market
securities, there is no collateral; that is, no item of value (such as real estate) is designated by the
issuer to ensure repayment. The investor relies primarily on the reputation and repayment history
of the issuer in expecting that he or she will be repaid.
Capital Market Securities

Capital market securities - are long-term securities issued by corporations and governments. Here
“long-term securities” refers to securities with original maturities greater than 1 year and perpetual
securities (those with no maturity). There are two types of capital market securities: those that
represent shares of ownership interest, also called equity, issued by corporations, and those that
represent indebtedness, issued by corporations and by the U.S. and state and local governments.
 Equity - The equity of a corporation is referred to as “stock”; ownership of stock is represented

by shares. Investors who own stock are referred to as shareholders. Every corporation has
common stock, and some corporations have another type of stock, preferred stock, as well.
Common stock is the most basic ownership interest in a corporation. Common shareholders
are the residual owners of the firm. If the business is liquidated, the common shareholders can
claim the business’ assets, but only those assets that remain after all other claimants have been
satisfied. Since common stock represents ownership of the corporation, and since the
corporation has a perpetual life, common stock is a perpetual security; it has no maturity.
Common shareholders may receive cash payments—dividends—from the corporation. They
may also receive a return on their investment in the form of increased value of their stock as
the corporation prospers and grows.
Preferred stock also represents ownership interest in a corporation and, like common stock,
is a perpetual security. However, preferred stock differs from common stock in several
important ways. First, preferred shareholders are usually promised a fixed annual dividend,
whereas common shareholders receive what the board of directors decides to distribute. And

although the corporation is not legally bound to pay the preferred stock’s dividend, preferred
shareholders must be paid their dividends before any common dividends are paid. Second,
preferred shareholders are not residual owners; their claim on a liquidated corporation takes
precedence over that of common shareholders. And finally, preferred shareholders generally
do not have a say in corporate matters, whereas common stockholders have the right to vote
for members of the board of directors and on major issues.
 Indebtedness - A capital market debt obligation is a financial instrument whereby the
borrower promises to repay the face amount of the obligation by the maturity date and, in most
cases, to make periodic interest payments to the holder of the debt obligation, referred to as the
lender. These debt obligations can be broken into two categories: bank loans and debt
securities.
While at one time, bank loans were not considered capital market instruments, in recent years
a market for the buying and selling of these debt obligations has developed. One form of bank
loan that is bought and sold in the market is a syndicated bank loan. This is a loan in which a
group (or syndicate) of banks provides funds to the borrower. The need for a group of banks
arises because the amount sought by a borrower may be too large for any one bank to be
exposed to the credit risk of that borrower.
Debt securities include (1) bonds, (2) notes, (3) medium-term notes, and (4) asset-backed
securities. The distinction between a bond and a note has to do with the number of years until
the obligation matures when the security is originally issued. Historically, a note is a debt
security with a maturity at issuance of 10 years or less; a bond is a debt security with a maturity
greater than10 years. The distinction between a note and a medium-term note has nothing to
do with the maturity but rather the way the security is issued. Throughout most of this section
we will simply refer to a bond, a note, or a medium-term note as simply a bond. We will refer
to the investors in any debt obligation as either the debt holder, bondholder, or note holder.
A debt security may provide a promise to pay the investor periodic interest (referred to as a
coupon); a debt security that does not include a promise to pay interest is referred to as a zero-
coupon debt. In the case of debt that pays interest, interest is generally paid at regular intervals
(say, semi-annually) and may be a fixed or floating (or variable) rate. The interest rate for a
floating rate security is usually tied to the interest rate on a market interest rate, the price of a
commodity, or the return on some financial instrument.
Bonds, notes, and medium-term notes are issued by corporations, the U.S. government, U.S.
government agencies, and municipal governments. Corporate debt securities backed by
specific assets as collateral are referred to as secured notes or secured bonds. If they are not
backed by specific assets, they are referred to as debentures. If a debt obligation is secured and
the borrower is unable to make interest or principal payments when promised, in theory the
creditors may be able to force the sale of the collateral for the purpose of collecting what is
due them. Collateral therefore reduces the security’s riskiness and the level of return, or yield,
the issuer (the borrower) must pay. Riskiness is an important determinant of the return on as
investment. The claims of debt holders take precedence over those of shareholders, but debt
holders are unlikely to be paid the full face value for their securities if a corporation must be
liquidated.
The major financing instrument for corporations that developed in the 1990s was the asset-backed
security. This is a debt security that is backed by loans or receivables. For example, Ford Credit,
a subsidiary of Ford Motor Company, has issued securities backed by a pool of automobile loans.
The process of issuing securities backed by a pool of loans or receivables is referred to as
securitization.
Derivative Instruments
A derivative instrument is any contract that gets its value directly from another security, a market
interest rate, the price of a commodity, or a financial index. Derivative instruments include: (1)
options, (2) futures/ forwards, (3) swaps, and (4) caps and floors
What is important to understand is that derivative instruments can be used to control the wide
range of risk faced by corporations and investors. This is one reason why derivatives are often
referred to as risk control instruments.
This key role played by derivative instruments in global financial markets was stated in a 1994
report published by the U.S. General Accounting Office:
“Derivatives serve an important function of the global financial marketplace, providing end-
users with opportunities to better manage financial risks associated with their business
transactions. The rapid growth and increasing complexity of derivatives reflect both the
increased demand from end-users for better ways to manage their financial risks and the
innovative capacity of the financial services industry to respond to market demands”
Securities Markets
The primary function of a securities market—whether or not it has a physical location—is to bring
together buyers and sellers of securities. Securities markets can be classified by whether they are
involved in original sales or resale of securities, and by whether or not they involve a physical
trading location.
Primary and Secondary Markets

When a security is first issued, it is sold in the primary market. This is the market in which new
issues are sold and new capital is raised. So it is the market whose sales directly benefit the issuer
of the securities.
There are three ways to raise capital in the primary market:-
1st - is the direct sale, in which the investor purchases, say, stock directly from the issuer.
2nd - A second method is through financial institutions, which are firms that obtain money from
investors in return for the institution’s securities and then invest that money.
3rd - The third method for primary market transactions operates through investment bankers, who
buy the securities issued by corporations and then sell those securities to investors for a higher
price.
A secondary market is one in which securities are resold among investors. No new capital is raised
and the issuer of the security does not benefit directly from the sale. Trading takes place among
investors.
Investors who buy and sell securities on the secondary markets may obtain the services of stock
brokers, individuals who buy or sell securities for their clients.
If a firm can raise new funds only through the primary market, why should financial managers be
concerned about the secondary market on which the firm’s securities trade? Because investors may
not be interested in buying securities that are not liquid—that they could not sell at a fair price at
any time. And the secondary markets provide the liquidity.
There are two types of secondary securities markets: exchanges and over-the-counter markets.
Exchanges are actual places where buyers and sellers (or their representatives) meet to trade
securities. Examples are the New York Stock Exchange and the Tokyo Stock Exchange. Over-the-
counter (OTC) markets are arrangements in which investors or their representatives trade
securities without sharing a physical location. For the most part, computer and telephone networks
are used for this purpose.
3.2 CONCEPTS AND MEASUREMENT OF EXPECTED RETURN OF
INDIVIDUAL SECURITY
In this section, we start from the basic premise that investors like returns and dislike risk.
Therefore, people will invest in risky assets only if they expect to receive higher returns. We define
precisely what the term risk means as it relates to investments. We examine procedures managers
use to measure risk, and we discuss the relationship between risk and return. Managers must

understand these concepts and think about them as they plan the actions that will shape their firms’
futures.
Risk can be measured in different ways, and different conclusions about an asset’s risk can be
reached depending on the measure used. Risk analysis can be confusing, but it will help if you
remember the following:
1. All financial assets are expected to produce cash flows, and the risk of an asset is judged
in terms of the risk of its cash flows.
2. The risk of an asset can be considered in two ways: (1) on a stand-alone basis, where the
asset’s cash flows are analyzed by themselves or (2) in a portfolio context, where the cash
flows from a number of assets are combined and then the consolidated cash flows are
analyzed. There is an important difference between stand-alone and portfolio risk and an
asset that has a great deal of risk if held by itself may be much less risky if it is held as part
of a larger portfolio.
3. In a portfolio context, an asset’s risk can be divided into two components: (a) diversifiable
risk, which can be diversified away and thus is of little concern to diversified investors,
and (b) market risk, which reflects the risk of a general stock market decline and which
cannot be eliminated by diversification, does concern investors. Only market risk is
relevant—diversifiable risk is irrelevant to rational investors because it can be eliminated.
4. An asset with a high degree of relevant (market) risk must provide a relatively high
expected rate of return to attract investors. Investors in general are averse to risk, so they
will not buy risky assets unless those assets have high expected returns.
3.2.1 Investment returns

With most investments, an individual or business spends money today with the expectation of
earning even more money in the future. The concept of return provides investors with a convenient
way of expressing the financial performance of an investment. To illustrate, suppose you buy 10
shares of a stock for $1,000. The stock pays no dividends, but at the end of one year, you sell the
stock for $1,100. What is the return on your $1,000 investment?
One way of expressing an investment return is in dollar terms. The dollar return is simply the total
dollars received from the investment less the amount invested:
Dollar return = Amount received - Amount invested
= $1100 - $1000 = $100
If at the end of the year you had sold the stock for only $900, your dollar return would have been
- $100.
Although expressing returns in dollars is easy, two problems arise:
1) To make a meaningful judgment about the return, you need to know the scale (size) of the
investment; a $100 return on a $100 investment is a good return (assuming the investment
is held for one year), but a $100 return on a $10,000 investment would be a poor return.
2) You also need to know the timing of the return; a $100 return on a $100 investment is a
very good return if it occurs after one year, but the same dollar return after 20 years would
not be very good.
The solution to the scale and timing problems is to express investment results as rates of return,
or percentage returns. For example, the rate of return on the 1-year stock investment, when $1,100
is received after one year, is 10 percent:
Rate of Return= Amount Received – Amount Invested

Amount Invested
= Dollar return = $100 = 10%
Amount invested $1000
The rate of return calculation “standardizes” the return by considering the return per unit of
investment. In this example, the return of 0.10, or 10 percent, indicates that each dollar invested
will earn 0.10($1.00) = $0.10. If the rate of return had been negative, this would indicate that the
original investment was not even recovered. For example, selling the stock for only $900 results
in a minus 10 percent rate of return, this means that each invested dollar lost 10 cents.
Note also that a $10 return on a $100 investment produces a 10 percent rate of return, while a $10
return on a $1,000 investment results in a rate of return of only 1 percent. Thus, the percentage
return takes account of the size of the investment.
Expressing rates of return on an annual basis, which is typically done in practice, solves the timing
problem. $10 return after one year on a $100 investment results in a 10 percent annual rate of
return while a $10 return after five years yields only 1.9 percent annual rate of return.
Although we illustrated return concepts with one outflow and one inflow, rate of return concepts
can easily be applied in situations where multiple cash flows occur over time. For example, when
Intel makes an investment in new chip-making technology, the investment is made over several
years and the resulting inflows occur over even more years. For now, it is sufficient to recognize
that the rate of return solves the two major problems associated with dollar returns—size and
timing. Therefore, the rate of return is the most common measure of investment performance.

3.2.2 Stand-alone risk
Risk is defined in Webster’s as “a hazard; a peril; exposure to loss or injury.” Thus, risk refers to
the chance that some unfavorable event will occur. If you engage in skydiving, you are taking a
chance with your life - skydiving is risky. If you bet on the horses, you are risking your money. If
you invest in speculative stocks (or, really, any stock), you are taking a risk in the hope of making
an appreciable return.
As we said previously an asset’s risk can be analyzed in two ways:
(1) On a stand-alone basis, where the asset is considered in isolation, and
(2) On a portfolio basis, where the asset is held as one of a number of assets in a portfolio.
Thus, an asset’s stand-alone risk is the risk an investor would face if he or she held only this one
asset. Obviously, most assets are held in portfolios, but it is necessary to understand stand-alone
risk in order to understand risk in a portfolio context.
To illustrate the risk of financial assets, suppose an investor buys $100,000 of short-term Treasury
bills with an expected return of 5 percent. In this case, the rate of return on the investment, 5
percent, can be estimated quite precisely, and the investment is defined as being essentially risk
free. However, if the $100,000 were invested in the stock of a company just being organized to
prospect for oil in the mid-Atlantic, then the investment’s return could not be estimated precisely.
One might analyze the situation and conclude that the expected rate of return, in a statistical sense,
is 20 percent, but the investor should recognize that the actual rate of return could range from, say,
+1,000 percent to -100 percent. Because there is a significant danger of actually earning much less
than the expected return, the stock would be relatively risky.
No investment should be undertaken unless the expected rate of return is high enough to
compensate the investor for the perceived risk of the investment. In our example, it is clear that
few if any investors would be willing to buy the oil company’s stock if its expected return were
the same as that of the T-bill.
Risky assets rarely produce their expected rates of return—generally, risky assets earn either more
or less than was originally expected. Indeed, if assets always produced their expected returns, they
would not be risky. Investment risk, then, is related to the probability of actually earning a low or
negative return—the greater the chance of a low or negative return, the riskier the investment.
However, risk can be defined more precisely, and we do so in the next section.
3.2.3 Probability distributions

An event’s probability is defined as the chance that the event will occur. For example, a weather
forecaster might state, “There is a 40 percent chance of rain today and a 60 percent chance that it
will not rain.” If all possible events, or outcomes, are listed, and if a probability is assigned to each
event, the listing is called a probability distribution.
For our weather forecast, we could set up the following probability distribution:
outcome Probability
(1) (2)
Rain 0.4 = 40%
No rain 0.6 = 60
1.0 = 100%
The possible outcomes are listed in Column 1, while the probabilities of these outcomes, expressed
both as decimals and as percentages, are given in Column 2. Notice that the probabilities must sum
to 1.0, or 100 percent.
Probabilities can also be assigned to the possible outcomes (or returns) from an investment.
If you buy a bond, you expect to receive interest on the bond plus a return of your original
investment, and those payments will provide you with a rate of return on your investment. The
possible outcomes from this investment are:-
(1) That the issuer will make the required payments or
(2) That the issuer will default on the payments.
The higher the probability of default, the riskier the bond and the higher the risk, the higher
required rate of return. If you invest in a stock instead of buying a bond, you will again expect to
earn a return on your money. A stock’s return will come from dividends plus capital gains. Again,
the riskier the stock—which means the higher the probability that the firm will fail to perform as
you expected—the higher the expected return must be to induce you to invest in the stock.
With this in mind, consider the possible rates of return (dividend yield plus capital gain or loss)
that you might earn next year on a $10,000 investment in the stock of either Martin Products Inc.
or U.S. Water Company. Martin manufactures and distributes routers and equipment for the
rapidly growing data transmission industry. Because it faces intense competition, its new products
may or may not be competitive in the marketplace, so its future earnings cannot be predicted very
well. Indeed, some new company could develop better products and literally bankrupt Martin. U.S.
Water, on the other hand, supplies an essential service, and because it has city franchises that
protect it from competition, its sales and profits are relatively stable and predictable.
The rate-of-return probability distributions for the two companies are shown in Table 3-1. There
is a 30 percent chance of strong demand, in which case both companies will have high earnings,
pay high dividends, and enjoy capital gains. There is a 40 percent probability of normal demand
and moderate returns, and there is a 30 percent probability of weak demand, which will mean low
earnings and dividends as well as capital losses. Notice, however, that Martin Products’ rate of
return could vary far more widely than that of U.S. Water. There is a fairly high probability that
the value of Martin’s stock will drop substantially, resulting in a 70 percent loss, while there is no
chance of a loss for U.S. Water.
3.2.4 Expected rate of return

If we multiply each possible outcome by its probability of occurrence and then sum these products,
as in Table 3-2, we have a weighted average of outcomes. The weights are the probabilities, and
the weighted average is the expected rate of return, ȓ, called “r-hat.” The expected rates of return
for both Martin Products and U.S. Water are shown in Table 3-2 to be 15 percent. This type of
table is known as a payoff matrix.
The expected rate of return calculation can also be expressed as an equation that does the same
thing as the payoff matrix table:

Here ri is the ith possible outcome, Pi is the probability of the ith outcome, and n is the number of
possible outcomes. Thus, ȓ is a weighted average of the possible outcomes (the ri values), with
each outcome’s weight being its probability of occurrence. Using the data for Martin Products,
we obtain its expected rate of return as follows:
Expected rate of return = P1 (r1) + P2 (r2) + P3(r3)
= 0.3(100%) + 0.4(15%) + 0.3(-70%)
= 15%.
U.S. Water’s expected rate of return is also 15 percent:
Expected rate of return = 0.3(20%) + 0.4(15%) + 0.3(10%)
= 15%.
We can graph the rates of return to obtain a picture of the variability of possible outcomes; this is
shown in the Figure 3-1 bar charts. The height of each bar signifies the probability that a given
outcome will occur. The range of probable returns for Martin Products is from -70 to +100 percent,
with an expected return of 15 percent. The expected return for U.S. Water is also 15 percent, but
its range is much narrower.
Thus far, we have assumed that only three situations can exist: strong, normal, and weak demand.
Actually, of course, demand could range from a deep depression to a fantastic boom, and there are
an unlimited number of possibilities in between. Suppose we had the time and patience to assign
a probability to each possible level of demand (with the sum of the probabilities still equaling 1.0)
and to assign a rate of return to each stock for each level of demand. We would have a table similar
to Table 3-1, except that it would have many more entries in each column. This table could be used
to calculate expected rates of return as shown previously, and the probabilities and outcomes could
be approximated by continuous curves such as those presented in Figure 3-2. Here we have
changed the assumptions so that there is essentially a zero probability that Martin Products’ return
will be less than -70 percent or more than 100 percent, or that U.S. Water’s return will be less than
10 percent or more than 20 percent, but virtually any return within these limits is possible.

The tighter, or more peaked, the probability distribution, the more likely it is that the actual
outcome will be close to the expected value, and, consequently, the less likely it is that the actual
return will end up far below the expected return. Thus, the tighter the probability distribution, the
lower the risk assigned to a stock. Since U.S. Water has a relatively tight probability distribution,
its actual return is likely to be closer to its 15 percent expected return than is that of Martin
Products.
3.3 CONCEPTS AND MEASUREMENT OF STAND-ALONE RISK
Measuring Stand-Alone Risk: The Standard Deviation

Risk is a difficult concept to grasp, and a great deal of controversy has surrounded attempts to
define and measure it. However, a common definition, and one that is satisfactory for many
purposes, is stated in terms of probability distributions such as those presented in Figure 3-2: The
tighter the probability distribution of expected future returns, the smaller the risk of a given
investment. According to this definition, U.S. Water is less risky than Martin Products because
there is a smaller chance that its actual return will end up far below its expected return.

To be most useful, any measure of risk should have a definite value—we need a measure of the
tightness of the probability distribution. One such measure is the standard deviation, the symbol
for which isσ, pronounced “sigma.” The smaller the standard deviation, the tighter the probability
distribution, and, accordingly, the lower the riskiness of the stock. To calculate the standard
deviation, we proceed as shown in Table 3-3, taking the following steps:
1. Calculate the expected rate of return:
For Martin, we previously found 15%.

2. Subtract the expected rate of return (rˆ) from each possible outcome (ri) to obtain a set of
deviations about ˆr as shown in Column 1 of Table 3-3:

3. Square each deviation, then multiply the result by the probability of occurrence for its related
outcome, and then sum these products to obtain the variance of the probability distribution as
shown in Columns 2 and 3 of the table:
4. Finally, find the square root of the variance to obtain the standard deviation:
Thus, the standard deviation is essentially a weighted average of the deviations from the expected
value, and it provides an idea of how far above or below the expected value the actual value is
likely to be. Martin’s standard deviation is seen in Table 3-3 to be σ = 65.84%. Using these same
procedures, we find U.S. Water’s standard deviation to be 3.87 percent. Martin Products has the
larger standard deviation, which indicates a greater variation of returns and thus a greater chance
that the expected return will not be realized. Therefore, Martin Products is a riskier investment
than U.S. Water when held alone.
If a probability distribution is normal, the actual return will be within +1 standard deviation of the
expected return 68.26 percent of the time. Figure 3-3 illustrates this point, and it also shows the
situation for +2and +3 σ For Martin Products, r = 15% and σ 65.84%, whereas ȓ = 15% and σ =
3.87% for U.S. Water. Thus, if the two distributions were normal, there would be a 68.26 percent
probability that Martin’s actual return would be in the range of 15 ± 65.84 percent, or from - 50.84
to 80.84 percent. For U.S. Water, the 68.26 percent range is 15 ± 3.87 percent, or from 11.13 to
18.87 percent. With such a small σ, there is only a small probability that U.S. Water’s return would
be significantly less than expected, so the stock is not very risky. For the average firm listed on the
New York Stock Exchange, σ has generally been in the range of 35 to 40 percent in recent years.

Using Historical Data to Measure Risk
In the previous example, we described the procedure for finding the mean and standard deviation
when the data are in the form of a known probability distribution. If only sample returns data over
some past period are available, the standard deviation of returns can be estimated using this
formula:
Measuring Stand-Alone Risk: The Coefficient of Variation

If a choice has to be made between two investments that have the same expected returns but
different standard deviations, most people would choose the one with the lower standard deviation
and, therefore, the lower risk. Similarly, given a choice between two investments with the same

risk (standard deviation) but different expected returns, investors would generally prefer the
investment with the higher expected return.
To most people, this is common sense—return is “good,” risk is “bad,” and consequently investors
want as much return and as little risk as possible. But how do we choose between two investments
if one has the higher expected return but the other the lower standard deviation? To help answer
this question, we often use another measure of risk, the coefficient of variation (CV), which is
the standard deviation divided by the expected return:
The coefficient of variation shows the risk per unit of return, and it provides a more meaningful
basis for comparison when the expected returns on two alternatives are not the same. Since U.S.
Water and Martin Products have the same expected return, the coefficient of variation is not
necessary in this case. The firm with the larger standard deviation, Martin, must have the larger
coefficient of variation when the means are equal. In fact, the coefficient of variation for Martin is
65.84/15 = 4.39 and that for U.S. Water is 3.87/15 = 0.26. Thus, Martin is almost 17 times riskier
than U.S. Water on the basis of this criterion.
For a case where the coefficient of variation is necessary, consider Projects X and Y in Figure 3-
4. These projects have different expected rates of return and different standard deviations. Project
X has a 60 percent expected rate of return and a 15 percent standard deviation, while Project Y has
an 8 percent expected return but only a 3 percent standard deviation. Is Project X riskier, on a
relative basis, because it has the larger standard deviation? If we calculate the coefficients of
variation for these two projects, we find that Project X has a coefficient of variation of 15/60=
0.25, and Project Y has a coefficient of variation of 3/8= 0.375. Thus, we see that Project Y actually
has more risk per unit of return than Project X, in spite of the fact that X’s standard deviation is
larger. Therefore, even though Project Y has the lower standard deviation, according to the
coefficient of variation it is riskier than Project X.
Project Y has the smaller standard deviation, hence the more peaked probability distribution, but
it is clear from the graph that the chances of a really low return are higher for Y than for X because
X’s expected return is so high. Because the coefficient of variation captures the effects of both risk
and return, it is a better measure for evaluating risk in situations where investments have
substantially different expected returns.

Risk Aversion and Required Returns
Suppose you have worked hard and saved $1 million, which you now plan to invest. You can buy
a 5 percent U.S. Treasury security, and at the end of one year you will have a sure $1.05 million,
which is your original investment plus $50,000 in interest. Alternatively, you can buy stock in
R&D Enterprises. If R&D’s research programs are successful, your stock will increase in value to
$2.1 million. However, if the research is a failure, the value of your stock will go to zero, and you
will be penniless. You regard R&D’s chances of success or failure as being 50-50, so the expected
value of the stock investment is 0.5($0) + 0.5($2,100,000) = $1,050,000. Subtracting the $1 million
cost of the stock leaves an expected profit of $50,000, or an expected (but risky) 5 percent rate of
return:
Thus, you have a choice between a sure $50,000 profits (representing a 5 percent rate of return)
on the Treasury security and a risky expected $50,000 profit (also representing a 5 percent expected
rate of return) on the R&D Enterprises stock. Which one would you choose? If you choose the less
risky investment, you are risk averse. Most investors are indeed risk averse, and certainly the
average investor is risk averse with regard to his or her “serious money.” Because this is a well-
documented fact.

What are the implications of risk aversion for security prices and rates of return? The answer is
that, other things held constant, the higher a security’s risk, the lower its price and the higher its
required return. To see how risk aversion affects security prices, look back at Figure 3-2 and
consider again U.S. Water and Martin Products stocks.
Suppose each stock sold for $100 per share and each had an expected rate of return of 15 percent.
Investors are averse to risk, so under these conditions there would be a general preference for U.S.
Water. People with money to invest would bid for U.S. Water rather than Martin stock, and
Martin’s stockholders would start selling their stock and using the money to buy U.S. Water.
Buying pressure would drive up U.S. Water’s stock, and selling pressure would simultaneously
cause Martin’s price to decline.
These price changes, in turn, would cause changes in the expected rates of return on the two
securities. Suppose, for example, that U.S. Water’s stock price was bid up from $100 to $150,
whereas Martin’s stock price declined from $100 to $75. This would cause U.S. Water’s expected
return to fall to 10 percent, while Martin’s expected return would rise to 20 percent. The difference
in returns, 20% - 10% = 10%, is a risk premium, RP, which represents the additional
compensation investors require for assuming the additional risk of Martin stock.
This example demonstrates a very important principle: In a market dominated by risk-averse
investors, riskier securities must have higher expected returns, as estimated by the marginal
investor, than less risky securities. If this situation does not exist, buying and selling in the
market will force it to occur.
3.4 FACTORS THAT AFFECT RISK AND RETURN
In this section, we continue our discussion of factors that you must consider when selecting
securities for an investment portfolio. You will recall that this selection process involves finding
securities that provide a rate of return that compensates you for: (1) the time value of money during
the period of investment, (2) the expected rate of inflation during the period, and (3) the risk
involved.
The summation of these three components is called the required rate of return. This is the
minimum rate of return that you should accept from an investment to compensate you for deferring
consumption. Because of the importance of the required rate of return to the total investment
selection process, this section contains a discussion of the three components and what influences
each of them.

The analysis and estimation of the required rate of return are complicated by the behavior of market
rates over time. First, a wide range of rates is available for alternative investments at any time.
Second, the rates of return on specific assets change dramatically over time. Third, the difference
between the rates available (that is, the spread) on different assets changes over time.
The yield data in Exhibit 1.5 for alternative bonds demonstrate these three characteristics. First,
even though all these securities have promised returns based upon bond contracts, the promised
annual yields during any year differ substantially. As an example, during 2009 the average yields
on alternative assets ranged from 0.15 percent on T-bills to 7.29 percent for Baa corporate bonds.
Second, the changes in yields for a specific asset are shown by the three-month Treasury bill rate
that went from 4.48 percent in 2007 to 0.15 percent in 2009. Third, an example of a change in the
difference between yields over time (referred to as a spread) is shown by the Baa–Aaa spread. The
yield spread in 2007 was 91 basis points (6.47–5.56), but the spread in 2009 increased to 198 basis
points (7.29–5.31). (A basis point is 0.01 percent.)
Bonds are rated by rating agencies based upon the credit risk of the securities, that is, the
probability of default. Aaa is the top rating Moody’s (a prominent rating service) gives to bonds
with almost no probability of default. (Only U.S. Treasury bonds are considered to be of higher
quality.) Baa is a lower rating Moody’s gives to bonds of generally high quality that have some
possibility of default under adverse economic conditions.
Exhibit 5
Because differences in yields result from the riskiness of each investment, you must understand
the risk factors that affect the required rates of return and include them in your assessment of
investment opportunities. Because the required returns on all investments change over time, and
because large differences separate individual investments, you need to be aware of the several
components that determine the required rate of return, starting with the risk-free rate. In this section
we consider the three components of the required rate of return and briefly discuss what affects
these components.
3.4.1 The real risk-free rate (RRFR)

The real risk-free rate (RRFR) is the basic interest rate, assuming no inflation and no uncertainty
about future flows. An investor in an inflation-free economy who knew with certainty what cash
flows he or she would receive at what time would demand the RRFR on an investment.
Earlier, we called this the pure time value of money, because the only sacrifice the investor made
was deferring the use of the money for a period of time. This RRFR of interest is the price charged
for the risk-free exchange between current goods and future goods.
Two factors, one subjective and one objective, influence this exchange price. The subjective factor
is the time preference of individuals for the consumption of income. When individuals give up
$100 of consumption this year, how much consumption do they want a year from now to
compensate for that sacrifice? The strength of the human desire for current consumption influences
the rate of compensation required. Time preferences vary among individuals, and the market
creates a composite rate that includes the preferences of all investors. This composite rate changes
gradually over time because it is influenced by all the investors in the economy, whose changes in
preferences may offset one another.
The objective factor that influences the RRFR is the set of investment opportunities available in
the economy. The investment opportunities available are determined in turn by the long-run real
growth rate of the economy. A rapidly growing economy produces more and better opportunities
to invest funds and experience positive rates of return. A change in the economy’s long-run real
growth rate causes a change in all investment opportunities and a change in the required rates of
return on all investments. Just as investors supplying capital should demand a higher rate of return
when growth is higher; those looking to borrow funds to invest should be willing and able to pay
a higher rate of return to use the funds for investment because of the higher growth rate and better
opportunities. Thus, a positive relationship exists between the real growth rate in the economy and
the RRFR.
3.4.2 Factors influencing the nominal risk-free rate (NRFR)

Earlier, we observed that an investor would be willing to forgo current consumption in order to
increase future consumption at a rate of exchange called the risk-free rate of interest. This rate of
exchange was measured in real terms because we assume that investors want to increase the
consumption of actual goods and services rather than consuming the same amount that had come
to cost more money. Therefore, when we discuss rates of interest, we need to differentiate between
real rates of interest that adjust for changes in the general price level, as opposed to nominal rates
of interest that are stated in money terms. That is, nominal rates of interest that prevail in the market
are determined by real rates of interest, plus factors that will affect the nominal rate of interest,

such as the expected rate of inflation and the monetary environment. It is important to understand
these factors.
Notably, the variables that determine the RRFR change only gradually because we are concerned
with long-run real growth. Therefore, you might expect the required rate on a risk-free investment
to be quite stable over time. As discussed in connection with Exhibit 1.5, rates on three-month T-
bills were not stable over the period from 2004 to 2010. This is demonstrated with additional
observations in Exhibit 1.6, which contains yields on T-bills for the period 1987-2010.
Investors view T-bills as a prime example of a default-free investment because the government
has unlimited ability to derive income from taxes or to create money from which to pay interest.
Therefore, one could expect that rates on T-bills should change only gradually. In fact, the data in
Exhibit 1.6 show a highly erratic pattern. Specifically, there was an increase in yields from 4.64
percent in 1999 to 5.82 percent in 2000 before declining by over 80 percent in three years to 1.01
percent in 2003, followed by an increase to 4.73 percent in 2006, and concluding at 0.14 percent
in 2010. Clearly, the nominal rate of interest on a default-free investment is not stable in the long
run or the short run, even though the underlying determinants of the RRFR are quite stable. As
noted, two other factors influence the nominal risk-free rate (NRFR): (1) the relative ease or
tightness in the capital markets, and (2) the expected rate of inflation.
Conditions in the Capital MarketYou will recall from prior courses in economics and finance
that the purpose of capital markets is to bring together investors who want to invest savings with
companies or governments who need capital to expand or to finance budget deficits.
The cost of funds at any time (the interest rate) is the price that equates the current supply and
demand for capital. Beyond this long-run equilibrium, change in the relative ease or tightness in
the capital market is a short-run phenomenon caused by a temporary disequilibrium in the supply
and demand of capital. For example, a change in the target federal funds rate or fiscal policy, a
change in the federal deficit. Such a change in monetary policy or fiscal policy will produce a
change in the NRFR of interest, but the change should be short-lived because, in the longer run,
the higher or lower interest rates will affect capital supply and demand.

As an example, an increase in the federal deficit caused by an increase in government spending
(easy fiscal policy) will increase the demand for capital and increase interest rates. In turn, this
increase in interest rates should cause an increase in savings and a decrease in the demand for
capital by corporations or individuals. These changes in market conditions should bring rates back
to the long run equilibrium, which is based on the long-run growth rate of the economy.
Expected Rate of Inflation: Previously, it was noted that if investors expected the price level to
increase (an increase in the inflation rate) during the investment period, they would require the rate
of return to include compensation for the expected rate of inflation. Assume that you require a 4
percent real rate of return on a risk-free investment but you expect prices to increase by 3 percent
during the investment period. In this case, you should increase your required rate of return by this
expected rate of inflation to about 7 percent [(1.04 × 1.03) -1]. If you do not increase your required
return, the $104 you receive at the end of the year will represent a real return of about 1 percent,
not 4 percent. Because prices have increased by 3 percent during the year, what previously cost
$100 now costs $103, so you can consume only about 1 percent more at the end of the year
[($104/103) -1]. If you had required a 7.12 percent nominal return, your real consumption could
have increased by 4 percent [($107.12/103) -1]. Therefore, an investor’s nominal required rate of
return on a risk-free investment should be:
1.11 NRFR = [(1 + RRFR) × (1 + Expected Rate of Inflation)] -1
Rearranging the formula, you can calculate the RRFR of return on an investment as follows:
1.12 RRFR = 1 + NRFR of Return-1

1 + Rate of Inflation

To see how this works, assume that the nominal return on U.S. government T-bills was 9 percent
during a given year, when the rate of inflation was 5 percent. In this instance, the RRFR of return
on these T-bills was 3.8 percent, as follows:
RRFR = [(1 + 0.09) /1 + 0.05)] -1
= 1.038 - 1
= 0.038 = 3.8%
This discussion makes it clear that the nominal rate of interest on a risk-free investment is not a
good estimate of the RRFR, because the nominal rate can change dramatically in the short run in
reaction to temporary ease or tightness in the capital market or because of changes in the expected
rate of inflation. As indicated by the data in Exhibit 1.6, the significant changes in the average
yield on T-bills typically were related to large changes in the rates of inflation. Notably,
2009–2010 were different due to the quantitative easing by the Federal Reserve.
The Common Effect: All the factors discussed thus far regarding the required rate of return affect
all investments equally. Whether the investment is in stocks, bonds, real estate, or machine tools,
if the expected rate of inflation increases from 2 percent to 6 percent, the investor’s required rate
of return for all investments should increase by 4 percent. Similarly, if a decline in the expected
real growth rate of the economy causes a decline in the RRFR of 1 percent, the required return on
all investments should decline by 1 percent.
3.4.3 Risk premium

A risk-free investment was defined as one for which the investor is certain of the amount and
timing of the expected returns. The returns from most investments do not fit this pattern. An
investor typically is not completely certain of the income to be received or when it will be received.
Investments can range in uncertainty from basically risk-free securities, such as T-bills, to highly
speculative investments, such as the common stock of small companies engaged in high-risk
enterprises.
Most investors require higher rates of return on investments if they perceive that there is any
uncertainty about the expected rate of return. This increase in the required rate of return over the
NRFR is the risk premium (RP). Although the required risk premium represents a composite of all
uncertainty, it is possible to consider several fundamental sources of uncertainty.
In this section, we identify and discuss briefly the major sources of uncertainty, including:
(1) Business risk,
(2) Financial risk (leverage),
(3) Liquidity risk,

(4) Exchange rate risk, and
(5) Country (political) risk.
Business risk is the uncertainty of income flows caused by the nature of a firm’s business. The
less certain the income flows of the firm, the less certain the income flows to the investor.
Therefore, the investor will demand a risk premium that is based on the uncertainty caused by the
basic business of the firm. As an example, a retail food company would typically experience stable
sales and earnings growth over time and would have low business risk compared to a firm in the
auto or airline industry, where sales and earnings fluctuate substantially over the business cycle,
implying high business risk.
Financial risk is the uncertainty introduced by the method by which the firm finances its
investments. If a firm uses only common stock to finance investments, it incurs only business risk.
If a firm borrows money to finance investments, it must pay fixed financing charges (in the form
of interest to creditors) prior to providing income to the common stockholders, so the uncertainty
of returns to the equity investor increases. This increase in uncertainty because of fixed-cost
financing is called financial risk or financial leverage, and it causes an increase in the stock’s risk
premium.
Liquidity risk is the uncertainty introduced by the secondary market for an investment. When an
investor acquires an asset, he or she expects that the investment will mature (as with a bond) or
that it will be salable to someone else. In either case, the investor expects to be able to convert the
security into cash and use the proceeds for current consumption or other investments. The more
difficult it is to make this conversion to cash, the greater the liquidity risk. An investor must
consider two questions when assessing the liquidity risk of an investment: How long will it take
to convert the investment into cash? How certain is the price to be received? Similar uncertainty
faces an investor who wants to acquire an asset: How long will it take to acquire the asset? How
uncertain is the price to be paid?
Uncertainty regarding how fast an investment can be bought or sold, or the existence of uncertainty
about its price, increases liquidity risk. A U.S. government Treasury bill has almost no liquidity
risk because it can be bought or sold in seconds at a price almost identical to the quoted price. In
contrast, examples of illiquid investments include a work of art, an antique, or a parcel of real
estate in a remote area. For such investments, it may require a long time to find a buyer and the
selling prices could vary substantially from expectations. Investors will increase their required

rates of return to compensate for this uncertainty regarding timing and price. Liquidity risk can be
a significant consideration when investing in foreign securities depending on the country and the
liquidity of its stock and bond markets.
Exchange rate risk is the uncertainty of returns to an investor who acquires securities
denominated in a currency different from his or her own. The likelihood of incurring this risk is
becoming greater as investors buy and sell assets around the world, as opposed to only assets
within their own countries. A U.S. investor who buys Japanese stock denominated in yen must
consider not only the uncertainty of the return in yen but also any change in the exchange value of
the yen relative to the U.S. dollar. That is, in addition to the foreign firm’s business and financial
risk and the security’s liquidity risk, the investor must consider the additional uncertainty of the
return on this Japanese stock when it is converted from yen to U.S. dollars.
As an example of exchange rate risk, assume that you buy 100 shares of Mitsubishi Electric at
1,050 yen when the exchange rate is 105 yen to the dollar. The dollar cost of this investment would
be about $10.00 per share (1,050/105). A year later you sell the 100 shares at 1,200 yen when the
exchange rate is 115 yen to the dollar. When you calculate the HPY in yen, you find the stock has
increased in value by about 14 percent (1,200/1,050) -
investor. A U.S. investor receives a much lower rate of return, because during this period the yen
has weakened relative to the dollar by about 9.5 percent (that is, it requires more yen to buy a
dollar—115 versus 105). At the new exchange rate, the stock is worth $10.43 per share
(1,200/115). Therefore, the return to you as a U.S. investor would be only about 4 percent
($10.43/$10.00) versus 14 percent for the Japanese investor. The difference in return for the
Japanese investor and U.S. investor is caused by exchange rate risk—that is, the decline in the
value of the yen relative to the dollar. Clearly, the exchange rate could have gone in the other
direction, the dollar weakening against the yen. In this case, as a U.S. investor, you would have
experienced the 14 percent return measured in yen, as well as a currency gain from the exchange
rate change.
The more volatile the exchange rate between two countries, the less certain you would be regarding
the exchange rate, the greater the exchange rate risk, and the larger the exchange rate risk premium
you would require.
There can also be exchange rate risk for a U.S. firm that is extensively multinational in terms of
sales and expenses. In this case, the firm’s foreign earnings can be affected by changes in the
exchange rate. As will be discussed, this risk can generally be hedged at a cost.

Country risk, also called political risk, is the uncertainty of returns caused by the possibility of a
major change in the political or economic environment of a country. The United States is
acknowledged to have the smallest country risk in the world because its political and economic
systems are the most stable. During the spring of 2011, prevailing examples include the deadly
rebellion in Libya against Moammad Gadhafi; a major uprising in Syria against President Bashar
al-Assad; and significant protests in Yemen against President Ali Abdullah Saleh. In addition,
there has been a recent deadly earthquake and tsunami in Japan that is disturbing numerous global
corporations and the currency markets. Individuals who invest in countries that have unstable
political or economic systems must add a country risk premium when determining their required
rates of return.
When investing globally (which is emphasized throughout the book, based on a discussion in
Chapter 3), investors must consider these additional uncertainties. How liquid are the secondary
markets for stocks and bonds in the country? Are any of the country’s securities traded on major
stock exchanges in the United States, London, Tokyo, or Germany? What will happen to exchange
rates during the investment period? What is the probability of a political or economic change that
will adversely affect your rate of return? Exchange rate risk and country risk differ among
countries. A good measure of exchange rate risk would be the absolute variability of the exchange
rate relative to a composite exchange rate. The analysis of country risk is much more subjective
and must be based on the history and current political environment of the country.
Risk Premium = f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country
Risk)
3.5 SYSTEMATIC AND UNSYSTEMATIC RISK
Systematic risk is the unavoidable or undiversifiable risk and it is due to the overall market risk
changes in the nation’s economy, tax reform by government or change in the world energy
situation. This risk affects all securities and not company specific.
The unsystematic risk is avoidable or diversifiable. It is also sometimes called residual risk or
company specific risk. This is risk that is unique to a company such as a strike or the outcome of
unfavorable litigation or a natural catastrophe. We have noticed that the unsystematic risk can be
eliminated. For individual assets or securities, therefore the relevant risk is not the standard
deviation that is total risk, but the systematic risk, as measured by beta. As the unsystematic risk
is relatively easily eliminated, we should not expect the market to offer investors a risk premium
for bearing such risk.

The relationship between an individual security’s expected rate of return and its systematic risk,
as measured by beta, will be linear. The relationship is known as the security market line (SML).
The relationship between expected rate of return and unavoidable risk and the valuation of
securities that follow is the essence of the Capital Asset Pricing Model. (CAPM)
According to CAPM, the expected return on a risky security is a combination of the risk-free rate
plus a premium for risk. The risk premium is necessarily to induce risk averse investors to buy a
risky security. Frequently, the rate on treasury security is used as surrogate for the risk free rate
(Rƒ). If the expected return for the market portfolio is Rm, then the expected return of a security j
(Rj) is:
Rj = Rf +βj (Rf-Rm)
Where j is the beta (systematic risk) of security j

The greater the beta of a security, the greater the risk and the greater the expected return required.
By the same token, the lower the beta, the lower the risk the more safe of investment, and the lower
expected rate of return required. An investor holding only a single security will be exposed to both
systematic and unsystematic risk but the market will reward him for only the systematic risk that
is borne.
Example
Suppose you went to evaluate the attractiveness of investing in XYZ corporation stock. Assume
that the expected return on treasury security is 6%, the expected return on the market portfolio is
11% and the beta of XYZ Corporation is 1.3. Determine the expected return for the stock according
to the CAPM.
Expected rate of return (R) = Rf +β (Rm – Rf)
= 6% +1.3(11% - 6%)
= 12.5%

CHAPTER FOUR: PORTFOLIO ANALYSIS
AND MODERN PORTFOLIO THEORY
4.1INTRODUCTION
The developments in the capital market and the new financial avenues, new challenges, risk &
return management, performance evaluation in turbulent, unpredictable and volatile traditional
financial environment have made the life challenging for the investors, financial economists,
leaders of financial services entities. To reduce the complexity of investment, risk, return and to
assess and evaluate the performance of securities the financial economists develop and adopted
portfolio management as an effective and efficient tool and technique. With acquired knowledge
and skills it regularly update financial purchases and comparative analyze prevailing market
condition. It measure the market movement, sentiment, emotion and impacts and determines the
virtual strengths and opportunities for sale and purchase of the security. It minutely evaluate the
risk and return factors of security market and of respective securities of portfolio in order to protect
the investment and to generate growth and improvement in future return
Portfolio theory, originally proposed by Harry Markowitz in 1050s, was the first formal attempt
to quantify the risk of portfolio and develop a methodology for determining the optimal portfolio.
Prior to the development of portfolio theory, investors dealt with the concepts of return and risk
somewhat loosely. Intuitively smart investors knew the benefit of diversification which is reflected
in the traditional adage “Do not put all your eggs in one basket”, Harry Markowitz was the first
person to show quantitatively why and how diversification reduces risk.
Very broadly, the investment process consists of two tasks. The first task is security analysis which
focuses on assessing the risk and returns characteristics of the available investments alternatives.
The second task is portfolio selection which involves choosing the best possible portfolio from the
set of feasible securities. Before discussing the portfolio analysis fist we discuss some related
concepts:
4.1.1 What is portfolio

A portfolio is a group of securities held together as investment. Investors invest their funds in a
portfolio of securities rather than in a single security because of risk factor. By constructing a
portfolio, investors attempt to spread risk by not putting all their eggs into one basket.
Selection of different securities with different risk factors and maturity as a one unit is called a

portfolio. It is simply a collection or a group of securities considered in total as a single investment
unit. The term portfolio refers to any collection of financial assets such as cash. It can be defined
very broadly as it include property, antiques, works of arts, commodities, financial securities such
as stocks, bonds, cash equivalents and money market instruments. Individual securities have risk
return characteristics of their own. Portfolio, which is combinations of securities, may or may not
take on the aggregate characteristics of their individual parts.
A portfolio is a group of securities held together as investment. Investors invest their funds in a
portfolio of securities rather than in a single security because of risk factor. By constructing a
portfolio, investors attempt to spread risk by not putting all their eggs into one basket. Thus
diversification of investment tends to reduce risk by spreading risk over many assets.
• Creation of portfolio reduces the risk factor without sacrificing returns.

• Portfolios are held directly by investors or are managed by financial professionals, hedge
funds, banks and other financial institutions
• It is generally accepted principle that a portfolio is designed according to the investor's risk
tolerance, time frame and investment objectives.
4.1.2 What is portfolio management?

Portfolio management is a dynamic function of evaluating and revising the portfolio in terms of stated
investor’s objectives. It is concerned with efficient management of investment in securities. The art of
selecting the right investment policy for the individuals in terms of minimum risk and maximum
return is called as portfolio management.
Portfolio management can also be defined as the art and science of making decisions about
investment mix and policy, matching investments to objectives, asset allocation for individuals
and institutions, and balancing risk against performance. Portfolio management is all about
determining strengths, weaknesses, opportunities and threats in the choice of debt vs. equity,
domestic vs. international, growth vs. safety, and many other trade-offs encountered in the attempt
to maximize return at a given appetite for risk.
Portfolio management refers to managing money of an individual under the expert guidance of
portfolio managers. In a layman’s language, the art of managing an individual’s investment is
called as portfolio management.
4.1.3 The key elements of portfolio management

Asset Allocation: The key to effective portfolio management is the long-term mix of assets. Asset
allocation is based on the understanding that different types of assets do not move in concert, and
some are more volatile than others. Asset allocation seeks to optimize the risk/return profile of an
investor by investing in a mix of assets that have low correlation to each other. Investors with a
more aggressive profile can weight their portfolio toward more volatile investments. Investors with
a more conservative profile can weight their portfolio toward more stable investments.
Diversification: The only certainty in investing is it is impossible to consistently predict the

winners and losers, so the prudent approach is to create a basket of investments that provide broad
exposure within an asset class. Diversification is the spreading of risk and reward within an asset
class. Because it is difficult to know which particular subset of an asset class or sector is likely to
outperform another, diversification seeks to capture the returns of all of the sectors over time but
with less volatility at any one time. Proper diversification takes place across different classes of
securities, sectors of the economy and geographical regions.
Rebalancing: This is a method used to return a portfolio to its original target allocation at annual
intervals. It is important for retaining the asset mix that best reflects an investor’s risk/return
profile. Otherwise, the movements of the markets could expose the portfolio to greater risk or
reduced return opportunities. For example, a portfolio that starts out with a 70% equity and 30%
fixed-income allocation could, through an extended market rally, shift to an 80/20 allocation that
exposes the portfolio to more risk than the investor can tolerate. Rebalancing almost always entails
the sale of high-priced/low-value securities and the redeployment of the proceeds into low-
priced/high-value or out-of-favor securities. The annual iteration of rebalancing enables investors
to capture gains and expand the opportunity for growth in high potential sectors while keeping the
portfolio aligned with the investor’s risk/return profile
4.1.4 Need for portfolio management
 Portfolio management presents the best investment plan to the individuals as per their
income, budget, age and ability to undertake risks.
 Portfolio management minimizes the risks involved in investing and also increases the
chance of making profits.
 Portfolio managers understand the client’s financial needs and suggest the best and unique
investment policy for them with minimum risks involved.

 Portfolio management enables the portfolio managers to provide customized investment
solutions to clients as per their needs and requirements.
4.1.5 Types of portfolio management
Portfolio Management is further of the following types:
 Active Portfolio Management: As the name suggests, in an active portfolio management

service, the portfolio managers are actively involved in buying and selling of securities to
ensure maximum profits to individuals.
 Passive Portfolio Management: In a passive portfolio management, the portfolio manager
deals with a fixed portfolio designed to match the current market scenario.
 Discretionary Portfolio management services: In Discretionary portfolio management
services, an individual authorizes a portfolio manager to take care of his financial needs on
his behalf. The individual issues money to the portfolio manager who in turn takes care of
all his investment needs, paper work, documentation, filing and so on. In discretionary
portfolio management, the portfolio manager has full rights to take decisions on his client’s
behalf.
 Non-Discretionary Portfolio management services: In non-discretionary portfolio
management services, the portfolio manager can merely advise the client what is good and
bad for him but the client reserves full right to take his own decisions.
4.1.6 Who is a portfolio manager?
An individual who understands the client’s financial needs and designs a suitable investment plan
as per his income and risk taking abilities is called a portfolio manager. A portfolio manager is one
who invests on behalf of the client. A portfolio manager counsels the clients and advises him the
best possible investment plan which would guarantee maximum returns to the individual. A
portfolio manager must understand the client’s financial goals and objectives and offer a tailor
made investment solution to him. No two clients can have the same financial needs.
4.2 PORTFOLIO ANALYSIS
4.2.1 What is portfolio analysis?

A process used to assess the suitability of a portfolio of securities or businesses 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'sallocation of different investment
classes according to changing market conditions or changes in his own circumstances
Portfolio analysis involves quantifying the operational and financial impact of the portfolio. It is
vital to evaluate the performances of investments and timing the returns effectively. The analysis
of a portfolio extends to all classes of investments such as bonds, equities, indexes, commodities,
funds, options and securities. Portfolio analysis gains importance because each asset class has
peculiar risk factors and returns associated with it. Hence, the composition of a portfolio affects
the rate of return of the overall investment.
Each of your investments won’t be a home run, but your portfolio’s performance should at least
be in line with your expectations. If the gap between your expectations and reality is consistently
the size of the Grand Canyon, it’s time to re-evaluate your portfolio. To assess your investments’
performance, you need to begin with your original investment plan and a process.
“The keyword is the ‘process,'” we truly need to have a process in place for how you’re buying,
how you’re re-evaluating and how to make the changes. Those three things create the process.”
Ideally, investors would assess the health of their portfolios at least once a year and after significant
life changes such as marriage, having kids, losing a job or coming into an inheritance. Your original
investment plan is really the blueprint for assessing what’s working. If your portfolio was
assembled willy-nilly, consulting a financial professional can help you put together a
comprehensive investment strategy.
To determine if your plan is working, review your investments. These should be contained in a
diversified portfolio that was constructed based on the parameters established by your risk
tolerance, time horizon and goals. In simpler terms, your investment plan should be based on how
much risk you’re willing to take, how long it will be until you need the money and your goals for
that money.
If your investments are in accord with those three considerations, it’s time to start digging. Begin
by looking at your allocation and weightings. Many investment advisers recommend rebalancing
your portfolio to stay within the allocation established at the outset of your plan.
Before rebalancing, take a look at the performance of the individual investments that make up your
asset allocation plan. Investors should understand why each asset is in the portfolio and what they

expect from it. Asset classes perform differently and have varying roles within a portfolio. One
sector, style or class might have a great year while other parts of the portfolio may turn in only a
middling performance. Together they mitigate volatile swings in the portfolio’s value.
The important thing to consider is how an investment performs compared to its benchmark or
similar securities. Was it a bad year for all small-cap growth companies, or just your small-cap
fund? If small companies in general underperformed, then selling it or switching it for a hot fund
in another sector could be a bad move.
4.2.2 What is involved in portfolio analysis?
Portfolio analysis is broadly carried out for each asset at two levels:
 Risk aversion: This method analyzes the portfolio composition while considering the
risk appetite of an investor. Some investors may prefer to play safe and accept low
profits rather than invest in risky assets that can generate high returns.
 Analyzing returns: While performing portfolio analysis, prospective returns are
calculated through the average and compound return methods. An average return is
simply the arithmetic average of returns from individual assets. However, compound
return is the arithmetic mean that considers the cumulative effect on overall returns.
The next step in portfolio analysis involves determining dispersion of returns. It is the measure of
volatility or standard deviation of returns for a particular asset. Simply put, dispersion refers the
difference between the real interest rate and the calculated average return.
4.3 MEASURING EXPECTED PORTIFOLIO RETURN AND RISK
A portfolio is the total collection of all investments held by an individual or institution, including
stocks, bonds, real estate, options, futures, and alternative investments, such as gold or limited
partnerships. Portfolio analysis is used to determine the return and risk for these combinations of
assets.
Most portfolios are diversified to protect against the risk of single securities or class of securities.
Hence, portfolio analysis consists of analyzing the portfolio as a whole rather than relying
exclusively on security analysis, which is the analysis of specific types of securities. While the
risk-return profile of a security depends mostly on the security itself, the risk-return profile of a

portfolio depends not only on the component securities, but also on their mixture or allocation, and
on their degree of correlation.
As with securities, the objective of a portfolio may be for capital gains or for income, or a mixture
of both. A growth-oriented portfolio is a collection of investments selected for their price
appreciation potential, while an income-oriented portfolio consists of investments selected for
their current income of dividends or interest.
The selection of investments will depend on one's tax bracket, need for current income, and the
ability to bear risk, but regardless of the risk-return objectives of the investor, it is natural to want
to minimize risk for a given level of return. The efficient portfolio consists of investments that
provide the greatest return for the risk, or—alternatively stated—the least risk for a given return.
To assemble an efficient portfolio, one needs to know how to calculate the returns and risks of a
portfolio, and how to minimize risks through diversification.
4.3.1 Measuring expected portfolio return

The expected return on portfolio, kp, is the weighted average of the expected returns on the
individual stocks in the portfolio. Since the return of a portfolio is commensurate with the returns
of its individual assets, the return of a portfolio is the weighted average of the returns of its
component assets. The portfolio weights must sum to 1.0. The weight assigned to the expected
return of each asset is the percentage of the market value of the asset to the total market value of
the portfolio. The realized rate of return is the return that is actually earned on a stock or portfolio
of stocks.
Expected value refers to:
– The single most likely outcome from a particular probability distribution

– The weighted average of all possible return outcomes
– Referred to as an ex ante or expected return
Given any set of risky assets and a set of weights that describe how the portfolio investment is
split, the general formulas of expected return for n assets is:
n
E (rP )   wi E  ri 
i 1
where:

n
w
i 1
i = 1.0;
n = the number of securities;

wi = the proportion of the funds invested in security i;
ri , rP = the return on ith security and portfolio p; and
E  = the expectation of the variable in the parentheses.
The return computation is nothing more than finding the weighted average return of the securities
included in the portfolio.
Note: The weight of a security represents the proportion of the portfolio value invested in the
security and the combined portfolio weighted equals 1
Example: A portfolio consists for four securities A, B, C & D with expected returns of 12%, 15%,
18% & 20% respectively. The portions of portfolio value invested in these securities are 0.2, 0.3,
0.3 & 0.2 respectively. Then the expected return on portfolio will be:
 Ra is the return and Wa is the weight of asset A.

 Rb is the return and Wb is the weight of asset B.
 Rc is the return and Wc is the weight on asset C.
 Rd is the return and Wd is the weight on asset D.
 Wa + Wb + Wc +Wd= 1.
E(Rp)=Wa(Ra)+Wb(Rb)+Wc(Rc)+Wd(Rd)
E(Rp) =0.2(12%) +0.3(15%) +0.3(18%) +0.2(20%)
The expected return of the portfolio E(Rp) is = 16.3%

 NB: - Expected return is by no means a guaranteed rate of return. However, it can be used
to forecast the future value of a portfolio, and it also provides a guide from which to
measure actual returns.
4.3.2 Measuring portfolio risk

Like 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.
Markozi (1952) quantified the concept of risk using variance and covariance. He define the risk
of portfolio as the sum of the variance of the investments and covariance among the investment.
Portfolio risks can be calculated, like calculating the risk of single investments, by taking the
standard deviation of the variance of actual returns of the portfolio over time. This variability of
returns is commensurate with the portfolio's risk, and this risk can be quantified by calculating the
standard deviation of this variability. Standard deviation, as applied to investment returns, is a
quantitative statistical measure of the variation of specific returns to the average of those returns.
One standard deviation is equal to the average deviation of the sample.
The variance of a portfolio combination of securities is equal to the weighted average

covariance1 of the returns on its individual securities:
Var  rp    p2   wi w j Cov  ri , rj 
n n
i 1 j 1
Covariance can also be expressed in terms of the correlation coefficient as follows:
Cov  ri , rj   ij i j   ij
 ij r
where = correlation coefficient between the rates of return on security i, i , and the rates of
r   r r
return on security j, j , and i , and j represent standard deviations of i and j respectively.
Therefore:
Var  rp    wi w j ij i j
n n
i 1 j 1
(X.4)
Overall, the estimate of the mean return for each security is its average value in the sample period;
the estimate of variance is the average value of the squared deviations around the sample average;
the estimate of the covariance is the average value of the cross-product of deviations.
OR
To measure the risk of the portfolio, we have to account for how the stocks move together. For
two stocks X and Y the relation is:
SD( R p ) = W 2X  2X + W Y2  Y2 + 2 W X W Y Cov XY
1
High covariance indicates that an increase in one stock's return is likely to correspond to an increase in the other. A
low covariance means the return rates are relatively independent and a negative covariance means that an increase in
one stock's return is likely to correspond to a decrease in the other.

Where: WX = % of wealth in asset X
WY = % of wealth in asset Y
WX + W Y = 1
And CovXY = Corr XY  X  Y

As the covariance gets more negative, the portfolio can be made less risky.
4.3.3 Variance and standard Deviation as a measure of risk

Portfolio Variance is a measure of a portfolio’s volatility, and is a function of two variables. The
first is variance of each asset in the portfolio. The second is how each of those assets moves in
relation to one another, that is, their covariance to one another.
A positive covariance means the asset’s returns move up or down together. A negative covariance
means the asset’s return move in opposite directions.
Using modern portfolio theory, investors bundle different types of investments together so that the
portfolio assets are inversely correlated. That is, the securities counter-balance one another such
that when some of the securities fall in value, other securities rise an equal amount. This type of
diversification reduces risk for the overall portfolio.
 Modern portfolio theory says that portfolio variance can be reduced by choosing asset
classes with a low or negative covariance, such as stocks and bonds. This type of
diversification is used to reduce risk.
 Portfolio variance looks at the covariance or correlation coefficient for the securities in the
portfolio.
 Portfolio variance is calculated by multiplying the squared weight of each security by its
corresponding variance and adding two times the weighted average weight multiplied by
the covariance of all individual security pairs.
 In case of asset return ,the variance is measure of dispersion of the possible rate of return
outcomes around the expected return
 The portfolio variance is a way to measure this diversification. Most investors and portfolio
managers calculate portfolio variance using built-in function available in most spreadsheet
applications or other specially designed soft wares
 The equation for variance of the expected return for asset i ,denoted σ2(Ri)

Portfolio variance looks at the co-variance or correlation coefficient for the securities in the
portfolio. Portfolio variance is calculated by multiplying the squared weight of each security by its
corresponding variance and adding two times the weighted average weight multiplied by the co-
variance of all individual security pairs.
Example: Portfolio Variance

Data on both variance and covariance may be displayed in a covariance matrix. Assume the
following covariance matrix for our two-asset case:
Stock Bond
Stock 350 80
Bond 150
From this matrix, we know that the variance on stocks is 350 (the covariance of any asset to
itself equals its variance), the variance on bonds is 150 and the covariance between stocks and
bonds is 80. Given our portfolio weights of 0.5 for both stocks and bonds, we have all the terms
needed to solve for portfolio variance.
Portfolio variance = w2A*σ2 (RA) + w2B*σ2 (RB) + 2*(WA)*(WB)*Cov (RA, RB)
= (0.5)2*(350) + (0.5)2*(150) + 2*(0.5)*(0.5)*(80)
= 87.5 + 37.5 + 40 = 165.
 NOTE if an asset is riskless, it has expected return dispersion of zero, in other word the
asset return is certain
Standard Deviation
Variance and standard deviation are conceptually equivalent, that means the larger the variance or
standard deviation, the greater the investment risk. Standard deviation can be defined in two ways:
 A measure of the dispersion of a set of data from its mean. The more spread apart the data,
the higher the deviation. Standard deviation is calculated as the square root of variance.

 In finance, standard deviation is applied to the annual rate of return of an investment to
measure the investment's volatility. Standard deviation is also known as historical
volatility and is used by investors as a gauge for the amount of expected volatility.
Standard deviation is a statistical measurement that sheds light on historical volatility. For
example, a volatile stock will have a high standard deviation while a stable blue chip stock will
have a lower standard deviation. A large dispersion tells us how much the fund's return is deviating
from the expected normal returns. To calculate the standard deviation we take a positive square
root of the variance
4.4 PORTFOLIO RISK-RETURN ANALYSIS OF TWO SECURITIES

A portfolio is the total collection of all investments held by an individual or institution, including
stocks, bonds, real estate, options, futures, and alternative investments, such as gold or limited
partnerships .Most portfolios are diversified to protect against the risk of single securities or class
of securities. Hence, portfolio analysis consists of analyzing the portfolio as a whole rather than
relying exclusively on security analysis, which is the analysis of specific types of securities. While
the risk-return profile of a security depends mostly on the security itself, the risk-return profile of
a portfolio depends not only on the component securities, but also on their mixture or allocation,
and on their degree of correlation. As with securities, the objective of a portfolio may be for capital
gains or for income, or a mixture of both.
A growth-oriented portfolio is a collection of investments selected for their price appreciation

potential, while an income-oriented portfolio consists of investments selected for their current
income of dividends or interest. The selection of investments will depend on one's tax bracket,
need for current income, and the ability to bear risk, but regardless of the risk-return objectives of
the investor, it is natural to want to minimize risk for a given level of return.
The efficient portfolio consists of investments that provide the greatest return for the risk, or—
alternatively stated—the least risk for a given return. To assemble an efficient portfolio, one needs
to know how to calculate the returns and risks of a portfolio, and how to minimize risks through
diversification.
Portfolio risks can be calculated, like calculating the risk of single investments, by taking the
standard deviation of the variance of actual returns of the portfolio over time. This variability of
returns is commensurate with the portfolio's risk, and this risk can be quantified by calculating the
standard deviation of this variability. Standard deviation, as applied to investment returns, is a

quantitative statistical measure of the variation of specific returns to the average of those returns.
One standard deviation is equal to the average deviation of the sample.
Although the diversifiable risk of a portfolio obviously depends on the risks of the individual
assets, it is usually less than the risk of a single asset because the returns of different assets are up
or down at different times. Hence, portfolio risk can be reduced by diversification—choosing
individual investments that rise or fall at different times from the other investments in the portfolio.
For most portfolios, diversifiable risk declines quickly at first, then more slowly, reaching a
minimum with about 20 – 25securities. However, how rapidly a risk decline depends on the
covariance of the assets composing the portfolio.
The basis for diversification is that different classes of assets respond differently to different
economic conditions, which causes investors to move assets from 1 class to another to reduce risk
and to profit from changing conditions. For instance, when interest rates rise, stocks tend to go
down as margin interest rises making it more expensive to borrow money to buy stocks, which
lowers their demand, and therefore their prices, while higher interest rates also causes investors to
move more money in to less risky securities, such as bonds, that pay interest.

Variance: One of the best-known measures of risk is the variance, or standard deviation of
expected returns. It is a statistical measure of the dispersion of returns around the expected value
whereby larger variance or standard deviation indicates greater dispersion. The idea is that the
more disperse the expected returns, the greater the uncertainty of future returns.
The variance of an asset A is calculated thus, Variance Formula for an Asset
 σ2= Variance of Asset A

 S = Number of Different States
(i.e., Boom, Normal, Recession)
 Ps= Probability of Economic State s
 rAs= Return for Asset A for the period.

 E(rA) = Expected Return for Asset A
Risk is typically represented by the standard deviation of the expected returns of an asset, equal to
the square root of its variance:
Standard Deviation = √σ2
Covariance is a statistical measure of how one investment moves in relation to another, formulated
as follows:
If two investments tend to be up or down during the same time periods, then they have positive
covariance. If the highs and lows of 1 investment move in perfect coincidence to that of another
investment, then the two investments have perfect positive covariance. If 1investment tends to be
up while the other is down, then they have negative covariance. If the high of 1 investment
perfectly coincides with the low of the other, then the 2 investments have perfect negative
covariance. The risk of a portfolio composed of these assets can be reduced to zero. If there is no
discernible pattern to the up and down cycles of 1investment compared to another, then the 2
investments have no covariance.
Perfect negative correlation gives a mean combined return for the two securities over time equal
to the mean for each of them, so the returns for the portfolio show no variability. Any returns above
and below the mean for each of the assets are completely offset by the return for the other asset,
so there is no variability in total returns, that is, no risk, for the portfolio. This combination of two
assets that are completely negatively correlated provides the maximum benefits of
diversification—it completely eliminates risk.
Because covariance numbers cover a wide range, the covariance is normalized into the correlation
coefficient, which measures the degree of correlation, ranging from -1 for a perfectly negative
correlation to +1 for a perfectly positive correlation. An uncorrelated investment pair would have
a correlation coefficient close to zero. Note that since the correlation coefficient is a statistical
measure, a perfectly uncorrelated pair of investments will rarely, if ever, have an exact correlation
coefficient of zero.

The most diversified portfolio consists of securities with the greatest negative correlation. A
diversified portfolio can also be achieved by investing in uncorrelated assets, but there will be
times when the investments will be either up or down, and thus, a portfolio of uncorrelated assets
will have a greater degree of risk, but it is still significantly less than positively correlated
investments. However, even positively correlated investments will be less risky than single assets
or investments that are perfectly positively correlated. However, there is no reduction in risk by
combining assets that are perfectly correlated.
a) Combining two securities whose returns are perfectly positively correlated (that is, the
correlation coefficient is +1) results only in risk averaging, and does not provide any risk
reduction. In this case the portfolio standard deviation is the weighted average of the two
standard deviations, which is (0.6) (0.20) + (0.4) (0.30) = 0.2400.
b) The real advantages of diversification result from the risk reduction caused by combining
securities whose returns are less than perfectly positively correlated.
c) The degree of risk reduction increases as the correlation coefficient between the returns on
the two securities decreases. The largest risk reduction available is where the returns are
perfectly negatively correlated, so the two risky securities can be combined to form a
portfolio that has zero risk (σp= 0).
Correlations can change over time and in different economic conditions. For instance, during the
late 1990's in USA, stock prices increased significantly, then crashed in 2000. Interest rates were
lowered to boost the economy, which caused real estate prices to increase significantly from 2001
- 2006. Hence, real estate prices were increasing while stocks were either declining, or not
increasing by nearly the same rate. This reflects the general negative correlation between the stock
market and the real estate market. The real estate market was forming a bubble due to the extremely
low interest rates at the time. The bubble finally burst in 2007, and especially 2008, leading to the
2007– 2009 credit crisis. This caused money to move into commodities during the summer of
2008, which formed another bubble, with oil prices, for instance, reaching $147 per barrel.
The fast increase in prices was not due to demand, but due to the transfer of money from assets
doing poorly—stocks and real estate—to commodities and future contracts. In other words, it was
another bubble. However, as credit dried up, due to the prevalence of many defaults of subprime
mortgages, almost every investment came crashing down in September and October of 2008: real
estate, stocks, bonds, commodities. Only United States Treasuries, which are virtually free of
credit-default risk, rose significantly in price, driving their yields down proportionately, with the
yields of short-term T-bills reaching almost zero. So the corollary of this story is that correlations
can and do change and that investment always have some risk.
Calculating the Covariance and Coefficient of Correlation between Assets

In this section, we will actually calculate the covariance and the coefficient of correlation between
2 assets, which is the simplest case, based on the following table:
Example: Expected Return in different Economic Time
Economic State Probability of State Asset A Return (%) Asset B Return (%)
Boom 20% 22 6
Normal 55% 14 10
Recession 25% 7 12
To calculate variances for the 2 assets, the probability of each state is multiplied by the return for
that state minus the expected return squared. The expected returns for these2 assets were calculated
in the 1s t example at the top of the page:
Expected Returns
E (RA) 13.9%
E (RB) 9.7%
Variance for Asset A
σ2A = 0.2 × (22 – 13.9)2 +0.55 × (14 – 13.9)2 +0.25 × (7 – 13.9)2 = 25.03
Variance of Asset B
σ2B = 0.2 × (6 – 9.7)2 +0.55 × (10 – 9.7)2 +0.25 × (12 – 9.7)2 = -4.11
Covariance is measured over time, by comparing the expected returns of each asset for each time
period. The time periods are selected for the different states of the economy, comparing the

expected returns of each asset during boom times, recessions, and normal times. Although returns
can be selected according to other criteria, such as monthly returns, it makes sense to sample the
returns based upon different states of the economy, since this is more likely to reveal their
covariance.
Covariance Formula for 2 Assets
 σAB= Covariance of Asset A with Asset B

 S = Number of Different States (i.e., Boom, Normal, Recession)
 Ps = Probability of Economic State s
 RA= Return for Asset A for the period.
 RB= Return for Asset B for theperiod.
 E(RA) = Expected Return for Asset A
 E(RB) = Expected Return for Asset B
The covariance of 2 assets is equal to the probability of each economic state multiplied by the
difference of the return for each asset for each economic state minus the expected return for that
asset. The covariance of these 2 assets, based on the table above, is:
σAB = 0.2*(22-13.9)*(6-9.7)+0.55*(14-13.9)*(10-9.7)+0.25*(7-13.9)*(12-9.7) = -9.95
The coefficient of correlation between Asset A and Asset B, designated as σ AB, which can range
from -1 to +1:
Coefficient of Correlation Formula for2 Assets
σAB = σAB/ σA σB
Therefore, Correlation Coefficient for Asset A and B
σAB = σAB/ σA σB
σAB = -9.95/√25.03*√4.11 = -0.98

As the number of assets increases, the computational complexity greatly increases, since
covariance must be measured between every 2 different assets in a portfolio, which leads to (n2 –
n) / 2 covariance calculations, where n = number of assets in the portfolio, in addition to the
calculations of the expected returns and variances for each asset . The number of covariance
calculations is divided by 2 because the covariance of Asset A to Asset B is the same as the
covariance of Asset B to Asset A. To avoid this complexity, simplifying models are used. The
simplest of these models is the single-index model, which can approximate the covariance of assets
in a portfolio by comparing the variance of each asset with the variance of the market.
Two Asset Case
The expected return of a two asset portfolio is simply a weighted average of the
Expected returns of each asset in the portfolio.
E (Rp) = W1 E(R1)+(1-W1)E(R2)…………………Eq 1
Where W1 and (1-W1) = W2 are the percentage of portfolio value invested in each asset.
From basic statistics we also know that the variance of two random variables is a function of the
variance of each variable and the covariance between the variables. This relationship directly
applies in calculating the variance of a two asset portfolio as follows:
σ2p=W21 σ2A + W22σ2B + 2W1.W2. σ 1,2 ………………………..Eq 2
Covariance
Co movements between the returns of securities are measured by covariance (an absolute measure)
and coefficient of correlation (a relative measure). Covariance reflected the degree to which the
returns of the two securities vary or change together. A positive covariance means that the returns
of the two securities move in the same direction whereas a negative covariance implies that the
returns of the two securities move in the opposite direction. It measures how two variables move
together. It measures whether the two move in the same direction (a positive covariance) or in
opposite directions (a negative covariance).
The covariance between any two securities I and j is calculated as follows:
Cov(Ri,Rj)=P1[Ri1-E(Ri)] [Rj1-E(Rj)]+ P2[Ri2-E(Ri)] [Rj2-E(Rj)]+ …+pn[Rin-E(Ri)] [Rjn-E(Rj)]
Where

 P1,P2,…Pn= Probabilities associated with states 1,…..n
 Ri1, Ri2,…Rin=returnon security i in state 1,...n
 Rj1, Rj2,….Rjn=return on security j in state 1,...n
 E(Ri),E(Rj) = expected return on security i and j
Example: The returns on securities 1 and 2 under five possible states of nature are given below:
State of nature Probability Return on security 1 Return on security 2
1 0.10 -10% 5%
2 0.30 15% 12%
3 0.30 18% 19%
4 0.20 22% 15%
5 0.10 27% 12%
E(R1)= 0.1(-10%)+0.3(15%)+0.3(18%)+0.2(22%)+0.1(27%)=16%
E(R2)= 0.1(5%)+0.3(12%)+0.3(19%)+0.2(15%)+0.1(12%)=14%
Deviation of the return On sec Deviation of the return On sec Product of the deviations
1 from its mean (R1-E (R1)) 1 from its mean (R1-E (R1)) times probability
-10-16 = 26% 5-14 = 9% 23.4
15-16 = 1% 12-14 = 2% 0.6
18-16 = 2% 19-14 = 5% 3.0
22-16= 6% 15-14 = 1% 1.2
27-16 = 11% 12-14 = 2% -2.2
Sum= 26.0
 The covariance between the returns on the securities is 26.0

 Meaning
In the example there is a positive covariance, so the two stocks tend to move together. When
one has a high return, the other tends to have a high return as well. If the result was negative,

then the two stocks would tend to have opposite returns; when one had a positive return, the
other would have a negative return.
Uses of Covariance: finding that two stocks have a high or low covariance might not be a useful
metric on its own. Covariance can tell how the stocks move together, but to determine the strength
of the relationship, we need to look at the correlation. The correlation should therefore be used in
conjunction with the covariance, and is represented by this equation:
Coefficient of correlation: Covariance and correlation are conceptually analogous in the sense
that both of them reflect the degree of co movement between two variables.
Where cov (X, Y) = covariance between X and Y
 σX = standard deviation of X
 σY = standard deviation of Y
The equation above reveals that the correlation between two variables is simply the covariance
between both variables divided by the product of the standard deviation of the variables X and Y.
While both measures reveal whether two variables are positively or inversely related, the
correlation provides additional information by telling you the degree to which both variables move
together.
The correlation will always have a measurement value between -1 and 1, and adds a strength value
on how the stocks move together. If the correlation is 1, they move perfectly together, and if the
correlation is -1, the stocks move perfectly in opposite directions. If the correlation is 0, then the
two stocks move in random directions from each other. In short, the covariance just tells you that
two variables change the same way, while correlation reveals how a change in one variable effects
a change in the other.
The covariance can also be used to find the standard deviation of a multi-stock portfolio. The
standard deviation is the accepted calculation for risk, and this is extremely important when
selecting stocks. Typically, you would want to select stocks that move in opposite directions. If

the chosen stocks move in opposite directions, then the risk might be lower given the same amount
or potential return. Covariance is a common statistical calculation that can show how two stocks
tend to move together. We can only use historical returns, so there will never be complete certainty
about the future. Also, covariance should not be used on its own. Instead, it can be used in other,
more important, calculations such as correlation or standard deviation.
4.5 PORTFOLIO RISK-RETURN ANALYSIS of N SECURITIES

The variance and standard deviation of the return of an n security portfolio are:
σp2= ∑∑WiWjPijσiσj
σp= [∑∑WiWjPijσiσj]
So far we have look the risk of portfolio consisting of two asset and the extension for three
securities look as follows:
σp2 =w2A*σ2(RA) + w2B*σ2(RB) + w2c*σ2(Rc) + 2*(wA)*(wB)*Cov (RA, RB)

+2*(wA)*(wc)*Cov (RA, Rc) + 2*(wB)*(wc)*Cov (RB, Rc)
In other word the above equation states that the variance of the portfolio return is the sum of the
squared weighted variances of the individual assets plus two times the sum of weighted pair wise
co variances of the asset.
Where:
 WA, WB and Wc are weights of securities in the portfolio,

 σ2 (RA),σ2(RB) and σ2(Rc) are variances
 Cov (RA,,RB,RB) is the covariance
Example: A portfolio consists of 3 securities 1,2 and 3.The proportions of these securities are
w1=0.5,w2=0.3 and w3=0.2.the standard deviation of returns of these securities are σ1=10 σ2=15
σ3=20.The correlation coefficient among security returns are p12=0.3 p13 =0.5 and p23 =0.6. What is
the standard deviation of portfolio returns?
We said Correlation coefficient P12= Cov(1,2)Implies▬►Cov (R1,R2)=P12*σ1σ2

σp2 =w21*σ12+ w22*σ22+ w23*σ32+ 2*(w1)*(w2)*P12*σ1σ2+2*w1*w3)*P13*σ1σ3+
2*(wB)*(wc)*P23*σ2σ3
σp=[0.52*102+0.32*152+0.22*202+2*0.5*0.3*0.3*10*15+2*0.5*0.2*0.5*10*20+2*0.3*0.2*
0.6*15*20]1/2
σp=10.79
NB: -As the number of securities included in a portfolio increases the importance of the risk of
each individual security decreases whereas the significance of the covariance relationship
increases.
4.6 DIVERSIFICATION AND PORTFOLIO RISK
Effect of spread and minimize risk take the form of diversification. The more traditional forms of
diversification have concentrated upon holding a number of securities type(stock, bonds)across
industry lines. The reasons are related to inherent differences in bond and equity contracts, coupled
with the notion that an investment in dissimilar industries would most likely do better than in firms
within the same industry. Carried to its extreme this approach leads to the conclusion that the best
diversification comes through holding large number of securities scattered across industries.
However, experts disagree with regard to the “right” kind of diversification and the “right” reason
.The discussion that follow introduce and explores a formal advanced notion of diversification
concaved by Harry Markwitz. Markwitz approach to coming up with good portfolio possibilities
has its root in risk return relationship. This is not at odds with traditional approaches in concept.
The key difference lie in Markowitz assumption that investor attitudes toward portfolios depend
exclusively upon expected return and risk, and quantification of risk and risk is by proxy, the
statistical notion of variance, or standard deviation of return. These simple assumptions are strong,
and they are disputed by many traditionalists.
Often investors diversify their portfolio to reduce portfolio risk without sacrificing return.
Including asset across all asset class could diversify portfolio, for example an investor can diversify
by investing in stock, bond and real estate, the question is how much should be invested in each
asset class and which specific stock should investor select? The Markowitz diversification strategy
is primarily concerned with the degree of covariance between asset returns in a portfolio.
Markowitz diversification seeks to combine assets in a portfolio with returns that are less than
perfectly positively correlated in an effort to lower portfolio risk (variance) without sacrificing
return.

It is the concern of maintaining return while lowering risk through an analysis of the covariance
between asset returns. Markowitz diversification and the importance of asset correlation can be
illustrated with a simple two asset portfolio example, Portfolio risk and return
Although the diversifiable risk of a portfolio obviously depends on the risks of the individual
assets, it is usually less than the risk of a single asset because the returns of different assets are up
or down at different times. Hence, portfolio risk can be reduced by diversification—choosing
individual investments that rise or fall at different times from the other investments in the portfolio.
For most portfolios, diversifiable risk declines, quickly at first, then more slowly, reaching a
minimum with about 20 - 25 securities. However, how rapidly risk declines depends on the
covariance of the assets composing the portfolio.
The basis for diversification is that different classes of assets respond differently to different
economic conditions, which causes investors to move assets from 1 class to another to reduce risk
and to profit from changing conditions. For instance, when interest rates rise, stocks tend to go
down as margin interest rises making it more expensive to borrow money to buy stocks, which
lowers their demand, and therefore their prices, while higher interest rates also causes investors to
move more money into less risky securities, such as bonds, that pay interest.
4.7 PORTFOLIO SELECTION MODELS

The process of selecting portfolio may be divided into two stages:
The first stage starts with observation and experience and ends with beliefs about the future
performances of available securities, and the second stage starts with the relevant beliefs about
future performances and ends with choice of portfolio.
One type of rule concerning choice of portfolio is that the investor does (or should maximize) the
discounted (or capitalized) value of future returns. Since the future is not known with certainty, it
must be ‘expected’ or ‘anticipated’ returns which we discount.
4.7.1 Markowitz portfolio selection model
In 1952, Harry Markowitz published a portfolio selection model that maximized a portfolio's return
for a given level of risk. This model required the estimation of expected returns and variances for
each security and a covariance matrix that calculated the covariance between each possible pair of
securities within the portfolio based on historical data or through scenario analysis.
Markowitz introduced a new concept that involved considering the portfolio as a whole, whereas
previously investors had been interested in securities on an individual basis. It therefore
considerably modified the practice of investment methods. Within the framework of this approach,
the role of financial analysts nevertheless remains essential, since they provide the evaluation of
the data used by the model. An efficient portfolio is defined as a portfolio with minimal risk for a
given return, or, equivalently, as the portfolio with the highest return for a given level of risk.
Assumptions of the model:
 Investors seek to maximize the expected return of total wealth.

 All investors have the same expected single period investment horizon.
 All investors are risk-adverse, that is they will only accept greater risk if they are
compensated with a higher expected return.
 Investors base their investment decisions on the expected return and risk.
 All markets are perfectly efficient (e.g. no taxes and no transaction costs).
Hence, of all feasible portfolios, the investor should only consider those that maximize expected
return for a given level of variance, or minimize variance for a given level of expected return.
Formulation of the model

Since a portfolio is a linear combination of assets, its expected return and variance are expressed
as a function of its composition, or
n
E ( R p )   wi E ( Ri )
i 1
σ2p=Σwi2σi2 +∑i∑j Wi Wj (kijσiσj)
(The 1st term is neglected for large n)
σ2p=∑i∑j Wi Wj (kijσiσj)
Where
kijσiσj- is covariance of i & j
According to Markowitz, the portfolio risk is not simply a weighted average of the risks brought
by individual securities in the portfolio but it also includes the risks that occur due to correlations
among the securities in the portfolio. As the numbeer of securities in the portfolio increases,
contribution of individual security’s risk decreases due to offsetting effect of strong performing
and poor performing securities in the portfolio and the importance of covariance relationships
among securities increases.

Whereas a stock portfolio selection problem might involve hundreds of stocks (and hence
thousands of correlations), an asset allocation problem typically involves a handful of asset classes
(for example stocks, bonds, cash, real estate, and gold). Furthermore, the opportunity to reduce
total portfolio risk comes from the lack of correlation across assets. Since stocks generally move
together, the benefits of diversification within a stock portfolio are limited. In contrast, the
correlation across asset classes is usually low and in some cases negative. Hence, mean-variance
is a powerful tool in asset allocation for uncovering large risk reduction opportunities through
diversification.
Major points of the model

 Markowitz developed a theory of portfolio choice in an uncertain future.
 He quantified the difference between the risk of portfolio assets taken individually and the
overall risk of the portfolio.
 He demonstrated that the portfolio risk came from the covariance of the assets that made
up the portfolio.
 The marginal contribution of a security to the portfolio return variance is therefore
measured by the covariance between the security’s return and the portfolio’s return and
not by the variance of the security itself.
 Markowitz thus established that the risk of a portfolio is lower than the average of the
risks of each asset taken individually.
 The theory developed by Markowitz is based on maximizing the utility of the investor’s
terminal wealth.
 This utility function is defined according to the expected return and the standard
deviation of the wealth.
 The theory offers a solution to the problem of portfolio choice for a risk-averse investor.
 The optimal portfolios, from the rational investor’s point of view, are defined as those
that have the lowest risk for a given return.
 These portfolios (optimal portfolios) are said to be mean–variance efficient.
 To simplify matters, the model assumes that there is only one investment period.
 Markowitz enables a mean–variance approach to be used to determine the optimal
portfolio.
Maximizing investor’s UTILITY can be worked out as follows:
U(RP ) = E(RP ) −1/2λvar(RP )
The Markowitz model seeks to minimize a portfolio's variance, while meeting a desired level of
overall expected return. However, the time needed to calculate the complete correlation matrix
was an obstacle to the implementation of the model as for n securities, it would require n estimates
of expected returns, n estimates of their variances, and a covariance matrix that consisted of n (n–
1) / 2 estimates of covariance.
Sharpe therefore postulated that the asset returns were made up of a factor that was common to
all assets and a component that was unique for each security. Studies showed that the best
explicative factor was the return of the market as a whole. This model is called the empirical market
model or Sharpe’s single-index model
4.7.2 Single index model

The model also assumes that the risk of return from each security has two components-
1. The market related component (βiRM) caused by macro events and

2. The company-specific component (ei) which is a random residual error caused by micro
events.
The security responds only to market index movement as residual errors of the securities are
uncorrelated. The residual errors occur due to deviations from the fitted relationship between

security return and market return. For any period, it represents the difference between the actual
return (Ri) and the return predicted by the parameters of the model (βiRM)
The Single Index model is given by the equation:
Ri=αi + βiRM + ei ………for security i, where
Ri= the return on security
RM=the return from the market index
αi =risk free part of security i’s return which is independent of market return
βi=sensitivity of security i, a measure of change of Ri for per unit change RM, which is a constant
ei=random residual error, which is company specific
We can also see that βiRm represents the stock's return due to the movement of the market
modified by the stock's beta (βi), and ei represents the unsystematic risk of the security due to
firm-specific factors.
Parallel to the return, total risk of a security, as measured by its variance, consists of two
components: market risk and unique risk and given by
σi2=βi2 (σM2)+ σei2
=Market risk + company-specific risk
This simplification also applies to portfolios, providing an alternative expression to use in finding
the minimum variance set of portfolios:
σp2=βp2 (σM2)+ σep2

The Single-Index model is an alternative to Markowitz model to determine the efficient frontiers
with much fewer calculations, 3n+2 calculations, instead of n(n-1)/2 calculations. For 20
securities, it requires 62 inputs instead of 190 in Markowitz model.
This relationship highlights the usefulness of diversification in reducing risk. The second term of
this relationship tends towards 0 for a sufficiently large n. Therefore, the risk of a broadly
diversified portfolio is only made up of the market risk.
The security responds only to market index movement as residual errors of the securities are
uncorrelated. The residual errors occur due to deviations from the fitted relationship between
security return and market return. For any period, it represents the differences between the actual
return (Ri) and there turn predicted by the parameters of the model (βiRM).
According to this model, the return of any stock can be decomposed into the expected excess return
of the individual stock due to firm-specific factors, commonly denoted by its alpha coefficient (α),
which is the return that exceeds the risk-free rate, the return due to macroeconomic events that
affect the market, and the unexpected microeconomic events that affect only the firm.
Macroeconomic events, such as interest rates or the cost of labor, causes the systematic risk that
affects the returns of all stocks, and the firm-specific events are the unexpected microeconomic
events that affect the returns of specific firms, such as the death of key people or the lowering of
the firm's credit rating, that would affect the firm, but would have a negligible effect on the
economy. The unsystematic risk due to firm-specific factors of a portfolio can be reduced to zero
by diversification.
The index model is based on the following assumptions:
 Most stocks have a positive covariance because they all respond similarly to
macroeconomic factors.
 However, some firms are more sensitive to these factors than others, and this firm-specific
variance is typically denoted by its beta (β), which measures its variance compared to the
market for one or more economic factors.
 Covariance among securities result from differing responses to macroeconomic factors.
Hence, the covariance (σ2) of each stock can be found by multiplying their betas by the
market variance:
Cov(Ri, Rk) = βiβkσ2

With this equation, only the betas of the individual securities and the market variance need to be
estimated to calculate covariance. Hence, the index model greatly reduces the number of
calculations that would otherwise have to be made for a large portfolio of thousands of securities.
4.7.3 Multi-factor model

A multi-factor model is a generalization of the single-index model that employs multiple factors
in its computations to explain market phenomena and/or equilibrium asset prices. The principle is
the same as in the case of a single index model, namely to obtain a simplified representation of the
assets’ variance–covariance matrix. The covariance between assets is evaluated with the help
of the covariance between indices. The multi-index models enable us to obtain a more accurate
result than the single index model, while still keeping the number of calculations to a reasonable
level.
Multi-factor models are used to construct portfolios with certain characteristics, such as risk, or to
track indexes. When constructing a multi-factor model, it is difficult to decide how many and
which factors to include. Also, models are judged on historical numbers, which might not
accurately predict future values.
Categories of Multi-Factor Models
Multi-factor models can be divided into three categories: macroeconomic models, fundamental
models and statistical models. Macroeconomic models compare a security's return to such factors
as employment, inflation and interest. Fundamental models analyze the relationship between a
security's return and its underlying financials, such as earnings. Statistical models are used to
compare the returns of different securities based on the statistical performance of each security in
and of itself.
Beta
The beta of a security measures the systemic risk of the security in relation to the overall market.
A beta of 1 indicates that the security theoretically experiences the same degree of volatility as the
market and moves in tandem with the market. A beta greater than 1 indicates the security is
theoretically more volatile than the market. Conversely, a beta less than 1 indicates the security is
theoretically less volatile than the market.
Multi-Factor Model Formula
Factors are compared using the following formula:

E(R )=a +b R +c NF + e , where NF=non-market factor
i i i M i i
Where:
 Ri, is the returns of security I

 ai,is risk free part
 Bi, is security’s beta
 RM, is the market return
 Ci, is the beta with respect to each factor including the market (m)
 NF, is non-market factor
 ei is the error term
4.7.4 Capital ASSET PRICING MODEL–CAPM

The capital asset pricing model (CAPM) extends the portfolio theory and describes the relationship
between systematic risk and expected return for assets, particularly stocks. CAPM is widely used
throughout finance for the pricing of risky securities, generating expected returns for assets given
the risk of those assets and calculating costs of capital.
Assumptions of CAPM
 Investors are risk averse and seek to maximize the expected utility of their wealth at the
end of the period.
 When choosing their portfolios, investors only consider the first two moments of return
distribution: the expected return and the variance.
 Investors only consider one investment period and that period is the same for all investors.
 Investors have a limitless capacity to borrow and lend at the risk-free rate.
 Information is accessible cost-free and is available simultaneously to all investors. All
investors therefore have the same forecast return, variance and covariance expectations for
all assets.
1. Markets are perfect: there are no taxes and no transaction costs. All assets are traded and
are infinitely divisible.
The formula for calculating the expected return of an asset given its risk is as follows:

When graphed, the formula is called the Security Markel Line (SML)
(For a market return of 15%)
The general idea behind CAPM is that investors need 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. The
risk-free rate is customarily the yield on government bonds like U.S. Treasuries.
The other half of the CAPM 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): the return of the market in excess of the risk-free rate. Beta reflects how risky an asset is
compared to overall market risk and is a function of the volatility of the asset and the market as
well as the correlation between the two. For stocks, the market is usually represented as the S&P
500 but can be represented by more robust indexes as well.
The CAPM model 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).
Example of CAPM
Using the CAPM model and the following assumptions, we can compute the expected return for a
stock:
The risk-free rate is 10% and the beta (risk measure) of a stock is 1.5. The expected market return
over the period is 15%, so that means that the market risk premium is 5% (15% - 10%) after
subtracting the risk-free rate from the expected market return. Plugging in the preceding values
into the CAPM formula above, we get an expected return of 17.5% for the stock:
18% = 2% + 2 x (10%-2%)
Contribution of CAPM
The CAPM established a theory for valuing individual securities and contributed to a better
understanding of market behavior and how asset prices were fixed. The model highlighted the
relationship between the risk and return of an asset and showed the importance of taking the risk
into account. It allowed the correct measure of asset risk to be determined and provided an
operational theory that allowed the return on an asset to be evaluated relative to the risk. The total
risk of a security is broken down into two parts: the systematic risk, called the beta, which measures
the variation of the asset in relation to market movements, and the unsystematic risk, which is
unique for each asset. This breakdown could already be established with the help of the empirical
market model. The unsystematic risk, which is also called the diversifiable risk, is not rewarded
by the market. In fact, it can be eliminated by constructing diversified portfolios.

The correct measure of risk for an individual asset is therefore the beta, and its reward is called the
risk premium. The asset betas can be aggregated: the beta of a portfolio is obtained as a linear
combination of the betas of the assets that make up the portfolio. According to the CAPM, the
diversifiable risk component of each security is zero at equilibrium.

CHAPTER FIVE: PORTFOLIO REVISION AND EVALUATION
INTRODUCTION
A portfolio manager needs to revise and evaluate continually his portfolio performance and
identify the key sources of strengths and weakness in the performance of the portfolio. Portfolio
revision is the process of adjusting the existing portfolio whereas, Portfolio evaluation is the
process of comparing the return earned on a portfolio with the return earned on one or more other
portfolios or on a benchmark portfolio. Revision makes an investor beneficiary of price change
on his securities (particularly equity securities) to maximize the return. The evaluation of the
portfolio provides a feedback about the performance to evolve better portfolio management
strategy in the ever changing business environment. Evaluation of portfolio performance is
considered as the last stage of investment process.
In a portfolio management, the major requirements of a portfolio manager are the ability to derive
above-average returns for a given risk class The ability to diversify the portfolio completely to
eliminate unsystematic risk Superior performance may come from superior timing ability changes
the portfolio’s duration in anticipation of interest rate changes by increasing the duration of the
portfolio in anticipation of failing interest rates and reducing the duration of the portfolio when
rates are expected to rise( fixed income securities) Consistently to select undervalued stocks or
bonds for a given risk class. Even without superior market timing, such a portfolio would likely
experience above-average risk-adjusted returns
Thus, this paper briefly presents the meaning and need for portfolio revision and its strategy how
an investor revises the composition of the investment portfolios so as to achieve the best possible
returns from the investment, need of portfolio evaluation and different models of portfolio
evaluation.
5.1 MEANING AND NEED OF PORTFOLIO REVISION
5.1.1 Meaning of portfolio Revision

A portfolio is a mix of securities selected from a vast universe of securities. Two variables
determine the composition of a portfolio; the first is the securities included in the portfolio and the
second is the proportion of total funds invested in each security.
Portfolio revision involves changing the existing mix of securities. This may be effected either by
changing the securities currently included in the portfolio or by altering the proportion of funds
invested in the securities. New securities may be added to the portfolio or some of the existing
securities may be removed from the portfolio. Thus, Portfolio revision is the process of adjusting
the existing portfolio in accordance with the changes in financial markets and the investor‘s
position so as to ensure maximum return from the portfolio with the minimum of risk. Portfolio
revision or adjustment necessitates purchase and sale of securities. Portfolio revision entails
portfolio rebalancing and portfolio upgrading.
Portfolio rebalancing involves reviewing and revising the portfolio composition (the stock-bond
mix). It involves shifting from stocks to bond or vice versa. There are three basic policies under
the portfolio rebalancing:
Buy and hold policy- buying an initial asset mix and doing nothing thereafter regardless of price
movements which results in a drifting mix of assets.
 It brings high risk exposure to volatile securities.
Constant mix policy - maintains a constant asset mix by responding price movements in the
market.
Portfolio insurance policy - allows an investor to maintain an exposure to an upward potential by

providing a capital guarantee against downward risk.
Portfolio upgrading is an act of re-assessing the risk-return characteristics of various securities,

selling over-priced securities, and buying underpriced securities
The objective of portfolio revision is the same as the objective of portfolio selection i.e.
maximizing the return for a given level of risk or minimizing the risk for a given level of return.
The ultimate aim of portfolio revision is maximization of returns and minimization of risk. It also
needs to pass certain processes which are similar to portfolio analysis and selection processes (this
is very true in the case of active portfolio revision strategy).
5.1.2 Need for Portfolio Revision

As any other plans, investment plan is not perfect to the extent that it would not need revision
sooner or later. In the case of portfolio management, the need for revision is even more important
since financial markets are continually changing. These needs can come from two basic factors:
Market related and investor related factors. Thus, portfolio revision can be taken place for either
of the following factors:
1. Availability of additional wealth (investor factor)
2. Change in the risk attitude and the utility function of the investor
3. Change in the investment goals of the investors
4. The need to liquidate part of a portfolio to provide fund for some alternative uses
5. Price fluctuation in the market (short term price fluctuation), etc.
5.2 PORTFOLIO EVALUATION
5.2.1 Constraints in portfolio revision

Since the practice of portfolio adjustment involves purchase and sale of securities, it gives rise to
certain problems which act as constraints in portfolio revision. Some of these areas discussed
hereunder:
Transaction cost
Buying and selling of securities involve transaction costs such as commission and brokerage.
Frequent buying and selling of securities for portfolio revision may push up transaction costs
thereby reducing the gains from portfolio revision. Hence, the transaction costs involved in
portfolio revision may act as a constraint to timely revision of portfolio.
Taxes
Tax is payable on the capital gains arising from sale of securities. Usually, long-term capital gains
are taxed at a lower rate than short-term capital gains. To qualify as long-term capital gain, a
security must be held by an investor for a period of not less than 12 months before sale. Frequent
sales of securities in the course of periodic portfolio revision or adjustment will result in short-
term capital gains which would be taxed at a higher rate compared to long-term capital gains. The
higher tax on short-term capital gains may act as a constraint to frequent portfolio revision.
Statutory stipulations
The largest portfolios in every country are managed by investment companies and mutual funds.
These institutional investors are normally governed by certain statutory stipulations regarding their
investment activity. These stipulations often act as constraints in timely portfolio revision.
Intrinsic difficulty
Portfolio revision is a difficult and time consuming exercise. The methodology to be followed for
portfolio revision is also not clearly established. Different approaches may be adopted for the
purpose. The difficulty of carrying out portfolio revision itself may act as a constraint to portfolio
revision.
5.3 PORTFOLIO REVISION STRATEGIES

Two different strategies may be adopted for portfolio revision, namely an active revision strategy
and a passive revision strategy. The choice of the strategy would depend on the investor‘s
objectives, skill, resources and time.

5.3.1 Active Portfolio revision strategy
It involves frequent and sometimes substantial adjustments to the portfolio. Investors who
undertake active revision strategy believe that security markets are not continuously efficient. They
believe that securities can be mispriced at times giving an opportunity for earning excess returns
through trading in them. Moreover, they believe that different investors have divergent or
heterogeneous expectations regarding the risk and return of securities in the market. The
practitioners of active revision strategy are confident of developing better estimates of the true risk
and return of securities than the rest of the market. They hope to use their better estimates to
generate excess returns. Thus, the objective of active revision strategy is to ‘beat the market’.
Active portfolio revision is essentially carrying out portfolio analysis and portfolio selection all
over again. It involves the process of portfolio analysis and selection which is based on
fundamental analysis (economic, industry and company analysis) as well as the technical factors
like demand and supply. Consequently, the time, skill and resources required for implementing
active revision strategy would be much higher. The frequency of trading is likely to be much higher
under active revision strategy resulting in higher transaction costs.
5.3.2 Passive Portfolio revision strategy

It involves only minor and infrequent adjustment to the portfolio over time. The practitioners of
passive revision strategy believe in market efficiency and homogeneity of expectation among
investors. They find little incentive for actively trading and revising portfolios periodically. The
objective of passive strategy is ‘performing as the market’
Under passive revision strategy, adjustment to the portfolio is carried out according to certain
predetermined rules and procedures designated as formula plans.
5.3.2.1 Formula plans

Formula plans are mechanical revision techniques or procedures developed to enable the investors
to benefit from price fluctuations in the market by buying stocks when prices are low and selling
them when prices are high.
Formula plans represent an attempt to exploit the price fluctuations in the market and make them
a source of profit to the investor. They help to make decisions on timings of buying and selling
securities automatic and eliminate the emotions surrounding the timing decisions. Formula plans
consist of predetermined rules regarding when to buy or sell and how much to buy and sell. These
predetermined rules call for specified actions when there are changes in the securities market.
The use of formula plans demands that the investor divide his investment funds into two portfolios,
one aggressive and the other conservativeordefensive. The aggressiveportfolio usually consists

of equity shares while the defensiveportfolio consists of bonds and debentures. The formula plans
specify predetermined rules for the transfer of funds from the aggressive portfolio to the defensive
portfolio and vice versa. These rules enable the investor to automatically sell shares when their
prices are rising and buy shares when their prices are falling. However, investors are hesitant to
buy when prices are low either expecting that prices will fall further lower or fearing that prices
would not move upwards again and similarly, investors hesitate to sell when prices are high
because they feel that prices may rise further and they may be able to realize larger profits. It is
these formula plans that would avoid the problem of timing decision and makes investors would
be able to benefit from the price fluctuations in the securities market.
Basic assumptions of formula plans
The formula plans based on the following assumptions:-
1. The stock prices move up and down in cycles
2. The stock price and the high grade bond prices move in opposite directions
3. The investor cannot or are not inclined to forecast direction of the next fluctuation in
stock price which may be due to lack of skill and resources or their belief in market
efficiency or both.
Based on these assumptions, there are different formula plans for implementing portfolio revision;
the following are the most commonly known formula plans:
i) Constant Dollar value plan (CDVP)
This is one of the most popular or commonly used formula plans. In this plan, the investor
constructs two portfolios, one aggressive, consisting of equity shares and the other, defensive,
consisting of bonds and debentures. The purpose of this plan is to keep the value of the aggressive
portfolio constant, i.e. at the original amount invested in the aggressive portfolio.
As share prices fluctuate, the value of the aggressive portfolio keeps changing. When share prices
are increasing, the total value of the aggressive portfolio increases. The investor has to sell some
of the shares from his portfolio to bring down the total value of the aggressive portfolio to the level
of his original investment in it. The sale proceeds will be invested in the defensive portfolio by
buying bonds and debentures.
On the contrary, when share prices are falling, the total value of the aggressive portfolio would
also decline. To keep the total value of the aggressive portfolio at its original level, the investor
has to buy some shares from the market to be included in his portfolio. For this purpose, a part of
the defensive portfolio will be liquidated to raise the money needed to buy additional shares.
Under this plan, the investor is effectively transferring funds from the aggressive portfolio to the
defensive portfolio and thereby booking profit when share prices are increasing. Funds are
transferred from the defensive portfolio to the aggressive portfolio when share prices are low.
Thus, the plan helps the investor to buy shares when their prices are low and sell them when their
prices are high.
In order to implement this plan, the investor has to decide the action points, i.e. when he/she should
make the transfer of funds to keep the dollar value of the aggressive portfolio constant. These
action points, or revision points, should be predetermined and should be chosen carefully. The
revision points have a significant effect on the returns of the investor. For instance, the revision
points may be predetermined as 10 percent, 15 percent, 20 percent, etc. above or below the original
investment in the aggressive portfolio. If the revision points are too close, the number of
transactions would be more and the transaction costs would increase reducing the benefits of
revision. If the revision points are set too far apart, it may not be possible to profit from the price
fluctuations occurring between these revision points.
Illustration 5.1
Let us consider an investor who has $100,000 for investment. He decides to invest $ 50,000 in an
aggressive portfolio of equity shares and the remaining $50,000 in a defensive portfolio of bonds
and debentures. He purchases 1250 shares selling at $ 40 per share for his aggressive portfolio.
The revision points are fixed as 20 percent above or below the original investment of $ 50,000.
After the construction of the portfolios, the share price will fluctuate. If the price of the share
increases to $45, the value of the aggressive portfolio increases to $56,250 (1250 * $45). Since the
revision points are fixed to 20 percent above or below the original investment, the investor will act
only when the value of the aggressive portfolio increases to $ 60,000 or falls to $ 40,000.If the
price of the share increases to $ 48 or above, the value of the aggressive portfolio will exceed $
60,000. Let us suppose that the price of the share increases to $ 50, the value of the aggressive
portfolio will be $ 62,500. The investor will sell shares worth $ 12,500 (250 * $50) and transfer
the amount to the defensive portfolio by buying bonds for $12,500. The value of the aggressive
and defensive portfolios would now be $ 50,000 and $ 62,500 respectively. The aggressive
portfolio now has only 1000 shares valued at $ 50 per share.
Thus, when the constant Dollar value plan is being implemented, funds will be transferred from
one portfolio to the other, whenever the value of the aggressive portfolio increases or declines to
the predetermined levels.
ii) Constant Ratio plan
This is a variation of the constant Dollar value plan. Here again the investor would construct two
portfolios, one aggressive and the other defensive with his investment funds. The ratio between
the investments in aggressive portfolio and the defensive portfolio would be predetermined such
as 1:1 or 1.5:1 etc. The purpose of this plan is to keep this ratio constant by readjusting the two
portfolios when share prices fluctuate from time to time. For this purpose, a revision point will
also have to be predetermined.
Suppose the revision points may be fixed as + 0.10. This means that when the ratio between the
values of the aggressive portfolio and the defensive portfolio moves up by 0.10 points or moves
down by 0.10 points, the portfolios would be adjusted by transfer of funds from one to the other.
Illustration 5.2
Let us assume that an investor starts with $ 20,000, investing $ 10,000 each in the aggressive
portfolio and the defensive portfolio. The initial ratio is then 1:1. The investor has predetermined
the revision points as + 0.20. As share price increases the value of the aggressive portfolio would
rise. When the value of the aggressive portfolio rises to $ 12,000, the ratio becomes 1.2:1 (i.e. $
12,000: $ 10,000). Shares worth $ 1,000 will be sold and the amount transferred to the defensive
portfolio by buying bonds. Now, the value of both the portfolios would be $ 11,000 and the ratio
would become 1:1.
Now let us assume that the share prices are falling. The value of the aggressive portfolio would
start declining. If, for instance, the value declines to $ 8,500, the ratio becomes 0.77:1 (i.e. $ 8,500:
$ 11,000). The ratio has declined by more than 0.20 points. The investor now has to make the value
of both portfolios equal. The investor has to buy shares worth $ 1,250 by selling bonds for an
equivalent amount from his defensive portfolio. Now the value of the aggressive portfolio
increases by $ 1,250 and that of the defensive portfolio decreases by $ 1,250. The values of both
portfolios become $ 9,750 and the ratio becomes 1:1. The adjustment of portfolios is done
periodically in this manner.
It is possible to note that constant ratio plan calls for more transaction than constant-dollar-value
plan did. This plan also yielded an increase or decrease in total at the end of the cycle compared
to total value yielded under constant dollar value plan.
iii) Variable-Ratio plan
It is a more flexible variation of constant ratio plan. Under this plan, it is provided that if the value
of aggressive portfolio changes by certain percentage or more, the initial ratio between aggressive
and conservative portfolio will be allowed to be change according to the pre-determined schedule.
The variation may result according to economic or market indices rather than the values of
aggressive portfolio.
Illustration 5.3
Suppose that if the current price per share of total shares value of $10,000 on the previous case is
$25 and the variable ratio plan states that if the value of aggressive portfolio rises by 20% or more
from its present price ($25), the appropriate ratio of aggressive portfolio will be 3:7 instead of 1:1.
Likewise, if the value of aggressive portfolio by 20% or more from the present price of $25, the
appropriate ratio of aggressive portfolio to defensive portfolio will be 7:3.
Variable ratio plan is more profitable than constant dollar value plan and constant ratio plan since
it has fewer reaction points compared to the two. But it needs more forecasting than other plans.
iv) Dollar cost averaging
This is another method of passive portfolio revision. All formula plans assume that stock prices
fluctuate up and down in cycles. Dollar cost averaging utilizes this cyclic movement in share prices
to construct a portfolio at low cost.
The plan stipulates that the investor invest a constant sum, such as $5,000, $ 10,000, etc. in a
specified share or portfolio of shares regularly at periodical intervals, such as a month, two months,
a quarter, etc. regardless of the price of the shares at the time of investment. This periodic
investment is to be continued over a fairly long period to cover a complete cycle of share price
movements.
If the plan is implemented over a complete cycle of stock prices, the investor will obtain his shares
at a lower average cost per share than the average price prevailing in the market over the period.
This occurs because more shares would be purchased at lower prices than at higher prices.
The dollar cost averaging is really a technique of building up a portfolio over a period of time. The
plan does not envisage withdrawal of funds from the portfolio in between. When a large portfolio
has been built up over a complete cycle of share price movements, the investor may switch over
to one of the other formula plans for its subsequent revision. The dollar cost averaging is especially
suited to investors who have periodic sums to invest.
v) Share averaging
Under this method, investor will buy the same quantity of stock every period (let say every month)
without any consideration of market price. That is when the market is bullish, the investor will
invest more money and when the market is bearish, he/she will invest less money. This process
automatically allows the investor to save more in bond when the market is not doing well and
invest more in stock when the market is doing well.
Limitations of formula plans
All formula plans (particularly the first three formula plans of above) have their own limitations.
By their very nature they are inflexible. Further, these plans do not indicate which securities from
the portfolio are to be sold and which securities are to be bought to be included in the portfolio.
Only active portfolio revision can provide answers to these questions. In addition, in the absence

of much faith in market efficiency, there may not be many followers of formula plans for portfolio
revision.
5.3.3 Meaning of Portfolio Evaluation

Portfolio evaluation refers to the evaluation of the performance of the portfolio. Evaluation is an
appraisal of performance. It is essentially the process of comparing the return earned on a portfolio
with the return earned on one or more other portfolios or on a benchmark portfolio. Portfolio
evaluation essentially comprises two functions, performance measurement and performance
evaluation. Portfolio evaluation is the last step in the process of portfolio management. It is the
stage when we examine to what extent the objective has been achieved. It is basically the study of
the impact of investment decisions. Without portfolio evaluation, portfolio management would be
incomplete. It has evolved as an important aspect of portfolio management over the last two
decades.
Performance measurement is an accounting function which measures the return earned on a
portfolio during the holding period or investment period.
Performance evaluation, on the other hand, addresses such issues as whether the performance
was superior or inferior, whether the performance was due to skill or luck, etc.
5.3.4 Need for Portfolio Evaluation

Investment may be carried out by individuals. The funds available with individual investors may
not be large enough to create a well-diversified portfolio of securities. Moreover, the time, skill
and other resources at the disposal of individual investors may not be sufficient to manage the
portfolio professionally. Institutional investors such as mutual funds and investment companies
are better equipped to create and manage well diversified portfolios in a professional fashion.
Hence, small investors may prefer to entrust their funds with mutual funds or investment
companies to avail the benefits of their professional services and thereby achieve maximum return
with minimum risk and effort.
Since evaluation is an appraisal of performance, whether the investment activity is carried out by
individual investors themselves or through mutual funds and investment companies, different
situations arise where evaluation of performance becomes imperative. These situations include:
i)Self Evaluation
Where individual investors undertake the investment activity on their own, the investment
decisions are taken by them. They construct and manage their own portfolio of securities. In such
a situation, an investor would like to evaluate the performance of his portfolio in order to identify

the mistakes committed by him/her. This self-evaluation will enable him to improve his/her skills
and achieve better performance in future.
ii)Evaluation of portfolio managers
A mutual fund or investment company usually creates different portfolios with different objectives
aimed at different sets of investors. Each such portfolio may be entrusted to different professional
portfolio managers who are responsible for the investment decisions regarding the portfolio
entrusted to each of them. In such a situation, the organization would like to evaluate the
performance of each portfolio so as to compare the performance of different portfolio managers.
iii) Evaluation Perspectives
A portfolio comprises several individual securities. In the building up of the portfolio several
transactions of purchase and sale of securities take place. Thus, several transactions in several
securities are needed to create and revise a portfolio of securities. Hence, the evaluation may be
carried out from different perspectives or viewpoints such as transactions view, security view or
portfolio view.
1. Transaction view
An investor may attempt to evaluate every transaction of purchase and sale of securities. Whenever
a security is bought or sold, the transaction is evaluated as regards its correctness and profitability.
2. Security view
Each security included in the portfolio has been purchased at a particular price. At the end of the
holding period, the market price of the security may be higher or lower than its cost price or
purchase price. Further, during the holding period, interest or dividend might have been received
in respect of the security. Thus, it may be possible to evaluate the profitability of holding each
security separately. This is evaluation from the security viewpoint.
3. Portfolio view
A portfolio is not a simple aggregation of a random group of securities. It is a combination of
carefully selected securities, combined in a specific way so as to reduce the risk of investment to
the minimum. An investor may attempt to evaluate the performance of the portfolio as a whole
without examining the performance of individual securities within the portfolio. This is evaluation
from the portfolio view.
Though evaluation may be attempted at the transaction level, or the security level, such
evaluations would be incomplete, inadequate and often misleading.
Investment is an activity involving risk. Proper evaluation of the investment activity must,
therefore, consider return along with risk involved. But risk is best defined at the portfolio level

and not at the security level or transaction level. Hence, the best perspective for evaluation is the
portfolio view.
5.4 PORTFOLIO PERFORMANCE EVALUATION MODELS

Understanding Risk and return as performance evaluation tools:
While evaluating the performance of a portfolio, the return earned on the portfolio has to be
evaluated in the context of the risk associated with that portfolio. The first step in portfolio
evaluation is calculation of the rate of return earned over the holding period. Return may be defined
to include changes in the value of the portfolio over the holding period plus any income earned
over the period. However, in the case of mutual funds, during the holding period, cash inflows into
the fund and cash withdrawals from the fund may occur. The unit-value method may be used to
calculate return in this case.
One obvious method of adjusting for risk is to look at the reward per unit of risk. We know that
investment in shares is risky. Risk free rate of interest is the return that an investor can earn on a
riskless security, i.e. without bearing any risk. The return earned over and above the risk free rate
is the risk premium that is the reward for bearing risk. If this risk premium is divided by a measure
of risk, we get the risk premium per unit of risk. Thus, the reward per unit of risk for different
portfolios or mutual funds may be calculated and the funds may be ranked in descending order of
the ratio. A higher ratio indicates better performance.
One approach would be to group portfolios into equivalent risk classes and then compare returns
of portfolios within each risk category. An alternative approach would be to specifically adjust the
return for the riskiness of the portfolio by developing risk adjusted return measures and use these
for evaluating portfolios across differing risk levels.
Accordingly, one period rate of return, r, for a mutual fund may then be defined as the change in
the per unit net asset value (NAV), plus its per unit cash disbursements (D) and per unit capital
gains disbursements (C) such as bonus shares. It may be calculated as:
RP = NAVt-NAVt-1+Dt+Ct
NAVt-1
Where,
NAVt = NAV per unit at the end of the holding period.
NAVt-1 = NAV per unit at the beginning of the holding period
Dt = Cash disbursements per unit during the holding period.
Ct = Capital gains disbursements per unit during the holding period.
This formula gives the holding period yield or rate of return earned on a portfolio. This may be
expressed as a percentage.

The rate of return earned by different mutual funds or mutual fund schemes may be calculated and
compared with the rate of return earned by a representative stock market index which can be used
as a benchmark for comparative evaluation. The mutual funds may also be ranked in descending
order of their rates of return. But such straight forward rates of return comparison may be
incomplete and sometimes even misleading. The differential return earned by mutual funds could
be due entirely to the differential risk exposure of the funds. Hence, the returns have to be adjusted
for risk before making any comparison.
Early Performance Measure Techniques
Before 1960, investors evaluated a portfolio’s performance based purely on the basis of the rate of
return. Research in the 1960’s showed investors how to quantify and measure risk. Grouped
portfolios into similar risk classes and compared rates of return within risk.
Pear group comparisons
This is the most common manner of evaluating portfolio managers.
 Collects returns of a representative universe of investors over a period of time and displays
them in a box plot format. To aid the comparison, the universe is typically divided into
percentiles, which indicate the relative ranking of a given investor.
 There is no explicit adjustment for risk.
 Risk is only considered implicitly.
Risk adjusted Performance Measures
The different risk- adjusted portfolio evaluation techniques are discussed below.
The first two methods (William Sharpe and Jack Treynor) are measuring the reward per unit of
risk in their pioneering work on evaluation of portfolio performance.
5.4.1 Sharpe Ratio

The performance measure developed by William Sharpe is referred to as the Sharpe ratio or the
reward to variability ratio. It is the ratio of the reward or risk premium to the variability of return
or risk as measured by the standard deviation of return. The formula for calculating Sharpe ratio
stated as:
𝑹𝒑−𝑹𝒇
Sharpe Ratio (SR) = 𝝈𝒑
Where,
Rp = Realized return on the portfolio
Rf = Risk - free rate of return
σp =Standard deviation of portfolio return

5.4.2 Treynor Ratio
The performance measure developed by Jack Treynor is referred to as Treynor ratio or reward to
volatility ratio. Treynor (1965) developed the first composite measure of portfolio performance
that included risk. He introduced the portfolio characteristic line, which defines a relation between
the rate of return on a specific portfolio and the rate of return on the market portfolio. It is the ratio
of the reward or risk premium to the volatility of return as measured by the portfolio beta. The
formula for calculating Treynor ratio stated as:
𝑹𝒑−𝑹𝒇
Treynor Ratio (TR) = βp
Where,
Rp= Realized return on the portfolio
Rf= Risk free rate of return
βp = Portfolio beta
Illustration 5.2
The return and risk figures of two mutual funds and the stock market index are given in the
table below:
Standard deviation
Return
Fund ( per $) Beta
(per $)
A 12% 18% 0.7

B 19 25 1.3
M( Market Index) 15 20 1.0
Given the risk - free rate of return is 7%.

The Sharpe ratios for the three funds are:
For A = 12-7 =0.277
18
For B = 19-7 =0.48
25
For M = 15-7 =0.40

20

Evaluation: As per Sharpe‘s performance measure, fund B has performed better than the
benchmark market index, while fund A has performed worse than the market index. The Treynor
ratios for the three funds are:
For A=12-7= 7.14
0.7
For B=19-7= 9.23
1.3
For M=15-7= 8.00
1.0
Evaluation : According to Treynor‘s performance measure also, fund Bhas performed
better and fund A has performed worse than the benchmark.
Comparison of Treynor Ratio and Sharp Ratio
Both the ratios are relative measures of performance because they relate the return to the risk
involved; not absolute rankings of portfolio performance. However, they differ in the measure
of risk used for the purpose. Sharpe uses the total risk as measured by standard deviation
(totalrisk), while Treynor employs the systematic risk as measured by the beta coefficient. In a
fully diversified portfolio, all unsystematic risk would be diversified away and the relevant
measure of risk would be the beta coefficient. For such a portfolio, Treynor ratio would be the
appropriate measure of performance evaluation and both measure give similar results. For a
portfolio that is not so well diversified, the Sharpe ratio using the total risk measure would be the
appropriate performance measure.
5.4.3 Jensen Ratio

Another type of risk adjusted performance measure has been developed by Michael Jensen and is
referred to as the Jensen measurer ratio. This ratio attempts to measure the differential between
the actual return earned on a portfolio and the return expected from the portfolio given its level of
risk.
The CAPM model is used to calculate the expected return on a portfolio. It indicates the return
that a portfolio should earn for its given level of risk. The difference between the return actually
earned on a portfolio and the return expected from the portfolio is a measure of the excess return
or differential return that has been earned over and above what is mandated for its level of
systematic risk. The differential return gives an indication of the portfolio manager‘s predictive
ability or managerial skills.
Using the CAPM model, the expected return of the portfolio can be calculated as follows:

E (Rp) =Rf+ βp (Rm-Rf)
Where,
E (Rp) = Expected portfolio return
Rf = Risk - free rate
Rm = Return on market index
βp = Systematic risk of the portfolio (Beta)
The differential return is calculated as follows:
αp=Rp-E (Rp)
Where,
αp = Differential return earned
Rp=Actual return earned on the portfolio
E (Rp) =Expected return
Thus, αp represents the difference between actual return and expected return. If αp has a positive
value, it indicates that superior return has been earned due to superior management skills. When
αp=0, it indicates neutral performance.
It means that the portfolio manager has done just as well as an unmanaged randomly selected
portfolio with a buy and hold strategy. A negative value of αp indicates that the portfolio‘s
performance has been worse than that of the market or a randomly selected portfolio of equivalent
risk.
The alpha value in Jensen measure can be tested for its degree of significance from a value of zero
by statistical methods. This means, an analyst can determine whether the differential return could
have occurred by chance or whether it is significantly different from zero in a statistical sense.
Illustration 5.3
Let us consider funds A and B of the above illustration. The actual returns realized from the two
funds are 12% and 19% with beta coefficients being 0.7 and 1.3, respectively. The market return
is 15% and the risk free rate is 7%. The expected return on the two funds can be calculated as
shown below:
Fund A: = 7 + 0.7 (15 - 7) = 12.6
Fund B: = 7 + 1.3 (15-7) = 17.4
The differential return or alpha (αp) value is shown below:
Fund A: = 12 – 12.6 = -0.6
Fund B: = 19 – 17.4 = 1.6

The negative value of alpha for fund A indicates that its performance has been inferior. The
positive value of alpha for fund B indicates that its performance has been superior, presumably
due to the superior management skills of its portfolio managers.
Summary -risk adjusted measures
 Treynor ratio considers the excess returns earned per unit of systematic risk(beta)
 It implicitly and assumes completely diversified portfolio.
 The Sharpe ratio measures the excess return per unit of total risk.
 It is suitable for a portfolio that is not well diversified. Like Treynor ratio Jensen measure
evaluates performance in terms of the systematic risk involved(beta)
 Unlike Sharpe and Treynor measures Jensen measure:
 is an absolute measure of performance
 can be tested statistically for its significance
Drawback of Composite measures:
 All composite measures of performance are biased to towards low risk exposure i.e the
lower the risk, the higher the ratio and the better performance.
 They do not indicate whether the superior performance have resulted from due to superior
managerial ability. Although there is high rank correlation among the alternative measures,
all the measures should be used because they provide different insights regarding the
performance of managers or institutions.
 An evaluation of a portfolio manager should be done many times over different market
environments before a final judgment is reached regarding the strengths and weaknesses.
5.5 CONCLUSION
The major goal of portfolio management is to derive rates of return that equal or exceed the returns
on a carefully selected portfolio with equal risk. Return maximization or risk minimization is the
optimal goal of rational investor. Attaining complete diversification relative to a suitable
benchmark to assess the strengths and weaknesses of a given portfolio manager is also additional
supplementary goal. For these objectives to be realized, an investor should revise and evaluate the
performance of its portfolio. As a revision strategy, a given investor can revise his/her portfolio
using either active or passive portfolio revision strategy or the combination these strategies. These
two opposing strategies have their own assumptions, advantages and disadvantages.
Furthermore, several techniques have been currently derived to evaluate portfolios in terms of both
risk and return (composite measures). The Treynor measure considers the excess returns earned
per unit of systematic risk. The Sharpe measure indicates the excess return per unit of total risk.
The Jensen Ratio measures likewise evaluate performance in terms of the systematic risk involved.

Although there is high rank correlation among the alternative measures, all the measures should
be used because they provide different insights regarding the performance of managers or
institutions. An evaluation of a portfolio manager should be done many times over different market
environments before a final judgment is reached regarding the strengths and weaknesses.
Moreover, a portfolio manager needs to continually evaluate the performance of a portfolio and
revise its composition of the portfolio to attain the best possible return from investment an ever
increasing completive business environment.

REFERENCE
Bodie Z., Kane A., & Marcus A., (2005). Investments. 6th Edition, McGraw-Hill/Irwin, New York,
U.S.A.
Brealey Myers Allen , 10th Edition ,Principles of corporate finance
Brentani C. (2004). Portfolio Management in Practice. Elsevier’s Science and Technology Rights
Department in Oxford, UK.
Campbell R. Harvey and Stephen Gray (1997). Global Financial Management (Portfolio Analysis
and Diversification)
Chandra P. (2005). Investment analysis and Portfolio Management. TATA McGraw-Hill, New
Delhi, India.
Michael C.Ehrhardt and Eugene F.Brigham (2007). Corporate Finance; A focused Approach 2nd
ed
Donald E. Fischer & Ronald J. Jordan. Security analysis and portfolio management. 6th Edition
Fabozzi F. J. & Drake P. P., (2009). Capital Markets, Financial Management, and Investment
Management. 10th Edition, John Wiley & Sons, Inc., Hoboken, New Jersey, U.S.A.
Frank Reilly and Keith Brown, 7th Edition, Investment analysis and portfolio management
Frank K. Reilly and Keith C. Brown. Investment Analysis and portfolio management 10th ed
Jeff Madura, Financial Markets and Institutions, 9th Edition, Florida Atlantic University, Joe
Sabatino.
Kristina, (2010), Investment analysis portfolio management
Md. Ashraful islam, Director, SEC. Security analysis & portfolio management.
Mishkin F. S. & Eakins S. G. (2006). Financial Markets and Institutions, 5th Edition, Pearson
Addison Wesley, U.S.A.
Reilly & Brown (2007). Investment Analysis and Portfolio Management. 7th Edition. John Wiley
& Sons, Inc., New Jersey, U.S.A.


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Table of Content

COURSE DESCRIPTION ............................................................................................................................ 4

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

After completion of the course, the student should be able to:

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

1.1 MEANING OF INVESTMENT:

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

1.2 INVESTMENT ALTERNATIVES/FORMS

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

2) DEBENTURES AND BONDS: A debenture is a document issued by a company as an

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

5) MONEY MARKET INSTRUMENTS: Money market is a centre in which financial

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

8) INVESTMENT IN REAL ESTATES: Investment in real estate includes properties like

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

11) COMMODITIES: A commodity may be defined as a product or material or any physical

1.3 OBJECTIVES OF INVESTMENT

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

1.4 CHARACTERISTICS OF INVESTMENT

1.5 INVESTMENT AND SPECULATION

Basis Investment Speculation

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

Difference between Investor and Speculator

a) Investor Speculator planninghorizon: An investor has a relatively longer planning horizon.

1.6 TYPES OF SECURITIES

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

1.7 MAJOR INVESTOR IN SECURITIES

II. Institutional investors: An institutional investor is an organization, rather than an

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

1.8 THE INVESTMENT PROCESS

1. Determine Objectives. Investment policy has to be guided by a set of objectives. Before

4. Portfolio Construction. Portfolio construction follows from security analysis. It is the

CHAPTER TWO: SECURITY ANALYSIS AND VALUATION

2.1 SECURITY ANALYSIS

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

2.2 FUNDAMENTAL ANALYSIS

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

 To make a projection on its business performance;

 To evaluate its management and make internal business decisions;

 And/or to calculate its credit risk.

 To find out the intrinsic value of the share.

Fundamental analysis includes:

Phase Nature of Analysis Purpose Tools and techniques

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

Fundamental analysis is a technique that attempts to determine a security's value by focusing on

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"?

 Quantitative – capable of being measured or expressed in numerical terms.

 Qualitative – related to or based on the quality or character of something, often as opposed

The concept of Intrinsic Value

AAU, CoBE, Department of Accounting & Finance, Compiled by Sewale Abate(PhD)

The big unknowns are: