Investment Management Notes

Study Material
Investment Management
(16MBAFM303)
Prof. Sathyanarayana K
Investment Management, 3rd Semester, VTU
Unit 1: (Theory) (6 Hours)

Investment: Attributes, Economic vs. Financial Investment, Investment and speculation, Features of a
good investment, Investment Process. Financial Instruments: Money Market Instruments, Capital
Market Instruments, Derivatives. Mutual Funds: Functions of Investment companies, Classification of
Investment companies, Mutual Fund types, Performance of Mutual Funds- NAV.
Unit 2: (Theory) (6 Hours)

Securities Market: Primary Market - Factors to be considered to enter the primary market, Modes of
raising funds, Secondary Market- Major Players in the secondary market, Functioning of Stock
Exchanges, Trading and Settlement Procedures, Leading Stock Exchanges in India. Stock Market
Indicators- Types of stock market Indices, Indices of Indian Stock Exchanges.
Unit 3: (Theory & Problems) (10 Hours)

Risk and Return Concepts: Concept of Risk, Types of Risk- Systematic risk, Unsystematic risk,
Calculation of Risk and returns of individual security, Portfolio Risk and Return

Valuation of securities: Bond- Bond features, Types of Bonds, Determinants of interest rates, Bond
Management Strategies, Bond Valuation, Bond Duration. Preference Shares- Concept, Features, Yields.
Equity shares- Concept, Valuation, Dividend Valuation models
Unit: 5 (Theory& Problems) (12 Hours)

Macro-Economic and Industry Analysis: Fundamental analysis-EIC Frame Work, Global Economy,
Domestic Economy, Business Cycles, Industry Analysis. Company Analysis- Financial Statement
Analysis, Ratio Analysis.
Technical Analysis – Concept, Theories- Dow Theory, Eliot wave theory. Charts-Types, Trend and
Trend Reversal Patterns. Mathematical Indicators – Moving averages, ROC, RSI, and Market
Indicators. (Problems in company analysis & Technical analysis)
Market Efficiency and Behavioral Finance: Random walk and Efficient Market Hypothesis, Forms of
Market Efficiency, Empirical test for different forms of market efficiency. Behavioral Finance –
Interpretation, Biases and critiques. (Theory only)

Modern Portfolio Theory: Markowitz Model -Portfolio Selection, Opportunity set, Efficient Frontier.
Capital Asset pricing model: Basic Assumptions, CAPM Equation, Security Market line, Extension of
Capital Asset pricing Model - Capital market line, SML VS CML. Arbitrage Pricing Theory: Arbitrage,
Equation, Assumption, Equilibrium, APT AND CAPM.
Portfolio Management: Diversification- Investment objectives, Risk Assessment, Selection of asset

mix, Risk, Return and benefits from diversification. Portfolio Management Strategies: Active and
Passive Portfolio Management strategy. Portfolio Revision: Portfolio Revision Strategies – Objectives,
Performance plans.
Portfolio Evaluation: Holding period’s returns, Measures of portfolio performance. Sharpe’s, Treynor’s
and Jenson’s.
Unit 1:
Investment
An Investment is a sacrifice of current money or other resources for future benefits. The Two
key aspects of any investment are Time and Risk. The sacrifice takes place now and is certain,
the benefits is expected in the future and tends to be uncertain. Everyone owns a portfolio of
investments, it comprise Financial Assets and Real Assets
An investment is an asset or item that is purchased with the hope that it will generate income
or will appreciate in the future. In an economic sense, an investment is the purchase of goods
that are not consumed today but are used in the future to create wealth.
Investment Attributes
Evaluation of investment involves evaluating the attributes of investments. Return, risk,
liquidity, duration, tax benefits and convenience are the key attributes taken into consideration
before investing in any particular type of investment. Investments are an integral part of any
business.
Attributes of investments are:

 Safety
 Rate of Return
 Liquidity
 Duration
Safety: Each investment option is differently affected by different types of risks. Risk affects
not only the return on investment but also return of the investment itself. The selected
investment avenue should be under the legal and regulatory framework. If it is not under the
legal framework, it will be difficult to represent grievances, if any. Approval of the law itself
adds a flavour of safety. Though approved by law, the safety of the principal differs from one
mode of investment to another. Investments made with the government assure more safety
than with a private party. From the safety point of view, investments can be ranked as follows:
Bank deposits, government bonds, UTI units, NCD, Convertible debentures, equity shares and
deposits with NBFC.
Rate of Return: Investors always expect a good rate of return from their investments. The rate
of return could be defined as the total income the investor receives during the holding period,
stated as a percentage of the purchasing price at the beginning of the holding period.
The rate of return is stated semi-annually or annually to help compare among the different
investment alternatives. If it is a stock, the investor gets the dividend as well as the capital
appreciation as returns. Market return of the stock indicates the price appreciation for the
particular stock.
Liquidity: Liquidity is an important aspect of any investment option as it determines the case,
time and cost involved in converting the investment into cash. While certain expenses like
purchasing a house, children’s education etc., can be reasonably planned. Emergencies such
as medical expenses necessitate redemption of an investment prematurely. The marketability

of investment provides it liquidity.
Liquidity depends upon marketing and trading facilities. If a portion of the investment could
be converted into cash without much loss of time, it helps the investor to meet emergencies.
Stocks are liquid only if they command a good market by providing adequate returns through
dividends and capital appreciation. Stocks in the Sensex, Nifty and Nifty Junior are more
liquid. Whereas stocks in the ‘Z’ group are illiquid.
Economic Investments Vs Financial Investment

An investment is an asset or item that is purchased Economic Investments:
with the hope that it will generate income or will • Investment in knowledge
appreciate in the future. In an economic sense, an • Buying or upgrading machinery
investment is the purchase of goods that are not • Adding to a labour force
consumed today but are used in the future to create • Tuition reimbursement program
wealth.
Financial Investments:
A financial investment is an asset that you put • Bank Deposit,
money into with the hope that it will grow or • Stocks, CDs & Bonds,
appreciate into a larger sum of money • Mutual funds,
• Foreign currency
• Derivatives
Investment Vs Speculation
Investment is the employment of funds on assets with the aim of earning income or capital
appreciation. In the process of investment the present consumption is sacrificed to get a return
in the future. The sacrifice that has to be borne is certain but the return in the future may be
uncertain.
Speculation is about taking up the business risk in the hope of achieving short-term gain.
Speculation essentially involves buying and selling activities with the expectation of making a
profit from price fluctuations.
The time factor involved in speculation and investment is different. The investor is interested
in a consistently good rate of return for a longer period. He is primarily concerned with direct
benefits provided by securities in the long-run. The speculator is interested in getting an
abnormal return. In simple terms, the investor wants a higher rate of return than the normal
return in the short-run. The speculator’s investments are made for a short-term.
The speculator is more interested in market action and its price movement. The investor
constantly evaluates the worth of security, whereas the speculator evaluates the price
movement. He is not worried about fundamental factors.
The main difference between speculating and investing is the amount of risk undertaken in the
trade. Typically, high-risk trades that are almost akin to gambling fall under the umbrella
of speculation, whereas lower-risk investments based on fundamentals and analysis fall into
the category of investing.
Investor Speculator
Time horizon Plans for longer time horizon, holding Plans for a very short period,
period will be from one year to few holding period varies from few days
years. to months.
Risk Likes to take moderate risk Willing to take high risk.
Return Likes to have moderate rate of return Likes to have high returns for taking
associated with limited risk. high risk.
Decision Considers fundamental factors and Considers inside information,
evaluates the performance of the hearsays and market behaviour.
company regularly.
Funds Uses his own funds and avoids Uses borrowed funds to supplement
borrowed funds. his personal resources.
Gambling
Gambling is usually a very short-term investment in a game or chance. Gambling is different
from speculation and investment. First, the time horizon involved in gambling is shorter than
in speculation and investment. The results are determined by the roll of a dice or the turn or a
card. Risk and return trade-off is not found in gambling and negative outcomes are expected.
A Stock price went up from $ 1,000 to $ 1,200

Speculator Investor
A gadget price went up from $100 to $200

Investment Objectives
The main objectives of investment are:
 Maximizing the return
 Minimizing the risk
Other subsidiary objectives are:

 Maintaining liquidity
 Hedging against inflation
 Increasing safety
 Saving tax
Maximizing the Return

Investor always expect a good rate of return from their investments. The rate of return could
be defined as the total income the investor receives during the holding period, stated as a
percentage of the purchasing price at the beginning of the holding period.
End period value - Beginning period value + Dividend
Return = X 100
Beginning period value
The rate of return is stated semi-annually or annually to help compare among the different
investment alternatives. If it is a stock, the investor gets the dividend as well as the capital
appreciation as returns.
Minimizing the Risk

The risk of holding securities is related to the probability of the actual return becoming less
than the expected return. The word ‘risk’ is synonymous with the phase ‘variability of return’.
Investment risk is just as important as measuring its expected rate of return because minimizing
risk and maximizing the rate of return are interrelated objectives in investment management.
An investment whose rate of return varies widely from one period to another is considered
riskier than one whose return does not change much. Even investor likes to reduce the risk of
his investment by proper combination of different securities. Investors, however differ in their
attitude towards risk.
Maintaining Liquidity
Liquidity is an important aspect of any investment option as it determines the ease, time and
cost involved in converting the investment into cash. While certain expenses like purchasing a
house, children’s education, etc., can be reasonably planned, emergencies such as a medical
expenses necessitate redemption of an investment prematurely. The marketability of
investment provides it liquidity.
Liquidity depends upon marketing and trading facilities. If a portion of the investment could
be converted into cash without much loss of time, it helps the investor to meet emergencies.
Stocks are liquid only if they command a good market by providing adequate returns through
dividends and capital appreciation. Stocks in the Senses, Nifty and Nifty Junior are more liquid,
whereas stocks in ‘Z’ group are illiquid.
Hedging against Inflation

The rate of return should ensure a cover against inflation to protect against a rise in prices and
fall in the purchasing value of money. The rate of return should be higher than the rate of
inflation. Otherwise, the investor will experience loss in real terms. Growth stocks would
appreciate in their values. Overtime and provide protection against inflation. The return thus
earned should assure the safety of the principal amount, regular flow of income and be a hedge
against inflation.
Increasing Safety
Each investment option is differently affected by different types of risks. Risk affects not only
the return on investment but also return on investment itself. The selected investment avenue
should be under the legal and regulatory framework. If it is not under the legal framework, it
will be difficult to represent grievances, if any. Approval of the law itself adds a flavour of
safety. Though approved y law, the safety of the principal differs from the one mode of
investment to another. Investments made with the government assures more safety than with a
private party. From the safety point of view, investments can be ranked as follows: Bank
deposits, government bonds, UTI units, non-convertible debentures, convertible debentures,
equity shares and deposits with non-banking financial companies.
Saving Tax
Tax is unavoidable. Different income levels and investment options attract different tax rates.
The tax rate may vary with the period of investment for a specific option. Certain investments
offer tax incentives. The investor tries to minimize the tax outflows and maximize tax returns.
Features of good Investment

The features of good investment are:
 Capital Protection (Safety of Principal)
 Adequate Liquidity and Collateral Value
• Reversible or Marketable
 Stability of Income
 Capital Growth
 Tax Benefit
 Purchasing Power Stability
Investment Process
Investment process involves a series of activities leading to the purchase of securities or other
investment alternatives. The investment process can be divided as:
Investment Process
Investment Security Valuation Portfolio Portfolio

Policy Analysis Construction Evaluation
Framing of Investment Policy

For systematic functioning the investor formulates the investment policy before proceeding to
invest. The essential ingredients of the policy are investible funds, objectives and knowledge
about investment alternatives and the market.
Investible funds: The entire investment procedure revolves around the availability of investible
funds. Funds may be generated through savings or from borrowings. If the funds are borrowed,
the investor has to be extra careful in the selection of investment alternatives. He must take
sure that the returns are higher than the interest he pays. Mutual funds invest their stockholders
money in securities.
Objectives: The objectives are framed on the premises of the required rate of return, need for
regular income, risk perception and the need for liquidity. The risk taker’s objective is to earn
a high rate of return in the form of capital appreciation, whereas the primary objectives of the
risk averse is the safety of principal.
Knowledge: Knowledge about investment alternative and markets plays a key role in policy
formulation. Investment alternatives range from security to real estate. The risk and return
associated with investment alternatives differ from each other. Investment in equity is high-
yielding but faces more risk than fixed income securities. Tax sheltered schemes offer tax
benefits to the investors.
The investor should be aware of the stock market structure and functions of the brokers. The
modes of operations and different in the Bombay Stock Exchange (BSE), National Stock
Exchange (NSE), and over-the Counter Exchange of India (OTCEI). Brokerage charges are
also different. Knowledge about stock exchanges enables an investor to trade the stock
intelligently.
Security Analysis
Securities to be bought are scrutinized through market, industry and company analyses after the
formulation of investment policy.
Market analysis: The stock market mirrors the general economic scenario. The growth in gross
domestic product and inflation is reflected in stock prices. Recession in the economy results in
a bear market. Stock prices may fluctuate in the short-run but in the long-run, they move in
trends, i.e., either upwards or downwards. The investor can fix his entry and exit points through
technical analysis.
Industry analysis: Industries that contribute to the output of major segments of the economy
vary in their growth rates overall contribution to economic activity. Some industries grow faster
than the GDP and are expected to continue in their growth. For example, the information
technology industry has experienced a higher growth rate than the GDP in 2014. The economic
significance and the growth potential of the industry have to be analysed.
Company analysis: The purpose of company analysis is to help the investors make better
decisions. The company’s earnings, profitability, operating efficiency, capital structure and
management have to be screened. These factors have a direct bearing on stock prices and
investors’ returns. The appreciation of stock value is a function of the performance of the
company. A company with a high product market share is able to create wealth for investors
in the form of capital appreciation.
Valuation
Valuation helps the investor to determine the return and risk expected from a investment in
common stock. The intrinsic value of the share is measured through the book value of the share
and price earnings ratio. Simple discounting models also can be adopted to value the shares.
Stock market analysts have developed many advanced models to value shares. The real worth
of the share is compared with the market price, and investment decisions are then made.
Future value: The future value of securities can be estimated by using a simple statistical
technique like trend analysis. The analysis of the historical behaviour of price enables the
investor to predict the future value.
Construction of a portfolio
A portfolio is a combination of securities. It is constructed in a manner so as to meet the
investor’s goals and objectives. The investor should decide how best to reach the goals with
the securities available. The investor tries to attain maximum return with minimum risk.
Towards this end, he diversifies his portfolio and allocates funds among the securities.
Diversification
The main objective of diversification is the reduction of risk in the form of loss of capital and
income. A diversified portfolio is comparatively less risky than holding a single portfolio.
Several modes are available to diversify a portfolio.
Debt and equity diversification: Debt instrument provides assured returns with limited capital
appreciation. Common stocks provide income and capital gain but with a flavour of
uncertainty. Both debt instruments and equity are combined to complement each other.
Industry diversification: Industries’ growth and their reaction to government policies differ
from each other. Banking industry shares may provide regular returns but with limited capital
appreciation. Information technology stocks yield higher return and capital appreciation, but
their growth potential in the post-global crisis years was unpredictable. Thus industry
diversification is needed, and it reduces the risk.
Company diversification: Securities from different companies are purchased to reduce the risk.
Technical analysis suggest that investors buy securities based on price movement. Fundamental
analysis suggest the selection of financial sound and investor-friendly companies.
Selection: securities have to be selected based on the level of diversification, industry and
company analysis. Funds are allocated for selected securities. Selection of securities and the
allocation of funds seal the construction of portfolio.
Evaluation
A portfolio has to be managed efficiently. Efficient management calls for evaluation of the
portfolio. This process consists of portfolio appraisal and revision.
Appraisal: The return and risk performance of security varies from time to time. The variability
in returns of securities is measured and compared. Developments in the economy, industry and
relevant companies from which stocks are bought have to be appraised. The appraisal warns
of the loss and steps can be taken to avoid such losses.
Revision: It depends on the results of the appraisal. Low-yielding securities with high risk are
replaced with high-yielding securities with low risk factors. The investor periodically revises
the components of the portfolio to keep the return at a level.
Financial Instruments
Financial Instruments
Capital Market Money Market Derivatives

Instruments Instruments
Equity
Call money market Forwards
Bond
Commercial Papers Futures
Debenture
Treasury Bills Options
Warrants
SWAPS
Certificate of Deposits
Mutual Fund
E T F’s Repo
Commercial Bills
Capital Market Instruments

Capital market instruments are those instruments which will be claimed on a long term.
Equity
Equity Shares are commonly referred to as common stock or ordinary shares. Even though the
terms ‘shares’ and ‘stocks’ are interchangeably used, there is a difference between them. The
share capital of a company is divided into a number of small units of equal value called shares.
The term ‘stock’ means the aggregate of a member’s fully paid-up shares of equal value merged
into one fund. It is a set of shares put together in a bundle. The ‘stock’ is expressed in terms
of money and not as many shares. Stock can be divided into fractions of any amount and such
fractions may be transferred like shares.
In a limited company, the equity shareholder are liable to pay the company’s debt only to the
extent of their share in the paid up capital. Equity shares have following advantages:
 Capital appreciation
 Limited liability
 Free tradability
 Tax advantages (in certain cases)
 Hedge against inflation
Sweat Equity: Sweat equity is a new equity instrument should be issued out of a class of equity
shares already issued by the company. It cannot form a new class of equity shares. All
limitations, restrictions and provisions applicable to equity shares are applicable to sweat
equity. Thus, sweat equity forms a part of the equity share capital.
Non-voting shares (DVR’s): Non-voting shares carry no voting rights. They carry additional
dividends instead of voting rights. Shareholders in possessions of non-voting shares have the
right to participate in bonus issues. Non-voting shares can also be listed and traded in stock
exchanges. In non-voting shares are not paid dividends for two years, shares would
automatically get voting rights. The company can issue this to a maximum of 25 percent of the
voting stock. The dividend on non-voting shares would have to be 20 percent higher than the
dividend on voting shares. All rights and bonus shares for non-voting shares have be issued in
the form of non-voting shares only.
Right Shares: Shares offered to existing shareholders at a price by the company are called right
shares. They are offered to shareholders as a matter of legal right. If a public company wants
to increase its subscribed capital by way of issuing shares after two years from its date of
formation or one year from the date of first allotment, whichever is earlier, such shares should
be offered first to existing shareholders in proportion to the capital paid up on the shares held
by them at the date of such offer.
Bonus Shares: A bonus share is the distribution of shares in addition to cash dividends to
existing shareholders. Bonus shares are issued to existing shareholders without any payment
of cash. The aim of a bonus share is to capitalize the free reserves. The bonus issue is made
out of free reserves built from genuine profit or share premium collected in cash only. The
bonus issue can be made only when all partly paid shares are fully paid-up.
The declaration of the bonus issue has a favourable on the psychology of shareholders. They
take it as an indication of high future profits. Bonus shared are declared by directors only when
they expect a rise in the profitability of the concern. The issue of bonus share enables
shareholders to sell shares and get capital gains while retaining their original shares.
Preference Shares: The characters of the preferred stock are hybrid in nature. Some of its
features resemble the bond and others the equity shares. Like the bonds, their claims on the
company’s income are limited, and they receive a fixed dividend. In the event of liquidation of
the company, their claims on the assets of the firm are also fixed. At the same time like the
equity it is a perpetual liability of the corporate. The decision to pay a dividend on the preferred
to stock is at the desecration of the Board of Directors. In the case of bonds, payment of interest
rate is mandatory.
The dividend received ty the preferred stock is treated on par with the dividend received from
the equity share for tax purposes. These shareholders do not enjoy any of the voting powers,
except when any resolution affects their rights.
Types of preference shares:

 Cumulative preference shares
 Non-cumulative preference shares
 Convertible preference shares
 Redeemable preference shares
 Irredeemable preference shares
 Cumulative convertible preference shares.
Debenture
Debentures are generally issued by the private sector companies as a long-term promissory note
for raising loan capital. The company promises to pay interest and principal as stipulated. A
bond is an alternative form of debenture in India. Public sector companies and financial
institutions issue bonds. The characteristic features of debentures are:
Form: It is given as a certificate of indebtedness by the company, specifying the date of

redemption and rate of interest
Interest: Rate of interest is fixed at a time of the issue itself which is known as the contractual
or coupon rate of interest. Interest is paid as a percentage of the par value of the debenture and
may be paid annually, semi-annually or quarterly. The company is legally bound to pay the
interest rate.
Redemption: As stated earlier, the redemption date would be specified in the issue itself. The
maturity period may range from 5 to 10 years in India. They may be redeemed in instalments.
Redemption is done thorough the creation of sinking fund by the company. A trustee in charge
of the fund buys the debentures either from the market or from owners. Creation of the sinking
fund eliminates the risk of facing financial difficulty at the time of redemption because
redemption requires a huge sum. Buy-back provisions help the company to redeem debentures
at a special price before the maturity date. The special price is usually higher than the par value
or debenture.
Types of debentures:
 Secured or unsecured debentures: A secured debenture is secured by a lien on the
company’s specific assets. In the case of default, the trustee can take hold of the specific
asset on behalf of the debenture holders. Secured debentures in Indian market includes a
charge on present and future immovable assets of the company.
When debentures are not protected by a security, they are known as unsecured or naked
debentures.
 Fully convertible debentures: This type of debentures is converted into equity shares of the
company on the expiry of a specific period. The conversion is carried out according to the
guidelines issued by SEBI.
 Partly convertible debenture: This debentures consists of two parts, namely convertible and
non-convertible. The convertible portion can be converted into shares after specific period.
Here, the investor has the advantage of convertible and non-convertible debentures blended
into one debenture.
 Non-convertible debenture: Non-convertible debentures do not confer any option on the

holder to convert the debentures into equity shares and are redeemed at the expiry of the
specified period.
Bond
A bond is a long-term debt instrument that promises to pay a fixed annual sum as interest for a
specified period of time. The basic features of the bonds are:
 Bonds have face a value. This is known as par value. The bonds may be issued at par, or at
a discount.
 The interest rate is fixed. It may sometimes vary as in the case of floating rate bond. The
interest is paid semi-annually or annually ad is known as the coupon rate. The interest rate
is specified in the certificate.
 The maturity date of the bond is usually specified at the time of issue, except in the case of
perpetual bonds.
 The redemption value is also stated in the bonds. It may be at a par value or at a premium.
 Bonds are traded in the stock market. When they are traded, the market value may be at par,
at a premium or discounted. The market value and redemption value need not be the same.
Secured bonds and unsecured bonds: The secured bond is secured by the real assets of the
issuer. In case of unsecured bond, the name and fame of an issuer may be the only security.
Perpetual bonds and redeemable bonds: Bonds that do not mature or never mature are called
perpetual bonds. The interest alone would be paid. In redeemable bonds, the bond is redeemed
after a specific period of time. The redemption value is specified by the issuer.
Fixed interest rate and floating interest rate bonds: In fixed interest rate bonds, the interest
rate is fixed at the time of the issue. Whereas the floating interest rate bonds, the interest rates
change according to already fixed norms.
Zero coupon bonds: these bonds sell a discount and face value is repaid at maturity. The
difference between the purchase cost and face value of the bond is the gain for the investor.
Since investor does not receive any interest on the bond, the conversion price is suitable
arranged to protect the loss of interest to the investor.
The advantage of this bond is that the company does not have the burden of servicing the debt
during the execution period of the project. The repayment could be adjusted to fall after the
completion of the project. This could result in considerable cost savings for the company.
Deep discount bonds: A deep discount bond is another form of zero coupon bond. The bonds
are sold at a large discount on their nominal value and interest is not paid of them. Also they
mature at par value. The difference between the maturity value and issue price serves as an
interest return. The deep discount bonds maturity period may range from three years to 25 years
or more.
Warrants
A warrant is a bearer document of title to buy a specified number of equity shares at specified
price. Warrants can usually be exercised over a number of years. Warrants are offered to make
the bond or preferred stock more attractive. Bonds may have a low interest rate but the warrants
offered along with them help the investor enjoy the equity appreciation value. Warrants are
detachable - the investor can sell them separately to be traded in the market.
The person who holds the warrant cannot enjoy the benefits of the equity holder before the
conversion of the warrant. The price at which the warrants are converted is called exercise
price. The exercise price is always greater than the current market price of the respective equity
at the time of tissue of the warrants.
Mutual Fund
If you find it difficult or cumbersome to invest directly in equity shares and debt instrument,
you can invest in these financial assets indirectly through a mutual fund. A mutual fund
represents a vehicle for collective investment. When you participate in a scheme of a mutual
fund you become a part-owner of the investments held under that scheme.
In India entities are involved in a mutual fund operations are: the sponsor, the mutual fund, the
trustees, the asset management company (AMC), the custodian and the registrars and transfer
agents.
Mutual fund schemes invest in three broad categories of financial assets, viz. stocks, bonds, and
cash. Stock refer to equity and equity related instruments. Bonds are debt instruments that
have a maturity of more than one year. Cash represents bank deposits and debt instruments that
have a maturity of less than one year.
Depending on the asset mix, mutual funds schemes are classified into three broad types, viz.
Equity schemes, Hybrid schemes and Debt schemes. Equity schemes invests the bulk of their
corpus in stocks and balance in cash. Hybrid schemes are also referred as balance schemes,
invests in a mix of stocks and debt instruments. Debt schemes invest in bonds and cash.
Mutual fund Schemes:
I. Equity Schemes
 Diversified equity schemes
 Index schemes
 Sectoral schemes
 Tax planning schemes
II. Hybrid Schemes (Balanced)

 Equity-oriented schemes
 Debt-oriented schemes
 Variable asset allocation schemes
III. Debt Schemes

 Gilt Schemes
 Mixed Schemes
 Floating rate debt schemes
 Money market schemes
Mutual funds in India are comprehensively regulated under the SEBI (Mutual Funds)
Regulations, 1996. Some of the important regulations are:
 A mutual funds hall be constituted in the form of a trust executed by the sponsor in favour
of the trustees.
 The sponsor or if so authorised by the trust deed, the trustees shall appoint an asset
management company (AMC).
 No schemes shall be launched by the AMC unless it is approve by the trustees and a copy of
the offer document has been filed with SEBI.
 The offer document and advertisement materials shall not be misleading.
 No guaranteed return shall be provided in a scheme unless such returns are fully guaranteed
by the sponsor of the AMC.
 The mutual fund shall not borrow except to meet temporary liquidity needs.
 The net asset value (NAV) and the sale and repurchase price of mutual fund schemes must
be regularly published in a daily newspapers and update on websites.
 The investments of a mutual fund are subject to several restrictions relating to exposure to
stocks of individual companies, debt instruments of individual issuers, so on.
 Cost associated with mutual fund investing such as initial expenses, loads (entry and exit)
and annual recurring expenses are subject to certain ceilings.
ETF’s: The objective of ETFs is to provide returns closely related to returns provided by the
price of respective asset. Investment is made in physical gold or other gold-based securities as
permitted by regulators from time to time. Most gold ETF’s are traded on the National Stock
Exchange. Some of them are Gold Bees, Kotak Gold, Quantum Gold, Reliance Gold and UTI
Gold ETF.
Money Market Instruments

Debt instruments which have a maturity of less than one year at the time of issue are called
money market instruments. These instruments are highly liquid and have negligible risk. The
major money market instruments are Treasury bills, certificate of deposits, commercial papers
repos. The money market is dominate by the government, financial institutions, banks and
corporates. Individual investors rarely participate in the money market directly.
Treasury Bills: Treasury Bills are the most important money market instruments. They
represent the obligations of the Government of India which have a primary tenor like 91days,
182 days and 364 days. They are sold on an auction basis every week in certain minimum
denominations by the Reserve Bank of India. They do not carry an explicit interest rate.
Instead, they are sold at a discount and redeemed at par. Hence the implicit yield of a Treasury
bill is a function of the size of the discount and the period of maturity.
Treasury bills can be transacted readily and there is a very active secondary market for them.
They have nil credit risk and negligible price risk.
Commercial Paper: A commercial paper (CP) is a short term unsecured money market
instrument. CPs can be issued by corporates, primary dealers and all India financial institutions
under the umbrella limit specified by the RBI. CPs can be issued for a maturity between 7 days
and one year from the date of issue.
Certificate of Deposit: A certificate of deposit (CD) is a negotiable money market instrument

issued by a bank or an eligible financial institutions for a specified time period, while banks can
issue CDs of maturities from 7 days to one year, financial institutions can issue of maturities
from 1 year to 3 years. CDs are issued in dematerialized form or as a Usance Promissory Note:
CDs are issue at a discount on face value or on a floating rate basis.
Call Money Market: Call money market is a market for unsecured lending or borrowing of
funds. Participants in this market include banks, development financial institutions, insurane
companies, and select mutual funds. While banks and can borrow as well as lend in the call
market, other participants can only lend. The call money market is predominantly an overnight
market.
Repos: A “repo” involves a simultaneous “sale and repurchase” agreement. A “repo” works
as, Party A needs short-term funds and Party B wants to make a short term investment. Party
A sells securities to Party B at a certain price and simultaneously agrees to repurchase the same
after a specified time at a slightly higher price. The difference between the sale price and
repurchase price represents the interest cost to party A and conversely the interest income to
party B. A “reverse repo” is the opposite of a “repo” – it involves an initial purchase of a
security followed by a subsequent sale. It is a safe and convenient form of short-term
investment.
Derivatives
Derivatives is an instrument whose value is derived from the value of its underlying asset, the
underlying assets can be bonds, stocks, indices, commodities etc.
Common derivative instruments are:
Futures:
Options: Option contract is a contract where the buyer of the option will be have right without
obligation to buy/sell the underlying asset whereas the writer of the options will have only
obligation without right to buy/sell the underlying asset.
Mutual Funds:
Investment Companies: These are financial intermediaries that collect funds from
individual investors and invest those funds in a potentially wide range of securities or other
assets. Pooling of assets is the key idea behind investment companies. Each investor has a
claim to the portfolio established by the investment company in proportion to the amount
invested. These companies thus provide a mechanism for small investors to term up to obtain
the benefits of large scale investing.
Functions of Investment Companies:

 Record keeping and administration: Investment companies issue periodic status reports,
keeping track of capital gains distributions, dividends, investments and redemptions. They
may reinvest dividends and interest income for shareholders.
 Diversification and divisibility: By pooling their money, investment companies enable
investors to hold fractional shares of many different securities. They can act as large
investors even if any individual shareholder cannot.
 Professional management: Investment companies can support full-time staffs of security
analysts and portfolio managers who attempt to achieve superior investment results for their
investors.
 Lower transaction cost: Because they trade large blocks of securities, investment companies
can achieve substantial savings on brokerage fees and commissions.
While investment companies pool assets of individual investors, they also need to divide claims
to those assets among those investors. Investors buy shares in investment companies and
ownership is proportional to the number of shares purchased. The value of each share is called
the Net Asset Value or NAV. Net asset value eauals assets minus liabilities expressed on a per-
share basis.
Classification of Investment Companies:

 Unit Investment Trusts
 Managed Investment Companies
Unit Investment trusts: UIT’s are pools of money invested in a portfolio that is fixed for the
life of the fund. To form a unit investment trust, a sponsor, typically a brokerage firm buys a
portfolio of securities that are deposited into a trust. It then sells shares or units in the trust
called redeemable trust certificates. All income and payments of principal from the portfolio
are paid out by the fund’s trustees to the shareholders.
Investors who wish t liquidate their holdings of a unit investment trust may sell the shares back
to the trustee for NAV. The trustee can either sell enough securities from the asset portfolio to
obtain the cash necessary to pay the investor or they may instead sell the shares to new investors.
Managed Investment Companies: There are two types of managed companies: Closed-end
and open-end. In both cases the fund’s board of directors which is elected by shareholders,
hires a management company to manage the portfolio for an annual fee that typically ranges
from 0.2% to 1.5% of assets.
Open-end funds stands ready to redeem or issue shares at their net asset value. When investors
in open-end funds wish to cash out their shares, they sell them back to the fund at NAV. In
contrast, closed-end funds do not redeem or issue shares. Investors in closed-end funds who
wish to cash out must sell their shares to others. Shares of closed-end funds are traded on
organized exchanges and can be purchased through brokers just like other common stoc; their
prices, therefore, can differ from NAV.
Types of Mutual Funds

Each mutual fund has a specified investment policy, which is described in the fund’s prospectus.
For example, money market mutual funds hold the short-term, low-risk instruments of the
money market, while bond funds hold fixed-income securities.
Money Market Funds: These funds invest in money market securities such as commercial
paper, repurchase agreements, or certificate of deposits. The average maturity of these assets
tends to be a bit more than 1 month. Money market funds usually offer check-writing features,
and NAV is fixed at 10 per unit, so that there are no tax implication such as capital gains or
losses associated with redemption of units.
Equity Funds: Equity funds invest primarily in stock, although they may at the portfolio
manager’s discretion also hold fixed-income or other types of securities. Equity funds
commonly will hold between some percentages of total assets in money market securities to
provide liquidity necessary to meet potential redemption of units.
Equity funds are traditionally classified by their emphasis on capital appreciation versus current
income. Thus income funds tend to hold shares of firms with consistently high dividend yields.
Growth funds are willing to forgo current income, focusing instead on prospects for capital
gains. While the classification of these funds is couched in terms of income versus capital
gains, in practice, the more relevant distinction concerns the level of risk these funds assume.
Growth stock and therefore growth funds, are typically riskier and respond ore dramatically to
changes in economic conditions than do income funds.
Sector Funds: Some equity funds called sector funds, concentrate on a particular industry, each
of which invests in a specific industry such as energy, realty, bank or telecommunications.
Bond Funds: As the name suggests, these funds specialise in the fixed-income sector. Within
that sector however, there is considerable room for further specialisation.
International Funds: Many funds have international focus, Global funds invest in securities
worldwide including the US. In contract international funds invest in securities of firms located
outside US. Regional funds concentrate on a particular part of the world and emerging market
funds in the companies of developing nations.
Balanced Funds: Some funds are designed to be candidates for an individual’s entire
investment portfolio. The balanced funds hold both equities and fixed income securities in
relatively stable proportions. Life cycle funds are balanced funds in which the asset mix can
range from aggressive to conservative.
Many balanced funds are fund of funds. These are mutual funds that primarily invest in units
of other mutual funds. Balanced funds of funds invest in equity and bond funds in proportions
suited to their investment goals.
Unit – 2
Security Market
Securities market helps in transfer of resources from those with idle or surplus resources to
others who have a productive need for them. To state formally, securities market provides
channels for allocation of savings to investments and thereby decouple these two activities. As
a result, the savers and investors are not constrained by their individual abilities, but by the
economy’s abilities to invest and save respectively, which inevitably enhances savings and
investment in the economy. A financial market consists of investors (buyers of securities),
borrowers (sellers of securities), intermediaries (providing the infrastructure for fair trading)
and regulatory bodies.
Security market is the market for equity, debt and derivatives, it is also called as capital market.
Indian Security Market
Capital market can be divided into:

 Primary Market
 Secondary Market
Primary Market (New Issue Market)

Primary markets serve a vital role in any economy in terms of not only effectively channelizing
the capital but also matching the risk return expectations of the investors as well as businesses
accessing the markets to raise capital. This market enables the frictionless flow of capital and
provides long term sustainability to the economy.
The surplus units in an economy are called investors. The deficit units are called issuers. In the
primary market, the surplus units supply funds to deficit units. In lieu of the funds supplied,
they receive a certificate of investment from the issuers. This certificate could be a share,
debenture or other securities.
The price at which the issue takes place in the primary market depends upon various factors
such as company fundamentals, company's future growth possibilities, and the demand‐supply
relationship at the time of issue. In addition, the broad market sentiment prevailing at that time
could also influence the issue price. It should be noted that the determination of issue price is
purely driven by the market process and the regulator has nothing to do with it except its
regulatory oversight of protecting market integrity.
The primary market is used by issuers for raising fresh capital from the investors by making
initial public offers or rights issues or offers for sale of equity or debt. The primary market
facilitates easy marketability and generation of funds for the company. It helps investors
monitor the company’s performance.
In the primary market, companies (issuers) sell shares directly to public (investors). Such a sale
could either be an Initial Public Offering or a Follow‐on offering. An IPO is the first public
offer; the subsequent public offers are called FPO. A QIP is an issue of shares to QIBs, not
offered to the public.
Factors to be considered to enter the primary market

Prospectus of the issue: An investor must read the prospectus carefully as this is the document
that gives details of the issue. The prospectus provides details about the company, the risk
factors involved, and the company’s financials. The risk factors given in the prospectus should
be reviewed. These are outlined below:
 Issue Price: When the market is buoyant, issuers could overprice the issue. Investors need
to decide if the issue is worth investing in at the price.
 Price-earnings (P/E) ratio: The P/E ratio should be analysed, the P/E multiples is the ratio
of the share price to the EPS which is given in the balance sheet. The P/E of the issue should
be compared with the industry average and other companies in that sector.
 Management of the issue: The lead managers for the issue have to be considered because
pre- and post-issue management rest heavily on the lead managers. Redressal of investors’
grievance depends on them.
 Market Sentiment: Along with other factors, market sentiment should also be considered.
In a bear run, prices usually fall after the stock lists. In a bull run, prices of the shares are
likely to zoom up. Hence, applying during the bear phase is the best way to get the shares
at its cheapest. If the investment is aimed at the long-term a changing market sediment has
little impact. If it is for the short-term, the market should be considered.
 Track record of the promoters: Investors should study the background and experience of
the promoters, management team and their expertise because they are responsible for the
profitability of the company. Analysing the track record of the promoters helps investors
avoid fly-by-night promoters and companies.
 Promoter’s holdings: The percentage of promoter holdings in a company is probably the
most significant indicators of their commitment and confidence in the venture. The structure
of their holding is also important. The transparent holding structure gives a clear view.
Often such holdings are made through a complex web of investment companies, which are
difficult to trace.
 Nature of investors: The presence of institutional investors such as venture capital funds,
commercial banks, private equity firms in the outstanding shareholders list of the company
give a positive signal. Such firms are better equipped to analyse companies. They invest
only after a detailed evaluation and are confident of the management. But they are not
infallible, and their presence in the shareholders list does not automatically make the
company investment worthy.
 Promoters and Management: Promoters of the company should have proven ability to run
successful business. Preferably, they should have sufficient experience in the same line of
business. If they are first time entrepreneurs, they should have held senior managerial
positions in companies engaged in the same business. Technical qualifications alone are not
sufficient, managerial experience is also essential.
 Financial Performance: The Company’s financial performance should be looked at
carefully. Its balance sheet is a valuable document and investors should study it carefully.
The company’s growth and focus can be understood through it.
 Business Analysis: The issue prospectus has a detailed analysis of the industry in which the
company operates and covers current developments, future growth potential, competition,
government policy etc. Studies conducted by industry bodies and associations should not
be taken as such. Sometimes they promote their interests. Projections have to be verified
with reliable data from sources like financial media, independent research organisations and
government departments.
 Government Policy: In a developing country like India, government policy can often build
or break industry fortunes. If the industry is prone to government intervention or is
politically sensitive, the company may face a lot of policy uncertainties. It may be wise to
stay away from politically sensitive business like agro-commodities and focus on
infrastructure-related business where the government has no choice but to spend more.
 Industry Analysis: The industry analysis gives a broader idea of how the company is
operating. Analysis of its competitive strengths as compared to other players in the industry
is needed. In an industry, many listed companies may be operating. Analysing the
operations of such companies can help to find the logic of the analysis provided by the
issuing company.
 Company’s product: The analysis of the company products and services would focus on
various aspects like the technology employed, design capabilities, geographic spread of the
market, market share in different segments etc. If the company is using an untested
technology or production method, the risk increases. In cases where the company operates
in a mature industry and has established products or services, one must verity the following
aspects as compared to its competition:
 Product superiority
 Technical innovation
 Market share
 Brand image
 Distribution strength
Modes of raising funds
Issues
Public Rights Preferential
IPO FPO
Offer through Book Building Private Offer for sale

Prospectus Placement
Public Issue
It is the most important method of issuing securities, a public issue involves sale of securities
to the public at large. Public issues in India are governed by the provisions of the Companies
Act 1956, ICDR Regulations of SEBI, and the listing agreement between the issuing company
and the stock exchanges. The companies act describes the procedure to be followed in offering
shares to the public and the types of information to be disclosed by the prospectus and the SEBI
guidelines impose certain conditions on the issuers besides specifying the additional
information to be disclosed to the investors.
Public Issue may be made for

 IPO
 FPO
An IPO is the first public offer; the subsequent public offers are called FPO. In a FPO, public
investors have the advantage of knowing more about the company as compared to an IPO.
An IPO or FPO may be done through:
Offer through Prospectus: According to companies Act 1985 (Amendment), application forms
for shares of a company should be accompanied by abridged prospectus. The prospectus gives
details regarding the company and invites offer for subscription or purchase of shares or
debentures from the public.
Book Building: When the price of an issue is discovered on the basis of demand received from
the prospective investors at various price levels, it is called “Book Built issue”. In this, book
building refers to the process of price discovery used in Initial Public Offerings. As per SEBI
guidelines, book building is a process undertaken by which a demand for the securities proposed
to be issued by a corporate is elicited and built‐up and the price for such securities is assessed
for the determination of the quantum of such securities to be issued. Investors bid at different
prices which may be equal to or more than the floor price and the issue price of shares is
determined at the end of the bidding period. Normally all public offerings are through the book
building route.
The issue is kept open for minimum of 3 days and a maximum of 10 days, including extension
due to price revision during which applications are received from investors. Based on investor
response, an order book is built. The order book indicates the quantities bid at different levels
of prices.
The price band can be revised during the bidding period. In such cases, the issue must be kept
open for an additional 3 days, subject to the maximum issue period of 10 days. The IPO is
finally closed after bidding is completed. After the bidding closes, the company finalizes the
issue price and completes the allotment process. The company must now update the prospectus
with information such as stock market data, audited results, etc. as applicable. The Board of
Directors of the company then meet to accept letters of underwriting, approve, sign and
authorize filing of prospectus with Registrar of Companies, note the listing application made
with the stock exchanges, authorize opening of accounts with the bankers and file the
prospectus with the Registrar of Companies, after pricing, along with material contracts and
documents.
At the end of this process the shares are allotted and transferred to the respective depository
accounts of the investors. They then become shareholders of the company.
Fixed Price Issue: When the issuer at the outset decides the issue price and mentions it in the
Offer Document, it is commonly known as “Fixed price issue”. This price is fixed in
consultation with the merchant bankers and the IPO team, based on various factors like
profitability, track record, promoters’ record, brand value, prices of similar companies, etc.
Nowadays, no public offerings are offered at fixed price. However, this route is not completely
closed. It is expected to benefit SMEs, for whom book building may not be the best option.
Smaller sized issues are still expected to use this route.
Private Placements: When an issuer makes an issue of securities to a select group of persons
not exceeding 49, and which is neither a rights issue nor a public issue, it is called a private
placement. It could be in the form of preferential allotment or a QIP.
Offer for Sale: To help Indian companies raise capital and increase public shareholding in
rough market conditions, SEBI allowed for two additional ways through which listed local
firms can sell shares without floating a public issue – IPP or the Institutional Placement Process
and the Offer for Sale (OFS) through Stock Exchanges.
IPPs can be used for both fresh issuance of capital and also for dilution of stake by promoters.
An IPP issue can be made only to QIBs. At least 25% of the issue is to be reserved for MFs
and Insurance Firms.
Every IPP must have a minimum of 10 allottees. No single investor can be given more that
25% of the total shares on offer.
The offer for sale can be compared to selling shares on the exchanges through auction. There
is a separate window for this which is open during normal trading hours. The minimum offering
in an offer for sale must be at least 1% of the paid‐up capital or Rs.25 crore worth of equity.
100% margin must be paid upfront by the bidders.
Rights Issue
When an issue of securities is made by an issuer to its shareholders existing as on a particular
date fixed by the issuer (i.e. record date), it is called a rights issue. The rights are offered in a
particular ratio to the number of securities held as on the record date.
Preferential Issues
As per the SEBI ICDR Regulations, “preferential issue” means an issue of specified securities
by a listed issuer to any select person or group of persons on a private placement basis and does
not include an offer of specified securities made through a public issue, rights issue, bonus
issue, employee stock option scheme, employee stock purchase scheme or qualified institutions
placement or an issue of sweat equity shares or depository receipts issued in a country outside
India or foreign securities. The issuer is required to comply with various provisions which
inter‐alia include pricing, disclosures in the notice, lock‐in etc, in addition to the requirements
specified in the Companies Act.
Green Shoe Option

Green Shoe Option is a price stabilizing mechanism in which shares are issued in excess of the
issue size, by a maximum of 15%. From an investor’s perspective, an issue with green shoe
option provides more probability of getting shares and also that post listing price may show
relatively more stability as compared to market volatility.
Secondary Market
While the primary market is used by issuers for raising fresh capital from the investors through
issue of securities, the secondary market provides liquidity to these instruments, through
trading and settlement on the stock exchanges. An active secondary market promotes the
growth of the primary market and capital formation, since the investors in the primary market
are assured of a continuous market where they have an option to liquidate their investments.
Thus, in the primary market, the issuer has direct contact with the investor, while in the
secondary market, the dealings are between two investors and the issuer does not come into the
picture.
The secondary market operates through two mediums, namely, the Over‐The‐Counter (OTC)
market and the Exchange Traded Market. OTC markets are the informal type of markets where
trades are negotiated. In this type of market, the securities are traded and settled bilaterally over
the counter. Indian markets have recognized OTC exchanges like the OTCEI (OTC Exchange
of India); however they do not give much volume. The other option of trading is through the
stock exchange route, where trading and settlement is done through the stock exchanges and
the buyers and sellers don’t know each other. The settlements of trades are done as per a fixed
time schedule. The trades executed on the exchange are settled through the clearing
corporation, who acts as a counterparty and guarantees settlement.
The securities traded on the stock exchanges are grouped into "listed securities" and "permitted
securities". The securities of companies which have signed a listing agreement with the
exchanges are known as listed securities. Almost all equity segment securities fall under this
category. An exchange may permit trade in unlisted securities provided they meet certain
norms specified by the exchange. Earlier, trading of securities was on the basis of open outcry
system where the brokers used to actually meet on the exchange floor for trading. This
necessitated setting up of regional exchanges in order to give liquidity to securities all over the
country. However, with the commencement of nationwide electronic trading on NSE and BSE,
the importance of the regional stock exchanges has diminished. Units of close‐ ended schemes
of mutual funds are also traded in the secondary market.
Major Players in the Secondary Market

 Companies issuing securities,
 Intermediaries & Brokers
 Public / Investors
Functions of Stock Exchanges

 Liquidity and Marketability of securities: Maintain active trading shares are traded on stock
exchanges, enabling investors to buy and sell securities. The prices may vary from
transaction to transaction. A continuous trading increases the liquidity or marketability of
shares traded on the stock exchange.
 Fix Share Prices: Prices are determined by the transactions that flow from investors’
demand and suppliers preferences. Usually the traded prices are made known to the public.
This helps investors make wise decisions.
 Safety of funds: Ensure safe and fair dealing, the rules, and regulations and by laws of the
stock exchanges provide a measure of safety to investors. Transactions conducted under
competitive conditions ensure that investors get a fair deal.
 Supply of Long term funds: A continuous market for shares provides a favourable climate
for raising capital. The negotiability and transferability of the securities help companies to
raise long-term funds. When it is easy to trade the securities, investors are willing to
subscribe the initial public offerings. This stimulates capital formation.
 Disseminate information: Stock exchanges provide information through their various
publications. They publish the share prices traded on a daily basis along with the volume
traded. The Directory of Corporate Information is useful for the investor’s assessment of
the corporations, handouts, handbooks and pamphlets provide information regarding the
functioning of stock exchanges.
 Motivation for improved performance: The prices of stock reflect the performance of the
traded companies. This makes corporates concerned with their public image and encourages
them to maintain superior performance.
 Facilitate self-regulation: The stock exchange monitors the integrity of the members,
brokers, listed companies and clients. Continuous internal audit safeguards investors
against unfair trade practices. The arbitration committees of the stock exchanges help to
settle disputes between a client and broker or disputes among brokers.
An Investor can be:

 Retail Investor - Person who buy and sell securities for their personal account
 Institutional Investor - Mutual Funds, Unit Trusts, Insurance Companies, Banks etc
 Foreign Institutional Investor (FII/FPI) - HSBC, Citigroup, Merrill Lynch, Crown
Capital, Fidelity, Goldman Sachs, Morgan Stanly, UBS, Capital International, ABN
Amro etc
Trading and Settlement Procedure

T + 2 Rolling
Activity
Settlement
Trading T
Custodial Confirmation T+1
Determination of Obligation T+1
Securities/Funds Pay-in T+2
Securities/Funds Pay-out T+2
Valuation Debit T+2
Auction T+2
Auction Pay-in/Pay-out T+3
Bad Delivery Reporting T+4
Rectified Bad Delivery Pay-in/Pay-out T+6
Re-bad Delivery Reporting T+8
Close out of re-bad delivery and funds pay-in & pay-out T+9
T+1
1.00 pm: Confirmation of all trades
2.30 pm: Processing and downloading of obligation files to brokers/custodians
T+2
10.30 am: Pay-in of securities and funds
1.30 pm: Pay-out of securities and funds
Leading Stock Exchanges in India
Bombay Stock Exchange (BSE)

The Bombay Stock Exchange Ltd is the oldest stock exchange in Asia. Popularly known as
BSE, it was established as ‘The Native Share and Stock Brokers Association’ in 1875. It is the
first stock exchange in the country to obtain permanent recognition, which was granted in 1956
from the Government of India under the SCRA. It was structured as a membership-based firm,
an association of persons. It is now a demutualized and corporatized entity. The
demutualization of BSE was completed in 2007.
The BSE shares were sold at ₹ 5,200 per share. The 800-odd brokers in BSE sold nearly half
their shareholding, constituting 41% of equity stake in the exchange. This means these
members would have collectively received ₹1,600 crore through the stake sale. The list of
investors includes six foreign entities, including Germany’s Deutsche Boerse and Singapore
Stock Exchange Ltd., (SGX), which bought 5% each recently, paying ₹ 189 crore each. The
other foreign investors in the deal are US private equity fund Atticus Mauritius Ltd and
Caldwell Asset Management. Both bought 4% in the exchange.
Listing of Securities in BSE.

A Company has to submit a letter of application to the stock exchange before filing the
prospectus with the registrar of companies. The company enters into a listing agreement with
the BSE. This agreement requires the company to make certain disclosures and perform certain
acts. If the company fails, it may face some disciplinary action, including suspension/delisting
of securities. A listing agreement is valuable. It is executed under the common seal of a
company. Under it, a company undertakes to do the following:
 To provide facilities for the prompt transfer, registration, sub-division, and consolidation
of securities.
 To give proper notice of closure of transfer books and record dates.
 To forward six companies of unabridged annual reports, balance sheets, and profit and
loss accounts to BSE and to file shareholding patterns and financial results on a quarterly
basis.
 To intimate promptly to the exchange happenings that are likely to materially affect the
financial performance of the company and its stock prices.
 To comply with the conditions of corporate governance.
Stock Market Indicators

Normally, stock markets are measured by the indices that are representative of the stocks.
However, there are other indicators also which help us measure market liquidity, value of a
portfolio, risk in a particular scrip, etc. Here are some indicators related to the Indian stock
markets.
Index and its Significance: A stock market index is a measure of the relative value of a group
of stocks. The index value depends on the value of the stocks in the group. In simple terms, if
an index increases by 2%, it means the total value of the group of stocks in that index has also
risen by 2%. There is a direct correlation between the index and the value of its group of stocks.
Giving a simple example, assuming an index called Super Index is made up of five companies.
The end of the day’s value is 2,134 points. The next day, two companies’ stock prices moved
up, one company’s stock price remained the same and two companies’ stock prices reduced.
However, the net change increased the index by 1%. So the Super index is now higher by 1%
or is at 2,155 points.
An index is a numerical representation of the value of the groups of stocks. Thus the values are
correlated A change in the value of stocks changes the value of index. The importance of an
index lies in its acting as a benchmark value to measure the performance of investments.
The major uses of indices are:

 The index can give a comparison of returns on investments in stock markets as opposed
to other investments like gold or debt, etc.
 For the comparison of performance with an equity fund, a stock market index can be the
benchmark
 The performance of the economy or any sector of the economy is indicated by the index
 Real time market sentiments are indicated by indices
 Acts us an underlying in Index Funds, Index Futures and Options in the fields of financial
investments and risk management.
Understanding Index
A group of stocks that represent the market or its segment are picked to create an index. In the
calculation of an index, a base period and a base index value is used. Indices can be used in
financial, commodities or any other markets to gather information about their movements in
price. Price movements of stocks, bonds, T‐Bills and other forms of investments are measured
by constructing financial indices. The overall behaviour of the stock markets is measured by
the movements in the stock market indices.
An index is just a benchmark of a segment or a stock market. A particular stock may not
actually follow the movement of the index. It could be higher or lower. It may also move in the
reverse direction to the index. However, on a particular day or over a particular period of time,
indices are good indicators of price movements. Investments are best measured against a
relevant index. If there is a constant lagging behind of the investment, it may be time to rethink
the strategy. However, if the investment outperforms the index, it may be good to hold.
Types of Indices
The most popular indices are the BSE Sensex (comprising 30 stocks) and the CNX Nifty of the
NSE (comprising 50 stocks). These are popular, but there are also broad based indices which
include stocks going to hundreds in number. There are also the sector indices like tech index,
bank index, consumer goods index, etc. They represent a particular segment of the economy.
Indices spanning across countries and exchanges are global indices.
Indices of Indian Stock Exchanges

BSE NSE
General indices
S&P BSE Sensex CNX Nifty
S&P BSE 100 CNX Nifty Junior
S&P BSE 200 CNX 100
S&P BSE 500 CNX 200
S&P Mid Cap CNX 500
S&P Small Cap CNX Midcap
Nifty Midcap 50
CNX Midcap 200
CNX Smallcap Index
Sectoral Indices
S&P BSE Auto CNX Auto Index
S&P BSE Banks CNX Bank Index
S&P BSE Consumer Durables CNX Energy Index
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Unit – 3
Risk & Return
Risk
The meaning of risk is the possibility of loss or injury and the degree or probability of such
loss. Risk is defined as variability in return or volatility in return. Risk is the chance of the
actual return being less than the expected return. Thus, risk means any deviation from expected
returns.
Sources of Risk
Risk emanates from several sources. The three major sources of risk are: Business risk, Interest
rate risk and Market risk.
Business Risk: As a holder of corporate security you are exposed to the risk of poor business
performance. This may be caused by a variety of factors like heightened competition,
emergence of new technology, development of substitute products, shifts in consumer
preference, in adequate supply of essential inputs, changes in government policies and so on.
Often, of course, the principal factor may be inept and incompetent management. The poor
business performance definitely affects the interest of equity shareholders, who have a residual
claim on the income and wealth of the firm. It can also affect the interest of debenture holders
if the ability of the firm to meet its interest and principal payment obligation is impaired. In
such a case, debenture holders face the prospect of default risk.
Interest Rate Risk: The changes in interest rate have a bearing on the welfare of investors. As
the interest rate goes up, the market prices of existing fixed income securities fall, and vice
versa. This happens because the buyer of a fixed income security would not buy it at its par
value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar
security.
For example: A debenture that has a face value of Rs.1,000 and a fixed rate of 10% will sell at
a discount if the interest rate moves up from say 10% to 12%. While the changes in interest
rate have a direct bearing on the prices of fixed income securities, they affect equity prices too,
albeit somewhat indirectly. The changes in the relative yields of debentures and equity shares
influence equity prices.
Market Risk: Even if the earning power of the corporate sector and the interest rate structure
remain more or less unchanged, prices of securities, equity shares in particular, tend to
fluctuate. While there can be several reasons for this fluctuation, a major cause appears to be
the changing sentiment of the investors. There are periods when investors become bullish and
their investment horizons lengthen. Investor optimism, which may border on euphoria during
such periods, drives share prices to great heights. The buoyancy created in the wake of this
development is pervasive, affecting almost all the shares. On the other hand, when a wave of
pessimism sweeps the market investors turn bearing and myopic. Prices of equity shares
register decline as fear and uncertainty pervade the market.
Types of Risks (Risk consists following components)
Total Risk = Systematic Risk risk + Unsystematic risk
Systematic Risk (Market Risk) - External factors cause unsystematic risk to a company. The
company is not able to control this risk. Systematic risk affects the market as a whole like, the
growth of GDP, the level of government spending, money supply, interest rate structure and
inflation rate. Since these factors affect all firms to a greater or lesser degree, investors cannot
avoid the risk arising from these factors, however diversified their portfolios ay be. Hence it
is also referred to as a systematic risk or non-diversifiable risk.
Unsystematic Risk (Unique Risk) – here, the factors are specific, unique and related to the
industry or company like the development of new product, a labour strike or the emergence of
new competitor. Events of this nature primarily affect the specific firm and not all firms in
general. Hence, the unique risk of a stock can be washed away by combining it with other
stocks. In a diversified portfolio, unique risk of different stocks tend to cancel each other. A
favourable development in one firm may offset an adverse happening in another and vice versa.
Hence, unique risk is also referred to as diversifiable risk and unsystematic risk.
Return
Return is the primary motivating force that drives investment. It represents the reward for
undertaking investment. Since the game of investment is about returns, measurement of
realised return is necessary to assess how well the investment manager has done. In addition,
historical returns are often used as an important input in estimating future returns.
The return of an investment consists of two components:
Current Return: The first component that often comes to mind when one is thinking about
return is the period cash flow (income), such as dividend or interest, generated by the
investment. Current return is measured as the periodic income in relation to the beginning
price of the investment.
Capital Return: The second component of return is reflected in the price changes called the
capital return. It is simply the price appreciation or depreciation divided by the beginning price
of the asset.
Total Return = Current return + Capital return
Measuring Historical Return

Holding Period Rate of Return (Total Return)
R = ((PE – PB + C1) / PB PE = Price at the beginning
PB = Price at the end
1. Price at a beginning of the year Rs.60.00, Dividend paid at
the end of year Rs.2.40, Price at the end of year Rs.69. C1= Current Return
Calculate the Total Return.
Solution:
= ((69 – 60) + 2.4) / 60
= 0.19 or 19%
Return Relative
Return Relative = (C+ PE)/ PB
Put differently:
Return Relative = 1 + Total Return
2. Following are the price and other details of three stocks for the year 2017. Calculate the
total return as well as the return relative for the three stocks.
Stock Beginning Price Dividend Paid Ending Price
A 30 3.4 34
B 72 4.7 69
C 140 4.8 146
Solution:
Stock Total Return Return Relative
A 24.7% 1.247
B 2.4% 1.024
C 7.7% 1.077
Stock A has given highest return
Cumulative Wealth Index
CWIn = WI0 (1+R1) (1+R2)…….. (1+Rn)
Where: CWIn = Cumulative wealth index at the end of n years
WI0= the beginning index value which is typically one rupee
Ri = Total return for year I (I = 1,…n)
3. Consider a stock which earns the following returns over a five year period, 1st Year 0.14,
2nd Year 0.12, 3rd Year -0.08, 4th Year 0.25 and 5th Year 0.02, What will be the Cumulative
Wealth Index at the end of five year period.
Solution:
CWI = 1 (1+0.14)(1-.08)(1+0.08)(1+0.25)(1+0.02)
= 1.50
Expected Value of Return

• Possibility that the cash inflows may not result as expected.
• Useful way to quantify the variability is to specify the probabilities.
• Probabilities of a future outcome is simply the chance that the specified amount would
occur.
• The sum of probabilities of all outcomes must be 1 because they describe all the likely
occurrences
4. An Investor has identified five possible outcomes for his return during next year.
Associated with each return is a probability or relative chance of occurrence. The five
possible outcomes are:
Return 20% 21% 22% 23% 24%
Probability 0.15 0.10 0.60 0.10 0.05
Solution:
• Different rates of return and the associated probabilities given in the above table is
known as the probability distribution of returns.
• This can be used to find out the expected return of the investment.
E(R) = Σ Pi Ri
% Expected Return Probability
Pi Ri
Ri Pi
20 0.15 3.00
21 0.10 2.10
22 0.60 13.20
23 0.10 2.30
24 0.05 1.20
Total 21.80
The Total Expected Return = 21.8%
Measuring Return from Historical Data
Arithmetic Mean
• It is the sum of total returns divided by the no. of years.
Ex: The return of 4 years are 18%, 15%, 23% and -5%
The Arithmetic average of the returns is
(18% + 15% + 23% – 5%) / 4 = 12.75%
Geometric Mean
• It is the average compounded rate of return.
• It is calculated by compounding the actual period by period return and then finding out the
equivalent per period return.
For the Above Example the Geometric Mean is
= [(1+.18) (1+.15) (1+.23) (1-.05)] 1/4 - 1
= 0.1221 or 12.21%
• A Geometric mean reflects the compounded rate of growth over time.
• A Geometric mean is always less than the arithmetic mean, except when all the return
value being considered are equal.
5. An investor invests in a share for 2 years. He gets a return @15% for first year but a loss
of 10% in next year. Find out the annual percentage cumulative rate of return of the investor.
Solution:
= [(1+.15) (1-.10)]1/2 - 1
= 1.73%
Measurement of Risk
• To gauge the extent to which the expected return and actual return are likely to differ we
use Statistical measures, they are:
Variance and Standard Deviation

Variance σ 2
σ 2 = [Σ ( X i – X )2 ] / n-1
Where: σ 2 = Variance of return X = Arithmetic mean
Xi = Return from the stock in period 1…n n = no. of periods
Standard Deviation σ
σ= [Σ (Xi - X ) 2] / n-1
or
σ= σ2
Where: Ri = Return from the stock in period 1…n
R = Arithmetic mean
n = no. of periods
σ = Standard deviation of return
When they give probabilities then

σ= Σ Pi(Ri – r ) 2
Where: Pi = Probability from period 1…n
Ri = Return from the stock in period 1…n
r = Σ Expected Return
6. The return on Securities A & B are given below:

Probability Security A Security B
0.5 4 0
0.4 2 3
0.1 0 3
Given the security of your preference. Select the security on the basis of return and risk.
Solution:
Return E(r) = R1P1+R2P2+R3P3

Security A = (4 X 0.5) + (2 X 0.4) + (0 X 0.1)
E(r) = 2 + 0.8 = 2.8
Security B = (0 X 0.5) + (3 X 0.4) + (3 X 0.1)
E(r) = 1.5
Return wise security A’s is higher
Risk:
σ = Σ Pi(Ri – r ) 2
Return RiPi X-X (Xi – X) 2 Pi(Xi - X ) 2

adadfdfad
A B A B A B A B
0.5 4 0 2 0 1.2 -1.5 1.44 2.25 0.72 1.13
0.4 2 3 0.8 1.2 -0.8 -0.3 0.64 0.09 0.26 0.04
0.1 0 3 0 0.3 -2.8 -1.2 7.84 1.44 0.78 0.14
X = (ƩRiPi ) 2.8 1.5 1.76 1.31
Stock A
σ= 1.76
= 1.33
Stock B
σ= 1.31
= 1.14
7. Consider the return from a stock over a 6 year period, R1 = 15%, R2 = 12%, R3= 20%, R4
= -10%, R5 =14%, R6 = 9%. Calculate the Variance and Standard Deviation for the returns.
Solution:
Period Return Deviation Square of deviation
Ri (Ri – R) (Ri – R) 2
1 15 5 25
2 12 2 4
3 20 10 100
4 -10 -20 400
5 14 4 16
6 9 -1 1
Σ Ri = 60 Σ (Ri - R ) 2= 536
R = 10
Variance σ 2
σ2= [Σ ( R i – R )2 ] / n-1
= 536 / 5
= 107.5
Standard Deviation σ
σ= [Σ (Ri - R ) 2] / n-1
= 536 / 5
= 10.4
Measuring Expected Return and Risk

Probability Distribution
• Suppose you say that there is a 4 to 1 chance that the market price of a stock A will rise
during the next fortnight.
• This implies that there is an 80% chance that the price of stock A will increase and a
20% chance that it will not increase during next fortnight.
• It can be represented in the form of probability distribution as follows:
Outcome Probability
Stock price will rise 0.80
Stock price will not rise 0.20
8. Consider two equity stocks, Pioneer Foods Stock and Sony Shipping stock. Pioneer Stock
may provide a return of 6%, 11% or 16% with a certain probabilities associated with them,
based on the state of economy. The second stock Sony Shipping Stock being more volatile,
may earn a return of – 20%, 10% or 40% with the same probabilities, based on the state of
economy. From the following details find out the expected rate of return and risk
associated with the return for both the stocks.
Probability Distribution of the Rate of Return

State of Economy Probability of Rate of Return (%)
Occurrence
Pioneer Foods Sony Shipping
Boom 0.30 16 40
Normal 0.50 11 10
Recession 0.20 6 -20
Solution:
For Pioneer Foods
State of
Economy Pi Ri PiRi Ri-E(R) (Ri-E(R))2 Pi(Ri- (R))2
Boom 0.30 16 4.8 4.5 20.25 6.075
Normal 0.50 11 5.5 -0.5 0.25 0.125
Recession 0.20 6 1.2 -5.5 30.25 6.050
11.5 12.25
E(R)= Σ RiPi Σpi (Ri - E(R))2
Expected Rate of Return

Expected rate of return is the weighted average of all possible returns multiplied by their
respective probabilities.
E(R) = Σ RiPi
The expected rate of return of Pioneer Foods stock is:
E(Ri) = (0.30)(16%)+(0.50)(11%)+(0.20)(6%)
= 11.5%
Risk Associated with Return

σ 2 = Σ Pi (Ri - E(R))2
= 12.25
σ= σ2
= 3.5%
For Sony Shipping
State of
Economy Pi Ri PiRi Ri-E(R) (Ri-E(R))2 Pi(Ri- (R))2
Boom 0.30 40 12.0 27 729 218.70
Normal 0.50 10 5.0 -3 0.25 4.5
Recession 0.20 -20 -4 -33 1089 217.8
13 441
E(R)= Σ RiPi Σpi (Ri - E(R))2

Expected rate of return is the weighted average of all possible returns multiplied by their
respective probabilities.
E(R) = Σ RiPi
The expected rate of return of Pioneer Foods stock is:
E(Ri) = (0.30)(40%)+(0.50)(10%)+(0.20)(-20%)
= 13%
Risk Associated with Return

σ 2 = Σ Pi (Ri - E(R))2
= 441
σ= σ2
= 21%
Coefficient of Variation
 Standard deviation cannot be used for comparing the risk of two or more investment.
 Standard deviation is an absolute measure of risk and does not consider the dispersion of
expected return in relation to expected values.
 It can be done by using Coefficient of Variation.
 CV is calculated by dividing the Standard Deviation for the investment by expected
Return.
CV = Standard Deviation/Expected Return.
 A Risk Averse investor should prefer investment with higher return and lower risk (i.e.
Lower Standard deviation).
 Out of two investment options having equal returns, the investor would opt for that
investment which has relatively low risk.
 If two investment options have same risk, then the investor would opt for that investment
which has the higher return.
9. A had purchased a bond at a price of Rs.800 with a coupon payment of Rs.150 and sold it
for Rs.1000. (i) what is his holding period return, and (ii) if the bond is sold for Rs.750
after receiving Rs.150 as coupon payment, then what is his holding period return?
Solution:
(i) Holding Period Return
= (1000 – 800 + 150)/800
= 43.75%
(ii) = (750 – 800 + 150) / 800

= 12.5%
10. Following information is available in respect of the return from Security X under different
economic conditions:
Economic Conditions Return Probability
Good 20% 0.1
Average 16% 0.4
Bad 10% 0.3
Poor 3% 0.2
Find out the expected return of security and the risk associated with that.
Solution:
Eco Cond Return (Ri) Prob (Pi) Ri Pi Pi (Ri - E(R) 2

Good 20 0.10 2.00 6.4
Average 16 0.40 6.40 6.4
Bad 10 0.30 3.00 1.2
Poor 3 0.20 0.60 16.2
12.00 30.2
The expected return is 12%
Risk = σ = [Σ Pi (Ri - E(R))2]1/2
= [30.2]1/2
= 5.6%
11. In a portfolio of the company, Rs.2,00,000 have been invested in asset X which has an
expected return of 8.5%, Rs.2,80,000 in asset Y which has an expected return of 10.2%
and Rs.3,20,000 in asset Z which has an expected return of 12%. What is the expected
return for the portfolio?
Solution
Weight Return
Asset Amount Wi Ri
(Wi) (Ri)
X 200,000 0.25 8.5 2.13
Y 280,000 0.35 10.2 3.57
Z 320,000 0.4 12 4.80
800,000 10.50
The expected return for the portfolio is 10.5%
12. The market price of an equity share is Rs.100. Following information is available in
respect of dividends, market price and the expected market condition after one year:
Market condition Prob. Market Price Dividend
Good 0.25 Rs. 115 Rs.9
Normal 0.50 Rs.107 Rs. 5
Bad 0.25 Rs.97 Rs.3
Find out the expected return and variability of returns of the equity shares.
Solution:
Mkt Prob Market Dividend Tot Amt. Tot Ret
Cond (Pi) Price Rec Cost (Ri) Ri Pi
Good 0.25 115 9 124 100 24 6
Normal 0.50 107 5 112 100 12 6
Bad 0.25 97 3 100 100 0 0
12
Expected Return E(R) = 12%
The variability of return can be studied in terms of Standard Deviation
σ2 = Pi (Ri - E(R)2
= 0.25(24 – 12)2 + 0.50(12 – 12)2 + 0.25(0 – 12)2
= 36 + 0 + 36
σ2 = 72
σ = 72 ½
= 8.49
13. Following information is available in respect of three securities, A,B and C
Security Expected Return Risk σ
A 18% 20%
B 10% 12%
C 10% 15%
Does any security dominates other one? Also calculate coefficient of variation of all these
securities. Explain how an investor would select a security?
Solution:
Security B and C have equal expected return of 10%, but the risk of security B is less than
C so security B dominates over C
C V of A = σ / E(R)
= 20 /18 = 1.11
B = 12/10 = 1.20
C = 15/10 = 1.5
A risk averse investor would like to invest in Security A as it is having less C.V
14. From the following information about the closing market price and annual dividend on a
shares, calculate the Arithmetic Average and Geometric Average return.
Year Closing MP Annual Dividend
2007 Rs. 74.60 -
2008 64.30 Rs.3.44
2009 67.70 3.44
2010 56.70 3.44
2011 96.25 3.44
2012 122.00 3.71
Solution:
Year MP Change in MP Dividend Tot Ret % of Ret
2007 74.60 - - - -
2008 64.30 -10.30 3.44 6.86 -9.20
2009 67.70 3.40 3.44 6.84 10.64
2010 56.70 -11.00 3.44 7.56 -11.17
2011 96.25 39.55 3.47 43.02 75.87
2012 122.00 25.75 3.71 29.46 30.61
96.76
Arithmetic Average = 96.76 / 5 = 19.35
Geometric Average = [(1-0.920)(1+0.1064)(1-0.1117)(1+0.7587)(1+0.3061)]1/5 – 1
= [2.0493]1/5 – 1
= 1.154 – 1 = 0.154
= 15.4%
15. A Mutual Fund having 300 units has shown its NAV of Rs.8.75 and Rs.9.45 at the
beginning and at the end of year respectively. The Mutual Fund has given two options:
(i) Pay Rs.0.75 per unit as dividend and Rs.0.60 per unit as a capital gain or
(ii) These distributions are to be reinvested at an average NAV of Rs.8.65 per unit.
What difference it would make in terms of return available and which option is preferable?
Solution:
Option I:
Change in Price (9.45 – 8.75) = Rs. 0.70
Dividend income = Rs. 0.75
Capital gain = Rs. 0.60
Total Income = Rs. 2.05
Holding Period Return = 2.05 / 8.75 = 0.2343 i.e 23.43%
Option II:
Amount available for reinvestment (0.75 + 0.60) = Rs. 1.35
Total Amount for 300 units (300 * 1.35) = Rs. 405.00
Rate per unit for Reinvestment = Rs. 8.65
No. of Units purchased (405 / 8.65) = 46.82
Total Units (300 + 46.82) = 346.82
Purchase cost (300 * 8.75) = Rs.2625.00
Market Value now (346.82 * 9.45) = Rs.3277.45
Gain = Rs. 652.45
Holding Period Return = 652 / 2625 = 0.2485 = 24.85%
So Option II is preferable
16. The risk and return characteristics of the two projects are shown below:
X Y
Expected return 12% 20%
An investor plans to invest 80% of its available funds in Project X and 20% in Y. Find out the
return of the portfolio of X and Y.
Solution:
The expected return of the portfolio is:
Investment E (R) Proportion Weighted Return

X 12% 0.8 9.6
Y 20% 0.2 4.00
13.6
Expected Portfolio Return is 13.6%
Unit – 4
Valuation of Securities
Bond Valuation
A bond is a contract that requires the borrower to pay an interest income to the lender. It
resembles the promissory note and is issued by governments and/or corporations. The par
value of the bond indicates the value of the bond. i.e the value stated on the bond paper.
Generally, the face value of bonds are ₹ 1,000, ₹ 2,000, ₹ 5,000 and the like. Most bonds offer
fixed interest payments till their maturity. This specific rate of interest is known as the coupon
rate. Coupons are paid quarterly, semi-annually and annually. At the end of the maturity
period, the value is repaid.
Risks in Bond
Generally stocks are considered to be risky but bonds are not, this is not absolutely correct.
Bonds do carry risk. But the nature and types of risks are different. The risks are related to the
interest rate default, marketability and culpability.
Interest Rate Risk: Variability in the return from debt instruments to investors is caused by the
changes in the market interest rate, this is known as interest rate risk. Changes in interest rates
affect bonds more directly than they affect equity. There is a relationship between the coupon
rate and market interest rate. If the market interest rate moves up the price of the bond declines
and vice versa.
Default Risk: The failure to pay the agreed value of the debt instrument by the issuer in full,
on time or both is known as default risk. Treasury bills and bonds issued by the central
government are devoid of this risk. The same cannot be assured of bonds/debentures issued
by the corporate bodies. Default risk can arise because of macroeconomic factors or firm-
specific factors. The macroeconomic factors affect the overall system. In the case of the CRP
Capital Market, the bankruptcy had more to do with firm-specific factors such as inefficient
management, rather than macroeconomic factors.
One of the steps taken to avoid default risk is to have rating agencies rate the capacity of a
company to serve the debt. Regulators use credit rating to determine the eligibility of the fixed
income instruments. The CRISIL, ICRA and CARE rate bonds and other fixed income
securities. In the international bond market Moody’s investor services and Standard and Poor’s
rating are well known.
Marketability Risk: Variation in return caused by difficulties in selling the bonds quickly
without having to make a substantial price concession is known as marketability risk. The risk
is different from the market risk that affect all securities in the market in that it is a specific
risk. The marketability or liquidity of a particular bond depends on the corporate entity that
issues it. There is a possibility of a particular company’s bond becoming illiquid owing to the
downgrading of the bond’s rating by the rating agencies. The managerial inefficiencies and fall
in profits may create a fear in the minds o investor, and they may not be willing to buy such
bonds in the secondary market. Sometimes, a particular instrument of a company whose other
instruments enjoy good liquidity may be illiquid. If an investor has to sell such illiquid
investments, he may be forced to sell it at a high discount.
Callability Risk: The uncertainty created for the investor’s return by the issuer’s ability to call
the bond at any time is known as Callability risk. Debt instruments used to carry a call option.
The call option provides the issuer the right to call back the instrument by redeeming them.
The facility provides a way out for the issuer if the market interest rate declines. The issuer
can call the bond with high interest rate and again raise funds at a lower interest rate. Since the
bond or debentures can be called at any time, there is a uncertainty regarding the maturity
period. This features of the bond may depress the price of the bond and the uncertainty element
attached to callable bonds market the investors as for higher yields.
Types of Bonds
Government Bonds: The largest borrowers in India and in most other countries are the central
and state governments. The Government of India periodically issues bonds which are called
government securities (G-Secs) or gilt-edged securities. These are essentially medium to long-
term bonds issued by the RBI on behalf of Government of India. Interest payments on these
bonds are typically semi-annual. State government also sell bonds. These are also essential
medium to long-term bonds issued by the RBI on behalf of state governments. Interest
payments on these bonds are typically semi-annual.
Apart from central and state governments, a number of governmental agencies issue bonds that
are generated by the central government or some state government.
Corporate Bonds: Companies like the governments, borrow money by issuing bonds called
corporate bonds. Internationally a secured corporate debt instrument is called a corporate bond
whereas an unsecured corporate debt instrument is called a corporate debenture. In India,
corporate debt instruments have traditionally been referred to as debentures, although typically
they are secured.
Straight Bonds: The straight bond (also known as plain vanilla bond) is the most popular type
of bond. It pays a fixed period coupon over its life and return the principal on maturity date.
Zero Coupon Bond: A zero coupon bond does not carry any regular interest payment. It is
issued at a steep discount over its face value and redeemed at face value on maturity.
Floating Rate Bonds: Straight bonds pay a fixed rate of interest, floating rate bonds on the
other hand pay an interest that is linked to a benchmark rate such as the T-Bill Yield.
Bonds with Embedded Options: Bonds may have options embedded in them. These options
give certain rights to investor and/or issuers. The more common types of bonds with embedded
options are:
 Convertible bonds: Convertible bonds give the bond holder the right to convert them
into equity share on certain terms.
 Callable Bonds: Callable bonds give the issuer the right to redeem them prematurely on
certain terms.
 Puttable Bonds: Puttable bonds give the investor the right to prematurely sell them back
to the issuer on certain terms.
Commodity Linked Bonds: The payoff from a commodity linked bond depends to a certain
extent on the price of a certain commodity.
Assumptions for valuation of Bond

• The coupon interest rate is fixed for the term of the bond.
• The coupon payments are made every year and the next coupon payment is receivable
exactly a year from now
• The bond will be redeemed at par on maturity.
Determinants of Interest Rates

Other things being equal, the price of a bond falls when the required rate of return rises and the
price of a bond rises when the required rate of return falls. Since the required rate of return has
an important bearing on bond price, you should know what drives the required rate of return,
which will hereafter for the sake of simplicity be referred to as the interest rate?
The interest rate on a bond is determined by four factors or variables: Short-term risk free
interest rate, maturity premium, default premium, and special features.
Short term Risk-free Interest Rate: The short-term risk-free interest rate is the yield on a
one-year government security, say a 364 day Treasury bills (note that government securities
are considered to be risk-free because the government is not expected to default on its
obligations). This may be decomposed into two parts:
Short-term risk-free interest rate = Expected real rate of return + expected inflation.
Expected Real Rate of Return: Intuitively, the expected real rate of return represents the rate
at which society is willing to trade current consumption for future consumption. For example,
if the society is willing to give up 100 units of real goods in return for 103 units a year from
now, the expected real rate of return is three percent. As there is a preference for current
consumption over future consumption, the expected real rate is positive, but it tends to vary
widely across time and across economies.
Maturity Premium: Maturity premium represents the difference between the yield to maturity
on a short-term risk-free security and the yield to maturity on a risk-free security of a longer
maturity. The maturity premium increases with time.
Default Premium: while there is no risk of default on government securities, corporate bonds
may default on interest and or principal payment. When such a possibility exists, investors
will ask for a default premium in addition of course to the maturity premium.
The default premium increases with default risk which inter alia is a function of the following:
 The business risk of the issuer as reflected in the volatility of its operating income
 The financial risk of the issuer measured usually by the ratio of outside liabilities to
shareholders funds.
 The size of the business and the value of collateral assets that are offered as security.
Credit rating agencies consider these factors and several others and express their opinion on
default risk through their rations.
Special Features: The factors discussed above determine the interest rate on a plain vanilla
bond, i.e a bond which pays a fixed amount of interest periodically and certain principal sum
at a given maturity date. While plain vanilla bonds remain popular bonds often have some
special features. They may have a call feature or a put feature, they may be convertible, partly
or fully, into equity shares on certain terms, they may carry a floating rate of interest, rathan
than a fixed rate of interest,, they may be zero coupon bonds issued at deep discount and
redeemed at par so on and so forth.
Bond Value = Present Value of Coupons + Present Value of Maturity Value
B0 = (C * PVAF r, n) + (M * PVF r, n)
Bond Return
When an investor buys a bond and sells it after holding it for a while, the rate of return in that
holding period is called the holding period return.
Price gain / loss during the holding period + Coupon Interest rate if any
Holding period return =
Price at the beginning of the holding period
1. An investor purchases a bond at ₹ 950 with ₹ 80 as coupon payment and sells at ₹ 1,000.
What is his holding period return? If the bond is sold for ₹ 800 after receiving ₹ 80 as coupon
payment, what is the holding period return?
Solution:
50 + 80
950
= 13.68%
50 + 80
950
= 7.37%
Current Yield
• Annual coupon interest to the market price.
Current Yield = (Int / B0) * 100

Where: Int = Annual Interest Amount,
B0 = Current Market Price of Bond
2. Find the value of the bond with a maturity period of 10 year, 12% coupon bond with a par
value of ₹.1, 000, required yield on this bond is 13%.
Solution:
 10 annual coupon payments of ₹ 120
 ₹ 1,000 principal repayment 10 years from now
The Bond Value is:

B0 = (120 X 5.426) + (1,000 X 0.295)
= 651.1 + 295
B0 = 946.1
3. A ₹ 1000 bond matures in 20 years and offers a 9% coupon rate. The required rate of return
is 11%. Compute the bond’s Value.
Solution:
The annual interest payment is ₹ 90. At the end of the year 20, the bondholder receives ₹ 90
interest payment and the ₹ 1,000 par value.
B0 = (C * PVAF r, n) + (M * PVF r, n)
B0 = (90 X 7.963) + (1,000 X 0.124)
B0 = 716.67 + 124
B0 = 840.67
4. A ₹ 5,000 bond with a 10% coupon rate matures in 8 years and currently sells at 97%. Is
this bond a desirable investments for an investor whose required rate of return is 11%.
B0 = (C * PVAF r, n) + (M * PVF r, n)
B0 = (500 X 5.146) + (5000 X 0.434)
B0 = 2573 + 2170
B0 = 4743
Current Price: 97% of 5,000 = 4,850
Since the bond is available at a price higher than its present value of returns, the investment
is bond is not desirable.
5. A Bond of ₹ 1,000 bearing a coupon rate of 12% is redeemable at par in 10 years. Find the
value of the bond if:
i. Required rate of return is 12% or 10% or 14%
ii. Required rate of return is 14% and the maturity period is 8 years or 12 years
iii. Required rate of return is 12% and redeemable at ₹ 950 or at ₹ 1,050 after 10 years.
Solution:
If required rate of return is 12%
B0 = (120 X 5.650) + (1000 X 0.322)
= 678 + 322
B0 = ₹ 1,000

B0 = (120 X 6.145) + (1000 X 0.386)
= 737.4 + 386
B0 = ₹ 1,123.4

B0 = (120 X 5.216) + (1,000 X 0.270)
= 625.92 + 270
B0 = ₹ 895.92
If Maturity period is 8 Years with required rate of return of 14%

B0 = (120 X 4.639) + (1,000 X 0.351)
= 556.68 + 351
B0 = Rs.907.68
Maturity period is 12 Years with required rate of return of 14%

B0 = (120 X 5.660) + (1,000 X 0.208)
= 679.20 + 208
B0 = Rs.887.20
Required rate of return is 12% and redeemable at ₹ 950 after 10 years.

B0 = (120 X 5.650) + (950 X 0.322)
= 678 + 305.9
B0 = Rs.983.90
Required rate of return is 12% and redeemable at ₹ 1,050 after 10 years

B0 = (120 X 5.650) + (1,050 X 0.322)
= 678 + 338.10
B0 = ₹ 1,016.10
6. The ILU & Co., is contemplating a debenture issue on the following terms:
Face Value = ₹ 100 per Debenture
Term to Maturity = 7 years
Coupon Rate of Interest:
Year 1 – 2 8% p.a
3 – 4 12% p.a
5 – 7 15% p.a
The current market rate of interest on similar debentures is 15% pa. The company proposes
to price the issue so as to yield a (compounded) return of 16% pa to the investor. Determine
the issue price assuming that the redemption of debenture will be at a premium of 5%.
Solution:
The interest payments over the life of the debentures and their present values are as follows:
Year Interest (₹.) PVF @ 16% PV of Interest
1 8 0.862 6.896
2 8 0.743 5.944
3 12 0.641 7.692
4 12 0.552 6.624
5 15 0.476 7.140
6 15 0.410 6.150
7 15 0.354 5.310
Total 45.756
The present value of the redemption amount of ₹ 105 (₹ 100 + ₹ 5) @ 16% is
(105 * 0.354) = 37.17
Therefore the present value of the debenture is ₹ 45.76 + 37.17 = 82.93. The company
should issue the debenture at this value in order to yield a return of 16% to the investor.
7. A 7% Bond was issued several years ago when the market interest rate was also 7%. Now,
the bond has a remaining life of 3 years when it would be redeemed at par, ₹ 1,000. The
market rate of interest has increased to 8%. Find out the current market price, price after 1
year and price after 2 years from today.
Solution:
The market price on various dates can be found as the present value (at 8%) of the remaining
payments after that date. So, the market prices would be:
Current price = (C * PVAF 8, 3) + (M * PVF 8, 3)

= (70 * 2.577) + (1,000 * 0.794)
= 974.39
After 1 Year = (C * PVAF 8, 2) + (M * PVF 8, 2)

= (70 * 1.783) + (1,000 * 0.857)
= 981.81
After 2 Year = (C + R V) * PVF 8, 1)

= (70 + 1,000) * 0.926
= 990.82
8. ABC Company has sold ₹ 1,000, 12% perpetual debentures 10 years ago. Interest rates have
risen since then, so that debentures of this company are now selling at 15% yield basis.
a. Determine the current indicated/expected market price of the debentures. Would you buy
the debentures for ₹ 700? What is the yield?
b. Assume that the debentures of the company are selling at ₹ 825. If the debentures have
8 years to maturity, compute the approximate effective yield an investor would earn on
his investment?
Solution:
i) The expected market price of the debenture may be found as follows:
The annual interest on perpetual debenture is Rs.120 and yield is 15%. So, the market
price may be:
₹ 120 / 0.15 = ₹ 800
If the debenture is available at ₹ 700, it can be bought and the yield in that case would
be:
₹ 120 / 700 = 17.14%
ii) The approximate yield on debenture investment may be found by using the YTM
formula as follows:
Approximate Yield = MV - B0
C+
N
Y=
RV + B0
2
= [120 + (1000 – 825) / 8] / [(1000 + 825) / 2]

= 15.55%
9. Swapna Ltd., issues a 14% 10 year bond with face value and maturity value of ₹ 1,000.
What is the value of the bond if the required rate of return is i) 12%, ii) 14% or iii) 16%?
Examine the difference in values.
Solution:
The value of the bond may be found by discounted the future cash flows at the required
rate as follows:

Value = (C * PVAF 12, 10) + (M * PVF 12, 10)
= (140 * 5.650) + (1,000 * 0.322)
= 1,113

Value = (C * PVAF 14, 10) + (M * PVF 14, 10)
= (140 * 5.216) + (1,000 * 0.270)
= 1,000

Value = (C * PVAF 16, 10) + (M * PVF 16, 10)
= (140 * 4.833) + (1,000 * 0.227)
= 903.62
The difference in values of the bond can be related to the required rate of return. The
coupon rate of the bond is 14%. When the required rate is 14%, both are same and the
value of the bond is equal to the face value. However when the required rate is 12% as
against the coupon rate of 14% the value is ₹ 1,113 which is more than the face value,
similarly when the require rate is 16%, the value is only ₹ 903.62, so the required rate of
return and value of the bond are inversely related.
Bond Value with Semi-annual Interest

• The annual interest payment C must be divided by two to obtain the semi-annual interest
payment.
• The number of years to maturity must be multiplied by two to get the number of half-yearly
periods.
• The discount rate has to be divided by two to get the discount rate applicable to half-yearly
periods.
B0 = [(C/2) * PVAF r/2, 2n] + [M * PVF r/2, 2n]
C = Annual Interest B0 = Current Market Price of Bond

M = Maturity Value
10. Find the value of a Bond of 8 year with 12% coupon with a par value of ₹ 1,000 on which
interest is payable semi-annually, the required return on this bond is 14%.
Solution:
B0 = [(120 /2) * 9.447) + (1,000 X 0.339)
= 566.82 + 339
B0 = ₹ 905.82
11. Following information is available in respect of a bond:

Face Value: ₹ 1,000 Coupon Rate: 8% Life : 3 Years
Maturity: At Par Expected Yield: 10%
How much price an investor should be ready to pay for the bond if the interest is payable
half yearly or yearly basis?
Solution:
Valuation of Bond if interest is payable half yearly:
B0 = [(C/2) * PVAF r/2, 2n] + [M * PVF r/2, 2n]
B0 = [(80/2) * PVAF 5, 6] + [1,000 * PVF 5, 6]
= (40 * 5.076) + (1,000 * 0.746)
= 949.04
Valuation of Bond if the interest is payable yearly:

B0 = (80 * PVAF 10, 3) + (1,000* PVF 10, 3)
= (80 * 2.487) + (1,000 * 0.751)
= 949.96
It may be noted that different values are obtained for annual and semi-annual interest
payments. In both the cases, the value is less than the par value because the required yield
(10%) is more than the coupon rate (8%).
Zero Coupon Bond

• No periodic interest payments
• Sold at a deep discount from face value.
• The buyer of the bond receives a return by the gradual appreciation of the security,
which is redeemed at face value on a specified maturity date.
• The greater the length until a zero-coupon bond's maturity, the less the investor
generally pays for it.
B0 = M / (1+r)n
Where: B0 = price M = maturity value
r = investor's required annual yield n = number of years until maturity
12. If you want to purchase a Company XYZ zero-coupon bond that has a ₹ 1,000 face value
and matures in three years, and you would like to earn 10% per year on the investment, what
is the amount you will pay for the bond.
Solution:
B0 = 1,000 / (1+.10)3
= 751
13. Zero coupon Bond with a face value of ₹ 1,000 and maturity period of 5 years is being
traded at ₹ 700 each. What is the YTM of the bond?
Solution:
FV = B0 (1+YTM) n
YTM = (FV / B0) 1/5 – 1
= (1000 / 700) 1/5 – 1
YTM = 0.7394 or 7.394%
Price Yield Relationship

• Bond Price varies inversely with yield.
• As required yield increases, the present value of cash flow decreases.
• When required yield decreases the price increases.
Relationship between Bond Price and Time

• Bond prices must equal its par value at maturity
• Bond Price change with time.
Bond Yields
• Bonds are generally traded on the basis of their prices
• Bonds are typically compared in terms of yields.
Commonly employed Yield measures are:

1. Current Yield
2. Yield to Maturity (YTM)
3. Yield to Call (YTC)
4. Realised Yield on Maturity (RYTM)
Current Yield
• Annual coupon interest to the market price.
Current Yield = (Int / B0) * 100

Where: Int = Annual Interest Amount, B0 = Current Market Price of Bond
Yield to Maturity (YTM)

• Using the information on Bond Price, Maturity date and Coupon payments YTM will
be calculated.
• YTM required a trial and error procedure.
B0 = [C * PVAF r, n] + [M * PVF r, n]
The Procedure for linear interpolation is as follows

a. Find the difference between the present value for two rates
b. Find the difference between the present value corresponding to the lower rate and the
target value
c. Divide the outcome of (b) with the outcome of (a). This gives the YTM
d. Add the outcome of (c) to lower rate.
14. A bond of ₹ 1,000 par value, carrying a coupon rate of 9%, maturing after 8 years. The
bond is currently selling for ₹ 800. What is the YTM on this bond?
Solution:
Let us begin with r = 12%
B0 = [C * PVAF r, n] + [M * PVF r, n]
= (90 * 4.968) + (1,000 * 0.404)
= 447.12 + 404
= 851.12
By Putting 12% for r we get ₹ 851.12
Since the value is greater than ₹ 800, we may have to try a higher value for r,
Let try r =14%

B0 = [C * PVAF r, n] + [M * PVF r, n]
= (90 * 4.639) + (1,000 * 0.351)
= 417.51 + 351
= 768.51
Since the value is less than ₹ 800, we try a lower value for r,
Let us try r = 13%

B0 = [C * PVAF r, n] + [M * PVF r, n]
= (90 * 4.799) + (1,000 * 0.376)
= 431.91 + 376
= 807.91
Thus r lies between 13 percent and 14 percent. Using a linear interpolation in the range
13 percent to 14 percent, we will find r
a. Find the difference between the present values for two rates, which in this case is
₹.39.4 (₹ 807.91 - 768.51).
b. Find the difference between the present value corresponding to the lower rate (₹
807.91 at 13%) and the target value (₹ 800), which in this case is ₹ 7.91
c. Divide the outcome of (b) with the outcome of (a)., which is 7.91/39.4 = 0.20.
d. Add this fraction (c) to the lower rate i.e 13 Percent.
This gives the YTM of 13.2 percent.
15. There is a 9% 5-year bond issue in the market. The issue price is ₹ 90 and the redemption
price is ₹ 105. For an investor with marginal income tax rate of 30% and capital gain tax
rate of 10% (assuming no indexation), what is the post-tax yield to maturity?
Solution:
In this case, the yield to maturity may be found as the IRR between the inflows and
outflows of the bond. The annual interest inflow would be ₹ 9 * (1 - 0.3) = ₹6.30, and the
redemption inflow would be ₹ 105 – (105 – 90) * 0.10 = ₹ 103.50.
Now the yield may be calculated as follows:

₹ 90 = 6.3 * PVAF (r, 5) + 103.50 * PVF (r, 5)
At 9% the value is
= (6.3 * 3.90) + (103.5 * 0.650)
= 91.78
At 10% the value is
= (6.3 * 3.791) + (103.5 * 0.621)
= 88.15
Interpolation between 9% and 10%:

= 9 + [(91.78 – 90) / (91.78 – 88.15)]
= 9.49% / 9.45%
16. An investor is considering the purchase of following bond:

Face value : ₹ 100 Coupon Rate: 11%
Maturity : 3 Years
i) If he wants a yield of 13%, what is the maximum price he should be ready to pay for?
ii) If the bond is selling for ₹ 97.60, what would be his yield?
Solution:
Calculation of maximum price. The price which will give yield of 13% to the investor may
be found as follows:
B0 = [C * PVAF 13, 3] + [M * PVF 13, 3]
B0 = [11 * 2.361] + [100 * 0.693]
= 95.27
Calculation of yield. If the bond is selling at ₹ 97.60 which is more than the fair value, the
YTM of the bond would be less than 13%
At 12% the value = (11 * 2.402) + (100 * 0.712)
= ₹ 97.62
The value is almost equal to the amount price of ₹ 97.60. Therefore the YTM of the bond
would be 12%.
Face value ₹ 10,000
Market Price ₹ 8,790
Coupon Rate 8%
Investors Yield 10%
Time to Maturity 4 years
Find out the YTM and Intrinsic value of the bond. Should an investor buy this bond based
on the YTM and intrinsic value?
Solution:
Calculation of YTM
₹ 8,790 = [800 * PVAF k, 4] + [10,000 * PVF k, 3]
At 11% the value is = (800 * 3.102) + (10,000 * 0.659)
= 9,071.60
At 12% the value is = (800 * 3.037) + (10,000 * 0.636)
= 8,789.60
At 12% the value is almost equal to the current market price. So, the YTM of the bond
may be taken at 12%.
Calculation of Intrinsic Value at 10%

B0 = [800 * PVAF 10, 4] + [10,000 * PVF 10, 4]
= (800 * 3.170) + (10,000 * 0.683)
= 9,366.
Decision to Buy: the YTM of the bond is 12% where as the required rate of return of the
investor is 10%. The intrinsic value of the bond is ₹ 9,366 whereas the market value is only
₹ 8,790. So he can buy the bond.
18. 11% bonds of Zoo Ltd., ( F V of ₹ 100 and maturity of 3 years) are being traded in the
market find out:
a. Fair value of the bond if the required rate of return of the investor is 13%
b. YTM of the bond, if it is being traded at ₹ 97.60
c. Why the YTM in (ii) above is different from required rate of return in (i) above? How
it can be justified?
d. Duration of the bond
e. If the investor has a horizon of 2 year or 3 years, why bond is risky?
Solution:
i) Fair value of the bond is:
B0 = [11 * PVAF 13, 3] + [100 * PVF 13, 3]
= (11 * 2.361) + (100 * 0.693)
= 95.27
ii) YTM of the bond:

₹ 97.60 = [11 * PVAF YTM, 3] + [100 * PVF YTM, 3]
By trial and error, YTM is found to be 12%
iii) YTM is different from required rate of return because it is being traded at a different
price than the fair price. As the market price is higher than the fair price, the YTM is
lesser than the required rate of return.
iv) Duration of the bond:

Year (T) C F PVF (YTM, M) PV T * PV W T*W
1 11 0.893 9.82 9.82 0.10 0.10
2 11 0.797 8.76 17.52 0.09 0.18
3 111 0.712 79.02 237.06 0.81 2.43
97.60 264.40 1.00 2.71
or
Duration =264.40 /97.360 = 2,71 Years
v) If the investor has a horizon of 2 years or 3 years, then he is subjected to future price
risk and future reinvestment rate-risk. So, the bond becomes risky for him.
19. A 5% Bond with face value of ₹ 1,000 is being traded in the market at ₹ 1,000. It is
redeemable at par after 10 years. Find out the duration of the bond if the required rate of
return or YTM of the investor is 5%.
Solution:
The duration of the bond may be found as follows:
Year CF PVF PV W T & PV W&T
1 50 0.952 47.60 0.048 47.60 0.048
2 50 0.907 45.35 0.045 90.70 0.090
3 50 0.864 43.20 0.043 129.60 0.129
4 50 0.823 41.15 0.041 164.60 0.164
5 50 0.784 39.20 0.039 196.00 0.195
6 50 0.746 37.30 0.037 223.80 0.222
7 50 0.711 35.55 0.036 248.85 0.252
8 50 0.677 33.85 0.034 270.80 0.272
9 50 0.645 32.25 0.032 290.25 0.288
10 1050 0.615 644.70 0.645 6,447.00 6.450
1,000.25 1.000 8,109.20 8.110
Duration = Sum of (PV * t) / B0

= 8,109.2 / 1000
= 8.109 Years
20. The following information are available on a bond:
Face value : ₹ 1,000 Coupon rate : 12% payable annually
Years to maturity : 6 Current market price : ₹ 1,087
a) What is the duration of the bond?
b) What will be the change in the price of the bond, if the interest rate changes by 1%
Solution:
To calculate duration of the bond we need Yield, since Yield is not given first we need
to find out YTM
YTM
₹ 1,100 = [120 * PVAF y, 6] + [1,000 * PVF y, 6]
At 11% the value is = (120 * 4.231) + (1,000 * 0.535)
= 1,042.72
At 10% the value is = (120 * 4.355) + (1,000 * 0.564)
= 1,086.6
At 10% yield the price of the bond is ₹ 1,086.6 which is almost 1,087, so Yield is 10%.
a) Duration the bond
Year CF PVF PV W T & PV W & T
1 120 0.909 109.09 0.100 109.091 0.100
2 120 0.826 99.17 0.091 198.347 0.182
3 120 0.751 90.16 0.083 270.473 0.249
4 120 0.683 81.96 0.075 327.846 0.302
5 120 0.621 74.51 0.069 372.553 0.343
6 1120 0.564 632.21 0.582 3793.265 3.489
1,087.11 1.000 5,071.58 4.67
Duration = Sum of (PV * t) / B0
= 5,071.58 / 1,087
= 4.67 Years
b) When interest rate changes by 1% then the change in the bond price will be:
- MD (∆BP)
CP =
100
D
MD =
1+Y
CP = Change in the price of the bond

MD = Modified duration
∆BP = Change in the Basis Points (Interest Rate)
D = Duration
MD = 4.67 / (1+ 0.10)

MD = 4.25
CP = - 4.25 (100) / 100

= - 4.25.
So, when interest rate increases by 1% then the bond price will change by - 4.25%
21. XYZ Ltd., is proposing to issue 8% bonds with a face value of ₹ 1,000 redeemable in 5
equal instalments of ₹ 200 each over 5 years period. If the required rate of return of
investors is 7%, at what price the bonds be offered to the investors?
Solution:
Year CF PVF PV
1 280 0.935 261.80
2 264 0.873 230.47
3 248 0.816 202.37
4 232 0.763 177.02
5 216 0.713 154.01
1,025.67
So the company should offer the bond at the price of ₹ 1,025.67. This would give a rate
of return of 7% pa to the investors.
22. 7% Bond having face value of ₹ 100 redeemable at par after 6 years is available for
investment. The term-structure of interest rates over next 6 years provides the following
one period annual interest rates: 6%, 6.25%, 6.50%, 7%, 7.5% and 8.5% pa for different
years respectively. Find out the value of the bond.
Solution:
Year Interest Rate CF PV of CF
1 6.00 70 66.04
2 6.25 70 62.15
3 6.50 70 58.36
4 7.00 70 54.54
5 7.50 70 50.74
6 8.50 1070 714.79
The Price of the Bond 1,006.62
Yield to Call (YTC)

• It entitles the issuer to call (Buy back) the bond prior to the stated maturity.
B0 = [C * PVAF r, n] + [M * PVF r, n]
C = Annual Interest B0 = Current Market Price of Bond
M = Call Price (in rupees) n = number of years until the assumed call date

Face Value ₹ 1,000
Coupon Rate 8%
Time to Maturity 10 Years
Market Price ₹ 1,140
Callable in 6 years ₹ 1,100
Solution:
Calculation of YTM at 8% the value is:
= (80 * 6.710) + (1,000 * 0.463)
= 1,000
At 7% the value is:
= (80 * 7.024) + (1,000 * 0.508)
= 1,069.92
At 6% the value is:
= (80 * 7.360) + (1,000 * 0.558)
= 1,146.80
Interpolation between 6% and 7%

YTM = 6% + [(1,146.80 – 1,140) / (1,146.80 – 1,069.92)
= 6.09%
Calculation of YTC:
At 7% the value is:
= (80 * 4.767) + (1,100 * 0.666)
= 1,113.96
At 6% the value is:
= (80 * 4.917) + (1,100 * 0.0.705)
= 1,168.86
Interpolation between 6% and 7%
YTC = 6% + [(1,168.86 – 1,140) / (1,168.86 – 1,113.96)
= 6.53%
Realised Yield to Maturity (RYTM)

• YTM calculation assumes that the cash flows received are reinvested at a rate equal to
the YTM.
• It may not be valid if reinvestment rate applicable is different.
24. Consider a ₹ 1,000 par value bond, carrying an interest rate of 14 percent payable annually
and maturing after 5 years. The present market price of this bond is ₹ 1,050. The
reinvestment rate applicable to the future cash flows of this bond is 12 percent. What is
the realized yield to maturity?
Solution:
Realized YTM = Future Value / Present Market Price
How to find out Future Value?

Future Value = Future value of Annual Interest + Maturity Value
n
FVAI = C (1 + r) - 1
r
5
FVAI = 140 (1 + .12) - 1
0.12
= 140 (6.35)
= 889.40
FV = 889.40 + 1,000
FV = 1,889.40
B0 = (1+ y)n = 1,889.40
1,050 (1+ y)5 = 1,889.40
(1+ y)5 = 1,889.40 / 1,050
(1+ y)5 = 1.994
1+y = 1.79941/5
1+y = 1.1247
y = 1.1247 – 1
y = 0.1247
Realised YTM = 0.1247 or 12.47%
Equity Valuation
Equity shareholders will have residual ownership character.
 They receive residual profits and residual assets in case of liquidation.
Equity shares have different features when compare with Bonds

 Uncertainty
 No Redemption
 Relation with EPS
Different approaches to the valuation of the Equity shares

a) Accounting Concept of Valuation
b) Valuation based on Dividend
c) Valuation based on Earnings
Valuation of Equity Share Based on Accounting Information
What do you mean by Accounting Information??
The Information taken from Financial Statements.

1. Book Value or Balance Sheet Value (BV)
The Book Value per share is the net worth (Based on the Balance Sheet Values) of the
Company (Which is Equal to Paid up equity capital Plus Reserves and surplus) divided by
the number of outstanding Equity shares.
Book Value = Net Worth / No. of O/S Equity Shares
For Example: If the net worth of ABC Ltd., is ₹ 50 Million and the Number of outstanding
Equity Shares of ABC Ltd., is 3 Million, the book value per share works out to ₹ 16.67
2. Liquidation Value (LV)

The LV of an equity shares is the amount of cash that would be received from the company
if all its assets are sold and the liabilities (including preference shares, if any) are paid.
LV = (Value realised from liquidating all the assets of the firm - Amount to be paid to all
the creditors and preference shareholders) / No. of Outstanding Equity Shares
For Example: Assume that XYZ Ltd., would realize ₹ 65 Million from the liquidation of
its assets and pay ₹ 24 Million to its creditors and preference shareholders in full settlement
of their claims. If the number of outstanding shares of XYZ Ltd., is 1.8 Million, the
liquidation value per shares will be:
= (65 Million - 24 Million) / 1.8 Million
= 22.78
Valuation of Equity Shares Based on Dividends
Dividend Discount Model (DDM)

Assumptions:
1. Dividends are paid annually
2. First dividend is received one year after the equity share is bought
3. Sale of Equity share, if any, occurs only at the end of a year and at the ex-dividend
terms.
Single Period Valuation Model

• Investor expects to hold the equity share for one year
D1 P1
Po = +
(1+ Ke /100) (1+ Ke /100)
Where: Po = Current price of the Equity Shares

D1 = Dividend Expected after one year
P1 = Price of the share expected after one year
Ke = Rate of return required on the Equity Share
1. Delta Software equity shares is expected to provide a dividend of ₹ 2.00 and fetch a price
of ₹ 18.00 a year hence. What price would it sell for now if investor required rate of return
is 12%?
Solution:
The Current Price will be:
D1 P1
Po = +
(1+ Ke /100) (1+ Ke /100)
2 18
Po = +
(1 + 0.12 /100) (1+ 0.12 /100)
= ₹ 17.86
What happens if the price of the equity is expected to grow at a rate of g % annually?
Po = D1/ (1+r) +[ P0 (1+g) / (1+r/100)]
By simplifying Equation we get

D1
Po =
Ke- g
2. The expected dividend per share on the equity share of FCS Software is ₹ 2.00. The dividend per
share of FCS Software has grown over the past five years at the rate of 5% per year. This growth
rate will continue in future. Further, the market price of the equity share of FCS Software too is
expected to grow at the same rate. What is the fair estimate of the intrinsic value of the equity share
of FCS Software if the required rate is 15%
Solution:
D1
Po =
Ke- g
2
Po =
0.15 – 0.05
Po = ₹ 20
D1
Ke = +g
P0
3. The expected dividend per share of XYZ Ltd., is ₹ 5.00. The dividend is expected to grow
at the rate of 6% per year. If the price per share now is ₹.50.00, what is the expected rate
of return?
Solution:
D1
Ke = +g
P0
5
Ke = + 0.06
50
Ke= 0.16 or 16%
Multi Period Holding Period:

(i) Zero Growth in Dividends or Constant Dividends
P0 = D/ Ke
4. A Firm pays a dividend of 20% on the equity share of face value of ₹ 10 each. Find out the
value of the equity share given that the dividend rate is expected to remain same and the
required rate of return of the investor is 15%.
Solution:
2
Po =
0.15
Po = 13.33%
(ii) Constant Growth Model (Gordon Model)
One of the most popular DDM, called the Gordon Model as it was originally proposed by
Myron J Gordon, Assumes that the dividends per shares grows at a constant rate (g).
D1
Po =
Ke- g
5. ABC Consultants Ltd have Equity share face value of ₹ 10 each, is expected to pay a
dividend of 20% at the end of year 1 and the growth rate in dividends is estimated is to be
5%. If the investor has a required rate of return of 14%, what is the value of equity share?
Solution:
2
Po =
0.14 – 0.05
Po = ₹ 22.22
Variable Growth in Dividends (Variable Growth Model)
6. A Firm is paying a dividend of ₹ 1.5 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:
D0= 1.5
Ke= 15%
g1 = 10% for 3 years
g2 = 5%
End of Years Dividend Amount PVF (15%, n Yrs)

1 1.65 0.870 1.44
2 1.82 0.756 1.38
3 2.00 0.658 1.32
4.14
P3 = D4/(Ke-g2)
= 2.1/(0.15-0.05)
= 21
P0 = 21 * 0.658
= 13.82
P0 = 4.14 + 13.82
P0 = 17.96
7. The Current dividend on an equity share of a firm is ₹ 2.00, it is expected to enjoy an above-
normal growth rate of 20% for a period of 6 years. Thereafter the growth rate will fall and
stabilize at 10%. Equity investors require a return of 15%. What is the intrinsic value of
the equity share of the firm?
Solution:
D0= 2
Ke= 15%
g2 = 10%
End of Year Dividend Amount PVF (15%, n Years)

1 2.40 2.09
2 2.88 2.18
3 3.46 2.27
4 4.15 2.37
5 4.98 2.47
6 5.97 2.58
13.96
P6 = D7/(Ke-g2)
= 6.57/(0.15-0.10)
= 131.40
P0 = PV of Rs.131.40
= 56.81
P0 = 13.96 + 56.81
P0 = 70.77
8. The current dividend on an equity share of International Computers Ltd., is ₹.3.00. The
present growth rate is 50%. However, this will decline linearly over a period of 10 years
and then stabilize at 12%. What is the intrinsic value per share of International Computers
ltd., if investors require a return of 16%?
9. Hanuman Limited earnings and dividends have been growing at a rate of 18% pa. This
growth rate is expected to continue for 4 years. After that the growth rate will fall to 12%
for next 4 years. Thereafter, the growth rate is expected to be 6% forever. If the lst dividend
per share was ₹ 2.00 and the investors required rate of return is 15%, what is the intrinsic
value per shares?
Solution:
D0= 2
Ke= 15%
g3 = 6%
End of Year Dividend Amount PVF (15%, n Years)

1 2.36 2.05
2 2.78 2.11
3 3.29 2.16
4 3.88 2.22
5 4.34 2.16
6 4.86 2.10
7 5.45 2.05
8 6.10 1.99
16.84
P8 = D9/(Ke-g3)
= 6.47/(0.15-0.06)
= 71.89
P0 = PV of Rs.71.89
= 23.50
P0 = 16.84 + 23.50
P0 = 40.34
10. Z Ltd., has just paid a dividend of ₹ 13 per share as a part of which major reorganization
of its operations, it has stated that it does not intend to pay any dividend for the next 2
years. In 3 years time it will commence paying a dividend at ₹ 10 per shares and the
directors have indicated that they expect to achieve a dividend growth at 12% PA
thereafter.
If the reorganization does not take place dividend will be paid in the next 2 years and
expected dividend growth will remain at the present value of 6%PA. The firm’s cost of
equity is 18% will be unaffected by the reorganization. Advice the company whether they
have to go for reorganization?
Solution:
a) D0 = 13
D3 = 10
g2 = 12%
P2 = D3/(ke-g)
Valuation of the shares currently not paying Dividends

11. A Firm is not expected to pay any dividend for first 3 years but thereafter will be paying a
dividend of ₹ 2 growing at 10% pa forever. What will be the value of Share given the
required rate of return 15%.
Solution:
Step 1: Calculate Value of Share at the end of 3 years
Step 2: Discount it to present value
P3 = D4/(Ke-g)
= 2 / (0.15-0.10)
= 40
P0 = PVF of P3
= 0.658 * 40
= 26.32
All the Equity valuation value should be compared with the CMP to make investment
decisions as follows:
i) If IV < MP, the equity share is overvalued in market and need not be bought, rather may
be sold, if held by the investor.
ii) If IV > MP, the share is undervalued and should be purchased or be held if already
purchased.
iii) If IV = MP, the MP is representative of true value and the investor may be indifferent.
12. SP limited has been growing @ 15% per year and this trend is expected to continue for 5
more years. Thereafter, it is likely to grow @ 8%. The investors expect a return of 12%,
the dividend paid by the firm per share for the last year is ₹ 5. Determine the price at
which an investor may be ready to buy the shares of the company at the end of period T 0,
T1, T2, T3, T4 and T5
Solution:
Growth rate, g1 for first 5 years 15%
th
Growth rate, g2, from 6 year onwards 8%
Required rate of return i.e Ke 12%
Now the value of share at different pint of time can be ascertained as follows:
Present value of dividends for first 5 years

Year Dividend PVF (12, n) PV
1 5.75 0.892 5.135
2 6.61 0.797 5.268
3 7.60 0.712 5.411
4 8.74 0.636 5.559
5 10.05 0.567 5.698
27.071
Now the price at the end of different years is to be calculated as follows:
(i) Price at the end of year 5 (T5)
The share price is P5 = D6 / (Ke – g)
= 10.85 / (0.12 – 0.08)
= ₹ 271.35
(ii) Price at the end of year 4 (T4)
P4 = PV of P5 for 1 year + PV D5 for 1 year
= (271.35 * 0.893) + (10.05 * 0.893)
= ₹ 251.29
(iii) Price at the end of year 3 (T3)
P3 = PV of P5 for 2 year + PV D5 for 2 year + PV D4 for 1 year
= (271.35 * 0.797) + (10.05 * 0.797) + (8.74 * 0.893)
= ₹ 232.08
(iv) Price at the end of year 2 (T2)
P2 = PV of P5 for 3 year + PV D5 for 3 year + PV D4 for 2 year + PV D3 for 1 year
= (271.35 * 0.712) + (10.05 * 0.712) + (8.74 * 0.797) + (7.60 * 0.893)
= ₹ 214.11
(v) Price at the end of year 1 (T1)
P1 = PV of P5 for 4 year + PV D5 for 4 year + PV D4 for 3 year + PV D3 for 2 year +
PV D2 for 1 year
= (271.35 * 0.636) + (10.05 * 0.636) + (8.74 * 0.712) + (7.60 * 0.797) +
(6.61 * 0.893)
= ₹ 197.15
(vi) Price at T0 Now
P0 = PV of P5 for 5 year + PV of all dividends
= (271.35 * 0.712) + 27.07
= ₹ 180.93
Therefore, the investor will be ready to pay a price of ₹ 180.93, ₹ 197.15, ₹ 214.11. ₹ 232.08,
₹ 251.29 and ₹ 271.35 at the end of years T0, T1, T2, T3, T4 and T5 respectively.
13. Manish Ltd., has an investment opportunity available which will involve a capital outlay
in each of the next 2 years and which will produce benefits during the following 3 years.
A summary of the financial implications of this investments is given below:
Year Cash Flow (₹ 000)

1 -1000
2 -1000
3 100
4 1300
5 3100
Company currently issued 1,00,000 shares and just now it has paid a dividend of ₹15 per
share. In the absence of above investment, dividends are expected to be at the same level
for next 3 years, after that the dividends are expected to growth of 10% p.a. The investor
are expecting a return of 18% p.a. The company has long established policy of not using
any debt finance, because of the current depressed state of the stock market, it is not in a
position issue any equity in near future. The only possible way of financing the
investment is to reduce the dividend payments for next 2 years. Cash received from the
new investment will all be distributed, growth in dividends @10% will also be
maintained because of other operations, you are required to:
a) Calculate the current share price of Manish Ltd.,
b) Calculate the share price after the investment has been accepted, assuming the market
knows of the dividend changes that will result from the investment using a dividend
valuation model.
Solution:
Situation I. When the investment proposal is not accepted.
The CMP of the share is the present value of expected future dividends discounted at the
required rate of return i.e 18%. Since the company is expected to pay a dividend of ₹ 15
per share for next three years and thereafter the dividend will grow @10%. The present
market price with these parameters can be ascertained as follows:
The present value of dividend for the three years:
Dividend per year = ₹15
PVAF (at 18%, 3 years) = 2.174
Therefore, PV of dividends = ₹ 32.61
Price of the share at the end of 3 years:
P3 = D4 / (Ke – g)
= 16.5 / (0.18 – 0.10)
= 206.25
Present value of this amount at 18% for 3 years: 206.25 * 0.609 = 125.61
Present market price is (125.61 + 32.61) = ₹ 158.22
Situation II: If the investment proposal is accepted, then the present value of dividend
will be as follows:
Year Old Div Change in Div Net Div PVF @ 18% PV

1 15 -10 5 0.847 4.24
2 15 -10 5 0.718 3.59
3 15 1 16 0.609 9.74
4 16.5 13 29.5 0.516 15.22
5 18.2 31 49.5 0.437 21.50
54.29
Price of the share at the end of year 5:

P5 = D6 / (Ke – g)
= 20.02 / (0.18 – 0.10)
= 250
PV of this amount at 18% for 5 years: 250 * .437 = 109.25
Therefore the market price under situation II when the investment proposal is accepted
is (₹ 109.25 + ₹ 54.29) = ₹ 163.54
Unit – 5
Fundamental Analysis, Technical Analysis, Efficient
Market Hypothesis and Behavioural Finance
Unit – 6
Modern Portfolio Theory, Portfolio Management &
Portfolio Evaluation
Modern Portfolio Theory
Portfolio Theory
Very broadly the investment process consists of two tasks. The first task is security Analysis
which focuses on assessing the risk and return characteristics of the available investment
alternatives. The second task is portfolio selection which involves choosing the best possible
portfolio from the set of feasible portfolios.
Portfolio theory originally proposed by Harry Markowitz in 1950s, was the first formal attempt
to quantify the risk of the portfolio and develop a methodology for determining the optimal
portfolio. Harry Markowitz was the first person to show quantitatively why and how
diversification reduces risk. In recognition of his seminal contributions in this field he was
awarded the Nobel Prize in Economics in 1990.
We will discuss how investors can construct the best possible risky portfolio with the help of
efficient diversification.
Diversification and Portfolio Risk
Let us understand somewhat intuitively how diversification influences risk. Suppose you have
Rs.1,00,000 to invest and you want to invest it equally in two stocks, A and B. The return on
these stocks depends on the state of the economy. Your assessment suggests that the
probability distributions of the returns on stocks A and B are as shows below table.
State of Probability Return on Return on Return on
Economy Stock A Stock B Portfolio
(%) (%) (%)
1 0.20 15 -5 5
2 0.20 -5 15 5
3 0.20 5 25 15
4 0.20 35 5 20
5 0.20 25 35 30
For the sake of simplicity, all the five states of the economy are assumed to be equal probable.
The last column shows the return on a portfolio consisting of stocks A and B in equal
proportions. The expected return and standard deviation of return on stocks A and B and the
portfolio consisting of A and B in equal proportions are calculated below.
Expected Return
Stock A : 0.2(15%) + 0.2(-5%) + 0.2(5%) + 0.2(35%) + 0.2(25%) = 15%
Stock B : 0.2(-5%) + 0.2(15%) + (0.2(25%) + 0.2(5%) + 0.2(35%) = 15%
Portfolio of A and B : 0.2(5%) + (0.2(5%) + 0.2(15%) + 0.2(20%) + 0.2(30%) = 15%
Standard Deviation
Stock A : σ 2A = 0.2(15-15)2 + 0.2(-5-15)2 + 0.2(5-15)2 + 0.2(35-15)2 +0.2 (25-15)2 = 200
σ A = (200)1/2 = 14.14%
Stock B : σ 2B = 0.2(-5-15)2 + 0.2(15-15)2 + 0.2(25-15)2 + 0.2(5-15)2 +0.2 (35-15)2 = 200
σ B = (200)1/2 = 14.14%
Portfolio: σ 2(A+B) = 0.2(5-15)2 + 0.2(5-15)2 + 0.2(15-15)2 + 0.2(20-15)2 +0.2 (30-15)2 = 90

σ B = (90)1/2 = 9.49%
Above example shows that if you invest only in stock A the expected return is 15% and the
standard deviation is 14.14%, likewise if you invest only in stock B the expected return is 15%
and the standard deviation is 14.14%. What happens if you invest in a portfolio consisting of
stocks A and B in equal proportions? While the expected return remains at 15% the same as
that of either stock individually, the standard deviation of the portfolio return 9.49% is lower
than that of each stock individually. Thus in this case diversification reduces risk.
In general if returns on securities do not move in perfect lockstep, diversification reduces risk.
In technical terms, diversification reduces risk if returns are not perfectly positively correlated.
The relationship between diversification and risk is shown graphically below.
Risk
Unique Risk
Market Risk
1 5 10 No. of Securities
When the portfolio has just one security, say stock 1 the risk of the portfolio σP is equal to the
risk of single stock included in it, σ1. As a second security say Stock 2 is added the portfolio
risk decreases. As more and more securities are added the portfolio risk decreases, but at a
decreasing rate and reaches a limit. Empirical studies suggest that the bulk of the benefit of
diversification, in the form of risk reduction, is achieved by forming a portfolio of about ten
securities. Thereafter the gain from diversification tends to be negligible.
Market Risk versus Unique Risk

Notice that the portfolio risk does not fall below a certain level, irrespective of how wide the
diversification is. Why? The answer lies in the following relationship which represents a basis
insight of modern portfolio theory.
Total Risk = Unique risk + Market risk
The Unique risk of a security represents that portion of its total risk which stems from firm-
specific factors like the development of a new product, a labor strike, or the emergence of a
new competitor. Events of this nature primarily affect the specific firm and not all firms in
general. Hence, the unique risk of a stock can be washed away by combining it with other
stocks. In a diversified portfolio unique risks of different stocks tend to cancel each other a
favourable development in one firm may offset an adverse happening in another and vice versa.
Hence, unique risk is also referred to as diversifiable risk or unsystematic risk.
The market risk of a stock represents that portion of its risk which is attributable to economy
wide factors like the growth rate of GNP, the level of government spending, money supply,
interest rate structure, and inflation rate. Since these factors affect all firms to a greater or
lesser degree investors cannot avoid the risk arising from them, however diversified their
portfolios may be. Hence, it is also referred to as systematic risk or non-diversifiable risk.
Portfolio Return and Risk

Investors generally hold a portfolio of securities. So while individual returns and risks are
important, what matters finally is the return and risk of the portfolio.
Portfolio Expected Return

The expected return on a portfolio is simply the weighted average of a expected return on the
individual securities in the portfolio.
E(Rp) = Σ wiE(Ri)
Where E(Rp) is expected return on the portfolio wi is the weight of security I in the portfolio,
(Ri) is expected return on security I, and n is the number of securities in the portfolio.
Note that the weight of a security represents the proportion of portfolio value invested in that
security and the combined portfolio weights equal 1.
Example: A portfolio consists of four securities A,B,C &d with expected return of 12%, 15%,
18% and 20% respectively. The proportions of portfolio value invested in these securities are
0.20, 0.30, 0.30 and 0.20 respectively. The expected return on the portfolio is :
E(Rp) = 0.20(12%) + 0.30(15%) + 0.30(18%) + 0.20(20%) = 16.3%
Portfolio Risk
Just as the risk of an individual security is measured by the variance (or Standard deviation) of
its return, the risk of a portfolio too is measured by the variance (or standard deviation) of its
return.
Although the expected return on portfolio is the weighted average of the expected return on the
individual securities in the portfolio, portfolio risk (measured by the variance or standard
deviation) is not the weighted average of the risks of the individual securities in the portfolio
(except when the returns from the securities are uncorrelated).
Measurement of Co movements in Security Returns
To develop the equation for calculating portfolio risk we need information on weighted
individual security risks and weighted co movements between the returns of securities included
in the portfolio.
Co movements between the returns of securities are measured by covariance (an absolute
measure) and coefficient of correlation (a relative measure).
Covariance: Covariance reflects 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 opposite direction.
Covariance between i and j securities is called 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 are the probabilities associated with states 1…. n, Ri1…… Rin are the returns
on security I in states 1…….. n, Rj1….. Rjn are the returns on security j in states 1…n and (Ri),
(Rj) are expected return on securities I and j.
Example:
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%
The expected return on security 1 is:

E(R1) = 0.10(-10%)+0.30(15%)+0.30(18%)+0.20(22%)+0.10(27%) = 16%
The expected return on security 2 is:
E(R2) = 0.10(5%)+0.30(12%)+0.30(19%)+0.20(15%)+0.10(12%) = 14%
The covariance between the return on securities 1 and 2 is calculated below:
State Probabi Return on Deviation of Return on Deviation of Product of the

of lity Security 1 the return on security 2 the return on deviations times
nature security 1 from security 2 probability
its mean from its mean
1 2 3 4 5 6 2x4x6
1 0.10 -10% -26% 5% -9% 23.4
2 0.30 15% -1% 12% -2% 0.6
3 0.30 18% 2% 19% 5% 3.0
4 0.20 22% 6% 15% 1% 1.2
5 0.10 27% 11% 12% -2% -2.2
Sum 26.0
Thus the covariance between the returns on the two securities is 26
Coefficient of correlation
Covariance and correlation are conceptually analogous in the sense that both of them reflect
the degree of Comovements between two variables. Thus the correlation coefficient is simply
covariance divided by the product of standard deviations.
The correlation coefficient can vary between -1.0 and +1.0. A value of -1.0 means perfect
negative correlation or perfect Comovements in the opposite direction; a value of 0 means no
correlation or Comovements whatsoever; a value of +1.0 means perfect correlation or perfect
Comovements in the same direction.
Calculation of Portfolio Risk

We will first look at the 2-security case and then generalize it to the n-security case.
Portfolio risk: 2 – Security Case
The risk of a portfolio consisting of two securities is given by the following formula:
2 2 2 2
σp = w1 σ1 + w2 σ2 + 2 w1 w2 p12 σ1 σ2
Where σp is the standard deviation of the portfolio return, w1, w2 are the weights of securities
1 and 2 in the portfolio, σ12, σ22 are the variances of the returns on securities 1 and 2, p12 is
Coefficient of correlation between security 1 and 2 and σ1 σ2 is the standard deviation of the
returns on securities 1 and 2.
Example: A portfolio consists of two securities, 1 and 2 in the proportions 0.6 and 0.4. The
standard deviations of the returns on securities 1 and 2 are σ1= 10 and σ2=16. The coefficient
of correlation between the returns on securities 1 and 2 is 0.5. What is the standard deviation
of the portfolio return?
2 2 2 2
σp = 0.6 x 10 + 0.4 x 16 + 2 x 0.6 x 0.4 x 0.5 x 10 x 16
= 10.7%
1. The risk and return characteristics of the two projects are shown below:
X Y
Expected return 12% 20%
Risk 3% 7%
An investor plans to invest 80% of its available funds in Project X and 20% in Y. The
correlation coefficient between the returns of the projects is +1.0. Find out the risk and return
of the portfolio of X and Y
Solution:
Expected return of the portfolio:
= (12 * 0.80) + (20 * 0.20)

= 9.6 + 4.
E (R) = 13.6%
2 2 2 2
σp = 0.8 x 3 + 0.2 x 7 + 2 x 0.8 x 0.2 x 1 x 3 x 7
σp = 14.44%
Portfolio Risk: n-Security Case
The variance and standard deviation of the return of an n-security portfolio are:
σp2 = Σ Σwiwjpijσi σj
σp = [ΣΣwiwjpijσi σj]1/2
Where σp2 is the variance of portfolio return, σp is the standard deviation of portfolio return, wi
is the proportion of portfolio value invested in security i, wj is the proportion of portfolio value
invested in security j, pij is the coefficient of correlation between the returns on securities I and
j, σi is the standard deviation of the return on security I, and σj is the standard deviation of the
return on security j.
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 deviations of returns on these securities are
σ110%, σ2=15% and σ3 = 20%. The correlation coefficients among security returns are P12=0.3,
P13=0.5 and P23 = 0.6. What is the standard deviation of portfolio return?
σp= w 2 σ 2 + w 2 σ 2 + w 2 σ 2 + 2 w w p σ σ + 2 w w p σ σ + 2 w w p σ σ
1 1 2 2 3 3 1 2 12 1 2 1 3 13 1 3 2 3 23 2 3
2 2 2 2 2 2
= 0.5 x 10 + 0.3 x 15 +0.2 x 20 + 2 x 0.5 x 0.3 x 0.3 x 10 x 15+ 2 x 0.5 x 0.2 x 0.5 x 10
x 20 + 2 x 0.3 x 0.2 x 0.6 x 15 x 20
= 10.79%

Investment Management Notes

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Study Material

Unit 1: (Theory) (6 Hours)

Unit 2: (Theory) (6 Hours)

Unit 3: (Theory & Problems) (10 Hours)

Unit 4: (Theory & Problems) (10 Hours)

Unit: 5 (Theory& Problems) (12 Hours)

Unit 6: (Theory & Problems) (12 Hours)

Portfolio Management: Diversification- Investment objectives, Risk Assessment, Selection of asset

Attributes of investments are:

as medical expenses necessitate redemption of an investment prematurely. The marketability

Economic Investments Vs Financial Investment

A Stock price went up from $ 1,000 to $ 1,200

A gadget price went up from $100 to $200

Other subsidiary objectives are:

Maximizing the Return

Minimizing the Risk

Hedging against Inflation

Features of good Investment

Investment Security Valuation Portfolio Portfolio

Framing of Investment Policy

Capital Market Money Market Derivatives

Capital Market Instruments

Types of preference shares:

Form: It is given as a certificate of indebtedness by the company, specifying the date of

 Non-convertible debenture: Non-convertible debentures do not confer any option on the

II. Hybrid Schemes (Balanced)

III. Debt Schemes

Money Market Instruments

Certificate of Deposit: A certificate of deposit (CD) is a negotiable money market instrument

Functions of Investment Companies:

Classification of Investment Companies:

Types of Mutual Funds

Indian Security Market

Capital market can be divided into:

Primary Market (New Issue Market)

Factors to be considered to enter the primary market

Modes of raising funds

Public Rights Preferential

Offer through Book Building Private Offer for sale

Public Issue may be made for

An IPO or FPO may be done through:

Green Shoe Option

Major Players in the Secondary Market

Functions of Stock Exchanges

An Investor can be:

Trading and Settlement Procedure

Leading Stock Exchanges in India

Bombay Stock Exchange (BSE)

Listing of Securities in BSE.

Stock Market Indicators

The major uses of indices are:

Indices of Indian Stock Exchanges

S&P BSE 500 Shariah CNX Shariah25

Types of Risks (Risk consists following components)

Total Risk = Systematic Risk risk + Unsystematic risk

The return of an investment consists of two components:

Total Return = Current return + Capital return

Measuring Historical Return

Expected Value of Return