Investment Management 6th Sem Mysore Uni Final.
Investment Management 6th Sem Mysore Uni Final.
Investment Management 6th Sem Mysore Uni Final.
UNIVERSITY OF MYSORE
CENTRAL COMMERCE FIRST GRADE COLLEGE, HASSAN
6th Sem B.com ( NEP )
Syllabus:
Module No. 1: Concept of Investment
Introduction - 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.
INVESTMENT–AN OVERVIEW
The income that a person receives may be used for purchasing goods and services that he
currently requires or it may be saved for purchasing goods and services that he may require in
the future. In other words, income can be what is spent for current consumption. savings are
generated when a person or organization abstain from present consumption for a future use. The
person saving a part of his income tries to find a temporary repository for his savings until they
are required to finance his future expenditure. this result in investment.
Meaning of investment
Investment is an activity that is engaged in by people who have savings, i.e. investments are
made from savings, or in other words, people invest their savings. But all savers are not
investors. investment is an activity which is different from saving. Let us see what is meant by
investment.
It may mean many things to many persons. If one person has advanced some money to another,
he may consider his loan as an investment. He expects to get back the money along with interest
at a future date. another person may have purchased on kilogram of gold for the purpose of price
appreciation and may consider it as an investment.
In all these cases it can be seen that investment involves employment of funds with the main aim
of achieving additional income or growth in the values. The essential quality of an investment is
that it involves something for reward. Investment involves the commitment of resources which
have been saved in the hope that some benefits will accrue in future.
Thus, investment may be defined as “a commitment of funds made in the expectation of some
positive rate of return “since the return is expected to realize in future, there is a possibility that
the return actually realized is lower than the return expected to be realized. This possibility of
variation in the actual return is known as investment risk. Thus, every investment involves return
and risk.
F. Amling defines investment as “purchase of financial assets that produces a yield that is
proportionate to the risk assumed over some future investment period.”
Definition-Economic sense
“Investment means the net additions to the economy’s capital stock which consists of goods and
services that are used in the production of other goods and services” (Capital formation)
Investment is the net addition made to the nation’s capital stock that consists of goods and
services that are used in the production process. A net addition to the capital stock means an
increase in the buildings, equipment’s or inventories. These capital stocks are used to produce
other goods & services
Definition–Financial sense
“Investment is a commitment / employment of funds made in the expectation of some positive
rate of return. If the investment is properly undertaken, the return will commensurate with the
risk that the investor assumes”.
- Donald E. Fischer and Ronald J. Jordan
Financial investment is the allocation of money to assets that are expected to yield some gain
over a period of time.
According to sharpe, “investment is sacrifice of certain present value for some uncertain future
values”.
Speculation
Speculation is the practice of engaging in risky financial transactions in an attempt to profit from
short- or medium-term fluctuations in the market value of a tradable good such as a financial
instrument, rather than attempting to profit from the underlying financial attributes embodied in
the instrument such as capital gains, interest, or dividends. Many speculators pay little attention
to the fundamental value of a security and instead focus purely on price movements. Speculation
can in principle involve any tradable good or financial instrument. Speculators are particularly
common in the markets for stocks, bonds, commodity futures, currencies, fine art, collectibles,
real estate, and derivatives.
Types of Investments
Real Investment – Purchase of fixed assets
Financial Investment – Purchase of securities
Nonnegotiable securities
Deposits earn fixed rate of return. Even though bank deposits resemble fixed income securities
they are not negotiable instruments. Some of the deposits are dealt subsequently
a) Bank deposits
It is the simplest investment avenue open for the investors. He has to open an account and
deposit the money. Traditionally the banks offered current account, Saving account and fixed
deposits account. Current account does not offer any interest rate. The drawback of having large
amount in saving accounts is that the return is just 4 percent. The saving account is more liquid
and convenient to handle. The fixed account carries high interest rate and the money is locked up
for a fixed period. With increasing competition among the banks, the banks have handled the
plain saving account with the fixed account to cater to the needs of the small savers.
c) NBFC deposits
In recent years there has been a significant increase in the importance of Non- Banking Financial
Companies (NBFC) in the process of financial intermediation. The NBFC come under the
purview of the RBI. The Act in January 1997, made registration compulsory for the NBFCs
1) Period the period ranges from few months to five years.
2) Maximum limit the limit for acceptance of deposit has been on the credit rating of the
company.
e) Life insurance
Life insurance is a contract for payment of a sum of money to the person assured on the
happening of event insured against. Usually, the contract provides for the payment of an amount
on the date of maturity or at a specified date or if unfortunate death occurs. The major advantage
of life insurance is given below;
1) Protection saving through life insurance guarantees full protection against risk of death of the
saver. The full assured sum is paid, whereas in other schemes only the amount saved is paid.
2) Easy payments for the salaried people the salary saving schemes are introduced. Further there
is an installment facility method of payment through monthly, quarterly, half yearly or yearly
mode.
3) Liquidity loans can be raised on the security of the policy
4) Tax relief tax relief in income tax and wealth tax is available for amounts paid by way of
premium for life insurance subject to the tax rates in force.
a) Endowment policy; The objective of this policy is to provide an assured sum, both in the
event of the policy holders’ death or at the expiry of the policy.
➢ Capital appreciation: an increase in the value of the units of the fund is known as capital
appreciation
➢ Dividend distribution: the profit earned by the fund is distributed among unit holders in the
form of dividends.
c) Whole life policy: It is a low-cost insurance plan where the sum assured is payable on the
death of the life insured and premium are payable throughout life.
e) ULIPs:
Unit Linked Insurance Policies are a combination of mutual fund and life insurance. Investments
in ULIPs have two component-one part is used as a premium for life insurance while the other
part acts s the investment fund.
The investment component works exactly like mutual fund money is invested in stocks, bonds;
government securities etc., an investor receive money in return.
f) Mutual fund
Investing directly in equity shares and debt instruments may be difficult task for a large number
of customers because they want to know more about the company, promoter, prospects,
competition for the product etc., in such a case, investor can go for investing in financial assets
indirectly through mutual fund. A mutual fund is a trust that pools the savings of a number of
investors who share a common financial goal. Each scheme of a mutual fund can have different
character and objectives.
Types of return
Capital appreciation: an increase in the value of the units of the fund is known as capital
appreciation
Dividend distribution: the profit earned by the fund is distributed among unit holders in
the form of dividends.
➢ Growth scheme: aims to provide capital appreciation over medium to long term. Generally,
these funds invest their money in equities.
➢ Income scheme: aims to provide a regular return to its unit holders. Mostly these funds
deploy their funds in fixed income securities.
➢ Balanced scheme: a combination of steady return as well as reasonable growth. The fund of
this scheme is invested in equities and debt instruments.
➢ Money market scheme: this type of fund invests its money-to-money market instruments.
➢ Tax saving scheme: this type of scheme offers tax rebates to investors.
➢ Index scheme: Here investment is made on the equities of the Stock index.
g) Real estate
The real estate market offers a high return to the investors. The word real estate means land and
buildings. There is a normal notion that the price of the real estate has increased by more than
12% over the past ten years. Real estate investments cannot be enchased quickly. Liquidity is a
problem. Real estate investment involves high transaction cost. The asset must be managed, i.e.
painting, repair, maintenance etc.
Silver: Yellow metal is treated as safe haven. but silver is used abundantly for industrial
applications. Investment in silver has given investor, super returns than what gold has given.
h) Financial Assets
DEBENTURES/BONDS
A Bond is a loan given by the buyer to the issuer of the instrument. Companies, financial
institutions, or even the government can issue bonds. Over and above the scheduled interest
payments as and when applicable, the holder of a bond is entitled to receive the par value of the
instrument at the specified maturity date.
EQUITY SHARE
Equity, also called shares or scrips, is the basic building blocks of a company. A company’s
ownership is determined on the basis of its shareholding. Shares are, by far, the most glamorous
financial instruments for investment for the simple reason that, over the long term, they offer the
highest returns. Predictably, they’re also the riskiest investment option.
There are personal objectives which are given due consideration by every investor while
selecting suitable avenues for investment. Personal objectives may be like provision for old age
and sickness, provision for house construction, provision for education and marriage of children
and finally provision for dependents including wife, parents or physically handicapped member
of the family. Investment avenue selected should be suitable for achieving both the objectives
(financial and personal) decided. Merits and demerits of various investment avenues need to be
considered in the context of such investment objectives.
(1) Period of Investment (2) Risk in Investment
To enable the evaluation and a reasonable comparison of various investment avenues, the
investor should study the following attributes:
1. Rate of return
2. Risk
3. Marketability
4. Taxes
5. Convenience
6.Safety
7. Liquidity
Each of these attributes of investment avenues is briefly described and explained below.
Rate of return: The rate of return on any investment comprises of 2 parts, namely the
annual income and the capital gain or loss. To simplify it further look below:
Rate of return= Annual income + (Ending price -Beginning price) / Beginning price
The rate of return on various investment avenues would vary widely.
2. Risk: The risk of an investment refers to the variability of the rate of return. To explain
further, it is the deviation of the outcome of an investment from its expected value. A further
study can be done with the help of variance, standard deviation and beta. Risk is another factor
which needs careful consideration while selecting the avenue for investment. Risk isa normal
feature of every investment as an investor has to part with his money immediately and has to
collect it back with some benefit in due course. The risk may be more in some investment
avenues and less in others.
The risk in the investment may be related to non-payment of principal amount or interest
thereon. In addition, liquidity risk, inflation risk, market risk, business risk, political risk, etc. are
some more risks connected with the investment made. The risk in investment depends on various
factors. For example, the risk is more, if the period of maturity is longer. Similarly, the risk is
less in the case of debt instrument (e.g., debenture) and more in the case of ownership instrument
(e.g., equity share). In addition, the risk is less if the borrower is creditworthy or the agency
issuing security is creditworthy. It is always desirable to select an investment avenue where the
risk involved is minimum/comparatively less. Thus, the objective of an investor should be to
minimize the risk and to maximize the return out of the investment made.
To gauge the marketability of other financial instruments like provident fund (which in itself is
non-marketable). Then we would consider other factors like, can we make a substantial
withdrawal without much penalty, or can we take a loan against the accumulated balance at an
interest rate not much higher than our earning rate of interest on the provident fund account.
Initial tax benefits. This is the tax gain at the time of making the investment, like life
insurance.
Continuing tax benefit. Is the tax benefit gained on the periodic return from the
investment, such as dividends.
Terminal tax benefit. This is the tax relief the investor gains when he liquidates the
investment. For example, a withdrawal from a provident fund account is not taxable.
5.Convenience: Here we are talking about the ease with which an investment can be made and
managed. The degree of convenience would vary from one investment instrument to the other.
6.Safety: While no investment option is completely safe, there are products that are preferred by
investors who are risk averse. Some individuals invest with an objective of keeping their money
safe, irrespective of the rate of return they receive on their capital. Such near-safe products
include fixed deposits, savings accounts, government bonds, etc.
7.Liquidity: A liquid investment is one you can easily convert to cash or cash equivalents. In
other words, a liquid investment is tradable-there are ample buyers and sellers on the market for
a liquid investment. An example of a liquid investment is currency trading. When you trade
currencies, there is always someone willing to buy when you want to sell and vice versa. With
other investments, like stock options, you may hold an illiquid asset at various points in your
investment horizon.
8. Duration: Investments typically have a longer horizon than cash and income options. The
duration of an investments typically has a longer horizon than cash and income options. The
duration of an-, particularly how long it may take to generate a healthy rate of return-is a vital
consideration for an investor. The investment horizon should match the period that your funds
must be invested for or how long it would take to generate a desired return.
A good investment has a good risk-return trade-off and provides a good return-duration trade-off
as well. Given that there are several risks that an investment faces, it is important to use these
attributes to assess the suitability of a financial instrument or option. A good investment is one
that suits your investment objectives. To do that, it must have a combination of investment
attributes that satisfy you.
Investment is made because it serves some objective for an investor. Depending on the life stage
and risk appetite of the investor, there are three main objectives of investment: safety, growth
and income. Every investor invests with a specific objective in mind, and each investment has its
own unique set of benefits and risks. Let us understand these objectives in detail.
9. Growth: While safety is an important objective for many investors, a majority of them invests
to receive capital gains, which means that they want the invested amount to grow. There are
Economic Investment
An economic investment puts resources in something that may yield benefits in excess of its
initial cost. Though these resources still include money, investments can also be made in time,
assistance and mentoring. Likewise, assets are not limited to financial instruments. Mike Stabler,
author of "The Economics of Tourism" explains economic growth arises from a broader
definition of an investment, such as an investment in knowledge. An economic investment may
include buying or upgrading machinery and equipment or adding to a labor force. For example,
an economic investment could be a tuition reimbursement program for employees. The
expectation is the company's expense will lead to an employee who will use the education in
ways to benefit the company. Furthermore, offering this benefit may attract a wider, more-skilled
pool of applicants from which the company can choose. States also engage in economic
investments. Art Rolnick of the Minneapolis Federal Reserve explains that every dollar invested
in early education yields $8 worth of benefits in economic growth.
3 small large
Quantity of risk
1. Equity Shares-: Investors can invest in equity shares of joint stock Company either in
primary market or secondary market. Investors of equity shares get ownership right in
company and receive dividends.
If company is a good performer in industry and has potential for future growth, market price of
share moves high consequently shareholders can sell shares at profit. High performer and
dividend paying company’s shares are named as blue chips/growth/income shares.
2. Preference Shares: Preference shares are a hybrid of equity shares and debentures.
Preference shareholders get ownership rights as well as retain the privilege of fixed return
on their investment. They have the priority to get a fixed rate of dividend and get back
their capital back at time of winding up of company before equity shareholders.
3. Debentures and Bonds: A bond or debenture is a creditor ship security on which the
investors get fixed rate of interest and principal amount back at specified time/date from
issuers. These are termed as long-term debt instruments. Many types of debentures and
bonds have been designed keeping in view the need of investors.
7. Bank Deposits: Depositing money with bank either in saving account or time deposit
accounts is highly liquid and suitable investment avenue. Deposits in savings bank
account provides less return but almost zero risk, is best option for setting aside funds for
emergencies, whereas bank fixed deposits is good for investors who want to preserve
money value in the short term. Though, over a long period of time returns on fixed
deposit may be lesser than inflation.
8. Company Fixed Deposits/Public Deposits: Many companies like banks offer public to
deposit their money with them for a fixed period of time. Companies offer higher rate of
interest on fixed deposits than bank but these are unsecured and carry risk. Credit rating
of company offering public deposits must be taken into consideration.
9. Post Office Deposits and Certificates: Indian Postal department also allow people to
deposit money in saving account, recurring deposit and fixed deposit account like banks.
There are also varieties of post office savings certificates which are risk free and provide
high yield to investors. For example, National Savings Certificates (NSC) is sold by post
office to investors. Maximum post office saving schemes offer tax
exemptions/concession.
10. Life Insurance Policies: Life insurance policies not only a protection of risk but also
serves as an investment avenue. These policies promote savings and additionally provide
insurance cover. Life insurance policies are also eligible from tax exemption.
11. Provident Fund Scheme: Public and private sectors employees can invest certain
percentage of their salary in different types of provident fund as applicable to them.
Moreover, investment in (PPF) Public Provident fund Scheme operated by the State Bank
of India is open for every member of public whether employed or not.
12. Equity Linked Savings Schemes (ELSSs): Investors who take risk in the expectation of
high return can invest in units of growth oriented mutual funds. ELSSs are equity/growth
oriented mutual funds where investors have to hold the investment for a minimum period
of three years. These schemes have higher risk than PPF and NSCs, but at the same time
offer higher returns. ELSSs investors get tax deduction under Sec. 80.
14. Government and Semi-Government Securities: Any member of public can invest in
the shares or bonds of Government/ semi-government/statutory bodies. The credibility of
the government and government undertakings is high that is why less risk exists in these
securities.
15. Mutual Fund Schemes: Investment in units of mutual fund mean indirectly investing in
corporate securities. Unit Trust of India was the first financial institution established as
mutual fund in our country. After that many commercial banks and financial institutions
of both public and private sector set up their subsidiary as mutual funds. Mutual funds
offer numerous investment schemes according to the needs of investors.
16. Real Assets: Investment in immovable property like land and commercial building is
most attractive because of high expected return. Most Investments in real assets are also
made when the expected returns are very attractive. But investment in real assets require
huge amount and further these are often linked with the future development plans of the
location.
17. Bullion Investment: Investment in gold, silver, and other precious metals is termed as
bullion investment. These metals are traded in the metals exchange. It is observed in the
past that investment in bullion never disappointed investors. It has always provided return
above inflation rate.
a. Longer life expectancy: Investment decisions have become more significant as most
people in India retire between the ages of 56 to 60. Investment decisions have to be
planned to make wise saving decisions. Saving on their own does not increase wealth; the
saving must be invested in such a way that the principal and income will be adequate for
b. Increasing rates of taxation: When tax rate is increased, it will focus on generating
savings by the tax payer. When the tax payer invests their income in provident fund,
pension fund, Unit Trust of India, Life Insurance, Unit Linked Insurance Plan, National
Saving Certificates, Development Bonds, Post Office Cumulative Deposit Schemes, etc.,
it affects their taxable income.
c. Interest rates: Interest rate is one of the most important aspects of a sound investment
plan. The interest rate differs from one investment to another. There may be changes
between degree of risk and safe investments. They may also differ due to different benefit
schemes offered by the institutions. A high rate of interest may not be the only factor
favoring the outlet for investment. Stability of interest is an important aspect of receiving
a high rate of interest.
d. Inflation: Inflation has become a continuous problem. It affects in terms of rising prices.
Several problems are associated and coupled with falling standards of living. Therefore,
investor’s careful scrutiny of the inflation will make further investment process delayed.
Investor ensures to check the safety of the principal amount and security of the
investment. Both are crucial from the point of view of the interest gained from the
investments.
f. Investment channels: The growth and development of the country leading to greater
economic prosperity has led to the introduction of a vast area of investment outlets.
Investment channels mean an investor is willing to invest in several instruments like
corporate stock, provident fund, and life insurance, fixed deposits in the corporate sector
and unit trust schemes.
a. Objective fulfillment: An investment should fulfil the objective of the savers. Every
individual has a definite objective in making an investment. When the investment objective is
contrasted with the uncertainty involved with investments, the fulfilment of the objectives
through the chosen investment avenue could become complex
.
c. Return: The return from any investment is expectedly consistent with the extent of risk
assumed by the investor. Risk and return go together. Higher the risk, higher the chances of
getting higher return. An investment in a low risk -high safety investment such as investment in
government securities will obviously get the investor only low returns.
d. Liquidity: Given a choice, investors would prefer a liquid investment than a higher return
investment. Because the investment climate and market conditions may change or investor may
be confronted by an urgent unforeseen commitment for which he might need funds, and if he can
dispose of his investment without suffering unduly in terms of loss of returns, he would prefer
the liquid investment.
e. Hedge against inflation: The purchasing power of money deteriorates heavily in a country
which is not efficient or not well endowed, in relation to another country. Investors who save for
the long term, look for hedge against inflation so that their investments are not unduly eroded;
rather they look for a capital gain which neutralizes the erosion in purchasing power and still
gives a return.
f. Concealability: If not from the taxman, investors would like to keep their investments rather
confidential from their own kith and kin so that the investments made for their old age/ uncertain
future does not become a hunting ground for their own lives. Safeguarding of financial
instruments representing the investments may be easier than investment made in real estate.
Moreover, the real estate may be prone to encroachment and other such hazards.
h. Tax shield: Investment decisions are highly influenced by the tax system in the country.
Investors look for front-end tax incentives while making an investment and also rear-end tax
reliefs while reaping the benefit of their investments. As against tax incentives and reliefs, if
investors were to pay taxes on the income earned from investments, they look for higher return
in such investments so that their after-tax income is comparable to the pre-tax equivalent level
with some other income which is free of tax, but is riskier.
PROCESS OF INVESTMENT
The investment process is a stream of activities which ultimately leads to investment. It enables
an investor to understand the various sources of investment strategies and philosophies. An
investment process consists of the following steps:
1. Deciding investment goals
2. Analysis of securities
3. Construction of portfolio
4. Evaluating performance of portfolio
1. Deciding Investment Goals: Investment goals differ from one investor to another. These
are set keeping in mind the basic goal of investment i.e. maximizing the return and
minimizing the risk. The secondary goals of investment include regular income, capital
gain, tax savings, liquidity and safety of principal. Further, investors have to select
securities or financial instruments to construct portfolio to meet their investment goals.
2. Analysis of Securities: This is done by fundamental and technical analysis to find the
intrinsic value of securities and the future trends of price movements in them
respectively. Analysis of securities helps the investors to identify whether the securities
are underpriced or overpriced. Investors can maximize return by investing currently
underpriced securities but having potential to touch the peak. Further under this step
investors are guided by the standard principal of investment buy at low price and sell
when it is high.
5. Revision of portfolio: Revision of the portfolio depends on the results of appraisal. If the
current portfolio is not serving the objectives of investment, the investor must design a
new portfolio by selling certain less /underperforming securities and buying others that
can improve return on portfolio.
Diversification - The main objective of diversification is the reduction of risk in the loss of
capital and income. There are several ways to diversify the portfolio.
Debt and equity diversification - 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. Hence industry diversification is needed and it reduces risk.
Company diversification – Securities from different companies are purchased to reduce risk.
Financial Instruments
Definition of 'Financial Instrument'
A real or virtual document representing a legal agreement involving some sort of monetary
value. In today's financial marketplace, financial instruments can be classified generally as equity
based, representing ownership of the asset, or debt based, representing a loan made by an
investor to the owner of the asset. Foreign exchange instruments comprise a third, unique type of
instrument. Different subcategories of each instrument type exist, such as preferred share equity
and common share equity, for example.
Financial instruments can be thought of as easily tradeable packages of capital, each having their
own unique characteristics and structure. The wide array of financial instruments in today's
marketplace allows for the efficient flow of capital amongst the world's investors.
A financial instrument is a tradeable asset of any kind; either cash, evidence of an ownership
interest in an entity, or a contractual right to receive or deliver cash or another financial
instrument.
According to IAS32 and 39, it is defined as "any contract that gives rise to a financial asset of
one entity and a financial liability or equity instrument of another entity Financial instruments
can be categorized by form depending on whether they are cash instruments or derivative
instruments:
Cash instruments are financial instruments whose value is determined directly by the
markets. They can be divided into securities, which are readily transferable, and other
Cash instruments such as loans and deposits, where both borrower and lender have to
agree on a transfer.
Derivative instruments are financial instruments which derive their value from the value
and characteristics of one or more underlying entities such as an asset, index, or interest
rate. They can be divided into exchange-traded derivatives and over-the-counter (OTC)
derivatives.
Foreign Exchange instruments and transactions are neither debt nor equity based and belong in
their own category.
Money Market
Money market is a market for dealing with financial assets and securities which have a maturity
period of up to one year. In other words, it is a market for purely short-term funds.
Money market is a segment of financial market. It is a market for short term funds. It deals with
all transactions in short term securities. These transactions have a maturity period of one year or
less. Examples are bills of exchange, treasury bills etc. These short-term instruments can be
converted into money at low transaction cost and without much loss. Thus, money market is a
market for short term financial securities that are equal to money.
Money Market Instruments: Money Market Instruments provide the tools by which one
can operate in the money market. Money market instrument meets short term requirements of the
borrowers and provides liquidity to the lenders. The most common money market instruments
are Treasury Bills, Certificate of Deposits, Commercial Papers, Repurchase Agreements and
Banker's Acceptance.
Treasury Bills (T-Bills): Treasury Bills are one of the safest money market instruments
as they are issued by Central Government. They are zero-risk instruments, and hence returns are
not that attractive. T-Bills are circulated by both primary as well as the secondary markets. They
come with the maturities of 3-month, 6-month and 1-year.
The Central Government Issues T-Bills at a price less than their face value and the difference
between the buy price and the maturity value is the interest earned by the buyer of the
instrument. The buy value of the T-Bill is determined by the bidding process through auctions.
At present, the Government of India issues three types of treasury bills through auctions, namely,
91-day, 182-day and 364-day.
Commercial Papers (CPs): Commercial Paper is the short term unsecured promissory
note issued by corporates and financial institutions at a discounted value on face value. They
come with fixed maturity period ranging from 1 day to 270 days. These are issued for the
purpose of financing of accounts receivables, inventories and meeting short term liabilities.
The return on commercial papers is higher as compared to T-Bills so as the risk as they are less
secure in comparison to these bills. It is easy to find buyers for the firms with high credit ratings.
These securities are actively traded in secondary market.
Repurchase Agreements (Repo): Repurchase Agreements which are also called as Repo
or Reverse Repo are short term loans that buyers and sellers agree upon for selling and
repurchasing. Repo or Reverse Repo transactions can be done only between the parties approved
Repurchase agreements are sold by sellers with a promise of purchasing them back at a given
price and on a given date in future. On the flip side, the buyer will also purchase the securities
and other instruments with a promise of selling them back to the seller.
Short-Term Tax Exempts: These instruments are short-term notes issued by state and
municipal governments. Although they carry somewhat more risk than T-bills and tend to be less
negotiable, they feature the added benefit that the interest is not subject to federal income tax.
For this reason, corporations find that the lower yield is worthwhile on this type of short-term
investment.
Call and Short Notice Money: These are short term loans. Their maturity varies between
one day to fourteen days. If money is borrowed or lent for a day it is called call money or
overnight money. When money is borrowed or lent for more than a day and up to fourteen days,
it is called short notice money. Surplus funds of the commercial banks and other institutions are
usually given as call money. Banks are the borrowers as well as the lenders for the call
money. Banks borrow call funds for a short period to meet the cash reserve ratio (CRR)
requirements. Banks repay the call fund back once the requirements have been met. The interest
rate paid on call loans is known as the call rate. It is a highly volatile rate. It varies from day to
day, hour to hour, and sometimes even minute to minute.
CAPITAL MARKET
CAPITAL MARKET The capital market is a market for financial assets which have a long or
indefinite maturity. Generally, it deals with long term securities which have a maturity period of
above one year.
Capital market simply refers to a market for long term funds. It is a market for buying and
selling of equity, debt and other securities. Generally, it deals with long term securities that have
a maturity period of above one year.
Primary markets
The primary market is that part of the capital markets that deals with the issuance of new
securities. Companies, governments or public sector institutions can obtain funding through the
sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers.
The process of selling new issues to investors is called underwriting. In the case of a new stock
issue, this sale is an initial public offering (IPO). Dealers earn a commission that is built into the
price of the security offering, though it can be found in the prospectus.
Secondary markets
The secondary market is the financial market for trading of securities that have already been
issued in an initial private or public offering. Alternatively, secondary market can refer to the
market for any kind of used goods. The market that exists in a new security just after the new
issue, is often referred to as the aftermarket. Once a newly issued stock is listed on a stock
exchange, investors and speculators can easily trade on the exchange, as market makers provide
bids and offers in the new stock.
In the secondary market, securities are sold by and transferred from one investor or speculator to
another. It is therefore important that the secondary market be highly liquid and transparent.
Before electronic means of communications, the only way to create this liquidity was for
investors and speculators to meet at a fixed place regularly. This is how stock exchanges
originated.
2.Equities (also called Common Stock): This instrument is issued by companies only and can
also be obtained either in the primary market or the secondary market. Investment in this form of
business translates to ownership of the business as the contract stands in perpetuity unless sold to
another investor in the secondary market. The investor therefore possesses certain rights and
privileges (such as to vote and hold position) in the company. Whereas the investor in debts may
be entitled to interest which must be paid, the equity holder receives dividends which may or
may not be declared.
The risk factor in this instrument is high and thus yields higher return (when successful). Holders
of this instrument however rank bottom on the scale of preference in the event of liquidation of a
company as they are considered owners of the company.
3.Preference Shares: This instrument is issued by corporate bodies and the investors rank
second (after bond holders) on the scale of preference when a company goes under. The
instrument possesses the characteristics of equity in the sense that when the authorized share
capital and paid-up capital are being calculated, they are added to equity capital to arrive at the
total. Preference shares can also be treated as a debt instrument as they do not confer voting
rights on its holders and have a dividend payment that is structured like interest (coupon) paid for
bonds issues.
3) Redeemable: here the principal sum is repaid at the end of a specified period. In this case
it is treated strictly as a debt instrument.
Note: interest may be cumulative, flexible or fixed depending on the agreement in the Trust
Deed.
4.Derivatives: These are instruments that derive from other securities, which are referred to as
underlying assets (as the derivative is derived from them). The price, riskiness and function of
the derivative depend on the underlying assets since whatever affects the underlying asset must
affect the derivative. The derivative might be an asset, index or even situation. Derivatives are
mostly common in developed economies.
Of all the above stated derivatives, the common one in Nigeria is Rights where by the holder of
an existing security gets the opportunity to acquire additional quantity to his holding in an
allocated ratio.
DERIVATIVES
A derivative is a financial instrument which derives its value from the value of underlying
entities such as an asset, index, or interest rate—it has no intrinsic value in itself. Derivative
transactions include a variety of financial contracts, including structured debt obligations and
deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations of
these.
There are two groups of derivative contracts: the privately traded Over-the-counter (OTC)
derivatives such as swaps that do not go through an exchange or other intermediary, and
exchange-traded derivatives (ETD) that are traded through specialized derivatives exchanges or
other exchanges.
Conservative: investors often invest in cash. THIS means that they put their money
in interest bearing savings accounts, money market accounts, mutual funds, US Treasury
bills, and Certificates of Deposit. These are very safe investments that grow over a long
period of time. These are also low risk investments.
Moderate: investors often invest in cash and bonds, and may dabble in the stock market.
Moderate investing may be low or moderate risks. Moderate investors often also invest in
real estate, providing that it is low risk real estate.
Aggressive: investors commonly do most of THEIR investing in the stock market, which
is higher risk. They also tend to invest in business ventures as well as higher risk real estate. For
instance, if an aggressive investor puts his or her money into an older apartment building, then
invests more money renovating the property, they are running a risk. They expect to be able to
rent the apartments out for more money than the apartments are currently worth or to sell the
entire property for a profit on their initial investments. In some cases, this works out just fine,
and in other cases, it doesn't. It's a risk.
To forecast future stock prices, fundamental analysis combines economic, industry, and company
analysis to derive a stock’s fair value called intrinsic value. If fair value is not equal to the
current stock price, fundamental analysts believe that the stock is either over or under valued. As
the current market price will ultimately gravitate towards fair value, the fair value should be
estimated to decide whether to buy the security or not. By believing that prices do not accurately
reflect all available information, fundamental analysts look to capitalize on perceived price
discrepancies. Fundamental Analysis is a method of evaluating a security by attempting to
measure its intrinsic value by examining related economic, financial and other qualitative and
quantitative factors. Fundamental analysts attempt to study everything that can affect the
security’s value, including macroeconomic factors (like the overall economy and industry
conditions) and individual specific factors (like the financial condition and management of
companies).
Economic Analysis:
Every common stock is susceptible to the market risk. This feature of almost all types of
common stock indicates their combined movement with the fluctuations in the economic
conditions towards the improvement or deterioration.
Stock prices react favorably to the low inflation, earnings growth, a better balance of trade,
increasing gross national product and other positive macroeconomic news. Indications that
unemployment is rising, inflation is picking up or earnings estimates are being revised downward
will negatively affect the stock prices. This relationship is reasonably reliable that the US
economy is better represented by the Standard & Poor 500 stock index, which is famous market
indicator. The stock market will forecast an economic boom or recession properly from the signs
in front of average citizen. The Federal bank of New York has conducted research that describes
that the slope of the yield curve is the perfect indicator of the economic growth more than three
months out. Recession is indicated by negative slope while positive slope is considered as good
one.
The implications of market risk should be clear to the investor. When there is recession in the
economy, the prices of stocks move downward. All the companies suffer the effects of recession
despite of the fact that these are high performing companies or low performing ones. Similarly,
the stock prices are positively affected by the boom period of the economy.
2. Price level and Inflation: If the inflation rate increases, then the growth rate would be
very little. The increasingly inflation rate significantly affect the demand of consumer
product industry. The industry which has a weak market and come under the purview of
price control policy of the government may lose the market, like sugar industry. On the
other hand, the industry which enjoy a strong market for their product and which do not
come under purview of price control may benefit from inflation. If there is a mild level of
inflation, it is good to the stock market but high rate of inflation is harmful to the stock
market.
4. Industry Growth rate: The GDP growth rate represents the average of the growth rate
of agricultural sector, industrial sector and the service sector. Publicly listed company
play a major role in the industrial sector. The stock market analysts focus on the overall
growth of different industries contributing in economic development. The higher the
growth rate of the industrial sector, other things being equal, the more favorable it is for
the stock market.
5. Agriculture and monsoons: Agriculture is directly and indirectly linked with the
industries. Hence increase or decrease in agricultural production has a significant impact
on the industrial production and corporate performance. Companies using agricultural
raw materials as inputs or supplying inputs to agriculture are directly affected by change
in agriculture production. For example- Sugar, Cotton, Textile and Food processing
industries depend upon agriculture for raw material. Fertilizer and insecticides industries
are supplying inputs to agriculture. A good monsoon leads to higher demand for inputs
and results in bumper crops. This would lead to buoyancy in stock market. If the
monsoon is bad, agriculture production suffers and cast a shadow on the share market.
7. Government budget and deficit: Government plays an important role in the growth of
any economy. The government prepares a central budget which provides complete
information on revenue, expenditure and deficit of the government for a given period.
Government revenue come from various direct and indirect taxes and government made
expenditure on various developmental activities. The excess of expenditure over revenue
leads to budget deficit. For financing the deficit, the government goes for external and
internal borrowings. Thus, the deficit budget may lead to high rate of inflation and
adversely affects the cost of production and surplus budget may results in deflation.
8. The tax structure: The business community eagerly awaits the government
announcements regarding the tax policy in March every year. The type of tax exemption
has impact on the profitability of the industries. Concession and incentives given to
certain industry encourages investment in that industry and have favorable impact on
stock market.
9. Balance of payment, forex reserves and exchange rate: Balance of payment is the
record of all the receipts and payment of a country with the rest of the world. This
difference in receipt and payment may be surplus or deficit. Balance of payment is a
measure of strength of rupee on external account. The surplus balance of payment
augments forex reserves of the country and has a favorable impact on the exchange rates;
on the other hand if deficit increases, the forex reserve depletes and has an adverse
impact on the exchange rates. The industries involved in export and import are
considerably affected by changes in foreign exchange rates. The volatility in foreign
exchange rates affects the investment of foreign institutional investors in Indian Stock
Market. Thus, favorable balance of payment renders favorable impact on stock market.
11. Demographic factors: The demographic data details about the population by age,
occupation, literacy and geographic location. These factors are studied to forecast the
demand for the consumer goods. The data related to population indicates the availability
of work force. The cheap labor force in India has encouraged many multinationals to start
their ventures. Population, by providing labor and demand for products, affects the
industry and stock market.
12. Sentiments: The sentiments of consumers and business can have an important bearing on
economic performance. Higher consumer confidence leads to higher expenditure and
higher business confidence leads to greater business investments. All this ultimately leads
to economic growth. Thus, sentiments influence consumption and investment decisions
and have a bearing on the aggregate demand for goods and services.
Forecasting for an individual firm obviously begins with a forecast for the industry or
industries in which it is involved. Beyond this, the analyst must determine the degree to
which the company’s share of each market may vary during the forecast period. Such
variations can result from the introduction of a new product, the improvement of an
existing product, the opening, closing, or expansion of plants, the activities of domestic
or foreign competitors, a change in sales effort, or a variety of other factors. Information
required to make such assessments may come in part from the company’s own
investment and marketing plans. Information on the activity and sales prospects of
competitors is frequently collected from the firm’s own salesmen. An increasing number
of companies now employ sophisticated market research techniques to determine the
probable reaction of their customers to new products.
1. Anticipatory Surveys: Some elements of the future are known with reasonable
accuracy. Government spending is reflected in existing budgets. These budgets
indicate how much will be spent and how much money will be extracted from the
stream of private spending by taxation. Similar information is available on some parts
of the private economy. Periodic surveys conducted both by government and by
private organizations measure business plans to invest in new plants and equipment.
Increasingly, attempts are made to probe the mood and intentions of consumers
concerning the possible purchase of automobiles, houses, appliances, and other
durable goods. Regular surveys are also made to determine the general mood of the
public—whether people are optimistic or pessimistic about their own economic future
and thus whether their spending is apt to be relatively strong or relatively weak. In
2. Barometric or Indicator approach: Some elements of the future are known with
reasonable accuracy. Government spending is reflected in existing budgets. These
budgets indicate how much will be spent and how much money will be extracted
from the stream of private spending by taxation. Similar information is available on
some parts of the private economy. Periodic surveys conducted both by government
and by private organizations measure business plans to invest in new plants and
equipment. Increasingly, attempts are made to probe the mood and intentions of
consumers concerning the possible purchase of automobiles, houses, appliances, and
other durable goods. Regular surveys are also made to determine the general mood of
the public—whether people are optimistic or pessimistic about their own economic
future and thus whether their spending is apt to be relatively strong or relatively
weak. In general, such information obtained from the various surveys of investment
plans, spending plans, and attitudes has been highly useful to economic forecasters.
Such information helps to limit the range of possibility. But plans and attitudes
change, sometimes quite abruptly, and although the surveys are useful tools, they are
not clear and reliable guides to the future.
3. Diffusion Indexes: Some economists also use sets of statistics called diffusion
indexes to calculate economic turning points. A diffusion index is a method of
summarizing the common tendency of a group of statistical series. If a greater number
of the series are rising than are declining, the index will be above 50; if fewer are
rising than declining, it will be below 50. In effect, a diffusion index measures the
degree to which either strength or weakness pervades the economy. If, for example,
most of a group of industries are increasing their production rates, the economy as a
whole is probably expanding; if the proportion of industries that are growing begins
to decline and falls significantly below 50 percent for a period of time, the economy
is probably in a recession, or at least moving in that direction.
4. Money and Stock Prices: Monetary theory in its simplest form states that
fluctuations in the rate of growth of money supply are of utmost importance in
determining GNP, corporate profits, interest rates, stock prices etc. Monetarists
contend that changes in growth rate of money supply set off a complicated series of
events that ultimately affects share prices. In addition, these monetary changes lead
stock price changes. Thus, while making forecasts, changes in growth rate of money
supply should be given due importance. Some thinker’s states that stock market leads
INDUSTRY ANALYSIS:
The mediocre firm in the growth industry usually out performs the best stocks in a stagnant
industry. Therefore, it is worthwhile for a security analyst to pinpoint growth industry, which has
good investment prospects. The past performance of an industry is not a good predictor of the
future- if one look very far into the future. Therefore, it is important to study industry analysis.
For an industry analyst- industry life cycle analysis, characteristics and classification of industry
is important. All these aspects are enlightened in following sections:
INDUSTRY LIFE CYCLE ANALYSIS: Many industrial economists believe that the
development of almost every industry may be analyzed in terms of following stages:
1. Pioneering stage: During this stage, the technology and product is relatively new. The
prospective demand for the product is promising in this industry. The demand for the
product attracts many producers to produce the particular product. This lead to severe
competition and only fittest companies survive in this stage. The producers try to develop
brand name, differentiate the product and create a product image. This would lead to non-
price competition too. The severe competition often leads to change of position of the
firms in terms of market share and profit.
2. Rapid growth stage: This stage starts with the appearance of surviving firms from the
pioneering stage. The companies that beat the competition grow strongly in sales, market
share and financial performance. The improved technology of production leads to low
cost and good quality of products. Companies with rapid growth in this stage, declare
dividends during this stage. It is always advisable to invest in these companies.
3. Maturity and stabilization stage: After enjoying above-average growth, the industry
now enters in maturity and stabilization stage. The symptoms of technology obsolescence
may appear. To keep going, technological innovation in the production process should be
introduced. A close monitoring at industries events are necessary at this stage.
4. Decline stage: The industry enters the growth stage with satiation of demand,
encroachment of new products, and change in consumer preferences. At this stage the
earnings of the industry are started declining. In this stage the growth of industry is low
even in boom period and decline at a higher rate during recession. It is always advisable
not to invest in the share of low growth industry.
CLASSIFICATION OF INDUSTRY
2. Cyclical Industries: A type of an industry that is sensitive to the business cycle, such
that revenues are generally higher in periods of economic prosperity and expansion, and
lower in periods of economic downturn and contraction. Companies in cyclical industries
can deal with this type of volatility by implementing cuts to compensations and layoffs
during bad times, and paying bonuses and hiring en masse in good times. Cyclical
industries include those that produce durable goods such as raw materials and heavy
equipment For example, the airline industry is a fairly cyclical industry; in good
economic times, people have more disposable income and, therefore, they are more
willing to take vacations and make use of air travel. Conversely, during bad economic
times, people are much more cautious about spending. As a result, they tend to take more
conservative vacations closer to home (if they go at all) and avoid expensive air travel.
3. Defensive Industries: Defensive industries are those, such as the food processing
industry, which hurt least in the period of economic downswing. For example- the
industries selling necessities of consumers withstands recession and depression. The
stock of defensive industries can be held by the investor for income earning purpose.
Consumer nondurable and services, which in large part are the items necessary for
existence, such as food and shelter, are products of defensive industry.
1. Post sales and Earnings performance: The historical performance of sales and earnings
should be given due consideration, to know how the industry have reacted in the past.
With the knowledge and understanding of the reasons of the past behavior, the investor
can assess the relative magnitude of performance in future. The cost structure of an
industry is also an important factor to look into. The higher the cost component, the
higher the sales volume necessary to achieve the firm’s break-even point, and vice-versa.
2. Nature of Competition: The top firms in the industry must be analyzed. The demand of
particular product, its profitability and price of concerned company scrip’s also determine
the nature of competition. The investor should analyze the scrip and should compare it
with other companies. If too many firms are present in the industry, this will lead to a
decline in price of the product.
3. Raw Material and Inputs: We need to have a look on industries which are dependent on
raw material. An industry which has limited supply of raw material will have a less
growth. Labor in also an input and problems with labor will also lead to growth
difficulties.
5. Management: An industry with many problems may be well managed, if the promoters
and the management are efficient. The management has to be assessed in terms of their
capabilities, popularity, honesty and integrity. A good management also ensures that the
future expansion plans are put on sound basis.
6. Labor Conditions and Other Industrial Problems: The industries which depend on
labor, the possibility of strike looms as an important factor to be reckoned with. Certain
industries with problems of marketing like high storage costs, high transport costs etc.
leads to poor growth potential and investors have to careful in investing in such
companies.
7. Nature of Product Line: The position of industry in the different stages of the life cycle
is to be noted. And the importance attached by planning commission on these industries
assessment is to be studied.
8. Capacity Installed and Utilized: If the demand is rising as expected and market is good
for the products, the utilization of capacity will be higher, leading to bright prospects and
higher profitability. If the quality of the product is poor, competition is high and there are
9. Industry Share Price Relative to Industry Earnings: While making investment the
current price of securities in the industry, their risk and returns they promise is
considered. If the price is very high relative to future earnings growth, the investment in
these securities is not wise. Conversely, if future prospects are dim but prices are low
relative to fairly level future patterns of earnings, the stocks in this industry might be an
attractive investment.
10. Research and Development: The proper research and development activities help in
increasing economy of an industry and so while investing in an industry, the expenditure
should also be considered.
11. Pollution Standards: These are very high and restricted in the industrial sector. These
differ from industry to industry, for example, in leather, chemical and pharmaceutical
industries the industrial effluents are more.
The five forces mentioned above are very significant from point of view of strategy formulation.
The potential of these forces differs from industry to industry. These forces jointly determine the
profitability of industry because they shape the prices which can be charged, the costs which can
be borne, and the investment required to compete in the industry. Before making strategic
decisions, the managers should use the five forces framework to determine the competitive
structure of industry.
1.Risk of entry by potential competitors: Potential competitors refer to the firms which are not
currently competing in the industry but have the potential to do so if given a choice. Entry of
new players increases the industry capacity, begins a competition for market share and lowers
the current costs. The threat of entry by potential competitors is partially a function of extent of
barriers to entry. The various barriers to entry are-
• Economies of scale
• Brand loyalty
• Government Regulation
• Customer Switching Costs
• Absolute Cost Advantage
• Ease in distribution
• Strong Capital base
2.Rivalry among current competitors: Rivalry refers to the competitive struggle for market
share between firms in an industry. Extreme rivalry among established firms poses a strong
threat to profitability. The strength of rivalry among established firms within an industry is a
function of following factors:
• Extent of exit barriers
• Amount of fixed cost
3.Bargaining Power of Buyers: Buyers refer to the customers who finally consume the product
or the firms who distribute the industry’s product to the final consumers. Bargaining power of
buyers refer to the potential of buyers to bargain down the prices charged by the firms in the
industry or to increase the firms cost in the industry by demanding better quality and service of
product. Strong buyers can extract profits out of an industry by lowering the prices and
increasing the costs. They purchase in large quantities. They have full information about the
product and the market. They emphasize upon quality products. They pose credible threat of
backward integration. In this way, they are regarded as a threat.
4.Bargaining Power of Suppliers: Suppliers refer to the firms that provide inputs to the
industry. Bargaining power of the suppliers refer to the potential of the suppliers to increase the
prices of inputs (labor, raw materials, services, etc.) or the costs of industry in other ways. Strong
suppliers can extract profits out of an industry by increasing costs of firms in the industry.
Supplier’s products have a few substitutes. Strong suppliers’ products are unique. They have
high switching cost. Their product is an important input to buyer’s product. They pose credible
threat of forward integration. Buyers are not significant to strong suppliers. In this way, they are
regarded as a threat
5.Threat of Substitute products: Substitute products refer to the products having ability of
satisfying customer’s needs effectively. Substitutes pose a ceiling (upper limit) on the potential
returns of an industry by putting a setting a limit on the price that firms can charge for their
product in an industry. Lesser the number of close substitutes a product has, greater is the
opportunity for the firms in industry to raise their product prices and earn greater profits (other
things being equal). The power of Porter’s five forces varies from industry to industry. Whatever
be the industry, these five forces influence the profitability as they affect the prices, the costs,
and the capital investment essential for survival and competition in industry. This five forces
model also help in making strategic decisions as it is used by the managers to determine
industry’s competitive structure.
Company Analysis:
In company analysis different companies are considered and evaluated from the selected industry
so that most attractive company can be identified. Company analysis is also referred to as
security analysis in which stock picking activity is done. Different analysts have different
approaches of conducting company analysis like
• Value Approach to Investing
• Growth Approach to Investing
Additionally in company analysis, the financial ratios of the companies are analyzed in order to
ascertain the category of stock as value stock or growth stock. These ratios include price to book
ratio and price-earnings ratio. Other ratios like return on equity etc. can also be analyzed to
ascertain the potential company for making investment.
A. Competitive Edge: Many industries in India are composed of hundreds of individuals
companies. The large companies are successful in meeting the competition and some
companies rise to the position of eminence and dominance. The companies who have
obtain the leadership position; have proven his ability to withstand competition and to
have a sizable share in the market. The competitiveness of the company can be studied
with the help of:
a) Market share: The market share of the company helps to determine a company’s
relative position within the industry. If the market share is high, the company would be
able to meet the competition successfully. The size of the company should also be
considered while analyzing the market share, because the smaller companies may find it
difficult to survive in the future.
b) Growth of annual sales: Investor generally prefers to study the growth in sales because
the larger size companies may be able to withstand the business cycle rather than the
company of smaller size. The rapid growth keeps the investor in better position as growth
in sales is followed by growth in profit. The growth in sales of the company is analyzed
both in rupee terms and in physical terms.
c) Stability of annual sales: If a firm has stable sales revenue, other things being remaining
constant, will have more stable earnings. Wide variation in sales leads to variation in
capacity utilization, financial planning and dividends. This affects the company’s position
and investor’s decision to invest.
B. Earnings: The earning of the company should also be analyzed along with the sales level.
The income of the company is generated through the operating (in service industry like banks-
interest on loans and investment) and non-operating income (ant company, rentals from lease,
dividends from securities). The investor should analyze the sources of income properly. The
investor should be well aware with the fact that the earnings of the company may vary due to
C. Capital Structure: Capital structure is combination of owned capital and debt capital which
enables to maximize the value of the firm. Under this, we determine the proportion in which the
capital should be raised from the different securities. The capital structure decisions are related
with the mutual proportion of the long-term sources of capital. The owned capital includes share
capital.
a) Preference shares: Preference shares are those shares which have preferential rights
regarding the payment of dividend and repayment of capital over the equity shareholders.
At present many companies resort to preference shares. The preference shares induct
some degree of leverage in finance. The leverage effect of the preference shares is
comparatively lesser than that the debt because the preference shares dividend is not tax
deductible. If the portion of preference share in the capital is large, it tends to create
instability in the earnings of equity shares when the earnings of the company fluctuate.
b) Debt: It is an important source of finance as it has the specific benefit of low cost of
capital because interest is tax deductible. The leverage effect of debt is highly
advantageous to the equity shareholders. The limits of debt depend upon the firm’s
earning capacity and its fixed assets.
D. Management: The basic objective of the company is to attain the stated objectives of the
company for the good of the equity holders, the public and employees. If the objectives of the
company are achieved, investor will have a profit. Good management results in high profit to
investors. Management is responsible for planning, organizing, actuating and controlling the
activities of the company. The good management depends upon the qualities of the manager.
E. Operating Efficiency: The operating efficiency of the company directly affects the earnings
capacity of a company. An expanding company that maintains high operating efficiency with a
low breakeven point earns more than the company with high breakeven point. If a firm has stable
operating ratio, the revenues also would be stable. Efficient use of fixed assets with raw
materials, labor and management would lead to more income from sales. This leads to internal
fund generation for the expansion of the firm.
F. Financial Performance:
a) Balance Sheet: The level, trends, and stability of earnings are powerful forces in the
determination of security prices. Balance sheet shows the assets, liabilities and owner’s equity in
a company. It is the analyst’s primary source of information on the financial strength of a
company. Accounting principles dictate the basis for assigning values to assets. Liability values
are set by contracts. When assets are reduced by liabilities, the book value of shareholder’s
equity can be ascertained. The book value differs from current value in the market place, since
b) Profit and Loss account: It is also called as income statement. It expresses the results of
financial operations during an accounting year i.e. with the help of this statement we can find out
how much profit or loss has taken place from the operation of the business during a period of
time. It also helps to ascertain how the changes in the owner’s interest in a given period have
taken place due to business operations.
2) Trend Analysis: In order to compare the financial statements of various years trend
percentages are significant. Trend analysis helps in future forecast of various items on the
basis of the data of previous years. Under this method one year is taken as base year and
on its basis the ratios in percentage for other years are calculated. From the study of these
ratios the changes in that item are examined and trend is estimated. Sometimes sales may
be increasing continuously and the inventories may also be rising. This would indicate
the loss of market share of a particular company’s product. Likewise, sales may have an
increasing trend but profit may remain the same. Here the investor has to look into the
cost and management efficiency of the company.
3) Common Size Statement: Common size financial statements are such statements in which
items of the financial statements are converted in percentage on the basis of common base. In
common size Income Statement, net sales may be considered as 100 percent. Other items are
converted as its proportion. Similarly, for the Balance sheet items total assets or total liabilities
may be taken as 100 percent and proportion of other items to this total can be calculated in
percentage.
5) Cash Flow Statement: The investor is interested in knowing the cash inflow and outflow of
the enterprise. The cash flow statement expresses the reasons of change in cash balances of
company between two dates. It provides a summary of stocks of cash and uses of cash in the
organization. It shows the cash inflows and outflows. Inflows (sources) of cash result from cash
profit earned by the organization, issue of shares and debentures for cash, borrowings, sale of
assets or investments, etc. The outflows (uses) of cash results from purchase of assets,
investment redemption of debentures or preferences shares, repayment of loans, payment of tax,
dividend, interest etc. With the help of cash flow statement, the investor can review the cash
movement over an operating cycle. The factors responsible for the reduction of cash balances in
spite of increase in profits or vice versa can be found out.
Valuation of Securities
Definition of 'Bond'
A debt investment in which an investor loans money to an entity (corporate or governmental)
that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by
companies, municipalities, states and U.S. and foreign governments to finance a variety of
projects and activities. Bonds are commonly referred to as fixed-income securities and are one of
the three main asset classes, along with stocks and cash equivalents.
Bonds are a popular form of investment because they offer regular income, capital
preservation, and diversification benefits. It is a loan agreement between a borrower and a
lender. When an entity or an individual buys a bond, they lend money to the issuer for a
specific period.
The issuer promises to repay the amount at the end of the term with an agreed-upon interest rate.
This article discusses different types of bonds in India, their features, advantages, limitations,
and things to consider before investing.
Types of Bonds
1. Treasury Bonds: The central government issues treasury bonds. Hence, it is the safest type
of bond because there is no credit risk. These bonds have a maturity period of ten to thirty years
and pay a fixed interest rate, which is a factor in the prevailing market conditions.
2. Municipal Bonds: Local and state governments use these to gather funds for development
projects such as schools, highways, and hospitals. Municipal Bonds are exempted from tax. They
are available in both short-term and long-term maturities.
3. Corporate Bonds: Companies or business conglomerates issue corporate bonds to raise
capital for their business operations. They are riskier than treasury bonds because the
creditworthiness of the issuing company backs them. Corporate bonds can have varying
maturities and interest rates, depending on the issuer's creditworthiness and market conditions.
4. High-yield Bonds: Companies issue high-yield bonds with lower credit ratings and are
riskier than investment-grade bonds. They offer a higher yield to compensate for the higher risk.
High-yield bonds are also known as junk bonds.
5. Mortgage-Backed Securities: Real estate companies create mortgage-backed securities by
pooling many mortgages and issuing bonds against the underlying mortgage pool. The cash flow
from the mortgages backs these securities, so they are safer than corporate bonds because they
carry less credit risk.
Features of Bonds
Bonds come with several features that distinguish them from other forms of investment.
A. Interest Rate: The interest rate is the coupon the bond issuer pays the bondholder.
Typically, it is a fixed percentage of the face value of the bond and is paid out periodically over
the bond’s life.
B. Maturity date: The maturity date refers to the redemption date, and the bond issuer must
repay the bond's principal amount to the bondholder. It is the date on which the bond "matures."
C. Face value: The face value is the amount the bond issuer will pay the bondholder at
maturity. It is also known as the par value of the bond.
D. Yield: The yield is the rate of return on a bond. It is a percentage of the bond's current
market price. It considers both the coupon rate and the bond's current market price.
E. Credit rating: Credit rating agencies assign a bond rating based on the issuer's
creditworthiness. This rating reflects the likelihood that the issuer will default on its bond
payments.
Advantages of Bonds
There are various types of bonds to invest in, each with pros and cons. Bonds are a stable
investment option for risk-averse investors due to the dependability of interest and principal
returns. Some of these advantages include the following.
1. Steady income: Bonds typically provide a fixed income source through periodic interest
payments. This feature makes bonds an attractive option for investors seeking regular income.
2. Diversification: Bonds offer an opportunity to diversify an investor's portfolio. They tend to
have a low correlation with other asset classes, such as equities and can help reduce overall
portfolio risk.
3. Lower risk: They are less risky than equities since they have a higher priority of payment if
the issuer defaults. Bondholders are also typically paid back before equity holders are in
liquidation.
4. Predictability: Bonds have a fixed term and interest rate, making them predictable
investments. This predictability can be especially attractive for investors seeking a stable, low-
risk investment.
5. Issuer flexibility: They can be issued in various forms and terms, allowing issuers
flexibility in raising capital. Bonds are customisable and meet the specific needs of the issuer,
such as funding long-term projects or managing short-term cash needs.
Limitations of Bonds
Despite their many advantages, bonds also have some limitations.
1. Interest rate risk: Generally, bond prices tend to fall when the interest rate increases. It
means that if an investor needs to sell their bond before maturity, they may have to sell at a loss.
This risk is particularly relevant in a rising interest rate environment.
2. Inflation risk: While bonds provide a steady income stream, inflation can erode the value of
that income over time. It means that investors may end up with less purchasing power.
3. Credit risk: Bonds are only as good as the issuer’s creditworthiness. If the issuer defaults,
bondholders may not receive their entire principal and interest payments. One can mitigate the
risk by investing in bonds with higher credit ratings, but this generally comes at the cost of lower
yields.
Debentures
There are various kinds of instruments depending on the characteristics and terms of borrowing.
Debentures come under the category of medium- or long-term debt instruments which a firm
gives in return for some money borrowed and provides the person with a fixed amount of
interest.
Debentures are a profitable option for a firm as when the company grows and thrives, debentures
attract only a fixed sum out of the profit, but equity becomes part of the profit. Hence, from a
firm’s point of view, selling debentures is better than diluting equity. It is a far better way to raise
funds when compared to shares and can be easily reddened. It is a slightly better option for
people who don’t want to take the risk of investing in equity as equity provides ownership, but
one has to bear losses as well. On the other hand, debentures always get a fixed interest if the
company has enough funds to do so. They are always preferred over shareholders.
Types of Debentures
Debentures are a debt to a firm, but they are preferred because there is no equity dilution. It is
just a form of loan which is used for a company’s long term profit and growth. There are various
types of debentures in the market and one should always know about these before choosing the
one to be purchased.
1. Convertible Debentures- One of the various types of debentures is convertible debentures.
The most significant feature of differentiation of a convertible debenture is that it can be
converted into shares or stocks at a certain point in time or when the firm notifies of the same.
Although these debentures have a lower interest rate when compared to stock, they are extremely
useful.
2. Partially Convertible Debentures- The debentures which can be converted into shares but to
a certain limit or a certain percentage are known as partially convertible debentures. It is hybrid
as after its partial conversion, some portion remains debenture while some become part of the
company’s share.
3. Non- Convertible Debentures- These are normal or basic kinds of debentures which can
never be converted into stocks after they have been issued and till the time they exist.
Preference shares:
Preference shares commonly known as preferred stocks; are those shares that enable
shareholders to receive dividends announced by the company before receiving to the equity
shareholders.
If the company has decided to pay out its dividends to investors, preference shareholders are the
first to receive payouts from the company.
Preference shares are released to raise capital for the company, which is known as preference
share capital. If the company is going through a loss and winding up, the last payments will be
made to preference shareholders before paying to equity shareholders.
Preference shares that can be easily converted into equity shares are known as convertible
preference shares. Some preference shares also receive arrears of dividends, which are called
cumulative preference shares.
In India, preference shares should be redeemed within 20 years of issuance, and these types of
preference shares are called redeemable preference shares.
As per the Companies Act 2013, companies do not have any right to issue irredeemable
preference shares in India.
Equity shares:
An equity share, normally known as ordinary share is a part ownership where each member is a
fractional owner and initiates the maximum entrepreneurial liability related to a trading concern.
Difference between Bonds, Preference shares and equity shares
Bond Duration
DEFINITION of 'Duration' -A measure of the sensitivity of the price (the value of principal) of
a fixed-income investment to a change in interest rates. Duration is expressed as a number of
years. Rising interest rates mean falling bond prices, while declining interest rates mean rising
bond prices.
First, it's important to understand how interest rates and bond prices are related. The key point to
remember is that rates and prices move in opposite directions. When interest rates rise, the prices
of traditional bonds fall, and vice versa. So, if you own a bond that is paying a 3% interest rate
(in other words, yielding 3%) and rates rise, that 3% yield doesn't look as attractive. It's lost
some appeal (and value) in the marketplace.
Duration is a way of measuring how much bond prices are likely to change if and when interest
rates move. In more technical terms, duration is measurement of interest rate risk.
Duration is measured in years. Generally, the higher the duration of a bond or a bond fund
(meaning the longer you need to wait for the payment of coupons and return of principal), the
more its price will drop as interest rates rise.
Elements of Duration
The concept of duration is straightforward: It measures how quickly a bond will repay its true
cost. The longer it takes, the greater exposure the bond has to changes in the interest rate
environment.
Here are some of factors that affect a bond's duration:
Time to maturity: Consider two bonds that each cost $1,000 and yield 5%. A bond that
matures in one year would more quickly repay its true cost than a bond that matures in 10
years. As a result, the shorter-maturity bond would have a lower duration and less price risk.
The longer the maturity, the higher the duration.
Coupon rate:A bond's payment is a key factor in calculating duration. If two otherwise
identical bonds pay different coupons, the bond with the higher coupon will pay back its
original cost quicker than the lower-yielding bond. The higher the coupon, the lower the
duration.
Types of Duration There are four main types of duration calculations, each of which differ in
the way they account for factors such as interest rate changes and the bond's embedded options
or redemption features. The four types of durations are
Macaulay duration
modified duration
effective duration and
Key-rate duration.
Macaulay Duration The formula usually used to calculate a bond\'s basic duration is the
Macaulay duration, which was created by Frederick Macaulay in 1938, although it was not
commonly used until the 1970s. Macaulay duration is calculated by adding the results of
multiplying the present value of each cash flow by the time it is received and dividing by the
total price of the security. The formula for Macaulay duration is as follows:
Example 1:Betty holds a five-year bond with a par value of $1,000 and coupon rate of 5%. For
simplicity, let's assume that the coupon is paid annually and that interest rates are 5%. What is
the Macaulay duration of the bond?
= 4.55 years
Fortunately, if you are seeking the Macaulay duration of a zero-coupon bond, the duration would
be equal to the bond's maturity, so there is no calculation required.
Modified Duration Modified duration is a modified version of the Macaulay model that accounts
for changing interest rates. Because they affect yield, fluctuating interest rates will affect
duration, so this modified formula shows how much the duration changes for each percentage
change in yield. For bonds without any embedded features, bond price and interest rate move in
opposite directions, so there is an inverse relationship between modified duration and an
approximate 1% change in yield. Because the modified duration formula shows how a bond's
duration changes in relation to interest rate movements, the formula is appropriate for investors
wishing to measure the volatility of a particular bond. Modified duration is calculated as the
following:
OR
Let's continue to analyze Betty's bond and run through the calculation of her modified duration.
Currently her bond is selling at $1,000, or par, which translatesto a yield to maturity of 5%.
Remember that we calculated a Macaulay duration of 4.55.
= 4.33 years
= 4.33 years
Effective Duration The modified duration formula discussed above assumes that the expected
cash flows will remain constant, even if prevailing interest rates change; this is also the case for
option-free fixed-income securities. On the other hand, cash flows from securities with
embedded options or redemption features will change when interest rates change. For calculating
the duration of these types of bonds, effective duration is the most appropriate. Effective duration
requires the use of binomial trees to calculate the option-adjusted spread (OAS). There are entire
courses built around just those two topics, so the calculations involved for effective duration are
beyond the scope of this tutorial. There are, however, many programs available to investors
wishing to calculate effective duration
Key-Rate Duration The final duration calculation to learn is key-rate duration, which calculates
the spot durations of each of the 11 "key" maturities along a spot rate curve. These 11 key
maturities are at the three-month and one, two, three, five, seven, 10, 15, 20, 25, and 30-year
portions of the curve.
In essence, key-rate duration, while holding the yield for all other maturities constant, allows the
duration of a portfolio to be calculated for a one-basis-point change in interest rates. The key-rate
method is most often used for portfolios such as the bond ladder, which consists of fixed-income
securities with differing maturities. Here is the formula for key-rate duration:
The sum of the key-rate durations along the curve is equal to the effective duration.
Bond Return
There are several ways of describing a rate of return on bond. Some of them are:
Holding period return
The current yield
Yield to maturity
Yield to Maturity
It is the single discount factor that makes the present value of future cash flowsfrom a
bond equivalent to the current price of the bond.
It is calculated as:
Present value = coupon1 + coupon2 +………. + coupon n + Face value
Unit – 3
CONCEPT OF RETURN AND RISK
There are different motives for investment. The most prominent among all is to earn a return on
investment. However, selecting investments on the basis of return in not enough. The fact is that
most investors invest their funds in more than one security suggest that there are other factors,
besides return, and they must be considered. The investors not only like return but also dislike
risk. So, what is required is:
I. Clear understanding of what risk and return are
II. What creates them, and
III. How can they be measured?
Return:
The return is the basic motivating force and the principal reward in the investment process. The
return may be defined in terms of (i) realized return, i.e., the return which has been earned, and
(ii) expected return, i.e., the return which the investor anticipates to earn over some future
investment period. The expected return is a predicted or estimated return and may or may not
occur. The realized returns in the past allow an investor to estimate cash inflows in terms of
dividends, interest, bonus, capital gains, etc, available to the holder of the investment. The return
can be measured as the total gain or loss to the holder over a given period of time and may be
defined as a percentage return on the initial amount invested. With reference to investment
inequity shares, return is consisting of the dividends and the capital gain or loss at the time of
sale of these shares.
Risk:
Risk in investment analysis means that future returns from an investment are unpredictable. The
concept of risk may be defined as the possibility that the actual return may not be same as
expected. In other words, risk refers to the chance that the actual outcome (return) from an
investment will differ from an expected outcome. With reference to a firm, risk may be defined
as the possibility that the actual outcome of a financial decision may not be same as estimated.
The risk may be considered as a chance of variation in return. Investments having greater
chances of variations are considered riskier than those with lesser chances of variations. Between
equity shares and corporate bonds, the former is riskier than latter. If the corporate bonds are
held till maturity, then the annual interest inflows and maturity repayment. Investment
management is a game of money in which we have to balance the risk and return.
Types of Risk
Systematic risk
Also called undiversifiable risk or market risk. A good example of a systematic risk is market
risk. The degree to which the stock moves with the overall market is called the systematic risk
and denoted as beta.
A risk that is carried by an entire class of assets and/or liabilities. Systemic risk may apply to a
certain country or industry, or to the entire global economy. It is impossible to reduce systemic
risk for the global economy (complete global shutdown is always theoretically possible), but one
may mitigate other forms of systemic risk by buying different kinds of securities and/or by
buying in different industries. For example, oil companies have the systemic risk that they will
drill up all the oil in the world; an investor may mitigate this risk by investing in both oil
companies and companies having nothing to do with oil. Systemic risk is also called systematic
risk or undiversifiable risk.
Systematic risk is due to the influence of external factors on an organization. Such factors are
normally uncontrollable from an organization's point of view.
It is a macro in nature as it affects a large number of organizations operating under a similar
stream or same domain. It cannot be planned by the organization. The types of systematic risk
are depicted and listed below.
1. Price risk arises due to the possibility that the price of the shares, commodity, investment, etc.
may decline or fall in the future.
2. Reinvestment rate risk results from fact that the interest or dividend earned from an
investment can't be reinvested with the same rate of return as it was acquiring earlier.
2. Market risk
Market risk is associated with consistent fluctuations seen in the trading price of any particular
shares or securities. That is, it arises due to rise or fall in the trading price of listed shares or
securities in the stock market.
The types of market risk are depicted and listed below.
B. Unsystematic Risk
Unsystematic risk is due to the influence of internal factors prevailing within an organization.
Such factors are normally controllable from an organization's point of view.
It is a micro in nature as it affects only a particular organization. It can be planned, so that
necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk.
The types of unsystematic risk are depicted and listed below.
3. Operational risk
Operational risks are the business process risks failing due to human errors. This risk will
change from industry to industry. It occurs due to breakdowns in the internal procedures, people,
policies and systems.
The types of operational risk are depicted and listed below.
Other types:
Default risk:This is the most frightening of all investment risks. The risk of non-payment
refers to both the principal and the interest. For all unsecured loans, e.g. loans based on
promissory notes, company deposits, etc., this risk is very high. Since there is no security
attached, you can do nothing except, of course, go to a court when there is a default in refund of
capital or payment of accrued interest.
Given the present circumstances of enormous delays in our legal systems, even if you do go to
court and even win the case, you will still be left wondering who ended up being better off - you,
the borrower, or your lawyer!
Political risk: The government has extraordinary powers to affect the economy; it may
introduce legislation affecting some industries or companies in which you have invested, or it
may introduce legislation granting debt-relief to certain sections of society, fixing ceilings of
property, etc.One government may go and another come with a totally different set of political
and economic ideologies. In the process, the fortunes of many industries and companies undergo
a drastic change. Change in government policies is one reason for political risk.
Whenever there is a threat of war, financial markets become panicky. Nervous selling begins.
Security prices plummet. In case a war actually breaks out, it often leads to sheer pandemonium
in the financial markets. Similarly, markets become hesitant whenever elections are round the
corner. The market prefers to wait and watch, rather than gamble on poll predictions.
Causes of Risk:
Some factors, which can be stated to cause risk in the investment arena, are
given below:
Wrong method of investment,
Wrong period of investment,
Wrong quantity of investment,
Investment Strategies:
a. Value Investing: The objective of value investing is to purchase assets that trade at a discount
to their intrinsic value. The main idea of value investing is that the price you pay matters. For
example, you can’t just buy a stock because it represents a great company. The price of the stock
may be overvalued because it has been bid up. Buying the stock at the high price will greatly
reduce your long-term returns and increase the chances of losing money.
b. Contrarian Investing: Similar to value investing, contrarian investors try to buy assets that
are bargains, but also attempt to use behavior science studies that measure technical indicators
such as consumer sentiment. Contrarians will do the opposite of what “the herd” is doing.
This is the theory: If 95% of investors believe an investment asset is moving in a certain
direction, then they have already acted and there is little or no catalyst to propel the asset in the
same direction.
c. Growth at a Reasonable Price: Investors who subscribe to growth at a reasonable price
invest in growth companies but attempt to exclude putting stocks in the portfolio that are
extremely overvalued.
d. Growth Stock Investing: This strategy advocates purchasing companies with above average
earnings growth regardless of valuation.
e. Momentum Investing: This is strategy of buying stocks that have done well in a short period
of time (i.e. 3 – 12 months) and selling stocks with poor momentum.
f. Top-down or bottom-up investing: Top-down investing strategies involve choosing assets
based on a big theme. For example, if a fund manager anticipates that the economy will grow
sharply, he or she might buy stocks across the board. Or the manager might just buy stocks in
particular economic sectors, such as industrial and high technology, which tend to outperform
Unit – 4
TECHNICAL ANALYSIS
A technical analysis believes that the share prices are determined by the demand and supply
forces operating in the market. These demand and supply forces in turn are influenced by a
number of fundamental factors as well as certain psychological or emotional factors.
Many of these factors cannot be quantified. The combined impact of all these factors is
reflected in the share price movement. A technical analyst therefore concentrates on the
movement of share prices. He claims that by examining past share price movements future
share prices can be accurately predicted. Technical analysis is the name given to forecasting
techniques that utilize historical share price data.
The rationale behind technical analysis is that share price behavior repeats itself over time and
analysts attempt to derive methods to predict this repetition. A technical analyst looks at the
past share price data to see if he can establish any patterns. He then looks at current price data
to see if any of the established patterns are applicable and, if so, extrapolations can be made to
predict the future price movements. Although past share prices are the major data used by
technical analyst, other statistics such as volume of trading and stock market indices are also
utilized to some extent.
The basic premise of technical analysis is that prices move in trends or waves which may be
upward or downward. It is believed that the present trends are influenced by the past trends
and that the projection of future trends is possible by an analysis of past price trends. A
technical analyst, therefore, analyses the price and volume movements of individual securities
as well as the market index. Thus, technical analysis is really a study of past or historical price
and volume movements so as to predict the future stock price behavior.
1. The market value of a security is related to demand and supply factors operating in the
market.
2. There are both rational and irrational factors which surround the supply and demand factors
of security.
3. Security prices behave in a manner that their movement is continuous in a particular
direction for some length of time.
4. Trends in stock prices have been seen to change when there is a shift in the demand and
supply factors.
5. The shifts in demand and supply can be detected through charts prepared specially to show
market action.
6. Patterns which are projected by charts record price movements and these recorded patters
are used by analysts to make forecasts about the movement of prices in future.
2) Time: The degree of movement in price is a function of time. The longer it takes for a reversal
in trend, greater will be the price change that follows.
3) Volume: The intensity of price changes is reflected in the volume of transactions that
accompany the change. If an increase in price is accompanied by a small change in transactions,
it implies that the change is not strong enough.
4) Width: The quality of price change is measured by determining whether a change in trend
spreads across most sectors and industries or is concentrated in few securities only. Study of
the width of the market indicates the extent to which price changes have taken place in the
market in accordance with a certain overall trend.
DOW THEORY
Whatever is generally being accepted today as technical analysis has its roots in the Dow
theory. The theory is so called because it was formulated by Charles H.Dow who was the editor
of the Wall Street Journal in U.S.A. In fact, the theory was presented in a series of editorials in
the Wall Street Journal during 1900 – 1902.
Charles Dow formulated a hypothesis that the stock market does not move on a random basis
but is influenced by three distinct cyclical trends that guide its direction.
According to Dow theory, the market has three movements and these movements are
simultaneous in nature. These movements are the primary movements, secondary reactions
and minor movements.
The primary movement is the long-range cycle that carries the entire market up or down. This is
the long – term trend in the market. The secondary reactions act as a restraining
force on the primary movement. These are in the opposite direction to the primary movement
and last only for a short while. These are also known as corrections. For example, when the
market is moving upwards continuously, this upward movement will be interrupted by
downward movements of short durations. These are the secondary reactions. The third
movement in the market is the minor movements which are the day – to – day fluctuations in
the market. The minor movements are not significant and have no analytical value as they are
of very short duration. The three movements of the market have been compared to the tides,
the waves and the ripples in the ocean.
According to Dow theory, the price movements in the market can be identified by means of a
line chart. In this chart, the closing prices of shares or the closing values of the market index
may be plotted against the corresponding trading days. The chart would help in identifying the
primary and secondary movements.
Dow developed
this theory on the basis of certain hypothesis, which is as follows:
a. No single individual or buyer or buyer can influence the major trends in the market.
However, an individual investor can affect the daily price movement by buying or selling huge
quantum of particular scrip.
b. The market discounts everything. Even natural calamities such as earth quake, plague and
fire also get quickly discounted in the market. The world trade center blast affected the share
market for a short while and then the market returned back to normalcy.
c. The theory is not infallible and it is not a tool to beat the market but provides a way to
understand the market.
1. Primary Trend: The price trend may be either increasing or decreasing. When the
market exhibits the increasing trend, it is called bull market. The bull market shows
three clear-cut peaks. Each peak is higher than the previous peak and this price rise is
accompanied by heavy trading volume. Here, each profit taking reversal that is followed
by an increased new peak has a trough above the prior trough, with relatively light
trading volume during the reversals, indicating that there is limited interest in profit
taking at these levels. And the phases leading to the three peaks are revival,
improvement in corporate profit and speculation. The revival period encourages more
and more investors to buy scrips, their expectations about the future being high. In the
second phase, increased profits of corporate would result in further price rise. In the
third phase, prices advance due to inflation and speculation.
The reverse trend is true with the bear market. Here, first phase starts with the abandonment
of hopes. The chances of prices moving back to the previous high level seemed to be low. This
would result in the sale of shares. In the second phase, companies are reporting lower profits
and dividends. This would lead to selling pressure. The final phase is characterized by the
distress selling of shares. During the bear phase of 1996, in the Bombay Stock Exchange more
than 2/3 of the stocks were inactive. Most of the scrips were sold below their par values. The
figure 3 shows the phases of bear market where the tops and troughs are lower than previous
ones.
2. Secondary Trend: The secondary trend moves against the main trends and leads to
the correction. In the bull market, the secondary trend would result in the fall of about
33-66 percent of the earlier rise. In the bear market, the secondary trend carries the
price upward and corrects the main trend. Compared to the time taken for the primary
trend, secondary trend is swift and quicker.
3. Minor Trends: Minor trends are just like the ripples in the market. They are simply
the daily price fluctuations. Minor trend tries to correct the secondary price movement.
It is better for the investor to concentrate on the primary or secondary trends than on
the minor trends.
The theory was formulated in 1934 by Elliot after analyzing seventy-five years of stock price
movements and charts. From his studies he concluded that the market movement was quite
orderly and followed a pattern of waves.
A wave is a movement of the market price from one change in the direction to the next
change in the same direction. The waves are the result of buying and selling impulses emerging
from the demand and supply pleasures on the market. Depending on the demand and supply
pressures, waves are generated in the prices.
According to this theory, the market moves in waves. A movement in a particular direction can
be represented by five distinct waves. Of these five waves, three waves are in the direction of
the movement and are termed as impulse waves. Two waves are against the direction of the
movement and are termed as corrective waves or reaction wave. Waves 1, 3 and 5 are the
impulse waves and waves 2 and 4 are the corrective waves.
The wave 1 is upwards and wave 2 corrects the wave 1. Similarly, wave 3 and 5 are those with
and upward impulse and wave 4 corrects wave 3.
Corrections involve correcting the earlier rise. Thus, wave 2 would correct the rise of wave 1;
wave 4 would correct the rise of wave 3 and after the completion of wave, 5 there would come
a correction which would be labeled ABC. This correction would be in three waves in which
waves A and C will be against the trend and wave b will be along the trend. This ABC correction
following the fifth wave would correct the entire rise from the start of wave 1 to the end of the
fifth wave. It would be greater in dimension than either the second or fourth corrective wave.
One complete cycle consists of waves made up of two distinct phases, bullish and bearish. One
the full cycle of waves is completed after the termination of the 8-wave movement, there will
be a fresh cycle starting with similar impulses arising out of market trading.
The Elliot wave theory is based on the principle that action is followed by reaction. Although
the wave theory is not perfect and there are many limitations in its practical use, it is accepted
as one of the tools of technical analysis. The theory is used for predicting the future price
changes and in deciding the timing of investment.
PRICE CHARTS
Charting represents a key activity in technical analysis, because graphical representation is the
very basis of technical analysis. It is the security prices that are charted. A share may be traded
in the market at different prices on the same day. Of these different prices prevailing in the
market on each trading day, four prices are important. These are the highest price of the day,
the lowest price of the day, the opening price (first price of the day) and the closing price (last
price of the day). Of these four prices again, the closing price is by far the most important price
of the day because it is the closing price that is used in most analysis of share prices.
The price chart is the basic tools used by the technical analyst to study the share price
movement. The prices are plotted on an XY graph where the X axis represents the trading days
and the Y axis denotes the prices.
The oldest charting procedure was known as the point and figure (P & F) charting. It is now out
of vogue. Three types of price charts are currently used by technical analysts. These are the line
chart or the closing price chart, the bar chart and the Japanese candlestick chart.
1. Line Chart
It is the simplest price chart. In this chart, the closing prices of a share are plotted on the XY
graph on a day-to-day basis. The closing price of each day would be represented by a point on
the XY graph. All these points would be connected by a straight line which would indicate the
trend of the market. A line chart is illustrated in Fig. 3.4
2. Bar chart
It is perhaps the most popular chart used by technical analysts. In this chart, the highest price,
the lowest price and the closing price of each day are plotted on a day – to –day basis. A bar is
formed by joining the highest price and the lowest price of a particular day by a vertical line.
The top of the bar represents the highest price of the day, the bottom of the bar represents the
lowest price of the day and a small horizontal hash on the right of the bar is used to represent
the closing price of the day. Sometimes, the opening price of the day is marked as a hash on the
left side of the bar. An example of a price bar chart is shown in Fig. 3.5
There are mainly three types of candlesticks, viz., white, the black and the doji or neutral
candlestick. A white candlestick is used to represent a situation where the closing price of the
day is higher than the opening price. A black candlestick is used when the closing price of the
day is lower than the opening price. Thus, a white candlestick indicates a bullish trend while a
black candlestick indicates a bearish trend. A doji candlestick is the one where the opening
price and the closing price of the day are same. Japanese Candlestick Chart is illustrated in Fig.
3.6.
CHART PATTERNS
When the price bar charts of several days are drawn close together, certain patterns emerge.
These patterns are used by the technical analyst to identify trend reversal and predict the
future movement of prices. The chart patterns may be classified as support and resistance
patterns, reversal patterns and continuation patterns.
1. Support and Resistance: Support and resistance are price levels at which the downtrend
or uptrend in price movements is reversed. Support occurs when price is falling but bounces
back or reverses direction every time it reaches a particular level. When all these low points are
connected by a horizontal line, it forms the support line. In other words, support level is the
price level at which sufficient buying pressure is exerted to halt the fall in prices.
Resistance occurs when the share price moves upwards. The price may fall back every time it
reaches a particular level. A horizontal line joining these tops forms the resistance level. Thus,
resistance level is the price level where sufficient selling pressure is exerted to halt the ongoing
rise in the price of a share. Fig. 3.7 illustrates support and resistance levels.If the scrip were to
break the support level and move downwards, it has bearish implications signaling the
possibility of a further fall in prices. Similarly, if the scrip were to penetrate the resistance level
it would be indicative of a bullish trend or a further rise in prices.
Once a support level is violated, it would reverse roles and become a resistance level for any
future upward movement in price. Similarly, resistance level which is violated becomes the new
support level for any future downward movement in price.
2. Reversal Patterns: Price movements exhibit uptrends and downtrends. The trends
reverse direction after a period of time. These reversals can be identified with the help of
certain chart formations that typically occur during these trend reversals. Thus, reversal
patterns are chart formations that tend to signal a change in direction of the earlier trend.
a)Head and Shoulder Formation: The most popular reversal pattern is the Head and Shoulder
formation which usually occurs at the end of a long uptrend. This formation exhibits a hump or
top followed by a still higher top or peak and then another hump or lower top. This formation
resembles the head and two shoulders of a man and hence the name head and shoulder
formation.
The first hump, known as the left shoulder, is formed when the prices reach the top under a
strong buying impulse. Then trading volume becomes less and there is a short downward swing.
This is followed by another high-volume advance, which takes the price to a higher top known
as the head. This is followed by another reaction on less volume which takes the price down to
a bottom near to the earlier downsizing. A third rally now occurs taking the price to a height
less than the head but comparable to the left shoulder. This rally results in the formation of the
right shoulder. A horizontal line joining the bottoms of this formation is known as the neckline.
As the price penetrates this neckline, the formation of the head and shoulder pattern is
completed. Fig.3.8 shows a header and shoulder formation. The head and shoulder formation
usually occurs at the end of a bull phase and is indicative of a reversal of trend. After breaking
the neckline, the price is expected to decline sharply.
b) Inverse Head and Shoulder Formation: This pattern is the reverse of the head and shoulder
formation described above and is really an inverted head and shoulder pattern. This occurs at
the end of a bear phase and consists of three distinct bottoms. The first bottom is the left
shoulder, then comes a lower bottom which forms a head, followed by a third bottom which is
termed the right shoulder.
The neckline is drawn by joining the tops from which the head and the right shoulder originate.
When the price rises above the neckline the formation of the pattern is considered to be
completed. An inverse head and shoulder formation is shown in Fig.3.9.
The inverse head and shoulder pattern is also a reversal pattern indicative of an oncoming
bullish phase. In the formation of this pattern a large increase in volume becomes necessary.
Double top formation, triple top formation, double bottom formation, triple bottom formation
etc. are some of the other reversal patterns.
3. Continuation Patterns: There are certain patterns which tend to provide a breathing
space to the earlier sharp rise or fall and after the completion of these patterns, the price tends
to move along the original trend. These patterns are formed during side way movements of
share prices and are called continuation patterns because they indicate a continuation of the
trend prevailing before the formation of the pattern.
a) Triangles: Triangles are the most popular among the continuation patterns. Triangles are
formed when the price movements result in two or more consecutive descending tops and two
or more consecutive ascending bottoms. The triangle becomes apparent on the chart when the
consecutive tops are joined by a straight line and the consecutive bottoms are joined by
another straight line. The two straight lines are the upper trend line and the lower trend line
respectively. A triangle is illustrated in fig. 3.10.
The triangle formation may occur during a bull phase or a bear phase. In either case it would
indicate a continuation of the trend. It is generally seen that the volume diminishes during the
movement within the triangular pattern. The breakout from the pattern is usually accompanied
by increasing volume.
c) Flags and Pennants: These are considered to be very reliable continuation patterns. They
represent a brief pause in a fast-moving market. They occur mid-way between a sharp rise in
price or a steep fall in price.
The flag formation looks like a parallelogram with the two lines forming two parallel lines. The
volume of trading is expected to fall during the formation of the flag and again pick up on
breaking out from the pattern. The fig.3.11 illustrates the flag formation.
The pennant formation looks like a symmetrical triangle. The upper trendline formed by
connecting the tops stoops downwards, whereas the lower trendline formed by connecting the
bottoms rises upwards. A pennant formation is illustrated in fig. 3.12
The pennant is formed midway between either a bullish trend or a bearish trend and signals the
continuation of the same trend. The break out from the pattern is market by increased volume
of trading.
D) Double Tops and Bottoms: This chart pattern is another well-known pattern that signals
a trend reversal - it is considered to be one of the most reliable and is commonly used. These
patterns are formed after a sustained trend and signal to chartists that the trend is about to
reverse. The pattern is created when a price movement tests support or resistance levels twice
and is unable to break through. This pattern is often used to signal intermediate and long-term
trend reversals.
E) Cup and Handle: A cup and handle chart is a bullish continuation pattern in which the
upward trend has paused but will continue in an upward direction once the pattern is
confirmed.
F) Wedge: The wedge chart pattern can be either a continuation or reversal pattern. It is
similar to a symmetrical triangle except that the wedge pattern slants in an upward or
downward direction, while the symmetrical triangle generally shows a sideways movement.
The other difference is that wedges tend to form over longer periods, usually between three
and six months.
G) Gaps: A gap in a chart is an empty space between a trading period and the following
trading period. This occurs when there is a large difference in prices between two sequential
trading periods. For example, if the trading range in one period is between $25 and $30 and the
next trading period opens at $40, there will be a large gap on the chart between these two
periods. Gap price movements can be found on bar charts and candlestick charts but will not be
found on point and figure or basic line charts.
H) Triple Tops and Bottoms: Triple tops and triple bottoms are another type of reversal
chart pattern in chart analysis. These are not as prevalent in charts as head and shoulders and
double tops and bottoms, but they act in a similar fashion. These two chart patterns are formed
when the price movement tests a level of support or resistance three times and is unable to
break through; this signals a reversal of the prior trend.
MATHEMATICAL INDICATORS
Share prices do not rise or fall in straight lines. The movements are erratic. This makes it
difficult for the analyst to gauge the underlying trend. He can use the mathematical tool of
moving averages to smoothen out the apparent erratic movements of share prices and
highlight the underlying trend.
1. Moving Average: Moving averages are mathematical indicators of the underlying trend of
the price movement. Two types of moving averages (MA) are commonly used by analysts – the
simple moving average and the exponential moving average. The closing prices of shares are
generally used for the calculation of moving averages.
a) Simple Moving Average :An average is the sum of prices of a share for a specific number of
days divided by the number of days. In a simple moving average, a set of averages are
calculated for a specific number of days, each average being calculated by including a new price
and excluding an old price. The calculation of a simple moving averages is illustrated below:
The first total of 180.5 in column 3 is obtained by adding the prices of the first five days, that is,
(33 + 35 + 37.5 + 36 + 39). The second total of 187.5 in column 3 is obtained by adding the price
of the 6th day and deleting the price of the first day from the first total, that is, (180.5 + 40 –
33). This process is continued. The moving average in column 4 is obtained by dividing the total
figure in column 3 by the number of days, namely 5.
b)Exponential Moving Average: Exponential moving average (EMA) is calculated by using the
following formula: EMA = (Current closing price – Previous EMS) x Factor + Previous EMA
Where
The EMA for the first day is taken as the closing price of that day itself. The EMA for the second
day is calculated as shown below.
EMA = (Closing price – Previous EMA) x Factor + Previous EMA
= (35 – 33) x 0.33 + 33 = 33.66
EMA for the third day = (37.5 – 33.66) x 0.33 + 33.66 = 34.93
If we are calculating the five-day exponential moving average, the correct five-day EMA will be
available from the sixth day onwards.
A moving average represents the underlying trend in the share price movement. The period of
the average indicates the type of trend being identified. For example, a five day or ten-day
average would indicate the short – term trend; a 50-day average would indicate the medium –
term trend and a 200 day average would represent the long – term trend.
The moving averages are plotted on the price charts. The curved line joining these moving
averages represent the trend line. When the price of the share intersects and moves above or
below this trendline, it may be taken as the first sign of trend reversal.
Sometimes, two moving averages – one short term and the other longer – term – are used in
combination. In this case, trend reversal is indicated by the intersection of the two moving
averages.
2. Oscillators : Oscillators are mathematical indicators calculated with the help of the closing
price data. They help to identify overbought and oversold conditions and also the possibility of
trend reversals. These indicators are called oscillators because they move across a reference
point.
a) Rate of change indicator (ROC): It is very popular oscillator which measures the rate of
change of the current price as compared to the price a certain number of days or weeks back.
To calculate a 7-day rate of change, each day ‘s price is divided by the price which prevailed 7
days ago and then 1 is subtracted from this price ratio.
The ROC values may be positive, negative or zero. An ROC chart is shown in Fig. 3.14 where the
X axis represents the time and the Y axis represents the values of the ROC. The ROC values
oscillate across the zero line. When the ROC line is above the zero line, the price is rising and
when it is below the zero line, the price is falling.
Ideally, one should buy a share that is oversold and sell a share that is overbought. In the ROC
chart, the overbought zone is above the zero line and the oversold zone is below the zero line.
Many analysts use the zero line for identifying buying and selling opportunities. Upside crossing
(from below to above the zero line) indicates a buying opportunity, while a downside crossing
(from above to below the zero line) indicated a selling opportunity. The ROC has to be used
along with the price chart. The buying and selling signals indicated by the ROC should also be
confirmed by the price chart.
b) Relative Strength Index (RSI): This is a powerful indicator that signals buying and selling
opportunities ahead of the market. RSI for a share is calculated by using the following formula.
The most commonly used time period for the calculation of RSI is 14 days. For the calculation a
14-day RSI, the gain per day or loss per day is arrived at by comparing the closing price of a day
with that of the previous day for a period of 14 days. Similarly, the losses are added up and
divided by 14 to get the average loss per day. The average gain per day and the average loss per
day are used in the above formula for calculating the RSI for a day. In this way RSI values can be
calculated for a number of days.
= 100 – (100/3.50)
= 100 – 28.58 = 71.42
This is the RSI for day 15. In this way the RSI values for the subsequent days can be calculated
by taking the closing prices of 14 previous days. The RSI values range from 0 to 100. These
values are then plotted on an XY graph as shown in below fig. 3.15RSI values above 70 are
considered to denote overbought condition and values below 30 are considered to denote
oversold condition. When the RSI has crossed the 30 lines from below to above and is rising, a
buying opportunity is indicated. When it has crossed the 70 lines from above to below and is
falling, a sell signal is indicated.
MARKET INDICATORS
Technical analysis focuses its attention not only on individual stock price behavior, but also on
the general trend of the market. Indicators used by technical analyst to study the trend of the
market as a whole are known as market indicators. Some of these indicators
a) Breadth of the Market: By comparing the number of shares which advanced and the
number of shares that declined during a period, the trend of the market can be ascertained.
Comparison of advances and decline is a means of measuring the dispersion or breadth of a
general price rise or decline. The difference between the advances and declines is called the
breadth of the market
The breadth is calculated by taking the daily net difference between the number of shares that
have advanced and the number of shares that have declined. Each day ‘s difference is added to
the next day‘s difference to form a continuous cumulative index as shown in the table below.
The index is plotted as a line graph and compared with the market index. Normally, breadth and
market index move in unison. When they diverge, a key signal occurs. In case of divergence, the
breadth line shows the true direction of the market. For instances, during a bull market if
breadth declines to new lows while the market index makes new highs a peak is suggested
followed by a downturn in stock prices. Breadth may also signal recovery. This happens when
the breadth line begins to rise even as the market index is reaching new lows.
b) Short Interest: A speculator often resorts to short selling which is selling a share that is
not owned by the person. This is done when the speculator feels that the price of the stock will
fall in future. He hopes to purchase the share at a later date (cover his short position) below the
selling price and reap a profit.
The volume of short sales in the market can be used as a market indicator. As a technical
indicator, short selling is called short interest. The expectation is that short sellers must
eventually cover these positions. This buying activity increases the demand for stocks. Thus,
short interest has significance for the market as a whole.
Monthly short selling volume is related to the average daily volume for the preceding month.
Thus, monthly short selling volume is divided by average daily volume to give a ratio which
indicates how many days of trading it would take to cover up total short sales.
In general, when the ratio is less than 1.0, the market is considered to be weakening or
overbought ‘. A decline should follow sooner or later. Values above 1.5 are considered to
indicate that the market is ‘oversold ‘and is likely to turn bullish shortly.
c) Odd-Lot Index: Small investors are presumed to buy smaller number of shares than the
normal trading lot of 100 shares. These are known as odd lots and the buyers and sellers of odd
lots are called odd lotters. Technical analysis believe that the odd lotters are inclined to do the
wrong thing at critical turns in the market because of their presumed lack of sophistication.
An odd-lot index can be calculated by relating odd-lot purchases to odd-lot sales. The odd-lot
index is obtained by dividing odd-lot by odd-lot sales. An increase in this index suggests
relatively more buying activity and vice versa. At or near the peak of a bull market, when the
investors should be selling their shares, the odd lotters would be buying proportionately more
than selling. Thus, the odd-lot index rises noticeably just before a decline in the market.
Similarly, the odd-lot sales increase greatly causing a fall in the odd-lot index just before a rise
in the market.
d) Mutual Fund Cash Ratio: Mutual funds represent one of the most important
institutional forces in the market. Mutual fund cash as a percentage of their net assets on a
daily or weekly basis has been a popular market indicator. Mutual funds keep cash to take
advantage of favorable market opportunities and to provide for redemption of their units by
holders. The theory is that a low cash ratio of, say about five per cent, would indicate a
reasonably fully invested position leaving negligible buying power in their hands. Low cash
ratios are equated with market highs indicating that the market is about to decline. At market
bottoms the cash ratio would be high. This is an indication of potential purchasing power which
can propel a rise in prices.
Thus, high mutual fund cash ratio signals a rise in prices of shares.A few other market indicators
are also being used but technical analysts to predict changes in the direction of the overall
market.
3. What is more important than why-It is said that ―A technical analyst knows the price
of everything, but the value of nothing‖. Technical analysts are mainly concerned with two
things:
1. The current price
2. The history of the price movement
Technical analysis represents a direct approach. The price is the final result of the fight between
the forces of supply and demand for any tradable instrument. The objective of analysis is to
forecast the direction of the future price. Fundamentalists are concerned with why the price is
what it is. For technicians, the why portion of the equation is too broad and many times the
fundamental reasons given are highly suspect. Technicians believe it is best to concentrate on
what and never mind why. Why did the price go up? It is simple, more buyers (demand) than
sellers (supply). The principles of technical analysis are universally applicable. The principles of
support, resistance, trend, trading range and other aspects can be applied to any chart.
Technical analysis can be used for any time horizon; for any marketable instrument like stocks,
futures and commodities, fixed income securities, forex, etc.
1. The market discounts everything: Technical analysis is criticized for considering only prices
and ignoring the fundamental analysis of the company, economy etc. Technical analysis
assumes that, at any given time, a stock ‘s price reflects everything that has or could affect the
company including fundamental factors. The market is driven by mass psychology and pulses
with the flow of human emotions. Emotions may respond rapidly to extreme events, but
normally change gradually over time. It is believed that the company’s fundamentals, along
with broader economic factors and market psychology, are all priced into the stock, removing
the need to actually consider these factors separately. This only leaves the analysis of price
movement, which technical theory views as a product of the supply and demand for a particular
Stock in the market.
2. Price moves in trends ―Trade with the trend‖ is the basic logic behind technical analysis.
Once a trend has been established, the future price movement is more likely to be in the same
direction as the trend than to be against it. Technical analysts frame strategies based on this
assumption only.
3. History tends to repeat itself : People have been using charts and patterns for several
decades to demonstrate patterns in price movements that often repeat themselves. The
repetitive nature of price movements is attributed to market psychology; in other words,
market participants tend to provide a consistent reaction to similar market stimuli over time.
Technical analysis uses chart patterns to analyze market movements and understand trends.
3. Supply, demand, and price action: Technicians make use of high, low and closing prices to
analyze the price action of a stock. A good analysis can be made only when all the above
information is present separately, these will not be able to tell much. However, taken together,
the open, high, low and close reflect forces of supply and demand.
4. Support and resistance : Charting is a technique used in analysis of support and resistance
level. These are trading range in which the prices move for an extended period of time, saying
that forces of demand and supply are deadlocked. When prices move out of the trading range,
it signals that either supply or demand has started to get the upper hand. If prices move above
the upper band of the trading range, then demand is winning. If prices move below the lower
band, then supply is winning.
5. Pictorial price history : A price chart offers most valuable information that facilitates reading
historical account of a security‘s price movement over a period of time. Charts are much easier
to read than a table of numbers. On most stock charts, volume bars are displayed at the
bottom. With this historical picture, it is easy to identify the following:
6. Assist with entry point: Technical analysis helps in tracking a proper entry point.
Fundamental analysis issued to decide what to buy and technical analysis is used to decide
when to buy. Timings in this context play a very important role in performance. Technical
analysis can help spot demand (support) and supply (resistance) levels as well as breakouts.
Checking out for a breakout above resistance or buying near support levels can improve
returns. First of all, you should analyze stock ‘s price history. If a stock selected by you was great
for the last three years has traded fl at for those three years, it would appear that market has a
different opinion. If a stock has already advanced significantly, it may be prudent to wait for a
pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend
reversal.
2. Open to interpretation: Technical analysis is a combination of science and art and is always
open to interpretation. Even though there are standards, many times two technicians will look
at the same chart and paint two different scenarios or see different patterns. Both will be able
to come up with logical support and resistance levels as well as key breaks to justify their
position. Is the cup half-empty or half-full? It is in the eye of the beholder.
3. Too late: You can criticize the technical analysis for being too late. By the time the trend is
identified, a substantial move has already taken place. After such a large move, the reward to
risk ratio is not great. Lateness is a particular criticism of Dow Theory.
4. Always another level: Technical analysts always wait for another new level. Even after a new
trend has been identified, there is always another ―important‖ level close at hand. Technicians
have been accused of sitting on the fence and never taking an unqualified stance. Even if they
are bullish, there is always some indicator or some level that will qualify their opinion.
The random walk theory presupposes that the stock markets are so efficient and competitive
that there is immediate price adjustment. This is the result of good communication system
through which information can be spread almost anywhere in the country instantaneously.
Thus, the random walk theory is based on the hypothesis that the stock markets are efficient.
Hence, this theory later came to be known as the efficient market hypothesis (EMH) or the
efficient market model.
The efficient market hypothesis (EMH) is an investment theory that states it is impossible to
"beat the market" because stock market efficiency causes existing share prices to always
incorporate and reflect all relevant information. According to the EMH, stocks always trade at
their fair value on stock exchanges, making it impossible for investors to either purchase
undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to
outperform the overall market through expert stock selection or market timing, and that the
only way an investor can possibly obtain higher returns is by purchasing riskier investments.
Fundamentalists believe that it may take several days or weeks before investors can fully assess
the impact of new information. As a consequence, the price may be volatile for a number of
days before it adjusts to a new level. This provides an opportunity to the analyst who has
superior analytical skills to earn excess returns.
The efficient market theory holds the view that in an efficient market, new information is
processed and evaluated as it arrives and prices instantaneously adjust to new and correct
levels. Consequently, an investor cannot consistently earn excess returns by undertaking
fundamental analysis or technical analysis
(2) Semi-strong form: The semi-strong of the efficient market hypothesis concentrates on how
rapidly and efficiently market prices adjust to new publicly available information. The investor,
in this form of market, will find it impossible to earn a return on the portfolio which is based
on the publicity available information in excess of the return which may be said to be
commensurate with the portfolio risk. Semi-strong form suggests the fruitlessness of efforts
to earn superior rates of return, it represents a direct challenge to traditional financial analysis
based on the evaluation of publicly available data. In the semi-strong market, any new
announcement would bring a reaction immediately upon the announcement. This reaction
prior to or immediately after the announcement would be caused by the additional information
which is not anticipated by the stock market participants.
(3) Strong form: The strong form is concerned with the possession of inside information. In the
strong form of the market it is stated that all information is represented in the security prices
in such a way that there is no opportunity for any person to make an extraordinary gain on the
basis of any information. The stock prices reflect not only what is generally known through
public announcements but also what is generally known through public announcements.
Certain groups have monopolistic access to information. This is the most extreme from of the
efficient market hypothesis. If the strong form holds, then, any day is as good as other day to
buy any stock. However, most of research work, has indicated that the efficient market
hypothesis in the strongest form does not hold good. There is no doubt that access to inside
information, such as that available to corporate officials and specialists, enables investors to
beat the market, this is not surprising and explains why market efficiency is usually restricted to
the weak and semi-strong forms.
1. The weak form of the efficient market hypothesis (EMH) says that the current prices of
stocks already fully reflect all the information that is contained in the historical
sequence of prices. The new price movements are completely random. They are
produced by new pieces of information and are not related or dependent on past price
movements. Therefore, there is no benefit in studying the historical sequence of prices
to gain abnormal returns from trading in securities. This implies that technical analysis,
which relies on charts of price movements in the past, is not a meaningful analysis for
making abnormal trading profits.
The weak form of the efficient market hypothesis is thus a direct repudiation of technical
analysis.
Two approaches have been used to test the weak form of the efficient market hypothesis. One
approach looks for statistically significant patterns in security price changes. The alternative
approach searches for profitable short-term trading rules.
a) Serial Correlation Test: Since the weak form EMH postulates independence between
successive price changes, such independence or randomness in stock price movements can be
tested by calculating the correlation between price changes in one period and changes for the
same stock in another period. The correlation coefficient can take on a value ranging from -1 to
1; a positive number indicates a direct relation; a negative value implies an inverse relationship
and a value close to zero implies no relationship. Thus, if correlation coefficient is close to zero,
the price changes can be considered to be serially independent.
b) Run Test: The run test is another test used to test the randomness in stock price movements.
In this test, the absolute values of price changes are ignored; only the direction of change is
considered. An increase in price is represented by + signs. The decrease is represented by –
sign. When there is no change in prices, it is represented by ‘O ‘. A consecutive sequence of the
same sign is considered as a run. For example, the sequence + + + - - - has two runs. In other
words, a change of sign indicates a new run. The sequence - - - + + 0 - - - + + + + has five runs; a
run of three - ‘s, followed by a run of two + ‘s, another run of one 0, a fourth run of three - ‘s
and a fifth run of four + ‘s. In a run test, the actual number of runs observed in a series of stock
price movements is compared with the number of runs in a randomly generated number series.
If no significant differences are found, then the security price changes are considered to be
random in nature.
c) Filter Tests: If stock price changes are random in nature, it would be extremely difficult to
develop successful mechanical trading systems. Filter tests have been developed as direct tests
of specific mechanical trading strategies to examine their validity and usefulness. It is often
believed that, as long as no new information enters the market, the price fluctuates randomly
within two barriers—one lower, and the other higher—around the fair price. When new
information comes into the market, a new equilibrium price will be determined. If the news is
favorable, then the price should move up to a new equilibrium above the old price. Investors
will know that this is occurring when the price breaks through the old barrier. If investors
purchase at this point, they will benefit from the price increase to the new equilibrium level.
Likewise, if the news received is unfavorable, the price of the stock will decline to a lower
equilibrium level. If investors sell the stock as it breaks the lower barrier, they will avoid much
of the decline. Technicians set up trading strategies based on such patterns to earn excess
returns.
The strategy is called a filter rule. The filter rule is usually stated in the following way: Purchase
the stock when it rises by x per cent from the previous low and sell it when it declines by x per
cent from the subsequent high. The filters may range from 1 per cent to 50 per cent or more.
The alternative to this active trading strategy is the passive buy and hold strategy.
The returns generated by trading according to the filter rule are compared with the returns
earned by an investor following the buy and hold strategy. If trading with filters results in
superior returns that would suggest the existence of patterns in price movements and negate
the weak form EMH.
d) Distribution Pattern: It is a rule of statistics that the distribution of random occurrences will
conform to a normal distribution. Then, if price changes are random, their distribution should
also be approximately normal. Therefore, the distribution of price changes can be studied to
test the randomness or otherwise of stock price movements.
In the 1960s the efficient market theory was known as the random walk theory. The empirical
studies regarding share price movements were testing whether prices followed a random walk.
Two articles by Roberts and Osborne, both published in 1959, stimulated a great deal of
discussion of the new theory then called random walk theory.
Semi-strong form tests deal with whether or not security prices fully reflect all publicly available
information. These tests attempt to establish whether share prices react precisely and quickly
to new items of information. If prices do not react quickly and adequately, then an opportunity
exists for investors or analysts to earn excess returns by using this information. Therefore,
these tests also attempt to find if analysts are able to earn superior returns by using publicly
available information.
The general methodology followed in these studies has been to take an economic event and
measure its impact on the share price. The impact is measured by taking the difference
between the actual return and expected return on a security. The expected return on a security
is generally estimated by using the market model (or single index model) suggested by William
Sharpe. The model used for estimating expected returns is the following:
Ri = ai + biRm + ei
Where
Ri = Return on security i.
Rm= Return on a market index.
ai& bi = Constants.
ei = Random error.
This analysis is known as Residual analysis. The positive difference between the actual return
and the expected return represents the excess return earned on a security. If the excess return
is close to zero, it implies that the price reaction following the public announcement of
information is immediate and the price adjusts to a new level almost immediately. Thus, the
lack of excess returns would validate the semi-strong form EMH.
The strong form efficiency tests involve two types of tests. The first type of tests attempt to find
whether those who have access to inside information have been able to utilize profitably such
inside information to earn excess returns. The second type of tests examine the performance of
mutual funds and the recommendations of investment analysts to see if these have succeeded
in achieving superior returns with the use of private information generated by them.
Unit- 5
Portfolio Management
MEANING OF PORTFOLIO
Portfolio means combined holding of many kinds of financial security that is shares, debentures,
government bonds, units and other financial assets. The term investment portfolio refers to the
various assets of an investor which are to be considered as a unit. It is not merely a collection of
a unrelated assets but a carefully blended asset combination within a unified framework. It is
necessary for investors to take all decisions as regards their wealth position in a portfolio context.
Making a portfolio putting one’s egg in different baskets with varying elements of a risk and
return. Thus, a portfolio is a combination of various instrument of investment. It is also
combination of securities with different risk return characteristics. A portfolio is built up out of
the wealth or income of the investors over a period of time with a view to manage the risk return
preferences. The analysis of the risk return characteristics of individual securities in the portfolio
is made from time-to-time and changes that may take place in combination with other securities
are adjusted accordingly. The object of portfolio is to reduce risk by diversification and
maximize gains.
PORTFOLIO MANAGEMENT
Portfolio Management is the art and science of making decisions about investment mix and
policy, matching investments to objectives, asset allocation for individuals and institutions, and
balancing risk against performance. The art of selecting the right investment policy for the
individuals in terms of minimum risk and maximum return is called as portfolio management. It
also refers to managing an individual’s investments in the form of bonds, shares, cash, mutual
funds, etc. so that he earns the maximum profits within the specific time frame. Portfolio
management refers to managing money of an individual under the expert guidance of portfolio
managers. It is done by analyzing the strengths, weaknesses, opportunities and threats in
different investment alternatives to have a risk return trade off. Portfolio management is all about
strengths, weaknesses, opportunities and threats in the choice of debt v/s. equity, domestic v/s.
international, growth v/s. safety, and many other tradeoffs encountered in the attempt to
maximize return at a given appetite for risk. Portfolio is nothing but the combination of various
stocks in it. Understanding the dynamics of market is the essence of Portfolio Management.
This means Portfolio Management basically deals with three critical questions of
investment planning.
1. Where to Invest?
2. When to Invest?
3. How much to Invest?
Portfolio analysis:
Portfolio analysis begins where security analysis ends.
Portfolio refers to invest in a group of securities rather to invest in a single security.
Portfolio analysis is the determination of the future risk and return in holding various
combinations of individual securities.
Portfolio analysis helps to make the investment activity more rewarding and less risky.
Portfolio analysis is broadly carried out for each asset at two levels:
*Risk aversion: This method analyzes the portfolio composition while considering the risk
appetite of an investor. Some investors may prefer to play safe and accept low profits rather than
invest in risky assets that can generate high returns.
*Analyzing returns: While performing portfolio analysis, prospective returns are calculated
through the average and compound return methods. An average return is simply the arithmetic
average of returns from individual assets. However, compound return is the arithmetic mean that
considers the cumulative effect on overall returns.
SELECTION OF PORTFOLIO
Portfolio Selection is the process of finding out the optimal portfolio which would be one
generating highest return with the lowest risk. This is done with the objective of maximizing the
investor’s return. Diversification is done for reducing the risk in a portfolio. The investor usually
combines a limited number of securities thereby creating a large number of portfolios and in
different proportions. This is known as portfolio opportunity set. Every portfolio in the
opportunity set is characterized by an expected return and some risk in terms of variance or
standard deviation. Some portfolios in a portfolio opportunity set are of interest to an investor
depending upon the risk and return as measured by standard deviation. A portfolio will dominate
over others if it has a lower standard deviation.
The selection of portfolio depends upon the objectives of the investor. The selection of
portfolio under different objectives are dealt subsequently.
● Asset Allocation: Dividing the assets minimizes the risk from a vulnerable market
environment. It is predicated on the knowledge that a balanced portfolio with low risk requires a
variety of assets. According to the investor's risk tolerance and financial objectives, experts
advise using systematic asset allocation.
● Diversification: Diversification is the process of distributing risk in a portfolio. It aims to
reduce volatility while capturing the long-term returns of all sectors since it is impossible to
predict which sector of a market or asset class will perform better at any given time. Diversifying
portfolios can significantly revamp the collection. It brings a perfect blend of risk and reward.
Investing in multiple assets helps in dealing with market fluctuations in a better way.
● Rebalancing: Rebalancing is the method of returning a portfolio to its original target
allocation at regular intervals. It is an important aspect of portfolio management as it helps
investors to capture gains and expand the opportunity for growth. The process involves selling
high-priced stocks and investing that amount in lower-priced stocks.
● Active Portfolio Management: In active portfolio management, the investor buys
undervalued stocks and sells them when their value rises. Portfolio managers pay close attention
to market trends and trade in securities. Investors have received higher returns through this
strategy.
● Passive Portfolio Management: This is stated as index fund management. It aligns with the
current and steady market trend. Investors invest with the objective of low and steady returns that
seem profitable in the long run.
Individual securities have risk return characteristics of their own. The future return expected
from a security is variable and this variability of returns is termed risk. It is rare to find investors
investing their entire wealth in a single security. This is because most investors have an aversion
to risk. It is hoped that if money is invested in several securities simultaneously, the loss in one
will be compensated by the gain in others. Thus, holding more than one security at a time is an
attempt to spread and minimize risk by not putting all our eggs in one basket.
Most investors thus tend to invest in a group of securities rather than a single security.
Such a group of securities held together as an investment is what is known as a portfolio. The
process of creating such a portfolio is called diversification. It is an attempt to spread and
minimize the risk in investment. This is sought to be achieved by holding different types of
securities across different industry groups.
From a given set of securities, any number of portfolios can be constructed. A rational investor
attempts to find the most efficient of these portfolios. The efficiency of each portfolio can be
evaluated only in terms of the expected return and risk of the portfolio as such. Thus,
determining the expected return and risk of different portfolios is a primary step in portfolio
management. This step is designated as portfolio analysis.
As a first step in portfolio analysis, an investor needs to specify the list of securities eligible for
selection or inclusion in the portfolio. Next, he has to generate the risk-return expectations for
these securities. These are typically expressed as the expected rate of return (mean) and the
variance or standard deviation of the return.
The expected return of a portfolio of assets is simply the weighted average of the return of the
individual securities held in the portfolio. The weight applied to each return is the fraction of the
portfolio invested in that security.
Let us consider a portfolio of two equity shares P and Q with expected returns of 15 per cent and
20 per cent respectively. If 40 per cent of the total funds are invested in share P and the
remaining 60 per cent, in share Q, then the expected portfolio return will be:
(0.40 x 15) + (0.60 x 20) = 18 per cent
RISK OF A PORTFOLIO
The variance of return and standard deviation of return are alternative statistical measures that
are used for measuring risk in investment. These statistics measure the extent to which returns
are expected to vary around an average over time. The calculation of variance of a portfolio is a
little more difficult than determining its expected return.
The variance or standard deviation of an individual security measures the riskiness of a security
in absolute sense. For calculating the risk of a portfolio of securities, the riskiness of each
security within the context of the overall portfolio has to be considered. This depends on their
interactive risk, i.e. how the returns of a security move with the returns of other securities in the
portfolio and contribute to the overall risk of the portfolio.
Covariance is the statistical measure that indicates the interactive risk of a security relative to
others in a portfolio of securities. In other words, the way security returns vary with each other
affects the overall risk of the portfolio.
The covariance is a measure of how returns of two securities move together. If the returns of the
two securities move in the same direction consistently the covariance would be positive. If the
returns of the two securities move in opposite direction consistently the covariance would be
negative. If the movements of returns are independent of each other, covariance would be close
to zero.
It may be noted from the above formula that covariance may be expressed as the product of
correlation between the securities and the standard deviation of each of the securities.
The correlation coefficients may range from - 1 to 1. A value of -1 indicates perfect negative
correlation between security returns, while a value of +1 indicates a perfect positive correlation.
A value close to zero would indicate that the returns are independent.
The variance (or risk) of a portfolio is not simply a weighted average of the variances of the
individual securities in the portfolio. The relationship between each security in the portfolio with
every other security as measured by the covariance of return has also to be considered.
Portfolio standard deviation can be obtained by taking the square root of portfolio
variance.
So far, we have considered a portfolio with only two securities. The benefits from diversification
increase as more and more securities with less than perfectly positively correlated returns are
included in the portfolio. As the number of securities added to a portfolio increases, the standard
deviation of the portfolio becomes smaller and smaller.
Hence, an investor can make the portfolio risk arbitrarily small by including a large number of
securities with negative or zero correlation in the portfolio. But, in reality, no securities show
negative or even zero correlation. Typically, securities show some positive correlation that is
above zero but less than the perfectly positive value (+ 1). As a result, diversification (that is,
adding securities to a portfolio) results in some reduction in total portfolio risk but not in
complete elimination of risk.
Moreover, the effects of diversification are exhausted fairly rapidly. That is, most of the
reduction in portfolio standard deviation occurs by the time the portfolio size increases to 25 or
30 securities. Adding securities beyond this size brings about only marginal reduction in
portfolio standard deviation.
Adding securities to a portfolio reduces risk because securities are not perfectly positively
correlated. But the effects of diversification are exhausted rapidly because the securities are still
positively correlated to each other though not perfectly correlated. Had they been negatively
correlated; the portfolio risk would have continued to decline as portfolio size increased. Thus, in
practice, the benefits of diversification are limited.
The total risk of an individual security comprises two components, the market related risk called
systematic risk and the unique risk of that particular security called unsystematic risk. By
combining securities into a portfolio, the unsystematic risk specific to different securities is
cancelled out. Consequently, the risk of the portfolio as a whole is reduced as the size of the
portfolio increases. Ultimately when the size of the portfolio reaches a certain limit, it will
contain only the systematic risk of securities included in the portfolio. The systematic risk,
however, cannot be eliminated. Thus, a fairly large portfolio has only systematic risk and has
The figure shows the portfolio risk declining as the number of securities in the portfolio
increases, but the risk reduction ceases when the unsystematic risk is eliminated.
Optimum portfolio:
Sharpe has identified the optimal portfolio through his single index model, according to Sharpe,
the beta ratio is most important in portfolio selection. The optimal portfolio is said to relate
directly to the beta value. It is the excess return to the beta ratio. The optimal portfolio is selected
by finding out the cut-off rate [c]. The stock where the excess return to the beta ratio is greater
than cut-off rate should only be selected for inclusion in the optimal portfolio. Shape proposed
that desirability of any stock is directly referred to its excess returns to betas coefficient.
Ri − Rf
β
Where Ri = expected return on stock
Rf = risk-free rate of return on asset
DHANANJAYA H.R ( M.com,KSET,NET ) Asst Prof in Commerce
CENTRAL COMMERCE COLLEGE, HASSAN
β = expected change in the rate of return on stock one associated with 1% change in the
market return
Following procedure are involved to select the stocks for the optimum portfolios.
• Finding out the stocks of different risks-return ratios
• Calculate excess return beta ratio for each stock and rank them from the highest to lowest
• Finding out the cut-off rate for each security
• Selecting securities of high rank above the cut-off rate which is common to all stocks
Thus, the optimum portfolio consists of all stocks for which (Ri-Rf) is greater than a particular
cut off-point (c*). The selection of the number of stocks depends upon the unique cut-off rate,
where all stocks with higher rate (Ri-Rf) will be selected and stocks with lower rates will be
eliminated.
PORTFOLIO EVALUATION
Portfolio managers and investors who manage their own portfolios continuously monitor and
review the performance of the portfolio. The evaluation of each portfolio, followed by revision
and reconstruction are all steps in the portfolio management.
The ability to diversify with a view to reduce and even eliminate all unsystematic risk and
expertise in managing the systematic risk-related to the market by use of appropriate risk
measures, namely, betas. Selection of proper securities is thus the first requirement.
Methods of evaluation:
1. Sharpe index model: It depends on total risk rate of the portfolio. Return of the security
compare with risk-free rate of return, the excess return of security is treated as premium
or reward to the investor. The risk of the premium is calculated by comparing portfolio
risk rate. While calculating return on security any one of the previous methods is used. If
there is no premium Sharpe index shows negative value (-). In such a case portfolio is not
treated as efficient portfolio.
Sharpe’s ratio (Sp) = rp – rf / σp
Where,
Sp = Sharpe index performance model
rp = return of portfolio
rf = risk-free rate of return
σp = portfolio standard deviation
PORTFOLIO REVISION
In portfolio management, the maximum emphasis is placed on portfolio analysis and selection
which leads to the construction of the optimal portfolio. Very little discussion is seen on portfolio
revision which is as important as portfolio analysis and selection.
A portfolio is a mix of securities selected from a vast universe of securities. Two variables
determine the composition of a portfolio; the first is the securities included in the portfolio and
the second is the proportion of total funds invested in each security.
Portfolio revision involves changing the existing mix of securities. This may be affected either
by changing the securities currently included in the portfolio or by altering the proportion of
funds invested in the securities. New securities may be added to the portfolio or some of the
existing securities may be removed from the portfolio. Portfolio revision thus leads to purchases
and sales of securities. The objective of portfolio revision is the same as the objective of
portfolio selection, i.e. maximizing the return for a given level of risk or minimizing the risk for
a given level of return. The ultimate aim of portfolio revision is maximization of returns and
minimization of risk.