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Security Analysis & Portfolio Management

Masters of Business Administration International Business

Semester IV

Amity University

PREFACE
Investing can be a fairly manageable, rewarding, and enjoyable experience, if you adhere to certain
principles and guidelines. Scientific research has provided valuable insights into investment issues and,
even more important, has significantly shaped the practice of investment management. In todays world
the researchers are keen on understanding issues like:
How should risk be measured?
What is the relationship between risk and return?
How should financial assets be valued?
How efficiently do financial markets function?
What is the importance of asset allocation?
How can financial derivatives like options and futures be valued?
What is the role of derivatives in portfolio management?
How successful are the various strategies followed by investment practitioners?

Capital markets have played a major role over the years in mobilizing and channelising private capital
for the economic development of the country. In the process, the functioning of capital markets has
become efficient and transparent. The securities market has undergone a structural transformation with
the introduction of computerized online trading and settlement procedures. The market has also
undergone a functional transformation with the introduction of derivatives trading.
Even as investment in securities gathered momentum in the country, security analysis and portfolio
management emerged as a separate academic discipline. Portfolio theory, which deals with rational
investor decision-making process, has now become an integral part of financial literature.
Security Analysis and Portfolio Management provides a guided tour of the so-called complex world of
investments and seeks to improve your skills in managing investments. The study material:
Describes the characteristics of various investment alternatives available to investors.
Discusses how the securities market function.
Explains the techniques used by professionals for analysing and valuing investment alternatives.
Explores the implications of modern research in the field of investments.
Explains how financial derivatives, viz. options and futures, are valued.
2

Presents a framework for portfolio management.

Provides insights into the strategies followed by the investment wizards of the world.
Sensitises the reader to the pitfalls in the investment game.
Offers a set of guidelines for investors with varying inclinations.
Written in a simple and easy-to-read style, the presentation of the book is lucid and intelligible even to
persons without much background knowledge in finance. The comprehensive study material covers all
the areas relevant to the theme of investment in securities. The contents are well-organised in a logical
sequence.
This study material would be useful to students of commerce and management and those undergoing
professional courses such as MBA, CA, ICWA, CFA etc. It would also be beneficial to professionals
working in the area of investment in financial institutions such as banks, insurance companies, unit
trusts, mutual funds etc. Investors making investment in securities market would also benefit from the
book. An understanding of securities market, security analysis, portfolio management and derivatives
trading is essential for profitable investment in securities.
This book seeks to discuss the intellectual framework for decision making. Of course, the necessary
emotional discipline must be provided by you.

SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

Course Objective:
The far-reaching developments in the world of finance have redefined the role of the finance manager,
placing a premium on well-trained young men and women possessing superior professional skills in
financial analysis and management. The finance manager of today is called upon to evolve finance
strategies that dovetail with the firms competitive business strategies.
Learning Outcomes:
On the successful completion of this module the student will be able to:
Assess the various financial market instruments and securities
Understand the factors effecting equity valuations
Analyse the various theories of portfolio management and apply quantitative tools for optimum
results
Course Contents:
Module I: Nature and Scope of Investment Management and Portfolio Analysis
Investment Management and Security Analysis - Portfolio Management Practices in International
markets.
Risk and Return - Total Risk - Portfolio Risk - How Diversification Helps? - Market Risk - Combining
Risky and Risk less - Securities.
Module II: Fundamental Security Analysis
Economic Environment Analysis - Industry Analysis - Company Analysis - Growth Stocks.
Technical Analysis : Basic Tenets of Technical Analysis - Dow Theory - Behaviour of Stock Prices Major Trends - Charts and Trend Lines - Resistance and support Lines - Different Patterns.
Efficient market theory.
Module III
Capital Asset Pricing Model - Assumptions - the Capital Market Line - Security Market Line - CAPM
with Relaxed Assumptions.
4

Portfolio Evaluation: Portfolio Formula Plans - Risk Adjusted Measures - Sharpe's Reward-to
Variability - Treynor's Volatility Ratio - Jensen's Differential Return.
Module IV: Equity Valuation
Financial Markets and Instruments, Analysis and Valuation of Equity Investments
Module V: Fixed Income Valuation and Analysis
Financial Markets and Instruments
Analysis of Derivatives and Other Products
Module VI: Portfolio Management
Modern Portfolio Theory, Investment Policy, Asset Allocation, Practical Portfolio Management,
Performance Measurement, Management of Investment Institutions.
Text & References:
Text:
Fisher, D.E. Security Analysis & Portfolio Management, Prentice Hall, N.D. 2001
References:
Gleason, J.T., Risk- The New Management Imperative in Management, Jaici, Kolkata 2001
Reilly, F.K. & Brown, K., Investment Analysis & Portfolio Management, Dryden Press, 2002
Brealey, R.A. & Myers, S.C., Principles of Corporate Finance, Tata Macgraw Hill, ND 2002
Luenberger, David G., Investment Science, Oxford University Press, 1998.
Malkiel, Burton G., A Random Walk Down Wall Street, 6e, W.W. Norton and Company, New
York, 1996.
Prassanna Chandra Investment Analysis & Portfolio Management Tata Macgraw Hill 2002

TABLE OF CONTENTS

MODULE TOPIC

PAGE NO.

Nature
and
Scope
of
Investment
Management and Portfolio Analysis.

Fundamental Security Analysis

68

Capital Asset Pricing Model

Portfolio Evaluation

108

Equity Valuation

130

Fixed Income Valuation and Analysis

168

Portfolio Management

215

MODULE-I

NATURE AND SCOPE OF INVESTMENT MANAGEMENT AND

PORTFOLIO ANALYSIS
Objectives of Investment Decisions
1.1

Introduction

In an economy, people indulge in economic activity to support their consumption requirements.

Savings arise from deferred consumption, to be invested, in anticipation of future returns.
Investments could be made into financial assets, like stocks, bonds, and similar instruments or into
real assets, like houses, land, or commodities.
Our aim in this book is to provide a brief overview of three aspects of investment: the various
options available to an investor in financial instruments, the tools used in modern finance to
optimally manage the financial portfolio and lastly the professional asset management industry as
it exists today.
Returns more often than not differ across their risk profiles, generally rising with the expected risk,
i.e., higher the returns, higher the risk. The underlying objective of portfolio management is
therefore to create a balance between the trade-off of returns and risk across multiple asset classes.
Portfolio management is the art of managing the expected return requirement for the corresponding
risk tolerance. Simply put, a good portfolio managers objective is to maximize the return subject
to the risk-tolerance level or to achieve a pre-specified level of return with minimum risk.
In our first chapter, we start with the difference between investor and speculator, various types of
investors in the markets today, their return requirements and the various constraints that an
investor faces.

1.2 Investment Versus Speculation

Basis of Difference
1. Planning horizon

2. Risk Disposition

3. Return expectation

Investor

Speculator

An investor has a relatively

longer planning horizon. His
holding period is usually at least
one year.

A speculator has a very

short planning horizon. His
holding period may be a
few days to a few months.

An investor is normally not A speculator is ordinarily

willing to assume more than willing to assume high risk.
moderate risk. Rarely does he
knowingly assume high risk.
An investor usually seeks a A speculator looks for a
modest rate of return which is high rate of return in
8

commensurate with the limited exchange for the high risk

risk assumed by him.
borne by him.
4. Basis for decision

5. Leverage

An investor attaches greater A speculator relies more on

significance to fundamental hearsay, technical charts
factors and attempts a careful and market psychology.
evaluation of the prospects of
the firm.
Typically an investor uses his A speculator normally
own
funds
and
eschews resorts to borrowings,
borrowed funds.
which
can
be
very
substantial, to supplement
his personal resources.

Gambling
Gambling is fundamentally different from speculation and investment in the following respects:
Compared to investment and speculation, the result of gambling is known more quickly.
The outcome of a roll of dice or the turn of a card is known almost immediately.
Rational people gamble for fun, not for income.
Gambling does not involve a bet on an economic activity. It is based on risk that is created
artificially.
Gambling creates risk without providing any commensurate economic return.

1.3 Types of investors

There is wide diversity among investors, depending on their investment styles, mandates,
horizons, and assets under management. Primarily, investors are either individuals, in that they
invest for themselves or institutions, where they invest on behalf of others. Risk appetites and
return requirements greatly vary across investor classes and are key determinants of the investing
styles and strategies followed as also the constraints faced. A quick look at the broad groups of
investors in the market illustrates the point.
1.3.1 Individuals
While in terms of numbers, individuals comprise the single largest group in most markets, the
size of the portfolio of each investor is usually quite small. Individuals differ across their risk
appetite and return requirements. Those averse to risk in their portfolios would be inclined
towards safe investments like Government securities and bank deposits, while others may be risk
9

takers who would like to invest and / or speculate in the equity markets. Requirements of
individuals also evolve according to their life-cycle positioning. For example, in India, an
individual in the 25-35 years age group may plan for purchase of a house and vehicle, an
individual belonging to the age group of 35-45 years may plan for childrens education and
childrens marriage, an individual in his or her fifties would be planning for post-retirement life.
The investment portfolio then changes depending on the capital needed for these requirements.
1.3.2

Institutions

Institutional investors comprise the largest active group in the financial markets. As mentioned
earlier, institutions are representative organizations, i.e., they invest capital on behalf of others, like
individuals or other institutions. Assets under management are generally large and managed
professionally by fund managers. Examples of such organizations are mutual funds, pension funds,
insurance companies, hedge funds, endowment funds, banks, private equity and venture capital
firms and other financial institutions. We briefly describe some of them here:

The Indian financial markets are also witnessing active participation by institutions with
foreign institutional investors, domestic mutual funds, and domestic insurance companies
comprising the three major groups, owning more than a third of the shareholding in listed
companies, with the Government and promoters another 50%. Over the years the share of
institutions has risen in share ownership of companies.

1.3.2.1

Mutual funds

Individuals are usually constrained either by resources or by limits to their knowledge of the
investment outlook of various financial assets (or both) and the difficulty of keeping abreast of
changes taking place in a rapidly changing economic environment. Given the small portfolio size
to manage, it may not be optimal for an individual to spend his or her time analyzing various
possible investment strategies and devise investment plans and strategies accordingly. Instead, they
could rely on professionals who possess the necessary expertise to manage their funds within a
broad, pre-specified plan. Mutual funds pool investors money and invest according to prespecified, broad parameters. These funds are managed and operated by professionals whose
remunerations are linked to the performance of the funds. The profit or capital gain from the funds,
after paying the management fees and commission is distributed among the individual investors in
proportion to their holdings in the fund. Mutual funds vary greatly, depending on their investment
objectives, the set of asset classes they invest in, and the overall strategy they adopt towards
10

investments.
1.3.2.2

Pension funds

Pension funds are created (either by employers or employee unions) to manage the retirement
funds of the employees of companies or the Government. Funds are contributed by the employers
and employees during the working life of the employees and the objective is to provide benefit to
the employees post their retirement. The management of pension funds may be in-house or through
some financial intermediary. Pension funds of large organizations are usually very large and form
a substantial investor group for various financial instruments.
1.3.2.3

Endowment funds

Endowment funds are generally non-profit organizations that manage funds to generate a
steady return to help them fulfill their investment objectives. Endowment funds are usually
initiated by a non-refundable capital contribution. The contributor generally specifies the
purpose(specific or general) and appoints trustees to manage the funds. Such funds are usually
managed by charitable organizations, educational organization, non-Government organizations,
etc.The investment policy of endowment funds needs to be approved by the trustees of the funds.
1.3.2.4

Insurance companies (Life and Non-life)

Insurance companies, both life and non-life, hold large portfolios from premiums contributed by
policyholders to policies that these companies underwrite. There are many different kinds of
insurance polices and the premiums differ accordingly. For example, unlike term insurance,
assurance or endowment policies ensure a return of capital to the policyholder on maturity, along
with the death benefits. The premium for such policies may be higher than term policies. The
investment strategy of insurance companies depends on actuarial estimates of timing and amount
of future claims. Insurance companies are generally conservative in their attitude towards risks and
their asset investments are geared towards meeting current cash flow needs as well as meeting
perceived future liabilities.
1.3.2.5

Banks

Assets of banks consist mainly of loans to businesses and consumers and their liabilities
comprise of various forms of deposits from consumers. Their main source of income is from what
is called as the interest rate spread, which is the difference between the lending rate (rate at which
banks earn) and the deposit rate (rate at which banks pay). Banks generally do not lend 100% of
their deposits. They are statutorily required to maintain a certain portion of the deposits as cash
11

and another portion in the form of liquid and safe assets (generally Government securities),
which yield a lower rate of return. These requirements, known as the Cash Reserve Ratio (CRR
ratio) and Statutory Liquidity Ratio (SLR ratio) in India, are stipulated by the Reserve Bank of
India and banks need to adhere to them.
In addition to the broad categories mentioned above, investors in the markets are also classified
based on the objectives with which they trade. Under this classification, there are hedgers,
speculators and arbitrageurs. Hedgers invest to provide a cover for risks on a portfolio they already
hold, speculators take additional risks to earn supernormal returns and arbitrageurs take
simultaneous positions (say in two equivalent assets or same asset in two different markets etc.)
to earn risk less profits arising out of the price differential if they exist.
Another category of investors include day-traders who trade in order to profit from intra-day price
changes. They generally take a position at the beginning of the trading session and square off their
position later during the day, ensuring that they do not carry any open position to the next trading
day. Traders in the markets not only invest directly in securities in the so-called cash markets, they
also invest in derivatives, instruments that derive their value from the underlying securities.

1.4

Constraints

Portfolio management is usually a constrained optimization exercise: Every investor has some
constraint (limits) within which he wants the portfolio to lie, typical examples being the risk
profile, the time horizon, the choice of securities, optimal use of tax rules etc. The professional
portfolio advisor or manager also needs to consider the constraint set of the investors while
designing the portfolio; besides having some constraints of his or her own, like liquidity, market
risk, cash levels mandated across certain asset classes etc. We provide a quick outline of the
various constraints and limitations that are faced by the broad categories of investors mentioned
above.
1.4.1 Liquidity
In investment decisions, liquidity refers to the marketability of the asset, i.e., the ability and
ease of an asset to be converted into cash and vice versa. It is generally measured across two
different parameters, viz., (i) market breadth, which measures the cost of transacting a given
volume of the security, this is also referred to as the impact cost; and (ii) market depth, which
measures the units that can be traded for a given price impact, simply put, the size of the
transaction needed to bring about a unit change in the price. Adequate liquidity is usually
characterized by high levels of trading activity. High demand and supply of the security would
generally result in low impact costs of trading and reduce liquidity risk.
12

1.4.2 Investment horizons

The investment horizon refers to the length of time for which an investor expects to remain
invested in a particular security or portfolio, before realizing the returns. Knowing the investment
horizon helps in security selection in that it gives an idea about investors income needs and
desired risk exposure. In general, investors with shorter investment horizons prefer assets with low
risk, like fixed-income securities, whereas for longer investment horizons investors look at riskier
assets like equities. Risk-adjusted returns for equity are generally found to be higher for longer
investment horizon, but lower in case of short investment horizons, largely due to the high
volatility in the equity markets. Further, certain securities require commitment to invest for a
certain minimum investment period, for example in India, the Post Office savings or Government
small-saving schemes like the National Savings Certificate (NSC) have a minimum maturity
of 3-6 years.
Investment horizon also facilitates in making a decision between investing in a liquid or relatively
illiquid investment. If an investor wants to invest for a longer period, liquidity costs may not be a
significant factor, whereas if the investment horizon is a short period (say 1 month) then the impact
cost (liquidity) becomes significant as it could form a meaningful component of the expected
return.
1.4.3 Taxation
The investment decision is also affected by the taxation laws of the land. Investors are always
concerned with the net and not gross returns and therefore tax-free investments or investments
subject to lower tax rate may trade at a premium as compared to investments with taxable returns.
The following example will give a better understanding of the concept:
Table 1.1:

Asset

Type

Expected Return

Net Return

10% taxable bonds (30% tax)

10%

10%*(1-0.3) = 7%

8% tax-free bonds

8%

8%

13

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

1.5 Goals of Investors

There are specific needs for all types of investors. For individual investors, retirement,
childrens marriage / education, housing etc. are major event triggers that cause an
increase in the demands for funds. An investment decision will depend on the
investors plans for the above needs. Similarly, there are certain specific needs for
institutional investors also. For example, for a pension fund the investment policy will
depend on the average age of the plans participants.
In addition to the few mentioned here, there are other constraints like the level of
requisite knowledge (investors may not be aware of certain financial instruments and
their pricing), investment size (e.g., small investors may not be able to invest in
Certificate of Deposits), regulatory provisions (country may impose restriction on
investments in foreign countries) etc. which also serve to outline the investment
choices faced by investors.

1.6 Stock Basics

Wouldn't you love to be a business owner without ever having to show up at work?
Imagine if you could sit back, watch your company grow, and collect the dividend
checks as the money rolls in! This situation might sound like a pipe dream, but it's
closer to reality than you might think.
As you've probably guessed, we're talking about owning stocks. This fabulous
category of financial instruments is, without a doubt, one of the greatest tools ever
14

invented for building wealth. Stocks are a part, if not the cornerstone, of nearly any
investment portfolio. When you start on your road to financial freedom, you need to
have a solid understanding of stocks and how they trade on the stock market.
Over the last few decades, the average person's interest in the stock market has grown
exponentially. What was once a toy of the rich has now turned into the vehicle of
choice for growing wealth? This demand coupled with advances in trading technology
has opened up the markets so that nowadays nearly anybody can own stocks.
Despite their popularity, however, most people don't fully understand stocks.
Much is learned from conversations around the water cooler with others who also don't
know what they're talking about. Chances are you've already heard people say things
like, "Bob's cousin made a killing in XYZ company, and now he's got another hot
tip..." or "Watch out with stocks--you can lose your shirt in a matter of days!" So much
of this misinformation is based on a get-rich-quick mentality, which was especially
prevalent during the amazing dotcom market in the late '90s. People thought that
stocks were the magic answer to instant wealth with no risk. The ensuing dotcom crash
proved that this is not the case. Stocks can (and do) create massive amounts of wealth,
but they aren't without risks. The only solution to this is education. The key to
protecting yourself in the stock market is to understand where you are putting your
money.

What Are Stocks?

The Definition of a Stock
Plain and simple, stock is a share in the ownership of a company. Stock represents a
claim on the company's assets and earnings. As you acquire more stock, your
ownership stake in the company becomes greater. Whether you say shares, equity, or
stock, it all means the same thing.

15

Being an Owner
Holding a company's stock means that you are one of the many owners (shareholders)
of a company and, as such, you have a claim (albeit usually very small) to everything
the company owns. Yes, this means that technically you own a tiny sliver of every
piece of furniture, every trademark, and every contract of the company. As an owner,
you are entitled to your share of the company's earnings as well as any voting rights
attached to the stock.
A stock is represented by a stock certificate. This is a fancy piece of paper that is proof
of your ownership. In today's computer age, you won't actually get to see this
document because your brokerage keeps these records electronically, which is also
known as holding shares "in street name". This is done to make the shares easier to
trade. In the past, when a person wanted to sell his or her shares, that person physically
took the certificates down to the brokerage. Now, trading with a click of the mouse or
a phone call makes life easier for everybody.

Example of Stock Certificate

Being a shareholder of a public company does not mean you have a say in the day-to-day
running of the business. Instead, one vote per share to elect the board of directors at
annual meetings is the extent to which you have a say in the company. For instance,
16

being a Microsoft shareholder doesn't mean you can call up Bill Gates and tell him how
you think the company should be run. In the same line of thinking, being a shareholder of
Anheuser Busch doesn't mean you can walk into the factory and grab a free case of Bud
Light!
The management of the company is supposed to increase the value of the firm for
shareholders. If this doesn't happen, the shareholders can vote to have the management
removed, at least in theory. In reality, individual investors like you and I don't own
enough shares to have a material influence on the company. It's really the big boys like
large institutional investors and billionaire entrepreneurs who make the decisions.
For ordinary shareholders, not being able to manage the company isn't such a big deal.
After all, the idea is that you don't want to have to work to make money, right? The
importance of being a shareholder is that you are entitled to a portion of the companys
profits and have a claim on assets. Profits are sometimes paid out in the form of
dividends. The more shares you own, the larger the portion of the profits you get. Your
claim on assets is only relevant if a company goes bankrupt. In case of liquidation, you'll
receive what's left after all the creditors have been paid. This last point is worth
repeating: the importance of stock ownership is your claim on assets and earnings.
Without this, the stock wouldn't be worth the paper it's printed on.
Another extremely important feature of stock is its limited liability, which means that, as
an owner of a stock, you are not personally liable if the company is not able to pay its
debts. Other companies such as partnerships are set up so that if the partnership goes
bankrupt the creditors can come after the partners (shareholders) personally and sell off
their house, car, furniture, etc. Owning stock means that, no matter what, the maximum
value you can lose is the value of your investment. Even if a company of which you are a
shareholder goes bankrupt, you can never lose your personal assets.
17

Debt vs. Equity

Why does a company issue stock? Why would the founders share the profits with
thousands of people when they could keep profits to themselves? The reason is that at
some point every company needs to raise money. To do this, companies can either
borrow it from somebody or raise it by selling part of the company, which is known as
issuing stock. A company can borrow by taking a loan from a bank or by issuing bonds.
Both methods fit under the umbrella of debt financing. On the other hand, issuing stock is
called equity financing. Issuing stock is advantageous for the company because it does
not require the company to pay back the money or make interest payments along the way.
All that the shareholders get in return for their money is the hope that the shares will
someday be worth more than what they paid for them. The first sale of a stock, which is
issued by the private company itself, is called the initial public offering (IPO).
It is important that you understand the distinction between a company financing through
debt and financing through equity. When you buy a debt investment such as a bond, you
are guaranteed the return of your money (the principal) along with promised interest
payments. This isn't the case with an equity investment. By becoming an owner, you
assume the risk of the company not being successful - just as a small business owner isn't
guaranteed a return, neither is a shareholder. As an owner, your claim on assets is less
than that of creditors. This means that if a company goes bankrupt and liquidates, you, as
a shareholder, don't get any money until the banks and bondholders have been paid out;
we call this absolute priority. Shareholders earn a lot if a company is successful, but they
also stand to lose their entire investment if the company isn't successful.

Risk
18

It must be emphasized that there are no guarantees when it comes to individual stocks.
Some companies pay out dividends, but many others do not. And there is no obligation to
pay out dividends even for those firms that have traditionally given them. Without
dividends, an investor can make money on a stock only through its appreciation in the
open market. On the downside, any stock may go bankrupt, in which case your
investment is worth nothing. Although risk might sound all negative, there is also a bright
side. Taking on greater risk demands a greater return on your investment. This is the
reason why stocks have historically outperformed other investments such as bonds or
savings accounts. Over the long term, an investment in stocks has historically had an
average return of around 10-12%.

Different Types of Stocks

There are two main types of stocks: common stock and preferred stock. Common Stock
Common stock is, well, common. When people talk about stocks they are usually
referring to this type. In fact, the majority of stock is issued is in this form. We basically
went over features of common stock in the last section. Common shares represent
ownership in a company and a claim (dividends) on a portion of profits. Investors get one
vote per share to elect the board members, who oversee the major decisions made by
management.
Over the long term, common stock, by means of capital growth, yields higher returns
than almost every other investment. This higher return comes at a cost since common
stocks entail the most risk. If a company goes bankrupt and liquidates, the common
shareholders will not receive money until the creditors, bondholders and preferred
shareholders are paid.
Preferred Stock
Preferred stock represents some degree of ownership in a company but usually doesn't
come with the same voting rights. (This may vary depending on the company.) With
19

preferred shares, investors are usually guaranteed a fixed dividend forever. This is
different than common stock, which has variable dividends that are never guaranteed.
Another advantage is that in the event of liquidation, preferred shareholders are paid off
before the common shareholder (but still after debt holders). Preferred stock may also be
callable, meaning that the company has the option to purchase the shares from
shareholders at anytime for any reason (usually for a premium).
Some people consider preferred stock to be more like debt than equity. A good way to
think of these kinds of shares is to see them as being in between bonds and common
shares.
Different Classes of Stock Common and preferred are the two main forms of stock;
however, it's also possible for companies to customize different classes of stock in any
way they want. The most common reason for this is the company wanting the voting
power to remain with a certain group; therefore, different classes of shares are given
different voting rights. For example, one class of shares would be held by a select group
who are given ten votes per share while a second class would be issued to the majority of
investors who are given one vote per share.
When there is more than one class of stock, the classes are traditionally designated as
Class A and Class B. Berkshire Hathaway (ticker: BRK), has two classes of stock. The
different forms are represented by placing the letter behind the ticker symbol in a form
like this: "BRKa, BRKb" or "BRK.A, BRK.B".
How Stocks Trade
Most stocks are traded on exchanges, which are places where buyers and sellers meet and
decide on a price. Some exchanges are physical locations where transactions are carried
out on a trading floor. You've probably seen pictures of a trading floor, in which traders
are wildly throwing their arms up, waving, yelling, and signaling to each other. The other
20

type of exchange is virtual, composed of a network of computers where trades are made
electronically.
The purpose of a stock market is to facilitate the exchange of securities between buyers
and sellers, reducing the risks of investing. Just imagine how difficult it would be to sell
shares if you had to call around the neighborhood trying to find a buyer. Really, a stock
market is nothing more than a super-sophisticated farmers' market linking buyers and
sellers.
Before we go on, we should distinguish between the primary market and the secondary
market. The primary market is where securities are created (by means of an IPO) while,
in the secondary market, investors trade previously-issued securities without the
involvement of the issuing-companies. The secondary market is what people are referring
to when they talk about the stock market. It is important to understand that the trading of
a company's stock does not directly involve that company.

21

1.7

PORTFOLIO

MANAGEMENT

PRACTICES

IN

INTERNATIONAL MARKETS
The New York Stock Exchange

The Trading Floor of NYSE

The most prestigious exchange in the world is the New York Stock Exchange (NYSE).
The "Big Board" was founded over 200 years ago in 1792 with the signing of the
Buttonwood Agreement by 24 New York City stockbrokers and merchants. Currently the
NYSE, with stocks like General Electric, McDonald's, Citigroup, Coca-Cola, Gillette and
Wal-mart, is the market of choice for the largest companies in America.

22

The NYSE is the first type of exchange (as we referred to above), where much of the
trading is done face-to-face on a trading floor. This is also referred to as a listed
exchange. Orders come in through brokerage firms that are members of the exchange and
flow down to floor brokers who go to a specific spot on the floor where the stock trades.
At this location, known as the trading post, there is a specific person known as the
specialist whose job is to match buyers and sellers. Prices are determined using an
auction method: the current price is the highest amount any buyer is willing to pay and
the lowest price at which someone is willing to sell. Once a trade has been made, the
details are sent back to the brokerage firm, who then notifies the investor who placed the
order. Although there is human contact in this process, don't think that the NYSE is still
in the stone age: computers play a huge role in the process.
The Nasdaq : The second type of exchange is the virtual sort called an over-the-counter
(OTC) market, of which the Nasdaq is the most popular. These markets have no central
location or floor brokers whatsoever. Trading is done through a computer and
telecommunications network of dealers. It used to be that the largest companies were
listed only on the NYSE while all other second tier stocks traded on the other exchanges.
The tech boom of the late '90s changed all this; now the Nasdaq is home to several big
technology companies such as Microsoft, Cisco, Intel, Dell and Oracle. This has resulted
in the Nasdaq
becoming

serious
competitor
the NYSE.

23

to

On the Nasdaq brokerages act as market makers for various stocks. A market maker
provides continuous bid and ask prices within a prescribed percentage spread for shares
for which they are designated to make a market. They may match up buyers and sellers
directly but usually they will maintain an inventory of shares to meet demands of
investors.
Other Exchanges The third largest exchange in the U.S. is the American Stock
Exchange (AMEX). The AMEX used to be an alternative to the NYSE, but that role has
since been filled by the Nasdaq. In fact, the National Association of Securities Dealers
(NASD), which is the parent of Nasdaq, bought the AMEX in 1998. Almost all trading
now on the AMEX is in small-cap stocks and derivatives.
There are many stock exchanges located in just about every country around the world.
American markets are undoubtedly the largest, but they still represent only a fraction of
total investment around the globe. The two other main financial hubs are London, home
of the London Stock Exchange, and Hong Kong, home of the Hong Kong Stock
Exchange. The last place worth mentioning is the over-the-counter bulletin board
(OTCBB). The Nasdaq is an over-the-counter market, but the term commonly refers to
small public companies that dont meet the listing requirements of any of the regulated
markets, including the Nasdaq. The OTCBB is home to penny stocks because there is
little to no regulation. This makes investing in an OTCBB stock very risky.
What Causes Stock Prices To Change?
Stock prices change every day as a result of market forces. By this we mean that share
prices change because of supply and demand. If more people want to buy a stock
(demand) than sell it (supply), then the price moves up. Conversely, if more people
24

wanted to sell a stock than buy it, there would be greater supply than demand, and the
price would fall.
Understanding supply and demand is easy. What is difficult to comprehend is what
makes people like a particular stock and dislike another stock. This comes down to
figuring out what news is positive for a company and what news is negative. There are
many answers to this problem and just about any investor you ask has their own ideas and
strategies.
That being said, the principal theory is that the price movement of a stock indicates what
investors feel a company is worth. Don't equate a company's value with the stock price. The
value of a company is its market capitalization, which is the stock price multiplied by the
number of shares outstanding. For example, a company that trades at $100 per share and has
1 million shares outstanding has a lesser value than a company that trades at $50 that has 5
million shares outstanding ($100 x 1 million = $100 million while $50 x 5 million = $250
million). To further complicate things, the price of a stock doesn't only reflect a company's
current value, it also reflects the growth that investors expect in the future.
The most important factor that affects the value of a company is its earnings. Earnings are the
profit a company makes, and in the long run no company can survive without them. It makes
sense when you think about it. If a company never makes money, it isn't going to stay in
business. Public companies are required to report their earnings four times a year (once each
quarter). Wall Street watches with rabid attention at these times, which are referred to as
earnings seasons. The reason behind this is that analysts base their future value of a company
on their earnings projection. If a company's results surprise (are better than expected), the
price jumps up. If a company's results disappoint (are worse than expected), then the price
will fall.
Of course, it's not just earnings that can change the sentiment towards a stock (which, in turn,
changes its price). It would be a rather simple world if this were the case! During the dotcom
25

bubble, for example, dozens of internet companies rose to have market capitalizations in the
billions of dollars without ever making even the smallest profit. As we all know, these
valuations did not hold, and most internet companies saw their values shrink to a fraction of
their highs. Still, the fact that prices did move that much demonstrates that there are factors
other than current earnings that influence stocks. Investors have developed literally hundreds
of these variables, ratios and indicators. Some you may have already heard of, such as the
price/earnings ratio, while others are extremely complicated and obscure with names like
Chaikin oscillator or moving average convergence divergence.
So, why do stock prices change? The best answer is that nobody really knows for sure. Some
believe that it isn't possible to predict how stock prices will change, while others think that by
drawing charts and looking at past price movements, you can determine when to buy and sell.
The only thing we do know is that stocks are volatile and can change in price extremely
rapidly. The important things to grasp about this subject are the following:

1. At the most fundamental level, supply and demand in the market determines stock
price.
2. Price times the number of shares outstanding (market capitalization) is the value of a
company. Comparing just the share price of two companies is meaningless.
3. Theoretically, earnings are what affect investors' valuation of a company, but there are
other indicators that investors use to predict stock price. Remember, it is investors'
sentiments, attitudes and expectations that ultimately affect stock prices.
4. There are many theories that try to explain the way stock prices move the way they do.
Unfortunately, there is no one theory that can explain everything.

Buying Stocks
You've now learned what a stock is and a little bit about the principles behind the stock
market, but how do you actually go about buying stocks? Thankfully, you don't have to

26

go down into the trading pit yelling and screaming your order. There are two main ways
to purchase stock:
1. Using a Brokerage: The most common method to buy stocks is to use a
brokerage. Brokerages come in two different flavors. Full-service brokerages
offer you (supposedly) expert advice and can manage your account; they also
charge a lot. Discount brokerages offer little in the way of personal attention but
are much cheaper.
At one time, only the wealthy could afford a broker since only the expensive, fullservice brokers were available. With the internet came the explosion of online
discount brokers. Thanks to them nearly anybody can now afford to invest in the
market.
2. DRIPs & DIPs: Dividend reinvestment plans (DRIPs) and direct investment
plans (DIPs) are plans by which individual companies, for a minimal cost, allow
shareholders to purchase stock directly from the company. Drips are a great way
to invest small amounts of money at regular intervals.

How to Read a Stock Table/Quote

Any financial paper has stock quotes that will look something like the image below:

27

Columns 1 & 2: 52-Week Hi and Low - These are the highest and lowest prices at which a
stock has traded over the previous 52 weeks (one year). This typically does not include the
previous day's trading.
Column 3: Company Name & Type of Stock - This column lists the name of the company.
If there are no special symbols or letters following the name, it is common stock. Different
symbols imply different classes of shares. For example, "pf" means the shares are preferred
stock.
Column 4: Ticker Symbol - This is the unique alphabetic name which identifies the stock. If
you watch financial TV, you have seen the ticker tape move across the screen, quoting the
latest prices alongside this symbol. If you are looking for stock quotes online, you always
search for a company by the ticker symbol. If you don't know what a particular company's
ticker is you can search for it at: http://finance.yahoo.com/l.
Column 5: Dividend Per Share - This indicates the annual dividend payment per share. If
this space is blank, the company does not currently pay out dividends.
Column 6: Dividend Yield This states the percentage return on the dividend, calculated as
annual dividends per share divided by price per share.
Column 7: Price/Earnings Ratio - This is calculated by dividing the current stock price by
earnings per share from the last four quarters.
Column 8: Trading Volume - This figure shows the total number of shares traded for the
day, listed in hundreds. To get the actual number traded, add "00" to the end of the number
listed.

28

Column 9 & 10: Day High & Low - This indicates the price range at which the stock
has traded at throughout the day. In other words, these are the maximum and the
minimum prices that people have paid for the stock.
Column 11: Close - The close is the last trading price recorded when the market closed
on the day. If the closing price is up or down more than 5% than the previous day's close,
the entire listing for that stock is bold-faced. Keep in mind, you are not guaranteed to get
this price if you buy the stock the next day because the price is constantly changing (even
after the exchange is closed for the day). The close is merely an indicator of past
performance and except in extreme circumstances serves as a ballpark of what you
should expect to pay.
Column 12: Net Change - This is the dollar value change in the stock price from the
previous day's closing price. When you hear about a stock being "up for the day," it
means the net change was positive.
Quotes on the Internet Nowadays, it's far more convenient for most to get stock quotes
off the Internet. This method is superior because most sites update throughout the day
and give you more information, news, charting, research, etc.
To get quotes, simply enter the ticker symbol into the quote box of any major financial
site like Yahoo Finance, CBS Marketwatch, or MSN Moneycentral. The example below
shows a quote for Microsoft (MSFT) from Yahoo Finance. Interpreting the data is exactly
the same as with the newspaper.

29

The Bulls, The Bears And The Farm

On Wall Street, the bulls and bears are in a constant struggle. If you haven't heard of
these terms already, you undoubtedly will as you begin to invest.
The Bulls A bull market is when everything in the economy is great, people are finding
jobs, gross domestic product (GDP) is growing, and stocks are rising. Things are just
plain rosy! Picking stocks during a bull market is easier because everything is going up.
Bull markets cannot last forever though, and sometimes they can lead to dangerous
situations if stocks become overvalued. If a person is optimistic and believes that stocks
will go up, he or she is called a "bull" and is said to have a "bullish outlook".
The Bears A bear market is when the economy is bad, recession is looming and stock
prices are falling. Bear markets make it tough for investors to pick profitable stocks. One
solution to this is to make money when stocks are falling using a technique called short
selling. Another strategy is to wait on the sidelines until you feel that the bear market is
nearing its end, only starting to buy in anticipation of a bull market. If a person is
30

pessimistic, believing that stocks are going to drop, he or she is called a "bear" and said
to have a "bearish outlook".
The Other Animals on the Farm - Chickens and Pigs Chickens are afraid to lose
anything. Their fear overrides their need to make profits and so they turn only to moneymarket securities or get out of the markets entirely. While it's true that you should never
invest in something over which you lose sleep, you are also guaranteed never to see any
return if you avoid the market completely and never take any risk,
Pigs are high-risk investors looking for the one big score in a short period of time. Pigs
buy on hot tips and invest in companies without doing their due diligence. They get
impatient, greedy, and emotional about their investments, and they are drawn to high-risk
securities without putting in the proper time or money to learn about these investment
vehicles. Professional traders love the pigs, as it's often from their losses that the bulls
and bears reap their profits.

What Type of Investor Will You Be?

There are plenty of different investment styles and strategies out there. Even though the
bulls and bears are constantly at odds, they can both make money with the changing
cycles in the market. Even the chickens see some returns, though not a lot. The one loser
in this picture is the pig.
Make sure you don't get into the market before you are ready. Be conservative and never
invest in anything you do not understand. Before you jump in without the right
knowledge, think about this old stock market saying:
"Bulls make money, bears make money, but pigs just get slaughtered!"

31

Conclusion
Let's recap what we've learned in this tutorial:
Stock means ownership. As an owner, you have a claim on the assets and earnings
of a company as well as voting rights with your shares.
Stock is equity, bonds are debt. Bondholders are guaranteed a return on their
investment and have a higher claim than shareholders. This is generally why
stocks are considered riskier investments and require a higher rate of return.
You can lose all of your investment with stocks. The flip-side of this is you can
make a lot of money if you invest in the right company.
The two main types of stock are common and preferred. It is also possible for a
company to create different classes of stock.
Stock markets are places where buyers and sellers of stock meet to trade. The
NYSE and the Nasdaq are the most important exchanges in the United States.
Stock prices change according to supply and demand. There are many factors
influencing prices, the most important of which is earnings.
There is no consensus as to why stock prices move the way they do.
To buy stocks you can either use a brokerage or a dividend reinvestment plan
(DRIP).
Stock tables/quotes actually aren't that hard to read once you know what
everything stands for!
Bulls make money, bears make money, but pigs get slaughtered!

32

1.8

ELEMENTARY STATISTICAL CONCEPTS

Mean
Mean is the arithmetic average of all the values in a data set. If there are 'N' elements of
data (Xi) in the data set, then the mean (

) is given by:

= Xi/N, where i = 1, 2, 3, ..., n

Example 1: What is the average rate of return of XYZ if the returns during the previous
three years are 10%, 15% and 20%?
Average Return = (10% + 15% + 20%)/3 = 15%
Therefore, average rate of return during previous three years of XYZ is 15%.
If there is a weightage/probability Pi associated with an element Xi, then the
weightage mean/expected value (

) is given by the equation:

= (Pi * XI ), where i = 1, 2, 3, ..., n

Example 2: What is the expected return of XYZ if it has the probability of
earning returns as given below?
Probability (%)

Return (%)

20

10

30

12

50

15

Expected value = (20%*10%) + (30%*12%) + (50%*15%)

= 13.10%
33

Geometric Mean
Geometric Mean (GM) is theoretically considered to be the best average in measuring
returns from securities. It is also considered more appropriate in averaging ratios and
percentages. It is defined as the nth root of the product of 'N' items. If there are two items,
square root is taken; if there are three items, then cube root and so on.
Symbolically,

GM =

(X1)*(X2)*(X3)* (Xn)

where X1 , X2, X3.refer to the various items of the series.

Example 3: What is the annual percentage rate of increase in security prices if it
increased @14% in 1999, 5% in 2000 and 2% in 2001?
Annual rate of increase =3 1.14*1.05&*1.02
= 1.0688 = 6.88%

1.9

RETURN AND RISK

Return and risk are the two key determinants of security prices or values. This calls for an
explicit and quantitative understanding of the concepts. For earning returns investors
have to almost invariably bear some risk. While investors like returns they abhor risk.
Investment decisions therefore involve a tradeoff between risk and return. Since risk and
return are central to investment decisions, we must clearly understand what risk and
return are and how they should be measured.

Return
34

Return is the primary motivating force that drives investment. It represents the reward for
undertaking investment. Since the game of investing is about returns (after allowing for
risk), measurement of realize (historical) returns is necessary to assess how well the
investment manager has done. In addition, historical returns are often used as an
important input in estimating future (prospective) returns.
The return of an investment consists of two components:
Current Return: The first component that often comes to mind when one is thinking
about return is the periodic cash flow (income), such as dividend or interest, generated by
the investment. Current return is measured as the periodic income in relation to the
beginning price of the investment.
Capital Return: The second component of return is reflected in the price change called
the capital return-it is simply the price appreciation (or depreciation) divided by the
beginning price of the asset. For assets like equity stocks, the capital return predominates.
Thus, the total return for any security (or for that matter any asset) is defined as:
Total return = Current return + Capital return
The current return can be zero or positive, whereas the capital return can be negative,
zero or positive.

Return and Risk of a Single Asset

Return on an investment/asset for given period, say a year, consists of annual
income (dividend) receivable plus change in market price.
Symbolically,
35

For example, for a security if price at the beginning of the year is Rs. 50.00;
dividend receivable at the end of the year is Rs. 2.50; and price at the end of the
year is Rs. 55.00 then, the rate of return on this security is:

The rate of return of 15 per cent has two components:

(i) Current yield i.e. annual income opening/beginning price = 2.50 50.00
=.05 = 5% and
(ii) Capital gains/loss yield, i.e. (end price-opening price) opening/beginning
price =
(Rs.55 Rs. 50) Rs. 50 =0.1 = 10%
Risk may be described as variability/fluctuation/deviation of actual return from
expected return from a given asset/investment. Higher the variability, greater is
the risk. In other words, the more certain the return from an asset, lesser is the
variability and thereby lesser is the risk.

With the markets moving up and down like a Six Flags roller coaster, is there
anything you can do to stomach the risk? Have you carefully considered the
various risks that are associated with each investment you make? The fact is,
36

many people either have no desire or no knowledge about how to protect

themselves from unneeded risk. In this tutorial, we'll introduce you to risk and
give you a good foundation to understand the relationship between return and
risk.

What Is Risk?
Whether it is investing, driving, or just walking down the street, everyone exposes
themselves to risk. Your personality and lifestyle play a big role in how much risk
you are comfortably able to take on. If you invest in stocks and have trouble
sleeping at night, you are probably taking on too much risk. Risk is defined as the
chance that an investment's actual return will be different than expected. This
includes the possibility of losing some or all of the original investment. Those of
us who work hard for every penny we earn have a harder time parting with
money. Therefore, people with less disposable income tend to be, necessity, more
risk averse. On the other end of the spectrum, day traders feel if they aren't
making dozens of trades a day there is a problem. These people are risk lovers.
When investing in stocks, bonds, or any investment instrument, there is a lot more
risk than you'd think. In the next section, we'll take a look at the different kind of
risk that often threaten investors' returns.

Different Types of Risk

Let's take a look at the two basic types of risk:
Systematic Risk - Systematic risk influences a large number of assets. A
significant political event, for example, could affect several of the assets in your
portfolio. It is virtually impossible to protect yourself against this type of risk.

37

Systematic Risk refers to that portion of total variability (risk) in return caused by
factors affecting the prices of all securities. Economic, political, and sociological
changes are the main sources of systematic risk. Though it affects all the
securities in the market, the extent to which it affects a security will vary from one
security to another. To put it differently, the systematic risks of various securities
differ due to their relationship with market. Systematic risk can not be diversified.
Systematic risk can be measured in terms of Beta (), a statistical measure. The
factor describes the movement in a securitys or a portfolios return in relation to
that of the market returns. The beta for market portfolio is equal to one by
definition. Beta of one (=1), indicates that volatility of return on the security is
same as the market or index; beta more than one (>1) indicates that the security
has more unavoidable risk or is more volatile than market as a whole, and beta
less than one (<1) indicates that the security has less systematic risk or is less
volatile than market.
Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific
risk". This kind of risk affects a very small number of assets. An example is news
that affects a specific stock such as a sudden strike by employees. Diversification
is the only way to protect yourself from unsystematic risk. (We will discuss
diversification later in this tutorial). Now that we've determined the fundamental
types of risk, let's look at more specific types of risk, particularly when we talk
about stocks and bonds.
Unsystematic Risk refers to that portion of total risk that is unique or peculiar to a
firm or an industry, above and beyond that affecting securities markets in general.
Factors like consumer preferences, labour strikes, management capability etc.
cause unsystematic risk (/variability of returns) for a companys stock. Unlike
systematic risk, the unsystematic risk can be reduced/avoided through
38

diversification. Total risk of a fully diversified portfolio equals to the market risk
of the portfolio as its specific risk becomes zero.
Credit or Default Risk - Credit risk is the risk that a company or individual will
be unable to pay the contractual interest or principal on its debt obligations. This
type of risk is of particular concern to investors who hold bonds in their
portfolios. Government bonds, especially those issued by the federal government,
have the least amount of default risk and the lowest returns, while corporate bonds
tend to have the highest amount of default risk but also higher interest rates.
Bonds with a lower chance of default are considered to be investment grade,
while bonds with higher chances are considered to be junk bonds. Bond rating
services, such as Moody's, allows investors to determine which bonds are
investment-grade, and which bonds are junk.
Country Risk - Country risk refers to the risk that a country won't be able to
honor its financial commitments. When a country defaults on its obligations, this
can harm the performance of all other financial instruments in that country as well
as other countries it has relations with. Country risk applies to stocks, bonds,
mutual funds, options and futures that are issued within a particular country. This
type of risk is most often seen in emerging markets or countries that have a severe
deficit.
Foreign-Exchange Risk - When investing in foreign countries you must consider
the fact that currency exchange rates can change the price of the asset as well.
Foreign-exchange risk applies to all financial instruments that are in a currency
other than your domestic currency. As an example, if you are a resident of
America and invest in some Canadian stock in Canadian dollars, even if the share
value appreciates, you may lose money if the Canadian dollar depreciates in
relation to the American dollar.
39

Interest Rate Risk - Interest rate risk is the risk that an investment's value will
change as a result of a change in interest rates. This risk affects the value of bonds
more directly than stocks.
Political Risk - Political risk represents the financial risk that a country's
government will suddenly change its policies. This is a major reason why
developing countries lack foreign investment.
Market Risk - This is the most familiar of all risks. Also referred to as volatility,
market risk is the the day-to-day fluctuations in a stock's price. Market risk
applies mainly to stocks and options. As a whole, stocks tend to perform well
during a bull market and poorly during a bear market - volatility is not so much a
cause but an effect of certain market forces. Volatility is a measure of risk
because it refers to the behavior, or "temperament", of your investment rather than
the reason for this behavior. Because market movement is the reason why people
can make money from stocks, volatility is essential for returns, and the more
unstable the investment the more chance there is that it will experience a dramatic
change in either direction.
As you can see, there are several types of risk that a smart investor should
consider and pay careful attention to.

The Risk-Reward Tradeoff

The risk-return tradeoff could easily be called the iron stomach test. Deciding
what amount of risk you can take on is one of the most important investment
decision you will make.
40

The risk-return tradeoff is the balance an investor must decide on between the
desire for the lowest possible risk for the highest possible returns. Remember to
keep in mind that low levels of uncertainty (low risk) are associated with low
potential returns and high levels of uncertainty (high risk) are associated with high
potential returns.
The risk-free rate of return is usually signified by the quoted yield of "U.S.
Government Securities" because the government very rarely defaults on loans.
Let's suppose that the risk-free rate is currently 6%. Therefore, for virtually no
risk, an investor can earn 6% per year on his or her money. But who wants 6%
when index funds are averaging 12-14.5% per year? Remember that index funds
don't return 14.5% every year, instead they return -5% one year and 25% the next
and so on. In other words, in order to receive this higher return, investors much
also take on considerably more risk.
The following chart shows an example of the risk/return tradeoff for investing. A
higher standard deviation means a higher risk:

41

Subsequently, we'll show you what you can do to reduce the risk in your portfolio
with an introduction to the diversification.
Diversifying Your Portfolio
With the stock markets bouncing up and down 5% every week, individual
investors clearly need a safety net. Diversification can work this way and can
prevent your entire portfolio from losing value.
Diversifying your portfolio may not be the sexiest of investment topics. Still, most
investment professionals agree that while it does not guarantee against a loss,
diversification is the most important component to helping you reach your longrange financial goals while minimizing your risk. Keep in mind, however that no
matter how much diversification you do, it can never reduce risk down to zero.
What do you need to have a well diversified portfolio? There are three main
things you should do to ensure that you are adequately diversified:
42

1. Your portfolio should be spread among many different investment vehicles

such as cash, stocks, bonds, mutual funds, and perhaps even some real estate.
2. Your securities should vary in risk. You're not restricted to picking only blue
chip stocks. In fact, the opposite is true. Picking different investments with
different rates of return will ensure that large gains offset losses in other areas.
Keep in mind that this doesn't mean that you need to jump into high-risk
investments such as penny stocks!
3. Your securities should vary by industry, minimizing unsystematic risk to small
groups of companies. Another question people always ask is how many stocks
they should buy to reduce the risk of their portfolio. The portfolio theory tells us
that after 10-12 diversified stocks, you are very close to optimal diversification.
This doesn't mean buying 12 internet or tech stocks will give you optimal
diversification. Instead, you need to buy stocks of different sizes and from various
industries.
Different individuals will have different tolerances for risk. Tolerance is not
static, it will change as your life does. As you grow older tolerance will usually
shrink as more and more obligations come up, including retirement. There are
several different types of risks involved in financial transactions. I hope we've
helped shed some light on these risks. Achieving the right balance between risk
and return will ensure that you achieve your financial goals while allowing you to
get a good night's rest.
Measurement of Risk for a Single Asset
The statistical measures of a risk of an asset are: (a) Standard Deviation and (b) Coefficient of variation.

43

Standard Deviation of Return

Standard deviation (s ), is the most common statistical measure of risk of an asset from
the expected value of return. It measures the fluctuations around mean returns. It
represents the square root of average squared deviations of individual returns ( i R ) from
the expected return ( R ). Symbolically,

Following are the returns of two securities X and Y for 5 years:

Calculate the covariance between the two securities X and Y.

Solution:

44

Thus the covariance between the two securities X and Y is positive.

Correlation Coefficient
Correlation coefficient describes the degree of relationship between the two variables
under consideration. It is given be the equation

It ranges between 1 and +1 (+1 perfectly correlated, 0 uncorrelated and 1 perfectly

negatively correlated).
45

Normal Distribution
The stock price over a period of time tends to follow a pattern, which is similar to the
Normal Distribution. The mean of the sample data and the standard deviation of the
individual data points can define the Normal Distribution. The Normal Distribution
can be represented graphically by symmetric, bell shaped curve described by mean
and standard deviation.
If there is a 99% probability of an outcome occurring, then it will lie within
3

deviation from the mean. At 95% probability, it will lie within 2

deviation from the mean and at 66% probability, it will lie within deviation from
the mean.
Example 7:

A stock is at Rs.1000 on day 1. The total risk ' ' of the stock is 3%

per day. What range of prices would be observed on day 2 with 99% probability?
At 99% probability, the value can lie anywhere between 3 from the mean That is,
the price can vary from 1000 (3 * 3% * 1000) = 1000 90 = Rs.910 to 1000 + (3 *
3% * 1000) = 1000 + 90 = Rs.1090
Hence, the price can vary between Rs.910 to Rs.1090 on the next day.

46

Calculation of Beta ()
The risk of a well diversified portfolio, as we have seen, is represented by its market
risk of the securities included in the portfolio. The market risk of a security reflects
its sensitivity to market movements. Such sensitivity of a security is called beta ().
As mentioned earlier, the beta for market portfolio is equal to 1 by definition. Beta
of one (=1), indicates that volatility of return on the security is same as the market
or index; beta more than one (>1) indicates that the security has more unavoidable
risk or is more volatile than market as a whole, and beta less than one (<1) indicates
that the security has less systematic risk or is less volatile than market.
Given return on security-X which is a dependent variable (Rx) and return on Market
portfolio, the independent variable (Rm), Beta for the security X is calculated by
following formula:

47

Example : Given return on security-X and the return on Market portfolio, calculate
beta of the security X:

Since Beta of Security X is 0.61 (which is less than 1), we may infer that its return is
less volatile than the return on the market portfolio. If the return on market portfolio
48

increases/decreases by 10% then return on security X would be expected to

increase/decrease by 6.1% (0.61*10%).

49

Relationship between Return and Risk

Capital Asset Pricing Model
Portfolio Theory developed by Harry Markowitz is essentially a normative approach
as it prescribes what a rational investor should do. On the other hand, Capital Asset
Pricing Model (CAPM) developed by William Sharpe and others is an exercise in
positive economics as it is concerned with:
(i)

what is the relationship between risk and return for efficient portfolio?

And
(ii)

what is the relationship between risk and return for an individual security?

CAPM assumes that individuals are risk averse. CAPM describes the
relationship/trade-off between risk and expected/required return. It explains the
behaviour of security prices and provides mechanism to assess the impact of an
investment in a proposed security on risks and return of investors overall portfolio.
The CAPM provides framework for understanding the basic risk-return trade-offs
involved in various types of investment decisions. It enables drawing certain
implications about risk and the size of risk premiums necessary to compensate for
bearing risks.
Using beta () as the measure of non-diversifiable risk, the CAPM is used to define
the required return on a security according to the following equation:

50

It is easy to see that the required return for a given security increases with increases
in its beta.
Application of the CAPM can be demonstrated:
Example : Assume that a security with a beta of 1.5 is being considered for
investment at a time when the risk-free rate of return is 8 % p.a. and the market
return is expected to be 20% p.a. The expected/required return can be calculated by
substituting the given data into the CAPM equation:

Rs= 8%+ [1.50* (20%-8%)]

= 8%+ [1.50* 12%]
= 8%+ 18% = 26%
The investor should, therefore, require a 26 percent return on this investment, a
compensation for the non-diversifiable risk assumed, given the securitys beta of 1.5.
Such security is aggressive security. If the beta is 1.00, then the security is
considered as

neutral and the required return would be 20 percent [8%+

[1.00*(20%-8%)]: and if the beta had been lower, say 0.80, then the security is
considered as a defensive security and the required return would be 17.6 percent
[8%+ [0.80* (20%-8%)]. Thus, CAPM reflects a positive mathematical relationship
between risk and return, since the higher the risk (beta) higher is the required return.
Return and Risk of a portfolio
51

Investors prefer investing in a portfolio of assets (combination of two or more

securities/assets) rather than investing in a single asset. The expected return on a
portfolio is a weighted average of the expected returns of individual securities or
assets comprising the portfolio. The weights are equal to the proportion to amount
invested in each security to the total amount.
For example, when a portfolio consists of two securities, its expected return is:

Example : What

is the portfolio return, if expected returns for the three

assets such as A, B, and C, are 20%, 15% and 10% respectively, assuming that the
amount of investment made in these assets are Rs. 10,000, Rs. 20,000, and Rs.
30,000 respectively.
Weights for each of the assets A, B, and C respectively may be calculated as follows:
Total Amount invested in the portfolio of 3 assets (A, B, and C) = Rs. 10,000 + Rs.
20,000 + Rs.30,000 = Rs. 60,000.

52

Measurement of Risk for a portfolio

According to the Modern Portfolio Theory, while the expected return of a portfolio is
a weighted average of the expected returns of individual securities (or assets)
included in the portfolio, the risk of a portfolio measured by variance (or standard
deviation) is not equal to the weighted average of the risk of individual securities
included in the portfolio. The risk of a portfolio not only depends on variance/risk of
individual securities but also on co-variances between the returns on the individual
securities.
Given the covariance between the returns on the individual securities, the portfolio
variance consisting of n securities is calculated as:

------------Eq 1
Since the covariance between two variables is the product of their standard
deviations multiplied by their co-efficient of correlation, covariance between
the returns on two securities,

[ Cov(Ra, Rb) ] may be expressed as:

53

Hence, in case co-variances are not known and correlation co-efficients are given, the
Portfolio variance (2p) can be calculated with following formula:

--------------Eq 1 a

Portfolio with Two Securities:

Assuming a portfolio consisting of two securities (i.e. n=2), Portfolio Variance for the two
securities is calculated by substituting n=2 in the formula (Eq 1) as follows:

--------Eq 2

54

Example: The standard deviation of the two securities (a, b) are 20% and 10%
respectively. The two securities in the portfolio are assigned equal weights. If their
correlation coefficient is +1, 0 or 1 what is the portfolio risk?

55

56

1.10 HOW DIVERSIFICATION HELPS?

Diversification is a risk management technique that mixes a wide variety of investments within a
portfolio. The rationale behind this technique contends that a portfolio of different kinds of
investments will, on average, yield higher returns and pose a lower risk than any individual
investment found within the portfolio.
Diversification strives to smooth out unsystematic risk events in a portfolio so that the
positive performance of some investments will neutralize the negative performance of others.
Therefore, the benefits of diversification will hold only if the securities in the portfolio are not
perfectly correlated.
Studies and mathematical models have shown that maintaining a well-diversified portfolio of
25 to 30 stocks will yield the most cost-effective level of risk reduction. Investing in more
securities will still yield further diversification benefits, albeit at a drastically smaller rate.
Further diversification benefits can be gained by investing in foreign securities because they
tend be less closely correlated with domestic investments. For example, an economic downturn
in the U.S. economy may not affect Japan's economy in the same way; therefore, having
Japanese investments would allow an investor to have a small cushion of protection against
losses due to an American economic downturn.
Most non-institutional investors have a limited investment budget, and may find it difficult to
create an adequately diversified portfolio. This fact alone can explain why mutual funds have
been increasing in popularity. Buying shares in a mutual fund can provide investors with
an inexpensive source of diversification.
Intuitively smart investors knew the benefit of diversification which is reflected in the
traditional adage Do not put all your eggs in one basket.
Diversification involves investing in a broad array of investment types, ranging from
conservative bonds and cash to riskier stocks and even commodities. It's crucial because it
reduces your risk over time while capturing most of the market's gains.

57

How Diversification Works

A diverse portfolio ensures that at least some of your investments will be in the market's hottest
sectors at any given time -- regardless of what's hot and what's not. And you will never be fully
invested in the year's losers.
The result is a portfolio that is rarely the top performer of the year. But it is rarely the biggest
loser, either -- a fact that can aid long-term returns while reducing the stomach-churning ups and
downs that riskier strategies produce.
Just as an example, consider a fairly typical comparison of portfolio results over the 20 years
from 1988 through 2007. A portfolio invested only in growth stocks ranged from a 51% gain in
its best year to a 30% loss in its worst, producing an annual average gain of only 8.8%. On the
other hand, a relatively conservative portfolio spread diversely among bonds and various types of
stocks gained a maximum of 28% but suffered a maximum loss of only 3.5%, posting a 9.65%
average annual gain.
Building the Portfolio
It's best for most investors to build portfolios with mutual funds or exchange traded funds,
because each fund is, in itself, a collection of many stocks and/or bonds. That averts the risk of
investing in only one company.
The stock component should include international as well as US stocks, and large as well as
small and medium-size companies. The bond component can generally be small for younger
investors, growing larger as retirement age looms.
When investing for some future goal, one of the most basic investment principles is that of
adopting a proper asset allocation. This really is just a fancy way of saying "diversify."
The idea of diversification might not seem all that worthwhile for many investors. It could seems
like a make-work project (now they have more things they have to monitor) or it could seem like
additional risk (now conservative investors are stuck with higher risk assets in their portfolio).
However, the truth is that once people understand the most basic benefits to diversifying their
investments, they quickly see just how powerful the practice can be (notwithstanding the fact
58

that it becomes a common sense practice as well). Here are two of the biggest and most powerful
benefits to diversifying your portfolio:
1. Spread of Risk. By diversifying your portfolio, yes you are adding more assets to it. That
could mean spreading out a bond portfolio to include short-term and long-term maturities,
government and corporate issues, etc. It can also mean moving some assets out the bond
portfolio and incorporating an equity position into the overall investment portfolio.
Regardless of what diversification means, whether it is intra-asset class or inter-class, you are
essentially spreading the risk among different assets. This means that if asset A fails you, assets
B, C, D, etc. might be able to retain or improve value after all. Spread of risk, therefore, is a
fundamental practice that investors can employ to reduce potential losses in their portfolio.
2. Multiple Sources of Income. As in the case above, suppose everything moves along at its
regular pace. Asset A, B, C, D, etc. show no signs of risk, but since they are all performing, the
investor now gets to enjoy the benefit of different sources of income. Some of that income might
come from interest, some from capital appreciation, some from dividends, and so on.
Different sources of income are important, particularly for longer-term investments where
income may be sporadic in some asset classes, such as dividend-paying securities and capital
appreciation. By enjoying different sources of income, investors are better positioned to be able
to continue leading the lifestyle they have chosen.
These two very basic and fundamental benefits truly highlight the importance of knowing and
sticking to your asset allocation. And this reality is only heightened during periods of market
instability which, like a car whose engine seizes, means it is too late to fix the problem.

59

1.11 MARKET RISK- COMBINING RISKY AND RISK LESS

SECURITIES
Introduction of a Risk-Free Asset
Adding a risk-free asset to the investment opportunities present on the efficient frontier effectively adds
the opportunity to both borrow and lend. A U.S. Treasury bill (T-bill) is a common risk-free security
proxy. Buying a T-bill loans the U.S. government money. Selling short a T-bill effectively borrows
money. The concept of a risk-free asset is a major element in developing Capital Market Theory (CMT).
Adding risk-free assets integrates investment and financing decisions. A risk-free asset has:
Expected return is entirely certain.
Standard deviation of return is zero.
Covariance with any risky asset or portfolio is always zero, as is the correlation.

The Capital Market Line

Introducing risk-free assets creates a set of expected return-risk possibilities that did not exist
previously. The new risk/return trade-off is a straight line tangent to the efficient frontier at the market
portfolio (point M) with a vertical intercept at the risk-free rate of return, Rf. This line is called the
Capital Market Line (CML).
The capital allocation line (CAL) is the graph of all possible combinations of the risk-free asset
and the risky asset for one investor.
The capital market line is the line formed when the risky asset is a market portfolio rather than a
single risky asset or portfolio. The market portfolio is a mutual fund or exchange-traded fund
based on a market index, for instance.

60

The introduction of the risk-free asset significantly changes the Markowitz efficient set of portfolios.
Investors are better off because they have improved investment opportunities. This new line leads all
investors to invest in the same risky portfolio, the market portfolio. That is, all investors make the same
investment decision. They can, however, attain their desirable risk preferences by adjusting the weight of
the market portfolio in their portfolios.
A strongly risk-averse investor will lend some fund at the risk-free rate and invest the remainder
in the market portfolio.
A less risk-averse investor will borrow some fund at the risk-free rate and invest all the fund in
the market portfolio.

The Market Portfolio

The market portfolio of risky securities, M, is the highest point of tangency between the line emanating
from Rf, and the efficient frontier and is the singular optimal risky portfolio. In equilibrium, all risky
assets must be in portfolio M because all investors are assumed to arrive at, and hold, the same risky
portfolio.
All assets are included in portfolio M in proportion to their market value. For example, if the market of
Google was 2 percent of the market value of all risky assets, Google would constitute 2 percent of the
market value of portfolio M. Therefore, 2 percent of the market value of each investor's portfolio of
risky assets would be Google. Think of portfolio M as a broad market index such as the S&P 500 Index.
The market portfolio is, of course, a risky portfolio, and its risk is designated M.

Portfolio M in a Global Context. In theory, the market portfolio (M) should include all risky assets
worldwide, both financial and real, in their proper proportions. It has been estimated that the value of
61

non-U.S. assets exceeds 60 percent of the world total. Further, U.S. equities make up only about 10
percent of total world assets. Therefore, international diversification is important.

Portfolio M and Diversification. Because the market portfolio includes all risky assets, portfolio M is
by definition completely diversified. The market portfolio is the optimal portfolio of risky assets for
investors to own, and therefore will form part of the CML. A portfolio that is completely diversified has
a correlation with the market of 1.0.
Differential Borrowing and Lending Rates. Most investors can lend unlimited amounts at the risk-free
rate by buying government securities, but they must pay a premium relative to the prime rate when
borrowing money. The effect of this differential is that there will be two different lines going to the
Markowitz efficient frontier.

The segment RFR-F indicates the investment opportunities available when an investor combines
risk-free assets (lending at RFR) and portfolio F on the Markowitz efficient frontier. However, it
is NOT possible to extend this line any further if it is assumed that you cannot borrow at this
risk-free rate to acquire further units of Portfolio F.
If you can borrow at Rb, you can use the proceeds to invest in portfolio K to extend the CML
along the line segment K-G.
Therefore, the CML is made up of RFR-F-K-G. This implies that you can either lend or borrow,
but the borrowing portfolio is not as profitable as when it was assumed that you could borrow at
RFR. Your net return is less as the slope of the borrowing line (K-G) is below that for RFR-F.

62

End Chapter Quiz

Q1. The issue price of T-bills is generally decided at an ______ .
(a) OTC market
(b) inter-bank market
(c) exchange
(d) auction
Q2. Portfolio management is the art of managing the expected _______ requirement for
the corresponding ________.
(a) income, expenditure
(b) gain, losses
(c) profit, loss tolerance
(d) return, risk tolerance
Q3.In addition to the perceived benefits of professional fund management, the major reason of
investment into funds is the ______ they afford the investor.
(a) Specialization
(b) Diversification
(c) Variety
(d) Expansion
Q4. In India, Commercial Papers (CPs) can be issued by _____.
(a) Mutual Fund Agents
(b) Insurance Agents
(c) Primary Dealers
(d) Sub-Brokers
Q5. Unlike term insurance, __________ ensure a return of capital to the policyholder on maturity, along
with the death benefits.
(a) high premium or low premium policies
(b) fixed or variable policies
(c) assurance or endowment policies
(d) growth or value policies

63

Q6. A ________, is a time deposit with a bank with a specified interest rate.
(a) certificate of deposit (CD)
(b) commercial paper (CP)
(c) T-Note
(d) T-Bill
Q7. ______ are a fixed income security.
(a) Equities
(b) Forex
(c) Derivatives
(d) Bonds
Q8. The share price of PQR Company on 1st April 2009 and 31st March 2010 is Rs. 20 and Rs. 24
respectively. The company paid a dividend of Rs. 5 for the year 2009-10. Calculate the return
for a shareholder of PQR Company in the year 2009-10.
(a) 45%
(b) 65%
(c) 75%
(d) 55%
Q9. __________ have precedence over common stock in terms of dividend payments, and the residual
claim to its assets in the event of liquidation.
(a) Preferred shares
(b) Equity shares
(c) Common shares
(d) Right shares
Q10. New stocks/bonds are sold by the issuer to the public in the ________.
(a) fixed income market
(b) secondary market
(c) money market
(d) primary market

64

Key to Questions
Question

Answer

Q1.

(d)

Q2.

(d)

Q3.

(b)

Q4.

(c)

Q5.

(c)

Q6.

(a)

Q7.

(d)

Q8.

(a)

Q9.

(a)

Q10.

(d)

65

MODULE-II

66

2.1

FUNDAMENTAL SECURITY ANALYSIS

Fundamental analysis of a business involves analyzing its financial statements and

health, its management and competitive advantages, and its competitors and
markets. When applied to futures and forex, it focuses on the overall state of the
economy, interest rates, production, earnings, and management. When analyzing a
stock, futures contract, or currency using fundamental analysis there are two basic
approaches one can use; bottom up analysis and top down analysis. The term is
used to distinguish such analysis from other types of investment analysis, such as
quantitative analysis and technical analysis.
Fundamental analysis is performed on historical and present data, but with the
goal of making financial forecasts. There are several possible objectives:
to conduct a company stock valuation and predict its probable price
evolution,
to make a projection on its business performance,
to evaluate its management and make internal business decisions,
to calculate its credit risk.

2.1.1 Two analytical models

When the objective of the analysis is to determine what stock to buy and at what
price, there are two basic methodologies
1. Fundamental analysis maintains that markets may misprice a security in the short
run but that the "correct" price will eventually be reached. Profits can be made by
trading the mispriced security and then waiting for the market to recognize its
"mistake" and reprice the security.
2. Technical analysis maintains that all information is reflected already in the stock
price. Trends 'are your friend' and sentiment changes predate and predict trend
67

changes. Investors' emotional responses to price movements lead to recognizable

price chart patterns. Technical analysis does not care what the 'value' of a stock is.
Their price predictions are only extrapolations from historical price patterns.
Investors can use any or all of these different but somewhat complementary methods
for stock picking. For example many fundamental investors use technicals for
deciding entry and exit points. Many technical investors use fundamentals to limit
their universe of possible stock to 'good' companies.
The choice of stock analysis is determined by the investor's belief in the different
paradigms for "how the stock market works". See the discussions at efficient-market
hypothesis, random walk hypothesis, capital asset pricing model, Fed model Theory
of Equity Valuation, Market-based valuation, and Behavioral finance.
Fundamental analysis includes:
1. Economic analysis
2. Industry analysis
3. Company analysis
On the basis of these three analyses the intrinsic value of the shares are determined.
This is considered as the true value of the share. If the intrinsic value is higher than
the market price it is recommended to buy the share. If it is equal to market price,
hold the share and if it is less than the market price sell the shares.

2.1.2 COMPANY ANALYSIS

The Analysis of Financial Statements

A companys financial statements provide the most accurate information to its
68

management and shareholders about its operations, efficiency in the allocation of

its capital and its earnings profile. Three basic accounting statements form the
backbone of financial analysis of a company: the income statement (profit &
loss), the balance sheet, and the statement of cash flows. Let us quickly
summarize each of these.
Income Statement (Profit & Loss)
A profit & loss statement provides an account of the total revenue generated by a
firm during period (usually a financial year or a quarter), the expenses involved
and the money earned. In its simplest form, revenue generation or sales accrues
from selling the products manufactured, or services rendered by the company.
Operating expenses include the costs of these goods and services and the costs
incurred during the manufacture. Beyond operating expenses are interest costs
based on the debt profile of the company. Taxes payable to the Government are
then debited to provide the Profit After Tax (PAT) or the net income to the
shareholders of the company.
Actual P&L statements of companies are usually much more complicated than
this, with so-called other income (income from non-core activities), negative
interest expenses (from cash reserves with the company), preferred dividends, and
non-recurring, exceptional income or expenses. The example given below is that
of a large company in the Pharmaceutical sector over the period 2006-2008.

Financial Ratios (Return, Operating and, Profitability

Ratios)
Financial ratios are meaningful links between different entries of financial
statements, as by themselves the financial entries offer little to examine a
company. In addition to providing information about the financial health and
69

prospects of a company, financial ratios also allow a company to be viewed, in a

relative sense, in comparison with its own historical performance, others in its
sector of the economy, or between any two companies in general. In this section
we examine a few such ratios, grouped into categories that allow comparison of
size, solvency, operating performance, growth profile and risks. The list below is
by no means exhaustive,
and merely serves to illustrate a few of the important ones.
Measures of Profitability: RoA, RoE
Return on Assets (RoA) in its simplest form denotes the firms ability to
generate profits
given its assets :
RoA = (Net Income + Interest Expenses)*(1- Tax Rate) / Average Total Assets
Return on Equity (RoE) is the return to the equity investor :
RoE = Net Income / Shareholder Funds
Sometimes this ratio is also calculated as RoAE, to account for recent
capital raising by
the firm
Return on Average Equity = Net Income / Average Shareholder Funds
Return on Total Capital = Net Income + Gross Interest Expense / Average total
capital
Measures of Liquidity
Short-term liquidity is imperative for a company to remain solvent. The
ratios below get
increasingly conservative in terms of the demands on a firm to meet near-term
payables.
70

Current ratio = Current Assets / Current Liabilities

Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities
Acid test ratio = (Cash + Marketable Securities) / Current Liabilities
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
Capital Structure and Solvency Ratios
Total debt to total capital = (Current Liabilities + Long-term Liabilities) /
(Equity + Total Liabilities)
Long-term Debt-Equity = Long-term Liabilities / Equity

Operating Performance
Gross Profit Margin = Gross Profit / Net Sales
Operating Profit Margin = Operating Income / Net Sales
Net Profit Margin = Net Income / Net Sales
Asset Utilization
These ratios look at the effectiveness of a firm to utilize its assets, especially its
fixed assets. A high turnover implies optimal use of assets. In addition to the two
below there are others like. Sales to inventories, and Sales to Working capital.
Total Asset Turnover = Net Sales / Average Total Assets
Fixed Asset Turnover = Net Sales / Average Net Fixed Assets
There are many other categories, like the common size ratios, which serve to
present the company in terms of one of its own denominators, like Net Sales, or
the market capitalization; and others that specifically look at the risk aspect of
things (business, financial, and liquidity).

71

2.3 Time Value of Money

One of the most important principles in all of finance is the relationship between
value of a rupee today and value of rupee in future. This relationship is known as the
time value of money. A rupee today is more valuable than a rupee tomorrow. This
is because current consumption is preferred to future consumption by the individuals,
firms can employ capital productively to earn positive returns and in an inflationary
period, rupee today represents greater purchasing power than a rupee tomorrow. The
time value of the money may be computed in the following circumstances.
(a)

Future value of a single cash flow

(b)

Future value of an annuity

(c)

Present value of a single cash flow

(d)

Present value of an annuity

Future Value of a Single Cash Flow

For a given present value (PV) of money, future value of money (FV) after a period
t for which compounding is done at an interest rate of r, is given by the equation
t

FV = PV (1+r)

This assumes that compounding is done at discrete intervals. However, in case of

continuous compounding, the future value is determined using the formula
rt

FV = PV * e

72

73

Where e is a mathematical function called exponential the value of exponential

(e) = 2.7183. The compounding factor is calculated by taking natural logarithm (log
to the base of 2.7183).
Example : Calculate the value of a deposit of Rs.2,000 made today, 3 years hence if
the interest rate is 10%.
By discrete compounding:
3

FV = 2,000 * (1+0.10) = 2,000 * (1.1) = 2,000 * 1.331 = Rs. 2,662

By continuous compounding:
FV = 2,000 * e (0.10 *3) =2,000 * 1.349862 = Rs.2699.72
Example : Find the value of Rs. 70,000 deposited for a period of 5 years at the end
of the period when the interest is 12% and continuous compounding is done.
Future Value = 70,000*

e (0.12*5) = Rs. 1,27,548.827.

The future value (FV) of the present sum (PV) after a period t for which
compounding is done m times a year at an interest rate of r, is given by the
following equation:
FV = PV (1+(r/m))^mt
Example : How much a deposit of Rs. 10,000 will grow at the end of 2 years, if the
nominal rate of interest is 12 % and compounding is done quarterly?

74

75

Future Value of an Annuity

An annuity is a stream of equal annual cash flows. The future value (FVA) of a
uniform cash flow (CF) made at the end of each period till the time of maturity t for
which compounding is done at the rate r is calculated as follows:

e.g. to know accumulated amount after a certain period,; to know how much to save
annually to reach the targeted amount, to know the interest rate etc.
Example : Suppose, you deposit Rs.3,000 annually in a bank for 5 years and our
deposits earn a compound interest rate of 10 per cent, what will be value of this series
of deposits (an annuity) at the end of 5 years? Assume that each deposit occurs at the
end of the year.
Future value of this annuity is:
4

=Rs.3000*(1.10) + Rs.3000*(1.10) + Rs.3000*(1.10) + Rs.3000*(1.10) +

Rs.3000
=Rs.3000*(1.4641)+Rs.3000*(1.3310)+Rs.3000*(1.2100)+Rs.3000*(1.10)
+ Rs.3000
= Rs. 18315.30
Example : You want to buy a house after 5 years when it is expected to cost 40 lakh
how much should you save annually, if your savings earn a compound return of
76

12%?

Present Value of a Single Cash Flow

Present value of (PV) of the future sum (FV) to be received after a period t for
which discounting is done at an interest rate of r, is given by the equation
In case of discrete discounting: PV = FV / (1+r)

Example : What is the present value of Rs.5,000 payable 3 years hence, if the
interest rate is 10 % p.a.
PV

= 5000 / (1.10)3

i.e. = Rs.3756.57

In case of continuous discounting:

77

78

Example :

What is the present value of Rs. 10,000 receivable after 2

years at a discount rate of 10% under continuous discounting?

Present Value = 10,000/(exp^(0.1*2)) = Rs. 8187.297

79

Present Value of an Annuity

The present value of annuity is the sum of the present values of all the cash inflows of this annuity.
Present value of an annuity (in case of discrete discounting)
t

PVA = FV [{(1+r) - 1 }/ {r * (1+r) }]

t

The term [(1+r) - 1/ r*(1+r) ] is referred as the Present Value Interest factor for an annuity (PVIFA).
Example :

What is the present value of Rs. 2000/- received at the end of each year for 3

continuous years ?
= 2000*[1/1.10]+2000*[1/1.10]^2+2000*[1/1.10]^3
= 2000*0.9091+2000*0.8264+2000*0.7513
= 1818.181818+1652.892562+1502.629602
= Rs. 4973.704
Example : Assume that you have taken housing loan of Rs.10 lakh at the interest rate of Rs.11
percent per annum. What would be you equal annual installment for repayment period of 15 years?
Loan amount = Installment (A) *PVIFA n=15, r=11%
t

10,00,000 = A* [(1+r) - 1/ r*(1+r) ]

10,00,000 = A* [(1.11)^15 - 1/ 0.11(1.11^15]
10,00,000 = A* 7.19087
10,00,000/7.19087 = A
A = Rs. 1,39,065.24
Present value of an annuity (in case of continuous discounting) is calculated as:
-rt

PVa = FVa * (1-e )/r

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2.4

TECHNICAL ANALYSIS

Technical analysis involves making trading decisions by studying records or charts of past stock
prices and volume, and in the case of futures, open interest. It is a method of evaluating securities
by analyzing statistics generated by market activity, such as past prices and volume. Technical
analysts do not attempt to measure a security's intrinsic value, but instead use charts and other
tools to identify patterns that can suggest future activity.
Technical analysts believe that the historical performance of stocks and markets are indications
of future performance. In a shopping mall, a fundamental analyst would go to each store, study
the product that was being sold, and then decide whether to buy it or not. By contrast, a technical
analyst would sit on a bench in the mall and watch people go into the stores. Disregarding the
intrinsic value of the products in the store, the technical analyst's decision would be based on the
patterns or activity of people going into each store.
The technical analysts do not attempt to measure a securitys intrinsic value but believe in
making short-term profit by analyzing the volume and price patterns and trends. Technical
analysts use statistical tools like time series analysis (in particular trend analysis), relative
strength index, moving averages, regressions, price correlations, etc. The field of technical
analysis is based on the following three assumptions.
a) The market discounts everything: Technical analysts believe that the market price takes into
consideration the intrinsic value of the stocks along with broader economic factors and the
market psychology. Therefore, what is important is an analysis of the price movement that
reflects the demand and supply of a stock in the short run.
b) Price moves in trends: Trends are of three types, viz. uptrend, downtrend and horizontal trend.
Technical analysts believe that once trends are established in the prices, the price moves in the
same direction as the trends suggests.
c) History tends to repeat itself: This assumption leads to a belief that current investors repeat
the behavior of the investors that preceded them and therefore recognizable price patterns can
be observed if a chart is drawn.
There are various concepts that are used by technical analysts like support prices, resistance
levels, breakouts, momentum, etc. These concepts can be heard very often in business channels
and business newspapers. Supports refer to the price level through which a stock price seldom
falls and resistance is the price level through which a stock seldom surpasses. Breakout refers to
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situation when the price actually falls below the support level or rises above the resistance level.
Once a breakout occurs, the role is reversed. If the price increases beyond the resistance level,
the resistance level becomes the support level and when the price falls below the support level,
the support level becomes the new resistance level for the stock. Momentum refers to the rate at
which price of a stock changes.

2.4.1 Difference between Technical and Fundamental Analysis

Technical analysis and fundamental analysis are the two main schools of thought in the financial
markets. Technical analysis looks at the price movement of a security and uses this data to
predict its future price movements. Fundamental analysis, on the other hand, looks at economic
factors, known as fundamentals. Let's get into the details of how these two approaches differ, the
criticisms against technical analysis and how technical and fundamental analysis can be used
together to analyze securities.

Fundamental Vs. Technical Analysis

Charts vs. Financial Statements
At the most basic level, a technical analyst approaches a security from the charts, while a
fundamental analyst starts with the financial statements.
By looking at the balance sheet, cash flow statement and income statement, a fundamental
analyst tries to determine a company's value. In financial terms, an analyst attempts to measure a
company's intrinsic value. In this approach, investment decisions are fairly easy to make - if the
price of a stock trades below its intrinsic value, it's a good investment. Although this is an
oversimplification
(fundamental analysis goes beyond just the financial statements) for the purposes of this tutorial,
this simple tenet holds true.
Technical traders, on the other hand, believe there is no reason to analyze a company's
fundamentals because these are all accounted for in the stock's price. Technicians believe that all
the information they need about a stock can be found in its charts.

Time Horizon
Technical analysis mainly seeks to predict short-term price movements, whereas
fundamental analysis tries to establish long term values.
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Fundamental analysis takes a relatively long-term approach to analyzing the market compared to
technical analysis. While technical analysis can be used on a timeframe of weeks, days or even
minutes, fundamental analysis often looks at data over a number of years.
The different timeframes that these two approaches use is a result of the nature of the investing
style to which they each adhere. It can take a long time for a company's value to be reflected in
the market, so when a fundamental analyst estimates intrinsic value, a gain is not realized until
the stock's market price rises to its "correct" value. This type of investing is called value
investing and assumes that the short-term market is wrong, but that the price of a particular stock
will correct itself over the long run. This "long run" can represent a timeframe of as long as
several years, in some cases.
Furthermore, the numbers that a fundamentalist analyzes are only released over long periods of
time. Financial statements are filed quarterly and changes in earnings per share don't emerge on a
daily basis like price and volume information. Also remember that fundamentals are the actual
characteristics of a business. New management can't implement sweeping changes overnight and
it takes time to create new products, marketing campaigns, supply chains, etc. Part of the reason
that fundamental analysts use a long-term timeframe, therefore, is because the data they use to
analyze a stock is generated much more slowly than the price and volume data used by technical
analysts.

Trading Versus Investing

Technical Analysis appeals mostly to short term traders, whereas fundamental analysis
appeals primarily to long-term investors.
Not only is technical analysis more short term in nature that fundamental analysis, but the goals
of a purchase (or sale) of a stock are usually different for each approach. In general, technical
analysis is used for a trade, whereas fundamental analysis is used to make an investment.
Investors buy assets they believe can increase in value, while traders buy assets they believe they
can sell to somebody else at a greater price. The line between a trade and an investment can be
blurry, but it does characterize a difference between the two schools.

Type of Data
The focus of technical analysis is mainly on internal market data, particularly price and volume
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data. The focus of fundamental analysis is on fundamental factors relating to the economy, the
industry, and the firm.

2.4.2 CHARTING TERMS AND INDICATORS

Concepts
Resistance a price level that may prompt a net increase of selling activity
Support a price level that may prompt a net increase of buying activity
Breakout the concept whereby prices forcefully penetrate an area of prior support or
resistance, usually, but not always, accompanied by an increase in volume.
Trending the phenomenon by which price movement tends to persist in one direction for an
extended period of time
Average true range averaged daily trading range, adjusted for price gaps
Chart pattern distinctive pattern created by the movement of security prices on a chart
Dead cat bounce the phenomenon whereby a spectacular decline in the price of a stock is
immediately followed by a moderate and temporary rise before resuming its downward
movement
Elliott wave principle and the golden ratio to calculate successive price movements and
retracements
Fibonacci ratios used as a guide to determine support and resistance
Momentum the rate of price change
Point and figure analysis A priced-based analytical approach employing numerical filters
which may incorporate time references, though ignores time entirely in its construction.
Cycles - time targets for potential change in price action (price only moves up, down, or
sideways)
Types of charts
OHLC "Bar Charts" Open-High-Low-Close charts, also known as bar charts, plot the span
between the high and low prices of a trading period as a vertical line segment at the trading time,
and the open and close prices with horizontal tick marks on the range line, usually a tick to the
left for the open price and a tick to the right for the closing price.

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Candlestick chart Of Japanese origin and similar to OHLC, candlesticks widen and fill the
interval between the open and close prices to emphasize the open/close relationship. In the West,
often black or red candle bodies represent a close lower than the open, while white, green or blue
candles represent a close higher than the open price.
Line chart Connects the closing price values with line segments.
Point and figure chart a chart type employing numerical filters with only passing references
to time, and which ignores time entirely in its construction.
Overlays
Overlays are generally superimposed over the main price chart.
Resistance a price level that may act as a ceiling above price
Support a price level that may act as a floor below price
Trend line a sloping line described by at least two peaks or two troughs
Channel a pair of parallel trend lines
Moving average the last n-bars of price divided by "n" -- where "n" is the number of bars
specified by the length of the average. A moving average can be thought of as a kind of dynamic
trend-line.
Bollinger bands a range of price volatility
Parabolic SAR Wilder's trailing stop based on prices tending to stay within a parabolic curve
during a strong trend
Pivot point derived by calculating the numerical average of a particular currency's or stock's
high, low and closing prices
Ichimoku kinko hyo a moving average-based system that factors in time and the average
point between a candle's high and low
Price-based indicators
These indicators are generally shown below or above the main price chart.
Advance decline line a popular indicator of market breadth

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Average Directional Index a widely used indicator of trend strength

Commodity Channel Index identifies cyclical trends
MACD moving average convergence/divergence
Relative Strength Index (RSI) oscillator showing price strength
Stochastic oscillator close position within recent trading range
Trix an oscillator showing the slope of a triple-smoothed exponential moving average
Momentum the rate of price change
Volume-based indicators
Accumulation/distribution index based on the close within the day's range
Money Flow the amount of stock traded on days the price went up
On-balance volume the momentum of buying and selling stocks

2.4.3 CHALLENGES TO TECHNICAL ANALYSIS

There are many questions, primarily raised by fundamental analysts, about the assumptions of
technical analysis. While it is understandable that price movements are caused by the interaction
of supply and demand of securities and that the market assimilates this information (as
mentioned in the first assumption), there is no consensus on the speed of this adjustment or its
extent. In other words, while prices may react to changes in demand-supply and other market
dynamics, the response could easily differ across securities, both in the time taken, and the
degree to which prices change. Other objections to technical analysis arise from Efficient
Markets Hypothesis, which is discussed subsequently. Proponents of the EMH aver that market
efficiency would preclude any technical trading patterns to repeat with any predictable
accuracy, rendering the profitability of most such trading rules subject to chance. Further, the
success of a trading rule could also make it crowded, in the sense that most technical traders
follow a small set of rules (albeit with possibly different parameterizations), speeding up the
adjustment of the market, and thus reducing the potential gains. Finally, technical analysis
involves meaningful levels of subjectivity-interpretations may vary widely on the same pattern of
stock, or index prices-which also hinders systematic reasoning and extensibility across different
securities.
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87

2.5

DOW THEORY

Introduction
Any attempt to trace the origins of technical analysis would inevitably lead to Dow theory. While
more than 100 years old, Dow theory remains the foundation of much of what we know today as
technical analysis. Dow theory was formulated from a series of Wall Street Journal editorials
authored by Charles H. Dow from 1900 until the time of his death in 1902. These editorials
reflected Dows beliefs on how the stock market behaved and how the market could be used to
measure the health of the business environment. Due to his death, Dow never published his
complete theory on the markets, but several followers and associates have published works that
have expanded on the editorials. Some of the most important contributions to Dow theory were
William P. Hamilton's "The Stock Market Barometer" (1922), Robert Rhea's "The Dow Theory"
(1932), E. George Schaefer's "How I Helped More Than 10,000 Investors To Profit In Stocks"
(1960) and Richard Russell's "The Dow Theory Today" (1961). Dow believed that the stock
market as a whole was a reliable measure of overall business conditions within the economy and
that by analyzing the overall market, one could accurately gauge those conditions and identify
the direction of major market trends and the likely direction of individual stocks. Dow first used
his theory to create the Dow Jones Industrial Index and the Dow Jones Rail Index (now
Transportation Index), which were originally compiled by Dow for The Wall Street Journal.
Dow created these indexes because he felt they were an accurate reflection of the business
conditions within the economy because they covered two major economic segments: industrial
and rail (transportation). While these indexes have changed over the last 100 years, the theory
still applies to current market indexes. Much of what we know today as technical analysis has its
roots in Dows work. For this reason, all traders using technical analysis should get to know the
six basic tenets of Dow theory. Lets explore them.

1. The Market Discounts Everything

The first basic premise of Dow theory suggests that all information - past, current and even
future - is discounted into the markets and reflected in the prices of stocks and indexes.
That information includes everything from the emotions of investors to inflation and interest-rate
data, along with pending earnings announcements to be made by companies after the close.
Based on this tenet, the only information excluded is that which is unknowable, such as a
massive earthquake. But even then the risks of such an event are priced into the market.
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It's important to note that this is not to suggest that market participants, or even the market itself,
are all knowing, with the ability to predict future events. Rather, it means that over any period of
time, all factors - those that have happened, are expected to happen and could happen - are priced
into the market. As things change, such as market risks, the market adjusts along with the prices,
reflecting that new information.
The idea that the market discounts everything is not new to technical traders, as this is a major
premise of many of the tools used in this field of study. Accordingly, in technical analysis one
need only look at price movements, and not at other factors such as the balance sheet.
Like mainstream technical analysis, Dow theory is mainly focused on price. However, the two
differ in that Dow theory is concerned with the movements of the broad markets, rather than
specific securities.
For example, a follower of Dow theory will look at the price movement of the major market
indexes. Once they have an idea of the prevailing trend in the market, they will make an
investment decision. If the prevailing trend is upward, it follows that an investor would buy
individual stocks trading at a fair valuation. This is where a broad understanding of the
fundamental factors that affect a company can be helpful. It's important to note that while Dow
theory itself is focused on price movements and index trends, implementation can also
incorporate elements of fundamental analysis, including value- and fundamental-oriented
strategies. Having said that, Dow theory is much more suited to technical analysis.

2. The market has three movements

(1) The "main movement", primary movement or major trend may last from less than a year
to several years. It can be bullish or bearish. (2) The "medium swing", secondary reaction
or intermediate reaction may last from ten days to three months and generally retraces
from 33% to 66% of the primary price change since the previous medium swing or start
of the main movement. (3) The "short swing" or minor movement varies with opinion
from hours to a month or more. The three movements may be simultaneous, for instance,
a daily minor movement in a bearish secondary reaction in a bullish primary movement.

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3. The Three-Trend Market

An important part of Dow theory is distinguishing the overall direction of the market. To do this,
the theory uses trend analysis. Before we can get into the specifics of Dow theory trend analysis,
we need to understand trends. First, it's important to note that while the market tends to move in
a general direction, or trend, it doesn't do so in a straight line. The market will rally up to a high
(peak) and then sell off to a low (trough), but will generally move in one direction.

An uptrend

An upward trend is broken up into several rallies, where each rally has a high and a low. For
a market to be considered in an uptrend, each peak in the rally must reach a higher level than
the previous rally's peak, and each low in the rally must be higher than the previous rally's
low.
A downward trend is broken up into several sell-offs, in which each sell-off also has a high
and a low. To be considered a downtrend in Dow terms, each new low in the sell-off must be
lower than the previous sell-off's low and the peak in the sell-off must be lower then the
peak in the previous sell-off.
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A downtrend

Now that we understand how Dow theory defines a trend, we can look at the finer points of
trend analysis.
Dow theory identifies three trends within the market: primary, secondary and minor. A
primary trend is the largest trend lasting for more then a year, while a secondary trend is an
intermediate trend that lasts three weeks to three months and is often associated with a
movement against the primary trend. Finally, the minor trend often lasts less than three
weeks and is associated with he movements in the intermediate trend.
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Dow Theory asserts that major market trends are composed of three phases: an
accumulation phase, a public participation phase, and a distribution phase. The
accumulation phase (phase 1) is a period when investors "in the know" are actively
buying (selling) stock against the general opinion of the market. During this phase, the
stock price does not change much because these investors are in the minority absorbing
(releasing) stock that the market at large is supplying (demanding). Eventually, the
market catches on to these astute investors and a rapid price change occurs (phase 2).
This occurs when trend followers and other technically oriented investors participate.
This phase continues until rampant speculation occurs. At this point, the astute
investors begin to distribute their holdings to the market (phase 3).

4. Market Indexes Must Confirm Each Other

Under Dow theory, a major reversal from a bull to a bear market (or vice versa) cannot be
signaled unless both indexes (traditionally the Dow Industrial and Rail Averages) are in
agreement.
For example, if one index is confirming a new primary uptrend but another index remains in
a primary downward trend, it is difficult to assume that a new trend has begun.
The reason for this is that a primary trend, either up or down, is the overall direction of the
stock market, which in Dow theory is a reflection of business conditions in the economy.
When the stock market is doing well, it is because business conditions are good; when the
stock market is doing poorly, it is due to poor business conditions. If the two Dow indexes
are in conflict, there is no clear trend in business conditions.
If business conditions cause the major indexes to travel in opposite directions, this disparity
suggests that it will be difficult for a primary trend to develop. When trying to confirm a
new primary trend, therefore, it's vital that more than one index shows similar signals within
a relatively close period of time. If the indexes are in agreement, it is a sign that business
conditions are moving in the indicated direction. Thus, rising indexes signal a new uptrend.

5. Volume Must Confirm The Trend

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According to Dow theory, the main signals for buying and selling are based on the price
movements of the indexes. Volume is also used as a secondary indicator to help confirm
what the price movement is suggesting.
From this tenet it follows that volume should increase when the price moves in the direction
of the trend and decrease when the price moves in the opposite direction of the trend. For
example, in an uptrend, volume should increase when the price rises and fall when the price
falls. The reason for this is that the uptrend shows strength when volume increases because
traders are more willing to buy an asset in the belief that the upward momentum will
continue. Low volume
during the corrective periods signals that most traders are not willing to close their positions
because they believe the momentum of the primary trend will continue.
Conversely, if volume runs counter to the trend, it is a sign of weakness in the existing trend.
For example, if the market is in an uptrend but volume is weak on the up move, it is a signal
that buying is starting to dissipate. If buyers start to leave the market or turn into sellers,
there is little chance that the market will continue its upward trend. The same is true for
increased volume on down days, which is an indication that more and more participants are
becoming sellers in the market.
According to Dow theory, once a trend has been confirmed by volume, the majority of
money in the market should be moving with the trend and not against it.

6. Trend Remains In Effect Until Clear Reversal Occurs

The reason for identifying a trend is to determine the overall direction of the market so that
trades can be made with the trends and not against them. As was illustrated in the third tenet,
trends move from uptrend to downtrend, which makes it important to identify transitions
between these two trend directions.
In Dow theory, the sixth and final tenet states that a trend remains in effect until the weight
of evidence suggests that it has been reversed.
Traders wait for a clear picture of a trend reversal because the goal is not to confuse a true
reversal in the primary trend with a secondary trend or brief correction. Remember that a
secondary trend is a move in the opposite direction of the primary trend that will not
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continue. For example, imagine that the primary trend is up, but the indexes are currently
selling off. If an investor were to take a short position, concluding that the sell-off is the start
of a new primary downward trend, they could get burned when the primary trend continues.
Unless you can safely conclude, based on the weight of evidence, that the trend has changed,
you will be trading against the trend. As a general rule, this is not a wise idea, as many have
been hurt by trading against the market.

Current Relevance
There is little doubt that Dow theory is of major importance in the history of technical
analysis. Many of its tenets and ideas are the basis of much of what we know today. Aspects
of Dow theory are also incorporated into other theories, such as Elliott Wave theory.
However, since its original adaptation and subsequent updates, its relevance as a stand-alone
analytical technique has weakened. The reason for this has been the advent of more
advanced techniques and tools, which in part build off of Dow theory, but greatly expand
upon it.
One of the bigger problems with the theory is that followers can miss out on large gains due
to the conservative nature of a trend-reversal signal. As we mentioned previously, a signal is
confirmed when there is an end to successive highs(uptrend) or lows (downtrend). However,
what often happens is that by the time the market has shown a clear sign of reversal, the
market has already generated a large gain.
Another problem with Dow theory is that over time, the economy - and the indexes
originally used by Dow - has changed. Consequently, the link between them has weakened.
For example, the industrial and transportation sectors of the economy are no longer the
dominant parts. Technology, for example, now takes up a considerable portion of economic
production and growth.
This is important because the basis for watching the indexes is that they are the leading
indicators of business conditions. The economy has clearly become more segmented,
requiring the analysis of more indexes, which could greatly reduce the accuracy and
timeliness of Dow theory analysis. Imagine having to look at six indexes while still adhering
to Tenet #4: Indexes Must Confirm Each Other.
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Even though there are weaknesses in Dow theory, it will always be important to technical
analysis. The ideas of trending markets and peak-and-trough analysisare found constantly
within technical writings and ideas. Also of importance in Dow theory is the idea of
emotions in the marketplace, which remains a characteristic of market trends.
Charles Dow and Dow theory helped investors improve their understanding of the markets
so that they could maker better investments and achieve investment success.

Conclusions
Dow theory represents the beginning of technical analysis. Understanding this theory should
lead you to a better understanding of technical analysis and of an analyst's view of how
markets work.
Let's recap what we've learned:
Dow theory was formulated from a series of Wall Street Journal editorials
authored by Charles H. Dow, which reflected Dows beliefs on how the stock
market behaved and how the market could be used to measure the health of the
business environment.
Dow believed that the stock market as a whole was a reliable measure of overall
business conditions within the economy and that by analyzing the overall market,
one could accurately gauge those conditions and identify the direction of major
market trends and the likely direction of individual stocks.
The market discounts everything.
Dow theory uses trend analysis to determine which way the market is headed.
Primary trends are major market trends.
Secondary trends are corrections of the primary trend.
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Primary trends are made up of three phases. For an upward trend, these phases
are: the accumulation phase, the public participation phase and the excess phase.
For a downward trend, the three phases are: the distribution phase, the public
participation phase and the panic phase.
Market indexes must confirm each other. In other words, a major reversal from a
bull or bear market cannot be signaled unless both indexes (generally the Dow
Industrial and Rail Averages) are in agreement.
Volume must confirm the trend. The indexes are the main signals that indicate a
security's movement, but volume is used as a secondary indicator to help confirm
what the price movement is suggesting.
A trend will remain in effect until a clear reversal occurs.
Dow relied solely on closing prices for determining trends, not intraday price
movements.
Peak-and-trough analysis is a key technique used to identify trends in Dow
theory.
Since the advent of Dow theory, more advanced techniques and tools have
expanded on this theory and begun to take its place.
One problem with Dow theory is that followers can miss out on large gains due
to the conservative nature of a trend-reversal signal.
Another problem with Dow theory is that over time, the economy - and the
indexes originally used by Dow - has changed.

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2.6

EFFICIENT MARKET THEORY

2.6.1 Introduction
The Efficient Markets Hypothesis (EMH) is one of the main pillars of modern finance theory,
and has an impact on much of the literature in the subject since the 1960s when it was first
proposed and on our understanding about potential gains from active portfolio management.
Markets are efficient when prices of securities assimilate and reflect information about them.
While markets have been generally found to be efficient, the number of departures seen in recent
years has kept this topic open to debate.
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.
Although it is a cornerstone of modern financial theory, the EMH is highly controversial and
often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict
trends in the market through either fundamental or technical analysis.
Meanwhile, while academics point to a large body of evidence in support of EMH, an equal
amount of dissension also exists. For example, investors, such as Warren Buffett have
consistently beaten the market over long periods of time, which by definition is impossible
according to the EMH. Detractors of the EMH also point to events, such as the 1987 stock
market crash when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as
evidence that stock prices can seriously deviate from their fair values.
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2.6.2 Market Efficiency

The extent to which the financial markets digest relevant information into the prices is an
important issue. If the prices fully reflect all relevant information instantaneously, then market
prices could be reliably used for various economic decisions. For instance, a firm can assess the
potential impact of increased dividends by measuring the price impact created by the dividend
increase. Similarly, a firm can assess the value of a new investment taken up by ascertaining the
impact on its market price on the announcement of the investment decision. Policymakers can
also judge the impact of various macroeconomic policy changes by assessing the market value
impact. The need to have an understanding about the ability of the market to imbibe information
into the prices has led to countless attempts to study and characterize the levels of efficiency of
different segments of the financial markets.
The early evidence suggests a high degree of efficiency of the market in capturing the price
relevant information. Formally, the level of efficiency of a market is characterized as belonging
to one of the following (i) weak-form efficiency (ii) semi-strong form efficiency (iii) strong-form
efficiency.
Weak-form Market Efficiency
This type of EMH claims that all past prices of a stock are reflected in today's stock price.
Therefore, technical analysis cannot be used to predict and beat a market. Theoretical in
nature, weak form efficiency advocates assert that fundamental analysis can be used to
identify stocks that are undervalued and overvalued. Therefore, keen investors looking for
profitable companies can earn profits by researching financial statements.
The weak-form efficiency or random walk would be displayed by a market when the consecutive
price changes (returns) are uncorrelated. This implies that any past pattern of price changes are
unlikely to repeat by itself in the market. Hence, technical analysis that uses past price or volume
trends do not to help achieve superior returns in the market. The weak-form efficiency of a
market can be examined by studying the serial correlations in a return time series.
Absence of serial correlation indicates a weak-form efficient market.
Semi-strong Market Efficiency
This form of EMH implies that all public information is calculated into a stock's current
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share price. Neither fundamental nor technical analysis can be used to achieve superior
gains. This class of EMH suggests that only information that is not publicly available can
benefit investors seeking to earn abnormal returns on investments. All other information is
accounted for in the stocks price and, regardless of the amount of fundamental and
technical analysis one performs, above normal returns will not be had.
The semi-strong form efficiency implies that all the publicly available information gets reflected
in the prices instantaneously.

Hence, in such markets the impact of positive (negative)

information about the stock would lead to an instantaneous increase (decrease) in the prices.
Semi-strong form efficiency would mean that no investor would be able to outperform the
market with trading strategies based on publicly available information.
The hypothesis suggests that only information that is not publicly available can benefit investors
seeking to earn abnormal returns on investments. All other information is accounted for in the
stocks price and regardless of the amount of fundamental and technical analysis one performs,
above normal returns will not be had.
The semi-strong form efficiency can be tested with event-studies. A typical event study would
involve assessment of the abnormal returns around a significant information event such as
buyback announcement, stock splits, bonus etc. Here, a time period close to the selected event
including the event date would be used to examine the abnormal returns. If the market is semistrong form efficient, the period after a favorable (unfavorable) event would not generate returns
beyond (less than) what is suggested by an equilibrium pricing model (such as CAPM, which has
been discussed later in the book).

Strong Market Efficiency

This is the strongest version, which states that all information in a market, whether public
or private, is accounted for in a stock price. Not even insider information could give an
investor an advantage. This class of EMH suggests that only information that is not
publicly available can benefit investors seeking to earn abnormal returns on investments.
All other information is accounted for in the stocks price and, regardless of the amount of
fundamental and technical analysis one performs, above normal returns will not be had.
The level of efficiency ideally desired for any market is strong form efficiency. Such efficiency
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would imply that both publicly available information and privately (non-public) available
information are fully reflected in the prices instantaneously and no one can earn excess returns.
A test of strong form efficiency would be to ascertain whether insiders of a firm are able to make
superior returns compared to the market. Absence of superior return by the insiders would imply
that the market is strongly efficient. Testing the strong-form efficiency directly is difficult.
Therefore, the claim about strong form efficiency of any market at the best remains tenuous.
In the years immediately following the proposal of the market efficiency, tests of various forms
of efficiency had suggested that the markets are reasonably efficient. Over time, this led to the
gradual acceptance of the efficiency of markets.
2.6.3 Departures from the EMH
Evidence accumulated through research over the past two decades, however, suggests that during
many episodes the markets are not efficient even in the weak form. The returns are found to be
correlated both for short as well as long lags during such episodes. The downward and upward
trending of prices is well documented across different markets (momentum effect). Then there is
a whole host of other documented deviations from efficiency. They include, the predictability of
future returns based on certain events and high volatility of prices compared to volatility of the
underlying fundamentals. All these evidences have started to offer a challenge to the earlier
claim of efficiency of the market. The lack of reliability about the level of efficiency of the
market prices makes it less reliable as a guideline for decision-making.
Alternative prescriptions about the behaviour of markets are widely discussed these days. Most
of these prescriptions are based on the irrationality of the markets in either processing the
information related to an event or based on biased investor preferences. For instance, if the
investors on an average are overconfident about their investment ability, they would not pay
close attention to new price relevant information that arises in the market. This leads to
inadequate price response to the information event and possibly continuation of the trend due to
the under reaction. This bias in processing information is claimed to be the cause of price
momentum. Biased investor preferences include aversion to the realization of losses incurred in a
stock. This again would lead to under reaction.
The market efficiency claim was based on the assumption that irrational (biased) investors would
be exploited by the rational traders, and would eventually lose out in the market, leading
to their exit. Therefore, even in the presence of biased traders the market was expected to evolve
100

as efficient. However, more recent evidence suggest that the irrational traders are not exiting the
market as expected, instead at many instances they appear to make profits at the expense of the
rational traders.
Some of the well-known anomaliesor departures from market efficiencyare calendar effects
like the January effect and various day-of-the-week effects and the so-called size effect. The
January effect was first documented in the US marketsstock returns were found to be higher in
January than in any other month. Since then, it has been empirically tested in a number of
international markets, like Tokyo, London, and Paris among others. While the evidence has been
mixed, the fact that it exists implies a persistent deviation from market efficiency.
Stock returns are generally expected to be independent across weekdays, but a number of studies
have found returns on Monday to be lower than in the rest of the week. One of the reasons put
forward to explain this anomaly is that returns on Monday are expected to be different, given that
they are across Friday-end-to-Monday-morning, a much longer period than any other day, and
hence with more information. This is why this departure from market efficiency is also
sometimes called the weekend effect.
The alternative prescriptions about the behaviour of markets based on various sources and forms
of investor irrationality are collectively known as behavioral finance. It implies that (i) the
estimation of expected returns based on methods such as the capital asset pricing model is
unreliable, and (ii) there could be many profitable trading strategies based on the collective
irrationality of the markets.
Departures from market efficiency, or the delays in markets reaching equilibrium (and thus
efficiency) leave scope for active portfolio managers to exploit mispricing in securities to their
benefit. A number of investment strategies are tailored to profit from such phenomena, as we
would see in later chapters.

101

END CHAPTER QUIZ

Q1.

A company's __________ provide the most accurate information to its management and
shareholders about its operations.

Q2.

(a)

advertisements

(b)

financial statements

(c)

products

(d)

vision statement

__________ would mean that no investor would be able to outperform the market with
trading strategies based on publicly available information.
(a)

Semi strong form efficiency

(b)

Weak-form efficiency

(c)

Strong form efficiency

(d)

Semi weak form efficiency

Q3. _______ measures the percentage of net income not paid to the shareholders in the form of
dividends.
(a)

Withholding ratio

(b)

Retention ratio

(c)

Preservation ratio

(d)

Maintenance ratio

Q4. The balance sheet of a company is a snapshot of the ______ of the firm at a point in time.
(a)

the sources and applications of funds of the company.

(b)

expenditure structure

(c)

profit structure
102

(d)

income structure

Q5. A ________ provides an account of the total revenue generated by a firm during a period
(usually a financial year, or a quarter).
(a)

Accounting analysis statement

(b)

financial re-engineering statement

(c)

promotional expenses statement

(d)

profit & loss statement

103

Q6. Which of the following accounting statements form the backbone of financial analysis of a
company?
(a)

the income statement (profit & loss)

(b) the balance sheet

(c)

statement of cash flows

(d) All of the above

Q7. Gross Profit Margin = Gross Profit / Net Sales
(a)

FALSE

(b)

TRUE

Q8. ______ orders are activated only when the market price of the relevant security
reaches a threshold price.
(a)

Limit

(b)

Market-loss

(c)

Stop-loss

(d)

IOC

Q9. The oldest and best theory of technical analysis is:

(a) Economy Theory
(b) Industry Theory
(c) Company Theory
(d) Dow Theory
Q10. Which among them is not the part of fundamental analysis?
(a) Technical Analysis
(b) Company Analysis
(c) Industry Analysis
(d) Economy Analysis

104

Key to Questions
Question

Answer

Q1.

(b)

Q2.

(a)

Q3.

(d)

Q4.

(a)

Q5.

(d)

Q6.

(d)

Q7.

(b)

Q8.

(c)

Q9.

(d)

105

Q10.

(a)

MODULE-III

106

3.

CAPITAL ASSET PRICING MODEL (CAPM)

In the chronological development of modern financial management, portfolio theory came first with
Markowitz in 1952. It was not until 1964 that William Sharpe derived the Capital Asset Pricing
Model (CAPM) based on Markowitzs portfolio theory. For example, a key assumption of the CAPM
is that investors hold highly diversified portfolios and thus can eliminate a significant proportion of
total risk.
The CAPM was a breakthrough in modern finance because for the first time a model became
available which enable academic, financiers and investors to link the risk and return for an asset
together, and which explained the underlying mechanism of asset pricing in capital markets.

TYPES OF INVESTMENT RISK

In the preceding chapter we have seen how the total risk (as represented by the standard
deviation, ) of a two-security portfolio can be significantly reduced by combining securities whose
returns are negatively correlated, or at least have low positive correlation the principle of
diversification.
According to the CAPM, the total risk of a security or portfolio of securities can be split into two
specific types, systematic risk and unsystematic risk.

This is sometimes referred to as risk

partitioning, as follows :
Total risk = Systematic risk + Unsystematic risk
Systematic (or market) risk cannot be diversified away : it is the risk which arises from market
factors and is also frequently referred to as undiversifiable risk.

It is due to factors which

systematically impact on most firms, such as general or macroeconomic conditions (e.g. balance of
payments, inflation and interest rates). It may help you remember which type is which if you think of
systematic risk as arising from risk factors associated with the general economic and financial system.
Unsystematic (or specific) risk can be diversified away by creating a large enough portfolio of
securities : it is also often called diversifiable risk or company-unique risk. It is the risk which relates,
107

or is unique, to a particular firm. Factors such as winning a new contract, an industrial dispute, or the
discovery of a new technology or product would contribute to unsystematic risk.
The relationship between total portfolio risk,

p,

and portfolio size can be shown

diagrammatically as in Figure below. Notice that total risk diminishes as the number of assets or
securities in the portfolio increases, but also observe that unsystematic risk does not disappear
completely and that systematic risk remains unaffected by portfolio size.

3.1 The CAPM Model

We have previously described the CAPM as a method of expressing the risk-return relationship for a
security or portfolio of securities: it brings together systematic (undiversifiable) risk and return. After
all, for any rational, risk-averse investor it is only systematic risk which is relevant, because if the
investor creates a sufficiently large portfolio of securities, unsystematic or company-specific risk can
be virtually eliminated through diversification.

It is therefore the measurement of systematic risk which is of primary importance for rational investors
in identifying those securities which possess the most desired risk-return characteristics. It is the
measurement of systematic risk which becomes critical in the CAPM because the model relies on the
assumption that investors will only hold well diversified portfolios, so only systematic risk matters.
The CAPM is quite a complex concept so if you find it difficult to grasp at first do not become
disillusioned, stick with it.
For reasons of presentation and ease of understanding we will approach our study of the CAPM
by breaking it down into five key components as follows:

1. The beta coefficient, ( );

2. The CAPM equation;
3. the CAPM graphthe security market line (SML);
4. Shifts in the SMLinflationary expectations and risk aversion;
5. Comments and criticisms of the CAPM.

Let us examine each component in turn, beginning with the key concept of beta, ,

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3.2 The beta coefficient ( )

Recall that the standard deviation, , is used to measure an asset or shares total risk, while the
beta coefficient, , in contrast is used to measure only part of a share or portfolios risk, namely the
part that cannot be reduced by diversification, that is the systematic or market risk of an individual
share or portfolio of shares.

Systematic risk can be further subdivided into business risk and financial risk. Business risk
arises from the nature of the firms business environment and the particular characteristics of the type
of business or industry in which it operates. For example the competitive structure of the industry, its
sensitivity to changes in macroeconomic variables such as interest rates and inflation and the stability
of industrial relations all combine to determine a firms business risk. The level of business risk in
some industries, for example catering and construction, is higher than in others and is a variable which
lies largely outside managements control.

Categories of beta
Shares or securities can be broadly classified as aggressive, average or defensive according to
their betas. Shares with a beta>1.0 are described as aggressive; they are more risky than the
market average, although they will tend to perform well in a rising or bull market. Consequently
investors would require a rate of return from the share which is greater than the market average.

Shares with a beta = 1.0 are described as average or neutral as their rate of return moves in exact
harmony with movements in the stock market average return; they are of average risk and yield
average returns. In contrast, shares with a beta < 1.0 are classed as defensive. A defensive share does
not perform well in a bulk market but conversely it does not fall as much as the average share in a
falling or bear market. But if they are held in portfolio then they will set off the returns also.

How are betas determined?

109

A shares beta is determined from the historical values of the shares return relative to market
returns. It is important to appreciate therefore that beta is a relative, not an absolute, measure of risk.
As each individual beta is derived from a common base, that is, the return on the market portfolio or a
suitable stock index substitute, then beta is a standardized risk measure, i.e. this makes the beta of one
share directly comparable with the beta of another.

One way of determining the beta for a share is to plot on a graph the historic (ex post) relationship
between the movement in the shares returns and the market (or stock index) returns over a defined
period of time. For example, if a stock market analyst considers that the shares actual performance
over the past five years also gives a fair indication of the shares likely future performance, then
deriving its beta is a matter of:

1.

Computing both the average individual shares return and the average market return (utilising an

appropriate stock market index) for each month of the five-year period. Sometimes betas are also
computed using daily averages.

2.

Plotting on a graph the co-ordinates for each monthly set of returns. Conventionally the markets

or indexs returns are platted on the horizontal (x) axis and the individual shares returns on the
vertical (y) axis. The results will probably appear in the form of a scattergram and the statistical
technique called regression analysis can then be used to derive the regression or characteristic line of
the data.

The characteristic line is the straight line that best represents or fits the relationship between the
shares return and the return from the market over the period. Beta is the slope of this characteristic
line for the share as illustrated in Figure above. Shares with high betas will have steeper the slope of
the line the more volatile (risky) are the returns from the share in relation to the returns from the
market.

110

Alternative derivation of beta

Using past data on individual share and market returns over a sufficiently lengthy period, say, the
most recent four to five years, betas can also be calculated statistically. For example the beta ( )of a
share (S) is equal to the covariance between the shares returns and the markets returns (COV sm)
divided by the variance of the markets returns (Varm)which in turn is the standard deviation of the
markets returns squared, that is:

Covariancesm
Beta,

COVsm

COVsm

= = =

Variancem

Varm

The returns on a suitable stock market index can be used as a proxy for the market returns. For
example, substituting the FTSE 100 Share Index, the beta ( ) of a share (S) would be calculated as:

COVs,FTSE100

COVs,FRSE100

Beta, s = =
VarFRSE100

FTSE100

As the covariance of each individual share is divided by a common denominator, the variance of
the market (Varm) or a suitable surrogate market index, we end up with a standardised measure of risk,
that is, the shares beta. Being a standardised measure we are able to directly compare the beta of one
share with the beta of another.

3.3 Portfolio betas

As it is learned that a shares beta represents only part of a shares risk, namely the element of
systematic or market risk, which is the risk element that cannot be diversified away. When it comes to
including a share in a portfolio we are only concerned with the impact of that shares market risk on
the portfolio risk. In a portfolio context market risk is also the only relevant risk and beta is the best
measure. The portfolio beta measures the portfolios responsiveness to macroeconomic variables such
as inflation and interest rates.

111

To determine the systematic risk for a portfolio, that is the portfolio beta, we simply calculate a
weighted average of the betas of the individual securities making up the portfolio, as follows:2

Portfolio beta,

= w1

+ w2

+ w3

+ wn

where,
p

= the portfolio beta (i.e. risk of the portfolio relative to the market)

wi = portfolio weightings of the individual securities (where I = 1, 2, n)

i

= beta of the individual security (where i = 1,2,n)

= number of securities in the portfolio

Obtaining and interpreting betas

Betas can be obtained from published sources e.g. the London Business School (LBS) and through
brokerage firms. The LBS published

values and other data for UK and Irish companies listed on the

London Stock Exchange every quarter in its Risk Measurement Service publication.

Individual betas are produced for all companies listed in the Financial Times (FT) All-Share
Index. The individual betas are calculated from the monthly returns over the most recent five-year
period related to the monthly returns from FT All-Share Index using a standard least squares
regression computer programme.

Most investment firms and analysts utilise

books which give beta values for all the major

companies listed on the stock market although different investment firms may give varying beta
estimates for the same company due to the different methods and timings used in their calculations.

In the United States beta value are commonly obtained from Value Line Investment Survey and
from brokerage and investment firms such as Merrill Lynch.

3.4 The CAPM equation

We will now examine the actual equation for the capital asset pricing model. It is one of the most
famous equations in financial management. The CAPM equation links together risk and the required
112

return for a share. It shows, for example, that the return a rational investor would require on a
particular share, R(ri), is a function of the shares market or systematic risk (beta),

i,

and a risk

premium to compensate for investing in the risky market. Thus the higher the risk, the higher the
return the investor will require a vice-versa.

Simply stated, the underlying precept of the CAPM is that the expected return on a security is
composed of two elements as follows:

Expected return, E(r) = a risk-free interest rate + a risk premium

Using the capital asset pricing model (CAPM) this relationship is expressed more formally as:

E(ri) = rf +

i(ERm

Rf)

where,
E(rI) = required return on asset/share I
Rf
i

share.

= risk-free rate of return

= beta coefficient for asset/share i

ERm = expected market return, that is the return expected on the market portfolio of

As it is seen above, the CAPM equation can be split into two segments:
1.

the risk-free rate of return, Rf; and

2.

The risk premium,

(ERm Rf)

We will discuss the risk-free rate of return Rf, first.

3.5 Underlying assumptions and limitations of the CAPM

The CAPM is a mathematical mode, and like any model it is merely a representations of reality.
All models (business economic and financial, etc. are constructed from a set of underlying
113

assumptions about the real world; they inevitably have their limitations. The CAPM is built on the
following set of assumptions and limitations:

1.

Historic data. CAPM is a future-oriented model yet it essentially relies on historic data to

predict future returns. Betas, for example, are calculated using historic data; consequently they may or
may not be appropriate predictors of the variability or risk of future returns. Thus the CAPM is not a
deterministic model, the required returns suggested by the model can only be viewed as
approximations.

2.

Investor expectations and judgements. The models includes the expectations and subjective

judgements of investors about future asset or security returns and these are very difficult to quantify.
In addition the model also assumes that investor expectations and judgements are homogenous, i.e.
identical. If investors have heterogeneous (i.e. varied) expectations about future returns they will
essentially have different SMLs, rather than a common SML as implied by the model.

3.

A perfect capital market. CAPM assumes an efficient or perfect capital market. An efficient

capital market is one where all securities and assets are always correctly priced and where it is not
possible to outperform the market consistently except by luck. An efficient capital market implies that
there are many small investors (all are price-takers), all of whom are rational and risk-averse; they
each possess the same information and the same future expectations about securities. It also assumes
that in the financial markets there are no transaction costs, no taxes and no limitations on investment.

4.

Investors fully diversified. The CAPM also assumes that investors are fully diversified. In

practice many investors, particularly small investors, do not hold highly diversified asset portfolios.

5.

Practical data measurement problems. There are also practical problems associated with the

model such as difficulties with specifying the risk-free rate, measuring beta and measuring the market
risk premium.

6.

One-period time horizon. CAPM assumes investors adopt a one-period time horizon. In

practice investors are likely to have differing time horizons and again this would imply varying SMLs.
114

7.

Single factor model. CAPM is a single factor model: it relies on the market portfolio to explain

security returns. The rate of return on a security is a function of the securitys beta times a risk
premium, that is (ERm Rf). Both beta and the risk premium are determined in relation to the market
portfolio. Recall that each securitys beta (risk factor) is derived by linear regression, plotting its return
against the return from the market portfoliothe characteristic line.

Rules of CAPM :------E ( Rp ) = Rf + p [E ( Rm ) - Rf ]

Where,
E (Rp) = Expected return of the portfolio
Rf
= Risk free rate of Return
= Portfolio Beta i.e. market sensitivity index
p
= change in expected rate of return change in market rate of return
E(Rm) = Expected Return on market portfolio
[E (Rm) Rf]

= Market risk premium.

Portfolio Beta ( p) =

(Rsm) (S.D. s )
S.D.m

Where,
Rsm = Correlation Coefficient with market .
S.D.m = Market Standard deviation .
Investment

S.D.s = Standard deviation of an asset .

E(Rm) =

( DIV + Cap. Gain )

Total

Capital Gain = Market Value - Value of Original Investment .

For further details on CAPM model, refer Module VI after Modern Portfolio Theory

115

3.6 PORTFOLIO EVALUATION

Many investors mistakenly base the success of their portfolios on returns alone. Few consider the risk
that they took to achieve those returns. Since the 1960s, investors have known how to quantify and
measure risk with the variability of returns, but no single measure actually looked at both risk and return
together. Today, we have three sets of performance measurement tools to assist us with our portfolio
evaluations. The Treynor, Sharpe and Jensen ratios combine risk and return performance into a single
value, but each is slightly different. Which one is best for you? Why should you care? Let's find out.
3.6.1 Treynor Measure
Jack L. Treynor was the first to provide investors with a composite measure of portfolio performance
that also included risk. Treynor's objective was to find a performance measure that could apply to all
investors, regardless of their personal risk preferences. He suggested that there were really two
components of risk: the risk produced by fluctuations in the market and the risk arising from the
fluctuations of individual securities.
Treynor introduced the concept of the security market line, which defines the relationship between
portfolio returns and market rates of returns, whereby the slope of the line measures the relative
volatility between the portfolio and the market (as represented by beta). The beta coefficient is simply
the volatility measure of a stock, portfolio or the market itself. The greater the line's slope, the better the
risk-return tradeoff.
The Treynor measure, also known as the reward to volatility ratio, can be easily defined as:
(Portfolio Return Risk-Free Rate) / Beta
The numerator identifies the risk premium and the denominator corresponds with the risk of the
portfolio. The

resulting

value

represents

the
116

portfolio's

return

per

unit

risk.

To better understand how this works, suppose that the 10-year annual return for the S& 500 (market
portfolio) is 10%, while the average annual return on Treasury bills (a good proxy for the risk free rate)
is 5%. Then assume you are evaluating three distinct portfolio managers with the following 10-year
results:

Managers

Average Annual Return

Beta

Manager A

10%

0.90

Manager B

14%

1.03

Manager C

15%

1.20

Now, you can compute the Treynor value for each:

T(market) = (.10-.05)/1 = .05
T(manager A) = (.10-.05)/0.90 = .056
T(manager B) = (.14-.05)/1.03 = .087
T(manager C) = (.15-.05)/1.20 = .083
The higher the Treynor measure, the better the portfolio. If you had been evaluating the portfolio
manager (or portfolio) on performance alone, you may have inadvertently identified manager C as
having yielded the best results. However, when considering the risks that each manager took to attain
their respective returns, Manager B demonstrated the better outcome. In this case, all three managers
performed better than the aggregate market.
Because this measure only uses systematic risk, it assumes that the investor already has an adequately
diversified portfolio and, therefore, unsystematic risk (also known as diversifiable risk) is not
considered. As a result, this performance measure should really only be used by investors who hold
diversified portfolios.
3.6.2 Sharpe Ratio
The Sharpe ratio is almost identical to the Treynor measure, except that the risk measure is the standard
deviation of the portfolio instead of considering only the systematic risk, as represented by beta.
Conceived by Bill Sharpe, this measure closely follows his work on the capital asset pricing model

117

(CAPM) and by extension uses total risk to compare portfolios to the capital market line.
The Sharpe ratio can be easily defined as:
(Portfolio Return Risk-Free Rate) / Standard Deviation
Using the Treynor example from above, and assuming that the S&P 500 had a standard deviation of
18% over a 10-year period, let's determine the Sharpe ratios for the following portfolio managers:

Annual

Portfolio Standard

Return

Deviation

14%

0.11

17%

0.20

Manager Z 19%

0.27

Manager
Manager
X
Manager
Y

S(market) = (.10-.05)/.18 = .278

S(manager X) = (.14-.05)/.11 = .818
S(manager Y) = (.17-.05)/.20 = .600
S(manager Z) = (.19-.05)/.27 = .519
Once again, we find that the best portfolio is not necessarily the one with the highest return. Instead, it's
the one with the most superior risk-adjusted return, or in this case the fund headed by manager X.
Unlike the Treynor measure, the Sharpe ratio evaluates the portfolio manager on the basis of both rate of
return and diversification (as it considers total portfolio risk as measured by standard deviation in its
denominator). Therefore, the Sharpe ratio is more appropriate for well diversified portfolios, because it
more accurately takes into account the risks of the portfolio.
3.6.3 Jensen Measure
Like the previous performance measures discussed, the Jensen measure is also based on CAPM. Named
after its creator, Michael C. Jensen, the Jensen measure calculates the excess return that a portfolio
generates over its expected return. This measure is also known as alpha.
118

The Jensen ratio measures how much of the portfolio's rate of return is attributable to the manager's
ability to deliver above-average returns, adjusted for market risk. The higher the ratio, the better the riskadjusted returns. A portfolio with a consistently positive excess return will have a positive alpha, while a
portfolio

with

consistently

negative

excess

return

will

have

negative

alpha

The formula is broken down as follows:

Jensen's Alpha = Portfolio Return Benchmark Portfolio Return

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

So, if we once again assume a risk-free rate of 5% and a market return of 10%, what is the alpha for the
following funds?

Manager

Average Annual Return

Beta

Manager D 11%

0.90

Manager E

15%

1.10

Manager F

15%

1.20

First, we calculate the portfolio's expected return:

ER(D)= .05 + 0.90 (.10-.05) = .0950 or 9.5% return
ER(E)= .05 + 1.10 (.10-.05) = .1050 or 10.50% return
ER(F)= .05 + 1.20 (.10-.05) = .1100 or 11% return
Then, we calculate the portfolio's alpha by subtracting the expected return of the portfolio from the
actual return:

119

Alpha D = 11%- 9.5% = 2.5%

Alpha E = 15%- 10.5% = 4.5%
Alpha F = 15%- 11% = 4.0%

Which manager did best? Manager E did best because, although manager F had the same annual return,
it was expected that manager E would yield a lower return because the portfolio's beta was significantly
lower than that of portfolio F.
Of course, both rate of return and risk for securities (or portfolios) will vary by time period. The Jensen
measure requires the use of a different risk-free rate of return for each time interval considered. So, let's
say you wanted to evaluate the performance of a fund manager for a five-year period using annual
intervals; you would have to also examine the fund's annual returns minus the risk free return for each
year and relate it to the annual return on the market portfolio, minus the same risk free rate. Conversely,
the Treynor and Sharpe ratios examine average returns for the total period under consideration for all
variables in the formula (the portfolio, market and risk-free asset). Like the Treynor measure, however,
Jensen's alpha calculates risk premiums in terms of beta (systematic, undiversifiable risk) and therefore
assumes the portfolio is already adequately diversified. As a result, this ratio is best applied with
diversified portfolios, like mutual funds.
Conclusion
Portfolio performance measures should be a key aspect of the investment decision process. These tools
provide the necessary information for investors to assess how effectively their money has been invested
(or may be invested). Remember, portfolio returns are only part of the story. Without evaluating riskadjusted returns, an investor cannot possibly see the whole investment picture, which may inadvertently
lead to clouded investment decisions.
For further details on Portfolio Evaluation : Refer Module VI

120

UNDERSTANDING THE SHARPE RATIO

Since the Sharpe ratio was derived in 1966 by William Sharpe, it has been one of the most referenced
risk/return measures used in finance, and much of this popularity can be attributed to its simplicity. The
ratio's credibility was boosted further when Professor Sharpe won a Nobel Memorial Prize in Economic
Sciences in 1990 for his work on the capital asset pricing model (CAPM). In this article, we'll show you
how this historic thinker can help bring you profits.
The Ratio Defined
Most people with a financial background can quickly comprehend how the Sharpe ratio is calculated and
what it represents. The ratio describes how much excess return you are receiving for the extra volatility
that you endure for holding a riskier asset. Remember, you always need to be properly compensated for
the additional risk you take for not holding a risk-free asset.

We will give you a better understanding of how this ratio works, starting with its formula:

121

Return (rx)
The returns measured can be of any frequency (i.e. daily, weekly, monthly or annually), as long as they
are normally distributed, as the returns can always be annualized. Herein lies the underlying weakness of
the ratio - not all asset returns are normally distributed.
Abnormalities like kurtosis, fatter tails and higher peaks, or skewness on the distribution can be a
problematic for the ratio, as standard deviation doesn't have the same effectiveness when these problems
exist. Sometimes it can be downright dangerous to use this formula when returns are not normally
distributed.
Risk-Free Rate of Return (rf )
The risk-free rate of return is used to see if you are being properly compensated for the additional risk
you are taking on with the risky asset. Traditionally, the risk-free rate of return is the shortest dated
government T-bill (i.e. U.S. T-Bill). While this type of security will have the least volatility, some would
argue that the risk-free security used should match the duration of the investment it is being compared
against.
For example, equities are the longest duration asset available, so shouldn't they be compared with the
longest duration risk-free asset available - government issued inflation-protected securities (IPS)?
Using a long-dated IPS would certainly result in a different value for the ratio, because in a normal
interest rate environment, IPS should have a higher real return than T-bills. Sometimes that yield on IPS
has been extremely high. For instance, in the 1990s, Canada's long-dated real return bonds were trading
as high as 5%. That meant that any investor purchasing these bonds would have a guaranteed inflationadjusted return of 5% per year for the next 30 years.

Given that global equities only returned an arithmetic average of 7.2% over inflation for the twentieth
century (according to Dimson, Marsh, and Staunton, in their book "Triumph Of The Optimists: 101
Years Of Global Investment Returns" (2002)), the projected excess in the example above was not much
for the additional risk of holding equities.

Standard Deviation (StdDev(x))

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Now that we have calculated the excess return from subtracting the return of the risky asset from the
risk-free rate of return, we need to divide this by the standard deviation of the risky asset being
measured. As mentioned above, the higher the number, the better the investment looks from a risk/return
perspective.
How the returns are distributed is the Achilles heel of the Sharpe ratio. Bell curves do not take big
moves in the market into account. As Benoit Mandelbrot and Nassim Nicholas Taleb note in their
article, "How The Finance Gurus Get Risk All Wrong", which appeared in Fortune in 2005, bell curves
were adopted for mathematical convenience, not realism.
However, unless the standard deviation is very large, leverage may not affect the ratio. Both the
numerator (return) and denominator (standard deviation) could be doubled with no problems. Only if the
standard deviation gets too high do we start to see problems. For example, a stock that is leveraged 10 to
1 could easily see a price drop of 10%, which would translate to a 100% drop in the original capital and
an early margin call.

Using the Sharpe Ratio

The Sharpe ratio is a risk-adjusted measure of return that is often used to evaluate the performance of a
portfolio. The ratio helps to make the performance of one portfolio comparable to that of another
portfolio by making an adjustment for risk.

For example, if manager A generates a return of 15% while manager B generates a return of 12%, it
would appear that manager A is a better performer. However, if manager A, who produced the 15%
return, took much larger risks than manager B, it may actually be the case that manager B has a better
risk-adjusted return.

To continue with the example, say that the risk free-rate is 5%, and manager A's portfolio has a standard
deviation of 8%, while manager B's portfolio has a standard deviation of 5%. The Sharpe ratio for
manager A would be 1.25 while manager B's ratio would be 1.4, which is better than manager A. Based
on these calculations, manager B was able to generate a higher return on a risk-adjusted basis.

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To give you some insight, a ratio of 1 or better is considered good, 2 and better is very good, and 3 and
better is considered excellent.

Conclusion
The Sharpe ratio is quite simple, which lends to its popularity. It's broken down into just three
components: asset return, risk-free return and standard deviation of return. After calculating the excess
return, it's divided by the standard deviation of the risky asset to get its Sharpe ratio. The idea of the
ratio is to see how much additional return you are receiving for the additional volatility of holding the
risky asset over a risk-free asset - the higher the better.

END CHAPTER QUIZ

Q1. Average Return of an investor's portfolio is 10%. The risk free return for the market is
8%. The Beta of the investor's portfolio is 1.2. Calculate the Treynor Ratio.
(a) 4
(b) 8
(c) 2
(d) 6
Q2. Average Return of an investor's portfolio is 55%. The risk free return for the market is
8%. The Beta of the investor's portfolio is 1.2. Calculate the Treynor Ratio.
(a) 41
(b) 39
(c) 43
(d) 45
Q3. Mean Return of an investors portfolio is 12%, the standard deviation of portfolio is 18 %.
The Beta of investors portfolio is 1.1. The mean risk-free rate was 6 per cent. Calculate the
Sharpe Ratio.
(a) 0.333
(b) 0.267
(c) 0.350
(d) 0.294
Q4. Mean Return of an investors portfolio is 12%, the standard deviation of portfolio is 18 %.
The Beta of investors portfolio is 1.1. The mean risk-free rate was 6 per cent. Calculate the
Jensen measure.
(a) 1.0
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(b) 1.0
(c) 0.5
(d) - 0.5
Q5. The CAPM is founded on the following two assumptions (1) in the equilibrium every mean
variance investor holds the same market portfolio and (2) the only risk the investor faces is
the beta.
(a)
TRUE
(b)
FALSE

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Q6. Prices (returns) which are not according to CAPM shall be quickly identified by the market
and brought back to the __________.
(a)
(b)
(c)
(d)

Average
standard deviation
mean
equilibrium

Q7. A sell order comes into the trading system at a Limit Price of Rs. 120. The order will get
executed at a price of _______.
(a) Rs. 120 or more
(b) Rs. 120 or less
Q8. Capital Asset Pricing Model was pioneered by:
(a) Eugene Fama
(b) William Sharpe
(c) Charles H Dow
(d) None of the above
Q9. The relationship between risk and expected return for an inefficient portfolio or a single
security is expressed by -----------------.
(a)
(b)
(c)
(d)

Capital Market Line

Security Market Line
Risk free rate
Market risk premium

Q10. The ------------- is represented by the rate of a 364-day Treasury Bill or the rate on a long
term government bond.
(a) Risk free rate
(b) Market Risk premium
(c) Beta
(d) Alpha

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Key to Questions
Question

Answer

Q1.

(c)

Q2.

(b)

Q3.

(a)

Q4.

(c)

Q5.

(a)

Q6.

(d)

Q7.

(a)

Q8.

(b)

Q9.

(b)

Q10.

(a)

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MODULE-IV

128

4. EQUITY VALUATION
4.1 Financial markets and Instruments
Introduction
There are a wide range of financial securities available in the markets these days. In this chapter, we take
a look at different financial markets and try to explain the various instruments where investors can
potentially park their funds.
Financial markets can mainly be classified into money markets and capital markets. Instruments in the
money markets include mainly short-term, marketable, liquid, low-risk debt securities. Capital markets,
in contrast, include longer-term and riskier securities, which include bonds and equities. There is also a
wide range of derivatives instruments that are traded in the capital markets.
Both bond market and money market instruments are fixed-income securities but bond market
instruments are generally of longer maturity period as compared to money market instruments. Money
market instruments are of very short maturity period. The equities market can be further classified into
the primary and the secondary market. Derivative market instruments are mainly futures, forwards
and options on the underlying instruments, usually equities and bonds.
4.1.1 Primary and Secondary Markets
A primary market is that segment of the capital market, which deals with the raising of capital from
investors via issuance of new securities. New stocks/bonds are sold by the issuer to the public in the
primary market. When a particular security is offered to the public for the first time, it is called an Initial
Public Offering (IPO). When an issuer wants to issue more securities of a category that is already in
existence in the market it is referred to as Follow-up Offerings.
Example: Reliance Power Ltd.s offer in 2008 was an IPO because it was for the first time that Reliance
Power Ltd. offered securities to the public. Whereas, BEMLs public offer in 2007 was a Follow-up
Offering as BEML shares were already issued to the public before 2007 and were available in the
secondary market.
It is generally easier to price a security during a Follow-up Offering since the market price of the
security is actually available before the company comes up with the offer, whereas in the case of an IPO
it is very difficult to price the offer since there is no prevailing market for the security. It is in the interest
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of the company to estimate the correct price of the offer, since there is a risk of failure of the issue in
case of non-subscription if the offer is overpriced. If the issue is underpriced, the company stands to lose
notionally since the securities will be sold at a price lower than its intrinsic value, resulting in lower
realizations.
The secondary market (also known as aftermarket) is the financial market where securities, which have
been issued before are traded. The secondary market helps in bringing potential buyers and sellers for a
particular security together and helps in facilitating the transfer of the security between the parties.
Unlike in the primary market where the funds move from the hands of the investors to the issuer
(company/ Government, etc.), in case of the secondary market, funds and the securities are transferred
from the hands of one investor to the hands of another. Thus the primary market facilitates capital
formation in the economy and secondary market provides liquidity to the securities.
There is another market place, which is widely referred to as the third market in the investment world. It
is called the over-the-counter market or OTC market. The OTC market refers to all transactions in
securities that are not undertaken on an Exchange. Securities traded on an OTC market may or may not
be traded on a recognized stock exchange. Trading in the OTC market is generally open to all registered
broker-dealers. There may be regulatory restrictions on trading some products in the OTC markets. For
example, in India equity derivatives is one of the products which is regulatorily not allowed to be traded
in the OTC markets. In addition to these three, direct transactions between institutional investors,
undertaken primarily with transaction costs in mind, are referred to as the fourth market.

4.1.2 Trading in Secondary Markets

Trading in secondary market happens through placing of orders by the investors and their matching with
a counter order in the trading system. Orders refer to instructions provided by a customer to a brokerage
firm, for buying or selling a security with specific conditions. These conditions may be related to the
price of the security (limit order or market order or stop loss orders) or related to time (a day order or
immediate or cancel order). Advances in technology have led to most secondary markets of the world
becoming electronic exchanges. Disaggregated traders across regions simply log in the exchange, and
use their trading terminals to key in orders for transaction in securities. We outline some of the most
popular orders below:
Types of Orders
Limit Price/Order: In these orders, the price for the order has to be specified while entering the order
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into the system. The order gets executed only at the quoted price or at a better price (a price lower than
the limit price in case of a purchase order and a price higher than the limit price in case of a sale order).
Market Price/Order: Here the constraint is the time of execution and not the price. It gets executed at
the best price obtainable at the time of entering the order. The system immediately executes the order, if
there is a pending order of the opposite type against which the order can match. The matching is done
automatically at the best available price (which is called as the market price). If it is a sale order, the
order is matched against the best bid (buy) price and if it is a purchase order, the order is matched
against the best ask (sell) price. The best bid price is the order with the highest buy price and the best ask
price is the order with the lowest sell price.
Stop Loss (SL) Price/Order: Stop-loss orders which are entered into the trading system, get activated
only when the market price of the relevant security reaches a threshold price. When the market reaches
the threshold or pre-determined price, the stop loss order is triggered and enters into the system as a
market/limit order and is executed at the market price / limit order price or better price. Until the
threshold price is reached in the market the stop loss order does not enter the market and continues to
remain in the order book. A sell order in the stop loss book gets triggered when the last traded price in
the normal market reaches or falls below the trigger price of the order. A buy order in the stop loss book
gets triggered when the last traded price in the normal market reaches or exceeds the trigger price of the
order. The trigger price should be less than the limit price in case of a purchase order and vice versa.
Time Related Conditions
Day Order (Day): A Day order is valid for the day on which it is entered. The order, if not matched,
gets cancelled automatically at the end of the trading day. At the National Stock Exchange (NSE) all
orders are Day orders. That is the orders are matched during the day and all unmatched orders are
flushed out of the system at the end of the trading day.
Immediate or Cancel order (IOC): An IOC order allows the investor to buy or sell a security as soon as
the order is released into the market, failing which the order is removed from the system. Partial match
is possible for the order and the unmatched portion of the order is cancelled immediately.

4.1.3 Matching of orders

When the orders are received, they are time-stamped and then immediately processed for potential
match. The best buy order is then matched with the best sell order. For this purpose, the best buy order is
the one with highest price offered, also called the highest bid, and the best sell order is the one with
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lowest price also called the lowest ask (i.e., orders are looked at from the point of view of the opposite
party). If a match is found then the order is executed and a trade happens. An order can also be executed
against multiple pending orders, which will result in more than one trade per order. If an order cannot
be matched with pending orders, the order is stored in the pending orders book till a match is found or
till the end of the day whichever is earlier. The matching of orders at NSE is done on a price-time
priority i.e., in the following sequence:

Best Price

Within Price, by time priority

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Orders lying unmatched in the trading system are passive orders and orders that come in to
match the existing orders are called active orders. Orders are always matched at the passive
order price. Given their nature, market orders are instantly executed, as compared to limit orders,
which remain in the trading system until their market prices are reached. The set of such orders
across stocks at any point in time in the exchange, is called the Limit Order Book (LOB) of the
exchange. The top five bids/asks (limit orders all) for any security are usually visible to market
participants and constitute the Market By Price (MBP) of the security.
4.1.4

The Money Market

The money market is a subset of the fixed-income market. In the money market, participants
borrow or lend for short period of time, usually up to a period of one year. These instruments are
generally traded by the Government, financial institutions and large corporate houses. These
securities are of very large denominations, very liquid, very safe but offer relatively low interest
rates. The cost of trading in the money market (bid-ask spread) is relatively small due to the high
liquidity and large size of the market. Since money market instruments are of high
denominations they are generally beyond the reach of individual investors. However, individual
investors can invest in the money markets through money-market mutual funds. We take a quick
look at the various products available for trading in the money markets.
T-Bills
T-Bills or treasury bills are largely risk-free (guaranteed by the Government and hence carry
only sovereign risk - risk that the government of a country or an agency backed by the
government, will refuse to comply with the terms of a loan agreement), short-term, very liquid
instruments that are issued by the central bank of a country. The maturity period for T-bills
ranges from 3-12 months. T-bills are circulated both in primary as well as in secondary markets.
T-bills are usually issued at a discount to the face value and the investor gets the face value upon
maturity. The issue price (and thus rate of interest) of T-bills is generally decided at an auction,
which individuals can also access. Once issued, T-bills are also traded in the secondary markets.
In India, T-bills are issued by the Reserve Bank of India for maturities of 91-days, 182 days and
364 days. They are issued weekly (91-days maturity) and fortnightly (182-days and 364- days
maturity).
Commercial Paper
Commercial papers (CP) are unsecured money market instruments issued in the form of a
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promissory note by large corporate houses in order to diversify their sources of short-term
borrowings and to provide additional investment avenues to investors. Issuing companies are
required to obtain investment-grade credit ratings from approved rating agencies and in some
cases, these papers are also backed by a bank line of credit. CPs are also issued at a discount to
their face value. In India, CPs can be issued by companies, primary dealers (PDs), satellite
dealers (SD) and other large financial institutions, for maturities ranging from 15 days period to
1-year period from the date of issue. CP denominations can be Rs. 500,000 or multiples
thereof. Further, CPs can be issued either in the form of a promissory note or in dematerialized
form through any of the approved depositories.
Certificates of Deposit
A certificate of deposit (CD), is a term deposit with a bank with a specified interest rate. The
duration is also pre-specified and the deposit cannot be withdrawn on demand. Unlike other bank
term deposits, CDs are freely negotiable and may be issued in dematerialized form or as a
Usance Promissory Note. CDs are rated (sometimes mandatory) by approved credit rating
agencies and normally carry a higher return than the normal term deposits in banks (primarily
due to a relatively large principal amount and the low cost of raising funds for banks). Normal
term deposits are of smaller ticket-sizes and time period, have the flexibility of premature
withdrawal and carry a lower interest rate than CDs. In many countries, the central bank provides
insurance (e.g. Federal Deposit Insurance Corporation (FDIC) in the U.S., and the Deposit
Insurance and Credit Guarantee Corporation (DICGC) in India) to bank depositors up to a certain
amount (Rs. 100000 in India). CDs are also treated as bank deposit for this purpose.
In India, scheduled banks can issue CDs with maturity ranging from 7 days 1 year and
financial institutions can issue CDs with maturity ranging from 1 year 3 years. CD are issued
for denominations of Rs. 1,00,000 and in multiples thereof.
Repos and Reverse Repos
Repos (or Repurchase agreements) are a very popular mode of short-term (usually overnight)
rrowing and lending, used mainly by investors dealing in Government securities. The
arrangement involves selling of a tranche of Government securities by the seller (a borrower of
funds) to the buyer (the lender of funds), backed by an agreement that the borrower will
repurchase the same at a future date (usually the next day) at an agreed price. The difference
between the sale price and the repurchase price represents the yield to the buyer (lender of funds)
for the period. Repos allow a borrower to use a financial security as collateral for a cash loan at a
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fixed rate of interest. Since Repo arrangements have T-bills as collaterals and are for a short
maturity period, they virtually eliminate the credit risk.
Reverse repo is the mirror image of a repo, i.e., a repo for the borrower is a reverse repo for the
lender. Here the buyer (the lender of funds) buys Government securities from the seller (a
borrower of funds) agreeing to sell them at a specified higher price at a future date.
4.1.5

The Bond Market

Bond markets consist of fixed-income securities of longer duration than instruments in the
money market. The bond market instruments mainly include treasury notes and treasury bonds,
corporate bonds, Government bonds etc.
Treasury Notes (T-Notes) and T-Bonds
Treasury notes and bonds are debt securities issued by the Central Government of a country.
Treasury notes maturity range up to 10 years, whereas treasury bonds are issued for maturity
ranging from 10 years to 30 years. Another distinction between T-notes and T-bonds is that Tbonds usually consist of a call/put option after a certain period. In order to make these
instruments attractive, the interest income is usually made tax-free.
Interest on both these instruments is usually paid semi-annually and the payment is referred to as
coupon payments. Coupons are attached to the bonds and each bondholder has to present
the respective coupons on different interest payment date to receive the interest amount. Similar
to T-bills, these bonds are also sold through auction and once sold they are traded in the
secondary market. The securities are usually redeemed at face value on the maturity date.
State and Municipal Government bonds
Apart from the central Government, various State Governments and sometimes municipal bodies
are also empowered to borrow by issuing bonds. They usually are also backed by
guarantees from the respective Government. These bonds may also be issued to finance specific
projects (like road, bridge, airports etc.) and in such cases, the debts are either repaid from future
revenues generated from such projects or by the Government from its own funds. Similar to Tnotes and T-bonds, these bonds are also granted tax-exempt status.
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In India, the Government securities (includes treasury bills, Central Government securities and
State Government securities) are issued by the Reserve Bank of India on behalf of the
Government of India.
Corporate Bonds
Bonds are also issued by large corporate houses for borrowing money from the public for a
certain period. The structure of corporate bonds is similar to T-Notes in terms of coupon
payment, maturity amount (face value), issue price (discount to face value) etc. However, since
the default risk is higher for corporate bonds, they are usually issued at a higher discount than
equivalent Government bonds. These bonds are not exempt from taxes. Corporate bonds are
classified as secured bonds (if backed by specific collateral), unsecured bonds (or debentures
which do not have any specific collateral but have a preference over the equity holders in the
event of liquidation) or subordinated debentures (which have a lower priority than bonds in claim
over a firms assets).
International Bonds
These bonds are issued overseas, in the currency of a foreign country which represents a large
potential market of investors for the bonds. Bonds issued in a currency other than that of the
country which issues them are usually called Eurobonds. However, now they are called by
various names depending on the currency in which they are issued. Eurodollar bonds are US
dollar-denominated bonds issued outside the United States. Euro-yen bonds are yendenominated bonds issued outside Japan.
Some international bonds are issued in foreign countries in currency of the country of the
investors. The most popular of such bonds are Yankee bond and Samurai Bonds. Yankee bonds
are US dollar denominated bonds issued in U.S. by a non-U.S. issuer and Samurai bonds are
yen-denominated bonds issued in Japan by non-Japanese issuers.
Other types of bonds
Bonds could also be classified according to their structure/characteristics. In this section, we
discuss the various clauses that can be associated with a bond.
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Zero Coupon Bonds

Zero coupon bonds (also called as deep-discount bonds or discount bonds) refer to bonds which
do not pay any interest (or coupons) during the life of the bonds. The bonds are issued at a
discount to the face value and the face value is repaid at the maturity. The return to the
bondholder is the discount at which the bond is issued, which is the difference between the issue
price and the face value.
Convertible Bonds
Convertible bonds offer a right (but not the obligation) to the bondholder to get the bond
converted into predetermined number of equity stock of the issuing company, at certain, prespecified times during its life. Thus, the holder of the bond gets an additional value, in terms of
an option to convert the bond into stock (equity shares) and thereby participate in the growth of
the companys equity value. The investor receives the potential upside of conversion into equity
while protecting downside with cash flow from the coupon payments. The issuer company is
also benefited since such bonds generally offer reduced interest rate. However, the value of the
equity shares in the market generally falls upon issue of such bonds in anticipation of the stock
dilution that would take place when the option (to convert the bonds into equity) is exercised by
the bondholders.
Callable Bonds
In case of callable bonds, the bond issuer holds a call option, which can be exercised after some
pre-specified period from the date of the issue. The option gives the right to the issuer to
repurchase (cancel) the bond by paying the stipulated call price. The call price may be more than
the face value of the bond. Since the option gives a right to the issuer to redeem the bond, it
carries a higher discount (higher yield) than normal bonds. The right is exercised if the coupon
rate is higher than the prevailing interest rate in the market.
Puttable Bonds
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A puttable bond is the opposite of callable bonds. These bonds have an embedded put option.
The bondholder has a right (but not the obligation) to sell back the bond to the issuer after a
certain time at a pre-specified price. The right has a cost and hence one would expect a lower
yield in such bonds. The bondholders generally exercise the right if the prevailing interest rate in
the market is higher than the coupon rate.
Since the call option and the put option are mutually exclusive, a bond may have both option
embedded.
Fixed rate and floating rate of interest
In case of fixed rate bonds, the interest rate is fixed and does not change over time, whereas in
the case of floating rate bonds, the interest rate is variable and is a fixed percentage over a certain
pre-specified benchmark rate. The benchmark rate may be any other interest rate such as T-bill
rate, the three-month LIBOR rate, MIBOR rate (in India), bank rate, etc. The coupon rate is
usually reset every six months (time between two interest payment dates).
4.1.6

Common Stocks

Simply put, the shareholders of a company are its owners. As owners, they participate in the
management of the company by appointing its board of directors and voicing their opinions, and
voting in the general meetings of the company. The board of directors have general
oversight of the company, appoints the management team to look after the day-to-day running of
the business, set overall policies aimed at maximizing profits and shareholder value.
Shareholders of a company are said to have limited liability. The term means that the liability of
shareholders is limited to the unpaid amount on the shares. This implies that the maximum loss
of shareholder

in a company is limited

to her original investment.

Being the owners,

shareholders have the last claim on the assets of the company at the time of liquidation, while
debt- or bondholders always have precedence over equity shareholders.
At its incorporation, every company is authorized to issue a fixed number of shares, each priced
at par value, or face value in India. The face value of shares is usually set at nominal levels (Rs.
10 or Re. 1 in India for the most part). Corporations generally retain portions of their authorized
stock as reserved stock, for future issuance at any point in time.
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Shares are usually valued much higher than the face value and this initial investment in the
company by shareholders represents their paid-in capital in the company. The company then
generates earnings from its operating, investing and other activities. A portion of these earnings
are distributed back to the shareholders as dividend, the rest retained for future investments. The
sum total of the paid-in capital and retained earnings is called the book value of equity of the
company.
Types of shares
In India, shares are mainly of two types: equity shares and preference shares. In addition to the
most common type of shares, the equity share, each representing a unit of the overall ownership
of the company, there is another category, called preference shares. These preferred shares have
precedence over common stock in terms of dividend payments and the residual claim to its assets
in the event of liquidation. However, preference shareholders are generally not entitled to
equivalent voting rights as the common stockholders.
In India, preference shares are redeemable (callable by issuing firm) and preference dividends
are cumulative. By cumulative dividends, we mean that in case the preference dividend remains
unpaid in a particular year, it gets accumulated and the company has the obligation to pay the
accrued dividend and current years dividend to preferred stockholders before it can distribute
dividends to the equity shareholders. An additional feature of preferred stock in India is that
during such time as the preference dividend remains unpaid, preference shareholders enjoy all
the rights (e.g. voting rights) enjoyed by the common equity shareholders. Some companies also
issue convertible preference shares which get converted to common equity shares in future at
some specified conversion ratio.
In addition to the equity and fixed-income markets, the derivatives market is one of Indias
largest and most liquid. We take a short tour of derivatives in the 5th chapter of this module.

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4.2 Analysis and Valuation of Equity Investment

4.2.1

Introduction

Investments in capital markets primarily involve transactions in shares, bonds, debentures, and
other financial products issued by companies. The decision to invest in these securities is thus
linked to the evaluation of these companies, their earnings, and potential for future growth.
In this chapter we look at one of the most important tools used for this purpose, Valuation. The
fundamental valuation of any asset (and companies are indeed assets into which we invest) is an
examination of future returns, in other words, the cash flows expected from the asset. The
value of the asset is then simply what these cash flows are worth today, i.e., their present
discounted value. Valuation is all about how well we predict these cash flows, their growth in
future, taking into account future risks involved.
4.2.2 The Analysis of Financial Statements
A companys financial statements provide the most accurate information to its management and
shareholders about its operations, efficiency in the allocation of its capital and its earnings profile.
Three basic accounting statements form the backbone of financial analysis of a company:the
income statement (profit & loss), the balance sheet, and the statement of cash flows. Let us
quickly summarize each of these.
Income Statement (Profit & Loss)
A profit & loss statement provides an account of the total revenue generated by a firm during a
period (usually a financial year or a quarter), the expenses involved and the money earned. In its
simplest form, revenue generation or sales accrues fromselling the productsmanufactured, or
services rendered by the company. Operating expenses include the costs of these goods and
services and the costs incurred during the manufacture. Beyond operating expenses are interest
costs based on the debt profile of the company. Taxes payable to the Government are then
debited to provide the Profit After Tax (PAT) or the net income to the shareholders of the
company.
Actual P&L statements of companies are usually much more complicated than this, with socalled
other income (income from non-core activities), negative interest expenses (from cash
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reserves with the company), preferred dividends, and non-recurring, exceptional income or
expenses. The example given below is that of a large company in the Pharmaceutical sector over
the period 2006-2008.

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Illustration
Income Statement (US$M)
Net sales
2006

2007

2008

16,380

21,340

33,565

(5,332)

(6,584)

(8,190)

(1,408)

(1,771)

(2,738)

(1,534)

(2,440)

(2,725)

(3,650)

(4,620)

(5,369)

4,457

5,926

14,543

Cost of sales
SG&A
Research & development
Other operating items
EBIT
Total other non-operating items
Associates
Net interest income/expense
Exceptional items
Pretax profit

543

1,336

305

869

1,072

1,146

Taxation

5,869

Minority interest

(239)

67

(485)

(559)

(640)

100

Preferred dividends
Net extraordinary items
Reported net income

5,733

8,334

7,843

15,994

14,869

The Balance Sheet

Assets owned by a company are financed either by equity or debt and the balance sheet of a
company is a snapshot of this capital structure of the firm at a point in time; the sources and
applications of funds of the company.
A company owns fixed assets (machinery, and other infrastructure), current assets
(manufacturing goods in progress, money it expects to receive from business partners
receivables, inventory etc.), cash and other financial investments. In addition to these three, a
company could also own other assets which carry value, but are not directly marketable, like
patents, trademarks, and goodwillvalue not linked to assets, but realized from acquisitions.
These assets are financed either by the companys equity (investments by shareholders) or by
142

debt. The illustrative example shown below is the balance sheet of a large Pharmaceutical
company.

143

Illustration
2006

2007

2008

15,628

14,106

17,290

Accounts receivable

3,609

6,789

14,177

Inventory

5,117

6,645

7,728

Other current assets

2,471

2,653

5,079

Balance Sheet (US$m)

Cash and marketable securities

Current assets

26,826

30,192

44,274

Net tangible fixed assets

8,977

10,122

11,040

Total financial assets

3,237

2,239

2,659

507

697

1,729

Net goodwill
Total assets

39,547

Accounts payable

43,250

59,701

2,279

2,966

3,722

Total other current liabilities

1,236

80

2,651

Current liabilities

3,515

3,046

6,373

18,747

11,144

1,436

1,053

895

92

Short-term debt

Long-term debt
Total other non-current liabilities
Total provisions
Total liabilities

23,314

Minority interest accumulated

15,085

7,901

332

438

1,886

Shareholders equity

15,902

27,728

49,915

Shareholders funds

16,233

28,166

51,800

Liabilities and shareholders funds

39,547

43,250

59,701

Cash Flow Statement

The cash flow statement is the most important among the three financial statements, particularly
from a valuations perspective. As the name implies, such a statement is used to track the cash
flows in the company over a period. Cash flows are tracked across operating, investing, and
financing activities. Cash flows from operations include net income generation adjusted for
changes in working capital (like inventories, receivables and payables), and non-core accruals
(like depreciation, etc). A firms investment activities comprise fixed, and current assets (capitaland operating expenditure), sometimes into other firms (like an acquisition), and generally
represent negative cash flows. Cash flows in financing activities are the net result of the firms
borrowing, and payments during the period. The sum total of cash flows from these three heads
144

represents the net change in cash balances of the firm over the period.

145

Cash generation from operating activities of the firm, when adjusted for its capital expenditure
represent the free cash available to it, for potential investment activities, acquiring other firms
or businesses, or distribution among its shareholders. As we will see in later topics, free cash
flows are the key to calculating the so-called intrinsic value of an asset in any discounted
valuation model. Our illustrative example below shows the cash flow statement (and free cash
flows) of a large pharmaceutical company over the period 2006-2008.
Illustration

5.3

Cash Flow (US$M)

2006

2007

2008

Reported net income

5,733

7,843

14,869

Minority interest

(3)

559

640

Depreciation and amortization

610

813

969

75

(511)

(1,337)

Total other operating cash flow

(1,365)

(2,156)

(753)

Net change in working capital

(3,177)

(4,154)

(9,340)

1,872

2,394

5,048

(3,387)

(2,000)

(1,995)

3,511

1,367

(5,242)

Total other investing cash flows

634

1,272

1,177

Cash from investing activities

758

639

Change in borrowings

805

(1,742)

768

Dividends paid

(793)

(2,629)

(18)

Total other financing cash flows

(156)

(127)

(88)

Preferred dividends

Cash tax adjustment

Cash from operations

Capital expenditure
Net acquisitions/disposals

Equity raised/share buybacks

(6,060)

Cash from financing activities

(144)

(4,498)

661

Change in cash

3,518

(1,465)

(352)

Free cash flow

(1,514)

146

394

3,052

4.3 EQUITY VALUATION

Using financial statements and ratios, we now examine some of the concepts relating to share
valuations and to be more specific, we will deal with valuation of common stocks. Common
shareholders are the owners of the firm, and as such are the final stakeholders in its growth, and
risks; they appoint the management to run its day-to-day affairs and the Board of Directors to
oversee the managements activities. The cash flows (return) to common shareholders from the
company are generally in the form of current and future dividends distributed from the profits of
the firm. Alternatively, an investor can always sell her holdings in the market (secondary
market), get the prevailing market price, and realize capital appreciation if the returns are
positive.

We now examine the valuation of common shares in some detail. As mentioned above, the
valuation of any asset is based on the present value of its future cash flows. Such a methodology
provides what is called the

intrinsic value of the asseta common stock in our case. The

problem of valuing the stock then translates into one of predicting the future free cash flow
profile of the company, and then using the appropriate discount factor to measure what they are
worth today. The appropriately named discounted-cash flow technique is also referred to as
absolute valuation, particularly when compared to another widely-followed approach in
valuation, called relative valuation.
Relative valuation looks at pricing assets on the basis of the pricing of other, similar assets
instead of pricing them independentlythe core assumption being that assets with similar
earnings and growth profile, and facing the same risks ought to be priced comparably. Two
stocks in the same sector of the economy could thus be compared, and the same sector (and its
stocks) across countries. The discussion on relative valuation follows that of absolute or intrinsic
valuation.
4.3.1

Absolute (Intrinsic) Valuation

Intrinsic value or the fundamental value refers to the value of a security, which is intrinsic to or
contained in the security itself. It is defined as the present value of all expected cash flows to the
company. The estimation of intrinsic value is what we would be dealing with in details in this
module.
4.3.1.1

Discounted Cash Flows

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The discounted cash flow method values the share based on the expected dividends from the
shares. The price of a share according to the discounted cash flow method is calculated as under:

Since the profits of the firm are not certain, the actual future dividends are not known in advance.
However, the market forms an expectation of the future dividends and the value of a share is the
present value of expected future dividends of the company. It can be shown that the formula can
be seen as an extension of the formula

As explained above, we can write the share price at the end of the year 1 as a function of the 2nd
year dividend and price of share at the end of the year 2. Or,

148

4.3.1.2 Constant Dividend Growth

Let us see a special case of the above model when it is assumed that amount paid as dividends
grows at a constant rate (say g) every year. In this case, the cash flows in various years will be
as under:
Year

Cash Flow

-P0

Div1

Div2 = Div1*(1+g)

Div3 = Div2*(1+g) = Div1*(1+g)2

Div4 = Div3*(1+g) = Div2*(1+g)2= Div1*(1+g)3

149

In this circumstance, where the dividend amount grows at a constant rate, the constant dividend
growth model states that the share price can be obtained using the simple formula:

This formula can be used only when the expected rate of return (r) is greater than the growth rate (g).
Otherwise, the present value of the growing perpetuity will reach infinite. This is even true in real world. It
is not possible for a stocks dividend to grow at a rate g, which is greater than r for infinite period. It can
only be for a limited number of years. This model is not applicable in such cases.
Example: RNL has paid a dividend of Rs. 10 per share last year (D 0) and it is expected to grow at 5%
every year. If an investors expected rate of return from RNL share is 7%, calculate the market price of the
share as per the dividend discount model.
Answer: The following are given:

The market price of RNL share as per the dividend discount model with constant growth rate is
Rs. 525.
If we know the market price of the share, the dividend amount and the dividend growth rate, then
we can compute the expected rate of return (r) by using the following formula:

150

4.3.1.3

Present Value of Growth opportunities (PVGO)

One can split the value of the shares as computed in the constant growth model into two parts
the present value of the share assuming level stream of earnings (a level stream of earnings is
simply the current income extrapolated into the future, with no growth; in which case, theres no
need to retain any of the earnings) and the present value of growth opportunities. The value of
growth opportunities is positive if the firm (and the market) believes that the firm has avenues to
invest which will generate a return that is more than the market expected rate of return. Now
when the firms income potential from additional investment is more than the market expected
rate of return, then for every penny re-invested (plow backed rather than distributed as dividend)
will generate a return that is higher than the market expectation. The value of such excess return
is referred to as present value of growth opportunities.
PVGO =Share Price Present value of level stream of earnings
=Share price EPS / r
The growth in the future dividend arises because the firms, instead of distributing 100% of the
earnings as dividends, plowbacks and invests certain portion of the current year profit on projects
whose yield will be greater than the market expected rate of return.
The growth rate in dividend (g), equals, the Plowback ratio * ROE.
4.3.1.4 Discounted Free-cash flow valuation models

Using the above concepts, we are now in a position to look at valuation using cash flows, with
the discounted free cash flow model. We first determine the value of the enterprise and then
value the equity by deducting the debt value from the firm value. Thus:
Market value of equity (V0) = Value of the firm + Cash in hand Debt Value
The price of the share (P0) is the market value of the equity divided by the number of shares
outstanding.
It is simple to calculate the debt value since the payments to be made to debt holders is
predetermined and certain. However, the real problem lies with determining the value of the
151

firm. As per the discounted free cash flow model, the value of a firm is the present value of the
future free cash flow of the firm. The discounting rate is the firms weighted average cost of
capital (WACC) and not the market expected rate of return on equity investment. WACC is the
cost of capital that reflects the risk of the overall business and not the risk associated with the
equity investment alone. WACC is calculated using the following formula:

rD and rE is the expected rate of return on debt and equity

T = Income Tax Rate
D = the market value of debt ; E = the market value of equity
The firm value (V0) is calculated using the following formula:

The terminal value at year N is often computed by assuming that the FCF will grow at
a constant growth rate beyond year N, i.e.

What is free cash flow (FCF)? The free cash measures the cash generated by the firm that can be
distributed to the equity shareholders after budgeting for capital expenditure and working capital
requirements. While computing FCF, we assume that the firm is a 100% equity owned company
and hence we do not consider any payment to debt or equity holders while calculating the free
152

cash flow. Thus the formula for computing FCF is:

We start with EBIT since we do not consider cash outflow in the form of interest payments.
Depreciation lowers the EBIT but is added back since it is a non-cash expenditure (does not result
in cash payments). Since the firm has to incur any planned capital expenditure and has to finance
any working capital requirement before distributing the profits to the shareholders the same is
deducted while calculating the free cash flows.
4.3.2

Relative Valuation

Relative valuation models do calculate the share price but they are generally based on the
valuation of comparable firms in the industry. Various valuation multiples such as price-earning
ratio, enterprise value multiples, etc. are used by the finance professionals which depends on the
industry, current economic scenario, etc. Most of these models are generally used for evaluation
purpose as to whether a particular stock is overvalued or undervalued and less for actual
valuation of the shares.
As discussed in the first chapter, the face value or nominal value of a share is the price printed on
the share certificate. One should not confuse a shares nominal value with the price at which the
company issues shares to the public. The price at which a company issues shares may be more or
less than the face value. The issue price is generally more than the face value and the difference
between the issue price and the face value is called as share premium.
Market price is the price at which the share is traded in the market. It is determined by the
demand and supply of the share in the market and depends on the market (buyers and sellers)
estimation of the present value of all future cash flows to the company. In an efficient market, we
assume that the market is able to gather all information about the company and price
accordingly. Market capitalization of a company is the total value of all shares of the company
and is calculated by multiplying the market price per share with the number of shares
153

outstanding in the market.

154

The book value or carrying value in accounting, is the value of an asset according to its balance
sheet account balance. For assets, the value is based on the original cost of the asset less any
depreciation, amortization or impairment costs made against the asset. Book value per share is
calculated by dividing the net assets of the company with the number of shares outstanding. The
net asset of the company is the values of all assets less values of all liabilities outstanding in the
books of accounts.
4.3.2.1

Earning per Share (EPS)

Earning per share is the firms net income divided by the average number of shares outstanding
during the year.
Calculated as:
EPS =

Net Profit Dividend on Preference Shares

Average number of shares outstanding during the year

4.3.2.2

Dividend per Share (DPS)

Dividends are a form of profit distribution to the shareholders. The firm may not distribute the
entire income to the shareholders, but decide to retain some portion of it for financing growth
opportunities. Alternatively, a firm may pay dividends from past years profit during years where
there is insufficient income. In this case, the dividends amount will be higher than the earnings.
The dividend per share is the amount that the firm pays as dividend to the holder of one share i.e.
total dividend / number of shares in issue.
The dividend payout ratio (DPR) measures the percentage of income that the company pays out
to the shareholders in the form of dividends. The formula for calculating DPR is:

Retention ratio is the opposite of dividend payout ratio and measures the percentage of net
income not paid to the shareholders in the form of dividends. It is nothing but (1-DPR).
Example: The following is the figure for Asha International during the year 2008-09:
Net Income: Rs. 1,000,000
Number of equity shares (2008): 150,000
Number of equity shares (2009): 250,000
Dividend paid: Rs. 400,000
155

Calculate the earnings per share (EPS), dividend per share (DPS), dividend payout ratio and retention
ratio for Asha International.

4.3.2.3

Price-earnings ratio (P/E Ratio)

Price earning ratio for a company is calculated by dividing the market price per share with the
earnings per share (EPS).

The earning per share is usually calculated for the last one year. Sometimes, we also calculate
the PE ratio using the expected future one-year return. In such case, we call forward PE or
estimated PE ratio.
Example: Stock XYZ, whose earning per share is Rs. 50 is trading in the market at Rs. 2000.
What is the price to earnings ratio for XYZ?

156

We cannot draw any conclusion as to whether a stock is undervalued or overvalued in the market
by just considering the PE ratio. A higher PE ratio implies that the investors are paying more for
each unit of net income, which implies that the investors are optimistic about the future
performance (or future growth rate) of the company. Stocks with higher PE ratio are also called
growth firms and stocks with lower PE ratio are called as income firms.
4.3.2.4

Price-Book Ratio

The price-book ratio is widely used as a conservative measure of relative valuation of an asset,
where the assets of the firm are valued at book. Investors also widely use the ratio to judge
whether the stock is undervalued or overvalued, as its less susceptible to fluctuations than the
PE ratio. The formula to calculate the ratio is:
Price-book ratio = Market price of the share / Book Value per share.
4.3.2.5

Return on Equity

Return on equity measures profitability from the equity shareholders point of view. It is the
return to the equity shareholders and is measured by the following formula:

Example: XYZ Company net income after tax for the financial year ending 31st March, 2009 was Rs. 10
million and the equity share capital as on 31st March, 2008 and 31st March 2009 was Rs. 80 million
and Rs. 120 million respectively. Calculate the return on equity of XYZ company for the year
2008-09.

157

54.3.3

The DuPont Model

The Du Pont model is widely used to decide the determinants of return profitability of a
company, or a sector of the economy. Returns on shareholder equity are expressed in terms of a
companys profit margins, asset turn, and its financial leverage.
DuPont Model breaks the Return on equity as under:
RoE = Return on Equity
= Net Profits/Equity
= Net Profits/Sales * Sales/Assets * Assets/Equity
= Profit Margin * Asset Turnover * Financial Leverage
The first component measures the operational efficiency of the firm through its net margin ratio.
The second component, called the asset turnover ratio, measures the efficiency in usage of assets
by the firm and the third component measures the financial leverage of the firm through the
equity multiplier. The analysis reflects a firms efficiency in different aspects of business and is
widely used now for control purpose. It shows that the firm could improve its RoE by a
combination of profitability (higher profit margins), raising leverage (by raising debt), by using
its assets better (higher asset turn) or a combination of all three.
The DuPont Analysis could be easily extended to ascertain a sectors profitability metrics for
comparability or for that matter an entire market.

Dividend Yield
Dividend yield is the ratio between the dividend paid during the last 1-year period and the current
price of the share. The ratio could also be used with the forward dividend yield instead
expected dividends, for either the next 12 months, or the financial year.

158

Example: ABC Company paid a dividend of Rs. 5 per share in 2009 and the market price of
ABC share at the end of 2009 was Rs. 25. Calculate the dividend yield for ABC stock.

Return to Investor
The return what the investor earns during a year by holding the share of a company is not equal
to the dividend per share or the earnings per ratio. An investors earning is the sum of the
dividend amount that he received from the company and the change in the market price of the
share. The investment amount is equal to the market price of the share at the beginning of the
year. An investors return can be calculated using the following formula:

Example: The share price of PQR Company on 1st April 2008 and 31st March 2009 is Rs. 80
and Rs. 84 respectively. The company paid a dividend of Rs. 6 for the year 2008-09. Calculate
the return for a shareholder of PQR Company in the year 2008-09.
Answer:

159

If we write the dividends during the year as Div1, the price of the share at the beginning and
at the end of the year as P0 and P1 respectively, we can write the above formula as:

160

161

This implies that given the expected rate of return for an investor, the price of a share can be calculated
based on the investor expectation of the future dividends and the future share price. We have already
learned in the previous chapter about the factors that affect the expected rate of returns and how one can
calculate the expected rate of returns (e.g. using CAPM). Now the question arises what determines the
next year price (P1) of a share.

162

END CHAPTER QUIZ

Q1. ABC Ltd. has paid a dividend of Rs. 10 per share last year and it is expected to grow at 5%
every year. If an investor's expected rate of return from ABC Ltd. share is 7%, calculate the
market price of the share as per the dividend discount model.
(a)

540

(b)

530

(c)

525

(d)

535

Q2. For longer investment horizons investors look at ______.

(a)

riskier assets like equities.

(b)

low risk assets like government securities.

Q3. Price movement between two Steel company stocks would generally have a ______ covariance.
(a)

positive

(b)

negative

(c)

zero

(d)

none of the above

Q4. Dividend Per Share = Total Dividend / Number of Shares in issue

(a)

TRUE

(b)

FALSE

Q5. Over pricing in a stock presents an opportunity to engage in _____ the stock.
(a)

short covering

(b)

short selling

(c)

active buying

(d)

going long

163

Q6. Stock returns are generally expected to be independent across weekdays, but a number
of studies have found returns on Monday to be lower than in the rest of the week. This
departure from market efficiency is also sometimes called the _____ effect.
(a) Monday-Friday
(b) Weekday
(c) Monday
(d) Weekend
Q7. Markets are inefficient when prices of securities assimilate and reflect information about
them.
(a)

TRUE

(b)

FALSE

Q8. A company's net income for a period is Rs. 15,00,00,000 and the average shareholder's fund
during the period is Rs. 1,00,00,00,000. The Return on Average Equity is :
(a)

13%

(b)

12%

(c)

15%

(d)

16%

Q9. In case of compound interest rate, we need to know the _______ for which
compounding is done.
(a)

period

(b)

frequency

(c)

time

(d)

duration

Q10. The ______ refers to the length of time for which an investor expects to remain
invested in a particular security or portfolio, before realizing the returns.
(a)

investment horizon

(b)

credit cycle horizon

(c)

duration horizon

(d)

constraint horizon
164

Key to Questions
Question

Answer

Q1.

(c)

Q2.

(a)

Q3.

(a)

Q4.

(a)

Q5.

(b)

Q6.

(d)

Q7.

(b)

Q8.

(c)

Q9.

(b)

Q10.

(a)

165

MODULE-V

166

5 FIXED INCOME VALUATION AND ANALYSIS

Fixed Income Securities
5.1

Introduction: The Time Value of Money

Fixed-income securities are securities where the periodic returns, time when the returns fall due
and the maturity amount of the security are pre-specified at the time of issue. Such securities
generally form part of the debt capital of the issuing firm. Some of the common examples are
bonds, treasury bills and certificates of deposit.
5.2

Simple and Compound Interest Rates

In simple terms, an interest payment refers to the payment made by the borrower to the lender as
the price for use of the borrowed money over a period of time. The interest cost covers the
Opportunity cost of money, i.e., the return that could have been generated had the lender
invested in some other assets and a compensation for default risk (risk that the borrower will not
refund the money on maturity). The rate of interest may be fixed or floating, in that it may be
linked to some other benchmark interest rate or in some cases to the inflation in the economy.
Interest calculations are either simple or compound. While simple interest is calculated on the
principal amount alone, for a compound interest rate calculation we assume that all interest
payments are re-invested at the end of each period. In case of compound interest rate, the
subsequent periods interest is calculated on the original principal and all accumulated interest
during past periods.
In case of both simple and compound interest rates, the interest rate stated is generally
annual. In case of compound interest rate, we also mention the frequency for which
compounding is done. For example, such compounding may be done semi-annually, quarterly,
monthly, daily or even instantaneously (continuously compounded).
5.2.1

Simple Interest Rate

The formula for estimating simple interest is :

I =P*R*T
167

Where,
P = Principal amount
R = Simple Interest Rate for one period (usually 1 year)
T = Number of periods (years)

Example
What is the amount an investor will get on a 3-year fixed deposit of Rs. 10000 that pays
8% simple interest?
Answer: Here we have
P = 10000, R = 8% and T = 3 years
I =P * R * T =

Amount = Principal + Interest = 10000+2400 = 12400.

5.2.2

Compound Interest Rate

In addition to the three parameters (Principal amount (P), Interest Rate (R), Time (T)) used for
alculation of interest in case of simple interest rate method, there is an additional parameter that
affects the total interest payments. The fourth parameter is the compounding period, which is
usually represented in terms of number of times the compounding is done in a year (m). So for
semi-annual compounding the value for m = 2; for quarterly compounding, m = 4 and so on.
Let us consider an interest rate of 10% compounded semi-annually and an investment of
Rs. 100 for a period of 1 year. The investment will become Rs. 105 in 6 months and
for the second half, the interest will be calculated on Rs. 105, which will come to 105*5%
= 5.25. The total amount the investor will receive at the end of 1 year will become 105 + 5.25
=

110.25.

The equivalent interest rate,

if

compounded

annually

becomes ((110.25-

100)/100)*100 = 10.25%. The equivalent annual interest rate is

The formula used for calculating total amount under this method is as under:
Where
168

A = Amount on maturity
R = interest rate
m = number of compounding in a year
T = maturity in years
Example
What is the amount an investor will get on a 3-year fixed deposit of Rs. 10000 that pay 8%
interest compounded half yearly?
Answer:

Example
Consider the same investment. What is the amount if the interest rate is compounded monthly?
Answer:

169

Continuous compounding
Consider a situation, where instead of monthly or quarterly compounding, the interest rate is
compounded continuously throughout the year i.e. m rises indefinitely. If m approaches infinity,
the equivalent annual interest rate is

which can be shown (using tools from

differential calculus), to tend to [2.718r 1] or

170

er 1 in the limit, (where e=2.71828 is the

base for natural logarithms). Further, for convenience, we use r (in small letters) to represent
continuously compound interest rate.
Thus, an investment of Re. 1 at 8% continuously compounded interest becomes e

0.08

=1.0833

after 1 year and the equivalent annual interest rate becomes 0.0833 or 8.33%. If the investment
rT

is for T years, the maturity amount is simply 1*e , where e = 2.718.

Continuous compounding is widely assumed in finance theory, and used in various asset pricing
modelsthe famous Black-Scholes model to price a European option is an illustrative example.
Example
Consider the same investment (Rs. 10000 for 3 years). What is the amount received on
maturity if the interest rate is 8% compounded continuously?
Answer:

171

5.3

Real and Nominal Interest Rates

The relationship between interest rates and inflation rates is very significant. Normally, the cash
flow from bonds and deposits are certain and known in advance. However, the value of goods
and services in an economy may change due to changes in the general price level (inflation).
This brings an uncertainty about the purchasing power of the cash flow from an investment. Take
a small example. If inflation (say 12%) is rising and is greater than the interest rate (say 10%
annually) in a particular year, then an investor in a bond with 10% interest rate annually stands to
lose. Goods worth Rs. 100 at the beginning of the year are worth Rs. 112 by the end of the year
but an investment of Rs. 100 becomes only Rs. 110 by end of the year. This implies that an
investor who has deposited money in a risk-free asset will find goods beyond his reach.
An economist would look at this in terms of nominal cash flow and real cash flows. Nominal
cash flow measures the cash flow in terms of todays prices and real cash flow measures the cash
flow in terms of its base years purchasing power, i.e., the year in which the asset was
bought/invested. If the interest rate is 10%, an investment of Rs. 100 becomes Rs. 110 at the end
of the year. However, if inflation rate is 5% then each Rupee will be worth 5% less next year.
This means at the end of the year, Rs. 110 will be worth only 110/1.05 = Rs. 104.76 in terms of
the purchasing power at the beginning of the year. The real payoff is Rs. 104.76 and the real
interest rate is 4.76%. The relationship between real and nominal interest rate can be established
as under:

172

173

5.4

Bond Pricing Fundamentals

The cash inflow for an investor in a bond includes the coupon payments and the payment on
maturity (which is the face value) of the bond. Thus the price of the bond should represent the
sum total of the discounted value of each of these cash flows (such a total is called the present
value of the bond). The discount rate used for valuing the bond is generally higher than the riskfree rate to cover additional risks such as default risk, liquidity risks, etc.
Bond Price = PV (Coupons and Face Value)
Note that the coupon payments are at different points of time in the future, usually twice each
year. The face value is paid at the maturity date. Therefore, the price is calculated using the
following formula:

Where C(t) is the cash flow at time t and y is the discount rate. Since the coupon rate is generally
fixed and the maturity value is known at the time of issue of the bond, the formula can be rewritten as under:

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Here t represents the time left for each coupon payment and T is the time to maturity. Also note
that the discount rate may differ for cash flows across time periods.
Example
Calculate the value of a 3-year bond with face value of Rs. 1000 and coupon rate being 8% paid
annually. Assume that the discount rate is 10%.

Here:
Face value = Rs. 1000
Coupon Payment = 8% of Rs. 1000 = Rs. 80
Discount Rate = 10%
t=1 to 3
T=3

Now let us see what happens if the discount rate is lower than the coupon rate:
Example
Calculate the bond price if the discount rate is 6%.

Since the discount rate is higher than the coupon rate, the bond is traded at a discount. If the
discount rate is less than the coupon rate, the bond trades at a premium.
5.4.1

Clean and dirty prices and accrued interest

Bonds are not traded only on coupon dates but are traded throughout the year. The market price
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of the bonds also includes the accrued interest on the bond since the most recent coupon payment
date. The price of the bond including the accrued interest since issue or the most recent coupon
payment date is called the dirty price and the price of the bond excluding the accrued interest is
called the clean price. Clean price is the price of the bond on the most recent coupon payment
date, when the accrued interest is zero.
Dirty Price = Clean price + Accrued interest
For reporting purpose (in press or on trading screens), bonds are quoted at clean price for ease
of comparison across bonds with differing interest payment dates (dirty prices jump on interest
payment dates). Changes in the more stable clean prices are reflective of macroeconomic
conditions, usually of more interest to the bond market.
5.5

Bond Yields

Bond yield are measured using the following measures:

5.5.1

Coupon yield

It is calculated using the following formula:

5.5.2

Current Yield

It is calculated using the following formula:

The main drawback of coupon yield and current yield is that they consider only the interest
payment (coupon payments) and ignore the capital gains or losses from the bonds. Since they
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consider only coupon payments, they are not measurable for bonds that do not pay any
interest, such as zero coupon bonds. The other measures of yields are yield to maturity and

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yield to call. These measures consider interest payments as well as capital gains (or losses)
during the life of the bond.
5.5.3

Yield to maturity

Yield to maturity (also called YTM) is the most popular concept used to compare bonds. It refers
to the internal rate of return earned from holding the bond till maturity. Assuming a constant
interest rate for various maturities, there will be only one rate that equalizes the present value of
the cash flows to the observed market price in equation (2) given earlier. That rate is referred to
as the yield to maturity.
Example
What is the YTM for a 5-year, 8% bond (interest is paid annually) that is trading in the market
for Rs. 924.20?
Here,
t= 1 to 5
T=5
Face Value = 1000
Coupon payment = 8% of Rs. 1,000 = 80
Putting the values in equation (1), we have:

Solving for y, which is the YTM, we get the yield to maturity for the bond to be 10%.
Yield and Bond Price:
There is a negative relationship between yields and bond price. The bond price falls when yield
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increases and vice versa.

Example
What will be the market price of the above bond (Example 3 7) if the YTM is 12%.
t= 1 to 5
T=5
Face Value = 1000
Coupon payment = 8% of 1,000 = 80
Putting the values in equation (1), the bond price comes to:

Further, for a long-term bond, the cash flows are more distant in the future and hence the impact
of change in interest rate is higher for such cash flows. Alternatively, for short-term bonds, the
cash flows are not far and discounting does not have much effect on the bond price. Thus, price
of long-term bonds are more sensitive to interest rate changes.
Bond equivalent yield and Effective annual yield: This is another important concept that is of
importance in case of bonds and notes that pay coupons at time interval which is less than 1 year
(for example, semi-annually or quarterly). In such cases, the yield to maturity is the discount
rate solved using the following formula, wherein we assume that the annual discount rate is the
product of the interest rate for interval between two coupon payments and the number of coupon
payments in a year:

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YTM calculated using the above formula is called bond equivalent yield.
However, if we assume that one can reinvest the coupon payments at the bond equivalent
yield (YTM), the effective interest rate will be different. For example, a semi-annual
interest rate of 10% p.a. in effect amounts to:

Yield rate calculated using the above formula is called effective annual yield.
Example
Calculate the bond equivalent yield (YTM) for a 5-year, 8% bond (semi-annual coupon
payments), that is trading in the market for Rs. 852.80? What is the effective annual yield for the
bond?
Here,
t= 1 to 10
T = 10
Face Value = 1000
Coupon payment = 4% of 1,000 = 40
Bond Price = 852.80
Putting the values in equation (3), we have:

Solving, we get the Yield to Maturity (y) = 0.12 or 12%.

The effective yield rate is

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5.5.4

Yield to call

Yield to call is calculated for callable bond. A callable bond is a bond where the issuer has a
right (but not the obligation) to call/redeem the bond before the actual maturity. Generally the
callable date or the date when the company can exercise the right, is pre-specified at the time of
issue. Further, in the case of callable bonds, the callable price (redemption price) may be
different from the face value. Yield to call is calculated with the same formula used for
calculating YTM (Equation 2), with an assumption that the issuer will exercise the call
option on the exercise date.
Example
Calculate the yield to call for a 5-year, 7% callable bond (semi-annual coupon payments), that is
trading in the market for Rs. 877.05. The bond is callable at the end of 3rd year at a call price of
Rs. 1040.
Here:
t= 1 to 6
T=6
Coupon payment = 3.5% of 1,000 = 35
Callable Value = 1040
Bond Price = 877.05
Putting the values in the following equation:

we have:

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Solving for y, we get the yield to call = 12%

5.6

Interest Rates

While computing the bond prices and YTM, we assumed that the interest rate is constant across
different maturities. However, this may not be true for different reasons. For example, investors
may perceive longer maturity periods to be riskier and hence may demand higher interest rate for
cash flow occurring at distant time intervals than those occurring at short time intervals. In this
section, we account for the fact that the interest demanded by investors also depends on the time
horizon of the investment. Let us first introduce certain common concepts.
5.6.1

Short Rate

Short rate for time t, is the expected (annualized) interest rate at which an entity can borrow for a
given time interval starting from time t. Short rate is usually denominated as rt.
5.6.2

Spot Rate

Yield to maturity for a zero coupon bond is called spot rate. Since zero coupon bonds
of varying maturities are traded in the market simultaneously, we can get an array of spot rates
for different maturities. Relationship between short rate and spot rate: Investors discount future
cash flows using interest rate applicable for that period. Therefore, the PV of an investment of T
years is calculated as under:

Example
If the short rate for a 1-year investment at year 1 is 7% and year 2 is 8%, what is the present
value of a 2-year zero coupon bond with face value Rs. 1000 :

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183

For a 2-year zero coupon bond trading at 865.35, the YTM can be calculated by solving the
following equation:

The resulting value for y is 7.4988%, which is nothing but the 2-year spot rate.
5.6.3

Forward Rate

One can assume that all bonds with equal risks must offer identical rates of return over any
holding period, because if it is not true then there will be an arbitrage opportunity in the market.
If we assume that all equally risky bonds will have identical rates of return, we can calculate
short rates for a future interval by knowing the spot rates for the two ends of the interval. For
example, we can calculate 1-year short rate at year 3, if we have the 3-years spot rate and 4-years
spot rate (or in other words are there are 3-year zero coupon and a 4-year zero coupon treasury
bonds trading in the market). This is because, the proceeds from an investment in a 3-year zero
coupon bond on the maturity day, reinvested for 1 year should result in a cash flow equal to the
cash flow from an investment in a 4-year zero coupon bond (since the holding period is the same
for both the strategies).
Example
If the 3-year spot rate and 4-year spot rates are 8.997% and 9.371% respectively, find the 1-year
short rate at end of year 3.
Given the spot rates, proceeds from investment of Re. 1 in a 3-year zero coupon bond will be
1* 1.089973 = 1.2949.
If we reinvest this (maturity) amount in a 1-year zero coupon bond, the proceeds at year 4 will be
1.2949*(1+r3).
This should be equal to the proceeds from an investment of Rs. 1 in a 4-year zero coupon
bond, assuming equal holding period return.
Proceeds from investment of Re. 1 in a 4-year zero coupon bond is 1*1.093714 = 1.4309
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Solving,
1.2949 * (1 + r3
r3= 0.11 or 11%, which is nothing but the 1 year short rate at the end of year 3.
Future short rates computed using the market price of the prevailing zero coupon bonds price
(or prevailing spot rates) are called forward interest rates. We use the notation fi to represent the
1-year forward interest rate starting at year i. For example, f2 denotes the 1-year forward interest
rate starting from year 2.
5.6.4

The term structure of interest rates

We have discussed various interest rates (spot, forward, discount rates), and also seen their
behaviour, and connections with each other. The term structure of interest rates is the set of
relationships between rates of bonds of different maturities. It is sometimes also called the yield
curve. Formally put, the term structure of interest rates defines the array of discount factors on a
collection of default-free pure discount (zero-coupon) bonds that differ only in their term to
maturity. The most common approximation to the term structure of interest rates is the yield to
maturity curve, which generally is a smooth curve and reflects the rates of return on various
default-free pure discount (zero-coupon) bonds held to maturity along with their term to
maturity.
The use of forward interest rates has long been standard in financial analysis such as in pricing
new financial instruments and in discovering arbitrage possibilities. Yield curves are also used as
a key tool by central banks in the determination of the monetary policy to be followed in a
country. The forward interest rate is interpreted as indicating market expectations of the timepath of future interest rates, future inflation rates and future currency depreciation rates. Since
forward rates helps us indicate the expected future time path of these variables, they allow a
separation of market expectations for the short, medium and long term more easily than the
standard yield curve.
The market expectations hypothesis and the liquidity preference theory are two important
explanations of the term structure of interest in the economy. The market expectation hypothesis
assumes that various maturities are perfect substitutes of each other and that the forward
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rate equals the market expectation of the future short interest rate i.e.

, where i is

a future period. Assuming minimal arbitrage opportunities, the expected interest rate can be used
to construct a yield curve. For example, we can find the 2-year yield if we know the 1-year short
rate and the futures short rate for the second year by using the following formula:

Since, as per the expectation hypothesis

f2=E(R2) , the YTM can be determined solely by

current and expected future one-period interest rates.

Liquidity preference theory suggests that investors prefer liquidity and hence, a short-term
investment is preferred to a long-term investment. Therefore, investors will be induced to hold a
long-term investment, only by paying a premium for the same. This premium or the excess of the
forward rate over the expected interest rate is referred to as the liquidity premium.
Therefore, the forward rate will exceed the expected short rate, i.e.

represent the liquidity premium. The liquidity premium causes the yield curve to be upward sloping since
long-term yields are higher than short-term yields.
Example
Calculate the YTM for year 2-5 if the 1-year short rate is 8% and the future rates for years 2- 5 is 8.5% (f2),
9% (f3), 9.5% (f4) and 10%(f5) respectively.

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It can be seen that because of the liquidity premium, the future interest rate increases with
time and this causes the yield curve to rise with time.

187

188

5.7

Macaulay Duration and Modified Duration

The effect of interest rate risks on bond prices depends on many factors, but mainly on coupon
ates, maturity date etc. Unlike in case of zero-coupon bonds, where the cash flows are only at he
end, in the case of other bonds, the cash flows are through coupon payments and the maturity
payment. One needs to average out the time to maturity and time to various coupon payments to
find the effective maturity for a bond. The measure is called as duration of a bond. It is the
weighted (cash flow weighted) average maturity of the bond.

The weights (Wt) associated for each period are the present value of the cash flow at each
period as a proportion to the bond price, i.e.

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This measure is termed as Macaulays duration1 or simply, duration. Higher the duration of the
bond, higher will be the sensitivity towards interest rate fluctuations and hence higher the
volatility in the bond price.
This tool is widely used in fixed income analysis. Banks and other financial institutions generally
create a portfolio of fixed income securities to fund known liabilities. The price changes for fixed
income securities are dependent mainly on the interest rate changes and the average maturity
(duration). In order to hedge against interest rate risks, it is essential for them to match the
duration of the portfolio of fixed income securities with that of the liabilities. A bank thus needs
to rebalance its portfolio of fixed-income securities periodically to ensure that the aggregate
duration of the portfolio is kept equal to the time remaining to the target date. One should note
that the duration of a short-term bond declines faster than the duration of the long-term bond.
When interest rates fall, the reinvestment of interests (until the target date) will yield a lower
value but the capital gain arising from the bond is higher. The increase or decrease in the coupon
income arising from changes in the reinvestment rates will offset the opposite changes in the
market values of the bonds in the portfolios. The net realized yield at the target date will be equal
to the yield to maturity of the original portfolio. This is also called bond portfolio immunization.
Example
What is the duration for a 5-year maturity, 7% (semi-annual) coupon bond with yield to
maturity of 12%?
Here:
t = 1 to 10
T = 10
Coupon payment = 3.5% of 1,000 = 35
YTM = 12 % or 6% for half year.

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The selling price of the bond as calculated from column (d) is Rs. 816.00. The duration of the
bond is 4.2142 years.
Since for a zero coupon bond, the cash flow is only on the maturity date, the duration equals the
bond maturity. For coupon-paying bonds, the duration will be less than the maturity period.
Since cash flows at each time are used as weights, the duration of a bond is inversely related to
the coupon rate. A bond with high coupon rate will have lower duration as compared to a bond
with low coupon rate.
Example
What is the duration for a 5-year maturity zero coupon bond with yield to maturity of 12%?
Answer: One does not need to do any calculation for answering this question. All cash flows are
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only on the maturity date and hence the duration for this bond is the maturity date.
Although duration helps us in measuring the effective maturity of the bond, investors are
concerned more about the bond price sensitivity with respect to change in interest rates. In order
to measure the price sensitivity of the bond with respect to the interest rate movements, we need
to find the so-called modified duration (MD) of the bond. Modified duration is calculated from
duration (D) using the following formula:

Where,
y = yield to maturity of the bond
n = number of coupon payments in a year.
The price change sensitivity of modified duration is calculated using the following formula:
Price Change (%) = ) MD * Yield Change
Note the use of minus (-) term. This is because price of a bond is negatively related to the yield
of the bond.
Example
Refer to the bond in Example 3 14 i.e. 5-year maturity, 7% (semi-annual) coupon bond with
yield to maturity of 12%. Calculate the change in bond price if the YTM falls to 11%.
Answer: In Example 3 14, we calculated the duration to be 4.2142 and the bond price to be
816. The modified duration of the bond is:

The price change will -3.976*1 = 3.976% or Rs. 816 * 3.976% = 32.45
New Price = 816 + 32.45 = 848.45
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Check: The actual market price of a 5-year maturity, 7% (semi-annual) coupon bond with YTM
= 11% would be:

Note that there is still some minor differences in the actual price and the bond price calculated
using the modified duration formula, due to what is called convexity. However, we would not
be covering the concept in this chapter.

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5.8 Valuation and Analysis of Derivatives

5.8.1

Introduction

Derivatives are a wide group of financial securities defined on the basis of other financial
securities, i.e., the price of a derivative is dependent on the price of another security, called the
underlying. These underlying securities are usually shares or bonds, although they can be various
other financial products, even other derivatives. As a quick example, lets consider the derivative
called a call option, defined on a common share. The buyer of such a product gets the right to
buy the common share by a future date. But she might not want to do sotheres no obligation
to buy it, just the choice, the option. Lets now flesh out some of the details. The price at which
she can buy the underlying is called the strike price, and the date after which this option expires
is called the strike date. In other words, the buyer of a call option has the right, but not the
obligation to take a long position in the underlying at the strike price on or before the strike date.
Call options are further classified as being European, if this right can only be exercised on the
strike date and American, if it can be exercised any time up and until the strike date.
Derivatives are amongst the widely traded financial securities in the world. Turnover in the
futures and options markets are usually many times the cash (underlying) markets. Our
treatment of derivatives in this module is somewhat limited: we provide a short introduction
about of the major types of derivatives traded in the markets and their pricing.
5.8.2

Forwards and Futures

Forward contracts are agreements to exchange an underlying security at an agreed rate on a

specified future date (called expiry date). The agreed rate is called forward rate and the
difference between the spot rate, the rate prevailing today, and the forward rate is called the
forward margin. The party that agrees to buy the asset on a future date is referred to as a long
investor and is said to have a long position. Similarly, the party that agrees to sell the asset in a
future date is referred to as a short investor and is said to have a short position.
Forward contracts are bilateral (privately negotiated between two parties), traded outside a
regulated stock exchange (traded in the OTC or Over the Counter market) and suffer from
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counter-party risks and liquidity risks. Here counter-party risk refers to the default risk that arises
when one party in the contract defaults on fulfilling its obligations thereby causing loss to the
other party.
Futures contracts are also agreements to buy or sell an asset for a certain price at a future time.
Unlike forward contracts, which are traded in the over-the-counter market with no standard
contract size or delivery arrangements, futures contracts are standardized contracts and are traded
on recognized and regulated stock exchanges. They are standardized in terms of contract sizes,
trading parameters and settlement procedures, and the contract or lot size (no. of
shares/units per contract) is fixed.
Since futures contracts are traded through exchanges, the settlement of the contract is
guaranteed by the exchange or a clearing corporation (through the process of novation) and
hence there is no counter-party risk. Exchanges guarantee execution by holding a caution amount
as security from both the parties (buyers and sellers). This amount is called as the margin money,
and is adjusted daily based on price movements of the underlying till the contract expires.
Compared to forward contracts, futures also provide the flexibility of closing out the contract
prior to the maturity by squaring off the transaction in the market. Occasionally the fact
forward contracts are bilateral comes in handytwo parties could suit a contract according to
their needs; such a futures may not be traded in the market. Primary examples are long-term
contractsmost futures contracts have short maturities of less than a few months.
The table here draws a comparison between a forward and a futures contract.

195

Comparison of Forward and Futures Contracts

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5.8.3

Call and Put Options

Like forwards and futures, options are derivative instruments that provide the opportunity to buy
or sell an underlying asset on a future date. As explained in the introduction, an option contract is
a contract written by a seller that conveys the buyers a right, but not an obligation to either sell
(put option) or buy (call option) a particular asset at a specified price in the future. In case of call
options, the option buyer has a right to buy and in case of put options, the option buyer has a
right to sell the security at the agreed upon price (called strike rate or exercise price). In return
for granting the option, the party (seller) granting the option collects a payment from the other
party. This payment collected is called the premium or price of the option.
Options are like insurance contracts. Unlike futures, where the parties are denied of any
favorable movement in the market, in case of options, the buyers are protected from downside
risks and in the same time, are able to reap the benefits from any favorable movement in the
exchange rate. The buyer of the option has a right but no obligation to enforce the execution of
the option contract and hence, the maximum loss that the option buyer can suffer is limited to the
premium amount paid to enter into the contract. The buyer would exercise the option only when
she can make some profit from the exercise, otherwise, the option would not be exercised, and be
allowed to lapse. Recall that in case of American options, the right can be exercised on any day
on or before the expiry date but in case of a European option, the right can be exercised
only on the expiry date.
Options can be used for hedging as well as for speculation purposes. An option is used as a
hedging tool if the investor already has (or is expected to have) an open position in the spot
market. For example, in case of currency options, importers buy call options to hedge against
future depreciation of the local currency (which would make their imports more expensive) and
exporters could buy put options to hedge against currency appreciation. There are other methods
of hedging toousing forwards, futures, or combinations of all threeand the choice of hedging
is determined by the costs involved.
5.8.4

Forward and Futures Pricing

Forwards/ futures contract are priced using the cost of carry model. The cost of carry model
calculates the fair value of futures contract based on the current spot price of the underlying
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asset. The formula used for pricing futures is given below:

F = SerT Where :
F = Futures Price
S = Spot price of the underlying asset
R = Cost of financing (using a continuously compounded interest rate)
T = Time till expiration in years
E = 2.71828 (The base of natural logarithms)

Example: Security of ABB Ltd trades in the spot market at Rs. 850. Money can be invested at
11% per annum. The fair value of a one-month futures contract on ABB is calculated as
follows:

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The presence of arbitrageurs would force the price to equal the fair value of the asset. If the
futures price is less than the fair value, one can profit by holding a long position in the futures
and a short position in the underlying. Alternatively, if the futures price is more than the fair
value, there is a scope to make a profit by holding a short position in the futures and a long
position in the underlying. The increase in demand/ supply of the futures (and spot) contracts
will force the futures price to equal the fair value of the asset.
Cost-of-carry and convenience yield
The cost of carry is the cost of holding a position. It is usually represented as a percentage of the
spot price. Generally, for most investment, we consider the risk-free interest rate as the cost of
carry. In case of commodities contracts, cost of carry also includes storage costs (also expressed
as a percentage of the spot price) of the underlying asset until maturity.
Futures prices being lower than spot price (backwardation) is also explained by the concept of
convenience yield. It is the opposite of carrying charges and refers to the benefit accruing to the
holder of the asset. For example, one of the benefits to the inventory holder is the timely
availability of the underlying asset during a period when the underlying asset is otherwise facing
a stringent supply situation in the market. Convenience yield has a negative relationship with
inventory storage levels (and storage cost). High storage cost/high inventory levels lead to
negative convenience yield and vice versa.
The cost of carry model expresses the forward (future) price as a function of the spot price and
the cost of carry and convenience yield.
F = S PV (storage cost)] * e(r c)t
Where F is the forward price, S is the spot price, r is the risk-free interest rate, c is
the convenience yield and t is the time to delivery of the forward contract (expressed as a
fraction of 1 year).
Backwardation and Contango
The theory of normal backwardation was first developed by J. M. Keynes in 1930. The theory
suggests that the futures price is a biased estimate of the expected spot price at the maturity. The
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underlying principle for the theory is that hedgers use the future market to avoid risks and pay a
significant amount to the speculators for this insurance. When the future price is lower than the
current spot price, the market is said to be backwarded and the opposite is called as a contango
market. Since future and spot prices have to converge on maturity (this is sometimes called the
law of one price), in the case of a backwarded market, the future price will increase relative to
the expected spot price with passage of time, the process referred to as backwardation. In case of
contango, the future price decreases relative to the expected spot price.
Backwardation and contango is easily explained in terms of the seasonal nature of commodities.
Commodity futures with expiration dates falling in post harvest month would face
backwardation, as the expected spot price would be lower. When hedgers are net short (farmers
willing to sell the produce immediately after harvest), or the risk aversion is more for short
hedgers than the long hedgers, the futures price would be a downward biased estimate of the
expected spot price, resulting into a backwarded market.
5.8.5

Option Pricing

Our brief treatment of options in this module initially looks at pay-off diagrams, which chart the
price of the option with changes in the price of the underlying and then describes how call and
option prices are related using put-call parity. We then briefly describe the celebrated BlackScholes formula to price a European option.
Payoffs from option contracts
Payoffs from an option contract refer to the value of the option contract for the parties (buyer and
seller) on the date the option is exercised. For the sake of simplicity, we do not consider the
initial premium amount while calculating the option payoffs.
In case of call options, the option buyer would exercise the option only if the market price on the
date of exercise is more than the strike price of the option contract. Otherwise, the option is
worthless since it will expire without being exercised. Similarly, a put option buyer would
exercise her right if the market price is lower than the exercise price.
The payoff of a call option buyer at expiration is:
Max [(Market price of the share Exercise Price), 0]
The following figures shows the payoff diagram for call options buyer and seller (assumed
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exercise price is 100)

201

The payoff for a buyer of a put option at expiration is:

Max [(Exercise price Market price of the share), 0]
The payoff diagram for put options buyer and seller (assumed exercise price is 100)

From the pay-off diagrams its apparent that a buyer of call options would expect the market
price of the stock to rise, and buying the call option allows him to lock in the benefits of such a
rise, and also cap the downside in the event of a fall. The price of course is the premium. On the
other side, a seller of call options has a contrarian view, and hopes to profit from the premium of
the call options sold that would expire unexercised. Its clear from the vertical axis of the payoff
diagram (which provides the payoff the contract), that while the downside of a call option buyer
is limited, it is not so for the seller.
In a similar sense, a buyer of put options would expect the market to fall, and profit from it, with
an insurance, or a hedge (in the event of an unexpected rise in the market), to cap the downside.
The price of the hedge is the put option premium.

202

203

Put-call parity relationship

The put-call parity relationship gives us a fundamental relationship between European call
options and put options. The relationship is derived by noticing that the payoff from the
following two strategies is the same irrespective of the stock price at maturity. The two strategies
are:
Strategy 1: Buy a call option and investing the present value of exercise price in risk-free
asset.
Strategy 2: Buy a put option and buying a share.
This can be shown in the form of the following diagram:
Strategy 1:

Strategy 2:

Since the payoff from the two strategies is the same therefore:

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205

5.8.6 Black-Scholes formula

The main question that is still unanswered is the price of a call option for entering into the option
contract, i.e. the option premium. The premium amount is dependent on many variables. They
are:
-

Share Price (S0)

Exercise Price (K)

The time to expiration i.e. period for which the option is valid (T)

Prevailing risk-free interest rate (r)

The expected volatility of the underlying asset ( s

One of the landmark inventions in the financial world has been the Black-Scholes formula
toprice a European option. Fischer Black and Myron Scholes2 in their seminal paper in 1973
gave the world a mathematical model to value the call options and put options. The formula
proved to be very useful not only to the academics but also to practitioners in the finance world.
The authors were later awarded The Sveriges Riksbank Prize in Economic Sciences in Memory
of Alfred Nobel in 1997. The Black-Scholes formula for valuing call options (c) and value of put
options (p) is as under:

206

207

Example: Calculate the value of a call option and put option for the following contract:
Stock Price (S) = 100
Exercise Price (K) = 105
Risk-free, continuously compounded interest Rate (r) = 0.10 (10%)
Time to expiration (T-t) = 3 month = 0.25 years
Standard deviation ( s

208

209

END CHAPTER QUIZ

Q1.

Security of ABC Ltd. trades in the spot market at Rs. 595. Money can be invested at 10% per
annum. The fair value of a one-month futures contract on ABC Ltd. is (using continuously
compounded method):
(a)

630.05

(b)

620.05

(c)

600.05

(d)

610.05

Q2. The price of a derivative is dependent on the price of another security, called the _____ .
(a)

basis

(b)

variable

(c)

underlying

(d)

options

Q3. What is the amount an investor will get on a 1-year fixed deposit of Rs. 10000 that pays 8% interest
compounded quarterly?
(a)

12824.32

(b)

13824.32

(c)

10824.32

(d)

11824.32

Q4. One needs to average out the time to maturity and time to various coupon payments to find the
effective maturity for a bond. The measure is called as _____ of a bond.
(a)

duration

(b)

IRR

(c)

YTM

(d)

yield

Q5. Security of ABC Ltd. trades in the spot market at Rs. 525. Money can be invested at 10% per
annum. The fair value of a one-month futures contract on ABC Ltd. is (using continuously
compounded method):
(a) 559.46
(b) 549.46
(c) 539.46
210

(d) 529.46
Q6. Mr. A buys a Call Option at a strike price of Rs. 700 for a premium of Rs. 5. Mr. A
expects the price of the underlying shares to rise above Rs. ______ on expiry date in
order to make a profit.
(a)

740

(b)

700

(c)

720

(d)

760

Q7. In a Bond the ____ is paid at the maturity date.

(a)

face value

(b)

discounted value

(c)

compounded value

(d)

present value

Q8. Mr. A buys a Put Option at a strike price of Rs. 100 for a premium of Rs. 5. On expiry of the
contract the underlying shares are trading at Rs. 106. Will Mr. A exercise his option?
(a)

No

(b)

Yes

Q9. ______ fund managers try to replicate the performance of a benchmark index, by
replicating the weights of its constituent stocks.
(a)

Active

(b)

Passive

Q10. Call Options can be classified as :

(a)

European

(b)

American

(c)

All of the above

211

Key to Questions
Question

Answer

Q1.

(c)

Q2.

(c)

Q3.

(c)

Q4.

(a)

Q5.

(d)

Q6.

(b)

Q7.

(a)

Q8.

(a)

Q9.

(b)

Q10.

(a)

212

MODULE-VI

213

PORTFOLIO MANAGEMENT

6.1

PORTFOLIO MANAGEMENT PROCESS

Investment management (or portfolio management) is a complex activity which may be broken
down the following steps:
1. Specification of Investment Objectives and Constraints: The typical objectives sought by
investors are current income, capital appreciation, and safety of principal. The relative
importance of these objectives should be specified. Further, the constraints arising from
liquidity, time horizon, tax, and special circumstances must be identified.
2. Choice of the Asset Mix: The most important decision in portfolio management is the asset mix
decision. Very broadly, this is concerned with the proportions of stocks (equity shares and
units/ shares of equity oriented mutual funds) and bonds (fixed income investment vehicles in
general) in the portfolio. The appropriate stock-bond mix depends mainly on the risk tolerance
and investment horizon of the investor.
3. Formulation of Portfolio Strategy: Once a certain asset mix is chosen, an appropriate portfolio
strategy has to be hammered out. Two broad choices are available: an active portfolio strategy or
a passive portfolio strategy. An active portfolio strategy strives to earn superior risk-adjusted
returns by resorting to market timings, or sector rotation or security selection, or some
combination of these. A passive portfolio strategy, on the other hand involves holding a broadly
diversified portfolio and maintaining a pre-determined level of risk exposure.
4. Selection of Securities: Generally, investors pursue an active stance with respect to security
selection. For stock selection, investors commonly go by fundamental analysis and/or technical
analysis. The factors that are considered in selecting bonds (or fixed income instruments) are
yield to maturity, credit rating, term to maturity, tax shelter, and liquidity.
5. Portfolio Execution: This is the phase of portfolio management which is concerned with
implementing the portfolio plan by buying and/or selling specified securities in given amounts.
Though often glossed over in portfolio management discussions, this is an important practical
step that has a bearing on investment results.

214

6. Portfolio Revision: The value of a portfolio as well as its composition---e relative proportions
of stock and bond components---may change as prices of stocks and bonds fluctuate. Of course,
the fluctuation in bond prices is often the dominant factor underlying the change. In response to
such changes, periodic rebalancing of portfolio is required. This primarily involves a shift from
stocks to bonds or vice versa. In addition, it may call for sector rotation as well as security
switches.
7. Performance Evaluation: The performance of the portfolio should be evaluated periodically.
The key dimensions of portfolio performance evaluation are risk and return and the key issue is
whether the portfolio return is commensurate with its risk exposure. Such a review may provide
useful feedback to improve the quality of the portfolio management process on a continuing
basis.

6.2

MODERN PORTFOLIO THEORY

6.2.1

Introduction

Understanding the risky behaviour of asset and their pricing in the market is critical to various
investment decisions, be it related to financial assets or real assets. This understanding is mostly
developed through the analysis and generalization of the behaviour of individual investors in the
market under certain assumptions. The two building blocks of this analysis and generalization
are (i) theory about the risk-return characteristics of assets in a portfolio (portfolio theory) and
(ii) generalization about the preferences of investors buying and selling risky assets (equilibrium
models). Both these aspects are discussed in detail in this chapter, where our aim is to provide a
brief overview of how finance theory treats stocks (and other assets) individually, and at a
portfolio level. We first examine the modern approach to understanding portfolio management
using the trade-off between

risk and

return and then look at some equilibrium asset-

pricing models. Such models help us understand the theoretical underpinning and (hopefully
predict) the dynamic movement of asset prices.
6.2.3

Diversification and Portfolio Risks

The age-old wisdom about not putting all your eggs in one basket applies very much in the
case of portfolios. Portfolio risk (generally defined as the standard deviation of returns) is not the
weighted average of the risk (standard deviation) of individual assets in the portfolio. This gives
rise to opportunities to eliminate the risk of assets, at least partly, by combining risky assets in a
portfolio. To give an example, consider a hypothetical portfolio with say, ten stocks. Each of
215

these stocks has a risk profile, a simple and widely used indicator of which is the standard
deviation of its returns. Intuitively, the overall risk of the portfolio simply ought to be an
aggregation of individual portfolio risks, in other words, portfolio risk simply ought to be a
weighted average of individual stock risks. Our assertion here is that the risk of the portfolio is
usually much lower. Why? As we shall see in the discussion here, this is largely due to the
interrelationships that exist between stock price movements. These so-called covariances
between stocks, could be positive, negative, or zero. An example of two IT services stocks,
reacting favourably to a depreciation in the domestic currencyas their export realizations
would rise in the domestic currencyis one of positive covariance. If however, we compare one
IT services company with another from the metals space, say steel, which has high foreign debt,
then a drop in the share price of the steel company (as the falling rupee would increase the debtservice payments of the steel firm) and rise in share price of the IT services company, would
provide an example of negative covariance. It follows that we would expect to have zero
covariance between stocks whose movements are not related.
Let us now examine why and how portfolio risk is different from the weighted risk of constituent
assets. Assume that we have the following two stocks, as given in table 6.1 here, and then
assume further that the returns of the two hypothetical stocks behave in opposite directions.
When A gives high returns, B does not and vice versa. We know this is quite possible, as in our
earlier comparison of a software company with a commodity play. For a portfolio with 60%
invested in A, the portfolio standard deviation becomes zero. Although the two stocks involved
were risky (indicated by the standard deviations), a portfolio of the two stocks with a certain
weight may become totally risk-free. The table below shows a portfolio of the two stocks with
weight of Stock A (W) being 0.6 and weight of stock B being (1-0.6) or 0.4. It can be seen that
irrespective of the market condition, the portfolio gives a return of 10%.

Why does the portfolio standard deviation go to zero? Intuitively, the negative deviation in the
216

returns of one stock is getting offset by the positive deviation in the other stock. Let us
examine this in a somewhat more formal and general context.
Let us assume that you can form portfolios with two stocks, A & B, having the
following characteristics:

The total available amount that can be invested, is Re. 1. The proportional investments in each of the
stocks are as below,
Stock A = W
Stock B = (1 - W)
where W is between 0 and 1.
Given this information, we can show that

That is, we would show that the variance of our portfolio, as denoted by the left hand side of this
equation, is dependent on the variance of stock A, that of stock B, and a third term, called
Cov(A,B). It is this third term that denotes the interrelationship between the two stocks. As
discussed before, such a relation could be positive, negative or zero. In cases with negative
covariance, portfolio variance would actually be lower than the (weighted) sum of stock
variances! In other words, since variance (or standard deviation) is the primary metric of risk
measurement, then we can say that the risk of the portfolio would be lower than individual stocks
considered separately.
So here is how we go about deriving this expression:
With these investments the portfolio return is,

217

The covariance can be regarded as a measure of how much two variables change together
from their means. It can also be expressed as,
is the correlation between returns of stocks A and B. Therefore, if the correlation is positive and
the stocks have high standard deviations, then the covariance would be positive and large. It
would be negative if the correlation is negative.
218

Substituting these, the portfolio variance can be expressed as,

Equation (4) suggests that the total portfolio variance comprises the weighted sum of variances
and weighted sum of the covariances too. Let us examine the insights from expression (4) for the
variance of combinations of stocks (or any other asset) with varying level of correlations.

Given the nature of the return relationship between the A and B (in Table 6.1), it is easy to see
that their correlation is -1.0. For the portfolio of stock A and B, the risk becomes zero, when
weight of stock A (W) = 0.6.

Although the two stocks involved were risky (indicated by the standard deviations), one of their
possible combinations becomes totally risk-free. The variances of the individual stocks are offset
by their covariance in the portfolio (as shown in Table 6.2).
When the correlation between the two stocks is 1.0, the standard deviation of the portfolio shall
be just a weighted average of the standard deviation of the two stocks involved. This implies that
a portfolio with two perfectly positively correlated stocks cannot reduce risk. The minimum
portfolio standard deviation would always correspond to that of the stock with the least standard
deviation.
The standard deviation of the portfolio with two uncorrelated (correlation = 0) stocks would
always be lower than the case with correlation 1.0. It is possible to choose a value for W in such
a way, so that the portfolio risk can be brought down below that of the least less risky stock
involved in the portfolio.
219

However, in the real world the correlations almost always lie between 0 and 1. It is very
straightforward to understand that the variance of portfolios with stocks having correlation in the
0 to 1 range would certainly be lower than those with stocks having correlation 1. At the same
time, the variance of these portfolios shall be higher than those with uncorrelated stocks.
Let us examine if we can reduce the portfolio variance by combining stocks with correlation in
the range of 0 to 1. Consider the two stocks, ACC and Dr. Reddys Laboratories (DRL) with
correlation around 0.21. As given in the following table, for a unique combination, the total
variance (standard deviation) of the portfolio is less than that of ACC, the least risky stock. The
details of the risk of this portfolio are provided in the following table.

This suggests that for certain values of W, the variance of the portfolio can be brought down by
combining securities with correlation the range of 0 to 1.

220

A comparison of the behaviour (return-variance) of portfolios made with stocks of varying

correlation is given in the following figure:

221

Note: the portfolio sigma is the standard deviation. The portfolios are created by using actual
return data and assumed correlations, except 0.4, which is the actual correlation between the two
stocks.
With these insights we can now examine the behaviour of portfolios with a larger number of
assets.
6.2.3

Portfolio variance - General case

Let us assume that there are N stocks available for generating portfolios. Then, the portfolio
variance (given by equation 4) can be expressed as,

where Wi is the proportional investment

in each of the assets and is the covariance

between the pair of assets i and j. The

double summation sign in the second part

indicates that the covariance would appear for all possible combinations of i and j, except with
themselves. For instance, if there are 3 stocks, there would be six covariance terms (1-2,
1-3, 2-1, 2-3, 3-1, 3-2).
To examine the characteristics of including a large number of stocks in the portfolio, assume that

222

we create an equally weighted portfolio (equal investment in the stocks) of N assets. Then,
The expression just above gives the following insights:
1.

As N becomes a large number, the portfolio variance would be dominated by the

covariances rather than variances. The variance of the individual stocks does not matter
much for the total portfolio variance. This is one of the most powerful arguments for
portfolio diversification.

2.

Even by including a large number of assets, the portfolio variance cannot be reduced to zero
(except when they are perfectly negatively correlated). The part of the risk that cannot be
eliminated by diversifying through investments across assets is called the market risk (also
called the

systematic risk or

non-diversifiable risk). This is something all of us

commonly experience while investing in the market. One can reduce the risk of
exposure to say HCL Technologies in the IT industry, by including other stocks from the IT
industry, like Infosys technologies, Tech Mahindra and so on. If you consider the exposure
to IT industry alone is troubling, you can also spread your investment to other industries like
Banking, Telecom, Consumer products and so on. Going further, you can even invest across
different markets, if you do not like to be exposed to anyone economy alone. But even after
international diversification a certain amount of risk would remain. (international markets in
the globalize world tend to move together). This is the market risk or systematic risk or nondiversifiable risk.
3.

Given the above, it appears that the relevant risk of an asset is what it contributes to a
widely-held portfolio, in other words, its covariance risk.

223

6.3

Equilibrium Models: The Capital Asset Pricing Model

The most important insight from the analysis of portfolio risk is that a part of the portfolio
variance can be diversified away (unsystematic or diversifiable risk) by selecting securities with
less than perfect correlation. This along with the other insights obtained from the analysis would
help us to understand the pricing of risky assets in the equilibrium for any asset in the capital
market, under certain assumptions.
These additional assumptions required are as follows:

All investors are mean-variance optimizers. This implies that investors are

concerned only about the mean and variance of asset returns. Investors would either
prefer portfolios which offer higher return for the same level of risk or prefer
portfolios which offer minimum risk for a given level of return (the indirect assumption
of mean-variance investors is that all other characteristics of the assets are captured by
the mean and variance).

Investors have homogenous information about different assets. The well-organized

financial

markets

have

remarkable

ability

to

digest

information

almost

instantaneously (largely reflected as the price variation in response to sensitive

information).

Transaction costs are absent in the market and securities can be bought and sold

without significant price impact.

Investors have the same investment horizon.

Given these assumptions, it is not impossible to see that substantive arbitrage opportunities
would not exist in the market. For instance, if there is a portfolio which gives a higher return for
same level of risk, investors would prefer that portfolio compared to the existing one.
In light of the behaviour of portfolio risk and the above assumptions, let us try to visualize what
would be the relationship between risk and return of assets in the equilibrium.
6.3.1

Mean-Variance Investors and Market Behaviour

We can use a so-called mean-variance space to examine the aggregate behaviour of the
224

market (as all investors are mean-variance optimizers, these are the only variables that matter).
Evidently, all the assets in the market can be mapped on to a return-standard deviation space
as follows.
Figure 6.2 : Return and Risk of Some of the Nifty stocks

225

All these stocks (in figure 6.2) have correlations between 0 and 1. Therefore, their combination
could theoretically be characterized as given in figure 6.3.

All the feasible portfolio combinations can be represented by the space enclosed by the curved
line and the straight-line. The curved line represents combinations of stocks or portfolios
where correlations are less than 1, whereas portfolios along the straight-line represent
combinations of stocks or portfolios with the maximum correlation (+1.0) (no portfolios would
lie to the right of the straight-line).
Obviously, a mean-variance investor would prefer portfolio A to B, given that it has lower risk
for the same level of return offered by B. Similarly, portfolio A would be preferred to portfolio
C, given that it offers higher return for the same level of risk. D is the minimum variance
portfolio among the entire feasible set. A close examination of the feasible set of portfolios
reveals that portfolios that lie along D-E represent the best available combination of portfolios.
Investors with various risk tolerance levels can choose one of these portfolios. These
portfolios offer the maximum return for any given level of risk. Therefore, these are called the
efficient portfolios (and the set of all such portfolios, the efficient frontier), as represented in
Figure 6.4.
226

Figure 6.4: Efficient Frontier

Ordinarily, the investor also has the opportunity to invest in a risk-free asset. Practically, this
could be a bank deposit, treasury bills, Government securities or Government guaranteed bonds.
With the availability of a risk-free security, the choice facing the mean-variance investor can be
conveniently characterised as follows:
Figure 6.5 : Efficient Portfolio in the Presence of a Risk-Free Asset

As given in figure 6.5, with the presence of the risk-free asset, that has no correlation with any
other risky asset, the investor also gets an added opportunity to combine portfolios along the
efficient frontier with the risk-free asset. This would imply that the investor could partly put the
money in the risky security and the remaining in any of the risky portfolios.
Apparently, the portfolio choice of the mean-variance investor is no more the securities along the
efficient frontier (D-E). If an investor prefers less risk, then rather than choosing D by going
down the efficient frontier, he can choose G, a combination of risky portfolio M and the risk-free
asset. G gives a higher return for the level of risk of D. In fact, the same applies for all the
227

portfolios along the efficient frontier that lie between D and M (they offer only lower returns
compared to those which lie along the straight-line connecting the risk-free asset and risky
portfolio M).
This gives the powerful insight that, with the presence of the risk-free security, the most
preferred portfolio along the efficient frontier would be M (portfolios to the right of M along the
straight line indicates borrowing at the risk-free rate and investing in M).
An investor who does not want to take the risk of M, would be better off by combining with the
risk-free security rather than investing in risky portfolios with lower standard deviation (that lie
along the M-D).
Identification of M as the optimal portfolio, combined with the assumptions (1) that all investors
have the same information about mean and variance of securities and (2) they all have the same
investment horizon, suggest that all the investors would hold only the following portfolios
depending on the risk appetite.
1.

The portfolio purely of risky assets, which would be M.

2.

The portfolio of risky assets and risk-free asset, which would be a combination of
M and RF.
All other portfolios are inferior to these choices, for any level of risk preferred by the
investors. Let us examine what would be the nature of the portfolio M. If all investors are
mean-variance optimizers
invariably

be the

and have

the same

information, their

portfolios

would

same. Then, all of them would identify the same portfolio as M.

Obviously, it should be a combination of all the risky stocks (assets) available in the market
(somebody should be willing to hold all the assets available on the market). This
portfolio is referred to as the market portfolio. Practically, the market portfolio can be
regarded as one represented by a very liquid index like the NIFTY. The line connecting the
market portfolio to the risk-free asset is called the Capital Market Line (CML). All points
along the CML have superior risk-return profiles to any portfolio on the efficient frontier.

228

With the understanding about the aggregate behaviour of the investors in the securities market,
we can estimate the risk premium that is required for any asset. Understanding the risk
premium dramatically solves the asset pricing problem through the estimation of the discounting
factor to be applied to the expected cash flows from the asset. With the expected cash flows and
the discounting rate, the price of any risky asset can be directly estimated.
Let RM be the required rate of return on the market (market portfolio, M), RF be the required rate
of return on the risk free asset and M be the standard deviation of the market portfolio. From
Figure 6.5, the rate of risk premium required for unit variance of the market is estimated
as,

In a very liquid market (where assets can be bought and sold without much hassles), investor has
the opportunity to hold stocks as a portfolio rather than in isolation. If investors have the
opportunity to hold a well-diversified portfolio, the only risk that matters in the individual
security is the incremental risk that it contributes to a well-diversified portfolio. Therefore, the
risk relevant to the prospective investor (or firm) is the covariance risk. Then, one can compute
the risk premium required on the security as follows

where, Cov(i,M), is the covariance between the returns of stock i and the market returns
(returns on portfolio M). The quantity represented by

229

is popularly called the beta (

market. A beta of 2.0 indicates that if the market moves down (up) by 1%, the security is
expected to move down (up) 2%. Therefore, we would expect twice the risk premium as
compared to the market. This implies that the minimum expected return on this stock is 2 x(Rm
Rf). In general, the risk premium on a security is times (Rm Rf) . Obviously, the market
portfolio will have a beta of 1.0 (covariance of a stock with itself is variance).
Now by combining the risk-free rate and the risk premium as estimated above, the total
required rate of return on any risky asset is,

This approach to the estimation of the required return of assets (cost of equity, in case of equity)
is called the Capital Asset Pricing Model (CAPM, pioneered by William Sharpe).
If CAPM holds in the market, all the stocks would be priced according to their beta. This would
imply that the stock prices are estimated by the market by discounting the expected cash flows
by applying a discounting rate as estimated based on equation (7).
Hence, all the stocks can be identified in the mean return-beta space, as shown below and
relationship between beta and return can be estimated. The line presented in the following figure
is popularly called the Securities Market Line (SML).

230

231

Figure 6.6 : Security Market Line

Note: this figure is not based on any real data.

Prices (returns) which are not according to CAPM shall be quickly identified by the market and
brought back to the equilibrium. For instance, stocks A and B given in the following figure (6.7)
shall be brought back to the equilibrium through market dynamics.
This works as follows. Stock A, currently requires a lower risk premium (required rate
of return) than a specified by CAPM (the price is higher). Sensing this price of A as relatively
expensive, the mean-variance investors would sell this stock. The decreased demand for the
stock would push its price downwards and restore the return back to as specified by CAPM (will
be on the line). The reverse happens in case of stock B, with increased buying pressure.
Figure 6.7 : Arbitrages around SML

6.3.2

Estimation of Beta

The beta of a stock can be estimated with the formula discussed above. Practically, the beta
232

of any stock can be conveniently estimated as a regression between the return on stock and that
of the market, represented by a stock index like NIFTY (the dependent variable is the stock
return and the independent variables is the market return).
Accordingly, the regression equation is,

where the regression coefficient i represents the slope of the linear relationship between the
stock return and the market return and i denote the risk-free rate of return. The SLOPE function
in MS-Excel is a convenient way to calculate this coefficient from the model.
The beta of an existing firm traded in the market can be derived directly from the market prices.
However, on many occasions, we might be interested to estimate the required rate of return on an
asset which is not traded in the market. For instances like, pricing of an IPO, takeover of another
firm, valuation of certain specific assets etc.. In these instances, the required rate of return can
be estimated by obtaining the beta estimates from similar firms in the same industry.
The beta can be related to the nature of the assets held by a firm. If the firm holds more risky
assets the beta shall also be higher. Now, it is not difficult to see why investors like venture
capitalists demand higher return for investing in start-up firms. A firms beta is the weighted
average of the beta of its assets (just as the beta of a portfolio is the weighted average of the beta
of its constituent assets).

6.4

Multifactor Models: The Arbitrage Pricing Theory (APT)

The CAPM is founded on the following two assumptions (1) in the equilibrium every mean
variance investor holds the same market portfolio and (2) the only risk the investor faces is the
beta. Evidently, these are strong assumptions about the market structure and behaviour of
investors. A more general framework about asset pricing should allow for relaxation of these
strong and somewhat counterfactual assumptions. A number of alternative equilibrium asset
pricing models, including the general arbitrage pricing theory (APT), attempt to relax these
233

assumptions to provide a better understanding about asset pricing.

The arbitrage pricing theory assumes that the investor portfolio is exposed to a number of
systematic risk factors. Arbitrage in the market ensures that portfolios with equal sensitivity to a
fundamental risk factor are equally priced. It further assumes that the risk factors which are
associated with any asset can be expressed as a linear combination of the fundamental risk
factors and the factor sensitivities (betas). Arbitrage is then assumed to eliminate all
opportunities to earn riskless profit by simultaneously selling and buying equivalent portfolios
(in terms of risk) which are overpriced and underpriced.
Under these assumptions, all investors need not have the same market portfolio as under CAPM.
Hence, APT relaxes the assumption that all investors in the market hold the same portfolio.
Again, as compared to CAPM, which has only one risk dimension, under the APT
characterization of the assets, there will be as many dimensions as there are fundamental risks,
which cannot be diversified by the investors. The fundamental factors involved could for
instance be the growth rate of the economy (GDP growth rate), inflation, interest rates and any
other macroeconomic factor which would expose the investors portfolio to systematic risk.
In the lines of the assumptions of arbitrage pricing theory, a number of multifactor asset
pricing models have been proposed. One such empirically successful model is the so-called
Fama-French three-factor model. The Fama-French model has two more risk factors, viz.,
size, and book-to-market ratio as the additional risk factors along with the market risk as
specified by CAPM. The size risk factor is the difference between the expected returns on a
portfolio of small stocks and that of large stocks. And the book-to-market ratio is the difference
in the expected return of the portfolio of high book-to market-ratio stocks and that of low bookto market-ratio stocks.
Theoretical and empirical evidence suggests that in the real market, expected returns are
probably determined by a multifactor model. Against this evidence, the most popular and simple
equilibrium model, CAPM, could be regarded as a special case where all investors hold the same
portfolio and their only risk exposure is the market risk.

234

6.5 ASSET ALLOCATION

An investment strategy that aims to balance risk and reward by apportioning a portfolio's assets,
according to an individual's goals, risk tolerance and investment horizon.
The three main asset classes - equities, fixed-income, and cash and equivalents - have different
levels of risk and return, so each will behave differently over time.
There is no simple formula that can find the right asset allocation for every individual. However,
the consensus among most financial professionals is that asset allocation is one of the most
important decisions that investors make. In other words, your selection of individual securities is
secondary to the way you allocate your investment in stocks, bonds, and cash and equivalents,
which will be the principal determinants of your investment results.
Asset-allocation mutual funds, also known as life-cycle, or target-date, funds, are an attempt to
provide investors with portfolio structures that address an investor's age, risk appetite and
investment objectives with an appropriate apportionment of asset classes. However, critics of this
approach point out that arriving at a standardized solution for allocating portfolio assets is
problematic because individual investors require individual solutions.
Asset allocation is the process of choosing among possible asset classes. A large part of
financial planning consists of finding an asset allocation that is appropriate for a given investor
in terms of their appetite for and ability to shoulder risk. This can depend on various factors; see
investor profile. Asset Allocation is the product of an examination of an investor's needs and
objectives. Asset allocation, done well, is a plan to invest in assets or asset classes which will
best meet the needs and objectives of the investor. Investors seeking high returns and willing to
expose their investments to an elevated amount of risk will allocate to equity (ownership)
investments. Investors seeking stability and income will allocate to debt investments. Most
investors, particularly personal investors, will find mixtures of equity and debt investments most
nearly meet their needs. Asset Allocation can be practised by optimization techniques,
minimizing risk for a given level of return or maximising return for a given level of risk. It also
can be accomplished as goal based investing.

235

Justification
Asset allocation is based on the idea that in different years a different asset is the best-performing
one. It is difficult to predict which asset will perform best in a given year. Therefore, although it
is psychologically appealing to try to predict the "best" asset, proponents of asset allocation
consider it risky. Experts in the field note that someone who "jumps" from the one asset to
another, according to whim, may easily end up with worse results than does someone following
any consistent plan.
A fundamental justification for asset allocation is the notion that different asset classes offer
returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of
the variability of returns for a given level of expected return. Therefore, having a mixture of asset
classes is more likely to meet the investor's wishes in terms of amount of risk and possible
returns.
In this respect, diversification has been described as "the only free lunch you will find in the
investment game". Academic research has painstakingly explained the importance of asset
allocation and the problems of active management (see academic studies section below). This
explains the steadily rising popularity of passive investment styles using index funds.
Although risk is reduced as long as correlations are not perfect, it is typically forecast (wholly or
in part) based on statistical relationships (like correlation and variance) that existed over some
past period. Expectations for return are often derived in the same way.
When such backward-looking approaches are used to forecast future returns or risks using the
traditional mean-variance optimization approach to asset allocation of modern portfolio theory,
the strategy is, in fact, predicting future risks and returns based on past history. As there is no
guarantee that past relationships will continue in the future, this is one of the "weak links" in
traditional asset allocation strategies as derived from MPT. Other, more subtle weaknesses
include the "butterfly effect", by which seemingly minor errors in forecasting lead to
recommended allocations that are grossly skewed from investment mandates and/or
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impracticaloften even violating an investment manager's "common sense" understanding of a

tenable portfolio-allocation strategy.

Asset Allocation Strategies

There are three basic types of asset allocation strategies based on investment goals, risk
tolerance, time frames and diversification: strategic, tactical, and core-satellite.
Strategic Asset Allocation - the primary goal of a strategic asset allocation is to create an asset
mix that will provide the optimal balance between expected risk and return for a long-term
investment horizon.
Tactical Asset Allocation - method in which an investor takes a more active approach that tries to
position a portfolio into those assets, sectors, or individual stocks that show the most potential
for gains.
Core-Satellite Asset Allocation - is more or less a hybrid of both the strategic and tactical
allocations mentioned above.
Systematic Asset Allocation is another approach which depends on three assumptions. These areThe markets provide explicit information about the available returns.
The relative expected returns reflect consensus.
Expected returns provide clues to actual returns.

Examples of asset classes

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cash (e.g., money market funds)

Bonds: investment-grade or junk (high-yield); government or corporate; short-term,
intermediate, long-term; domestic, foreign, emerging markets
stocks: value or growth; large-cap versus small-cap; public equities versus private equities,
domestic, foreign, emerging markets
real estate (also REITs)
foreign currency
natural resources: oil, coal, cotton, wheat
precious metals
collectibles such as art, coins, or stamps
insurance products (life settlements, catastrophe bonds, personal life insurance products, etc.)

To further break down equity investments into additional asset sub-classes consider the following:
By size:
Large-cap
Mid-cap
Small-cap
By style:
Growth
Blend
Value

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Note that 'funds' are not an asset class; funds are filed under what they own, e.g. stocks for stock
funds, bonds for bond funds, et cetera.

6.6 PRACTICAL PORTFOLIO MANAGEMENT

Practical Portfolio Management is an effective approach to business re-alignment via portfolio
management. It combines the 'best practice' from the emerging portfolio management discipline.
This is combined with practical experience to ensure that delegates obtain the right balance of
theory and practical understanding to effectively manage portfolios in the workplace.

It includes:
Business Change Management Utilizing Portfolio Management Principles.
How to be an effective Portfolio Manager.
Running the right projects and programmes.
Prioritizing change and business as usual with portfolio management.
The importance of portfolio alignment with strategic direction.
Smart use of portfolio management to gain efficiencies.
Improving senior management engagement and communication.

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6.7 MANAGEMENT OF INVESTMENT INSTITUTIONS

6.7.1

Introduction

In the final chapter of this module we take a brief look at the professional asset management
industry. Worldwide, the last few decades have seen an increasing trend away from direct
investment in the markets, with the retail investor now preferring to invest in funds or the index,
rather than direct exposure into equities. This has naturally led to a sharp increase in the assets
under management of such firms.
The asset management industry primarily consists of two kinds of companies, those engaged in
investment advisory or wealth management activities, and those into investment management. In
the first category, investment advisory firms recommend their clients to take positions in various
securities, and wealth management firm either recommend, or have custody of their clients
funds, to be invested according to their discretion. In both cases, the engagement with clients is
at an account level, i.e., funds are separately managed for each client. In contrast,
investment management companies combine their clients assets towards taking positions in a
single portfolio, usually called a fund (or a mutual fund). A unit of such a fund then represents
positions in each of the securities owned in the portfolio. Instead of tracking returns on their own
portfolios, clients track returns on the net asset value (NAV) of the fund. In addition to the
perceived benefits of professional fund management, the major reason of investment into
funds is the diversification they afford the investor. For instance, instead of owning every
large-cap stock in the market, an investor could just buy units of a large-cap fund.
In this chapter, we shall examine the various types of such funds, differentiated by their
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investment mandates, choice of securities, and of course, investment performance, where we

would outline a few of the key metrics used to measure investment performance of funds.
6.7.2

Investment Companies

Investment companies pool funds from various investors and invest the accumulated funds in
various financial instruments or other assets. The profits and losses from the investment
(after repaying the management expenses) are distributed to the investors in the funds in
proportion to the investment amount. Each investment company is run by an asset management
company who simultaneously operate various funds within the investment company. Each fund
is managed by a fund manager who is responsible for management of the portfolio.
Investment companies are referred to by different names in different countries, such as mutual
funds, investment funds, managed funds or simply funds. In India, they are called mutual funds.
Our treatment would use these names interchangeably, unless explicitly stated.

6.7.2.1 Benefits of investments in managed funds

The main advantages of investing through collective investment schemes are:
- Choice of Schemes: There are various schemes with different investment themes.
Through each scheme an investor has an opportunity to invest in a wide range of
investable securities.
-

Professional Management: Professionally managed by team of experts.

- Diversification: Scope for better diversification of investment since mutual fund assets
are invested across a wide range of securities.
- Liquidity: Easy entry and exit of investment: investors can with ease buy units from
mutual funds or redeem their units at the net asset value either directly with the mutual
fund or through an advisor / stock broker.
- Transparency: The asset management team has to on a regular basis publish the NAV of
the assets and broad break-up of the instruments where the investment is made.

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- Tax benefits: Dividends received on investments held in certain schemes, such as equity
based mutual funds, are not subject to tax.
6.7.3

Active vs. Passive Portfolio Management

If asset prices always reflect their equilibrium values (expected returns equal to the value
specified by an asset pricing model), then an investor is unlikely to benefit from actively
searching for mispriced (overpriced/underpriced) opportunities in assets. In other words, the
investor is better off by simply investing in the market, or a representative benchmark. For
instance, under such assumptions, an Indian equity investor would achieve the best possible
outcome by trying to replicate the Nifty 50 by investing in the constituent stocks in the same
proportion as they are in the index.
Such investment assumes that gains in the market are those of the benchmark, and not in the
choice of individual securities, as opportunities in their selection, or timing of entry/exit are too
short to be taken advantage of. This, passive approach to investment rests upon the theory
of market efficiency, which we saw in chapter 4. Recall that the EMH postulates that prices
always fully reflect all the available information and any deviation from the full information
price would be quickly arbitraged away. In an efficient market, information about fundamental
factors related to the asset, or its market price, volume or any other related trading data related
has little value for the investor.

Passive fund managers try to replicate the performance of a benchmark index, by replicating the
weights of its constituent stocks. Given daily price movement in stock prices, the challenge for
such managers is to minimize the so-called tracking error of the fund, which is calculated as the
deviation in its returns from that of the index. The choice of the index further differentiates
between the funds, for example, an equity index fund would simply try to maintain the return
profile of the benchmark index, say, the NIFTY 50; but if investments are allowed across asset
classes, then the benchmark could well consist of a combination of a equity and a debt index.
Recent evidence of systematic departures of asset prices in the from equilibrium values, as
envisaged under the market efficiency, has renewed interest in active fund management, which
entails that optimal selection of stocks, and the timing of entry/exit could lead to marketbeating returns.
This represents an opportunity for investors to engage in active strategies based on their
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objective views about the assets. In a generic sense, such views are about the relative under
pricing or over pricing of an asset. Over pricing presents an opportunity to engage in short
selling, under pricing an opportunity to take a long position, and combinations of the two are
also possible, across stocks, and portfolios.
The objective of an active portfolio manager is to make higher profits from investing, with
similar, or lower risks attached. The risk of a portfolio, as noted in an earlier chapter, is usually
measured with the standard deviation of its assets. A good portfolio manager should have good
forecasting ability and should be able to do two things better than his competitors: market
timing and security selection.
By market timing, we refer to the ability of the portfolio manager to gauge at the beginning of
each period the profitability of the market portfolio vis--vis the risk-free portfolio of
Government bonds. The strength of such a signal would indicate the level of investment required
in the market.
By security selection, we refer to ability of a portfolio manager in identifying mispricing in
individual securities and then investing in securities with the maximum mispricing, which
maximizes the so-called alpha. The alpha of a security refers to the expected excess return of the
security over the expected rate of return (for example, estimated by an equilibrium asset-pricing
model like the CAPM). The mispricing may be either way: If the portfolio manager believes that
a security is going to generate negative return, his portfolio should give a negative weight for the
same i.e. short the security and vice versa. The tradeoff for the active investor is the presence of
nonsystematic risk in the portfolio. Since the portfolio of an active investor is not fully
diversified, there is some nonsystematic (firm-specific) risk that is not diversified away. Active
fund management is a diverse businessthere are many ways to make money in the market
almost all the investment styles we would examine further in the chapter are illustrative
examples.
Active and passive fund management are not always chalk and cheesethere are techniques that
utilize both, like portfolio tilting. A tilted portfolio shifts the weights of its constituents towards
one or more of certain pre-specified market factors, like earnings, valuations, dividend yields, or
towards one or more specific sectors.
By their very nature of operations, active and passive investments differ meaningfully in terms of
243

their costs to the investors. Passive investment is characterized by low transaction costs (given
their low turnover), management expenses, and the risks attached.

Active fund

management is understandably more expensive, but has seen costs falling over the years on
competitive pricing and increased liquidity of the markets, which reduced transaction costs.
6.7.4

Costs of Management: Entry/Exit Loads and Fees

Running a mutual fund involves certain costs (e.g. remuneration to the management team,
advertising expenses etc.) which may be recurring or non-recurring in nature. These costs are
recovered by the fund from the investors (e.g. from redemption fees) or from charges on the
assets (transaction fees, management fees and commission etc.) of the funds.
Generally, the management team is paid a fixed percentage of the asset under management as
their fees.
Investment management companies can be broadly classified on the basis of the securities they
invest in and their investment objectives. Before we look at either, we define the core measure of
return for a fund, the NAV, and so-called open, and closed-ended funds.
6.7.5

Net Asset Value

The net asset value NAV is the most important and widely followed metric of a funds
performance. It is calculated per share using the following formula:
NAV per share = Market Value of Assets- Market Value of liabilities
Number of shares outstanding
Net asset value (NAV) is a term used to describe the per unit value of the funds net assets
(assets less the value of its liabilities). Hence the NAV for a fund is
Fund NAV = (Market Value of the fund portfolio Fund Expenses) / Fund Shares Outstanding
Just like the share price of a common stock, the NAV of a fund would rise with the value of the
fund portfolio, and is instantly reflective of the value of investment.

6.7.6

Classification of funds
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6.7.6.1 Open ended and closed-ended funds

Funds are usually open or closed-ended. In an open-ended fund, the units are issued and
redeemed by the fund, at any time, at the NAV prevalent at the time of issue / redemption. The
fund discloses the NAV on a daily basis to facilitate issue and redemption of units. Unlike openended funds, closed-ended funds sell units only at the outset and do not redeem or sell units once
they are issued. The investors can sell or purchase units to (or from) other investors and to
facilitate such transactions, such units are traded on stock exchanges. Price of closed ended
schemes are determined based on demand and supply for the units at the stock exchange and can
be more or less than the NAV of the units.
We now examine the different kind of funds on the basis of their investments. While we had
earlier mentioned mutual fund investments represented as units in a single portfolio, in real life,
fund houses float various schemes from time-to-time, each a constituting a portfolio where
inputs translate into units. These schemes are differentiated by their charter which mandates their
investment into asset classes.
Beyond the type of instruments they invest in, fund houses are also differentiated in terms of
their investment styles. The approaches to equity investing could be diversified or undiversified,
growth, income, sector rotators, value, or market-timing based.
Each mutual fund scheme has a particular investment policy and the fund manager has to ensure
that the investment policy is not breached. The policy is laid right at the outset when the fund is
launched and is specified in the prospectus, the Offer Document of the scheme.
The investment policy determines the instruments in which the money from a specific scheme
will be primarily invested. Based on these securities, mutual funds can be broadly classified into
equity funds (growth funds and income funds), bond funds, money market funds, index funds,
etc. Generally, fund houses have dozens of schemes floating in the market at any given time,
with separate investment policies for each scheme.

6.7.6.2 Equity funds

Equity funds primarily invest in common stock of companies. Equity funds can be growth funds
or income funds. Growth funds focus on growth stocks, i.e., companies with strong growth
245

potential, with capital appreciation being the major driver, while income funds focus on
companies that have high dividend yields. Income funds focus on dividend income or coupon
payments from bonds (if they are not pure equity).
Equity funds may also be sector-specific wherein the investment is restricted to stocks from a
specific industry. For example, in India we have many funds focusing on companies in power
sector and infrastructure sector.
6.7.6.3 Bond funds
Bond funds invest primarily in various bonds that were described in the earlier segment. They
have a stable income stream and relatively lower risk. They could potentially invest in corporate
bonds, Government. bonds, or both.

6.7.6.4 Index funds

Index funds have a passive investment strategy and they try to replicate a broad market index. A
scheme from such a fund invests in components of a particular index proportionate to their
representation in the benchmark. It is possible that a scheme tracks more than one index (in some
pre-specified ratio), in either equity, or across asset classes.
6.7.6.5 Money market funds
Money market mutual funds invest in money market instruments, which are short-term securities
issued by banks, non-bank corporations and Governments. The various money market
instruments have already been discussed earlier.
6.7.6.6 Fund of funds
Fund of funds add another layer of diversification between the investor and securities in the
market. Instead of individual stocks, or bonds, these mutual funds invest in units of other mutual
funds, with the fund managers mandate being the optimal choice across mutual fund schemes
given extant market conditions.
246

6.7.7 Other Investment Companies

In addition to the broad categories mentioned here, there are many other kinds of funds,
depending on market opportunities, and investor appetite. Total return funds look at a
combination of capital appreciation and dividend income. Hybrid funds invest in a combination
of equity, bonds, convertibles, and derivative instruments. These funds could be further
distributed as asset allocation, balanced, or flexible portfolio funds, based on the breadth of
their investment in different asset classes, and the frequency of modifying the allocation.
Global, regional, or emerging market funds recognize investment opportunities across the world,
and accordingly base their investment focus. Such funds could again comprise either, or a
combination of equity, debt, or hybrid instruments. We mention some other, specific types of
investment vehicles below.

6.7.7.1 Unit Investment Trusts (UIT)

Similar to mutual funds, UITs also pool money from investors and have a fixed portfolio of
assets, which are not changed during the life of the fund. Although the portfolio composition is
actively decided by the sponsor of the fund, once established the portfolio composition is not
changed (hence called unmanaged funds).
The way an UIT is established is different from that of other mutual funds. UITs are usually
created by sponsors, who first make investment in the portfolio of securities. The entire portfolio
is then transferred to a trust and the trustees issue trust certificates to the public, which is similar
to shares. The trustees distribute the incomes from the investment and the maturity (capital)
amount to the shareholders on maturity of the scheme.
6.7.7.2 REITS (Real Estate Investment Trusts)
REITS are also similar to mutual funds, but they invest primarily in real estates or loans
secured by real estate. REIT can be of three types equity, mortgage or hybrid trusts. Equity
trusts invest in real estate assets, mortgage trusts invest in loans backed by mortgage and hybrid
trusts invest in either.
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6.7.7.3 Hedge Funds

Hedge funds are generally created by a limited number of wealthy investors who agree to pool
their funds and hire experienced professionals (fund managers) to manage their portfolio. Hedge
funds are private agreements and generally have little or no regulations governing them. This
gives a lot of freedom to the fund managers. For example, hedge funds can go short (borrow)
funds and can invest in derivatives instruments which mutual funds cannot do.
Hedge funds generally have higher management fees than mutual funds as well as performance
based fees. The management fee (paid to the fund managers), in the case of hedge funds is
dependent on the assets under management (generally 2 - 4%) and the fund performance
(generally 20% of the excess returns over the market return generated by the fund).

6.8

Performance measurement of managed funds

Prior to the development of the modern portfolio theory (MPT), portfolio managers were
evaluated by comparing the return generated by them with some broad yardstick. The risk borne
by the portfolio managers or the source of performance such as market timing, market volatility,
the security selections and valuations were not considered. With the development of the MPT,
the goal of performance evaluation is to study whether the portfolio has provided superior returns
compared to the risks involved in the portfolio or compared to an equivalent
passive benchmark.
The performance evaluation approach tries to attribute the performance to the following:
-

Risk

Timing: market or volatility

Security selection of industry or individual stocks

Therefore:
a)

The focus of evaluation should be on excess returns

b)

The portfolio performance must account for the difference in the risk
248

c)

It should be able to distinguish the timing skills from the security selection skills.

The assessment of managed funds involves comparison with a benchmark. The benchmark could
be based on the Capital Market Line (CML) or the Security Market Line (SML). When it is
based on capital Market Line, the relevant measure of the portfolio risk is and when based on
Security Market Line, the relevant measure is
portfolio performance, viz. Sharpe Ratio, Treynor Ratio and Jensen Alpha.
6.8.8.1 Sharpe Ratio

Sharpe ratio or excess return to variability measures the portfolio excess return over the sample
period by the standard deviation of returns over that period. This ratio measures the effectiveness
of a manager in diversifying the total risk ( ). This measure is appropriate if one is evaluating
the total portfolio of an investor or a fund, in which case the Sharpe ratio of the portfolio can be
compared with that of the market. The formula for measuring the Sharpe ratio is:

This will be compared to the Shape ratio of the market portfolio. A higher ratio is preferable
since it implies that the fund manager is able to generate more return per unit of total risks.
However, managers who are operating specific portfolios like a value tilted or a style tilted
portfolio generally takes a higher risks, and therefore may not be willing to be evaluated based
on this measure.
6.8.8.2 Treynor Ratio
Treynors measure evaluates the excess return per unit of systematic risks (

risks.

If a portfolio is fully diversified, then becomes the relevant measure of risk and the
performance of a fund manager may be evaluated against the expected return based on the SML
(which uses to calculate the expected return). The formula for measuring the Treynor Ratio is:

Treynor Ratio

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6.8.8.3 Jensen measure or (Portfolio Alpha)

The Jensen measure, also called Jensen Alpha, or portfolio alpha measures the average return on
the portfolio over and above that predicted by the CAPM, given the portfolios beta and the
average

market

returns.

It

is

measured

using

the

following

formula:

The returns predicted from the CAPM model is taken as the benchmark returns and is indicated
by the formula within the brackets. The excess return is attributed to the ability of the managers
for market timing or stock picking or both. This measure investigates the performance of funds
and especially the ability of the managers in stock selection in terms of these contributing
aspects.
This measure is widely used in evaluating mutual fund performance. If

is positive and

significant, it implies that the fund managers are able to identify stocks with high potential for
excess returns. Market timing would refer to the adjustment in the beta of the portfolio in tandem
with market movements. Specifically, timing skills call for increasing the beta when the market
is rising and reducing the beta, when the market declines, for example through futures position.
If the fund manager has poor market timing ability, then the beta of the portfolio would not have
been significantly different during a market decline compared to that during a market increase.
Example: The data relating to market portfolio and an investor P portfolio is as under:

Assuming that the risk-free rate for the market is 8%, calculate (a) Sharpe Ratio (b)
Treynor Ratio and (c) Jensen Alpha for the investor P and the market.
Answer:

250

251

END CHAPTER QUIZ

Q1. A portfolio comprises of two stocks A and B. Stock A gives a return of 14% and stock
B gives a return of 1%. Stock A has a weight of 60% in the portfolio. What is the
portfolio return?
(a)

10%

(b)

9%

(c)

12%

(d)

11%

Q2. A portfolio comprises of two stocks A and B. Stock A gives a return of 8% and stock B
gives a return of 7%. Stock A has a weight of 60% in the portfolio. What is the
portfolio return?
(a)

9%

(b)

11%

(c)

10%

(d)

8%

Q3. A portfolio comprises of two stocks A and B. Stock A gives a return of 9% and stock B
gives a return of 6%. Stock A has a weight of 60% in the portfolio. What is the
portfolio return?
(a)

11%

(b)

9%

(c)

10%

(d)

8%

Q4. Banks and other financial institutions generally create a portfolio of fixed income
securities to fund known _______ .
(a) assets
(b) liabilities
Q5. In investment decisions, _______ refers to the marketability of the asset.
(a) value
(b) profitability
(c) price
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(d) liquidity

Q6. Investment advisory firms manage ______.

(a) each client's account separately
(b) all clients accounts in a combined manner
(c) only their own money and not client's money
Q7. Term structure of interest rates is also called as the ______.
(a) term curve
(b) yield curve
(c) interest rate curve
(d) maturity curve
Q8. Price movement between two Information Technology stocks would generally have a
______ co-variance.
(a)

zero

(b)

positive

(c)

negative

Q9. Each investment company is run by an _______.

(a)

asset deployment company

(b)

revenue management company

(c)

asset management company

(d)

asset reconstruction company

Q10. The need to have an understanding about the ability of the market to imbibe information
into the prices has led to countless attempts to study and characterize the levels of
efficiency of different segments of the financial markets.
(a)

TRUE

(b)

FALSE

253

Key to Questions
Question

Answer

Q1.

(b)

Q2.

(d)

Q3.

(d)

Q4.

(b)

Q5.

(d)

Q6.

(a)

Q7.

(b)

Q8.

(b)

Q9.

(c)

Q10.

(a)

254