BBA VI

Semester
Security Analysis and Portfolio Management VI SEM BBA

MODULE 1: INTRODUCTION

SYLLABUS CONTENT

Meaning of securities, types of securities like debt, equity and derivatives. Forms of Investment
– Financial and Non Financial forms of Investment, Factors influencing selection of Investments
– Investment Process, Introduction to Risk & Return including problems, Correlation concepts
with problems, Beta concept and problems.

LEARNING OBJECTIVES

• Introducing the Concept of Investment

• To know about the objectives of Investment

• To know about the factors influencing the section of Investment.

• Understanding of Return & Risk(Expected Return, Standard Deviation, Correlation &

Beta)
Meaning of Investment:

Investment or investing is a term with several closely-related meaning in business management,

finance, and economics, related to saving or deferring consumption. Investment is the choice by
the individual to risk his savings with the hope of gain.

Investment is an activity that is undertaken by those who have savings. Savings can be defined as
the excess of income over expenditure.

Investment and Speculation

Investment Speculation
Risk Limited risk High
Return Moderate returns High profits and high gains
Time Long term Short term
Use of funds Own funds through savings Own and borrowed funds
Decisions Safety liquidity, profitability Market behavior information
and stability consideration judgment on movement in the
stock market.

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Security Analysis and Portfolio Management VI SEM BBA

Investment Vs Gambling

Investment can also to be distinguished from gambling. Examples of gambling are horse race,
card games, lotteries, and so on. Gambling involves high risk not only for high returns but also
for the associated excitement. Gambling is unplanned and unscientific, without the knowledge of
the nature of the risk involved. It is surrounded by uncertainty and a gambling decision is taken
on unfounded markettips and rumors. In gambling, artificial and unnecessary risks are created
for increasing the returns.

Investment is an attempt to carefully plan, evaluate, and allocate funds to various investment
outlets that offer safety of principal and expected returns over a long period of time. Hence,
gambling is quite the opposite of investment even though the stock market has been referred to
as a “gambling den”.

Characteristics of investment

The features of economic and financial investments can be summarized as return, risk, safety,
and liquidity.

Return: All investments are characterized by the expectation of a return. In fact, investments are
made with the primary objective of deriving a return. The expectation of a return may be from
income (yield) as well as through capital appreciation. Capital appreciation is the difference
between the sale price and the purchase price of the investment. The dividend or interest from
the investment is the yield. Different types of investments promise different rates of return. The
expectation of return from an investment depends upon the nature of investment, maturity
period, market demand, and so on. The purpose for which the investment is put to use influences,
to a large extent, the expectation of return of the investors. Investment in high growth potential
sectors would certainly increase such expectations.

The longer the maturity period, the longer is the duration for which the investor parts with the
value of the investment. Hence, the investor would expect a higher return from such investments.

Risk: Risk is inherent in any investment. Risk may relate to loss of capital, delay in repayment of
capital, non-payment of interest, or variability of returns. While some investments such as
government securities and bank deposits are almost without risk, others are more risky. The risk

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Security Analysis and Portfolio Management VI SEM BBA

of an investment is determined by the investment’s maturity period repayment capacity, nature of

return commitment,and so on. The longer the maturity period, greater is the risk. When the
expected time in which the investment has to be returned is a long duration, say 10 years, instead
of five years, the uncertainty surrounding the return flow from the investment increases. This
uncertainty leads to a higher risk level for the investment with longer maturity rather than on an
investment with shorter maturity.

Safety: The safety of investment is identified with the certainty of return of capital without loss
of money or time. Safety is another feature that an investor desires from investments. Every
investor expects to get back the initial capital on maturity without loss and without delay.
Investment safety is gauged through the reputation established by the borrower of funds. A
highly reputed and successful corporate entity assures the investors of their initial capital. For
example, investment is considered safe especially when it is made in securities issued by the
government of a developed nation.

Liquidity: An investment that is easily saleable or marketable without loss of money and without
loss of time is said to possess the characteristic of liquidity. Some investments such as deposits
in unknown corporate entities, bank deposits, post office deposits, national savings certificate,
and so on are not marketable. There is no well-established trading mechanism that helps the
investors of these instruments to subsequently buy/sell them frequently from a market.
Investment instruments such as preference shares and debentures (listed on a stock exchange) are
marketable. The extent of trading, however, depends on the demand and supply of such
instruments in the market for the investors. Equity shares of companies listed on recognized
stock exchanges are easily marketable.

A well-developed secondary market for securities increases the liquidity of the instruments
traded therein. An investor tends to prefer maximization of expected return, minimization of risk,
safety of funds, and liquidity of investments.

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Security Analysis and Portfolio Management VI SEM BBA

Objectives of Investment

• Income: investments are made with the expectation of earning regular income through
dividend or interest. The investment should be made in such a manner that investors get stable
income. An investment is said to be stable, only when it is able to generate a constant stream of
dividend or interest.
• Capital appreciation: it refers to increase in the value of investment held. The investment
should be made in those avenues that have the feasibility of having capital appreciation. It is
determined by taking into consideration the difference between the value of an investment today
and the value when the investment at the beginning over the value of investment at the beginning
• Minimum Risk: Risk may be understood as the probability that actual returns realized
from an investment may be different from expected return. An investor generally commits his
funds to low risk investments. Each investor tries to maximize his welfare by choosing the
optimum combination of risk and expected return in accordance with his preference and
capacity.
• Hedge against inflation: Cash is idle resource, which does not add up to an investor’s
earnings. It also loses its value to the extent of rise in prices. An inflationary tendency prevailing
in the economy erodes the value of money. Savings are invested to provide a hedge against
inflation.
• Tax advantage: Most of the investors try to reduce their tax liability via tax planning and
management. They seek to invest in those avenues which provide them maximum tax advantage.
Dividends from shares, insurance premium paid on life insurance policies, interest on bank
deposits and others provide tax benefits.

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Security Analysis and Portfolio Management VI SEM BBA

Investment Process

The investment process consists following five –step procedure:

Investment
policy

Performing
security analysis

Asset Allocation
and portfolio
Construction

Portfolio
Revision

. Portfolio
performance
evaluation

a.Investment policy should be set: the investment process start by identifying goals and creating
a new plan and policy. Investment policy involves determining the investment objectives and
amount of one's investable wealth. The plan may consist of many future funding needs such as
retirement, college education, and land purchase. The investment policy qualifies the investment
goal. Making money alone cannot be an appropriate objective. It is appropriate to state that the
objective is to make a lot of money by recognizing the possible losses. A clear investment policy
help to plan, implement and manage portfolio that achieve high return while controlling risk.
Policies assist in strategic assets allocation. Settinga clear investment policy also involves the
identification of potential categories of financial assets for consideration in ultimate portfolio.
The identification of assets depends upon many things such as investment objectives, investable
wealth, tax consideration, retirement, education expenses, mortgage, stocks, bonds, mutual
funds, pensions, social security etc.

b. Performing security analysis: There are thousands of securities to purchase on the financial
markets. So these securities must be analyzed. Analyzing securities is to find out the mis-priced
securities. Performance analysis of security is carried out through.

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Security Analysis and Portfolio Management VI SEM BBA

1) Stock screening by considering earning growth, recent earnings surprises, price /earnings
ratio, dividends, market cap or size, industry, relative strength of each stock.

2) Stock Research: Stock research is carried out after narrow down the list of stock by stock
screening. There is availability of great resources for researching stocks. Company's annual
report and its financial statement are used for financial resources as:

3) Analysis: Many approaches can be used to analyze the securities. These approaches, in broad
sense, can be classified into two types.

i) Technical Analysis: Technical Analysis of security prices involves the study of previous
market price in an attempt to predict the future price movement. Technical analysis ignores the
company underlying the stock and instead tries to predict price changes by studying the market
itself. In technical Analysis past trends in the price is examined and is compared with the recent
emerging trends. The matching of emerging trends or patterns with the past one patterns repeat
themselves. Moving averages, support, and resistance, advance/decline lines, relative, strength,
momentum and volume of trading are examined in the technical Analysis.

ii) Fundamental Analysis: Fundamental analysis tries to identify the real or true value of
financial assets. The real value of any kind of financial assets is the present value of the future
cash flow given by the assets or expected by the holder. Fundamental analysis evaluates a stock
by examining the company, especially its operations and its financial conditions. In fundamental
analysis several valuation methods, factoring in P/E ratio, dividend yields, book value,
price/sales ratio, return on equity etc. are looked. The fundamental analyst attempts to forecast
the timing and size of the cash flows and then converts them into their equivalent present value
by using appropriate discount rate.

c.Asset Allocation and portfolio Construction: Assets allocation is based on investment goals,
Investor experience, and risk tolerance. Assets allocation is putting savings into investments, as
opposed to letting it sit in bank. Dividing your money across different assets classes (stocks,
bonds, money, market etc.) is the first step when making investments and is arguably the most
important decision. A well-constructed portfolio help investors archive at desired investment
goals. The portfolio construction should ensure the optimum use of people, money, and other

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Security Analysis and Portfolio Management VI SEM BBA

resources. Assets allocation and portfolio construction is of two types- active and passive. Active
assets allocation and portfolio construction is based on market views.

d. Portfolio Revision: Portfolio revision is the repetition of previous three steps of investment
process. Over the period of time, the objectives of investor at may change and the current
portfolio may no longer be optimal. Portfolio revision is the evaluation of outcome with the help
of performance measures. Thus it can be said that portfolio revision is the art of optimizing
assets and raising the worth of a portfolio. A timely revision of portfolio helps in obtaining
maximum profit because:

- The investor can sell some unattractive securities and introduce attractive ones to form a new
optimal portfolio.

- Some securities that are initially unattractive may turn out to be attractive later and Vice Versa.

e. Portfolio performance evaluation: The last step in investment process is portfolio performance
evaluation. This step gives the answer of the question. “How the portfolio performed?" the
performance of portfolio should be evaluated in term of return earned and the risk experienced
by the investor. For evaluation of portfolio performance, appropriate measures of return and risk
is needed. Evaluation must be carried out by relevant standards.

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Security Analysis and Portfolio Management VI SEM BBA

RETURNS:

Returns refer to income or revenue generated on employment of fund.

The returns are divided into

1. Revenue Returns.
2. Capital Returns.
3. Total Returns / Maximum / Holding Returns.
4. Real Rate of Returns.

1. Revenue Returns: It refers to dividend or interest received by the investor.

The Revenue Returns are calculated

RR = (Dividend / Price of Share) *100

2. Capital Returns: It refers to the returns generated out of the sales of securities.

The Capital Returns are calculated

CR = (End Price of Share – Beginning Price / Beginning Price) *100

3. Total Returns / Maximum / Holding Returns: It refers to the total returns that is generated during the
period of time, which includes Capital & Revenue Returns.

TR/MR/HR = (P1-P0) + Dividend / Po) *100

P1 – refers to end price.

P0 – refers to beginning price.

4. Real Rate of Returns: It refers to the rate of return which is calculated based on the inflation rate.

Real Rate of Returns are calculated:

RR = {1+r/1+IR} – 1

r = refers to returns.

IR = Inflation rate.

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Security Analysis and Portfolio Management VI SEM BBA

PRACTICAL PROBLEMS:

1. If an investor makes an investment of Rs 60,000 on 1st Jan 2015 when the price of the share of Cipla
was Rs 505 and as on 31st Dec 2015 the price of the same security is Rs 678. What is the capital gain
yield of the investor?

2. There are two securities Sun Pharma and Lupin with the following price at the beginning and the end
of the year. Calculate the capital gain yield of both the securities and also suggest which security is
better to invest.

Securities Sun Pharma Lupin

Year 2017 Rs 435 Rs 720
Year 2018 Rs 670 Rs 980
Annual Income (Dividend) Rs 2.00 Rs 5.00

3. Calculate the current yield of the securities Tata Steel & Tata Motors.

Securities Tata Steel Tata Motors

Year 2017 Rs 493 Rs 164
Year 2018 Rs 755 Rs 443
% of Dividend 100% 0%

Face Value of Equity Share Rs 10.00 Rs 2.00

4. An investor wants to know which of the following securities would have yield good rate of return. The
details are as follows:

Securities Eicher Motors Ashok Leyland SML Isuzu Ltd MRF

25th November 2008 Rs 280 Rs 6.90 Rs 214 Rs 1,985
17th September 2018 Rs 29,663 Rs 127.40 Rs 793 Rs 70,244
Dividend for the year
1100% 243% 15% 600%
2018 (%)
Face Value of Equity Rs 10.00 Rs 1.00 Rs 10.00 Rs 10.00
Compute rate of return.

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Security Analysis and Portfolio Management VI SEM BBA

5. Which of the following securities have high current yield?

Securities Rain Industries J K Tyres Bharat Forge Ltd.

Year 2017 Rs 142 Rs 87 Rs 542
Year 2018 Rs 475 Rs 193 Rs 797
Dividend for the
100% 75% 225%
year 2018 (%)
Face Value Rs 2.00 Rs 2.00 Rs 2.00

6. An investor wants to know which of the following securities will yield good rate of return when
invested for one time horizon of 1 year. The details are as follows:

Jindal Stainless Steel Authority of

Securities JSW Steel Ltd
Steel (Hisar )Ltd India Ltd(SAIL)
Year 2017 Rs 84 Rs 238 Rs 61
Year 2018 Rs 250 Rs 427 Rs 100
Dividend for the
0% 320% 0%
year 2018 (%)
Face Value Rs 2.00 Rs 1.00 Rs 10.00
Compute rate of return.

7. From the following calculate the Average Rate Return of State Bank of India for Year 2018

Month Stock Price State Bank of India (Rs.)

18-Jan 310
18-Feb 316.05
18-Mar 266.8
18-Apr 251
18-May 246.4
18-Jun 269.5
18-Jul 259.9
18-Aug 295
18-Sep 312
18-Oct 265.5
18-Nov 282.5

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Security Analysis and Portfolio Management VI SEM BBA

8. From the following calculate the Average Rate Return of TCS & INFOSYS for Year 2018. Suggest which
company is better.

TCS INFOSYS
Month
Stock Price (Rs.) Stock Price (Rs.)
18-Jan 2,689.80 1,040.00
18-Feb 3,120.00 1,150.00
18-Mar 3,041.00 1,173.45
18-Apr 2,845.00 1,135.50
18-May 3,533.00 1,200.00
18-Jun 1,758.00 1,231.90
18-Jul 1,829.95 1,313.90
18-Aug 1,951.00 1,365.85
18-Sep 2,080.05 1,458.00
18-Oct 2,186.00 735.1
18-Nov 1,940.10 693.9

9. From the following calculate the Average Rate Return & Real Rate of Return, MAHINDRA &
MAHINDRA LTD & INFOSYS for Year 2018. Suggest which company is better. The average inflation rate
for the year 2018 is 3.31%.

M&M Stock Price

Month TVS MOTOR (Rs.)
(Rs.)

18-Jan 752 764

18-Feb 765 697
18-Mar 730 681
18-Apr 743.25 622.3
18-May 880 675
18-Jun 924 591
18-Jul 908.5 570
18-Aug 936 518
18-Sep 976.6 580
18-Oct 863.7 560
18-Nov 769 543.9

10. From the following calculate the Average Rate Return & Real Rate of Return of Page Industries Ltd
for the year 2018. The average inflation rate for the year 2018 is 3.31%. The Investor has purchased in
the year 2010 (invested) 1,000 shares at Rs.13, 760 per share.

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Security Analysis and Portfolio Management VI SEM BBA

Page Industries
Month
Stock Price (Rs.)

18-Jan 25,488.00
18-Feb 21,749.95
18-Mar 21,850.00
18-Apr 22,501.00
18-May 24,244.00
18-Jun 25,201.00
18-Jul 27,750.00
18-Aug 29,228.95
18-Sep 34,600.00
18-Oct 32,567.20
18-Nov 29,385.55

11. From the following information calculate return and real rate of return and suggest which company
is better. The inflation rate during the year 2015 was 7.35%

% of Dividend
Company Face Value Beginning Price (Rs.) End Price (Rs.)
Declared

TCS Rs 1 4350% 2,200 2,400

ITC Rs 1 850% 280 320
COAL INDIA Rs10 274% 280 310
SBI Rs 1 260% 176 320
CORPORATION
Rs 2 0% 38 42
BANK

RISK:

Company analysis involves not only an estimation of future returns, but also an assessment of the
variability in returns called risk.

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Security Analysis and Portfolio Management VI SEM BBA

Problems:

1. From the following calculate the average return, variance & standard deviation (Risk).

Month CRISIL (Rs.)

18-Jun 1,719.10
18-Jul 1,800.95
18-Aug 1,770.15
18-Sep 1,825.00
18-Oct 1,727.60
18-Nov 1,449.00

2. From the following calculate average returns and standard deviation (Risk) of Puravankara Ltd &
DLF Ltd.

YEAR Puravankara Ltd (Rs.) DLF Ltd (Rs.)

2010 92 361.15
2011 112 294.85
2012 57 183.9
2013 101.8 233.5
2014 81 167.4
2015 83.85 137.3
2016 63.7 116
2017 45.55 115.5
2018 167.65 260

3. Calculate the average returns and standard deviation (Risk) of FDC LTD.

YEAR FDC LTD (RETURN) %

2009 30.22
2010 -89.83
2011 -71.75
2012 24.21
2013 -12.88
2014 -35.90
2015 -23.24

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Security Analysis and Portfolio Management VI SEM BBA

2016 -42.84
2017 3.64
2018 -15.01

4. Calculate the average returns and standard deviation (Risk) of PIRAMAL ENTERPRISES LTD &
DR.REDDY'S LABORATORIES LTD.

DR.REDDY'S
PIRAMAL ENTERPRISES
YEAR LABORATORIES
LTD.(RETURN) %
LTD.(RETURN) %
2009 -32.41 -35.40
2010 55.83 140.00
2011 25.40 46.14
2012 -18.98 -5.75
2013 38.42 16.54
2014 5.32 38.48
2015 50.09 28.02
2016 20.89 -3.85
2017 61.91 -1.48
2018 76.16 -21.43

5. From the following calculate the expected return, variance & standard deviation.

ALBERT DAVID LTD. Return

YEAR Probability / Weights
(%)
2020 -6.67 0.1
2021 120.24 0.1
2022 233.73 0.5
2023 160.82 0.2
2024 172.27 0.1

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Security Analysis and Portfolio Management VI SEM BBA

6. From the following calculate the expected return, standard deviation (risk) of Nath Bio Genes
(India) Ltd.

Nath Bio Genes (India) Ltd Probability /

YEAR
Expected Return (%) Weights
2019 148.40 0.25
2020 -37.16 0.20
2021 92.38 0.30
2022 212.55 0.25

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Security Analysis and Portfolio Management VI SEM BBA

CORRELATION:

Correlation coefficient measures the degree to which two variables move together. Its value ranges
between -1 and 1. -1 indicates perfectly negative relationship, 1 shows a perfectly positive relationship
and zero means there is no relationship between the variables.

Correlation coefficient refers to the relationship between two variables where one is considered as
dependent variable and other as an independent variable.
Correlation coefficient is a very important number in finance because it helps tell whether there is a
relationship between say population growth and GDP growth, crude oil price and stock price of oil and
gas companies, a mutual fund and the broad market index, etc.
Two variables might have a very high correlation, but it might not necessarily mean that one causes the
other.

The most common measure of correlation is called the Pearson correlation which can be calculated
using the following formula:

Problems:

1. From the following calculate correlation between syndicate bank stock price and NSE index
which is given for 6 days.

Date NSE Index Stock Price (Rs.)

1/12/2017 8192.9 66.5
2/12/2017 8086.8 66.1
5/12/2017 8128.75 66.4
6/12/2017 8143.15 66.6
7/12/2017 8102.05 66.1
8/12/2017 8246.85 66.5

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Security Analysis and Portfolio Management VI SEM BBA

2. Calculate the correlation between BSE Index and Bata India Ltd.

Month BSE Index Bata India Ltd (Rs.)

18-Jan 35,965.02 706

18-Feb 34,184.04 732
18-Mar 32,968.68 730
18-Apr 35,160.36 802
18-May 35,322.38 778
18-Jun 35,423.48 859
18-Jul 37,606.58 908
18-Aug 38,645.07 1082
18-Sep 36,227.14 972
18-Oct 34,442.05 976
18-Nov 36,194.30 1040

3. Calculate the correlation between the NSE Index and BSE Index

Date NSE Index BSE Index

22-Nov 10,527 34,981

26-Nov 10,629 35,354

27-Nov 10,686 35,513
28-Nov 10,729 35,717
29-Nov 10,859 36,170
30-Nov 10,877 36,194
3-Dec 10,884 36,241

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Security Analysis and Portfolio Management VI SEM BBA

4. Calculate the correlation between the NSE Index and Yes Bank Stock Price & Comment.

Yes Bank Stock Price

Date NSE Index
(Rs.)

22-Nov 10,527 196

26-Nov 10,629 188
27-Nov 10,686 183
28-Nov 10,729 162
29-Nov 10,859 160
30-Nov 10,877 170
3-Dec 10,884 178

BETA

Beta is a measure of a stock’s systematic risk. It is estimated by comparing the sensitivity of a stock’s
return to the broad market return. The broad market has a beta of 1 and a stock’s beta of less than 1
means that it has lower systematic risk than the market and vice versa.

The market beta i.e. the average beta of all the investments that are out there is 1 and an individual
investment’s systematic risk is measured relative to the overall market risk. A beta of more than 1
means that the investment has higher exposure to systematic risk than the market in general and a beta
less than 1 means that the investment is less exposed to the systematic risk factors.

It is calculated with help of the following:

N ∑XY – (∑X) ( ∑Y)

β = -------------------------
N ∑X2 – (∑X)2

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Security Analysis and Portfolio Management VI SEM BBA

1. From the following data calculate Beta.

MARUTI SUZUKI
Date BSE Index
INDIA LTD.
3/12/2018 7,759.80 36,241.00
4/12/2018 7,724.75 36,134.31
5/12/2018 7,559.55 35,884.41
6/12/2018 7,209.70 35,312.13
7/12/2018 7,314.10 35,673.25
10/12/2018 7,350.10 34,959.72

2. From the following data calculate Beta.

TATA CONSULTANCY
Year BSE Index
SERVICES LTD. (Rs.)
2008 9647 478
2009 17465 750
2010 20509 1165
2011 15455 1161
2012 19427 1259
2013 21171 2171
2014 27499 2555
2015 26118 2433
2016 26626 2362
2017 34057 2700
2018 35673 1975

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Security Analysis and Portfolio Management VI SEM BBA

3. From the following data calculate Beta.

Year BSE Index L&T FINANCE HOLDINGS LTD.

2011 15454.92 42.95

2012 19426.71 89
2013 21170.68 74.7
2014 27499.42 67.7
2015 26117.54 66.4
2016 26626.46 87.45
2017 34056.83 173.8
2018 35673.25 133.8

4. From the following data calculate Beta.

Year BSE Index VST Industries Ltd (Rs.)

1991 1909 190

1992 2615 302.5
1993 3346 455
1994 3927 335
1995 3110 172
1996 3085 112.5
1997 3659 87
1998 3055 141
1999 5006 61
2000 3972 105
2001 3262 155

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Security Analysis and Portfolio Management VI SEM BBA

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Security Analysis and Portfolio Management
VI SEM BBA

BBA VI
Semester
Security Analysis and Portfolio Management VI SEM BBA

MODULE 2: Time Value of Money

SYLLABUS CONTENT

Bond Valuation- Meaning, Types of bonds, Yield to Maturity (YTM) - meaning, problems,
Duration- meaning, problems, Interest Cover ratio- meaning, problems, Equity Valuation
meaning, problems with balance sheet and discounted cash flow method.

LEARNING OBJECTIVES

After studying this module students will be able to-

 To understand the meaning and types of bonds

 To calculate the yield to maturity

 To assess the duration of bond

 To explain the concept of equity valuation

Bonds
A bond is a contract that requires the borrower to pay the interest income to the lender. Financial
institutions, banks and corporate bodies offer attractive bonds like Deep discount bonds, Index
bonds etc. The par value of the bond indicates the face value of the bond. Most bonds offer fixed
interest payments till their maturity. This specific rate of interest is known as the coupon rate.

Bond Risk

Risks as with any investment, there are risks inherent in buying even the most highly rated
bonds. For example, your bond investment may be called, or redeemed by the issuer, before the
maturity date. Economic downturns and poor management on the part of the bond issuer can also
negatively affect your bond investment. These risks can be difficult to anticipate, but learning
how to better recognise the warning signs — and knowing how to respond — will help you
succeed as a bond investor.

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Security Analysis and Portfolio Management VI SEM BBA

1. Calls

If a company, agency or the government calls the bonds you own, it redeems your investment
and pays back your principal. Issuers may call bonds if the interest rates drop and they have
enough money on hand to pay back outstanding debt. By calling the bonds, they eliminate the
expense of making further fixed-interest payments for the duration of the bond term and can
issue new bonds at a lower rate and save money. If your bond is called, you receive no more
interest payments from the investment, forcing you to find another place to invest the money
earlier than you anticipated. And if the company called your bonds due to an interest rate drop,
you will find yourself reinvesting the money at a lower, less attractive interest rate.

2. Economic risks

Economic conditions affect the value of bond investments. Interest rates and inflation are two
major economic factors that directly affect the worth and future of a bond.

Interest rates - Changing interest rates represent a significant risk. If you own a bond that was
issued before an interest rate increase, you may lose money if you sell the bond before maturity,
since its price will probably be lower than par value. As interest rates fluctuate, the bonds you
hold can become less attractive, as investors and traders seek other bonds that pay higher interest
rates. Further, when interest rates are low, many investors put their money into stocks to get a
higher return. Lack of interest in bonds can depress bond prices.

Inflation - The other economic risk that bond holders face is rising inflation. The risk of holding
a bond to maturity is that rising inflation could erode the buying power of the interest payments
as well as the value of the principal. The longer you hold a fixed income investment, the more
likely it is that inflation will erode its value.

3. Management risks

The bond issuer may find itself in financial trouble. This risk, occurring most often with
corporate bonds, can seriously diminish your return, or make it disappear completely.

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Security Analysis and Portfolio Management VI SEM BBA

4. Downgrading

One danger bondholders face — and one you can’t anticipate — is that a rating service may
downgrade its rating of a company or municipal government during the life of a bond, creating a
fallen angel. That happens if the issuer’s financial condition deteriorates, or if the rating service
feels a business decision might have poor results. If downgrading occurs, investors instantly
demand a higher yield for the existing bonds. That means the price of the bond falls in the
secondary market. It also means that if the issuer wants to float new bonds, the bonds will have
to be offered at a higher interest rate to attract buyers.

5. Default

The greatest risk you face is the default, which occurs when the issuer doesn’t live up to its
promise to pay. Issuers who default on their loans can default on interest — which means you
receive your principal but the interest is not paid. An issuer can also default on repayment, which
means you receive some of your interest but lose your principal. Thoroughly researching bonds
can help you protect yourself from some risk, but sometimes even the best-looking investments
can, in time, turn out to be troublesome.

Types of Bonds

1. Secured bonds and unsecured bonds

Secured bonds, or bonds backed by collateral, involve a pledge from the issuer that a specific
asset will be sold to pay off the outstanding debt in the event of default. Secured bonds normally
have a lower yield than unsecured bonds.

Unsecured bonds are not backed by any assets whatsoever, only by the good faith and credit of
the issuer.

2. Perpetual bonds and redeemable bonds

Bonds that do not mature or never mature are called perpetual bonds. The interest alone would
be paid. In the redeemable bond, the bond is redeemed after a specific period of time. The
redemption value is specified by the issuer.

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Security Analysis and Portfolio Management VI SEM BBA

3. Fixed interest rate bonds and floating interest rate bonds

In the fixed interest rate bonds, the interest rate is fixed at the time of issue. Whereas, in the
floating interest rate bonds, the interest rate change according to prefixed norms.

4. Zero Coupon bonds

A zero-coupon bond is a bond that makes no periodic interest payments and is sold at a deep
discount from face value. The buyer of the bond receives a return by the gradual appreciation of
the security, which is redeemed at face value on a specified maturity date.

5. Capital Indexed bonds

In the capital indexed bond, the principal amount of the bond adjusted for inflation for every
year. The benefit of the bond is that it gives the investor an increase in return by taking inflation
into account. The investor enjoys the benefit of a return on his principal, which is equal to the
average inflation between the issue (purchase) and maturity period of the instrument.

Time Value Concept

The time value a concept of money is that the rupee received today is more valuable than the
rupee received tomorrow. The interest the borrower pays to the lender causes the money to have
a future value different from its present value. The time value of money makes the rupee
invested today grow more than a rupee in future.

Future Value = Present Value (1 + interest rate)

𝑭𝒖𝒕𝒖𝒓𝒆 𝑽𝒂𝒍𝒖𝒆
Present value of money =
𝟏+𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆

Bond Returns
Holding period return: An investor buys bonds and sells it after holding for a period. The rate
of return in that holding period is:

𝑷𝒓𝒊𝒄𝒆 𝒈𝒂𝒊𝒏 𝒐𝒓 𝒍𝒐𝒔𝒔 𝒅𝒖𝒓𝒊𝒏𝒈 𝒕𝒉𝒆 𝒉𝒐𝒍𝒅𝒊𝒏𝒈 𝒑𝒆𝒓𝒊𝒐𝒅+𝑪𝒐𝒖𝒑𝒐𝒏 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆,𝒊𝒇 𝒂𝒏𝒚
Holding period return = 𝑷𝒓𝒊𝒄𝒆 𝒂𝒕 𝒕𝒉𝒆 𝒃𝒆𝒈𝒊𝒏𝒏𝒊𝒏𝒈 𝒐𝒇 𝒕𝒉𝒆 𝒉𝒐𝒍𝒅𝒊𝒏𝒈 𝒑𝒆𝒓𝒊𝒐𝒅

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Security Analysis and Portfolio Management VI SEM BBA

With this measure, the investor can find out the rate of cash flow from their investments every
year.

YTM (Yield to Maturity)

The concept of YTM is one of the widely used tools in bond investment management. YTM is
the single discount factor that makes the present value of future cash flows from a bond equal to
the current price of the bond. YTM is the rate of return that an investor can expect to earn if the
bond is held to maturity.

YTM is calculated based on certain assumption. They are –

1. There should not be any default. Coupon and principal amount should be paid as per schedule.
2. The investor has to hold to the bond till maturity.
3. All the coupon payments should be re-invested immediately at the same interest rate as the
same YTM of the bond.
To find out the YTM the present value technique is adopted. The formulae are:

𝑪+(𝑷𝒓𝒆𝒎𝒊𝒖𝒎 𝒐𝒓 𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕/𝒚𝒆𝒂𝒓𝒔 𝒕𝒐 𝒎𝒂𝒕𝒖𝒓𝒊𝒕𝒚)

Y=
(𝑷𝒐+𝑭)/𝟐

Where,
C= Coupon rate
P0= Present Value
F= Face value

Present Value = Coupon1 + Coupon2 + ….....+ (Couponn + Face value)

(1 + y)1 (1 + y)2 (1 + y)n
Y= Yield to maturity

In case of Zero Coupon Bond

Present Value/ Price = Face Value

(1 + y)n

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Security Analysis and Portfolio Management VI SEM BBA

Duration

Duration means the time structure of the bond and the bond’s interest rate risk. The time
structure of investments in bonds is expressed in two ways. The common way is to state how
many years an investor has to wait until the bond matures and the principal money is paid back.
This is known as asset time to maturity or its years to maturity. The other way is to measure the
average time taken for all interest coupons and the principal to be recovered. This is called
Macaulay's Duration.

Duration is defined as the weighted average of time periods to maturity, with the weights being
present values of the cash flow in each time period. The formula for the duration is,

𝑪𝟏 𝑪𝟐 𝑪𝒕
D= (𝟏+𝒓)𝟏
×𝟏 + (𝟏+𝒓)𝟐
× 2 + ……. + (𝟏+𝒓)𝒕
×t
𝑷𝟎 𝑷𝟎 𝑷𝟎

Here,
D = Duration
C = Cash flow
r = current yield to maturity
t = number of years
P0 = sum of the present value of cash flow

Interest Cover Ratio

The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a
company can pay interest on its outstanding debt. The interest coverage ratio is commonly used
by lenders, creditors, and investors to determine the riskiness of lending capital to a company.
The interest coverage ratio may be calculated by dividing a company's earnings before interest
and taxes (EBIT) during a given period by the company's interest payments due within the same
period.

The method for calculating interest coverage ratio may be represented with the following
formula:

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Security Analysis and Portfolio Management VI SEM BBA

𝑬𝑩𝑰𝑻
Interest Coverage Ratio = 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆

Equity Valuation

Equity shares can be described more easily than fixed income securities. However, they are
difficult to analyse. Fixed income securities typically have a limited life and a well-defined cash
flow stream. While the basic principles of the valuations are the same for fixed income securities
as well as equity shares, the factors of growth and risk create greater complexity in the case of
equity shares.

Equity analysts employ two kinds of analysis, viz., fundamental analysis and technical analysis.
Fundamental analysts assess the fair market value of equity shares by examining the assets,
earnings prospects, cash flow projections and dividend potential. Fundamental analysts differ
from technical analysts who essentially rely on price and volume trends and other market
indicators to identify trading opportunities.

Balance sheet valuation: Asset based valuation

The value of the enterprise indicates the net assets of the enterprise as shown in the books of
accounts. It shows the historical value of the assets. It is the cost price less depreciation provided
so far on assets. It does not reflect position of profitability. Under this method, the valuation of
enterprise is based on the net assets of the company. It is a simplest form of valuation of business
enterprise. The net asset valuation is the difference between the assets and liabilities based on
their balance sheet values adjusted for certain accounting principles.

While calculating the net assets the following should be considered:

1. All tangible and intangible assets are to be taken at net realisable value.
2. All factious assets are to be ignored.
3. Present worth of goodwill should be included in the net assets. The carrying amount of
goodwill as shown in the balance sheet is not relevant.
4. All outside liabilities are to be taken at the values payable on the date of valuation of
shares.

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Security Analysis and Portfolio Management VI SEM BBA

5. Any arrears of dividends, provision for tax, provision for doubtful debts etc. should be
considered.
6. From the amount of net assets, the claim of preferences shareholders is to be deducted to
get the net amount of assets available to equity shareholders.

𝑵𝒆𝒕 𝒂𝒔𝒔𝒆𝒕𝒔 𝒂𝒗𝒂𝒊𝒍𝒂𝒃𝒍𝒆 𝒕𝒐 𝒆𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔

Intrinsic value of Equity Share = 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔

Dividend discount model

According to the dividend discount model, conceptually a very sound and appealing model, the
value of an equity share is equal to the present value of dividends expected from its ownership
plus the present value of the sale price expected when the equity share is sold. For applying the
dividend discount model, we will make the following assumptions: (i) dividends are paid
annually – this seems to be a common practice for business firms in India; and (ii) the first
divided is received one year after the equity share is bought.

1. Single Period Valuation Model

It is assumed that the investor holds the stock for a year, and the return occurs at the end of the
period. If it is to be expressed at the beginning of the holding period, it has to be given in terms
of the present value.

𝑫𝟏 𝑷𝟏
P0 = +
𝟏+𝒓 𝟏+𝒓

Here,

P0 = Present selling price

P1 = selling price at the end of the one year
D1 = dividend received during the one year holding period
r = Investor’s required rate of return

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Security Analysis and Portfolio Management VI SEM BBA

2. Multi- period Valuation Model

The share may not be held for a year and the investor may hold it for several periods. In that
case, the valuation can be done with the help of the following models

A. Zero Growth Model

The estimation of the stock value for a finite period is straightforward. The future dividend and
the predicted future price of the stock are discounted to arrive at the net present value of the
stock.

𝟏 𝑫 𝟐 𝑫 𝟑 𝑫 𝒏 𝑫 𝒏 𝑷
𝟏 +(𝟏+𝒓)𝟐 + (𝟏+𝒓)𝟑 + (𝟏+𝒓)𝒏 + (𝟏+𝒓)𝟏
P0 = (𝟏+𝒓)

Here,

P0 = Intrinsic /present value of equity share today or at the time period zero
D1 = dividend per share in period t
r = Investor’s required rate of return

B. Constant Growth Model

In this model, the basic assumption is that dividends will grow at the same rate (g) into an
indefinite future.

𝑫𝟎 (𝟏+𝒈)𝟏 𝑫𝟎 (𝟏+𝒈)𝟐 𝑫𝟎 (𝟏+𝒈)𝟑 𝑫𝟎 (𝟏+𝒈)𝒏

P0 = + + + ⋯…+
(𝟏+𝒓)𝟏 (𝟏+𝒓)𝟐 (𝟏+𝒓)𝟑 (𝟏+𝒓)𝒏

When the period approaches to infinity the equation takes the form

𝟏𝑫
P0 = (𝒓−𝒈)

D1= D0 (1+g)

Here,
P0 = Intrinsic /present value of equity share
D1 = next year dividend
D0 = Previous year dividend

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Security Analysis and Portfolio Management VI SEM BBA

g = Growth rate
r = Investor’s required rate of return

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Security Analysis and Portfolio Management VI SEM BBA

Practical Problems

1. (a) An investor ‘A’ purchased a bond at price of Rs. 900 with Rs 100 as
Coupon payment and sold it at Rs 1000. What is his holding return?
(b) If the bond is sold for Rs 750 after receiving Rs 100 as coupon payment,
then what is the holding period return?
2. A four year bond with 7% coupon rate and maturity value of Rs. 1000 is
currently selling at Rs. 905. What is its yield to maturity?
3. A Rs. 100 par value bond bearing a coupon rate of 11% matures after 5 years.
The expected yield to maturity is 15%. The present market price is Rs. 82. Can
the investor buy it?
4. (a) Determine the value of Rs. 1000 zero coupon bond yield to maturity of 18%
and 10 years to maturity
(b) What is YTM of this bond if its present value is Rs 200?
5. Arvind considers Rs. 1000 par value bond bearing a coupon rate of 11% that
matures after 5 years. He wants a minimum yield to maturity of 15%. The bond
is currently sold at Rs 870. Should he buy the bond?
6. A bond of Rs 1000 face value, bearing a coupon rate of 12% will mature after 7
years. What is the value of the bond if the discount rates are 14% and 12%?
7. Anand owns Rs 1000 face value bond with five years to maturity. The bond has
an annual coupon of Rs 75. The bond is currently priced Rs 970. Given an
appropriate discount 10%, should Anand hold or sell the bond?
8. Calculate the duration for bond A and bond B with 7 % and 8% coupons having
maturity period of 4 years. The face value is Rs 1000. Both the bonds are
currently yielding 6%.

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Security Analysis and Portfolio Management VI SEM BBA

9. Calculate the duration for bond A and bond B with 7% and 8% coupons having
maturity period of 4 years. The face value is Rs 1000. Both the bonds are
currently yielding at 9%.
10. Determine duration of bond that has a face value of Rs 1000 with 10% annual
coupon rate and 3years term to maturity. The bond’s yield to maturity is 12%.
11.Arun buys a bond with four years to maturity. The bond has coupon rate of 9
per cent and is priced at Rs. 100 in the market. What is the duration of the
bond?
12. XYZ Ltd.’s balance sheet shows the following structure of finance for the year
ended 31st March, 2018.
Rs. (Lakhs)
Equity share capital (5,00,000 shares of Rs. 10 each) 50
12% Preference share capital (10,000 shares of Rs. 100 each) 10
General reserve 15
14% Non-convertible debentures 40
Current liabilities 5

The profit earned during the year before interest payments and tax @ 25%
amounted to Rs. 34 lakhs. Board of Directors recommended a dividend @ 18%
on equity shares. Calculate Interest Coverage ratio.
13. Vigilant company stock is currently selling at Rs. 25 per share. The stock is
expected to pay Rs. 1 dividend per share at the end of the next year. It is
reliably estimated that the stock will be available for Rs. 29 at the end of one
year.
a) If the forecasts about the dividend and price are accurate, is it advisable to
buy at the present price? His required rate of return is 20%.

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Security Analysis and Portfolio Management VI SEM BBA

b) If the investor requires 15% return when the dividend remains constant, what
should be the price at the end of the first year?
14.Gandhi Petro is expected to pay Rs. 3 in dividends next year, and the market
price is projected to be Rs. 75 by year end. If the investor’s required rate of
return is 20%, what is the current value of the stock?
15. An investor holds an equity share giving him an annual dividend of Rs. 30. He
expects to sell the share for Rs. 300 at the end of a year. Calculate the value of
the share if the required rate of return is 10%.
16. Suppose that a stock pays three annual dividends of Rs. 10 per year and the
discount rate is 15%. What is the present value of the stock?
17. Suppose ABC Co., stock pays three annual dividends of Rs. 10, Rs. 20 and Rs.
30 in year 1, 2 and 3 respectively, and the discount rate is 10 percent. What is
the present value of the stock?
18. D.K. Rao has invested in Apex Auto. The capitalization rate of the company is
15 percent and the current dividend is Rs. 2 per share. Calculate the value of the
company’s equity share if the company is showing sinking with an annual
decline rate of 5% in the dividend.
19. Repeat the Apex Auto problem (previous problem) and assume that it grows at
an average rate, which is taken to be an average annual increase in dividend of
7 percent. Calculate the value of equity share.
20. What would be the value of the equity share of Apex Auto problem (14) if the
company shows no growth but is able to maintain its dividend.
21. Suppose dividends for a particular company are projected to grow at 5%
forever. If the discount rate is 15% and the current dividend is Rs. 10. What is
the value of the stock?
22. BPT Ltd. paid Rs. 2.75 in dividends on its equity shares last year. Dividends
are expected to grow at 12% annual rate for an indefinite number of years.
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Security Analysis and Portfolio Management VI SEM BBA

(a) If BPT’s current market price is Rs. 37.50, what is the stock’s expected rate
of return?
(b) If your required rate of return is 14%, what is the value of the stock for you?
(c) Should you make the investment?
23. On Sudha Enterprises’ equity shares, the dividend paid at Rs. 1.32 per equity
share last year and this is expected to grow indefinitely at an annual 7% rate.
What is the value of each equity share of Sudha Enterprises if the investor
requires an 11% return?
24. Ahuja Textile’s equity share currently sells for Rs. 23 per share. The
company’s finance manager anticipates a constant growth rate of 10.5% and an
end of year dividend of Rs. 2.50.
(a) What is the expected rate of return?
(b) If the investor requires a 17% return, should he purchase the stock?
25. The following are the balance sheet of XYZ Ltd. and ABC Ltd. as on 31 st
March, 2018: (Rs.)
Particulars XYZ Ltd. ABC Ltd.
Liabilities
Equity share capital of Rs. 10 each 4,00,000 1,80,000
General reserve 5,00,000 1,00,000
Profit and loss A/c 3,00,000 80,000
Debentures 3,50,000 -
Creditors 2,00,000 1,00,000
Bills payable 50,000 40,000
18,00,000 5,00,000
Assets
Fixed assets 7,00,000 3,00,000

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Security Analysis and Portfolio Management VI SEM BBA

Investments 5,00,000 -
Current assets 6,00,000 2,00,000
18,00,000 5,00,000

The board of directors of XYZ Ltd. approved to take over ABC Ltd. as on 30 th
Sept. 2018. Find out the ratio of exchange of shares on the basis of the book
values.

26. From the following particulars, calculate the intrinsic value of an equity share
assuming that out of total assets, those amounting to Rs. 41,00,000 are
fictitious:
Share capital:
5,50,000 10% Preference shares of Rs. 100 each, fully paid up
55,00,000 Equity shares of Rs. 10 each, fully paid up
Liability to outsiders Rs. 75,00,000
Reserves and surplus Rs. 45,00,000

27. The balance sheet of Diamond Ltd. as on 31st March, 2017 is given below:
Liabilities Rs. Assets Rs.
Equity share capital 50,00,000 Land 14,00,000
(5,00,000 shares of Rs. 10
each)
General Reserve 15,00,000 Buildings 23,00,000
14% Debentures 10,00,000 Plant and machinery 28,00,000
Sundry creditors 5,00,000 Sundry debtors 6,00,000
Bank overdraft 4,00,000 Inventory 8,00,000
Provision for taxation 1,00,000 Cash and bank 2,00,000

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Security Analysis and Portfolio Management VI SEM BBA

Patents and trade 3,00,000

marks
Preliminary expenses 1,00,000
85,00,000 85,00,000

On 31st March, 2017, independent expert valuer has assessed the following
assets:
Rs.
Land 26,00,000
Buildings 40,00,000
Plant and machinery 32,00,000
Debtors (after bad debts) 5,00,000
Patents and trade marks 2,00,000
Based on the information above, calculate the intrinsic value of company’s
share by the net assets methods.
28. Balance sheet of Superb Ltd. as on 31st March, 2017.

Liabilities Rs. (Lakhs) Assets Rs. (Lakhs)

Equity share capital: Land and building 110
Fully paid up shares of 200 Plant and machinery 130
Rs. 100 each
General reserve 40 Patent and trade 20
marks
Profit and loss account 32 Stock 48
Sundry creditors 128 Sundry debtors 88
Provision for Income- 60 Bank balance 52
tax

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Security Analysis and Portfolio Management VI SEM BBA

Preliminary expenses 12
460 460

The expert valuer valued the land and building at Rs. 240 lakhs, goodwill at Rs.
160 lakhs and plant and machinery at Rs. 120 lakhs. Out of the total debtors, it is
found that debtors for Rs. 8 lakhs are bad.

Ascertain the value of shares of the company under intrinsic value method.

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 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT VI SEM BBA

MODULE 3: FUNDAMENTAL ANALYSIS

SYLLABUS CONTENT

Meaning, Macroeconomic and Industry Analysis, Company Analysis using methods EPS,
Diluted EPS, P/B, B/P, Cash EPS, Dividend Yield.

LEARNING OBJECTIVES

 Introducing the concept of Analysis,

 Understanding the various types of Analysis, Technical & Fundamental Analysis
 Understanding the importance of Fundamental Analysis – through EPS, Diluted EPS,
P/B, B/P, Cash EPS, Dividend Yield.

Introduction
Fundamental analysis generally comprises of evaluating economic, political and financial
information that are broadcast across various sections of the media from time to time.
Research analysts offering investment strategies and advisory services in the financial markets
generally do so by either evaluating the markets using fundamental data or technical analysis,
with a small proportion following both forms of analysis simultaneously. Fundamental analysis
generally comprises of evaluating economic, political and financial information that are
broadcast across various sections of the media from time to time. Analysts, economists, and
investors use these statistics to forecast future price movements and put together long- term
investment or short- term trading strategies. The approach to analyzing markets based on
fundamentals could differ slightly depending on the market segment an investor is looking to
invest in.
Fundamental analysis is really a logical and systematic approach to estimate the future
dividends and share price. It is based on the basic premise that share price is determined by a
number of fundamental factors relating to the economy, industry and company. The economy
fundamentals, industry fundamental and company fundamentals have to be considered while
analyzing a security for investment purpose. Fundamental analysis is, in other words, a detailed
analysis of the fundamental factors affecting the performance of companies.

Each share is assumed to have an economic worth based on its present and future earning
capacity. This is called its intrinsic value or fundamental value. The purpose of fundamental
analysis is to evaluate the present and future earning capacity of a share based on the economy,
industry and company fundamental and thereby assess the intrinsic value of share.

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 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT VI SEM BBA

Fundamental Analysis involves three steps:

1. Economy Analysis
2. Industry Analysis
3. Company Analysis

Economy Analysis:

The performance of a company depends on the performance of the economy. If the

economy is booming, incomes rise, demand for goods increases, and hence the industries and
companies in general tend to be prosperous. On other hand, if the economy is in recession, the
performance of companies will be generally bad.

The investors are concerned with those variables in the economy which affect the
performance of the company in which they intend to invest.

Some of the economic variables that an investor must monitor

1. Growth Rate of National Income

2. Inflation
3. Interest Rates
4. Government Revenue, Expenditure and Deficits
5. Exchange Rates
6. Infrastructure
7. Monsoon
8. Economic and Political Stability

Growth Rate of National Income

The rate of growth of the national economy is an important variable to be considered by

an investor. GNP (gross national product), NNP (net national product) and GDP (gross domestic
product) are the different measures of the total income or total economic output of the country as
a whole. The growth rate of these measures indicates the growth rate of the economy. The
estimates of GNP, NNP and GDP and their growth rates are made available by the government
from time to time.

An economy passes through different phases of prosperity, known as the different stages
of the economic or business cycle. The four stages of an economic cycle are depression,
recovery, boom and recession.

Inflation

Inflation prevailing in the economy has considerable impact on the performance of

companies. Higher rates of inflation upset business plan that leads to cost escalation and result
in squeeze on profit margins. On the other hand, inflation leads to erosion of purchasing power
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 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT VI SEM BBA

in the hands of consumers. This will result in lower demand for products. Thus, high rate of
inflation in an economy are likely to affect the performance of companies adversely. Industries
and companies prosper during times of low inflation.

Interest Rates

Interest rates determine the cost and availability of credit for companies operating in an
economy. A low interest rate stimulates investment by making credit available easily and
cheaply. It implies lower cost of finance for companies and thereby assures higher profitability.
Higher interest rates result in higher cost of production which may lead to lower profitability and
lower demand.

Government Revenue, Expenditure and Deficits

As the government is the largest investor and spender of money, the trends in government
revenue, expenditure and deficits have a significant impact on the performance of industries and
companies. Expenditure by the government stimulates the economy by creating jobs and
generating demand. Since a major portion of demand in the economy is generated in
determining the fortunes of many industries. When government expenditure exceeds its revenue,
there occurs a deficit. This deficit is known as budget deficit.

Exchange Rates

The performance and profitability of industries and companies that are major importers or
exporters are considerably affected by the exchange rates of the rupee against major currencies
of the world. A depreciation of rupee improves the competitive position of Indian products in
foreign markets, thereby stimulating exports. But it would also make imports more expensive. A
company depending heavily on imports may find devaluation of the rupee affecting its
profitability adversely.

The exchange rates of the rupee are influenced by the balance of trade deficit, the balance
of payment deficit and also the foreign exchange reserves of the country. The excess of imports
over exports is called balance of trade deficit.

Infrastructure

The development of the economy depends very much on the infrastructure available.
Industry needs electricity for its manufacturing activities, roads and railways to transport raw
materials and finished goods, communication channels to keep in touch of with suppliers and
customers. The availability of infrastructural facilities such as power, transportation and
communication systems affects the performance of companies. Bad infrastructure leads to
inefficiencies, lower productivity, wastage and delays. An investor should assess the status of
the infrastructure facilities available in the economy before finalizing his investment plans.

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Monsoons

The Indian economy is essentially an agrarian economy and agriculture forms a very
important sector of the Indian economy. Because of the strong forward and backward linkages
between agriculture and industry, performance of several industries and companies are
dependent on the performance of agriculture. As the agriculture incomes rise, the demand for
industrial products and services will be good and industry will prosper. But the performance of
agriculture to a very great extent depends on the monsoon. The adequacy of the monsoon
determines the success or failure of the agriculture activities in the India. The progress and
adequacy of the monsoon becomes a matter of great concern for an investor in the Indian
context.

Economic and Political Stability

A stable political environment is necessary for steady and balanced growth. No industry
or company can grow and prosper in the midst of political turmoil. Stable long term economic
policies are what are needed for industrial growth. Such stable policies can emanate only from
stable political systems as economic and political factors are interlined. A stable government
with clear cut long term economic policies will be conducive to good performance of the
economy.

2. Industry Analysis

An investor ultimately invests his money in the securities of one or more specific
companies. Each company can be characterized as belonging to an industry. The performance
of companies would, therefore, be influenced by the fortunes of the industry to which it belongs.
For this reason an analyst has to undertake an industry analysis so as to study the fundamental
factors affecting the performance of different industries.

At any stage in the economy, there are some industries which are fast growing while
others are stagnating or declining. If an industry is growing, the companies within the industry
may also be prosperous. The performance of companies will depend, among other things, upon
the state of the industry to which they belong. Industry analysis refers to an evaluation of the
relative strengths and weaknesses of particular industries.

Industry

An industry is generally described as a homogenous group of companies. We may define

an industry “as a group of firms producing reasonably similar products which serve the same
needs of a common set of buyers” Industries are traditionally classified on the basis of products.
According to this product wise classification we have cement industry, steel industry, cotton
textile industries, pharmaceutical industry, and so forth. However, industry classification
becomes difficult when dealing with firms having a diversified product line. And such firms are

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now on increase. Even though classification of industry poses practical difficulties, each country
follows a standardized classification to facilitate data collection and reporting.

Industry Life Cycle

Marketing experts believe that each product has life cycle. They have identified four
stages in the life of a product, namely introduction stage, growth stage, maturity stage and
decline stage. In the same way, an industry is also said to have a life cycle. According to the
industry life cycle theory, the life of an industry can be segregated into the pioneering stage, the
expansion stage, stagnation stage and decay stage. This kind of segregation is extremely useful
to an investor because the profitability of an industry depends upon its stage of growth. In fact,
each development stage is unique and exhibits different characteristics.

A. Pioneering Stage

This is the first stage in the industrial life cycle of a new industry where the
technology as well as the product are relatively new and have not reached a state of
perfection. The pioneering stage is characterized by rapid growth in demand for the
output of industry. As a result there is a great opportunity for profit. Many companies
compete with each other vigorously. As large number of companies attempt to capture
their share of the market, there arises high business mortality rates. Weak firms are
eliminated and a lesser number of firms survive the pioneering stage.

B. Expansion Stage

Once an industry has established itself it enters the second stage of expansion or
growth. The industry now includes only those companies that have survived the
pioneering stage. These companies continue to become stronger. Each company finds a
market for itself and develops its own strategies to sell and maintain its position in the
market. The competition among the surviving companies brings about improved
products at lower prices.

Companies in the expansion stage of an industry are quite attractive for

investment purposes. Investors can get high returns at low risk because demand exceeds
supply in this stage.

C. Stagnation Stage

This is the third stage in the industry life cycle. In this stage, the growth of the
industry stabilizes. The ability of the industry to grow appears to have been lost. Sales
may be increasing but at a slower rate than that experienced by competitive industries or
by the overall economy. The industry begins to stagnate. The transition of the industry
from the expansion stage to the stagnation stage is often very slow. Two important

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reasons for this are change in social habits and development of improved technology. The
black and white television industry in India provides a good example of an industry
which passed from the expansion stage to the stagnation stage during the eighties.

D. Decay Stage

From the stagnation stage the industry passes to the decay stage. This occurs
when the products of the industry are no longer in demand. New products and new
technologies have come to the market. Customers have changed their habits, style and
liking. As a result, the industry becomes obsolete and gradually ceases to exist. Thus,
changes in social habits, changes in technology and declining demand are the causes of
decay of an industry. An investor should get out of the industry before the onset of the
decay stage.

The industry life cycle approach has important implications for the investor. It
gives an insight into the apparent merits of investment in a given industry at a given time.
An industry usually exhibits low profitability in the pioneering stage, high profitability in
the growth or expansion stage, medium but steady profitability in the stagnation or
maturity stage and declining profitability in the decay stage.

3. Company Analysis

Company analysis is the final stage of fundamental analysis. The economy

analysis provides the investor a broad outline of the prospects of growth in the economy.
The industry analysis helps the investor to select the industry in which investment would
be rewarding. Now he has to decide the company in which he should invest his money.

Company analysis deals with the estimation of return and risk of individual
shares. This calls for information. Many pieces of information influence investment
decisions. Information regarding companies can be broadly classified into two broad
groups: internal and external. Internal information consists of data and events made
public by companies concerning their operations. The internal information sources
include annual reports to shareholders, public and private statements of officers of the
company, the company’s financial statements, etc. External sources of information are
those generated independently outside the company. These are prepared by investment
services and the financial press.

In company analysis, the analyst tries to forecast the future earnings of the
company because there is strong evidence those earnings have a direct and powerful
effect upon share prices. The level, trend and stability of earnings of a company,
however, depend upon a number of factors concerning the operations of the company.

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Financial Statement

The prosperity of a company would depend upon its profitability and financial
health. The financial statement published by a company periodically helps us to assess
the profitability and financial health of the company. The two basic financial statement
provided by a company are the Balance Sheet and profit and loss account.

Analysis of Financial Statements

The financial statement of a company can be used to evaluate the financial

performance of the company. Financial ratios are most extensively used for the purpose.
Ratio analysis helps an investor to determine the strengths and weaknesses of a company.

1. Liquidity Ratios ( Current ratio = Current Asset / Current Liabilities & Quick
Ratio = Current Assets –Stock – Prepaid expenses / Current Liabilities)
2. Leverages Ratio (Debt Equity Ratio = Debt / Shareholder Fund or Equity, Debt to
Total Assets ratio = Total Debt / Total Assets, Interest Coverage Ratio= EBIT/ I)
3. Profitability Ratio (Gross Profit ratio, Operating profit ratio, Net profit ratio,
Administrative expenses ratio, Selling expenses ratio)
4. Profitability related to Investment (Return on Assets = PAT/ Total Assets, Return
on Capital Employed = EBIT / Total Capital Employed)
5. Profitability related to Equity Shares (EPS = Profit available to Equity
Shareholder / No of Equity Shares, Earnings Yield = EPS/Market price per share,
Dividend Payout Ratio = DPS / EPS)

Earnings per share-EPS

Earnings per share- EPS are very important tool of fundamental analysis and it is the
primary focus of every investor. EPS = Net earnings of the company/ Outstanding
shares.

One cannot decide which company shares to buy depending only on the basis of
earnings.
For example: Company X earns 5,00,000 and company Y earns Rs 10,00,000, but
company X has 10,000 outstanding shares whereas company Y has 1,00,000 outstanding
shares. Let’s calculate EPS for both companies. For Company X:EPS =
5,00,000/10,000=50 For company Y: EPS=1,00,0000/1,00,000=10 In fundamental
analysis, earnings is not the only consideration, and one cannot decide which company
shares to buy only on the basis of earnings.

In the above example company Y has higher earnings of 10 Lakhs and company X has 5

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lakhs, both companies may be good but primary focus of investment is making profit. So
along with earnings, total outstanding shares are also taken into consideration. In the
above example company X has EPS of 50, but company Y has EPS of 10 despite earning
more profit so company X shares will give more profit to investors.

Diluted Earnings Per Share (diluted EPS)

Diluted earnings per share is essentially the earnings made on every share of a
public company that is calculated assuming that all the securities that are convertible
were duly exercised. Instead of taking only the existing common stock into consideration,
Diluted Earnings Per Share assumes that all the securities including convertible bonds,
convertible preferred shares, stock options, warrants as well as other things, which can be
altered into common stock is altered actually.
Diluted EPS is important for shareholders simply because it lays down the
earnings that a shareholder would get in the worst of the scenarios. If a public listed
entity has more of different stock types in its capital framework, it should provide
information pertaining to both diluted EPS and Basic EPS.

Diluted Earnings per Share Formula

In order to calculate diluted EPS, one must include the impact of all the common
shares that are dilutive. Thus, it is basically the company’s net income that needs to be
divided by the total sum of a company’s average shares as well as other instruments that
are convertible. While, the net income of a company can be acquired through the income
statement prepared by it, the average share of a company is basically the weighted
common shares average for the entire year. Thus, the weights of each and every factor
typically include the duration for which each common share would have remained
outstanding.

Diluted Earnings per Share

= Net Income−Preferred Dividends / Outstanding shares + Dilutive
Common Shares

E.g. Ashok Leyland the basic EPS is Rs. 5.34 and diluted EPS is Rs. 5.32.

Price to Book (P/B)

This ratio, also known as the price to equity ratio, compares a stock's book value to its market
value. You can arrive at it by dividing the stock's most recent closing price by last quarter's book
value per share. Book value is the value of an asset as it appears in the company's books. It's
equal to the cost of each asset less cumulative depreciation.

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Cash EPS

Cash earnings per share (cash EPS), or more commonly called operating cash flow, Cash
earnings per share is a financial ratio that measures the operating cash flows attributable to each
share of common stock. It is a variation of the earnings per share which substitutes net income
with net cash flows from operations. While net income is subject to management judgment and
discretion in choice of accounting policies and preparation of accounting estimates, the net cash
flows from operating activities is more concrete figure, and potentially more reliable.

Cash Flows from Operating Activities – Preferred Dividends

Cash flow per share =
Weighted Average Number of Shares

Dividend Yield

Dividend yield is the ratio of dividend paid per share by a company to its current share price. It is
a dividends received by investors for their investments in the stock.
Dividends are one of the two sources for return equity shareholders receive on their investment
in a company’s stock, the other being capital gains. Dividend yield measures the percentage
return on a particular stock that has resulted from the company’s dividend payments.
Dividend Yield =Total Dividend Payment / Total Market Capitalization

(or)

= Dividend Per Share / Current Share Price

Dividend per share information can be obtained from the company’s financial statements.
Alternatively, it can be calculated by dividing total dividend payments by the total number of
shares.
Dividend yield is a measure of investor return that has come from dividend payments.
Dividend yield ratio provides a comparison of amount of dividend to investment needed to
purchase the shares. A company might be paying out a relatively high, say 50%, of its earnings
to investors, but if the dividend payments are too low as compared to its current share price, the
investors who prefer dividends over capital gains might not be attracted by even the high payout
ratio.
Dividend yield should be analyzed in the context of the company’s industry and any
share buybacks. A fast growing company might not be paying any dividends resulting in a zero
dividend yield, but it might be generating high capital gains for investors. On the other hand, a
company in a mature industry may generate a decent dividend yield for its investors but it may
not have very high future growth potential.

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MODULE 4: MODERN PORTFOLIO THEORY BBA VI SEM

SYLLABUS CONTENT
Modern Portfolio theory: Markowitz diversification model- history, assumption,
problems, Capital Asset pricing model-Capital Market Line(CML) & Security
Market Line(SML) - history, assumption, problems, Arbitrary pricing model-
history, assumption, Sharpe Single Index Model- history, assumption, problems,
Asset allocation decision, Dominant & efficient portfolio, Simple
diversification.
OBJECTIVES OF THE CHAPTER
 Introducing the Portfolio Theories
 To know about the Modern Portfolio Theory

Portfolio management is all about strengths, weaknesses, opportunities and

threats in the choice of debt vs. equity, domestic vs. international, growth vs.
safety, and many other tradeoffs encountered in the attempt to maximise return
at a given appetite for risk. A portfolio refers to a collection of investment tools
such as stocks, shares, mutual funds, bonds, and cash and so on depending on
the investor’s income, budget and convenient time frame.

Portfolio Construction is all about investing in a range of funds that work

together to create an investment solution for investors. Building a portfolio
involves understanding the way various types of investments work, and
combining them to address your personal investment objectives and factors such
as attitude to risk the investment and the expected life of the investment. When
building an investment portfolio there are two very important considerations.

Approaches in portfolio construction

There are two approaches to the construction of securities:
a) Traditional Approach
b) Modern Approach

Traditional Approach

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Portfolio Analysis

Portfolios which are the combinations of securities, may or may not take on the
aggregate characteristic of their individual parts. Portfolio analysis considers the
determination of future risk and returns in holding various blends of individual
securities. The goal of the portfolio manager should be to minimise the portfolio
risk for any level of expected returns. Portfolio analysis phase of portfolio
management consists of identifying the range of possible portfolio that can be
constituted by a given set of securities and calculating their return and risk for
further analysis.

Assumptions

 Securities are interrelated

 They are combined to reduce risk
 The theory used to maximise return and minimise risk.

Portfolio analysis can be divided into 2 parts:

1. Portfolio return
2. Portfolio risk

1. Portfolio Return: a portfolio is a collection of securities. Since it is rarely

desirable to invest the entire funds of an individual or an institution in a single
security, it is essential that every security is viewed in a portfolio context. Thus,
it seems logical that the expected return of a portfolio should depend on the
expected return of each of the security contained in the portfolio. It also seems
logical that the amounts invested in each security should be important. Since the
expected return of a portfolio is the weighted average of the expected return of
the individual securities in the portfolio, the contribution of each security to the
portfolio’s expected returns depends on its expected returns and its
proportionate share of the initial portfolio’s market value.

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It follows that an investor who simply wants the greatest possible expected
return should hold one security: the one which is considered to have the greatest
expected return. Very few investors do this. Instead, investors should diversity,
meaning that their portfolio should include more than one security. This is
because diversification can reduce risk.

The portfolio return can be measured either by actual return or expected return.
The actual return of a portfolio over some specific period of time is equal to the
weighted average of the returns of individual assets or securities in the portfolio.
It is calculated as follows:

Rp = R1 X1 + R2 X2+……RnXn

Rp = 𝑊𝑖 Ri

Where-

Ri- return on ‘ith’ security

𝑊𝑖 - weight of ‘ith’ security

Rp - Return to portfolio

2. Portfolio Risk: Risk refers to variability in the expected return. Just as the
risk of an individual security is measured by the variance or standard deviation
of its return, the risk of a portfolio is measured by the variance of its return.

Although the expected return on a portfolio is the weighted average of the

expected returns on the individual securities in the portfolio, portfolio risk is not
the weighted average of the risks of the individual securities in the portfolio
(expected when the returns from the securities are correlated).

There are three tools in measuring risk:

1. Covariance
2. Correlation

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3. Standard deviation
1. Covariance- reflects the degree to which the returns of two securities
vary. When two or more securities or assets are combined in a portfolio, their
covariance or interactive risk is to be considered. Thus, if the returns on two
assets move together, a positive value for covariance indicates that the securities
returns tend to go together- for example, a better- than- expected return for one
is likely to occur along with a better-than-expected return for the other. A
negative covariance indicates a tendency for returns to offset the other. A small
or zero value for the covariance indicates that there is little or no relationship
between the two returns.
When we consider two portfolio case, co- movement of the assets should be
given due consideration. Covariance or returns on two assets measure their co-
movement.

Basically, the following steps are involved in the calculation of covariance

between the two assets.

 Determine the expected return on assets.

 Determine the deviation of a possible return from the expected return (mean)
for each asset.
 Determine the sum of the product of each deviation of returns of two assets
and respective probability.

Mathematically, the covariance is defined as

Covariance of x&y = 1/n 𝑹𝒙 − 𝑹𝒙 ( 𝑹𝒚 − 𝑹𝒚)

2. The coefficient of correlation: the relationship between the two

variables can be found easily with the help of correlation analysis. Correlation is
a measure of linear relationship between the return of 2 securities. It reflects the
degree of movements between the 2 variables. The coefficient of correlation is

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another measure designed to indicate the similarity in the behaviour of the two
variables.

Correlation coefficients always lie between +1.0 and -1.0 inclusive. The former
value represents perfect positive correlation and the latter represents perfect
negative correlation. If the coefficient is 0 then the returns are to be
independent. To sum up, correlation between two securities depends on
covariance between them the standard deviation of each correlation

i.e., correlation (r) = covariance of xy/𝝈𝒙𝝈𝒚

3. Standard deviation: Standard deviation of a portfolio is defined as the

square root of the sum of the individual asset variances plus twice their
Covariance’s. It is simply the square root of the variances.

Security 𝝈𝒙 = 𝑹𝒊 − 𝑹 2/n

Dominant and Efficient Portfolio

Dominant Portfolio is part of the efficient frontier in modern portfolio theory.

If a portfolio has a higher expected return than another portfolio with the same
level of risk, a lower level of expected risk than another portfolio with equal
expected return or a higher expected return and lower expected risk than the
portfolio is dominant. A portfolio that provides the greatest expected return for
a given level of risk, or equivalently, the lowest risk for a given expected return
also called as an Efficient portfolio. According to Markowitz Portfolio Theory,
a portfolio with the highest level of return at a given level of risk is called
efficient portfolio. One who carries such a portfolio cannot further diversify to
increase the expected rate of return without accepting a greater amount of risk.
Likewise, one cannot decrease his/her exposure to risk without proportionately
decreasing the expected return.

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Selection of Portfolio

The process of portfolio selection a portfolio may be divided into two stages.
The first stage starts with observation and experience and ends with beliefs
about the future performances of available securities. The second stage starts
with the relevant beliefs about future performances and ends with the choice of
the portfolio. The rule that the investor does (or should) Maximise discounted
expected, or anticipated, returns is first considered. This rule is rejected both as
a hypothesis to explain, and as a maximum to guide investment behaviour. Then
the rule that the investor does (or should) consider expected return a desirable
thing and variance of return an undesirable thing. This rule has many sound
points, both as a maxim for and hypothesis about investment behaviour. We
illustrate geometrically relations between beliefs and choice of portfolio
according to the "expected returns-variance of returns” rule.

One type of rule concerning the choice of the portfolio is that the investor
should maximise the discounted (or capitalised) value of future returns. Since
the future is not known with certainty, it must be "expected” or "anticipated'
returns which we discount. Variations of this type of rule can be suggested. The
hypothesis (or maxim) that the investor does (or should) maximise discounted
return must be rejected. If we ignore market imperfections the foregoing rule
never implies that there is a diversified portfolio which is preferable to all non-
diversified portfolios. Diversification is both observed and sensible; a rule of
behaviour which does not imply the superiority of diversification must be
rejected both as a hypothesis and as a maxim.

Selection of Optimal Portfolio

An investment portfolio is a distribution of wealth among several financial

assets such as stock, bonds, and their derivatives. The main goal of building a
portfolio is to diversify risk while attaining a high level of return. However,

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depending on the situation and the investor’s needs, variations of this goal could
be defined. Two most commonly sought goals are the maximisation of return
for a given acceptable level of risk and minimization of risk to achieve a given
required level of return. Arbitrage ensures that increasing the level of return is
not possible without taking any risk. However, the required return and the
highest acceptable level of risk are not the only constraints that determine the
amount of wealth that should be invested in each asset. Time allocated to
achieve the required return dictates the speed at which the wealth should be
accumulated.

Time to maturity of each asset certainly limits the set of assets available to take
part in a portfolio especially when the goal needs to be achieved quickly.
Transaction cost,which could be a fixed amount or a portion of the transferred
amount, also influences the dynamics of a portfolio, that is whether the portfolio
is to be held fix during the entire time period allocated to achieve the main goal
of an investor or the portfolio could be adjusted after certain time intervals.
Finally, an investor might prefer a particular portfolio structure. For example, a
person close to retirement is usually risk averse and prefers to invest in less
risky government bonds, while a young enthusiastic individual might be more
risk prone and willing to invest in several high-risk stocks with hope to quickly
earn a large amount of money. Time allocated for portfolio growth, time to
maturity of each financial asset, transaction cost, and preferable portfolio
structure is only a few of numerous constraints that might limit the options
when creating an optimal investment portfolio. Other circumstances that might
affect the portfolio selection include the amount of money available as well as
the possibility for short selling which is whether an investor could sell assets
that he/she does not owe in order to increase the amount of money available to
invest in other assets that will hopefully yield better results. Moreover, the

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choices for the optimal portfolio are limited by the preference of an investor
whether all the available wealth must be invested or not.

To determine the optimal portfolio on the efficient frontier, the investor’s risk-
return trade-off must be known. The following diagram or graph represents it as
follows:

Expected return E(Rp) Iq I

Standard deviation 𝜎p

The indifference curve Iq and Ip represent the risk-return tradeoffs of two

hypothetical investors, P and Q. Both P and Q, like most investors, are risk
averse. In general the steeper the slope of the indifference curve, the greater the
degree of risk aversion.

Utility indifferences curves

(Rp) Ip4 Ip3 Ip2 Ip1

Standard deviation 𝜎p

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In the above figure, four risk-return indifference curves offer the same level of
satisfaction. For example the point A and B, which lie on the indifference curve
Ip1 offer the same level of satisfaction; likewise the points R and S, which lie on
the indifference curve Ip2 , offer the same level of satisfaction. The level of
satisfaction increases as one move towards the left. When compared the curve
Ip1 represents a higher level of satisfaction than curve Ip2. The indifference curve
Ip3represents a higher level of satisfaction than curve Ip4.

Optimal Portfolio

The optimal portfolio is found between the efficiency frontier and the utility
indifference curve. This point represents the highest level of utility the investor
can reach. In the graph below two investors, P and Q confronted with the same
efficient frontier but having different utility indifference curves (Ip3, Ip2 and Ip1
for P and Iq1, Iq2 and Iq3 for Q ) are shown to achieve their highest utilities at
points P* and Q* respectively.

Expected return E(Rp) Ip3 Ip2 Ip1

I q3 Iq2 Iq1

P B

Q M

Standard deviation 𝜎p

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Modern Approach

Harry Markowitz Model

The Markowitz model, proposed in 1952 by harry Markowitz, is the first

modern portfolio theory which provides A normative approach to the investor to
make decisions to invest their funds in assets of securities under risk. It is an
optimisation model for balancing the expected return and risk of a portfolio.
The model uses the statistical variance of a stock price as the measure of its risk
and its expected return as the measure of its long-term prospects. Markowitz
model is thus a theoretical framework for the analysis of risk and return and
their interrelationship.

Assumptions

1. Efficient market and absorb the information quickly and perfectly.

2. Investors are risk averse and try to minimise the risk and maximise
return
3. Investors are rational and behave in a manner as to maximise their utility
with a given level of income or money.
4. Investors have free access to fair and correct information on the returns
and risk.
5. Investors base decisions on expected returns and variance or standard
deviation of these returns from the mean.
6. Investors prefer higher returns to lower returns for a given level of risk.
Markowitz – Modern Portfolio theory
1. Portfolio Analysis
2. Selection of portfolio

Portfolio Analysis: Portfolio, which are combinations of securities, may or may

not take on the aggregate characteristic of their individual; parts. Portfolio

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analysis considers the determination of future risk and returns in holding

various blends of individual securities.

a) Portfolio Returns: The portfolio return can be measured either by actual

return or expected return. The actual return of a portfolio over some specific
period of time is equal to the weighted average of the returns of individual
assets or securities in the portfolio.
Rp = ∑ P i R i
b) Portfolio Risk:

𝝈p=√w12𝝈12 +w22𝝈22+2w1w2𝒓12

Where

𝜎p – Standard deviation of the portfolio return

W1, W2 - weights of securities 1 and 2 in the portfolio

𝜎12𝜎22 – variances of the return on securities 1 and 2

r12– Correlation between securities 1 and 2

There are three tools o parameters in measuring risk:

1. Covariance

Cover xy = 1/n 𝑹𝒙 − 𝑹𝒙 ( 𝑹𝒚 − 𝑹𝒚)

2. Correlation

Correlationxy = Covariancexy/ σx σy

3. Standard deviation

𝝈= 𝑹𝒊 − 𝑹𝒊 2/n- 1

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Portfolio Section

Types of investors

1. Risk averse: they are those investors who avoid risk. They always prefer
to invest in securities which have a minimum or low risk.
2. Neutral risk: These investors are neutral to risk, they may or may not
invest in securities which have high risk
3. Risk Taking: these investors are risk takers. They generally have active
portfolio strategies. They are continuously investing in securities with high risk.

Limitations

1. A model is a large number of input data required for calculation. An

investor must obtain an estimate of returns and variance of returns for all
security as also covariance of returns for each pair of security included in the
portfolio.
2. The model is the complexity of computations required. The computation
required are numerous and complex in nature.
3. It has found a little use in the practical application of portfolio analysis
much simplification is needed before the theory can be used for practical
application.
4. Cumbersome
5. Large number of input data required for calculations

Capital Asset Pricing Model

The CAPM was introduced by Jack Treynor (1961, 1962), William Sharpe
(1964), John Lintner (1965a, b) and Jan Mossin (1966) independently, building
on the earlier work of Harry Markowitz on diversification and modern portfolio
theory. The capital asset pricing model (CAPM) is used to determine a
theoretically appropriate required rate of return of an asset, if that asset is to be

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MODULE 4: MODERN PORTFOLIO THEORY BBA VI SEM

added to an already well-diversified portfolio, given that asset's non-

diversifiable risk. The model takes into account the asset's sensitivity to non-
diversifiable risk (also known as systematic risk or market risk), often
represented by the quantity beta (β) in the financial industry, as well as
theexpected return of the market and the expected return of a theoretical risk-
free asset. The CAPM is a model for pricing an individual security or portfolio.
Assumptions

1. Aim to maximise economic utilities (Asset quantities are given and

fixed).
2. Are rational and risk-averse.
3. Are broadly diversified across a range of investments.
4. Are price takers, i.e., they cannot influence prices.
5. Can lend and borrow unlimited amounts under the risk-free rate of
interest.
6. Trade without transaction or taxation costs.
7. Deal with securities that are all highly divisible into small parcels (All
assets are perfectly divisible and liquid).
8. Have homogeneous expectations.
9. Assume all information is available at the same time to all investors.
For individual securities, we make use of the security market line (SML) and its
relation to expected return and systematic risk (beta) to show how the market
must price individual securities in relation to their security risk class. The SML
enables us to calculate the reward-to-risk ratio for any security in relation to that
of the overall market. Therefore, when the expected rate of return for any
security is deflated by its beta coefficient, the reward-to-risk ratio for any
individual security in the market is equal to the market reward-to-risk ratio,
thus:

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Capital market line (CML)

All investors are assumed to have identical (homogeneous) expectations. Hence,

all of them will face the same efficient frontier. Every investor will seek to
combine the same risky portfolio with different levels of lending or borrowing
according to his desired level of risk. This portfolio of all risky securities is
referred to as the market portfolio. All investors will hold combinations of only
two assets, the market portfolio and a riskless security. All these combinations
will lie along the straight line representing the efficient frontier. This line
formed by the action of all investors mixing the market portfolio with the risk-
free asset is known as the Capital Market Line (CML). All efficient portfolio of
all investors will lie along this Capital Market Line.

Ri = Rf +λ σp
Ri = Rf + Rm- Rf σp
σm
Rp

CML

X
Rf

σp

Security Market line

The SML essentially graphs the results from the capital asset pricing model
(CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents

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MODULE 4: MODERN PORTFOLIO THEORY BBA VI SEM

the expected return. The market risk premium is determined from the slope of
the SML.

The relationship between β and required return is plotted on the securities

market line (SML), which shows expected return as a function of β. The
intercept is the nominal risk-free rate available for the market, while the slope is
the market premium, E(Rm)− Rf. The securities market line can be regarded as
representing a single-factor model of the asset price, where Beta is exposure to
changes in thevalue of the Market. The equation of the SML is thus:

Ri = Rf + ( Rm- Rf) * β
β = Correlation*σP
σm
Rp

Rightly Valued
Undervalues
Securities
Securities

Overvalued
securities

βp

It is a useful tool in determining if an asset being considered for a portfolio

offers a reasonable expected return for risk. Individual securities are plotted on
the SML graph. If the security's expected return versus risk is plotted above the
SML, it is undervalued since the investor can expect a greater return for the
inherent risk. And a security plotted below the SML is overvalued since the
investor would be accepting less return for the amount of risk assumed.

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Limitations

 The model assumes that the variance of returns is an adequate

measurement of risk. This would be implied by the assumption that returns are
normally distributed, or indeed are distributed in any two-parameter way, but
for general return distributions, other risk measures (like coherent risk
measures) will reflect the active and potential shareholders' preferences more
adequately. Indeed risk in financial investments is not variance in itself; rather it
is the probability of losing: it is asymmetric in nature. Barclays Wealth has
published some research on asset allocation with non-normal returns which
shows that investors with very low-risk tolerances should hold more cash than
CAPM suggests.
 The model assumes that all active and potential shareholders have access
to the same information and agree about the risk and expected return of all
assets (homogeneous expectations assumption).
 The model assumes that the probability beliefs of active and potential
shareholders match the true distribution of returns. A different possibility is that
active and potential shareholders' expectations are biased, causing market prices
to be informational inefficient. This possibility is studied in the field
of behavioural finance, which uses psychological assumptions to provide
alternatives to the CAPM such as the overconfidence-based asset pricing model
of Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam (2001).
 The model does not appear to adequately explain the variation in stock
returns. Empirical studies show that low beta stocks may offer higher returns
than the model would predict. Some data to this effect was presented as early as
a 1969 conference in Buffalo, New York in a paper by Fischer Black, Michael
Jensen, and Myron Scholes. Either that fact is itself rational (which saves
the efficient-market hypothesis but makes CAPM wrong), or it is irrational

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(which saves CAPM, but makes the EMH wrong – indeed, this possibility
makes volatility arbitrage a strategy for reliably beating the market).
 The model assumes that given a certain expected return, active and
potential shareholders will prefer lower risk (lower variance) to higher risk and
conversely given a certain level of risk will prefer higher returns to lower ones.
It does not allow for active and potential shareholders who will accept lower
returns for higher risk. Casino gamblers pay to take on more risk, and it is
possible that some stock traders will pay for risk as well.
 The model assumes that there are no taxes or transaction costs, although
this assumption may be relaxed with more complicated versions of the model.
 The market portfolio consists of all assets in all markets, where each asset
is weighted by its market capitalization. This assumes no preference between
markets and assets for individual active and potential shareholders, and that
active and potential shareholders choose assets solely as a function of their risk-
return profile. It also assumes that all assets are infinitely divisible as to the
amount which may be held or transacted.
 The model assumes economic agents optimise over a short-term horizon,
and in fact, investors with longer-term outlooks would optimally choose long-
term inflation-linked bonds instead of short-term rates as this would be amore
risk-free asset to such an agent.
 CAPM assumes that all active and potential shareholders will consider all
of their assets and optimise one portfolio. This is in sharp contradiction with
portfolios that are held by individual shareholders: humans tend to have
fragmented portfolios or, rather, multiple portfolios: for each goal one portfolio
— see behavioural portfolio theory and Maslowian portfolio theory.

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Arbitrage Pricing Theory

Arbitrage is the practice of taking positive expected return from overvalued or

undervalued securities in the inefficient market without any incremental risk
and zero additional investments.

Arbitrage pricing theory (APT) is a general theory of asset pricing that holds
that the expected return of a financial asset can be modelled as a linear function
of various macro-economic factors or theoretical market indices, where
sensitivity to changes in each factor is represented by a factor-specific beta
coefficient. The theory was proposed by the economist Stephen Ross in 1976.
The model-derived rate of return will then be used to price the asset correctly -
the asset price should equal the expected end of period price discounted at the
rate implied by the model. If the price diverges, arbitrage should bring it back
into line.

That is, the expected return of an asset j is a linear function of the asset's
sensitivities to then factors.

Assumptions:

1. The investors have homogeneous expectations.

2. The investors are risk averse and utility maximises.

3. Perfect competition prevails in the market and there is no transaction cost.

Arbitrage Portfolio: according to the APT an investor tries to find out the
possibility to increase returns from the portfolio without increasing the funds in
the portfolio.

∆Xa + ∆Xb + ∆Xc = 0

APT Model: according to Stephen Ross, returns of the securities are influenced
by a number of macroeconomic factors. The macroeconomic factors are

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thegrowth rate of industrial production, therate of inflation, spread between long

term and short term interest rates and spread between low- grade and high-grade
bonds.

Ri = λ0 + λ1 bi1 + λ2 bi2……+ λn bin

Ri= average expected return

λ1 = sensitivity of return to bi1

bi1= the beta co- efficient to the particular factor

Arbitrage Pricing Equation: in the single factor model, the linear relationship
between the return Ri and the sensitivity bi can be given in the following form:

Ri = return on individual security

λ0 = risk-free rate of return

λ1 = slope of the arbitrage pricing line

b1 = sensitivity related to the factor

Relationship with the capital asset pricing model (CAPM and APT)

The APT along with the capital asset pricing model (CAPM) is one of two
influential theories on asset pricing. The APT differs from the CAPM in that it
is less restrictive in its assumptions. It allows for an explanatory (as opposed to
statistical) model of asset returns. It assumes that each investor will hold a
unique portfolio with its own particular array of betas, as opposed to the
identical "market portfolio". In some ways, the CAPM can be considered a
"special case" of the APT in that the securities market line represents a single-
factor model of the asset price, where beta is exposed to changes in thevalue of
the market.

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Additionally, the APT can be seen as a "supply-side" model, since its beta
coefficients reflect the sensitivity of the underlying asset to economic factors.
Thus, factor shocks would cause structural changes in assets' expected returns,
or in the case of stocks, in firms' profitabilities.

On the other side, the capital asset pricing model is considered a "demand side"
model. Its results, although similar to those of the APT, arise from a
maximisation problem of each investor's utility function, and from the resulting
market equilibrium (investors are considered to be the "consumers" of the
assets).

The APT has a number of benefits. First, it is not as a restrictive as the CAPM
in its requirement about individual portfolios. It is also less restrictive with
respect to the information structure it allows. The APT is a world of arbitrageurs
and vendors of information. It also allows multiple sources of risk, indeed these
provide an explanation of what moves stock returns. The benefits also come
with drawbacks. The APT demands that investors perceive the risk sources, and
that they can reasonably estimate factor sensitivities.

Sharpe Single Index model

The Markowitz Model was theoretically elegant and conceptually sound.

However, its serious limitation was that it related each security to every other
security in the portfolio, demanding the sophistication and volume of work well
beyond the capacity of all but a few analysts. Consequently, its application
remained severely limited until William F. Sharpe published by the Markowitz
Model. Sharpe assumed that, for the sake of simplicity, the return on a security
could be regarded as being linearly related to a single index like the market
index.Theoretically, the market index could consist of all the securities traded

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on the market. The simplification of the Markowitz Model has come to be

known as the market model or single index Model.

Assumption

1. All investors have identical expectations regarding risk and return.

2. No corporate tax and transaction cost
3. Borrowings and lending rates are same
4. One period time horizon
5. Securities are related to each other through some index represented by m

Sharpe Model

1. Portfolio analysis
2. Portfolio Selection

Portfolio analysis: portfolio analysis and selection require as inputs the

expected portfolio return and risk for all possible portfolio that can be
constructed with a given set of security. The return and risk or portfolio can be
calculated using index model.

Return on securities

Ri = αi + βi Rm + ei

Here,

Ri = Return on security
αi = Constant
βi = slope of regression line or systematic risk
Rm = Return on market
ei = Error term

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Sharpe’s Optimal Portfolio

William Sharpe has developed a model for the selection of appropriate
securities in a portfolio.
To determine which securities are included in the optimum portfolio, the
following steps are necessary.
1. Step 1
Calculate excess returns to Beta = ( Ri – Rf)
Βi
2. Step 2
Calculate Unsystematic risk = ( Ri – Rf) βi
σ ei2
3. Step 3 = β i2
σ ei2
4. Step 4
Cumulate step 2
5. Step 5
Cumulate step 3
6. Step 6
Calculation off rate (C) = σ m2 (step 4)
1+ σ m2 (step 5)

Step 7
Calculation of Optimal Security
Zi = βi (Ri – Rf)/ β i – C*
σ ei2
Step 8 calculation of Optimal portfolio
Xi = (Zi / ∑Zi )*100

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Optimal portfolio without short sales

.at first, the stocks have to be ranked by an excess return to beta. Here, all the
stocks are not added to the portfolio. The stocks ranked below C* have low
excess returns to beta are not considered to form a part of the optimal portfolio.
Therefore only the stocks ranked above the C* and stock pertaining to C* is
considered. If the number of stocks is larger there is no need to calculate Z
values for all the stocks after ranking has been done. it can be calculated until
the C* value is found, the calculations can be terminated.
Optimal portfolio with short sales
The procedure used to calculate the optimal portfolio when short sales are
allowed is, more or less similar to the procedure adopted for no short sales,
except the cut-off point concept. Here, all the stocks are added to the portfolio.
They are either held long or short. All stock affects the cut-off point. The Z
value has to be calculated on each stock. If the Z value is positive, the stock will
be held long and if negative the stocks will be sold short.

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Practical Problems

1. A portfolio has 4 securities and the expected returns from the 4 securities
are 15%, 12%, 14% and 20%. The funds invested in securities are Rs. 2
lakhs, Rs 2.8 lakhs, Rs. 3.2 lakhs and Rs. 4 lakhs respectively. Find the
expected return from the portfolio.

2. A portfolio has 5 securities and the expected returns from the 5 securities
are 17%, 15%, 13%, 11% and 16%. The funds invested in securities are
Rs. 2.5 lakhs, Rs. 3.6 lakhs, Rs. 2 lakhs, Rs. 4 lakhs and Rs. 4.25 lakhs
respectively. Find the expected return from the portfolio.

3. Stocks X and Y have yielded the following returns for the past 2 years:

Year Return on X Return on Y

(%) (%)
2017 12 14
2018 18 12

a) What is the expected return on portfolio made up of 60% of X and 40%

of Y?
b) Find out the standard deviation of each stock.
c) What is the co-variance and co-efficient of correlation between stock X
and Y?
d) What is the portfolio risk of a portfolio made up of 60% of X and 40% of
Y?

4. Stocks A and B has yielded the following returns for the past 3 years:

Year Return on A Return on B (%)

(%)

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2016 14 12
2017 16 18
2018 20 15

a) What is the expected return on stock A & B

b) Find out the standard deviation of each stock
c) What is the co-variance and co-efficient of correlation between stock X
and Y?
d) What is the portfolio risk of a portfolio made up of 35% of A and 65% of
B?

5. The expected rates of return and the possibilities of their occurrence for X
and Y scrip are given below:
Probability of Return on X Return on Y
Occurrence (%) (%)
0.05 -2.0 3.0
0.20 9.0 6.0
0.50 12.0 11.0
0.20 15.0 14.0
0.05 26.0 19.0

a) Find out the expected rates of return for X and Y.

b) If an investor invests equal proportion on both the scrip what would be
the return?
c) If the proportion is changed to 25% and 75% and then to 75% and 25%
what would be the expected rates of return?

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6. A financial analyst is analyzing 2 investment alternatives of A and B. the

estimated rates of return and their chances of occurrence for the next year
are given in the table below:

Probability of Return on A Return on B (%)

Occurrence (%)
0.20 22 5
0.60 14 15
0.20 -4 25

a) Determine each alternative expected rate of return, variance and

standard deviation.
b) Is B comparatively riskless?
7. The return of two assets under four possible states of nature are given
below:-
State of Nature Probability X Y
1 0.10 5% 10%
2 0.30 10% 8%
3 0.50 15% 18%
4 0.10 20% 26%
From the above data calculate:-
a) Expected return on the portfolio
b) Standard deviation of the stock
c) Correlation between stock X and Y
d) Portfolio risk
8. The return of two assets under four possible states of nature are given
below:-

State of Nature Probability X Y

1 0.30 8% 8%
2 0.20 11% 4%
3 0.10 -8% 12%
4 0.40 10% 7%

From the above data calculate:-

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a) Expected return on the portfolio

b) Standard deviation of the stock
c) Correlation between stock X and Y
d) Portfolio risk

9. The expected return for Sensex is 15% with the standard deviation of
25%. The risk free return is 8%. The following information is available
for 4 securities. All assumed to be efficient.
Security AAA BBB CCC DDD
Standard deviations 16 13 19 20
(%)

Calculate:
a) Slope of CML
b) Expected portfolio return.

10.The expected return for Nifty is 12% with the standard deviation of 15%.
The risk free return is 6%. The following information is available for 4
mutual funds. All assumed to be efficient.
Mutual Fund LIC HDFC UTI SBI
Standard deviations 12 19 17 22
(%)

Calculate:
a) Slope of CML
b) Expected return of each Mutual Fund.

11.The risk free return on a portfolio is 6%. The expected return on BSE
Index is 14% and the risk measured by standard deviation is 2%. Now to

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construct an efficient portfolio to produce a 12%expected rate of returns,

what would be its risk and slope of CML?

12.From the following data calculate the standard deviation and slope of
CML.
Security Expected
Return
A 13%
B 16%
Return on market = 16%, risk free rate of return = 6%, S.D of market
=10%

13.The risk free return on portfolio is 8%. The expected return on BSE Index
is 18% and the measured by standard deviation is 5%.Now to construct
an efficient portfolio to produce a 15% expected rate of return, what
would be its risk and slope of CML.

14.The expected return for Nifty is 14%, with a S.D of 18%. The risk free
return is 7%. The following information is available for 4 securities. All
assumed to be efficient.
Security A B C D
S.D 10 12 15 19

a) Calculate slope of CML.

b) What is the expected return for each security?

15.The following information is available expected return from nifty- 19%

SD of nifty return- 15%
Risk free return- 13%
Correlation co efficient between ITC and Nifty 0.6

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Correlation co efficient between Dabur and Nifty 0.9

SD of ITC- 20%
SD of Dabur- 22%
Calculate required rate of return of ITC and Dabur.

16.From the following details find out the securities that are overpriced or
underpriced in terms of the SML.
Security Actual return (%) ß σ
A 13 1.7 12
B 23 1.4 10
C 14 1.1 13
D 18 0.95 16
E 15 1.05 12
F 19 0.70 10
Nifty 13 1 20
Index
T-Bills 9 0 0

17.From the following details find out the securities that are overpriced or
underpriced in terms of the SML
Security Actual Returns ß σ
(%)
A 15 1.5 12
B 13 1 10
C 16 1.25 14
D 17 0.5 16
E 18 1.5 12
F 16 0.25 10

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Nifty 13 1 20
Index
T-Bills 08 0 0

18.The following data are available to you.

Security Actual ß σ
Returns (%)
Blue 32 1.7 15

White 30 1.4 20

Red 25 1.1 25

Black 22 0.9 20

Brown 20 0.7 25

BSE 14 1 18

t- bills 12 0 0

a) Draw the SML. Plot each stock on your graph

b) In terms of SML, which of the securities listed above are
undervalued?

19.Expected return for the market is 10%, with a S.D of 18%. The expected
risk free rate is 8%. Information is available for five stocks:-

Stocks Beta Return on

Stock
AA 1 12%
BB 1.25 13%
CC 0.5 14%
DD 1.1 11%

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EE 1.5 12%
a) Draw the SML. Plot each stock on your graph
b) Determine which stocks are undervalued or overvalued.

20.From the following details find out the securities that are overpriced or
underpriced in terms of the SML
Security Actual Returns ß σ
(%)
A 13 1.5 11
B 11 1 10
C 15 1.25 15
D 18 0.5 11
E 15 1.5 17
F 16 0.25 15
Nifty 13 1 20
Index
T-Bills 08 0 0

21. Mr. Raj is constructing an optimum portfolio. The market return forecast
says that it would be 13.5% for the next two years with the market variance of
10%. The risk-free rate of return is 5%. The following securities are under
review. Find out the optimum portfolio.
Company α β σ2ei
A 3.72 0.99 9.35
B 0.60 1.27 5.92
C 0.41 0.96 9.79
D -0.22 1.21 5.39
E 0.45 0.75 4.52

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22. Mr. Aswanth received Rs. 10 lakh from his pension fund. He wants to invest
in the stock market. The Treasury bill rate is 7% and the market return variance
is 20. The following table gives the details regarding the expected return, beta
and residual variance of the individual security. What is the optimal portfolio
assuming no short sales.

Company α β σ2ei
A 20 0.75 25
B 18 1.3 16
C 16 1.3 9
D 12 0.75 16
E 10 0.6 9
F 15 1.8 36

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MODULE 5: PORTFOLIO PERFORMANCE
EVALUATION

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MODULE 5: PORTFOLIO PERFORMANCE EVALUATION
BBA VI SEM

Syllabus Content
Portfolio performance evaluation, Sharp & Treynor & Jensen’s measure,
Portfolio revision, Active and passive strategies & formula plans in portfolio
revision, asset management companies- Functions of asset management
companies, Performance measurement and return attribution for portfolios.

Portfolio Evaluation
It refers to the evaluation of the performance of the portfolio. It is essentially the
process of comparing the returns earned on a portfolio with the return earned on
one or more other portfolio or on a benchmark portfolio.

Portfolio Performance Measure:

For evaluating the performance of a portfolio it is necessary to consider both
risks and return. There is three most popularly employed portfolio performance
measure precisely. They are:
1. Sharpe’s Performance Index
It gives a single value to be used for the performance ranking of various funds
or portfolios. Sharpe index measures the risk premium of the portfolio relative
to the total amount of risk in the portfolio. The risk premium is the difference
between the portfolio’s average rate of return and the riskless rate of return. The
standard deviation of the portfolio indicates the risk. The index assigns the
highest values to assets that have the best risk- adjusts the average rate of return.
Sharpe Index = ( Rp– Rf)
σp
2. Treynor’s Performance Index
The characteristic line of a stock is the same as the security market line and is
very useful when employing the capital asset pricing model, or when using

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MODULE 5: PORTFOLIO PERFORMANCE EVALUATION
BBA VI SEM

modern portfolio techniques. the slope of the line which is ameasure of

systematic risk determines the risk- return trade-off.
The relationship between the given market return and the fund’s return is given
by the characteristic line. The fund’s performance is measured in relation to the
market performance. The ideal fund’s return rises at a faster rate that the general
market performance when the market is moving upwards and its rate of return
declines slowly that the market return.
Treynor’s performance Index = ( Rp – Rf)
βp
3. Jensen’s performance Index
The absolute risk-adjusted return measure was developed by Micheal Jensen. It
measures the absolute performance because a definite standard is set and against
that the performance is measured. The standard is based on the manger’s
predictive ability is superior; he should earn more than other funds at each level
of risk.
Jensen Alpha performance Index= Rp – CAPM
or
Rp- [Rf +(Rm-Rf] β
This index compares the actual or realised return of the portfolio with the
calculated or predicted return. Better performance of the funds depends on the
predictive ability of the managerial personnel of the funds.

Asset Management Company

A company that invests its clients' pooled fund into securities that match its
declared financial objectives. Asset management companies provide investors
with more diversification and investing options than they would have by
themselves.

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BBA VI SEM

AMCs offer their clients more diversification because they have a larger pool of
resources than the individual investor. Pooling assets together and paying out
proportional returns allows investors to avoid minimum investment
requirements often required when purchasing securities on their own, as well as
the ability to invest in a larger set of securities with a smaller investment.

Functions of AMC

An asset management company (hereinafter the AMC) is a legal entity that

conducts a professional activity on the management of assets of collective
investment institutions (hereinafter CII) based on the license issued by the
Securities and Stock Market State Commission of Ukraine, and cannot combine
its activity with other kinds of a professional activity in the securities market.

The AMC charges a fee for managing assets of CII the amount of which is set in
accordance with the fund’s bylaw. The AMC can manage assets of some CII at
one time. An activity of the AMC is strictly regulated by legislation and
overseen by the Securities and Stock Market State Commission.

Major functions of an asset management company are as follows:

 Establishing CIIs:
 Issuing, placing and buying back CII’s securities;
 Engaging agents that place/repurchase CII’s securities among the
investors;
 Exercising management of CII’s assets;
 After the money has been transferred to the CII’s account,
 The AMC directs it to the purchase of assets with the aim to create the
portfolio structure of the given CII, specified in its Investment Declaration;
 Analysing the securities market, the housing and other markets, the
instruments of which are part of CII’s assets;

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BBA VI SEM

 Seeking new objects for investments;

 Regular evaluation of assets, drawing up agreements on purchase and sale
of assets, preparing reports for government bodies;
 Conducting daily activities of CII.

Portfolio Revision

The art of changing the mix of securities in a portfolio is called as portfolio

revision.
The process of addition of more assets in an existing portfolio or changing the
ratio of funds invested is called as portfolio revision. The sale and purchase of
assets in an existing portfolio over a certain period of time to maximize returns
and minimize risk is called as Portfolio revision.

Need for Portfolio Revision

 An individual at certain point of time might feel the need to invest more.
The need for portfolio revision arises when an individual has some
additional money to invest.
 Change in investment goal also gives rise to revision in portfolio.
Depending on the cash flow, an individual can modify his financial goal,
eventually giving rise to changes in the portfolio i.e. portfolio revision.
 Financial market is subject to risks and uncertainty. An individual might
sell off some of his assets owing to fluctuations in the financial market.

Portfolio Revision Strategies

There are two types of Portfolio Revision Strategies.

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1. Active Revision Strategy

Active Revision Strategy involves frequent changes in an existing

portfolio over a certain period of time for maximum returns and
minimum risks.

Active Revision Strategy helps a portfolio manager to sell and purchase

securities on a regular basis for portfolio revision.

2. Passive Revision Strategy

Passive Revision Strategy involves rare changes in portfolio only under

certain predetermined rules. These predefined rules are known as formula
plans. According to passive revision strategy a portfolio manager can
bring changes in the portfolio as per the formula plans only.

What are Formula Plans?

Formula Plans are certain predefined rules and regulations deciding when and
how much assets an individual can purchase or sell for portfolio revision.
Securities can be purchased and sold only when there are changes or
fluctuations in the financial market.

Why Formula Plans ?

 Formula plans help an investor to make the best possible use of

fluctuations in the financial market. One can purchase shares when the
prices are less and sell off when market prices are higher.
 With the help of Formula plans an investor can divide his funds into
aggressive and defensive portfolio and easily transfer funds from one
portfolio to other.

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Aggressive Portfolio

Aggressive Portfolio consists of funds that appreciate quickly and guarantee

maximum returns to the investor.

Defensive Portfolio

Defensive portfolio consists of securities that do not fluctuate much and remain
constant over a period of time.

Formula plans facilitate an investor to transfer funds from aggressive to

defensive portfolio and vice a versa.

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Practical Problems

1. The following information is provided regarding the performance of the funds viz., A,
B and C for a period of 6 month ending December, 2015. The risk free rate of interest
is assumed to be 9% and return on market is 13%. Rank the following funds with the
help of Sharpe and Treynor’s Index and Jensen performance index.

Securities Rp σp β
(%)
A 25.38 4 0.23
B 25.11 9.01 0.56
C 25.01 3.55 0.59

2. The following information is provided regarding the performance of the funds viz., A,
B and C for a period of 6 month ending August, 2015. The risk free rate of interest is
assumed to be 6% and return on market is 13%. Rank the following funds with the
help of Sharpe and Treynor’s Index and Jensen performance index

Securities Rp β σp
A 0.087 0.499 0.007
B 0.134 1.2493 0.009
R 25.38 4 0.23
T 25.11 9.01 0.56
C 25.01 3.55 0.60

3. Mr. A is having units in a mutual fund for the past 3 years. He wants to evaluate its
performance by comparing it to the market. Find out Sharpe’s and Treynor’s indices.
Comment. Also calculate Jensen performance index

Funds Market
Return 70.60 41.40
σp 41.31 19.44

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Rf 12% 12%
β 1.12 1

4. There are 2 equity funds A and B, the details are as below:

A B
Actual Return 17% 19%
from the fund
β co-efficient 1.60 0.70
The market return is 18% and the risk free interest rate is 6%. Evaluate the portfolios on the
basis of Jensen’s measure.

5. Given are 4 mutual funds and their risk return characteristics:

Name of the funds Return earned β σ

Super Star 25 1.13 22.70
True Balance 17 0.95 17.20
Sure Return 20 0.98 20.90
Safety Net 15.30 1.00 15.60

Risk free rate of return is 8.50%. Using Jensen’s measures identify the funds that have earned
excess return assuming market returns id 10%.

6. The following three portfolios provide the particulars given below:

Portfolio Average Annual Standard Correlation Co-

Return Deviation efficient
A 18 27 0.8
B 14 18 0.6
C 15 8 0.9
Market 13 12 -

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Risk free rate of interest is 9%.

a) Rank these portfolios using Sharpe’s and Treynor’s Jensen methods.
b) Compare all three the indices.

7. With the given details, evaluate the performances of the different funds using Sharpe,
Treynor and Jensen performance index
Funds Return Standard Deviation Beta
A 2 20 .98
B 12 18 .97
C 8 22 1.17
D 9 24 1.22
E 17 15 1.6
Risk free return is 4%
Return on Market is 9%

8. Rank the three funds given below with Treynor and Sharpe index.

Growth Fund Return Standard Beta

Deviation
A 15 12 1.5
B 17 14 1.6
C 13 11 0.75
D 2 20 1.17
E 13 24 1.22
T-bill rate is 8 %

9. Sun rise company manages mutual funds. The data below provides the key statistical
information calculate Treynor and Sharpe index

Mutual Fund Return Standard Beta

Deviation
A 15 18 .83
B 13 16 .68
C 14 10 1
D 16 12 1.3
E 12 14 .9
T Bill 8 - -

10. An investor wants to build a portfolio with the following four stocks. With the given
details, find out his portfolio return and portfolio variance. The investment is spread
equally over the stocks.

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Stock α β ei2
1 0.27 1.50 45
2 1.12 1.15 50
3 1.38 1.20 25
4 1.47 0.54 35
The market variance is 27. The markets’ expected return is 12%.
11. Given the following returns and risks, calculate Sharpes and Treynors measure of
portfolio performance

Mutual Fund Return Standard Beta

Deviation
A 14 3 .4
B 20 8 1
C 26 6 1.1
D 30 13 1.2
E 36 15 1.4
T Bill 6 - -

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MODULE 6: SPECTRUM OF INVESTMENT BBA VI SEM

SPECTRUM OF INVESTMENT
Investment Avenues
Investment is an activity that engaged in by people who has savings that are investments are
made from savings or in other words people invests their savings. Investment is an activity
which is different from savings.
Investment may be defined as “a commitment of funds made in the expectation of some
positive rate of return”
There are a large number of investment avenues in India. Some of them are marketable and
liquid while others are non-marketable. Some of them are highly risky while some others are
almost riskless. The investor has to choose proper avenues from among them depending on
his preferences, needs and ability to assume the risk.
Investment Avenues:
All financial assets are further classified into marketable and non-marketable financial assets.
1. Marketable Forms
Marketable financial assets are those which have an active secondary market. In other words,
they can be bought and sold any time before their maturity. Some securities have a highly
liquid secondary market some may have an average liquid secondary market.
E.g. Equity shares, Preference shares, Bonds, Debentures
2. Non-Marketable Forms
Non-marketable financial assets are those which do not have an active secondary market.
They have to be held till maturity and can be redeemed back to the issue of maturity. They
cannot be bought and sold during their maturity.
E.g.; national savings certificate, provident fund, fixed deposits, life insurance policies, etc
FINANCIAL FORMS OF INVESTMENT(Marketable Forms)
Bonds
Bonds or debentures represent long-term debt instruments. The issuer of a bond promises to
pay a stipulated stream of cash flow.
Bond is a negotiable certificate evidencing indebtedness. It is normally unsecured. A debt
security is generally issued by a company, municipality or government. A bond investor
lends money to the issuer and in exchange. The issuer promises to repay the loan amount on a
specified maturity date. The issuer usually pays the bond holder periodic interest payments
over the life of the bond.
Types of Corporate Bonds

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Bonds primarily issued by the private sector companies and financial institutions are referred
to as corporate bonds. During the early 1990s, there has been a bewildering range of
innovative debt securities in India. These innovations are the results of the multifaceted
factors. The most important being the volatility in the interest rates and the changes in the
taxation policies and regulatory framework. The various types of corporate bonds are
explained below:
a) Convertible Bonds
Convertible bonds can be one of the attractive investment vehicles for the investor looking
for both currency yield (interest) and capital appreciation. it is a cross between a bond and a
stock. At the option of the holder, the bond can be converted into a stock into a
predetermined number of shares at a specified price.
b) Non-convertible Bonds
Non-convertible bonds are those which cannot be converted into stocks. They are redeemed
on maturity.
c) Sinking Fund Bonds
Sinking fund bonds arise when the company decides to redeem its bond issue systematically
by setting aside a certain amount each year from its current earnings to meet this purpose.
The amount aside is generally known as sinking fund/ debenture redemption fund.
d) Secured Bonds
The bonds which are secured by the company‟s assets are known as secured bonds. They are
also known as mortgaged bonds. Since they are secured there is a guarantee of the investment
to its investor.
e) Unsecured Bonds
The bonds which do not create a charge on the charge on the asset of a company are known
as unsecured debentures. They are also known as naked debentures
(bonds). The holders of these bonds do not have any cover to guarantee the safety of their
investment.
f) Redeemable Bonds
A redeemable bond is one which has been issued for a certain period on the expiry which its
holder will be repaid the amount thereof with or without premium.
g) Irredeemable Bonds
A bond without the redemption period is termed as irredeemable/ perpetual bond. They are
redeemed either in the event of the winding-up of the company or on the happening of a
certain event. They are also known as perpetual bonds or consoles.

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h) Straight Bond
Straight bond is also known as plain vanilla bond. It pays a fixed periodic coupon rate of
interest usually semi-annually over its life. It is redeemed on the maturity date.
i) Floating Rate Bonds
Floating rate bonds pays an interest rate that is often linked to a benchmark rate such as
Treasury bill interest rate. For example, In December 1992, the state bank of India issued
floating rate bonds worth Rs.5 million for the first time in India. It carried an interest at 3%
per annum over the bank's maximum term deposit rate of interest.
j) Junk Bonds
Junk bonds are highly yielding instruments with a significant probability of default
k) Zero coupon bonds
These bonds are sold at a discount and repaid at par value at its maturity. These bonds do not
carry any interest. The difference between the purchase price and the face value of the bond
is the gain to the investor.
E.g.: IDBI issued deep discount bonds in 1996 at Rs 5300 with a maturity period of 25 years.
These bonds have options embedded in them.
l) Commodity-Linked Bonds
The bonds whose payoff depends on the price of a certain commodity, to a certain extent are
called commodity-linked bonds.
m) Capital Indexed Bonds:In this, the principal amount of the bond isadjusted for
inflation for every year. The benefit of the bond is that it gives the investor an increase in
returns by taking into account. An investor can exit before the maturity through a secondary
market.
Features of Bonds
A bond is a long-term fixed income security that assures to pay a fixed rate of interest for a
specified period of time. The basic features of a bond are:
1) Face Value
Bonds have face value/ par value. A bond may be issued at par value or at a discount. Interest
is paid on the face value
2) Interest Rate
The interest rate of bonds (debentures) is fixed. Sometimes it may be variable (floating rate
bonds). The interest rate is also known as coupon rate. Interest paid on a bond/ debenture is
tax deductible.

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3) Maturity
The maturity date of the bond is usually specified at the time of issue. It is repaid at maturity.
4) Redemption Value
Redemption value is the value that a holder will get on maturity. A bond/ debenture may be
redeemed at par value or at a premium. It is also known as terminal value or maturity value.
5) Market Value
Bonds/ debentures are traded in the stock market, the price at which it is currently traded as
known as its market value.
6) Protective Covenants
The bond or debenture usually contains several covenants which protect the interest of the
investors. These restrictive covenants impose certain restrictions on the company and repose
a great confidence to investors that the company will honour its commitments.
Hedge Funds

Hedge means to safeguard, and in the context of investing, it means to safeguard against
risks. A hedge fund uses the funds collected from accredited investors like banks, insurance
firms, High Net-Worth individuals (HNIs) & families, and endowments and pension funds.
This is the reason why these funds often function as overseas investment corporations or
private investment partnerships. They do not need to be registered with SEBI, nor do they
need to disclose their NAV periodically like other mutual funds.

A hedge fund portfolio consists of asset classes like derivatives, equities, bonds, currencies
and convertible securities. Hence, they are also called as alternative investments. As a
collection of assets that strives to „hedge‟ risks to investor‟s money against market ups and
downs, they need aggressive management. Unlike the typical equity mutual fund, they tend to
employ substantial leverage. They hold both long and short positions, including positions in
listed and unlisted derivatives.

Hedge funds are mutual funds that are privately managed by experts. For this reason, they
tend to be a bit on the costlier side. Hence, they are affordable and feasible only for the
financially well-off.

Hedge fund industry in India is relatively young and it got a green flag in 2012 when
Securities and Exchange Board of India (SEBI) allowed alternative investments funds (AIF).
They have following features:

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a. High Net-Worth Investors

Only qualified or accredited investors can invest in hedge funds. They are mainly high net
worth individuals (HNIs), banks, insurance companies, endowments and pension funds. The
minimum ticket size for investors putting money in these funds is Rs 1 crore.

b. Diverse Portfolio

Hedge funds have a wide portfolio of investments ranging from investments in currencies,
derivatives, stocks, real estates, equities, and bonds. Yes, they essentially cover all the asset
classes only limited by the mandate.

c. Higher Fees

They work on the concept of both expense ratio and management fee. Globally, it is „Two
and Twenty‟, meaning there is a 2% fixed fee and 20% of profits. As for hedge funds in
India, the management fee can well below 2% to below 1%. And the profit sharing varies
between 10% to 15% generally.

d. Higher Risks

Hedge funds investment strategy can expose funds to huge losses. Lock-in period generally
for investment is relatively long. Leverage used by these funds can turn investments into a
significant loss.

e. Taxation

The Category III AIF (hedge funds) is still not given pass-through status on tax. This implies
that income from these funds is taxable at the investment fund level. Hence, the tax
obligation will not pass through to the unit-holders. This is a disadvantage for this industry as
they are not on a level playing ground with other mutual funds.

f. Regulations

It is not required that Hedge funds be registered with the securities markets regulator and
have no reporting requirements including regular disclosure of Net Asset Values (NAV).

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