Security Analysis Short Notes
Security Analysis Short Notes
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These are identified and analysed for drawing inferences.
C. Economic Model Building Approach: In this approach, a precise
and clear relationship between dependent and independent variables is
determined. GNP model building or sectoral analysis is used in practice
through the use of national accounting framework.
Industry Analysis: In this Factors Affecting Industry Analysis like:
a. Product Life-Cycle;
b. Demand Supply Gap;
c. Barriers to Entry;
d. Government Attitude;
e. State of Competition in the Industry;
f. Cost Conditions and Profitability;
g. Technology and Research; etc.
Are studied and inferences are drawn. Techniques such as Correlation and
Regression analysis, input – output analysis etc. Are used.
Company Analysis: In this:
a. Net Worth and Book Value;
b. Sources and Uses of Funds;
c. Cross Sectional and Time Series Analysis;
d. Size and Ranking;
e. Growth Record;
f. Financial Analysis;
g. Quality of Management;
h. Location of the unit;
i. Labour and Management relations;
j. Pattern of Existing stockholding;
k. Marketability of shares etc.
Are studied. Techniques used for study are, Correlation and Regression
Analysis, Trend Analysis, Decision Tree Analysis, etc.
Technical Analysis:
Technical Analysis is a method of study of share price movements with the
help of graphs and charts on the assumption that share price trends are
repetitive, since investor psychology follows a certain pattern. It
presupposes that price behaviour follows certain cyclic patterns that are
repetitive. This analysis attempts to answer:
a. Whether any trend exists? and if so,
b. When will it reverse?
Charts like Bar chart, Line chart, Point figure chart etc. are used to ascertain
the direction of movement of share prices. All said and done this does not
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totally affirm that the past trend observed will continue in future and it could
be a totally different scenario as well.
Bar Chart: This is drawn with days on X Axis and prices on Y axis. For
each day, a small vertical line is drawn indicating the high and low prices.
Closing price of the day is indicated by small horizontal line across the
vertical line. Day volume is indicated below each vertical line.
Line Chart: Closing price of each day is plotted on the graph and joined by
a line.
Point and Figure Chart: These charts are little complicated. Point and
figure chart is unique. It does not plot price against time as all other
techniques do. Instead it plots price against changes in direction by plotting
a column of Xs as the price rises and a column of Os as the price falls. The
correct way to draw a point and figure chart is to plot every price change but
practicality has rendered this difficult to do for a large quantity of stocks so
many point and figure chartists use the summary prices at the end of each
day. Some prefer to use the day’s closing price and some prefer to use the
day’s high or low depending on the direction of the last column.
Dow Theory: This is the oldest theory explaining the behaviour of stock
prices named after its propounder.
The Dow Theory is based upon the movements of two indices, constructed
by Charles Dow, Dow Jones Industrial Average (DJIA) and Dow Jones
Transportation Average (DJTA). These averages reflect the aggregate impact
of all kinds of information on the market. The movements of the market are
divided into three classifications, all going at the same time; the primary
movement, the secondary movement, and the daily fluctuations. The
primary movement is the main trend of the market, which lasts from one
year to 36 months or longer. This trend is commonly called bear or bull
market. The secondary movement of the market is shorter in duration than
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the primary movement, and is opposite in direction. It lasts from two weeks
to a month or more. The daily fluctuations are the narrow movements from
day-to-day and are not considered by Dow.
The theory, in practice, states that if the cyclical swings of the stock market
averages are successively higher and the successive lows are higher, then
the market trend is up and a bullish market exists. Contrarily, if the
successive highs and successive lows are lower, then the direction of the
market is down and a bearish market exists.
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Wedge: A wedge is formed when the tops (resistance levels) and bottoms
support levels) change in opposite direction (that is, if the tops, are
decreasing then the bottoms are increasing and vice versa), or when they
are changing in the same direction at different rates over time.
Gap: Gap is the difference between the preceding day’s closing price and
current day’s opening price. The larger the gap, the stronger will be the
continuation of the observed trend.
Decisions based on Data Analysis: This is based on statistical analysis of
historical data.
Moving Averages: Moving averages are frequently plotted with prices to
make buy and sell decisions. The two types of moving averages used by
chartists are:
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Arithmetic Moving Average (AMA), and
Exponential Moving Average (EMA).
An n-period AMA, at period t, is nothing but the simple average of the last n
period prices. Analysts use long term (> 30 weeks) moving averages to
ascertain long trends, medium term (30 – 60 days) moving averages for
medium trends and short term (around 10 days) moving averages for short
trends.
In the case of AMA, equal weightage is given to all results. But, in case of
EMA, more weightage is given to latest result and the weight decreases for
older results. The weights decrease exponentially, according to a scheme
specified by the exponential smoothing constant, also known as the
exponent, a. Formula for calculation is:
EMAT = aPt + (1 - a) * EMAt-1 = EMAt-1 + a (Pt – EMAt-1)
Where, a = Exponent Constant; Pt = Price on respective day and EMAt-1 =
Preceding day’s EMA.
Bond Valuation:
A bond or debenture is an instrument of debt issued by a business or
government. Basics of bonds are:
Coupon Rate: Coupon rate is the interest payable on the bond. This is
expressed as a percentage linked to the face value of the bond.
Maturity Period: Corporate bonds have a maturity period of 3-10 years and
Government bonds maturity may extend upto 25 years. Face value of bond
along with premium, if any is payable on maturity.
Value of a Bond: Value of a bond is sum of the discounted values of the
series of interest payments and principal amount at maturity. Formula is:
𝐼 𝐹
V= 𝑛
𝑡=1 1+𝑘 𝑡 + where,
𝑑 1+𝑘 𝑑 𝑛
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a. When the required rate of return equals the coupon rate, the bond
sells at par value.
b. When the required rate of return exceeds the coupon rate, the bond
sells at a discount. The discount declines as maturity approaches.
c. When the required rate of return is less than the coupon rate, the
bond sells at a premium. The premium declines as maturity
approaches.
d. The longer the maturity of a bond, the greater is its price change with
a given change in the required rate of return.
e. Price of a bond varies inversely with yield (Yield is the payment at
maturity) because as the required yield increases, the present value of
the cash flow decreases; hence the price decreases and vice versa.
This is converse of return on bond and coupon rate.
f. Value of the bond changes with duration. As the bond approaches its
maturity date, the premium / discount will tend to be zero.
Yield to maturity: The rate of return one earns is called the Yield to
Maturity (YTM). The YTM is defined as that value of the discount rate (“k d”)
for which the Intrinsic Value of the Bond equals its Market Price (Note the
similarity between YTM of a Bond and IRR of a Project). If we ignore the
issue related expenses, kd equals the relevant cost of (debt) capital for the
company.
Duration of Bond: Duration is nothing but the average time taken by an
investor to collect his investment. If an investor receives a part of his
investment over the time on specific intervals before maturity, the
investment will offer him the duration which would be lesser than the
maturity of the instrument. Higher the coupon rate, lesser would be the
duration.
Duration of a financial asset that consists of fixed cash flows, like a bond, is
the weighted average of the times until those fixed cash flows are received.
When an asset is considered as a function of yield, duration also measures
the price sensitivity to yield, the rate of change of price with respect to yield
etc.
Macaulay duration is the weighted average time until cash flows are
received, and is measured in years. Modified duration is the percentage
change in price for a unit change in yield. When yields are continuously
compounded Macaulay duration and modified duration will be numerically
equal. When yields are periodically compounded Macaulay and modified
duration will differ slightly, and there is a simple relation between the two.
For bonds with fixed cash flows a price change can come from two sources:
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1. The passage of time (convergence towards par). This is of course
totally predictable, and hence not a risk.
2. A change in the yield. This can be due to a change in the benchmark
yield, and / or change in the yield spread.
The yield-price relationship is inverse, and we would like to have a measure
of how sensitive the bond price is to yield changes. The modified duration is
a measure of the price sensitivity to yields and provides a linear
approximation.
Macaulay duration and modified duration are both termed "duration" and
have the same (or close to the same) numerical value, but it is important to
keep in mind the conceptual distinctions between them. Macaulay duration is
a time measure with units in years. For a standard bond the Macaulay
duration will be between 0 and the maturity of the bond. It is equal to the
maturity if and only if the bond is a zero-coupon bond.
Modified duration, on the other hand, is a derivative (rate of change) or
price sensitivity and measures the percentage rate of change of price with
respect to yield. The concept of modified duration can be applied to
interest-rate sensitive instruments with non-fixed cash flows, and can thus
be applied to a wider range of instruments than can Macaulay duration.
The equality (or near-equality) of the values for Macaulay and modified
duration can be a useful aid to intuition. For example a standard ten-year
coupon bond will have Macaulay duration little less than 10 years and also
implies that modified duration (price sensitivity) will also be somewhat but
not dramatically less than 10%. Formula is:
𝒕∗𝑪 𝒏∗𝑴
Macaulay Duration (in years) =[ 𝒏
𝒕=𝟏 (𝟏+𝒊)𝒕 + ]/P where,
(𝟏+𝒊)𝒏
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value) equal to the initial investment plus interest that has been accrued on
the investment made. The maturity dates on zero coupon bonds are usually
long term. These maturity dates allow an investor for a long range planning.
Zero coupon bonds are issued by banks, government and private sector
companies. However, bonds issued by corporate sector carry a potentially
higher degree of risk, depending on the financial strength of the issuer and
longer maturity period, but they also provide an opportunity to achieve a
higher return. I C I C I, I D B I etc. have issued zero coupon bonds with the
name as deep discount bonds.
Questions:
a. Explain in detail the Dow Jones Theory.
b. Explain the Elliot Wave Theory of technical analysis.
c. Why should the duration of a coupon carrying bond always be less
than the time to its maturity?
d. Mention the various techniques used in economic analysis.
e. Write short notes on Zero coupon bonds.
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