DIRECTORATE OF CORRESPONDENCE COURSES

KURUKSHETRA UNIVERSITY
KURUKSHETRA-136119

MBA (2ndYear) Distance Education

MBADFM-306: Security Analysis Max. Marks 100
External: 70
Internal: 30
Time: 3 Hrs

Note: The examiner will set nine questions in all. Question No. 1, comprising of 5 short answer type

questions of 4 marks each, shall be compulsory and remaining 8 questions will be of 10 marks out of

which a student is required to attempt any 5 questions.

Objective: The objective of this course is to impart knowledge to students regarding the theory

and practice of Security Analysis.

Course Contents:

Unit-1

Investment background – meaning and avenues of investment, concept of risk and return,

determinants of required rates of return, relationship between risk and return, security risk and

return analysis and measurement.

Unit-2

Financial assets – type and their characteristics including derivatives; asset allocation decision –

individual investor life cycle, the portfolio management process, the importance of asset

allocation &organization.

Unit-3

Functioning of financial markets in India - primary capital markets, secondary markets, financial

intermediaries, listing of securities, securities trading, securities settlement, and regulation,

evaluation of securities, and stock exchanges.

Unit-4

Security analysis and management strategies – efficient market hypothesis, macro-analysis and

micro-valuation of the stock market; fundamental analysis – economic analysis, industry analysis,

company analysis and stock valuation; technical analysis – techniques, DOW theory;

Unit-5

Equity portfolio management strategies – passive versus active management strategies; analysis

and management of fixed income securities - bond fundamentals, the analysis and valuation of

bonds, bond portfolio management strategies – passive, semi-active and active strategies.

Suggested Readings:

1. Alexander, G.J., Sharpe, W.F. and Bailey, J.V., Fundamentals of Investments, Prentice

Hall.

2. Bodie, Z., Kane, A., Marcus, A.J. and Mohanty, P., Investments, Tata McGraw-Hill.

3. Chandra, P., Investment Analysis and Portfolio Management, Tata McGraw-Hill.

4. Elton, E.J. and Gruber, M.J., Modern Portfolio Theory and Investment Analysis, John

Wiley and Sons.

5. Fabozzi, F.J. and Markowiz, H.M., The Theory and Practice of Investment Management:

6. Graham and Dodd, “Security Analysis Asset Allocation, Valuation, Portfolio

Construction, and Strategies, Wiley.

7. Fischer, Donald E. and Jordan, Ronald J., Security Analysis and Portfolio Management,

Prentice Hall.

8. Mayo, H.B., Investments: An Introduction, Thomson Asia.

 DIRECTORATE OF CORRESPONDENCE COURSES

KURUKSHETRA UNIVERSITY

KURUKSHETRA-136119

_____________________________________________________________________________

MBA-III

_____________________________________________________________________________

MBADFM-306: Security Analysis

___________________________________________________________________________________

L.No. Title Writer Page No.

1. Investment background – Dr. Anshu Bhardwaj 05-20

Meaning and Avenues of investment.

2. Concept of risk and return, Dr. Anshu Bhardwaj 21-43

determinants of required rates of return,

relationship between risk and return,

security risk and return analysis and

measurement.

3. Financial assets – Type and their Dr. Anshu Bhardwaj 44-55

characteristics including derivatives

4. Asset allocation decision – individual Dr. Anshu Bhardwaj 56-69

investor life cycle, the portfolio

management process, the importance

of asset allocation & organization.

5. Functioning of financial markets in Dr. Anshu Bhardwaj 70-87

India - primary capital markets,

 Secondary markets, financial

intermediaries.

6. Listing of securities, securities trading, Dr. Anshu Bhardwaj 88-108

securities settlement, and regulation,

evaluation of securities, and stock exchanges.

7. Security analysis and management strategies- Dr. Anshu Bhardwaj 109-126

efficient market hypothesis, macro-analysis

and micro-valuation of the stock market;

8. Fundamental analysis – Economic analysis, Dr. Anshu Bhardwaj 127-161

Industry analysis, Company analysis and

Stock valuation; Technical analysis –

Techniques, DOW theory.

9. Equity portfolio management strategies – Dr. Anshu Bhardwaj 162-170

passive versus active management strategies

10. Analysis and management of fixed income Dr. Anshu Bhardwaj 171-192

securities - bond fundamentals, the analysis

and valuation of bonds, bond portfolio

management strategies – passive, semi-active

and active strategies.

 DIRECTORATE OF CORRESPONDENCE COURSES
KURUKSHETRA UNIVERSITY
KURUKSHETRA-136119

__________________________________________________________________________

Paper: MBADFM-306: Writer: Dr. Anshu Bhardwaj

Lesson No.1

_____________________________________________________________________________

Investment background –Meaning and Avenues of investment

1. Introduction

2. Learning Objective

3. Presentation of Contents

3.1 Investment: Meaning, types and characteristics

3.1.1 Attributes and Objectives of investment

3.1.2 Risk and Return

3.1.3 Risk-Return Trade off

3.1.4 Types of investors

3.1.5 Investment vs. Speculation

3.2 Avenues of investment

4. Summary

5. References

6. Self-Assessment Questions
1. Introduction

The term investment when related to security analysis is about making investment in marketable

securities. Broadly, investment is termed as employment of funds by sacrificing the current

present value for future returns. Thus, there are two important factors one is time (which is

certain) and other is risk (which is uncertain). The investment may be real investment (tangible

assets such as land, building, machinery) and financial investments are defined as exchange of

financial claims (such as common stocks and bonds). There is trade-off between risk and return

while taking investment decisions. There is inter-relationship between financial investment and

economic investment as both results in creating physical assets directly in later case and indirectly

in former case.

The investment avenues available for investors differ in terms of risk-return characteristics. The

investors are having different levels of risk bearing capacity, thus, risk averter investors are those

who are not ready to take risk and risk takers are those who are ready to take risk in financial

market as a whole. Depending upon their preferences, objectives and constraints, investors take

decisions for making investment from the wide array of investment avenues available to them.

2. Learning Objective
The objective of this lesson is to make the students familiar with the actual meaning of

investment, basis of investment decision, scope of investment decision, risk and return as

component of investment decisions, organization of investment decision process. After studying

this lesson, you will be familiar with the characteristics and basis of investment decision, concept

of investment and how it differs from speculation, scope and components of investment decision,

various types of investors and organization of investment decision process and different avenues

of investments available to investors.

3. Presentation of Contents
3.1. Investment: Meaning, types and characteristics

Investment may be defined as allocation of funds with an expectation to gain some returns

over a period of time. Investment may also be defined as sacrificing from the current consumption

with the prospect of some benefits that may accrue in future. Thus investment may be termed as

financial assets in general and marketable securities in particular. Savings and investment are

important aspect in the investment process as a whole. An investor has option either to invest or to

save the surplus amount from the amount generated as earnings. The amount kept as savings may

not give return but if investment is done judiciously from the different types of assets with

different risk-return characteristics, an investor may expect high degree of return. The choice of

investment in assets is based upon the risk taking ability of the investor.

An investor gives more preference to the regular stream of returns and speculator is more

concerned about the capital appreciation. Thus, speculator invests in those securities which can

give quicker return. The planning horizon for the speculator is very short and holding period

ranges from few days to months. At the same time, speculator is ready to take high risk with an

expectation to earn high returns and relies on borrowings in order to supplement own resources.

For any investor, there are different objectives of investment focusing on maximization of returns,

minimization of risk and providing hedge against inflation. Thus, investors make investment to

increase their monetary wealth and protect it from inflation, taxes and any other factor that could

be either in the form of physical assets or financial assets.

The following are the different forms of making investment:

 A buys a piece of land with an objective of selling at some future date with capital

appreciation.

 B purchases machinery for Rs.10, 00,000 for the production unit.

 C deposits Rs. 10,000 in savings account in a bank.

 D purchases 300 shares of TCS at Rs.4045.80 per share.

From the examples mentioned above, it can be ascertained that the investment may be classified

as either financial investments or economic investments. Financial investments are those which

are done to purchase shares or debentures, bank deposits, post office investments, insurance

policies etc. Economic investments are those that are done with the sole aim of formation of

productive capital that results into increasing the value of current economic capital stock. Thus,

investment may also be termed as where the commitment of funds is being done with the

expectation to get some reward at some future date. Thus, investors are holding it for a certain

period of time may be for short term, medium term and long term. The returns are higher if the

duration of investment is long because of the uncertainty involved with the future. The various

dimensions of investment are sacrifice being made for utilizing the money at present and thus the

utility of money is postponed for future. The other dimensions are uncertainty of returns and risk

associated with it. The investors are making the investments as they are expecting returns from the

same may be defined as risk premium for taking particular level of risk.

3.1.1 Attributes and Objectives of investment

The investments are being done by various investors and the two important attributes for

investment are time and risk. These are the two important criteria or basis for making the

investment decisions. The investors also expect safety of return on the investment made along

with generating regular income. An investor expects return from income as well as capital

appreciation. There are different expectations from the investment being affected by various

factors like maturity, market fluctuations, type of investment etc. The returns available in the form

of dividend and interest from the investment are referred to as yield and high capital appreciation

is received from investment in stock price but it carries high risk as well. The other objectives are
related to liquidity and marketability of investments being made. When investors can easily

convert their investment into cash with ease and without loss of time and original value, it is

considered to be a liquid investment. It also depends upon marketability of the investment so that

it can be purchased and sold and also offering the buyback option like in case of mutual funds.

The criterion for making the investment by investors is the tax-incentives available on the

investment. Thus, government also provides tax based incentives to encourage the investment and

investors invest in such securities to reduce their tax expenses and payment. From such type of

investment very marginal returns are available to investors and it leads to achievement of short

term objective for diverse set of investors.

3.1.2 Risk and Return

Thus, investors always expect maximum return and minimum risk at the time of making

investment decision thus, ensuring safety and liquidity in the investments. It is also important to

discuss about anticipated return or expected return which is available to investors for some future

date and actual return or realized return is actually earned from their holdings over a period of

time. Thus, investors need to consider the risk involved in the investment and accordingly move

for the investment process as a whole. The risk may be defined as variability of returns or in other

words when actual return is different from the realized return. There are different avenues

available for investment and investors may decide on the basis of the risk available and returns

associated to it. The preference for the selection of investment depends upon the risk-return

proposition. If investor wants to take less risk than the investment shall be made in those securities

where risk free returns are available and there is very less degree of risk like government

securities. The investment in corporate deposits comes under the category where there is high

degree of risk as returns are impacted by various factors which is beyond the control, but at the

same time proportionately higher returns is also a criterion for making the investment considering

the risk-return trade off by investors.

3.1.3 Risk-Return Trade off

Figure 1.1 Expected Risk-return trade off available to investors

Return

High Risk
High Return

Rf Low Risk Low Return

Risk
0

See figure 1.1, it is depicted that investors may consider any point on the line which is emanating

from the point Rf i.e. Risk- free rate of return to X. The figure also shows that there is a trade-off

between expected return and risk available for all investors. Expected return is depicted on the X-

axis and risk is shown on the y-axis and upward sloping curve reflects the wide range of

investment avenues available to the investors. Those investors who are not willing to take much

risk are interested to invest in those securities where there is negligible degree of risk such as

treasury bills. Such investors may be referred to as risk averter since the degree of return available

to investor is equivalent to current return. The other investment alternatives from the point of view

of individual investors are bank deposits, post-office deposits, fixed deposits, public provident

funds, certificate of deposits, commercial papers, and deposit in life insurance corporations etc.

which are considered as risk-free investments. There are riskier securities like corporate deposits

which entail higher degree of returns to the investor but at the same time there is a higher degree

of risk as moving up on the risk-return trade off propositions. Such investors are risk-taker and are

willing to take more risk with the expectation that there shall be higher degree of returns. Thus,

investors are actually expecting from the different investment being made by risk-averter or risk-

taker investors before making the investment, the actual position shall be known only after a

certain period of time may be a month or year or may involve longer duration.
Figure 1.2 Risk-Return Trade off

Risk-Return Trade Off

Higher Risk
Higher Probability of Higher Returns

Lower Risk
Lower Probability of Lower Returns

3.1.4 Types of investors

Investors may be classified on the basis of their risk taking capacity or level of tolerance for risk.

3.1.4.1 Risk-averter or conservative investors

The investors are ready to take risk on the basis of certain aspects may be relating to their personal

factors or some situational factors. Thus, those investors who expect safety of investments should

invest in those securities where there is not much variability in terms of return.

3.1.4.2 Moderate investors

There is another category of investors termed as moderate investors who expects moderate level

of risk and may be termed as moderate investors and the risk taking ability is little bit more than

the conservative investors.

3.1.4.3 Risk-taker investors or aggressive investors

Those investors who are ready to take high risk should invest in those securities where there is

high return assuming that higher the risk and higher the return. Those investors are termed as

aggressive investors and making investment for a longer time-horizon depending upon their

attitude towards risk.

Thus, the investors may be differentiated on the basis of their attitude and preference for making

the investment, capacity to take risk with regard to the financial aspect and the steps required to be
taken to achieve their objectives. The financial understanding is required more in case of moderate

and aggressive investors but it is comparatively less in case of conservative investors. The risk

tolerance level of investors depends upon certain factors and keeps on changing from time to time

as per level of income, age of the investor, attitude of the investors, financial knowledge and

environment prevailing in the family is also one of the important factors to evaluate the risk

tolerance level which does not remain constant always.

Investors may also be classified on the basis of two broad categories i.e. Individual investors and

Institutional investors. Individual investors are those who are very large in number but who has

small amount to invest their savings in the financial assets and often lack knowledge and expertise

required for making the investment. Institutional investors are those organizations who mobilize

funds from individuals and other sources with an objective of investment from the surplus funds.

The institutional investors adopt very systematic approach and carefully analyze before making

the investment and manage their portfolio professionally. They are also constantly engaged in

evaluating the portfolio and reconstruct the same resulting into maximum return and minimum

degree of risk.

3.1.5 Investment vs. Speculation

According to Benjamin Graham mentioned in his book “An investment operation is one which,

upon thorough analysis, promises safety of principal and an adequate return.” Further states that if

any investment operation does not meet all these requirements, it is speculative. The investment

and speculation both involves employment of funds but at the same time there is a difference

existing between the two on many facets which are as follows:

1. The element of risk inherited in investment is low/medium risk and expecting moderate

returns as per the level of risk. The speculator invests in high risk securities with the expectation

of higher returns.
2. The planning horizon in investment is relatively for a longer duration and holding period is

at least one year with an expectation to get more returns. However, speculator has a short term

planning horizon and holding period may be from few days to months.

3. The investment is done by investor by carefully evaluating the securities and expect

regular stream of income and capital appreciation is not completely ignored but may accrue when

trading of securities are done. The speculator expects capital appreciation rather than returns from

the securities hoping for quick returns and engaged in quick buying and selling with an

expectation of earning higher returns.

4. The investment is considered to be planned activity where investor evaluates the securities

and make investment in a systematic manner. The speculator takes very quick decision and

analyzes the market environment quickly with the sole objective of short term gains by purchasing

from one market and selling it hastily.

5. The investment is done by investor by evaluating the securities through fundamental

analysis and evaluating the prospectus of the industry. The speculator involves in evaluating the

securities by considering the technical analysis, sentiment indicators, market psychology etc.

6. The investment gives stable return to the investors while returns available to speculator is

uncertain because the decision is taken for a short term and quick return.

7. The investment reflects the conservative approach of investor and speculator seems to be

more aggressive in his approach.

The speculators are considered important in the stock market because it provides liquidity in the

market and there are two categories of speculator i.e. bull (buys shares with an expectation of

selling in future at higher price) and bears (sells shares in the market with an expectation of
buying the shares in future at lower price). These bullish and bearish trends result into increase in

price of the shares in former case and decrease in price of the share in latter case.

3.2 Avenues of investment

An investor is available with various investment alternatives having varies risk-return

characteristics and investor has the opportunity to choose and take investment decision

accordingly. However, investors are having very limited knowledge and at the same time investor

wants to fulfill his objective of investing the surplus funds in such a manner so that he can get

some returns at some future date. The investor also has to keep into consideration the risk bearing

capacity as there are few investment avenues offering assured return and some offer returns based

on the market fluctuations. The various investment instruments like bank deposits, government

saving schemes, bonds or debentures, insurance products, real estate, derivatives etc. have

different risk-return proposition and investors need to match the same with their expectations and

preferences.

Fig 1.3 Investment Avenues

Investment Avenues
Mutual Fixed Money Retirem Financi
Life Preciou
Deposit Fund Income Market ent Real al
Insuran s
s Scheme Securiti Instrum Product Estate Derivati
ce Objects
s es ents s ves

There are some security forms of investment avenues which are negotiable instruments and non-

security forms of investments which are non-negotiable and cannot be transferred from one party

to another.
3.2.1 Deposits are those investment avenues available to investors in the form of financial assets

which are as follows:

3.2.1.1 Bank Deposits are selected as an avenue for investment by investors where safety of

investment is the first objective. There is also assured return in the form of interest and there is no

default risk. There are different options available to investors through which investment can be

made by investors. There can be following type of deposits that can be made by an investor:

 Fixed Deposits

 Savings Bank Account

 Recurring Deposit Account

 Flexi Deposit Account

 Public Provident Fund Account

3.2.1.2 Post Office Deposits provides several deposit schemes where investors have this option of

opening an account and through obtaining certificate of deposits. The some of the deposit schemes

offered are as follows:

 Savings Account

 Recurring Deposit Account

 National Saving Scheme

 Kissan Vikas Patra (KVP)

 Public Provident Fund Account

 Postal Linked Insurance Scheme

 National Savings Certificate

 Fixed Deposit Scheme

 Monthly Income Schemes

3.2.1.3 Life Insurance schemes are being offered to investor through which various policy

benefits are availed such as assured return, health risk coverage, tax benefits, life risk coverage,

savings etc. The some of the policies are mentioned below:

 Money back Policy

 Whole Life Policy

 Endowment Plan

 Term assurance Policy

 Equity linked insurance schemes

 Equity linked savings schemes

3.2.1.4 Mutual Fund Schemes are provided as an option to investor where funds are collected

from the savings of different investors and further invested in stock market. There are only few

schemes which were being offered by Unit Trust of India till 1986. Generally, investments under

mutual fund schemes are done under the financial assets in the form of stocks, bonds and cash.

The some of the schemes are mentioned below:

 Equity Schemes have certain schemes included under this which is diversified, equity

schemes, index schemes, tax planning schemes and sectoral schemes.

 Debt Schemes include mixed schemes, floating rate debt schemes, gilt schemes and money

market schemes.
 Balanced or Hybrid Schemes consists of making investment in equity-oriented schemes,

variable asset allocation schemes and debt- oriented schemes.

3.2.1.5 Fixed Income Securities are the debt instruments where investment can be made by

investors and can be considered as investment avenues and some of these are mentioned below:

 Preference Shares

 Debentures and Bonds

 Government Securities

 Public Sector Undertaking (PSU) Bonds

3.2.1.6 Money Market Instruments are those which are having a maturity period of less than

one year and considered to be highly liquid and have very less degree of risk and major

instruments are mentioned below:

 Treasury Bills

 Certificate of Deposits

 Commercial Papers

 Repos

3.2.1.7 Retirement Products are those which may be further segregated into mandatory

retirement schemes and voluntary retirement schemes and are mentioned below:

 Employee’s Pension Scheme

 Employee’s Provident Fund

 National Pension Scheme

 Pension Schemes of Insurance Companies and Mutual Funds

3.2.1.8 Real Estate is considered to be one of the most promising investment avenues available to

investors and the following are the ways through which investments can be made:

 Agricultural Land

 Semi-urban Land

 Commercial property

3.2.1.9 Precious Objects may be defined as those valuable objects which are not in large volume

but quite costly in monetary terms and making investments in such objects has its own advantages

and disadvantages. The some of the types are mentioned below where investment can be made by

investors:

 Precious Stones

 Gold and Silver

 Art Objects

3.2.1.10 Financial Derivatives are those investment avenues considered by investors or portfolio

managers where they want to provide hedge and these are the instruments whose value actually

depends upon the value of the underlying assets and which may be termed as follows:

 Options

 Futures
4. Summary

The investment is made by investors with an expectation to receive returns with minimum risk

depending upon the attitude towards risk taking capacity. There are two important aspects of

investment one is time and other one is risk. For evaluating an investment, there are various

characteristics which are considered by investors besides rate of return, risk is

liquidity/marketability, tax-benefits and convenience. The financial markets facilitate in providing

liquidity and reducing the cost of investment. There are different types of financial markets

through which investments are being made by investors. There are different forms of investment

and different objective on the basis of which investments are being made by investors. There are

different types of investors i.e. individual and institutional investors having different purpose for

making the investments. The investor may be conservative, moderate and aggressive investor. The

investment may also be differentiated from speculation. There are different avenues of investment

available to investors and the choice can be made from these opportunities considering the

features and risk-return dynamics attached to the marketable or non-marketable assets or

securities.

5. References

1. Chandra, P., Investment Analysis and Portfolio Management, Tata McGraw-Hill.

2. Mukherjee, Subrata, Security Analysis and Portfolio Management, Vikas Publishing.

3. Bhalla, V.K., Investment Management, S. Chand Publications.

4. Khatri, Dhanesh, Security Analysis and Portfolio Management, Macmillan Publishers.

5. Fischer, Donald E. and Jordan, Ronald J., Security Analysis and Portfolio Management,

Prentice Hall.

6. Self-Assessment Questions

Q1. Define the term investment. What are the various attributes and objectives of investment?
Q2. What are the types of investors and organization of investment decision process?

Q3. What is the difference between investor and speculator?

Q4. Define the concept of risk and return. What are the expected risk-return trade off available to

investors? Show graphically.

Q5. What are the characteristics and basis of investment decision?

Q6. What are the scope and components of investment decision?

Q7. What are the various investment avenues available to the investors? Compare these

investment alternatives in terms of various objectives of investment.

Q8. Suppose investor can earn a return of 8% per 6 months on a treasury bill of Rs. 5,00,000 with

6 months remaining until maturity. What price would you expect a six month treasury bill to sell

for?

Q9. Gilt edged securities may be defined as__________________________________________.

Q10. Give three examples of non-security forms of investment.

Q11. Give rankings to the following investment avenues as per the level of risk associated with it.

The rankings to be provided from 1 (least risk) to 4 (maximum risk).

(a) Corporate Fixed deposit (b) Deposits with commercial banks

(c) Public Provident Fund (d) Non-convertible zero coupon bond

Q12. What are the advantages and disadvantages in investing in precious metals and other art

objects?
 DIRECTORATE OF CORRESPONDENCE COURSES
KURUKSHETRA UNIVERSITY
KURUKSHETRA-136119
__________________________________________________________________________

Paper: MBADFM-306: Writer: Dr. Anshu Bhardwaj

Lesson No. 2
_____________________________________________________________________________

Concept of risk and return, Determinants of required rates of return, Relationship between

risk and return, Security risk and return analysis and measurement

1. Introduction

2. Learning Objective

3. Presentation of Contents

3.1 Concept of Risk and Return

3.1.1 Return

3.1.1.1 Components of Return

3.1.1.2 Measuring Historical Returns

3.1.1.3 Summary Statistics for Returns

3.1.2 Risk

3.1.2.1 Sources of Risk

3.1.2.2 Types of risk

3.1.2.3 Summary Statistics for Risk

4. Summary

5. References

6. Self-Assessment Questions
1. Introduction
Every investment is characterized by two important variables i.e. risk and return. The

investors are also having varied preferences for risk and return and always want to maximize

expected return subject to their tolerance level of risk. The investors compare alternative

investments on the basis of expected return on the amount invested in securities. The risk may be

further classified in the form of systematic or non-diversifiable risk and unsystematic or

diversifiable risk and there are various sources also through which this risk emerges. In the

investment process, return is considered as a motivating force because it is reward for making the

investment. Even evaluating the past performance also paves the way for making the future

decisions, thus measurement of return is important for investors. Thus, the concept of realized

return and risk from investing can be used as a base for evaluating the relationship existing

between them.

In order to analyze securities within the risk-return framework, it is required to understand

the concept of risk and return, how these are created and measured while taking the investment

decision. Thus, investor has to focus on deciding the securities to be held and estimates are being

made of risk and return over a forward holding period known as security analysis. Since risk and

return are central to investment decision making we need to understand the concept of risk and

return and how they are measured.

There are various statistical tools and techniques to calculate the risk and return. After

ascertaining the return, the investors are interested to know about the variability of returns. There

are various measures of calculating the risk i.e. standard deviation, coefficient of correlation,

variance etc. The return may be calculated for a specified period of time by calculating total

returns, return relative and wealth index and by employing arithmetic mean and geometric mean

for a series of return.

2. Learning Objective
The objective of this lesson is to make the students familiar with the concept of risk and

return and determinants of required rates of return. The students will be able to understand the

following:

1. What are the different types of risk and components of return?

2. What are the sources of risk and rationale for using different measures of risk?

3. What are the various methods of measuring returns?

4. What is the relationship between risk and return while investing in securities?

3. Presentation of Contents

3.1 Concept of Risk and Return

Risk and return are the two sides of the investment coin and investment decisions are

influenced by various motives. The prime reason for making the investment is to earn return on

their investment; however, some of them invest in order to gain power or prestige. In turn,

investors have to bear the risk, therefore, risk and return goes hand in hand.

3.1.1 Return: The primary motivating force that derives investment is the reward available on

investment. Every investor expects to maximize the returns subject to certain constraints and

tolerance for risk. The investors need to assess and measure the realized return and even historical

returns play a significant role for estimation of future returns.

There are two types of return which are generally considered in investment process by investors

i.e. realized return and expected return. Realized return may be defined as the actual return that

we have earned on the investment. Expected return may be available on the investment in due

course of time for holding the securities which may or may not occur.
3.1.1.1 Components of Return

There are generally two components of returns i.e.

(a) Yield: The yield is generally used to express return on the investments. It may be considered

as an internal rate of return from the investment and is considered as a function of multiple

factors-risk, time duration and market environment etc. It is also defined as a principal component

which consists of periodic cash flow either in the form of interest or dividend. The interest

payments are made either on annual basis or semi-annual basis on bonds and on the other hand

dividends are generally paid on stocks on annual basis.

(b) Capital gain or loss: The capital gain or loss is very much relevant for common stocks. It is

actually the difference between ending price and beginning price of the stock or securities. There

are two situations which may occur:

When Ending price >Beginning price (Capital gain occurs)

When Beginning price > Ending price (Capital loss occurs)

3.1.1.2 Measuring Historical Returns

The returns available to investors from the investment consist of the following two components

i.e.

(a) Total Return= Yield + capital gain (loss)

Where yields may be defined as income component and price change as capital gain or loss.

The current return can be positive or zero whereas the capital return can be positive, negative or

zero.

For Example:

Price at the beginning of the year =Rs.150

 Price at the end of the year = Rs. 250

Dividend paid during the year = Rs. 3.50 per share

In this example there are two returns 1) Current Return or dividend yield 2) Capital gain

Total Return = Cash received as dividend+Ending price- Beginning price

Beginning Price Beginning Price

= 3.50 + 250-150
150 150

Current Income Capital Gain

= 0.0233+ 0.666 = 69%

Total Return = 3.50 +( 250-150)

150

= 69%

(b) Return Relative

Return Relative=C+ PE
PB
Or, in other words

Return Relative= 1+ Total Return

Return Relative= 1 + Cash received as dividend + Ending price- Beginning price

Beginning Price

= 1 + 0.69 or 1.69

Return relative may be less than 1.0, it will be greater than zero and in worst case it will be zero

but it cannot be negative.

(c) Cumulative Wealth Index

The cumulative wealth index measures the cumulative effect of returns over time or it measures

the level of wealth rather than changes in level of wealth as measured in total return.

Thus, cumulative wealth index CWIn is computed as follows

CWIn =WI0 (1+ TR1) (1+ TR2)……..(1+ TRn)

Where CWIn = Cumulative weight index at the end of n years

WI0 = Beginning Index value, typically one rupee

TR1,n = Periodic TRs in decimal form (when added to 1.0 in Equation 2, it becomes return

relative)

Ri is the total return for the year (i=1………n)

For Example:

Consider a stock which earns the following returns over a six-year period

R1 =0.13, R2 = 0.12, R3 =-0.15, R4 = 0.04, R5 = 0.10 R6 = 0.05

CWI6 =1(1.13) (1.12) (1.15), (1.04) (1.10) (1.05) = 1.748

Thus 1 rupee invested at the beginning of year 1 would be worth Rs. 1.748 at the end of year 6.

You can apply the values for the cumulative index to obtain the total return for a given period,

using the following equation:

Rn = CWIn 1
CWIn-1

Where Rn is the total return for the period n and CWI is the cumulative wealth index.

3.1.1.3 Summary Statistics for Returns

For a particular period of time, the total return, return relative and wealth index are considered as

useful measures of return. But, there is need to describe a series of returns for which arithmetic

mean and geometric mean is applied statistically to measure returns in investment analysis. The

two most popular summary statistics are arithmetic mean and geometric mean.

(a) Arithmetic Mean is the most popular summary statistics for measuring returns. Symbolically,

it may be represented as

The sum of all the values are being done which is further divided by the total number of

observation where n= total number of observations

As per the figures mentioned in the example 2,

Year Total Return (%)

1 13

2 12

3 15

4 0.04

5 0.10

6 0.05

Thus, we have returns of 13 %, 12%, 15 %, 0.04 %, 0.10 % and 0.05 %. Therefore, the arithmetic

mean or X = (13+12+15+4+10+5)/6= 9.83%

The arithmetic mean of series of total returns is defined as:

Arithmetic Mean or

Where,

Ri is the value of total return (i=1….n) and

n is the number of total returns.

(b) Geometric Mean The arithmetic mean is considered to be more appropriate measure to know

the central tendency of mean of returns for a single period of time may be 6 years, 10 years or so.

However, arithmetic mean may not give accurate results in case if you want to know the average

compounding rate of growth or changes in value over time. It measures the realized change in

wealth over multiple periods and applied in investment and finance.

For Example: Consider a stock whose price at the end of the year 0 is 150. The price declines to

100 at the end of year 1 and recovers to 150 at the end of year 2. During this two-year period there

is no dividend which is paid the calculation for annual return and arithmetic mean are as follows:
Return for year 1= 100-150 = -0.333 or 33 %
150

Return for year 2= 150-100 = 50 or 50 %

150

Arithmetic mean return = -33+50= 8.5 %

2

Thus, there is a variation in the return when calculated with the help of arithmetic mean but the

measure of average return cannot be accurate and true representative. So, geometric mean is

applied in a multi-period context which is representing accurately the average return.

Geometric Mean is also defined as nth root of the product resulting from multiplying a series of return relatives

minus 1.

Symbolically,

GM = ⟦ ( 1+ R 1 )( 1+ R 2)… .. ( 1+ Rn ) ⟧1/n -1

Where, GM is the geometric mean,

Ri is the total return for period I (i=1,……., n), and

n is the number of time periods.

For Example:

Consider the total return and return relative for stock A over a 5-years period

Year Total Return Return Relative

1 13 1.13

2 12 1.12

3 15 1.15

4 0.04 1.04

5 0.10 1.10

6 0.05 1.05

The geometric mean of the returns over the 5-year period is calculated as follows:
GM=⟦ ( 1.13 ) (1.12)(1.15)( 1.04)(1.10)(1.05)⟧ 1/6 -1

= (1.748)1/6 -1

= 0.0975 or 9.75 %

Thus, it reflects the compound rate of growth over the time period of 6 years. From the example

exhibited above, it is ascertained that stock A has generated a compound rate of growth of 9.75

% over a period of 6 years. It also reflects that an investment of 1 Rs. is producing a cumulative

ending wealth of 28.527 1(1.748)6

It can also be extracted from the above calculation that geometric mean is lower than the

arithmetic mean i.e. 9.83%.

The geometric mean is always less than the arithmetic mean except when all the return values are being

considered equal. On the basis of variability of distribution, there is a difference between arithmetic mean and

geometric mean.

Thus, greater the variability, the greater the difference between the two means.

(c) Arithmetic mean vs. Geometric Mean

The arithmetic mean and geometric mean may be differentiated on the following aspects:

The arithmetic mean is a best measure of expected return for the next period in investment

decision and it is employed to calculate the average over single period. The geometric mean is

considered as a best measure to apply in measuring the changes in wealth over multiple periods.

There is a scenario in which the decision is to be taken to apply the geometric mean to describe

the returns from the financial assets.

Table 2.1: Calculation of Arithmetic mean and Geometric mean

 Stocks Beginning Ending value Ending value Annual rate of Annual rate of return

Value (at the end of (at the end of return (Arithmetic (Geometric Mean)

(in terms of year 1) year 2) Mean)

Rs.)

A 30 60 30 = 100-(50%)1/2 = = 2.0 (0.5)1/2 -1=0

25%

B 30 24 36 = -20% + (50%)1/2 =0.8(1.5)1/2 -1= 9.54%

= 15%

See table 2.1 and it is concluded that both the stocks are having value at the beginning of the

period is Rs. 30.

In case of stock A, the beginning value of Rs. 30 increases to Rs. 60 at the end of the year 1 and

declines to Rs. 30 at the end of year 2 reflecting 100% increase and 50 % decrease at the end of

year 1 and year 2 respectively. The rate of return at the end of year 2 in case of arithmetic mean is

25% which is not realistic because the beginning and ending price is same i.e. Rs. 30. From the

calculation with geometric mean average annual rate of change in price per year i.e. 0 % which

seems to be true value.

In case of stock B, the arithmetic mean is calculated as 15%. But in actual if there is an increase

of 15% per year, then the price at the end of 2 nd year would have been Rs. 30 (1.15) (1.15) or Rs.

39.675. However, it does not seem to be a realistic situation because ending price is Rs. 36 .The

calculation of geometric mean annual rate of return at the end of 2 years gives Rs. 36 which seems

to be true representative of price at the end of year 2: Rs 30 (1.0954) (1.0954)is equal to Rs. 36.

Real Return may be defined as a return where adjustment has to be made for the factor or

inflation. Symbolically, it is calculated as follows

Real Return = 1+ Nominal Return_ 1

1+ Inflation Rate
For Example

Consider an equity stock having a total return during the year was 15.5 %. During that year, the

inflation rate was 4.5%. Calculate the real return (total return is inflation adjusted return).

= 1.155 _ 1
1.045

= 0. 0669 or 6.69 percent

3.1.2 Risk

Risk may be defined as likelihood of receiving the return and there is a possibility that realized

return is different from the expected return on the investment. Those investments which does not

involve any risk is refers to as risk-free assets. Those investments which carry a return either in

the form of dividend or interest is also being affected by numerous factors. Due to which, there is

a possibility of variation in returns on such investments either in stocks or bonds/ debentures etc.

Thus, it refers to the variability of returns or in other words dispersion may be termed as risk. The

wider the range of outcomes, there is possibility of more risk.

3.1.2.1 Sources of Risk

There are different sources from which risk may emerge. There are various factors that affect

large number of securities and which are external to the firm and cannot be controlled referred to

as systematic risk. Thus, the sources of systematic risk may be due to socio-economic and political

factors that causes variability in return of securities. There are other forces which are internal to

the firm and are controllable related to particular industry or firm are referred to as unsystematic

risk. The variations in the stock prices are greatly impacted by the kind of economic environment

and the factors like inflation also affect the profits generated by various securities. There are some

empirical studies conducted and which suggest that at least half of the variations in the stock price

may be explained by the variations in the market index.

 Total Risk= Unique Risk + Market Risk

The portion of total risk that is unique to particular firm or industry is known as unsystematic risk.

This risk may be reduced or avoided by including stocks carrying different risk in a portfolio of

securities and that may be offset by each other. That is why such type of risk is called as

diversifiable risk also.

For Example: Management capability in decision making, launching a new product, strike in an

organization.

The portion of the risk which is related to the economy-wide factors is known as systematic risk.

This risk may not be reduced or avoided by including stocks of varied risk in a portfolio of

securities even though the various factors affect all the firms and some firms are impacted more as

compared to others, thus, referred to as non-diversifiable risk.

For Example: Inflation rate, Interest rate, supply of money, GDP (Gross Domestic Product) etc.

3.1.2.2 Types of risk

The various types of risk are as follows which are further bifurcated into systematic risk,

unsystematic risk and other risks.

3.1.2.2.1 Systematic Risk: The main component of systematic risk is market risk, interest rate

risk and purchasing power risk.

(a) Market Risk

The stock prices of various securities are being impacted by changes in the overall market

resulting in variability in returns from such investments. The market risk may emerge due to

cyclical fluctuation in business, changing state of the economy i.e. inflationary or recessionary

trends, structural reforms in economy, change in investor attitude and expectations.

(b) Interest Rate Risk

The interest rate has inverse relationship with the market price of the fixed-income securities. The

increase in interest rate results into decline in the price of the securities. Such situation happens
because if the fixed interest rate is lower than the prevailing interest rate than buyer of such

securities may not purchase it at the par value.

For Example

Consider a debenture having face value of Rs. 90 and a fixed rate of 12% sell at a discount only

when interest rate goes up from 12% to 14%.

Thus, changes in interest rate shall have direct impact on debentures and indirect impact on

equity. Further, the returns available on fixed income and securities and equity shares shall affect

equity prices.

(c) Purchasing Power Risk

Purchasing Power Risk may be defined as a risk that is caused by variation in real returns from

securities caused due to inflation. This depends upon the economy-wide factors which is beyond

the control of the investors. Such type of risk is more for fixed-income securities i.e. for bonds

and debentures as compared to equities.

For Example

Suppose an investor buys a debenture of face value Rs. 100, interest rate of 12% and maturity

period of 1 year. On the basis of given information, investor would receive return of Rs. 12 after 1

year and if there is 8% inflation rate in the economy, then purchasing power of Rs. 108 shall be

equal to present purchasing power of Rs. 100. Although the amount of Rs. 100 invested would

become 112 after 1 year in real terms but the actual return earned is less than 12%.

Though the return would have increased by 12%, his purchasing power would have increased by

3.70 %.

Increase in Purchasing Power = (100 X 112) _ 100 = 3.70%

108

The actual return and real return shall be same only when there is no inflation in the economy.
 3.1.2.2.2 Unsystematic Risk: The main component of unsystematic risk is business risk, financial

risk and default risk.

(a) Business risk

The performance of the business is impacted by various factors and may result into affecting the

interest of shareholders or debenture holders. The equity shareholders have residual claim on the

earnings of the firm and the interest paying capability along with principal amount by debenture

holders are being affected by the poor performance of business.

The factors are as follows:

• Shift in preference of the customer

• Emerging new technologies

• Change in policy of the government

• Less supply of inputs

• Increased competition with competitors

• Availability of substitute products in the market at affordable price

For Example

There is lot of competition in various service providers such as airline industry,

telecommunication industry and the tremendous competition can be seen in various industries like

cement industry, real estate industry etc.

(b) Financial Risk

There may be financial risk on account of various reasons such as more debts in the capital

structure which results into fluctuation in earnings, profits and dividends to shareholders. This
happens because of liquidity problems that have arisen due to fall in current assets, bad debts,

delayed receivables or rise in current liabilities.

(c) Default Risk

There may be delay in payment of interest along with principal due to insolvency if either issuer

or borrower. In such situations, investor may not get any return on the investment or there may be

negative returns. There can be impact on the share price and it may fall below its face value.

3.1.2.2.3 Other Risks: There are other risks such as Exchange Rate Risk and Country Risk.

(a) Exchange Rate Risk

Due to increase in global investment, there is a possibility of uncertainty of returns due to

currency fluctuations and such currency risk affects the foreign stocks, foreign bonds, American

Depository Receipts, Global Depository Receipts, international mutual funds etc. in which

investments are done by investors globally.

(b) Country Risk

Since there is increase in investment at the international level so it is considered as an important

risk for the investors in present scenario. Thus, political risk is a main consideration by investors

and evaluation of political as well as economic viability and stability is very important to be

considered by investors before making investments.

Figure 2.1: Impact of Diversification on Risk

Risk

Non-Systematic Risk
 Systematic Risk

Number of Securities

3.1.2.3 Summary Statistics for Risk

The risk is being impacted by variety of factors such as socio-economic, political and managerial

and quantitative measurement of risk becomes important. The measurement of risk is central to

the investment decision making. An investor can take better decisions if the risk is correctly

assessed and choice can be made out of the available securities. The choice of securities depends

upon the risk-return characteristics of securities and risk taking capability of the investors. There

is different type of investors who are involved in measuring the level of risk and accordingly

makes the investment for different securities available. The risk averter investor shall make

investment in those securities where there is less degree of risk and risk taker shall invest in those

securities where there is presence of risk. The most common measure for calculating the degree of

risk is standard deviation. Risk may further be defined as possibility that actual return is different

from the expected return from an investment. In an investment decision making, investor would

like to know about the variability of returns along with the mean return on securities. The

following are the two types of risk and methods of measurement of systematic risk and

unsystematic risk.

3.1.2.3.1 Unsystematic Risk

(a) Standard Deviation and Variance

Standard Deviation is a statistical tool to measure risk and is defined as a measure of the values of

the variables around mean. It is obtained as the square root of the average of squared deviation. It

is an absolute measure and can be applied when the mean is same. It is widely used as it is less

affected by fluctuations in sampling.

Variance is a most commonly used measure of risk in finance and it is the square root of standard

deviation.

Where σ 2 is the variance of return,

σ is the standard deviation of return,

Ri is the return from the stock in period i (i= 1,………,n),

̿R is the arithmetic return, and n is the number of periods.

For Example: Consider the return from the stock A over a 6 years period

R1 = 13 %, R2 = 12 %,R3 = 18 %, R4 = -10 %, R5 = 15%, R6 = 8 %

Period Return Deviation Square of Deviation

Ri ( in percentage) (Ri – R¯) (R i – R ¯ )2

1 13 3 9

2 11 1 1

3 14 4 16

4 -10 -20 400

5 15 5 25

6 7 -3 9

∑ Ri=¿ ¿60 ∑ (R i – ̿ R)2=¿460

R̿ =10

σ2= ∑ (R i – ̿ R)2
n-1

σ = ∑ (R i – ̿ R)2 1/2

n-1
1/2
= 460
6-1
= 9.59
From the calculation the following points are extracted:

1. The values which are far away from the mean values affect more the standard deviation.

2. The comparison can be done directly because standard deviation and means are measured in

same units.

The other measures used to explain the measure of risk are coefficient of variation, Coefficient of

correlation, covariance, and beta coefficient besides standard deviation, variance as explained

above.

(b) Coefficient of variation and Covariance

Coefficient of variation is a relative measure of the degree of uncertainty or dispersion for

comparing similar series.

Covariance is an absolute measure in which movement of prices of securities is either moving

upwards or downwards and its measurement is done from their means and its comparison.

Where x and y are the arithmetic means of the respective sets.

There can be positive covariance or negative covariance.

Coefficient of correlation is used as a relative measure to depict the relationship between two sets

of variables.

ϒxy = Cov x,y

σx,σy

The numerator of the term indicates that how much variations are there in x and y together

The denominator indicates that how much is the combined individual variations of the two sets,

measured by the product of their standard deviations.

It will take values only in the range of -1.00 to + 1.00 and it is a normalized measure and used in a

better way for analysis.

The variables are said to be positively correlated if the value of one variable increases with the

value of another variable and it means that their values move in the same direction.

For Example

If the consumption of fuel increases with the increases with the increase in the use of automobile,

these variables are said to be positively correlated to each other.

The variables are said to be negatively correlated if the value of one variable decreases with the

increase in the value of another variable and it means that their values move in the opposite

direction.

The variables are not correlated if the value of one variable does not bring any change in the value

of another variable.

For example

If there is change in price of tea, it may not have any impact on the demand for the computers.

Figure 2.2: Different types of correlation between two variables

Positive Correlation Perfect positive correlation

Y-axis . . . Y-axis .
. . . . .
. . . .
. . .

X- axis X- axis

No Correlation

Y-axis . . . ..

. . . . . . .

. ..

X- axis
Negative correlation Perfect Negative Correlation

Y-axis . . . Y-axis .
. . .
. . . .. . .
. . . .
. . .
. . . .

X-axis X-axis

3.1.2.3.2 Systematic Risk

Systematic Risk is measure of variability of returns caused by changes in the economy. Such

changes in the economy shall bring changes in the market as a whole. When there is a change in

the market return, the return available on various securities also changes. However, the variations

in returns of different securities will not be same. It means that if there is change in the market it

will not bring similar changes in the returns of the securities, it may be less or it may be more in

some cases.

Stock market index is indicative of any change in market return brought due to change in the

economic conditions. Thus, if there is variability in the returns of the securities due to variations

in the stock market index, it is said to have the systematic risk.

There is higher systematic risk if there are more variations in the returns of securities due to variations in

the stock market return.

Beta is a statistical tool to measure the systematic risk of a security. It can be calculated by using

the following:

Beta = Covariance (Re , Rm )

Variance (Rm)

Re = Re is the return on the individual stock

Rm = Rm is the return on the market

Covariance refers to changes in the stock return related to changes in the market return.

Variance refers to the variations in the market return from the average mean.

4. Summary

There are two important variables i.e. risk and return considered by investors for making the

investment in the financial assets. The returns available to investors are in the form of interest or

dividend and capital appreciation in the value of the assets. The probability of occurrence of the

returns is termed as risk. These are being impacted by certain factors and these factors are either

controllable or uncontrollable.

There are two types of return which are generally considered in investment process by investors

i.e. realized return and expected return. There are generally two components of returns i.e. yield

and capital gain or loss and may be termed as total return. There are different measures to

calculate historical returns besides total return i.e. return relative and cumulative wealth index.

There are summary statistics for returns where arithmetic mean, geometric mean and real return is

applied to calculate and measure returns.

There are various types of risk related to securities and which can be further bifurcated into

systematic risk, unsystematic risk and other risks.The main component of systematic risk is

market risk, interest rate risk and purchasing power risk. The main component of unsystematic

risk is business risk, financial risk and default risk.There are other risks such as Exchange Rate

Risk and Country Risk. Thus, total risk of an investment consists of two components: diversifiable

and non-diversifiable risk. There are various measures of risk i.e. variance, standard deviation,

coefficient of variation and covariance. The systematic risk may be measured with the help of beta

and can be used to determine the appropriate required return on the security.

5. References

1. Chandra, P., Investment Analysis and Portfolio Management, Tata McGraw-Hill.

2. Mukherjee, Subrata, Security Analysis and Portfolio Management, Vikas Publishing.

3. Bhalla, V.K., Investment Management, S. Chand Publications.

4. Khatri, Dhanesh, Security Analysis and Portfolio Management, Macmillan Publishers.

5. Fischer, Donald E. and Jordan, Ronald J., Security Analysis and Portfolio Management,

Prentice Hall.

6. Self-Assessment Questions

Q.1.What is risk? Differentiate between systematic risk and unsystematic risk.

Q2. What do you mean by return? What are its different components?

Q3. Explain in detail the following:

(a) Geometric Mean (b) Arithmetic Mean (c) Return Relative

Q4. What are the different sources of risk? Explain briefly.

Q5. What are the statistical tools to measure the degree of risk in securities? Explain with practical

examples/illustrations?

Q6. Explain how inflation affects the purchasing power risk associated with debentures.

Q7. Define the term covariance and correlation coefficient and indicate the relationship between

them.

Q8. Explain the following

(a) Perfectly positive correlation (b) Beta (c) Capital Gain

Q9. Why standard deviation is commonly employed as a measure of risk?

Q10. Give recent examples of Socio-economic and political events that has affected the following:
(a) Stock Market

(b) Stocks of particular industry

DIRECTORATE OF CORRESPONDENCE COURSES

KURUKSHETRA UNIVERSITY
KURUKSHETRA-136119
______________________________________________________________________________
Paper: MBADFM-306: Writer: Dr. Anshu Bhardwaj
Lesson No. 3
______________________________________________________________________________
Financial assets – Type and their characteristics including derivatives

1. Introduction
2. Objectives

3. Presentation of Contents

3.1 Financial Assets-Types and their characteristics

3.1.1 Properties of Financial Assets

3.1.2 Functions of Financial Assets

3.2 Derivatives

3.2.1 Exchange-Traded Vs Over the counter derivatives

3.2.2 Types of derivatives and benefits

3.2.3 Advantages of the Derivative market

3.2.4 Users of the Derivative Market

4. Summary

5. References

6. Self-Assessment Questions
1. Introduction

An investor makes some investment for acquiring various financial assets that has a

contractual value like shares, debentures, mutual funds etc. and also leads to increase in capital

stock. Financial assets can be easily tradable asset and its value is affected by market fluctuation

and level of risk associated with it. The financial assets are considered important because it results

in wealth creation in investment landscape. As an investor it is required to understand the nature

and various attributes of financial assets so as to maximize the return and also result in

achievement of their specified objectives. From the perspective of any business, such financial

assets play a crucial role in revenue generation, liquidity and provide numerous opportunities for

growth.

There are different types of financial assets having unique characteristics. The various

types of financial assets are cash or cash equivalent, bank deposits, stocks, bonds, loans and

receivables and any other derivative instruments kept for trading or as risk-reducing approach in

financial decision making. Thus, financial assets are considered as a vehicle for making

investment and become a part of financial market as a whole.

2. Learning Objectives

The objective of this lesson is to discuss the important concepts related to financial assets – Type

and their characteristics including derivatives. Further, this lesson acquaints the users with the

following:

1. What is the concept of financial assets?

2. What are the different types of financial assets along with their properties?

3. What is the concept of derivatives?

3. Presentation of Contents

3.1 Financial Assets-Types and their characteristics

Financial assets define the allocation of wealth among the investors and these are the investments

which are financed by issuers of securities. The investments done in securities by investors helps

them in deriving returns on these financial assets but these are the liabilities to the issuers of such

securities. Financial markets may be defined as a platform for buying and selling of financial

assets through this mechanism and considered as a market for creation and exchange of financial

assets.

Figure 3.1: Classification of Assets

Assets

Physical Assets Financial Assets Intangible Assets

Currency
Fixed Assets Goodwill
Instruments
-Land Patents
-Cash
-Building Copyrights
-Foreign
-Machinary Royalty
Currency
Claim
Instruments
- Debentures
Movable
-Deposits
Assets -Shares
-Tax Saving
Investments
3.1.1 Properties of Financial Assets

Financial assets are different from physical assets and intangible assets in an economy. Thus,

financial assets are different from real assets that generate net income in the economy and

investors earn return on financial assets and in terms of the term investment it means investing in

marketable securities. The following are the properties of financial assets:

3.1.1.1 Monetary Value

Financial Assets are measured in terms of the value in the denominated currency which is

determined by the concerned government in an economy. The cash is represented in the form of

coins or currency either in terms of domestic currency or foreign currency of respective countries.

3.1.1.2 Divisibility

The financial assets has another important property i.e. divisibility in nature which means that

these financial instruments can be further divided into smaller units. The firm raises the capital in

the form of shares which is considered for collecting in this form of financial instrument. The

participants in the market take benefit of the divisibility feature of financial assets and each unit

represent the face value of the total capital.

3.1.1.3 Convertibility

The financial assets can be converted into other type of assets, for example a debt instrument may

be converted into shares after certain period of time, thus brings flexibility and trading of financial

assets. It is not necessary that the conversion must be in any other form of financial assets rather it

can be in any other type of asset class also.

3.1.1.4 Reversibility

The financial assets may be exchanged as well as reversed back to the original financial

instruments, for example, acceptance of deposit certificate in return of the deposits made in the
bank in the form of currency and utilized for earning rate of return. Another example can be

where any company can buy back the shares which were earlier issued in return for the cash to be

paid to the holder of the share. Thus, cash or money has a very important feature of reversibility

where in case of emergency; the cash deposit may be withdrawn and may be utilized for buying

any other assets.

3.1.1.5 Liquidity

Financial assets have another important property of liquidity where the present requirements and

needs can be met if held in the financial form. The various financial assets can always be

exchanged for currency and the reversibility feature also helps in increasing the liquidity.

3.1.1.6 Cash Flows

Financial assets held by holders for a certain period of time results in increasing the cash flows,

for example, money deposited in a bank gives return in the form of interest and holders of shares

may receive dividend or bonus. The amount of returns available to the holders varies and that

depends upon the investments being made in other forms of assets i.e. physical assets or intangible

assets.

3.1.2 Functions of Financial Assets

There are different functions performed by financial assets and perform an important role in

allocation of resources in the economy. These are as follows:

1. It facilitates in price discovery.

2. It provides liquidity to financial assets

3. It reduces the cost of transaction

Due to globalization of financial markets, the investors from one country can freely invest in other

countries and can raise money by issuing shares or debentures in international markets. The

following factors are the driving force behind it:

1. Liberalization of financial markets

2. Advancement in technology, communication network and market structures

3. Growth of institutionalization of financial markets

There is a high degree of competition in the financial market and the information is quickly

available and reflected in share price which makes them fairly priced. There is a complete trade-

off between risk and return and if investors want to earn higher return they have to take more risk.

3.2 Derivatives

In the modern global financial system, there are financial market participants and institutions

across geographic and market boundaries. Over the years, the presence of derivative market has

increasingly traded in over the counter market and exchange traded market. While formulation of

financial sector strategy, derivatives are considered as an important component to ensure financial

development and economic growth. The trading in derivatives may be either standard or

customized as per the preferences and needs of participants and standard trades are traded on

exchanges and the customized trades are traded on over the counter market.

3.2.1 Exchange-Traded Vs Over the counter derivatives

There is a considerable growth in the over the counter market due to developments in the banking

and modernization of financial activities. There are different options to enter into derivatives

contract either through exchange traded or OTC market. At the same time there are some risks

posed due to uncertainties in the financial markets and causes risk and market instability.

Derivatives are defined as those instruments whose value is derived from an underlying asset. The
underlying assets may be in the form of commodity, securities (shares or debentures), currency

etc. Since there is a high degree of risk that is involved in trading in these securities, thus, the

regulations and control are done by stock exchanges provision for securities and by concerned

commodity exchange for transactions in commodities so that counter party risk can be minimized

or eliminated.

3.2.2 Types of derivatives and benefits

There are some common derivatives such as future contract, forward contract, option contract,

index futures and swaps. Derivatives are being utilized to provide protection against risk which

exists because of making investment in these underlying assets as mentioned above. Thus, these

are being applied to frame investment strategies for risk-free investment. There are numerous

benefits of investing in derivatives such as by investing in options the amount of loss is restricted

to the amount of premium and may have unlimited gain from price fluctuation of underlying

assets. The future contract also provides for counterbalancing risk that arises from the

commitment and swap provides an option to obtain loans at a lowest possible rate of interest.

3.2.2.1 Option Contracts: Option contract may be defined as an agreement where right is given

to buy or sell the underlying assets at some future date as per the terms and conditions entered on

the date of transactions by both the parties. In case of exchange traded options, the underlying

assets, its lot size, expiration date and margins are regulated by the exchange. The premium which

is paid by the buyer of the option is called option price and being decided on the basis of

volatility, expiration date, strike price, market trends, dividend and interest rate.

3.2.2.2 Future Contracts: Future Contract may be defined as such contracts where both the

parties decide to buy or sell underlying asset on certain terms at the time of transactions to settle

on some future date. The buyer and seller have to deposit the margin with the stock exchange and
various parameters like duration of transaction, lot size, value date and underlying assets are

decided in case of exchange traded future transactions.

3.2.2.3 Forward Contract: Forward Transactions may be defined as such transactions where

buying and selling carried out in present and settlement is done at some future date. Such

transactions are OTC (Over The Counter) traded customized transactions decided by the parties

on certain aspects i.e. exercise price, value, date and quantity for underlying assets.

3.2.2.3.1 Difference between Futures and Forward Contract

Basis of Difference Future Contract Forward Contract

Underlying assets and It is specified by concerned stock exchange It is specified by both the parties

quantity and size of the lots, its quantity also. mutually and quantity also.

Duration and value date The stock exchange decides the duration and It is decided by the parties mutually.

value date.

Trading on exchange The trading is done on the stock exchange. The trading is done on the OTC

exchange.

Rules and Regulations The regulations of the stock exchanges are

applicable.

Nature of transactions Standardized Customized

Settlement of transactions The settlement is done with through clearing The limits of OTC are applicable for

houses. settlement and decided mutually.

3.2.2.3.2 Difference between Options and Futures/Forward Contract

Basis of Difference Option Contract Future Contract/ Forward Contract

Right The buyer of the option contract has The buyer and seller, both the parties have
 right only. rights to exercise.

Risk The risk is there with sellers only. The risk is there with both the parties.

Obligation The obligation is there with seller of The obligation is there with buyer and seller

the option only. both.

Premium The buyer in the option contract needs Both the parties are not required to pay for it.

to pay the premium.

Hedging tool The option contract is a hedging tool. The future/forward contract is not a hedging

tool.

Margin Only seller is required to deposit the Both the parties are required to deposit the

margin. margin.

3.2.2.4 Index Futures: It is like any other future contract where all parameters are specified by

the stock exchange except strike price, choice of the duration etc., thus, mentioned as standardized

contract. It is a kind of transaction where buying and selling is entered at present but settlement is

done at some future date on a particular index. It is also applied to hedge the risk thus mentioned

as a speculative tool also.

3.2.2.5. Swaps

Swap contracts are being entered in the future market for spot purchase/spot sale with a

simultaneous future sales/future buy leading to exchange of future cash flows with spot cash

flows. There are different types of swaps such as interest rate swaps, currency swaps and equity

swaps.
3.2.3 Advantages of the Derivative market: There are various advantages of derivative market

which area as follows:

3.2.3.1 Hedging: The derivative contract is entered for reducing the risk and in such position its

values move in the opposite direction to their underlying position.

3.2.3.2 Price discovery: Derivatives are considered as a major tool for discovery of future

demand and supply of the underlying assets.

3.2.3.3 Arbitrage: In the derivatives market, arbitrageurs are involved in making riskless profit

by taking position based on the two values i.e. theoretical values or fair values of the future

market.

3.2.3.4 Speculation: In the derivatives market, speculators intend to take the benefit due to price

volatility by taking different position i.e. long position and short position and are taking risk also.

3.2.3.5 Quick and low-cost transactions: The transactions in derivative market are done at a

considerably low cost when compared to the total value of the underlying asset and there are

quick trades leading to huge profits.

Besides, there are other benefits such as the risk of counterparty default is not there and it leads to

protection of interest of the market participants in exchange traded transactions.

3.2.4 Users of the Derivative Market: During trade in derivatives market, the various traders

enter into different transactions to earn profits or to reduce the risk. The various users of the

derivative markets are individuals, arbitrageurs, dealers, speculators and operators, fund

managers, corporate consumers, financial institutions etc.

4. Summary

Financial market is a place that provides market for exchange i.e. buying and selling of financial

assets in the financial system. Financial market provides various benefits to the investors which
help in providing liquidity in the market and also helps in reducing the cost of transactions.

Another important feature of financial market is that it helps in facilitating the price discovery and

very much beneficial to the investors. Thus these are the important functions of financial markets

that contribute towards the economy. There are different types of financial markets on different

aspects that covers debt market as well as equity market, money market and capital market,

primary market and secondary market, spot market and forward market, exchange traded market

or over the counter market.

5. References

1. Chandra, P., Investment Analysis and Portfolio Management, Tata McGraw-Hill.

2. Mukherjee, Subrata, Security Analysis and Portfolio Management, Vikas Publishing.

3. Bhalla, V.K., Investment Management, S. Chand Publications.

4. Khatri, Dhanesh, Security Analysis and Portfolio Management, Macmillan Publishers.

5. Fischer, Donald E. and Jordan, Ronald J., Security Analysis and Portfolio Management,

Prentice Hall.

6. Self-Assessment Questions

Q1. Define the term financial assets. What are the specific properties of financial assets that

distinguish it from real assets?

Q2. What do you mean by financial markets? What are the various types on the basis of which it

can be further classified?

Q3. Explain the functions of financial assets in detail.

Q4. How will you differentiate between forward market and future market?

Q5. “Options and futures are zero-sum games.” Do you agree?

Q6. Mention the major players in the derivatives markets and their role/functions.
 DIRECTORATE OF CORRESPONDENCE COURSES
KURUKSHETRA UNIVERSITY
KURUKSHETRA-136119
______________________________________________________________________________
Paper: MBADFM-306: Writer: Dr. Anshu Bhardwaj
Lesson No. 4
______________________________________________________________________________
Asset allocation decision – individual investor life cycle, the portfolio management process,

the importance of asset allocation &organization

1. Introduction
2. Learning Objective

3. Presentation of Contents

3.1 Asset allocation decision – individual investor life cycle

3.1.1 Phases in Individual life cycle

3.2 Portfolio management process

3.2.1 Specifications of Investment objectives and constraints

3.2.2 Quantification of capital market expectations

3.2.3 Asset allocation

3.2.4 Formulation of Portfolio Strategy

3.2.5 Other Phases

3.3 Importance of asset allocation and organization

4. Summary

5. References

6. Self-Assessment Questions
 1. Introduction

An investor adopts a process for achieving the investment goals by taking certain steps in

an investment activity and investment decision making. The other important decision is related to

choice of proportion of stocks and bonds in the portfolio as an investment decision that depends

on certain factors. After selection of securities to be included in the portfolio, the next step in

portfolio management process is portfolio execution by considering the portfolio strategy that

consider the goals and constraints of investor. After this step, there is a need to adjust the portfolio

as per the market fluctuations and needs of investors that results into portfolio revision. In the

whole investment process, another important aspect is portfolio performance evaluation

considering the two important variables i.e. risk and return.

The return available on portfolio depends upon the attitude and preference of investors

whether they are risk-taker or risk-averter. Even the needs and requirements of an individual

investors change over a period of time. So, before taking any investment decision, investor needs

to evaluate the risk-tolerance level and accordingly the investment strategy shall change over their

life time.

2. Learning Objective

The most important part of investment process is asset allocation decision which focuses upon the

types of assets that should be included in the portfolio. From the moment investor takes the

investment decision as per the investor preferences till attainment of investment goals, the lesson

will focus on individual investor life cycle. The lesson also explains the steps in the portfolio

management process and discusses the importance of asset allocation and its organization that

determines the portfolio returns.

3. Presentation of Contents

3.1 Asset allocation decision – individual investor life cycle

The decision of allocation of assets is considered to be one of the most important decisions

to be taken by investor. The investment in assets depends upon the attitude and preferences of the

investors over long term period. Those investors who expects greater appreciation in capital

prefers to make investment in equity shares. The investment in risk-free securities may be

considered as a risky strategy for the longer term horizon as compared to investment in equity

shares.

The needs and preferences for investments are different for investors over an individual’s

life time. The investment plan is made by investors on the basis of the certain criteria such as age

of the investor, needs and preferences of the investors, financial capability, future goals, risk

tolerance level etc. The basic requirements for all the investors including safety of returns as well

as reserve kept in cash to meet the unexpected contingency are ensured by all the investors.

Basic personal aspects considered before investing by investors:

Housing and shelter

Protection for life through insurance cover

Savings for future requirements

Investing for gaining returns through capital appreciation

Thus, investors are making the investment to meet the varied needs and requirements ranging

from meeting the living expenses and reserves maintained in cash to meet contingencies and
emergencies arising in future. The insurance cover for life is a part of financial plan by various

investors and meant to serve various needs such as retirement plan, requirements of family

members after death of the prime insurer before the date of maturity, medical bills reimbursement

etc. There are other unforeseen events that may occur in the lifetime of an individual’s that causes

financial hardships such as loss of job, unexpected calamity etc. In order to provide protection

against any such occurrence of events, there is a requirement of cash to be maintained as reserve

and also to explore the investment opportunity that may emerge and provide benefits to the

investors. Over the life time of an individual investor, there may be change in the proportion of

the cash reserve and it provides a safety cushion to them to deal with any unforeseen occurrence

of event in the future. The cash means investment also that can be utilized to meet such expenses

without change or loss of value of investment. There are different money market instruments in

which investment can be made such as investing in mutual funds, depositing in a bank account

etc. The investment program may be developed by investors as per the savings and their

expectations towards meeting the objectives and goals. The strategies related to investment shall

also be changed by the investors over the life time due to change in levels of risk tolerance and net

worth.

3.1.1 Phases in Individual life cycle

there are three phases over the life time of an individual i.e. accumulation phase, consolidation

phase and spending phase related to net worth of an individual, From the figure given below, it is

ascertained that
Figure 4.1: Phases in Individual life cycle

Phases in life cycle

Accumulation Phase Consolidation Phase Spending Phase

During the accumulation phase, an individual spends on acquiring assets to meet the current

requirements such as installments for the house, payment of car loans or to meet the long term

goals such as education of the children, retirement etc. During this phase of an individual life

generally the net worth is very small and investors are ready to invest in those investments where

there is high return even though relatively it carries a high degree of risk. The investments are

being done considering the fact that there is a long term horizon and expect to earn superior-risk

adjusted returns on the investment. The earlier the investments are done the more beneficial it is

for the investor to receive the better returns in the later phase due to the principal of compounding

on the investment over time.

During the consolidation phase, an individual in the mid-point of their life cycle where most of

the expenses are actually being paid off. Now, at this point of life time, an individual may invest

as per the future requirements may be related to retirement or investing in real estate. Even the

time horizon during this phase is also very long, typically may be for 20-25 years, so individuals
are willing to make investment where there is moderate high degree of risk. But at the same time

individuals are very cautious before making the investment because they are more concerned

towards retaining the capital instead of taking high risk.

During the spending phase, an individual enters into that phase of one’s life where living

expenses are met by the earlier savings in the form of pension funds, social security income as

retirement is there. As they know that there may be decline in the value of their savings due to

some inflationary factors they would like to preserve their capital to meet their requirements. The

focus of an individual is to make investment in those assets which are less risky if compared with

the consolidation phase. An individual may make some investment in high risk investments such

as stock to provide hedge from inflation and annuities to transfer the risk from individual to

insurance company where life-long stream of income is received.

There is another phase which is referred to as gifting phase where individuals have sufficient

income to meet their current and future requirements. There is savings also which is kept as a

reserve for any unforeseen or contingency event that may arise in future. The financial support

can be provided to friends or relatives as well as contributions may be given for some charitable

purposes.

3.2 Portfolio management process

Portfolio Management is also known as investment management which are interrelated to each

other and divided into eight phases. The first four phases are collectively referred to as investment

policy and strategy. The next four phases are referred to as an investment implementation and

review. The same may be depicted in the figure below:

Figure 4.2: Interrelationship among different phases of Portfolio Management

Specifications of Investment objectives and constraints

Quantification of capital market expectations

Asset allocation

Formulation of Portfolio Strategy

Selection of Securities

Portfolio Execution

Portfolio Revision

Portfolio Evaluation
3.2.1 Specifications of Investment objectives and constraints

The specifications of investment objectives and constraints as a part of investment policy and

strategy by investors are the first step in portfolio management process. The purpose and goals of

investment by investors are specified in the objectives focusing on two important components i.e.

return and risk (risk depends upon the level of tolerance). There are various constraints and

preferences while making investments by the investors. The various constraints are related to the

factors such as liquidity, investment horizon, taxes, regulations and unique circumstances. The

objectives or investment goals are income, stability; growth etc. depends upon the willingness of

investor and risk disposition for earning higher returns. The level of risk tolerance of investors

depends upon the financial capability and attitude towards taking the degree of risk.

Figure 4.3: Investor preferences through Indifference Curve

E(R) I1

I2

. I3

σ2
See figure 4.3 where risk return tradeoff is depicted by the indifference curve plotted above as per

the investor’s preferences. The points lying on one indifference curve give same level of

satisfaction and I1 offers high degree of satisfaction than I 2 and I2 offers high degree of satisfaction

than I3.In the figure given above, all the curves are upward sloping depicting investors want higher

expected return as there is an increase in the risk and also depict that the expected return increase

at an increasingly greater rate. There is another important term i.e. Risk Tolerance which means
that any addition in the variance offsetting the added expected return brings same level of

expected utility for the investors.

UNL = E(RN)- σ2N / tL

UNL is the expected utility of asset mix N for investor L,

E(RN) is the expected return for mix N and t L is the risk tolerance of investor L.

σ2N / t L is termed as risk penalty in the above equation.

It may also be defined as where the level of tolerance of investors with regard to risk is small and

standard deviation is greater than risk penalty is greater.

The investors may be assessed on the basis of their attitude towards investment whether they are

conservative, aggressive or moderator investor through questionnaire and may not always be

considered as a precise measure of understanding the risk tolerance level of investor.

3.2.2 Quantification of capital market expectations

The next step in the portfolio management process is to take decisions with regard to selection of

securities to be included in the portfolio. After that, the decision is to be taken on assigning the

weights and in what quantity the investments to be made in each securities. The investors are

required to make long term estimates relating to expected return, risk and coefficient of

correlation existing between various securities. The assessment of market situation is based upon

certain aspects such as the past trends, sentiment of investors as an important indicator,

quantitative analysis through ratios. The investors are earning superior risk-adjusted returns on

taking more risk as compared to the investment being made in risk-free securities. There are

different measures of risk i.e. arithmetic mean and geometric mean applied in case of independent

and serial dependence respectively.

3.2.3 Asset allocation

The next step in asset allocation is to take the decision for making the asset-mix of the portfolio

are being framed in this regard considering the economy fluctuations. There are various aspects on

the basis of which allocation is done it may be strategic allocation and tactical allocation as well.

Investors would be doing the investment on the basis of balanced asset allocation and dynamic

asset allocation as per the long term objectives for the portfolio. The strategic asset allocation is

related to formulation of portfolio with the asset-mix for the long term horizon in accordance to

the market fluctuations. Thus, asset allocation decision is considered to be one of the important

decisions made by investor which maximizes the utility of the portfolio.

Figure 4.4: Various types of asset allocation

Asset Allocation
Strategic Tactical Drifting
Balanced Asset Dynamic Asset
Asset asset Asset Allocation Allocation
Allocation Allocation Allocation

3.2.4 Formulation of Portfolio Strategy

After selection of securities for the portfolio, the investor is available with broadly two strategies

i.e. active portfolio strategy and passive portfolio strategy. In active portfolio strategy, there are

two approaches followed by investor’s i.e. fundamental approach and technical approach. In

passive portfolio strategy, the commonly applied strategies are buy and hold strategy and indexing

strategy.
3.2.5 Other Phases: The other phases of portfolio management are related to Investment

implementation and review and related to selection of securities for the portfolio by investors,

portfolio execution as per the investors objectives, portfolio revision so that the returns can be

increased by focusing on need and constraints and finally portfolio evaluation is very important

through various portfolio performance evaluation measures.

3.3 Importance of asset allocation and organization

This is considered to be an important decision made by the investors which maximizes the utility

of the investor. There is a study conducted by Brinson, Hood, and Beehower for 91 large pension

funds to measure the importance of three-way asset allocation during the year 1974 to 1983. The

asset mix was divided into four types i.e. cash equivalents, bonds, stocks and others at the start of

each quarter and then shadow asset mix was formed with the same proportion.

For example: The composition of the fund is in the proportion of 20 percent in cash equivalents,

25 percent in bonds, 40 percent in stocks and 15 percent in others. The return was calculated for

all quarters for shadow asset-mix on three indices i.e. cash index, bond index and stock index. The

shadow asset mix includes only market related indices and the impact of decision of security

selection and shifting of asset from one quarter to another quarter deviates away from the return.

The return obtained from the shadow asset mix was compared with the actual return on the fund

and regressed again and again on the return on the shadow asset mix for all funds under study.

There was calculation of average R-square value and it was also found out that there are some

other factors that accounts for variability of returns.

4. Summary

The investors are making the investment for the long term and asset- mix of the portfolio is

directed towards maximizing the utility of the portfolio. During the lifetime of individual
investors, there are different phases i.e. Accumulation phase, consolidation phase and spending

phase. According to the objectives during that phase the selection of assets are being made by the

investors. There are different steps in portfolio management also known as investment

management process focusing on two important aspects broadly, one is investment policy and

strategy and the other is investment implementation and review. The investment policy and

strategy includes the objectives, constraints and preferences of the investors for making the

portfolio. There are different types of asset allocation i.e. strategic asset allocation, tactical asset

allocation, drifting asset allocation, balanced asset allocation and dynamic asset allocation. Thus,

asset allocation is an important decision considered by academicians and practioners as well and

there are various ways of measuring the same. The market wide indices are considered in case of

shadow asset mix and returns on it are compared with actual return on the fund. The study

conducted also concluded that there are other decisions also which impact the variability of

returns but the percentage for the same was very less.

5. References

1. Chandra, P., Investment Analysis and Portfolio Management, Tata McGraw-Hill.

2. Mukherjee, Subrata, Security Analysis and Portfolio Management, Vikas Publishing.

3. Bhalla, V.K., Investment Management, S. Chand Publications.

4. Khatri, Dhanesh, Security Analysis and Portfolio Management, Macmillan Publishers.

5. Fischer, Donald E. and Jordan, Ronald J., Security Analysis and Portfolio Management,

Prentice Hall.

6. Self-Assessment Questions

Q1. What are the phases in the lifecycle of individual investors? Also mention the important

aspects considered by investors before investing.

Q2. What are the various phases of portfolio management process? Explain in detail.

Q3. How will you define the term asset allocation? Also highlight the importance of asset

allocation and its organization.

Q4. Write notes on

(a) Risk Tolerance

(b) Drifting Asset Allocation

(c) Balanced Asset Allocation

(d) Shadow asset mix

Q5. Write a detailed note on the following (a) investment policy and strategy and (b) Investment

Implementation and Review depicting the interrelationship among various phases of portfolio

management.
 DIRECTORATE OF CORRESPONDENCE COURSES
KURUKSHETRA UNIVERSITY
KURUKSHETRA-136119
______________________________________________________________________________
Paper: MBADFM-306: Writer: Dr. Anshu Bhardwaj
Lesson No. 5
______________________________________________________________________________
Functioning of financial markets in India - primary capital markets, secondary markets,

financial intermediaries

1. Introduction

2. Learning Objective

3. Presentation of Contents

3.1 Functioning and Characteristics of financial markets in India

3.2 Types of Financial Markets

3.2.1 Classification on the basis of Nature of Claim

3.2.2 Classification on the basis of Maturity of Claim

3.2.3 Classification on the basis of Seasoning of Claim

3.2.4 Classification on the basis of Timing of Delivery

3.2.5 Classification on the basis of Organization Structure

3.3 Financial intermediaries

3.3.1 Primary Market Intermediaries

3.3.2 Secondary Market Intermediaries

4. Summary

5. References

6. Self-Assessment Questions
1. Introduction

Financial markets contribute towards the economy by providing monetary support through

trading in these markets and act as an indicator for the growth of the economy. These financial

markets are further classified into money market and capital market in the Indian Financial

System. Over the years, capital market has undergone significant structural transformation in

India. Capital market is one which provides an opportunity to various companies to raise funds

from investors directly and securities are also bought and sold in these markets under the

supervision of Securities and Exchange Board of India (SEBI) and as per the regulations

prevailing in India. Thus, Primary market is one which deals only in new securities by providing a

platform to companies to issue it directly to investors. On the other hand, secondary market or

stock market or stock exchange is one in which outstanding securities of government as well as

corporate houses are bought and sold as per the regulations of Securities Contract and Regulation

Act (SCRA) in India. There are different intermediaries or channel of distribution i.e. merchant

bankers, brokers etc. that facilitate for trading in the capital market in India.

2. Learning Objective

The objective of this lesson is to make the students familiar with the functioning of financial

markets in India focusing on primary capital markets as well as secondary markets and financial

intermediaries in securities market. After studying this lesson, you will be familiar with

1. What is the concept of financial market?

2. What are the types of financial market?

3. What are the functions of primary market and secondary market?

4. What is the relationship between primary market and secondary market?

5. What are the financial intermediaries in securities market?

3. Presentation of the contents

3.1 Functioning and Characteristics of financial markets in India

There is a lot of competition in the financial markets which impacts the forces of the market and

participants are constantly engaged in analyzing the market. Such situation leads to the following

implications

1. The information is freely available and quickly absorbed and reflected in the securities

depicting the fair price of the assets and securities.

2. There is a risk-return trade off that means for higher expected return; high risk is to be taken.

3.2 Types of Financial Market: There are different ways of classifying financial markets:

Figure 5.1: Types of Financial Markets

Classification of Financial Markets

Nature of Maturity of Seasoning Timing of Organizatio

Claim Claim of Claim Delivery n Structure
Spot
Exchang
Debt Money Primary Market
e Traded
Market Market Market or cash
Market
market

Forward Over the

Equity Capital Secondar
or future Counter
Market Market y Market
market Market
3.2.1 Classification on the basis of Nature of Claim

3.2.1.1 Debt Market

Debt market differs in case of developed and developing economy and considered to be one of the

critical components of the financial system and contribution in GDP. The various types of debt

market existed in the post reforms period are government securities market, private sector debt

market, public sector undertaking debt market. The government securities or G-secs are

considered to have the largest segment of the long-term debt market in primary as well as in

secondary market in India. The rules and regulations of RBI are followed to regulate the debt

market. The various participants in the debt market are state government, central government,

primary dealers, Public Sector Undertakings (PSUs), corporate, banks, mutual funds, insurance

companies, Foreign Institutional Investors (FIIs), provident funds, pension funds etc.

3.2.1.2 Equity Market

Equity market is another form of market where equity instruments provides ownership to the

holder of the security. There is a claim of the owners in the distribution of profits in the form of

dividends having varying dividend rates for different time periods may be annually or quarterly.

The additional returns in the form of bonus shares are also claimed by the equity owners. There

are different types of equity instruments i.e. preference equity and ordinary equity where

preference equity has a preferential claim over the dividend payments and also at the time of

liquidation but such rights are not available to common equity.

3.2.2 Classification on the basis of Maturity of Claim

It is interpreted from the above figure that money market and capital market are the two

prominent financial markets on the basis of maturity of claims. The growth of the economy
depends upon the functioning of these markets and hence considered as a backbone of the

economy.

3.2.2.1 Money market is a market for short term deployment of funds having a maturity period of

less than one year and can be converted into cash with minimum transaction cost. The main

participants are banks and financial institutions and individual investors do not participate

directly. The major money market instruments are call money market, treasury bills, certificate of

deposits, commercial papers, repos and reverse repos etc.

3.2.2.2 Capital Market provides a platform for purchase and sale of securities for raising funds

through new and existing securities from the market which functions as per the provisions of

SEBI (Securities and Exchange Board of India) and regulatory provisions of other acts like SCRA

(Securities Contract and Regulation Act), FEMA (Foreign Exchange and Management Act) etc.

There are two segments in which capital market is divided i.e. Primary Market and Secondary

Market.

3.2.3 Classification on the basis of Seasoning of Claim

3.2.3.1 Primary Market

Primary Market provides an opportunity to the investors to raise finds from the general public at

large for new companies as well as existing companies by issuing directly. The companies can

raise funds through different securities i.e. Equity Shares, Preference Shares and

Debentures/bonds.

There are some important changes introduced by Securities and Exchange Board of India are

related free pricing of the securities, following the guidelines of Issue of Capital and Disclosure

Requirements (ICDR) and Initial Public Offerings to be done in dematerialized form and to bring

more efficiency in the delivery mechanism.

Methods of raising capital in the primary market

The companies can issue securities in the primary market by different ways which may be

depicted with the help of the following:

Figure 5.2 Methods of issuing securities in the primary market

Methods of raising capital

Private
Public issue Right Issue Buyout deals
Placement
Preferential
Allotment

Qualified
Institutional
Placement

I. Public issue: It is considered as a most important way of issuing the securities to general public

i.e. individual investors, institutional investors etc. to raise capital for the company. The securities

are being issued at par, premium or discount as per the provisions of the Companies Act 2013 and

guidelines of SEBI (Securities and Exchange Board of India).

Steps for issuance of securities: The following steps are considered for issue of securities

considering the listing agreement between the issuer and stock exchanges. The approval of the

board of directors and shareholders are required to issue the securities and appointment of lead

managers to perform the due diligence on the company. There is an appointment of other

intermediaries such as underwriters, brokers, advisors also who play an important role in handling

the public issue. Than the draft prospectus is prepared and filled with Registrar and application for

listing on stock exchange is submitted. The printing and distribution of application are being done

and statutory guidelines are being followed for further collection and processing of applications.
After that, the final allotment is done for the applications received and liability of underwriters is

determined. The refunds and demat credits are being done and, then finally listing of securities

takes place as per the provisions and guidelines.

Aspects to be considered by investors regarding public issue

 Public issue is being informed through various modes of media and investors can make

application through intermediaries as per statutory announcements.

 The oversubscription of shares shall result into refund within few weeks of closing of

subscriptions.

 The balance amount may be called by the company in first call or final call.

 The non-payment shall result into forfeiture of shares.

 The issue of shares either bonus issue or right issue entitled for dividend only from the

last date of allotment.

 The book built issue may be done at prices determined on the basis of bids received from

the investors as per the provisions given by SEBI (Securities and Exchange Board of India)

Mechanism of Book- Building

An indicative price band is determined by the company in discussion with lead merchant bankers.

The electronic platforms of Bombay Stock Exchange and National Stock Exchange are used by

investors to submit application including the price and volume which is uploaded on the system.

The terminals provide the complete information and revision of bids can be done by investors

also. Further, the lead manager involves in discussion with issuer for issue price and the pattern to

be followed for allocation. The investors make the application and also provide authorization to

the banks to block the money in their bank account. Once the allotment is done, the funds are

released to the issuer. There is a facility introduced by SEBI known as ASBA (Application
Supported by Blocked Assets) to process application and accordingly the money is either received

in full or refunded due to non-allotment either in part or full.

II. Private Placement is a process where individual as prospective investors or select group of

persons not exceeding 50 are approached for subscribing towards the capital by private limited

companies. There can be two types of private placements:

(i) Preferential Allotment may be defined as when allotment of shares or debentures is done to a

select group of persons as per the provisions of SEBI (ICDR) guidelines by the listed company

following the regulations of passing the special resolution, fixing the price for preferential

allotment, making an open offer to the existing shareholders and having a lock-in period during

which it cannot be transferred.

(ii) Qualified Institutional Placement (QIP)are considered as a popular form of raising capital

through private placement as per the provisions of SEBI (ICDR) Regulations to institutional

investors at a price closer to the current market price. The issue cost of QIP is very less, involves

less marketing effort and can be completed in few hours.

There is a new concept “anchor investor” introduced by SEBI in 2009, who qualified

institutional buyer (QIB) is submitting an application of Rs. 10 crores or more through book

building process.

III. Right Issue is being offered to the existing shareholders as an additional equity capital which

involves selling the securities in the primary market on pro-rata basis as per the provisions of

Companies Act 2013.The following procedure is being adopted by the company by sending a

letter of offer along with application forms of different categories of forms i.e. Form A, B, C, D to

the shareholders. The application form with all information to be sent to the company within a

stipulated period of 30 days.

 Form A – Acceptance of the rights and application for additional shares.

Form B– Renounce the rights in favour of others.

Form C– Application by renouncee (The original allottee has renounced the right in favour of

renouncee)

Form D– Request for split forms

IV. Buyout deals is defined as a mechanism through which a company can issue the shares on

Over the Counter Exchange of India (OTCEI) and dealer has the option to sell it directly to public

in the general market.

Requirements of Listing of shares/debentures on stock exchange:

The following are the requirement for listing of securities on stock exchange as listing norms

 Minimum capital as public offer should be 25% for the general public.
 Single shareholder should not hold more that 0.5% of the paid up capital of the company
except in case of banks, financial institutions etc.
 As security deposit, a company is required to deposit 1% of the issue amount with the
recognized stock exchange.
 Initial listing fees and annual listing fees to be paid by the company by the stock
exchange.
 Allotment of shares to be done within 30 days from closure of the issue.

3.2.3.2 Secondary Market

Secondary market is a market in which outstanding securities and listed securities are traded as

per the regulations. In India, the development of stock market in 1875 was related to formation of

Native Share and Stock Brokers Association at Bombay. Afterwards, there were formation of

stock exchanges in Ahmadabad, Calcutta, Madras and other stock exchanges. The Securities

Contract and Regulation Act (SCRA), 1956 was introduced as a legislation by the government.

The most important development in the Stock Market was setting up of National Stock Exchange
in 1995 and which was designated as largest stock exchange even above Bombay Stock Exchange

which was already there in India. The stock market provides the platform for trading, settlement

and clearing as per the regulations prescribed by SEBI.

3.2.4 Classification on the basis of Timing of Delivery

The following are the classification on the basis of which the trade takes place either in the spot

market and future market and accordingly the settlement for trade is done.

3.2.4.1 Spot Market or cash market

Spot market may be defined as the market that represents the current trading price of the financial

instruments. The transactions in the spot market are being settled as per the immediate settlement

date may be it can be a rolling settlement or fixed day settlement.

3.2.4.2 Forward or future market

Forward market or future market is one where trade is taking place but the settlement for the same

shall be done at future date on the basis of the rates determined at present. Such type of contracts

entered into the forward market is mutually decided by the parties while entering into buying or

selling the financial instrument at a predetermined date in the future at a predetermined price.

3.2.5 Classification on the basis of Organization Structure: The following are the classification

on the basis of organization structure and the secondary market is operating through the following

mediums:
Figure 5.3: Operations of Stock Market/Secondary Market

Secondary Market

Exchange Traded Market Over the Counter Market

National Stock Bombay Stock

Exchange Exchange OTCEI

3.2.5.1 Exchange Traded Market

The two most popular markets are National Stock Exchange and Bombay Stock Exchange that

covers maximum percentage of securities transactions. Bombay Stock Exchange has also

introduced BSE Online Trading System (BOLT) in 1995 and later on promoted demat trading and

established central depository system.

(i) National Stock Exchange was established in the year April 1993 with the following objectives

and contributed as a catalyst in bringing a transformation the Indian capital market:

1. To establish a trading facility for all types of securities at national level.

2. To provide a communication network for equal access to all investors.

3. To implement electronic trading system to ensure transparency, efficiency etc.

4. To ensure book entry settlements and short settlement cycle.

5. To meet the international standards.

Figure 5.4: National Stock Exchange Trading Platforms for all types of securities
 Trading platform provided by NSE

Wholesale Debt NSE Capital NSE Futures & NSEs Currency

Market Market Options Derivatives

(ii) Bombay Stock Exchange is considered as an oldest stock exchange and from 1861 to 1875

the trading was done under Banyan Tree where it was situated and later on registered in the year

1887 and recognized as a stock exchange. The trading was done in an open outcry system and

trading ring was provided where by shouting of quotation by stock brokers the trading took place

in a trading hall. The following are the difference existing between the old and new system of

trading in the stock exchange.

In old system of trading In new system of trading

In trading ring of the stock exchange, members In central online system, orders are placed by

used to shout for buying and selling of shares brokers/members and automatically trades are

confirmed and displayed on the screen.

The following stock exchanges are initially established as follows:

 Ahmadabad Stock Exchange (1894)- Voluntary Non-Profit making organization

 Calcutta Stock Exchange (1908)- Joint Stock Company

 Madras Stock Exchange (1937)- Private Limited Company Limited with guarantee

 Hyderabad Stock Exchange- Private Limited Company Limited with guarantee

 Delhi Stock Exchange (1947)-Joint Stock Company

The technology is considered to be a boon in the capital market as a whole and its application in

National Stock Exchange has made it the first exchange in the world to utilize satellite

communication technology for trading. The trading system applicable here is termed as NEAT

(National Exchange for Automated Trading) which is a client server based application. The

various application systems are being utilized for trading, clearing, settlement and various other

operations has actually redefined the shape of the security market. The facility is also being

provided to its members to make use of the front end software through CTCL (Computer to

computer link facility). The exchange is also offering internet based trading to NSE members and

their authorized clients for transactions, trading etc. and its named as NOW (NEAT on Web).

Thus, it is concluded that primary/new issue market cannot function without the secondary market

because it provides liquidity to the issued securities. The primary market provides a market with

no geographical location to the prospective investors and company, thus establishes a direct link

between them. The investors are transacting in the stock market due to marketability and capital

appreciation and thus establish an indirect link between them. The company listing their shares on

the stock exchange has to follow the provisions and guidelines thus exercise control over the

primary market. Thus, it is concluded that there are differences existing between them but at the

same time primary market and secondary market are complementary to each other.

3.2.5.2 Over the Counter Market: It may be defined as an informal market in which trading is

done and negotiated such as government securities.

Over the counter Exchange of India (OTCEI): The first stock exchange in India is established

with the objective of providing an alternate market for the smaller companies. It is a screen based

automated exchange providing ringless trading system in India. The securities listed on this

exchange could not be listed on other exchanges but later on the securities listed on other

exchanges are allowed to list on these exchanges also. The automated transaction results into
settling the transactions immediately without the process of netting. It is promoted jointly by UTI,

ICICI, SBI Capital Markets Ltd., IDBI, GIC, IFCI and Canbank Financial Services Ltd. as a

company u/sec 25 of the Companies Act 1956 with the following objectives. Thus, following are

the objectives of OTCEI:

(a) Investors can access the market with full safety and convenience.

(b) Companies can raise the capital from the market at low cost and minimal terms.

(c) Other companies which cannot be listed on other stock exchanges.

(d) Providing such platform where investors can enter into trade and settlement of securities with

more transparency and liquidity.

I. Over-the-Counter Market:

Market Mechanism at Over the Counter Exchange of India (OTCEI)

The trading mechanism followed is quote driven and online trading cum depository system and

following a T+2 settlement system.

1. Primary market Activities

There are two ways through which public issue can be made through over the counter exchange of

India:

(i) By inviting application from investors: The issue involves appointment of market maker can

be a dealer (who gives both bid and ask rate) and who is like a jobber, gives two-way quotes to

improve liquidity of the shares of the company.

(ii) Buyout Deals may be defined as when where selling takes place by issuing the whole or part

of it to the dealers which in turn further sells these shares to the public at a later date.

2. Secondary Market Transactions

The mechanism adopted for trading of shares through such exchange is done through

telecommunication facilities in an online manner. Initially, an investor approaches the dealer and

review the quotations displayed on the screen, then a unique code number i.e. “OTC Investor
Code No” is issued to the investor. After that, investor places the order, dealer feeds into the

system and become available to nationwide across the network. Then, the automatic matching for

buying and selling as per the rates is done and dealer issues a conformation receipt (temporary) on

execution of the trade. After payment of amount to the dealer, the permanent

Confirmation receipt is issued by the dealer and vice versa.

Benefits of Over the counter Exchange of India (OTCEI)

Benefits to the investors Benefits for issuing Companies

1. Easy Accessibility 1. Low cost of issuing shares

2. Improved Liquidity 2. Beneficial for small companies

3. Transparency 3. Benefit on account of market

4. Immediate transfer of shares maker

5. Speedy settlement of trades

Features of Over the Counter Exchange of India (OTCEI): The small companies can make

public offer through such exchanges and taking benefit of the market maker. A company can also

make issue through mechanism of buyout deal where trading is done through network of

computers or ringless trading having a rolling settlement individually on the basis of the

transaction and finally result into immediate transfer of holding through the custodian.

3.3 Financial intermediaries

The financial intermediaries are playing a vital role in facilitating the transactions and maintain

transparency in the security market. The security market facilitates in providing trading and

investment opportunities through various financial instruments such as stocks, bonds, debentures

etc. to the investors. The financial intermediaries are acting as a bridge between them to facilitate

the trading process in the stock market as a whole. There are various financial intermediaries in
the stock market who link demanders of funds with suppliers of funds. The intermediaries in the

securities market is as follows:

3.3.1 Primary Market Intermediaries

Underwriters are required to register with SEBI (Securities and Exchange Board of India) and all

registered merchant bankers and stock brokers and mutual funds can act as underwriters. In case

there is inadequate public subscription, an underwriter gives guarantee for public subscription and

agrees to subscribe to shares.

Merchant Bankers are the firms that manages the issue of securities and need to be registered with

SEBI under various categories I, II and III.

Mutual Funds are considered for collective investment where pooling and managing the funds of

investors are done and are registered with SEBI. A Custodian is also there in the back-end office

to receive and deliver securities, collect income and give dividends and also divides the assets

among various schemes.

Bankers to an issue are engaged in collecting money on behalf of the company from various

prospective applicants.

Debenture Trustees are registered with SEBI and continuously monitored for compliance of all

the terms stated in debenture trust deed and are appointed in order to ensure the contractual

obligations to be fulfilled by borrowing firms.

Registrars and Transfer Agents are registered with SEBI and. manages all investor related

services. There are two categories which are as follows:

Category I is related to act as both registrars to the issue and share transfer agent.

Category II is related to act as either registrar to an issue or share transfer agent.

3.3.2 Secondary Market Intermediaries

Brokers dealing in securities are registered with SEBI and through them investors can actually

transact in India. Thus, broker as an intermediary help in linking the individuals and stock

exchange and charge fees for providing assistance based upon knowledge and experience.

Sub-brokers have requisite knowledge to assist individual investors in trading in securities and

they are not directly linked to the stock exchange.

4. Summary

The functioning and organization of primary market is different from the secondary market yet

complementary to each other. In case of new issue of securities, the lead managers, underwriters,

banks play a pivotal role in managing, subscribing for the unsubscribed portion and collecting

application along with the requisite amount. The financial institutions and underwriters also

support various companies by lending loans to them. While issuing the securities through stick

exchange, the prospectus containing all information as per the SEBI guidelines, are circulated for

investors. There are various ways of issuing the shares in the primary market i.e. public issue,

private placement, right issue and bought out deals. In the public issue, the book building deals

with determining the pricing of the securities on the basis of the bids received from prospective

investors. In private placement, issue of securities may be done through preferential allotment and

qualified institutional placement. Stock exchange is a market place regulated by SEBI to provide

trading opportunities through brokers for the listed securities. Thus, SEBI regulates the primary

market, secondary market, intermediaries, companies and investors.

5. References
1. Chandra, P., Investment Analysis and Portfolio Management, Tata McGraw-Hill.

2. Mukherjee, Subrata, Security Analysis and Portfolio Management, Vikas Publishing.

3. Bhalla, V.K., Investment Management, S. Chand Publications.

4. Khatri, Dhanesh, Security Analysis and Portfolio Management, Macmillan Publishers.

5. Fischer, Donald E. and Jordan, Ronald J., Security Analysis and Portfolio Management,

Prentice Hall.

6. Self-Assessment Questions

Q1. Define the concept and functioning of financial market. What are the various types of

financial markets?

Q2. What are the various ways through which public issue can be made?

Q3. “New issue market and stock exchange are complementary to each other”. Justify.

Q4. What are the various aspects on the basis of which primary market can be differentiated from

secondary market?

Q5. What are the key features of National Stock Exchange (NSE) and Bombay Stock Exchange

(BSE)?

Q6. Mention the trading platform provided by National Stock Exchange (NSE)?

Q7. Write Notes on: (i) Right Issue (ii) Anchor investor (iii) Buy-out deals

Q8. What are the guidelines issued by the SEBI in pricing and allotment of new issue?

Q9. Define the functions of underwriters, registrars, lead managers.

Q10. What are the intermediaries in the primary market and secondary market?
 DIRECTORATE OF CORRESPONDENCE COURSES
KURUKSHETRA UNIVERSITY
KURUKSHETRA-136119
______________________________________________________________________________
Paper: MBADFM-306: Writer: Dr. Anshu Bhardwaj
Lesson No. 6
______________________________________________________________________________
Listing of securities, securities trading, securities settlement, and regulation, evaluation of

securities, and stock exchanges

1. Introduction

2. Learning Objective

3. Presentation of Contents

3.1 Listing of securities

3.1.1 Objectives of Listing

3.1.2 Advantages of Listing

3.2 Provisions and Requirements for Listing of Securities on Recognized Stock

Exchange

3.3 Securities trading

3.3.1 Trading and Settlement

3.3.1.1 Open outcry system

3.3.1.2 Screen-based system

3.3.2 Types of Orders

3.3.3 Circuit Breakers/Scrip wise daily circuit breakers/price bands

3.3.4 Settlement

3.3.5 Transaction Costs

3.4 Securities settlement and Regulation

 3.4.1 Governing Laws in the securities market

3.4.1.1 The Securities Contracts (Regulation) Act, 1956

3.4.1.2 The Securities and Exchange Board of India Act, 1992

3.5 Evaluation of securities

3.6 Stock exchanges

4. Summary

5. References

6. Self-Assessment Questions

1. Introduction

The companies are also required to fulfill the listing requirements to be listed on stock

exchange for trading as specified in the listing norms. The shareholders also derive manifold

benefits if shares are traded through stock exchanges. Thus, stock exchange provides a platform

to companies as well as investors for purchase and sale of securities. The companies have to

follow a proper procedure for listing the securities on recognized stock exchanges as per the

provisions in this regard in India. These steps are essential to ensure the compliance of

requirements by the issuer prior to listing of securities on the Bombay Stock Exchange and

National Stock Exchange. The delisting of securities may be done from the exchange as per

SEBI (Securities Exchange Board of India) guidelines in this regard.

2. Learning Objective

The purpose of this chapter is to understand the process of Listing of securities and its

advantages. The students will also be familiar about the different ways to raise capital in

primary market and process of trading in secondary market along with securities settlement as

per the provisions of SEBI (Securities and Exchange Board of India). The students will also

understand the evaluation of securities and stock exchanges.

3. Presentation of contents

3.1 Listing of securities

Listing of securities may be defined as including the securities on the stock exchange for trading

and company must satisfy all the requirements of SEBI (Securities and Exchange Board of India)

Act and bye-laws of the concerned recognized stock exchange. A company is permitted to trade

on the recognized stock exchange by listing the securities is referred to as listed on a particular

stock exchange.

3.1.1 Objectives of Listing

There are various objectives of listing which are as follows:

1. It provides supervision and control over the securities and the transactions related to it.

2. It protects the interest of the investors.

3. It provides benefits of liquidity and marketability to the securities listed therof.

3.1.2 Advantages of Listing

The advantages of listing are as follows:

1. From the point of view of shareholders.

2. From the point of view of Companies.

Listing of securities are beneficial for companies because it helps them to gain world-wide

recognition, increasing the investors base including institutional investors, enable to diversify

shareholdings that brings growth and stability in the company. It also results into reducing the cost

of raising additional capital may be for expansion or for other purposes and enhances value of the

company. By quoting the shares or securities on the stock exchange, the shareholders can do

better estimation of value of the shares as compared to the price. It also enables the company to

acquire or merge by offering securities to closely held companies or unlisted company in

exchange thereof. The shareholders can do trading through stock exchange because it provides
marketability and liquidity to their holdings. The process of trading through stock exchange is

transparent through auction bids and quotation helps the investors to make them updated about the

price change in the security. If the securities are listed on stock exchange, it brings more collateral

value to the investor in case they want to apply for loans and advances. There is another important

aspect that needs to be discussed here is related to the statutory obligation on the part of the

company to list its shares on the stock exchange. A public limited company desirous of raising

capital from general public by issue of prospectus must get its securities listed on the recognized

stock exchange. Under section 73 of the Companies Act, the company intends to apply for listing

has mentioned the same in prospectus can make application to the concerned stock exchange for

listing of securities.

3.2 Provisions and Requirements for Listing of Securities on Recognized Stock Exchange

The listing agreement is entered by company listing its securities and stock exchange as per the

provisions of the Companies Act, 1956, Securities Contract and Regulation Act, 1956 regulations

of the concerned stock exchange and various guidelines issued by Central Government and SEBI

from time to time. A recognized stock exchange may be defined as one which is being recognized

by SEBI (Securities and Exchange Board of India) and earlier it was given by Central

Government. The transactions for dealing in securities on the recognized stock exchange as per

the provisions leads to reduction in the counter party default risk as there is supervision and

monitoring on continuous basis by the concerned stock exchange.

General Guidelines as per SCRA, 1956

The listed securities on the recognized stock exchange can be traded and company is required to

satisfy the requirements of SEBI Act (earlier known as SCRA, 1956) and also the rules,

regulations and bye-laws of the concerned recognized stock exchange. A company is required to

apply along with the requisite documents along with the fees for the purpose of getting its
 securities listed on the recognized stock exchange. The following documents and particulars are

required:

 Memorandum of Association and Articles of Association and if applicable debenture trust deed.

 Prospectus or Statement in lieu of prospectus

 Circulars or Advertisement making offer for sale or subscription of securities in last 5 years.

 Balance sheet and audited accounts for last 5 years, or such shorter period as the company has

been in existence.

 Statement of dividends and cash bonuses, if any paid during the last 10 years or dividends or

interest in arrears, if any.

 Agreements existing either with them or between them i.e. vendors and promoters, underwriters

and sub underwriters, brokers and sub-brokers. (Certified copies)

 Agreements with managing agents, directors and technical directors (Certified copies)

 Documents relating to letter, report, balancesheet referred to in prospectus/offer for

sale/circular/advertisement during the last 5 years.

 History of the company including brief about the activities, reorganization, reconstruction,

amalgamation, change in capital structure, debenture borrowings, if any.

 Issue of shares or debentures at a premium/discount or for consideration other than cash.

 Details of commission, brokerage, discount or any option relating to issue of securities

 Diligence certificate (certified copy)

 Forfeited shares, if any

A company desirous of getting its securities listed on Bombay stock Exchangeneed to comply

with the listing requirements in accordance with the provisions of the various Act, guidelines,

bye-laws and regulations that companies are required to fulfill these requirements and make

disclosure relating to company as required at various stages by company.

3.3 Securities trading

Security market is being impacted by rise or fall in sensitivity index, decision of Reserve Bank of

India relating to repo rate, issuance of bonds by government. The trading in securities markets are

done broadly in three parts i.e. equity market, debt market and derivatives market. The equity

market is further divided into two parts i.e. primary market and secondary market. The debt

market is further divided into four parts i.e. government securities market, corporate debt market,

public sector undertakings and money market.

The derivatives market is divided into option market and futures market depicted as follows:

Figure 6.1: Structure of Securities Market

Securities Market
Equity Market Derivatives
Debt market
Market
Government
Primary
Securities Options
Market
Market

Secondary Public Sector

Futures
Market Undertakings

Corporate
Debt Market

Money
Market
 3.3.1 Trading and Settlement

The trading on recognized stock exchange can be done by members for the securities which are

listed securities and permitted securities and traded on the stock exchange. The order may be

placed with the brokers for buying and selling of securities and there are two ways through which

trading can be done:

3.3.1.1 Open outcry system is a system which was prevalent few years ago on the regional stock

exchanges which consist of trading posts where members approach for buying and selling of

securities as they shout and then after getting the trading signals reach there. After negotiations for

buying and selling the mutually agreed upon price is finally reached for bid and ask offers by

members.

3.3.1.2 Screen-based system is a system where computer screen is there in place of trading ring

and traders can connect from far off places with the computer network. This is also known as

open electronic limit order book (ELOB) market system as a screen based trading system in India.

The following are the advantages of trading:

 It results into improving the efficiency of the market and information is available at

a greater speed to the participant members

 It increases the confidence of the member or market participants because the

complete information about the market is available.

 It enhances the transparency of the trading system prevalent.

3.3.2 Types of Orders

There are different types of orders placed by buyers and sellers on the computer.

Limit Price Order is an order that pre-specifies the price while entering the order into the system.

Market Price Order is an order to buy or sell securities at the best prevailing price at the time of

entering into the order.

Stop Loss Price/Order is an order placed by the member and there is a matching done by the

computer and the order will be executed only when it reaches or go beyond that level of threshold

price. In the stop loss book, when the last traded price reaches or falls below the triggered price in

normal market conditions, a sell order gets executed and when the last traded price reaches or

exceeds the triggered price, a buy order is executed.

Day Order is an order which is valid for the day on which it is entered and automatically gets

cancelled at the end of trading day, if not matched.

Goods till Cancelled (GTC) is an order that remains in the system until it is cancelled by the

trading member.

Goods till Days/Date (GTD) is an order that allows the trading member to mention the days/date

till which it should be remain in the system.

Immediate or Cancel (IOC) is an order that allows the trading member to buy or sell security as

and when it is released in the market; otherwise it will be removed from the market.

There are different types of traders on the basis of duration or investment horizon period:

Position Trader- Traders are holding the position from months to years.

Swing Trader – Traders are holding the position from days to weeks.

Scalp Trader- Traders are holding the position from seconds to minutes.

Day Trader- Traders are holding the position throughout the day only.

3.3.3 Circuit Breakers/Scrip wise daily circuit breakers/price bands

The various Stock Exchanges such as National Stock Exchange and Bombay Stock Exchange utilizes

Market Wide Circuit Breakers (MWCB) to check excessive market volatility as made it compulsory by

SEBI by introducing circuit breakers in 1995.It does not stop the trading but no order is permitted if it is

beyond the specified range. If it is triggered by change in Sensex or Nifty, the one which is occurring

earlier is being considered and circuit breakers are applied only when there is movement in index by

10/15/20 percent, it is known as Index-based circuit breakers. Thus, index-based market-wide circuit
breakers system is implemented by Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).

The market-wide circuit breakers would be triggered by movement of either of the indices i.e. Sensex or

NSE or S&P CNX Nifty. In addition to this, there are individual scrip-wise bands of 20 % either way are

also fixed.

The SEBI has allowed trading members such as brokers to provide direct market access (DMA) to

institutional investors such as foreign institutional investors (FIIs), mutual funds and insurance companies,

thus, they can execute directly all the trades of buying and selling without any brokers.

There is another important aspect that needs to be discussed here and that is related to advantages

being offered to the investors by screen based trading so that there is no requirement of intermediaries in

the secondary market. But, this is not the actual scenario in case of institutional investors being impacted

by the adverse price when trading in large quantities even though there is transparency in the trading. Thus,

there is a preference of portfolio managers or institutional investors to trade in other markets as compared

to the screen based trading.

3.3.4 Settlement

In order to settle transactions in earlier times traditionally, there used to be physical movement of

shares through exchange or directly from sellers to buyers via brokers as an intermediary in the

trading transactions. The transactions so entered used to take 2-3 months and there was so much

paper work which was involved and there was risk also while transferring the securities from one

party to another as it could get lost also.

Due to the risk and other factors mentioned above, the developed markets have started settling the

trade transaction with the help of electronic transfer with the help of depositories. Depository is an

organization that keeps investors securities in an electronic form or in other words, it is referred to

as banks for the securities.

Figure 6.2: Types of Depository

Depository

Central Depository Services (India) Ltd. National Securities Depository Ltd.(set

(managed by professionals and promoted by
BSE) up by NSE with UTI and IDBI)

National Securities Depository Ltd (NSDL) was the first depositories in India and was set up in

1996. It was later on followed by Central Depository Services (India) Ltd. and there has been

significant growth in their operations specifically in NSDL.

The dematerialized trading in India was facilitated by depositories by the central government

under Depository Ordinance, 1995 and later on followed by Depository Act, 1996.

Dematerialization of securities means when securities are credited into the beneficiaries owner’s

account from physical form. A depository cannot open the account directly and depository so

established can facilitate services like entering of allotment of securities, transfer of ownership of

securities in the record of depository. As per Depository Act, 1996,every depository is an entity

who is registered with SEBI as per the provisions of SEBI Act and can offer depository related

services only after obtaining a certificate of registration from SEBI. There are some custodial

agencies such banks, financial institutions and large brokerage firms with whom the investors can

register. SEBI has made it mandatory for all stock exchanges to follow dematerialised trading in

India.
3.3.4.1 Shift to rolling settlement

In a very phased manner, SEBI has decided to introduce rolling settlement from 2022. Before this,

all the transactions in India were settled on a weekly account period that can be squared up at the

end of period and transactions could be settled on net basis. The trading cycle which was earlier

one week has now reduced to one day means that an investor has to square an open position the

same day otherwise the delivery shall take place as per the position. Thus, at present all trades are

being settled on a T+2 basis and NSCCL (National Securities Clearing Corporation Ltd.) clears

and settles trade as per the settlement cycle. On the trade day, it notifies the relevant trade details

to the clearing members or custodians, which are confirmed on T+1. Then, the obligations of each

party are being identified on the basis of netting the position of counterparties. The pay-in or pay-

out funds or securities has to be determined on the basis of obligation latest by T+1 and which are

netted for the member across all securities. It is forwarded on the same day so that they can settle

their obligations on T+2. The activity schedule for the T+2 rolling system is as follows:

Table 6.1: Settlement Cycle (T+2)

S. No. Day Details of Activity

1 T Trade Day

2 T+1 Custodial Confirmation of trade is being completed

3 T+2 Accept pay in from investors of funds and securities

Pay-out of securities and funds

3.3.5 Transaction Costs: The transaction cost may be divided into these broad areas:

Trading Cost: There are different types of trading cost involved in buying and selling of

securities i.e. brokerage cost, market impact cost, transaction tax on securities and other charges.

Brokerage Cost is the brokerage paid to the brokers.

Market Impact Cost is the difference between the actual transaction price and the ideal price.
Securities transaction tax (STT)is a levy on securities transactions.

Clearing costs are the costs incurred to resolve the conflict which arises due to counterparty

default or there is default on the part of the exchange to make the payout.

Settlement Cost are the costs associated with transfer of securities and funds and due to screen

based trading, dematerialization of shares, advancement in technology, settlement cost has

reduced substantially

3.4 Securities settlement and Regulation

Securities markets are mainly regulated by SEBI Act 1992, SCRA 1956 and Depository Act 1998

in India. The effectiveness and stability of financial system depends upon the regulations adopted

for better mechanism in these markets. Regulation of securities market can be either central

regulation or self-regulation. In context of India, regulation of securities market has evolved in

two phases. In the first phase, the provisions of CCI were applied to implement control in the

environment. But, there is a change in the environment to a regulated one from the year 1991-

1992 and there are some limitations in the controlled environment which are as follows:

Lack of proper control system (Primary Market)

Lack of control due to improper provisions for intermediaries (Secondary Market)

Lack of freedom in deciding the timings, pricing and selection of securities for raising capital

(primary market)

Due to the introduction of SEBI provisions and rules, the regulation of capital market,

regulation of intermediaries and free pricing of securities are done with the help of SEBI Act. The

market forces also help in determining the price of the securities in the regulated environment as

compared with controlled environment. Another major development that took place in the

securities market is that now all intermediaries i.e. underwriters, brokers, registrar to issue,

merchant bankers etc. are required to be registered with SEBI. As far as the recent development in
the stock market are concerned, it is related to brokers where they need to complete KYC (Know

your Client) in order to bring efficiency and transparency in the market.

3.4.1 Governing Laws in the securities market: There are various regulators or the key agencies

involved to provide a regulated environment for the market. In India, the regulation of the capital

market is done by SEBI (Securities and Exchange Board of India) and proper functioning of

financial market is done by Capital Market Division of Department of Economic Affairs (DEA),

Ministry of Finance and responsible for the protecting the interest of the shareholder and

regulating the activities of all the participants. There are other regulators such as The Reserve

Bank of India (RBI) responsible for the supervision of the banks, government securities, money

market etc., Ministry of Company Affairs (MCA) is another regulator responsible for the

administration of corporate agencies. There are other laws which affect the capital market are:

1. Company Law Board (CLB) – administration of Companies Act 2013.

2. Banking Regulation Act

3. The Depositories Act, 1996

4. Foreign Exchange Regulation Act, 1973.

The most important are the one described below:

3.4.1.1 The Securities Contracts (Regulation) Act, 1956

Since 1957, the government is establishing control on primary as well as secondary market

through the provisions of SCRA over the capital market. From 1992, SEBI has been empowered

by The Central government to exercise control and regulations over the market. The following are

the provisions of SCRA relating to regulation of the market:

 Section 3 and Section 4 of SCRA Act provides for the recognition of a stock exchange in

India.

 Nomination of SEBI on the board of stock exchange and supersede in case of not proper

functioning of the stock exchange.

 Providing rules for trading and also disallows the securities from trading in India.

3.4.1.2 The Securities and Exchange Board of India Act, 1992 was implemented in May 1992

by replacing the earlier Act of CCI and as per provisions of SEBI, there is a requirement of full

disclosure to bring more efficiency and transparency in the capital market. The primary and

secondary market activities are regulated under the provisions and also results into protection of

the rights of the investors and regulating the functioning of intermediaries also.

3.5 Evaluation of securities

The securities are being evaluated continuously by the investors and they are getting the

information on stock activity through various modes of media such as newspapers, periodicals,

other publications, radio etc.

Stock Market Quotations and Indices

The investors want to know complete information about the stocks, changes taking place in the

market and coverage through various modes such as print media in the form of newspapers which

is considered to be one of the most accurate and adequate mode of getting the information. Stock

market indices are utilized to evaluate the performance of the stock, returns available in the

market and also to estimate the market movements. The following are the factors that affect the

stock market index i.e. sample (representative of the whole population, base year (normal year)

and weighted criteria. Stock indices are considered as performance indicators of a specific

segment of the market and comparison of performance of individual stock with market indicators

are being done.

Individual Stock Quotations

The NSE and BSE websites are generally explored by investors to know about the individual

stocks and market as a whole. The following are the various concepts used to evaluate and

compare the stock price and stock index quotations.

Symbols: It represents the name of the company whose stocks are considered and index.

Series: It represents the series of the stock.

Date: It represents the date of the transactions on which the trade has undertaken.

Open: It represents the price on which the stock trades when the exchange is opened on that

trading day.

High and Low: It represents the price range reflecting the trading of the stock at the minimum and

maximum price paid by the investors on the stock.

Closing: It represents the last trading price recorded when the market closed on the day.

Last: It represents the last trade for a stock and being determined by the demand and supply for

that scrip or stock.

Previous Close: It represents the final price at which a security traded on the previous trading day.

Traded Volumes (Number): It represents the total number of shares traded for the day.

Value of Trades: It represents the total value of trades happened in that day.

P/E: It represents how much the investors are willing to pay per unit of earnings. It is calculated

by dividing the current stock price by earnings per share.

P/B: It represents the comparison of stock market value with the book value. It is calculated by

dividing the current closing price of the stock by latest quarter book value.

Dividend Yield: It represents the percentage return on the dividend. It is calculated as annual

dividend per share divided by price per share.

52-week high and 52-weel low: It represents the highest and lowest price at which a stock has

traded over the 52 weeks.

Stock Market Index

Stock market index is considered as a most important measure that reflects the market directions

and fluctuations in the stock prices on daily basis. It also provides information to the investors

regarding average share price in the market. It is also termed as leading economic indicators
because it reflects the situation prevailing in the economy. The good market index is considered to

be the one which is including the different scrips having high market capitalization and high

liquidity. There are various methodologies for calculating the index which are as follows:

Market Capitalization Weighted: It may be defined as one where the number of outstanding

shares is multiplied by the market price of the company’s share. The shares with the highest

market capitalization will have a higher weightage in such type of index.

Free-float market capitalization method: It may be defined as one where percentage of share is

freely available for purchase in the market. Now, BSE is a free float sensex.

Modified Capitalization weighted: It may be defined as one which puts a limit on the percentage

weight of the group of stocks.

Price Weighted Index: It may be defined as one where the price of each stock is aggregated and

which is than equated to an index starting value.

Stock Market Indices in India and Abroad

There are number of stock market indices in India such as Sensex, S&P CNX Nifty Index, BSE-

100, BSE-500, S&P CNX Nifty Junior. There are other stock market indices abroad such as Dow

Jones Industrial Average (DJII), New York Stock Exchange (NYSE) etc. The few are explained

below:

S&P CNX Nifty: This is considered to be that value weighted stock market index (weights

represent the relative market capitalization) in India i.e. Nifty which reflects the price movement

of 50 stocks selected on the basis of market capitalization and liquidity. It was constructed on the

basis of full market capitalization but now on the basis of free float which represent the non-

promoter, non-strategic shareholdings.

Sensex: The Bombay Stock Exchange Sensitive Index is known as Sensex and is the most popular

stock market index in India depicting the movement of 30 sensitive shares from specified and

non-specified groups. It is a value-weighted index and the base date for Sensex is 1 st April, 1979
and from 1st September 2003 is constructed on the basis of free float market capitalization. The

factors considered for including the stock in the Sensex are market capitalization, nature of

industry, listing history and frequency of trading of shares.

3.6 Stock exchanges

The stock exchanges may be divided on the basis of those stock exchanges which are popular in

India and in the leading stock markets abroad.

3.6.1 In India, National Stock Exchange and Bombay Stock Exchange are two popular stock

exchanges.

National Stock Exchange is the first stock exchange to promote institutional infrastructure of the

capital market. Besides this, National Securities Clearing Corporation Limited (NSCCL) provides

the settlement guarantee and being established by NSE. Even, the first depository i.e. National

Securities Depository Limited (NSDL) was jointly set up with Unit Trust of India (UTI) and

Industrial Development Bank of India (IDBI) to provide dematerialization of securities. There are

four entities linked with NSCCL in the clearing and settlement process which are as follows:

Fig 6.3: Entities linked with National Securities Clearing Corporation Limited (NSCCL)

Clearing
Custodians
Banks
NSCCL

Professional
Clearing
Depositories
Maembers
(PCMs)
Bombay Stock Exchange provides an efficient and transparent market for trading in debt

instruments, equity, derivatives and mutual funds. It provides trading platform to Small and

Medium Enterprises for dealing in equities.

3.6.2 There are leading stock markets abroad and some are explained below:

3.6.2.1 Stock Market in US: These are the two largest stock exchanges in the US and around the

world i.e. New York Stock Exchange (NYSE) and NASDAQ.

New York Stock Exchange is considered to be the biggest stock exchange in terms of market

capitalization, having strict and precise listing requirements so that only financially strong

companies get qualified to be listed. The brokers and specialists are acting as an intermediary for

trading and acting as a link between investors and market. The specialists are engaged in matching

of buying and selling orders and also buy them if customer orders are not matched.

NASDAQ (National Association of Securities Dealers Automated Quotation System) is the

dealer market and biggest exchange having the highest turnover and most of the investors are

doing trade in technology stocks listed on this exchange. The listing requirements are quite light

so new technology firms prefer to list here where listing cost is also on the lower side.

3.6.2.2 Stock Market in the UK

Due to reforms in stock market in UK in1986, there has been consolidation of all the exchanges in

UK and Ireland into the International Stock Exchange of UK and Ireland and known as ‘big

bang’. This resulted into closing of all regional stock exchanges and single electronic national

market of UK has emerged which can be accessed through local brokers and local branches of

national brokers. The trading is done in equities through Stock Exchange Automatic Quotation

(SEAQ) System which is quote-driven system (where market makers are providing two-way

quotes) and through Stock Exchange Automatic Execution Facility (SEAF) which is order-driven

system.
3.6.2.3 Stock Market in Japan

The most popular and dominant stock exchange was Tokyo Stock Exchange (TSE) in Japan

consisting of two sections of actively traded stock and less actively traded stock. In such

exchange, there is saitories who match market and limit orders, maintains proper books but do not

trade on their own account.

3.6.2.4 Emerging Stock Market

It refers to that Emerging Stock Markets (ESM) in developing countries which is based on market

based system. These are further classified in three categories i.e. the first category consist of the

markets from Africa, Eastern Europe, and former Soviet Union, the second category represent the

market in Brazil, India, Philippines, Pakistan and China which are developed having a large

number of listed companies and the third category represent Hong Kong, Singapore and South

Korea which are comparatively matured markets in context of liquidity, trading, risk premium etc.

4. Summary

The listing of securities enables companies to raise capital from general public through various

stock exchanges and they are also required to follow the provisions and guidelines of regulatory

body i.e. SEBI. There are certain objectives of listing of securities such as providing liquidity,

marketability etc. to listed stocks or shares. At the same time, the advantages of listings may be

viewed from point of view of companies and shareholders. The security market is broadly divided

into three parts i.e. equity, debt and derivatives for trading in securities market. The trading in

stock exchanges are done in two ways i.e. open outcry system and screen based system through

different type of orders which are placed. Now days, trading transactions are being settled through

electronic modes and depositories i.e. NSDL and CDSL. Even, SEBI has made it mandatory to do

all trading in dematerialized form of trading. There are various types of transaction cost which are

also involved in buying and selling of securities. There are various regulations adopted in order to
regulate the environment of the stock market such as SCRA 1956, SEBI Act 1992, and Depository

Act 1998. The Stock Market Quotations and Indices are considered as performance indicators of a

specific segment of the market. The indices are further divided in two parts i.e. Individual Stock

Quotation and Stock Market Index. There are various methods for calculating the stock market

index i.e. Market Capitalization Weighted, Free-float market capitalization method, Modified

Capitalization weighted, Price Weighted Index. Besides this, stock market indices in India and

abroad are also explained on the basis of popular stock exchanges in various parts of the world.

5. References

1. Chandra, P., Investment Analysis and Portfolio Management, Tata McGraw-Hill.

2. Mukherjee, Subrata, Security Analysis and Portfolio Management, Vikas Publishing.

3. Bhalla, V.K., Investment Management, S. Chand Publications.

4. Khatri, Dhanesh, Security Analysis and Portfolio Management, Macmillan Publishers.

5. Fischer, Donald E. and Jordan, Ronald J., Security Analysis and Portfolio Management,

Prentice Hall.

6. Self-Assessment Questions

Q1. What are the objectives and advantages of listing of securities in stock exchange?

Q2. What are the various types of depositories in India?

Q3. Differentiate between open outcry system and screen based system in trading of securities?

Q4. The rolling settlement period introduced in the stock exchange is _____________.

Q5. A limit buy order is a order to buy stock that is executed_______________.

Q6. An over the counter market is an example of __________________________.

Q7. Write a note on key regulators or regulating agency involved in securities market.

Q8. Write notes on: (i) Stock Market quotations (ii) Individual stock quotations
Q9. What do you mean by stock market index and what are the methodologies for calculating the

index?

Q10. Describe S&P CNX Nifty and Sensex.

Q11. Briefly describe the working of NYSE and NASDAQ.

 DIRECTORATE OF CORRESPONDENCE COURSES
KURUKSHETRA UNIVERSITY
KURUKSHETRA-136119

__________________________________________________________________________

Paper: MBADFM-306: Writer: Dr. Anshu Bhardwaj

Lesson No. 7
_____________________________________________________________________________

Security analysis and management strategies- Efficient market hypothesis

1. Introduction

2. Learning Objective

3. Presentation of Contents

3.1 Security analysis and management strategies

3.1.1 Efficient market hypothesis

3.1.1.1 Random Walk Theory

3.1.1.2 Efficient Market

3.1.2 Forms of Efficient Market Hypothesis

3.1.2.1 Weak-Form Efficiency Market Hypothesis

3.1.2.2 Semi strong-form Efficient Market Hypothesis

3.1.2.3 Strong-form Efficient Market Hypothesis

3.1.3 Empirical Evidences of Efficient Market Hypothesis

3.1.3.1 Empirical Evidence on Weak-Form Efficiency Market Hypothesis

3.1.3.2 Empirical Evidence on Semi-strong form Efficient Market Hypothesis

3.1.3.3 Empirical Evidence on Strong-form Efficient Market Hypothesis

4. Summary
5. References

6. Self-Assessment Questions
1. Introduction

The securities are being analyzed by various investors on the basis of two important variables i.e.

risk and return and accordingly investments are being done. The pricing of securities is also

important while inclusion in the portfolio. The security analysis is focused on identifying the over-

priced and under-priced securities. A security that is over-priced is not to be included in the

portfolio and the investment to be done in under-priced securities. Thus, risk may be considered as

an important component to identify the pricing of the security. If the security is priced lower

compared to the risk involved it is under-priced means the securities available in the market may

be having higher price for the same level of risk.

There are three basic theories of investment considered by investment analyst to study the

behavior of the stock prices. In fundamental approach, analysis of intrinsic value of shares and in

technical analyst believes that the future price movement can be predicted with the help of the

historical information. In efficient market hypothesis, the price can deviate from the intrinsic

value but such deviations are not correlated with any observable variable and are considered to be

random. In order to test market efficiency, empirical studies are conducted in weak form, semi-

strong form and strong form of efficient market hypothesis.

2. Learning Objectives
The objective of this lesson is to make the students familiar with Security analysis and

management strategies. After studying this lesson, you will be familiar with the following:

1. Random Walk Theory and Efficient market hypothesis

2. Forms of Efficient market hypothesis.

3. Empirical evidences on various forms of Efficient market hypothesis.

3. Presentation of Contents

3.1 Security analysis and management strategies

The security analysis is considered to be very important aspect in investment management

because it helps the investors to take decisions for buying and selling of securities. The investor

also focuses on analyzing the security from these two important characteristics of risk and return.

There are two approaches of security analysis i.e. fundamental analysis and technical analysis.

Fundamental analysis is related to analysis of company, industry and economy and technical

analysis is related to analysis of charts and graphs. The investor has to make strategies while

making investment decision relating to risky securities and risk free securities as well as over-

priced securities and under-priced securities.

3.1.1 Efficient market hypothesis

The concept of “efficient” was introduced by Eugene Fama in the mid-1960s in the literature of

financial economics. Thus, the efficient market hypothesis was considered as a main theme in

modern finance and it has certain implications also. The efficient market may be defined as one

where share price actually follows an independent path. If we talk about the empirical evidence in

terms of efficiency available in the capital market the result would be mixed. There is a lot of

competition in the capital market that leads to pricing of debt and equity securities.

3.1.1.1 Random Walk Theory

Before Eugene Fama, there was a quite surprising discovery made by Maurice Kendall in 1953

and found that the movement of price change of security are independent of one another and are

not related to the previous changes in the security prices. In other words, we can say that prices

are following a random walk which means that the successive price changes are independent of

one other. The random walk theory was also supported by Harry Roberts and Osborne (an
eminent physicist) by publishing papers in the year 1959. Harry Roberts mentioned that if we

culminate the series of random numbers, it was reflected that it resembles to the time series of

stock prices. The other study by Osborne reflected that behavior of stock prices is similar to the

small practices suspended in a liquid medium and this movement is named as “Brownian motion.

A Random Walk may be defined as the one where successive price changes are independent of

one other and are normally distributed, thus referred to as Random walk theory. There has been

other researches which has been conducted later to test the random walk hypothesis i.e.

randomness of stock price behavior. The conclusion of the empirical evidence is that such

randomness in behavior of stock price was the result of efficient market. The following are the

arguments in this regard:

 All market participants have access to the information which is quickly and freely

available for all.

 Market price reflects the intrinsic value due to keen completion among all the participants

in the market.

 There is change in the price because of new information and unrelated to the previous

information.

 The price actually behaves in a random walk because future is uncertain and it is difficult

to forecast the new information.

3.1.1.2 Efficient Market

Efficient market is one in which all the errors in the market prices are unbiased estimator of the

intrinsic value. It means that there can be deviation of the price from the intrinsic value but such

deviations are not correlated with any observable variable and of course these are random in

nature. Thus, it is ascertained that prices are influenced by the equilibrium of demand and supply.
The efficiency of market is related to full disclosure, transparency, regulatory provisions related to

market which was not earlier present in the Indian market. There have been some changes which

has been done in relation to regulations and procedural aspects and thus resulted into efficiency in

the market.

There is an article published by Fischer Black in July 1986 issue of Journal of Finance titled

“ Noise” and define “ efficient market as one in which the price is more than half of value and

less than two times the value” and concluded that all markets are efficient and that to 90% of the

time.

There are some other evidences given by various researchers relating to foundations of market

efficiency such as Andrei Shleifer and mentioned that the conditions given below will lead to

market efficiency and any one of these conditions need to suffice for market efficiency:

Rationality of investors, deviation from rationality is independent and effective arbitrage.

3.1.2 Forms of Efficient Market Hypothesis

There are numerous empirical evidence and analysis relating to the efficiency of capital market

and focused in supporting the random walk hypothesis. In 1970, Eugene Fama has come up with a

publication after reviewing and organizing the empirical evidence and presented a theory

mentioning that current price of a security reflects the all available information and defined in

terms of fair game model which resulted into this that expected return from securities will be

consistent with risk.

3.1.2.1 Weak-Form Efficiency Market Hypothesis states that each subsequent price is

independent of the previous price. It also implies that past prices and volume related information

is having no value in assessment of the future change in the prices. Thus, the investors cannot take
the benefit of technical analysis which is based on past price trends and traded volume and thus

not helpful in taking the investment decisions under this form of market hypothesis.

3.1.2.2 Semi strong-form Efficient Market Hypothesis implies full disclosure, transparency and

in terms of level of market efficiency it includes publicly available information, thus subsumed

the weak form of efficient market (depicted in the figure below). The information may be related

to macro-economic data, dividends, stock split, earnings, industry reports, new product

development, mergers, price-earnings ratios etc. Thus, it reflects the market data and non-market

information and security prices reflect all information. Thus, the investors cannot take the benefit

of fundamental analysis which is based on study of fundamental factors about economy, industry

and company (E-I-C framework) for taking the investment decisions.

3.1.2.3 Strong-form Efficient Market Hypothesis states that security prices reflect all available

information including publicly available information and private information thus, subsumed both

weak form and semi-strong form of efficient market hypothesis (depicted in the figure below). It

means if the market is of strong form of efficiency than investors cannot earn abnormal rate of

return by taking more risk and utilizing information in such a way to receive superior risk-

adjusted returns.

Figure 7.1: Three levels of Market Efficiency

 Semistrong- form
Weak-Form Efficiency
Strong-form Efficiency
Efficiency

3.1.3 Empirical Evidences of Efficient Market Hypothesis

3.1.3.1 Empirical Evidence on Weak-Form Efficiency Market Hypothesis

The weak form of efficient market suggests that there is no relationship between the price

movement related to the past and future and the security current price reflects only the trends

related to past and volume of trades and any other information related to the market.

(i) Returns over Short Horizons

In order to test the randomness in the short run, there are various tests employed in the short run

under weak form of market efficiency.

 Serial Correlation Test is also known as auto-correlations and number of serial

correlation studies is conducted find the presence of serial correlation on different stocks

with different time periods and different time durations. The focus is to identify if there is

price change in one period whether it is correlated with the price change in some other

period. The price change is considered to be serially independent if such changes are

negligible. There have been various empirical studies conducted in this regard in

1950s,1960s, 1970s related to uncertainty of stock returns either on daily or on monthly

 returns of individual securities.

 Runs Test is conducted on series of price change for independence and most of studies

strongly support the random walk model. The study focused on identifying it by

comparing the number of runs in the series and to see whether it is statistically

significantly different from the number of runs of the same size in random series.If series

of stock price is given and there is change in the price and this is represented by plus (+)

when there is an increase and by minus (-) when there is a decrease in the share price.

+++--++---++

A run may be defined as, when there is no difference between the sign of two changes.

For Example, there are five runs in the above figure, when there is change in sign it is

considered as a run where one run ends and there is a new run which actually starts. From

the above explanation, it can be ascertained that sign test also support independence.

 Filter Rules Test is also known as trading rules test in weak form of efficient market

hypothesis. The trading rules are employed to determine whether superior returns can be

obtained by considering the transaction costs and risk. There are empirical studies

conducted in this regard and it was suggested that filter rule do not actually beat the simple

buy and hold strategy specifically after giving due consideration to commission on

transactions. An n percent filter rule may be defined as the one in which

 If the price of a stock increases by at least n percent, buy and hold it until it decreases by at

least n percent from the subsequent high.

 If the price decreases by n percent or more, sell it.

Thus, it is also concluded that if there is randomness in change of the stock price than filter
 rule should not outperform a buy and hold strategy.

(ii) Returns Over Long Horizons are considered as characterized by negative correlation over

long term horizon where change in stock prices are occurring due to long term horizon and

corrections are made in the long run. There are different viewpoints on this and as per the

arguments given by Fama it is not market inefficiency as propounded by others; rather it results in

mean reversion and excessive volatility.

3.1.3.2 Empirical Evidence on Semi-strong form Efficient Market Hypothesis

The semi-strong form of market hypothesis suggests that there is an adjustment of stock prices to

the publicly available information. This means that the investors are not able to earn any superior

risk adjusted return by utilizing the publicly available information. Empirical studies have been

conducted in this regard to test the market efficiency:

(i) Event Study is based on the aspect where trading is done on the basis of certain events such as

bonus issue, earnings announcement, stock split etc. to earn superior risk-adjusted returns.

(ii) Portfolio Study is based on the aspect where trading is done on an observable characteristics

of a firm such as dividend yield, price earnings ratio, price-bookvalue ratio etc.to earn superior

risk-adjusted returns.

(iii) Time Series Analysis is based on the aspect where the public available information over

different time horizon i.e. short term or long term can provide superior risk-adjusted returns.

I. Event Study

Event study deals with excess market returns because of an event announcement such as

acquisition announcement and examining the impact of the market reactions. There are various

key steps involved in an event study which are as follows:

Figure 7.2: Steps in the Event Study
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From the above figure, the following points can be explained in detail:

The first step is to identify the event and the date because event study suggests that the financial

markets react to the announcement so it focuses on the announcement date.

Announcement date of the event

The second step is to identify the period for returns and duration of periods to be considered

whether time period before the announcement date or after the announcement date on weekly or

daily or monthly basis.

Rj, -n ---------------------------------Rj,0 --------------------------------Rj, + n

Return Window -n to +n

Rj,t = Return for the firm j for period t (t = -n,…..0…..+n)

The third step is to calculate the abnormal return is the difference between the actual return and
expected return for the firm. The symbolic representation is as follows

ARjt = Rjt - E (Rjt)

ARjt= Abnormal Return on firm j for period t

Rjt= Actual return on firm j for period t

The expected return is calculated using the CAPM (Capital Assets Pricing Model)

E (Rjt) = Rf t + β jt( RMt – Rf t )

E (Rjt) = Expected Return on firm j for the time period t

Rf t = Risk-free return for period t

β jt = Beta for stock j for the period t

RMt = Return on the market portfolio for period t

The fourth step is to calculate the average return

ARt = Average abnormal return for period t.

ARjt = Abnormal Return for jth firm for period t

m = m is the number of firms in the event study

The standard deviation of the sample average = Standard error of the abnormal return

The fifth step is to determine whether the returns around announcement date are different from

zero

T statistics for return on day t = Average Excess Return

Standard Error

Statistically significant T statistics means that the event has an impact on the returns and sign

indicates whether the impact is positive or negative.

II. Portfolio Study

Portfolio study deals with creating and evaluating them so as to earn superior risk-adjusted returns

and portfolio is having observable characteristics such as price-earnings ratio etc.The following

are the steps involved in a portfolio study:

Figure 7.3: Steps in the Portfolio Study

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See figure 7.3 and you can study the following steps which are being discussed in detail:

The first step is to define the variable which must be observable and the investment strategy is

very important aspect in this and the variable need not be quantitative such as price-earnings ratio,

price-book value ratio, bond rating etc.

The second step is to collect the data at the start of the period for every firm and on the basis of

the information; the firms are classified into different portfolios.

For example: if the bond rating is the selected variable, then firms may be classified on the basis

of the firms having the higher bond ratings and lower bond ratings.

The third step is to collect information on the returns for each firm in each portfolio and calculate

the return for each portfolio and assigning equal weights to them.

The fourth step is to calculate the abnormal return by applying the risk-return model is the Capital
Asset Pricing Model (CAPM). It can be calculated by the following formula:

ARjt = Rjt - E [ Rft + βjt (RMt – Rf t )]

ARjt = Abnormal Return for jth firm for period t

Rjt = Return on Portfolio j for the period t

Rft = Risk-free return for period t

β jt = Beta for portfolio j for the period t

RMt = Return on the market portfolio for period t

Beta of the portfolio is estimated by taking average of the betas of individual stocks in the

portfolio.

The fifth step is to test whether the average abnormal returns differ across these portfolios by

applying statistical tests.

III. Time Series Analysis

Time series analysis is based upon the assumption that the historical rates of return is considered

as a best estimator for future rate of return. The study highlights on identifying whether superior

estimates of return are available with different duration and for short term or long term.

Dividend Yield (D/P) and Stock Market Returns

There is a positive relationship existing between dividend yield and stock market returns and bond

default spread and returns on stocks and bonds in future for the long term duration.

Bond Default Spread may be defined as the difference between the returns which are available on

higher rated bonds (with AAA rating) and lower rated bonds. The following interpretations are

there on the basis of the empirical findings in this regard.

Investors expect a higher return (when bond default spread and dividend yield is high) that means

investors wants to avert the risk in such situation.

Quarterly Earnings Report are considered as one of the important basis for evaluating and
examining the returns on the basis of published reports on quarterly basis. Various empirical

studies and studies conducted in this regard also conclude that there is an adjustment in the stock

prices on the basis of announcement of changes, if any in the earnings.

Winer and Loser Portfolio are formed in order to evaluate their performance over a period of

time and it was ascertained that loser portfolios outperform the winner portfolios and it may be

because of the risk factor. The explanations can further be understood like this when prices

overreact in the market in post formation period:

Loser Portfolios become less expensive and earn superior risk adjusted returns.

Winner portfolios become very expensive and earn inferior returns.

There is a study also which is published in the year 1985 on the two group of companies i.e.

extreme winners and extreme losers by De Bondt and Thaler. They have formed the portfolios on

the basis of performance and compared the performance of those portfolios i.e. best performing

stocks and worst performing stocks for 5 years since 1933 and concluded the same as mentioned

above.

Calendar Anomalies may be defined as one when there is a predictable deviation from the

expected return and week end effect is one such anomaly which exist from Friday at the closing

time and Monday at the opening time during this time period stock reflects negative returns.

Another example is January effect because there is increase in the prices of the stock in the month

of January as compared to other months and there could be different reasons for that.

 To get tax benefit at the end of the year by selling the stocks in which the losses have

occurred.

 Firms make important announcements about the firm at the beginning of the year i.e. in

January.

 Inflows may be there in the portfolios around the end of the year.
Interest Rate Range may be defined as one where there is a movement of market interest rate

within a normal range, accordingly there is an increase (when interest rates are towards the lowest

end) and decrease (when interest rates are towards the highest end) in the interest rate. This is also

supported by the yield curve which reflects that future estimations of interest rate for different

time periods and different maturity dates shows that interest rate is upward sloping when interest

rate is low and downward sloping when interest rate is high.

Overreactions in Price means that when there is any information or announcement, the prices of

stocks overreact to it but after a certain period corrections take place and even profit opportunities

are there even though there seems to be negative correlation in price.

3.1.3.3 Empirical Evidence on Strong-form Efficient Market Hypothesis

The strong form of market hypothesis holds that stock price reflect all available information

whether it is publicly available or privately available information. In order to test this hypothesis,

the information which are not available to outsiders and have considerable bearing on the returns,

the researchers have tried to analyze this by analyzing the performance of the following:

(i) Corporate Insiders are the board of directors and top level managers and as per the empirical

studies conducted it was concluded that they earn superior risk adjusted returns consistently. Thus,

they are also required to disclose the transactions related to sale or purchase of stocks of those

firms where they are insiders.

(ii) Stock Exchange Specialists are the market maker who ensures liquidity in the secondary

market by acting as an intermediary may be broker or dealer in India. The stock exchange

specialists do not exist in Indian stock market but in US definitely they are having access to

important information and earn superior risk-adjusted returns also.

(iii) Security Analysts are the full-time investment professional and not having much access to

information as compared to corporate insiders and stock exchange specialists.

(iv) Professional Money Managers are those who have not yet earned superior risk-adjusted

returns on an average as compared to any of the portfolios selected randomly.

4. Summary

The efficient market hypothesis is based on the fundamentals that markets are efficient and the

prices move independently as compared to the previous price and such hypothesis is referred to as

Random Walk Theory. The concept of efficient market was introduced by Eugene Fama in mid

1960s and also mentioned that there is tremendous competition in the market that leads to fair

pricing of securities. Further, it was suggested to differentiate three levels of efficiency i.e. weak

form, semi-strong form and strong form of efficient market hypothesis. The weak form of

efficient market hypothesis states that the current price of the stock reflects all information based

upon the historical data. There are few tests that supports the weak form of efficient market

hypothesis are Serial correlation test, runs test and filter test. The semi strong-form of efficient

form hypothesis holds that the stock prices adjust to the publicly available information. There are

two studies conducted to test the semi strong-form of efficient market hypothesis i.e. event study

and portfolio study. Event study deals with identifying the reactions of the market around a

specific announcement like stock split and impact on the earnings or returns. Portfolio study is

related to examine the returns available on a portfolio having observable characteristics such as

price-earnings ratio. There are mixed results on event study and portfolio study. The string form

of efficient market hypothesis states that all public and privately available information is reflected

in the stock price. The empirical evidence in this regard does not hold true and support it much.

Apart from this, there have been many studies relating to the behavior of stock prices and interest

rate has been done so far. The studies reflect that the there is an overreaction in market, existence

of anomalies were also there, volatility was also observed in the stock prices and movement of

interest rate can be seen within the normal range.

5. References

1. Chandra, P., Investment Analysis and Portfolio Management, Tata McGraw-Hill.

2. Mukherjee, Subrata, Security Analysis and Portfolio Management, Vikas Publishing.

3. Bhalla, V.K., Investment Management, S. Chand Publications.

4. Khatri, Dhanesh, Security Analysis and Portfolio Management, Macmillan Publishers.

5. Fischer, Donald E. and Jordan, Ronald J., Security Analysis and Portfolio Management,

Prentice Hall.

6. Self-Assessment Questions

Q1. Stock price follow a random walk because_____________________.

Q2. What is meant by Efficient Market Hypothesis (EMH)?

Q3. If the Efficient Market Hypothesis is true, what are the implications for investors?

Q4. Define Weak form of EMH. Give a detailed note on the tests under empirical evidence.

Q5. How is event study and Portfolio study done in Semistrong-form of market hypothesis?

Q6. Define Strong Form of EMH. Evaluate the empirical evidence on strong form of market

efficiency.
 DIRECTORATE OF CORRESPONDENCE COURSES
KURUKSHETRA UNIVERSITY
KURUKSHETRA-136119

_____________________________________________________________________________

Paper: MBADFM-306: Writer: Dr. Anshu Bhardwaj

Lesson No. 8
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Macro-analysis and Micro-valuation of the stock market. Fundamental analysis – Economic

analysis, Industry analysis, Company analysis and Stock valuation; Technical analysis –

Techniques, Dow Theory

1. Introduction

2. Learning Objective

3. Presentation of Contents

3.1 Fundamental analysis

3.1.1 Economic analysis

3.1.1.1 The Global Economy

3.1.1.2 Macroeconomic Analysis

3.1.2 Industry analysis

3.1.2.1 Industry Life Cycle Analysis

3.1.2.2 Study of the structure and characteristics of an industry

3.1.2.3 Profit potential of industries: Profit Potential

3.1.3 Company analysis and Stock valuation

3.1.3.1 Qualitative Factors

3.1.3.2 Quantitative Factors

 3.2 Technical analysis

3.2.1 Assumptions and indicators of technical analysis

3.2.2 Charting Techniques of technical analysis

3.2.2.1 DOW Theory

3.2.2.2 Bar and Line Chart

3.2.2.3 Point and Figure Chart

3.2.2.4 Moving Average Analysis

3.2.2.5 Relative Strength Analysis

3.3 Technical Indicators

3.3.1 Breadth Indicators

3.3.2 Sentimental Indicators

4. Summary

5. References

6. Self-Assessment Questions

1. Introduction

The Fundamental analysis is considered as a most popular method for analyzing the security for

making investment. The changes in the stock price are attributed to various factors including

major global economic influences, government policies and impact of macroeconomic variables

on the stock market. Another important aspect is analyzing the industry prospects and how it is

influenced by the development in the macro-economy. Even assessing the projected performance
and analyzing the financial statistics along with qualitative aspect of company’s position is also

considered important in fundamental analysis.

The technical analysis is done by predicting the future behavior on the basis of analysis of

the internal data depicting with the help of various charting techniques. The prices and volume of

data are some important concepts underlying chart analysis to predict the future direction of price

movements. The Dow Theory is the oldest and best known theory of technical analysis reflecting

three movements i.e. daily fluctuations, secondary movements and primary trends.

2. Learning Objective

The objective of this lesson is to make the students familiar with the Fundamental analysis. The

focus would be on E-I-C framework i.e. Economic analysis, Industry analysis, Company analysis

and Stock valuation. The students will be able to understand the technical analysis and its

techniques including Dow Theory. After studying this lesson, they will be familiar with:

1. Concept of Fundamental Analysis (E-I-C framework)

2. Assumptions and indicators of technical analysis

3. Techniques of technical analysis

4. Dow Theory

3 Presentation of Contents

3.1 Fundamental analysis

Fundamental Analysis is a most popular method used by investment analyst or security analyst

and experts for determining the intrinsic value of shares. The fundamental analysis is related to

long term forecast of economy, industry and company related aspects. The short-run fluctuations

are also considered as important because it affects the dividend, earnings expected from the stock.
Figure 8.1: Fundamental Analysis consisting of E-I-C Framework

Fundamental Analysis
Economic Analysis

Fundamental Analysis

Technical Analysis

Thus, the growth, success and stability of the firm depends upon the macroeconomic factors,

business environment, industry analysis, company’s future prospectus and there are some other

factors also. Empirical studies and researches have been done in this area and it was concluded

that the changes in stock prices are attributed to the economy-wide factors (ranges from 30 -35

percent), industry related factors (15-20 percent), company related factors (ranges from 30-35

percent) and other factors (15-25 percent).

Figure 8.2: Step by Step examination of Fundamental Procedures

To understand the
Step 1 macroeconmic environment.

To analyze the prospects of

Step 2 the concerned industry.

To determine the intrinsic value and

Step 3 company's projected performance.
3.1.1 Economic analysis

3.1.1.1 The Global Economy

The stock prices are being impacted by the events, financial information etc. at International level

thus, there is a need to analyze the situation prevailing in the globalized environment. The analysis

of the global economy is a first step towards analyzing the prospectus of the firm. There has been

recession and financial crisis at global level which has affected the stock market throughout the

globe. Even there is a difference existing in the economic performance of countries that is also

considered as a major aspect in evaluating and understanding the degree of impact it can have on

the stock market. It shows that even though there are wide variations in the economic performance

still the economies are connected to each other. In addition, the political risk is also present in the

global environment which also has considerable impact on the world economy. The political

uncertainties lead to impact the economic environment which further impacts the country as a

whole. There are some instances which can be mentioned here such as currency crisis, stock

market crisis, devaluation of currency, debt crisis and geopolitical factors also affect the countries

at global level. Thus, economic growth and investment return at international level is also being

impacted by the trade policy, flow of capital/investment at the global level and exchange rate also

affects the international competitiveness.

Global Expansion is considered as one of the important aspect having considerable bearing on

the growth prospects of the companies. Since 1980s, 1990s US economy is having the incremental

growth and viewed as principal engine of the word economy. There is a large contribution to the

global output expansion by US but now China has also emerged as agreat contributor in GDP and

it is forecasted that growth rate of China is going to be more as compared to other economies. The

proportion of foreign exchange reserves are largely held by US dollars and Euro held by Japanese

Yen, British pound and others hold 5% of the total reserves. The US has dominated the world

economy on certain factors such as gross domestic products, strength in terms of trade but at
present there is a new world economic order in which China and other economies have also

emerged as an engine for economic growth.

Central Government Policy

There are two broad classes of macroeconomic policies which are employed by the Central

Government i.e. demand side policies and supply side policies related to goods and services. The

example for demand side policy is increase in money supply and for supply side policy is related

to one that influences the production and cost.

The demand side policy includes fiscal policy and monetary policy.

Fiscal Policy is related to the policies of tax and allocation for spending of the money and

considered as a tool that either speed up the growth of the economy or slows down it. Thus, it has

impact on the economy and there may be surplus or deficit in the government budget which is the

different between the revenues and expenditures. For example, if there is increase in the

infrastructure related projects that results into a profitable venture only when revenue expenditure

(interest payment, subsidies, administrative expenses etc.) is less otherwise it will result into

deficit and not favorable for the economy as a whole.

Monetary Policy is impacting the economy and which is because of the impact on interest rate.

The policy may be formulated and implemented by Reserve Bank of India (RBI) but it has less

immediate impact on the economy as compared to fiscal policy. There are various tools of the

monetary policy which are as follows:

Figure 8.3: Tools of Monetary Policy

Tools of Monetary Policy

Open Market Reserve Direct Credit

Repo Rate
Operations Requirements Controls

Open Market Operations deals with buying and selling of government securities by Reserve Bank

of India in which money supply increases if RBI buys government bonds, pays for it without

diminishing funds at bank account and issues a cheque and money supply decreases where RBI

sells governments securities, it receives money.

Repo Rate is the rate at which RBI lends to the scheduled commercial and co-operative banks.

If there is a reduction in repo rate, it means expansion in monetary policy.

If there is increase in repo rate, there is contraction in monetary policy.

Reserve Requirements are in the form of cash reserve ratio and statutory liquidity ratio.

Cash Reserve Ratio may be defined as cash as a percentage of demand and time liabilities that

banks maintain with the Reserve Bank of India (RBI).

Statutory Liquidity Ratio may be defined as the ratio of cash in hand, balance in current account

with public sector banks and the RBI, gold and approved securities such as central and state

government securities, securities of local bodies and government guaranteed securities to the

demand and time liabilities.

 A decrease in Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) signals an

expansion in monetary policy.

An increase in Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) signals a

contraction in monetary policy.

Direct Credit Controls may be defined as one where Reserve Bank of India (RBI) directs the

scheduled commercial and cooperative banks to finance in priority sectors sometimes having

some benefits but results into inefficiency and reduction in competition.

Supply Side Policies are required to focus on creating such environment where production of

goods and services is more and that leads in enhancing the environments efficiency. It is not

possible to reach full employment equilibrium only with demand side policies and supply side

policies are required to create such environment that supports in productive capacity of the

environment. The impact of tax on demand and supply side policies are different, if there is lower

interest rate it, there will be more tax collection that further leads to more investment, better

working opportunities and enhancing the economic growth. There is another argument that

reflects that if there is reduction in tax rates that leads to increase in increase in revenues and thus

improving the efficiency and leads to growth in the economy.

3.1.1.2 Macroeconomic Analysis

Macroeconomic analysis deals with an environment in which overall firms operate. There are

various variables that that explain the macroeconomic variables are as follows:

Savings and Investments are important aspect and investment analyst must know the about the

level of investment (Domestic Savings + inflow of foreign capital – investment made abroad) and

proportion of investment in the capital market. There has been considerable increase in the

savings rate in India as well as in other parts of the countries in the world. There is a need to know
the proportion in which weights are beings assigned to various alternatives such as equities,

bonds, bank deposits, small saving schemes etc.

Higher the level of savings and investment more will be investment in equities and more favorable

it is for stock market.

Business Cycles is defined as having recurring period or cycle of recession and recovery.

Troughs represent the end of recession and the beginning of an expansion whereas a peak

represents the end of an expansion and the beginning of a recession. Thus, fiscal and monetary

policy provides direction and magnitude of economic expansion and contractions. There are other

measures i.e. economic indicators and further divided into parts classified below:

Figure 8.4: Various forms of Economic Indicators

Economic Indicators

Leading Economic Coincident Economic Leading Economic

Indicators Indicators Indicators

Leading indicators are important to the investors if they want to estimate corporate profits and

expected price increase in the stock market. It includes 10 economic series along with factor

weights that usually reach peaks and troughs before corresponding peaks or troughs in the

aggregate economic activity.

Coincident indicators are those indicators which move with the general economy. It includes 4

economic series which has peaks and troughs that coincide with the peaks and troughs in the

business cycle.
Lagging indicators are those which changes direction after business conditions have turned

around. It includes 7 series that experience their peaks and troughs after those of the aggregate

economy.

Gross Domestic Product is considered as a gross measure of economic activity which is the total

amount of final sale value of goods and services produced currently in a country during the year.

Figure 8.5: Components of Gross Domestic Product

Components of GDP

Consumption Spending Investment Spending

Consumption Spending may be defined as one where production of goods and services are for

consumption of public. It may be further divided into durable goods (furniture, home appliances

etc.), nondurable goods (food, clothing etc.) and services (rent paid on premises, transport

expenses).

Investment Spending represents the usage of capital for future productive purposes. It consists of

non-residential fixed investment (installation of new machines), residential investment (Building

of new house) and inventory changes (change in the level of stocks).

Government Budget and Deficit plays an important role in Indian and is related to spending on

goods and services such as infrastructure, research, defence etc. There are various measures of

deficit in the economy and most popular one is fiscal deficit and another one is revenue deficit.

Fiscal Deficit is the excess of government’s total expenditure over its non-borrowed receipts.

Revenue Deficit is the excess of revenue expenditure over revenue receipts from taxes, interest.
Price Level and Inflation may be defined as where change in price may affect the purchasing

power and when there is rise in price due to demand exceeding supply is referred to as inflation. If

there is a steady change in price than consumers will be able to buy only few goods and services

on the basis of an assumption that there is no change in the income.

Interest Rates are very less or there is negligible degree of risk on the short term debt instruments

which are money market instruments. There is higher degree of risk on the government securities

and corporate deposits carry even higher degree of risk. The interest rates were controlled and

regulated in organized sector in India and then there has been some regulatory changes due to

which interest rates are deregulated.

A rise in interest rates declines bond yields, diminishes profitability and leads to an increase in

the discount rate and have adverse impact on stock prices.

A fall in interest rates improves profitability and leads to decline in discount rates and have

positive impact on stock prices.

In general terms, we can say that increase in interest rates affected by inflation, government

policy, rising risk premium or other factors leads to reduction in borrowing and economic

slowdown.

Balance of Payment, Foreign Exchange Reserves and Exchange Rate

Balance of Payment reflects the external receipts and payments of a country and maintains

systematic record of all economic transactions between the residents of the host country and

residents of foreign country during a given period of time. There detailed view of balance of

payments can be depicted with the help of diagram below:

Fig 8.6: Components of Balance of Payments

Balance of Payment

Current Account Capital Account

Trade Flow Capital Flow

Visible Physical Flow Portfolio Flow

Equity
Market Stock

Invisible

Fixed income
market bond

Trade Account Balance is the difference between exports and imports of goods.

Current Account Balance is the difference between receipts and payments on account of current

account which includes trade balance.

Capital Account Balance is the difference between the receipts and payments on account of

capital account.

Foreign Exchange Reserves are generally held in foreign currency such as dollars, Pound, Euros,

Special Drawing Rights etc. and it also depends upon the foreign exchange position. There is

increase in foreign exchange reserves when there is surplus in both current account and capital
account. The deficit, if any is met out of such situation where current account deficit exceeds the

inflow in capital account.

Exchange Rate in context of trade in Indian foreign exchange market is done in US Dollars

(USD) for Indian National Rupee (INR). The exchange for the third currency is arrived at by

“crossing” the USD: INR with the third currency’s exchange rate against the USD. The managed

floating rate policy is followed by India. The volatility is kept under control by RBI but it is not

possible to keep it stable as per the empirical evidences in this regard. There is also interference

by RBI by modifying the regulations and interest rates and also by purchase and sale of foreign

currency.

Foreign Investments are considered as one of the important factors emerged as a powerful force

in the Indian capital market. Foreign Direct Investments and foreign portfolio investments are the

two ways of doing the foreign investment in India. There are various factors also that drive

foreign institutional investment in India.

Foreign Direct Investment is done for long term and related to setting up of new projects.

Foreign Portfolio Investments is related to purchase of outstanding securities in the capital

market.

Infrastructural facilities and Arrangements significantly influences industrial performances. The

Indian industry can be transformed by adequate and regular supply of electric power, better

transportation and communication system, availability of basic raw materials and better financial

support.

Sentiments are also considered to have considerable bearing on aggregate demand for goods and

services and are impacted by consumption and investment decisions, thus, having an important

impact on the economic performance. If there is high consumer confidence than expenditure will

increase and if there is high business confidence, then investment will increase.
3.1.2 Industry analysis

The industry analysis is related to assessment of prospects of various industrial groupings and its

impossible that there is a positive growth in all sectors but with careful assessment it can be

ascertained about the problems and prospects available in the industries as a whole. The following

are the basics of Industry analysis:

Figure 8.7: Basics of Industry Analysis

Basics of Industry Analysis

Profit potential of
Sensitivity to Industry Life Cycle Study of the structure
and characteristics of industries: Profit
Business Cycle Analysis an industry Potential

Sensitivity to Business Cycle is an important aspect in industry analysis where impact on different

industries can be analyzed after analysis of the macro economy. There is difference in response of

industry towards the business cycle and some industries are performing better as compared to

other industries and not at all affected by macroeconomic environment prevailing. The firm

earnings are determined by various factors which are as follows:

Sensitivity of Sales is different for various firms such as the necessity goods (food, personal care

products etc.) are considered to be less sensitive than other firms (automobile, transport etc.) are

more sensitive to business conditions prevailing.

Operating Leverage depicts the division between fixed cost (that remains constant even though

there is change in the volume of production) and variable cost (that changes with the change in the

volume of production).

Those firms which are having high fixed cost as compared to variable cost are having high

operating leverage.

Those firms which are having high variable cost as compared to fixed cost are having low

operating leverage.

Financial Leverage is another factor that affects the sensitivity of a firm to business cycle.

Higher the degree of financial leverage, greater is the sensitivity of a firm towards business cycle.

3.1.2.1 Industry Life Cycle Analysis: The following figure depicts the various stages of Industry

life cycle:

Fig 8.8: Stages of Industry Life Cycle

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During the first stage i.e. pioneering stage, the product is new as well as technology is also latest

and there is lot of competition and only few ventures survive and enters into the next stage.
The next stage is rapid growth stage and during this stage the firms that survive the competition

reflects significant expansion in sales as well as in profits.

The industry enters into maturity and stabilization stage after earning above average growth rate

and industry is fully developed and growth rate can be compared with the economy as a whole.

There is saturation in demand due to entry of new products, change in the preference of the

consumers, the industry enters into the decline stage comparable to the economy as a whole. The

firm may continue to remain in this stage for a longer period of time or it may grow during the

boom period or may decline during the recessionary period and remain stagnant during the normal

period in the economy.

3.1.2.2 Study of the structure and characteristics of an industry is an integral part of the

investment decision process and focuses on the following:

3.1.2.2.1 Structure of the Industry and Nature of Competition is to be considered while doing

the industry analysis. The various factors related to number of firms in the industry and evaluated

on various aspects such as licensing policy, entry barriers, pricing policy, and degree of

homogeneity, differentiation among products, competition from foreign firms, and competition of

the products with substitutes in terms of quality, price etc. and financial performance as well.

3.1.2.2.2 Nature and Prospects of Demand is another aspect on which focus is required and

related to major customers and their requirements, determinants of demand, cyclical fluctuations

in demand and expected rate of growth in future.

3.1.2.2.3 Cost, Efficiency and Profitability is related to the cost elements (such as raw materials,

labor, overheads), productivity of labor, turnover of inventory and receivables, control of prices of

output and inputs, behavior of prices of input and output, gross profits, operating profit and return

on assets, earning power and return on equity.

3.1.2.2.4 Technology and Research is related to technological stability, technological changes on

horizon and implications, research and development outlays, proportions of sales growth related

to new products.

3.1.2.3 Profit potential of industries: Profit Potential

The profit potential of an industry depends upon the following competitive forces:

3.1.2.3.1Threat of New Entrants may be defined as where new entrants in the business increase

the capacity but at the same time cost is increased and prices are reduced that leads to reduction in

profitability. If entry barriers are having advantage over the existing firms and there is less threat

from new entrants. The entry barriers are high when new entrants invest the resources to enter into

the industry. The existing firms control the distribution channel as well as benefitted from the

brand image and customer loyalty. Even the switching cost (one time cost of switching from

products of one supplier to another) is very high. Sometimes, the government policies also restrict

or limit the new entrant from entering into the market.

3.1.2.3.2 Rivalry among existing Firms in an industry depends on certain factors such as quality,

price, promotion, warranties, and service. The average profitability in an industry is affected by

competition among firms in an industry and the degree of competition depends upon certain

factors such as number of firms in an industry, competition among the firms to sustain and

survive, to achieve higher market share, capacity utilization level is high and there are high exit

barriers also.

3.1.2.3.3 Pressure from Substitute Products leads to have certain impact on the profit potential

of the industry and there is lot of competition that can be seen among various firms in an industry.

The situation where threat from substitute products is high because of various reasons which are

as follows i.e. the switching cost is minimum, industries are earning superior profits and those

firms are producing substitute products. Even, the price offered for the substitute products is very

much attractive to buyers.

3.1.2.3.4 Bargaining Power of Buyers relates to reduced price, superior quality of products,

better services and also creates more rivalry and competition among competitors. The profitability

of the supplier industry may be impacted more if buyers are powerful. The bargaining power of

buyers is high in certain situation which are as follows i.e. switching costs are low, where

purchases are more as compared to the seller and also causing lot of threat of backward

integration.

3.1.2.3.5 Bargaining Power of Suppliers relates to creating a competitive pressure in an industry

as it leads to increasing the price, lower down the quality and any free services, if any and which

in turn affects the profitability of an industry. There are various situations where bargaining

powers of suppliers are very strong such as absence of any other substitute suppliers, switching

costs for the buyer is high, only few suppliers dominate and suppliers also present threat of

forward integration.

3.1.3 Company analysis and Stock valuation

In order to analyze securities, financial analysts employ various tools and techniques and

fundamental analysis is one of the tools applied for market efficiency and to determine whether

security is to be purchased or sold. To assess intrinsic value of shares, fundamental analysis deals

with aspects like earnings in future, dividend etc. This is the approach where estimated intrinsic

value of shares is compared with prevailing market price to determine whether security is

underpriced or overpriced. The fundamental analyst also need to understand the firm’s strategy,

analysis of the past performance, accounting data related to the firm and other non-financial

criteria.

Company analysis may be defined as one where evaluation of financial performance is done on

the basis of qualitative factors and quantitative factors.

Figure 8.9: Criteria of Company Analysis

Company Analysis
Qualitative Factors- Qualitative Quantitative Factors- Quantitative
Factors are non-quantifiable factors. Factors are measurable factors.

3.1.3.1 Qualitative Factors

There are various qualitative factors that helps in analyzing the firm and the security prices that

are fairly priced or not.

Strategy Analysis deals with the analyzing the profit potential of the firms and the factors which

impact it are related to choice of the industry, competitive strategy followed to compete with other

firms and corporate strategy.

Competitive Strategy is one of the important framework developed for strategy formulation by

Michael E. Porter in shaping the management practices through two very important way of

gaining competitive advantage i.e. cost leadership and product differentiation.

Cost Leadership may be defined as one which can be implemented by developing mechanism to

control cost, take benefit from economies of scale, minimizing the cost in advertising, research

and development etc. For Example: Reliance in Petrochemicals etc.

Product Differentiation involves creating a product for customers considered as unique and

customers are ready to pay higher price for the same. For Example: Rolls Royce in automobiles,

Rolex in wristwatches etc.

Gaining Competitive Advantage is possible for firms by strengthening core competencies,

improving the value chain required while converting the inputs into outputs. The analyst evaluates

the following to gain competitive advantage i.e. what are the key success factors and associated

risks, what are the resources and capabilities to deal with the risks, what are the competitive

strategies chosen by the firm for various activities i.e. production, marketing, distribution etc.,

what are the steps taken by firm to adopt sustainable practices, how to change the structure of

industry so that it can adapt to the changes.

Corporate Strategy Analysis deals with managing different firms or multi business firms where

not only the profit potential but also the economic implications are being evaluated in terms of its

favourable or unfavourable impact for managing the firms. It is also important to create value in

the firm by minimizing the cost as compared to the market cost for performing certain activities.

The transaction cost related to firm and present inside the firm is less as compared to the market

related transactions because of the following reasons: less communication cost, less corporate

office cost because cost related to agreement processing can be shared among various firms, non-

divisible asset non-tradable asset can also be reduced where it can be shared by the different units

of the firms.

3.1.3.2 Quantitative Factors

These are measurable factors and encourage the need to have transparent financial reporting in

order to ensure effectiveness of the capital markets. The markets have become very close to each

other due to rapid changes in technology, mode of telecommunications enabling the flow of

resources and currency at global level. So, the investors need to identify and focus on the accurate

and reliable information not only related to the company but also of their competitors. The
accounting analysis also deals with evaluating the financial reports which provides information

related to financial indicators, financial performance and risk profile of the firm. The financial

reports provide the complete overview of its past and present performance and helps in

understanding the financial position of the firm through annual reports, financial statements etc.

The methods of preparation of these financial statements involve different procedures and rules

and also vary from firm to firm and country to country as well.

Users of Financial Statements are being provided with the information for decision making and

understanding the financial position of the firm. The users may be external users (investors,

lenders, customers, government and other regulatory agencies, researchers, practioners etc.) or

internal users (management, employees). The various financial statements being prepared are

balance sheet, profit and loss account, cash flow statement, statement of changes in equity etc.

Financial Analysis deals with analyzing the key financial metrics to understand the financial

position of the firm. There are two principal methods of equity valuation: dividend discount

method and earnings multiplier method. The earnings multiplier method is applied to evaluate and

analysis the historical data and utilize the same for developing forecasts required for estimating

the intrinsic value.

Earnings and Dividend level

Investment analysts consider the following in order to assess the earnings and dividend level.

Return on Equity is considered as a most important indicator and calculated as follows:

Return on Equity = Equity Earnings

Equity

Book Value per Share is calculated as follows:

Book Value per Share = Paid-up equity capital + Reserves and Surplus
Number of outstanding equity shares

Earnings per Share may be calculated as follows

Earnings per Share = Equity Earnings________________

Number of outstanding equity shares
Dividend Payout Ratio may be defined as that portion of earnings which is paid out as dividends

and calculated as follows:

Dividend Payout Ratio = Dividend Earnings____

Equity Earnings

Dividend per Share may be defined as dividend declared per share and it is explained as a paid up

value per share.

Dividend per Share = Earnings per share * Dividend payout ratio

Growth Performance is evaluated by measuring the historical growth through various tools

mentioned below:

Compounded Annual Growth Rate is calculated by applying the variables such as sales, net profit,

earning per share and dividend per share.

Sustainable Growth Rate is calculated as follows:

Sustainable Growth Rate = Retention ratio * Return on Equity

Risk Exposure is considered as one important measure through which risk can be identified by

calculating the following:

Beta may be defined as a risk in a stock and can be measured by its sensitivity on an individual

stock as compared to the variations in the market return.

Required Return = Risk-free return + Beta (Market Risk Premium)

Volatility of Return on Equity may be calculated as follows:

Volatility of Return = Range of return on equity over n years

Average return on equity over n years

Valuation Multiples

The following are the most common valuation multiples for investment analysis:

Price to Earnings Ratio is one of the popular methods that reflects the price investors are willing

to pay for every rupee of earning per share which is calculated as follows:
Retrospective PE Ratio is defined as

Price to Earnings Ratio = Price per share at the end of year n

Earnings per share for year n

Prospective PE Ratio is defined as

Price to Earnings Ratio = Price per share at the beginning of year n

Earnings per share for year n

Price to Book Value Ratio is another valuation statistics that reflects the price investors are

willing to pay for every rupee of book value per share. It may also be defined in terms of

retrospective and prospective manner.

3.2 Technical analysis

The concept of technical analysis is different from fundamental analysis and deals with the

internal data with the help of charts and graphs. This is one of the oldest tools for investment

analysis of securities/equities since 19 th century. The technical analysis can also be applied to

bonds, currencies, commodities etc.

Technical analysis deals with internal market data such as price, volume to be generated in order

to determine the future direction of price movements. Thus, technical analyst develops some

trading rules from the movement or observations of stock prices in the stock market as a whole. It

is a method of evaluating securities by analyzing the statistics and data extracted from the market

movements of share prices. It deals with taking the investment decision by investor relating to

buying and selling of securities and the timings for making the investments.

3.2.1 Assumptions and indicators of technical analysis

The technical analysis has certain basic assumptions which are as follows:

1. There are two forces of market i.e. demand and supply that are applied to find out the market

prices.
2. There are various rational and irrational factors influences supply and demand forces, that

includes fundamental factors including some aspects related to cognitive factors and emotional

factors.

3. There is a consistent trends followed by stock market for a long period of time but at the same

time there may have been some minor fluctuations in the market.

4. There is a change in the trends of the stock market because of shift in demand and supply.

5. The charts and graphs may be helpful to understand the change in the market and also to

understand the shift in demand and supply but it does not focus on the reason of occurrence of the

same.

6. There is consistency in the trend that persist for a longer duration of time and such past market

data may be analyzed to predict the change in the behavior of the stock prices.

3.2.2 Charting Techniques of technical analysis

The charts and graphs are the essential tools used in the technical analysis and help the investors

to understand the trends of the price so that the buying and selling decisions may be taken. There

are various techniques that are employed to depict the historical movements of the stock prices,

future projections and also highlight the support and resistance level. Thus, there are various basic

concepts underlying the chart analysis which are as follows:

Trends are the movement of price in a persistent manner either going upwards, downwards till

there is shift in demand and supply forces in the market.

Volume and Trends are related to each other and chartist also reflects that there is an impact of

volume of trading on the price of the stock.

The volume of trading increases as there is advancement in prices and decreases if there is decline

in price; this is a situation of major upturn.

The volume of trading increases as there is decline in prices and decreases as the price rallies; this

is a situation of major upturn.

Support and Resistance Level considered by chartist are the one where it is not possible for the

price to rise above a certain level and is known as resistance level and price fall below a certain

level it is known as support level. Thus, both support and resistance levels are an integral part of

the technical analysis.

3.2.2.1DOW Theory is the oldest and best known theory of technical analysis. It was originally

proposed by Charles H. Dow, the Editor of the Wall Street Journal in the late nineteenth century.

There are three movements in the Dow theory which describe the past price movements.

Daily Fluctuations are the short run movements which are random and are like ripples. Such

fluctuations are considered to be of minor significance.

Secondary Movements or technical corrections may be defined as those that last from weeks to

months and are like waves. It is actually representing the adjustments to the excess which might

have occurred in the primary movements.

Primary Trends are those major trends that represent the bull and bear phase of the market and are

like tides in the ocean. If there is an upward primary trend, it represents bull market.

If there is a downward primary trend, it represents bear market.

Fig 8.10: Bullish and Bearish Trend

Price Price

Time Time

Bullish Trend Bearish Trend

A major upward move is said to occur when the high point of each rally is higher than the high

point of the preceding rally and low point of each decline is higher than the low point of the

preceding decline.
A major downward move is said to occur when the high point of each rally is lower than the high

point of the preceding rally and the low point of each decline is lower than the low point of the

preceding decline.

3.2.2.2 Bar and Line Chart is one of the tools of technical analysis which seems to very simple

and used commonly. It depicts the daily price range as well as the closing price. The same is

depicted with the help of diagram representing the line chart and bar chart representing the daily

volume of transactions. A line chart is simplified version over the bar chart depicted with the help

of lines connecting the successive closing prices.

Figure 8.11: Bar and Line Graph

Price Price

Trading Day Trading Day

Bar Chart Line Chart

Head and Shoulder Top (HST) Pattern has a left shoulder, a head and a right shoulder as

depicted in the figure below. It represents a bearish trend and there is line which is drawn

tangentially between left and right shoulder and if the price falls below the neckline, it is expected

that price will decline which represents a signal to sell.

Figure 8.12
Price
\\\\\ \\\\\\\\\\\\\\

\\\\\ \\\\\\\\\\\\\ \

\\\\\\ \\\\
\
\ Time
Inverse Head and Shoulder Top (HST) Pattern is the inverse of the HST formation which

represent a bullish development and if the price rise above the neck line, it is expected that the

price will rise which is a signal to buy.

Figure 8.13
Price

\\\\\\\\\\\\\\\\\
Time

Triangle or Coil Formation reflects a pattern of uncertainty. It is very difficult to predict that in

which direction the price is going to move or break out. It is depicted in the figure below:

Figure 8.14 Price

\\\\\ \\\\\\\\

\\\\ \\\\
\
Time
Flags and Pennants Formation represents a pause or break after which there is a previous price

pattern that is likely to continue.

Figure 8.15
Price
\\\\\ \\\\

\\\\\ \\\\

\\\\\\ \\\\
\
Time
Double top formation represents a bearish development which signifies that the price is expected

to fall.

Figure 8.16

Price
\\\\\ \\\\\\\\\\\\\\

\\\\\ \\\\\\\\\\\\\ \

Time

Double Bottom Formation represents a bullish development which signifies that the price is

expected to rise.

Figure 8.17 Price

\\\\\ \\\\\\\\\\\\\\

\\\\\ \\\\\\\\\\\\\ \

Time

3.2.2.3 Point and Figure Chart is considered to be a more complex than bar chart and has the

following features:

1. Only significant price changes are recorded on point and figure chart.

2. The vertical scale represents the price of the stock but time scale is not depicted in the usual

way on the horizontal axis.

3. Each and every column represents a major reversal of price movements on the horizontal scale

but does not represent a trading day.

For example: Following are the daily closing price of the XYZ stock which are as follows for the

last 30 days:
30,30.50,31,31.50,32,32.50,32.75,33,32.50,32.75,33,32,31.50,31.25,31,31.50,32,32.50,33,33.25,3

3.50,34,35,34.50,34,33.50,33.75,33.50,33,34.

The point and figure chart is constructed for XYZ stock using a one-point scale which means that

the price is recorded only when change in the price is one rupee. The following points may also be

considered here while depicting the closing price of the stock on the point and figure chart.

 An X is recorded to depict if there is increase in the stock price of XYZ by one rupee over

the previously recorded price.

 An O is recorded to depict if there is decline in the stock price of XYZ by one rupee over

the previously recorded price.

 When there is change in the direction of price i.e. there is a decline after previous increase

or there is a rise after previous decline than the price is being recorded in the next column.

Figure 8.18: Point and Figure Chart

Price

38

36

34

32

30

28

Time

See Figure 8.18, the price change is recorded but small changes are not considered. It also helps in

identifying the pattern and changes in the stock prices more easily. There is a congestion area in

the point and figure chart which is represented by X’s and O’s on the horizontal axis in the figure
where it is developed because there is a series of reversals around the certain price level. A

congestion area is highlighted in the figure when demand and supply are considered to be more or

less equal. The upward price movement is there when there is breakout from the top of the

congestion area and there is a downward price movement when there is penetration through the

bottom of the congestion area.

3.2.2.4 Moving Average Analysis is done where most recent n observations are considered. In

order to explain it more, the closing price of the stock on 10 successive trading days are

calculated:

Trading Day Closing Price

1 24.0
2 25.0
3 24.5
4 23.5
5 25
6 25
7 25.5
8 25.5
9 25
10 26

On the basis of the data given above, 5-day moving average of daily closing price is calculated

which is as follows:

Trading day Closing Price Sum of most recent Moving Average

closing price
 1 24.0

2 25.0

3 24.5

4 23.5

5 25 122.0 24.4

6 25 123 24.6

7 25.5 123.5 24.7

8 25.5 124.5 24.9

9 25 126 25.2

10 26 127 25.4

To identify a long term trend- 200 days moving average of daily prices or 30 weeks moving

average of weekly prices may be utilized.

To identify the intermediate trend- 60- day moving average of daily prices may be utilized.

To identify the short term trend- 10-day moving average of daily prices may be utilized.

3.2.2.5 Relative Strength Analysis

It is assumed in relative strength analysis that during the bull phase, the prices of some securities

rise rapidly and during the bear phase, the prices of some securities fall rapidly in comparison to

the market as a whole. Technical analyst evaluates the industry strength by assessing the various

ratios. Thus, a simpler approach is to calculate the rate of return, segregating the securities those

which have earned superior historical return are supposed to have the relative strength. The ratios

of the security in relation to the industry are plotted on the graph for analyzing the relative

strength.

3.3 Technical Indicators are utilized by technical analyst to understand the market

environment along with the charts and graphs as described above.

3.3.1 Breadth Indicators

 The Advance-Decline Line is also known as breadth of the market which involves the

following two steps:

1. Net advance/decline are calculated on daily basis in the first step.

2. Cumulating daily net advances/declines to find out the breadth of the market in the second

step.

It can be well explained by taking the hypothetical figures and as detailed below:

Table 8.3: Breadth of the Market

Day Advances Declines Net Advances or Declines Breadth of the

market

Tuesday 530 425 105 105

Wednesday 590 375 215 318 (105+215)

Thursday 646 320 326 644 (318+215)

Friday 458 525 -67 577 (644-67)

Monday 356 600 -244 333 (577-244)

Tuesday 425 545 -120 213 (333-120)

See table 8.3 , it is concluded that breadth of the market moves in conformity with the market

average and also compared with one or two market averages. There is also the possibility that the

breadth of the market is going upwards and market average is not moving in a reverse direction

which reflects that market is going to be bearish. In another scenario, market average is not

moving in an upward direction and the breadth of the market is going downwards that means that

market is going to be bullish. This divergent situation is analyzed by the technical analyst to

understand the signals depicted in the market.

 New Highs and Lows depicts the high and low prices of the stock for 52-weeks and it

helps the technical analyst to understand the market, when most of the stock hit the highs during

this period, it reflects that the market is bullish.

 Volume analysis is a part of technical analysis and when high trading volume is

considered as bullish sign.

3.3.2 Sentimental Indicators

Short-Interest Ratio may be defined as one where those securities are considered having number

of shares that has been sold short but it is not yet purchased back. It may be calculated as follows

Short-Interest Ratio = Total number of shares sold short

Average daily trading volume

Put/Call Ratio is another indicator considered by technical analysts. The response of speculators

is somewhat different than the technical analysts, if there is rise in put/call ratio that means

speculators are pessimistic and on the other hand, technical analysts believe that it is a buy signal.

Thus, technical analyst considers it as a useful indicator and may be calculated as follows:

Put/Call ratio = Number of puts purchased

Number of calls purchased

4 Summary

The analysis of the economy at global level is considered to be very important in this era of

globalized business environment. The government policies are also very important that influences

the demand and supply for goods and services produced in an economy. The fiscal policy is

related to the expenditure or spending as well as tax aspects and monetary policy is concerned

with the decisions related to the money supply in the economy. The macroeconomic environment

is related to the overall environment in which all firms are operating. The industry is being

analyzed from the phases of industry life cycle and various characteristics related to it. The

investment decision process for all the firms in the industry differ because of the unique features.
The combined strength of five forces of the Porter model is also explained focusing on all

important stakeholders. Thus, fundamental analysis is related to the intrinsic value of shares and

economy, industry and company analysis is also done to evaluate the share prices. The company

analysis may be done by considering the qualitative and quantitative factors for better investment

decision making and assessing the earnings and dividend level. The earnings multiplier method is

considered to be very popular method for equity valuation. There are different metrics that are

applied to measure the financial performance, historical growth, risk and these are being

considered as a foundation for developing the estimates required for predicting the intrinsic value.

Technical analysis deals with the timings of the investment and various charts and graphs are

considered as important techniques for analyzing the securities. Dow Theory is also considered as

one of the oldest tool of technical analysis highlighting the daily fluctuations, secondary

movements and primary trends. In addition to the charts, technical analysts make use of certain

indicators such as breadth indicators, market indicators and sentiment indicators.

5 References

1. Chandra, P., Investment Analysis and Portfolio Management, Tata McGraw-Hill.

2. Mukherjee, Subrata, Security Analysis and Portfolio Management, Vikas Publishing.

3. Bhalla, V.K., Investment Management, S. Chand Publications.

4. Khatri, Dhanesh, Security Analysis and Portfolio Management, Macmillan Publishers.

5. Fischer, Donald E. and Jordan, Ronald J., Security Analysis and Portfolio Management,

Prentice Hall.

6 Self -Assessment Questions

Q.1 What are the key economic variables and their impact on the stock market?

Q2. What are the various forces that influence profit potential and drive competition for industries

according to profit potential of industries model of Michael Porter?

Q3. What are the stages of Industry Life Cycle Analysis? Explain in detail.

Q4. What are the non-financial factors considered in fundamental analysis?

Q5. How will the estimation of intrinsic value of shares is done by investment analyst?

Q6. Write Notes on: (i) Dividend per share (ii) Dividend payout Ratio

Q7. Write a detailed note on Dow Theory.

Q8. Differentiate between fundamental analysis and technical analysis?

Q9. Define the concept of technical analysis. What are the various techniques of technical

analysis?

Q10. Write Notes on: (i) Point and Figure Chart (ii) Moving Average Analysis

Q11. Write a detailed note on the technical indicators.

Q12. Describe briefly the important technical formations on bar and line chart and the indications

provided by them.

DIRECTORATE OF CORRESPONDENCE COURSES

KURUKSHETRA UNIVERSITY
KURUKSHETRA-136119
______________________________________________________________________________

Paper: MBADFM-306: Writer: Dr. Anshu Bhardwaj

Lesson No. 9
_____________________________________________________________________________
Equity portfolio management strategies – passive versus active management strategies

1. Introduction

2. Learning Objective

3. Presentation of Contents

3.1 Equity Portfolio Management

3.1.1 Strategies for Asset Allocation:

3.1.2 Managing Stock Portfolio

3.2 Passive and Active Equity Portfolio Management Strategies

3.2.1 Passive Portfolio Strategy

3.2.2 Active Portfolio Strategy

4. Summary

5. References

6. Self-Assessment Questions

1. Introduction

The equity portfolio management strategies are formulated by investors for the selected asset mix

for the portfolio. The investors forecast the economic environment and on the basis of the

analyses portfolios are formed. There are different expectations of individual investors and

institutional investors from the constructed portfolio. The management of the portfolio depends
upon the selection of approach whether it is active approach or passive approach for the securities

in a logical and orderly manner. The portfolio management as a process is an ongoing and

continuous process and applicable to various avenues of investment available to investors. Thus,

asset allocation is considered as a most important decision considered by investors.

2. Learning Objectives

The objective of this lesson is to make the students familiar with the various types of Equity

portfolio management strategies - passive versus active management strategies. The chapter

further explores the various investment strategies followed by equity portfolio managers.

3. Presentation of Contents

3.1 Equity Portfolio Management

There are various forecasting model and tools applied for security analysis and optimal

model for portfolio construction by analyst. The security analyst or portfolio manager focuses on

taking such decisions or actions that lead to bring the security prices in equilibrium or aggregate

portfolio to be held by the investor.

The investors manage their portfolio and select and hold the financial assets by following

either active portfolio strategies or passive portfolio strategies. Thus, managing the portfolio is a

continuous process and followed in an order by the investors. The investors have numerous

investment alternatives and managing this portfolio is a dynamic, flexible, continuous and

systematic process where investments are being made in real estate, gold and other options of

investments.

The investors frame an investment policy that provides a direction to them considering

their investment objectives, preferences and constraints. The investors also consider the

expectations of the capital market for securities and accordingly the strategies are developed and
implemented. Thus, investors select the securities; allocate the assets so that the value of portfolio

may be optimized. The portfolio is continuously monitored as per the objectives of investors and

market expectations may change over a period of time. Thus, the monitoring may be done from

the investor related input factor as well as market and economic input factor. Thus, it is concluded

that the portfolio rebalancing is an important part of portfolio management process.

There are two types of investors i.e. individual investors and institutional investors and one

of the aspect on which they differ on account of the duration i.e. time horizon. Institutional

investors are adopting the quantitative approach to define the concept of risk i.e. standard

deviation and also having some legal and regulatory constraints. The taxes are not considered to

be of much importance to institutions like pension funds but it has great relevance for individual

investors. The investors may be individual and institutional investor and differ on expected return

and tolerance level of risk. Even investors are having unique preferences and different situations

prevailing in an environment.

3.1.1 Strategies for Asset Allocation

In order to determine the asset mix of the portfolio, there are different strategies which are

considered as an investors overall portfolio. The strategies of asset allocation are depicted in the

table below:

Fig 9.1: Strategies for asset allocation

 Strategies of Asset Allocation

Integrated Strategic Tactical Insured

The integrated asset allocation strategies examined the capital market situations and investors

constraints and preferences to create the portfolio asset-mix. The portfolio so formed is

consistently reviewed on the basis of the returns generated from such portfolio. The optimal

portfolio is considered to be the one having the asset mix where the portfolio is generating a

highest level of expected utility. The portfolio manager may make the adjustments and

modifications due to some fundamental change or change in investor’s circumstances in portfolio

by including any new information. The investors with high tolerance level may select more

volatile portfolios with higher expected returns.

The strategic asset allocation is related to assigning weights to various assets and include in the

portfolio on long term basis. In order to estimate the results of capital market, the security returns,

risks are used as an estimate. An efficient frontier is also delineated and different risk return

combinations are depicted and investors select it on the basis of their risk-return preferences and

needs.

The tactical asset allocation is related to taking benefit from the changing market conditions and

changes in the values of the assets. It will eventually revert to the long term average value and the

assessment is done on a comparative basis. An investor adjusts the asset class mix in the portfolio
and that depends upon certain factors such as risk premium available to debt and equity relatively,

volatility in the capital market, changes in the macroeconomic environment.

The insured asset allocation is one where it is assumed that expected market return and risk are

constant and if there is a change in investor’s wealth it results into change in investor’s objectives

and constraints. Thus, there is continuous change in the allocation of assets in the portfolio in

insured asset allocation. It may also be known as constant proportion strategy because of shifting

from one asset to another as wealth changes.

3.1.2 Managing Stock Portfolio

There are various ways of managing the stock by active manager and passive manager, Even there

are different expectations of the investors which keeps on changing as per the change in the

market conditions and there is variability in investors constraints also. The investor may select

different asset allocation method depending upon the situations prevailing in the capital market.

The insured allocation method may be used by investor if capital market conditions remain

constant over a period of time. The tactical asset allocation is adopted by the investor if goals,

preferences and constraints remain constant over a period of time. When there is a variation in the

capital market conditions and expectations of investor’s goals and preferences than integrated

asset allocation may be applied by the investor for selection of asset-mix. These are the different

conditions that may be there while selecting the asset, it is expected that the portfolio mix must be

update on regular basis to reflect these changes.

3.2 Passive and Active Equity Portfolio Management Strategies

There has been a continuous changes in the investment process which has evolved over a period

of time and which resulted into numerous investment management style and processes followed

by portfolio managers. In order to manage common stock or securities, there are two management
styles which are used i.e. passive strategies and active strategies. The various asset-mix available

as an option and once it is selected, the next step is to formulate portfolio strategy for equity

(stocks) and bonds and thus different types of strategies are selected such as equity portfolio

strategy and passive portfolio strategy which are explained below:

3.2.1 Passive Portfolio Strategy

It is based on constructing a portfolio that depends on the performance of specific index and the

information available in the capital market for earning superior returns.

Index Portfolio Construction Techniques are those which are utilized to construct a passive index

portfolio.

Full Replication securities are those that are bought in proportion to their weights in the index.

There are few reasons due to which the efficiency of the technique is being affected one reason is

increase in transaction cost because of increase in purchase leading to affect on the performance.

And the other reason is increase in commission costs because firms reinvest the dividend, which is

paid at different interval of time.

Sampling is another technique that focused on addressing the various stock issues. One of the

advantages of this technique is that it reduces transaction costs and balancing cost. But the

disadvantage is that the return on portfolio does not match the benchmarking index. The various

methods of index portfolio investing is index mutual funds or exchange-traded funds.

An index mutual fund is an equity fund that invests the funds in various equity stocks consisting of

stock market index such as S&P Nifty Index or Sensex and weights are being assigned with each

stock equal to what it has in the index.

An Exchange Traded Fund (ETF) is a hybrid of close ended index fund (listed on the stock

exchange) and an open-ended index fund (due the rise or fall in demand, the units are redeemed or

created)

3.2.2 Active Portfolio Strategy is considered by individual and institutional investors so that they

can outperform the benchmark index and earn return on the risk-adjusted basis. There are two

approaches followed by active managers which are Fundamental Approach and Technical

Approach. Under fundamental approach there are different ways that can be employed to enhance

returns. The sector rotation is based on the assessment of securities and shifting of weights from

one industry or sector to another. Another way is stock picking which is related to identifying the

individual stocks that seems to be undervalued but having more weights in the portfolio relative to

their position in the market portfolio or vice-versa. Another way is to utilize the specialized

investment concept to earn superior returns. The investment practioners are applying various

concepts i.e. growth stocks, value stocks, asset-rich stocks, technology stocks and cyclical stocks

through sustained practices reflecting their expertise. The active portfolio managers adopt various

styles i.e. growth management and value management. The portfolio managers buy those stocks

which has low price earnings ratio but high dividend yield known as value stocks. On the other

hand, growth stocks are those which are having high earnings at present and expected to have high

earnings in future as well.

Value managers buy out-of-favour stock and are known as contrarian managers.

Technical Approach is one where different types of strategies are followed by technical analysts

and contrarian strategy and momentum strategy which are explained below:

Contrarian strategy are those which is based on the concept of mean reversion where it suggests

that the stock can be purchased when other investors expect that there is a bearish trend in the
market and stock can be sold when other investors expect that there is a bullish trend in the

market.

Momentum strategy may be defined are those which is based on the concept that the current trend

in the prices will continue and persistence of trends exist because the new information in the

market may not be reflected in the share prices. The new information may be positive, negative

which is absorbed by the market and as a result the stocks may be cold stock or hot stock remains

at the same level.

4. Summary

There are passive portfolio strategy and active portfolio strategy considered before making an

investment. An active portfolio strategy is considered by investment professionals and aggressive

investors and the vectors of an active strategy are market timing, sector rotation, security selection

and use of a specialized concept. The stock market returns are determined by interaction of two

factors i.e. investment returns and speculative returns. The passive strategy adopted by investors is

buy and hold strategy and indexing strategy. The various strategies of asset allocation are

strategic, tactical, integrated and insured considered for allocation of assets for portfolio mix.

There are two types of investors i.e. individual investors and institutional investors. There are

different techniques which are considered for constructing the portfolio under passive portfolio

strategies to earn superior returns such as index portfolio construction techniques where full

replication and sampling are applied. The methods of index portfolio investing techniques are

index mutual funds or exchange traded funds. The active portfolio strategy follows variety of

approaches that falls into three broad categories i.e. sector rotation, security selection, use of a

specialized concept under fundamental approach. There are two strategies which are considered

under technical approach i.e. contrarian strategy and momentum strategy.

5. References

1. Chandra, P., Investment Analysis and Portfolio Management, Tata McGraw-Hill.

2. Mukherjee, Subrata, Security Analysis and Portfolio Management, Vikas Publishing.

3. Bhalla, V.K., Investment Management, S. Chand Publications.

4. Khatri, Dhanesh, Security Analysis and Portfolio Management, Macmillan Publishers.

5. Fischer, Donald E. and Jordan, Ronald J., Security Analysis and Portfolio Management,

Prentice Hall.

6. Self-Assessment Questions

Q1. Discuss the active portfolio strategy.

Q2. Discuss the passive portfolio strategy. Explain the strategies in detail.

Q3. What are the various vectors of active equity portfolio strategy? Explain in detail.

Q4. What are the techniques considered for constructing the portfolio under passive portfolio

strategies?

Q5. Write notes on: (i) Momentum Strategy (ii) Sector Rotation (iii) Indexing Strategy
 DIRECTORATE OF CORRESPONDENCE COURSES
KURUKSHETRA UNIVERSITY
KURUKSHETRA-136119
______________________________________________________________________________

Paper: MBADFM-306: Writer: Dr. Anshu Bhardwaj

Lesson No. 10
_____________________________________________________________________________

Analysis and management of fixed income securities - Bond fundamentals, the analysis

and valuation of bonds, Bond portfolio management strategies – passive, semi-active

and active strategies.

1. Introduction

2. Learning Objective

3. Presentation of Contents

3.1 Bond fundamentals, the analysis and valuation of bonds

3.1.1 Bond Prices

3.1.2 Relationship between Bond Price and Time

3.1.3 Bond Yields

3.2 Bond portfolio management

3.2.1 Determinants of interest rate

3.3 Bond Portfolio Management Strategies

3.3.1 Passive Management Strategies

3.3.2 Quasi-passive strategy

3.3.3 Semi-active Strategy or hybrid strategy

3.3.4 Active Management strategies

3.3.4.1 Forecasting changes in the interest rates

 3.3.4.2. Identifying mispricing between various fixed –income securities

4. Summary

5. References

6. Self-Assessment Questions

1. Introduction

The bonds are fixed income securities are having a specified payment schedule and

maturity period. The investment in such securities are done by those investors those who are

generally risk averter and expect steady returns with safety of principal amount invested. Thus,

over the life of the securities, there is a periodic payment of interest and principal payment is

generally done at the time of maturity. In India, the growth of bonds took place in mid 1990s and

since then there is increase in complexity as well as the interest rates have become more volatile

and market determined and scientific method of analysis are considered by investors. The

portfolio managers are following either the active or passive strategies that commensurate with

achieving the return and risk exposure.

2. Learning Objectives

The objective of this lesson is to make the students familiar with the fundamentals of

bond, its analysis and valuation. The students will also understand the various bond portfolio

management strategies for generating superior risk-adjusted returns. After studying this lesson,

you will be familiar with

1. Analysis and management of fixed income securities

2. Bond portfolio management strategies

3. Presentation of Contents

3.1 Bond fundamentals, the analysis and valuation of bonds

The bonds are considered as fixed income securities consisting of a periodic interest payment

during the life of a bond and principal payment at the time of maturity. Since mid 1990, there has

been growth in bond market and it contributed to the complexity also. The bond market has

evolved over a period of time and there are a lot of changes that has occurred from pre-

liberalization scenario to post-liberalization scenario. The bonds are the long-term instruments

representing the issuer contractual obligations. At the time of issue of bond, the interest payment

and maturity dates are being decided. The future streams of cash flows are known to the buyer and

will receive the specified payment (interest and principal) till the date of maturity when principal

amount is to be paid. The bond may be explained in terms of the following characteristics:

The par value or face value is the value mentioned on the face of the bond.

The coupon rate is the interest rate payable to the bondholder and termed as periodic rate of

interest paid by the issuer to the holders of the bond.

The maturity date is the date when the principal amount is payable to the bondholder. The last

coupon payment is also paid on the maturity date.

The redemption value is value which is received by bondholder at the time of maturity and it may

be redeemed at par, premium and discount.

The market value is the price at which the bonds are usually bought and sold.

The call date represents the date at which the bonds can be called.
3.1.1 Bond Prices

The value of bond may be defined as the one which is equal to the present value of the cash flows

expected from it. In order to determine the value of bond, it is required to estimate expected cash

flows and required return. While doing the valuation of the bond, the assumptions are: the coupon

interest rate is fixed for the life time of the bond and payments are made every year and another

assumption is that at the time of maturity, the bonds will be redeemed at par. It may be

represented as follows:

Where, P is the value (in rupees),

n is the number of years to maturity,

C is the annual coupon payment (in rupees),

r is the periodic required return,

M is the maturity value,

t is the time period when the payment is received.

For the present value of an ordinary annuity, bond value is given by the following formula

P= C*PVIFAr,n + M * PVIFr,n

Value of the bond with semi-annual Interest rate:

The bond valuation with semi-annual interest rate considers a unit period of six months and not

one year. In such case, the bond valuation may be done as follows:
or

P is the value of the bond expressed in terms of rupees, C/2 is the semi-annual interest payment

(in rupees), r/2 is the discount rate applicable to a half yearly period, M is the maturity value, 2n is

the number of years to maturity period expressed in terms of half yearly periods.

The basis property of the bond is that there is an inverse relationship between price and yield.

The increase in yield leads to decrease in the present value of cash flows; hence decrease in price is there.

The decrease in yield leads to increase in the present value of cash flows; hence increase in price is there.

Figure 10.1: Price-Yield Relationship

Price

Yield
3.1.2 Relationship between Bond Price and Time

The price of a bond must equal its par value at maturity (there is no risk of default), the bond

prices change with time.

For example:
A bond that is redeemable at Rs.1000 (which is its par value) and at the time of maturity it will

have a price of Rs. 1000.

A bond that is having a current price of Rs. 1100 is said to be a premium bond and if there is no

change between the present and the maturity date, the premium will decline over time.

A bond that is having a current price of Rs. 900 is said to be a discount bond and this discount

shall disappear over time as depicted by curve B.

Figure 10.2: Change in price of the bond over time

Value of Bond

Premium Bond rd = 11%

A Par Value Bond

------------------------------------------------------------------ rd = 13%

Discount Bond rd = 15% B

8 7 6 5 4 3 2 1 0
Years to Maturity

3.1.3 Bond Yields

The following are the commonly employed yield measures and calculation of the yields is also

explained below:

Current Yield is related to the annual coupon interest to the market price.

Current Yield = Annual interest

Price
For Example: If the current market price of a 10%, 1000 Rs. Bond is Rs. 920, than the current

yield will be 100/920 or 10.87%.

Thus, current yield as calculated above may not be the true measure of the return to the

bondholder as it does not differentiate between the purchase price of the bond and redemption at

par value.

Yield to Maturity represents the discount rate which equates the bonds future cash flows to its

current market price. In other words, the rate of return expected by the investor on the bond being

purchased at current market price and held till maturity is called Yield to Maturity (YTM).

P= C + C +…. + C + M___
(1+r) (1+r)2 (1+r)n (1+r)n

P is the price of the bond

C is the annual interest (in terms of rupees)

M is the maturity value (in terms of rupees)

n is the number of years till maturity

Yield to Call is calculated in the same manner as yield to maturity. The bonds which can be

called back (buy-back) before the date of the maturity as per the call schedule.

C is the annual interest (in rupees)

M* is the call price (in rupees)

n* is the number of years until the assumed call date

Realised Yield to Maturity

The returns received through cash flow streams during the life of the bonds are reinvested at a rate

which is equal to the yield to maturity. The reinvestment rate considered here are different from

the future cash flows, thus, this assumption does not seem to be valid.

Yield to Maturity and Default Risk

There is a difference between the bond’s stated Yield to Maturity (maximum possible YTM on the

bond) and expected Yield to Maturity (possibility of default). When all the obligations on the

bond issue are met by issuing firms than stated/expected YTM shall be realized.

Yield to Maturity versus Holding Period Return

Yield to Maturity may be defined as one which is held by the bondholder till the date of maturity

and representing the single discount rate at which the present value of payments received from the

bond equals its price. On the other hand, holding period return may be defined as return earned

over a given holding period as a percentage of its price at the beginning of the period.

For Example: The par value of a bond is 10,000 for 10 years and paying a annual coupon of Rs.

900 is purchased for Rs. 10,000, its Yield to Maturity is 9 percent. If there is increase in the price

of a bond to Rs. 10,600 by the end of the year, its Yield to Maturity shall fall below 9 percent

(because it is being sold at a premium), but its holding period return for the year exceeds 9

percent. The calculation is as follows:

Holding Period Return = 900+(10600-10000)

10000
= 0.15 or

= 15 percent

3.2 Risks in Bond Investment

3.2.1 Interest Rate Risk is also referred to as the market risk where investors, fund managers are

impacted by interest rate that varies over time, thus causing fluctuations in the bond prices. If

there is an increase in the interest rate, the expected yield will increase and bond prices will fall.

On the other hand, if there is decline in interest rate, the yield will fall and bond prices will rise.

Thus, it is measured by percentage change in the value of a bond in response to change in the

interest rate. The following formula is considered to calculate the current price of the bond:

Current price of the bond = Present value of interest payments + Present value of principal

repayments

or

It can also be interpreted from the calculation mentioned above:

If there is longer maturity period, than there is greater sensitivity of price with regard to changes

in interest rate.

If there is large coupon payment, than there is lesser sensitivity of price with regard to changes in

interest rate.

3.2.2 Inflation Risk is greater for the long term bonds so in case of volatility in inflation rates

floating rate bonds and bonds having shorter maturity periods are given preference. In those cases

where inflation is very high, the borrower gains at the expense of the lender and vice –versa.

Thus, inflation is considered as a zero sum game. Interest rate defines the rate of exchange

between the current and future rupees in nominal terms.

For Example:

If there is a nominal interest rate of 11% on a one year loan means Rs. 111 is payable after one

year if Rs. 100 are borrowed today. But, the real rate of interest is considered more important

which is defined as a rate of exchange between the current and future goods and services.

Nominal Rate of Interest = Real Rate + Adjustment of Expected Inflation

According to Fischer effect, the relationship between nominal rate, real rate and expected inflation

rate holds good which are as follows:

Nominal Rate (r), real rate (a), expected inflation rate (α)

(1+r) = (1+a) + (1+ α) or

r = a+ α + a α

It can also be explained with the help of example:

If the required real rate is 5% and the expected inflation rate is 9%, the nominal rate will be

calculated as follows:

r = a+ α + a α

r = (0.05) + (0.09) + (0.05) (0.09)

r = 0.1445 or 14.45 percent

3.2.3 Reinvestment Risk is considered as greater for the bonds having longer maturity period and

those bonds having higher interest payments. It may be defined as one where periodic interest is

paid on bonds; there is a risk that the interest payment may be reinvested at lower interest rates.

3.2.4 Marketability Risk may also be termed as liquidity risk which arises when investors face

difficulty in trading debt instruments in those cases specifically where the quantity is very large. It

may be possible that government securities may traded easily but most of the debt instruments
does not have a liquid market. The investors may have to sell these instruments on discount i.e.

below the quoted price and may have to buy the instruments at premium. This may not be an issue

with those investors who buys the securities and hold it till maturity and even institutional

investors is required to mark the market on daily basis, thus concerned with the liquidity risk.

3.2.5 Default Risk may arise when either interest or principal or both are not paid on time by the

borrower. Thus, bonds carry a very high default risk having lower credit rating and trade at a

higher yield to maturity, considering other things being constant and equal. On the other hand,

government securities are considered to have a lower default risk. Investors are concerned about

the perceived risk of default rather than the actual risk of default except those highly risky debt

instruments.

3.2.6 Call Risk may be defined as one where issuers are given the opportunity to redeem the bond

before the date of the maturity. The issuer will exercise the call option when there is decline in the

interest rate. At this point of time, investors have to accept the lower yield after receiving the

amount on premature redemption and being reinvested as they are not having much comparable

investment options.

3.2.7 Real Interest Rate risk may have impact on the borrowers and lenders even though there is

no inflation risk. There will be change in real rate of interest due to shift or change in demand or

supply which can be explained with the example. For example, there is a decline in the real

interest rate from 5 to 3 percent because of certain factors may be there is change in tax laws or

there is increase in the competitors that has resulted into decline of real interest rate, In such

scenarios, those firms who have borrowed at 5 percent real interest rate shall be impacted because

the firm shall be earning only 3 percent on its assets but it has to pay 5 percent on its debt. Thus,

whenever there is change in the real interest rate and irrespective of the fact that whether the firm
has gained or incurred loss from this change, only those firms that has long term debt at a real cost

shall be impacted more due to change in real rate of interest.

3.2.8 Sovereign Risk may occur due to the decision of the foreign government where foreign

bonds are issued by foreign company to Indian investors.

3.2.9 Currency Risk may arise due to appreciation or depreciation in any of the currencies in

which trade is done. For Example: There is a payment which is to be done on bond denominated

in foreign currency (dollars) and cash flows are not certain in Indian currency (rupees). There is

an emergence of currency risk if Indian currency falls as compared to the foreign currency and

there will be currency risk to the Indian bondholders.

3.2 Bond portfolio management

The management of bond portfolios and change in the market interest rate is considered to be very

important by investors. The interest rate risk may be there on account of these factors i.e.

reinvestment of annual interest and at the time of maturity when bonds are sold resulting into

either capital gain or loss. If there is increase in interest rate, there is gain on reinvestment and loss

on liquidation and vice- versa. There may be balancing on each other means if there is loss on

reinvestment it can be compensated by gain on liquidation and vice-versa.

Duration

The holding period for which interest rate risk disappears is known as duration of the bond.

The duration may be considered as a very useful tool for bond management the properties of

maturity and coupons are combined. It may also be defined as the one which measures the

weighted average maturity of bond’s cash flows on a present value basis.

Where, t = time periods at which the cash flows is expected to be received.

n = number of periods to maturity

PV (CFt) = the bond’s current price or present value of all the cash flows

Properties of Duration

 In case of zero coupon bond, a bond’s duration is equal to the term to maturity.

 The duration is less than the term to maturity for all the bonds which pay periodic

coupons.

 The duration increases but at a slower rate as in such cases where there is increase in the

maturity of coupon bearing bond.

 The greater difference is there between terms to maturity and duration in case of coupon

paying bond’s term to maturity is longer.

 There is an inverse relationship between Yield to maturity and duration.

 The duration increase when there is an increase in price which further reduces yield to

maturity.

 The larger the coupon rate, the smaller the duration of a bond.

 The duration decreases due to increase in the frequency of coupon payments.

 When bond reaches near to the maturity date, the duration of bond declines.

3.2.1 Determinants of interest rate

The increase in interest rate results into decline in the price of the bond and when there is decrease

in interest rates, it results into rise in price of the bond. The following are the four factors on the

basis of which interest rate depend which are explained below:

Figure 10.2: Determinants of Interest Rate

Future Expectations Inflation Rate

Liquidity Preference Real Growth Rate
Preferred Habitat Time Preference

Maturity Short-term Risk-

Premium free interest rate

Default
Special Features
Premium
Business Risk Call/put features
Financial Risk Conversion Features
Collateral Other features

Short-term Risk-free interest rate is considered on the risk-free government securities such as

Treasury bills etc. on which chances of default are very less. The components are as follows:

Short-term Risk-free interest rate = Expected real rate of return + Expected Inflation

Expected Real Rate of Return is the rate at which trading is done on current consumption for

future consumption. The preference is given to current consumption over future consumption

which may be positive but differs across economies.

Expected Rate of Inflation is calculated as follows:

Price Level = (Money supply in the economy) (Velocity of money in circulation)

Real Output in the economy

Maturity Premium may be defined as one depicting the difference on the basis of short term and

long term yield to maturity of risk free security.

Figure 10.3: Yield Curve

Yield to Maturity

Term to Maturity

From the above figure, it is interpreted that there is increase in the maturity premium over a period

of time. It also shows the relationship between Yield to maturity and Term to maturity. The yield

curve is sloping upwards which shows that the investor expects a higher yield for the investment

being made for a long period of time.

The following explanation focuses on the various aspects that determine the yield curve:

Expectations Theory may be defined as one under which the yield curve may be increasing or

decreasing as per the expectations of the investors towards the short term rates to rise or fall.

Liquidity Preference Theory may be defined as one where investors are having preference for the

liquidity so they hold bond for a longer period of time with the motivation that they will get

higher yield on it.

Preferred Habitat Theory explains that the demand and supply of funds contribute towards in

determining the shape of the yield curve having different range of maturity.

Default Premium is expected by investor in addition to the maturity premium, if there is any

default on the interest and/or principal payment by the corporate bonds. The default premium

increase with increase in the default risk.

Special Features may be defined as those features which may have some effect on the interest

rate being paid by bondholder along with the principal amount at the time of maturity. There may
be call feature or put feature or may be a combination of call and put feature, may be convertible

(partly or fully), may carry a floating rate of interest, may be zero coupon bond issued at deep

discount and redeemed at par. It may be explained as follows:

 Investors risk may increase because of call risk may result in increase of interest rate.

 Investors are availing the put option and put features results in lowering the risk.

 Investors have option to convert and this feature leads to lowering the interest rate.

 Investors get protection from inflation risk because floating interest rate lowers the interest

rate.

 Investors get protection from reinvestment risk as zero coupon features reduce the interest

rate.

3.3 Bond Portfolio Management Strategies

3.3.1 Passive Management Strategies

An investor continuously monitors the portfolio as per their preferences, objectives, constraints

and risk tolerance level. The capital market is dynamic and keeps on changing so investors must

make changes in the holdings as per their preferences. The two most common passive strategies

are buy and hold and indexing.

Buy and Hold strategy is one where investors construct a portfolio as per their requirements and

does not enter into frequent buying and selling for getting higher returns. The investors need to

have complete knowledge and information about advantages of bonds, risks such as default risk,

call risk and marketability, taxes etc.

Indexing Strategy is one where investor buys the bonds that are in index so that the return and

risk of a bond can be replicated. The bond index should be large to replicate an index. The

periodic revision of the portfolio is done on the basis of the periodic rebalancing of the index.
3.3.2 Quasi-passive strategy

The following are the techniques of quasi-passive strategy:

Ladders may be defined as portfolio of individual bonds having different maturity dates. The

portfolio is divided into equal parts and invested in bonds with different maturity time period

during the investor’s life.

Bullets may be defined as maturity matching strategy where investors can invest in several bonds

having different maturity period but approximately maturing at the same time. The investing in

different bonds by staggering the purchase date reduces the interest risk. There are different

advantages such as availability of funds at particular time, providing protection against interest

rate risk because bonds are purchased at different point of time.

Barbells may be defined as a strategy where investors make investment in short term bonds

maturing in two or less and long term bonds maturing in 20 to 30 years. Such strategy is adopted

by investors when it is expected that there is going to be fall in interest rate in the long-term and

an increase in the bond prices. This strategy is comparatively difficult than the ladder portfolio

strategy because in former case, investor has the change the two sets of bonds from the portfolio

every year. There are different advantages which can be availed by investors such as taking

benefit of the high interest rates to increase the finance flexibility, liquidity is maintained as some

investments are maturing every year and making part of their investment in long term bonds

reduces the risk associated with rising rates which may further impacts the value of long term

bonds.

3.3.3 Semi-active Strategy or hybrid strategy

 Immunization

The investments in bonds are done and the interest rate risk is cause of concern for the investors.

There will be two type of effect due to change in the interest rate and those are reinvestment effect
and price effect. If the interest rate moves up after the purchase of the bond, interest income from

the bond will be reinvested at a higher rate and so interest earned on reinvestment will be higher.

Due to rise in interest rate, there is reduction in bond price and hence resulting into capital loss to

investors. Thus, rise in interest rate has positive reinvestment effect but negative price effect is

also there. But, it cannot be offset by each other rather the positive effect can outweigh the

negative effect, thus, resulting into difference in realized yield and expected yield.

Bond immunization is a type of strategy of matching the bonds duration with the time horizon of the investors.

 Rebalancing

There is a change in the interest rate and portfolio manager need to rebalance the portfolio in

response to such changes. Even though such changes are not there in terms of interest rate, there is

need to rebalance the portfolio as it affects the duration. At the same time, portfolio manager

cannot engage continuously in rebalancing the portfolio because it increases the transaction cost

because of purchase and sale of assets.

3.3.4 Active Management strategies

The bonds are generally purchased and held till the date of the maturity, however, there are some

portfolio managers those who follow the active bond portfolio strategies and take benefit from

management of bonds which are as follows:

3.3.4.1 Forecasting changes in the interest rates

The forecasting in the interest rate is considered as an important aspect because it helps the

investors to take the decision and has impact on duration. If there is fall in the interest rate, the

duration of the portfolio would be increased and the increase in the interest rate leads to fall in

duration. Another important consideration in forecasting the interest rate is the yield curve

because it provides valuable information and helps in deciding the investment in bonds.
Horizon Analysis may be defined as one which helps in interest rate forecasting and projections of

the performance over an investment horizon for the bonds. An investor evaluates the bonds over a

certain holding period on the certain assumptions related to reinvestment rates and future market

rates. So, under horizon analysis assumptions are being made but it also considers the different

aspects that are going to impact the performance of the bonds.

3.3.4.2. Identifying mispricing between various fixed –income securities

The bond swaps are generally being considered by portfolio managers to make adjustments in the

environment which is dynamic and continuously changing. The rate of return can be improved on

the bond portfolios by purchase and sale of bonds and also by finding out the mispricing in the

bond market. There are some common bond swaps which are explained below:

The substitution swap may be defined as one where there is an exchange of one bond for identical

substitutes. There is similar kind of feature in terms of coupon rate, maturity, call feature, credit

quality etc. There is mispricing of bonds that has resulted into the discrepancy between the bonds

and represents a profit opportunity. Such kind of opportunities is very limited in the market.

Rate Anticipation swap may be defined as one where investors can swap long-term bonds selling

at premium for long term discount bonds in such cases where investors are expecting lower

interest rates. The expectation of lower interest rates results into the more capital gains in the

discount bonds as compared to the premium bonds. The expectation of higher interest rates leads

to exchange of discount bonds with premium bonds or there is a swap of long term bonds with

short term bonds.

Yield spread or inter-market swap may be defined as that strategy where different types of bonds

are involved such as corporate bonds and government bonds. When there is change in market

conditions, even similar types of bonds behave in a different manner and leads to difference in
yield. The leading indicators are generally applied to understand and analyze the market

conditions.

Yield Pick-up-swap may be defined as that active strategy where investors identify the bonds

which are similar but trading at different yields for a certain period of time. In such cases, where

bonds are trading at different yields, investors can take different positions such as long position in

case of underpriced securities and short position in case of overpriced securities and abnormal

returns may be realized. There is one condition to earn profit from the yield pick-up-swap is that

the bonds need to be identical with each other.

Tax swap may be defined as that strategy which is adopted to take the benefit of tax. For Example:

An investor may have this option of shifting or swap from one bond to another which has

decreased in price but if it results into capital loss than it is advantageous to investor for tax

purposes.

4. Summary

The estimation for the price of bonds and determination of bonds requires an estimate of expected

cash flows and required returns. The bond valuations are calculated on the basis of either annual

or semi-annual interest payment. There is an inverse relationship between the bond price and yield

and also changes with time. The duration of a bond is one which the weights are proportional to

the present value of cash flows, thus it may be termed as weighted average maturity of cash flow

stream. There are some commonly employed yield measures which are current yield, yield to

maturity, yield to call and realized yield to maturity. The term structure of interest rates is

explained with the principles such as the expectations theory, the liquidity preference theory, and

the preferred habitat theory. The interest rates are determined by four factors such as short term

risk-free interest rate, maturity premium, default premium and special features as important

variables. There are different strategies for managing the bond portfolio such as active strategy,

semi-active strategy and passive strategy. The approaches which are considered under passive
bond portfolio management strategy are buy and hold strategy and indexing strategy. The semi-

active or quasi passive bond portfolio management includes ladders, bullets, barbells etc. The

active portfolio management strategies include focuses on forecasting changes in the interest rates

where horizon analysis are done and identifying mispricing between various fixed –income

securities which includes substitution swap, rate anticipation swap, yield spread or inter-market

swap and yield pick-up-swap.

5. References

1. Chandra, P., Investment Analysis and Portfolio Management, Tata McGraw-Hill.

2. Mukherjee, Subrata, Security Analysis and Portfolio Management, Vikas Publishing.

3. Bhalla, V.K., Investment Management, S. Chand Publications.

4. Khatri, Dhanesh, Security Analysis and Portfolio Management, Macmillan Publishers.

5. Fischer, Donald E. and Jordan, Ronald J., Security Analysis and Portfolio Management,

Prentice Hall.

6. Self-Assessment Questions

Q1. State the basic bond valuation techniques.

Q2. Explain in detail the bond pricing relationships with diagrammatic representation.

Q3. What is duration and how it is calculated? What are the important properties of duration?

Q4. What is immunization?

Q5. Discuss the steps involved in the horizon analysis.

Q6. What are the various types of bond portfolio management strategies? Explain in detail.

Q7. What are the various risks in bonds investment?

Q8. Write notes on:

(i) Yield to Maturity (ii) Yield to call (iii) Current Yield (iv) Realised yield to maturity

Q9. Discuss the following theories in brief:

(i) Pure Expectations Theory (ii) Liquidity Preference Theory (iii) Market segmentation theory

(iv) Preferred habitat theory

Q10. Consider an six-year, 12 percent coupon bonds with a par value of Rs. 100 on which interest

is payable semi- annually. The required return on this bond is 14 percent. Calculate the value of a

bond.

Q 11. Consider a 10-year, 14 percent coupon bond with a par value of 1,000. The required yield

estimated on this bond is 13 percent. The cash flows for the bond are as follows: 10 annual

coupon payments of Rs. 120, Rs. 1000 principal repayment 10 years from now. Calculate the

value of bond.