security analysis and portfolio management ------dr p alekhya

Security Analysis and Portfolio Management

------Dr P Alekhya

Dr P Alekhya, Associate Professor, MBA, CMRCET

UNIT – I Introduction to investment

Investment environment in India

• Securities

• Risk, Return and Diversification

• Security Markets

• Financial Intermediaries

Overview of Indian Financial System

• Financial Market

• Financial Instruments/Assets

• Financial intermediation

Security Trading in stock Market

• Stock Market \ Stock Exchanges

• Securities Trading Activities

• Types of Stock trading

• Buying and selling shares process

Investment Alternatives

Investment Management Process


Introduction to Investment

It is the commitment of funds made in the

expectation of some positive rate of return

It is a sacrifice of current money or other

resources for future benefits.


Characteristics of Investment

Rate of return – It is income on investment. It depends on nature of investment, maturity period.

Risk – Variability in returns is called risk. It depends on credit worthiness, maturity period and nature of investment

Marketability or Liquidity – An investment is highly liquid if - It can be transacted quickly The transaction cost if low The price change between two transactions is negligible

Tax shelter – some investments provide tax benefit. Tax benefits are of three kinds :

Initial tax benefit Continuing tax benefit Terminal tax

Convenience – the ease with which the investment can be made and looked after.

Safety


Objectives of investment

Maximizing the return

Minimizing the risk

Maintaining Liquidity

Hedging Against inflation

Increasing safety

Saving tax


Points of difference Investor Speculator

Planning horizon An investor has a relatively

longer planning horizon. His

holding period is usually at least

one year.

A speculator has a very short

planning horizon. His holding

may be a few days to a few

months. A speculator is

ordinarily willing to assume high

risk.

Risk disposition An investor doesn’t take more

than moderate risk. Rarely does

he takes high risk.

A speculator ordinarily takes

high risk.

Return expectation An investor usually seeks a

modest rate of return which is

equal to the limited risk assumed

by him

A speculator looks for a high rate

of return in exchange for the

high risk borne by him.

Basis for decisions An investor gives greater

importance to fundamental

factors and careful evaluation of

the prospects of the firm.

A speculator relies more on

hearsay. Technical charts and

market.

Leverage (Funds) An investor uses his own

funds and eschews borrowed

funds

A speculator normally

resorts to borrowings, which

can be very substantial to

supplement his personal

resources.Dr P Alekhya, Associate Professor, MBA, CMRCET

Investment Gambling

Investment is planned and scientific Gambling is unplanned and non

- scientific

Investment involves taking calculated

risk with the expectation of moderate

and continuous return over a long

period of time

Gambling involves taking high risks

not only for high returns but also for

thrill and excitement.

In investment there is no artificial risks In gambling artificial risks are created

for increasing the returns


Investment Management Process

Investment Process

Investment Policy

Analysis ValuationPortfolio

ConstructionPortfolio

Evaluation

•Market•Industry•company

•InvestmentFund

•Objectives•Knowledge

• Intrinsic Value

•Future Value

•Diversification•Selection and

allocation•Appraisal•Revision


Investment Avenues

Securities Deposits Postal Schemes

Insurance Real assets

•Stocks•Bonds/Debentures•G-Securities•Money market instruments•Derivatives•Mutual Funds

•Bank Deposits•Non-Banking financial company Deposits(NBFC)

•Monthly Income Schemes•National Savings Schemes (NSC)•Vikas patras•Public provident Funds(PPF)

•Life insurance policies•ULIP

•Real estate•Precious Metals•Art and Antiques

INVESTMENT AVENUES


Securities

Equity Shares: Equity share holders have a residual claim to the income of the firm

Equity share holders elect the board of directors and have the right to vote on every resolution placed before the company

They enjoy the pre-emptive right which enables them to maintain their proportional ownership by purchasing the additional equity shares issued by the firm.

They have the residual claim over the assets of the company in the event of liquidation


Stock market classification of equity shares

Blue-chip shares – shares of large well established and financially strong companies with an impressive record of earnings and dividends

Growth shares – shares of companies that have a fairly stable position in the market and have an above average rate of growth and profitability

Income shares – shares of companies that have stable operations, relatively limited growth opportunities and high dividend payout

Cyclical shares – shares of the company that have a pronounced cyclicality in their operations

Defensive shares – shares of the companies that are relatively unaffected by the ups and downs in the general business conditions

Speculative shares – shares that tend to fluctuate widely because there is a lot of speculative trading in them.


Fixed income securities

Preference Shares:

Bonds/Debentures

Government Securities

Money Market Securities

Mutual Funds



Bonds:

Bonds are debentures are long term debt instruments

A periodic interest is paid over the life of the bond and principle is paid at

the time of redemption

Government securities:

Debt securities issued by the central government, state government, and

quasi-government agencies are referred to as government securities or gilt-

edged securities.

Have maturity period of 3 to 20 years

Carry interest rate of 8 % to 10 %



• Money Market instruments

Debt instruments which have a maturity period of less than one year at the

time of issue are called money market instruments.

Highly liquid and negligible risk

Major players in the money market are government, financial institutions,

banks and corporates.

The different types of money market instruments are –

Treasury bills

Certificates of deposits

Commercial paper



Treasury bills :

Sold on auction basis every week by the Reserve bank of India

Maturity period of 91 days to 364 days

Sold at discount and redeemed at par

Easy available

Have nil credit risk

Certificates of deposits

Short term deposits which are transferable from one party to another

Banks and financial institutions are major issuers

Principle investors in CDs are banks, financial institutions, corporates and

mutual funds.

Maturity period of 3 months to 1 year

Carry interest rate higher than that of treasury bills and term deposits

Risk free



Commercial papers

Short term unsecured promissory note issued by the financially

strong firms

Has maturity period of 90 to 180 days

Sold at discount and redeemed at par



Mutual Funds: Till 1986 Unit Trust of India was the only mutual fund in India

After 1986 public sector banks and insurance companies were allowed

into the mutual fund industry.

SBI, Canara bank, LIC,GIC and a few other public sector banks entered

the mutual fund industry

In 1992 the mutual fund industry was opened to the private sector mutual

funds such as Birla Mutual Fund, DSP Merrill Lynch Mutual fund, HDFC

Mutual Fund, IDBI-Principal Mutual Fund, JM Mutual Fund, Kotak

Mahindra Mutual Fund etc..

At present there are about 30 mutual funds managing nearly 1000

schemes.


DepositsBank Deposits: Deposits in schedules banks are very safe because of the regulations of the

Reserve Bank of India and the guarantee provided by the Deposits Insurance Corporation, which gurantees deposits up to Rs.1,00,000. per depositor of a bank.

There is a ceiling on the interest rate payable on deposits in savings account.

The interest rate on fixed deposits varies with the term of the deposit. In general, it is lower for fixed deposits of shorter term and higher for fixed deposits of longer term.

If the deposit period is less than 90 days the interest is paid on maturity; otherwise it is paid quarterly

Bank deposits are highly liquid as they can be enchased prematurely by incurring a small penalty

Loans can be raised against bank deposits

Most banks calculate interest on the minimum deposit between 10th and the last date of the month.


Deposits

NBFC Deposits• Non-banking financial companies, or NBFCs, arefinancial institutions that provide bankingservices, but do not hold a banking license. Theseinstitutions are not allowed to take deposits fromthe public. Nonetheless, all operations of theseinstitutions are still covered under bankingregulations.

• Examples of NBFC’s Reliance Capital, Bajaj Holdings, LIC

Housing Finance


Postal Schemes

Monthly Income Scheme: It is a popular scheme of the post office meant to provide regular monthly

income to the depositors.

The term of the scheme is 6 years

The minimum amount of investment is Rs.1000. The maximum

investment can be Rs.300000 in a single account or Rs.600000 in a joint

account.

The interest rate is 8% payable monthly. A bonus of 10% is payable on

maturity.

There is no tax deduction at source

There is a facility of premature withdrawal after one year, with 5 %

deduction before 3 years.


Postal Schemes

National Savings Certificate: NSCs are issued at the post offices

It comes in denominations of Rs.100,Rs.500, Rs.1000,Rs.5000 and

Rs.10000

It has a term of 6 years. Over this period Rs.100 becomes Rs. 160.1. hence

the compound rate of return works out to 8.16 %

Investment in NSC can be deducted before computing the taxable income

under section 80 C.


It can be pledged as a collateral for raising loans.


Postal Schemes

Kisan Vikas Patra: The minimum amount of investment is Rs.1000.There is no maximum

limit.

The investment doubles in 8 years and 7 months. Hence the compound

interest rate works out to 8.4 %


KVPs can be pledged as a collateral security for raising loans

There is a withdrawal facility after 21/2 years


Postal Schemes

• Public Provident Fund Scheme: Individuals and HUFs can participate in this scheme. A PPF account may

be opened at any branch of the State Bank of India or its subsidiaries or at

specified branches of other nationalised banks

The Duration of the scheme is 15 years but can be extended for1-5 years.

The minimum deposit in PPF is Rs. 500 per year and maximum deposit is

Rs.100000 per year.

Deposits in PPF are subject to deduction under section 88.

A compound interest of 8 % per annum is paid on PPF which is totally

exempt from taxes. The interest is accumulated in the PPF account and not

paid annually to the subscriber.


Postal Schemes

The balance in PPF is fully exempt from wealth tax.

The subscriber of PPF is eligible to take loan from 3 rd to 6th year after

opening PPF account. The amount of loan cannot exceed 25% of the

balance in PPF account. The interest on loan is 1% higher than PPF

account interest rate.

The limitations is that the investor cannot withdraw it until seven years are

completed, after which 50 percent of the deposits can be withdrawn, if

needed.

On maturity the credit balance in PPF account can be withdrawn however

at the option of the subscriber the account can be continued.


Insurance

Insurance = Investment + Assurance

The major advantages of life insurance are as below:

Protection

Easy Payments

Liquidity

Tax relief


Endowment Policy

An endowment Policy covers the risk for a periodspecified by the insurer.

This policy is a combination of insurance and investment.

A certain portion of the premium gets invested andgenerates a certain return every year. This return isdeclared as a bonus.

At the end of the specified period , the sum assured ispaid back to the policy holder,along with the bonusaccumulated during the term of the policy.


Endowment Policy

• The various types of endowment policies are as described below:

Unit-linked endowment: This is a popular form of the

endowment policy. Under this, the insurance premium is

invested in several units of a specified unitized insurance fund.

Often, the insurance holder can select the funds in which he

prefers to invest the premium.

Full endowment: This is usually with-profits endowment. The

basic amount assured is equivalent to the death benefit from

the beginning of the policy. Based on the growth, the final

payout is higher than the initial sum.


Endowment Policy

Low-Cost endowment: A low-cost endowment is a

combination of a specific investment to meet the target amount anda declining life insurance component. The entire target amount ispaid as a minimum if any kind of physical illness or death occurs.

Whole Life Policy: a typical whole life policy remains in force aslong as the policy holder is alive. The risk is covered for the entirelife of the policy holder. Hence, it is known as whole life policy. Thewhole life policy amount and the bonus are payable to the nomineeof the beneficiary upon the death of the policy holder. The policyholder is not entitled to receive any money during his or her ownlifetime, i.e. there is no survival benefits. LIC provides whole lifepolicy, whole life policy with limited payment and whole life policywith single premium. LIC ‘Jeevan Anand’ is a fusion of whole lifeand endowment policy.


• Term life policy: Term insurance is said to be the purest form of life

insurance. If the insured person passes away, the family is protected

by a certain amount. The policy is taken for a chosen period and the

risk is covered for that period only.

• Money back plan: This is a portion of the sum assured is paid to the

policy holder in the form of survival benefits at fixed intervals,

before the maturity date. The risk cover on life continues for the full

sum assured even after payment of survival benefits, and bonus is

also calculated on the full sum assured. If the policy holder survives

till the end of the policy term , the survival benefits would be

deducted from the maturity value.

• Joint life Policy: Joint life policies are categorized separately as they

cover two lives simultaneously. These policies offer a unique

advantage for a married couple or for partners in a business firm.


• Children’s insurance policy: Children’s insurance policiesinclude those that parents or legal guardians provide as lifeinsurance for their children from their birth. The risk covercommences from the time the child attains the age of12\17\18\21 as per the policy document.

• Group policy: Life insurance protection under group policies isprovided to various groups such as employers, employees,professionals, co-operatives, weaker sections of society,etc.

Unit linked insurance plan: This is a market –linkedinsurance plan .ULIPs provide life insurance combined withsavings at market linked returns.ULIPs premium is mainlyinvested in risk-free securities like govt securities and fixedincome securities with high credit rating.


Real Assets

Gold: gold is the oldest form of investment in the world

and is popular across continents and cultures. There is a

wide range of reasons for the investor to seek gold as a

form of investment. These are:

o Expectations of growth in demand for gold

o Steady increase in the price of gold except for minor

fluctuations

o Ability to insure against uncertainty and stability.


Real Assets

• Gold investment can take many forms those are:

Gold Bars and coins

Gold Ornaments

Gold Securities:o Exchange trade funds (ETFs)

o Gold Mining Companies’ stocks

o Gold options and futures

o Gold bullion Securities


Real Assets

Silver

Platinum

Real Estate: Real estate as an asset class has rewarded investors with superior returns. Real estate refers to various fixed assets which can be classified into three categories.

Residential Property- flats, apartment, cottages and houses

Commercial property- hotels, resorts, hospitals, educational institutions and commercial premises

Land-farmhouse plots, industrial plots, and agricultural land


Investment Environment in India

Securities:

Characteristics of securities:

Securities are tradable and represent a financial value

Securities are fungible.

Classification of Securities:

i. Debt securities

ii. Equity securities

iii. Derivatives



Risk, Return and Diversification:

The Main Objectives of Investment Environment in India. They

are

i. Minimizing the Risk

ii. Maximizing the Returns

iii. Diversification of the company

Debt and Equity diversification

Industry Diversification

Company Diversification

Selection



Security Markets

Participants in the Securities Market:

The Issuer

The Buyer

Market intermediaries

The regulators

Financial intermediaries



Financial Market:

Money Market: Short term Instruments

Capital Market: Long Term Instruments

Forex Market: Multicurrency Requirements

Credit Market: Banks, FIs and NBFCs provides short, Medium

and long term loans to corporate and individuals.



Financial Instruments/ Assets:

Money Market Instruments:

i. Call/Notice- Money Market

ii. Inter- Bank Term Money

iii. Treasury Bills

iv. Certificate of Deposits

v. Commercial Paper

Capital Market Instruments

Hybrid Instruments

Financial Intermediation:


Security Trading In Stock Market

Open Outcry System

Screen-based

System

Security Trading


Types of Orders In Stock Market

Types of

Orders

Market Order

Limit Order

Stop Order

Stop Limit Order


Nature of Transaction in Security Trading

Transactions in Cash Market• Carry Forward Transactions• Ready Forward Transactions Forward Trading Rolling SettlementMargin Trading Scrip less Trading Internet Trading and WAP Trading Circuit Breaker System Demat Trading


Buying and Selling Shares

Mechanics Of Share Trading

Procedure of Purchase of shares:

i. Purchase of Existing shares from the Market

a) Purchase the order with the Broker

b) Receipt of Contract Note

c) Intimation of Delivery

d) Sending Shares for Transfer

ii. Purchase of Shares being issued by a Company


Buying and Selling Sharesii. Purchase of Shares being issued by a Company

a) Filling Application Form with Application Money

b) Receipt of allotment Letter/Refund Order

c) Payment of Allotment Money and Call Money

d) Endorsement of Payment on Share Certificate

Procedure for selling of shares

i) Placement of Order

ii) Execution Of Order


Unit-2

Portfolio Theory and Capital Market Theory


Components of return on investment

•Current Return

•Capital Return

Determinants of the rate of return

• The time preference risk-free real rate

• The expected rate of inflation

• The risk associated with the investment, which is unique to the investment


Risk is expressed in terms of variability of

return.

An investor before investing in securities must

properly analyze the risks associated with

these securities.

There are two types of risks:

Systematic risk

Unsystematic risk

Concept of Risk


Risks

Systematic Risk

Market Risk

Interest Rate Risk

Purchasing Power Risk

Unsystematic Risk

Business Risk

Internal Risk External Risk

Financial RiskDefault or

Insolvency Risk

Other Risks

Political Risk

Management Risk

Marketability Risk

Types Of Risks


Markowitz Portfolio theory

• Markowitz model is thus a theoretical framework for

measurement of risk & return and their interrelationships.

• Harry max Markowitz is an American economist & he won the

Jon von nevimann theory prize & Nobel memorial prize in

economic sciences.

• He is a professor of finance at the Rady school of management

at the university of California.

• He is best in his primary work in modern portfolio theory,

Studying the effects of asset risk, return, correlation and

diversification on probable investment portfolio returns.


Assumptions of Markowitz model

• Investors are rational and behave in a manner as to maximize

their utility with a given level of income or money.

• Investors have free access to fair and correct information on

the returns and risk.

• The markets are efficient & absorb the information quickly&

perfectly.

• Investors are risk averse and try to minimize the risk &

maximize the return.

• Investors base decisions on expected returns and variance or

standard deviation of there returns from the mean.


Assumptions of Markowitz model

• Investors prefer higher returns to lower returns for a given

level of risk.

Traditional portfolio theory proposed that the relation of assets

should be based on lowest risk.

Modern theory emphasis the need for maximization of returns

through a combination of securities whose total variability is

lower.


Single Index Model / Sharpe Model

• There is a limitation in Markowitz model that is a

no. of covariance's have to be estimated.

• Williams sharp has developed a simplified model to

develop the portfolio.

• He assumed that the return of security is linearly

related to a single index like the market index.

• Any movement in the security process could be

understood with the help of index movement.


Capital Asset Pricing Model (CAPM)

• It was developed in mid 1960’s by 3 researchers

William Sharpe, John Litner and Jan mossin

independently.

• It is often refered as Sharpe – litner – mossin capital

asset pricing model.

• It is extension of portfolio theory of markowitz. it

derives the relation ship between the expected return

and risk of individual securities and portfolios in the

capital markets


Assumptions of CAPM

• Investors make their investment decisions on the

basis of risk return assessments measured in terms of

expected returns and standard deviation of returns.

• The purchase and sale of a security can be undertaken

in infinitely divisible units.

• Purchases & sales by a single investor cannot affect

prices this means that there is perfect competition

where investors in total determine prices by their

actions.


Assumptions of CAPM

• There are no transaction costs. given the fact that

transaction costs are small, they are probably of minor

importance in investment decision-making, and hence

they are ignored.

• There are no personal income taxes alternatively, the tax

rates on dividend income and capital gains are the same,

thereby making the investor indifferent to the form in

which the return on the investment is received.

• The investor can sell short any amount of any shares.


Arbitrage Pricing Theory

• Stephen Ross Introduced an alternative modelfor CAPM.

• It explains the nature of equilibrium in theasset pricing in a less complicated mannerwith fewer assumptions compared to CAPM.

• Arbitrage is a process of earning profit bytaking advantage of differential pricing for thesame asset.


Assumptions of APT

• The investors are risk averse & UtilityMaximiser.

• Perfect competition prevails in the market andthere is no transaction cost.

• According to APT an investor tries to find outthe possibility to increase returns from hisportfolio without increasing the funds in theportfolio.


Unit-3

Bond Valuation


Bond Risk

Interest Rate Risk:

Default Risk:

Marketability Risk:

Callability Risk:


Bond Pricing Theorems

• The value of the bonds depends upon threefactors namely, the coupon rate, years tomaturity and the expected yield to maturity.The relationship between them is determinedby certain principles known as “Bond pricetheorems”.


Theorem-1

• The Yield to maturity is inversely related to price of the bond.As yield to maturity increases, the price of the bond decreasesand as yield to maturity decreases, the prices of the bondincreases.

Example:

Bond A Bond B

Face Value 1000 1000

Coupon Rate 10% 10%

Maturity 5 years 5 years

YTM 12% 14%


Theorem-1

• Determine Price of bond A and bond B.

i) Calculation of Price of Bond A

Po = C ( PVIFA 12%, 5) + P n (PVIF 12%, 5 )

= 100(3.605)+1000(0.567)

= 360.50+567.00

=Rs. 927.50

ii) Calculation of Price of Bond BPo = C ( PVIFA 14%, 5) + P n (PVIF 14%, 5 )

= 100(3.433)+1000(0.519)

= 343.30+519.00

=Rs. 862.30


Theorem-1

• Hence , it is being proved that, if YTMincreases (i.e., from 12% to 14%) then bondprice decreases (i.e., from 927.50 to 862.30)Keeping the other determinants constants.


Theorem-2

• For the difference between the coupon and the YTM, the extent of change in the price of the bond depends on the remaining term of the maturity, the larger the period, the greater will be the price change.

Example:

Bond A Bond B


Coupon Rate 10% 10%

Maturity 2 years 3 years

YTM 15% 15%


Theorem-2

• Determine Price of bond A and bond B. i) Calculation of Price of Bond A

Po = C ( PVIFA 15%, 2) + P n (PVIF 15%, 2 )= 100(1.6257)+1000(0.7561)= 162.57+756.1=Rs. 918.67

Price change= Pn- Po

=1000-918.67=81.33

ii) Calculation of Price of Bond BPo = C ( PVIFA 15%, 3) + P n (PVIF 15%, 3 )

= 100(2.2832)+1000(0.658) = 228.32+658 =Rs. 886.32


Theorem-2

Price change= Pn- Po

=1000-886.32

=113.68

For a given difference between coupon rate(10%) and YTM(15%), the price change for bond A having 2 years ofmaturity is 81.33 whereas for B with a maturity of 3 years is113.68.Hence, it is proved that larger the maturity thegreater will be the price change.


Theorem-3

• The percentage change in the price of a bond associated with the changes in the yield to maturity will be at a diminishing rate as the term to maturity increases.

Example:

YTM\Maturities 3 years 5 years 8 Years

12% 952.20 927.88 900.59

14% 907.13 862.30 814.45

Percentage Change

4.83% 7.77% 10.24%


Theorem-4

• For any given maturity, a decrease in yield causes the capital gain which is larger than the capital loss resulting from an equal increase in yields. Example:

Face Value =1000

Coupon Rate=10%

Maturity= 5Years

Calculate Price of a bond, if its YTM is 12%.Also find out capital gain\loss when YTM changes to 8% and 16%

12%=927.91 *YTM increases from 12% to 16%=capital loss=124.37

16%=803.54 * YTM decreases from 12% to 8%=capital gain=151.94

8%=1079.85


Theorem-5

• The percentage change in a bond’s price owing to change in its yield will be smaller if its coupon rate is higher.

Example: Calculate price of a bond A and B when YTM is 12% and 14%

Bond A Bond B


Maturity 5 Years 5 Years

Coupon Rate 10% 12%

YTM 12%,14% 12%,14%


Theorem-5

Hence percentage change in bond’s price with a given change in YTM is smaller when coupon rate is higher.

Bond A Bond B


Maturity 5 Years 5 Years

Coupon Rate 10% 12%

YTM 12%,14% 12%,14%


Bond Convexity

• Price of a bond and its yield are inversely relative. The rise in bond price would cause a fall in yield and vice versa. This has been proved in theorem 1 of bond price theorem.

• The concept of convexity is applicable to all types of bonds. The degree of convexity differs from bond to bond depending upon the size of the bond, the years to maturity and the current market price.


Bond Strategies

• Active Bond strategies

• Passive Bond Strategies


Passive Bond Strategies

• In a passive strategy, the investor whopurchases a bond feels that the price at whichhe purchased the security was giving him afair return. In other words, his expectedreturns is equal to his acceptance of risks. Inthese circumstances, the investor is not activebecause he does not try to outperform themarket. As a passive bond holder, the investoruses two strategies to assess the value of hisbond.


Passive Bond Strategies

• Buy and hold strategy:

• Indexing Strategy


Active Bond strategies

• Bond investors do not always follow passive strategies. Some investors purchase bonds for price appreciation as well as for protection of income.

Interest Rate Forecasting strategy:

Horizon Analysis:


Security Analysis & Derivatives

Unit-4


Chapter Objectives

To understand fundamental analysis

To know economic analysis

To explain industry analysis

To learn about company analysis


Concept of Fundamental Analysis

It is the examination of various factors such as earnings of the company, growth rate and risk exposure that affects the value of shares of a company.

Fundamental analysis consists of:

Economic analysis

Industry analysis

Company analysis


Economic Analysis

It is the analysis of various macro economic factors that have a significant bearing on the stock market.

The various macro economic factors are:

Gross Domestic Product (GDP)

Savings and investment

Inflation

Interest rates

Budget

Tax structure


Economic Forecasting Forecasting the future state of the economy is needed for

decision making.

The following forecasting methods are used for analyzing the

state of the economy: Economic indicators: Indicate the present status, progress or slow

down of the economy.

Leading indicators: Indicate what is going to happen in the economy. Popular leading indicators are fiscal policy, monetary policy, rainfall and capital investment.

Coincidental indicators: Indicate what the economy is — GDP, industrial production, interest rates and so on.

Lagging indicators: Changes occurring in leading and coincidental indicators are reflected in lagging indicators. Unemployment rate, consumer price index and flow of foreign funds are examples of such indicators.

Diffusion index: It is a consensus index, which has been constructed by the National Bureau of Economic Research in USA.


Industry Analysis It is used to analyze the performance of the industries over

the years. An industry is a group of firms that are engaged in the

production of similar goods and services. Industries can be classified into:

Growth industry: Has high rate of earnings and growth is independent of business cycle.

Cyclical industry: Growth and profitability of the industry move along with the business cycle.

Defensive industry: It is an industry which defies the business cycle.

Cyclical growth industry: It is an industry that is cyclical and at the same time growing.

An investor must analyze the following factors:

Growth of the industry Cost structure and profitability Nature of the product Nature of the competition Government policy


Company Analysis

In company analysis, the growth of the company is analyzed by the investor so that the present and future value of the shares can be known.

The present and future value of shares is affected by a following number of factors such as:

Competitive edge of the company

Market share

Growth of sales

Stability of the sales


Financial Analysis

It involves analyzing the financial statements of the company.

The financial statements of the company include:

Balance sheet: It shows the status of a company’s financial position at the end of the year.

Profit and loss account: It shows the profit and loss made

by the company during a period.


Analysis of Financial Statements

It helps the investor in determining the financial position and progress of the company.

The various simple analyses that are performed to ascertain the financial position of the company are: Comparative financial statement: In this , data from the current year’s

balance sheet is compared with similar data from the previous year’s balance sheet.

Trend analysis: It shows the growth and decline of sale and profit over the years.

Common size income statement: It shows each item of expense as a percentage of net sales.

Fund flow analysis: It is a statement of the sources and application of funds.

Cash flow analysis: It shows cash inflow and outflow of a company during the year.

Ratio analysis: It is the numerical relationship between the two items.Dr P Alekhya, Associate Professor, MBA, CMRCET

Technical Analysis


Chapter Objectives

To know the concept of technical analysis

To understand the Dow theory

To find out the support and resistance level

To comprehend the indicators and oscillators

To explain the chart form of price analysis


Technical Analysis

A process of identifying trend reversals at an earlier stage to formulate the buying and selling strategy.

Technical analyst study the relationship between price-volume and supply-demand for the overall market and the individual stock.


Assumptions

The market value of the scrip is determined by the interaction of supply and demand.

The market discounts everything.

The market always moves in trend.

History repeats itself. It is true to the stock market also.


Origin of Technical Analysis

Technical analysis is based on the doctrine given by Charles H. Dow in 1884, in the Wall Street Journal.

A. J. Nelson, a close friend of Charles Dow formalised the Dow theory for economic forecasting.

Analysts used charts of individual stocks and moving averages in the early 1920s.


Dow Theory

Dow developed his theory to explain the movement of the indices of Dow Jones Averages.

The theory is based on certain hypothesis:The first hypothesis is that no single individual or buyer

can influence the major trend of the market.

The second hypothesis is that market discounts every thing.

The third hypothesis is that the theory is not infallible.

According to Dow theory the trend is divided into Primary Intermediate/Secondary Short term/Minor


Primary Trend

The security price trend may be either increasing or decreasing.

When the market exhibits the increasing trend, it is called ‘bull market’ and when it exhibits a decreasing trend it is called ‘bear market’.


Bull MarketThe bull market shows three clear-cut peaks.

Each peak is higher than the previous peak.

The bottoms are also higher than the previous bottoms.

T1

T2

T3

B1

B2

Speculationphase

Good corporateearnings

Revivalof marketconfidencephase-1

Y

PRICE

X

Bull market

Days


Bear MarketThe market exhibits falling trend.

The peaks are lower than the previous peaks.

The bottoms are also lower than the previous bottoms.

PRICE

Y

Loss of hope (phase-1)

Recession in business (phase-2)

B1

B2

B3

T1

T2

Distress selling(phase-3)

XDays

Bear market


The Secondary Trend

The secondary trend or the intermediate trend moves against the main trend and leads to correction.

The correction would be 33% to 66% of the earlier fall or increase.

Compared to the time taken for the primary trend, secondary trend is swift and quicker.


Minor Trends

Minor trends or tertiary moves are called random wriggles.

They are simply the daily price fluctuations.

Minor trend tries to correct the secondary trend movement.


Support and Resistance Level

In the support level, the fall in the price may behalted for the time being or it may result even inprice reversal.

In this level, the demand for the particular scrip isexpected.

In the resistance level, the supply of scrip would begreater than the demand.

Further rise in price is prevented.

Selling pressure is greater and the increase in price ishalted for the time being.


IndicatorsVolume of Trade Volume expands along with the bull market and narrows down in the

bear market.

Technical analyst use volume as an excellent method of confirming the trend.

Breadth of the Market The net difference between the number of stock advanced and

declined during the same period is the breadth of the market.

A cumulative index of net differences measures the market breadth.

Short sales This is a technical indicator also known as short interest.

It refers to the selling of shares that are not owned.

They show the general situations.Dr P Alekhya, Associate Professor, MBA, CMRCET

Moving Average

The word moving means that the body of data moves ahead to include the recent observation.

The moving average indicates the underlying trend in the scrip.

For identifying short-term trend, 10 to 30 days moving averages are used.

In the case of medium-term trend 50 to 125 days are adopted.

To identify long-term trend 200 days moving average is used.


Oscillators

Oscillator shows the share price movement across a reference point from one extreme to another. The momentum indicates:

Overbought and oversold conditions of the scrip or the market.

Signaling the possible trend reversal.

Rise or decline in the momentum.


Relative Strength Index (RSI)RSI was developed by Wells Wilder.Identifies the inherent technical strength and

weakness of a particular scrip or market. RSI can be calculated for a scrip by adopting the following formula

RSI =

Rs =

If the share price is falling and RSI is rising, a divergence is said to have occurred.

Divergence indicates the turning point of the market.

100100

1 Rs

Average gain per day

Average loss per day


Rate of Change (ROC)

ROC measures the rate of change between the current price and the price ‘n’ number of days in the past.

ROC helps to find out the overbought and oversold positions in a scrip.

ROC can be calculated by two methods.

In the first method current closing price is expressed as a percentage of the 12 days or weeks in past.

In the second method, the percentage variation between the current price and the price 12 days in the past is calculated.


Charts

Charts are graphic presentations of the stock prices. These also have the following uses:

Spots the current trend for buying and selling

Indicates the probable future action of the market by projection

Shows the past historic movement

Indicates the important areas of support and resistance


Point and Figure Charts

These charts are one-dimensional and there is no indication of time or volume.

The price changes in relation to previous prices are shown.

The change of price direction can be interpreted.Some inherent disadvantages are:

They do not show the intra-day price movement.

Only whole numbers are taken into consideration, resulting in loss of information regarding minor fluctuations.

Volume is not mentioned in the chart.


Bar ChartsThe bar chart is the simplest and most commonly

used tool of a technical analyst.

A dot is entered to represent the highest price at which the stock is traded on the day, week or month.

Another dot is entered to indicate the lowest price on that particular date.

A line is drawn to connect both the points.

A horizontal nub is drawn to mark the closing price.

Chart PatternsV Formation Tops and bottoms

Double top and bottom Head and shoulders

Inverted head and shoulders


Triangles

The triangle formation is easy to identify and popular in technical analysis.

The different triangles are:

Symmetrical

Ascending

Descending—inverted


Technical Analysis and Fundamental Analysis

1. Fundamental analysts analyses financial strength of corporate, growth of sales, earnings and profitability. The technical analysts mainly focus the attention on the past

history of prices.

2. Fundamental analysts estimate the intrinsic value of the shares. Technical analysts mainly predict the short term price

movement.3. Fundamentalists are of the opinion that supply and

demand for stocks depend on the underlying factors. Technicians opine that they can forecast supply and demand

by studying the prices and volume of trading.


Chapter Summary

By now, you should have:

Obtained knowledge of technical analysis

Understood the various technical tools

Understood the chart form of technical analysis


Efficient Market Theory


Learning Objectives

To know the concept of market efficiency

To understand the random-walk theory

To learn the empirical tests

To comprehend the market inefficiencies


Efficient Market Theory

Efficient market theory states that the share price fluctuations are random and do not follow any regular pattern.

The expectations of the investors regarding the future cash flows are translated or reflected on the share prices.

The accuracy and the quickness in which the market translates the expectation into prices are termed as market efficiency.


Two Types of Market Efficiencies

Operational efficiency: Operational efficiency is measured by factors like time taken to execute the order and the number of bad deliveries. Efficient market hypothesis does not deal with this efficiency.

Informational efficiency: It is a measure of the swiftness or the market’s reaction to new information.New information in the form of economic reports,

company analysis, political statements and announcement of new industrial policy is received by the market frequently.

Security prices adjust themselves very rapidly and accurately.


History of the Random-Walk Theory

French mathematician, Louis Bachelier in 1900 wrote a paper suggesting that security price fluctuations were random.

In 1953, Maurice Kendall in his paper reported that stock price series is a wandering one.

Each successive change is independent of the previous one.

In 1970, Fama stated that efficient markets fully reflect the available information.


Forms of Efficiencies

They are divided into three categories:

Weak form

Semi-strong form

Strong form

The level of information being considered in the market is the basis for this segregation.


Market EfficiencyStrongly efficient marketAll information is reflectedon prices.

Semi-strong efficient marketAll public information isreflected on security prices

Weakly efficient marketAll historical informationis reflected on securityprices.

Levels of Information and the MarketsDr P Alekhya, Associate Professor, MBA, CMRCET

Weak Form of EMH

Current prices reflect all information found in the volumes.

Future prices can not be predicted by analysing the prices from the past.

Buying and selling activities of the information traders lead the market price to align with the intrinsic value.


Empirical Tests Filter rule:

According to this strategy if a price of a security rises by atleast x per cent, investor should buy and hold the stock until its price declines by atleast xper cent from a subsequent high.

Several studies have found that gains produced by the filter rules were much below normal than the gains of the simple buy and hold strategy adopted by the investor.

Runs test: It is used to find out whether the series of price movements have occurred

by chance.

A run is an uninterrupted sequence of the same observation.

Studies using runs test have suggested that runs in the price series of stocks are not significantly from the run in the series of random numbers.

Serial correlation:Serial correlation or auto-correlation measures the correlation co-efficient

in a series of numbers with the lagging values of the same series.

Many studies conducted on the security price changes have failed to show any significant correlations.


Semi-Strong Form

The security price adjusts rapidly to all publicly available information.

The prices not only reflect the past price data, but also the available information regarding the earnings of the corporate, dividend, bonus issue, right issue, mergers, acquisitions and so on.

The market has to be semi-strongly efficient, timely and correct dissemination of information and assimilation of news are needed.


Strong Form

All information is fully reflected on security prices.

It represents an extreme hypothesis which most observers do not expect it to be literally true.

Information whether it is public or inside cannot be used consistently to earn superior investors’ return in the strong form.


Market Inefficiencies

Announcement effect

Low PE effect

Small firm effect


Derivatives

Derivatives are financial contracts which derive their values from the underlying assets or securities.

Some examples are:

Options

Futures

Swaps


Option

An option is the right, but not the obligation to buy or sell something on a specified date at a specified price.

In the securities market, an option is a contract between two parties to buy or sell specified number of shares at a later date for an agreed price.

Three parties are involved in the option trading, the option seller, buyer and the broker.


Process

The option seller or writer is a person who grants someone else the option to buy or sell. He receives a premium on its price.

The option buyer pays a price to the option writer to induce him to write the option.

The securities broker acts as an agent to find the option buyer and the seller, and receives a commission or fee for it.


Call Options

The call option that gives the right to buy.

The contract gives the particulars of:

The name of the company whose shares are to be bought or the underlying asset.

The number of shares to be purchased.

The purchase price or the exercise price or the strike price of the shares to be bought.

The expiration date, the date on which the contract or the option expires.


Put Options

Strongly efficient marketAll information is reflected on prices.

Weakly efficient marketAll historical information is reflected on security

Semi strong efficient marketAll public information is reflected on security prices







Put option gives its owner the right to sell (or put) an asset or security to someone else.

Like the call option the contract contains:

The name of the company whose shares are to be sold.

The number of shares to be sold.

The selling price or the striking price.

The expiration date of the option.


Factors Affecting the Value of Call Option

1. The market price of the underlying asset

2. The striking price

3. Option period

4. Stock volatility

5. Interest rates

6. Dividends


Intrinsic Value and Time Value

The price of an option has two components intrinsic value or expiration value and time value.

Call option intrinsic value

or expiration value = Stock price – Striking price

Put option intrinsic value

or expiration value = Striking price – Stock price

Time value = Premium – Intrinsic value


Gain or Loss of Call Buyer

When the market price exceeds the strike price by just enough to cover the premium, the profit is zero for the buyer if he exercises the option.

This is the point of no profit and no loss and hence known as break-even point.

If there is a rise in the price of the stock beyond the break-even point, the call buyer gains profit.


Call Buyer’s Position

10 20 30 40 60 70 80 90 100

– 25

– 20

– 15

– 10

– 5

0

5

10

15

20

25

30

Option Profit

Loss of Premium

Break-even Rs 55

Exercise Price(Rs 50)

Profit line to

Call option buyer

Intrinsicvalue

Market price ofoptioned stock


Call Writer’s Gain or Loss

When the market price is lower than the strike price, the call buyer may not exercise his option, hence the premium is the only profit the call writer can gain.

If the price increases further it would be a loss to the call writer.


Writing a Call

10 20

Option profit

– 25

– 20

– 15

– 10

– 5

0

5

10

15

20

25

30 40 60 70 80 90 100

Intrinsic valueMarket price ofoptioned stock

Exercise Price(Rs 50)

Premium gain

Break-even Rs 55

Loss line tocall writer


Put Buyers Position

Put buyer gains in the bearish market when the price falls.

When the price increases, the put buyer has to pay the premium alone and his liability is limited to the premium amount he has paid.


Put Buyers Gain or Loss40

30

20

10

10

20

30 70 90

Premium loss

Break-even Rs 45

Exercise Price Rs 50

Intrinsic value

Profit line to put buyer

Price of the optioned stock


Put Writer’s Position

The gains of the put buyer are the losses of the put writer.

If the market price increases the put writer will gain the premium because the put buyer may not be willing to sell the shares at the lower rate i.e., the strike price is lower than the market price.


Writing a Put

10

20

30

– 5

– 15

– 25

– 35

20 40 60 80Price of theoptioned stock

Break-even Rs 45

Strike Price Rs 50

Intrinsic value

Premium gain

Loss line of put writer

0


Profits inStocks, Bonds and Options

Stock, Bond and Option Details

Stock Bond Call Put

Current price Rs 70 Rs 100 Rs 5 Rs 5

Exercise price - - - - - - Rs 70 Rs 70

Terms to expiration - - - 6 months 6 months 6 months

Prices at termination Variable Rs 100 Variable Variable


Bond Return

40 50 60 80 90 100

30

20

10

10

20

30

Profit Rs

ReturnStock Price atTermination

LOSS Rs

Exercise Price= 70


Stock Return

40 50 60 80 90 100

30

20

10

10

20

30

PROFIT Rs

Stock Price atTermination

LOSS Rs

Exercise Price= 70


Selling the Stock Short

40 50 60 80 90 100

30

20

10

10

20

30

PROFIT Rs

Stock Price atTermination

LOSS Rs

Exercise Price= 70


Investment in Calls

Protective – buy the stock and buy a put

Covered call writing – own the stock and sell a call

Artificial convertible bonds – buy bonds and buy calls


The Black-Scholes Option Pricing Model

The Black-Sholes model (1973) is given below:

where V = Current value of the optionP = Current price of the underlying shareN(d1), N(d2) = Areas under a standard normal functionS = Striking price of the optionR = Risk free rate of interestT = Option periods = Standard deviatione = Exponential function

RT

1 2V = P{N(d )} e S{N(d )}2

1

ln(P/S) + (R + 0.5σ )Td =

σ T

2 1d = d T s


Futures

Futures is a financial contract which derives its value from the underlying asset.

There are commodity futures and financial futures.

In the financial futures, there are foreign currencies, interest rate, stock futures and market index futures.

Market index futures are directly related with the stock market.


Forward and Futures

In a forward contract, two parties agree to buy or sell some underlying asset on some future date at a stated price and quantity.

The forward contract involves no money transaction at the time of signing the deal.

Forward contract safeguards and eliminates the price risk at a future date.

But the forward market has the problem of:(a) lack of centralisation of trading (b) liquidity (c) counterparty risk


Future Market

The three distinct features of the future markets are:

Standardised contracts

Centralised trading

Settlement through clearing houses to avoid counterparty risk


Benefits of the Index Based Futures Liquidity: The index based futures attract a much more substantial order

flow and have greater liquidity in the market.

Information: Information flow is more in the index than in the case of securities. The insiders are privileged to have more information in securities.

Settlement: In the settlement, stocks have to be delivered either in the physical mode or in the depository mode. No such delivery is needed in the index based futures. They are settled through cash.

Less volatile: The changes that occur in index values are less compared to the price changes that occur in the individual securities. This leads to lower prices for the index futures and can work with lower margins.

Manipulation: The securities in the index are carefully selected, keeping the liquidity considerations and as such are hard to manipulate. But security prices could be manipulated more easily than the index.

Beneficial to the mutual funds.


security analysis and portfolio management ------dr p alekhya

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