Introduction to

Security Analysis

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The Icfai University Press

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 Contents

Chapter I : Investment Scenario 1

Chapter II : Risk and Return 21

Chapter III : Stock Market in India 63

Chapter IV : Security Market Indicators 118

Chapter V : Sources of Financial Information 135

Chapter VI : Fundamental Analysis 141

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Chapter VII : Impact of Changes in Accounting Policies 171

Chapter VIII
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: Equity Stock Valuation Models 179

Chapter IX : Bond Valuation 204

Chapter X : Efficient Market Hypothesis 251

Chapter XI : Technical Analysis 281

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Chapter XII : Futures 332

Chapter XIII : Options 352

Chapter XIV : Warrants and Convertibles 370

Chapter XV : Real Assets 388

Chapter XVI : Mutual Funds 401

Glossary 420
 Detailed Curriculum
Investment Scenario: Concept of Investment – Investment Objectives and Constraints –
Investment Classification – Financial Markets – Real Investment Avenues.
Risk and Return: Concept of Risk and Return – Reduction of Risk through Diversification –
Quantifying Portfolio Risk and Return – Measurement of Risk in Portfolio Context – Security
Market Lines and its Applications.
Stock Market in India: Markets and their Features – Development of Securities Markets in India –
Regulation of Securities Markets – Stock Issuing Market (Primary Market) – Secondary Market –
Trading and Settlement – Clearing and Settlement Procedure.
Security Market Indicators: Utility of Security Market Indices – Construction of Security
Market Indices – Types of Security Market Indices in India – Limitations of Various Indices.
Sources of Financial Information: Sources of Economic Data – Sources of Market Data –
Sources of Company Data – Sources of International Economic Data.
Fundamental Analysis: Objectives and Beliefs of Fundamental Analysis – Framework for
Fundamental Analysis – Concept of Intrinsic Value – Economic Forecasting Methods – Industry
Analysis – Key Characteristics in an Industry Analysis – Industry Life Cycle – Business Cycle
Analysis – Structural Analysis – Company Analysis.
Impact of Changes in Accounting Policies: Changes in Accounting Policies – Depreciation –
Valuation of Fixed Assets – Foreign Exchange Transactions – Amortization of Preliminary and

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other Expenses – R&D Expenditure – Valuation of Inventory – Treatment of Gratuity – Lease
Accounting.
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Equity Stock Valuation Models: Valuation Methods – Measures of Relative Value – Free Cash
Flow Model to Equity Model – Quantitative Analysis – Value Added Concept – Evaluation of
Security Analysis.
Bond Valuation: Strategic Role of Bonds: An Investor’s Point of View – Bond Terminology –
Types of Bonds – Value of a Bond – Bond Returns – Assumptions Underlying YTM – Bond Price
Theorems – Accrued Interest – Riskiness of Bonds – Determining the Interest Rates – Forecasting
Interest Rate Trends – Term Structure of Interest Rates – Interest Rate Risk and Duration – Bond
Price Volatility – Immunization – Analysis of Deep Discount Bonds – Analysis of Convertible
Bonds – Analysis of Tax-Sheltered Fixed Investment Avenues.
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Efficient Market Hypothesis: Concept of Efficiency of the Stock Markets – Forms of EMH –
Empirical Tests of EMH in the Indian Market – Description of Tests of EMH.
Technical Analysis: Concept of Technical Analysis – The Dow Theory – Types of Charts – Price
Patterns – Trend Lines – Trend Channels – Support and Resistance Levels – Relative Strength
Analysis – Moving Averages – Breadth of the Market – Volume – Momentum – Advanced
Technical Tools – The Confidence Index – Contrary Opinion Theories – Oscillators – Stochastics –
Elliott Wave Theory – Academic Perspective of Technical Analysis.
Futures: Forward Contracts – Futures Contract – Interpretation of Futures Price Quotations –
Trading Mechanism of Futures – Basis and Spread – Hedging with Futures – Clearing and
Settlement of Futures – Interest Rate Derivatives in India.
Options: What Options Mean? – Options Terminology – Pay-off from Options – Trading Process –
Options Market in India – Settlement of Options Contracts.
Warrants and Convertibles: Bonds with Warrants – Convertible Bonds – Callable Bonds –
Floating Rate Notes – Dual Currency Bonds – Equity Index-linked Notes – Commodity-linked
Bull and Bear Bonds – Swap-Linked Notes.
Real Assets: Real Assets – Appraisal of Real Assets – Approaches to Estimate the Market Value –
Methods to Calculate the Capitalization Rate – Subjective Factors Affecting the Value of Real
Estate.
Mutual Funds: The Concept and Objectives of a Mutual Fund – Types of Mutual Funds –
Advantages of Mutual Funds – Mutual Fund Services – Organization and Management of Mutual
Funds – The Mutual Fund Scene in India.
Chapter I

Investment Scenario

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After reading this chapter, you will be conversant with:

Concept of Investment
• Investment Objectives and Constraints
• Investment Classification
• Financial Markets
• Real Investment Avenues
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Security Analysis

CONCEPT OF INVESTMENT
We can define investment as the process of, ‘Sacrificing something now for the
prospect of gaining something later’. Our definition implies that there are three
dimensions to an investment – time, today’s sacrifice and prospective gain.
We can, of course, think of a number of transactions which will qualify as
‘investments’ as per our definition. Consider, for example, the following transactions:
1. In order to settle down, a young couple buys a house for Rs.3 lakh in
Bangalore.
2. A wealthy farmer pays Rs.1 lakh for a piece of land in his village.
3. A cricket fan bets Rs.100 on the outcome of a test match in England.
4. A government officer buys ‘units’ of Unit Trust of India worth Rs.10,000.
5. A college professor buys, in anticipation of good return, 100 shares of
Reliance Industries Ltd. for Rs.40,000.
6. A lady clerk deposits Rs.5,000 in a Post Office Savings Account.
7. Based on the rumor that it would be a hot issue in the market in no distant
future, our friend John invests all his savings in the newly floated share
issue of Fraternity Electronics Ltd., a company intending to manufacture
audio and video magnetic tapes to start with, and cine sound tapes at a later

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stage.
A common feature of all these transactions is that something is sacrificed now for
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the prospects of gaining something later. For example, the wealthy farmer in
transaction 2 sacrifices Rs.1 lakh now for the prospects of crop income later. The
lady clerk in transaction 6 sacrifices Rs.5,000 now for the prospect of getting a
larger amount later due to interest earned on the savings account. Thus, in a broad
sense, all these seven transactions qualify as investment.

Are all Investments Speculative?

We know that investment means sacrificing or committing some money today in
anticipation of a financial return later. The investor indulges in a bit of speculation
as to how much return he is likely to realize. There is an element of speculation
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involved in all investment decisions. It does not follow though that all investments
are speculative by nature.
Genuine investments are carefully thought out decisions. They involve only
calculated risks. The expected return is consistent with the underlying risk of the
investment. A genuine investor is risk averse and usually has a long-term
perspective in mind. The government officer’s investment in the units of UTI
(transaction 4), the college professor’s Reliance stockholding (transaction 5), and
the lady clerk’s Post Office Savings Deposit (transaction 6), all may be regarded as
genuine investments. Each person seems to have made carefully thought out
decision and each has taken only a calculated risk.
Speculative investments on the other hand are not carefully thought out decisions.
They are based on rumors, hot tips, inside dopes and often simply on hunches. The
risk assumed is disproportionate to the return expected from speculation. The
intention is to profit from short-term market fluctuations. In other words, a
speculator is relatively less risk averse and has a short-term perspective for
investment. Our friend John’s decision to invest all his savings in the new issue of
Fraternity Electronics based only on the rumors (transaction 7) may be labelled as
speculative investment. John does not seem to have carefully thought out this
decision. He is taking a high risk by putting all his savings in just one stock and
that too in a new stock.
An investment can be distinguished from speculation by (a) the time horizon of the
investor and (b) the risk-return characteristics of the investments. A genuine
investor is interested in a good rate of return, earned on a rather consistent basis

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for a relatively long period of time. The speculator, on the other hand, seeks
opportunities promising very large returns, earned rather quickly. In this process,
he assumes a risk that is disproportionate to the anticipated return.
From the foregoing discussion, it cannot be however, inferred that there exists a
clear-cut demarcation between investment stocks and speculative stocks. The same
stock can be purchased as a speculation or as investment, depending on the motive
of the purchaser. For example, the decision of the professor to invest in the stock
of Reliance Industries is considered as a genuine investment because he seems to
be interested in a regular dividend income and prospects of long-term capital
appreciation. However, if another person buys the same stock with the anticipation
that the share price is likely to raise to Rs.350 very quickly and gain from the rise,
such decision will be characterized as speculation.

Are Investment and Gambling the Same?

Gambling is defined in Webster’s Dictionary as ‘An act of betting on an uncertain
outcome’. Since the prospective return on investment is uncertain at the time
investment is made, one may say that there is an element of gambling involved in
every investment. This is particularly so in the case of those investments in respect
of which little information exists at the time of investment decision. However,
genuine investments cannot be labelled as gambling activities.

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In gambling, the outcome is largely a matter of luck; no rational economic reason
can be given for it. This is in contrast to what we can say about genuine
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investments. Unlike investors and speculators, the gamblers are risk lovers in the
sense that the risk they assume is quite disproportionate to the expected reward.
Though the pay-off, if won, is extraordinary, the chances of winning the bet are so
slim that no risk averse individual would be willing to take the associated risk. The
cricket fan’s bet of Rs.100 on the outcome of test match in England (transaction 3)
is an act of gambling; it is not a genuine investment.
It should, however, be noted that a clear demarcation between investment,
speculation, and gambling is not always easy. Often it becomes a matter of degree
and opinion. Aggressive investors are likely to decide on investments based,
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among other things, on their speculative and gambling instincts more than the
defensive or conservative investors do.
Having understood what genuine financial investments are, let us consider the
objectives sought to be fulfilled by investors seeking such investments.

INVESTMENT OBJECTIVES AND CONSTRAINTS

Investment Objectives
Rationally stating, all personal investing is designed in order to achieve a goal,
which may be tangible (e.g., a car, a house, etc.) or intangible (eg., social status,
security, etc.). Goals can be classified into various types based on the way
investors approach them viz:
a. Near-term High Priority Goals
These are goals which have a high emotional priority to the investor and he
wishes to achieve these goals within a few years at the most. Eg: A new
house. As a result, investment vehicles for these goals tend to be either in the
forms equivalent to cash or as fixed-income instruments with maturity dates
in correspondence with the goal dates. Because of the high emotional
importance these goals have, investor, especially the one with moderate
means will not go for any other form of investment which involves more risk
especially where his goal is just in sight.

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b. Long-term High Priority Goals

For most people, this goal is an indication of their need for financial
independence at a point some years ahead in the future. Eg: Financial
independence at the time of retirement or starting a fund for the higher
education of a three-year old child. Normally, we find that either because of
personal preference or because the discounted present value is large in
relation to their resources, the time of realization for such goals is set around
60 years of age for people of moderate means. Because of the long-term
nature of such goals, there is not a tendency to adopt more aggressive
investment approaches except perhaps in the last 5 to 10 years before
retirement. Even then, investors usually prefer a diversified approach using
different classes of assets.
c. Low Priority Goals
These goals are much lower down in the scale of priority and are not
particularly painful if not achieved. For people with moderate to substantial
wealth, these could range from a world tour to donating funds for charity. As
a result, investors often invest in speculative kinds of investments either for
the fun of it or just to try out some particular aspect of the investment

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process.
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Enterpreneurial or Money Making Goals
These goals pertain to individuals who want to maximize wealth and who are
not satisfied by the conventional saving and investing approach. These
investors usually put all the spare money they have into stocks preferably of
the company in which they are working/owning and leave it there until it
reaches some level which either the individual believes is enough or is scared
of losing what has been built-up over the years. Even then, the process of
diversification and building up a conventional portfolio usually takes him a
long time involving a series of opportunities and sales spread over many
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years.

Investment Constraints
An investor seeking fulfillment of one of the above goals operates under certain
constraints:
• Liquidity
• Age
• Need for Regular Income
• Time Horizon
• Risk Tolerance
• Tax Liability.
The challenge in investment management, therefore, lies in choosing the
appropriate investments and designing a unit that will meet the investment
objectives of the investor subject to his constraints. To take on this challenge the
first step will be to get acquainted with the different types of investments that are
available in our financial market.

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INVESTMENT CLASSIFICATION
Broadly speaking investment can be categorized as follows:
This study will concentrate more on the financial investment part and so only
financial instruments are elaborated with a brief introduction to real investments.

Fixed Income
Financial Investment
Investment Avenues

Investment Variable Income

Real Avenues
Investment

Security Forms of Financial Investment

We know that the recipient of money in a financial investment issues a document
or a piece of paper to the investor (supplier of money), evidencing the liability of
the former to the latter to provide returns. This document also outlines the rights of
the investor to certain prospects and/or property and sets the conditions under
which the investor can exercise his/her rights. This document is variously called
‘Security Certificate’, ‘Note’ and so on.

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The term ‘security’ is a generic term used generally for those documents
evidencing liabilities that are negotiable – that can be bought and sold in the stock
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market. The security form of investment has received great impetus since 1980
following the Central Government’s liberal policy towards foreign investments –
direct and portfolio, streamlining of licensing, capital issues, and other procedural
formalities to facilitate faster capital formation; providing incentives for exports;
and encouraging private sector to tap the primary market for meeting their long-
term capital requirements.
There are different types of securities conferring different sets of rights on the
investors and different sets of conditions under which these rights can be
exercised. They are gilt-edged securities, corporate debentures, preference shares
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and equity shares. The important characteristic features of these securities are
described below.

Gilt-Edged Securities
The debt securities issued by the government and semi-government bodies are
called gilt-edged securities. They comprise the treasury bills and the dated
securities (also called bonds or dated loans) of the central government, state
government, and semi-government bodies like Port Trusts and State Electricity
Boards. They are the acknowledgments of debt incurred by the issuing government
or semi-government body. Gilt-edged securities thus represent the public borrowings
of the issuing government or semi-government bodies. Over the years, the central
and state governments and the semi-government bodies have made an extensive
use of these securities for meeting their short and long-term resource requirements.
TREASURY BILLS
These short-term securities are issued by the RBI on behalf of the Central
Government. Currently, the T-Bills having a maturity of 91 and 364 days only are
being traded. No interest is paid on these bills. Instead they are sold at a discount.
In other words, the buyer pays a price less than the face value of the bill and
receives the full face value on the last day of maturity. The difference
between the discount price and face value represents the interest income to the
investor.

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Example: Suppose the 91-day treasury bills of Rs.100 each are sold for Rs.99 per
bill. The buyer pays Rs.99 and will receive Rs.100 after 91-days from the
Government of India for every bill he buys today. These bills are said to have been
sold at
Re.1 365 days
x x 100 = 4.01% discount per annum. The rupee income, the
Rs.100 91 days
buyer makes for 91-days investment is Re.1 per bill and the return on his
investment works out to be
Re.1 365 days
x x 100 = 4.05% per annum.
Rs.99 91 days
Since April 1st, 1996 the sale of treasury bills by Public Debt Office of the RBI
had been stopped. Now it is carried out by the RBI by conducting auctions:
Weekly for 91 days T-bills and fortnightly for 364 days T-bills.
The discount rate on treasury bills being very low, the return to the investor is
meager. However, they are the safest and the most liquid securities you can find in
the market. They are a safe investment because the central government will never
default on making payment when the bills mature. They are liquid because the
commercial banks are ready to buy them at any time due to the facility of
rediscounting with the RBI. There is however little public interest in treasury bills
because of the availability of equally safe investment opportunities providing a

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better return and also because they are sold in large denominations. Frequent
buyers of treasury bills are the commercial banks, state governments, and semi-
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government bodies. Due to rediscounting facility, the RBI generally ends up
holding nearly 80 percent of the outstanding treasury bills at any given time.
As against the periodic issue of the ad hoc treasury bills to the RBI in the past, the
government is now raising funds through the Ways and Means financing.
Since the RBI has started selling treasury bills auction, through, the discount rate is
now determined by market forces and on a competitive basis. The discount rates on
treasury bills increase as the number of days to maturity increase. However, the
discount rates on T-Bills are lower than the rates on the dated government securities.
CENTRAL GOVERNMENT DATED SECURITIES
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These securities of the central government have a maturity period longer than one
year and carry a fixed rate of interest. The interest is payable semi-annually and
the payment is usually made by issuing coupons which can be encashed at any
bank. Though these securities are redeemed at par, their issue price can be higher
or lower than the face value depending upon the prevailing market conditions.
These securities are held either in the form of promissory notes or stock
certificates. The difference between a promissory note and a stock certificate is
that while the former is negotiable and transferable by a simple endorsement, a
stock certificate can be transferred only by executing a transfer deed and
submitting a copy of the deed to the RBI. The RBI issues a new certificate to the
transferee. A promissory note has to be presented to RBI every time the payment
of interest is due, but no such presentation of the stock certificate is required
because the RBI knows who the present owner is and mails the interest coupon to
him on the due date. The public/recognized provident funds are required to hold
these securities only in the form of stock certificates.
The coupon rate on the central government dated securities is higher than the
discount rate on treasury bills, due to the fact that the maturity of dated securities
is longer. Hence, there is a need for providing liquidity premium to the investor.
These securities are the next best alternative from the stand point of safety. There
is no default risk, but the real value of income and capital returned on maturity
could be lower due to possible inflation. The market for central government
securities is captive in the sense that certain institutions such as commercial banks,
Life Insurance Corporation (LIC), General Insurance Corporation (GIC),
development financial institutions like the Industrial Development Bank of India

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(IDBI), recognized/public provident funds, registered trusts, government and semi-

government bodies are required by law to invest at least a certain percentage of
their investible funds in the central government securities. Besides the central
government, and the state governments also issue dated securities.
Recently, a number of innovations have been introduced in the gilt-edged
securities market. The credit policy announced by the Bank on April 21, 1992,
underlined the need for the center to reduce its dependence on the RBI and the
banking system for its credit requirements. As a first step in this direction,
treasury bills of varying maturities have been introduced by the RBI which
would help to widen the market for treasury bills. Moreover, in order to develop
dated securities as monetary instruments with flexible yields to suit investors’
expectations, the Government of India also offered to sell dated securities of
5 years maturity in auctions. The Discount and Finance House of India (DFHI)
started offering a two way quote in government securities with the intention of
developing a secondary market.
SEMI-GOVERNMENT DATED SECURITIES
These are the promissory notes issued by the institutions and corporations set-up
by the central/state governments. They also include the securities of municipal
corporations. The semi-government bodies such as electricity boards, housing
boards, port trusts, central and state financial institutions issue securities to meet
the financial needs of their developmental activities. Semi-government securities
are guaranteed by their respective governments and carry a higher coupon rate or

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lower issue price than for their counterpart state government dated securities.
The price quotations for gilt-edged dated securities are reported to stock exchange
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for inclusion in the official quotations list by the licensed dealers. While the issue
of securities, payment of interest, and transfer of the central and state government
securities are handled by the RBI, the issue, interest payment and transfer of semi-
government securities are handled by the commercial banks for a fee. As
mentioned earlier, the gilt-edged securities market is dominated by the institutional
investors like the LIC, GIC, banks, and provident funds. There are a few members
of the stock exchanges who specialize in gilt-edged securities. But they operate
primarily as brokers and not as dealers.

Corporate Debentures
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Corporate debentures are the promissory notes issued by the joint stock companies
in the private sector. They are thus the debt obligations of the issuing corporation.
Like government securities, they have an issue price at which they are originally
issued, a coupon interest rate, and a specified maturity date.
Debenture Trust Deed
When a debenture issue is sold to the investing public, the debenture trust deed
calls for appointing a trustee. Banks, insurance companies and firms of attorneys
usually act as trustees to corporate debenture issues. The main job of the trustee is
to look after the interest of debentureholders by ensuring that the company adheres
to the provisions of the indenture – the agreement entered into between the issuing
company and the debentureholders. To perform their role effectively, the trustees
are vested with adequate powers which include the right to appoint a nominee
director on the board of the company in consultation with the institutional
debentureholders.
The indenture is a legal document describing in considerable detail the contractual
relationship between the issuing company and the debentureholders. This agreement
specifies, among other things, the periodicity of interest payment; mode of
redemption of debentures; collateral securities, if any; rights of the
debentureholders in the event of default; rights, duties, and responsibilities of the
trustee to the issue; and restrictive covenants such as limit on dividend payment,
restriction on the company’s capacity to create additional debt, etc. If corporate
debentures are placed privately with one or more institutions like LIC, UTI and
banks, then no trustee is appointed and no indenture is created. Instead, there is a
loan agreement between the parties with similar provisions as in an indenture.

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Special Features of Corporate Debentures

Corporate debentures are less liquid and more risky than government securities.
They do not have a captive market; the success of an issue and the marketability of
debentures subsequent to the issue depend largely on the reputation of issuing
corporation, financial market conditions, and the interest shown by the institutional
investors. Since prompt payment of interest and repayment of principal on the due
dates depend upon the earnings prospects and the financial conditions of the
issuing corporation (which tend to fluctuate over time), the investors will naturally
demand a higher return on corporate debentures than on government securities.
The prevailing market returns on these securities are generally consistent with this
expectation.
In most cases, the interest on corporate debentures is payable semi-annually. There
are, however, some issues with annual or quarterly interest payment. It is mandatory
on the part of the company to pay interest irrespective of its financial conditions.
In the event of a default, the debentureholders have the right to force the company
to go into liquidation. If liquidated, they have a priority claim over shareholders in
the sense that their accrued interest and principal amount are paid-off first before
anything from the operating income and liquidation proceeds is distributed to
shareholders.
The maximum rate of interest payable on debentures was fixed from time to time.
All restrictions on interest rates on debentures and public sector undertakings,

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other than tax-free bonds of the public sector undertakings are now removed. The
interest rate on such debt instruments will hereafter be governed by the market
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forces. The interest rate and period of redemption shall be approved by the
government on a case-by-case basis.
TYPES OF DEBENTURES
Debentures can be classified into two or more categories along the following
dimensions: Security, transferability, and convertibility.
Straight and Mortgage Debentures
Based on security dimension, debentures can be classified as unsecured (or
straight) debentures and secured (or mortgage) debentures. Unsecured debentures
have no charge on any specific asset(s) of the company while secured debentures
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carry a fixed or floating charge on the assets of the company. The usual practice is
to create a charge on the immovable properties of the company both present and
future by way of an equitable mortgage. The equitable mortgage is effected by
depositing the title deeds relating to the mortgaged assets in favor of the trustees of
the debentureholders. The public limited companies issuing debentures to the
public are permitted to issue only secured debentures.
Registered and Bearer Debentures
As per dimension of transferability, debentures can be classified as registered and
unregistered debentures. Unregistered debentures (or bearer debentures) are freely
negotiable and can be transferred by a simple endorsement. On the other hand,
registered debentures can be transferred only by executing a transfer deed and
filing a copy of it with the company. The registered debentureholders receive
interest cheques from the company whereas interest is paid on bearer debentures
only upon presentation. According to the Companies Act, 1956, only registered
debentures are to be issued to public.
Convertible and Non-convertible Debentures
Debentures can also be classified into convertible and non-convertible debentures
depending upon whether they carry a conversion feature or not. Convertible
debentures are the ones which can be converted into equity shares at the option of
the debentureholders. In this case, the ratio of conversion (the number of shares
exchanged for the converted portion) or alternatively the conversion price (the
price at which equity shares are exchanged for the converted portion of the

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debentures), and the period during which the conversion can be effected are
specified at the time of the issue. Convertible debentures can be either fully
convertible or partly convertible. In the case of partly convertible debentures, the
non-converted portion will carry interest until it is repaid as per the provisions in
the indenture. Of late, non-convertible debentures have been issued with warrants
which entitle the holder to buy a specified number of shares on a specified future
date at a fixed price.
For example, Tata Metaliks Ltd. came out with a public issue in May, 1993 of
23,22,000, 14% secured redeemable Partly Convertible Debentures (PCDs) of
Rs.125 each, the terms of which are as follows:
a. Each PCD will have a face value of Rs.125 and shall consist of two parts.
Part A Convertible portion of Rs.40.
Part B Non-Convertible portion of Rs.85.
b. Part A of each PCD will be automatically and compulsorily converted into
4 equity shares of Rs.10 each at par on allotment.
c. Part B of the PCD will be redeemed at par in three installments of Rs.28,
Rs.28 and Rs.29 at the end of 7th, 8th and 9th years respectively from the
date of allotment.
‘Convertible’ Zero-Coupon Bond

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A zero-coupon bond is a loan instrument slightly different from a debenture. A
debenture is usually offered at a face value (say Rs.100), earns a stream of interest
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(say, 14 percent p.a.) till redemption and is redeemed with or without premium.
Unlike the above, a zero-coupon bond, say a five-year bond, may be offered at a
discount (say, at Rs.50), fetches no periodic interest and is redeemed at the face
value (say, Rs.100). The return on such a bond when subscribed to at Rs.50, is also
about 14 percent. It is just that in this case the interest is reinvested in the company
for a period of five years. A zero-coupon bond may also be redeemed by allocation
of ordinary share(s). For want of better terminology, such a bond has been referred
to as a ‘Convertible’ zero-coupon bond.
Redemption
Irredeemable corporate debentures are perhaps non-existent. In fact, all corporate
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debentures are redeemable and the redemption takes place in a pre-specified
manner. Typically, debentures have a term-to-maturity of 7 to 10 years and are
redeemed in installments over a period of time. Recently, companies have been
permitted to issue debentures of shorter maturities like debentures with a maturity
period of one year. Corporate debentures can be redeemed by creating a sinking
fund. A sinking fund provision in the indenture requires the issuing company to
make periodic payments to the trustees. The trustee can retire the debentures by
purchasing them in the market or calling them in a manner acceptable to the
debentureholders. In some cases, however, the company itself can handle the
retirement with the sinking fund amount.
Debenture Redemption Reserve
The guidelines for protecting the interests of debentureholders requires, among
other things, the issuing company to create a Debenture Redemption Reserve
(DRR) out of its profits to the extent of 50% of the amount of debentures to be
redeemed before the date of redemption. The company can utilize the DRR for
redeeming debentures only after 10% of the debenture liability has been actually
redeemed by the company.
Call Option
Some debenture issues have a call feature attached to them, which provides an
option to the issuing company to redeem debentures at a specified price before the
maturity date. In this case, there is, what is known as an effective call option
period during which the option can be exercised. The call option period usually

9
 Security Analysis

commences after 1 to 3 years from the date of allotment. When the debentures are
redeemed by call, they are done so at the call price which can be 5% above the par
value. The call price is maximum at the start of the effective call option period and
declines step-wise towards the face value as the call date approaches the maturity
date. The effective call option period and the time-series schedule of call price are
announced at the time of issue.

Preference Shares
These are a hybrid variety of securities which have some features of equity shares
and some features of debentures. Preference shares carry a fixed rate of dividend.
Preference dividend is payable only out of distributable profits. Generally, dividend
on preference shares is cumulative. Hence, dividend not paid in one year has to be
paid during the subsequent years before equity dividend is paid. All preference
shares shall be redeemable within 20 years as per the Companies Act, 1956.

Equity Shares
Investors’ Classification of Equity Stocks
Unlike in the West where we find different classes of common stock with differing
voting rights and rights to income and assets of the company, the equity stocks of all
Indian joint stock companies belong to just one class. The rights and privileges
conferred on the shareholders are all the same and they are enjoyable in proportion to

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one’s shareholdings. With the commencement of the Companies Amendment Act,
2000, companies are allowed to issue shares with disproportionate voting rights.
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The investment community in India, however, has its own categorization of equity
stock, not on the basis of voting or any other right, but on the basis of behavior of
prices (and returns) of equity stocks. These categories include Blue chips, Growth
stocks, Income stocks, Cyclical stocks, Defensive stocks, Speculative stocks,
Glamor stocks, and so on.

Non-security Forms of Financial Investment

There are a number of non-security forms of investment opportunities available to
an investor in India. Unlike stocks and debentures discussed above, the certificates
or notes evidencing these investments are neither transferable nor are they traded
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in any organized financial market. Hence, the nomenclature ‘Non-security form’,
although, in the strict sense, is a misnomer.
Broadly, these financial investment media can be classified into (1) National
Savings Schemes, (2) Post Office Savings Deposit Schemes, (3) Deposits with
Commercial Banks, (4) Corporate Fixed Deposits, and (5) Unit Schemes of UTI.
As can be seen from the above classification, most of the non-security forms of
investment are the schemes or the plans of the central government, and the bodies
controlled by it. These schemes are meant to mobilize small private savings for
public use. Excepting corporate deposits, the other non-security forms of
investment provide adequate safety and a reasonable liquidity. Many of these
investments also have significant tax advantages. Although nominal returns on
these investments are low vis-a-vis security returns, the features of tax advantage
and safety can swing many small investors into their fold, particularly the
conservative investors. In fact, statistics indicate that nearly 80% of the household
savings are in these forms of investment.
The knowledge of non-security forms of investment is important not only because
they are popular among small investors, but also because they help in fulfilling an
important task of an investor, money manager/investment counselor – to obtain a
balanced portfolio that satisfies a given set of objectives. The financial investments
in media – security and non-security types differ in their return, risk, liquidity, and
tax characteristics. So, it would be possible to form a portfolio by spreading one’s
investment across these forms such that investment objectives are best served. In
this section, we will discuss the salient features of the major non-security forms of
investment media available in India.

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 Investment Scenario

National Savings Schemes

Over the years, the Government of India has floated several national savings
schemes with a view to mobilize private savings for public use. These schemes are
operated mainly through the Post Offices because of the familiarity of these places
to the masses. Some series of National Savings Schemes are operated through the
State Bank of India and other nationalized banks. These series are known as ‘Bank
Series’. Investment in the eighth series of this scheme qualifies for a tax rebate. At
present, the rate of return on NSS is 9% p.a. credited annually on April 1. Interest
income qualifies for a limited tax deduction.
Public Provident Fund Scheme
This was introduced on July 1, 1968 and is primarily meant for self-employed
individuals. The salaried individuals are also allowed to make contributions to this
scheme over and above their contributions to the recognized provident funds in
their organizations. It is a 15-year scheme with a facility to accept the last
contribution in the 16th year.
At the option of the investor, the tenure of the account opened under this scheme
can be extended by blocks of 5 years each.
A PPF Account can be opened in a Head Post Office or in a branch of SBI or its
subsidiaries or at specified branches of some other nationalized banks by an
individual on his own behalf or on behalf of a minor of whom he is a guardian or

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on behalf of a Hindu Undivided Family of which he is a member.
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The minimum amount that can be contributed in a year is Rs.100 and the
maximum amount is Rs.60,000.
The interest is paid annually, but the rate is determined by the central government
from time to time. The current rate of interest is 9.5% per annum compounded
annually. The interest on PPF contributions is tax-free under Section 10 of the
Income Tax Act, 1961 and the contributions towards the scheme qualify for 20%
tax rebate up to Rs.60,000 under Section 88 of the Act. The investment is exempt
from Wealth Tax subject to the overall exemption limit of Rs.15 lakh. Besides the
tax benefits, the other attractive features of the scheme are as follows:
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i. Yearly contributions can be made in one lump sum or in 12 or less
installments of varying amounts, in multiples of Rs.5.00.
ii. It provides liquidity as loans and withdrawals are permitted. The application
for the first loan can be made in the third year from the year of opening the
PPF account. That is, if an investor opened the account in say 2000-01, the
application for the first loan can be made in the year 2002-03. The loan
amount is restricted to 25% of the balance amount to the credit at the end of
the preceding financial year.
Also one can withdraw 50% of the balance amount to his credit at the end of
the sixth year immediately preceding the year in which the amount is
withdrawn. That is on 1-4-07, an investor can withdraw 50% of the balance
standing to his credit on 31-3-01. Similar withdrawals can be made
subsequently at three year intervals with the amount loanable remaining at
the 50% of the amount due to ones credit at the end of the sixth year
immediately preceding the year in which the withdrawal is made.
iii. A PPF account can be revived by paying a fee of Rs.10 for each year of
default along with the arrears of subscription of Rs.100 for each year of such
default. The credit balance in the PPF account is not subject to attachment
under an order or decree of court with respect to any debt or other liability.
iv. The facility of nomination is available.

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 Security Analysis

Post Office Savings Deposits Schemes

These include savings bank account, time, and recurring deposit accounts. These
accounts can be operated in the post offices throughout the country. Interest so
earned is totally tax-free under Section 10 of the Income Tax Act.
Interest on the time deposit schemes qualifies for deduction under Section 80L of
Income Tax Act. Premature withdrawal of deposits are, however, allowed only
after 6 months at a discount.
The Post Office 5-year Recurring Deposit Account carries a comparable
compound interest rate (9.5%). The interest on recurring deposits is covered by
Section 80L of the Income Tax Act.
Investment in post office/bank accounts also qualifies for exemption under the
Wealth Tax Act subject to the overall exemption limit.
Deposits with Commercial/Co-operative Banks
The major deposit schemes of the Commercial/ Co-operative banks include the
savings bank account, fixed deposits, recurring deposits, and annuity deposit
schemes.
A savings bank account at a commercial bank carries a nominal interest of 4% per
annum with some limit on the number of withdrawals (usually 25 times a quarter).
If this account is opened with district or industrial co-operative bank, the interest
rate is higher by about 1%. The interest is calculated on the monthly minimum
balance, but credited to the account twice or four times a year. This is a very liquid

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interest earning account because frequent withdrawals are permitted.
Banks accept fixed (i.e., term) and recurring deposits. Such deposits for a period
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longer than 10 years are not accepted by the nationalized banks because of a
directive issued by the RBI. Under the fixed deposit scheme, the deposit is made in
lump sum initially for a set term, whereas, under recurring deposit scheme, the
depositor deposits a certain amount periodically on a regular basis over a specified
period of time.
The interest on fixed deposits can be on a compounding or non-compounding
basis, but the interest on recurring deposits is always on a compounding basis.
Those banks offering simple interest term-deposit schemes generally provide for
reinvestment of interest at the rate allowed on term-deposits.
Banks also offer annuity deposit schemes. Under an annuity scheme, a lump sum
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deposit is made with the bank initially and the bank agrees to make payment of a
certain uniform amount at regular intervals over the annuity period, either to the
deposit holder or to his nominee. Each periodical payment under the annuity deposit
scheme consists of two components – the principal repayment and interest. In the
initial years the interest component of the annuity is higher and in the later years
the principal component is higher.
Given the rate at which the bank pays interest on the outstanding balance of the
principal amount, these periodical uniform payments can be figured out using the
PVIFA tables. For example, if one buys a 5-year, 10% annuity deposit certificate
for Rs.26,535.6, the annuity he is entitled to receive over the 5-year period can be
determined as follows:
26,535.6
Annuity =
PVIFA (10,5)
26,535.6
=
3.791
= Rs.7,000
It is to be noted that besides these deposit schemes, banks do have other schemes
to attract small savings like cash certificate scheme, perennial income scheme, etc.
The other points worth noting about bank deposits are (i) premature encashment is
possible; (ii) the interest on these deposits is covered under Section 80L of the
Income Tax Act; (iii) the Deposit Insurance Corporation offers a cover up to
Rs.100,000 per account.

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 Investment Scenario

Corporate Fixed Deposits

Investors can also consider depositing their money for a fixed term with
companies. These fixed deposits which are considered as a part of the unsecured
liabilities of the company, have a maximum maturity period of 3 years and carry a
maximum rate of interest of 12.5% (earlier 14%). The public deposits accepted by
the companies are governed by the provisions of the Companies (Acceptance of
Deposits) Rules, 1975. The important features of this regulation are (a) Public
Deposits cannot exceed 10% of the share capital plus free reserves; (b) The
maximum maturity period cannot exceed 3 years and the minimum maturity period
cannot be less than 6 months; (c) No company with a net owned fund of less than
rupees one crore shall invite public deposits. (d) The company inviting public
deposits must disclose the prescribed information relating to its financial
performance and position. These guidelines apply with certain modifications to
finance companies.
The interest on public deposits is paid semi-annually on a cumulative or non-
cumulative basis. While the interest rates offered on company deposits are attractive
vis-a-vis bank deposits, it should be noted that there is no tax benefit neither on the
interest income, nor, does the investment in CFD qualify for any tax rebate.
Besides, company deposits have a higher degree of default risk than bank deposits.
For one thing, these deposits do not enjoy any risk cover from the Deposit
Insurance Corporation like bank deposits. Further, these deposits are serviced and

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finally repaid from the earnings of the company which by nature are uncertain and
fluctuate over time. To add to this, these deposits are unsecured and rank pari
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passu with other unsecured liabilities for repayment in the event of liquidation.
Therefore, the decision to invest in public deposits must be necessarily based on a
thorough analysis of the financial stability and profitability of the company1 or on
the credit ratings provided by rating agencies like CRISIL and ICRA.
Units of UTI
The Unit Trust of India (UTI) in the public sector is the only units investment trust
in the country. It was set-up in 1964 with a view to mobilize small savings by
selling ‘units’ and invest the proceeds in the corporate stocks and debentures and
gilt-edged securities. A unit represents a share in the income earned and in the
assets (portfolio of securities) held by the trust under a given scheme. Some
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important unit schemes offered by UTI are discussed below.
Unit Scheme, 1964
One of the major unit schemes of UTI is the Unit Scheme, 1964. Under this scheme
which is an open-ended one, units of the face value of Rs.10 each are sold on a
continuous basis at a price quoted by the UTI from time to time. During the month
of July, for about 3 – 6 weeks, these units are sold at a special price which
normally is lower than the price quoted during the other periods of the year. A unit
holder can avail himself of this facility, if so desired, for automatic reinvestment of
dividend income in further units at the reduced price.
Unit Scheme, 1971
This unit scheme is a unit-linked insurance plan. Under this scheme, the units are
not sold on tap. Instead, they are issued to the participants of the plan. It is a
contractual savings plan for a target total contribution of Rs.6,000 at the minimum
and Rs.75,000 at the maximum over a period of either 10 years or 15 years. A
small amount of the contribution is paid to LIC for the insurance cover and the rest
is invested. The total contribution to be made by a participant represents the
insurance cover amount and this amount is paid to the nominee or legal heir in the
event of the participant’s death. The plan also provides for personal accident
insurance cover up to Rs.15,000 free of cost to the participant.

1 The company (Amendment) Bill, 1987 has proposed serious penalties for companies defaulting on
payment of interest and repayment of these deposits.

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 Security Analysis

Unit Scheme for Charitable and Religious Trusts and Societies

The units sold under the scheme have a face value of Rs.100 and a participating
trust or society is required to buy at least a 100 units. A participant can opt for
reinvestment of dividends. The investment, however, cannot be withdrawn for the
first three years.
Children’s Gift Growth Fund 1986
Under this scheme, an irrevocable gift can be given by any adult to any child under
15 years of age. This investment remains with UTI till the child attains the age of
21 years. As it is indicated by the name, its primary aim is to build-up a fund for
children. Till the scheme matures, there is an assured dividend of 12.5% p.a. which
is automatically reinvested in further units, so the investment grows at a compound
rate. Units can be gifted in multiples of 10 subject to a minimum of 50. Units are
sold at par at Rs.10 throughout the year.
Mutual Fund Unit Scheme 1986 (Mastershares)
This scheme provides an opportunity to the investors to participate in the growing
equity market. The funds mobilized through Mastershares are invested in a basket
of equities spread over a wide range of industries, thus giving the benefit of
diversification and spread of risk to the common investor. Mastershares are quoted
on the stock market and so can be bought or sold at any time.
Growing Monthly Income Scheme (GMIS’91)
This scheme is launched to satisfy the growing need of middle class investors for

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regular income schemes and to cope with the rising cost of living. The scheme
offers two options. Option ‘A’ provides regular monthly income of 14.5% p.a. for
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the first 3 years and 15% p.a. for the last two years with a minimum 2% capital
appreciation on maturity. Under Option ‘B’ invested amount more than doubles
itself in 5 years.
The investment in units under the unit-linked insurance plan qualifies for
deduction under Section 88 of the Income Tax Act. The investment in units is also
eligible for exemption under the Wealth Tax Act subject to the overall exemption
limit. Dividend income qualifies u/s 80L of the IT Act.
FINANCIAL MARKETS
Financial markets are the markets where financial instruments are traded and
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consist of the following:
• Borrower
• Lender
• Instruments
• Intermediaries.
Financial markets are further divided into two parts. Money market and Capital
market as per the structure given below.

Primary

Money
Secondary
Market

Financial Markets
Primary

Capital
Market

Secondary

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 Investment Scenario

Money market is the market for short-term funds, while Capital markets are the
markets for the long-term funds. The corporate entities borrow money through the
issue of long-term instruments in the primary market, the secondary market refers
to the place where such instruments are traded in the stock exchanges. As the
secondary market is created for the securities raised in the primary markets, the
depth of the secondary market depends upon the primary market. From the
investor’s point of view, while he can obtain the instruments both by applying for
them in the primary market or purchasing them in the secondary market, the
liquidity for these instruments is created only in the secondary markets. Hence, the
movements in both these markets is important for him.

REAL INVESTMENT
Real investment is the investment in tangible or physical goods which are different
from monetary assets or financial claims. The important categories of real assets are
a. Land and house property.
b. Bullion.
c. Precious stones.
d. Art objects.

Land and House Property

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Land and House property is also called real estate. This investment is taken by a
large number of people for hedging against the inflation rates. A real estate
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represents a very attractive investment proposition for the following reasons:
1. Capital appreciation of real estate is, in general, very high. Real estate in most
of the towns in India have appreciated ten times or so in the last 10-15 years.
2. Loans are available from various quarters for buying or constructing a
residential property.
3. For wealth tax purposes, the value of a residential property is reckoned at its
historical cost and not at its present market price.
4. Interest on loans taken for buying or constructing a residential home is tax
deductible within certain limits.
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5. Ownership of a residential property provides psychological satisfaction.
Due to the above formidable advantages, a residential property represents the most
important part of the portfolio for most of the investors. But the return on these
investments depends on the following rules:
a. The holding period of the property is important.
b. A person who does not have enough time to supervise his property should not
invest in it.
c. Property requires care. If it is rented out there is a requirement of repair and
maintenance.
d. Investment in real estate is also very risky. Although the average rate of
return is high, a cautious investor should not think of property because it
involves the exercising of a lot of pressures such as tax payments, capital
gains tax, annual property tax and so on.
PRINCIPLES OF INVESTING IN REAL ESTATE
Price
The price of property is most valuable for determination of real estate. The property
must be evaluated with regard to its price in relation to its position and its use.
Regarding position, it should be situated in a place where higher rent is recoverable.
So the productivity will determine the price. Therefore, when an investor buys and
sells property he would evaluate it according to its most productive use.

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 Security Analysis

Land as an Asset
Land as an asset is fixed but its demand keeps on increasing every time. The
increasing population and affluence will increase the rate and value of land. Land
from the point of view of long-term investment can be expected to be a good
proposal because it is expected to cover purchasing power risk with the prices of
land which keep on increasing. On short-term basis, property cannot be called as a
good investment.
Land as Collateral
Land is accepted as collateral by banks and other financial institutions. In India, it
is found that almost all banks consider land as a good collateral, but lending on
property is restricted by the banks to the market price as a collateral value. If an
investor can purchase land and borrow money on such an investment at a lower
rate of interest is a good form of investment.
Tax
The purchase of land must always be determined after carefully examining the
payment of tax on property. Tax must be paid on house property as well as after
property is sold under Capital Gains Act.
Sources of Housing Finance
A major deterrent for investing in house property is the huge investment required.
Hence, you may have to explore for sources of loan finance. The organizations that

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offer housing loan in India are as follows:
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Employers:
Many employers offer housing finance at subsidized interest rates.
Life Insurance Corporation: Traditionally, the most important formal source of
housing finance, the Life Insurance Corporation has been offering housing finance
as a bait to sell insurance policies. It has three main schemes for housing finance:
(i) Own Your Home (OYH) Scheme. (ii) Own Your Apartment Scheme.
(iii) Property Mortgage Scheme.
Housing Finance Companies: In the last decade, a number of Housing Finance
Companies (HFCs) have come into existence. There are presently about 280
HFCs, big and small. Leading the pack is the Housing Development Finance
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Corporation (HDFC). Other well-known names are Canfin Homes, SBI Homes,
Dewan Housing, LIC Housing Finance (this is a subsidiary of LIC set-up to
provide housing finance only).
Co-operative Housing Societies: In almost every city, co-operative house building
societies exist. They offer a housing loan up to a certain amount to its members.
Schemes of HFCs
The housing finance schemes offered by HFCs fall into three broad
categories: (a) straight loans for purchase of a house or for undertaking
extensions/repairs, (b) loans linked to savings made by the customer over a
period of time, and (c) preferential sanction of loans to depositors.
The typical features of housing finance schemes are as follows:
a. Loans are sanctioned against the mortgage of the house property bought with
the loan proceeds.
b. The eligibility interest rates are varying with minimum of 12% and the
maximum repayment period is 15-20 years. Table 1 provides information
about several HFCs.
c. The repayment is typically in the form of Equated Monthly Installments
(EMIs) over the period of the loan. For example, the EMI on a Rs.2 lakh
loan from HDFC repayable over a 15-year period presently works out to
Rs.2,514 at 12.5% p.a. However, most HFCs are willing to structure the

16
 Investment Scenario

pattern of repayment to suit the convenience of the borrower. For example,

the Housing Development Finance Corporation offers a ‘Step Up Repayment
Facility’, under which the installments increase progressively.
Table 1
Housing Finance at a Glance
Features LIC Hsg Fin SBI Dewan Housing Home Trust HDFC
Maximum Rs.50 lakh Rs.25 lakh Rs.25 lakh Rs.10 lakh Rs.50 lakh
Amount
Maximum Residents: 20 15 years 15 years 15 years 15 years
Tenure years
NRIs: 7-10 years
Security First Mortgage of First Mortgage of Processing fee: First Mortgage of First Mortgage of the
the property, a the property & a % of the the property, a property & a
guarantor & LIC guarantor property, a guarantor & LIC guarantor
policy guarantor & LIC policy
Policy
Processing & 0.5% of loan Up to 25,000-nil Processing fee: 1.2% of sanctioned Processing fee:
other charges amount to a 25,000 to 2 lakh: 1% of the loan amount 0.8% of the loan
maximum of 0.5% of sanctioned applied. applied.
Rs.5,000 amount to a max. Admn. Charges: Admn. Charges:1%
of Rs.5,000 1% of the of the sanctioned
Above 2 lakh: sanctioned amount
0.5% amount amount
Other features NA NA Double Free personal NA
Protection plan accident cover

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Own contribution Residents: 20% 20% of the Own NA 20% of the
NRIs: 25% sanctionunt construction: sanctioned amount
30%
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Prepayment 1% of the amount 1 month interest on Nil
Purchase: 20%
for purchase
Nil 2% of the amount
charges prepaid within first outstanding loan prepaid
5 years
Source: ICFAI Research team.

Bullion – Lure of Gold

Bullion comprising of gold and silver is a favorite avenue of investment to Indian
investors as:
• They provide a hedge against inflation
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• The sentimental and social value attached to these precious metals
• It has ornamental value and medicinal uses.
GOLD
Gold is one of the most valuable assets in any economy. It has been used in India
primarily as a form of saving by the housewives. It used to be a money metal and
public memory tells that gold is universally acceptable as a medium of exchange
and it is now used for its ‘Store of Value’ function. Although the price of gold is
always on the rise and it fetches higher resale value, in India, it is retained for the
feeling of security and status it gives rather than for sale or with the intention of
making profit or income on this investment. Gold to the investor in the recent
years has become very important mainly because of rise in prices due to inflation.
Investment in gold may be in the form of gold coins, gold bars or gold jewelry.
Import of Gold to the Economy
Two years after the government headed by Chandrasekhar came in for flak on its
decision to ship out gold to the Bank of England, the Narasimha Rao Government
is being applauded for the massive collections recorded under the Gold Bond
Scheme. But the objective of both governments was the same: To convert gold
into a quasi-financial asset. Once gold is developed into a financial asset it can
emerge as an alternative to external borrowings. This means that the government
could in future raise dollar resources by using gold as a collateral in international
markets. As a result, the country would be able to save on substantial interest
charges if commercial borrowings were resorted to. At a conservative estimate, the
stock of gold in the country is estimated at around 8000 tonnes.

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 Security Analysis

Liberalization of India’s Gold Policy

Before the new gold import policy was introduced, carrying of gold biscuits or
bars was banned in India. Average NRI’s took home chains or bangles. Since the
ban on gold biscuits (TT bars) was withdrawn, most people prefer carrying TT
bars each weighing around 116.64 gms. and they take home 42 biscuits weighing
less than the 5 kg that is the maximum allowed. Thus the government aided in
making gold, a lucrative invetment. Thus, the government aided in making gold, a
lucrative investment.
SILVER
Silver is sold in the form of weight in kilograms in India. Like gold, this is a useful
hedge against inflation. It is worthwhile to note the following facts about silver.
Demand and Supply
Silver has a wide range of industrial applications. Silver, so used, cannot be
recycled and, hence, is lost irretrievably. There has been no major discovery of
silver mines in the last several decades. Given the growing industrial demand and
a somewhat stagnant supply, the long run prospects of silver may be considered
bright.
Price Parity

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Historically, the price of silver in India tended to be lower than the price of silver
abroad. Hence, it was illegally exported from India. In recent years, the price
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relationship has reversed. Currently, the price of silver in India is higher than the
price of silver abroad.
Form
For investment purposes, silver may be bought in the form of bars – 5 kg bars are
the most common. There is a ready market for silver bars. Hence, silver can be
traded very easily.
PRECIOUS STONES
Diamonds, rubies, emeralds, sapphires, and pearls have appealed to investors
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from times immemorial because of their aesthetic appeal and rarity.
Diamonds, in particular, have attracted most because of their high per carat value.
The quality of a diamond is basically judged in terms of the 4 Cs, viz. carat, color,
cut, and clarity.
Carat
This is the unit for weighing diamonds. A carat is about 0.2 grams. Most of the
diamonds are less than one carat. The higher the carat value, the higher the price
per carat.
Clarity
This refers to how clear a diamond looks. Almost every diamond has some flaw in
it in the form of bubbles or lines. The fewer these imperfections, the more valuable
a diamond is.
Color
The color of a diamond determines its ability to refract. The most valuable
diamonds are brilliant white.
Cut
On the basis of its contour, a diamond is cut. The cut determines the shape of a
diamond. The common shapes are rectangles, ovals, and rounds. The cut of a
diamond brings out its color and clarity.

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 Investment Scenario

While precious stones may have appeal for the affluent investors and those who
have skill in buying them, they are not suitable for the bulk of the investors for the
following reasons.
Poor Liquidity
Precious stones can be very illiquid. It may not be easy to sell them quickly
without giving major price concessions.
Subjectivity in Valuation
The grading process by which the quality and value of precious stones is
determined can be quite subjective. It is not uncommon to find a price variation of
20 percent or more in valuation done by two experts.
Substantial Investments
For investment purposes larger precious stones are suitable. Most investment grade
precious stones (diamonds, in particular) require huge investments.
No Regular Returns
Precious stones do not earn a regular return during the period they are held. On the
contrary, the investor has to incur the costs of insurance and storage.
Art Objects
Objects which possess aesthetic appeal because their production requires skill,

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taste, creativity, talent, and imagination may be referred to as art objects.
According to this definition, paintings, sculptures, etchings, and so on may be
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regarded as art objects. The value of an art object is a function of its aesthetic
appeal, rarity, reputation of the creator, physical condition, and fashion.
This section describes briefly two of the more commonly bought objects, viz.,
paintings and antiques.
Paintings
Paintings appear to be the most popular among objects of art. In the last decade or
so, interest in paintings has grown considerably, thanks to the substantial
appreciation in the market value of paintings of Hussain, Raza, Menon, and others.
The prospective investor with an inclination to buy paintings, should bear in mind
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the following guidelines:
a. Put bets more on fledging painters: Works of established painters may be
too expensive and beyond the reach of the small investors. More important,
the expected appreciation in their value may not be considerable. Hence, it
makes more sense to buy good quality paintings done by fledging painters –
the potential Hussains of tomorrow. True, when one bets on an ‘emerging’
painter, he is taking some risk. Often, the potential rewards justify such risk.
b. Develop a sense for the quality of painting: Even if the investor does not
have the skills of a connoisseur, he can judge the basic qualities of painting
by looking at attributes like spontaneity, maturity of strokes, balance of color,
and originality. Over a period of time one can refine his sensibility, provided
of course he has a basic aesthetic sense.
Antiques
An object of historical interest may be regarded as an antique. It could be a coin, a
manuscript, a sculpture, a painting, or any other object.
If one is interested in investing in an antique, bear in mind the following:
a. The owner of an antique is required to register it with the Archeological
Society of India. If the registering authority is satisfied about the authenticity
of the antique, it issues a ‘Certificate of Registration’.
b. Whenever an antique is sold the registering authority has to be informed and
the ownership must be transferred.

19
Security Analysis

c. Export of antiques, in general, is banned. In exceptional cases, it is allowed

only at the instance of the Director General of the Archeological Society of
India.
d. The government has the right to acquire an antique if it is felt that the same
must be kept in a museum for the general good.
e. Antiques are available in places like Chor Bazar (Mumbai), Mullick Market
(Calcutta), and Burma Bazar (Chennai). However, it may not be easy to get
good bargains at these places. To buy antiques at bargain prices, investor has
to actively look for them in smaller towns and villages.
f. There is a flourishing market for ‘fake’ antiques. These are objects which are
chemically treated to give an ‘antique’ look, though they are not genuine
antiques.
g. Antiques tend to appreciate in value over time, but in a very unpredictable
manner.
h. Antiques seem to make sense only for those who has patience to wait and
who derive psychological satisfaction from owning objects of historical
interest. One may even argue that, since very few investors have the ability to
assess the value of antiques, investments in these may largely be left to
connoisseurs.

I
SUMMARY
• An investment may be defined as a process of sacrificing something now for

•
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the prospect of gaining something later.
Rationally stating all personal investing is designed in order to achieve a
goal, which may be tangible (e.g. a car, a house, etc.) or intangible
(e.g. Social status, security, etc.)
• Liquidity, age, need for regular income, time horizon, risk tolerance and tax
liability are identified as constraints for an investor seeking fulfillment of the
goals stated above.
• The investments can be classified into security form and non-security form of
financial investment. Gilt-edged securities, corporate debentures, preference
IC
shares, equity shares can be grouped under security form of investments.
National Savings Scheme, Public Provident Fund Scheme, Post office
savings bank deposits, bank deposits, corporate fixed deposits and Units of
UTI can be grouped under Non-security form of financial investment.
• The next chapter focuses on the risk-return aspects of the above-stated
investments.

20
Chapter II

Risk and Return

I
•
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After reading this chapter, you will be conversant with:

Concept of Risk and Return

• Reduction of Risk through Diversification
• Quantifying Portfolio Risk and Return
• Measurement of Risk in Portfolio Context
• Security Market Lines and its Applications
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 Security Analysis

Introduction
No investor is obliged to take any amount of risk on his or her investment. One
may invest one’s money in a government bond or a fixed bank deposit and receive
fixed interest. This interest may be called risk-free return (near risk-free) on
investment. On the other hand, one may also invest in rather risky investments, in
the expectation of earning very high returns. It appeals to common sense that one
will invest in a risky venture only if one expects to earn a return in excess of the
risk-free return. But what do we mean by return from a venture? For that matter,
what do we mean by riskiness of a venture? Let us have a closer look at the
concept of return and risk.
CONCEPT OF RISK AND RETURN
Return
Intuitively, it should be clear that by the term return from a venture we are
concerned with benefit from that venture. In the field of finance in general and
security analysis in particular, the term return is almost invariably associated with
a percentage (for example, return on investment of 15%) and not the amount (like,
profit of Rs.100). But then again, even in terms of a percentage, exactly what is
return? Is it the return on investment or return on assets (profit as a percentage of
assets)? Is it the return on total capital or return on equity? Is it the accounting rate
of return or the internal rate of return? In corporate finance, from the corporate
perspective, each of these definitions have a specific significance and the use of

I
any one specific definition depends upon the purpose for which the return is being
measured. For example, if the purpose is to measure the productivity of capital as a
FA
whole, one may measure the return on total capital; if one is concerned with the
productivity of assets, one may compute return on assets and so forth.
In security analysis, we are primarily concerned with returns from the investors’
perspective. Our main concern is to compute or estimate the return for an investor
on a particular investment. The investment is looked by a security analyst as
essentially a financial asset, say, a share or a debenture or some other financial
instrument. So then, what is the return on a financial asset for the investor?
Single Period Returns
Let us at the outset consider situations where we are concerned with only a single
period (say, one day, one week, one month or one year, etc.). Consider the
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following illustration.
Illustration 1
Let us consider a share whose prices now (period 0 or P0), one year later (period 1 or P1),
two years later (period 2 or P2) etc. over a 10 year period are as follows:
Period P0 P1 P2 P3 P4 P5 P6 P7 P8 P9 P10
Prices 100 110 108 130 154 145 160 170 193 220 264
We need to compute the return from the share in each of the periods.
Solution
If all the prices are cum-dividend (that is, prior to the payment of dividends), the
single period return to the investor in period 1 (r1), period 2 (r2), etc. could be
expressed as below:
P1 − P0 110 − 100
r1 = = = 10% Eq... (1)
P0 100
Similarly,
P2 − P1 108 − 110
r2 = = = –2%
P1 110

P10 − P9 264 − 220

r10 = = = 20%
P9 220

22
 Risk and Return

The computed single period percentage returns (rounded off to the nearest digit)
have been shown below:
Period P0 P1 P2 P3 P4 P5 P6 P7 P8 P9
Returns 10 –2 20 18 –6 10 6 13 14 20
As analysts or investors, we may want to know the average annual return (single
period return) over the period 0 to 10. This may be computed from above as
follows:
1 n r + r + r + .... + r10
∑ ri = 1 2 3 = 10%. Eq...(2)
n i =1 n
where i is the subscript for the period.
This is nothing but the arithmetic average of the returns over the ten year period. While
this computation appears quite reasonable, and serves the purpose in most cases, we
run into trouble when the change in prices is rather erratic (See Example 2).
Multi-Period Returns
Let us now consider returns when more than a single period is under consideration.
In this context we are concerned with computing the return per period, over a
longer period. For example, over a span of ten years, what has been the annual

I
return on a security? Consider the following illustration.
Illustration 2
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Period P0 P1 P2
Prices 100 200 110
What is the per period return in this case? In other words, if P0, P1, and P2
represent prices now, a year from now, and two years from now, what is the
annual return over the two year period in this example?
Solution
In this illustration, we have r1 = 100% and r2 = – 45%, so that the average annual
return = 27.5%.
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However, it is obvious that an investor who bought the share for 100 in period 0
and sold it for 110 in period 2, made a return of only 10% over the two year
period.
The single period return over the period 0 to 2 (r0,2) is arrived at as follows:
P2 − P0 110 − 100
r0,2 = = = 10% Eq....(3)
P0 100
This return (r0,2) can be reduced to an equivalent per period return (r). One way of
computing the per period return is as follows:
P0 (1 + r)2 = P2, or r = ( P2 /P0 ) –1 = 1.1 – 1 = 4.88% Eq....(4)
Alternatively,

(1 + r)2 = 1 + r0,2, or r = (1 + r0,2 ) – 1 = 4.88%

Thus, r is the annual rate of return on a time adjusted basis.

One could also compute the annual rate of return without adjusting for time.
The unadjusted annual rate of return
= r0,2 / n = 10 / 2 = 5%. Eq... (5)
Thus we see that in this example, the annual rate of return is about 5% per annum,
so that the average annual return of 27.5% as computed earlier has little meaning.

23
 Security Analysis

Multiplicative Relationships of Returns

In the context of computing multi-period returns, it may be useful to note the
following relationships:
r0,2 in Example 2 above (from Eq. 3) may be expressed as
P2 P P
1 + r0,2 = = 1 x 2 = (1 + r1) x (1 + r2)
P0 P0 P1
In general,
Pn P P P
1 + r0,n = = 1 x 2 x... x n Eq..(6)
P0 P0 P1 Pn -1
= (1 + r1) x (1 + r2) x … x (1 + rn)where r0,n is the return over the
period 0 to n.
Logarithmic Returns
Another important relationship results by taking the natural logarithm of the two
sides of Eq. 6 above:
ln (Pn / P0) = ln (P1 / P0) + ln (P2 / P1) + ... + ln (Pn / Pn – 1) Eq..(7)
or
ln (1 + r0,n) = ln (1 + r1) + ln (1 + r2) + ...... + ln (l + rn)

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where ‘ln’ stands for logarithm with base e, that is, natural logarithm.
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Note that by using logarithms, we are able to reduce a multiplicative relationship
(Eq. 6) into an additive one (Eq. 7). The additive relationship of the logarithmic
returns is much simpler to handle in arithmetic manipulations. For this reason,
logarithmic returns frequently find their way into security research.
Once r0,n (or Pn / P0, which is equal to 1 + r0,n) has been computed, the time
adjusted annual rate of return r is given by:
P0 (1 + r)n = Pn or r = n ( Pn /P0 ) –1 Eq..(8)
alternatively,
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(1 + r)n = 1 + r0,n or r = n (1+ r0,n ) –1 Eq..(9)

Estimation of Return Using Regression Method

We note that the computed value of annual rate of return (r) using Eqs.(8) and (9)
depends upon merely two observations; namely, the share price on period 0 and
that on period n. All the prices of the intermediate period (P1, P2, .... Pn-1) are
irrelevant to the computation of r (since r0,n depends on only P0 and Pn – see
Eq.(6)). Clearly, the estimate of r can be further improved if all the price
observations could be used in the process of estimation. This can be done using a
regression procedure with the following specification:
Ln (Pn) = ln (P0) + ln (1 + r) n + e
where n is the time variable and e is the error term.
Through the regression procedure, the coefficient of n, ln (1+ r) is estimated, using
the data on share prices for the entire period under consideration. The annual rate
of return r is then computed from the estimate of ln (1+ r).
Measuring Historical (ex-post) Returns
To properly measure the return generated by an investment, one must account for
both the price change and the cash flow derived from the asset during the period
the asset was held. In other words, we can say that the return (the reward) from the
investment includes both current income and capital gains (or losses) brought
about by the appreciation (or depreciation) of the price of the security. The income
and capital gains are then expressed as a percentage of the initial investment.

24
 Risk and Return

Hence, return usually represents the total annual income and capital gain as a
percentage of investment.
In bond investment, yield is the compounded rate of return on the purchase price
of the bond over its life. Simply stated, it is referred to as yield to maturity. Since
yield to maturity includes interest and capital gains or losses, it is also the return.
The yield on a common stock, however, assumes no maturity date. Therefore, the
stock yield is simply the current dividend divided by the current market price of
the stock; there is no compounding of returns. It is known as the current yield.
When bond yields are compared with stock yields, errors of judgment might be
made, since the measures are different.
The return on a stock is calculated by including annual gains. If an investor receives
Rs.2 per share in dividends and earns Rs.3 per share per year in capital gains and has
an average investment of Rs.25, the return on the stock would be 20%.
Illustration 3
ABC Ltd. XYZ Ltd.
Price as on 31-3-X1 (Rs.) 20.00 10.00
Price as on 31-3-X2 (Rs.) 15.00 15.00
Dividends for the year X1 – X2 1.00 1.00
Let r stand for the rate of return on investment
P stand for the price, and

I
D stand for dividend.
the return from holding, the stock of ABC Ltd. and XYZ Ltd., for one year is
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calculated as follows:

ABC Ltd. rx2 =

( Px 2
− Px1 + D x 2
)
Px1

(15 − 20) + 1 −5 + 1 −4
= = = = – 0.2 = –20%
20 20 20

XYZ Ltd. rx2 =

( Px 2
− Px1 + D x 2
)
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Px1

(15 − 10) + 1 5 +1 6
= = = = 0.6 = 60%
10 10 10
Thus, for stocks the return for a particular time period is equal to the sum of the
price change plus dividends received, divided by the price at the beginning of the
time period. For bonds, the holding-period return is equal to the price change plus
interest received, divided by the beginning price.
In general, for the ith asset and the tth time period
(Pit − Pi, t -1 ) + D it
rit =
Pi, t -1
The subscript notation used above might seem complex at first. However, it is
really a very useful method of keeping track of variables associated with different
assets and different time periods.
To compute the ex-post, or historical, average return for the ith stock, we use the
standard formula for computing arithmetic means.
1
ri = (ri1 + ri2 + ri3 + ri4 + .... + rin)where ‘n’ equals the number of time periods.
n
1 n
This can be expressed as ri = ∑ rit
n t =1

25
Security Analysis

Consider the following example of PQR Ltd. The annual returns given are as
follows:
Year Annual returns (%)
1 16.98
2 –11.36
3 7.64
4 21.12
5 –22.14
6 –30.01
7 37.68
8 28.27
9 1.76
10 13.93
The mean annual return of these returns would be,
1 10
ri = ∑ rit
n t =1

I
1
= [16.98 – 11.36 + 7.64 + 21.12 – 22.14 – 30.01 + 37.68 + 28.27 + 1.76 + 13.93]
10
FA =
1
10
(63.87) = 6.387%.

Thus, calculating the arithmetic mean for historical returns is a relatively

straightforward process.
The majority of investors tend to emphasize the return they expect from a security.
They also tend to view both return and risk in subjective terms. Intuitive judgment
is used to make decisions about risk. The reasoning, for example, goes something
like this: Chrysler is more risky than General Motors, General Telephone is more
risky than AT&T and Polaroid is more risky than Eastman Kodak. And in India,
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Reliance is more risky than Tisco.

Return also receives subjective and intuitive analysis. The usual statement about
return is something like, “The stock offers a dividend yield of 7% and has
prospects for future price appreciation”. The dividend yield, which is current price
dividend into the current rupees dividend is mentioned specifically, but little or no
attempt is made to estimate in a formal way the likely impact of capital gains or
losses on the total return.
It is, therefore, appropriate to develop a measure of return that includes both
dividends or interest and capital gains in the calculation. This measure will then be
applied to the calculation of historic or future expected returns. The precise
measure of return will make it easier to estimate and judge the magnitude of
returns of various securities. The return includes dividends and capital gains. The
best proxy for return is the future expected return. Thus, the basic equation for
measuring return for a yearly period or less is
(Pi − P0 ) + D i
=
P0
where,
P0 = the rupees beginning price of the security
Pi = the rupees end-of-period price
Di = the rupees amount of dividends paid in period 1.

26
 Risk and Return

Expected Return (ex-ante) of a Security

Frequently, in security analysis, we talk of expected return rather than historical
return. Let us now understand the meaning of the term “expected return” in the
context of the return on securities through an example.
Illustration 4
Investors’ assessment of return on a share of Xylene Corporation under three
different scenarios is as follows:
Scenario Chance Return (%)
1 0.25 36
2 0.50 26
3 0.25 12
How investors make an overall assessment about the return on the share based on
the above anticipated returns under different scenarios?
Solution
As a first step in dealing with so many values, investors tend to ask the question,
“What return can we expect on an average?” This is known in statistics as the
expected value of the return and is nothing but the sum of each possible return
multiplied by the chance of its occurrence. The expected return E(x) in this case
will be 25% (being 0.25 x 36 + 0.50 x 26 + 0.25 x 12).

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Illustration 5
Consider the following illustration, where the expected value of the returns for a
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stock is computed when probability of occurence is given.
Conditional return Probability of Occurrence
(%) (Xi) (Pi) XiPi

–24 0.05 –1.20

–10 0.15 –1.50

0 0.15 0
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12 0.20 2.40
18 0.20 3.60

22 0.15 3.30

30 0.10 3.00
9.60
n
Expected value of returns = E(x) = ∑ X i Pi = 9.60%
i =1

It is important to note that the sum of all the chances must add up to one.
We could generalize the above approach. If the return on a security is expected to
be r1 with a chance of P1, r2 with a chance of P2, ..., and rn with a chance of Pn, then
the overall assessment of investors is based on the expected value of returns,
which is computed as follows:
Expected Return, Er = P1r1 + P2r2 + ... + Pnrn
Expected Return of a Portfolio of Securities
The expected return on a portfolio of securities is nothing but the weighted average
of the return on individual securities in the portfolio. For a portfolio of two
securities:
Expected portfolio return, Ep = W1E1 + W2E2

27
Security Analysis

where,
E1 is the expected return on security 1
W1 is the proportion of money invested in security 1
E2 is the expected return on security 2
W2 is the proportion of money invested in security 2
Similarly, the expected return of a portfolio of n assets, Ep is given by:
Ep = W1E1 + W2E2 + ... + WnEn, or
n
Ep = ∑ WiEi
i =1

where,
Wi is the proportion of investment in asset i,
Ei is the expected return on asset i, and
n is the total number of assets in the portfolio.
The above fact can be proved using the following illustration.
Stock Price as on Price as on Yearly Rate of
1.4.x1 (Rs) 31.3.x2 Dividend Return (%)
X 20 30 2 60.00%

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Y 30 40 3 43.33%
Z 50 60 5 30.00%
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Portfolio of (X, Y, Z) 100
Rate of return is computed as Eit
130 10 40.00%

(Pit − Pi, t -1 ) + D it
= (for X, Y, Z)
Pi, t -1

Ept =
( Ppt − Pp,t-1 ) + Dpt (for portfolio)
Pp,t-1

(30 − 20) + 2
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X = = 60%
20
(40 − 30) + 3
Y = = 43.33%
30
(60 − 50) + 5
Z = = 30%
50
(130 − 100) + 10
Portfolio = = 40.00%
100
The above portfolio return can also be computed as using the formula (for ex-post data)
Ept = ExtWx + EytWy + EztWz
where,
Ept = Expected return on portfolio
Ex = Expected return on security X
Wx = Proportion of money invested in security X and so on.
20 30 50
= 60% x + 43.33% x + 30% x
100 100 100
= 12% + 13% + 15% = 40%
This confirms that portfolio returns are simply a weighted average of the returns
associated with the individual securities in the portfolio.

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 Risk and Return

Risk
Suppose we are evaluating two shares M and N for investment. We have collected
data on the returns earned by investors on these shares in the last five years which
are as follows:
Share M : 30%, 28%, 34%, 32% and 31%
Share N : 26%, 13%, 48%, 11% and 57%
If we have to choose only one of the two shares for investment, which share shall
we choose?
One approach would be to compute the average return for each share and choose
the one which has higher average return. If we do that we find that both the shares
have an average return of 31%. Can there be any other criterion for choice? Now,
most investors would regard Share N (or return on share N) to be riskier as its
return fluctuates substantially from year to year. They would, therefore, prefer
share M to N. Thus, investors appear to make their choices based on two
considerations – expected return and riskiness of returns.
What is Riskiness of Returns?
In the context of security analysis, we interpret risk essentially in terms of the
variability of security returns. The most common measures of riskiness of a
security are the standard deviation and variance of returns.

I
Standard Deviation and Variance of Returns
Standard deviation (commonly denoted as σ) of returns merely measures the
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extent of deviation of returns from the average value of return. Precisely put,
standard deviation of returns is the square root of the average of squares of
deviations of the observed returns from their expected value of return.
The square of standard deviation is called variance (commonly denoted by σ2).
Thus, variance of security returns is the average value of the squares of deviations
of the observed returns from the expected value of return.
The variance is computed as follows:
Variance, σ2 = P1 (r1 – E)2 + P2 (r2 – E)2 + ... + Pn (rn – E)2
Where r1....... rn = Observed returns;
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E = Expected rate of return; and
P1 .... Pn = Probability
Since variance is the square of standard deviation, we have standard deviation,
σ= (Variance)
Illustration 6
Let us continue with the shares of Xylene Corporation mentioned in example 2.3.
What is our assessment about the risk of these shares?
Solution
Scenario Chance P Return Ex (P.rx) Deviation (Deviation)2 Chance (P) x
(%) rx (rx – Ex) (rx – Ex)2 (Deviation)2
1 0.25 36 9 11 121 30.25
2 0.50 26 13 1 1 0.50
3 0.25 12 3 –13 169 42.25
Σ Ex = 25
Variance ( σ 2x ) = 73.00 (sum of the last column)
Standard deviation (σx) = 8.54%
Thus, the riskiness of a Xylene share as measured by standard deviation is 8.54%.

29
Security Analysis

The equations for quantifying the return, variance and standard deviation of
individual security returns for both ex-post and ex-ante data are summarized in the
following table:
Table 1
Historical (ex-post) Expected (ex-ante)
Arithmetic mean return Expected return
1 n n
ri = ∑ rit E(ri) = ∑ ris Ps
n t =1 s =1

Variance (Risk) Variance (Risk)

1 n n
σi2 = ∑ (r − r )2 σi2 = ∑ [ris − E(ri )]2 x Ps
n − 1 t =1 it i s =1

Standard deviation Standard deviation

1 n n
σi = ∑ (r − r ) 2 σi = ∑ [ris − E(ri )]2 x Ps
n −1 t =1 it i s =1

where,
rit = Historical (ex-post) return generated by the ith stock in time period t.
ris = Expected (ex-ante) return for the ith stock assuming that S state of

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the world occurs
Ps = Probability that the S state of the world will occur.
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REDUCTION OF RISK THROUGH DIVERSIFICATION
Consider an alien planet Delta, which in a given year is either under a spell of hot
wave, or a cold wave, either of which is equally likely to prevail. Let us assume
that the only two companies constituting the entire market on the planet are an Ice
cream firm and a Hot Coffee firm. Assume further that if the hot wave dominates
the planet in a given year, the Ice cream company would register a high return of
30%, while the Coffee company would suffer, earning only 10%. If on the other
hand the cold wave dominates the planet in a given year, the Coffee company
would register a return of 30%, while the Ice cream company would earn only
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10%. Thus, on an average both companies are expected to produce a yield of 20%,
and they would have the same variance (σ2).
What should be the best investment strategy for an investor in the above planet?
In this contrived scenario, if we invested in only one of the two companies, our
expected return will be 20%, with a σ of 10%. If, however, we split our investment
between the two companies equally, so that our investment replicates the total
market in miniature, half of our investment would certainly earn 30%, while the
other half would earn 10%, so that our average return would always be 20%, no
matter what the vagaries of weather during the year. Clearly, the diversification
results in 20% return without risk, whereas holding individual securities was
yielding an expected return of 20% with risk (σ = 10%).
In the above example, diversification eliminated all risk because the returns of the
two companies moved diametrically opposite to each other: when one return was
30%, the other was 10% and vice-versa. This was because there was only one
source of risk on planet Delta – the weather – and it affected the two securities in
exactly opposite directions.
Such a situation seldom occurs in real life. More often than not in practice, there
are several sources of risk some of which affect only one of the securities, some
affect both in opposite directions and some others affect them in the same
direction. Clearly, it is important to know what is the net affect of all these
multiple causes which affect the security returns. Do the securities move in the
same direction or in opposite directions? In either case, what is the strength of the

30
 Risk and Return

relationship? Statisticians use a measure called correlation coefficient to answer

these questions. The correlation coefficient ranges from –1 to +1. If the two returns
move exactly opposite to each other, the correlation coefficient is –1, if they move
exactly in step with each other, then it is +1, while if the two returns are entirely
unrelated to each other, it is zero. A positive correlation coefficient which is less
than +1 indicates that the two returns have a tendency to move in the same
direction, but are not always in exact step with each other. This kind of imperfect
correlation is most commonly observed, since two different securities belonging to
two different firms can hardly be expected to move in perfect harmony with each
other. Positive correlation between two securities implies, for example, that when
the market as a whole booms, both the securities would register a rise in prices, or
when the market crashes, both the securities would show a decline in prices.
Variance of a Portfolio of Securities
Let us, next, move from planet Delta to planet Earth and consider a more realistic
illustration.
Illustration 7
Consider two securities X and Y with the following attributes:
Expected return on Security X = 20%
Expected return on Security Y = 30%
σ of Security X = 10%

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σ of Security Y = 16%, and
FACoefficient of Correlation between the Returns of X and Y = –1, 0.5, +1
We shall evaluate the impact on the gains from diversification, for the three
different values of the correlation coefficients.
Solution
Let us first analyze the case where we hold a portfolio with 40% invested in X and
60% invested in Y. The expected portfolio return is nothing but the weighted
average of the expected returns from each security in the portfolio, the weights
being the proportion of investment in each security. Therefore, the expected
portfolio return will be 26% (being 20 x 0.4 + 30 x 0.6).
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Is the standard deviation of portfolio return the same as the weighted average of
the σ‘s of the security returns? That is, would the σ of portfolio return be 13.6%
(being 10 x 0.4 + 16 x 0.6)? No, because the variance of portfolio return depends
not only on the variability of the security returns, but also on the correlation
coefficient, as shown below:
σ 2p = W12 σ 12 + W22 σ 22 + 2W1W2σ1,21 Eq.. (10)

where,
W1 and W2 are the proportions of investment of securities X and Y
respectively and
σ1 and σ2 are the standard deviations of X and Y respectively
σ12 is the co-variance between returns on stocks, X and Y
But, since the correlation coefficient ρ1,2 = σ, σ1,2 / σ1σ2, Eq. (10) may also be
expressed as:
σ 2p = W12 σ 12 + W22 σ 22 + 2W1W2ρ1,2 σ1 x σ2 Eq...(11)

Thus, the σ of portfolio return will be 13.6% only when the two securities X and Y
move in perfect tandem with each other, that is, when the correlation coefficient
(ρ) between returns on X and returns on Y is +1. So long as X and Y have a

1 In this chapter; σ1,2 and Cov(1,2) are used interchangeably to indicate co-variance.

31
 Security Analysis

correlation coefficient of less than +1, the σ of the portfolio return will be less than
13.6%. For example, if the correlation coefficient is only 0.5, then the σ of the
portfolio will be only 12.1% (we shall see shortly as to why this should be so).
The fact that the portfolio σ is only 12.1% as against the weighted average σ of
13.6%, implies there has been some gain from diversification. Let us see why this
is so. If we invest all our money in Y, the expected return is 30% and the risk is
16%; while if we invest all our money in X, the expected return is 20% and risk is
10%. We have assumed 6% additional risk for 10% additional return. This implies
that if there were no gains from diversification, as we move our money from X to Y,
on an average, for every 1% additional return, we have to take 0.6% additional
risk. For example, if the correlation is +1, since the σ of portfolio return is nothing
but the weighted average of the σ‘s of security returns, there is no gain from
diversification, because every 1% increase in return is accompanied with the
average 0.6% increase in risk. It can be shown that except in this extreme case of a
correlation coefficient of +1, investing in two securities does result in gains
because the increase in risk for every 1% increase in return is below the average
increase in risk. In our illustration above, the return rose from 20% to 26% and the
risk from 10% to 12.1%, implying that there was only a 0.35% increase in risk for
every 1% increase in return. Gain from diversification allows us to get additional
return with less than commensurate increase in the risk level.
Illustration 8

I
Consider a portfolio of two securities with 50% investment in A and 50%
investment in B. The characteristics of returns under three different scenarios with
FA
different probabilities for the two securities and the portfolio are as follows:
Scenario Chance Return on rA x P (Deviation)2 x P Return on rB x P (Deviation)2 x P Portfolio of
P A rA (%) B rB(%) 0.5 A + 0.5 B
1 0.25 40 10 25 20 5 6.25 30
2 0.50 30 15 0 30 15 12.50 30
3 0.25 20 5 25 20 5 6.25 20
90 30 50 70 25 25.00
What is the portfolio variance?
Solution
IC
A B Portfolio
Expected Return (E) 30 25 27.50
Variance (σ2) 50 25 18.75
co-variance (σ1,2) = [(40 – 30) (20 – 25) x 0.25] + [(30 – 30) (30–25) x 0.50]
+ [(20 –30) (20 – 25) x 0.25] = 0
σ 12
Correlation Coefficient = ρ1,2 = =0
σ1 x σ 2

Portfolio Variance = σ 2p
= 0.52 x 50 + 0.52 x 25 + 0
= 18.75%
Note that the variance thus arrived is considerably less than the average of
variance of A and B, which is 37.5% (75/2).
Let us consider a mechanical procedure which will give correct portfolio variance.
Two Assets Case
Let us first consider two assets 1 and 2. The rows and columns in the 2 x 2 box
below correspond to the two assets as shown. The diagonal boxes starting from the
left hand top corner correspond to the variances (σ12 ) , while the other boxes
correspond to co-variance terms (σi,j). As can be seen in the box, the variance and

32
 Risk and Return

co-variance terms are multiplied by the weights or proportions associated with the
corresponding assets depicted in the rows and columns.
1 2
1 W12 σ 12 W1W2σ1,2
2 W1W2σ1,2 W22 σ 22
The variance of the portfolio with two assets σ 2p is merely the sum of the expressions
in the four smaller boxes above.
σ 2p = W12 σ 12 + W22 σ 22 + 2W1W2 σ1,σ2 Eq..(12)

where σ1,2 = σ1 σ2 ρ1,2 and ρ1,2 is the correlation coefficient between returns on the
two assets, 1 and 2.
The following table summarizes the necessary mathematics for calculating
portfolio returns and variances.

QUANTIFYING PORTFOLIO RETURNS AND RISKS

Table 2
Historical (ex-post) Anticipated (ex-ante)

I
Historical holding period return: Expected holding period return:
n n
rpt = ∑ rit Wit E(rp) = ∑ E(ri )Wj
i =1
FA i =1

Variance: Variance:
n n n n
σ 2p = ∑ σ i2 Wi2 + ∑ σ 2j W j2 + 2Σ*CovijWiWj σ 2p = ∑ σ i2 Wi2 + ∑ σ 2j W j2 + 2Σ*CovijWiWj
i =1 j =1 i =1 j =1

Co-variance: Co-variance:
1 n n
Covij = ∑ (rit − ri ) (r jt − r j ) / n − 1 Covij = ∑ [ris - E(ris )] [r js − E(r j )] Ps
n − 1 i =1 s =1
IC
Correlation Coefficient: Correlation Coefficient:
Cov ij Cov ij
ρij = ρij =
σiσ j σiσ j
Where,
Wi = Weight of the ith asset defined as the market value of the ith
asset divided by the market value of the portfolio.
* ΣCovijWiWj = Sum of the unique co-variances (multiplied by their weights)
2

(when there are n assets in a portfolio there are

(n − n)
unique co-variances)
2
The last two equations in this table are used to calculate co-variances and
correlation coefficients. The following illustrations will help in understanding
these concepts more clearly.
Illustration 9
Given the following information, calculate the co-variance between the stocks
ACD Co. & AMB Co.
Mean ( x ) % Standard deviation (σ)
ACD Co. 0.86 7.45
AMB Co. 0.94 6.28

33
 Security Analysis

ρ = 0.46 (coefficient of correlation)

We know that coefficient of correlation is computed using the following formula
Cov xy
ρ=
σxσy

Cov ACD,AMD
∴ρ=
σ ACD σ AMD

Substituting the given values

Cov ACD,AMD
0.46 =
7.45 x 6.28

∴ CovACD,AMB = 0.46 x 7.45 x 6.28

= 21.52156 ∼ 21.52
Hence for calculating the co-variance we can also use the following equation
Covij = ρijσi σj
(provided the information about the coefficient of correlation is given).

I
Illustration 10
Use the following data to calculate the variance and standard deviation for a
FA
portfolio containing stocks 1 and 2.
ρ1,2 = 0.75 σ1 = 10.00 W1 = 2/3
σ2 = 20.00 W2 = 1/3
The portfolio contains two stocks 1 & 2 in the proportion of 2/3 and 1/3.

∴ The portfolio mean return = rp = r 1 W1 + r 2 W2

Portfolio variance = σ 2p
IC
2
= ∑ σ i2 Wi2 + 2ΣCovijWiWj
i =1

= W12 σ 12 + W22 σ 22 + 2Cov12W1W2

Cov12 is computed using the formula Covij = ρijσi σj

∴ Cov12 = ρ1,2 σ1 σ2
= 0.75 x 10 x 20 = 150
2 2
2 1 2 1
∴ σ 2p = 102 x   + 202 x   + 2 x 150 x x
3  3 3 3

 4  1  2 1
= 100 x  +  400 x  +  2 x 150 x x 
 9  9  3 3

400 400 600 1, 400

= + + = = 155.56
9 9 9 9
We know that the portfolio standard deviation is equal to the square root of the
variance of the portfolio

∴ σp = σ 2p = 155.56 = 12.47%.

34
 Risk and Return

‘n’ Assets Case

In this case we replace the 2 x 2 box by a n x n box as shown below. The rows and
columns in the box correspond to the n assets as shown in table 3.
Table 3
1 2 3 n
1 W12 σ 12 W1 W2σ1,2 W1 W3σ1,3 … W1 Wnσ1,n
2 W2 W1σ2,1 W22 σ 22 W2 W3σ2,3 … W2 Wnσ2,n
3 W3 W3σ3,1 W3 W2σ3,2 W32 σ 32 … …
… …. … … … …
n Wn W1σn,1 Wn W2σn,2 Wn W3σn,3 … Wn2 σ 2n
As before, the diagonal boxes starting from the left hand corner correspond to the
variances ( σ i2 ), while the other boxes correspond to co-variance terms σi, j. Again as
before, the variance and co-variance terms are multiplied by the weights or
proportions associated with the corresponding assets depicted in the rows and
columns.
Again, the variance of the portfolio with n assets ( σ 2p ) is the sum of the

I
expressions in the smaller boxes above. The expression resulting from the
procedure is as follows:
FA
σ 2p = W12 σ 12 + W22 σ 22 + . . . + Wn2 σ 2n + 2W1 W2σ1,2 + 2W1 W3σ1,3 + . . . +
2Wn -1 Wnσn - 1, n
or
n n
σ 2p = ∑ ∑ Wi W j σ i , j Eq..(13)
i =1 j = 1

[Note that σi,i = σ i2 ].

Illustration 11
IC
Given the following export data for stocks X, Y & Z, calculate all the unique
co-variances and correlation coefficients.
Annual returns (%)
Year X Y Z
1 6.2 –9.5 26.5
2 3.6 –11.7 –12.3
3 4.0 13.8 2.6
4 2.4 –5.3 10.5
5 0.2 9.5 9.2
Stock X
Year Return (Xi) % 2
(X − X)
i (X − X)
i

1 6.2 2.92 8.5264

2 3.6 0.32 0.1024
3 4.0 0.72 0.5184
4 2.4 –0.88 0.7744
5 0.2 –3.08 9.4864
16.4 0 19.408

35
Security Analysis

n
∑ Xi
i =1 16.4
X = = = 3.28%
n 5
n 2
∑ Xi − X ( ) 19.408 19.408
σ 2x
i =1
= = = = 4.852
n −1 5 −1 4

σx = σ 2x = 4.852 = 2.20%

Stock Y
Year Return (Yi) (%) 2
(Y − Y)
i (Y − Y )
i

1 –9.5 –8.86 78.4996

2 –11.7 –11.06 122.3236
3 13.8 14.44 208.5136
4 –5.3 –4.66 21.7156
5 9.5 10.14 102.8196

I
–3.2 0 533.8720

Y
FA =
n
∑ Yi
i =1
=
−3.2
= – 0.64%
n 5
n 2
∑ Yi − Y ( )
i =1 533.872 533.872
σ 2Y = = = = 133.468
n −1 5 −1 4

σY = σ 2Y = 133.468 = 11.55%
IC
Stock Z
Year Return (Zi) (%) 2
( Z − Z)
i (Z i −Z )
1 26.5 19.2 368.64
2 –2.3 –19.6 384.16
3 2.6 –4.7 22.09
4 10.5 3.2 10.24
5 9.2 1.9 3.61
36.5 0 788.74
n
∑ Zi
i =1 36.5
Z = = = 7.3%
n 5
n 2
∑ Zi − Z ( )
i =1 788.74 788.74
σ 2z = = = = 197.185
n −1 5 −1 4

σz = σ 2z = 197.18 5 = 14.04%

36
 Risk and Return

Since, there are 3 stocks, the number of unique co-variances are 3 i.e.
n2 −n 32 − 3 9−3 6
= = = = 3, namely Covxy, Covxz and Covyz.
2 2 2 2
n
∑ Xi − X
( ) (Y − Y)
i
i =1
CovXY =
n −1
n
∑ Xi − X
( ) ( Z − Z)
i
i =1
CovXZ =
n −1
n
∑ Yi − Y
( ) ( Z − Z)
i
i =1
CovYZ =
n −1
Stocks X & Y
Year
(X − X) i (Y − Y)
i (X − X) (Y − Y)
i i

1 2.92 –8.86 –5.8712

I
2 0.32 –11.06 –3.5392
3 0.72 14.44 10.3968
FA 4 –0.88 –4.66 4.1008
5 –3.08 10.14 –31.2312
0 0 –46.144
Co-variance
n
∑ X −X( ) ( Yi − Y )
i =1
i
∴ Covxy =
n −1
IC
−46.144
= = –11.536
4
Coefficient of correlation:
Cov xy −11.536 −11.536
ρxy = = = = – 0.454
σxσy 2.20 x11.55 25.41
Stocks X & Z
Year
( X − X ) ( Z − Z)
i i ( X − X ) ( Z − Z)
i i

1 2.92 19.2 56.064

2 0.32 –19.6 –6.272
3 0.72 –4.7 –3.384
4 –0.88 3.2 –2.816
5 –3.08 1.9 –5.852
0 0 37.740
Co-variance:
n
∑ Xi − X
( ) ( Z − Z) i
i =1 37.74
Covxz = = = 9.435
n −1 4

37
Security Analysis

Coefficient of correlation:
Cov xz 9.435 9.435
ρxz = = = = 0.30
σxσz 2.2 x 14.04 30.888
Stocks Y & Z
Year
( Y − Y ) ( Z − Z) ( Y − Y ) ( Z − Z)
i i i i

1 –8.86 19.2 –170.112

2 –11.06 –19.6 216.776
3 14.44 –4.7 –67.868
4 –4.66 3.2 –14.912
5 10.14 1.9 19.266
0 0 –16.850
Co-variance:
n
∑ Yi − Y
( ) ( Z − Z)
i
i =1 −16.850
Covyz = = = –4.2125
n −1 4
Coefficient of correlation:

I
Cov yz
ρyz =

ρyz =
FA σyσz

−4.2125
=
−4.2125
= –0.026
2.2 x14.04 162.162
The above computations can be summarized as follows:
X Y Z
Mean Return (%) 3.28 –0.64 7.3
Variance ( σ i2 ) 4.852 133.468 197.185
Standard deviation (σi) % 2.20 11.55 14.040
IC
Co-variance (Covij)
X –11.536 9.435
Y –4.2125
Coefficient of correlation (ρij)
X 1.000 –0.454 0.30
Y – 1.000 –0.025
Z – – 1.000
Now we can construct any types of portfolios, involving these three stocks, and we
can easily compute the average rate of return, the variance and the standard
deviation for each of these portfolios.
Suppose the following four portfolios are opted
i. Stocks X & Y in equal proportions
ii. Stocks X & Z in equal proportions
iii. Stocks Y & Z in equal proportions
iv. Stocks X, Y & Z in equal proportions.
The average returns, variance and standard deviation for these portfolios can be
computed as follows:
i. Portfolio consisting of stocks X & Y in equal proportion:
rxy = X Wx + Y Wy

38
 Risk and Return

1 1
= 3.28 x + (–)0.64 x
2 2
= 1.64 – 0.32 = 1.32%
n
σ 2xy = ∑ σ i2 Wi2 + 2ΣCovijWiWj
i =1

= σ 2x Wx2 + σ 2y Wx2 + 2CovxyWxWy

2 2
1 1 1 1
= (2.20)2   + (11.55)2   + (2) (–11.536)   x  
2 2 2 2
1 1 1
= 4.84 x + 133.4025 x – 23.072 x
4 4 4
115.1705
= = 28.80
4

σxy = σ 2xy = 28.80 = 5.37%.

ii. Portfolio consisting of stocks X & Z in equal proportion:

rxz = X Wx + Z Wz

I
1 1
= 3.28 x + 7.3 x
2 2
FA = 1.64 + 3.65 = 5.29%
n
σ 2xz = ∑ σ i2 Wi2 + 2ΣCovijWiWj
i =1

= σ 2x Wx2 + σ 2z Wz2 + 2CovxzWxWz

2 2
1 1 1 1
= (2.20)2   + (14.04)2   + 2 x 9.435 x    
2
  2 2 2
1 1 1
IC
= 4.84 x + 197.1216 x + 18.87 x
4 4 4
220.8316
= = 55.20
4

σxz = σ 2xz = 55.20 = 7.43%

iii. Portfolios consisting of stocks Y and Z in equal proportion:
ryz = Y Wy + Z Wz
1 1
= – 0.64 x + 7.3 x
2 2
= – 0.32 + 3.65 = 3.33%
n
σ 2yz = ∑ σ i2 Wi2 + 2ΣCovijWj
i =1

= σ 2y Wy2 + σ 2z Wz2 + 2CovyzWyWz

2 2
1 1 1 1
= (11.55)2   + (14.04)2   + 2 x – 4.2125 x   x 
2
  2 2 2
1 1 1
= 133.4025 x + 197.1216 x – 8.425 x
4 4 4

39
Security Analysis

322.0991
= = 80.52
4
σyz = σ 2yz = 80.52 = 8.97%.
iv. Portfolio consisting of stocks X, Y & Z in equal proportion:
rxyz = X Wx + Y Wy + Z Wz
1 1 1
= 3.28 x – 0.64 x + 7.3 x
3 3 3
9.94
= = 3.313%
3
n
σ 2xyz = ∑ σ i2 Wi2 + 2ΣCovijWiWj
i =1

= σ 2x Wx2 + σ 2y Wy2 + σ 2z Wz2 + 2 [CovxyWxWy + CovxzWxWz +

CovyzWyWz]
2 2 2
1 1 1 1
= (2.20)2   + (11.55)2   + (14.04)2   + 2 [–11.536 x
 3  3  3 3
1 1 1 1 1

I
x + 9.435 x x – 4.2125 x x ]
3 3 3 3 3
FA = 4.84 x
1
9
+ 133.4025 x
1
9
+ 197.1216 x
1
9
+ 2 [–11.536 x
1
9
1 1
+ 9.435 x – 4.2125 x ]
9 9
4.84 133.4025 197.1216 12.627
= + + –
9 9 9 9
322.7371
= = 35.86
9
IC

σxyz = σ 2xyz = 35.86 = 5.99%

The details about the individual stocks and the above mentioned portfolios can be
tabulated as:
Stock X Stock Y Stock Z Portfolio of Portfolio of Portfolio of Portfolio of
X&Y X&Z Y&Z X, Y & Z
Mean r (%) 3.28 –0.64 7.3 1.32 5.29 3.33 3.313
i

Variance σ2 4.852 133.468 197.185 28.80 55.20 80.52 35.86

Standard deviation (%)σ 2.20 11.55 14.04 5.37 7.43 8.97 5.99

MEASUREMENT OF RISK IN PORTFOLIO CONTEXT

While we discussed the variance of a portfolio of securities as a measure of risk,
according to portfolio theory, the total risk (variance) is not the relevant risk in the
portfolio context. Also, it is useful to understand that the riskiness of a security
when held in isolation is not the same as the riskiness of a portfolio of securities,
when that security is included in the portfolio. For such purposes, it may be useful
to regard risk or variability in the profits of a firm as being caused by factors
specific to an industry as well as those specific to a firm in that industry.
Business and Firm Specific Risks
A little reflection reveals that some of the risk factors may affect the performance
of an industry as a whole, while some others affect only a specific firm. For
example, the unpredictability of monsoons affecting the profitability of

40
 Risk and Return

agro-industry in general may be regarded as contributing to the business risk of

agro-industry, whereas, sourcing of raw materials (e.g. imported or indigenous) in
a specific company affecting its profitability, contributes to its firm specific risk.
In general, however, business risk of an industry or a company is not something
which changes often. However, major technological changes may change the
riskiness of an industry over a period of time. A company’s riskiness may change
when it is merging or taking over a new company or investing heavily in a very
different line of business altogether.
Business and firm specific risk factors affecting a security may also be understood
in terms of unsystematic and systematic risks of diversifiable and non-diversifiable
risks. Unsystematic risk is the extent of variability in the security’s return on
account of the firm specific risk factors. This is diversifiable or avoidable because
it is possible to eliminate or diversify away this component of risk to a
considerable extent by investing in a large portfolio of securities, say, 15 or more.
This is because, the firm specific risk factors are mostly random. For example, if
the management of one company in the portfolio is poor, the management of
another company in the portfolio may be very good; at a given point of time if the
productivity in one company is low, that of another may be high and so on, so that
by including sufficient number of securities in a portfolio, such factors tend to
cancel out the effect of each other.
However, the systematic or non-diversifiable risk factors cannot be diversified.

I
This is because these factors affect the entire market in a certain direction. For
example, a steep increase in the international crude oil prices is almost certain to
FA
affect the entire market adversely. Hence no amount of diversification can make a
portfolio free from such risk.
The Non-diversifiable Risk of a Portfolio
In order to understand why a certain amount of risk is always present in a portfolio
or the nature of the risk that cannot be diversified away at all, let us consider a case
of n securities, the proportion of investment in each security being 1/n. The
variance of the portfolio return will be given by Eq (11). Since there are n diagonal
boxes in the n x n box shown earlier, there will be n variance boxes and n2 – n
co-variance boxes. Since the proportion of investment in each security is 1/n, the
IC
weight factor in each box will be 1/n2. Thus the portfolio variance, σ 2p , will be
given by:
σ 2p = n / n2 (Average Variance) + (n2 – n) / n2 (Average Co-variance)
= 1/n (Average Variance) + (1–1/n) (Average Co-variance)
When n → ∞, 1/n →0, and we have
σ 2p = Average Co-variance

Thus the residual risk in a well diversified portfolio equals the average co-variance
of the securities in the portfolio, representing the market risk. This is the amount of
risk that cannot be diversified away no matter how much the diversification of the
portfolio.
So then, how large should be the diversification for us to be able to diversify away
all the diversifiable risk?
In general, as the number of securities in a portfolio increases, say up to 20 or 25,
the diversification reduces the portfolio risk (σ2) rapidly. However, soon
thereafter, the marginal reduction to portfolio risk of any further diversification
becomes very small (see figure1). Thus, diversified portfolio of about 25 securities
selected from different industries more or less represents a market portfolio.
Consider for example, the BSE Sensex index which comprises a mere 30
securities, but is deemed to represent the entire market. Again, it is for this reason

41
Security Analysis

that both the Sensex Index with its 30 securities and the BSE National Index
comprising 100 securities are actually very highly correlated. Clearly, increasing
the number of securities from 30 to 100 does not necessarily improve the
diversification substantially.
Figure 1: Reducing Risk by Diversification

Risk Decomposition
We have already seen that the total risk of a security is measured in terms of the
variance (σ2 ) [or standard deviation (σ)] of its returns. We have also seen that the

I
risk comprises both systematic and unsystematic components. How do we split the
total risk, namely, the variance, into the systematic and unsystematic risk
FA
components. This is relatively simple.
Total Risk of a Security i = σ i2
Systematic Risk of a Security i = β i2 σ 2m
where, βi is the beta of security i and σ 2m is the variance of the market portfolio.
But, βi = σi,m/ σ 2m Eq.. (14)
Substituting for β i in Eq. (14), we have
Systematic Risk of Security i = σ i,2 m / σ 2m
IC

ρ i2m .σ i2 . σ 2m
= = ρ i2m σ i2
σ 2m
σ i, m
since ρi m =
σiσm
where ρi m is the correlation coefficient between the security return and the market
return.
Therefore, Unsystematic Risk of a Security i
= σ i2 – β i2 σ 2m Eq.. (15)
= σ i2 (1 – ρ i2m ) Eq.. (16)
In terms of percentage of total risk (security variance):
Systematic Risk = ( ρ i2m σ i2 / σ i2 ) x 100

= 100 ρ i2m Eq.. (17)

Unsystematic Risk = ( σ i2 (1 – ρ i2m )/ σ i2 ) x 100

= 100 (1 – ρ i2m ). Eq.. (18)

42
 Risk and Return

BETA (β )
We have discussed the distinction between diversifiable risk and non-diversifiable
risk at such length because from the point of view of an investor whose portfolio is
well diversified, the diversifiable risk is of no importance as it gets eliminated.
What is important to such an investor is the non-diversifiable risk arising from
market wide movements of security prices. This is one of the most important
conclusions of the Modern Portfolio Theory (MPT)2.
The MPT, therefore, defines the riskiness of a security as its vulnerability to
market risk. This vulnerability is measured by the sensitivity of the return of the
security vis-a-vis the market return and is denoted by the Greek letter Beta β. A β
of 2 implies that if the market return increases or decreases by 10% over a period,
the security return increases or decreases respectively by 20%. Thus in this case
the security return moves twice as much as the market return. A β of 0.5 on the
other hand implies that the security return moves only half as much as the market
does. The market portfolio which refers to the portfolio consisting of all securities
in the stock exchange has a β of 1, since such a portfolio behaves like the market
index and moves in line with it. A β of zero characterizes a risk-free security like a
government bond whose return is almost insensitive to the market return.
Thus β measures the only kind of risk (the non-diversifiable risk) which matters;
the higher the riskiness of a security, the higher the value of its β. A security with a

I
β value greater than 1 is referred to as an aggressive security and one with a β
value less than one is referred to as a defensive security.
FA
The β of a portfolio is nothing but the weighted average of the β‘s of the securities
that constitute the portfolio, the weights being the proportions of investments in
the respective securities. For example, if the β of security X is 1.5 and that of
security Y is 0.9 and we hold a proportion of 70% and 30% of the two securities
respectively, the β of the portfolio will be 1.32 (1.5 x 0.7 + 0.9 x 0.3).
Estimating β Values
We have already seen that β is the sensitivity of the security returns to the market
returns. The statistical method of estimating this kind of dependence of one
variable on another is known as simple linear regression. Typically, the regression
specification takes the following general form:
IC

Y = a + bX + e
where, y and x are dependent and independent variables respectively and e is the
error term.
Accordingly, β is estimated from the following regression specification:
r i = α + β rm + e Eq.. (19)
where, ri is the dependent variable representing the return on the security, rm is the
independent variable representing the return on the market portfolio and ‘e’ is the
error term.
If we have access to a computer or to a good statistical calculator, we do not need
to know the details of this statistical technique at all. The machine does the hard
work and gives us the results. In the case of personal in standard spreadsheet and
other software packages.
The security return on any day is defined as:
Today's Price − Yeserday's Price
Today’s Return =
Yesterday's Price
If the market was closed ‘yesterday’, we must use the price of the previous trading
day instead of ‘yesterday’s price’. Instead of the daily returns defined above, we

2 The first reference to is perhaps owing to the early works of William Sharpe. See, W Sharpe, “A Simplified
Model for Portfolio Analysis”, Management Science. Vol. 9 (January 1963), pp 277-293.

43
 Security Analysis

can compute weekly returns using this week’s and last week’s price instead of
today’s and yesterday’s price in the above formula. Similarly, we can compute
monthly returns also. The market return on any day is similarly defined as:
Today' s Index − Yeserday' s Index
Today’s Market Return =
Yesterday' s Index
Again, weekly and monthly index returns, etc. can be consistently defined.
Once we have computed the security and market returns for a sufficiently long
period to get a large number (50 or more) of pairs of returns, we can use the linear
regression technique to estimate the β.
There are a few things about β estimation that we must be careful about:
1. Daily, weekly or monthly returns: We prefer daily returns because it gives us
more number of returns and therefore improves the accuracy of the β
estimate. In some cases, however, we may use weekly or monthly returns
because these may be easier to collect.
2. Period of analysis: In general, using a longer period gives us more data to
estimate the β correctly. But if we believe that β has changed in the recent
past because of any changes in the riskiness of the company, we may wish to
use a shorter period. We have found that using daily returns for 18-24 months
is usually a good compromise between these conflicting requirements.

I
3. Exceptional price movements: Occasionally, we find that on some specific
days, the share price has recorded an exceptional rise or fall of a kind which
FA we do not expect to recur in future. We may sometimes find it advantageous
to eliminate the returns of these days before estimating the β.
Some of the factors discussed above do, at times, require some degree of judgment
and statistical analysis. For this reason, in many developed countries, there are
specialized agencies which perform all this analysis and publish their β estimates
for various stocks at regular intervals.
Illustration 12
Let us consider the daily prices of the company X and the daily Bombay Sensitive
Index for the period January 2001 – July 2002 (BSE data), based on the trading
IC
days. Columns 2 of Table 4 give the share prices (adjusted for dividend, bonus,
etc.) and share price indices respectively for January 2001 and June – July 2002.
The intermediate values have been omitted, since the objective of this example is
only to illustrate the computation of β and the use of CAPM. Compute the β of
ITC for the above period.
Table 4: ITC Price & BSE Sensex Data
Returns
Date Company X Price BSE National Index
Company X Index
(1) (2) (3) (4) (5)
2001
January 1 343.00 3260.56 – –
2 339.25 3225.24 –0.011% –0.011%
3 336.25 3264.00 –0.008% 0.012%
6 326.00 3252.31 –0.030% –0.004%
7 323.00 3264.21 –0.009% 0.004%
8 323.00 3288.88 0 0.007%
9 330.00 3362.39 0.022% 0.022%
10 345.75 3418.32 0.048% 0.016%
13 363.00 3453.16 0.049% 0.010%
14 381.00 3492.26 0.049% 0.011%
15 416.25 3646.73 0.093% 0.044%

44
 Risk and Return

Returns
Date Company X Price BSE National Index
Company X Index
16 399.75 3455.88 –0.039% –0.052%
17 395.00 3422.35 –0.012% –0.009%
20 396.75 3389.49 0.004% –0.009%
21 395.50 3382.74 –0.003% –0.002%
22 400.50 3427.09 0.013% 0.013%
24 385.75 3435.62 –0.037% 0.002%
27 402.00 3562.74 0.042% 0.037%
28 403.00 3604.20 0.002% 0.012%
June 9 647.00 3468.07 0.610% –0.038%
10 610.75 3311.41 –0.056% –0.045%
11 623.75 3335.76 0.021% 0.007%
12 647.75 3347.41 0.038% 0.003%
15 603.50 3152.96 –0.068% –0.058%
16 617.00 3161.08 0.022% 0.003%
17 678.50 3400.95 0.099% 0.076%
18 659.00 3292.33 –0.028% –0.032%
19 612.25 3143.10 –0.070% –0.045%
22 630.75 3078.51 0.030% –0.021%

I
23 628.00 3037.34 –0.004% –0.013%
24 644.50 3143.64 0.026% 0.035%
FA 25
26
646.50
640.75
3208.54
3168.82
0.003%
–0.009%
0.021%
–0.012%
29 659.75 3289.56 0.029% 0.038%
30 652.00 3250.69 –0.012% –0.012%
2002
1 July 632.75 3230.60 –0.029% –0.006%
2 634.50 3180.73 0.003% –0.015%
3 619.00 3089.02 –0.024% –0.029%
6 650.50 3178.31 0.051% 0.029%
IC
7 653.25 3195.94 0.004% 0.006%
8 673.00 3245.88 0.030% 0.015%
9 693.00 3331.98 0.030% 0.026%
10 703.50 3401.74 0.015% 0.021%
13 675.00 3322.17 –0.040% –0.023%
14 693.00 3371.50 0.027% 0.015%
Solution
First step is to compute the security and market returns. This is done in Columns 3 and 5 of the
Table 4. We then used a spreadsheet program on a PC to calculate the β. The output from the
computer was as follows:
Regression Output
Constant 0.001995
Std. Error of Y Est 0.019766
R Squared 0.999347
No. of Observations 383
Degrees of Freedom 381
X Coefficient(s) 1.192726
Std. Error of Coefficient 0.073587

45
Security Analysis

The β is nothing but the “X Coefficient” in the above output. The β of Company X
for the period is therefore 1.193.
We may also compute the expected return from Company X share based on the
above example. During the period January 2001 – July 2002, the market return
was about 45% per annum, and the value of β was 1.193.
It is useful to note that mathematically, the β coefficient in specification 19
expressed earlier is given by the following expression:
β = Cov(ri, rm)/ σ 2m ......... Eq.(20)
Instead of running a regression in order to estimate, it can be directly computed by
first computing the co-variance between the security return and the market return
and then dividing this co-variance by the variance of the market return.
Further, this relationship between ri and rm is a simple linear function and be
graphed as follows:
Figure 2: A Hypothetical Regression (Characteristic) Line

I
FA
The straight line represents the line of best fit between the actual observation of
security returns and market returns.
one independent (rmt),
and variable
IC
Since it is
linear model
with one dependent variable (rit)
Simple linear regression is the empirical methodology used when dealing with the
market model.
Thus, there are clear interpretations of the variables in the equation (rit = ai + βi rmt + eit).
The intercept term ‘ai’ can be interpreted as simply the average return on the ith
security when the market index return is zero.
In regression analysis, the ‘eit’ term is a random error term which will have a mean
value of zero and is assumed to be unwarranted with the market returns, the error
terms of other securities, and the error terms of the same security over time.
More formally the key assumptions in regression analysis regarding the error terms are
Cov(eirm) = 0
Cov(eiej) = 0
Cov(eiet) = 0
In addition, by construction, the regression model forces E(ei) = 0
The most interesting parameter is the Beta coefficient βi.
Beta is the slope of the regression (sometimes referred to as the characteristic line)
and is calculated as

46
 Risk and Return

 
 β i = Cov im 
 σ m 
2

That is, beta measures the co-variance of ri with rm divided by the variance of rm.
Beta is frequently referred to as the measure of a security’s systematic risk or
market risk, since it indicates the manner in which a security’s returns changes
systematically with changes in the market’s returns.
For example, if the market’s return increased by 20% then for a stock with a beta of 1.5
we would expect the security’s return to increase by 30% (i.e. 20% x 1.5 = 30%).
Let us consider an example in which a stock has the following regression line
rit = ai + βi rmt + eit
rit = 3% + 1.5rmt + eit
Since on average, the error term eit equals zero, we will ignore it here. If the
market index return is 8%, the return for the stock would be 15% calculated as
rit = 3% + 1.5 (8%) + 0
rit = 3% + 12% = 15%
If the market return increases by 10% (i.e. from 8% to 18%) the stocks return
would increase by 15% to 30% (10 x 1.5 = 15%)
rit = 3% + 1.5 (18%) + 0

I
rit = 3% + 27% = 30%
When market return increased from 8% to 18% = (10% increase)
∴
FA The security’s return increased from 15% to 30% = (15% increase).
Thus, the returns for a stock with beta 1.5 are said to be one and a half times as
volatile as the returns for the market index.
To see that beta is a measure of relative market risk, note from equations
n
Covij = ∑ [ris − E(ri )][rjs − E(rj )]πs
s =1

or
n
( )(
∑ rij − r i r js − r j )
IC
i =1
Covij =
n −1
that the co-variance of a variable with itself is the variable’s variance.
That is Cov(ii) = σ i2
 Cov im 
∴ As per equation  β i =  the beta for market index has to be 1.00
 σ 2m 
 
Cov mm σ 2m
i.e. β i = = = 1.00
σ 2m σ 2m
By using the market index’s beta of 1.00 as a benchmark, one can classify the
systematic risk of securities into two groups.
Any stock which has a beta greater than 1.0 (β i > 1.00) has above average
market-related, systematic risk.
A stock with a beta of less than 1.00 (βI < 1.00) has below-average market-related,
systematic risk.
Thus, beta provides a convenient measure of relative market risk.
β > 1 = above-average systematic risk
β < 1 = below-average systematic risk

47
 Security Analysis

Estimating Betas
Since betas are a measure of market-related risk, investors should be interested in
the betas for individual securities and portfolios.
It can be shown that the beta for a portfolio is a weighted average of the betas of
the individual securities in the portfolio from the following example,
 n 
that is, β = ∑ β i Wi 
 i = 1 
There are at least three methods of estimating betas:
1. Estimating historical betas based strictly on ex-post return data.
2. Estimating ex-ante betas based upon explicit probability distribution.
3. Estimating ex-ante betas by adjusting historical betas, depending upon a
variety of factors which may cause the security’s beta to change in the future.
1. Historical Betas
Historical betas are calculated using ex-post data and the equations
n
∑ (rit − r i ) (rmt − r m )
t =1  COVim 
Covim = and β i = 
n −1  σ 2n 

I
To illustrate the procedure, the hypothetical ex-post returns for 3 stocks are
listed, along with a hypothetical return series for a market index.
Illustration 13
FA Time period 1(%) 2(%) 3(%) Market index %
1 10 11 –6 11
2 8 4 18 7
3 –4 –3 4 –2
4 22 –2 –5 8
5 8 14 32 9
6 –11 –9 –7 –5
7 14 15 24 12
IC
8 12 13 –17 11
9 –9 –3 2 3
10 12 4 27 10
Stock (1) and Market Index
Year Returns (rit − r i ) (rit − r i ) 2 Return (rmt − r m ) (rmt − r m ) 2 (rit − r i )
from from
stock market (rmt − r m )
(1) index
1 10 3.8 14.44 11 4.6 21.16 17.48
2 8 1.8 3.24 7 0.6 0.36 1.08
3 –4 –10.2 104.04 –2 –8.4 70.56 85.68
4 22 15.8 249.64 8 –1.6 2.56 25.28
5 8 1.8 3.24 9 2.6 6.76 4.68
6 –11 –17.2 295.84 –5 –11.4 129.96 196.08
7 14 7.8 60.84 12 5.6 31.36 43.68
8 12 5.8 33.64 11 4.6 21.16 26.68
9 –9 –15.2 231.04 3 –3.4 11.56 51.68
10 12 5.8 33.64 10 3.6 12.96 20.88
62 0 1029.60 64 0 308.40 473.20

48
 Risk and Return

n
∑ ri
i =1 62
ri = = = 6.2%
n 10
n
∑ rm
i =1 64
rm = = = 6.4%
n 10
n
∑ (rit − r i ) 2
t =1 1029.60
σ i2 = = = 114.40
n -1 9

∴ σi = 114.40 = 10.69579357 ~ 10.70

i
∑ (rmt − r m ) 2
t =1 308.40
σ 2m = = = 34.27
n -1 9

∴ σm= 34.27 = 5.85%

n
∑ (rit − r i )(rmt − r m )

I
t =1
Covim =
n −1
FA =
473.20
= 52.5777778 ~ 52.58
9
Cov im 52.58 52.58
ρim = = =
σiσm 10.70 x 5.85 62.595
= 0.840003195 ~ 0.84
Covim 52.58
βim = = = 1.534286548 ~ 1.53
σ 2m 34.27
IC
Stock (2) and Market Index
Year Returns (r2i − r 2 ) 2 (rmi − r m ) (rmi − r m ) 2
(r2i − r 2 ) (r2i − r 2 )
from
stock (rmi − r m )
(2) (%)
1 11 6.6 43.56 4.6 21.16 30.36
2 4 –0.4 0.16 0.6 0.36 –0.24
3 –3 –7.4 54.76 –8.4 70.56 62.16
4 –2 –6.4 40.96 1.6 2.56 –10.24
5 14 9.6 92.16 2.6 6.76 24.96
6 –9 –13.4 179.56 –11.4 129.96 152.76
7 15 10.6 112.36 5.6 31.36 59.36
8 13 8.6 73.96 4.6 21.16 39.56
9 –3 –7.4 54.76 –3.4 11.56 25.16
10 4 –0.4 0.16 3.6 12.96 –1.44
44 0 652.40 0 308.40 382.40
n
∑ r2i
i =1 44
r2 = = = 4.4%
n 10

49
Security Analysis

n
∑ (r2i − r 2 )2
i =1 652.40
σ 22 = = =
n −1 9

= 72.488889 ~ 72.49

∴σ = 72.49 = 8.514040691 = 8.51%

i
∑ (rmt − r m )2
t =1 308.40
σ 2m = = = 34.27
n −1 9

σm = 34.27 = 5.85%
n
∑ (r2i − r 2 ) (rmt − r m )
t =1 382.40
Cov2m = =
n −1 9

= 42.4888889 ~ 42.49
Cov 2m 42.49 42.49
= = =

I
ρ2m
σ 2σ m 8.51 x 5.85 49.7835
FA = 0.853495636 ~ 0.85
Cov 2m 42.49
β 2m = = = 1.239859936 ~ 1.24
σ 2m 34.27

Stock (3) and Market Index

Year r3 (r3 − r 3 ) (r3 − r 3 ) 2 (rm − r m ) (rm − r m ) 2 (r3i − r 3 )
(rm − r m )
1 –6 –13.2 174.24 4.6 21.16 –60.72
IC
2 18 10.8 116.64 0.6 0.36 6.48
3 4 –3.2 10.24 –8.4 70.56 +26.88
4 –5 –12.2 148.84 1.6 2.56 –19.52
5 32 24.8 615.04 2.6 6.76 64.48
6 –7 –14.2 201.64 –11.4 129.96 161.88
7 24 16.8 282.24 5.6 31.36 94.08
8 –17 –24.2 585.64 4.6 21.16 –111.32
9 2 –5.2 27.04 –3.4 11.56 17.68
10 27 19.8 392.04 3.6 12.96 71.28
72 0 2553.60 0 308.40 251.20
n
∑ r3t
t =1 72
r3 = = = 7.2%
n 10
n
∑ (r − r3) 2
t = 1 3t 2553.60
σ 32 = = = 283.733333 ~ 283.73
n −1 9

σ3 = 283.73 = 16.84438581 ~ 16.84%

50
 Risk and Return

i
∑ (rmt − r m )2
t =1 308.40
σ 2m = = = 34.27
n −1 9

σm = 34.27 = 5.85%
n
∑ (r − r 3 )(rmt − r m )
t = 1 3t 251.20
Cov3m = = = 27.91
n −1 9
Cov 3m 27.91 27.91
ρ3m = = =
σ 3σ m 16.84 x 5.85 98.514
= 0.283309986 ~ 0.28
Cov 3m 27.91
β 3m = = = 0.81441494 ~ 0.81
σ 2m 34.27
The above computations can be summarized in the following table:
Stock (1) Stock (2) Stock (3) Market Index
ri 6.2% 4.4% 7.2% 6.4%

I
σ i2 114.40 72.49 283.73 34.27

10.70% 8.51% 16.84% 5.85%

FA
σi
Covim 52.58 42.49 27.91 34.27
ρim 0.84 0.85 0.28 1.00
β im 1.53 1.24 0.81 1.00
Covim
We know ρim = ∴ Covim = ρim σi σm
σi σ m
Cov im
and we know β im =
σ 2m
IC

∴ Substituting the value of Covim in the above equation,

ρ im σ i σ m σi
β im = = ρim
σ 2m σm

σi
∴ βim = ρ im . This is another method of calculating the value of Beta.
σ 2m
10.70
∴ βlm = 0.84 x = 0.84 x 1.829059829
5.85
= 1.536410256 ~ 1.53
8.51
β 2m = 0.85 x = 0.85 x 1.454700855
5.85
= 1.236495726 ~ 1.24
16.84
β 3m = 0.28 x = 0.28 x 2.878632479
5.85
= 0.806017094 ~ 0.81
5.85
β 4m =1x =1x1=1
5.85

51
 Security Analysis

Thus, beta is equal to the correlation coefficient for security (i) and the market
index, multiplied by the ratio of the standard deviation of the security return to the
standard deviation of the market index’s returns.
In other words, the security’s beta is function of the correlation of the security’s
returns with the market index returns (ρim) and the variability of the security’s
σ 
returns relative to the variability of the index returns  i 
 σm 
σi Cov im
∴ βim = ρ im =
σm σ 2m
Now notice that the beta for stock (3) is considerably smaller than the beta for
stock (1) (i.e. 0.81 vs 1.53).
Yet the standard deviation of stock (3) is substantially higher than the standard
deviation for stock (1) (16.84% vs 10.70%).
Why does stock (3) have less systematic risk than stock (1).
 σi 
Looking at the equation  βim = ρim  the answer becomes quite obvious. For
 σ m 

stock (1) ρim is 0.84 and for stock (3) ρ3m is only 0.28.

I
Thus, the returns of stock (3) are not nearly highly correlated with the market
index as are stock (1)’s returns – Because of this low correlation a large part of the
FA
variability of stock (3) returns can be eliminated by diversification. The remaining
systematic risk is relatively small, resulting in low Beta.
∴ Low correlation between security returns and market index returns results in
lower Beta (of course depending upon the variability of return of the security).
High correlation between security returns and market index returns results in high
Beta value (of course depending upon the variability of returns on the security).
2. Ex-Ante Betas
Ex-ante or expected betas can be estimated from explicit probability
distribution such as those presented below:
IC
Illustration 14
State of the Conditional return
world
πs r4s r5s r6s rms
1 0.20 –18 –13 –4 –9
2 0.25 +16 16 –2 8
3 0.30 +12 32 21 16
4 0.25 +40 12 20 20
1.00

σ i2 376.00 245.00 136.50 109.00

σi % 19.39 15.65 11.68 10.44

E(ri)% 14.00 14.00 10.00 10.00
Covim 182.00 129.00 104.00 109.00
ρim 0.90 0.79 0.85 1.00
βim 1.67 1.18 0.95 1.00

52
 Risk and Return

n
We know σ i2 = ∑ (ris − ri )2 πs
s =1

n
σi = ∑ (ris − ri ) 2 πs
s =1

n
Covim = ∑ (ris − ri ) (rms − r m )πs
s =1

Cov im
Correlation Coefficient = ρim =
σiσm
∴ Covim = ρim σi σm
Covim
βim =
σ 2m
ρim σi σ m σi
βim = = ρ im
σ 2m σm
Stock (4) and Market Index

I
Scenario πs r4s r4s πs. r4s − r 4 2 2
(r 4s −r4 ) (
πs x r4s − r 4 )
FA 1 0.20 –18 –3.60 –32 1024 204.80
2 0.25 16 4.00 2 4 1.00
3 0.30 12 3.60 –2 4 1.20
4 0.25 40 10.00 26 676 169.00
1.00 14.00 376.00
n
E(r4) = ∑ (r4s π s ) = 14%
IC
s =1

n 2
σ 24 = ∑ r4s − r 4( ) πs = 376
s =1

∴ σ4 = 376 = 19.39%

Scenario πs rm πs rm rm − r m 2 πs x
(r m − rm ) 2
(r m − rm )
1 0.20 –9 –1.80 –19 361 72.2
2 0.25 8 2.00 –2 4 1.0
3 0.30 16 4.80 6 36 10.8
4 0.25 20 5.00 10 100 25.0
1.00 10.00 109.0
n
E(rm) = ∑ (π s rm ) = 10%
s =1

n
σ 2m = ∑ rms − r m πs = 109
( )
s =1

∴ σm = 109 = 10.44030651 = 10.44%

53
Security Analysis

Scenario πs ( r4s − r s ) (r ms − r m ) πs( r4s − r 4 ) rms − r m

( )
1 0.20 –32 –19 121.60
2 0.25 +2 –2 –1.00
3 0.30 –2 6 –3.60
4 0.25 26 10 65.00
182.00
n
∴ Cov4m = ∑ (r4s − r 4 ) (rms − r m ) π s = 182
s =1

Cov 4m 182 182

ρ4m = = =
σ 4σm 19.36 x 10.44 202.4316
= 0.899069117 ~ 0.90
Cov 4m 182
β 4m = = = 1.669724771 ~ 1.67
σ 2m 109

Stock (5) and Market Index

Scenario r5s πs. r5s ( r 5 s − r s )2
πs
( r5s − r s ) πs. ( r5s -r 5 )2 (rms −rm ) (
πs( r5s - r 5 ) rms − r m )

I
1 0.20 –13 –2.6 –27 729 145.80 –19 102.60

3
0.25

0.30
FA
16

32
4.0

9.6
2

18 324
4 1.00

97.20
–2

6
–1.00

32.40

4 0.25 12 3.0 –2 4 1.00 10 –5.00

1.00 14.0 245.00 129.00

n
E(r5) = ∑ (r5s π s ) = 14%
s =1

n 2
σ 52 = ∑ r5s − r 5 .πs = 245
( )
s =1
IC

σ5 = 245 = 15.35247584 ~ 15.65

n
Cov5m = ∑ (r5s − r 5 ) (rms − r m ) πs = 129
s =1

Cov 5m 129 129

ρ5m = = =
σ5σ m 15.65 x 10.44 163.386
= 0.789541331 ~ 0.79
Cov 5m 129
β 5m = = = 1.183486239 ~ 1.18
σ 2m 109

Stock (6) and Market Index

Scenario πs r6s πs. nr6s
( r6s − r 6 ) ( r6s − r 6 )2 πs. ( r6s − r 6 )2 ( rms − r m )2 πs( r6s − r 6 ) (rms − rm )

1 0.20 –4 –0.80 –14 196 39.20 –19 53.20

2 0.25 –2 –0.50 –12 144 36.00 –2 6.00
3 0.30 21 6.30 11 121 36.30 6 19.80
4 0.25 20 5.00 10 100 25.00 10 25.00
1.00 10.00 136.50 104.00
n
E(r6) = ∑ (r6s π s ) = 10%
s =1

54
 Risk and Return

n 2
σ62 = ∑ r6s − r 6
( ) πs = 136.50
s =1

∴ σ6 = 136.50 = 11.68332145 ~ 11.68%

n
Cov6m = ∑ (r6s − r 6 ) (rms − r m ) πs = 104
s =1

Cov 6m 104 104

ρ6m = = =
σ6σm 11.68 x 10.44 121.9392

= 0.85288406 ~ 0.85
Cov 6m 104
β 6m = = = 0.95412844 ~ 0.95
σ 2m 109

Given the above information, the Beta for the stock can also be calculated as
σ4 19.39
β 4m = ρ 4m = 0.90 x = 0.90 x 1.85729693 = 1.671551724 ~ 1.67
σm 10.44

σ5 15.65
β 5m = ρ 5m = 0.79 x = 0.79 x 1.499042146

I
σm 10.44

= 1.184243295 ~ 1.18
FA β 6m = ρ 6m
σ6
= 0.85 x
11.68
= 0.85 x 1.118773946
σm 10.44

= 0.950957854 ~ 0.95
The above computations can be tabulated as follows:
Stock (4) Stock (5) Stock (6) Market
Expected return [E(ri)] % 14.00 14.00 10.00 10.00
IC
Variance ( σ i2 ) 376.00 245.00 136.50 109.00

Standard deviation (σi)% 19.39 15.65 11.68 10.44

Covim 182.00 129.00 104.00 109.00

SECURITY MARKET LINES AND ITS APPLICATION

One of the contributions of modern portfolio theory to the field of investments is
the concept of Security Market Line (SML).
The SML simply represents the average or normal, trade-off between risk and
return for a group of securities – where risk is measured typically, in terms of the
securities betas.
(The risk measures do not have to be limited to beta. For example, Kidder,
Peabody and Company constructs a SML using as its measure of risk what it terms
its Fundamental Risk Estimate (FRE)).
The FRE is a composite risk measure based on the securities betas and other more
traditional risk measures such as financial leverage.
The following figures illustrate both an ex-post and an ex-ante SML.

55
Security Analysis

Figure 3: An ex-post SML

Figure 4: An ex-ante SML

I
Normal return N( ri ) r0 + riβ im Required return R(ri) = rf + βim[E(rm) – rf]
FA
ro = intercept of ex-post SML rf = risk free interest rate
ri = slope at SML E(rm) – rf = slope of SML
αi = ri – N( ri ) α = E(ri) – R(rf)

= ri – (ro + riβ im) = E(ri) – [rf + βim[E(rm) – rf]

In the ex-post SML, average historical rates of return for securities are plotted
against their betas for a particular time period.
Typically, a straight line is fitted to the plots, by regression and this is called the
IC
SML.
Thus, the SML represents the “normal” or average, trade-off between return and
risk.
The SML can be written as

Normal return : N( ri ) = ro + riβim

ro = intercept of the SML

ri = slope of the SML
Those securities which plot above the ex-post SML generated above normal
returns for their risk (as measured by their beta) for the particular time period used
in constructing the SML.
Those securities which plot below the SML generated below normal rates of
returns for the systematic risk.
The amount by which a security’s return differed from the normal return for its
level of risk is simply the vertical distance of the security’s plot on the graph from
the SML.
This vertical distance is called the security’s abnormal return or its alpha.

56
 Risk and Return

Thus, alpha is calculated as

α i = ro − N(r i ) 
  ex-post alpha
ri = (ro + ro β im )
It is easy to see that securities with above normal returns have positive alpha and
securities with below normal returns have negative alphas.
Figure 5: Above Normal Expected Returns

Normal return : N( ri ) = ro + riβim

ro = intercept of the SML
ri = slope of the SML

I
α = ri – N( ri )
FA = ri – (ro + riβim)
α > 0 : above normal returns
α < 0 : below normal returns
Figure: 6(a)
IC

Figure: 6(b)

Students should note that the SML is not the same as the characteristic line for a
simple security.
[Security Market line ≠ Characteristic line]
For a characteristic line, the y-axis represents the returns for a particular security
and the x-axis represents the returns for the market index.
The slope of the characteristic line is the beta for the particular security involved.
The y-axis of the ex-post SML represents the average returns for a number of
different securities. (For the ex-ante SML the y-axis represents expected returns).
The x-axis for the SML represents the betas for different securities.

57
 Security Analysis

Thus, a unique characteristic line is needed for each individual security in order to
determine its beta.
Then the average (or expected) returns for each security are plotted against their
respective betas on a Single Market Line (SML).
To construct an ex-ante SML, analysts must estimate the expected returns and risk
of individual securities.
These returns and risk estimates can then be plotted and a regression line fitted to
the observations.
Figure 7: Above Normal Expected Returns

Required return
R(ri) = [E(rm) – rf] βim

I
rf = risk-free interest rate
E(rm) – rf = slope of the line SML
α
FA = E(ri) – R(ri)
= E(ri) – [rf + [E(rm) – rf] βim
Here we assumed that the assumptions of the CAPM are correct.
Therefore, the intercept of the SML is equal to the risk-free rate (rf) and the slope
is equal to E(rm) – rf.
We will use the term required return denoted by R(ri) to refer to the average, or
normal return implied by an ex-ante SML.
Required return R(ri) = ro + riβim
If the assumptions at the CAPM are correct, then
IC

R(ri) = rf + [E(rm) – rf] βim

Each security’s ex-ante alpha is calculated as the difference between the expected
return and the “required” return implied by the SML.
α = E(ri) – R(ri)
= E(ri) – [rf + [E(rm) – rf] β im
Illustration 15
E(r4) = 14% β4m = 1.67 E(rm) = 10%
E(r6) = 10% β6m = 0.95
Now suppose the CAPM assumptions are valid and
Rf = 3%
Then
R(ri) = rf + (E(rm) – rf) βim
R(r4) = 3 + (10 – 3) 1.67
= 3 + 7 x 1.67 = 3 + 11.69 = 14.69%
R(r6) = rf + (E(rm) – rf) βim
R(r6) = 3 + (10 – 3) 0.95
= 3 + 7 x 0.95 = 3 + 6.65 = 9.65%

58
 Risk and Return

α4 = E(ri) – R(ri) = 14 – 14.69 = –0.69%

α6 = E(ri) – R(ri) = 10 – 9.65 = 0.35%
Thus, based on the set of expectations and the SML of equation
R(ri) = 3% + (E(rm) – rf) βim
Stock (4) would be considered overpriced since it has a negative alpha, and
stock (6) would be considered underpriced because it has a positive alpha.
Figure 8

α4 = –0.69 ∴ Stock (4) is overpriced

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α6 = 0.35 ∴ Stock (6) is underpriced
FA
Stock (4) plots below the SML.
Stock (6) plots above the SML.
Applications of Security Market Lines
There are a number of applications of ex-post SML.
Among these are
1. Evaluating the performance of portfolio manager.
2. Tests of asset-pricing theories, such as the CAPM.
3. Tests of market efficiency.
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Some of the applications of ex-ante SMLs are
1. Identifying undervalued securities.
2. Determining the consensus, ‘price of risk’ implicit in current market prices.
Applications of Ex-post SMLs
The performance of portfolio managers is frequently evaluated based on security
market line-criteria. Large positive alphas indicate above normal performance and
negative alphas indicate below normal performance.
Unfortunately, the measurement of performance is not quite as simple as it might
first appear.
Find the relative performance of a portfolio manager, as measured by alpha, can
vary depending upon which index is used to determine the beta of the portfolio.
Perhaps more importantly, one would prefer a measure of performance which is
predictive in nature. That is, if a portfolio manager performed well in the past he
will also perform well in the future. Unfortunately, no such consistency among
portfolio managers has been demonstrated.
Many researchers have attempted to test the validity of the CAPM by constructing
ex-post SML’s.
However, these studies are particularly vulnerable since the CAPM specifies that
betas are to be measured against the returns for the market portfolio – the value of
weighted portfolio of all risky assets.

59
 Security Analysis

Since the true “market portfolio” is not observable proxies have to be used in its
place and these proxies may give results which are different from those that would
be obtained if one was able to use the market portfolio.
Another area of inquiry utilizing ex-post SMLs involves the testing of market
efficiency.
Broadly speaking efficient markets imply the absence of abnormal returns.
That is, all securities are correctly priced and provide a normal return for their
level of risk. Tests of this nature require a model to specify what constitutes a
normal return.
Tests of market efficiency which utilize the market model assume that a normal
return plots on the SML and that abnormal returns are measured by alpha.
A number of tests of market efficiency have utilized this general technique.
Applications of Ex-ante SMLs
The most obvious use of ex-ante SMLs is for identifying under and over-valued
securities.
Unlike some of the ad hoc methods of identifying mispriced securities which have
traditionally been used in the securities industry, the use of a security market line
allows one to quantify how much a security is over or underpriced. The general
procedure is for security analysts to estimate the expected return for individual
securities over some future holding period – for example the next 5 years.

I
The analysts also estimate the risk associated with each security. The risk measure
may be the security’s ex-ante, beta, or it may be a more traditional measure of risk.
FA
In order for the SML concept to be valid, two conditions must be met:
1. Security returns must be a function of a single factor
2. The functional relationship must be linear.
One of the strongest arguments for constructing SMLs based on the market model
is that there is a well-developed theory (CAPM) which suggests that return is a
linear function of beta.
Thus, before using a risk measure other than beta in constructing a SML, one
should have strong evidence supporting the alternative risk measure.
Another application of ex-ante security market lines is their use in determining the
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“market price of risk”.
A security market line is then fitted by regression to these expected returns and
risk (beta estimate producing an equation similar to the equation)
E(ri) = r0 + riβim
One can see from this equation that the slope of the SML (ri) is a measure of the
“market price of risk” in the sense that for each unit of Beta, the expected return
for a security increased by an amount equal to (ri). By constructing SMLs in this
manner at various points of time, one can observe how the price of risk changes
with market cycles.
The steeper the slope of the SML, the higher the price of risk, and vice versa.
Expressed in other terms, the steeper the slope of the ex-ante SML the more averse
investors (in the aggregate) are to assuming additional risk.
Application of Utility Theory to Risk Return Analysis
The two parameters in security evaluation are the expected return and the
variability in the rate of return (measured by the standard deviation of the rates of
return). Since we have assumed that rational investors are risk-averse, it follows
that, among two securities that provide the same expected return, preference will
be for the security with lower risk. Utility theory provides an elegant theoretical
support to this argument. In this note, we shall examine the relevance of this
theory to our hypothesis.
Utility theory points that when the wealth of an individual increases, so does his or
her satisfaction or utility derived from it but the amount of satisfaction derived

60
 Risk and Return

from one additional rupee at a higher level of wealth is less than the satisfaction
derived from one additional rupee at a lower level of wealth. In other words, the
total utility or satisfaction is an increasing function of wealth, whereas, the
marginal utility is a decreasing function of wealth. The behavior of most rational
economic units conform to this logic.
There is a direct correspondence between rate of return and wealth, if the rate of
return is high, the wealth so created is large. So, wealth and rate of return can be
used interchangeably for utility analysis. Calling one unit of satisfaction as UTIL,
the relationship between satisfaction and return (r) can be graphically represented
as follows:
Figure 9

Let us consider the two alternative investment propositions.

I
Proposition I with certain return outcome of 10%. Proposition II having uncertain
outcomes of either 5% or 15% with 50-50 chance. So, the expected value (Eu) of
FA
Proposition II’s outcome (i.e. 0.5 x 5% + 0.5 x 15% = 10%) is the same as the
certain outcome of Proposition I. Consistent with what the utility theory points, if
we assign 10 utils for 5% outcome, 18 utils for 10% outcome, and 24 utils for a
15% outcome, the utility implications of the given propositions are as follows:
Proposition I provides 18 utils i.e. U (10%).
Proposition II provides 0.5 x 10 utils + 0.5 x 24 utils = 17 utils i.e. Eu (10%).
From the standpoint of utility or satisfaction, clearly Proposition I is better than
Proposition II. The above may be graphically depicted as follows:
Figure 10
IC

The return outcome of Proposition I is certain, hence it is a no risk proposition.

Whereas, the return outcome of Proposition II is uncertain, hence it is a risky
proposition. The fact that the expected utility from proposition I is more than the
expected from Proposition II implies that no risk (or less risky) proposition is
preferred to a risky (or more risky) proposition by the expected utility maximizer,
if the expected return from both the propositions is the same.
Utility theory also provides support to the consideration of standard deviation of
returns as a measure of risk of a security. How? In the above graphs, we have
described the relationship between Utils and return by way of drawing a utility
curve. Alternatively, the relationship can be described in the form of a quadratic
function defined as follows:
u(r) = ar – br2, where a and b are constants.

61
Security Analysis

The argument that quadratic utility function best fits the utility behavior of rational
economic units is attributed to Von. Neumann J and Morgenstern U; Theory of
Games and Economic Behavior. The argument is justified on the ground that the
first derivative with respect to ‘r’ is positive whereas the second derivative is
∂u(r) ∂ 2 u(r)
negative, i.e. > 0 and < 0 which implies that the utility function is
∂r ∂r 2
an increasing function of ‘r’ but at a decreasing rate.
Since the outcomes of most investments are uncertain, investors are said to
maximize their expected utility. Taking the expectation of the above utility function,
the function that investors attempt to maximize can be expressed as follows:
E[u(r)] = aE(r) – bE(r2)
A further expansion of the expected utility function shows that it is a function of
expected return and standard deviation of returns and that the expected utility is an
increasing function of expected return and a decreasing function of the standard
deviation of returns:
E[u(r)] = aE(r) – b[∂2 + E(r)2] = f[E(r), ∂2r]
It also follows that if investors utility function is quadratic in form, the two
parameters of the distribution of returns that matter for evaluation are the expected
value and the standard deviation, the former representing benefit and the latter

I
representing risk. They both must be considered together. Utility theory thus
provides a sound theoretic foundation for the consideration of both expected return
and risk in security evaluation.

SUMMARY
FA
• The risk associated with a common stock is interpreted in terms of the
variability of its return. The most common measures of riskiness of security
are standard deviation and variance of returns.
• Unsystematic risk is the extent of the variability in the security’s return on
account of the firm specific risk factors. This is also called diversifiable or
avoidable risk factors.
Systematic risk refers to factors which affect the entire market and hence the
IC
•
firm too. This is also called non-diversifiable risk.
• If a portflio is well diversified, the unsystematic risk gets almost eliminated.
The non-diversifiable risk arising from the wide movements of security
prices in the market is very important to an investor. The modern portfolio
theory defines the riskiness of a security as its vulnerability to market risk.
This vulnerability is measured by the sensitivity of the return of the security
vis-á-vis the market return and is called beta.
• The concept of security market line is developed by the modern portfolio
theory. SML represents the average or normal trade-off between risk and
return for a group of securities. Here the risk is measured typically in terms
of the beta values. The ex post SML is used to evaluate the performance of
portfolio manager; tests of asset-pricing theories, such as the CAPM and to
conduct tests of market efficiency. The ex ante SML is used to identify
undervalued securities and determine the consensus, price of risk implicit in
the current market prices.
• Alpha of a security helps to determine whether the scrip is underpriced (it is
then eligible to be purchased) or overpriced (it is then eligible to be sold).
• With this background, the next chapter focuses on the stock market in India.

62
Chapter III

Stock Market in India

I
•
FA
After reading this chapter, you will be conversant with:

Markets and their Features

• Development of Securities Markets in India
• Regulation of Securities Markets
• Stock Issuing Market (Primary Market)
• Secondary Market
• Trading and Settlement
IC
• Clearing and Settlement Procedure
Security Analysis

Introduction
In this chapter, we will study briefly about markets and their functions and then
cover in detail the various nuances of the secondary market in India.
In studying about markets and their functions, we will acquaint ourselves with
i. What is meant by a market?
ii. Features of a market
iii. Efficiency of a market in terms of features like breadth, depth, etc.
iv. Classification of markets, and
v. Functions of markets.
In case of secondary markets, we will deal with the following aspects:
• Development of stock market in India.
(National Stock Market System)
• Organization and management of stock exchanges.
• Membership of stock exchanges.
• Listing of securities.

I
• Trading procedures.
FA
MARKETS AND THEIR FEATURES
A market is a location where buyers and sellers come into contact to exchange
goods or services.
Markets can exist in different forms depending upon the nature of location and
mode of contact. It can have a physical location where buyers and sellers come in
direct contact with each other or a virtual location where the buyers and sellers
contact each other employing advanced means of communication. There is another
form of market where actual buyers and sellers achieve their objectives through
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intermediaries.
The essential features of a market are:
i. Existence of the buyers (demand side of the market) and sellers (supply side
of the market);
ii. Existence of price for every asset;
iii. Allocation of resources;
iv. Existence of regulatory mechanism.
One of the essential features of a market is the existence of price for every asset.
That is, the consumers have to pay a price to acquire an asset. How can one define
price? It can be defined as certain amount of money expected or given for the sale
(exchange) of some asset. Another frequently used term in relation to markets is
value. It can be defined as the quality or worth of an asset that makes it valuable.
Quantitatively, to rate an asset considering its importance or usefulness (value), we
assign it a numerical quantity in terms of money. Does this mean that price and
value are one and the same? No. Value can be highly subjective. An asset can have
different values in different situations for different persons and accordingly its
price changes. So, value and price are related to each other and it can be said that
value can be expressed in terms of price of an asset.

64
 Stock Market in India

The reflection of true value of an asset in its price is an indicator to the existence
of an efficient market. The following are some of the other salient features of an
efficient market:
1. Breadth: By breadth we understand that there are a large number of rational
participants with homogenous expectations in the market. The decision taken
by any of these participants will not affect the market in a significant manner.
2. Depth: A market is said to have depth when the volume of securities traded
(number of transactions) is very large. This ensures that an investor can enter
and exit according to his preference and convenience.
It essentially indicates the liquidity in the market.
3. Information arbitrage efficiency is said to exist if the participants do not have
any scope to reap abnormal profits using information which is of common
knowledge.
4. Fundamental valuation efficiency is said to exist if the price of an asset is
equal to its intrinsic value. That is, the asset is neither overvalued nor
undervalued.
5. Full insurance efficiency is said to exist, if participants can adopt hedging as
an effective tool against possible risks in future.

I
6. Operational efficiency is said to exist, if the operating costs (administrative
and transaction costs) are minimum possible to the participants, but still
FA
7.
provide a fair return to the intermediaries for their services.
Allocational efficiency is said to exist, if the market channelizes resources
into projects where the marginal efficiency of capital adjusted for risk
differences is the highest. It means that funds flow to such investment
opportunities where the returns, risk adjusted basis are highest.
Under these ideal conditions, the markets attain the equilibrium position. That is,
the demand for assets matches (equals) their supply.

Classification of Markets
IC
With reference to goods and services traded, the markets can be broadly classified as
financial markets and commodities markets. Here, we look at only financial markets.
Financial markets can be broadly classified as
a. Securities markets, and
b. Forex markets.
Further, the principal securities markets are:
a. Markets for government securities
b. Money markets
c. Capital markets, and
d. Derivatives market.
A detailed discussion on all markets is beyond the scope of this book.
The Gilt-edged Securities (securities issued by government) are the most liquid
securities one can think of. As regarding the money and capital markets, there is
no statutory difference as such. But one perceives that in money markets, financial
instruments whose maturity does not exceed a period of one year are traded, while
in capital markets the maturity period usually exceeds one year. In derivatives
market, risk contract instruments like futures and options are traded.

65
Security Analysis

Functions of Markets
We will look at the functions of the markets taking into account their
classification.
The function of primary market is to bring the savers and the users together
resulting in transfer of funds from one to the other.
The functions of secondary markets are:
1. That the investor should be able to dispose of his stock at the most
competitive price. The most competitive price in case of selling is the highest
price, while for buying it is the lowest price;
2. They should provide liquidity to the investors without any loss. That is, an
investor should be able to convert stock into cash at a short notice;
3. That resulting transaction costs are minimum for the investor.
The function of the capital market is to provide funds to organizations on a long-
term basis.

DEVELOPMENT OF SECURITIES MARKETS IN INDIA

Evolution
In India the stock market originated in the latter part of the 18th Century. The

I
earliest security dealings were transactions in loan securities of the East India
Company, the dominant institution in those days. Corporate shares came into
FA
picture by 1830s, and assumed significance with the enactment of the Companies
Act in 1850. The introduction of limited liability marked the beginning of the era
of modern joint stock enterprises. This was followed by the American Civil War in
1860-65. However, the bubble burst with the end of the Civil War and was
followed by a disastrous slump. It was long and severe. It also resulted in complete
ostracism of the broker community. The tremendous social pressure on the brokers
led to their forming an informal association which later gave birth to ‘The Native
Share and Stock Brokers’ Association’, (now known as the Bombay Stock
Exchange) in 1887. This stock exchange played a major role during the phase of
IC
recovery from the seven-year depression. It continued to grow in stature and size
of operations and became the nerve center of all financial activity and the first one
to be recognized by the Government of India.
The cotton textile industry which contributed a lot in the establishment of the
Bombay Stock Exchange, was also the prime factor in the development of
Ahmedabad as a center for dealing in stocks and shares. As new cotton textile
mills were floated and the volume of business grew, the ‘Ahmedabad Share and
Stock Brokers’ Association’ was formed in 1894, which later came to be known as
the Ahmedabad Stock Exchange.
The next stock exchange was established in Calcutta in 1908. Jute, coal and
mining the industries contributed to its birth and subsequent development. Like the
Bombay Stock Exchange, it was born out of a crisis when the boom of 1904-08
broke and a need was felt for an organized body for mutual protection of brokers and
safety of the trade.
With the outbreak of World War I, all imports into India ceased and the Indian
manufacturers faced a boom. The three stock exchanges flourished during this
period. However, the boom also led to the formation of many rival stock
exchanges. World War II also resulted in a boom and mushroom growth of stock
exchanges. However, many of them perished during the slump that followed. Most
of the other stock exchanges languished till 1956 when the government came out
with a comprehensive legislation called the ‘Securities Contract (Regulation) Act’

66
 Stock Market in India

to regulate the functioning of stock exchanges. This legislation made it mandatory

for the stock exchanges to secure recognition from the Central Government. Only
the established stock exchanges in Mumbai, Ahmedabad, Kolkata, Chennai, Delhi,
Hyderabad and Indore were recognized under the Act. More stock exchanges were
recognized subsequently. At present there are 23 such recognized stock exchanges
in India including the OTCEI and National Stock Exchange. The names of these
stock exchanges with their geographical location, and the date of receiving
government recognition are given in the following table.
Table 1: Recognized Stock Exchanges in India
Sl. Date of initial
Name of the Exchange & Location
No. recognition
1. The Stock Exchange, Mumbai 31-03-1957
2. The Ahmedabad Stock Exchange Association Ltd. 16-09-1957
3. The Calcutta Stock Exchange Ltd., Kolkata 10-10-1957
4. Madras Stock Exchange Ltd., Chennai 15-10-1957
5. The Delhi Stock Exchange Association Ltd., New Delhi 09-12-1957

I
6. The Hyderabad Stock Exchange, Hyderabad 29-09-1958
7. Madhya Pradesh Stock Exchange, Indore 24-12-1958
FA
8. Bangalore Stock Exchange Ltd., Bangalore 16-02-1963
9. Cochin Stock Exchange Ltd., Ernakulam, Cochin 10-05-1979
10. The Uttar Pradesh Stock Exchange Association Ltd., Kanpur 03-06-1982
11. Pune Stock Exchange Ltd., Pune 02-09-1982
12. Ludhiana Stock Exchange Association Ltd., Ludhiana 29-04-1983
13. The Gauhati Stock Exchange Ltd., Gauhati 01-05-1984
IC
14. Kanara Stock Exchange Ltd., Mangalore 09-09-1985
15. The Magadh Stock Exchange Ltd., Patna 11-12-1980
16. Jaipur Stock Exchange Ltd., Jaipur 09-01-1989
17. Bhubaneswar Stock Exchange Association Ltd., 05-06-1989
Bhubaneswar
18. Saurashtra Kutch Stock Exchange Ltd., Rajkot 10-07-1989
19. The Vadodara Stock Exchange Ltd., Baroda 05-01-1990
20. The Coimbatore Stock Exchange Ltd., Coimbatore 18-09-1991
21. The Meerut Stock Exchange Ltd., Meerut 20-09-1991
22. National Stock Exchange 26-4-1993
23. Over The Counter Exchange of India (OTCEI), Mumbai 23-08-1994

The recognition accorded to a stock exchange is normally valid for a period of

5 years or a shorter period as prescribed. It is renewed after the expiry of that
period, subject to a satisfactory performance of the exchange during this period.
The stock exchanges located at Mumbai, Kolkata, Chennai, Ahmedabad, Delhi,
Hyderabad, Madhya Pradesh and Bangalore have been granted permanent
recognition.

67
 Security Analysis

The Bombay Stock Exchange is the principal stock exchange in the country
accounting for nearly 70 percent of the aggregate paid-up share capital of all listed
companies1 and 80 percent of the aggregate market capitalization2 of the listed
companies.

REGULATION OF SECURITIES MARKETS

In India, the incorporation, regulation and liquidation of companies is under the
purview of The Companies Act, 1956. This Act is administered by the Department
of Company Affairs under the Ministry of Law, Justice and Company Affairs of
the Central Government. The Companies Act, 1956 specifies the form and
contents of the prospectus which is required to accompany an issue of securities.
Legislations were also enacted which provide statutory role for Chartered
Accountants, Cost Accountants and Company Secretaries. Matters relating to form
and contents of financial statements and other matters relating to the disclosures of
information to the members are governed by DCA, and in some instances through
the professional bodies.
For the first four decades of independence, securities markets in India remained in
the backwaters of the Indian financial system. The capital markets did not develop
in consonance with the rest of the economy due to the limitations imposed on the
role of private sector and the control on issue of securities. Dilution of the holdings

I
of multinational companies at low prices in the late ‘70s kindled the interests of
lay investors. However, the interests soon dampened as they could not be sustained
FA
for long. It was not until the middle of the next decade that the interest rekindled
again and became widespread to have a palpable impact on the growth of the
securities market. The changes introduced in the economic policies in the late ‘80s
also provided an active stimulus to the market. Paucity of resources of the
financial institutions, hitherto the sole purveyors of long-term capital, also forced
companies to tap capital markets.
However, the trading and settlement infrastructure was poor and the disclosure
norms were largely ad hoc in nature. This was accompanied by very poor
enforcement of regulations and penal action was hardly initiated against violators.
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It is in this context that the need for a single independent regulatory body
empowered to supervise and regulate the securities market was felt. Thus,
Securities and Exchange Board of India (SEBI) was set-up initially as an
administrative arrangement and later as a statutory body.
PHILOSOPHY OF REGULATIONS
Markets depend upon credibility and fairness. A sound regulatory framework is
expected to provide transparency, to maintain market integrity and fairness, and to
ensure investor protection. A school of thought believes that markets are
inherently efficient and over-regulation leads to inefficiency in the market. This
school of thought argues for minimal or no regulations. However, it is seen that
lack of adequate regulations can lead to manipulations and market abuses, which
endangers market integrity and damage investors’ confidence. In addition, fairness
in the market is essential for price discovery, which in turn leads to better investor
participation. Regulation also helps in reducing the systemic risk in the market.
The perception of sound regulation is as important as the reality of regulation. The
very existence of a regulatory body improves the confidence of market participants
and investors.

1 Listing is the means for admitting the securities of a company to the trading privileges of a stock
exchange. All companies whose shares and/or debentures have been listed on the recognized stock
exchange(s) are called listed companies.
2 The aggregate market capitalization is the aggregate market value of the paid-up share capital of listed
companies.

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 Stock Market in India

Securities and Exchange Board of India (SEBI)

Securities and Exchange Board of India (Sebi) was established in 1988 to regulate
and develop the growth of the capital market. It regulates the working of stock
exchanges and intermediaries such as stock brokers and merchant bankers, accords
approval for mutual funds, and registers Foreign Institutional Investors who wish
to trade in Indian stocks.
SEBI also promotes investor’s education and training of intermediaries of
securities markets. It prohibits fraudulent and unfair trade practices relating to
securities markets, and insider trading in securities, by imposing monetary
penalties on erring market intermediaries. It also regulates substantial acquisition
of shares and takeover of companies by calling for information from, carrying out
inspection, conducting inquiries and audits of the stock exchanges and
intermediaries and self-regulatory organizations in the securities market.
Objectives of SEBI
According to the preamble of the SEBI Act, 1992, the objectives of SEBI are
three-fold:
• To protect the interests of investors in securities.

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• To promote the development of securities market in India.
• To regulate the securities market.
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To achieve these objectives, SEBI maintained a continuous interface with the
stock exchanges on various issues related to investor protection, improvement in
the quality of intermediation and building an automated market infrastructure.
SEBI extends its oversight to the 22 stock exchanges in the country and in this
area; it directed its efforts towards encouraging the stock exchanges to become
effective as self-regulatory organizations.

Organization
The Securities & Exchange Board of India organizes its affairs through a board.
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The board consists of the following members:
a. A Chairman.
b. Two members from amongst the officials of the Ministry of the Central
Government dealing with Finance and Administration of the Companies Act,
1956.
c. One member nominated by the RBI from among its officials.
d. Five other members, nominated by the Central Government, of whom at least
three shall be whole-time members.
The Chairman and the members should be persons of ability, integrity and
standing who have shown capacity in dealing with problems of the securities
market. They are required to have good knowledge or experience in the areas of
finance, law, economics, accountancy, administration, or any other discipline
deemed useful by Central Government.
SEBI also has four advisory committees for primary markets, secondary markets
and derivatives markets, and for mutual funds to provide advisory inputs in
framing policies and regulations. These committees constitute the market players,
recognized investor associations and eminent persons associated with capital
markets. These committees are non-statutory and their advice is only
recommendatory in nature.

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 Security Analysis

DEPARTMENTS OF SEBI
Under its internal administrative arrangements, SEBI is divided into various
departments in order to concentrate on various aspects of the securities market.
These departments are as follows:
i. Primary Market Department: This department looks after the policy
matters and regulatory issues concerning the primary market. The department
is responsible for regulations regarding underwriters, registrars to issue,
credit rating agencies, share transfer agents, debenture trustees, merchant
bankers, bankers to an issue and portfolio managers. The department also
deals with disclosure norms and investor protection and regulations regarding
various SROs.
ii. Secondary Market Department: All the regulation and protection of
secondary markets is done through this department. Regulations and
committees regarding stockbrokers, sub-brokers, delisting of securities,
demutualization and corporatization of the stock markets are handled by this
department.
iii. Venture Capital Department: The venture capital department, as the name
suggests, is entrusted with the job of regulating Indian and foreign venture
capital firms.
iv. Mutual Funds Department: The Mutual Funds Department is responsible

I
for the regulation of mutual funds that operate in the securities market.
v. Collective Investment Schemes Department: This department regulates the
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Collective Investment Schemes (CIS). Any scheme or arrangement made or
offered by any company under which the contributions, or payments made by
the investors are pooled and utilized with a view to receive profits, income, and
produce or property is managed on behalf of the investors is a CIS.
vi. Takeovers Department: This department takes care of the substantial
acquisition of shares and takeover of companies.
vii. Legal Department: The legal department undertakes the job of providing
legal advisory services to the organization. It also handles all litigations and
other legal issues.
viii. Foreign Institutional Investors Department: The Foreign Institutional
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Investors Department regulates the registration and functioning of all FIIs in
India.
ix. Depositories Department: Regulation of Depository Participants (DPs) and
Custodians of Securities is done by this department.
x. Derivatives Department: This department regulates and promotes the
market for derivative instruments.
xi. Investigation, Enforcement and Surveillance Department: This
department is the watchdog of the securities market. Its responsibilities
include investigating and surveying security markets and their transactions to
catch persons involved in acts prescribed by the SEBI Act.
The head office of SEBI is located at Mumbai and it has established regional
offices at New Delhi, Kolkata and Chennai.
FUNCTIONS OF SEBI
According to the SEBI Act, 1992, the main functions of SEBI are:
1. Regulating the securities market.
2. Recognition and regulation of the Stock Exchanges.
3. Registering and regulating the working of various intermediaries
including Merchant bankers, Registrars, Share Transfer agents, Stock
brokers, sub-brokers, Debenture trustees, Bankers to the Issue,
Underwriters, Portfolio Managers, etc.

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 Stock Market in India

4. Registering and regulating the functioning of Depositories, Custodians and

Depository Participants.
5. Registration of Foreign Institutional Investors.
6. Registering and regulating the working of Venture Capital Funds, Mutual
Funds and other collective investment schemes including plantation schemes.
7. Promotion and Regulation of Self-Regulatory Organizations.
8. Prohibiting fraudulent and unfair trade practices relating to the securities
market.
9. Prohibiting insider trading in securities.
10. Regulating substantial acquisition of shares and takeover of companies.
11. Promoting investor education and training of intermediaries.
12. Conducting research relating to securities market.
13. Call information, undertake inspection, conduct inquiries and order audit of
stock exchanges, intermediaries, mutual funds or any other person associated
with the securities market.
14. Perform the functions and exercise the powers of the Central Government
under The Securities Contract (Regulation) Act, 1956. These powers have
now been delegated to SEBI.

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POWERS OF SEBI
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For the purpose of regulation of the securities market, SEBI has been vested with
all the powers of a Civil Court as per Code of Civil Procedure, 1908. The powers
include:
i. The discovery and production of any books of accounts and other documents.
ii. Summoning and enforcing the attendance of persons, and examining them on
oath.
iii. Inspection of any books, registers and other documents.
iv. To inspect any book, register, other documents and records of a listed
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company or a public company (not being any of the intermediaries mentioned
above) intending to get its securities listed on a stock exchange where the
Board suspects the company of indulging in insider trading or fraudulent and
unfair trade practices related to the securities market.
v. Issuing commission for the examination of witnesses or documents.
vi. During an investigation or a pending enquiry, in order to protect the interests
of investors or the securities market, the Board may
a. Suspend trading of a stock in a stock exchange.
b. Restrain persons from accessing the securities market and prohibit any
person associated with the securities market to buy, sell or deal in securities.
c. Suspend any office bearer of any stock exchange or self-regulatory
authority.
d. Impend and retain the proceeds or securities of any transaction under
investigation.
e. Attach after the specified process, for a period not exceeding one
month, the bank account(s) or any intermediary or person associated
with the securities market in a matter involving violation of the
provisions of the SEBI Act.

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Security Analysis

f. Direct any intermediary or person associated with securities market not

to dispose of or alienate an asset forming part of any transaction under
investigation.
The board may take any of the measures in clause (d), (e) & (f) in
respect of any listed company or a public company intending to get its
securities listed, where it suspects the company to be indulging in
insider trading or fraudulent and unfair trade practices relating to the
securities market.
vii. With respect to prospectus, offer documents and advertisements soliciting
money, the board may for protection of investors,
a. Specify by regulation
– Matters relating to issue of capital, transfer of securities and
matters incidental thereto
– The manner in which such matters are disclosed.
b. Specify by special orders
– Prohibit any company from issuing prospectus, any offer
document or issue advertisements, soliciting money for issue of
securities
– Specify the conditions subject to which these documents can be
issued.

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viii. The Board may specify the requirements for listing and transfer of securities.
In addition to the above, the other powers of SEBI are:
•
FA Levy penalties for certain offenses.
• Levy fees and other charges.
• Issue orders/directions in the interest of investors or orderly development of
securities market. However, such orders can be issued only after conduct of
an inquiry.
• Hear appeals by companies against the decision of stock exchanges to refuse
listing of their securities.
• Suspend or cancel the registration of any intermediary.
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Since its inception, Sebi initiated more programs for the development of capital
markets rather than acting as watchdog (Table 2). This attitude of Sebi is perhaps
responsible to a certain extent for market volatility.
Table 2
Developments Shortcomings
Transformation of the trading, clearing No dent on price manipulation.
and settlement infrastructure.
Transformation to a paperless market Poor rate of conviction and very few
and transparent trading system. cases of exemplary penal action.
Introduction of rolling settlement – No due process for framing or changing
cutting the settlement cycle. regulations.
Setting up of the Central Listing Waking up to trouble spots too late in
Authority. the day.
Introduction of derivative trading. Turning a blind eye to bullish markets.
Use of Greenshoe option for IPOs Inadequate implementation of existing
through book building route. disclosure norms.
Demutualization of stock exchanges. Regulatory bias towards corporate
sector and large investors.
Source: The ICFAI Treasury Management, July 2004.

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 Stock Market in India

Despite all the changes in the equity market, there have been some spectacular
cases of fraud and market manipulation on the securities markets in the 1990s. In
the decade of the 1990s, the equity market suffered from a series of crises, major
and minor. The most important of these were the four crises of 1995, 1997, 1998
and 20013:
• In 1995, the Bombay Stock Exchange closed for three days in the context of
payments problems on M. S. Shoes.
• In 1997, there was a scandal where CRB Mutual Fund defrauded its
investors, which cast doubts upon the supervisory and enforcement capacity
of SEBI and RBI.
• In Summer 1998, there was an episode of market manipulation involving
three stocks (BPL, Sterlite, and Videocon). In this case, a variety of
questionable methods were employed at the BSE to avoid a failure of
settlements. The actions partly led to the dismissal of the BSE President by
SEBI.
• In March 2001, led to the second dismissal of a BSE president, the dismissal
of all elected directors on the Bombay Stock Exchange and the Calcutta
Stock Exchange, and payments failures on the Calcutta Stock Exchange.
The most common thing it has been seen in all crisis discussed above is the
leveraged market manipulation. Investigation in this crisis revealed that many

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situations where the administrators of the securities exchanges failed to enforce
stated rules, or explicitly violated rules.
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All above discussed crisis has significant negative effect on the stock market either
in terms of price or liquidity. The most important challenges for the policy maker
at this stage were that of addressing this vulnerability to crises. To protect the
stock market from further crisis, there was great need to identify the proper market
design.
However, after these major scandals, Sebi is bent upon more stringent regulatory
measures to benefit all the market participants but these regulatory developments
are certain shortcomings also (see table 2). Now the question is whether or not
these regulatory measures play a constructive role in protracting the hard money of
investor.
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Box 1
The entry of Ghyanendra Nath Bajpai as the Chairman of securities market
regulator in February 2002 was the cheer for the market. Being proactive, Sebi
and Bajpai have set a new order in the Indian securities market.
The foremost aim of Bajpai was to restore investor confidence. For this, he spelt
out a four-pronged game plan of information sharing, corporate governance,
enforcement and investor education. The first pillar, information sharing,
involves a need for disclosures that are adequate, appropriate and potent enough
to help the investor make choices and maintain trust in the market. Corporate
governance, the second pillar, should not be just another function of an
organization but should be of trust, since investors have entrusted their money
to corporations. Enforcement of Sebi regulations, the third pillar, would help to
ensure that violators are kept at bay, and investors are reassured that violators
are punished. The fourth pillar, investor education, has to be widespread i.e.,
investors should be able to interpret and make use of the information available.
Sebi has drawn a comprehensive ‘Strategic Action Plan’ that enables more
disclosure, a greater degree of enforcement and the strengthening of the capital
market structure. The plan envisages achievement of strategic aims laid down
for: (a) investors, (b) corporates, (c) markets, and (d) regulatory regime. The
Strategic Action Plan has identified four key spheres and has set strategic aims
for each of the spheres.

3 Ajay Shah and Susan Thomas “Policy Issues in the Indian Securities” 2001

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 Security Analysis

By opting for a “big bang” approach in announcing these reforms, rather than
slow reforms, Sebi has also dexterously avoided falling prey to any resistance
from the market players, who would have built up if they had anticipated that
the regulator was planning such a sequel of reforms. In August 2003, Sebi
barred Samir Arora, the famed fund manager of Alliance Capital Mutual Fund,
and the FII/sub-accounts of US-based Alliance Capital Management, from
trading directly or indirectly in the capital market with allegations of insider
trading. The ban on Samir Arora is an example that Bajpai is not diffident about
exercising the powers vested in Sebi.
Sebi is now reviewing all old regulations and introducing modifications,
whereever necessary. There is an expansion of the derivatives segment, the
corporatization and demutualization of the bourses, the central listing authority,
sweat equity norms, delisting norms, etc. It has also undertaken a partial
implementation of straight through processing since December 2002, while
most other markets across the world still have delivery-against-payment
systems. It has already amended the takeover code and modified the portfolio
management services guidelines. Disclosure standards have been improved;
initial public offer documents are becoming more streamlined with more
information on business and revenue models. As far as corporates are
concerned, it has streamlined accounting standard requirements. For mutual
funds, it has laid down comprehensive risk management guidelines, which is
unprecedented even on a global basis.

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Previously, when Sebi committees made recommendations there were
accusations that they reflected the views of certain people with vested interests.
FA
Therefore, Sebi now posts the reports of the committees on its website and
invites comments and suggestions from the general public. These are small
changes but they will certainly have a profound effect on investors’’
confidence. Investors can now give valid comments and suggestions. Sebi’s
orders are put on the website, so that all categories of investors know the
reasoning behind the orders issued. The intention is to make regulatory
decision-making totally transparent.
At Sebi, Bajpai has taken up organizational restructuring to induce efficiency
and harmonize its activities. A number of new divisions have been created and
people have been moved around and homogeneous activities have been
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consolidated. Bajpai’s teams undertook inspections of large brokers with an
unprecedented scale of actions against them. In 2002-03, 135 brokers and 58
sub-brokers were inspected, 122 had their registrations cancelled and 24 were
suspended. In 2002-03, Sebi filed 229 prosecutions against 848 persons and
passed 561 orders a record in Sebi’s history. The institution has added strength
to surveillance and investigation that is effective enough to visualize in advance
what is happening in the market and identifies any lapses and takes proactive
steps. Sebi has won the right to undertake search and seizure operations for
insider trading and market manipulations but with the rider that only the
chairman or a magistrate can authorize such an exercise4.
Source: sebi.gov.in
STOCK ISSUING MARKET (PRIMARY MARKET)
The stock issuing market in the Indian context refers to the primary market for
equity and preference shares. The primary markets serve the purpose of raising
funds in the form of new securities. The operation of this market is governed by the
provisions of the Indian Companies Act, 1956, and the recently issued SEBI
guidelines.
According to the Companies Act, a public company, or a private company which
is a subsidiary of a public limited company, can issue only two kinds of shares–
equity and preference shares.

4 Portfolio Organizer, March 2004

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 Stock Market in India

The basic difference between the two classes of shares is in terms of the
rights/privileges attached to them. Preference shareholders have a claim prior to
that of equity shareholders with respect to dividends, and also repayment of capital
in the event of liquidation. Equity shareholders, on the other hand, enjoy the
exclusive rights to –
a. Vote on every resolution placed before the company. (A preference
shareholder also acquires the right to vote if the preference dividend is in
arrears for a specified period of time.)
b. To maintain their proportional ownership by purchasing the additional equity
shares offered by the company.
The Companies Act requires the company to offer any issue of additional equity
capital to existing shareholders on a pro rata basis.
The other important distinction is with respect to their entitlement to dividends.
Preference shares carry a fixed rate of dividends. It should, however, be noted that
neither preference dividend nor equity dividend is an obligatory payment for the
company. Further, the company can declare dividends out of distributable profits
only after transferring a specified percentage of such profits to the general reserves
of the company, the percentage varying with the rate of dividend declared.
Equity share capital constitutes the bulk of the paid-up share capital of any

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company. Preference shares have not been popular with the investing public
because there is no legal obligation to pay preference dividends and the dividend
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rate is rather modest. Even the recently introduced instrument called ‘Cumulative
Convertible Preference Shares (CCPS)’ which provides for the compulsory
conversion of preference shares into equity shares within five years from the date
of issue, has failed to evoke the expected response.
A company is also allowed to issue debentures, offering them to the public through
issuing a prospectus. Debenture is an acknowledgment of a debt under a seal of the
company and containing a contract for repayment of a principal sum on specified
date and for the payment of interest at a fixed rate until the principal is repaid.
Modes of Raising Capital
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A company can raise share capital from the primary market in three ways:
i. Public issue
ii. Rights issue
iii. Private placement.
Of these, the public issue is the most popular mode of raising share capital. The
rights issue comes next in popularity. Raising funds through private placement is
the least popular way and investors in this case are generally financial institutions.
Public issue method of raising capital involves raising of funds direct from the
public, i.e. primary market. Public limited companies can raise share capital
through public issue. Private companies, insurance companies and government
companies are not permitted to offer their shares for public subscription. Public
issue is a fairly elaborate and complex process.
Rights issue is a method of raising additional finance from existing members by
offering securities to them on pre-emptive basis.
In private placements, funds are raised in the primary market by selling the
securities to the investors either singly or institutionally.
In addition, the company can also issue bonus shares to the existing shareholders
of the company by capitalizing the free reserves and profits of the company.

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 Security Analysis

PLANNING A CAPITAL ISSUE

Successfully raising capital from the market needs well planned and well chalked
out marketing strategy. It is, therefore, essential to make an analytical study of
various sources, the quantum, the appropriate time, the cost of raising capital and
the possible impact of such resources on the overall capital structure and
profitability of the company, besides the law governing their issue. There should
be proper balancing between the shareholders’ funds and the fixed interest bearing
funds. The company’s capacity to serve its debt should be given due consideration
in fixing the quantum of different sources. Issue of shares or debentures to the
public through prospectus will provide an opportunity to the investors. However,
response from these investors will depend upon the special features of the issue.
LAW GOVERNING CAPITAL ISSUES
While raising the funds due regard has to be given to the following Acts, Rules,
Regulations and Guidelines.
i. Provisions of the Companies Act, 1956
ii. SEBI Guidelines and Clarifications (see note on SEBI and SEBI Guidelines)
iii. The Securities Contracts (Regulation) Act, 1957
iv. The Securities Contracts (Regulation) Rules, 1957.

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Students are required to have a reasonable working knowledge in respect of the
following sections of the Companies Act, 1956, which have a bearing on the
FA
capital market activities.
SEBI’s Role in Primary Markets
The major change brought about by SEBI in the primary markets was the
improvement in the quality of disclosure norms for IPOs or listed companies
raising additional capital through the securities markets. SEBI’s attempts are
directed towards ensuring full and fair disclosure by issuers. SEBI also has set a
standard for companies that can issue securities through the securities market. An
unlisted company, in order to issue its securities, has to have a pre-issue net worth
of Rs.1 crore in three out of the last five years, and should have made profits in
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at least three out of the preceding five years. Also, the issue size must not exceed
5 times the companies’ pre-issue net worth. There is no restriction of pricing of
issues, though issuers have to justify pricing in the offer document. Further, SEBI
has prohibited companies from giving future profitability projections in the offer
document to prevent investors from being misled. The offer document issued by
companies has come under the ambit of SEBI regulations. The SEBI (Disclosure
and Investor Protection) Guidelines 2000 stipulate the contents of the offer
document. It also contains the post-issue obligations of the issuer.
Filing all the offer documents with SEBI has been made mandatory. SEBI reserves
the right to direct any amendment to the draft offer documents within 21 days from
filing the draft. SEBI has also decided to treat all the offer documents filed with it
as public documents and put the same on Internet. This enables SEBI to deal with
public complaints of misstatements before the issue opens for the public. SEBI has
now delegated the task of vetting the offer document to the Lead Manager. The
Lead Manager is required to exercise due diligence with regard to the accuracy and
adequacy of the disclosures made in the offer document.
SEBI has allowed issuer companies to access the market through book building.
Book building facilitates the process of price discovery and also reduces
transaction costs. SEBI has raised the limits for listing on regular stock exchanges
to Rs.5 crore. Issues below Rs.5 crore in size are permitted to be listed only on
OTCEI. As market making is mandatory to list on OTCEI, this move provides

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 Stock Market in India

liquidity to securities of small cap companies. SEBI issued guidelines for issue
related advertisements to prevent fraudulent inducements to invest. It permits
reservation for certain categories of investors of public issues both on firm and
competitive basis. Further, in case of private placement of equity by listed
companies, it has directed that they take place only at market related prices.
Book Building
According SEBI guidelines, book building is defined as “a process undertaken by
which a demand for the securities proposed to be issued by a body corporate is
elicited and built-up and the price for such securities is assessed for the
determination of the quantum of such securities to be issued by means of a notice,
circular, advertisement, document or information memoranda or offer document”.
Book Building is basically an efficient process efficient of price discovery used in
Initial Public Offer (IPO). Under this process, when IPO is open, bids are collected
from investors at various prices, which are above or equal to the floor price using
network of NSE/BSE/lead mangers. After bid closing date, based on certain
evaluation criteria the offer/issue price is determined.

The Process
Bidding shall be permitted only if an electronically linked transparent facility

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•
is used.
•
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Issuing company nominates a lead merchant banker called book runner, and
syndicate members with whom orders can be placed by the investors.
• Issuing company should disclose the number of securities to be issued, price
band, nominated lead merchant banker, syndicate members with whom
orders can be placed by the investors.
• With the help of syndicate member investor can quote their price. The
process is called bidding. Bids price should always more than the floor price
and it can be revised before closure of the issue.
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• After the closure of issue the book runner evaluated the bids using the certain
evaluation criterion. These evaluation criteria may be based on price
aggression, investor quality or earliness of bids, etc.
• Finally the book runner and the company concluded the final price at which it
is willing to issue the stock and allocation of securities.
• Allocation of securities is made to the successful bidders.

Guidelines for Book Building

Important guideline for book building is discussed below:
In case the issuer chooses to issue securities through the book building route then
as per SEBI guidelines, an issuer company can issue securities in the following
manner:
• 100% of the net offer to the public through the book building route.
• 75% of the net offer to the public through the book building process and 25%
through the fixed price portion.
• Under the 90% scheme, this percentage would be 90 and 10 respectively.
• The date of opening and closing of the bidding (not less than 5 days).
• The investors shall have the right to revise their bids.

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 Security Analysis

NSE and BSE’s Book Building System

• BSE and NSE offer the book building services through the Book Building
software that runs on the BSE Private network.
• This system is one of the largest electronic book building networks anywhere
spanning over 350 Indian cities.
• Bids are placed electronically through syndicate members and the
information is collected on line real-time until the bid date ends.
• In order to maintain transparency, the software gives visual graphs displaying
price vs quantity on the terminals.
Table 3: Difference between shares offered through book
building and offer of shares through normal public issue

Features Fixed Price Process Book Building Process

Pricing Price at which the securities are Price at which securities will be
offered/allotted is known in offered/allotted is not known in
advance to the investor. advance to the investor. Only an
indicative price range is known.

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Demand Demand for the securities Demand for the securities offered
FA offered is known only after the can be known everyday as the book
closure of the issue. is built.

Payment Payment if made at the time of Payment only after allocation.

subscription wherein refund is
given after allocation.
Source: bseindia.com
Reverse Book Building5
‘Reverse book building’ is similar to the process of book building, which is aimed
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at securing the optimum price for a company’s share. In the case of book building,
the issuing company decides the price of the security it is selling by allowing the
investors to decide the number of shares and the price they would be interested in.
While in the ‘reverse book building’ process, the acquirer company offers to
buyback shares from the shareholders, the investors’ aim is to sell the shares to
exit from the company. The reverse book building is a process used for efficient
price discovery.
As per the ‘reverse book building’ system, shareholders can bid by taking the floor
price as a benchmark, and the price at which maximum shares are tendered will be
the offer price. However, there is no cap for bidding. This floor price is arrived at
as the average of 26 weeks traded price preceding the date of the public
announcement. The companies do not accept the bids, which are below the floor
price. Bidding is to be done only in the electronic form, and through the stock
exchanges trading mechanism, similar to the current book building process.
Therefore only those shareholders with dematerialized shares will be allowed to
bid. This is to ensure that the entire process is undertaken with ease and
transparency is maintained.

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 Stock Market in India

SECONDARY MARKET
The secondary market is that segment of the capital market where the outstanding
securities issued by the Central and the State Governments, public bodies, and
corporate entities are traded. However, we will be discussing the securities issued
by companies. Traditionally, this was an open auction market where buyers and
sellers meet and evolve a competitive price for the securities. Commenting upon
the role and functions of a well-organized securities market, the former finance
minister Shri C D Deshmukh observed, “The economic services which a well-
constituted and efficiently run securities market can render to a country with a
large private sector, operating under the normal incentives and impulses of private
enterprise are considerable.”
“In the first place, it is only an organized securities market which can provide
sufficient marketability and price continuity for shares so necessary for the needs
of the investors. Secondly, it is only such a market that can provide a reasonable
measure of safety and fair dealing in the buying and selling of securities. Thirdly,
through the interplay of demand for and supply of securities a properly organized
stock exchange assists in a reasonably correct evaluation of securities in terms of
their intrinsic worth. Lastly, through such evaluation of securities, the stock
exchange helps in the orderly flow of distribution of savings as between different
types of competitive investments.”

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This observation succinctly summarizes the role of a secondary market in a
financial system.
FA
Secondary markets facilitate the existing (previously issued) securities to change
hands among investors. That is, they facilitate maturity transformation (an investor
has a certain idea of the period for which he can commit the funds. Usually, this
period is not sufficient for the funds user to remit them back. Therefore, the investor
has to find another investor who is willing to make available funds to the user. This
he does by selling the securities issued by the funds user to the other investor.)
SEBI’s Role in Secondary Markets
The ability of companies to mobilize capital from the market depends, to a large
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extent, on the efficiency and liquidity of the secondary market. Investors must have
confidence that they will be able to exit from the investment at prices reflective of its
future earning potential. The main focuses of SEBI’s efforts have been to modernize
market infrastructure and to introduce risk containment measures.
The major reform initiated by SEBI is to direct all the stock exchanges to
introduce on-line screen based trading. By the end of 2002, there are 23 stock
exchanges, accounting for 99.8% of the total trading in securities. SEBI introduced
on-line screen based trading at BSE & NSE. Further, to ensure effective clearing
mechanism, SEBI has directed all stock exchanges to set-up clearing
house/clearing corporation to settle all trades only through them. By the end of
2002, 24th stock exchange called the ‘Capital Stock Exchange, was set-up, and
all the 24 stock exchanges set-up clearing houses while the NSE has set-up a
clearing corporation viz. National Securities Clearing Corporation Limited
(NSCCL). NSCCL assumes the counterparty risk for all the trades executed on the
capital market segment of NSE. SEBI has also advised the stock exchanges to set-
up a Trade Guarantee Fund. This would ensure timely completion of settlement in
the event of defaults by member brokers. Rolling settlements have been introduced
in BSE and NSE from July 2, 2001. The carry forward system has been
discontinued. The system of margin collection has been streamlined and the
concept of mark-to-market margin has been introduced. A number of checks and
balances have been introduced in the modified system to prevent its abuse. SEBI

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Security Analysis

has also introduced the Stock Lending Scheme to facilitate timely delivery of
securities. The introduction of depositories has helped to overcome the problems
of bad deliveries and reduce the transaction costs. SEBI is encouraging the
investors to dematerialize their holdings.
SEBI has introduced capital adequacy norms for brokers. Further, SEBI has
directed that the upper limit for gross exposure would be fixed at 20 times the sum
of their base minimum capital and additional capital. This is in addition to the
intra-day trading limits of 33 1/3 times the sum of their base minimum capital and
additional capital. SEBI has been encouraging the process of corporatization of
broking houses. As on 31st March, 2002, 3682 of the 9687 registered brokers were
corporate entities, representing approximately 38% of the total.
SEBI has directed stock exchanges to amend their listing agreements to enforce
continuing disclosures. The cash flow statement, which is a part of financial
statements in several countries, is not mandatory under the Companies Act, 1956.
The inclusion of cash flow statement has been made a condition for continuation
of listing. The listing agreement has also been modified requiring companies to
provide shareholders with complete unabridged accounts. Companies have been
directed to disclose actual utilization of funds and actual profitability against the
projected utilization of funds and profitability projections given in the offer
document. SEBI has also accepted the Bhave Committee recommendations for

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quarterly disclosure of financial performance and disclosure of material events by
companies immediately after their occurrence.
FA
Listing of Securities
Listing means admission of securities for trading on a stock exchange through a
formal agreement between the stock exchange and the company, Members of the
recognized stock exchanges in India can deal only in the securities listed on their
exchange unless the governing board permits dealings in securities listed on any
other recognized stock exchange in the country. The bye-laws of the stock
exchanges prohibit listing.
This section dealing with the listing of securities in the Indian context covers the
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following aspects:
i. The obligation on the part of the companies to get their securities listed;
ii. Advantages of listing;
iii. Important listing requirements;
iv. Listing agreement;
v. Particulars of listing fees; and
vi. Delisting of securities.

Meaning of Listing
Listing means admission of securities to dealings on a recognized stock exchange
of any incorporated company, Central and State Governments, quasi-governmental
and other financial institutions/corporations, municipalities, electricity, housing
boards, etc. The term ‘Securities’ has been defined under Section 2 of the
Securities Contracts (Regulation) Act, 1956. It includes (a) shares, scrips, stocks,
bonds, debentures, debenture stock or other marketable securities of a like nature
in or of any incorporated company or any other body corporate; (b) government
securities; (c) such other instruments as may be declared by the Central
Government to be securities; and (d) rights or interest in securities. It would thus
appear that only securities issued by the aforesaid categories of persons can be
admitted to dealings in a recognized stock exchange.

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 Stock Market in India

Section 2(f) of the Securities Contracts (Regulation) Act, 1956 defines ‘recognized
stock exchange’ as a stock exchange which is for the time being recognized by the
Central Government under Section 4 of the said Act. Section 2(39) of the
Companies Act, 1956 defines ‘recognized stock exchange’ as, in relation to any
provision of this Act (the Companies Act, 1956) in which it occurs, a stock
exchange, whether in or outside India which is notified by the Central Government
in the Official Gazette as a recognized stock exchange for the purposes of that
provision. Stock exchange means any body of individuals, whether incorporated or
not, constituted for the purpose of assisting, regulating or controlling the business
of buying, selling or dealing in securities.
Securities are bought and sold in recognized stock exchanges through members
who are known as brokers. The price at which the securities are bought or sold on
a recognized stock exchange is known as Official Quotation.

Is Listing Compulsory?
Section 73(1) of the Companies Act, 1956 makes it obligatory for companies
intending to offer shares or debentures to the public for subscription by the issue of a
prospectus, to make an application to one or more recognized stock exchanges
seeking permission for the shares or debentures intending to be so offered to be dealt
with in the stock exchange or each such stock exchange. Under Section 73(1A) of
the Companies Act, 1956, where a prospectus states that an application has been

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made seeking permission for the shares or debentures offered and thereby to be dealt
in one or more recognized stock exchanges, any allotment made on an application in
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pursuance of such prospectus shall, whenever made be void, if the permission has
not been granted by the stock exchange or each stock exchange, as the case may be,
before the expiry of ten weeks from the date of closing of the subscription list.
Thus, listing of securities in stock exchange(s) is compulsory.

Advantages of Listing
Listing of securities on the stock exchanges is advantageous to the company as
well as to the investors as seen hereunder:
a. To the Company
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i. The company enjoys concessions under Direct Tax Laws – In such
companies the public is substantially interested resulting in lower rate of
income tax payable by them;
ii. The company gains national and international importance by its share
value quoted on the stock exchanges;
iii. Financial institutions/bankers extend term loan facilities in the form of
rupee currency and foreign currency loan;
iv. It helps the company to mobilize resources from the shareholders
through ‘Rights Issue’ for programs of expansion and modernization
without depending on the financial institutions in line with the
government policies;
v. It ensures wide distribution of shareholding thus avoiding fears of easy
takeover of the organization by others.
b. To the Investors
i. Since the securities are officially traded, liquidity of investment by the
investors is well ensured;
ii. Rights entitlement in respect of further issues can be disposed off in the
market;
iii. Listed securities are well preferred by bankers for extending loan
facility;

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 Security Analysis

iv. Official quotations of the securities on the stock exchanges corroborate

the valuation taken by the investors for purposes of tax assessments
under Income Tax Act, Wealth Tax Act, etc.;
v. Since securities are quoted, there is no secrecy of the price realization of
securities sold by the investors;
vi. The rules of the stock exchange protect the interest of the investors in
respect of their holdings;
vii. Listed companies are obligated to furnish unaudited financial results on
a half-yearly basis within two months of the expiry of the period. The
said details enable the investing public to appreciate the financial results
of the company in between the financial year;
viii. Takeover offers concerning listed companies are to be announced to the
public. This will enable the investing public to exercise its discretion on
such matters.

Types of Listing
Listing of securities is of five types as follows:
Initial Listing
A company whose securities have not been listed earlier in a recognized stock

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exchange, if desirous of listing its securities, should follow procedures applicable
to initial listing.
FA
Listing of Public Issue of Shares and/or Debentures
A company whose shares are listed on a recognized stock exchange may issue
shares and/or debentures to the public for subscription. In such cases the company
under the Listing Agreement has to submit necessary application to the stock
exchange(s) for listing of its securities. It may so happen that a green field
company, i.e., a company shortly after incorporation may issue its shares and/or
debentures to the public for subscription. In that event, it has to comply with the
formalities applicable to initial listing.
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Listing of Rights Issue of Shares and/or Debentures
Companies whose securities are already listed may issue shares and/or debentures
by way of ‘rights’ to the existing shareholders. Under the listing agreement, such
companies have to list shares and/or debentures allotted by way of rights to the
shareholders with stock exchange(s).
Listing of Bonus Issue of Shares
Companies which issue bonus shares by capitalization of its reserves, pursuant to
the listing agreement should enlist with the stock exchange(s). Bonus shares
should issue by submitting necessary application form for official quotation of the
bonus shares.
Listing of Shares Issued on Amalgamation, Mergers, etc.
Amalgamated companies which issue shares to the shareholders have to get the
shares listed on the stock exchanges to enable the erstwhile shareholders with such
shares.
FORMALITIES ASSOCIATED WITH LISTING
The company executes a listing agreement with the stock exchange before formal
trading can begin. Through these regulations the stock exchange aims to protect
the interests of shareholders. The listing agreement requires the listing company to
make certain disclosures and perform certain deeds. The information disclosures
relate to annual reports, periodic statements of Profit and Loss, Balance Sheet,

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 Stock Market in India

information pertaining to distribution of dividends, rights issues, bonus shares and

other relevant information deemed essential for the shareholders. The company
should also provide for prompt transfer, registration, subdivision and consolidation
of shares.
SEBI has issued guidelines to the stock exchanges to amend the compliances that
are necessary for a company to enlist its equity shares. These revised guidelines
which were announced in April, 1996 are as follows:
i. The listing agreement should provide for payment of interest by companies to
investors from the 30th day after the closure of a public issue. This has been
reduced from the earlier requirement of 70 days. The interest payable by the
company is 15 percent.
ii. Further, it has been prescribed as an initial and continuing listing requirement
that, there should be at least 5 public shareholders for every Rs.1 lakh of
fresh issue of capital and at least 10 shareholders for Rs.1 lakh in case of
offer for sale.
The issuing company has to mention in the prospectus the names of all stock
exchanges, where the securities are to be listed. However, if any of the stock
exchanges within 10 weeks from the date of closing of the subscription list, have
not granted permission for listing of such securities, the allotment will be void and
the entire issue proceeds should be refunded forthwith.

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The issuing company is also required to deposit percent of the issue price of the
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securities offered for subscription with the regional stock exchange. Fifty percent
of this amount will be paid by cash (subject to a maximum of Rs.3 crore) and
balance by way of bank guarantee. This deposit will be refunded after getting
confirmation from the company duly supported by the certificate from the auditors
of the company/practising company secretary that all allotment letters, share
certificates and refund orders have been dispatched within the stipulated period.
From the point of view of the investors, the holder of equity capital is no doubt
interested in the dividend but the main attraction for an individual to invest in a
company is capital appreciation. Since the value of a company can be gauged from
the equity capital, investors normally prefer exiting from the investment after their
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investments have shown the required rate of appreciation. To ensure no change in
the share capital of the company, exit by a shareholder with a particular number of
shares has to be matched by the investments of one or more other investor(s) in the
share.
With the geographic spread of the investor community, there has got to be a
common place where the present and prospective investors of all the companies in
operation can effect the buy and sell of the security. This place of trading is called
a stock exchange in technical terms. A company has to get itself listed so as to
avail the benefits of secondary trading by its investors. Listing in other words
mean admission of a security for the purpose of dealing on a recognized stock
exchange. The security so listed could belong to anybody. Securities belonging to
financial institutions, manufacturing concerns, central or state undertakings,
municipalities, etc. Stock exchanges in India have separate listing departments
which decide whether or not to allow a company to list at their exchange. The
listing arrangements are made in accordance with the Securities Contracts
(Regulation) Act, 1956/1957, Indian Companies Act, 1956, guidelines issued by
the Securities and Exchange Board of India (SEBI) and the listing norms of the
exchange where the company is going to be listed. Listing of a company has
several benefits:
• Listing provides liquidity to the security.

• It helps to mobilize savings for the overall development of the economy.

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 Security Analysis

• A listed company has to adhere to several disclosure agreements. This

ensures transparency and better corporate governance.
• Listing and subsequent trading allows the investors who had missed the
opportunity or could not get allotment during the IPO stage to buy the shares
of the company through the stock exchange.
• A listed company has to inform any significant developments pertaining to its
business to the stock exchange. This helps in the process of information
dissemination and draws attentions of the academicians, consultants,
analysts, etc.
A company desirous of getting its security listed has to enter into an agreement
with the stock exchange, known as the listing agreement. The listing agreement
aims to protect the interest of the shareholder or whoever deals with the security.
The agreement requires the company to do certain periodic disclosures with the
exchange. These disclosures in turn are accessible to the members of the
investment community. A listed company is bound to submit the annual statements
of accounts to the exchange.
Listing Requirement at NSE
Listing on NSE provides qualifying companies with the broadest access to
investors, the greatest market depth and liquidity, cost-effective access to capital,

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the highest visibility, the fairest pricing, and investor benefits. Securities listed on
the Exchange are required to fulfill the eligibility criteria for listing. Various types
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of securities of a company are traded under a unique symbol and different series.
For Eligibility Criteria for Listing, Listing Procedure, Listing Fees, Listing
Agreement, and other regulation see annexure III.
Listing Requirement at BSE
In BSE, companies are required to provide information to the exchange through a
listing agreement. The listing agreement of BSE is given in the annexure IV of the
chapter.

TRADING AND SETTLEMENT

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Introduction of automated trading systems has enabled market participants to login
orders, execute deals and receive online market information. The competition from
NSE has forced the regional stock exchanges including BSE to switch over to screen
based trading. The NSE trading system is order driven while the OTCEI system is
quote driven. In an order driven environment, the system captures all the orders and
matches them with each other to execute the transaction. A quote driven system is
based on the market making concept (dealer giving two way quotes) and the order
logged in is matched against the best quote given by the market maker. BSE Online
Trading (BOLT) is a mixture of both quote driven and order driven system as the
system permits both jobbing and direct matching of orders.
Market Timings
Trading on the equities segment takes place on all days of the week (except
Saturdays and Sundays and holidays declared by the Exchange in advance). The
Normal market timings of the equities segment on BSE and NSE are:
Normal Market Open : 09:55 hours
Normal Market Close : 15:30 hours
Trading Process
Let us look at how trading and settlement procedure in stock market. Investor who
wants to either buy or sell the share has to understand how it works. After deciding
what to buy or sell the first step is to place the order for with a broker. When an
order is placed to the broker, it is communicated to the stock exchange through the

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 Stock Market in India

broker. The order stays in the queue exchange’s systems and gets executed within
buy/sell limit that has been specified. The share buy or sell will be sent to the
purchaser by the broker in their demat account.

Depository System
The traditional settlement system existing in Indian stock exchanges proved
inefficient due to physical transfer of securities and increased delays. The system
involved transfer of ownership, where every transfer involved a physical
movement of paper securities to the issuer for registration, with the change of
ownership being evidenced by an endorsement on the securities. In most of the
transfers, the process would take much longer than the two months stipulated in
the Companies Act, and a considerable proportion of transactions were resulting in
bad delivery due to faulty compliance of paper work. Moreover, other
irregularities such as forgery, mutilation and theft of certificates were rampant. In
addition, the issuer had the right to refuse the transfer of a security. All this added
to costs and delays in settlement, restricted liquidity and made investor grievance
redress time consuming and, at times, intractable. In 1996, to preclude these
problems, the Depositories Act, was passed.
The Depositories Act provides for the establishment of depositories in securities.
The new settlement mechanism was set-up with the objective of ensuring free
transferability of securities with speed, accuracy and security. The Act allows the

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Depository to
a. make a free transfer of securities of public limited companies (subject to
FA certain exceptions);
b. dematerialize the securities in the depository mode; and
c. provide for maintenance of ownership records in a book entry form.
In order to streamline both the stages of settlement process, the Act envisages
transfer ownership of securities electronically by book entry without making the
securities move from person to person, and has also made the securities of all
public limited companies freely transferable. In order to provide instantaneous
electronic transfer of securities, two depositories, viz., NSDL and CDSL, have
been set-up.
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National Securities Depository Limited (NSDL)
National Securities Depository Limited is the first depository to be set-up in India.
It was incorporated on December 12, 1995. The Industrial Development Bank of
India (IDBI) – the largest development bank in India, Unit Trust of India (UTI) –
the largest Indian mutual fund, and the National Stock Exchange (NSE) – the
largest stock exchange in India, sponsored the setting up of NSDL and subscribed
to the initial capital. NSDL commenced operations on November 8, 1996. NSDL
had a paid-up equity capital of Rs.105 crore. It has been reduced to Rs.80 crore since
NSDL has bought back its shares of the face value of Rs.25 crore in the year 2000.
However, its net worth is above the Rs.100 crore, as required by SEBI regulations.
FUNCTIONS OF DEPOSITORY
Dematerialization
One of the important functions of the depository is to eliminate or minimize
physical movement of securities. This is done by converting securities held in
physical form into holdings in book entry form. This process is referred to as
dematerialization of securities.
Account Transfer and Registration
Another important function carried out by a depository is transfer of ownership of
securities resulting from trade settlements. It records such entries in the accounts
of beneficial owners. A transfer being a legal procedure includes endorsement,
execution of a transfer instrument and payment of stamp duty. The depository
accelerates the process of transfer by registering the ownership of entire issue in

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 Security Analysis

the name of the depository. Under this system, transfer of security occurs merely
by passing book entries in the records of the depositories, on the instructions of the
beneficial owners.
Corporate Actions
A depository may handle corporate actions in two ways. In the first case, it simply
provides information about the persons entitled to receive corporate benefits to the
issuer. In the other case, it takes the responsibility of distribution of corporate benefits.
Pledge and Hypothecation
Traditionally, borrowers willing to pledge the securities in physical form had to get
the securities verified for authenticity. This would require a transfer of the security
in the name of lender, involving time and cost by way of transfer fees or stamp
duty. With the use of depository services for pledging/hypothecating the securities
makes the process very simple and cost effective. The securities
pledged/hypothecated are transferred to a segregated or collateral account through
book entries in the records of the depository.
Linkages with Clearing System
The clearing system performs the functions of receiving and delivering from the
respective traders (brokers) who have traded on the stock exchange. Actual
delivery of securities to the clearing system from the selling brokers, and delivery
of securities from the clearing system to the buying broker is done by the

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depository. For this purpose, depositories and the clearing system should be
electronically linked.
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A depository cannot directly open accounts and provide services to clients. Any
person willing to avail the services of the depository can do so by entering into an
agreement with the depository through any of its Depository Participants.

Depository Participant (DP)

A Depository Participant (DP) is an agent of the depository and intermediaries
between the depository and the investors. The relationship between the DPs and
the depository is governed by an agreement made between the two under the
Depositories Act. A DP has to register with SEBI to offer depository related
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services. According to SEBI Guidelines, financial institutions, banks and stock
brokers can act as Depository Participants. As per SEBI (D&P) Regulations,
1996, a minimum net worth of Rs.50 lakh for stockbrokers, R&T agents and
Non-Banking Finance Companies (NBFC), is prescribed for granting them a
certificate of registration to act as DPs. NSDL requires a minimum net worth of
Rs.100 lakh to be eligible to become a DP as against Rs.50 lakh.
The function of a DP is similar to brokers in the stock exchange market. They
maintain the investor’s securities account balances from time to time and intimate
the investor about his status of holding. This also helps to sort out any discrepancy
that arises in the due course of trading. Investors can open account with more than
one depository participant.
PROCESS OF DEMATERIALIZATION
Now we look at the actual procedure as to how this system works and in the
process can understand the role played by Registrars and Transfer Agents.
An investor who wants to hold his securities in electronic form has to approach a
Depository Participant and through him he can open an account at NSDL. If he
wants to dematerialize the shares of say Reliance Industries, then he has to fill up a
Dematerialization form available with the DP and submit along with the share
certificates to be dematerialized after writing, “Surrendered for Dematerialization”
on the face of each certificate.

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 Stock Market in India

The DP will then intimate the NSDL about the investor’s intention through the
system and then submit the share certificates to the Registrars and Transfer
Agents. After confirming the genuineness of the certificates the Registrar destroys
them and sends the confirmation of dematerialization of shares to NSDL.
NSDL then makes appropriate entries and updates its system and informs the DP,
which in turn updates its records and conveys the same to the investor.
We observe that there is a one way correspondence between the depository
participant and the registrar. Also, the request from the DP and the confirmation of
the same from the registrars acts as a cross-check for NSDL. The whole process
takes fifteen days.
This mechanism also provides for rematerialization of shares if the investor so
desires. The procedure is similar to dematerialization. First, the investor sends a
requisition to the DP who in turn intimates the same to NSDL. Then NSDL
confirms the same with the Registrar. The Registrar then updates the accounts and
provides for the printing of the share certificates with new range of certificate
numbers and the same folio number if he had any dematerialization before and
then confirms the with to NSDL. NSDL then updates its account and intimates the
same to the DP. The registrar dispatches the certificates to the an investor who also
receives an intimation from the DP.

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Advantages of the Depository System
The advantages of the Depository System to the investors are:
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1. Filling up transfer deeds and lodging the same with the company for transfer
is not necessary;
2. There would not be any bad deliveries;
3. Exemption from paying stamp duty on transfer of shares;
4. Shares purchased in electronic form will be transferred to the investors’ name
within a day of completion of settlement;
5. Faster payments on sale of shares; and
6. No scope for forgery of share certificates.
Even if the shares are held in electronic form, the investors are eligible for all the
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benefits like dividend payments, bonus issues and rights, that arise from their
holdings as the depository will provide the registrars with details of the specific
investors in that regard before the record/book closure date.
The securities held in electronic form can also be pledged/hypothecated whenever
the need arises. Eventually, brokers may not prefer to trade in physical shares, as
they will be free from worries of bad deliveries once the market starts dealing in
electronic form. Also, SEBI has proposed that all the new IPOs should be in the
Demat form, the modalities of which are being worked out by SEBI.

Trading Mechanism at BSE

BSE, had an open outcry trading system till the mid 1990s. Brokers used to
assemble in the trading ring for buying and selling securities. The exchange
switched over to a fully automated computerized mode of trading known as BOLT
from March 14, 1995. BOLT refers to BSE On Line Trading system. After the
adaptation of the BOLT system, the traders enter orders for purchase or sale of
securities from Trader Work Stations (TWSs), instead of assembling in the trading
ring. At present this system is order driven.
Trading on the BOLT System is conducted from Monday to Friday between 9:55 a.m.
and 3:30 p.m. The scrips traded on BSE have been classified into ‘A’, ‘B1’, ‘B2’,
‘F’ and ‘Z’ groups. The number of scrips listed on the Exchange under ‘A’, ‘B1’,
‘B2’ and ‘Z’ groups, which represent the equity segment, as on March 31, 2003
was 198, 801, 562 and 2857 respectively.

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 Security Analysis

Category of Shares at BSE

A Group: A group shares are known as specified shares. These companies have
the best fundamentals and growth prospects. Many of them are blue chips. The
trading interest in these shares is high and previously exchanges used to offer the
carry-forward facility, which enables speculative trading of these shares. Because
of the high trading volumes, the spreads are low and it is possible to easily enter
and exit from these shares.
B1 Group: B1 group of Shares includes companies, which have less trading
interest, are put in this group. These companies are usually middle-sized. Their
financial performance is reasonable. Companies which show exceptional profit
growth in the B1 group are often promoted to the A group. Conversely, poor
performing A group shares are demoted to the B1 group.
B2 Group: Most of the companies in this group are small or show poor profits.
The trading volumes in this group are very low even though the number of shares
are very large. It is difficult to sell these shares since they have low liquidity.
Z Group: This is a new group of shares in the process of being created on the
Bombay Stock Exchange (BSE). The shares put in this group are those which
would otherwise have been delisted from the exchange. It is better to avoid
investing in these shares since they have an uncertain future.
The shares in the Z group have the following deficiencies:

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1. Non-compliance with listing norms.
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2.
3.
Non-payment of listing fees.
Non-submission of quarterly results and annual reports.
4. Failure to redress investor complaints.
5. Non-fixation of book closure.
The ‘F’ group represents the debt market (fixed income securities) segment
wherein 740 securities were listed as on March 31, 2003. The Exchange has
commenced trading in Govt. Securities for retail investors under “G” group w.e.f.
January 16, 2003 and 85 Government. Securities traded on the Exchange under
this group as on March 31, 2003.
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The ‘Z’ group was introduced by the Exchange in July 1999 and covers the
companies which have failed to comply with listing requirements. The Exchange
also provides a facility to the market participants of on-line trading in “C” group
which covers the odd lot securities in ‘A’, ‘B1’, ‘B2’ and ‘Z’ groups and rights
renunciations in all the groups of scrips in the equity segment. The facility of
trading in odd lots of securities not only offers an exit route to investors to dispose
off their odd lots of securities but also provides them an opportunity to consolidate
their securities into market lots.
The ‘C’ group facility can also be used by investors for selling up to 500 shares in
physical form in respect of scrips of companies where trades are required to be
compulsorily settled by all investors in the demat mode. This scheme of selling
physical shares in compulsory demat scrips is called an Exit Route Scheme.
With effect from December 31, 2001, trading in all securities listed in equity
segment of the Exchange takes place in one market segment, viz., Compulsory
Rolling Settlement Segment.

Trading Mechanism at NSE

NSE introduced for the first time in India, fully automated screen based trading.
The National stock exchange uses a modern, fully computerized trading system
designed to offer wide spread access to the investors across the length and breadth
of the country. Its trading system, the ‘National Exchange for Automated Trading’
(NEAT), is an order driven, fully automated screen based trading system.

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 Stock Market in India

The Capital Market (Equities) segment of NSE facilitates trading in the following
instruments:
A. Shares
Equity Shares
Preference Shares
B. Debentures
Partly Convertible Debentures
Fully Convertible Debentures
Non Convertible Debentures
Warrants / Coupons / Secured Premium Notes/ other Hybrids
Bonds
C. Units of Mutual Funds.

Clearing and Settlement Procedure

As already discussed, the trades of all the members in all the securities in
Compulsory Rolling Settlement (CRS) are now settled by payment of money and
delivery of securities on T + n basis. All deliveries of securities are required to be
routed through the Clearing House, except for certain off-market transactions
which, although required to be reported to the Exchange, may be settled directly

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between the members concerned.
Table 4: Securities Information Window National Stock Exchange
FA
Security Name Symbol
As on 01-MAR-2005 11:11:16 Hours IST
Series Market Type Market Lot
Reliance
RELIANCE EQ N 1
Industries Ltd
Face Value ISIN Code Ex Date Purpose
10.00 INE002A01018 20-MAY-04 DIVIDEND-52.5%
No delivery start No delivery 52 week high
52 week low price
date end date price
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– – 650.00 381.70
Price & Turnover Information
Prev. Close Open High Low Average Price
556.25 557.50 557.50 544.50 548.72
Change from % Change from Total traded Turnover in
Last Price
previous close previous close quantity Rs.lakhs
547.05 –9.20 –1.65 1745316 9576.9
Order Book
Buy Qty Buy Price Sell Price Sell Qty
99 547.05 547.20 463
1660 547.00 547.25 413
1 546.95 547.30 10
11 546.90 547.35 980
448 546.80 547.40 79
Total Buy Qty 104272 Total Sell Qty 250326

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Security Analysis

Other Information
Security-wise Delivery Position - Rolling Settlement - 28FEB2005
Quantity Deliverable Quantity (gross % of Deliverable Quantity to
Traded across client level) Traded Quantity
7580763 2311130 30.49
Value at Risk (VaR) for
Security VAR Adhoc
Index VAR Applicable Margin Rate
VAR Margin Margin
4.90 – 4.90 –
The upper screen of NSE provides information like the 52 weeks high and low
price dividend and stock split. The second window provides information about the
total quantities traded, turnover, day high and low price. An other information
window provides details about the risk in securities in terms of VAR (Value at
Risk) and the margin rate applicable to particular securities.

Compulsory Rolling Settlement (CRS) Segment

The Bombay Stock Exchange introduced the compulsory rolling settlement so as
to introduce the best international trading practices and achieve greater efficiency

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in the settlement procedure. Trades in all the equity shares listed on the Exchange
in CRS Segment, were required to be settled on T+5 basis w.e.f. December 31,
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2001. From April 1, 2002, SEBI directed the Stock Exchanges that all trades
would be settled on T + 3 basis. Later SEBI, directed that all trades would be
settled on t+2 basis with effect from April 1, 2003.
Under a rolling settlement environment, the trades done on a particular day are
settled after a given number of business days rather than settling all trades done
during an ‘account period’ of a week or fortnight. A T+2 settlement cycle means
that the final settlement of transactions done on T, i.e., trade day by exchange of
monies and securities between the buyers and sellers respectively occurs on second
business day after the trade day.
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Clearing and Settlement Procedure at BSE
The Clearing House of BSE is the Bank of India Shareholding Ltd. (BOISL). This
company was promoted jointly by Bank of India and BSE for handling the clearing
and settlement operations of funds and securities on behalf of the Exchange. For
this purpose, the Clearing & Settlement Dept. of the Exchange liaises with the
Clearing House on a day to day basis.
The Information Systems Department (ISD) of the Exchange generates Delivery
and Receive Orders for transactions done by the members in A, B1, B2 and F
group scrips after netting purchase and sale transactions in each scrip whereas
Delivery and Receive Orders for “C”, “Z” group scrips and scrips on trade to trade
basis are generated on gross basis, i.e., without netting of purchase and sell
transactions in a scrip.
The Delivery Order provides information like scrip and quantity of securities to be
delivered through the Clearing House. The Money Statement provides scrip
wise/item wise details of payments/receipts for the settlement. The
Delivery/Receive Orders and money statements can be downloaded by the
members in their back offices.
The bank accounts of members maintained with the nine clearing banks, viz., Bank
of India, HDFC Bank Ltd., Global Trust Bank Ltd., Standard Chartered Bank,
Centurion Bank Ltd., UTI Bank Ltd., ICICI Bank Ltd., Indusind Bank Ltd., and
Hongkong Shanghai Banking Corporation Ltd. are directly debited through
computerized posting for their settlement and margin obligations and credited with
receivables on account of pay-out dues and refund of margins.

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The securities, as per the Delivery Orders issued by the Exchange, are required to
be delivered by the members in the Clearing House on the day designated for
securities pay-in, i.e., on T+2 day. In case of delivery of securities in demat form,
the members are required to give out delivery instructions from their clearing
member pool accounts/ principal account. In case of delivery of securities in
physical form, the members have to deliver the securities in special closed pouches
(supplied by the Exchange) along with the relevant details (distinctive numbers,
scrip code, quantity, and receiving member) on a floppy. The data submitted by
the members on floppies is matched against the master file data on the Clearing
House computer systems. If there are no discrepancies, then a scroll number is
generated by the Clearing House and a scroll slip is issued. The members can then
submit the securities at the receiving counter in the Clearing House.
Clearing and Settlement Procedure at NSE
NSCCL carries out clearing and settlement functions as per the settlement cycles
of different sub-segments in the equities segment. Settlement is a two way process
which involves legal transfer of title to funds and securities or other assets on the
settlement date. The clearing function of the clearing corporation is designed to
workout what counterparties owe or what is due to them on the settlement date.

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Clearing Function of NSE
Clearing is the process of determination of obligations, after which the obligations
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are discharged by settlement. NSCCL has two categories of clearing members:
trading members and custodians. The trading members can pass on their obligation
to the custodians if the custodians confirm the same to NSCCL. All such trades
whose obligation the trading member proposes to pass on to the custodian are
forwarded to the custodian by NSCCL for confirmation. The custodian is required
to confirm these trades on T+1 days basis.
Once, the above activities are completed, NSCCL starts its clearing function. It
uses the concept of multi-lateral netting for determining the obligations of
counterparties. Accordingly, a clearing member would have either to pay-in or
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pay-out obligations for funds and securities separately. Thus, members pay-in and
pay-out obligations for funds and securities are determined latest by T + 1 day and
are forwarded to them so that they can settle their obligations on the settlement day
(T+2). (See annexure V)
Risk Management System at NSE
A efficient clearing and settlement system requires a sound risk management
system. NSE introduced for the first time in India, risk containment measures.
NSCCL has put in place a comprehensive risk management system, which is
constantly upgraded to pre-empt market failures. The Clearing Corporation
ensures that trading member obligations are commensurate with their net worth.
Risk containment measures include the following:
• Capital adequacy requirements of members,
• Monitoring of member performance and track record,
• Stringent margin requirements,
• Position limits based on capital,
• Online monitoring of member positions,
• Automatic disablement from trading when limits are breached.
(Risk management system of NSE is given in annexure VI)

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 Security Analysis

Margin Trading
To buy securities, an investor must have funds in his account and to sell securities
he must have the share in his demat account. But sometimes investors may not
have sufficient money to buy particular securities. In such a situation, he can take a
loan from his broker up to a certain percentage as prescribed by the norms. In
addition, if there is a fall in the share price to a certain level he has to pay the
deficit amount. In other words, the investor has to maintain a margin throughout
the period. If the margin falls by a level (Normally prescribed by SEBI) the broker
can liquidate the client’s holdings. The “margin” here is the money actually
borrowed from the broker, who uses the investor’s stocks thus purchased as
collateral for the funds advanced. Margins are thus collected to safeguard against
any adverse price movement. Margins are quoted as a percentage of the value of
the transaction. Let us understand the process by an example.
Suppose an investor wants to buy 100 Reliance Industries Limited (RIL) shares,
whose market price is Rs.500. This transaction requires Rs.50,000 but the has only
Rs.30,000 as bank balance. He can approach a broker who will invest money on his
behalf, taking interest for the same. Now he invests 50% of the amount (i.e.,
Rs.25,000) and the broker puts in the other half on his behalf and buys 100 RIL
shares in his name. Suppose maintenance margin is 40%, and if falls below 30%,
the broker has the right to sell the stock. Now the stock may fall to 410, then the
loss is Rs.90 per share. In this case the loan from the broker is still 25,000 but the
investor’s own account equity will fall to Rs.16,000. Now his maintenance margin

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equals 39.02% (Equity Account/Market Value of Holding x 100 i.e., 16,000/41,000 x
100). In this case the broker can ask him for the balance to take the margin to the
40% mark. He has to deposit (41,000 X 40% – 16,000) or 400 to maintain the level
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of 40%.
Now, assume a market crash whereby the RIL shares fall to 350. The margin loan
still remains at what he originally took, i.e., Rs.25,000, but now his equity account
falls to Rs.10,000. The maintenance margin has come down to only 28.57%
(10,000/3,35,000 x 100). Thus, the investor can sell the share and recover the
balance amount.
Box 2: Partial Sebi Rules
After banning the badla in 2001, Sebi has introduced Margin Trading in order
to increase liquidity in the market. After issuing the complete Margin Trading
norms, the system will officially take off when exchanges and other markets
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intermediaries are ready for them. The partial norms for margin transactions
indicated by Sebi are as follows:
• The initial margin can be up to 50% of the amount sought to be invested.
• The maintenance margin is 40% of the market value of the shares held at
all times.
• If the margin falls below 30% of the market price of the shares, the broker
can liquidate the clients’ holdings.
• To start with, only corporate brokers with a minimum net worth of Rs.3 cr.
are allowed to offer Margin Trading.
• Margin trading will be allowed only for buying BSE A Group Securities.
• Brokers can extend advances from their own resources or can borrow from
banks, Non-banking Financial Companies (NBFCs) and other qualified
lenders such as insurance companies.
• The total borrowing by the broker from the above institutions is capped to
five times his or her net worth.
• The broker cannot use the funds of other clients or individuals to extend
margin loans.
• Brokers have to disclose client-wise, scrip-wise, position-wise gross
exposure limits to the exchanges.
• Brokers also have to maintain separate client-wise accounts of all the
securities against which loans have been advanced and this should be
made available to the client at any given point of time.
Source: Compiled by The ICFAI University Press Research Center

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Exchange Traded Fund

An Exchange Traded Fund (ETF), is a type of Investment Company whose
investment objective is to achieve the same return as a particular market index. An
ETF is similar to an index fund in that it will primarily invest in the securities of
companies that are included in a selected market index. An ETF will invest in
either all of the securities or a representative sample of the securities included in
the index. An ETF invests in a basket of stocks which blindly mimics a chosen
market index (say, the S&P, CNX, Nifty, or the BSE Sensex). For convenience,
the Net Asset Value (NAV) of the ETF is usually represented as a fraction of its
underlying index. For instance, the Benchmark Nifty ETF has an NAV that is
one-tenth of the prevailing Nifty value. Unlike regular open-end mutual funds,
ETFs can be bought and sold throughout the trading day like any stock.
The total market in India for ETF is very small at less than Rs.300 crore. UTI has
an ETF called SUNDERS, Prudential ICICI has SPICE, (India’s first exchange
traded fund) but the most focused player is a little known fund house called
Benchmark Mutual Fund with several products on offer.
CIRCUIT BREAKERS
Circuit breakers help tackle the problem of volatility in stock. In simple words, if a
stock registers a high limit in a day or low limit in a day, a circuit breaker is

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applied. At this level trading on that particular level is either stopped for a number
of hours or for a day. SEBI rule says that, there will be two circuit breakers, one is
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for a particular stock and other for the whole market .The market circuit breaker is
applicable when a market index moves by a prescribed limit. For example, after
the parliamentary election, when the BJP lost the election, the sensex and nifty fell
by more then 20% in a single day, and circuit breaker trigger that day.
The index-based market-wide circuit breakers is applied at three stages:
• When the index moves up or down by 10 percent
• When the index moves up or down by 15 percent
• When the index moves up or down by 20 percent.
Table 5
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Movement in Time Trading halted for

either index
10% Before 1:00 pm 1 hour

At or after 1:00 pm before 2:30 0.5 hours

At or after 2:30 pm No halt in trading

15% Before 1:00 pm 2 hour

At or after 1:00 pm before 2:00 1 hours

At or after 2:00 pm Halt for remainder of

the day
20% Anytime during the trading Halt for remainder of
hours the day
Source: www.ey.com
As discussed earlier the circuit breaker is applicable to individual stocks, and this
is known as price filter or price bands. But the reader should remember that the
circuit breaker is not applicable to the 30 stocks included in the Sensex or the 50
included in the Nifty. For other stocks different price bands are applicable at NSE
or BSE.

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 Security Analysis

Box 3: Black Monday

On May 17, 2004, the Sensex opened at 5020.89 points, about 50 points lower
than it’s previous close. At 9:56 a.m. a minute after opening, it fell to 4927, and
by 9:59 a.m. it touched 4792 registering a fall of 135 points in 3 minutes. At
10:17 a.m., the Sensex fell to 4516, 553 points or a full 10% below its previous
close. The market-wide circuit breaker was applied, and all trading was stopped
for an hour. The market was to reopen at 11:15 a.m.
At 11:15 a.m., the unrelenting selling pressure continued. In the next three
minutes and forty seconds, the Sensex fell to its intraday low of 4247 points, a
full 822 points below the previous day’s close. The circuit breakers were hit
once again at 11:20 a.m., and the stock exchanges suspended trading for two hours.
At this point, Dr. Manmohan Singh addressed the media in which he assured
the stock markets that the new government was committed to the development
of the financial markets. He also warned of strict action against those found
guilty of market manipulation. The RBI announced that it was ready to provide
additional liquidity to banks in order to ensure that settlements in the market
took place smoothly. There was also some talk of ‘select’ financial institutions
picking up stocks in the remainder of the day.
When trading resumed, the Sensex recovered its strength, and gained in a
zigzag manner, before closing the day at 4505.16 points. Black Monday saw

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564.71 points or 11.25% of the Sensex the second highest of all time. The intra
day fall of 822 points was the highest in the history of the index.
FA
Source: The hindubusinessline.com, 18th May 2004
Buy Back of Shares
The much awaited proposal for buy-back of shares was cleared by the Union
Cabinet on 26th October, 1998. The prudential norms for buy-back of shares in
case of listed shares have been evolved by SEBI, while for unlisted shares they
have been evolved by the Department of Company Affairs.
The buy-back of shares will be permitted only for restructuring the equity and not
for treasury operations. The cabinet also ruled against evaluating the buy-back
proposal on a case to case basis, but allowed for such provisions which call for
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stringent punishment including provisions for imprisonment in case of any
violations.
Any company which wants to buy-back its shares, should do so only after the
shareholders have given their mandate in that direction through a special resolution
following an approval from the Board of Directors.
However, the government did not come up with any specific measures regarding
the applicability of buy-back of shares provision for Fera companies. These
companies by using the buy-back route, may buy the shares from the public and
extinguish them, resulting in an increase in the promoter’s stake. This obviates the
need for seeking FIPB/RBI approval for enhancing the promoter’s stake.

SUMMARY
• The last one-decade overall growth and development of the world equity
markets was phenomenal. During this period, several countries liberalized
their economy and also made the necessary changes for the rapid growth of
the secondary market.
• The 1990-96 period witnessed huge growth in the international issuance
particularly in Europe, Africa, the Middle East, Asia-Pacific and Japan.
European IPO market registered miraculous increase of the US $35 billion in
1996. During the last three decades the dominance of the US market
capitalization over the total world market capitalization has decreased from
60% to 35%.

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• The last two decades witnessed opening up of stock exchanges in several

countries. Several countries opened their stock market for foreign
institutional investors. In Asia, countries like India, Indonesia, Malaysia,
Thailand, Korea and Taiwan experienced the most vibrant growth.
• Stock Exchanges can be categorized as Public, Private and bankers bourses.
Trading procedures in different stock markets vary because of diverse
operational set-up and legal procedures. In some stock markets, transactions
are to be settled essentially in cash. However, some stock exchanges such as
London, Paris and Rio de Janeiro follow forward settlements.
• The microstructure layer of the equity markets consists of identification of
trading process such as price driven versus order driven systems. Good
information system and transparency is an important issue that decides the
popularity of any security market.
• Stock indices are the convenient indicators to measure the pulse of secondary
market. An ideal stock index should represent the changes in the overall
stock price and it should indicate the price changes of a typical share. A stock
index is generally based on a sample of stock. For example, BSE consists of
30 stocks.
• Among the most famous and popular stock exchanges, New York Stock

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Exchange, London Stock Exchange and Tokyo Stock Exchange accounts are
the most prominent. The huge amount of average daily trading in these
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exchanges reflects their importance in the world equity markets.
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 Security Analysis

Annexure I
Types of Orders at BSE
There are different types of orders that can be routed through the BSEwebx based
on certain parameters of time, price and quantity.
• Limit Order: This is the price specified by the client while entering the
order into the system. The client specifies a stated price to buy at or below, or
to sell at or above that price. The order shall be executed only on satisfying
these conditions.
• Market Order: It is an order to buy or sell securities at the current market
price at that particular time.
• Stop Loss Order: This order allows the client to place an order, which gets
activated only when the market price of the relevant security reaches or
crosses a threshold price. Until then, the order does not enter the market. You
can enter the threshold price.

Types of Order at NSE1

At the National Stock Exchange a Trading Member can enter various types of
orders depending upon his/her requirements. These conditions are broadly

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classified into three categories: time related conditions, price-related conditions
and quantity related conditions.
TIME CONDITIONS
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DAY: A day order, as the name suggests, is an order which is valid for the day on
which it is entered. If the order is not matched during the day, it gets cancelled
automatically at the end of the trading day.
GTC: A Good Till Cancelled (GTC) order remains in the system until it is
cancelled by the Trading Member. It will therefore be able to span trading days if
it does not get matched. The maximum number of days a GTC order can remain in
the system is notified by the Exchange from time to time.
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GTD: A Good Till Days/Date (GTD) order allows the Trading Member to specify
the days/date up to which the order should stay in the system. At the end of this
period the order will get flushed from the system. Each day/date counted is a
calendar day and inclusive of holidays and the day/date on which the order is
placed. The maximum number of days a GTD order can remain in the system is
notified by the Exchange from time to time.
IOC: An Immediate or Cancel (IOC) order allows a Trading Member to buy or
sell a security as soon as the order is released into the market, failing which the
order will be removed from the market. Partial match is possible for the order, and
the unmatched portion of the order is cancelled immediately.
PRICE CONDITIONS
Limit Price/Order: An order that allows the price to be specified while entering
the order into the system.
Market Price/Order: An order to buy or sell securities at the best price obtainable
at the time of entering the order.
Stop Loss (SL) Price/Order: It allows the Trading Member to place an order
which gets activated only when the market price of the relevant security reaches or
crosses a threshold price. Until then the order does not enter the market.

1 www.nseindia.com

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 Stock Market in India

A sell order in the Stop Loss book gets triggered when the last traded price in the
normal market reaches or falls below the trigger price of the order. A buy order in
the Stop Loss book gets triggered when the last traded price in the normal market
reaches or exceeds the trigger price of the order.
For example, if for stop loss buy order, the trigger is 83.00, the limit price is 85.00
and the market (last traded) price is 80.00, then this order is released into the
system once the market price reaches or exceeds 83.00. This order is added to the
regular lot book with time of triggering the time stamp, as a limit order of 85.00
QUANTITY CONDITIONS
Disclosed Quantity (DQ): An order with a DQ condition allows the Trading
Member to disclose only a part of the order quantity to the market. For example,
an order of 1000 with a disclosed quantity condition of 200 will mean that 200 is
displayed to the market at a time. After this is traded, another 200 is automatically
released and so on till the full order is executed. The Exchange may set a
minimum disclosed quantity criteria from time to time.
MF: Minimum Fill (MF) orders allow the Trading Member to specify the
minimum quantity by which an order should be filled. For example, an order of
1000 units with minimum fill 200 will require that each trade be for at least 200
units. In other words there will be a maximum of 5 trades of 200 each or a single
trade of 1000. The Exchange may lay down norms of MF from time to time.

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AON: All or None orders allow a Trading Member to impose the condition that only
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the full order should be matched against. This may be by way of multiple trades. If
the full order is not matched it will stay in the books till matched or cancelled.
Note: Currently, AON and MF orders are not available on the system as per SEBI
directives.
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 Security Analysis

Annexure II
Integration of Stock Exchanges2
Liberalization of trade and production enforced the international economy towards
a single market which allowed better and more efficient allocation of resources.
Integration of stock market is an important area of development, that accompanied
the globalization of securities markets. Is the manner in which markets are
regulated.
One of the important results of globalization of securities market is the freedom of
an Investor of one market for buying and selling shares in other markets without
restriction and issuance and trading of identical securities at the same price across
the markets after foreign exchange adjustment; this process is termed as Stock
market integration. The main reason behind the integration of market is to link
stock exchange electronically with other stock exchanges in the world so the
broker of one stock exchange can execute order in the second stock exchange and
offer the best rate to their clients. This could help the market in terms of liquidity,
depth and efficiency.
The concept of regionalization of stock exchange also arises here as only very few
stock exchanges all over the world have the size and liquidity that matches the
global exchanges.

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A regional stock market means a group of stock exchanges located within a region
which is free to issue and redeem capital via any stock exchange that is the
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member of the regional stock exchange. The member and investor of regional
stock market can be also benefit from liquidity, optimum turnover and price
advantages, those bigger and wider markets can provide. However, before taking
decision of regionalization, countries should cautiously analyze the cost and
benefit associated with it. In addition, countries should ensure that stock exchange
is able to face the competition, and is able to try and specialize in different types of
securities. Failed merger between London and Frankfurt Exchanges is an example
where London exchange specialize a in blue chip companies whereas Frankfurt
exchange in high growth companies.
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Factors that Must be Present Prior to Integration
Following factors must be considered prior to integration of the market:
• Advanced technology, telecommunication along with common language,
legal system.
• The home country stock exchange should be in a position to compete with
international stock exchange, in terms of risk management, listing rules,
membership rule trading and settlement mechanism etc.
• Integration of stock exchange in home country should be priority work before
regional integration.
• Harmonization of accounting policies and other companies rule.
• Prior to regional integration, government should liberalize their economic
rules, such as removal of trade barrier, capital account convertibility etc.

Benefits of Stock Exchanges Integration

The main benefit for investor due to integration of stock market is broad market
for trading i.e., investors can buy and sell shares in each market without restriction.
Identical securities can be issued, redeemed and traded in all markets in the region.

2. Source: World Stock Exchanges are integrating/consolidating/merging: what could be done by Arab
Exchanges? Mrs. Hebalah El Serafie Dr. Shahira, and F. Abdel Shahid

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 Stock Market in India

The other advantages of integration following:

• Efficient secondary market can facilitate mobilization of capital in primary
markets. Integration of stock market can provide more efficient, liquid, and
transparent trading and settlement system.
• Integration can create the platform for large foreign portfolio investment flow
which can result in better corporate governance by raising the level of
information disclosure and reporting to match internationally acceptable
standards.
• Integration can provide better hedging tools to companies that can improve
the risk management system.
• It encourages the institutional investor in home country.
• It can provide the best platform for privatization of large companies.
• Integration provides low transaction cost for investors like brokerage cost as
a result of achieved economics of scale due to efficient utilization of
technology and sharing its costs among several markets.
• Regional Integration can enhance market capitalization to the level of
developed market that can further increase the interest of foreign players in
the region.

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Barrier in Stock Exchanges Integration
FA
There are various factors that act as a barrier to integration of stock exchange.
These barriers may be in direct or indirect form. Some of the direct barriers are
summarized below:
• Capital Market segmentation can arise due to price difference in two different
markets. It can provide huge mispricing anomalies on exchanges, because it
will prevent the laws of supply and demand from interacting fully across
national frontiers.
• Since the investment abroad includes stock return and foreign exchange
return, it can create a barrier to integration of the exchange.
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• Capital account convertibility is another barrier; capital control can create
arbitrage opportunity in the market.
• Different time zone, different trading system and their clearing and
settlement system is also a big barrier in integration of the market.
• Different accounting policies, regulatory systems, information systems and
tax regimes are also obstacles to integration.
• Poor capital market development resulting in Low turnover, liquidity and size
are also barriers in some markets.
• Updation of technology also affects the consolidation process. For example,
stock exchange where trading takes place electronically is difficult to merge
with the stock exchange which has no electronic system.
• Some market barriers result from market structure or dynamics that
government action may not readily or perhaps appropriately change.

Stock Exchanges Integration/Alliances in Various Regions

In the recent past, the process of integration has started in terms of strategic
alliances, mergers, launch takeovers, allowing remote membership, signing of
cooperation and technological agreements. Some of the exchanges have changed
their juridical forms and ownership structures, some of them have even listed their
shares. But the real integration can be made possible by deregulation and
technological development, like trading and settlement procedure etc. Some of the

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Security Analysis

beginning process of integration in Europe, United States, and Asian market is

discussed below:
Europe
Various stock exchanges in past two decades have taken initiative for integration,
one such active exchange among them is European exchange. European exchange
is among the first, which started alliances and mergers, because investors were
demanding to reduce their transaction cost and wanted a mix of stocks and
derivatives under one roof. They started constituting new exchanges, even within
the same country.
For this, various European exchanges took some bold steps in terms of
harmonization of legislative measures. One of the main examples is formation of
single currency euro. The single currency will eliminate the main reason for
fragmentation of firm listing among different national exchanges. There are some
exchanges which started operations across boarders and function electronically.
Some of them are discussed below:
Euronext: Euronext is a most developed exchange in Europe and offers a range
of integrated services including the listing of financial instruments, trading in
securities and derivatives, clearing through its associate LCH. Clearing, netting
and settlement is being-done through its subsidiaries CIK and Interbolsa and its
partner Euroclear, as also market data dissemination and IT solutions and support.
Euronext is leading the way in the integration of Europe’s financial markets. The

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company derives its strength from its roots in each of its local markets, its ability
to generate synergies through the integration of the cash and derivatives markets it
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manages, and from its diversified revenue streams.
Growth has been central to the company’s strategy: In 2002, Euronext acquired
LIFFE, the London-based international derivatives market and merged with
BVLP, the Portuguese exchange.
Eurex: Eurex is a leading exchange, which mostly deal in derivative products. It
has linked two derivatives exchanges – Deutsche Börse AG and SWX Swiss
Exchange. Its electronic trading platform provides access to a broad range of
international benchmark products, with market participants connected from 700
locations worldwide. Trading volume at Eurex exceeded 1.07 billion contracts in
2004 and on 10th January, 2005 Eurex became the US First Exchange to List 3-
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Year U.S. Treasury Note Derivatives.
Virt-x: Virt-x is designed to meet the requirements of contemporary investors in
European blue chips. It is based on a highly efficient, flexible market model and
world class technology providing the scope for significant reduction in cross
border transaction costs at each stage of the trading, clearing and settlement
process. Its goal is to provide cross border trading at the equivalent of domestic
cost. virt-x has the support of a consortium of global investment banks and
financial intermediaries and the Swiss financial community.
United States
US stock exchange has a long history of consolidation. The number of stock
exchanges came down to 5 by 1995 from 100 in 19th century. In the US, there are
mainly two stock exchanges operating presently. Other than these two stock
exchanges, there are five other regional stock exchanges namely, Boston, Chicago,
Cincinnati, Pacific and Philadelphia. NASDAQ is one of the growing OTC based
stock market over the world. It’s home to some 2,800 companies with a global
market value of approximately $20 trillion. These companies include a cross-
section of large, midsize and small capitalization companies. Non-US issuers play
an increasingly important role on the Exchange. Nearly 460 non-US companies are
valued at $7.1 trillion.
In 1975, with the motive of integration of stock market, developed an Integrated
National Market System for US exchanges that linked all markets with
communications and data processing facilities. In spite of large consolidation in
the stock market, there were some hurdles due to different trading systems and

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poor governance among the stock market. Currently the coalitions of large
exchanges, like NYSE, AMEX, Chicago Mercantile Exchange, Chicago Board
Options Trade are largely dependant upon the shifting of floor trading systems to
screen-based system. But the result has shown faster; Electronic communication
network started rising in 1997, as at the end of 2004, according to NSDAQ figure,
100 percent of the Exchange’s investor orders are delivered electronically to the
NYSE’s central point of sale. The two largest ECNs operating in the US were
Instinet and Island and accounted for most of NASDAQ’s total number of
transactions but later increase in the number of ECN created competition and lead
to major fragmentation of the market. These competitions finally ended with the
consolidation of Instinet and Island, whereby Island Holding Company has
become a wholly-owned subsidiary of Instinet Group.

Asia
Asian market has also seen consolidation due to increasing competition in the
market. But the process is not as faster as in the US and Europe. Impediments to
the integration of Asian stock exchanges include the following:
i. Lack of cooperation among countries.
ii. Competition.
iii. Limited foreign shareholdings or high ceilings on total foreign ownership of

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Domestic shares.
iv. Non-existence of cross-listing instruments among exchanges except
FASingapore, which does not generally restrict acquisitions of shares by
foreigners.
v. Limited membership of exchanges are prohibited for foreign brokers.
vi. Ceilings on foreign investment generally apply to foreign financial
institutions, so that a broker from one country in the region would be limited
in establishing a subsidiary in a neighboring country.
vii. Same time-zones. The congruent trading times put the exchanges in direct
competition with one another, making cooperation harder.
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In spite of these barriers in the Asian stock market, a slow process of integration
initiated cooperation among the Asian countries. Most of the Asian countries have
started making agreement of free trade Zone; they have even started talking about
common currency, relaxation of capital controls, starting with the Securities and
Exchange Board of India (SEBI) entering into Memorandums of Understanding
for securities markets with all SAARC countries.

Integration of Exchanges in the Indian Market

In India, there are 23 stock exchanges but the activities are mainly focused on four
stock exchanges – Mumbai, Delhi, Kolkata and Chennai that accounted for more
than 90% of market capitalization. Out of these stock exchanges the Bombay
Stock Exchange is the oldest stock exchange with highest number of members and
trading companies. Being the single big stock market in India till 1993, the BSE
indulged malpractices like price manipulation, strikes, etc. The Securities and
Exchange Board of India (Sebi) was formed under the Sebi Act, 1992, with the
prime objective to protect the interests of the investors, promote the development
of the securities market and to regulate it. In 1993, National Stock Exchange of
India Ltd (NSE) was established that encouraged competition in the Indian market
and controlled malpractices of Bombay Stock Exchange. NSE was established as a
demutualised stock exchange.

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Security Analysis

Box: Mutual to Demutualized Exchanges

Most of the stock exchanges across the world are “not for profit” organizations
and are owned by members organized as mutual association. These members
have ownership rights and decision-making power and try to control trading at
the exchange. The owners of the exchanges are also the customers of the
exchange. The profit gained at these exchanges is the gain of the enterprise in
proportion to its ownership. Decision-making at these exchanges is on one
member one vote basis, where committees that represent the member firms may
influence the decisions. Moreover, ownership rights are not freely tradable or
exchangeable. Trading at these exchanges is physical and through verbal
interaction. The rules and regulations governing the conduct of business transactions
are framed and run by the traders themselves. Brokers represent the paid members of
the association and become intermediaries for investors’ transactions.
The transformation of a stock exchange into a “for-profit shareholder owned
company” is referred to as demutualization. Though this is not the standard
definition, the main difference between a traditional stock exchange and a
demutualized exchange is that the latter is run on “for-profit” basis, where
ownership and management are delinked. The process of demutualization can be
defined as moving away from member controlled exchange to become a public
traded company.
The transformation of mutual member-based exchange to demutualized exchange

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involves the transferability of ownership from members to non-members
(shareholders). This involves the conversion of existing membership to share
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ownership. The members of the mutual-based exchange either have the option of
selling their membership or retaining their hold on the demutualized exchange by
converting their membership into share ownership. To avoid potential and hostile
takeover by other exchanges and to prevent individuals and group holders with
vested interests from having greater control on the demutualized exchange,
regulators restrict the ownership holding of an individual or group of holders to
below 5% or 10%.
Source: Portfolio Organizer, November, 2004
NSE is the first fully automated electronic exchange in India, and it is also the first
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demutualized stock exchange in India, which set up facilities and employed rules
that matched international standards of securities markets in terms of trading
systems, practices and procedures. The quick settlement process made a marked
difference at NSE. NSE was the first exchange in the world to introduce a nation-
wide VSAT based online driven-screen trading system. Thus, members of NSE are
connected to trading system of NSE from their workstations via satellites using
VSATs, which allowed participation from over 400 cities spread all over India.
NSE can handle up to 1 million trades per day. NSE has also put in place NIBIS
(NSE’s Internet Based Information System) for on-line real-time dissemination of
trading information over the Internet. In order to capitalize on in-house expertise in
technology, NSE set up a separate company, NSE.IT, in October 1999. The NSE-
network is the largest private wide area network in the country and the first
extended C-Band VSAT network in the world. Currently more than 9000 users are
trading on the real-time-online NSE application. At present NSE has become the
market leader, accounting for more than 60% of turnover of all stock exchanges in
India
The increasing volume of single national stock is a big signal of transformation of
large number of stock exchanges into one stock exchange. This leads to the
increase in liquidity and price transparency in the market. In addition to the above,
NSE introduced advantaged risk management systems that were common
internationally. With increasing confidence and faster clearing and settlement,
investors of other stock exchanges started shifting to NSE; and in the near future
existence of other stock exchange is questionable.

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Annexure III
Listing of Securities (NSE)
Eligibility Criteria for Listing
IPOs by Knowledge Based Companies
Knowledge based companies are companies in the field of Information Technology, Internet
Commerce, Telecommunication, Pharmaceuticals, etc. The qualifications for listing Initial Public
Offerings (IPOs) by knowledge based companies are as below:
1. Paid-up Capital: The paid-up equity capital* of the applicant shall not be less than
Rs.5 crores and the capitalization** of the applicant’s equity shall not be less than
Rs.50 crores.
* For this purpose, the existing paid-up equity capital and the proposed issue for which
listing is sought shall be taken into account.
** For this purpose, capitalisation will be the product of the issue price and the post-issue
number of equity shares.
2. Conditions Precedent to Listing: The issuer shall have adhered to conditions precedent to
listing as emerging from inter alia, Securities Contracts (Regulations) Act, 1956 Companies
Act 1956, Securities and Exchange Board of India Act 1992, any rules and/or regulations
framed under foregoing statutes, as also any circular, clarifications, guidelines issued by the
appropriate authority under foregoing statutes.

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3. At least, a 3 year track record of either:
– the applicant seeking the listing; or
–
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the promoting company, incorporated in or outside India.
For this purpose, the applicant or the promoting company shall submit the audited balance
sheet of 3 trailing financial years of the company to NSE.
4. The Project/Activity plan of the applicant must have been appraised by a financial institution
u/s 4A of the Companies Act, 1956 or a state finance corporation or a scheduled commercial
bank with a paid-up capital exceeding Rs.50 crores or a Category I Merchant Banker with a
net worth of at least Rs.10 crores.
Provided that, this Clause 4 shall not be applicable to listing of securities issued by
Government Companies, Public Sector Undertakings, Financial Institutions, Nationalised
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Banks, Statutory Corporations and Banking Companies who are otherwise bound to adhere to
all the relevant statutes, guidelines, circulars, clarifications, etc. that may be issued by various
regulatory authorities from time to time and in case of an Offer for Sale.
5. The revenue from the core activity undertaken (knowledge based) as stated in the prospectus
shall not be less than 75% of the total income during the two immediately preceding years.
The Listing Advisory Committee (LAC) of the Exchange shall approve and recommend the
listing.
6. Applicant desirous of listing its securities should meet the following criteria:
– No Disciplinary action has been taken by other stock exchanges and regulatory
authorities in the past three years. The promoting company (if any) has not been in
default in payment of listing fees to any stock exchange in the last three years or has not
been delisted or suspended in the past and has not been proceeded against by SEBI or
other regulatory authorities in connection with investor related issues or otherwise.
– Redressal mechanism of investor grievance.
i. promoting company’s (if any) track record in redressal of investor grievances
ii. promoting company’s arrangements envisaged are in place for servicing its
investor
iii. promoting company’s general approach and philosophy to the issue of investor
service and protection.

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 Security Analysis

– Distribution of shareholding: The promoting company’s (if any) shareholding pattern

on March 31 of last three calendar years separately showing promoters and other
groups’ shareholding pattern should be as per the regulatory requirements.
Details of litigation: The promoting company’s (if any) litigation record, the nature of
litigation, status of litigation during the preceding three years period need to be clarified
to the exchange.
IPOs by Companies
Qualifications for listing Initial Public Offerings (IPO) are as below:
1. Paid-up Capital: The paid-up equity capital* of the applicant shall not be less than Rs.10 crores
and the capitalization* of the applicant’s equity shall not be less than Rs.25 crores.
* For this purpose, the post-issue paid-up equity capital for which listing is sought shall
be taken into account.
** For this purpose, capitalisation will be the product of the issue price and the post-issue
number of equity shares.
2. Conditions Precedent to Listing: The issuer shall have adhered to conditions precedent to
listing as emerging inter-alia from Securities Contracts (Regulations) Act 1956, Companies
Act 1956, Securities and Exchange Board of India Act 1992, any rules and/or regulations
framed under foregoing statutes, as also any circular, clarifications, guidelines issued by the
appropriate authority under foregoing statutes.

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3. At least, a 3 year track record of either:
– the applicant seeking the listing; or
–
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the promoting company, incorporated in or outside India.
For this purpose, the applicant or the promoting company shall submit audited balance sheet
of three preceding financial years of the company to the NSE.
4. The Project/ Activity plan of the applicant must have been appraised by a financial institution
u/s 4 A of the Companies Act, 1956 or a state finance corporation or a scheduled commercial
bank with a paid-up capital exceeding Rs.50 crores or a category I Merchant Banker with a
net worth of at least Rs.10 crores, or a venture capital fund with a net worth of atleast Rs.50 crores.
Provided that this clause 4 shall not be applicable to listing of securities issued by
Government Companies, Public Sector Undertakings, Financial Institutions, Nationalised
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Banks, Statutory Corporations, Banking Companies and subsidiaries of scheduled
commercial bank who are otherwise bound to adhere to all the relevant statutes, guidelines,
circulars, clarifications, etc. that may be issued by various regulatory authorities from time to
time and in case of an Offer for Sale.
5. The applicant desirous of listing its securities should satisfy the exchange on the following:
– No disciplinary action has been taken by other stock exchanges and regulatory
authorities in the past three years. The promoting company (if any) has not been in
default in payment of listing fees to any stock exchange in the last three years or has not
been delisted or suspended in the past, and has not been proceeded against by SEBI or
other regulatory authorities in connection with investor related issues or otherwise.
– Redressal mechanism of investor grievance
i. promoting company’s (if any) track record in redressal of investor grievances,
ii. promoting company’s arrangements envisaged are in place for servicing its investor,
iii. promoting company’s general approach and philosophy to the issue of investor
service and protection.
– Distribution of Shareholding: The promoting company’s (if any) shareholding pattern
on March 31 of last three calendar years separately showing promoters and other
groups’ shareholding pattern should be as per the regulatory requirements.
– Details of Litigation: The promoting company’s (if any) litigation record, the nature of
litigation, status of litigation during the preceding three years period need to be clarified
to the exchange.
– The preceding three years period need to be clarified to the exchange.

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 Stock Market in India

Securities of Existing Companies

Qualifications for listing securities of existing companies are:
1. Paid-up Capital & Market Capitalisation: The paid-up equity capital* of the applicant
shall not be less than Rs.10 crores and the market capitalization** of the applicant’s equity
shall not be less than Rs.25 crores.
or
The paid-up equity capital* of the applicant shall not be less than Rs.25 crores
or
The market capitalization** of the applicant’s equity shall not be less than Rs.50 crores.
or
The applicant company shall have a net worth of not less than Rs.50 crore in each of the three
preceding financial years. The company shall submit a certificate from the statutory auditors
in respect of net worth.
* For this purpose, the existing paid up equity capital as well as the paid up equity capital
after the proposed issue for which listing is sought shall be taken into account.
** The average of the weekly high and low of the closing prices of the shares as quoted on
the National Stock Exchange during the last twelve months preceding the date of
submission of application by the company and if the shares are not traded on the
National Stock Exchange such average price on any of the recognised Stock Exchanges

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where those shares are frequently traded should be taken into account while determining
market capitalisation after making necessary adjustments for Rights/Bonus Issues.
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Unless the market capitalisation is more than Rs.25 crores the securities of the company
should be traded for at least 25% of the trading days during the last twelve months
preceding the date of submission of application by the company on at least one of the
Stock Exchanges where it is traded.
Provided that the requirement of Rs.25 crores market capitalisation under this clause 1(a)
shall not be applicable to listing of securities issued by Government Companies, Public
Sector Undertakings, Financial Institutions, Nationalised Banks, Statutory Corporations and
Banking Companies who are otherwise bound to adhere to all the relevant statutes,
guidelines, circulars, clarifications, etc. that may be issued by various regulatory authorities
from time to time.
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However, as a one time exception, securities of companies which entered the capital market
with public offering and have not completed a period of 12 months during the relevant period
(June 1, 1998 to May 31, 1999), may be granted permission to list provided the companies
qualify for listing under the earlier norms (i.e., market capitalisation based on average price
of six months preceding the date of application).
2. Conditions Precedent to Listing: The applicant shall have adhered to conditions precedent
to listing as emerging from inter alia, Securities Contracts (Regulations) Act 1956,
Companies Act 1956, Securities and Exchange Board of India Act 1992, any rules and/or
regulations framed under foregoing statutes, as also any circular, clarifications, guidelines
issued by the appropriate authority under foregoing status.
3. At least, a 3 year track record of either:
– the applicant seeking the listing; or
– the promoting company, incorporated in or outside India.
For this purpose, the applicant or the promoting company shall submit audited balance sheet
of three preceding financial years of the company to NSE and also provide a certificate to the
Exchange in respect of the following:
– The company has not been referred to the Board for Industrial and Financial
Reconstruction BIFR).
– The net worth of the company has not been wiped out by the accumulated losses
resulting in a negative net worth.
– The company has not received any winding up petition accepted by a court.

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 Security Analysis

4. The applicant should have been listed on any other recognised stock exchange for at least last
three years.
or
The project/activity plan must have been appraised by a financial institution u/s 4A of the
Companies Act, 1956, or a state finance corporation, or a scheduled commercial bank with a
paid-up capital exceeding Rs.50 crores, or a category I Merchant Banker with a net worth of
at least Rs.10 crores, or a venture capital fund with a net worth of at least Rs.50 crores.
5. The applicant has paid dividend in at least two out of the last three financial years
immediately preceding the year in which listing application has been made.
or
The networth*** of the applicant is at least Rs.50 crores
*** Networth means:
Paid-up equity capital
+ Reserves excluding revaluation reserve
– Miscellaneous expenses not written off
– Negative balance in profit and loss account to the extent not set off
Clauses 4&5 shall not be applicable to listing of securities issued by Government Companies,
Public Sector Undertakings, Financial Institutions, Nationalised Banks, Statutory

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Corporations, Banking Companies and subsidiaries of scheduled commercial bank who are
otherwise bound to adhere to all the relevant statutes, guidelines, circulars, clarifications, etc.
that may be issued by various regulatory authorities from time to time and in case of an Offer

6.
for Sale.
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The applicant desirous of listing its securities should satisfy the exchange on the following:
– a. No disciplinary action has been taken by other stock exchanges and regulatory
authorities in the past three years. The promoting company (if any) has not been in
default in payment of listing fees to any stock exchange in the last three years or
has not been delisted or suspended in the past and has not been proceeded against
by SEBI or other regulatory authorities in connection with investor related issues
or otherwise.
– Redressal mechanism of investor grievance
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i. promoting company’s (if any) track record in redressal of investor grievances

ii. promoting company’s arrangements envisaged are in place for servicing its
investor,
iii. promoting company’s general approach and philosophy to the issue of investor
service and protection.
– Distribution of shareholding: The promoting company’s (if any) shareholding pattern
on March 31 of last three calendar years separately showing promoters and other
groups’ shareholding pattern should be as per the regulatory requirements.
– Details of Litigation: The promoting company’s (if any) litigation record, the nature of
litigation, status of litigation during the preceding three years period need to be clarified
to the exchange.

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 Stock Market in India

Annexure IV
Listing of Securities (BSE)
Listing means admission of the securities to dealings on a recognised Stock Exchange. The
securities may be of any public limited company, Central or State Government, quas-
governmental and other financial institutions/corporations, municipalities, etc.
The objectives of listing are mainly to :
• provide liquidity to securities;
• mobilize savings for economic development;
• protect interest of investors by ensuring full disclosures.
The Exchange has a separate Listing Department to grant approval for listing of securities of
companies in accordance with the provisions of the Securities Contracts (Regulation) Act, 1956,
Securities Contracts (Regulation) Rules, 1957, Companies Act, 1956, Guidelines issued by SEBI
and Rules, Bye-laws and Regulations of the Exchange.
A company intending to have its securities listed on the Exchange has to comply with the listing
requirements prescribed by the Exchange. Some of the requirements are as under:
I Minimum Listing Requirements for new companies,
II Minimum Listing Requirements for companies listed on other stock exchanges,

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III Minimum Requirements for companies delisted by this Exchange seeking relisting of this
Exchange,
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IV Permission to use the name of the Exchange in an Issuer Company’s prospectus
V Submission of Letter of Application
VI Allotment of Securities
VII Trading Permission
VIII Requirement of 1% Security
IX Payment of Listing Fees
X Compliance with Listing Agreement
XI “Z” Group
XII Cash Management Services (CMS) – Collection of Listing Fees
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[I] Minimum Listing Requirements for new companies
(A) Minimum Capital
1. New companies can be listed on the Exchange, if their issued and subscribed equity
capital after the public issue is Rs.10 crores. In addition to this the issuer company
should have a post issue net worth (equity capital + free reserves excluding revaluation
reserve) of Rs.20 crores.
2. For new companies in high technology (i.e., information technology, internet, e-commerce,
telecommunication, media including advertisement, entertainment, etc.,) the following
criteria will be applicable regarding threshold limit:
i. The total income/sales from the main activity, which should be in the field of
information technology, internet, e-commerce, telecommunication, media
including advertisement, entertainment, etc. should not be less than 75% of the
total income during the two immediately preceding years as certified by the
Auditors of the company.
ii. The minimum post-issue paid-up equity capital should be Rs.5 crores.
iii. The minimum market capitalisation should be Rs.50 crores. (The capitalisation
will be calculated by multiplying the post-issue subscribed number of equity
shares with the issue price).
iv. Post-issue net worth (equity capital + free reserves excluding revaluation reserve)
of Rs.20 Crores.

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 Security Analysis

(B) Minimum Public Offer:

As per Rule 19(2)(b) of the Securities Contracts (Regulation) Rules, 1957, securities of a company
can be listed on a Stock Exchange only when at least 25% of each class or kind of securities is
offered to the public for subscription.
In case of IPOs by unlisted companies in the IT & entertainment sector, at least 10% of the
securities issued by the company may be offered to the public subject to the following:
• Minimum 20 lakh securities are offered to the public (excluding reservation, firm allotment
and promoters contribution).
• The size of the offer to the public is minimum 50 crores.
For this purpose, the term “offered to the public” means only the portion offered to the public and
does not include reservations of securities on firm or competitive basis.
SEBI may, however, relax this condition on the basis of recommendations of stock exchange(s),
only in respect of a Government company defined under Section 617 of the Companies Act, 1956.
[II] Minimum Listing Requirements for companies listed on other stock exchanges
The Governing Board of the Exchange at its meeting held on 6th August, 2002 amended the direct
listing norms for companies listed on other Stock Exchange(s) and seeking listing at BSE. These
norms are applicable with immediate effect.
1. The company should have minimum issued and paid-up equity capital of Rs.3 crores.

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2. The company should have profit making track record for the last three years. The
revenues/profits arising out of extra ordinary items or income from any source of non-

3.
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recurring nature should be excluded while calculating distributable profits.
Minimum net worth of Rs.20 crores (net worth includes equity capital and free reserves
excluding revaluation reserves).
4. Minimum market capitalisation of the listed capital should be at least two times of the paid-up
capital.
5. The company should have a dividend paying track record for the last 3 consecutive years and
the minimum dividend should be at least 10%.
6. Minimum 25% of the company’s issued capital should be with Non-Promoters shareholders
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as per Clause 35 of the Listing Agreement. Out of the above Non-Promoter holdings no
single shareholder should hold more than 0.5% of the paid-up capital of the company
individually or jointly with others except in case of Banks/Financial Institutions/Foreign
Institutional Investors/Overseas Corporate Bodies and Non-Resident Indians.
7. The company should have at least two years listing record with any of the Regional Stock
Exchange.
8. The company should sign an agreement with CDSL & NSDL for demat trading.
[III] Minimum Requirements for companies delisted by this Exchange seeking relisting of
this Exchange
The companies delisted by this Exchange and seeking relisting are required to make a fresh public
offer and comply with the prevailing SEBI’s and BSE’s guidelines regarding initial public
offerings.
[IV] Permission to use the name of the Exchange in an Issuer Company’s prospectus
The Exchange follows a procedure in terms of which companies desiring to list their securities
offered through public issues are required to obtain its prior permission to use the name of the
Exchange in their prospectus or offer for sale documents before filing the same with the concerned
office of the Registrar of Companies. The Exchange has formed a “Listing Committee” to analyse
draft prospectus/offer documents of the companies in respect of their forthcoming public issues of
securities and decide upon the matter of granting them permission to use the name of “The Stock
Exchange, Mumbai” in their prospectus/offer documents. The committee evaluates the promoters,
company, project and several other factors before taking decision in this regard.

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[V] Submission of Letter of Application

As per Section 73 of the Companies Act, 1956, a company seeking listing of its securities on the
Exchange is required to submit a Letter of Application to all the Stock Exchanges where it
proposes to have its securities listed before filing the prospectus with the Registrar of Companies.
[VI] Allotment of Securities
As per Listing Agreement, a company is required to complete allotment of securities offered to the
public within 30 days of the date of closure of the subscription list and approach the Regional
Stock Exchange, i.e. Stock Exchange nearest to its Registered Office for approval of the basis of
allotment.
In case of Book Building issue, allotment shall be made not later than 15 days from the closure of
the issue failing which interest at the rate of 15% shall be paid to the investors.
[VII] Trading Permission
As per Securities and Exchange Board of India Guidelines, the issuer company should complete
the formalities for trading at all the Stock Exchanges where the securities are to be listed within 7
working days of finalisation of Basis of Allotment.
A company should scrupulously adhere to the time limit for allotment of all securities and dispatch
of Allotment Letters/Share Certificates and Refund Orders and for obtaining the listing
permissions of all the Exchanges whose names are stated in its prospectus or offer documents. In
the event of listing permission to a company being denied by any Stock Exchange where it had

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applied for listing of its securities, it cannot proceed with the allotment of shares. However, the
company may file an appeal before the Securities and Exchange Board of India under Section 22
of the Securities Contracts (Regulation) Act, 1956.
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[VIII] Requirement of 1% Security
The companies making public/rights issues are required to deposit 1% of issue amount with the
Regional Stock Exchange before the issue opens. This amount is liable to be forfeited in the event
of the company not resolving the complaints of investors regarding delay in sending refund
orders/share certificates, non-payment of commission to underwriters, brokers, etc.
[IX] Payment of Listing Fees
All companies listed on the Exchange have to pay Annual Listing Fees by the 30th April of every
financial year to the Exchange as per the Schedule of Listing Fees prescribed from time to time.
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The schedule of listing fees for the year 2004-2005, prescribed by the Governing Board of the
Exchange and approved by the Securities and Exchange Board of India is given hereunder:
SCHEDULE OF LISTING FEES FOR THE YEAR 2004-2005
Sr. Amount
Particulars
No. (Rs.)
1 Initial Listing Fees 20,000
2 Annual Listing Fees
(i) Companies with paid-up capital* up to Rs.5 crores 10,000
(ii) Above Rs.5 crores and up to Rs.10 crores 15,000
(iii) Above Rs.10 crores and up to Rs.20 crores 30,000
3 Companies which have a paid-up capital* of more than Rs.20 crores will pay
additional fee of Rs.750/- for every increase of Rs.1 crores or part thereof.
4 In case of debenture capital (not convertible into equity shares) of companies,
the fees will be charged @ 25% of the fees payable as per the above mentioned
scales.
*includes equity shares, preference shares, fully convertible debentures, partly convertible
debenture capital and any other security which will be converted into equity shares.

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 Security Analysis

[X] Compliance with Listing Agreement

The companies desirous of getting their securities listed are required to enter into an agreement
with the Exchange called the Listing Agreement and they are required to make certain disclosures
and perform certain acts. As such, the agreement is of great importance and is executed under the
common seal of a company. Under the Listing Agreement, a company undertakes, amongst other
things, to provide facilities for prompt transfer, registration, sub-division and consolidation of
securities; to give proper notice of closure of transfer books and record dates, to forward copies of
unabridged Annual Reports and Balance Sheets to the shareholders, to file Distribution Schedule
with the Exchange annually; to furnish financial results on a quarterly basis; intimate promptly to
the Exchange the happenings which are likely to materially affect the financial performance of the
Company and its stock prices, to comply with the conditions of Corporate Governance, etc.
The Listing Department of the Exchange monitors the compliance of the companies with the
provisions of the Listing Agreement, especially with regard to timely payment of annual listing
fees, submission of quarterly results, requirement of minimum number of shareholders, etc. and
takes penal action against the defaulting companies.
[XI] “Z” Group
The Exchange has introduced a new category called “Z Group” from July 1999 for companies who
have not complied with and are in breach of provisions of the Listing Agreement. The number of
companies placed under this group as at the end of February, 2005 was 50.
The number of companies listed at the Exchange as at the end of May 2001 was 5,874. This is the

I
highest number among the Stock Exchanges in the country and in the world.
New Direct Listing Norms: The Governing Board of the Exchange at its meeting held on 6th
FA
August, 2002 amended the direct listing norms for companies listed on other Stock Exchange(s)
and seeking listing at BSE. These norms are applicable with immediate effect.
1. The company should have minimum issued and paid-up equity capital of Rs.3 crores.
2. The company should have profit making track record for the last three years. The
revenues/profits arising out of extraordinary items or income from any source of non-
recurring nature should be excluded while calculating distributable profits.
3. Minimum net worth of Rs.20 crores (net worth includes equity capital and free reserves
excluding revaluation reserves).
4. Minimum market capitalisation of the listed capital should be at least two times of the paid-up
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capital.
5. The company should have a dividend paying track record for the last 3 consecutive years and
the minimum dividend should be at least 10%.
6. Minimum 25% of the company’s issued capital should be with Non-Promoters shareholders
as per Clause 35 of the Listing Agreement. Out of above Non-Promoter holding no single
shareholder should hold more than 0.5% of the paid-up capital of the company individually
or jointly with others except in case of Banks/Financial Institutions/Foreign Institutional
Investors/Overseas Corporate Bodies and Non-Resident Indians.
7. The company should have at least two years listing record with any of the Regional Stock
Exchange.
8. The company should sign an agreement with CDSL & NSDL for demat trading.
[XII] Cash Management Services (CMS) – Collection of Listing Fees
As a further step towards simplifying the system of payment of listing fees, the Exchange has
entered into an arrangement with HDFC Bank for collection of listing fees, from 141 locations,
situated all over India. Details of the HDFC Bank branches, are available website
www.bseindia.com as well as on the HDFC Bank website www.hdfcbank.com. The above facility
is being provided free of cost to the companies.
Companies intending to utilise the above facility for payment of listing fee would be required to
furnish the information, in the Cash Management Cash Deposit Slip. These slips would be
available at all the HDFC Bank centres.

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 Stock Market in India

Annexure V
Clearing and Settlement Function at NSE11

Clearing
Clearing is the process of determination of obligations, after which the obligations are discharged
by settlement.
NSCCL has two categories of clearing members: trading members and custodians. The trading
members can pass on the obligation to the custodian if the custodian confirms the same to NSCCL.
All the trades whose obligations the trading member proposes to pass on to the custodian are
forwarded to the custodian by NSCCL for their confirmation. The custodian is required to confirm
these trades on T + 1 days basis.
Once, the above activities are completed, NSCCL starts its function of clearing. It uses the concept
of multi-lateral netting for determining the obligations of counterparties. Accordingly, a clearing
member would have either pay-in or pay-out obligations for funds and securities separately. Thus,
members pay-in and pay-out obligations for funds and securities are determined latest by T + 1
day and are forwarded to them so that they can settle their obligations on the settlement day (T+2).

Cleared and Non-cleared Deals

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NSCCL carries out the clearing and settlement of trades executed in the following sub-segments of
the equities segment:
1.
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All trades executed in the Book entry/Rolling segment.
2. All trades executed in the Limited Physical Market segment.
NSCCL does not undertake clearing and settlement of deals executed in the Trade for Trade sub-
segment of the Equities (Capital Market) Segment of the Exchange. Primary responsibility of
settling these deals rests directly with the members and the Exchange only monitors the settlement.
The parties are required to report settlement of these deals to the Exchange.

Clearing Mechanism
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Trades in rolling segment are cleared and settled on a netted basis. Trading and settlement periods
are specified by the Exchange/Clearing Corporation from time to time. Deals executed during a
particular trading period are netted at the end of that trading period and settlement obligations for
that settlement period are computed. A multilateral netting procedure is adopted to determine the
net settlement obligations.
In a rolling settlement, each trading day is considered as a trading period and trades executed
during the day are netted to obtain the net obligations for the day.
Trade-for-trade deals and Limited Physical Market deals are settled on a trade for trade basis and
settlement obligations arise out of every deal.

Securities Settlement
The securities obligations of members are downloaded to members/custodians by NSCCL after the
trading period is over. The members/custodians deliver the securities to the Clearing House on the
pay-in day in case of physical settlement and make available the required securities in the pool
accounts with the depository participants in case of dematerialised securities. Members are
required to open accounts with depository participants of both the depositores, NSDL and CDSL.
Delivering members are required to deliver all documents to the Clearing House (in case of
physical settlement) during its regular business hours from 10 a.m. to 5 p.m. but not later than

11 Nseindia.com/clearing and settlement.

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 Security Analysis

10:00 a.m on the pay-in day. Receiving members are allotted specific time slots on pay-out day to
collect the documents from the Clearing House.
In case of dematerialised settlement, the delivering member should have clear balances of
securities in his delivery account within his CM clearing account with the depository on or before
10:00 a.m. on the pay-in day. The depository would debit the delivering members’ account on or
after 10:00 a.m. The depository would credit the receiving members’ receipt account within his
CM clearing account with the depository on or after 2:30 p.m. on the pay-out day.
Pursuant to SEBI directive (vide its circular SMDRP/Policy/Cir-05/2001 dated February 1, 2001)
NSCCL has introduced a settlement system for direct delivery of securities to the investors
accounts with effect from April 2, 2001.

Funds Settlement
NSCCL offers settlement of funds through 10 clearing banks namely Canara Bank, HDFC Bank,
IndusInd Bank, ICICI Bank, UTI Bank, Bank of India, IDBI Bank, Hongkong & Shanghai
Banking Corporation Ltd., Kotak Mahindra Bank and Standard Chartered Bank.
Every Clearing Member is required to maintain and operate a clearing account with any one of the
empanelled clearing banks at the designated clearing bank branches. The clearing account is to be
used exclusively for clearing & settlement operations.

Shortages Handling
On the securities pay-in day, NSCCL identifies short deliveries and the respective clearing

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member is debited by an amount equivalent to the securities not delivered by him and valued at a
valuation price. This is called a valuation debit. A valuation debit is also conducted for bad
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delivery by clearing members.
NSCCL conducts a buy-in auction for security shortages on the day after the pay-out day through
the NSE trading system. If the buy-in auction price is more than the valuation price, the member is
required to make good the difference.
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 Stock Market in India

Annexure VI
Risk Management System at NSE
Margins
Categorization of stocks for imposition of margins
• The Stocks which have traded at least 80% of the days for the previous 18 months shall
constitute the Group I and Group II.
• Out of the scrips identified above, the scrips having mean impact cost of less than or equal to
1% shall be categorized under Group I and the scrips where the impact cost is more than 1,
shall be categorized under Group II.
• The remaining stocks shall be classified into Group III.
• The impact cost shall be calculated at 15th of each month on a rolling basis considering the
order book snapshots of the previous six months. On the basis of the impact cost so
calculated, the scrips shall move from one group to another group from the 1st of the next
month.
Daily margins payable by members consists of the following:
1. Value at Risk Margin
2. Mark-to-Market Margin

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Daily margin, comprising of the sum of VaR margin and mark-to-market margin is payable.
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Value at Risk Margin
VaR margin is applicable to all securities in rolling settlement. All securities are classified into
three groups for the purpose of VaR margin.
For the securities listed in Group I Scrip wise daily volatility is calculated using the exponentially
weighted moving average methodology that is used in the index futures market and the scrip wise
daily VaR would be 3.5 times the volatility so calculated.
For the securities listed in Group II the VaR margin shall be higher of scrip VaR (3.5 sigma) or
three times the index VaR, and it shall be scaled up by root 3.
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For the securities listed in Group III, the VaR margin would be equal to five times the index VaR
and scaled up by root 3.
VaR margin rate for a security constitutes the following:
1. Value at Risk (VaR) based margin, which is arrived at, based on the methods stated above.
The index VaR, for the purpose, would be the higher of the daily Index VaR based on S&P
CNX NIFTY or BSE SENSEX. The index VaR would be subject to a minimum of 5%.
2. Additional VAR Margin : 6% as specified by SEBI.
3. Security specific Margin : NSCCL may stipulate security specific margins for the securities
from time to time.
The VaR based margin would be rounded off to the next higher integer (For example, if the VaR
based Margin rate is 10.01, it would be rounded off to 11.00) and capped at 100%.
The VaR margin rate computed as mentioned above will be charged on the net outstanding
position (buy value-sell value) of the respective clients on the respective securities across all open
settlements. The net position at a client level for a member are arrived at and thereafter, it is
grossed across all the clients for a member to compute gross exposure for margin calculation.
For example, in case of a member, if client A has a buy position of 1000 in a security and client B
has a sell position of 1000 in the same security, the net position of the member in the security
would be taken as 2000. The buy position of client A and sell position of client B in the same
security would not be netted. It would be summed up to arrive at the member’s exposure for the
purpose of margin calculation.

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 Security Analysis

VaR Margin Rate & Security Category

Mark-to-Market Margin
Mark-to-market margin is computed on the basis of mark-to-market loss of a member. Mark-to-
market loss is the notional loss which the member would incur in case the cumulative net
outstanding position of the member in all securities, at the end of the relevant day were closed out
at the closing price of the securities as announced at the end of the day by the NSE. Mark to
market margin is calculated by marking each transaction in a scrip to the closing price of the scrip
at the end of trading. In case the security has not been traded on a particular day, the latest
available closing price at the NSE is considered as the closing price.
In the event of the net outstanding position of a member in any security being nil, the difference
between the buy and sell values would be considered as notional loss for the purpose of calculating
the mark-to-market margin payable.
MTM profit/loss across different securities within the same settlement is set off to determine the
MTM loss for a settlement. Such MTM losses for settlements are computed at client level.

VaR Margin Rate, Security Category and Impact Cost

The data for VAR margin rates and security category are made available in the specified format as
DAT files.

Margin Payment & Payout

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Payment of Margin
The daily margin for rolling settlements is payable on T+1 day. The margin is collected together
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for all settlements for all clients. Members are responsible to compute margin payable and to make
suitable margin payments on the due date. Members are required to deposit the margin money due
in cash, bank guarantee or FDRs, rounded off to the next higher multiple of Rs.10,000.
Pay-out of Margin
The margins deposited in cash on a given day may, if NSCCL chooses not to exercise its lien, be
returned to the member on the subsequent day after adjustment for margin, additional base capital
and any other funds dues. NSCCL may, at its discretion retain part or whole of the amount
releasable cash margin, with respect to any member as a risk containment measure.
Upfront Margins Collection
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Members are required to ensure collection of upfront margin from their clients at rates mentioned
below and deposit the same in a separate clients account, in respect of trades in Normal market
which would result in a margin of Rs.50,000 or more, after applying the margin percentages as
given below:
Groups (Securities Covered) Upfront Margin Rate
Group I 15%
Group II 30%
Group III 45%
Failure to Pay Margins
Non-payment of either the whole or part of the margin amount due will be treated as a violation of
the Bye Laws of the Clearing Corporation and will attract penal charges @ 0.09% per day of the
amount not paid throughout the period of non-payment.
In case a member has a margin shortage of Rs.10 lakh or above for more than 10 occasions in the
past 4 weeks, the gross exposure multiple of the member will be reduced to one level lower at the
time of re-activation of their trading terminals as given under:
Slab Multiple
Full Exposure 8.50 times
1st Level 7.00 times
2nd Level 5.00 times
3rd Level 3.00 times
4th Level 2.00 times

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 Stock Market in India

If there is no margin shortage for the next 1 week of Rs.10 lakhs or more, the exposure limits shall
be restored to the previous levels.
In addition, NSCCL may, within such time as it may deem fit, advise the Exchange to withdraw
any or all of the membership rights of the member including the withdrawal of trading facilities
without any notice.
In the event of withdrawal of trading facilities, the outstanding positions of the member may be
closed out, to the extent possible, forthwith or any time thereafter by NSCCL, at its discretion by
placing at the Exchange, counter orders in respect of the outstanding position of the member,
without any notice to the member, and such action shall be final and binding on the member.
Margins based on Turnover & Exposure Limits (Initial Margins)
Intra-day Turnover Limit
Members are subject to intra-day trading limits. Gross turnover (buy + sell) intra-day of the
member should not exceed twenty five (25) times the base capital (cash deposit and other deposits
in the form of securities or bank guarantees with NSCCL and NSE).
A members violating the intra-day gross turnover limit at any time on any trading day are not be
permitted to trade forthwith
Members’s trading facility is restored from the next trading day with a reduced intra-day turnover
limit of 20 times the base capital till deposits in the form of additional deposits (additional base
capital) is deposited with NSCCL.

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Members are given a maximum of 15 days time from the date of the violation to bring in the
additional capital. Upon members failing to deposit the additional capital within the stipulated
time, the reduced turnover limit of 20 times the base capital would be applicable for a period of
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one month from the last date for providing the margin deposits.
Upon the member violating the reduced intra-day turnover limit, the above mentioned provisions
apply and the intra-day turnover limit will be further reduced to 15 times. Upon subsequent
violations, the intra-day turnover limit will be further reduced from 15 times to 10 times and then
from 10 times to 5 times the base capital. Members are not permitted to trade if any subsequent
violation occurs till the required additional deposit is brought in.
Gross Exposure Limits
Members are also subject to gross exposure limits. Gross exposure for a member, across all
securities in rolling settlements, is computed as absolute (buy value – sell value), i.e. ignoring +ve
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and –ve signs, across all open settlements. Open settlements would be all those settlements for
which trading has commenced and for which settlement pay-in is not yet completed. The total
gross exposure for a member on any given day would be the sum total of the gross exposure
computed across all the securities in which a member has an open position.
Gross exposure limit would be:
Total Base Capital Gross Exposure Limit
up to Rs.1 crore 8.5 times the total base capital
8.5 crore + 10 times the total base capital in excess of Rs.1 crore or any
> Rs.1 crore
such lower limits as applicable to the members.
The total base capital being the base minimum capital (cash deposit and security deposit) and
additional deposits, not used towards margins, in the nature of securities, bank guarantee, FDR, or
cash with NSCCL and NSE.
Security-wise Differential Exposure Limits
In case of securities that are traded in the Rolling settlement (Type ‘N’ and security series ‘EQ’),
the GE multiple for each security is as under:
Groups (Securities Covered) Covered Multiple
Group I 1.25 times
Group II 2 times
Group III 8.5 times

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 Security Analysis

All new securities to be traded on the Exchange shall be subject to exposure multiple of 8.5 times.
It is clarified that while computing the gross exposure at any time for a particular trading day, for
the purpose of the above limits, members are required to add the net outstanding positions of the
previous settlement period to the cumulative net outstanding positions as of that particular trading
day until the securities pay-in day for the previous settlement period.
Members exceeding the gross exposure limit are not permitted to trade with immediate effect and
are not permitted to do so until the cumulative gross exposure is reduced to below the gross
exposure limits (as defined above or any such lower limits as applicable to the members) or they
increase their limit by providing additional base capital.
Members who desire to reduce their gross exposure may submit their order entry requirements as
per the prescribed format.
If members desire to increase their limits, additional deposits by way of cash, bank guarantee or
Fixed Deposit Receipt (FDR) have to be submitted to NSCCL. Additional deposits by way of
securities in electronic form (‘demat securities’) may be deposited as per procedures.
The additional deposits of the member is used first for adjustment against gross exposure of the
member. After such adjustments, the surplus additional deposits, if any, excluding deposits in the
form of securities, is utilized for meeting margin requirements.
Violation Charges
A penalty of Rs.5,000 is levied for each violation of gross exposure limit and Intra Day Turnover

I
limits, which shall be paid by next day. The penalty is debited to the clearing account of the
member. Non-payment of penalty in time will attract penal interest of 15 basis points per day till
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the date of payment.
In case of second and subsequent violation during the day the penalty will be in multiples of
Rs.5000 for each such instances. (For example, in case of second violation for the day the penalty
levied will be Rs.10,000, Rs.15,000 for third instances and so on).
In respect of violation of stipulated limits on more than one occasion on the same day, each
violation would be treated as a separate instance for purpose of calculation of penalty.
The penalty as indicated above, would be charged to the members irrespective of whether they
bring in additional capital subsequently.
Additional Base Capital
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Members may provide additional margin/collateral deposit (additional base capital) to NSCCL,
over and above their minimum deposit requirements (base capital), towards margins and/or
exposure/turnover limits.
Members may submit such deposits in any one form or combination of the following forms:
1. Cash
2. Fixed Deposit Receipts (FDRs) issued by approved banks and deposited with approved
Custodians or NSCCL
3. Bank Guarantee in favor of NSCCL from approved banks in the specified format. If a bank
guarantee is submitted by a bank, whose net worth is above Rs.500 crores, then the same is
considered as cash component and all other bank guarantees will be considered as non-cash
component as per past procedures.
List of the Banks, whose net worth is more than 500 crores.
4. Approved securities in demat form deposited with approved custodians.
5. Government Securities: The procedure for acceptance and list of securities is as specified in
circular. The haircut for the Government Securities shall be 10%.
6. Units of the schemes of liquid mutual funds or government securities mutual funds. The
haircuts for units of liquid funds or government securities mutual funds shall be 10% of Net
Asset Value (NAV). Units of all Mutual Funds schemes except Liquid Mutual Funds and
Government Securities Mutual Funds (in demat) shall be eligible security for the purpose of
non-cash component of additional capital and margin subject to a haircut equivalent to the
VaR of the unit’s NAV plus any exit load charged by the mutual fund.

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 Stock Market in India

All Additional Base Capital (ABC) given in the form of cash/FDR/BG’s from approved Banks
whose net worth is above 500 crores, (hereinafter referred to as ‘Cash Component’) should be at least
50% of the total ABC and Cash Margins in respect of every trading member. In case where non-
cash component is more than 50% of the total additional base capital, the excess non-cash
component is ignored for the purpose of exposure limits requirements and/or margins
requirements.

Exemption for Institutional Deals

While computing margins, institutional deals are excluded. Deals executed on behalf of the
following entities are considered as institutional deals:
1. Financial Institutions
2. SEBI registered FIIs
3. Banks
4. SEBI registered Mutual Funds.
Deals are identified by the use of the participant code in the trades reported on the NSE.
Deals entered into on behalf of custodial participants i.e. carrying custodial participant code are
considered as institutional deals unless not confirmed by the respective custodians in which case
the deals shall attract margins.
Non-Custodial Institutional Deals are identified by the use of the participant code ‘NCIT’. The

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‘NCIT’ deals will be exempted for margin purposes (However, VaR based margin which is
charged on institutional trades on the net outstanding sale position, in securities shall be applicable
in this case also) and the settlement obligation will remain with TM clearing member. Non-
FA
Custodial Institutional deals, which are not marked as ‘NCIT’ at the time of order entry, will not
be exempted.
All TM clearing members are required to provide details of the contract notes for all Non-
Custodial Institutional Trades through a file upload as per the procedure.

Exemption upon Delivery of Securities

If a member delivers securities prior to the securities pay-in day, then the margin payable by the
member will be recomputed after considering the above pay-in of securities. The margin benefit on
account of early payin (EPI) of securities shall be given to the extent of the net delivery position
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across all clients of the member. The EPI would be allocated to clients having net deliverable
position, on a random basis, till such time that the system is developed to provide the EPI benefit
on a client basis. However, members are required to ensure to pass on appropriate early pay-in
benefit of margin/exposure to the relevant client, until the above system is in place.
The value of the advance pay-in made is reduced from the cumulative net outstanding sale position
of the member for the purpose of gross exposure limits.
Members may note that early pay-in of securities only up to the working day prior to the scheduled
settlement pay-in day shall be considered for the purpose of early pay in benefits. In case any
member makes early pay-in on the scheduled day of pay-in for the settlement, no benefit will
accrue to the member. Such early pay-in shall not be adjusted against the settlement pay-in
obligation and it would be treated as short delivery. Members are therefore alerted to ensure that
no early pay-in is made on the scheduled day of settlement pay-in.

Pay-in of Funds/Securities Prior to Scheduled Pay-in Day

The relevant authority may require members to pay-in funds and securities prior to the scheduled
pay-in day for funds and securities. The relevant authority would determine from time to time, the
members who would be required to pay-in funds and securities prior to the pay-in day. The
relevant authority would also determine securities and funds which would be required to be paid in
and the date by which such pay-in shall be made by the respective member.
The value of such prior pay-in of funds and securities will not be reduced from the cumulative net
position of the member for the purpose of gross exposure reduction. There will be no margin
exemption available for such pay-in of funds and securities.

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Security Analysis

Chapter IV

Security Market Indicators

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•
FA
After reading this chapter, you will be conversant with:

Utility of Security Market Indices

• Construction of Security Market Indices
• Types of Security Market Indices in India
• Limitations of Various Indices
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 Security Market Indicators

Introduction
“How’s the market doing?” is frequently the first question investors ask their
brokers. This interest in market movements results from the fact that the prices of
individual securities tend to vary with market movements.
The general movement of the stock market is usually measured by averages or
indices consisting of groups of securities that are supposed to represent the entire
stock market or particular segments of it. Thus, Security Market Indices (or)
Security Market Indicators provide a summary measure of the behavior of security
prices and the stock market.
In this chapter, we will discuss in detail about the salient features of the principal
share price index numbers used in India i.e. the Bombay Stock Exchange Sensitive
Index (BSE Sensex) and the Bombay Stock Exchange National Index (BSE
National Index). The other known indices like Reserve Bank of India Equity Share
Index, Financial Express All India Equity Index and Economic Times Ordinary
Share Price Index will also be described for a comparative study.
However, before examining these index numbers we will look into
a. the need for having a summary measure;
b. the objectives sought to be achieved by constructing index numbers; and
c. the factors that influence the construction of index numbers.

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FA
UTILITY OF SECURITY MARKET INDICES
The security market indices are indicators of different things and are useful for
different purposes. Following are the important uses of an index:
• Security market indices are the basic tools to help and analyze the
movements of prices of various stocks listed in stock exchanges and is a
useful indicator of a country’s economic health.
• The return on the index, which is known as market return, is helpful in
evaluating the portfolio risk-return analysis. According to modern portfolio
theory’s capital asset pricing model, the return on a stock depends on whether
the stock’s price follows prices in the market as a whole; the more closely the
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stock follows the market, the greater will be its expected return.
• Indices can be calculated industry-wise to know their trend pattern and also
for comparative purposes across the industries and with the market indices.
• Generally, market indices are designed to serve as indicators of broad
movements in the securities market and as a sensitive barometer to the
changes in trading patterns in the stock market.
• The growth in the secondary market can be measured through the movement
of indices.
• The index can be used to compare a given share price behavior with its
movements.
• The investors can make their investment decisions accordingly by estimating
the realized rate of return on the index between two dates.
• Funds can be allocated more rationally between stocks with a knowledge of
the relationship of prices of individual stocks to the movements in the
market.

The Objectives sought to be achieved by Constructing Index Numbers

An ideal index number of share prices must serve two purposes:
i. It must represent the changes in the values of all shares i.e. changes in the
overall market performance, and
ii. It must reflect the price movement of typical shares.

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 Security Analysis

CONSTRUCTION OF SECURITY MARKET INDICES

The Factors that Influence the Construction of Index Numbers
To ensure that an index number serves the objectives/purposes mentioned above,
a careful attention must be given to the following factors that influence the
construction of index numbers:
i. selecting the shares for inclusion in the index-sampling;
ii. determining the relative importance of each share included in the sample
weighting; and
iii. averaging the included shares into a single measure.
Selecting Stocks for Inclusion
An index can be based on a sample of stocks or all of them. When the index is
based on all listed shares, then the question of sampling does not arise. But when
the index is based on a sample1 the utility of the index will depend upon the degree
to which one can infer movements in excluded shares on the basis of movements
in the included shares.
So, an index based on a sample will be the desired measure only when: (a) the
shares of relatively few listed companies constitute a large proportion of the value
of the shares of all listed companies; and (b) there is a tendency for all share prices
to move together.

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Determining the Relative Importance of the Share
To determine the relative importance of each included share in the overall index,
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we need to have a system of weighing the shares. The system of weighting is
usually determined by the purpose for which the index number is constructed.
There are two popular ways of weighting the shares included in the sample:
(a) assign weights based on the market values, and (b) assign equal weights to
equal relative price changes. When weights are assigned on market value basis, the
index number is typically defined as follows:
N

∑ PR
t =1
it Wi
N
x100 Eq.. (1)
∑ Wi
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t =1

where,
Pit
PRit = Price relative of share i in period t which is equal to
i.e. price
Pio
of share i in period t divided by the price of the share in the base year.
Wi = Weight proportional to the market value of share i in the base year
divided by market value of all shares of the sample during the base
year.
N = Size of the sample.
When relative price changes are equally weighted, the index number is defined as
N

∑ PR
t =1
it

x100 Eq.. (2)

N
Where N denotes the size of the sample.
The method of weighing based on market values is appropriate for indicating
changes in the aggregate market value of stocks, while the latter method is more
appropriate for indicating price movements of typical stocks.

1 As we will see later in this chapter, all principal share price index numbers in India are based on a sample
of shares unlike the New York Stock Exchange (NYSE) Index in the US which is based on all stocks listed
on Exchange.

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 Security Market Indicators

Methods of Averaging
Two kinds of averages are used in constructing share price indices – arithmetic
mean and the geometric mean. Between the two averages, the arithmetic mean is
more widely used. However, before we evaluate these methods, it must be
emphasized that the indices based on averages are not the same as the averages.
The following table clarifies this point2.
Table 1
Share Base period price Current period price
(Rs.) (Rs.)
A 70 110
B 50 72
C 65 45
D 40 44
Average Rs.56.25 Rs.67.75
Index Number 100 120.44
The index number in the above table is based on the arithmetic average. The
difference between this average and the average we defined in equation (1) being
that the former is an unweighted arithmetic average while the latter is a weighted
arithmetic average. Instead of using the arithmetic average, we can use the

I
geometric average to determine the index number. In the above example, the index
number based on the geometric mean will be given by
FA  110 72 45 44  4
 x x x  x100
1

 70 50 65 40 
= 1.1457 x 100
= 114.57
So, we find that there is a variation in the index numbers based on the two methods.
It is important to recognize this fact because the degree of divergence increases with
the degree of variability in the component prices. An index based on the geometric
mean will increase more slowly and decrease more rapidly than an index based on
the arithmetic mean. So arithmetic mean has an upward bias, while geometric mean
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has a downward bias. The implication of this property is that an index based on
arithmetic mean will outperform most of the components in the long run. Table 2
illustrates the relative movements in the index based on both these methods.
Table 2
Period
Share Base Price 1 2 3 4
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
A 50 60.00 90.00 70.00 65.00
B 50 75.00 140.00 50.00 40.00
C 50 65.00 87.00 60.00 50.00
D 50 55.00 75.00 55.00 45.00
Average:
Arithmetic 50 63.75 98.00 58.75 50.00
Geometric 50 63.33 95.22 58.30 49.18
Index:
Arithmetic 100 127.50 196.00 117.50 100.00
Geometric 100 126.66 190.44 116.60 98.36
The main purpose of index is to measure the prevailing investor sentiment. The investor
sentiment being a human state of mind fluctuates frequently and so does index.

2 The quantities like 110/70 are called price relatives.

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Security Analysis

How does one calculate and interpret an index? Generally, an index can be
developed and compiled in the following manner:
• Select those scrips which fairly reflect the stock market movements. The
number of scrips could depend on how broad based the index has to be made.
• Select a base year when the stock markets were relatively stable and is in
proximity to the year in which the index is being constructed.
• Take the average price aggregates of all the selected scrips in the base year.
This will be the base year value.
• Take the aggregate price value of the selected scrips, as on a particular day.
• Find the price relative of the current price aggregate as against the base year
aggregate.
That will be the index for that particular day.
An illustration is given in Table 3 to further elucidate how the index is set-up and
calculated.
Table 3: Calculation of Hypothetical Index
Scrip Name A B % Change
Abc 50 65 30.00
Pqr 100 125 25.00
Xyz 75 70 –6.67

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Total 225 260 15.55
FA Note:
A – Average price in the year 19x0
B – Price as on a day in the year 19x2
Total A – Average price aggregate in the base year
Total B – Price aggregate as on a particular day
INDEX – 260/225 x 100
= 115.55 (Base 19 x 0 = 100)
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From Table 3 it is clear, though individual scrips may have changed by 30, 25, 7
percent, the market as a whole has gained by 15.55 percent. However, in the above
hypothetical example each of the scrip is considered to have equal importance in
the market. But in reality such examples are hard to find. The degree of influence
each scrip has on the market, varies from the other. Thus, if weights are introduced
in the index, depending upon influence of the scrip in the market, a more reliable
index figure can be calculated. Table 4 introduces market capitalization of the
scrips as weights for the above example.
Table 4: Calculation of Hypothetical Index
Scrip Name M.Cap Weights A B AW BW
(Rs. in crore) (W)
Abc 125 0.625 50 65 31.250 40.625
Pqr 50 0.250 100 125 25.000 31.25
Xyz 25 0.125 75 70 9.375 8.750
Total 175 1.000 225 260 65.625 80.625
Weighted Index : 80.625/65.625
= 122.86 (Base 19x0 = 100)
Thus when weights are introduced the index changes dramatically. The weighted
index shows that the market has risen by 22.86 percent from what was in 19x0.

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 Security Market Indicators

TYPES OF SECURITY MARKET INDICES IN INDIA

Ever since stock market started playing a major role in mobilization of resources
by the companies, a strong need was felt for some kind of an indicator which
would reflect the general trend of the market i.e. whether money is flowing into
the market or out of it. With this purpose, various stock indices were compiled and
published by RBI, The Economic Times, Financial Express, Bombay Stock
Exchange, etc. The indices differ in the coverage of scrips, base year, weighting
and compilation, but the adjustments made for rights and bonus issues, conversion
of debentures, etc. are basically the same. The methods of compilation follow
closely to that followed by Standard & Poor, Dow Jones, USA. The indices are
useful to investors, share brokers, research analysts, etc. in gauging the prevalent
investment mood, the state of the economy, likely response to primary issues, etc.
But the indices are not without their limitations. Some limitations are inherent in
the coverage of scrips and method of compilation while others are caused by
distortions in weightages used and the adjustments made. This calls for appropriate
changes in the construction of indices so that they can be easily interpreted and
correctly followed by everyone interested in the measurement of stock-market
behavior. Next few pages deal with very popular indices, used in different spheres
of investment world on day to day basis.

BSE – Sensex

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The absence of an index number of equity prices reflecting the general trend of the
market at the end of a day’s session was felt from a long time, by the share brokers
FA
and investors and also by newspapers who do not compile their own index
numbers. With this end in view, the stock exchange of Bombay compiled and
published a sensitive index number of equity prices from 2nd January, 1986
onwards. The index called “The Stock Exchange Sensitive Index Equity Prices”
along with the cyclostyled quotations from the The Daily Official list of stock
exchange.
COVERAGE
On the 50th Independence Day, the BSE revised the SENSEX by replacing 15
scrips. The selection was made on the basis of the market activity with due
representation to the major industries. The new SENSEX was the better
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representation of the market; and accounted for 33 percent of market capitalization
against the earlier level of 22 percent. It included the scrips both from ‘Specified’
and ‘Non-specified’ groups.
Revised list of SENSEX scrip is given below.
Sr. No. New Portfolio
1 ACC
2 Bajaj Auto
3 BHEL
4 BSES
5 Castrol Ind.
6 Cipla
7 Colgate
8 Dr. Reddy
9 Glaxo India
10 Grasim
11 Gujarat Ambuja
12 HPCL
13 Hindalco
14 Hindustan Lever
15 ICICI

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 Security Analysis

Sr. No. New Portfolio

16 Infosys Tech
17 ITC
18 L&T
19 Mahindra & Mahindra
20 MTNL
21 Nestle
22 NIIT
23 Ranbaxy
24 Reliance Petrol
25 Reliance
26 Satyam Computers
27 SBI
28 TELCO
29 TISCO
30 Zee Telefilms
CHOICE OF BASE YEAR
The financial year 1978-79 was chosen as the base year. Considerations for the
choice were the price stability during that year and the proximity to the current

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period.
METHOD OF COMPILATION
FA
The method of compilation was the same as used by Standard & Poor, USA3 in
the construction of their share price indices. The index for a day is calculated as
the percentage of the aggregate market value of the equity shares of all the
companies in the sample on that day to the average market value of the equity
shares of the same companies during the base period. This method of compilation
had the advantage that it had the necessary flexibility to adjust for arbitrary price
changes caused by the issue of right and bonus shares.
WEIGHTING
The price of each component share in the index was weighted by the number of
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shares outstanding so that it would influence the index in proportion to its respective
market importance. The current market value for any particular share was obtained
by multiplying the price of the share by the number of shares outstanding.
A drawback in using market capitalization as the weight in the index is that the
companies influence the market by the sheer size of their business and the way
they finance their projects.
ADJUSTMENTS FOR BONUS ISSUES
When a company included in the compilation of the index issues bonus or
subdivides or consolidates the existing equity shares, the new weighting factor will
be the number of equity shares outstanding after the bonus issue, subdivision or
consolidation has become effective. This new weighting factor will be used while
computing the index from the day the change becomes effective.
ADJUSTMENTS FOR RIGHT ISSUES
When a company included in the compilation, issues right shares, the weighting
factor for that share is increased by the number of additional shares actually issued.
An offsetting or proportionate adjustment is then made to the Base Year Average.

3 It is one of the best known indexes in USA, published by Standard & Poor’s Corporation – USA. This
index measures the price index of 500 widely held equity shares, mostly of the New York Stock
Exchange. It is considered to be more representative of stock market trends and often called as S & P’s
500 index. The S & P’s 500 index has 400 industrials, 40 public utilities, 20 transportation companies and
40 financial institutions.

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 Security Market Indicators

OTHER ISSUES
Weighting factors are revised when new share issues are made by way of
conversion of debentures, loans into equity by financial institutions, mergers, etc.
The Base Year Average is also suitably adjusted to offset the increase in the
market value thus added. Similarly, when convertible/non-convertible bonds/
debentures, preference shares, etc., are issued as rights to equity shareholders, the
Base Year Average is suitably adjusted on the basis of the ex-right price of the
equity share.
BASE CHANGES
Base changes are in effect proportional adjustments in the Base Year Average
Market Value to offset arbitrary price changes in market values upon which the
index is based. The formula for changing the Base Year Average is as follows:
New Market Value
New Base Year Average = Old Base Year Average x
Old Market Value
To illustrate, a company issues right shares which increases the market value of
the shares of that company by, say, Rs.100 crore. The existing Base Year Average,
say, is Rs.963.93 crore and the aggregate market value of all the shares included in
the index before the right issue is made is, say, Rs.2294.72 crore. The New Base
Year Average will then be
(2294.72 +100.00)

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963.93 x = 1005.94
2294.72
FA
This figure of Rs.1005.94 crore will be used as the Base Year Average for
calculating the index number from then onwards till the next base change becomes
necessary.

Latest Changes in BSE Sensex

The composition of the SENSEX was again revised in March 2000. Over the last
few years, Indian economy has made successful transition, first moved from
manufacturing economy to a service economy and now it is heading towards
knowledge-based economy. To reflect this, Infosys Technologies and NIIT were
included in the SENSEX in November 1998 replacing Arvind Mills (Textiles) and
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Great Eastern Shipping to give due importance to the up-and-coming software
sector. Further, Castrol and Novartis replaced SAIL and IPCL (Petrochemicals).
With increasing changes in Global Economy, it was felt that the BSE Sensitive
Index needed to be reviewed. Thus, in March 2000, four scrips – IDBI, Tata
Power, Tata Chem and Indian Hotels – were replaced by Zee Telefilms, Satyam
Computer, Dr. Reddy’s Lab and Reliance Petroleum. In 2001, Novartis was
replaced with Cipla Ltd. The replaced and replacing companies are shown below.
Table 5
Date Outgoing Scrips Replaced by
01.01.1986 Bombay Burmah Voltas
Asian Cables Peico
Crompton Greaves Premier Auto.
Scinda G.E.Shipping
03.08.1992 Zenith Ltd. Bharat Forge
19.08.1996 Ballarpur Inds. Arvind Mills
Bharat Forge Bajaj Auto
Bombay Dyeing BHEL
Ceat Tyres BSES
Century Text. Colgate
GSFC Guj. Amb. Cement

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Security Analysis

Date Outgoing Scrips Replaced by

Hind. Motors HPCL
Indian Organic ICICI
Indian Rayon IDBI
Kirloskar Cummins IPCL
Mukand Iron MTNL
Phillips Ranbaxy Lab.
Premier Auto State Bank of India
Siemens Steel Authority of India
Voltas Tata Chem
16.11.1998 Arvind Mills Castrol
G.E. Shipping Infosys Technologies
IPCL NIIT Ltd.
Steel Authority of India Novartis
10.04.2000 IDBI Dr. Reddy’s
Laboratories
Indian Hotels Reliance Petroleum
Tata Chem Satyam Computers

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Tata Power Zee Telefilms
FA 08.01.2001
07.01.2002
Novartis
NIIT Ltd.
Cipla Ltd.
HCL Technologies Ltd.
Mahindra & Mahindra Hero Honda Ltd.
For latest revisions, the students are advised to log on to www.bseindia.com.
The objective of recasting the most familiar index in the country was to give fair
representation to those sectors in the economy, which of late started playing a
crucial role. The weightages given to different companies in the recasted Sensex is
as given below.
Table 6
IC
Sr. No. Name Market Weight in
Capitalization Index
(Rs. cr.) (%)
1 Hind. Lever Ltd. 48361.33 17.79
2 Reliance Industries 33398.85 12.28
3 Infosys Tech. 31922.23 11.74
4 ITC Ltd. 17590.11 6.47
5 Rel. Petrol. 14590.68 5.37
6 Satyam Computers 10335.78 3.80
7 State Bank 10161.07 3.74
8 HCL Technologies 9050.96 3.33
9 Ranbaxy Laboratories 8298.12 3.05
10 MTNL 7994.70 2.94
11 Dr. Reddy’s Laboratories 7460.40 2.74
12 Cipla 6996.67 2.57
13 Hero Honda 5835.87 2.15
14 Zee Telefilms 5300.69 1.95
15 Hindalco 5212.25 1.92
16 Nestle 4868.99 1.79
17 L&T 4812.05 1.77

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 Security Market Indicators

Sr. No. Name Market Weight in

Capitalization Index
(Rs. cr.) (%)
18 HPL 4670.88 1.72
19 Bajaj Auto 4039.25 1.49
20 Tisco 3637.43 1.34
21 ICICI 3502.64 1.29
22 BHEL 3381.36 1.24
23 Gujarat Ambuja Cement 3205.87 1.18
24 A.C.C. 2853.94 1.05
25 BSES Ltd. 2788.44 1.03
26 Grasim Industries 2630.92 0.97
27 Telco 2547.05 0.94
28 Castrol 2367.24 0.87
29 Colgate Palmolive 2292.16 0.84
30 Glaxo Ltd 1783.98 0.66
BSE 100 Index
This index was introduced by BSE in 1988-89 with 1983-84 as its base year.
It was constructed with an objective of having a broad based index so as to have

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more smoother curve of the trend in the stock markets unlike the sensitive index
which fluctuates widely. Thus, while the sensex can be used by the speculators,
who need to have a daily or even momentary watch on the share prices, the Natex
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can be used by investors having a long-term investment perspective. However,
even the Natex faces the same problem like the sensex, that is, inclusion of lesser
market representative scrips.
METHOD OF COMPILATION
The methodology adopted for compiling BSE National Index is the same as the
one used in compilation of the BSE Sensitive Index except that in this case where
a scrip is actively quoted on more than one exchange, the average price of that
scrip on these exchanges is used in compilation of the index. The coverage is,
however, limited to the major stock exchanges of Mumbai, Calcutta, Delhi,
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Chennai and Ahmedabad.
The BSE National Index is being updated once in two minutes during market
hours and displayed along with the BSE Sensitive Index through the PTI
Stockscan Service. The day-to-day administration of the index is done by the
Department of Research, Statistics and Data Processing of the exchange.
COVERAGE
The equity shares of 100 companies from both the Specified and Non-specified
lists of the five major stock exchanges, viz., Mumbai, Calcutta, Delhi, Ahmedabad
and Chennai, have been selected for the purpose of compiling the Bombay Stock
Exchange National Index of Equity Prices with 1983-84 as the base year. The
major criteria for selection have been market activity, due representation to various
industrial groups and to the major stock exchanges. The 30 scrips comprising the
BSE Sensitive Index are all included in the new BSE National Index.
Designation of the BSE National Index to the BSE 100 Index
As discussed above, the BSE National index is used to consider prices of some
scrips from other stock exchanges or weighted average of some scrips that were
popular on other exchanges to reflect national wide market sentiments. However,
because of rapid advancements in information technology, there is now almost
instantaneous availability of information across the country. This ensured that
there is very little or no difference in prices of the index scrips. Therefore, the BSE
administration decided, since October 1996, to calculate the index based on the
prices of all scrips at BSE. It also redesignated the BSE 100 National Index as the
‘BSE 100’ index.

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 Security Analysis

Choice of Base Year

The price stability during 1983-84 and the proximity to the current period are the
main considerations for choosing it as the base year.
Adjustments for Bonus Issues
(Same as that for BSE Sensitive Index)
Adjustments for Right Issues
(Same as that for BSE Sensitive Index)
Other Issues
(Same as that for BSE Sensitive Index)
Base Changes
(Same as that for BSE Sensitive Index)

NSE-Fifty (Nifty)
The National Stock Exchange (NSE) had replaced the NSE-100 with a new equity
index, NSE-50, comprising of 50 actively traded stocks. The index had a base of
1000. The stocks selected represent 20 broad industry groups with an aggregate
market capitalization of Rs.1,70,000 crore. The exchange publishes periodically
the weightage of every security included in the index.

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LATEST CHANGES IN NSE-FIFTY
S&P CNX 50
FA
The two different stock indices NSE-50 of National Stock Exchange and CRISIL
500 of Credit Rating and Information Services of India Limited will be now
maintained by India Index Services and Products which is a joint venture between
NSE and CRISIL. India Index Services and Products will in turn have a consulting
and licensing agreement with Standard and Poor. Under this agreement the indices
NSE-50 and CRISIL 500 Equity will be now known as S & P CNX 50 and S & P
CNX 500 Equity respectively. The dollar equivalent of NSE-50 will be called as
S & P CNX defty. Also we have CNX Mid Cap 200 and CNX Nifty Junior which
will be maintained by India Index Services and Products for NSE and CRISIL.
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OBJECTIVES OF S&P CNX 50
The objectives of constructing this index are as follows:
a. It should reflect the market trends accurately.
b. It should act as a benchmark for fund managers to compare the return from
the portfolio with the market returns.
c. It should serve as a cornerstone for index based derivatives.
The base period selected for this index is the closing prices on November 3, 1995.
The base value is 1000.
The criteria for eligibility to be included into S & P CNX 50 are:
i. The market capitalization of Rs.500 crore, and
ii. High liquidity.
We define market capitalization of a company as the product of the market price of
the share and the number of shares outstanding. Liquidity is measured in terms of
trading frequency and impact cost. Impact cost is defined as the percentage
difference between the executed price and the mean of the best buy and sell prices.
It can be noticed that impact cost determines the liquidity of the company’s stock.
All the securities included in the index, necessarily satisfy the required execution
on 85% of the trading days at an impact cost of less than 1.5%.
We may find quite a number of companies which satisfy these criteria, but it is left
to the discretion of the exchange officials to make a final decision about the
inclusion of the companies in the index.

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 Security Market Indicators

The index is computed by giving weights in proportion to the market capitalization

of the companies on the lines of the internationally renowned index S & P 500. It
takes into consideration, inclusion of new companies and omission of the existing
ones in the index from time to time and adjusts for corporate actions like stock
splits, rights, etc. without affecting the index value. It is calculated as follows.
(Market capitalization of index stocks) (Initialindex value)
Index value =
Base capitalization of index
Since, an unbiased index ought to reflect various corporate events and actions from
time to time the base capitalization value has to be adjusted to a level, it was
before the announcement of such events. The adjustments are incorporated by
calculating new base capitalization. It is given by
New Base = Old Base Capitalization + (Changed issue size x Issue price)
 Initial index value 
x  
 Previous closing price 
Depending on this criteria, from October 7, 1998, seven companies have been
replaced with seven others. The seven companies which are replacing Andhra
Power Valley Supply, Ashok Leyland, Bharath Petroleum Corporation, Indo Gulf
Fertilizers, MRPL, Pond’s India and Thermax Ltd. are Bank of India, Cipla, Hero
Honda, Infosys Technologies, NIIT, Procter and Gamble and SmithKline-

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Beecham Healthcare Ltd.
Table 7: Outstanding S&P CNX Nifty Shares
FA As on January 29, 2002
Security Market Capitalization Weightage
(Rs. crore)
Asea Brown Boveri Ltd. 902.92 0.27
Asian Paints India Ltd. 1749.07 0.53
Associated Cement Co. Ltd. 2705.99 0.82
Bajaj Auto Ltd. 4450.05 1.34
Bharat Heavy Electricals Ltd. 3635.91 1.10
IC

Britannia Industries Ltd. 1557.73 0.47

BSES Ltd. 2738.77 0.83
Castrol India Ltd. 2370.65 0.72
Cipla Ltd. 6658.13 2.01
Colgate Palmolive India Ltd. 2072.53 0.63
Dabur India Ltd. 1831.98 0.55
Digital Globalsoft Ltd. 1888.68 0.57
Dr. Reddy’s Laboratories Ltd. 7267.10 2.19
Glaxo (India) Ltd. 2504.59 0.76
Grasim Industries Ltd. 2566.29 0.77
Gujarat Ambuja Cement Ltd. 2977.14 0.90
HDFC Bank Ltd. 6375.95 1.92
Hero Honda Motors Ltd. 6062.51 1.83
Hindalco Industries Ltd. 5219.37 1.57
Hindustan Lever Ltd. 48779.56 14.72
Hindustan Petroleum Corporation Ltd. 5678.69 1.71
Housing Development Finance 7646.24 2.31
Corporation Ltd.

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Security Analysis

Security Market Capitalization Weightage

(Rs. crore)
ICICI Bank Ltd. 1960.09 0.59
ICICI Ltd. 3962.07 1.20
Indian Hotels Co. Ltd. 630.70 0.19
Indian Petrochemicals Corpn. Ltd. 1507.61 0.45
Infosys Technologies Ltd. 24972.36 7.53
ITC Ltd. 17225.67 5.20
Larsen & Toubro Ltd. 4790.23 1.45
Mahanagar Telephone Nigam Ltd. 7326.90 2.21
Mahindra & Mahindra Ltd. 1251.27 0.38
Nestle India Ltd. 4822.71 1.46
NIIT Ltd. 846.23 0.26
Novartis India Ltd. 760.54 0.23
Oriental Bank of Commerce 693.14 0.21
Procter & Gamble India Ltd. 976.53 0.29
Ranbaxy Laboratories Ltd. 8626.10 2.60

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Reliance Industries Ltd. 33361.95 10.07
Reliance Petroleum Ltd. 14356.60 4.33
FA
Satyam Computer Services Ltd. 8126.14 2.45
Smithkline Beecham Consumer 1770.75 0.53
Healthcare Ltd.
State Bank of India 11068.09 3.34
Sun Pharmaceuticals Industries Ltd. 2925.09 0.88
Tata Chemicals Ltd. 734.30 0.22
Tata Engineering and Locomotive 3053.14 0.92
Co. Ltd.
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Tata Iron and Steel Co. Ltd. 3517.55 1.06
Tata Power Co. Ltd. 2296.92 0.69
Tata Tea Ltd. 919.48 0.28
Wipro Ltd. 36228.57 10.93
Zee Telefilms Ltd. 5102.69 1.54

Crisil 500 Equity Index

Crisil 500, as its name projects, comprises of 500 scrips spread over 97 industries.
It is constructed on the lines of world famous Standard and Poor index and is a
weighted average index. The base year is 1994 and the base value, 1000. Selection
of the companies has been made on the basis of four parameters:
• Market capitalization of the company.
• Industry representation.
• Trading interests in the scrips.
• Fundamentals of the company.
As already studied CRISIL 500 will be known as S & P CNX 500 Equity Index
and will be maintained by India Index Services and Products Ltd. CRISIL wants
this index to serve as a cornerstone for index based derivatives.

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 Security Market Indicators

Business Line-250 Index

The Business Line-250 Index is a portfolio of 250 stocks that has been designed
comprehensively to capture and disseminate the underlying spirit of the Indian
economy. The Business Line-250 is a portfolio of stocks from 41 industry groups,
one diversified group and one miscellaneous group. It is broad based and includes
stock of companies in which the public has a significant stake.
Companies tracked by this index should
a. have a significant share in the markets in which they operate, and
b. have a significant part of whose equity is held by individual and institutional
investors.
There are certain distinguishing features of the Business Line-250.
1. The Business Line-250 is weighted by market capitalization. A big price
spurt in a stock that has small market capitalization will have only a small
impact on the index.
2. The Business Line-250 can be easily adjusted for dividends, buy back of
equity, offerings of equity and convertible debt and issue and exercise of
warrants. It is, therefore, a full-fledged wealth index and not just a price index.
3. The Business Line-250 is a composite of 43 groups of stocks and the
performance of individual industry groups is captured by the composite.

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4. The Business Line-250 is designed to facilitate the easy deletion and addition
of stocks. It is immunized against fossilization.
FA
5. The deletion of a stock is usually followed by the addition of a stock in the same
industry. A cement stock will not be replaced by a sugar stock and vice versa.

OTCEI-Composite Index
The OTCEI Index is a pure price index. The sum of the prices of all shares as of
June, 1993 is in the denominator. The current prices are in the numerator. New scrips
are added to both the numerator and denominator. Adjustments for right and bonus
are also made. There is no element of market capitalization in the OTCEI index.
This is not intended for portfolio managers and traders. It is intended to reflect the
IC
mood [bullish or bearish] accurately for small investors. This index is similar to
TOPIX in Japan.
The OTCEI carried out several simulations to study the variations in the index.
A weighted index system was also simulated, before selecting the basis. With only
41 companies listed, and with more than 40 percent market capitalization
accounted by 3 companies [Renewable Energy System, Maxwell Apparel, and
Biochem Synergy], a weightage system at this stage would not achieve much.
Hence, they opted for pure price index.

Other Indices
List of stock market indicators is long and gaining momentum day by day. Many
indices are introduced by many players in the market. Most prominent among
them are:
Three debt indices:
a. Credit Capital’s Debt Index,
b. I-Sec’s Bond Index (i–BEX), and
c. J. P. Morgan India Treasury Bill Index.
Two GDR indices:
a. DSP’s GDR Valuation Index
b. 22-Basket Skindia GDR Index

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Security Analysis

Others being FE index, RBI index, ET index, etc. Salient features of some of them
are given in the table below.
Table 8: Comparison of the Various Security Market Indices
Bombay Stock Bombay Stock Reserve Bank Of Financial Express Economic Times
Exchange Exchange 100 India Index Number Equity Index (FE) Ordinary Share Price
Sensitive Index Index Of Index (ET)
(Sensex) Security
Prices (RBI)
Base Period 1978-79 = 100 1983-84 = 100 1980-81 = 100 1979 = 100 1984-85 = 100
Bombay, Bombay, Delhi,
Stock Bombay, Delhi, Bombay, Delhi,
Delhi, Calcutta, Calcutta, Madras,
exchanges Bombay Calcutta, Madras, Calcutta, Madras,
Madras, Bangalore, Pune, and
covered Ahmedabad Ahmedabad
Ahmedabad Kanpur
Number of
30 100 338 100 72
scrips
Method of The index for a day Same as sensex The weekly average Price relatives for Simple arithmetic
compilation is calculated as the except that in case price of each each of the scrips average of the price
percentage of where a scrip is sample scrip is are worked out by relatives of all the
aggregate market actively quoted on obtained as the dividing the scrips price relatives
value of the equity more than one arithmetic average closing quotation for each day are
shares of all the exchange, of daily closing price of the day by its obtained by dividing
companies in the the average price quotations in the corresponding the daily quotations by
sample on that day of that scrip on week. Price relative average daily the correspon-
to the average these exchanges is for a scrip during a base price in ding average prices
market value of the used in the particular week is 1979 and of the base year.
equity shares of the compilation of the worked out as the multiplying it by

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same companies index. ratio of the average 100.
during the base price of the week to
period. the base year
FA
Weighting The price of each Same as Sensex.
average price of
that scrip.
Weights are The approximate No specific weights
system component share in proportional to the volume of trading have been assigned.
the index is aggregate average of the share. Care has been taken
weighted by the market value of to give adequate
number of shares share capital of all representation to
outstanding companies quoted large stock
so that it will on the respective exchanges, larger
influence the index stock exchanges as industry groups, the
in proportion to its on 31.3.81. no. of scrips listed in
respective market each industry group,
importance. the no. of scrips listed
IC
for trading in each
stock exchange and
their paid-up capital.
Criteria for Selection of scrips Same as Sensex. Selection of scrips 100 briskly traded Those shares which
selection of is on the basis of is on the basis of scrips have been are very actively
scrips their market i) the size of chosen for traded on the basis of
activities and average market compiling the both the frequency of
adequate represen- value of the share index irrespective price changes and the
tation of the various capital of the of which magnitude of price
industry groups. company during exchange they fluctuations.
base year and are quoted upon.
ii) the activity of the
scrip as indicated
by no. of price
changes during the
base year.
Dividend None None None None None
Adjustments
Bonus The new weighting Same as Sensex. The correction In the proportion The base year price is
adjustments factor will be the no. factor is computed of new issues to multiplied by no. of
of equity shares as the ratio of the old issues for shares held and
outstanding after theoretical ex-bonus calculating further divided by the bonus
the bonus issue has price to cum-bonus index numbers issue.
been effective. price to adjust the after taking into
base year average. account the
premium, if any.
Rights issue The new weighting Same as sensex Cum-right prices In the proportion It is adjusted by
adjustments factor will be the no. are divided by (1+p) of new issue to calculating an
of equity shares where ‘p’ is the no. the old issues for estimated ex-right
outstanding after of rights shares calculating further price
the rights issue, and issued per old share index numbers
an offsetting or after making after taking into the

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 Security Market Indicators

Bombay Stock Bombay Stock Reserve Bank Of Financial Express Economic Times
Exchange Exchange 100 India Index Number Equity Index (FE) Ordinary Share Price
Sensitive Index Index Of Index (ET)
(Sensex) Security
Prices (RBI)
Base Period 1978-79 = 100 1983-84 = 100 1980-81 = 100 1979 = 100 1984-85 = 100
proportionate adjustments for premium if any.
adjustments is cash payment. C + r(f + p)/1+ p
made of the base Er = r
Cr
year average.
Cr = last cum-right
price
r = rights ratio
f = face value of a
share
p = premium per
share.
Stock indices reflect market direction as well as day-to-day fluctuations. If one
wants to know the market trend as a whole and as to which direction it is moving,
there should be one common indicator or index to represent the mood.
There are many reasons as to why people are concerned about the movement of
aggregate security prices.
The return on individual stock is largely dependent on the aggregate market
movements. Investors would like to see the increase in share prices of their
portfolio attuned to the upward mobility of an index. Investors generally compare

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their holdings with movements of the indices and the returns associated with them
and so on. Although the return on individual share prices are a product of a large
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number of economic and political events, a significant portion of such events
affects the prices of all securities. Many investors believe that the market tends to
move on identifiable patterns.
• Investors believe that the size and direction of current moves can be related
to historical movements and be used to determine the correct timing for
buying or selling the securities.
• The prices of securities also depend upon various stock market indices.
• Each underlying index implies a separate portfolio strategy.
There are a variety of indications now available but no one tells the whole story of
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the market. On a given day, the indices may differ from one another but over a
period of time all indices generally move together.
The index has established a place for itself amongst investors, chartists, technical
analysts of the market, academicians, researchers, students of finance, the
newspapers and all others concerned with the securities market. And the index has
been widely accepted by all sections of people as a fair reflector of the trend of
prices on the stock market. A layman who is not an active investor may not be
interested in individual share price fluctuations, but if he wants to know the mood
of the stock market, then the behavioral pattern of the index is his choice.

LIMITATIONS OF VARIOUS INDICES

Though stock market indices are the basic tools to help and analyze the
movements of price of the stock markets and is a useful indicator of a country’s
economic wealth, they have their own limitations too. The following points deal
with those limitations:
1. Whenever a company issues rights in the form of CDs (to be converted at a
later stage) or other instruments (warrants) entitling the holder to acquire one
equity share of the company at specified price at a notified future date,
Secured Promissory Notes (SPNs), etc., the equity capital increases only on
conversion of debentures or the exercise of warrants/SPNs option for equity
shares but the market adjusts the ex-rights price of the share immediately
(on the day the share starts trading ex-rights) on the basis of the anticipated

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 Security Analysis

increased equity capital and likely reduced earnings per share, etc. Hence,
some modification is needed to adjust the equity capital suitably in advance.
But the exact procedure by which this can be done is very difficult to state
since the internal market mechanism which adjusts the ex-rights share price
is almost impossible to know precisely.
Again, this is a common limitation of all the indices and so far, the increased
equity capital is considered only after the debentures are converted into
shares and are acquired for warrants/SPNs and the new shares are listed for
trading on the stock exchange.
2. The coverage (in terms of number of scrips, number of stock exchanges used
and the respective weights assigned) is different for all the indices and hence,
each index may give only a partial picture of the movement of prices or the
state of the market presented may be misleading.
3. The financial institutions like ICICI, IDBI, LIC, GIC, etc., sometimes convert
the loans extended by them to companies into equity shares at a specified
date. This causes sudden and significant changes in the market capitalization
and hence the weights assigned to those scrips change violently.

Some International Stock Indices

DOW JONES INDUSTRIAL AVERAGE (DJIA)
DJIA, the most widely watched stock market index of the US, scales the share

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price level at the New York Stock Exchange (NYSE). It has 30 scrips under its
purview and is not influenced by any weights. But it was constructed long time
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back and has not been changed substantially, and one can see a chart which covers
many past years.
STANDARD AND POOR’S COMPOSITE 500 (S&P)
One of the most comprehensive indices in the USA, the S&P index is compiled
using share prices of 500 scrips. By virtue of it having such a large number of
scrips, the index covers large and small, old and new, profitable and unprofitable
companies listed on the NYSE. It uses market capitalization as its weights. In fact,
the BSE indices have been constructed using the concept followed by the S & P
index. The value of S & P Index is reported relative to the average index value of
10 in the year 1941-1943 (Base Year).
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THE FINANCIAL TIMES 100 SHARE INDEX (FTSE)
Covering 100 scrips on the London Stock Exchange, the FTSE is very similar to
the BSE National Index except that, the latter considers the prices of regional
Stock Exchanges.

SUMMARY
• The objective of constructing index numbers is that it shall represent changes
in the values of all shares i.e. changes in the overall market performance and
it must reflect the price movement of typical shares.
• BSE sensex is constructed with 30 scrips. The sensex was revised in 1998
duly giving weightage to service sector taking into account its contribution to
GDP.
• NSE-Fifty (Nifty) consists of 50 actively traded stocks.
• S&P CNX 50 has 50 scrips which have market capitalization of Rs.500 crore
and above and have high liquidity.
• CRISIL 500 index has 500 scrips spread over 97 industries.
• There are debt indices and GDR indices also.
• Investors while investing in a security are concerned about the financial
performance of the issuer of that security. Therefore the next chapter focuses
on the sources of financial information.

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Chapter V

Sources of Financial

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Information
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After reading this chapter, you will be conversant with:

• Sources of Economic Data

• Sources of Market Data
• Sources of Company Data
• Sources of International Economic Data
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Security Analysis

Introduction
Barring a few such as government securities, bank and post office deposits, most
investments are risky. An investment decision, therefore, calls for carefully
evaluating available alternatives; assessing the reward and risk associated with
each of these alternatives and selecting such of the alternatives that are believed to
best serve the investment objectives at hand. Despite the fact that luck and
experience play their role in making the correct choice, the objective and
intelligent investment decisions are always based on sound information.
As the prospect for better rewards on an investment depends upon what the future
holds, a primary task of an investor, an investment manager, an investment broker or
counsellor is to look ahead. This looking ahead involves making projections about
prospective rewards and risks of investments in the near as well as distant future.
The investment results in general and the results of security investments in
particular are influenced by a whole gamut of events, public policy changes,
market conditions, policies and performance of companies, and so on. So, data has
to be gathered on economic and market events, national and international events,
public and corporate policies, and performance facts.
Since the gathering of primary data is both time consuming and costly, the
investing public has to resort to the sources of secondary information. Further, to
facilitate quick analysis and decision-making, it would be useful to collect data

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from such sources that have already done a good deal of data analysis and
condensed them into a capsule form.
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Various agencies publish various types of data. There are a number of trade
journals, periodicals, official documents, advisory reports published by the
investment brokers and counsellors that can be valuable sources of information for
investment decision-making. The finance newspapers and magazines of course
carry a lot of investment and finance data on a regular basis. Most of the national
newspapers invariably carry a financial page. The delay in the publication of latest
information by agencies, in particular public agencies, is, however, quite common.
The updating service, the reliable and well-researched economic and financial
forecasts are generally lacking in India. So, an Indian investor would have to walk
an extra mile to gather the most recent data and put in an extra effort to generate
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meaningful projections.
Some of the important sources of investment information are briefly described below:

SOURCES OF ECONOMIC DATA

Economic and Industry Data
i. Two important publications of the Central Statistical Organization provide
monthly Abstract of Statistics and Monthly Statistics of the production of
Selected Industries in India. The former contains information on selected
economic indicators such as national income, agricultural production,
industrial production, money supply, wholesale prices, imports, exports, etc.
The latter provides industry-wise production data, plan outlays, industry
trends, etc., together, they provide a good deal of economic and industry data
useful for gauging the economy’s well-being, trends in direction of the
economy and business trends and cycles.
ii. The Economic Survey, The Explanatory Memorandum on the Budget of the
Central Government, and the Finance Budget of the Government of India
provide data analysis of current economic scene, the effects of fiscal and
monetary policies in the past, government revenues, expenditures and deficit
financing, proposed fiscal and monetary measures to be adopted in the
forthcoming year, policy revisions concerning imports, exports, investments,
industry, agriculture, etc.

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 Sources of Financial Information

iii. The Weekly Statistical Supplement, Monthly Bulletin, Report on Currency and
Finance, and the Annual Report of the Reserve Bank of India (RBI) are an
invaluable source of macrodata. In these publications, the RBI provides
considerable data in a concise form, among others, money supply, prices,
exchange rates, money market rates, balance of payment situation, bank credit,
liquidity position of the banking system, and the strategy and review of many
monetary tools employed by the RBI. Thus, these sources shed considerable
light on the financing and investment climate prevailing in the country.
iv. The Center for Monitoring Indian Economy (CMIE), and the Commerce
Research Bureau (CRB) are two non-government agencies that collect, classify,
and present main economic data in a capsule form. These agencies, besides
compilation, review the data, analyze trends, and discuss current policy
developments in their publications.
The Economic Intelligence Service of the Center for Monitoring Indian Economy
publishes a Monthly Review of Indian Economy, Index Numbers of Wholesale
prices. Economic Indicators, and Economic Outlook (yearly) provide data on
money and prices, outlook in various economic fields, and a review of economic
events, trends in corporate finance, investments, etc.
The Economic Monitoring Service of the Commerce Research Bureau brings out a
Weekly Report on Prices, Banking Money and World Currency Developments, a
Monthly Review of the Indian Economy, and a monthly document on Investment
Climate in India. Its annual publications include Basic Statistics on Indian Economy,

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Basic Statistics on State Economics of India, Companies Inviting Deposits and the
rates they offer, Selected Statistics of Eighty Countries of the World, Foreign Trade
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Statistics of India, and position papers on major Indian industries besides many special
documents and reports such as a Pre-Budget Review, Industrial Policy and Investment
Incentives, CII reports, etc.

SOURCES OF MARKET DATA

A number of sources provide stock market data ranging from price quotations to
review of stock market trends in India. Important sources of market information
include:
i. Stock Exchanges’ Daily Official List: It provides daily price quotations and
various characteristics (i.e. redemption, tax status, dividend announcement,
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gross dividend per share, date of closure of register of members, etc.) of the
quoted securities – central and state government securities, corporate bonds,
preference shares, equity shares.
ii. Official Year Book/Directory of the Stock Exchange: These publications
review stock market trends, new issues made during the year, official policy
in regard to capital issues, brokerage, stamp duty, etc. besides providing a
wealth of information on the working of companies.
iii. RBI’s Weekly Statistical Supplement, Monthly Bulletin, and Report on
Currency and Finance: As noted before, these publications are a valuable
source of economic and industry data. Besides that they give All-India,
regional, and industry-wise index numbers of security prices, running and
redemption yield on various types of securities.
iv. The Economic Times, Financial Express, Business Standard, Fortune India,
Investments Today, Economic Scene, Commerce and Business India are
some of the newspapers and periodicals that carry, on a regular basis, a
wealth of stock market information, market quotations, reviews of stock
market trends, and very incisive and thought provoking articles on current
developments affecting stock market’s future movements and other matters of
interest to the investor.
v. The Reports and Newsletters of investment brokerage and counselling firms are
other important sources of market data. They provide, among others, stock
market reviews, trends, prices and yields for gilt-edged and corporate
securities and a detailed analysis of securities in which they are specialized.

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Security Analysis

SOURCES OF COMPANY DATA

The fundamental analysis and valuation of stocks calls for gathering and
examination of the company’s specific data. Further, a considerable insight in
respect of prospective return and risk of a security can be gained from going
through the announcements and future plans often publicized by the companies.
So, the company data, historic and futuristic, is of interest to the investors.
i. Company’s annual reports and prospectuses are the main sources of company
data, the former being an annual feature of a public company and the latter
being published while making public issue. The annual report contains the
chairman’s speech, balance sheet and profit and loss account with
explanatory notes, and a review of the working of the company over the last
5 to 10 years. The chairman’s speech outlines the events that occurred in the
previous year having a bearing on the company’s performance and how the
company responded to those events. It also outlines what the company
proposes to do in the next year. Some companies include in their annual
reports also a statement of changes in financial position and a forecast of
earnings for the next couple of years besides presenting the trends in earnings
per share, dividend per share, and their share prices vis-à-vis the market and
industry indices. In the prospectuses, companies present a review of their
working, the composition of their management team, and their future
investment plans for which the capital is sought from the public.
ii. Stock Exchange Official Directory is another important source. It covers all the

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companies whose shares are listed on the stock exchange and gives for each
company, its brief history, progress, and balance sheet and profit and loss
FA accounts for a period of ten years. Moreover, important financial ratios, their
trend over the last ten years, and yearly high and low prices quoted for the
company’s shares are presented as well in the directory.
iii. Kothari’s Economic and Investment Guide of India, a yearly publication of
the Kothari and Sons, is yet another important source of company data. This
guide contains a lot of data on individual companies, their progress and
management besides a good write-up on industry scene.
iv. In their regular feature columns such as investors’ guide, company profiles
reports, company news and comments, and business notes, etc. The
Economic Times, Financial Express, Business Standard, Commerce and
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Business India, and India Today present reports, comments, reviews of the
working of individual companies, changes in company policy and
management, future plans and prospects of the companies.
v. Some government sources provide company or company related information,
‘The Company News and Notes’, a monthly publication of the Department of
Company Affairs, Government of India, carries circulars and notifications in
respect of changes and/or interpretation of the provisions of the Companies
Act. The Office of the Registrar of Companies supplies on request, for a
minimal charge, a company’s annual report, list of members, prospectuses,
product-by-product information in respect of licensed capacity, installed
capacity, actual production, exports, imports, exchange earnings, etc. The
Director General, Technical Development and the Licensing Committee of
the Ministry of Commerce supply excellent supplementary data relating to
capacity, expansion plans and export performance of the companies.

SOURCES OF INTERNATIONAL ECONOMIC DATA

In today’s interdependent world, the international economic, political, market,
business and technological developments have a considerable bearing on the
conditions and prospects prevailing in a country’s economy, the market, and for the
business firms. The oil crisis of 1970’s, the international financial (debt) crisis, and
the growing protectionist attitude of the western countries whose effects are felt
worldover are the good examples of this impact.

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 Sources of Financial Information

To evaluate the investment worth of securities of companies engaged in joint

ventures with foreign collaborators, export oriented companies, and of those that
have diversified their direct investments beyond the national borders (i.e.
multinational companies), it is important to collect and examine the international
economic market, and business data. Furthermore, information relating to the
international money, capital, and currency exchange, market data is important for
international portfolio investment if and when such investment is allowed by the
RBI. For example, an Indian stock broker or investment counsellor intending to
attract non-residents of Indian origin clientele, who are allowed to make portfolio
investments in India need to compile this type of data so that he can offer a good
advice on the portfolio investment choices.
Some important sources of international data include the following:
i. International Financial Statistics, a monthly publication of the International
Monetary Fund (IMF) provides each country’s yearly, quarterly and monthly
data on major economic indicators such as GNP, money supply, consumer price
index, stock market indices, currency exchange rate expressed in the US
dollars, and balance of payment condition. The IMF also brings out
occasionally supplementary documents on prices, production, balance of
payments, exchange rates, etc. covering a long historical period.
ii. Moody’s and Standard and Poor’s Industrial, Banking and Finance,
Transportation, Utility and International Manuals cover extensively the

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individual company profiles of both the US and international companies. For
each company, the historical background, the management team and a lot of
FAfinancial information are provided in these manuals. The International
Manual provides the above information, for a large segment of well-known
foreign companies, the information being presented on a country-wise basis.
iii. Capital International Perspective, a Geneva publication, reports on the
various national stock market indices, world capital market, international
interest rates, and capital flows.
iv. The Financial Times of London, The Economist, a UK weekly, The Wall
Street Journal, a US daily, Baron’s National Business and Financial Weekly
of the USA, International Business Week, Fortune International and the Far
Eastern Economic Review are some of the international newspapers and
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periodicals that contain a lot of information on current international
developments of interest to business executives and the investors.

New Ways to Serve the Customers

With the revolution in the electronic industry, different ways to provide the
information are sweeping the market. Various financial packages are competing in
the market for their position. These packages provide the information about the
various facets of the economy, industry and companies in the user friendly
manner. Some of the financial packages are introduced herein brief.
CIMM
CIMM is a data-base, introduced by the well-known research organization called
Center for Monitoring the Indian Economy (CMIE). It provides company’s
specific information, both qualitative and quantitative, under the different heads. It
also provides industry specific data in a very lucid fashion. Stock market
information is also given by this package and updated on a monthly basis. This
package also gives the flexibility to give queries and select the companies on the
basis of specific needs of users.
CLINE-OLE
This package is designed and marketed by Capital Market, a well-known
organization in the field of finance. This package also provides the information on
companies, industry and economy. International information is also provided by
this package.

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Security Analysis

VANS
This is a unique product introduced by the Vans Information Services Ltd., a
Mumbai based company. This is basically a package which provides the
information of various articles and news in the different magazines and
newspapers. The whole package is so designed that the access to information can
be had on the basis of certain keywords also.
Various other similar products are available in the market, competing to provide
the information about the various sectors to the market. Some information
companies are busy in providing the tailor-made information products to their
clients.

SUMMARY
• The investments are influenced by a whole gamut of events, public policy
changes, market conditions, policies and performance of companies, and so
on. So, data have to be gathered on economic and market events, national and
international events, public and corporate policies, and performance facts.
• The gathering of primary data is both time consuming and costly, the
investing public has to resort to the sources of secondary information.
Further, to be useful tool collect data from such sources that have already one
good deal of data analysis and condensed them into a capsule form.

I
• Various agencies publish various types of data. There are a number of trade
journals, periodicals, official documents, advisory reports published by the
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investment brokers and counselors that can be valuable sources of
information for investment decision-making.
• Sources of economic and industry data, market data and company data
include economic survey, final budget of the Government of India, the
RBI monthly bulleting, the RBI’s report on currency and finance, CMIE
reports, etc.
• Most of the times, only financial information of the issuer is not sufficient.
The investors are interested in knowing the performance of the economy in
general, industry and the specific company.
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 Fundamental Analysis

Chapter VI

Fundamental Analysis

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•
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After reading this chapter, you will be conversant with:

Objectives and Beliefs of Fundamental Analysis

• Framework for Fundamental Analysis
• Concept of Intrinsic Value
• Economic Forecasting Methods
• Industry Analysis
• Key Characteristics in an Industry Analysis
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• Industry Life Cycle
• Business Cycle Analysis
• Structural Analysis
• Company Analysis
 Security Analysis

OBJECTIVES AND BELIEFS OF FUNDAMENTAL ANALYSIS

Security analysis is the first step undertaken in the process of investment decisions.
The task involves determining prospective benefits from investment in a security,
the conditions subject to which they may be received, and the likelihood of such
conditions.
In a sense, the task involves forecasting future conditions, the prospective benefits
from holding a security given these conditions, and arriving at ‘what ought to be’
the price for the security, given these benefits and adjusting for the inherent time
and risk. Security valuation is the end objective of security analysis in this sense.
Fundamental analysis is an approach to determine this ‘what ought to be price’. Its
objective is to identify the underpriced and overpriced securities in the market
place so that the investment decisions – buying and selling – can be made.
(A security is said to be underpriced if its current market price is below the ‘what
ought to be price’ otherwise known as ‘intrinsic’ or ‘true’ value. Conversely, it is
an overpriced security if its current market price is above its intrinsic value.)
The fundamental analysts believe that due to temporary market disequilibrium, the
current market price may be at variance with its intrinsic value, but in the long run
the market price would get back to its intrinsic value. As Graham, et al1 have
pointed out that the fundamental analysts do not invest this value with an aura of
permanence. Instead, they believe that the intrinsic value is likely to change from

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year to year as the factors determining this value take on different values. But in
most cases of securities, the intrinsic value changes less drastically than changes in
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market price. So, an investor usually has an opportunity to profit from a wide
discrepancy between the current market price and the intrinsic value. By buying an
underpriced security, and selling an overpriced security, an investor would be able
to make profits.
It may be noted that the end objective of fundamental analysis is not to make
speculative profits which call for frequent entering in and exiting from the market
and/or switching from one security of portfolio to another. Rather, it is to avoid the
risk of loss from buying an overpriced stock and selling an underpriced stock. The
fundamentalists view investments as long-term decisions, in fact, for such a long
period that the holding of a security or portfolio can be considered permanent.
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The fundamentalists may buy a security if the current market price matches its
intrinsic value, that is, when it is a fair price. By buying a fair priced security, a
person earns the normal rate of return on his investment. Buying an underpriced
stock enables one to earn some abnormal return (relative to risk) on his
investment. This is known as beating the market. The fundamentalists are a cadre
of participants in the market who believe that the stock market can be beaten.

FRAMEWORK FOR FUNDAMENTAL ANALYSIS

Fundamental Analysis is based on the premise that a security has an intrinsic value
at any given time. This value is a function of underlying economic values –
specifically, expected returns and risk. By assessing these fundamental
determinants of intrinsic value of a security, it is possible to determine an estimate
of its intrinsic value. This estimated intrinsic value can then be compared to the
current market price of the security. A basic assumption of fundamental analysis is
that market price and intrinsic value can differ from time to time, but eventually
investors will recognize the discrepancy and act to bring the two values together.
Those investors who can perform good fundamental analysis and spot
discrepancies should be able to realize profits by taking a suitable decision before
the disparity is eliminated by the market.

1 Graham B D Dodd, and S Cottle, Security Analysis 4th ed. McGraw-Hill, New York, 1962.

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 Fundamental Analysis

The proper order in which to proceed in fundamental analysis is, first to analyze
the overall economy and securities markets. Second, analyze the industry within
which a particular company operates. Finally, analysis of the company should be
considered. The above analysis involves making careful estimates of the expected
stream of benefits and the required rate of return (this depends on the risk) for a
common stock. The intrinsic value can then be obtained through the present value
analysis – that is, the dividend discount model. An alternative method of valuation
is the P/E ratio or earnings multiplier approach.
Figure 1: Framework for Fundamental Analysis

Company
Industry
Economy

EIC Framework CIE Framework

Economic Analysis Economic Analysis

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Industry Analysis Industry Analysis
FA Company Analysis Company Analysis

Professionals, do follow both the approaches for investment and disinvestment

decision making. Strategic considerations in economic, industry and company
analysis are elaborated and are following in the next few pages.

Economic Analysis
• A study of economic trends as indicated by the rate of growth in gross
national product, employment, aggregate corporate profits, personal
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disposable income, balance of payment position, inflation, government
spending, money supply, etc.
• A study of economic policies of the government including plan priorities,
monetary policies, Exim policy, fiscal policy, industrial policy, regulation
and control of prices, wages, and production.
• An analysis of the relationship between economic trends and economic
policies and the stability of such relationships.
• A study of world economic trends and their impact on Indian economy.

Industry Analysis
• Implications of projected growth in gross national product for various
industries.
• Implications of plan priorities and plan expenditures for various industries.
• Vulnerability of an industry under government regulation, and control of
prices and production.
• Implications of industrial and fiscal policies of the government for an
industry.
• Input-output analysis of an industry’s sales.
• Degree of dependence on scarce non-renewable or imported raw materials
and energy intensity.

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 Security Analysis

• Vulnerability of industry to business cycle.

• Linkage between the sectors vulnerable to business cycle and the industry.
• Life cycle position of industry.
• Price and income elasticity of the end-products of the industry.
• An analysis of competitive conditions as reflected in any barriers to entry.

Company Analysis
• A trend analysis of company’s market share.
• An analysis of cost structure and break even analysis.
• An analysis of turnover of assets, operating and production efficiencies
through ratio analysis.
• Leverage and coverage ratio analysis.
• Funds flow analysis.
• Profitability analysis.
• A trend analysis of book value per share.
• An analysis of growth in dividend per share and retention policy.
Estimation of dividend yield.

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•
• Estimation of price-to-earnings multiple.
•
•
FAAn assessment of the quality of assets.
An assessment of the quality of management.

CONCEPT OF INTRINSIC VALUE

John Burr Williams, offers perhaps one of the earlier but narrow definitions of a
stock’s intrinsic value2. He calls it as the investment value and says that the
investment value of a security is the present value of all future cash payments to be
paid on the security. The cash payments to the investor may be in the form of
dividends, interest, liquidation proceeds, or repayment of the principal amount.
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A general definition of intrinsic value is given by Graham and Dodd. They define
the intrinsic value of a security as “that value which is justified by the facts, e.g.
assets, earnings, dividends, definite prospects, including the factor of management
(of the company)”. This rather aptly covers the work of a fundamental analyst. His
primary focus is, however, on earnings and dividends, the earnings being the
payment stream received by the company and the dividends being the payment
stream from the company’s earnings stream received by the shareholder.
The intrinsic value of a stock is estimated by discounting the company’s
prospective earnings stream or the shareholder’s prospective dividend stream. As
the prospective earnings of a company and the prospective dividends to its
shareholders depend very much on the economic and industrial environment,
relative importance of the company within its industry, company’s financial
strength, its policies, quality of assets and management, the fundamental analysts
seek to establish quantitative relationships between economic, industrial, and
company indicators with a view to forecast earnings and dividends. For this
purpose, an economic analysis, industrial analysis, and company analysis are
undertaken. The quality of assets (technology) and the quality of management are,
of course, the factors about which a qualitative assessment is made.
It should be noted that in practice, a fundamental analyst calculates a range of
intrinsic values rather than a single value. A stock is said to be mispriced
(overpriced or underpriced) if its current price falls outside this range.

2 John Burr Williams, The Theory of Investment Value, Harvard University Press, 1938.

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 Fundamental Analysis

What does Intrinsic Value Imply?

The traditional rule in investments specifies a relationship between the intrinsic
value of an asset and its current market price. Specifically, if intrinsic value
exceeds current market price, the asset is undervalued and should be purchased or
held if already owned. If intrinsic value is less than the current market price, the
asset is overvalued and it should be sold if held, or possibly sell it short.
A problem with intrinsic value is that it is derived from a present value process
involving estimates of uncertain (future) benefits and use of (varying) discount
rates by different investors. Therefore, the same asset may have many intrinsic
values – it depends on who, and how many, are doing the valuing. This is why, for
a particular asset on a particular day, some investors are willing to buy and some
to sell. The market price of an asset at any point in time is, in this sense, the
consensus intrinsic value of that asset for the market.
As mentioned earlier, the preferred order for fundamental security analysis is
(1) the economy and market, (2) the industry and (3) the company. It is very
important to assess the state of the economy and the outlook for primary variables
such as corporate profits. If a recession is likely, or underway, stock prices will be
heavily affected at certain times during the contraction. Conversely, if a strong
economic expansion is underway, stock prices will be affected heavily, again at
particular times during the expansion. Thus, the status of economic activity has a
major impact on overall stock prices. It is, therefore, very important for investors

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to assess the state of the economy and its implications for the stock market.
In turn, the stock market impacts on each individual investor. Investors cannot
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very well go against market trends – if the market goes up (or down) strongly, the
majority of stocks are carried along. Company analysis is likely to be of limited
benefit in a period when there is a severe depression in stock market. Conversely,
many investors would do well regardless of their specific company analysis
because the market is up.
In a well known study in the year 1966, Benjamin King analyzed the relationship
between market returns and individual stock returns. King found that for the period
1927-1960, roughly half of the variance for an average stock was explained by the
overall market. The impact was observed to be in the range 20-45 percent in a
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recent study conducted by this author for Indian securities.
This impact is much higher for well diversified portfolios. For instance, the
percentage of the variability in return of Mastershare NAV and Canshare NAV
explained by the market (BSE National Index as proxy for the market) was
observed to be as high as 84 and 72.6 respectively. Thus, the impact of the market
factor on security returns is quite powerful. Another indication of the overall
market impact is on earnings of a particular company. Available evidence for
developed economies suggests that from one-fourth to one- half of the variability
in a company’s annual earnings is attributable to the overall economy. Thus,
economy/market analysis is considered extremely important.
After completing an analysis of the economy and the overall market, an investor
can decide if it is favorable to invest in common stocks. If so, the next step should
be industry analysis. King also identified the industry factor as the second
component (after overall market movements) affecting the variability in stock
returns. In the Indian context, the industry factor is observed to be extremely
powerful in influencing the fortunes of individual companies. In a controlled
economy like India, changes in government policies generally affect all companies
in a given industry. We will discuss some examples later.
After an analysis of economy market and industries, the next step is to concentrate
on specific companies. The bottom line in financial statements, i.e. earnings per
share is considered to have a powerful impact on the price of the share. While a
number of factors are important in analyzing a company, investors tend to focus on
earnings and dividends that are paid out of them.

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Market Analysis
We have discussed the importance of market analysis. Ultimately, investors must
make intelligent judgments about the current state of the market and possible
changes in the future. A logical starting point in assessing the market is to
understand the economic factors that determine stock prices. Understanding the
current and future state of the economy is the first step in understanding what is
happening and what is likely to happen to the market. The state of the market is
measured by the security market indicators.
What determines stock prices? As discussed earlier, the two determinants of stock
prices are – the expected stream of benefits (earnings or dividends) and the
required rate of return (or its counterpart, the P/E ratio). Although these are the
ultimate determinants, a more comprehensive model is desirable when attempting
to understand the stock market.
The positive impact of a change in expected real corporate earnings on stock prices
has been noticed in the Indian scenario. However, the variables that have led to a
change in expected real corporate earnings have been more qualitative in nature –
the various liberalization and deregulation measures, gradual elimination of
administrative and bureaucratic controls in the industrial and financial sector and
the like.
In the absence of proper qualification of all the variables, empirical testing of the
model would be inadequate and misleading. Moreover, the process of interest rates

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affecting stock prices is not testable as the interest rates are not allowed to be fully
determined by market forces. However, with a gradual phasing out of administered
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interest rates, one may witness the kind of interaction indicated by the model.
We cite some of the major factors that influence corporate earnings and hence,
stock prices in the Indian context.
Economic Policies: This is a major variable affecting the stock market, especially
in the context of a highly regulated environment like India. While some policy
changes affect specific industries, (this will be discussed in the section on industry
analysis) some have a general positive or negative impact on the entire market.
The recent move towards economic liberalization has noticeably affected the
market sentiments. Changes in credit policy announced by the Reserve Bank of
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India are seen to affect corporate performance. Similarly, changes in interest rate
structure, import and export policies have a direct bearing on the corporate profits
and hence, on the stock market.
Fiscal Policies: Presentation of national budget is a major event in the stock
market circles. While changes in tax structure introduced in the budget may affect
specific industries, or even specific companies, some provisions affect the entire
corporate sector.
Monsoons: The agricultural sector being a dominant sector in India, the arrival of
monsoon is also a major event. The rainfall pattern affects the fortunes of the
corporate sector indirectly in several ways. A good monsoon leading to a good
harvest results in greater purchasing power with the rural households. This leads to
greater demand for the output of the corporate sector. On the other hand, the
agricultural produce, such as, cotton, sugarcane, etc. are inputs for many
industries. A good monsoon naturally results in a downward pressure on prices of
such inputs. The final outcome is spurt in corporate profits.

ECONOMIC FORECASTING METHODS

An understanding of economic forces that affect stock prices facilitates forecasting
likely changes in the market by using data on the economic variables. What
follows is a brief evaluation of some of the important economic forecasting
techniques like: (a) Lead Indicator Approach, (b) Diffusion Indices, (c) Econometric
Model Building and (d) GNP Model Building.

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Lead Indicator Approach

The lead indicator approach attempts to forecast the general economic conditions
by identifying economic indicators that turn ahead of the change in the general
level of economic activity. Economic indicators are nothing but time series which
tend to turn up or down in advance of or concurrent with, or after the economic
upturn or downturn. From figure 2, we find that indicator A turns ahead of the
peak and trough of the business cycle whereas indicators B and C turn in unison
with or after the peak and trough of the cycle.
Figure 2

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Source: ICFAI, Research Team.
So, to forecast the change in the economic conditions, we will be obviously
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interested in leading indicators because they provide advance signals of the turning
points in the economic activity.
While identifying a lead indicator for the purposes of forecasting, the analyst must
ensure that the lead indicator fulfills the following criteria as closely as possible:
(1) It should move smoothly from one period to another as it rises or falls and
should turn sharply at its peaks and troughs. If a series zigzags during its upward
or downward swings, it becomes difficult to know whether the ‘zig’ is a genuine
turning point or a temporary reversal of trend. (2) An ideal lead indicator should
always lead turning points of general business activity by the same number of
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months with no ‘false’ leads. (False leads are predictions of business turning points
which do not materialize). (3) It should lead by enough time to permit the user to
make necessary alterations in his plans, but do not lead by a long time interval that
will make him disbelieve the indicator. (4) The indicator should fit logically with
the business cycle theory. The more logical it appears that a particular series will
turn ahead of economic conditions, the more assured the user can be that its
historical lead relationship will continue in the future.
Some of the leading economic indicators are the utilization of manufacturing
capacity, residential construction, corporate profits, and of course the general level
of stock prices. Since the movement in the general level of stock prices is what we
are ultimately interested in forecasting, we should look for that leading indicator
which would act as a lead to the leading indicator under consideration.
The lead indicator approach is most valuable in suggesting the direction of change in
economic activity. But it does not convey any information on the magnitude and
duration of the change. The other important limitation of this approach is that the
signals provided by the different lead indicators can be mixed. In other words, some
of the leading series might signal a turn while the others might not, resulting in a
serious problem of interpreting the same for the purpose of arriving at a forecast.
This limitation can of course be resolved by shortlisting only such lead indicator(s)
that satisfy the criteria mentioned above. The diffusion index approach discussed
in the next section partly attempts to resolve the problem of mixed signals.

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Diffusion Indices
A diffusion index (as the name implies) is a measure of how widespread (diffused)
a phenomenon is. We can set up a diffusion index for leading indicators by
counting the number of indicators that rise during a particular period and
expressing it as a proportion of the total number of lead indicators and more
desirably in a percentage form. If five out of, say, ten leading indicators rise during
a particular month, the diffusion index for that month will be 50 percent. If, in the
next month, seven rise (not necessarily including all the five which rose in the
previous month), the index for that month will be 70 percent. The user must
interpret the diffusion index relative to the levels of the index in the past. Certainly
a rise from 50% to 70% in the index is a stronger confirmation of a period of
economic advance.
Econometric Model Building Approach
As far as short-term economic forecasting is concerned, an approach based on
econometric methods has the advantage of providing a magnitude and direction to
the dependent variable (unlike the lead indicator approach), say GNP. However,
the user must understand that a precise estimate of the dependent variable (forecast
value for GNP) obtained from the econometric model need not be an accurate one,
because accuracy of the forecast will ultimately depend upon the quality of data
input, the validity of the assumptions underlying the model, and above all upon the
model builder’s understanding of the underlying economic theory.

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Further, as stated in the Indian context it must be noted that, an econometric model
for forecasting GNP in a planned economy may not have much of a practical
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relevance because the planning priorities may change significantly, besides the
likely changes in government regulation, fiscal policy, and the control mechanisms
of money, credit, prices and wages. Econometric models can be meaningful for
future projections if and only if the estimated co-efficients (like the intercept ‘a’
and slope ‘b’ in a linear regression model) are found to be acceptable in respect of
their stability over time.
GNP Model Building Approach
The GNP model building approach forecasts GNP in the short run by estimating
the magnitudes of the various components constituting GNP. If GNP is defined as
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C + I + G + X – M where C, I, G, X and M stand for their standard definitions,
then forecast for GNP under this approach is determined by estimating the likely
values of C, I, G, X and M. To estimate these components, the forecaster relies
extensively on the budget estimates of the Central and State Governments, the
socio-economic surveys carried out by the Government and private agencies, and
the field data collected for this purpose.
Once the forecaster estimates these major components, he adds them together to
come up with his estimate of the GNP. He tests the forecast for internal
consistency because of the interrelatedness of the GNP accounts. For example, a
given level of consumption implies a certain level of savings, which affects
business investments which in turn affects production activities, and thus affects
income and savings.
While these circular effects take place, other factors like interest rates and inflation
will also be affected. So, the forecaster must ensure that his estimates for the
different components take care of such interlinkage. Apart from testing the
forecast for internal consistency, the forecaster also examines it for external
consistency by comparing it with forecasts obtained under other methods like the
econometric model building approach.
The major advantage of this approach is its versatility. Since the GNP forecast is
adjusted for all anticipated changes and tested for internal consistency, it is likely
to be a reliable one. But the approach is data demanding and calls for a vast deal of
judgment and ingenuity.

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The approach has been succinctly described by Lewis and Turner as ‘an effort to
build a view of the short run business outlook that is comprehensive, that is as
quantitatively precise as the state of our knowledge permits, that is internally
consistent, that draws upon rather than sidesteps all the pertinent insights of
modern aggregative economics but, at the same time, does not make a fetish of the
theoretical rigor. Instead, the technique seeks to exploit any and all evidences of
business prospects that may come to hand. It is particularly distinguished from
pure econometric model building by its heavy use of data concerning the advance
plans and commitments of certain spending groups, and it retains a sizeable place
for judgment and free-hand adjustments’.

Economic Forecasting in India

The state-of-the-art of business/economic forecasting in India suggests that
economic forecasting is yet to acquire a professional stature in the country. Though
some projections on major macroeconomic variables are made by the government
and private bodies like Planning Commission, Center for Monitoring Indian
Economy (CMIE) and the Commerce Research Bureau (CRB), there appears to be
no agency like the National Bureau of Economic Research (NBER) in the US that
has done extensive research in forecasting business cycles. Some of the economic
forecasting tools like the econometric model building approach may have limited
relevance in the Indian context, but other approaches like the lead indicator approach
can serve as valuable tools in forecasting economic conditions.

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INDUSTRY ANALYSIS
The second step in the fundamental analysis of common stocks is industry
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analysis. Convinced that the economy and the market are attractive from the
standpoint of investing in common stocks, the investor should proceed to consider
those industries that promise the most opportunities in the coming years.
The significance of industry analysis can be established by considering the
performance of other industries too in a similar fashion. The analysis indicates the
value to investors in selecting certain industries while avoiding others. The analysis
also establishes the need for investors to continue analyzing industries by showing
the inconsistency of industry performance over consecutive yearly periods.
Industry analysis usually involves several steps. As a first step, industries are
analyzed in terms of their stage in the life cycle. The idea is to assess the general
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health and current position of the industry. This may be followed by an assessment
of the position of the industry in relation to the business cycle and macroeconomic
conditions; an analysis of the competitive structure prevailing in the industry and a
study of the impact of changes in government policy on the industry.
KEY CHARACTERISTICS IN AN INDUSTRY ANALYSIS
The most important of the characteristics that are to be evaluated in an Industry
Analysis can be enumerated as given below:
1. Past sales and earnings performance.
2. Permanence of the industry.
3. The attitude of the government towards the industry.
4. Labor conditions within the industry.
5. The competitive conditions as reflected by the existence of the entry barriers
and
6. The stock prices of the firms in the industry relative to their earnings.
Past Sales and Earnings Performance
For an analyst, the past sales and earnings performance of the firm form a crucial
input in forecasting future trends. This is not to say that the firm is going to repeat
the same performance again. Rather, the analyst is more interested in examining the
contribution of the various factors in the past so that the relevance of these factors
individually and relatively can be properly evaluated under present conditions.

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In any firm, sales and the earnings play an important role. These variables will
exhibit a degree of consistency only when the firm has weathered a variety of
economic conditions. The analyst from the observation of these variables will be
able to judge the stability of the performance in terms of sales and earnings as well
as the growth rates. Another crucial factor is that of the relationship between the
sales and the fixed costs. The more the fixed costs, the higher will be the break
even point and higher will be the sales volume to be achieved.

Permanence
By permanence, we understand the products and the technology of a particular
industry not becoming obsolete in a short span of time. If the industry is not
permanent, then investing in that industry altogether becomes a losing proportion.
In some of the cases a product with additional features manufactured by
employing superior technology makes the existing product totally irrelevant or at
least results in the manufacturing process becoming a commercially enviable
proposition.
In this age of rapid technological developments, this factor plays a crucial role in
Industry Analysis. The Government’s role is also an important factor affecting the
permanence of the industry.

The Government Attitude

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It is imperative for an Analyst that he should be well aware of the various
Government policies and regulations with reference to an industry in which he is
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going to invest. The government policies like deregulating an industry by allowing
foreign investment, imposing high tariffs on imports and restrictive legislation
have a bearing on their performance. Some of the legal restrictions result in the
profits being very low for a particular industry. Thus an analyst, for that matter, an
investor should be thorough with various government regulations and their
implications and should be able to predict, at least broadly, the changes likely to
take place in the regulations in the near future.

Labor Conditions
This is an important factor to be considered in industries which are labor intensive.
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An analyst should examine the various provisions of the labor laws and also go
into the possible reasons that may halt the production process and its fallout on the
profits of the industry. In case of a prolonged strike, a labor intensive firm will not
only lose its customers and goodwill but also may not be able to cover its fixed
costs in certain cases.

Competitive Conditions
While analyzing this situation, the three general types of barriers that an analyst
should concentrate on, are
1. Existence of product differentiation
2. Absolute cost advantages and
3. Advantages rising from economies of scale.
The existence of the first barrier assures that a new entrant will not be able to
charge as much as the existing firms. Also he has to spend large amounts of money
on advertising to capture an acceptable share of the market as this situation is
usually found in cases where the customers exhibit a high degree of brand loyalty.
By absolute cost advantages, we understand that the existing firms are capable of
producing and distributing the products at lower costs than the new entrants
irrespective of the volume produced. As a result, they enjoy wider profit margins.
This may be due to the fact that the existing firms may have exclusive patents,
own the resources or superior management skills that are not available to the new
entrants.

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 Fundamental Analysis

Economies of scale are usually realized when the production levels are quite high.
A new entrant in this case also has to garner a significant market share so that he
can avail the benefits from economies of scale. If he fails to do so, he will be able
to compete with the prices offered by the existing players.
An analyst or a prospective investor should consider investment in an industry
which is well protected.

Industry Share Prices Relative to its Earnings

In addition to the various factors we have been looking at, the analyst also has to
look at the present share prices. In this case an underpriced share would be the best
bet. Also he should examine the fact that the share prices are not high due to the
overzealous nature of the investors to acquire the shares of the firms in a new
industry. Usually the shares of these companies experience high fluctuations
depending on the crowd behavior.

INDUSTRY LIFE CYCLE

Many observers believe that industries evolve through four stages – the pioneering
stage, the expansion stage, the stabilization stage and the declining stage. There is
an obvious parallel in this idea to human development. The concept of an industry
life cycle could apply to industries or product lines within industries. The industry
life cycle concept is depicted in figure 3 and each stage is discussed in the

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following section.
Figure 3
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Pioneering Stage
In this stage, rapid growth in demand occurs. Although a number of companies
within a growing industry will fail at this stage because they will not survive the
competitive pressures, most experience rapid growth in sales and earnings,
possibly at an increasing rate. The opportunities available may attract a number of
companies, as well as venture capital. Considerable jockeying for position occurs
as the companies battle each other for survival, with the weaker firms failing and
dropping out. Investor risk in an unproven company is high, but so are expected
returns if the company succeeds. At the pioneering stage of an industry it can be
difficult for security analysts to identify the likely survivors, just when the ability
to identify the future strong performers is most valuable. By the time it becomes
apparent who the real winners are, their prices may have been bid up considerably
beyond what they were in the earlier stages of development.

Expansion Stage
In this second stage of an industry’s life cycle the survivors from the pioneering
stage are identifiable. They continue to grow and prosper, but the rate of growth is
more moderate than before. At the expansion stage of the cycle, industries are
improving their product and perhaps lowering their prices.

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Security Analysis

They are more stable and solid, and at this stage they often attract considerable
investment funds. Investors are more willing to invest in these industries now that
their potential has been demonstrated and the risk of failure has decreased.
“Financial policies become firmly established at this stage. The capital base is
widened and strengthened dividends often become payable, further enhancing the
attractiveness of these companies to a number of investors.

Stabilization Stage
Finally, industries evolve into the stabilization stage (sometimes referred to as the
maturity stage), at which the growth begins to moderate. Sales may still be
increasing, but at a much slower rate than before. Products become more
standardized and less innovative, the market place is full of competitors, and costs
are stable rather than decreasing through efficiency moves and so on. Industries at
this stage continue to move along, but without significant growth.
Stagnation may occur for considerable period of time, or intermittently.
This three-part classification of industry evolvement is helpful to investors in
assessing the growth potential of different companies in an industry. Based on the
stage of the industry, they can better assess the potential of companies within that
industry. However, there are limitations to this type of analysis. First, it is only a
generalization, and investors must be careful not to attempt to categorize every

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industry, or all companies within a particular industry, into neat categories that
may not apply. Second, even the general framework may not apply to some
industries that are not categorized by many small companies struggling for
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survival. Finally, the bottom line in security analysis is stock prices, a function of
the expected stream of the benefits and risk involved. The industrial life cycle
tends to focus on sales and share of the market and investment in the industry.
Although all of these factors are important to investor, they are not the final items
of interest. Given these qualifications to industry life cycle analysis, what are the
implications to investors?
The pioneering stage may offer the highest potential returns, but also offers the
greatest risk. Several companies in a particular industry will fail, or do poorly.
Such risk may be appropriate for some investors, but many will wish to avoid the
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risk inherent in this stage.
The maturity stage is to be avoided by investors interested primarily in capital
gains. Companies at this stage may have relatively high dividend pay-outs because
their growth prospects are fewer. These companies often offer stability in earnings
and dividend growth.

Declining Stage
In this stage of the industrial life cycle – decline is indicated on either a relative or
absolute basis. Clearly, investors should seek to spot industries in this stage and
avoid them.
It is the second stage i.e. expansion, that is probably of most interest to investors.
Industries that have survived the pioneering stage often offer good opportunities as
the demand for their products and services is growing more rapidly than the
economy as a whole. Growth is rapid, but orderly, an appealing characteristic to
investors.

BUSINESS CYCLE ANALYSIS

A second way to analyze industries is by their operating ability in relation to the
economy as a whole. That is, some industries perform poorly during a recession
whereas others are able to weather it reasonably well. Some industries move
closely with the business cycle, outperforming the average industry in good times
and underperforming it in bad times. Investors, in analyzing industries, should be
aware of these relationships.

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Most investors have heard of, and are usually seeking, growth companies. In
growth industries, earnings are expected to be significantly above the average of
all industries and such growth may occur regardless of setbacks in the economy.
Clearly, one of the primary goals of fundamental security analysis is to identify the
growth industries of the near and far future.
At the opposite end of the scale are the defensive industries, which are least
affected by recessions and economic adversity. Food has long been considered one
such an industry. Public utilities might also be considered a defensive industry.
Cyclical industries are most volatile – they do unusually well when the economy
prospers and are likely to be hurt more when the economy falters. Durable goods
are a good example of the products involved in cyclical industries. Autos,
refrigerators, and stereos, for example, may be avidly sought when times are good,
but such purchases may be postponed during bad times because consumers can
often make do with the old units.
These three classifications of industries according to economic conditions do not
constitute an exhaustive set. Additional classifications are possible and logical. For
example, some industries are interest-sensitive, that is, particularly sensitive to
expectations about changes in interest rates. The financial services industry, the
banking industry, and the real estate industry are obvious examples of interest-
sensitive industries. Another is the building industry.
What are the implications of these classifications to investors? To predict

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performance of an industry over shorter periods of time, investors should carefully
analyze the stage of the business cycle and the likely movements in interest rates.
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If the economy is heading into a recession, cyclical industries are likely to be
affected more than other industries, whereas defensive industries are the least
likely to be affected. With such guidelines, investors may make better buy or sell
decisions. Similarly, an expected rise in interest rates will have negative
implications for the savings and loan industry and the home-building industry,
whereas an expected rise in interest rates will have opposite effects.
These statements reinforce the importance of market analysis. Not only do investors
need to know the state of the economy and market before deciding to invest, but
such knowledge is valuable in selecting, or avoiding particular industries.
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STRUCTURAL ANALYSIS
The nature of the competitive conditions existing in an industry can provide useful
information in assessing its future. The intensity of competition in an industry
determines that industry’s profitability. Professor Micheal Porter in his famous
book on ‘Competitive Strategy’ has undertaken a detailed analysis of the forces
that shape the competitive structure in an industry. The following sections are
based on excerpts from this book.
Competition in an industry continually works to drive down the rate of return on
invested capital towards the competitive floor rate of return, or the return that
would be earned by the economist’s ‘perfectly competitive’ industry. This
competitive floor, or ‘free market’ return, is approximated by the yield on long-
term government securities adjusted upward by the risk of capital loss. Investors
will not tolerate returns below this rate in the long run because of their alternative
of investing in other industries, and firms habitually earning less than this return
will eventually go out of business. The presence of rates of return higher than the
adjusted free market return serves to stimulate the inflow of capital into an
industry either through new entry or through additional investment by existing
competitors. The strength of the competitive forces in an industry determines the
degree to which this inflow of investment occurs and derives the return to the free
market level, and thus the ability of firms to sustain above average returns.
The five competitive forces – entry, threat of substitution, bargaining power of
buyers, bargaining power of suppliers, and rivalry among current competitors –
reflect the fact that competition in an industry goes well beyond the established

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players. Customers, suppliers, substitutes, and potential entrants are all

‘competitors’ to firms in the industry and may be more or less prominent
depending on a particular circumstance. Competition in this broader sense might
be termed extended rivalry. Of course different forces take on prominence, in
shaping competition in each industry.

Threat of Entry
New entrants to an industry bring new capacity, the desire to gain market share,
and often substantial resources. Prices can be bid down or incumbent costs inflated
as a result, reducing profitability. Companies diversifying through acquisition into
the industry from other markets often use their resources to cause a shake-up. This
acquisition into an industry with intent to build market position should probably be
viewed as entry even though no entirely new entity is created.
The threat of entry into an industry depends on the barriers to entry that are
present, coupled with the reaction from existing competitors that the entrant can
expect. If barriers are high and/or the newcomer can expect share retaliation from
entrenched competitors, the threat of entry is low.
There are six major sources of barriers to entry.
ECONOMIES OF SCALE
Economies of scale refer to decline in unit cost of a product (or operation or
function that goes into producing a product) as the absolute volume per period

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increases. Economies of scale deter entry by forcing the entrant to come in at large
scale and risk strong reaction from existing firms or come in at a small scale and
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accept a cost disadvantage, both undesirable options. Scale economies can be
present in nearly every function of a business, including manufacturing,
purchasing, research and development, marketing, service network, sales force
utilization, and distribution.
Scale economies may relate to an entire functional area, as in the case of a sales
force, or they may stem from particular operations or activities that are part of a
functional area. For example, in the manufacture of television sets, economies of
scale are large in color tube production and they are less significant in cabinet
making and set assembly. It is important to examine each component of costs
separately for its particular relationship between unit cost and scale.
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Units of multibusiness firms may be able to reap economies similar to those of scale
if they are able to share operations or functions subject to economies of scale with
other businesses in the company. For example, the multibusiness company may
manufacture small electric motors, which are then used in producing industrial fans,
hairdryers, and cooling systems for electronic equipment. If economies of scale in
motor manufacturing extend beyond the number of motors needed in any one
market, the multibusiness firm diversified in this way will reap economies in motor
manufacturing that exceed those available if it only manufactured motors for use in,
say, hairdryers. Thus related diversification around common operations or functions
can remove volume constraints imposed by the size of a given industry3. The
prospective entrant is forced to be diversified or face cost disadvantage. Potentially
shareable activities or functions subject to economies of scale can include sales
forces, distribution systems, purchasing, and so on.
The benefits of sharing are particularly potent if there are joint costs. Joint costs
occur when a firm producing product A (or an operation or function that is part of
producing A) must inherently have the capacity to produce product B. An example is
air passenger services and air cargo, where because of technological constraints only

3 For this entry barrier to be significant it is crucial that the shared operation or function be subject to
economies of scale which extend beyond the size of any one market. If this is not the case, cost savings
of sharing can be illusory. A company may see its costs decline as overhead is spread, but this depends
solely on the presence of excess capacity in the operation or function. These economies are short run
economies, and once capacity is fully utilized and expanded the true cost of the shared operation will
become apparent.

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so much space in the aircraft can be filled with passengers, leaving available cargo
space and pay load capacity. Many of the costs must be borne to put the plane into
the air and there is capacity for freight regardless of the quantity of passengers the
plane is carrying. Thus the firm that competes in both passenger and freight may
have a substantial advantage over the firm competing in only one market.
A common situation of joint costs occurs when business unit can share intangible
assets such as brand names and know-how. The cost of creating an intangible asset
need only be borne once; the asset may then be freely applied to other business,
subject only to any costs of adapting or modifying it. Thus situations in which
intangible assets are shared can lead to substantial economies.
A type of economies of scale entry barrier occurs, when there are economies in
vertical integration, that is, operating in successive stages of production or
distribution. Here the entrant must enter the market, integrated or face a cost
disadvantage, as well as possible foreclosure of inputs or markets for its product if
well-established competitors are already in. Foreclosure in such situations stems
from the fact that most customers purchase from in-house units, or most suppliers
‘sell’ their inputs in-house. The independent firm faces a difficult time in getting
comparable prices and may become ‘squeezed’ if integrated competitors offer
different terms to it than to their captive units. The requirement to enter the market
in an integrated fashion may heighten the risks of retaliation and also elevate other
entry barriers discussed below.
PRODUCT DIFFERENTIATION

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Product differentiation means that established firms have brand identification and
customer loyalties, which stem from past advertising, customer service, product
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difference, or simply being first into the industry. Differentiation creates a barrier
to entry by forcing entrants to spend heavily to overcome existing customer
loyalties. This effort usually involves start-up losses and often takes an extended
period of time. Such investments in building a brand name are particularly risky
since they have no salvage value if entry fails.
CAPITAL REQUIREMENTS
The need to invest large financial resources in order to compete creates a barrier to
entry, particularly if the capital is required for risky or unrecoverable upfront
advertizing or research and development (R&D). Capital may be necessary not
only for production facilities but also for things like customer credit, inventories,
or covering start-up losses. Even if capital is available on the capital market, entry
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represents a risky use of that capital which should be reflected in risk premiums
charged to the prospective entrant; these constitute advantages for going firm.
SWITCHING COSTS
A barrier to entry is created by the presence of switching costs, that is, one-time
costs facing the buyer of switching from one supplier’s product to another’s.
Switching costs may include employee retraining costs, cost of new ancillary
equipment, cost and time in testing or qualifying a new source, a need for technical
help as a result of reliance on seller engineering aid, product redesign, or even
psychic costs of severing a relationship. If these switching costs are high, then new
entrants must offer a major improvement in cost or performance in order for the
buyer to switch from an incumbent.
ACCESS TO DISTRIBUTION CHANNELS
A barrier to entry can be created by the new entrant’s need to secure distribution
for its product; to the extent the logical distribution channels accept its product
through price breaks, co-operative advertising allowances, and the like, there will
be a reduction in the profits. The manufacturer of a new food product, for example,
must persuade the retailer to give its space on the fiercely competitive supermarket
shelf via promises of promotions, intense selling efforts to the retailer, or some
other means.
The more limited the wholesale or retail channels for a product are and the more
existing competitors have these tied up, obviously, the tougher the entry into the
industry will be. Existing competitors may have ties with channels based on long
relationships, high-quality service, or even exclusive relationships in which the

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Security Analysis

channel is solely identified with a particular manufacturer. Sometimes this barrier

to entry is so high that to surmount it a new firm must create an entirely new
distribution channel.
Cost Disadvantage Independent of Scale
Established firms may have cost advantages not replicable by potential entrants, no
matter what their size and attained economies of scale. The most critical
advantages are factors such as the following:
• Proprietary product technology: Product know-how or design
characteristics that are kept proprietary through patents or secrecy.
• Favorable access to raw materials: Established firms may have locked up
the most favorable sources and/or tied-up foreseeable needs early at prices
reflecting a lower demand for them than the existing one.
• Favorable locations: Established firms may have cornered favorable
locations before market forces bid up prices to capture their full value.
• Government subsidies: Preferential government subsidies may give
established firms lasting advantages in some business.
• Learning or experience curve: In some businesses, there is an observed
tendency for unit costs to decline as the firm gains more cumulative
experience in producing a product. Costs decline because workers improve
their methods and become more efficient (the classic learning curve), layout

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improves, specialized equipment and processes are developed, better
performance is coaxed from equipment, product design changes make
FA manufacturing easier, techniques for measurement and control of operations
improve, and so on. Experience is just a name for certain kinds of
technological changes and may apply not only to production but also to
distribution, logistics, and other functions. As is the case with scale
economies, cost declines with experience relate not to the entire firm but
arise from the individual operations or functions that make up the firm.
Experience can lower costs in marketing, distribution, and other areas as well
as in production or operation within production, and each component of costs
must be examined for the effects of experience.
Cost declines with experience seem to be the most significant in businesses
involving a high labor content performing intricate tasks and/or complex assembly
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operations (aircraft manufacture, ship building). They are nearly always the most
significant in the early and growth phase of a product’s development, and later
reach diminishing proportional improvements. Often economies of scale are cited
among the reasons that costs decline with experience. Economies of scale are
dependent on volume per period and not on cumulative volume, and are very
different analytically from experience, although the two often occur together and
can be hard to separate.
If costs decline with experience in an industry, and if the experience can be kept
proprietary by established firms, then this effect leads to an entry barrier. Newly
started firms, with no experience, will have inherently higher costs than
established firms and must bear heavy start-up losses from below or near-cost
pricing in order to gain the experience to achieve cost parity with established firms
(if they ever can). Established firms, particularly the market share leader who is
accumulating experience the fastest, will have higher cash flow because of their
lower costs to invest in new equipment and techniques. However, it is important to
recognize that pursuing experience curve cost declines (and scale economies) may
require substantial upfront capital investment for equipment and start-up losses. If
costs continue to decline with volume even as cumulative volume gets very large,
new entrants may never catch up.
The decline in cost from experience can be augmented if there are diversified firms
in the industry whose share operations or functions subject to such a decline with
other units in the company, or where there are related activities in the company
from which incomplete though useful experience can be obtained. When an
activity like the fabrication of raw material is shared by several business units,

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experience obviously accumulates faster than it would if the activity were used
solely to meet the needs in one industry. Or when the corporate entity has related
activities within the firm, sister units can receive the benefits of their experience at
little or no cost since such experience is an intangible asset. This sort of shared
learning accentuates the entry barrier provided by the experience curve, provided
the other conditions for its significance are met.
Government Policy
The last major source of entry barriers is government policy. Government can limit
or even foreclose entry into industries with such controls as licensing requirements
and limits on access to raw materials. More subtle government restrictions on entry
can stem from control such as air and water pollution standards and products
safety and efficacy regulations. Government policy in such areas certainly has
direct social benefits, but it often has secondary consequences for entry which are
unrecognized.
Expected Retaliation
The potential entrant’s expectations about the reaction of existing competitors also
will influence the threat of entry. If existing competitors are expected to respond
forcefully to make the entrant’s stay in the industry an unpleasant one, then entry
may well be deterred. The following are the conditions that signal the strong
likelihood of retaliation to entry and hence deter it:
A history of vigorous retaliation to entrants;

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•
• Established firms with substantial resources to fight back, including excess
FA cash and unused borrowing capacity, adequate excess productive capacity to
meet all likely future needs, or great leverage with distribution channels or
customers;
• Established firms with great commitment to the industry and highly illiquid
assets employed in it;
• Slow industry growth, which limits the ability of the industry to absorb a new
firm without depressing the sales and financial performance of established firms.
Intensity of Rivalry among Existing Competitors
Rivalry among existing competitors takes the familiar form of jockeying for
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position – using tactics like price competition, advertising battles, product
introductions, and increased customer service or warranties. Rivalry occurs
because one or more competitors either feels the pressure or sees the opportunity
to improve positions. In most industries, competitive moves by one firm have
noticeable effects on its competitors and thus may incite retaliation or efforts to
counter the move; that is, firms are mutually dependent. This pattern of action and
reaction may or may not leave the initiating firm and the industry as a whole better
off. If moves and countermoves escalate, then all firms in the industry may suffer
and be worse off than before.
Some forms of competition, notably price competition, are highly unstable and quite
likely to leave the entire industry worse off from the standpoint of profitability. Price
cuts are quickly and easily matched by rivals, and once matched they lower revenues
for all firms unless industry price elasticity of demand is high enough. Advertizing
battles, on the other hand, may well expand demand or enhance the level of product
differentiation in the industry for the benefit of all firms.
Rivalry in some industries is characterized by such phrases as ‘warlike’, ‘bitter’, or
‘cut-throat’ whereas in other industries it is termed ‘polite’ or ‘gentlemanly’.
Intense rivalry is the result of a number of interacting structural factors.
NUMEROUS OR EQUALLY BALANCED COMPETITORS
When firms are numerous, the likelihood of mavericks is great and some firms
may habitually believe they can make moves without being noticed. Even where
there are relatively few firms, who are relatively balanced in terms of size and
perceived resources, it creates instability because they may be prone to fight with
each other and have the resources dominated by one or a few firms. On the other

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hand, one cannot underemphasize the relative strength of the firms and the leader
or leaders can impose discipline as well as play a co-ordinative role in the industry
through devices like price leadership.
In many industries foreign competitors, either exporting into the industry or
participating directly through foreign investment, play an important role in
industry competition.
Slow Industry Growth
Slow industry growth turns competition into a market share game for firms
seeking expansion. Market share competition is a great deal more volatile than is
the situation in which rapid industry growth insures that firms can improve results
just by keeping up with the industry, and where all their financial and managerial
resources may be consumed by expanding with the industry.
High Fixed or Storage Costs
High fixed costs create strong pressures for all firms to fill capacity which often
leads to rapidly escalating price cutting when excess capacity is present. Many
basic materials like paper and aluminum suffer from this problem, for example.
The significant characteristic of costs is fixed costs relative to value added, and not
fixed costs as a proportion of total costs. Firms purchasing a high proportion of costs
in outside inputs (low value added) may feel enormous pressures to fill capacity to
break even, despite the fact that the absolute proportion of fixed costs is low.
A situation related to high fixed costs is one in which the product, once produced,

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is very difficult or costly to store. Here firms will also be vulnerable to temptations
to shade prices in order to insure sales. This sort of pressure keeps profits low in
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industries like fishing and the manufacture of certain hazardous chemicals and
some service businesses.
Lack of Differentiation or Switching Costs
Where the product or service is perceived as a commodity or near commodity,
choice by the buyer is largely based on price and service, and pressures for intense
price and service competition result. These forms of competition are particularly
volatile, as has been discussed. Product differentiation, on the other hand, creates
layers of insulation against competitive warfare because buyers have preferences and
loyalties to particular sellers. Switching costs, described earlier, have the same effect.
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Capacity Augment in Large Increments
Where economies of scale dictate that capacity must be added in large increments,
capacity additions can be chronically disruptive to the industry supply/demand
balance, particularly where there is a risk of bunching capacity additions. The
industry may face recurring periods of overcapacity and price cutting.
DIVERSE COMPETITORS
Competitors diverse in strategies, origins, personalities and relationships to their
parent companies have differing goals and differing strategies for how to compete
and may continually run head into each other in the process. They may have a hard
time reading each other’s intentions accurately and aggreeing on a set of ‘rules of
the game’ for the industry. Strategic choice right for one competitor will be wrong
for others.
Foreign competitors often add a great deal of diversity to industries because of
their differing circumstances and often differing goals. Owner-managers of small
manufacturing or service firms may as well be satisfied with a subnormal rate of
return on their invested capital to maintain the independence of self-ownership,
whereas such outlook and philosophy is unacceptable and may appear irrational in
case of large publicly held companies.
In such an industry, the posture of the small firms may limit the profitability of the
larger concern. Similarly, firms viewing a market as an outlet for excess capacity
(e.g. in the case of dumping) will adopt policies contrary to those of firms viewing
the market as a primary one. Finally, difference in the relationship of competing
business units to their corporate parents is an important source of diversity in an

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industry as well. For example, a business unit that is part of a vertical chain of
businesses in its corporate organization may well adopt different and perhaps
contradictory goals than a free-standing firm competing in the same industry.
High Strategic Stakes
Rivalry in an industry becomes even more volatile if a number of firms have high
stakes in achieving success there. For example, a diversified firm may place great
importance on achieving success in a particular industry in order to further its
overall corporate strategy. Or a foreign firm may perceive a strong need to
establish a solid position in the market in order to build global prestige or
technological credibility. In such situations, the goals of these firms may not only
be diverse but even more destabilizing because they are expansionary and involve
potential willingness to sacrifice profitability.
Shifting Rivalry
The factors that determine the intensity of competitive rivalry can or do change. A
very common example is the change in industry growth brought about by industry
maturity. As an industry matures, its growth rate declines, resulting in intensified
rivalry, declining profits, and (often) a shake out.
Another common change in rivalry occurs when an acquisition introduces a very
different personality to an industry. Also, technological innovation can boost the
level of fixed cost in the production process and rise the volatility of rivalry.
Although a company must live with many of the factors that determine the intensity

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of industry rivalry because they are built into industry economics – it may have some
latitude in improving matters through strategic shifts. For example, it may try to raise
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buyer’s switching costs by providing engineering assistance to customers to design
its product into operations or to make them dependent for technical advice. Or the
firm can try to raise product differentiation through new kinds of services, marketing
innovations, or product changes. Focussing selling efforts on the fastest growing
segments of the industry or on market areas with the lowest fixed costs can reduce
the impact of industry rivalry. Also, if it is feasible a company can try to avoid
confronting competitors with high exit barriers and can thus sidestep involvement in
bitter price-cutting, or it can lower its own exit barriers.
Exit Barriers
Exit barriers are economic, strategic, and emotional factors that keep companies
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competing in businesses even though they may be earning low or even negative
returns on investment. The major source of exit barriers are the following:
• Specialized assets: Assets highly specialized to a particular business or
location have low liquidation values or high costs of transfer or conversion.
• Fixed costs of exit: These include labor agreements, resettlement costs,
maintaining capabilities for spare parts, and so on.
• Strategic interrelationships: Interrelationships between the business unit
and others in the company in terms of image, marketing ability, access to
financial markets, shared facilities, and so on. They cause the firm to attach
high strategic importance of being in the business.
• Emotional barriers: Management’s unwillingness to make economically
justified exit decisions is caused by identification with the particular business,
loyalty to employees, fear for one’s own career, price, and other reasons.
• Government and social restrictions: These involve government denial or
discouragement of exit out of concern for job, loss and regional economic
effects.
When exit barriers are high, excess capacity does not leave the industry, and
companies that lose the competitive battle do not give up. Rather, they grimly hang
on and because of their weakness, have to resort to extreme tactics. The
profitability of the entire industry can be persistently low as a result.

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Although exit barriers and entry barriers are conceptually different, their joint level
is an important aspect of the analysis of an industry. Often exit and entry barriers
are related. Substantial economies of scale in production, for example are usually
associated with specialized assets, as is the presence of proprietary technology.
Taking the simplified case in which exit and entry barriers can be either high or low:
Exit Barriers
Entry Low High
Barriers Low Low, stable returns Low, risky returns
High High, stable returns High, risky returns
The best case from the viewpoint of industry profits is one in which entry barriers
are high but exit barriers are low. Here entry will be deterred, and unsuccessful
competitors will leave the industry. When both entry and exit barriers are high,
profit potential is high but is usually accompanied by more risk. Although entry is
deterred, unsuccessful firms will stay and fight in the industry.
The case of low entry and exit barriers is merely unexciting, but the worst case is
one in which entry barriers are low and exit barriers are high. Here entry is easy
and will be attracted by upturns in economic conditions or other temporary
windfalls. However, capacity will not leave the industry when results deteriorate.
As a result capacity stacks up in the industry and profitability is usually
chronically poor. An industry might be in this unfortunate position for example, if

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suppliers or lenders will readily finance entry, but once in, the firm faces
substantial fixed financing costs.
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Pressure from Substitute Products
All firms in an industry are competing, in a broad sense, with industries producing
substitute products. Substitutes limit the potential returns of an industry by placing
a ceiling on the prices firms in the industry can profitably charge. The more
attractive the price performance alternative offered by substitutes, the firmer the
lid on industry profits.
Identifying substitute products is a matter of searching for other products that can
perform the same function as the product of the industry. Sometimes doing so can
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be a subtle task, and one which leads the analyst into businesses seemingly far
removed from the industry. Securities brokers, for example, are being increasingly
confronted with such substitutes as real estate, insurance, money market funds, and
other ways for the individual to invest capital accentuated in importance by the
poor performance of the equity markets.
Position vis-a-vis substitute products may well be a matter of collective industry
actions. For example, although advertising by one firm may not be enough to
bolster the industry’s position against a substitute, heavy and sustained advertising
by all industry participants may well improve the industry’s collective position.
Similar arguments apply to collective response in areas like product quality
improvement, marketing efforts, providing greater product availability, and so on.
Substitute products that deserve the most attention are those that are (1) subject to
trends improving their price performance trade off with the industry’s product, or
(2) produced by industries earning high profits. In the latter case, substitutes often
come rapidly into play if some development increases competition in their
industries and causes price reduction or performance improvement.

Bargaining Power of Buyers

Buyers compete with the industry by forcing down prices, bargaining for higher
quality or more services, and playing competitors against each other – all at the
expense of industry profitability. The power of each of the industry’s important
buyer groups depends on a number of characteristic of its market situation and on the

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relative importance of its purchases from the industry compared with its overall
business. A buyer group is powerful if the following circumstances hold true:
If they are concentrated or makes purchases in large volumes relative to sales of
the supplier. If a large portion of sales is purchased by a given buyer this raises the
importance of the buyer’s business. Large volume buyers are particularly potent
forces if heavy fixed costs characterize the industry – and raise the stakes to keep
capacity filled.
The products it purchases from the industry represent a significant fraction of the
buyer’s costs or purchases. Here buyers are prone to expend the resources
necessary to shop for a favorable price and purchase selectively. When the product
sold by the industry in question is a small fraction of buyer’s costs, buyers are
usually much less price sensitive.
The products it purchases from the industry are standard or undifferentiated.
Buyers, sure that they can always find alternative suppliers, may play one
company against another.
It faces few switching costs. Switching costs, defined earlier, lock the buyer to
particular sellers. Conversely, the buyer’s power is enhanced if the seller faces
switching costs.
It earns low profits. Low profits create great incentives to lower purchasing costs.
Highly profitable buyers, however, are generally less price sensitive (that is, of
course, if the item does not represent a large fraction of their costs) and may take a

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longer run view toward preserving the health of their suppliers.
Buyers pose a credible threat of backward integration. If buyers either are partially
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integrated or pose a credible threat of backward integration, they are in a position
to demand bargaining concessions. They engage in the practice of tapered
integration, that is producing some of their needs for a given component in house
and purchasing the rest from outside suppliers. Not only is their threat of further
integration particularly credible, but also partial manufacture in-house gives them
a detailed knowledge of costs which is a great aid in negotiation. Buyer power can
be partially naturalized when firms in the industry offer a threat of forward
integration into the buyers’ industry.
The industry’s product is unimportant to the quality of the buyer’s products or
services. When the quality of the buyers’ products is very much affected by the
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industry’s product, buyers are generally less price sensitive.
The buyer has full information. Where the buyer has full information about
demand, actual market prices, and even supplier costs, this usually yields the buyer
greater bargaining leverage than when information is poor. With full information,
the buyer is in a greater position to ensure that it receives the most favorable prices
offered to others and can counter supplier’s claims that their viability is threatened.
Most of these sources of buyer power can be attributed to consumers as well as to
industrial and commercial buyers; only a modification of the frame of reference is
necessary. For example, consumers tend to be more price sensitive if they are
purchasing products that are undifferentiated, expensive relative to their incomes,
or of a sort where quality is not particularly important to them.
The buyer’s power of wholesalers and retailers is determined by the same rules,
with one important addition. Retailers can gain significant bargaining power over
manufacturers when they can influence consumers’ purchasing decisions, as they
do in audio components, jewelry, appliances, sporting goods, and other products.
Wholesalers can gain bargaining power, similarly, if they can influence the
purchase decisions of the retailers or other firms to which they sell.

Bargaining Power of Suppliers

Suppliers can exert bargaining power over participants in an industry by
threatening to raise prices or reduce the quality of purchased goods and services.
Powerful suppliers can thereby squeeze profitability out of an industry unable to
recover cost increases in its own prices.

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The conditions making suppliers powerful tend to mirror those making buyers
powerful. A supplier group is powerful if the following apply:
• It is dominated by a few companies and is more concentrated than the
industry it sells to. Suppliers selling to more fragmented buyers will usually
be able to exert considerable influence in prices, quality, and terms.
• It is not obliged to contend with other substitute products for sale to the
industry. The power of even large, powerful suppliers can be checked if they
compete with substitutes.
The industry is not an important customer of the supplier group. When suppliers
sell to a number of industries and a particular industry does not represent a
significant fraction of sales, suppliers are much more prone to exert power. If the
industry is an important customer, suppliers’ fortunes will be closely tied to the
industry and they will want to protect it through reasonable pricing and assistance
in activities like R&D and lobbying.
The supplier’s product is an important input to the buyer’s business. Such an input
is important to the success of the buyers’ manufacturing process or product
quality. This raises the supplier power. This is particularly true where the input is
not storable, thus enabling the buyer to build up stocks of inventory.
The supplier group’s products are differentiated or it has built up switching costs.

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Differentiation or switching costs facing the buyer cut off their options to play one
supplier against another. If the supplier faces switching costs the effect is the
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reverse.
The supplier group poses a credible threat of forward integration. This provides a
check against the industry’s ability to improve the terms on which it purchases.
We usually think of suppliers as other firms, but labor must be recognized as a
supplier as well, and one that exerts great power in many industries. There is
substantial empirical evidence that scarce, highly skilled employees and/or tightly
unionized labor can bargain away a significant fraction of potential profits in an
industry. The principles in determining the potential power of labor as a supplier
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are similar to those just discussed. The key additions in assessing the power of
labor are its degree of organization, and whether supply of scarce varieties of labor
can expand. Where the labor force is tightly organized or the supply of scarce
labor is contained from growing, the power of labor can be high.

Government as a Force in Industry Competition

Government has been discussed primarily in terms of its possible impact on entry
barriers, but in the 1970s and 1980s government at all levels must be recognized as
potentially influencing many if not all aspects of industry structure both directly
and indirectly. In many industries, government is a buyer or supplier and can
influence industry competition by the policies it adopts.
Many times government’s role as a supplier or buyer is determined more by
political factors than by economic circumstances, and this is probably a fact of life.
Government regulations can also set limits on the behavior of firms as suppliers or
buyers.
Government can also affect the position of an industry with substitutes through
regulations, subsidies or other means. Government can also affect rivalry among
competitors by influencing industry growth, the cost structure through regulations
and so on.
Thus no structural analysis is complete without a diagnosis of how present and
future government policy, at all levels, will affect structural conditions.

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Following figure helps in summarizing the industry analysis process.

Figure 4: Industry Analysis

Strategic considerations in industry analysis can be summarized in the following

points.
Inputs
• What are inputs?

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• Who the supplier is?
• Demand-supply position.
•
•
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Dependency on foreign countries.
Alternative inputs.
• Organized or unorganized markets.
Outputs
• What is it?
• Who uses it?
• Customer Analysis Sex
Age
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Religion
Demographic Conditions
• Organized or unorganized markets.
• Demand supply position.
Exit Barriers
• Switching Cost.
Players
• Who are the players?
• Their niches.
• Their SWOT.
• Their competitive positioning.
• Their market shares.
• Their future plans New Products (Product Portfolio change)
& strategies
New Markets (Market Portfolio change)
Diversification or disinvestment plant, etc.

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Economy Industry Linkages

• Government’s attitude Promotional
towards Industry
Regulatory

Restrictive
• Government’s policies & how they effect Industry.
Entry Barriers
Artificial Natural
– Control over raw material. – Labor intensive.
– Licencing policy of Government. – Capital intensive.
– Control over Tech. – Learning curve.
– Control over Market through strong brand equity. – Economies of scale.
Other Factors
• Export orientation of industry (exp. Potential)
• Import substitution potential of industry
• Industry life cycle stage.

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COMPANY ANALYSIS
FA
Significance of Company Analysis
The industry analysis enables us to shortlist industries for the purpose of equity
investment. The next step is to identify the superior performers in this industry.
Even though an industry might be doing well, some companies in the industry can
be in doldrums as revealed by the following example.
The two wheeler industry has stabilized in the recent past and Bajaj Auto is doing
extremely well. But there are many companies like Chamundi Mopeds, and A.P.
Scooters which are in deep trouble.
To identify those companies that are doing relatively well in the industry, we have
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to make a penetrating analysis of the financial and non-financial strengths and
weaknesses of the company. This lesson provides a discussion on the important
financial and non-financial parameters that have to be examined in this context.

Financial Indicators
Financial statements are a primary internal source of information for evaluating the
investment prospects of various companies.

Analyzing Financial Statements: Ratio Analysis

Ratios are among the best known and widely used tools of financial analysis.
Ratios allow one to make intra-firm and inter-firm comparisons. A ratio expresses
the mathematical relationship between one quantity and another. The ratio of 200
to 100 is expressed as 2:1 or 2.
While the computation of ratio simply involves the division of one variable by
another, the interpretation of a ratio is very complicated as there are many factors
which one has to consider which influence variables involved in the ratio. In
addition the investor needs to be alert to the fact that the ratios can be manipulated.
Since ratios are future oriented, the analyst must be able to adjust the factors
present in a relationship to their probable shape and size in future. Thus, in the
final analysis, the usefulness of ratios is wholly dependent on their intelligent and
skillful interpretation.

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A great many ratios can be developed from the multitude of items included in the
enterprise’s financial statements.
Investors or analysts are primarily interested in the profitability and the leverage
position of the company. For this purpose, they examine the following ratios.

Profitability Ratios
Earnings Before Interest and Taxes
Return on Investment =
Total Asssets

Profit After Tax

Net Profit Margin =
Net Sales

Profit After Tax − Preference Dividends

Return on Equity =
Paid-up Equity Capital + Reserves

Profit After Tax − Preference Dividends

Earnings Per Share =
Number of Outstanding Equity Shares
Earnings Per Share
Dividend Cover =
Dividends Per Share

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Besides these ratios, the equity investors contemplating investment through the
secondary market consider the following market-related measures.
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Earnings-Price Ratio =
Earnings Per Share
Market Price Per Share
Dividend + Price Change
Market Yield =
Initial Price
In practice the market price per share is calculated as the simple average of the
opening and closing prices or the high and low prices during the period under
consideration. Other things being equal, investors prefer companies with a
consistent track record of profitability, to companies, which experience sharp
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fluctuations in their profitability. A company with an erratic profitability record is
perceived to have a higher degree of business risk.

Leverage Ratios
Leverage ratios help in assessing the financial risk of a firm. The typical ratios that
are examined in this context are:
Total Debt (i.e.Long-term +Short-term)
Debt-Equity Ratio =
Equity (Equity+Preference)

Earnings Before Interest and Taxes

Interest Coverage Ratio =
Interest
A company with a high debt-equity ratio (say more than 2:1) and a low interest
coverage ratio (say less than 2) is perceived to have a high degree of financial risk.
Obviously, the equity investors will demand a high rate of return on their
investment to compensate for a high degree of business and financial risks.
The other ratios that are calculated are liquidity ratios like current ratio and quick
ratio and asset-turnover ratios like total assets turnover ratio, fixed assets turnover
ratio, accounts receivable turnover ratio, inventory turnover ratio and average
collection period.

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Security Analysis

Box 1: Is Cash Earnings Per Share a Better Indication?

Earnings per share, or EPS as it is popularly known, has been a favorite measure
for investment analysis. But of late, the Cash Earnings Per Share (CEPS) is seen
as an improvement. CEPS is arrived at by adding back the depreciation provision
to the Profit After Tax (PAT) thus,
PAT + Depreciation
CEPS =
No.of Shares
Why are CEPS considered more efficient investment signals? Depreciation
policies differ widely among companies and even within a company from one
year to another and hence makes comparisons difficult. Another advantage is that
they give a better idea of the cash available for use within a company, since
depreciation is a non-cash charge. A third factor for preference is that EPS
discriminates against growing companies which have been building their gross
block of assets compared with companies which are growing slowly and
therefore are not investing in fixed assets. If a company’s profit figure is low due
to high depreciation it does not indicate less efficiency.
ROE Analysis
The measure of Return On Equity (ROE) can be analyzed in terms of profitability,

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turnover and leverage as follows:
ROE = Net profit margin x Total assets turnover ratio x Total assets to net worth
FA = (PAT/NS) x (NS/TA) x (TA/NW)
PAT/NS can also be expressed as the product of pre-tax margin and post-tax
retention ratio
 TAXES PAT 
 i.e. 1 − or 
 PBT PBT 

PBT PAT NS TA
Then ROE = x x x
NS PBT TA NW
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PAT/NS provides a measure of profitability, NS/TA indicates the efficiency with

which the total assets are employed, and TA/NW serves as a measure of leverage.
A trend analysis of PAT/NS, and TA/NW provides an idea of the business and
financial risks assumed by the company.
The higher the post tax margin and total assets turnover ratio the more profitable
the firm. But interpretation of high turnover ratio is rather complex. An extremely
high turnover ratio may indicate that the firm is up against the capacity limits of its
plant and equipment and therefore provides a warning signal that the firm may
have to expand its capacity.
Non-Financial Parameters
The important non-financial parameters to be examined by an investor are as
follows:
BUSINESS OF THE COMPANY
The investor should know whether the company is a well-established one, whether
it has a good product range and whether its lines of business have considerable
potential to grow.
TOP MANAGEMENT
The quality of top management team, particularly, the competence and the
commitment of the chief executive officer matters a lot in shaping the destiny of
the company.

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 Fundamental Analysis

PRODUCT RANGE
Progressive companies like ITC and Hindustan Lever create competition for their
existing products by launching new products with regular frequency. Hence, investors
must examine whether the company under review belongs to this group or not.
DIVERSIFICATION
An issue related to that of product range is diversification. To reduce the degree of
business risk and improve profitability, many companies resort to diversification.
Hence this issue is to be carefully examined by the investor.
FOREIGN COLLABORATION
Where a company has entered into technical collaboration with a foreign company,
the investor must find out more about the nature of the collaboration agreement.
AVAILABILITY OF COST OF INPUTS
If the company depends upon imported raw materials, it is important for the
investors to assess the raw material position, because any shortage of the raw
material and/or escalation in the cost of raw material will adversely affect the
profitability.
RESEARCH AND DEVELOPMENT
Progressive companies spend substantial sums of money on R&D to upgrade their
existing products, introduce new products, adapt foreign technology to suit the
local conditions, achieve import substitution, etc.

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GOVERNMENTAL REGULATIONS
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The investor must assess the implications of governmental regulations such as
MRTP Act, FERA, etc., for the company under review.
PATTERN OF SHAREHOLDING AND LISTING
The pattern of shareholding has a baring on the floating stock available in the
market and the trading volume of these issues will have an effect on the company,
hence it will be analyzed by the investor before taking any investment decision.
SUMMARY
• The intrinsic value of a share is estimated by discounting the company’s
prospective earnings stream or the shareholders’ prospective dividend stream.
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This depends very much on the economic and industrial environment, the
particular company’s market share, its own financial strength, its policies,
quality of asset management, etc.
• The fundamental analysis framework mainly deals with (a) Economic
Analysis, (b) Industry Analysis and (c) Company Analysis.
• The industry life cycle helps to understand the characteristics of pioneering
stage, expansion stage, stabilization stage and declining stage of an industry.
It is the second stage namely expansion stage which is probably most
important to investors. The growth is rapid but orderly, which is an appealing
characteristic to investors.
• The business cycle analysis helps the investors to predict performance of an
industry over shorter periods of time.
• The structural analysis helps to analyze the competitive conditions existing in
an industry and this provides useful information in assessing its future.
• The industry analysis enables the investors to shortlist the industries for the
purpose of equity investment.
• Under the company analysis, an investor can study the performance of the
particular firm with regard to profitability ratios, leverage ratios and ROE
Analysis and decide about choosing to invest.
• Many a time, companies resort to changing of their accounting policies for
various reasons. The next chapter focuses on the impact of changes in
accounting policies.

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Security Analysis

Case Study
Aluminum Industry
PROFITABILITY HINGES ON RE-EVALUATING FUTURE STRATEGY
The Variables dictating the trends in the aluminium industry have changed
dramatically in the last three years. In a mature and cyclical commodity industry
such as aluminium, these three years have been the most dynamic and instructive
phase in almost a decade. In this period players such as Alcan, Alcoa and Pechiney
responded to some key factors influencing the industry. Delivering the keynote
address at the Metal Bulletin’s International Aluminium Conference in September
1999, Mr Jacques Bougie, the then President and Chief Executive Officer of Alcan
Aluminium, outlined the key influences as: Declining aluminium prices and
eroding margins, Pressures to improve returns on investment, Maturing of terminal
markets such as the London Metals Exchange (LME), Technological changes -
particularly on the upstream side, Intense competition from other materials such as
steel and plastics, and The need to respond to the changing demands of global
customers. The influence of these factors set the stage for a three-phased change in
the industry in 1999-2001. Phase I: Consolidation in 1999 The decline in
aluminium prices at the LME to a five-year low of $1,140 in March 1999 proved
to be the last straw for an already strained industry. It finally triggered the

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much-needed “consolidation”. In August 1999, Alcan Aluminium, the industry’s
second-largest player, announced a merger with Pechiney SA, France, and the
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aluminium business of Alusuisse-Lonza Group of Switzerland in a $9.2-billion all-
stock buyout. However, in a swift response to the APA (Alcan-Pechiney-Algroup)
combine, Alcoa, US, acquired Reynolds Metals Company, the third largest
aluminium player, in a $5.6-billion cash and stock deal. The two mega mergers
were dictated by the rationale of cost savings, price stability, global focus and
creation/preservation of shareholder value. The combined entities were expected to
be substantially stronger financially, operationally and technically than their peers.
These mergers were also likely to force other aluminium majors - such as Billiton,
Norsk Hydro, Kaiser Aluminium, and Billiton - into the consolidation act.
Phase II: Retarding the ‘urge to merge’ The mergers of Alcoa-Reynolds and the
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APA combine went before the anti-trust authorities for review. The Alcoa-
Reynolds deal was okayed by the European Commission (EC) in mid-2000 as
Alcoa acceded to all the divestment demands. The EC demanded that Reynolds
sacrifice its alumina assets and the Alcoa its Longview smelter. However, vis-à-vis
the other merger, the EC asked the combine to sell the equity stake in downstream
aluminium namely - Aluminium Norf, the rolling mill held by Alcan Aluminium
in Germany. Alcan’s unwillingness to do this, led to the collapse of the APA in
2000. Ultimately, only the Alcan-Algroup merger went through, with Pechiney
dropping out of the deal. Basically, Pechiney’s exit clearly exposed a weak link in
the consolidation chain. With strong technological thrust and focus on speciality
aluminium products, Pechiney was expected to complement the Alcan and
Algroup’s product profile and contribute significantly to APA’s value-creation.
Hence, the combine’s breakdown achieved the objectives of the consolidation only
to a limited extent. The EC’s tough review may discourage mergers of this ‘scale’
and ‘size’. This is largely because the anti-trust authorities were concerned not by
the size or the market share of individual players, but by the effect the merger
might have on the global aluminium market. If mergers are examined along these
lines it will be an onerous task for companies to put through mergers of the
APA/Alcoa-Reynolds kind. Phase III: Back to fundamentals There has been a
distinct slowdown in mergers and acquisitions since late 2000 and early 2001,
mainly because of the toughness of the anti-trust authorities. This stance is
probably correct from the consumers’ viewpoint. But from the producers’

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 Fundamental Analysis

standpoint, these developments have triggered volatility in international price

trends again. The international prices, which witnessed a steady uptrend in 2000,
eased up following a slowdown in demand from the US and Japan in mid-2001.
Aluminium prices then began to steadily decline, from $1,539 a tonne in May to
$1,377 in August. In July, Alcan announced its second quarter earnings for 2001
and predicted that the world consumption was likely to drop by 1.9 percent in
2001 to 27.99 million tonnes from 28.53 million tonnes in 2000.
Citing weak economic conditions, Alcan also reported lower post-tax earnings in the
second quarter ended June. And then came the terrorist attacks on New York and
Washington on September 11, which may end up changing the global demand-supply
equation and consumption patterns of the industry altogether. Alcoa closed third
quarter in September with an 8 percent decline in post-tax earnings, ending its
record run of growth in post-tax earnings. In response to these weak earnings
announcements by aluminium majors and lowered consumption outlook,
aluminium prices, towards the end of October, started slipping to March 1999
lows. But the US progress in the war against Afghanistan helped prices recover in
November and early December from the October’s low of $1,282. However, the
aluminium industry is not out of the woods yet. In a crisis of this kind, every
industry participant goes back to the fundamentals and re-evaluates strategy from
the basics. The players are grappling with a complex mosaic of variables in
evolving the industry’s future strategy. Challenges facing long-term planners

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Global demand and cost patterns: After September 11, Alcoa forecast a drop in the
West’s demand (the key constituent) by almost 5 percent in 2001. This can be
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attributed mainly to the deteriorating economic environment, and cuts in capacity
that were still insufficient to offset the slowdown in demand.
In 2002, Alcoa estimates that the aluminium demand will rise by 3 percent, but
with higher supplies, the global demand-supply equation may be in balance. In this
backdrop, if the 2002 price levels remain at $1,300-1,400, producers can maintain
margins only by massive cost-cutting. But the challenge is in reducing costs
consistently and innovatively. Slowing pace of consolidation: After APA’s
collapse, it became obvious that such mergers were unlikely to win easy approval
from anti-trust authorities. In a slight dilution of their tough stand, Europe’s
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anti-trust authorities have since, late-2000 indicated that they will evaluate
mergers/acquisitions not only in the context of the overall aluminium market, but
also with regard to other materials. However, this is unlikely to lead to major
acquisitions in the aluminium market. For instance, as late as the third quarter of
2001, Pechiney was reluctant to bid for VAW, the aluminium subsidiary of
German power utility E.ON, because of fears of overlapping business interests.
Although small acquisitions will continue, the absence of large mergers will keep
aluminium prices volatile, and curtail the scope for significant value creation.
Upstream vs downstream disintegration: Aluminium has so far remained a
vertically-integrated industry, with the same producers operating in upstream and
downstream aluminium. In an address to the International Aluminium Forum in
May, Mr. Richard Evans, Executive Vice-President, Alcan Inc, raised an
interesting question: Are upstream and downstream aluminium fundamentally
different lines of businesses? He felt the factors of success for these two segments
were different and reiterated that the successful entrants in upstream aluminium
were from the mining and energy fields, while in downstream aluminium, the
success factors depended on customer needs and a combination of lead times,
prices, product attributes and customer perceptions. As the industry matures, it is
likely that the upstream-downstream distinction will actually emerge. And
companies equipped to make this transition will succeed in the long run.
Technological changes: As the industry is likely to face greater pressure on prices
and margins, its challenge lies in developing and employing new and efficient
refining and smelting technologies.

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Security Analysis

As environmental consciousness grows and energy efficiency becomes paramount,

“super-smelters”, with capacities of up to 5 lakh tonnes and capable of producing
at lower cost per unit of output, will become the industry norm. At the same time,
aluminium majors are also working on other technology initiatives - such as the
Pechiney AP50 Smelting System that may be commercially operational in the next
few years. Alcoa’s inert anode technology is at an advanced experimental stage.
These technological breakthroughs will continue to challenge the need for
aluminium majors to create greenfield capacities at competitive cost. Create new
end-user segments: For an industry excessively focussed on the auto and container
segments, the biggest challenge will be to create new end-user segments. Although
the auto industry will continue to be one of the biggest users of aluminium in the
next five years, unless alternative end-uses can be created, the industry could be
foreclosing on long-term growth opportunities. The other challenge will be the
downstream players’ ability to engineer/customise solutions to customer
requirements. Unless the integrated/standalone downstream producers work on
this, their viability may be called into question.
© Business Line, December 9, 2001. Originally Published as ‘Profitability Hinges
on Re-evaluating Future Strategy.’ Reprinted with permission.

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Chapter VII

Impact of Changes in

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Accounting Policies
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After reading this chapter, you will be conversant with:

• Changes in Accounting Policies

• Depreciation
• Valuation of Fixed Assets
• Foreign Exchange Transactions
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• Amortization of Preliminary and other Expenses
• R&D Expenditure
• Valuation of Inventory
• Treatment of Gratuity
• Lease Accounting
Security Analysis

Introduction
The financial statements of a company which reflect both the performance of the
company during a particular period as well as the worth of the company as on a
particular date are of great significance to an investor. Most investors look at the
price of a security as the present value of the future cash flows, which they expect
to receive, where the discount rate is appropriately adjusted for the risk associated
with the cash flow stream. The reported earnings and the earnings forecast help
investors estimate the future dividend stream. It can be reasonably expected that
with a growth in income, the dividends are also expected to grow. On the other hand, a
sudden fall in income rates can forewarn a cut in dividends too. Studies in the stock
market have also shown that earnings are important determinants of stock prices
and that changes in stock prices are highly correlated with changes in earnings.
The return on equity which is calculated based on the information provided by the
financial statements is also an important factor in determining stock prices. It can
be shown on the basis of the constant growth model, that stock prices are a
positive function of return on equity, book value, pay-out ratio and the growth rate
and a negative function of the risk adjusted discount rate. Thus, everything else
held constant, the higher the return on equity the higher the stock price.
The cash flow is also used by many investors in addition to earnings and
dividends. For example, the analysis of stock prices based on the ‘value line’

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drawn on price charts is based on cash flow. The value line which represents the stock’s
intrinsic value drawn on the price chart is equal to cash flow per share multiplied
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by some appropriate number. Sometimes, an analysis of the cash flow may provide
insights into the company’s profitability which earnings may not reveal.
It is, therefore, evident that the financial statements play a major role in security
evaluation. The questions now arise as to the validity of the ‘profit’ figures as
reported in the financial statements. Although the Companies Act requires that the
profit and loss account and the balance sheet should reflect a ‘true and fair view’
of the profit/loss for a particular period and the net worth of the company as of that
date, the concept of ‘true and fair’ has not been defined anywhere. Being situation
specific no certain definition of ‘true and fair position’ is possible either.
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A number of areas require estimates to be made. Varying judgments on the nature,
timing and the form of transaction can lead to different accounting treatments.
Above all, the different accounting policies followed by the companies and
changes in such accounting policies can distort the profit figures and asset values
to a great extent.
Within a certain broad legal framework, it is quite possible to report profits which
suit the specific organizational needs, thanks to the accounting jugglery. In order
to follow a conservative system of profit-reporting, the following practices can be
adopted:

• Do not take into account any income until it is/can be realized without doubt.

• Take into account all expenses, which have arisen or which are likely to arise or
which are under dispute.

• Make full provisions for obsolete stores and unusable spares, tools, designs, etc.

• Estimate all contingent liabilities like gratuity, and make adequate provisions for
them.

• Charge depreciation fully at the maximum rates prescribed in law.

The list can no doubt be extended. In the final analysis, the profit is what you
wish to report, at least, in the short run.

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 Impact of Changes in Accounting Policies

CHANGES IN ACCOUNTING POLICIES

The divergent accounting policies followed by companies and changes in such
policies are major factors which lead maneuverability to accounts. The following
are some areas where divergent accounting policies are followed. The list is,
however, not exhaustive.
• Depreciation
• Valuation of fixed assets
• Conversion or translation of foreign currency items
• Valuation of inventories
• Amortization of preliminary expenses and other miscellaneous expenditure
• Lease accounting
• Treatment of gratuity liability
• Treatment of Research and Development expenditure.
The repercussions of changes in accounting policies in some of the more important
areas are examined below, with illustrations.
DEPRECIATION

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Depreciation offers a range of tools by which the profit figure can be tampered
with. To begin with, depreciation is to be arrived at in such a manner that the cost
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is written-off over the useful life of the asset. But ‘the useful life’ is determined by
the company with an eye on profits.
Again, Section 350 of the Companies Act allows two methods of depreciation –
the straight line method and the written down value method. Nothing prevents a
company from changing its method of depreciation. This lends a helping hand to the
company management which would like to raise or lower the actual profit figure.
The depreciation calculated under the written down value method is higher than
that calculated under the straight-line method in the initial years of the life of the
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asset, and is considerably lower under WDV method than under straight-line
method in the later years. Thus, a company can change the method of
depreciation from straight-line method to WDV method in the later years and
show a higher profit figure and vice versa. A number of companies which run
the machines on extra shifts do not provide extra depreciation leading to
excess profits. For instance, the auditors of DCW Home Products Limited have
commented that “the company has not provided extra shift depreciation
amounting to Rs.32,78,371 during the year, resulting in the loss for the year being
lower by the same amount”.
Illustration 1
The annual report of the “ABC Tea and Industries” for 2002-03 contains the
following note no. 11 under the notes forming part of the accounts.
During the year the basis for providing depreciation in respect of the fixed assets at
the pharmaceutical division has been changed from the written down value method
to the straight-line method. Consequently, Rs.65.52 lakh being the resultant excess
amount of depreciation provided for in earlier years has been written back in the
current year. However, due to this change, depreciation with the consequential
impact on the profit and net fixed assets is higher by Rs.4.08 lakh.

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 Security Analysis

The Profit and Loss account of the Company for the year ended 2002-03 is
reproduced below:
Profit and Loss of Dhunseri Tea Company for the Year ended 31.3.03
(Rs. in lakh)
Year ended Year ended
31.3.02 31.3.03
Income
Sales 2,026.45 143.04
Decrease/Increase in Stock 64.54 65.86
Other Income 184.54 64.42
2,275.53 1,567.32
Expenditure
Materials 387.06 240.79
Excise duty and Cess 95.43 74.12
Expenses 1,103.93 765.52
Interest 91.39 61.20
Depreciation 63.90 47.30
1,741.71 1,188.93
Profit before Taxation 533.82 378.39

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The writing back of excess depreciation of Rs.65.52 lakh due to the change in the
method of provision of depreciation has been included under ‘Other Income’. This
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has to be deducted from the current income (net of higher depreciation in the
current year on account of the change) to arrive at a more realistic figure of the
profit. The profit before tax, after the aforesaid adjustment would be only
Rs.472.38 lakh and the change in PBT over the previous year would be only 24
percent as against the increase of 41 percent before adjustments.
VALUATION OF FIXED ASSETS
Capitalization of Interest
One area which was prone to controversies was the capitalization of interest on
loans for acquiring fixed assets. The AS-10 “Accounting for fixed assets” requires
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that interest charges on loans obtained for acquiring capital assets up to the date of
putting the asset to use should be capitalized. However, this was only
recommendatory up to 31.3.91 (made mandatory with effect from 1.4.91) and the
International Accounting Standard in this regard does not insist on such
capitalization. Hence divergent policies were used in this regard, making
comparability of performances by different companies difficult. The controversy
appears to have been put to rest with the AS-10 becoming mandatory with effect
from 1.4.91.
When interest charges are capitalized, the interest expense against profits becomes
reduced leading to increased profits; the asset cost goes up with consequent higher
depreciation. It is also to be noted that the Accounting Standard only provides for
capitalization of interest up to the date of commencement of operations of the
asset, whereas some companies tend to capitalize the interest beyond this point
also. When such deviations are found, it is the auditor’s duty to point it out in his
report. The impact of change in the policy followed in this regard is shown in the
following illustrations.
Illustration 2
An extent from the auditor’s report of Kirloskar Cummins Ltd. runs as follows:
“Financing costs relating to borrowed funds attributable to the acquisition of fixed
assets for the period up to the date when the assets are ready for use, have not been
capitalized. This is not in accordance with AS-10 issued by the Institute of
Chartered Accountants of India which is mandatory for accounting years
beginning on or after 1.4.91. Consequently, the profit after tax for the year and the
reserves and surplus are lower by Rs.13.53 million and the net block of fixed
assets is lower by Rs.22.06 million”.

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 Impact of Changes in Accounting Policies

The Company reported an EBIT of Rs.203 million and with the profit being
adjusted for the interest charge not capitalized, the earnings before tax rise to
Rs.216.53 million.
Again, in the case of TISCO, the company was writing-off the interest charges on
loans used for capital expenditure up to financial year 1990-91. However, in
1991-92, such interest charges were capitalized. Therefore, the profits were higher
in that year by Rs.46.51 crore after the consequential higher depreciation due to
such capitalization of Rs.0.12 crore than what it would have been had the previous
basis been followed. Although such treatment is in conformity with AS-10 the
difference in profits on account of the change in policy should be adjusted to
enable comparability with previous years.
FOREIGN EXCHANGE TRANSACTIONS
Treatment of differences arising out of foreign exchange transactions is also an
avenue which offers scope for manipulation of accounts. Gains or losses arising
out of fluctuations in exchange rates between the transaction dates and the
settlement dates are treated differently by companies. The AS-11 on “Accounting
for effects of changes in foreign exchange rates requires that gains or losses on
settlement of the transactions within the same accounting period should be
recognized in the Profit and Loss statement of the period except in the case of
exchange differences relating to amounts incurred for the acquisition of fixed

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assets, which would be adjusted in the carrying amount of the related excess.”
Where a company does not capitalize the differences arising out of exchange
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fluctuation relating to loans for fixed assets or does not charge the differences
arising out of other transactions to the profit and loss account of the relevant
periods, there is a distortion in the report figures.
Illustration 3
Here is an extract from the Auditor’s report of M/s. Praga Tools Ltd. “Capitalization
of foreign exchange fluctuations as per the Accounting Policy no. 7 of the
company amounts to Rs.162.66 lakh. Consequently, current year’s loss is reduced
by Rs.19.94 lakh”.
The company had, up to the financial year 1990-91, charged off to revenue, the
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differences arising out of fluctuations in the commercial rate of exchange between
the dates of draw down and the dates of effecting actual payments. Such
differences arising for the year 1991-92 in respect of foreign currency
loans/deferred payments for imported capital equipment have been capitalized
resulting in reduction of losses by Rs.19.94 lakh than it would have been had the
earlier policy was followed.
Although the change in the company’s accounting policy in this regard is in
conformity with the Accounting Standard-11, the change in policy does affect the
current year’s earnings power and consequently defeats comparison with earlier
years unless the profits/losses are reworked making adjustments for such changes.
AMORTIZATION OF PRELIMINARY AND OTHER EXPENSES
The amortization of preliminary expenses and other miscellaneous expenditure of
capital nature offers ample scope for increasing or decreasing the profits. There is
no legal rule prescribed for the write-off of such expenditure. Although the income
tax rules may provide for the write-off of such expenditure within a period of time
this is relevant only for computation of taxable income and nothing prevents the
company from writing-off heavy amounts in years of rich harvest and nothing at all
during the lean years. Alternatively, heavy expenses incurred during the period may be
camouflaged and treated as ‘deferred revenue expenditure’ and written-off over a
number of years. Patent rights which were previously written-off might be
capitalized resulting in higher profit figures.

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 Security Analysis

RESEARCH AND DEVELOPMENT EXPENDITURE

Research and Development expenses are incurred by almost all companies who
wish to stay ahead in their fields. But it is the accounting treatment of such
expenditure that raises a number of questions. Research and Development
expenditure can be basically classified into:
a. Pure and applied research which can be regarded as a part of a continuing
operation required to maintain a company’s business and its competitive
position.
b. Development research, the end result of which is a new and developed
product with enduring benefits.
The Accounting Standard no. 8 on Accounting for Research and Development
requires that expenditure on pure research be written-off to the profit and loss
accounts of the relevant periods and development research expenses can be
deferred and amortized on a systematic basis either by reference to the sale and use
of the product or process or by reference to a reasonable time period. However, the
classification of research as pure and developmental and the basis and time period
of write-off of the deferred research costs are left to the discretion of the company
management. Thus, there is enough ground for them to amortize the expenditure
when profits are low and/or alter the periods and the amount of write-off as they
deem fit.

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VALUATION OF INVENTORY
Inventory valuation plays a key role in determining profits as any change in the
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inventory value directly affects the profit figure and the financial position of a
company as at a particular date. Three methods of valuation are recognized,
normally, for valuing inventory viz., FIFO, LIFO and ‘average cost’ methods of
valuation. As such, the companies may switch over from one method of valuation
to another, which would have repercussions on the profits. For instance, under
inflationary circumstances, a company may switch over from the LIFO method to
FIFO method and increase its profits. Not only can the companies change the
method of valuation, but also their policy regarding the costs that are
inventoriable. The changes in inventory value due to such policy changes not only
affect profit figures, but also the current assets figure and hence the funds flow
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evaluation too.
TREATMENT OF GRATUITY
Several companies account for retirement gratuity only on cash basis even though
the other incomes and expenditures are accounted for on accrual basis. This is so
in spite of the fact that companies are required to provide for gratuity liability on
the basis of actuarial valuation. Such non-provision of gratuity leads to higher
profits. Some companies may even switch over from the accrual basis of
accounting for gratuity to cash basis during lean years to save on the provision for
gratuity, thereby showing higher profit figures.
For instance, an extract from the Auditor’s Report of Greaves Cotton and Co. Ltd.
runs as follows: “No provision has been made for gratuity liability in respect of
employees of Heavy Engineering Unit, Madras, estimated on actuarial valuation of
Rs.7,77,307, with consequential effect of profits.” Thus while comparing profits,
the required provision for gratuity liability would have to be adjusted.
REVENUE RECOGNITION
The point of time at which revenue can be recognized in accounts is a totally
subjective decision and refers to the particular situation and nature of revenue. The
important factor underlying the decision is only (a reasonable certainty) regarding
receipt of such revenue. It is, therefore, no wonder that a change in the policy of
revenue recognition in relation to any particular item can lead to a substantial
change in profits.

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 Impact of Changes in Accounting Policies

For instance, the Hindustan Gas & Industries Ltd., which accounted for premium
of EXIM scrips only on actual sale of such scrips up to the year 1990-91 changed
its policy and accounted for such premium on accrual basis for the year 1991-92
thereby increasing their profits by Rs.9,88,890.
Another case in point is M/s Stanrose Ltd. who took account the estimated import
duty benefit aggregating to Rs.294.72 lakh in respect of duty-free imports of raw
materials yet to be made in respect of exports effected during the year and earlier
years. The auditors, however, mentioned this in their report.
LEASE ACCOUNTING
Lease accounting is another area where manipulations are resorted to. A lease can
be either a financial lease or an operating lease. The generally accepted accounting
principles related to lease accounting require the lessee acquiring the use of a
financial lease to capitalize the asset and create a corresponding liability equal to
the fair value of the leased property or the present value of the minimum lease
payments. The rentals paid by the lessee must be apportioned between the finance
charge and the reduction of the outstanding liability and the annual finance charges
must be debited to the revenue account over the lease period. In the case of an
operating lease, the annual rentals must be charged off as operating expense to the
revenue account.
In India, the prevalent lease accounting practices are, however, not in conformity
with the aforesaid principles. Irrespective of the nature of a lease, the lessee is not

I
obliged to disclose the value of the leased asset in the balance sheet and the rentals
are charged off to the profit and loss account according to the terms of payment
contained in the lease agreement. The lease, therefore, enjoys the benefit of “off-
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balance sheet financing” which is often labeled as a dubious advantage of leasing.
The analyst should also guard himself against other ways of maneuvering profits.
Changing the method of bonus payment from accrual to cash basis, thereby not
providing for the bonus due to be paid, is one such method. Writing back of excess
provision made in the earlier years is an excellent way of adding to the other
income. An evidence of such writing back can be seen from our earlier example on
depreciation where the Dhunseri Tea & Industries has included the excess
depreciation of earlier years of Rs.65.52 lakh under other income.
The entire scenario as regards transparency in accounts has undergone a sea
change with the Accounting Standards issued by the Institute of Chartered
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Accountants of India being made mandatory. The following Accounting Standards
have been made mandatory in respect of accounts for periods commencing on or
after 1.4.1991.
AS-1 Disclosure of accounting policies.
AS-7 Accounting for construction contracts.
AS-8 Accounting for Research and Development.
AS-9 Revenue recognition.
AS-10 Accounting for fixed assets.
AS-11 Accounting for the effects of changes in Foreign Exchange Rates.
AS-4 on contingencies and events occurring after Balance Sheet date and AS-5 on
prior period and extra-ordinary items and changes in accounting policies were
earlier made mandatory.
The Accounting Standard-1 (AS – 1) on ‘Disclosure Accounting Policies’ is of
special importance to the analysts because it provides inter alia that any changes in
accounting policies must be disclosed with their effect on profits quantified if it is
ascertainable.
The Accounting Standard-2 (AS – 2): Valuation of inventories and AS-3:
Changes in financial position are recommendatory in nature.
In addition to the above standards the following Accounting Standards have been
made mandatory.

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Security Analysis

AS-13: Accounting for Investments.

AS-14: Accounting for Amalgamations.
AS-15: Accounting for Retirement benefits in the Financial Statements of
Employer.
AS-16: Borrowing Costs.
AS-17: Segment Reporting.
AS-18: Related Party Disclosures.
AS-19: Leases.
AS-20: Earnings Per Share.
AS-21: Consolidated Financial Statements.
AS-22: Accounting for Taxes on Income.
AS-23: Accounting for Investments in Associates in Consolidated Financial
Statements.
Box 1: Instances of changes in Accounting Policies
Tat Robins Fraser (TRF) reported a net profit of Rs.72 lakh for 1989-90 by
changing the method of valuation of closing inventory of unfinished contracts,
using estimated future overhead rates. This change resulted in increasing the
profits by Rs.325 lakh. In other words, TRF actually made a loss of Rs.253 lakh,

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for this highly controversial change in accounting method. Having done that,
TRF proceeded to pay a dividend of 16 percent to its shareholders.
FA
Orkay Silk Mills puffed up its bottom line for 1989-90 by following
unconventional accounting policies. A small profit of Rs.103 lakh was reported by
under-providing depreciation (Rs.434 lakh), by overstating closing inventories
(Rs.42 lakh) and by not providing for excise and customs liabilities (Rs.2,064
lakh).
The significance of the Accounting Standards being made ‘mandatory’ is that, if
there are deviations from the provisions of these standards, the auditor’s duties
require him to qualify his report by mentioning such deviation along with the
quantum of the effect of such deviations where it is ascertainable. This again
means that the Directors are required to give explanations to the auditor’s
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qualifications as required by Section 217(3) of the Companies Act.
Therefore, a perusal of the notes to accounts, auditor’s report and the Director’s
report is likely to bring into light any deviations from accepted practices of
accounting or any changes in accounting policies which have a bearing on profits.
This facilitates the analyst to make necessary adjustments to the reported incomes
to effect meaningful comparisons.
If the Companies Act is also amended suitably, the companies would be under a
statutory obligation to stick to accepted accounting practices and also to increase
the transparency of their accounts, much to the advantage of the analyst of the
financial statements.
SUMMARY
• Most of the investors look at the prices of a security as the present value of
the future cash flows which are influenced by the reported earnings. The
reported earnings can be manipulated by bringing certain changes in the
accounting policies. Some such areas in which the accounting policies can be
changed are: Depreciation, Valuation of Assets, Conversion or translation of
foreign currency items, valuation of inventories, amortization of preliminary
expenses and other miscellaneous expenditure, lease accounting treatment of
gratuity liability and treatment of R & D expenditure.
• All the chapter until now focused on the general aspects. The next chapter
deals in depth about the equity stock valuation models.

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Chapter VIII

Equity Stock Valuation Models

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•
FA
After reading this chapter, you will be conversant with:

Valuation Methods
• Measures of Relative Value
• Free Cash Flow Model to Equity Model
• Quantitative Analysis – Value Added Concept
• Evaluation of Security Analysis
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Security Analysis

Introduction
The basic model for valuing equity is the dividend discount model. There are
many variants of this model. According to these models, the intrinsic value of a
security is equal to the present value of the expected dividends on the stock. We
discuss here the variants of the basic model which make different assumptions
about the future growth rates.

VALUATION METHODS

Dividend Capitalization Models

For an equity share, the payments are in the form of dividends declared by the
company. As the equity share is a perpetual security i.e., with no maturity date, the
dividend payments are made in perpetuity. So, the intrinsic value of a share is
represented by the equation,
D1 D2 Dα α
Dt
V = +
(1 + k e ) (1 + k e ) 2
+ ...... +
(1 + k e )α
= ∑
t =1 (1 + k e ) t
Eq. (1)

where,

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Dt = dividend payment at time t
ke = equity capitalization rate, and
FA V = present value
With the progress of time the dividend payments may increase, i.e. D1 < D2 <
D 3 < D 4 <.... Given this phenomenon, equation (2) can be rewritten as follows:
D1 D (1 + g) D1(1 + g) 2 D1(1 + g)α D1
V= + 1 + + = Eq. (2)
(1 + k e ) (1 + k e ) 2 (1 + k e )3 (1 + k e )α ke + g

Equation (3) assumes a constant growth rate in dividends and hence is called the
Constant Growth Dividend Capitalization Model. This equation can also be
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modified to reflect the possibility of supernormal growth in the initial years
followed by a normal growth rate. This model popularly known as the H model is
discussed later in this chapter.
From equation (3), it is clear that for valuation of stock, the analyst has to estimate
the expected dividend in year 1, the growth rate(s) in dividend, and the appropriate
capitalization rate. Since the dividend payments are not known in advance, both
dividend in year 1 and the dividend growth rate (g) have to be forecasted.
Equation (3) can also be modified to include the earnings per share. Assuming a
constant pay-out ratio, equation (3) can be rewritten as:
(1 − b) E1 D1
V= =
ke − g ke − g

where,
E1 = earnings per share in year 1, and
b = constant retention ratio
Forecasting EPS
The approaches that are commonly followed for estimating the EPS are (a) the
Market Share to Profit Margin Approach, and (b) the Financial Statement Analysis
Approach.

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 Equity Stock Valuation Models

Under the first approach, a forecast of the EPS (assuming no outstanding

preference shares) is arrived at as follows:
Si x M c x f c
EPS = Eq. (3)
Nc
where,
Si = estimated industry sales
Mc = estimated market share of the company
fc = estimated net profit margin of the company, and
Nc = number of outstanding shares.
This industry sales is estimated based on one of the analytical methods. An estimate
of the company’s market share is made on the basis of historical market shares with
due allowance for any significant step, the company might take or is likely to take in
the near future to improve its market share. The estimate of the market share may be
equal to the current market share or an average of the market share over the last 3-5
years plus or minus an adjustment factor.
The net profit margin is estimated based on the current net profit margin or the
average of the net profit margins over the last 3-5 years adjusted for any
anticipated changes in the variables affecting the net profit margin (the variables

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that affect the net profit margin are the production efficiency, operating efficiency,
financial leverage, and the corporate tax rate).
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Under the second approach, a forecast of the EPS is obtained by estimating the
value for the variables that are included in the EPS-EBIT relationship. The
relationship between these two parameters is given by:
(EBIT − iD) (1 − T) − dP
EPS =
N
[r(A) − iD] (1 − T) − dP
=
N
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[r(NW + P + D) − iD] (1 − T) − dP
=
N
P D
NW [r (1 + )+ (r − i) (1 − T) − dP
= NW NW Eq. (4)
N
where,
EBIT = earnings before interest and taxes
NW = net worth
P = preference capital
D = debt capital
d = preferred dividend rate
i = interest rate
A = total assets (total capital employed)
r = return on total assets (ROI)
T = corporate tax rate
N = number of outstanding equity shares

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Security Analysis

Equation (5) suggests that the EPS is a function of

i. Book value of equity share (NW/N)
ii. Debt to net worth ratio (D/NW)
iii. Preference capital to net worth ratio (P/NW)
iv. Rate of return on capital employed (r) and its spread over the interest rate (r – i)
v. The corporate tax rate, and
vi. The preferred dividend rate.
The EPS is directly proportional to the first four factors and inversely proportional
to the last two factors.
The first four factors can be estimated by adjusting the historical value of these
factors for the anticipated changes. From equation (5), it is evident that the EPS is
a function of the profitability, efficiency, leverage and coverage, asset utilization
and book value of equity. Figure 1 shows the functional relationships between
these factors. So, a more refined way of forecasting EPS can be to estimate the
value of these determining factors and combine them according to the functional
relationship indicated in figure 1.
Figure 1

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FA
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Source: Samuel S. Stewart, Jr. “Corporate Forecasting in Financial Analysts”

Handbook (Homewood III: Dow Jones Inc. 1975), 1, 912
The explanation of the symbols used in figure 8.1 are given below:
EPS = earnings per share
PAT = profit after tax
NW = net worth
n = number of outstanding equity shares
TA = total assets
S = sales
GM = gross margin
C = cash
R = receivables
I = inventory
FA = fixed assets.

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 Equity Stock Valuation Models

ESTIMATING THE CAPITALIZATION RATE

The estimation of capitalization rate for the equity stock of a company must take into
consideration the business risk and financial risk (of which default risk is a part)
besides the interest rate, purchasing power, and market risks borne by the shareholders.
Business risk arises out of the fluctuations in the earnings of a company – the wider the
fluctuations, the greater is the business risk. Financial risk stems from the use of
leverage – the use of external debt relative to net worth. Other things being equal, the
higher the debt to net worth ratio, the greater is the financial risk.
Estimation of risk premium for an equity stock is a difficult task. One approach
can be, to classify the equity stocks of companies into some homogeneous risk
classes and estimate the risk premium (the premium for a particular risk class will
be the difference between the average rate of return1 on the stocks in that class and
the risk-free rate). For example, the equity stocks can be classified industry-wise
and a mean risk premium can be calculated for each class using the time-series
data. However, this classification does not take into account the heterogeneity
among companies with respect to size, capital structure, etc.
So, a further classification within each industrial class is warranted for fine tuning the
estimation of risk premium on equity stocks. Based on this classification, the
capitalization rate for an equity stock can be obtained as the sum total of the risk-free
rate and the appropriate risk premium. Alternatively, the capitalization rate for an

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equity stock can also be determined from the Constant Growth Dividend Capitalization
Model. Under this approach, the equity capitalization rate (ke) will be as follows:
FA ke =
D1
P0
+g Eq. (5)

So, the capitalization rate is obtained as the sum total of the dividend yield and
long-term growth rate of dividends.
An estimate of ‘g’ is usually obtained by determining the compound growth rate of
dividends over a long historical period. However, this procedure will not make any
sense in the case of companies with a nil or erratic record of dividends. In such
cases the compound growth rate in earnings per share is used as a surrogate.
D1
To determine (the dividend yield), a common approach that is followed to
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Po
determine the average dividend yield over a reasonable length of time in the past.
Some analysts, however, attempt to obtain a more refined estimate by developing a
dividend yield regression model which considers the key factors determining
dividend yield and provides their relative significance in terms of regression
coefficients. One such model (Weaver&Hall) developed by a firm of stockbrokers
in the USA is given below:
log dz = a + b log y + c log x + d log w + e log v + f log u Eq. (6)
where,
dz = mean dividend yield
y = mean dividend, pay-out ratio
x = forecasted short-term earnings growth rate
w = forecasted long-term dividend growth rate
v = historical earnings variability
u = historical earnings growth rate.
It is possible to develop a similar model for the Indian equity stocks and use it as
the basis for dividend yield estimation.

Dt + (Pt - Pt-1 )
1 The rate of return referred to here is the one-period rate of return defined as x 100
Pt-1
where, Dt = dividend per share in year t
Pt = market price at the end of year t
and Pt–1 = market price at the end of year t – 1

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 Security Analysis

Different Models of Valuation of Stock

There are several dividend discount models based on different assumptions for
calculating the value of a stock. Some of them are:
• Gordon model
• Two-stage dividend discount model
• H-model
• Three-stage dividend discount model.
GORDON MODEL
This model assumes a constant growth rate over a long-term. According to this
model, the value of a stock is given by,
DPS1
Value of a stock = Eq.(7)
r −g

Where, DPS1 = Dividend per share during next year

r = Required rate of return on stock
g = Growth rate in dividends for an infinite period.
Illustration 1
XYZ Ltd. had earnings per share of Rs.10.16 last year and paid-out 52% of its

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earnings as dividends. Its earnings and dividends had grown at 4% per year in the
last 4 years and are expected to grow at the same rate in the long-term. The
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required rate of return on the stock of XYZ Ltd. is 12%. Compute the value of the
stock using Gordon’s Model.
EPS = Rs.10.16
DPS = 0.52(EPS) = 0.52(10.16) = Rs.5.28
Expected growth rate in earnings and dividends = 4%
5.28(1.04)
Value of the equity = = 68.64
(0.12 − 0.04)
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Value of the stock of XYZ Ltd. is Rs.68.64.
Limitations of Gordon Model
• The use of this model is restricted to firms that are growing at a stable
growth rate: The same growth rate is assumed for the firm’s earnings also.
In the long-term, there may be situations when the dividends grow at a rate
higher than the earnings in which case the dividends will exceed earnings.
Thus, if the firm is in a steady state, then the analysts should be able to
substitute the expected growth rate of earnings in the dividend growth rate.
• The second limitation of the model is that if the growth rate is equal to
the required rate of return, then the value of the stock approaches
infinity: If the growth rate is higher than the required rate of return, then the
value of the stock becomes negative. A firm cannot grow in the long-term at
a rate significantly greater than the growth rate in the economy. Thus the
stable growth rate cannot be larger than the nominal (real) growth rate in the
economy in which the firm operates, when the valuation is performed in
nominal (real) terms. The sensitivity of the model to changes in growth rate
implies that the stable growth rate cannot be 1% or 2% more than the growth
rate in the economy. When the deviation becomes larger, it is better to go in
for a two-stage model or a three-stage model. Even when one assumes a
stable growth rate, it cannot be stable over a long time.

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 Equity Stock Valuation Models

TWO-STAGE DIVIDEND DISCOUNT MODEL

This model assumes two stages of growth, the first phase in which the growth rate
is high and the second phase which represents steady state in which the growth
rate is assumed to be stable and is expected to continue for a long-term. The initial
supernormal growth is assumed to last for a fixed time say n years, after which a
stable growth is assumed forever.
According to this model, value of the stock is given by,
Value of the stock = PV of dividends during supernormal growth + PV of
terminal price
DPS Pn
Value of the stock = t
+ Eq.(8)
(1 + r) (1 + r) n

DPS n +1
Where, Pn =
r − gn
DPSt = Expected dividend per share in year ‘t’
r = Required rate of return
Pn = Price at the end of year n
g = Extraordinary growth rate for the first n years

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gn = Growth rate forever after year n.
FA
This formula can be restated as,
 (1+g)n 
DPS0 (1+g ) 1 − n 
 (1+r)  + DPS n+1
Po = Eq.(9)
r-g (r − g n ) (1+r)n

Illustration 2
Assume that the firm discussed in the previous illustration has two stages of
growth. (1) High-growth period (2) Stable-growth period. The length of high-
growth period is 4 years. The growth rate after 4 years is expected to be 3%. Find
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out the value of the stock of XYZ Ltd. taking the other data as given in the above
illustration. Pay-out ratio in the stable growth period is 60%.
 (1+g)n 
DPS0 (1+g ) 1 − n 
P0 =  (1+r)  + DPS n+1
r −g (r − g n ) (1+r)n
Current EPS = Rs.10.16
Growth rate in high-growth period = 4%
Length of high-growth period = 4 years
Pay-out ratio during high-growth period = 52%
Return on equity = 12%
Expected growth rate in the stable phase = 3%
DPSn+1 (0.60) (10.16) (1.04) 4 (1.03)
Terminal price = = = 81.62
r − gn (0.12 − 0.03)

 (1.04)4 
(0.52) (10.16) (1.04)  1 − 
 (1.12)4  81.62
P0 = + = 17.61 + 51.87 = 69.48
(0.12 − 0.04) (1.12)4

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 Security Analysis

Limitations of the Two-Stage Dividend Discount Model

• Defining the length of the supernormal growth period: It is difficult to
specify the supernormal growth period with precision since the growth rate is
expected to reduce to a stable level after this period, and the investment
increases as this period becomes longer. Though the supernormal growth
period can be related to product life cycle and projects opportunities, it is not
easy to convert these qualitative terms into quantitative terms.
• The change of high supernormal growth to a lower stable growth rate at
the end of the supernormal growth period: It is unrealistic to assume such
a sudden change in the growth rate. There should be a gradual change over a
time period rather than a sudden change of growth.
• The terminal price calculated in this model is derived from Gordon
model and hence it suffers from the limitations of the Gordon model: The
terminal value is sensitive to the assumptions about the stable growth, the
underestimation or overestimation of which will lead to significant errors in
the value calculated.
Uses of the Model
It is most suitable to firms that register high growth and they also expect to
maintain this growth rate for a certain period of time after the growth rate tends to
decline.
It is also suitable for firms with modest growth rates in the initial phase.

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Determinants of the Value of Growth
The factors which influence the value of growth are:
•
FA Growth rate during extraordinary growth period: The higher the growth rate
during supernormal growth period, the higher the estimated value of growth.
• Length of the extraordinary growth period: The longer the supernormal
growth period, the greater the value of growth.
• Profitability of projects: The profitability of projects is a determinant of
supernormal growth rate and the stable growth rate. When the projects
become more profitable, both the growth rates increase, and the resulting
value from supernormal growth will be greater.
Riskiness of the stock or equity: Depending on the risk associated with the
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•
equity investment, the discount factor to be used is determined. The higher
the risk, the higher the discount rate and lower the supernormal growth.
H-MODEL
This model is similar to the two-stage model except that a gradual change in the
growth rate is assumed rather than a sudden change. This is explained in Figure 2.
Assumptions under H-Model
• The growth rate of earnings starts at a high initial rate and declines over the
supernormal growth period linearly.
• Dividend pay-out is constant over a time period and not affected by the
shifting growth rates.
Figure 2

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 Equity Stock Valuation Models

Value of the Stock

The value of the stock Po as per this model is given by,
DPS 0 (1+g) DPS0 H (g a −g n )
P0 = + Eq.(10)
r − gn r − gn

Stable Growth Supernormal Growth

Where,
P0 = Present value of the share
DPSt = Dividend per Share in year t
r = Required rate of return on equity
ga = Initial growth rate
gn = Growth rate at the end of 2H years which extends to an infinite period.
Limitations of the Model
The decline in the growth rate is assumed to follow a strict structure based upon
the initial growth rate, the stable growth rate and the length of the supernormal
growth period. Large deviations from this assumption affect the value

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significantly. When growth rate declines, pay-out ratio has to increase, but the
assumption of constant pay-out ratio violates this rule.
Best Use
FA
This model is best suited to those firms which have a high growth rate in the
beginning and a gradual decline in the growth rate over a time period.
Illustration 3
Vinay Enterprises was expected to have earnings per share of Rs.2 last year and to
pay-out dividends of Re.1 in the same year. The earnings had grown at the rate of
18% a year for the previous 5 years, but the growth was expected to decline at the
rate of 2% a year over the next 6 years to a stable growth of 6%. The decline in
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growth can be attributed to the following factors.
• Declining profitability due to increased competition
• Lower profitability in the industry
• Substantial growth in the size of the firm.
The required rate of return on equity of the firm is 13%.
Current EPS = Rs.2
Current DPS = Re.1
Current growth rate = 18%
Length of transition period = 5 years
Stable growth rate = 6%
Required rate of return on equity = 13%
EPS (pay-out ratio) (1+g n )
Value of the stock during growth phase =
r−gn

2 (0.5) (1.06)
= = 15.14
(0.13-0.06)

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Security Analysis

Value of the stock during extraordinary growth phase

6
1   (0.18 − 0.06)
DPS0 x H x (ga − g n ) 2
= = = 5.14
(r − g n ) (0.13 − 0.06)

Value of the stock = 15.14 + 5.14 = Rs.20.28

THREE-STAGE DIVIDEND DISCOUNT MODEL
It is a combination of two-stage model and H-model. This model assumes three
stages of growth:
i. An initial period of high-growth
ii. An intermediate period during which the growth declines
iii. A final stable-growth phase.
The main feature of this model that distinguishes it from the other models is the
absence of any restriction on the pay-out ratio.
The assumptions of this model can be depicted in the following figure.
Figure 3: Dividend Pay-outs

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FA
(1) High Stable Growth
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(2) Declining Growth

(3) Infinite Stable Growth.

Value of the stock as per this model is given by,

n1 EPS 0 (1+g a ) t π a t=n DPS t EPS n (1+g n ) (π n )
P0 = ∑ t
+ ∑ t
+ Eq.(11)
t=1 (1+r) t=n 1 +1 (1+r) (r-g ) (1+r) n
1 4 44 2 4 4 43 1 44 2 4 43 1 4 44n 2 4 4 43
High Growth Phase Transition Stable Growth Phase

Where,
EPSt = Earnings per Share in year t

DPSt = Dividends per Share in year t

ga, gn = Growth rates in high growth phase and stable growth phase
respectively
πa πn = Pay-out ratio in high growth phase and stable growth phase
respectively.
r = Required rate of return on equity.

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 Equity Stock Valuation Models

Illustration 4
Consider the same data as given in Illustration 3. But let us assume that Vinay
Enterprises has three stages of growth. A high-growth phase with 18% growth rate
for 5 years, a transition period of 5 years after which the firm reaches stable-
growth phase with the growth rate of 6%. Earnings per share after the growth
stabilized will be Rs.2.5 and the pay-out ratio will be 60%. The required rate of
return after the growth rate stabilized is 12%.
n1
EPSo (1 +g a ) t (pay-out ratio1 ) EPS n (1 +g n ) (pay-out ratio 2 )
P0 = ∑ (1 + r) t
+
(r −g n ) (1 + r) n
t =1

2(0.5) (1.18) 2(0.5) (1.18) 2 2(0.5) (1.18)3

= + +
(1.13) (1.13)2 (1.13)3
2(0.5) (1.18) 4 2(0.5) (1.18)5 2(0.5) (1.18)6
+ + +
(1.13) 4 (1.13)5 (1.13)6

(1.18)7 (1.18)8 (1.18)9 (1.18)10 2.5 (1.06) (0.06)

+ 7
+ 8
+ 9
+ 10
+
(1.12) (1.12) (1.12) (1.12) (0.12 − 0.06) (1.12)10
= 5.704 + 7.62 + 0.05 = 13.374

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Uses
FA
This model is best suited to firms that are growing at different rates and in addition
have varying pay-out policies. It is also suitable to firms which have an
extraordinary growth period followed by a declining growth period and a stable
growth to continue forever.

MEASURES OF RELATIVE VALUE

The three widely used measures of relative value are:
i. Price/Earnings ratio (P/E ratio)
ii. Price/Book Value ratio (P/BV ratio)
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iii. Price/Sales ratio (P/Sales ratio).
Price/Earnings Ratio
HOW TO CALCULATE P/E RATIOS
We can relate the dividend discount model discussed in the previous section to
arrive at price-earnings multiple. P/E ratio for a stable firm which is growing at a
rate comparable to the normal growth rate in the economy in which it operates is
given by,
P0 Pay-out ratio
= P/E1 Eq.(12)
EPS 1 r−gn

DPS1
Where, P0 =
r −g n
DPS1= Expected dividends per share next year
r = Required rate of return on equity
gn = Growth rate in dividends (forever)
EPS1 = Expected earnings per share next year.
The P/E ratio is an increasing function of the pay-out ratio and the growth rate and
a decreasing function of the riskiness of the firm.

189
 Security Analysis

Illustration 5
ABC Ltd. has an EPS of Rs.2.75 last year and it paid out 50% of its earnings as
dividends that year. The growth rate in earnings and dividends in the long-term is
expected to be 5%. The required rate of return on equity for ABC Ltd. is 12%.
Calculate its P/E ratio.
Current dividend pay-out ratio = 50%
Expected growth rate in earnings and dividends = 5%
Pay-out ratio 0.5 (1.05) 0.5 (1.05)
P/E ratio = = = = 7.5
r −g n 0.12 − 0.05 0.07

Forecast of P/E ratio

Under the P/E multiplier approach for stock valuation, the two inputs that are
required to determine the intrinsic value of the stock are the estimates of EPS and
P/E multiple.
One way to estimate the P/E multiple is to calculate the normalized earnings over
the last few years, determine the P/E ratios for these years using the normalized
EPS and take the average of the P/Es. But, in practice, P/E ratio is often estimated
on the basis of a subjective evaluation of the various factors that have a bearing on
the P/E multiple like the projected earnings, dividends, company performance,
variability in its performance, fluctuations in the share price, corporate policies,
and management ability. The analysts usually estimate an average P/E multiple for

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stocks with similar characteristics along the aforesaid dimensions.
FA Box 1: PEG – The Shining Armor
The PEG ratio is developed by Peter Lynch and popularized by Motley Fool, who
also named it the “Fool Ratio.” Peter Lynch, the former star manager of Fidelity’s
Magellan Fund puts it aptly in his book ‘One up on Wall Street’ that “In a fully
and fairly valued situation, a growth stock price-to-earnings ratio should equal the
percentage of the growth rate of its company’s earnings per share.” Therefore, the
PE ratio of a company will be equal to its profit growth rate. And the PEG ratio of
a stock should be equal to one, as PEs come into line with the growth rate in net
profits.
If the PEG ratio is greater than one, it indicates that the stock is possibly
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overvalued or that the market expects future EPS growth to be greater than what is
currently prevailing. Growth stocks typically have a PEG ratio greater than one
because investors are willing to pay more for a stock that is expected to grow
rapidly (also known as “growth at any price”). It can also be interpreted that the
earnings forecasts have been lowered while the stock price remains relatively
stable for other reasons. Traditional wisdom held that a stock should sell for a P/E
equal to its growth rate (i.e., a PEG of 1.0). However, that thinking changed when
technology companies started selling for higher PEGs than the industries.
If the PEG ratio is less than one, it is a sign of a possibly undervalued stock or that
the market does not expect the company to achieve the earnings growth that is
reflected in the market estimates. Value stocks usually have a PEG ratio less than
one because the stock’s earnings expectations have risen and the market has not
yet recognized the growth potential. On the other hand, it could also indicate that
earnings expectations have fallen faster than the new forecasts. Overpriced stocks
have higher PEs and underpriced stocks have lower PEs than their respective
growth rates.
PEG is considered particularly helpful in valuing small and mid-cap growth
stocks, which typically pay no dividend. For valuing larger stocks, the company’s
dividend yield should be added to its projected five-year earnings growth rate
because larger and more established firms are valued by investors for their current
pay-out as well as for their future prospects of price appreciation. PEG ratios are
considered less useful in assessing cyclical stocks and those in industries such as
banking, oil or real estate, where assets are a more important indicator of value.

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 Equity Stock Valuation Models

During the tech boom, the PE and PEG ratio were used to justify the high
valuations. Though the expectations were belied, this ratio can still add glitter to
one’s portfolio if used judiciously. The following table shows the expected PEG
ratios of some of the top rung software stocks in India.
Company PEG March 31, 2003
Infosys Technologies Ltd. 1.37
NIIT –0.40
Hughes Software Systems Ltd. –1.55
Digital Globalsoft Ltd. 0.66
Mascot Systems Ltd. 1.67
Satyam Computer Services Ltd. 1.89
Visualsoft Technologies Ltd. –0.91
Wipro Ltd. 1.81
Source: www.icicidirect.com
Limitations of PEG
Certain financial magazines challenged the rule of thumb of PEG that the stocks,
which are having a PEG of less than 1, are good picks. However, does the

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financial theory support the PEG ratio? Not really. Consider the example of
Aventis Pharma and Cipla stocks. Suppose if an investor perceives that Cipla is
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less risky than Aventis, and therefore gets satisfied with lower returns from
investments in the Cipla stock. This means that he would be willing to pay more
for every Re.1 of Cipla’s EPS. In other words, lower the risk of a stock, higher its
PE ratio. However, the flip side is that higher the risk, lower the PE ratio. Since
Aventis is expected to be more risky by the investor, its PE ratio will be lower than
that of Cipla. Suppose the PE ratio for Cipla is 10, and that of Aventis is 5 and the
expected growth rate for Cipla and Aventis is 20% and 15% respectively, the PEG
ratio for Cipla will be 0.5, while that for Aventis will be just 0.33. Therefore, an
investor may choose Aventis based on the PEG ratio even though his perception
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for Cipla is better. Hence based on stock picks just on the PEG ratio may be
wrong, as the ratio is biased towards stocks that have low PE ratio. The PEG ratio
is not perfect. Even if a stock has a very low PEG, it does not mean that the stock
will definitely go up. However, it is generally more likely that a stock with a low
PEG is a good investment.
PEG ratio is generally construed to capture the growth component of valuation.
This is generally true where the growth rates of the two businesses are similar. In
such cases incorporating the growth rate into a comparative valuation is largely an
exercise in redundancy. In other words, where growth rates are the same, taking
the PE ratio and using the same divisor for each ratio does little to alter the
assessment leaving aside the aspect of providing different numbers to compare.
The important aspect of growth in the valuation metric is its impact in terms of
compounding revenue or income over time.
Incorporating the growth rate into a new formula to derive a new ratio does not
result in accuracy of the growth component of value. It simply provides a new and
different benchmark to assess a business. Moreover, when a forward-looking data
point is combined with a backward looking data point, one can derive another
static or backward looking data point. The PEG is typically utilized to compare
two companies in the same sector. When two businesses with differing growth
dynamics and different industries are compared, PEG fails to capture the growth
component of value.

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 Security Analysis

Where the underlying growth rates of two businesses are substantially different,
PEG would not be a good valuation tool. It is necessary to assess the PEG in the
context of growth rates and margins in order to truly know the relative
differences between two prospective investments. If the growth and margin
dynamics are reasonably similar, the PEG is likely to be a safe tool to use for
benchmarking. PEG does not account for differences in growth rates simply
because it incorporates growth into an artificially created formula. Just as the
P/E can be misapplied and misunderstood, the PEG is susceptible to the same
issues as well.
Source: “Is the Primacy of the PE in Ruins?” by K Bhramaramba, Portfolio
Organizer, November 2002.
PROBLEMS WITH P/E RATIOS
• P/E ratios are not meaningful when EPS is negative.
• P/E ratios may have wide variations over a time period depending on the
variability of earnings.
Price/Book Value Ratios
The relationship between the price and the book value has often helped the
investors to identify the undervalued and overvalued portfolios and stocks.
ESTIMATION OF PRICE TO BOOK VALUE RATIO

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The book value of an equity is calculated as the difference between the book value
of assets and book value of liabilities. According to the accounting convention
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followed, the assets are valued at historical cost minus depreciation. So, book
value of assets declines over time. The book value of liabilities is their value at
their issue.
The price to book value ratio for a stable growth firm is calculated from the price
of the stock determined as per the Gordon model.
As per the Gordon model,
DPS
P0 = r − g 1
n

Where,
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P0 = Value of the stock
DPS1 = Expected dividends per share next year
r = Required rate of return on equity
gn = Perpetual growth rate in dividend
DPS1 = EPS0 (pay-out ratio) (1 + gn)
EPS0 (Pay-out ratio) (1 + g n )
Then P0 = r − gn

EPS0 can be defined as,

EPS0 = Return on Equity x Book Value of Equity = RoE x BV0
RoE x BV0 x (Pay-out ratio) (1 + gn )
∴ P0 = r − gn ...Eq.(13)

P0 RoE x (Pay - out ratio) x (1 + g n )

=
BV0 r − gn
If RoE is calculated based on the expected earnings in the next time period, then
the above equation can be rewritten as,
P0 P RoE x (Pay-out ratio)
=
BV00 BV
= r −g n

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 Equity Stock Valuation Models

P/BV is directly proportional to RoE and pay-out ratio and inversely proportional
to the riskiness of the firm.
If g = (1 – Pay-out ratio) RoE, then
g
1 – Pay-out ratio =
RoE
g
Pay-out ratio = 1 − ...Eq.(14)
RoE
 g 
RoE 1 − n 
P  RoE  RoE − g
=   = n
BV r−g r−gn
n

Thus, value of P/BV ratio is nothing but the differential between the RoE and the
required rate of return. The advantage of this representation of P/BV ratio is that it
can be estimated even for firms which do not pay dividends.
Illustration 6
XYZ Ltd. is a firm which has a stable growth of 6%. It pays out 50% of its
earnings as dividends. The RoE of XYZ in the beginning of the year was 15%. The

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required rate of return is 12%. Calculate its P/BV ratio.
Solution
FA
P/BV ratio =
RoE x Pay-out ratio x (1+g n )
=
0.15 x 0.5 (1.06)
=1.325
r − gn 0.12 − 0.06

DETERMINANTS OF P/BV RATIO

When RoE goes down, the growth rate or the pay-out ratio or both go down. RoE
indirectly affects the P/BV ratio.
P/BV ratio is affected by the required rate of return. When the required rate of
return is high, P/BV ratio goes down.
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INVESTMENT STRATEGIES BASED ON P/BV RATIO
A low value P/BV ratio indicates that the firm has a price which is below the book
value. Such a firm is more likely to go out of business. So, investors are advised to
make careful decisions about investing in these firms. The excess returns which
are offered by such a firm should match with the additional risk it is exposed to by
making such an investment decision.
ADVANTAGES OF USING PRICE/BOOK VALUE RATIO
• Book value serves as a reliable intuitive measure of value compared to the
market price.
• P/BV ratios of different firms can be compared to identify undervalued or
overvalued stocks.
• P/BV ratios can be calculated even for firms with negative earnings.
DISADVANTAGES OF P/BV RATIO
• Book values are influenced by the method of depreciation used. When
different firms use different methods, then P/BV ratio comparison across
firms may not be meaningful.
• If the firms do not have significant fixed assets, the book value may not be
meaningful.
• If a firm has continuous negative earnings, then the book value of equity can
become negative leading to a negative P/BV ratio.

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Security Analysis

Price/Sales Ratio (P/S Ratio)

P/S ratio can be estimated using earnings growth rate, pay-out ratio and risk. For a
firm which has a stable growth rate, the value of equity as per Gordon model is
given by,
DPS1
Po =
r −g n
Po = Price of the stock
DPS1= Expected dividends per share next year
r = Required rate of return
gn = Perpetual stable growth rate.
Substituting DPS1 = EPSo (1 + gn) (Pay-out ratio)
we get,
EPSo (Pay-out ratio) (1 + g n )
Po =
r − gn
When net profit margin is defined as,
EPSo

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NPM =
Sales per share
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Po =
NPM x Sales per share x Pay-out ratio x (1 + g n )
r − gn
...Eq.(15)

If the NPM is based upon expected earnings, then

Po NPM x Pay-out ratio
= ...Eq.(16)
Sales r − gn
Thus, P/S ratio is directly proportional to NPM and pay-out ratio and is inversely
proportional to the required rate of return.
Box 2: P/E Ratio Alone is not Enough
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Valuing a company with inconsistent schedule of earning, or worse, with no
earning at all requires a delicate balancing act on part of the analysts. At these
instances, traditional methods of valuations befall to helplessness. That’s where
the price/sales ratio comes in. Just like its more popular alternative the P/E ratio,
PSR (Price-to-Sales Ratio) is useful to value any company. Price-to-Sales Ratio
for a company can be calculated by dividing the market capitalization of a
company by its total revenue for the last four quarters. As compared to PE ratio,
Price-to-Sales Ratio is a more reliable measure because, unlike earnings, revenue
for a company is difficult to manipulate. Besides earnings is a complex figure
which may include inflows from non-recurring events also. Therefore, analysts
look to both the PE ratio and PS ratio of companies before taking any investment
decision. PS ratio is useful while valuing companies even with no earnings at all.
PS ratio comes handy to value companies in today’s dynamic set-up where
mergers and divestitures are a part of the daily routine. For example, need for
economy of scale has driven companies in telecom sector for sometime. Owing to
write-offs related to merger, several such companies report negative earnings soon
after the process. Such write-offs present a minuscule PE estimate for the
company. However, strategically and fundamentally, the company may well be on
its way to a bright future. This can be verified by analyzing the Price-to-Sales
Ratio, which may be growing immediately after the merger, thus presenting a
more realistic presentation of the prospect of the company.

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 Equity Stock Valuation Models

Like any other ratio, a high or low PS ratio connotes different interpretations for an
analyst. High or low PS ratio depends on the profit margin of the company. Thus,
PS ratio for a steel manufacturer may vary from the PS ratio for a chip maker.
Price-to-Sales Ratio may also vary consequent to the capital structure of the
company. A company with a lot of debt component in its balance sheet may have
to allocate more resources for servicing the interest burden, and thus might see
erosion in its profits. Another problem with PSR is that sales figure does not
contain any information about the debt burden of the company. Thus, it may so
happen that some companies may have no profits but only huge debt and could be
on the verge of bankruptcy. Due to all these, it is advisable to compare both the PE
ratio and PS ratio for the company on a historical basis for a reliable analysis.
Mathematically, relationship between these two ratios can be established as:
Price-to-Sales Ratio = Price-to-Earnings Ratio x (Profit Margin)
Source: The ICFAI Research Team.
Illustration 7
A firm has the following characteristics. Calculate its P/S ratio.
The growth rate is stable and it is 5%
Dividend pay-out ratio = 30%
Net profit margin = 5%
Required rate of return = 12%

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0.05 x 0.3 x 1.05
P/S ratio = = 0.225
0.12 − 0.05
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DETERMINANTS OF P/S RATIO
When firms have high profit margins, they have high P/S ratio. When there is a drop
in profit margin, it has dual effects– (i) It has a direct effect on P/S ratio which gets
reduced, and (ii) It lowers the growth rate, which in turn affects the P/S ratio.
Profit margin can also be defined in terms of growth rate and retention ratio as
follows:
Expected growth rate = Retention ratio x RoE
Net profit  Sales 
= Retention ratio x x  
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Sales  BV of equity 
Sales
= Retention ratio x NPM x
BV of equity
BV of equity 1
Profit margin = Expected growth rate x x
Sales Retention ratio
Thus, it is clear that when NPM is reduced, the expected growth rate will decline if
the sales do not increase proportionately.
The relationship between NPM and P/S ratio is clearly indicated in Figure 3.
Figure 4

In Figure 5, P/S ratio is expressed as a function of profit margin, keeping the

sales/BV of equity constant.

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Security Analysis

ADVANTAGES OF USING P/S RATIO

• P/S ratio can never be negative unlike P/E and P/BV ratios.
• P/E ratio is not influenced by accounting methods used for depreciation,
inventory, etc.
• P/S ratios are not so volatile as P/E ratios. This is because earnings are more
sensitive than revenues to economic variations.
• P/S ratio is a useful tool to examine the effects of changes in pricing policy
and other corporate decisions.
DISADVANTAGES OF USING P/S RATIO
Revenues are considered more stable than earnings but when a firm faces
problems in cost control the revenues may not be affected while the earnings and
value may drop suddenly. This disadvantage may fail to capture the differences
across the firms in cost and profit margins and hence may cause misleading
valuations.
INVESTMENT STRATEGIES USING P/S RATIOS
Firms with low profit margins and high P/S ratios are overvalued and those with

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high profit margins and low P/S ratios are undervalued. Investors should be able to
identify them correctly and make investment decisions.
FA Figure 5: Identifying Undervalued and Overvalued Securities
P/S
Low High
Low Correctly Overvalued
NPM valued
Undervalued Correctly
High valued
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FREE CASH FLOW TO EQUITY MODEL (FCFE)

The models discussed here are akin to those we had discussed in the dividend
discount model, with one significant change – FCFE replaces dividends in the
models.
Constant Growth FCFE Model
The value of equity under this method is defined as a function of the expected
FCFE in the next period, constant growth rate and the required rate of return.
FCFE
Po = K −g1 ...Eq.(17)
e

which is similar to equation no.(2)

Where,
Po = Value of stock today
FCFE1 = Expected FCFE for the next year
Ke = Cost of equity or required rate of return
g = Constant growth rate in FCFE for the firm.
Thus, computation of FCFE and the cost of equity becomes essential to find the
value of equity.

196
 Equity Stock Valuation Models

It is a very common practice of the firms to avail debt to meet the capital
expenditure and working capital needs. Then if the target debt ratio B and the
principal repayments are made from new debt issues, then
FCFE = Net Income – (1 – b) (Capital Expenditure – Depreciation) – (1 – b)
(Change in Working Capital)
It may be noted that (1 – b) represents the margin invested by the firm in meeting
the capital expenditure and working capital.
Let us try to understand the components of equation better through an example.
A firm had an EPS of Rs.40.65 and paid dividends of Rs.13 last year. The capital
expenditure per share was Rs.109 and depreciation was Rs.91.12 per share.
The working capital increased by Rs.4.48 per share. The growth rate of the firm is
6% in the long run.
The firm had a debt ratio of 11.71% only (since EPS was quite high, the
management opted for a limited debt from outside). The stock’s β is 0.89. The risk-
free rate of return is 6.42% and market return is 9.92%. Calculate the value of stock.
To calculate FCFE:
FCFE = Net Income – (1 – b) (Capital Expenditure – Depreciation) – (1 – b)
(Change in Working Capital)
= 40.65 – (1 – 0.1171) (109.00 – 91.12) – (1 – 0.1171) (4.48) = 20.91

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Cost of equity = R f +β (R m − R f ) = 6.42 + 0.89 (9.92 – 6.42) = 9.54%
FA g = 6%
20.91 x 1.06
∴ Po = = 626.12.
(0.0954 − 0.06)

Valuation with Variable Growth in Free Cash Flows

Consider a firm with supernormal growth in the initial period followed by a
constant normal growth in the long-term.
Then, Po = Present value of FCFE stream up to nth year + PV of terminal price
FCFE t FCFE 1
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n
=∑ + x ...Eq.(18)
t =1 (t + K e ) t (K e − g n ) (1 + K e ) n
Where,
FCFEt = Free cash flow to equity in year t
FCFE n +1
= Price at the end of the supernormal growth period t
(K e − g n )
Ke = Required rate of return
n = Supernormal growth period.
Illustration 8
The following data pertains to a promising firm in ‘Communication
Technology’. Its Current EPS = Rs.4.00; Capital expenditure per share = Rs.3.70
and depreciation = Rs.1.70 per share. The increase in working capital = Rs.1.00 per
share. The debt ratio of the firm = 20%; the risk-free rate = 7%; β = 1.3 and Rm = 10%.
If the supernormal growth rate = 22% during the next 5 years and thereafter at
10% throughout, calculate the value per share.
Required rate of return = Rf + β (Rm – Rf) = 7% + 1.3 (10 – 7) = 10.9%
The growth rate in FCFE from 6th year onwards is 10%.
∴ The FCFE in the year 6 = 4.71 x 1.10

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Security Analysis

Year 1 Year 2 Year 3 Year 4 Year 5

EPS 4.88 5.95 7.26 8.86 10.8
(Capital expenditure –
Depreciation) (1 – B) 1.95 2.38 2.91 3.55 4.33
(Change in Working
Capital) (1 – B) 0.80 0.98 1.19 1.45 1.77
FCFE 2.13 2.59 3.16 3.86 4.71
Present value
discounted at required
rate of return 1.92 2.10 2.32 2.55 2.81 =
11.70
1 4.71 x 1.10 575.66
The PV of terminal value = 5
x = = 343.17
(1.109) (0.109-0.10) (1.109)5
The value of stock or the Value per share = 11.70 + 343.17 = 354.87.
The Three-Stage Future Cash Flow to Equity Model
This model is an extension of earlier two-stage model. In this model, it is assumed

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that the company expects initially an increasing growth rate up to a certain period
called high growth period. Thereafter, the growth rate shows a downward trend
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during the second phase called transition period and the last phase is called infinite
stable growth rate period. Thus, in this case, the present value of all the FCFE of
the three periods are summed up to obtain,
t = n1 FCFE t t =n2 FCFE Pn 2
P0 = ∑ t
+ ∑ t
x ...Eq.(19)
t =1 (1 + r) t = n1+1 (1 + r) (1 + r) n
Where,
Po = Present value of stock
FCFEt = Future Cash Flow to Equity in year t
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Ke = Discount rate or cost of equity

Pn 2 = Price of the stock at the end of declining growth period

FCFE n 2 +1
Pn 2 =
(r −g n )
n1 = End of the high growth period
n2 = End of declining period or transition.
Here again the assumptions are as per constant growth model. In this case, the
capital expenditure is expected to be more than the depreciation during the
increasing growth phase. And the difference between capital expenses and
depreciation gradually comes closer to zero during declining phase of growth. It
approximates to zero during the constant growth phase. The beta of the firm also
gradually converges to 1.0 from a positive value during the initial growth phase.

QUANTITATIVE ANALYSIS – VALUE ADDED CONCEPT

When the corporate finance managers aim at raising new capital for their business
expansion, the investors choose a particular firm on their behalf on the basis of how
their investments would fetch them returns. There are several methods to value the
stocks of the firms. The value added methods differ from the conventional methods
which focus on translating the operating performance into a useful single figure that
will serve as a measure of enhancement in shareholder value.

198
 Equity Stock Valuation Models

One such value added measure is the economic value added, popularly referred to
as EVA. In this approach, capital means only the operating assets of the firm. This
assumption is made to avoid any discrepancies arising out of accounting
distortions.
According to Modigliani and Miller, the finance managers tend to maximize the
shareholders’ wealth by maximizing the net present value of all the available
projects. This net present value is nothing but the discounted value of the cash
flow generating capabilities of a firm during its life. The task is to measure these
cash flow generating capabilities. When the cash flows are measured for a
particular period, it may not produce the true result because a negative cash flow
could deplete the value. To overcome this drawback, corporate finance managers
should look at the free cash flows over a considerably long period as is usually
done by the market. The market assumes that these negative cash flows are only
for a short period of time and the reinvestment of cash flows will give rise to
significant positive cash flows thus enhancing the shareholder’s wealth.
Economic Value Added
There are two methods of calculating EVA:
i. Residual income method, and
ii. Refined earnings method.
RESIDUAL INCOME METHOD

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This method can also be called the spread method because it involves computation
of the spread between two returns of same risk level.
FA
Steps involved in arriving at EVA:
i. Calculate the current returns.
ii. Subtract (1) from the returns available in an equal-risk category.
iii. Multiply the result obtained in (2) by the amount to be invested.
EVA number should be positive. Any negative value of EVA is not a good sign for
an investor to choose an investment. EVA of a firm can be calculated by,
i. Computing the net profit after tax, which it generates in a given period.
IC

ii. Dividing the result of (1) by the total capital invested.

iii. Subtract the weighted average cost of capital (WACC) from (2).
iv. Multiply the result of (3) by the total capital of the firm.
The above steps can be mathematically stated as follows:

 NOPLAT 
EVA =  − WACC  (Total Capital)
 Total Capital 
= (Spread over WACC) (Total Capital)
= Excess return generated over cost of capital
Where,

 Book Value of Debt 

WACC =   (Cost of Debt) (1 – Tax Rate)
 Total Book Value 
 Book Value of Equity 
+   (Cost of Equity)
 Total Book Value 
Note: Cost of equity is calculated based on the CAPM model.
NOPLAT = Net Operating Profits Less Adjusted Taxes.

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Security Analysis

From the foregoing discussion, it is clear that profitability is captured in the first
component of the equation and the growth is captured in the second component.
But a firm should not try to add value to the shareholder’s wealth by just making
an attempt to increase profitability. Because if low earning projects are not omitted
for the calculation of profits, the return on capital employed will increase but EVA
will be destroyed especially if those projects despite earning a low value were
yielding a return higher than the cost of capital. This is because, these projects
were adding value to the firm.
REFINED EARNINGS METHOD
According to this method, EVA is calculated as follows:
EVA = (Sales – Operating expenses) – (WACC) (Net assets)
In this method, WACC is multiplied by the net asset to arrive at the capital charge.
Then this capital charge and other expenses are subtracted from the revenues
received to arrive at the EVA. If this EVA is a positive figure, then the firm is said
to have earned high quality profits. This method focuses on the factors that create
growth in a company. It also helps the management and analysts to recognize that
true growth can be created by increasing the firm’s return on capital or by reducing
WACC.

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Figure 6
FA
IC

EVA ANALYSIS
Traditional earnings analysis sometimes may not clearly provide an intuitive
conclusion about the choice of the firm to make investments for an investor. But a
firm’s performance can be measured through EVA analysis by breaking EVA into
its components as given in figure 7:
Figure 7

Sales

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 Equity Stock Valuation Models

Though Economic Value Added (EVA) is conceived as a popular measure, there is

little evidence that suggests companies with a high value of EVA performed well
above the market. Moreover, the portfolios built using other measures of corporate
valuation are seen to outperform those built based on EVA.
ADVANTAGES OF EVA
• EVA is primarily used for evaluating the performance of management.
• It serves as a proxy for measuring a firm’s stock performance.
• EVA can be applied to capital budgeting like NPV.
Market Value Added (MVA)
MVA serves as a measure of a firm’s external performance. This reflects the view
of the market on the firm’s performance in terms of market value of debt and
market value of equity compared to the capital invested in the firm. This can be
expressed mathematically as follows:
MVA (Market Value Added) = (Market Value of Firm) – Capital – Market Value
of Debt – Market Value of Equity
To analyze a firm’s performance, it is required to look for positive changes over
time i.e., the percentage change each year. Comparison of changes in MVA each

I
year with those of the aggregate stock and bond markets is required, since the
market values will be affected by the changes in interest rates and other
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macroeconomic factors.
MVA can also be computed by discounting the EVA of each year by the weighted
average cost of capital. The relationship between EVA and MVA can be expressed
as follows:
EVA EVA EVA
MVA= + +...+ Eq. (20)
(1+WACC)1 (1+WACC) 2 (1+WACC)n

Where, WACC = Weighted Average Cost of Capital

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n = Estimated life of the firm.

Box 3: Measures of Fair Value of Growth

With the tech debacle, the years 1999 and 2000 witnessed phenomenal wealth
destruction across the globe. The world’s major indices lost about 60% from
their earlier peaks. With this, the investors have learnt the lesson in a hard way
that investing in equities should not be done in fervor or blind enthusiasm. The
article details a study to guide the investors, to spot the companies that have
good growth prospects in the future, by applying sanity test that was first
presented in Fortune magazine valuing US stocks. The model computes the
present value, future growth, and sanity test for a large set of companies. A
company with more than 50% sanity test would have a higher EVA growth and
is a good investment. While a company with negative sanity test is a bad bet.
However, many of India’s largest companies have a negative sanity test.
Investors beware.
Present Value of EVA Earned to Perpetuity (PV)
This model computes the value of each company as the discounted value of
future earnings earned to perpetuity. The model has taken the previous year’s
EVA as unchanged in all future years.
PV= EVA/Expected Rate of Return

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Security Analysis

Future Growth Value (FGV)

While computing PV, we assumed that EVA will remain constant to perpetuity.
The difference between the market capitalization of the company and the PV
indicates the market’s forecast of EVA for the future years.
FGV = Market Capitalization – Present Value
Sanity Test %
The ratio of FGV to MV of a company indicates the extent to which the market
is valuing future growth. Higher the percentage, greater is the optimism for the
stock. To invest in a company with more than 50% Sanity Test, an investor
must be certain about the substantially higher EVA growth estimate. A negative
Sanity Test, shows tremendous negative sentiment about the company.
Sanity Test % = Future Growth Value/Market Value x 100
For Indian Stocks
We have estimated the current year’s EVA rather than use the previous year’s EVA.
EVA = {Current Year’s NPAT(Est.) – Non-Recurring Items + Depreciation}
Less: {Net Worth x Opportunity Cost of Equity}
Opportunity Cost of Capital = Risk-Free Rate of Return = 8.5%
The model was used to compute the PV, FG and Sanity Test for a large set of
companies. A separate category was created for companies with a Sanity Test

I
ratio > 30%. Since the FGV/PV ratio is higher than 30%, it suggests that the
market has forecasted a higher growth rate for these companies. For the high
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growth companies, we have computed PV, FGV, and the Sanity Test assuming
a 25% compounded EVA growth rate for 10 years.
Additional Criteria
i. PV is computed assuming that the EVA will grow at a constant
compounding rate of 25%. The present value is computed taking 10
years EVA and thus called PV10.
ii. The FGV10 and Sanity Test ratio is based on the PV10.
Undervalued or Inefficient Companies?
The model has brought forth a long list of companies with a negative Sanity
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Test. Some of these are India’s largest companies. Most of these companies
own valuable and vast resources, have shown constant earnings performance,
and have rewarded dividends to its shareholders for the last decade.
Are we to assume that these companies will only suffer from negative growth in
the future?
Is the market being too biased?
High Growth Category
In the US markets GE, IBM, Microsoft, Oracle are valued at Sanity Test ratios
above 50%. For the Indian market, the model using optimistic growth estimates
that (compounded 25% growth for the next decade) Infosys, Ranbaxy,
Hindustan Lever and Wipro fall between Sanity Test ratios 30% to 80%.
Are these valuations justified?
Is the future much, much brighter than today?
Is this growth as viable as perceived by the market?
Theory suggests that the market is efficient and at any moment of time, market
capitalization is the equilibrium valuation. Experience suggests that
opportunities are best realized by challenging the current valuation. Revaluation
in a rising market can be either an expansion in valuation of “trendy” stocks or
a price discovery of “dull” stocks. A mix of both with realistic valuation
methods may be the best path.

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 Equity Stock Valuation Models

If one believes in the future existence of many of the companies with FGV
negative ratios, the returns from exposure to these stocks over a longer period
should be higher.
Which is a better strategy?
Investing in Value Already Created available at a large discount, or
Investing in Estimated “Visible” growth largely discounted.
Source: “What is the Fair Value of Growth?” by Amit Dalal, Portfolio Organizer,
March 2002.

SUMMARY
• Apart from the basic dividend discount models, there are several kinds of
models available to measure the value of a stock based on different
assumptions for calculations. Some of them are Gordon model, Two-stage
dividend discount model, H-model and Three-stage dividend discount model.
• Gordon model assumes a constant growth rate over a long-term. This is a
very popular equity valuation model. However, there are certain limitations
of Gordon model.
• The two-stage dividend discount model assumes two stages of growth; the
first stage in which the growth rate is high, and the second stage which

I
represents steady rate in which the growth rate is assumed to be stable and is
expected to continue for the long-term.
•
FA H-model is similar to the two-stage model except that a gradual change in the
growth rate is assumed rather than a sudden change. This model is best suited
to those firms, which have high growth rate in the beginning and a gradual
decline in the growth rate over a period of time.
• Traditional earning analysis may not provide a clear conclusion about the
choice of the firm to make investments for an investor. Besides value added
models focus on translating the operating performance that serves as a
measure of enhancement in shareholder value.
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203
Chapter IX

Bond Valuation
After reading this chapter, you will be conversant with:

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• Strategic Role of Bonds: An Investor’s Point of View
• Bond Terminology
•
•
FA
Types of Bonds
Value of a Bond
• Bond Returns
• Assumptions Underlying YTM
• Bond Price Theorems
• Accrued Interest
• Riskiness of Bonds
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• Determining the Interest Rates
• Forecasting Interest Rate Trends
• Term Structure of Interest Rates
• Interest Rate Risk and Duration
• Bond Price Volatility
• Immunization
• Analysis of Deep Discount Bonds
• Analysis of Convertible Bonds
• Analysis of Tax-Sheltered Fixed Investment Avenues
 Bond Valuation

Introduction
In comparison to equities, bond at first sight appears less glamorous and exciting.
But bonds too have their subtleties and pitfalls for the investors. In general, there is
less uncertainty about the cash flows accruing to the bondholders as compared to
the shareholder. The emphasis is, therefore, more on fine tuned calculations and
analysis. Such careful computations may not be worthwhile in equities because
there is greater uncertainty about the numbers that one is working with. Typically,
bond prices fluctuate less than equity prices, and the investor who desires superior
performance has to be on the lookout for even small differentials in prices and
returns. In this lesson, we look at the nuances of bond valuation in detail.
STRATEGIC ROLE OF BONDS: AN INVESTOR’S POINT OF VIEW
While constructing a portfolio, it is quite important to consider the risk-return
profile of an investor. The portfolio of an investor who is willing to take high risks
to earn high returns might consist of common stock. On the other side, the
portfolio of an investor whose only objective is to minimize the risk might consist
wholly of securities issued by government and other bodies whose default risk is
almost nil.
Most of the investors adopt a middle path. These investors find that their
investment needs are modest and usually prefer less volatility in returns. These

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investors will be at an advantage if corporate bonds are incorporated into their
portfolios. We know that each and every security in the portfolio contributes to the
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total risk. Some securities individually or as a group tend to increase the risk while
some others tend to decrease it. That is, there can be different constituents of a
portfolio so that their returns move in opposite directions negating the effect of one
on the other so that a portfolio of little or no risk can be constructed.
Quantitatively, this association is measured by correlation. Therefore, the
correlation between the constituents should be as low as possible if not negative. It
has been observed that the correlation of risk although positive is very low
between common stock and corporate bonds. This fact should be taken into
consideration while constructing a portfolio, as bonds which normally not only
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possess lower risk than common stocks but also tend to reduce the portfolio’s risk
more than proportionately than the reduction in the overall returns.
The interest paid on bonds is a tax-deductible expenditure unlike dividends which
are not only post-tax expenditure, but also attract additional tax in terms of the
current guidelines. Consequently, an issuer will be able to offer better interest rates
on bonds, an advantage to the investor.
Unlike the stockholder who faces uncertainty regarding the rate as well as returns
on his investment, a bondholder receives interest payments regularly irrespective
of the profits of the firm since payment of interest is an obligation on the part of
the issuer unlike dividend which is discretionary and dependent on the profits of
the firm. Thus, a bondholder can lock-in income as compared to a stockholder.
Also, in case of the firm being liquidated the debt-holder will have a preferential
rights over a stockholder to recover his investment.
BOND TERMINOLOGY
In order to value a bond correctly, we must understand the terms and conditions of
the bond precisely. These terms define the contractual rights of the bondholder and
of the issuer and determine the cash flows that the bondholder will receive. In this
lesson, we describe the terminology that is used in the bond market to specify the
terms and conditions of the bond. They facilitate easy description of the salient
features of the bond.

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 Security Analysis

Face Value
The face value or nominal value of the bond can be thought of as the principal
amount on which interest is paid by the issuer. In many cases, this is also the
amount which is repaid at the end of the life of the bond. This is also often the
price at which the bond is originally issued by the issuer. But there are exceptions
to both of these as explained subsequently.
Coupon
Bonds typically pay interest periodically at a prespecified rate of interest. The
annual rate at which this interest is paid is known as the coupon rate or simply the
coupon. Interest is paid half-yearly, monthly, quarterly, annually or at some other
frequency. For example, a bond of the face value of Rs.1,000 with a 10% coupon
payable semi-annually will pay Rs.50 as interest every six months. The dates on
which the interest payments are made are known as the coupon due dates.
Maturity Date and Maturity
The maturity date of the bond is the date on which the bond is repaid and
extinguished. A bond is often described by specifying the coupon rate, the name of
the issuer and the maturity date. For example 11.5% GoI 2010 denotes a bond with
a coupon rate of 11.5% issued by the Government of India (GoI) maturing in 2010.
The holder of this bond will receive 11.5% interest every year till 2010 and also
receive the principal amount of the bond in the year 2010.

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Some bonds do not repay the principal amount in one installment but spread it out
over several years. In this case, the date of the last installment is often taken as the
maturity date though the very notion of a maturity date becomes less useful in this
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case.
The maturity at issue refers to the time to maturity from the date of issue of the
bond and the residual maturity refers to the time to maturity at any subsequent
point of time. For example, a bond with a maturity date of 2005 issued in 1990 has
a maturity at issue of 15 years, but in 2000 its residual maturity is only 5 years.
Redemption Premium
Bonds are not always redeemed at par on the maturity date. In other words, the
repayment on the maturity date is not necessarily equal to the face value. Some
bonds pay a redemption premium in addition to the face value. For example, in the
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case of a bond with a face value of Rs.1,000 and a redemption premium of 5%, the
amount repaid on maturity will be Rs.1,050 and not Rs.1,000.
Call Option
Internationally, many bonds contain a call option which entitles the issuer to call
back the bonds and redeem them before maturity. For example, in 1993 a company
issues a bond with a maturity of 10 years (redeemable in 2003) which is callable at
any time after 5 years (i.e. after 1998). Suppose the bond has a coupon of 17%
while in 1999, interest rates have come down and the company can issue new
bonds at a coupon of only 14%. The company could then issue fresh bonds at 14%
and call back the earlier issued more expensive 17% bonds. If the bonds do not
have a call option, the company cannot do this and the bondholders would
continue to enjoy the benefit of the higher coupon rate till 2003.
Put Option
Internationally, many bonds contain a put option which entitles the bondholder to
put the bonds back to the issuer for redemption before the maturity date. For
example, in 1994 a company issues a bond with a maturity of 10 years
(redeemable in 2004) which is puttable at any time after 3 years (i.e. after 1997).
Suppose the bond has a coupon of 15% while in 2001, interest rates have gone up
and a similar company is issuing new bonds at a coupon of 17%. The bondholder
could then buy these fresh bonds and put his existing 15% bonds back to the issuer
for redemption. If the bonds do not have a put option, the shareholder cannot do
this and would, therefore, be stuck with the lower coupon rate till 2004.

206
 Bond Valuation

Bond Price
The price of a bond in the market is often expressed as a percentage of face value.
For example, if the price of a bond with a face value of Rs.5,000 is stated as 105,
the actual price would be Rs.5,000 x 105/100 = Rs.5,250.
Basis Point
A basis point is simply one-hundredth of one percent. Changes in interest rates and
differences between two interest rates are usually stated in basis points for the sake
of convenience. For example, if interest rates rise from 8.25% to 8.40%, we say
that the rate has risen by 15 basis points. Similarly, if the yield on a high grade
bond is 11.5% while the yield on a low grade bond is 12.25%, we say that the
yield spread is 75 basis points. The use of this unit of measure serves to highlight
the fact that the bond portfolio manager is always fighting for that last basis point
of return and cannot afford the luxury of the equity manager who may be content
to measure returns in percentage points.
TYPES OF BONDS
Bonds can be classified into the following categories:
Secured versus Unsecured Bonds
Along the dimension of security, bonds can be classified into unsecured (straight)

I
bonds and secured (mortgage) bonds. Unsecured bonds have no charge on any
specific assets of the company while secured bonds carry a fixed or floating charge
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on the assets of the company.
The distinction between secured and unsecured bonds becomes relevant in case the
issuer defaults in the payment of interest or principal. The secured bondholders
are entitled to take possession of the security given to them and realize their
dues by selling these assets (typically land, building, machinery, etc). This
right is valuable to the bondholders provided the security is valuable, easily
saleable and has not been simultaneously given as security to other creditors as
well. All these factors have to be examined while evaluating a secured bond.
Unsecured bonds are not backed by any such security, but the bondholder does
not need to worry about this if he believes that the company is financially very
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sound and is unlikely to default.
Senior versus Subordinate Bonds
This is again a distinction which becomes important in the case of a default. The
senior bondholders have to be paid before the subordinated bondholders. This
means that if the assets of the company are insufficient to pay even the senior
bondholders, they get whatever amount can be realized and the subordinated
bondholders will get nothing. If the assets are a little more, the senior bondholders
may be paid in full and the subordinated bondholders may get partial payment. Of
course, if the company has sufficient assets, all bondholders will be paid in full. In
general, a company may have more than two classes of debt and the rules
regarding the seniority of these different classes can become quite complex.
Registered and Unregistered Bonds
On the dimension of transferability, debentures can be classified as registered and
unregistered debentures. Unregistered debentures (or bearer debentures) are freely
negotiable and can be transferred by a simple endorsement. On the other hand,
registered debentures can be transferred only by executing a transfer deed and
filing a copy of it with the company. The registered debenture holders receive
interest cheques automatically from the company whereas interest is paid on bearer
debentures only on presentation.

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Security Analysis

Convertible and Non-convertible Bonds

Bonds can also be classified into convertible and non-convertible depending upon
whether they carry a conversion feature or not. Convertible bonds are the ones
which can be converted into equity shares at the option of the bondholders. In this
case, the ratio of conversion (the number of shares exchanged for the converted
portion) or alternatively the conversion price (the price at which equity shares are
exchanged for the converted portion of the debentures), and the period during
which the conversion can be effected are specified at the time of the issue.
Convertible bonds can be either fully convertible or partly convertible. In the case
of partly convertible bonds, the non-converted portion will carry interest until it is
repaid as per the provisions in the indenture.
Bond Market Innovations
As the liberalization bandwagon is gathering momentum, the corporate treasurers
and merchant bankers are dreaming of new products to suit the needs of investors
and corporates. They are looking for something more than plain debt and equity
instruments from the pack. The process of financial engineering involves creating
new instruments and techniques by unpackaging and rebundling the same
characteristics in a different fashion to suit the ever changing needs of the issuers
and investors.

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The recent years have been witnessing the emergence of some innovative financial
instruments in the Indian financial market.
FA
Pure debt instruments have become almost forgotten instruments. The
preference of the investors for equity to other fixed income investments has
been the attractions of capital gains. Taking this cue, the companies formulated
instruments with mixed features and varying attributes.
Zero Interest Fully Convertible Debentures
Interest is not paid to the holders of these instruments. However, after a specified
notified period fully convertible debentures are automatically and compulsorily
converted into shares. Mahindra and Mahindra was the first company to issue
these instruments. It has offered the investors two options –
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a. 12.5% debentures of Rs.110 each fully convertible into two shares of

Rs.10 each at a premium of Rs.45 per share after the expiry of 18 months;
and
b. Zero bonds of Rs.90 each fully convertible into two shares of Rs.10 each
at a premium of Rs.35 per share after the expiry of 18 months.
Zero interest partly convertible debentures with detachable and tradeable
warrant are those instruments which have two parts – Part A and Part B.
Part A is the convertible portion and is convertible into equity shares at a fixed
amount on the date of allotment and Part B, the non-convertible portion which
carries a detachable warrant provides an option to the warrant holder to receive
equity share for every warrant held at a price as worked out by the company.
Detachable Equity Coupons/Warrants
An equity warrant is an instrument attached to non-convertible debentures which
gives the holder the right to apply for an equity share of the company at a future
date. The price is either announced in advance or later just before the option is
exercised. The holder may either elect to purchase or not to purchase the share.
Mahindra & Mahindra, Ceat Tyres, Gujarat Ambuja Cement are some of the
companies which have issued NCDs with detachable warrants. Deepak Fertilizers
has issued PCDs with detachable warrants.

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 Bond Valuation

Secured Premium Notes

SPNs with the detachable warrants are designed such that investors are repaid the
principal between the fourth and seventh years with the option of taking their
returns as either interest or redemption premium. In addition, investors are given a
warrant entitling them to buy a stated number of equity shares within the time limit
notified by the issuer company. This instrument offers investors flexibility of tax
planning and scope for sizable capital appreciation. SPNs were first issued by
TISCO.
Triple Option Convertible Debentures
The convertible portion entitles the holders to acquire equity shares and a warrant
is attached to the non-convertible portion of the debt instrument, thus leaving the
investors with three options – Retain the non-convertible portion and sell the
warrants or surrender the non-convertible portion with warrants and get equity
shares in return or retain non-convertible portion, surrender the warrants and apply
for equity shares.
Auction Rated Debentures
It is a fully redeemable non-convertible debenture secured by specific movable and
immovable assets of the company.

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Third-party Convertible Debentures
These are debt instruments with warrants allowing the investor to subscribe to the
FA
equity of a third firm at a preferential price vis-a-vis the market price. The coupon rate
is lower on account of the conversion option. This may be a convenient means of
raising funds for companies which do not have a track record but there are strong
companies in the group whose stocks could be offered.
Floating Rate Bonds
More recently, the floating rate bonds have been issued by institutions such as
IDBI, ICICI, as also corporates such as Tata Sons, Arvind Mills, etc. These bonds
which have maturities of either 3 years or 5 years have been priced with reference
to 364-day T-Bill as the benchmark.
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Floating Rate versus Fixed Rate Bonds
While discussing the coupon rate, we have so far assumed that the coupon rate is
fixed in advance. In a floating rate instrument on the other hand, the coupon rate is
linked to some well-known rate of interest. For example, the issuer may state that the
coupon rate for any quarter will be 3% above the yield on 91-day Treasury bills
during that quarter. So if the T-bill yield during a year (four quarters) are 7.88%,
8.12%, 8.45%, and 8.02%, then the quarterly coupons in that year would be 10.88%,
11.12%, 11.45%, and 11.02%.
Interpretation of Debt Market Quotations
Here, we present a clipping from “The Economic Times” which explains the
various terms used in quoting debt instruments (Government securities and
debentures issued by various organizations) in the wholesale debt market of
National Stock Exchange. The table quotes the market as on 29th January 2002.
Table 1
NSE Debt Market Deals Part I
Market as on 29 January, 2002
WDM Trades (Rs. Cr.) Corporate Debentures (Rs. lakhs)
Category Today This Week Today This Week
Traded Value 6,489.23 11,992.19 1,052.46 1,827.71
No. of Trades 993 1,873 2 4

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 Security Analysis

Top Securities Traded Today Non Repo Trades

Category Sec Security Issue Traded Value Weighted Yield (%)
type
(Rs. Cr.) Trade Value > 1 Cr. Trade Value <
1 Cr.
Govt. Securities GS CG2015 9.85% 895.00 7.92 –
GS CG2011A 11.50% 895.00 7.69 –
GS CG2013 9.81% 760.00 7.76 –
NSE-Mibid/Mibor
MIBID MIBOR
Period IST Rate Std. Dev. Rate Std. Dev.
OVER NIGHT 09.40 AM 6.51 0.0155 6.64 0.0112
14 DAY 11:30 AM 6.88 0.1054 7.36 0.1066
1 MONTH 11:30 AM 7.10 0.0651 7.67 0.0836
3 MONTH 11:30 AM 7.62 0.0887 8.31 0.1209
Traded Securities on WDM Segment
Sectype Security Issue Trade No. of Trade Low High Last Weighted
Name Type Trades Value Price/Rate Price/Rate Traded Yield

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Price/Rate
BB PNB08 10% NR 1 5.00 103.3801 103.3801 103.3801 9.2460
BB
BB
SBI06
SBI08
FA 11.55%
11.90%
NR
NR
1
1
5.00
5.00
109.4174
113.7915
109.4174
113.7915
109.4174 8.7450
113.7915 8.8890
CP BPCL 220402 NR 1 25.00 98,3495 98,3495 98,3495 7.4700
DB GACEM08 9.60% NR 1 5.00 104.6973 104.6973 104.6973 9.5321
DB HDFC03 11.30% NR 1 5.00 105.7944 105.7944 105.7944 8.6860
GS CG2002 11.15% NR 2 15.00 102.5500 102.5500 102.5500 6.6530
GS CG2002 13.80% NR 1 5.00 102.3000 102.3000 102.3000 6.7460
GS CG2003 11.10% NR 1 10.00 104.9800 104.9800 104.9800 6.6590
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GS CG2004 12.50% NR 10 75.00 111.2400 111.3000 111.3000 6.7693
GS CG2004 12.59% NR 3 45.00 112.3700 112.4300 112.4200 6.8640
NSE Debt Market Deals
GS CG2021 10.25% NR 25 140.00 119.1900 119.6000 119.5000 8.2216
GS CG2026 10.18% NR 5 16.50 119.2500 119.4300 119.2500 8.3181
ID ICIC03C 16% NR 1 12.00 112.2061 112.2061 112.2061 9.3800
ID ICIC03E 16% NR 1 5.00 112.0798 112.0798 112.0798 9.3800
ID ICIC06B 10.25% NR 1 2.00 100.5342 100.5342 100.5342 10.0240
ID IDBI04A 12.50% NR 1 2.75 104.7694 104.7694 104.7694 10.2070
PT BHEL08 8.85% NR 2 10.00 100.2210 100.2408 100.2408 8.7790
PT BPCL08 9.95% NR 2 10.00 104.6790 104.6790 104.6790 8.9120
PT NHPC07 9.55% NR 1 25.00 101.1489 101.1489 101.1489 9.2500
PT NTPC07 10% NR 1 7.40 105.7780 105.7780 105.7780 8.6780
SG AP09 12.50% NR 1 1.00 122.0300 122.0300 122.0300 8.2950
SG MAH08 12.50% NR 1 1.50 121.2300 121.2300 121.2300 8.3010
TB 364D 100103 NR 1 30.00 94.0945 94.0945 94.0945 6.6400
TB 364D 271202 NR 1 15.00 94.3124 94.3124 94.3124 6.6300
TB 364D 310502 NR 1 10.00 97.8432 97.8432 97.8432 6.5950
Total 993 6489.23

Description No. of Total Consideration Open High Low Close Indicative

Trades Qty. (Rs. in lakh) Yield
GUJ AMB CEM 9.60% 2008(S-19)* 1 500000 523.4865 104.70 104.70 104.70 104.70 9.53
HDFC 11.30% 2003(S-16)* 1 500000 528.9720 105.79 105.79 105.79 105.79 8.69
Total 2 1000000 1052.4585
* Indicates trades done on WDM segment of the Exchange.

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 Bond Valuation

Legend for Daily Market Reports

Traded Securities on WDM Segment:
1. Security Type: The instruments issued by various issuers are clubbed under
different homogeneous categories which are known as Security Types.
Security type starting with ‘Z’ indicates retail lot in which small/odd value
transactions can be done.
2. Security: Security indicates either issuer name and year of maturity or term
of the instrument, depending upon nature of the instrument.Suffixes such as
A, B, etc. to the security name have been given purely for the purpose of
differentiating various securities issued by the same issuer and maturing in
the same year and carrying the same coupon rate.
3. Issue: Issue indicates either maturity date, coupon rate or mark-up rate over
benchmark depending upon the nature of the instrument. Explanation of
Security and Issue for different types of instruments is given hereunder.
Sr.No/Type of instrument/Security Indicates/Issue Indicates/Example
1. T-Bills\Term of T-bills – 91 days, 364 days\Date of maturity\“TB 364D
290102” stands for Treasury Bill issued for 364 days and maturing on
29/01/2002.
2. Discounted instrument other than T-bills\Issuer\Date of maturity\“CP
BPCL 220402” stands for Commercial Paper issued by Jindal Polyester

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maturing on 22nd April, 2002.
3. Coupon bearing instruments including zero coupon instruments\Issuer
FA and year of maturity\Coupon rate\“GS CG2005 14%” stands for Govt.
dated security, issued by the Central Government and maturing in 2005
carrying a coupon of 14%.
“PT NHPC 02 18%” stands for taxable PSU bonds issued by the NHPC
maturing in 2002 carrying a coupon rate of 18%.
4. Floating rate instruments\Issuer and year of maturity\Mark-up over
benchmark\“BF SBI04 + 3%” stands for Floating Rate Bond issued by
SBI maturing in 2004 with a mark-up of 3% over the benchmark.
4. Weighted Yield: Weighted yield indicated for the traded security is
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calculated on the basis of all trades done in the security during the day.
Debentures Traded on NSE:
The opening, closing, high and low prices are given separately for WDM & CM
segments. Similarly, the total quantity and number of trades are also shown
separately for both the segments.
If a debenture is traded on both WDM and CM segments, then the trade in WDM
segment is shown with ‘*’.
Yield is calculated assuming the settlement date falls on the trading day.
List of Security Types:
Issuer\Description\Regular Lot\Retail Lot Central Government\Compensation
Bond\GD\ZM; Converted Stock\GC\ZG; Floating Rate Bond\GF\ZN; Government
Loan\GS\ZG; Partly Paid-up Loan\GP; Treasury Bill\TB\ZB; Zero Coupon
Bond\GZ\ZZ; State Government\ Development Loan\SG\ZS; Public Sector
Unit\Promissory Note\PD; Taxable Bond\PT\ZT; Tax-Free Bond\PF\ZF; Zero
Coupon Bond\PZ; Cumulative Bond\PE\ZE; Institutions\Floating Rate
Bond\FB\ZR; Non-SLR Bond\ID\ZD; SLR Bond\IB\ZI; Zero Coupon
Bond\IZ\ZL; Deep Discount Bond\DI; Tax-Free Bond\IF; Banks\Bonds\BB\ZO;
Certificate of Deposit\CD\ZC; Floating Rate Bond\BF\ZK; Zero Coupon
Bonds\BZ\ZA; Corporate\Commercial Paper\CP; Debentures\DB; Promissory
Note\CN; Deep discount Debentures\DC; Securitized Debt\SD; Mutual Funds\Unit
64\US\ZU; Mutual Funds units\MF.

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 Security Analysis

VALUE OF A BOND
To understand how a bond may be valued, let us consider the following
illustration.
Illustration 1
A debenture of Rs.100 face value that carries an interest rate of 14 percent is
redeemable after 6 years, at a premium of 2 percent. If you own this debenture,
you will enjoy the following benefits:

End of year Interest income Principal repayment

Rs. Rs.

1 14

2 14

3 14

4 14

5 14

6 14 102

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If you require a rate of return of 16 percent from this debenture, the present value
of it to you will be:
FA Rs.14 (PVAF16%, 6 yrs) + Rs.102 (DF16%, 6 yrs)
= Rs.14 (3.685) + Rs.102 (0.41)
= Rs.51.59 + Rs.41.82
= Rs.93.41
In general terms, the value of a bond may be expressed as follows:
V = I (PVAFk,n) + F (DFk,n) Eq. (1)
 Present 
 Annual   
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  value   Redemption   Discount 
Value of a bond =  interest   +    

 payable   annuity   value   factor 
  factor
 
Bond Values with Semi-annual Interest
Most of the bonds pay interest semi-annually. To value such bonds, we have to
work with a unit period of six months, and not one year.
The basic bond valuation equation becomes:
V = I/2 (PVAFk/2,2n) + F (DFk/2,2n) Eq. (2)
Illustration 2
Consider a debenture of Rs.100 par value bond that carries a coupon rate of
14 percent (interest payable semi-annually) and has a maturity period of 6 years
and your required rate of return (discount rate) for this bond is 8 percent for six
months, the value of the bond to you is:
V = Rs.14/2 (PVAF16%/2,2x6 yrs) + Rs.100
(DF16%/2,2x6 yrs)
= Rs.7 (PVAF8%,12 yrs) + Rs.100 (DF8%,12 yrs)
= Rs.7 (7.536) + Rs.100 (0.397)
= Rs.92.45

212
 Bond Valuation

BOND RETURNS
The investor in bond typically receives income from the following:
i. Interest payments at a contracted rate i.e. coupon interest.
ii. Capital gain or loss arising out of sale of the bond.
iii. Cash realization on sale of bond.
iv. Redemption of the bond by the issuer at a contracted value.
Items (i) and (ii) constitute returns to the bond investor, while (iii) and (iv) are
principal recoveries. An investor’s income on bond investment depends on
whether he holds the bond to maturity or disinvests before maturity. If the bond is
held to maturity, cash flows (i) and (iv) will accrue. However, if he sells before
maturity he receives cash flows (i), (ii) and (iii) above. The return to the bond
investor can be measured in terms of the following:
a. Current Yield (CY)
b. Yield to Maturity (YTM)
c. Realized Yield (RY)
Current Yield
CY is measured by comparing (i) with the prevailing market price. Thus,
Coupon int erest
CY =

I
Pr evailing market price
Illustration 3
FA
An 8% bond (Face value of Rs.100) selling for Rs.96, would have a current yield of
8
rc = = 8.33%
96
Current yield of bonds selling at par would be equal to the coupon interest rate.
Current yield of bonds selling at a premium (discount) would be less (more) than
the coupon interest rate.
An important drawback of current yield is that it considers only coupon income as
a source of return to the investor, ignoring interest and capital gains (loss) that
would also accrue to him.
IC

Yield to Maturity
The correct way of computing the return on any asset involves considering the
entire sequence of cash flows and their timing and calculating the Internal Rate of
Return (IRR). In the case of a bond, there is a cash outflow (equal to the price of
the bond) when the bond is bought and there are cash inflows when the periodic
interest coupons are received and there is also a cash inflow when the redemption
value is received on maturity. Calculating the IRR of this stream of cash flows
gives the true return on the bond which is known as the Yield to Maturity (YTM).
Thus, yield to maturity is measured by comparing the present value of (i) & (iv) to
the prevailing market price.
Illustration 4
Consider a bond with an annual coupon of 12.5% redeemable on 1/7/x4 selling at
Rs.80.60 on 1/7/x1. What is the return earned by the investor, who buys the bond
on 1/7/x1 and holds it till maturity?
The investor incurs a cash outflow on 1/7/x1 of Rs.80.60 and receives interest of
Rs.12.50 each on July 1 in x2, x3 and x4. On maturity (1/7/x4), he also receives
Rs.100. The structure of cash flow is thus:
Date 1/7/x1 1/7/x2 1/7/x3 1/7/x4
Cash flow –80.60 12.50 12.5 112.50

213
Security Analysis

The IRR of this stream of cash flows works out to 22% as shown by the following
calculation.
Solution
Date 1/7/x1 1/7/x2 1/7/x3 1/7/x4

Cash flow 80.60 12.50 12.50 112.50

Present Value of cash flow at 22% 80.60 10.25 8.40 61.95

Net Present Value 0.00

The YTM is therefore 22% compounded annually.

In bond valuation, the convention is to quote yields in terms of half-yearly
(semi-annual) compounded rates of interest. This convention is useful because
most bonds have semi-annual coupons; therefore, the YTM of such a bond selling
at par would be equal to the coupon rate only if the YTM uses semi-annual
compounding. Since 11% compounded half-yearly equals 22% compounded
annually, the yield to maturity of the bond would be quoted as 11% rather than
22%. However, for simplicity, in many of our illustrations, we shall assume annual

I
coupons and annual compounding of the interest rates.
For the mathematically inclined, the semi-annually compounded YTM can be
FA
defined as the value of r which solves the following equation:
− t1 − t2
 r  r
P = C1  1 +  + C2  1 +  +... +
 2  2
− t 2n − t 2n
 r  r
Cn  1 +  + RV 1 +  Eq. (3)
 2   2 
Where P is the price of the bond today, C1 is the next coupon and t1 is the time
from today till the next coupon date and, in general, Ci is the ith coupon and t1 is
IC
the time (in years) from today at which this coupon will be received, while t2n is
the time to maturity and RV is the redemption value.
Eq. (3) essentially restates algebraically the IRR calculation except that it uses
semi-annually compounded rates of interest. This equation can be solved by trial
and error either manually or using a computer.
For a bond with a constant semi-annual coupon redeemable at par, we can use the
formula for the present value of annuities to obtain:
r  r 
P = C PVIFA  , 2n  + RVPVIF  , 2n  Eq. (4)
 2   2 
where ‘C’ is half-yearly coupon.
This equation can also be solved by trial and error. This formula is especially
useful when there are several more coupons to be received, because, in this case,
Eq.(3) would have a large number of terms (one for each coupon in fact).
Approximation to YTM
Many investors do not bother to calculate the YTM, and instead analyze the
return earned in a very simple way. The reason is that the total return consists of
interest payments and the capital gain/loss on redemption. The average annual
return is then:

214
 Bond Valuation

Annual interest + capital gains

Average annual return1 =
Number of years
Similarly, one can also calculate the average investment as the average of the
current price and the redemption value. Many investors then compute the yield as
the average annual return divided by the average investment.
For the bond of Illustration 4, the annual interest is Rs.12.50, the total capital gain
is Rs.19.40, the annual capital gain is Rs.6.47, the annual average return is
Rs.18.97 and the average investment is Rs.90.302. Hence, the yield by this method
works out to 18.97/90.30 = 21%. We have already seen that the correct yield is
22% compounded annually an error of 100 basis points. The reason for this error is
that the approximate calculation ignores the fact that capital gains and the interest are
received at different points of time. To compute an average return is not quite correct.
Many other approximations of this kind are in common use. Some approximations
do not use the notions of average investment, but divide the return either by the
redemption value or by the price. There are some who divide the annual interest by
the price and divide the capital gains by the redemption value. All these
approximations involve the same error of ignoring the timing of the cash flows.
While some of them may give a nearly correct answer, for some bonds they can all
be off by a hundred basis points or more.

I
These approximations are, however, very useful in calculating the YTM by trial
and error since they provide a very good initial guess, the process of trial and error
FA
gives the true YTM in a few steps.
Figure 1 illustrates how current yield, yield to maturity and coupon rate interact
with the market price of a bond of face value of Rs.1,000 with coupon rate of 6%
and 25 years to maturity.
Figure 1
IC

The above figure depicts graphically the fact that the current yield and yield to
maturity varies inversely with the market price.
From the above figure it is also clear that
a. If market price = face value, i = YTM = current yield.
b. If market price <face value, i <current yield <YTM.
c. If market price >face value, i >current yield >YTM.

C + (F − P)/n
1 Annual return can also be calculated by the formula, where ‘C’ is coupon, ‘F’ is the
(F + P)/2
redemption value and ‘P’ is the purchase price.
2 Average investment is equal to half the redemption price and purchase price, i.e. (F + P)/2

215
 Security Analysis

Realized Yield
Realized yield is the yield actually earned by the investor on his investment and
depends on the reinvestment rate and the holding period chosen by him.
ASSUMPTIONS UNDERLYING YTM
The YTM of a bond represents the expected or required rate of return on a bond.
While computing the YTM, the following assumptions are made:
1. All coupon and principal payments are made on schedule.
2. The bond is held to maturity.
3. The coupon payments are fully and immediately reinvested at precisely the
same interest rate as the promised YTM.
The YTM and the realized yield would be equal if the above conditions are
fulfilled. Any violation of the above assumptions will cause YTM to differ from
realized yield.
Let us see the effects of relaxing the above assumptions on realized yield.
An investor may hold a bond to maturity, or decide to sell the bond before that.
Similarly, the reinvestment rate, or the rate at which coupon payments are
reinvested can be more or less than the promised YTM.

I
After relaxing the assumptions on holding period and reinvestment rates, the
returns available to the investor can be redefined as follows:
•
FAIf the investor disposes the bond before maturity, the price at which he sells
the bond3 depends on the reinvestment rate.
• Since the reinvestment rates are different from the YTM, the interest earned
on the coupon interest will be at the reinvestment rate and has to be
separately considered.
The total returns to an investor, as already noted, is = Coupon interest + Interest
on interest + Capital gains (or loss)
We shall consider these components in detail for the effect of interest rate changes,
and varying the holding periods on the total return.
IC
Coupon Interest
Coupon interest, as already known to us, is stated in the bond indenture, and is
computed by applying the interest rate to the face value of the bond.
Interest on Interest
The coupon interests received on bonds may be reinvested and in turn earn
interest. The interest on interest can be computed as,
I = C1 (1 + r) n −1 + C2 (1 + r) n −2 + C3 (1 + r)n −3 ......

+ C n (1 + r)0 − [C1 + C2 + C3 + ..... + C n ]...... Eq. (5)

In case of equal coupons received, the above equation will reduce to
 (1 + r) n − 1  n
= Ct 
  − ∑ C t = CtFVIFAr,k – n.Ct Eq. (6)
 r  t =1
where ‘r’ is the relevant reinvestment rate.
Illustration 5
Consider a 13% bond (face value Rs.200) redeemable after 5 years at a premium
of 5%. Let the purchase price of the bond be Rs.191.50.

3 The market price available on the bond would also depend on the market interest rates. An increase in
interest rates would be accompanied by a fall in market prices and vice versa. It may be different from the
acquisition price, resulting in capital gains or losses.

216
 Bond Valuation

The YTM of the bond is the value of ‘r’ in the equation:

191.50 = 26 PVIFAr,5 + 210 PVIFAr,5
At r = 15%, the RHS of the above equation
= 87.152 + 104.37 = 191.52
The YTM of the bond is about 15%.
The interest on interest earned by the bond, if the reinvestment rate is equal to the
YTM, is
= 26 FVIFA15,5 – 26 x 5
= 175.29 – 130 = Rs. 45.29
Suppose the reinvestment rate is 12%, the interest on interest would be
= 26 FVIFA12,5 – 26 x 5
= 165.18 – 130 = Rs.35.18
The realized yield can vary from the promised YTM if coupons are reinvested at a
rate different from the YTM. In the above case, while the promised interest is
Rs.175.29, only Rs.165.18 can be realized if the reinvestment rate available is
12%. A fall in interest rates, therefore, reduces the return available from the
interest on interest component.
Suppose the bond is not held to maturity, the interest on interest component would
vary with the holding period. The interest on interest at both the reinvestment

I
rates, 12% and 15% for various holding periods, is summarized below:
Table 2
FA Interest on Interest
At
reinvestment 1 2 3 4 5
rate
15% 26 x 26 x 26 x 26 x 26 x
FVIFA15,1 FVIFA15,2 FVIFA15,3 FVIFA15,4 FVIFA15,5
– (26 x 1) – (26 x 2) – (26 x 3) – (26 x 4) – (26 x 5)
=0 = 3.9 = 12.3 = 25.82 = 45.29
IC
12% 26 x 26 x 26 x 26 x 26 x
FVIFA12,1 FVIFA12,2 FVIFA12,3 FVIFA12,4 FVIFA12,5
– (26 x1) – (26 x 2) – (26 x 3) – (26 x 4) – (26 x 5)
=0 = 3.12 = 9.72 = 20.25 = 35.18
CAPITAL GAIN (LOSS)
If the bond is held to maturity, the redemption value is known in advance, but if
the bondholder decides to disinvest before maturity, the price at which he will be
able to dispose it off should be determined.
Returning to the basic bond valuation equation (also the equation of the YTM), we
are aware that the price at which a bond is expected to sell, is the present value of
future cash inflows discounted at the YTM rate. With the help of this equation, we
can determine the expected market price for any holding period, up to the maturity
of the bond, using the formula
Market value at the end of t years
= C x PVIFAr, (n – t) + F x PVIFr, (n – t)
where, r = reinvestment rate
n = term to maturity
t = holding period
Illustration 6
Reconsider the previous illustration. The redemption value of Rs.210 can be
realized if the bond is held to maturity. The expected market prices for various

217
 Security Analysis

holding periods at a reinvestment rate of 15% (YTM) and the capital gains that
would arise if the bond is sold at that price is given below in Table 3.
Table 3
Capital Gains
At reinvestment rate Holding Period (Years)
of 15% 1 2 3 4 5
1. Purchase 191.5 191.5 191.5 191.5 191.5
Price (Rs.)
26 x 26 x 26 x 26 x
2. Market Price at
PVIFA15,4 + 210 x PVIFA15,3 + PVIFA15,2 + 210 PVIFA15,1 + 210 26 x 0 + 210
the end of the
PVIF15,4 210 x PVIF15,3 x PVIF15,2 x PVIFA15,1 = 210
holding period
= 194.35 197.543 = 201.04 = 205.32 18.5
(Rs.)
3. Capital gain 2.85 6.04 9.54 13.82
(2) – (1) (Rs.)

We shall work the capital gains at a reinvestment rate of 12% to illustrate the
effect of a different reinvestment rate, on the capital gains component. Table 4
provides the capital gains for various holding periods. The inverse relationship
between YTM and market prices results in increased capital gains when interest
rate falls to 12%.
Table 4
Capital Gains

I
Holding Period (Years)
At reinvestment rate of 12%
1 2 3 4 5
1. Purchase 191.5 191.5 191.5 191.5 191.5

2.
FA
Price (Rs.)
Market Price at the
end of the holding
26 x 26 x 26 x 26 x
PVIFA12,4 + 210 PVIFA12,3 + PVIFA12,2 + 210 PVIFA12,1 + 210
26 x 0 + 210
= 210
period (Rs.) x PVIF12,4 210 x PVIF12,3 x PVIF12,2 x PVIFA12,1
= 213.46 = 211.973 = 211.31 = 210.75 18.5
3. Capital gain 21.96 20.47 19.81 19.25
(2) – (1) (Rs.)
Total Return
As noted earlier, total return comprises of the three elements explained above –
namely coupon payments, interest on interest, and capital gains.
Let us consider the total returns for the bond while coupons, interest on interest,
IC
and capital gains for varying holding periods, have already been computed by us.
The total returns earned for various holding periods and the two reinvestment rates
can be summarized as follows:
Table 5
Total Return (Rs.)
At reinvestment rate Holding Period (Years)
1 2 3 4 5
15% (YTM) Coupon Income 26 52 78 104 130
Interest on Interest 0 3.9 12.3 25.82 45.29
Capital Gains 2.85 6.04 9.54 13.82 18.5
Total Return 28.85 61.94 99.84 143.64 193.79
12% (YTM) Coupon Income 26 52 78 104 130
Interest on Interest 0 3.12 9.72 20.25 35.18
Capital Gains 21.96 20.47 19.81 19.25 18.5
Total Return 47.96 75.59 107.53 143.5 183.68

From table 5, we can see the combined effect of varying the holding period, and
the reinvestment rate, on the total return. It can be observed that two opposing
forces work on the return. A fall in interest rates reduces interest on interest, while
increasing the capital gains. This is due to the inverse relationship between YTM
and the market prices. The choice of the holding period can be made after
considering the realized yield.
Realized Yield
As already mentioned, the realized yield on a bond is the actual yield earned by an
investor, and is computed as the value of ‘r’ in the equation

218
 Bond Valuation

Po (1 + r)n = Total cash flows received by the investor.

In other words, realized yield is the rate that equates the future value of the
purchase price to the total cash flow realized on the bond. The above equation can
be rewritten as
Po FVIFr,n = Total returns + Purchase Price.
Total returns include coupon income, interest on interest and capital gains realized
on sale. Adding the purchase price results in considering the cash flows arising out
of sale.
Alternatively, realized yield can also be looked upon as the discount rate, that
discounts the total cash inflows to the purchase price.
Illustration 7
Consider the total return computed in Table 5. The realized yield for both the
reinvestment rates, and various holding periods, would be computed as follows:
4
The realized yield for holding period of 1 year, at reinvestment rate of 15% is
computed as the value of ‘r’ in the equation
191.5 FVIFr,1 = 28.85 + 191.5
191.5 FVIFr,1 = 220.35
FVIFr,1 = 1.150
Looking at the FVIF tables, we find the value for r = 15%. The realized yield,

I
therefore, is 15%.
The realized yield for holding period of 1 year, at reinvestment rate of 12%, is
FA
computed as the value of ‘r’ in the equation
191.5 FVIFr,1 = 47.96 + 191.5
191.5 FVIFr,1 = 239.46
FVIFr,1 = 1.250
The value of ‘r’ lies between 24% and 28%. Using linear approximation,
 1.250 − 1.240 
r = 24 +   x4
 1.280 − 1.240 
= 24 + (0.25 x 4) = 25%
IC

The realized yield for both the reinvestment rates for various holding periods is
summarized in Table 6.
Table 6
Realized Yield (%)
Reinvestment Holding Period (Years)
rate 1 2 3 4 5
15% 15 15 15 15 15
12% 25 18.54 16 15 14.4
Realized yield thus depends on the holding period chosen and reinvestment rate
available. In an environment of falling interest rates, the investor realized a lower
yield as term to maturity approaches. He benefits by shortening his holding period
and realizing capital gains. Realized yield falls beyond a holding period of 4 years
(at interest rates of 12%) because the reduction in interest on interest is not offset
by increase in the capital gains component.
It is apparent that the opposing forces – interest on interest and capital gains – are
balanced at a holding period of 4 years. The determination of such a holding
period that immunizes the two opposing forces is done, with the help of a concept
called Duration. We shall discuss duration later.

4 Student may also use the approximation formula ARY = 2C + [Ps - Po)/Ns]/(Ps + Po)/2; where
Ps = expected price at the end of the holding period of Ns years and ARY = approximate realized yield.

219
 Security Analysis

Note that the realized yield is equal to the YTM for all holding periods if the
reinvestment rate is equal to the YTM.
Properties of the Realized Yield
The realized yield will have the following properties:
1. The realized yield will always lie between the YTM and the reinvestment
rate. If the reinvestment rate is equal to the YTM, realized yield will also be
equal to the YTM. If reinvestment rate is greater (smaller than YTM),
realized yield will also be greater (smaller) than the YTM. Note from Table 5
that when reinvestment rate 12% is less than YTM of 15%, realized yield is
14.4%.
RI = RY = YTM
RI > RY > YTM
RI < RY < YTM
2. For bonds with longer term to maturity realized yield will be closer to the
reinvestment rate.
For bonds with shorter term to maturity, realized yield will be closer to the
YTM.
BOND PRICE THEOREMS
Illustration 8

I
a. The market price of the bond will be equal to the par value of the bond, if the
YTM equals its coupon rate.
FA Intrinsic value/market price of a Rs.1,000 par value bond and bearing 10%
coupon rate with an expected YTM of 10% and maturity of 10 years is equal
to
100 PVIFA10%,10 + 1,000 PVIF10%,10
= 100 x 6.145 + 1,000 x 0.386
= Rs.1,000.50
Thus, when YTM is equal to coupon rate, market value is equal to the face
value of the bond.
b. If YTM increases above the coupon rate, the market value drops below the
IC
face value.
If the YTM of the above bond increases to 12%, the market value of the bond
will drop to Rs. 887.
100 PVIFA12%,10 + 1,000 PVIF12%, 110 x 5.65 + 1,000 x 0.322 = Rs.887.
c. Inversely to the above principle, if YTM drops below the coupon rate, the
market value will be more than the face value of the bond.
In case of the above bond, if the YTM falls to 8%, the market value of the
bond will rise to
100 PVIFA8%,10 + 1000 PVIF8%, 10 = 100 x 6.71 + 1000 x 0.463 = Rs.1,134.
As YTM determines a bond’s market price and vice versa, we can say that the
bond’s price will fluctuate in response to the change in market interest rates in the
following ways:
i. A bond’s price moves inversely proportional to its yield to maturity.
The present value principle states that the present value of a cash flow varies
in inverse proportion to the interest rate used as a discount rate. As such if the
YTM of the bond rises, the bond’s market price drops and if the YTM falls,
the bond’s market prices rises.
Illustration 9
The YTM of a Rs.1,000 par value bond bearing a coupon rate of 10% and
maturing in 10 years is 12%. Thus, the market value of the bond is Rs.887 (as
calculated previously). If the YTM increases to 14%, the market value of the bond
will drop to Rs.791.60, as calculated below:

220
 Bond Valuation

100 PVIFA14%,10 + 1,000 PVIF14%,10

= 100 x 5.216 + 1000 x 0.270= Rs.791.60.
If the YTM of the same bond comes down to 8%, then the market value of
the bond rises to Rs.1,134. [i.e. 100 x 6.710 + 1000 x 0.4632]
ii. For a given difference between YTM and coupon rate of the bonds, the longer
the term to maturity, the greater will be the change in price with change in
YTM. It is so because, in case of long maturity bonds a change in YTM is
cumulatively applied to the entire series of the coupon payments and the
principle payment is discounted at the new rate for the entire number of years
to maturity; whereas in case of short-term maturity bonds, the new YTM is
applied to comparatively few coupon payments; and also, principal payment is
discounted for only a short period of time. Thus, long-term bonds are more
variable to changes in interest rates than short-term bonds.
Illustration 10
Let us take two hypothetical bonds differing only in term to maturity.
A B
Face value Rs.1,000 Rs.1,000
Coupon rate 10% 10%
YTM 10% 10%
Years to Maturity 3 6

I
Market Value at YTM of 10% Rs.1,000 Rs.1,000
Market Value at YTM of 11% 100 PVIFA11%,3 100 PVIFA11%,6 +
+ 1,000 1,000 PVIF11%,6
FA PVIF11%,3
= 975.56
= 957.69

Change in Price – 2.5% – 4.2%

The market value of the bonds when the YTM was equal to coupon rate was equal
to the face value of the bonds i.e. Rs.1,000. When, however, the YTM increased to
11%, the market value of the bond with shorter maturity period dropped by only
2.5% to Rs.975 whereas the market value of the bond with longer maturity period
of 6 years has dropped by 4.2% to Rs.958. Thus the long-term bonds are
characteristically more sensitive to interest rate changes than short-term bonds.
iii. The percentage price change described above increases at a diminishing rate
IC
as the bond’s maturity time increases.
Box 1: Principles of Bond Price Movements
• The yield to maturity is inversely related to price of the bond. As yield to
maturity increases, the price of the bond decreases and as the yield to
maturity decreases, the price of the bond increases.
• For a difference between the coupon and the YTM, the extent of change in
the price of the bond depends on the remaining term to the maturity. The
larger the period, the greater will be the price change.
• The increase in the price of a bond associated with the changes in the
interest rates will be at a diminishing rate as the term to maturity increases.
• For every change in the interest rate, there will be corresponding change in
the price of the bond. However, for the same change in the interest rate in
either direction (that is, if the interest rate increases and decreases by say
1%), the corresponding change in the price is not by the same magnitude.
The price decrease caused by a yield decrease is always more than the
increase from a yield increase.
• For a given change in a bond’s yield to maturity, the percentage price
change will be higher for low coupon bonds than for high coupon bonds.
Let us take the case of bond B above with face value of Rs.1000, coupon rate and
YTM of 10% and maturity period of 6 years. Suppose the YTM changes to 11% at
the end of the fifth year i.e. when the time to maturity of the bond is 1 year, the
value of the bond will fall to Rs.991.1.

221
 Security Analysis

Similarly, at differing maturity periods, with the change in the YTM, the price of
the bond changes as follows:
Time to maturity Bond Price (Rs.) Change %
1 991.10 0.89
2 982.87 0.83
3 975.40 0.76
4 969.20 0.64
5 963.04 0.635
Thus, the longer the maturity, the greater the change with the change in YTM, but
the change (increase/decrease) will be at a diminishing rate.
iv. Given the maturity, the change in bond price will be greater with a decrease
in the bond’s YTM than the change in bond price with an equal increase in
the bond’s YTM. That is, for equal fixed increases and decreases in the
YTM, price movements are not symmetrical.
Illustration 11
Take Rs.1,000 par value bond with a coupon rate of 10% and maturity period of 5
years. Let the YTM be 10%. Market price of the bond will be equal to Rs.1,000. A
1% increase in YTM to 11% changes price to Rs.963.04 (100 PVIFA11%,5 + 1,000
PVIF11%,5), a decrease of 3.7%. A decrease of 1% YTM to 9% changes the price to
Rs.1039 (100 PVIFA9%,5 + 1000 PVIF9%,5) an increase of 3.9%.

I
Thus, an increase in bond’s yield caused a price decrease that is smaller than the

v.
FA
price increase caused by an equal-size decrease in yield.
For any given change in YTM, the percentage price change in case of bonds
of high coupon rate will be smaller than in the case of bonds of low coupon
rate, other things remaining the same.
Illustration 12
Consider the two bonds A and B with the par value of Rs.1,000, maturing in
4 years and YTM of 10%. Bond A bears coupon rate of 10% whereas bond B
bears coupon rate of 12%.
Bond A Bond B
IC
Market price at YTM of 10% (Rs.) 1,000 1,063.4
Market price at the changed YTM of 12% (Rs.) 939.7 1,000.44
Change in price 6.03% 5.92%
Change in the price with the change in YTM in case of bond B carrying a higher
coupon rate of 12% is only 5.92%, whereas in case of bond with a coupon rate of
10%, the change in the price is 6.03%.
vi. A change in the YTM affects the bonds with a higher YTM more than it does
bonds with a lower YTM.
Illustration 13
Consider a Rs.1,000 par value ABC bond with a coupon rate of 12%, maturity
period of 6 years and YTM of 10%. The market value of the bond will be
Rs.1,087.
Consider another identical bond XYZ but with differing YTM of 20%. The market
value of this bond will be Rs.734.
Suppose there is an increase in YTM by 20% i.e. YTM of bond ABC rises to 12%
(10 x 1.2) and bond XYZ rises to 24% (i.e. 20 x 1.2). Then the market value of
both the bonds will change to
Bond ABC : 120 PVIFA12%,6 + 1,000 PVIF 12%,6 = Rs.1000
Bond XYZ : 120 PVIFA24%,6 + 1,000 PVIF24%,6 = Rs.638

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 Bond Valuation

Market value of ABC bond with a lower YTM decreased by 8% whereas in case of
XYZ bond with a higher YTM the decrease is 13%.
ACCRUED INTEREST
In illustration 4, the YTM was calculated on a coupon date and there was,
therefore, no accrued interest. As already discussed, in the government bonds
market in India and in most bond markets in the world, the buyer has to pay
accrued interest to the seller. In this case, the bond price for the YTM calculation
must be taken inclusive of accrued interest.
Suppose a bond pays interest semi-annually on July 1 and January 1. If a person
sells the bond on May 1, he gets no interest for the four months from January 1 to
April 30 for which he held the bond while the buyer would get six months interest
on July 1 though he held it only for two months (May 1 to June 30). The interest
for the period from the last coupon due date to the date of the sale is known as
accrued interest. In the above illustration, if the bond had a face value of Rs.100
and carried a coupon of 12%, the accrued interest would amount to
Rs.100 x 12/100 x 4/12 = Rs.4.
It is often a convention in the bond markets that the buyer pays the accrued interest
to the seller in addition to the price. In other words, the actual cash price paid is
equal to the quoted price plus the accrued interest. In India, this is the practice in

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the government bonds markets, but not in the corporate bonds market. In the above
illustration, if the quoted price is Rs.98 then under this convention, the actual cash
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price would be Rs.98 + 4 = 102.
Illustration 14
In the middle of July, x1, the 12.75% bonds issued by Exec Ltd. maturing in year
x3, was quoted at Rs.104. The coupon dates for this bond are in the middle of
April and October and the bond matures in the middle of April, x3. What is the
YTM of this bond?
Solution
Using Eq. (3)
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P: We have to consider accrued interest for three months from mid-April to
mid-July. This comes to Rs.3.19. So the full cash price of the bond is
Rs.104 + Rs.3.19 = Rs.107.19. Hence P = 107.19.
t1 : The next coupon is in mid-Oct which is 3 months or 0.25 years away.
So t1 = 0.25
c: c is clearly 12.75.
n: There are 4 more coupons: Oct., x1, Apr., x2, Oct., x2 and Apr., x3. So n = 4.
By trial and error in Eq. (4), we obtain r = 0.1017
Therefore, the YTM (semi-annually compounded) is 10.17%.
Eq. (4) can be used to obtain the price of the bond (P) if the YTM (r) is known. In
this case there is no need for a process of trial and error. The P that is obtained
includes accrued interest. This has to be subtracted to obtain the quoted price. For
example, in the above illustration, if we were given the yield of 10.17, we would
use Eq. (2) to find that P is Rs.107.19. We would then subtract the accrued interest
of Rs.3.19 to get the quoted price of Rs.104.

Yield to Call
There is a difficulty in calculating the yield of bonds which are redeemable (either
at the option of the issuer or of the investor or both) before its full maturity. For

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Security Analysis

example, some time back a well-known financial institution issued 25 year bonds
which can be redeemed at the end of 5 years at the option of either the investor or
the issuer. How do we calculate the yield on such bonds? The usual practice is to
calculate two yields: the yield to maturity assuming that the bond will run its full
course (25 years in the above illustration) and the yield to call assuming that the
bond will be redeemed at the earliest possible date (5 years in the above
illustration). In case of certain complicated issues, it may be necessary to calculate
the yield under several different assumptions.
RISKINESS OF BONDS
Suppose that the investor has calculated the YTMs of all the major bonds available
in the market. Should he then simply pick up the bonds with the highest YTMs? In
equity investment, we know that it is not just a question of choosing the stock with
the highest expected return. We have to look at both risk and return before taking a
decision. But what risks should we worry about when it comes to bonds? Are
bonds not supposed to be risk-free?
The answer is that bonds are less risky than equities, but are not entirely risk-free.
Specifically, two main types of risk are involved:
1. Default Risk: This arises when the company defaults the interest or principal
obligations. In case the company goes bankrupt and is unable to pay all its
debts fully, a part of the money may be completely lost, and even the
remaining part may be paid after a long delay resulting in a loss of present
value. As investors, we must always recognize that, even if no money is

I
ultimately lost, the loss of present value can be very substantial if there is a
long delay.
FA
2. Interest Rate Risk: When calculating the YTM, we assumed that the bond is
simply held till maturity. In practice, matters are not so simple. In some
cases, the bond may be sold before maturity; in some other cases, the
redemption value of the bond may be reinvested in other bonds. It is only in
rare cases that the maturity of the bond exactly matches the investment
horizon of the investor. Even in this case, the annual interest on the bond may
have to be reinvested unless it exactly matches the annual requirements of
funds of the investor. In all these cases, the YTM of the bond does not
represent the true return to the investor over his holding period unless the
interest rates remain unchanged throughout the holding period. The holding
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period return is exposed to interest rate risk.
To manage bond portfolios, therefore, we must assess these two components of
risk and evaluate the YTM in relation to these risks.
DETERMINING THE INTEREST RATES
From time to time we hear that the yield on T-Bills has changed by so many basis
points. The rate on T-Bills is considered to be equivalent to risk free rate, as the
government seldom defaults in its obligations. In relation to this risk-free rate,
interest rates in the whole of the economy get readjusted. Also, in an economy
different sectors play their own role in determining the level of the interest rates
and the subsequent changes in the interest rates.
In this section, we look at two theories: (i) The Loanable Funds theory and (ii) The
Liquidity Preference theory, both of which explain the determination of interest
rates. Let us look at the Loanable Funds Theory.
Loanable Funds Theory
This theory mainly focuses on the demand and supply aspects of the funds in an
economy. In any economy, we will find different sectors like the household sector,
the business sector and the government sector. At any particular instance, one or
more of these sectors have a tendency to save a part of their income for later
consumption. Generally, the household sector leads in this aspect as compared to
business and government sectors. These units postpone current consumption in the
expectation that at a later stage they can have more funds for consumption.
Therefore, on the funds they make available for investments, they demand an

224
 Bond Valuation

interest charge. As we have units who supply funds, there are also units who
require funds. The pattern of consumption of these units is such that, they spend
more than what their current income warrants. These units do not differ from the
ones we have seen above. Only that, at a particular instance of time some units
behave as supplier of funds and other units behave as the demander of the funds.
Since these units demand and employ funds saved by others they have to pay an
interest charge for employing the funds.
If the interest charge is more, the suppliers of funds are willing to make available
more funds and if the interest charge is less, the borrowing units ask for more
funds. That is, the supply of funds is directly related to the changes in interest rates
and demand for funds is inversely related to the changes in interest rates. In this
scenario, an equilibrium interest rate is reached, when the demand for funds
matches the supply of funds.
The spending units issue securities evidencing the fact that they are in debt to the
suppliers of funds. The funds supplied by savers may reach the demanding units
either directly or through intermediaries. This is because, it is not always possible
for the savers and spenders to come into direct contact with each other.
Intermediaries collect funds from the savers and make them available to the
spenders. The importance of this fact is that the nature (risk) of the securities differ
if they are issued by an intermediary rather than the spender himself.

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This theory is also widely used to predict interest rates in different sectors of the
economy.
FA
Liquidity Preference Theory
According to this theory, spenders keep a proportion of their assets as cash
balances for maintaining liquidity. These funds being idle, do not earn any returns.
Therefore, such balances have an opportunity cost to the extent of what can be
earned by employing them productively. The opportunity cost differs from one
spending unit to another.
The opportunity cost increases as the cost of funds i.e. as the interest rate
increases. Also, as the opportunity cost increases, the demand for cash balances
decreases. That is, there is an inverse relationship between the rate of interest and
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the demand for cash balances.
The demand for cash balances across various industrial sectors depends on the
level of activity in those sectors. The level of activity can be gauged broadly from
the overall economic scenario. The long run growth rate of the economy has an
important bearing in deciding the direction of the interest rates. This is because, in
the years of rapid economic growth, the investors have more qualitative
opportunities to choose from and invest. During this period, most of the projects
earn positive rate of return and as a result the suppliers demand higher rate of
return on their investments.
Therefore, the relationship between the demand for funds and the interest rates can
be expressed as
DM = f(Y, i )
where, DM is demand for funds
Y is the gross national product and
i is the market interest rate.
In this function, the relationship between demand for money (DM) and the interest
rate is inverse in nature and positive between DM and the rate of growth of
economy measured by GNP. The inverse relationship with “i” has been indicated
by the minus sign.

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Security Analysis

If M denotes the supply of money balances, at the equilibrium interest rate, the
demand for funds matches the supply.
Therefore, DM =M
that is f(Y, i ) = M.
If we express the same in terms of the interest rate “i” we have
i = f ( M, Y ) Eq. (7)
Simultaneously, the nature of relationships stated above changes.
If the suppliers of funds expect that the price level is going to increase during the
investment horizon, they demand a compensation in terms of higher rate of return.
Unless they increase the required rate of return, they cannot realize the expected
rate of return net of the change in purchasing power of money. Therefore, as the
rate of inflation increases, the interest rates also increase. If we take into account
the inflation rate also the relationship given by (1) above will be
i = f( M, Y, P ) Eq. (8)
In the above relationship, P denotes the rate of change in the price level expected
at the beginning of the period when we committed funds and this change in the
price level will occur during the investment horizon.
From this relation, we conclude that increase in the rate of inflation increases the
interest rates and increase in the money supply decreases them. Also, when the

I
prices do not change i.e. when the rate of inflation remains the same, the nominal
interest rate represents the real interest rate. This can be explained as follows:
FA Nominal rate = Real risk free rate + Inflation rate
When the inflation rate for the investment horizon is zero, “i” in (2) represents real
interest rate and not the nominal interest rate. Therefore, it can be said that the real
interest rate is affected only by changes in the aggregate demand and supply of
money as determined by the central bank and not by the changes in the inflation rate.
The determination of the equilibrium interest rate can also be explained with the
help of a diagram. In the diagram, the demand for the money at various levels of
income and price expectations is represented by line L1 and the supply of the funds
by line L2. It has been assumed that the amount of money supply is held fixed by
the monetary authority. Therefore, the line L2 is vertical.
IC
Figure 2

The equilibrium interest rate is given by the intersection point of the lines L1 and
L2 at the point i. Depending on whether the income or the price expectation
increases or decreases, the line L1 shifts to the right or the left. Suppose, there is an
increase in the inflationary expectations and more money is demanded across the
entire range of interest rates. The line L1 moves to the right and is shown as L3.
The interest rates rise to i1. If the Central Bank increases the money supply, the
interest rates decline. However, this change is expected to be effective only for a
temporary period.
FORECASTING INTEREST RATE TRENDS

226
 Bond Valuation

While forecasting the interest rates, we should take into account the state of the
social, political, economic environment and the expectations of the people
regarding the price changes in the country. Since these are all interrelated,
significant changes in one bring about changes in other spheres also. These
changes have a cumulative effect on the magnitude of the interest rates and move
them upwards or downwards.
It is essential for those who invest in fixed income securities to take a view about
the movement in interest rates for two reasons:
i. The degree of impact of changes in interest rates on securities belonging to
the same class depends on maturity.
ii. For securities of the same maturity, the degree of impact of changes in
interest rates depends on the quality of the security.
Assumption of an Economic Model
To begin with, an analyst should build an economic model. A realistic economic
model can be developed taking into consideration the recent economic trends and
the existing government policies will go a long way in accurately predicting the
interest rates.

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The emphasis should be on determining the present level of economic activity and
the future course it is likely to take. This is because a recession in the economy
FA
generally brings in the regime of falling interest rates and rising bond prices and an
economic boom is generally accompanied by rising interest rates and falling bond
prices. This helps the analyst to formulate a strategy for investing in the fixed
income securities. He can go ahead and invest in bonds, if his prognosis is that the
interest rates are not going to rise over his investment period and choose the time
to sell if the rates are expected to rise.
While forecasting economic cycles, one should actively search for coincident
economic indicators like industrial production and manufacturing and trade sales.
PRICES AND EMPLOYMENT
IC
The prevailing interest rates in the country is a result of the existing economic and
business scenario in the country. It is logical that the after effects of an economy
which, till recently, has been in depression to exist for some time even after the
trend has reversed. The effect of this is a difference in the interest rate cycles and
the business cycles. Therefore, the bond markets which are bearish during the
depression periods continue to do so, after the economy has started recovering.
In this scenario, an analyst should also probe the price behavior of raw materials
and the cost of labor, specially from employment point of view as they affect the
formulation of monetary and fiscal policies. Existence of stable prices and high
unemployment rate will prompt the government to adopt expansionary policies
without worrying much about the inflation rate. This, in turn, results in stable or
falling bond yields.
If the economic scenario is accompanied by low unemployment rates and rising
prices, the opposite of what we have studied above would occur.
Supply and Demand for Credit
After the analyst has prepared an outlook for the economy, his next task is to
prepare a statement of various components which affect demand and supply of
funds. Clearly, the aim of this exercise is to quantify the forces of supply and
demand in the economy and to identify whether the balance of the force lies in the

227
Security Analysis

direction of the low or high interest rates and whether the funds will be
forthcoming for short or long-terms. This helps the analyst to identify the specific
sectors in the economy where the flow of funds has been (i) adequate, (ii) has
experienced a shortage or (iii) experienced a surplus.
Monetary and Fiscal Policy
The monetary policy of a country affects its economy and its international
standing. In the domestic arena the monetary policy is a major determinant of
economic growth, price stability, and employment. In the international arena it has
a direct impact on the Balance of Payments and the value of the currency. The
domestic objectives are achieved by keeping a tight control on the spending and
investment activities of the government and by influencing the cost and
availability of the funds. If the government tightens the monetary policy, the
money supply in the economy decreases and as a result the interest rates increase.
This prompts the savers of funds to increase the supply of funds and a decrease in
the demand.
Also, the Central Bank on behalf of the government controls the money supply in
the economy. It makes changes in the short-term interest rates and these changes
are transmitted to the long-term interest rates in a phased manner. This is done by

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“Open Market Operations” of the Central Bank. If the bank wants to increase the
money supply, it purchases the government securities in the market and if it wants
FA
to decrease the money supply it sells the securities in the market. The Apex Bank
can also bring about the changes in the interest rates by specifying reserve
requirements of the banks.
The government’s policy with respect to spending and taxation is called fiscal
policy. The manner in which the government handles its borrowing objectives has
a bearing on the credit markets and the interest rates. This is due to the fact that in
the presence of budgetary deficits, the government tends to roll over the securities
issued by it. Reducing the deficit does not necessarily bring down the interest
rates. If the deficit is bridged through, say additional taxes, the changes in the
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interest rates depend on who has been taxed and how the people taxed have tried to
maintain their income. For example, increasing the tax on interest income may
result in the interest rates increasing.
At this stage it will be worthwhile to note that the government under certain
conditions formulates the monetary policy in a direction which would contain
inflationary tendencies and simultaneously pursue a fiscal policy which would
stimulate growth and under some other conditions exactly opposite of this. The
result of these two policies, opposing in nature to some extent results in a
moderating effect on inflation and growth. In other words, the rate in growth will
not be to the desired level, if the monetary policy is formulated with a view to
contain inflation and the magnitude of inflation will not be reduced to that extent
which was envisioned, if the fiscal policy was formulated in order to stimulate
growth.
On the whole, monetary and the fiscal policies are influenced by the economic
outlook, the price and employment characteristics and the supply and demand of
the funds in the light of the first two factors. Therefore, the investor should
carefully analyze the probable effects of monetary and fiscal policies on the
interest rates.
TERM STRUCTURE OF INTEREST RATES

228
 Bond Valuation

The difference in yields observed for bonds which are similar in all respects except
in the term to maturity is called as the term structure of interest rates. The
graphical representation of the interest rates of a class of securities, against the
term to maturity is called as the yield curve.
For example, in early 1994, the following YTMs were observed in government
securities:
Table 7
Security Maturity Yield (%)
Treasury Bill 91 days 8.5
Treasury Bill 364 days 10.9
12% GOI 1995 Oct 1995 11.1
12.75% GOI 1996 Apr 1996 11.5
13% GOI 1998 Jun 1998 12.3
13.12% GOI 1999 Sep 1999 12.5
13.25% GOI 2000 Jul 2000 12.8
13.31% GOI 2001 Nov 2001 12.8
13.4% GOI 2002 Jun 2002 12.9
Figure 3

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FA
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The yield curve is usually plotted for the securities issued by the government and
this serves as a benchmark for all other fixed income securities issued by other
organizations in the country. The interest rate levels, their direction and their
pattern can be analyzed by categorizng them as short-term, medium-term and
long-term. Short-term trends last from few weeks to few months, the medium-term
usually coincides with a business cycle and the long-term trends are measured over
several cycles lasting several decades.
Some Common Patterns Observed in Yield Curves:
i. At two different points of time we find that the yield curves do not coincide
for the same class of securities.
ii. Over a business cycle, there is a greater magnitude of variation in the pattern
of the short-term rates as compared to long-term rates.
iii Over a period during which the economy has experienced a complete cycle
i.e. a recession, a boom and again a recession the short-term rates move more
frequently and to a greater extent than the long-term rates.
iv. The long-term prices fluctuate more than short-term prices.
v. The shape of the yield curve during a recession, a boom and a recession
moves from upward to horizontal and to downward sloping.
Causes of the Term Structure of Interest Rates

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Security Analysis

The yield curve may have different shapes. Some of them are shown below:
Figure 4 (i)

(ii)

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FA
(iii)
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(iv)

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 Bond Valuation

The yield curve which we have looked at in fig. 4 (i) is called as Normal or
Upward sloping yield curve, that in fig. 4 (ii) is called as Inverted or Downward
sloping yield curve, that in fig. 4 (iii) is Humped yield curve and the final one is
called as Flat yield curve. Why do different shapes of yield curves exist?
At present, we have two major theories, which try to explain this phenomena.
They are (i) the expectations theory and (ii) the market segmentation theory.
Further there are three forms of the expectations theory. They are
i. The pure expectations hypothesis
ii. The liquidity premium hypothesis and
iii. The market habitat hypothesis
The fact that the pure expectations hypothesis takes into account only the
expectations of the investors without considering other factors has resulted in the
formulation of the other two hypothesis. Later on, they acquired their own body of
knowledge and were referred to as theories. We will study each of them briefly.
THE PURE EXPECTATIONS THEORY
According to this theory, the current term structure of interest rates are determined
by the consensus forecast of future interest rates. To understand this hypothesis let
us consider the following.
Figure 5

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FA r0,1 r1,2
IC
r0,2
At time 0 there is short-term interest rate r0,1 for money borrowed in year 0 and
repayable in year 1. There is also a long-term interest rate r0,2 for money borrowed
in year 0 for repayment in year 2. Linking these two rates is an unobservable
“forward” rate r1,2 that is expected to prevail in year 1 for money to be borrowed
then for repayment in year 2. In terms of this forward rate, one can write the
arbitrage condition as,
(1 + r0,2)2 = (1 + r0,1) (1 + r1,2)
This says that the total money (principal plus interest) repaid in year 2 should be
the same whether the money is borrowed long-term at r0,2 or borrowed short-term
at r0,1 and then “rolled-over” in year 1 at the then prevailing short-term rate r1,2. Of
course, exactly the same condition holds if we look at the matter from the point of
view of the investor: the investor has the choice between investing, his money in a
long-term bond at r0,2 or investing short-term at r0,1 and then “rolling-over” his
investment in year 1 at the then prevailng short-term rate r1,2. The arbitrage
condition says that the investor must be indifferent between these two alternatives.
For example, if the one year interest rate is 15% (r0,1 = 15%) but is expected to go
up to 20% at the end of one year (r1,2 = 20%), then the arbitrage condition says
that,
(1 + r0,2)2 = (1 + 0.15) (1 + 0.20) = 1.38
so that the two-year rate r0,2 will be 17.5%.

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 Security Analysis

On the other hand, if the short-term rate had been expected to go down to 10%,
then we would have had
(1 + r0,2)2 = (1 + 0.15) (1 + 0.10) = 1.265
so that the two-year rate r0,2 would have been 12.5%.
That is, an investor will opt for one year security now only when he is certain that
the interest rate after one year is greater than the interest rate on two year security. In
case he feels that the interest rate on one year security is going to decline after one
year, he will opt for a two-year instrument. An upward sloping yield curve according
to this theory indicates that the investors expect the interest rates to rise, a flat yield
curve indicates that the investors expect the rates to remain at the same level and a
downward sloping curve indicates that the investors expect a fall in the interest rates.
How forward rates are determined given the current spot rates for bonds with a
term-to-maturity longer than one year is explained by the illustration 15 below.
The current spot rate is nothing but the present Yield-to-Maturity (YTM) on a
bond. The expected future one-year spot rate embodied in the current spot rate is
called the forward rate. Assuming that expectations are unbiased the relationship
between current spot rate and forward rate(s) can be expressed as follows:
1 + rn = [(1 + r1) (1 + f2) .... (1 + fn)]1/n Eq. (9)
where rn = current spot rate or YTM on a n-year bond

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fn = expected spot rate prevailing at the end of year ‘t’
t = time period
FA n = forward rate for the nth year.
How to determine f2, f3, etc. given information on the current spot rates? This
question is answered through the following illustrations.
Illustration 15
The spot rate on one-year, two-year, and three-year central government securities
on 1.1.x1 were 8.5%, 9%, and 10.5% respectively. Find the forward rates f2 and f3
embodied in the prevailing term structure?
Forward rate denoted by f2 can be determined from the equation
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1 + r2 = [(1 + r1) (1 + f2)]1/2
(1 + r2 )2
i.e. 1 + f2 =
(1 + r1 )

(1 + r2 )2
or f2 = –1
(1 + r1 )
Given r2 = 0.09 and r1 = 0.085
(1 + 0.09) 2 (1.09) 2
f2 = –1 = –1
(1 + 0.085) (1.085)
= 0.09502 or 9.502%
Forward rate (f3) can be determined from the equation
1 + r3 = [(1 + r1) (1 + f2) (1 + f3)]1/3
(1 + r3 )3
Therefore f3 = –1
(1 + r1 ) (1 + f 2 )

(1.105)3
= –1
(1.085) (1.09502)
= 0.13559 or 13.559%

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 Bond Valuation

Illustration 16
Assume that 4-year bonds are currently yielding 7 percent and 3-year bonds are
yielding 6 percent. What is the implied yield for 1-year bonds starting 3 years from
now?
We are given that r3 = 0.06 and r4 = 0.07. We are required to determine f4
(1 + r3) = [(1 + r1) (1 + f2) (1 + f3)]1/3
(1 + r1) (1 + f2) (1 + f3) = (1 + r3)3 Eq. (10)
4
Similarly, (1 + r1) (1 + f2) (1 + f3) (1 + f4) = (1 + r4) Eq. (11)
Dividing (2) by (1) we get
(1 + r4 ) 4
1+ f4 =
(1 + r3 )3

(1.07) 4
f4 = –1
(1.06)3
= 0.1006 or 10.06%
Two cautions are in order in using the above arbitrage relationship:
• The relationship is postulated ex-ante in the sense that r1,2 is what we in year 0

I
expect the one year rate to be at the end of year 1. The actual one year rate in
year 1 may be more or less than r1,2, but that is what we would expect it to be
on average. The arbitrage condition would, therefore, hold ex-post on an
FAaverage but not in each individual case.
• Even ex-ante, the equation need not hold if either borrowers or lenders
demand a risk premium to cover the “roll-over” risk in year 1. It is usually
believed that the risk premium causes the long-term rate to be slightly higher
than what is prescribed by the arbitrage condition.
THE LIQUIDITY PREMIUM THEORY
The shortcoming of the pure expectations theory is that, it assumes that the
investors will act only on the basis of expected returns on bonds of different
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maturities. It does not take into account the possibility that the actual returns may
deviate from the returns expected. In order to overcome such shortcomings, the
liquidity premium theory has been formulated. According to this theory, the
investors are not indifferent to risk and they charge higher rates than the expected
future rates, if the maturity of the instrument increases. That is, the investors
realize that the prices of bonds with longer maturity are more sensitive to the
interest rate changes and the liquidity premium they charge is actually the risk
premium. The extent of the premium increases as does the maturity but at a
decreasing rate. Since the future rates include the liquidity premium, they are
biased and do not reflect only the expectations of the investors. Therefore, an
upward sloping yield curve reflects the expectations of the investors, that
irrespective of the changes in the future interest rates, the liquidity premium will
increase at a fast pace along with maturity, which would assure the upward slope
of the yield curve.
THE PREFERRED HABITAT THEORY
According to this theory, it is not necessary that the liquidity premium should
increase at a uniform rate with maturity.
Different players in the market have assets and liabilities maturing at different
periods, which in turn, dictate their borrowing and investment needs. However, the
availability of funds in the market and the interest rate depend on the demand and
supply in various maturities. If funds are not available in the maturities desired by

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 Security Analysis

some of the players, they may be forced to move on to other maturities and for this
they demand a premium. Therefore, the premium should be paid to the extent of
price or reinvestment risk which they are subjected to while investing in securities
with other maturities. This theory considers price risk as well as reinvestment risk
as against the price risk considered by the liquidity premium theory.
As this theory takes into account both expectations and the premiums, positive or
negative, the yield curve can be of any shape.
THE SEGMENTATION MARKET THEORY
According to this theory, in the market a group of investors always prefer
instruments maturing within certain periods against instruments maturing in other
periods. This may be due to investors liabilities maturing in certain periods. The
assumption that neither the lenders nor the borrowers are willing to shift from their
preferred maturity period to another differentiates it from the preferred habitat
theory. The investors by not willing to shift out of their preferred maturities, are
not taking the advantage of differences in the expected and future interest rates.
According to this theory, the shape of the yield curve is dependent on the supply
and demand of securities available within each maturity sector.
INTEREST RATE RISK AND DURATION
To understand the significance of interest rate risk, let us look at a series of

I
numerical illustrations. We begin by computing the price of the bond that we shall
be analyzing in the subsequent illustrations.
Illustration 17
FA
Consider a 12.5% bond with annual coupons redeemable on 1/7/2006 at a
premium of 5%. If the interest rate prevailing in the market on 1/7/2001 is 15%
(compounded annually), at what price will this bond be traded in the market on
1/7/2001?
Solution
The market price of the bond will be Rs.94.11 which is the present value of the
following sequence of cash flows:
Date 1/7/02 1/7/03 1/7/04 1/7/05 1/7/06
IC
Cash flow 12.50 12.50 12.50 12.50 117.50
Present Value of cash flows 10.87 9.45 8.22 7.15 58.42
(at 15% compounded annually)
Net Present Value 94.11
We next look at an investor who intends to hold the bond to maturity and compute
the amount of money that he will have at maturity.
Illustration 18
Consider what happens to an investor who needs money only after five years, and
decides to hold the bond of illustration 17 till maturity, and reinvest the annual
interest payments. How much money will he have at the end of 5 years? What
happens if immediately after he buys the bond, the interest rate drops to 14%?
What if the interest rate rises to 16%?
Solution
Interest rate of 15%
At the current interest rate of 15%, he will have Rs.189.28 at the end of the 5
years:
Date 1/7/02 1/7/03 1/7/04 1/7/05 1/7/06 Total
Cash flow 12.50 12.50 12.50 12.50 117.50
Terminal Value (at 15%) 21.86 19.01 16.53 14.38 117.50 189.28

234
 Bond Valuation

Interest rate of 14%

Now assume that immediately after the investor buys the bond, the interest rate in
the market falls to 14% (compounded annually). The terminal value that our
investor will have at the end of 5 years now drops to Rs.187.63 because the
reinvestment of the annual interest fetches a lower rate of interest:
Date 1/7/02 1/7/03 1/7/04 1/7/05 1/7/06 Total
Cash flow 12.50 12.50 12.50 12.50 117.50
Terminal Value (at 14%) 21.11 18.52 16.25 14.25 117.50 187.63
Interest rate of 16%
Similary, one can show that if interest rates rise to 16% (compounded annually),
our investor will be better off having Rs.190.96 at the end of 5 years instead of
Rs.189.28 previously.
Illustration 18 shows that the investor with a holding period of 5 years stands to
gain from a rise in interest rates, and lose from a fall in interest rates; the important
point is that he is exposed to risk due to changes in interest rate.
We now look at an investor who intends to hold the bond for only three years. In
other words, he plans to sell the bond after three years.
Illustration 19

I
Consider an investor who has a holding period of only 3 years. He buys a bond of
illustration 17 on 1/7/2001, reinvests all interest for three years and sells the bond

Solution
FA
on 1/7/2004. How much money will he have at the end of 3 years?

At the end of 3 years (i.e. on 1/7/2004), he will have to sell the bond. What price
can he expect to get? At that point the cash flows from the bond will look like this:
Date 1/7/2005 1/7/2006
Cash flow 12.50 117.50
Present Value on 1/7/2004 (at 15%) 10.87 88.85
Net Present Value 99.72
IC
Therefore, the bond can be expected to fetch Rs.99.72 when it is sold after 3 years.
The 3-year investment can expect to receive a total of Rs.130.625 at the end of 3
years.
Date 1/7/02 1/7/03 1/7/04 Total TV
Cash flow 12.50 12.50 99.72
Present value on 1/7/04 (at 15%) 16.53 14.38 99.72 130.625
What happens to this investor if interest rates rise? Illustration 20 provides the
answer.
Illustration 20
What happens to the 3-year investor when interest rate rises to 16% immediately
after he buys the bond?
Solution
It is reasonable to expect that bond prices drop when interest rates rise and vice
versa. In this illustration, the price of the bond at the end of 3 years would drop to
98.10:
Date 1/7/05 1/7/2006
Cash flow 12.50 117.50
Present Value 10.78 87.32
Net Present Value on 1/7/04 (at 16%) 98.10

235
 Security Analysis

The investor can, now expect to receive a total of only Rs.129.42 at the end of 3
years as against Rs.130.625 previously.
Date 1/7/02 1/7/03 1/7/04 Total TV
Cash flow 12.50 12.50 98.10
Terminal Value (at 16%) 16.82 14.50 98.10 129.42
It will be observed from illustration 20 above that the 3-year investor gains in the
reinvestment of annual interest, but his gain is less than the loss in sale value of the
bond. He, therefore, stands to lose from a rise in interest rates and gain from a fall.
His position is the opposite of the 5-year investor. Both, however, are exposed to
risk from changing interest rates. Is it possible that somewhere between 3 and 5
years there is holding period for which there is no interest rate risk? Let us look at
a 4-year investor.
Illustration 21
Consider an investor who has a holding period of 4 years. He buys the bond of
illustration 17 on 1/7/2001, reinvests all interest for 4 years and sells the bond on
1/7/2005. How much money will he have at the end of 4 years? What happens if
immediately after he buys the bond, the interest rates rise to 16% (compounded
annually)? What if interest rates drop to 14% (compounded annually)?
Solution

I
His sale value on 1/7/05 is simply the present value of Rs.117.50 receivable after
one year at 15%, this is Rs.102.17. His terminal value is:
FA
Date
Cash flow
1/7/02
12.50
1/7/03
12.50
1/7/04
12.50
1/7/05
12.50
1/7/05
102.17
Total

Terminal Value 19.01 16.53 14.38 12.50 102.17 164.59

(at 15%)
Interest rates rise to 16%
The sale value of the bond will drop to Rs.101.29, but he gains from reinvestment
of annual interest. The terminal value of the 4-year investor is left virtually
unchanged as follows:
IC
Date 1/7/02 1/7/03 1/7/04 1/7/05 1/7/05 Total
Cash flow 12.50 12.50 12.50 12.50 101.29
Terminal Value 19.51 16.82 14.50 12.50 101.29 164.62
(at 16%)
Interest rates drop to 14%
The 4-year investor gains from a higher sale price of the bond (Rs.103.07) but his
reinvestment fetch him less. Once again, his terminal value is unchanged.
Date 1/7/02 1/7/03 1/7/04 1/7/05 1/7/05 Total
Cash flow 12.50 12.50 12.50 12.50 103.07
Terminal Value (at 14%) 18.52 16.25 14.25 12.50 103.07 164.58
Illustration 21 shows that the investor with a 4-year holding period is not subject to
any interest rate risk at all. Whether interest rates rise or fall, he can be assured of
the same value at the end of 4 years.
Duration
Generalizing from Illustration 18, Illustration 19, Illustration 20, Illustration 21,
we can conclude:
1. Investors are subject to interest rate risk on two counts – the reinvestment of
annual interest and the capital gain/loss on sale of the bond at the end of the
holding period.

236
 Bond Valuation

2. When interest rates rise, there is a gain on reinvestments and a loss on

liquidation. The converse is true when interest rates fall.
3. For any bond there is a holding period for which these two effects exactly
balance each other. What is lost on reinvestment is exactly compensated by a
capital gain on liquidation and vice versa. For this holding period there are no
interest rate risks.
This holding period for which interest rate risk disappears is known as the duration
of the bond. Fortunately, we do not need to try out various holding periods to
determine the period for which the interest rate risk is eliminated. There is a
simpler way of computing the desired holding period (duration). To do this, we go
back to the present value computation of Illustration 17 on which we determined
that the current price of the bond is Rs.94.11. We will do an additional calculation
– we multiply each of the present values by the respective number of years left
before that present value is received, sum these products up and divide by the
present value to get the duration of the bond. This is illustrated below:
Illustration 22
Compute the duration of the bond of Illustration 17.
Solution
Date 1/7/02 1/7/03 1/7/04 1/7/05 1/7/2006 Total

I
No of Years 1 2 3 4 5
FA
Cash flow 12.50 12.50 12.50 12.50 117.50

Present Value 10.87 9.45 8.22 7.15 58.42 94.11

Year x P V 10.87 18.90 24.66 28.59 292.09 375.11

We divide the sum of the products (Rs.375.11) by the present value (Rs.94.11) to
get the duration.
Duration = 375.13/94.11 = 3.99
The duration as computed in the above illustration agrees with the value of 4 years
IC
for which we found (Illustration 21) that the interest rate risk had disappeared.
This method of computing duration also shows that the duration is the average
time at which the present value is received (it is a weighted average of time with
the present values as the weights).
For the mathematically inclined, the formula for duration (denoted by D) is as
follows:
C1t1 (1 + r) − t1 + C2 t 2 (1 + r) − t 2 + ...... + Cn t n (1 + r) − t n + RVt n (1 + r) − t n
D =
P
Eq.(12)
Duration can also be found out by
IC x PVIFr,1 + 2C x PVIFr,2 + 3C x PVIFr,3 + n(C + F) PVIFr,n
D =
P0
Eq.(13)
Where,

C = Coupon interest payments

r = Promised yield to maturity
n = Number of years to maturity
F = Redemption value

237
 Security Analysis

When interest is payable semi-annually, the above formula is modified as

(IC x PVIFr / 2,1 ) + (2C x PVIFr / 2,2 ) + 2n (C + F) PVIFr / 2,2n
D= Eq.(14)
P0
Duration of a bond measures the weighted average time which elapses before all
the cash flows are received. While the term to maturity of a bond reflects the
length of time required to receive the final cash flows, duration reflects the timing
of every cash flow received. Since the concept was first introduced by F.
Macaulay, duration as defined above is also called Macaulay’s Duration.
For the case of bond with a constant half-yearly coupon, the above formula can be
simplified to:
c r r   r c r
(1 + ) PVIFA  , 2n  + n  +  (1 + ) − t 2n
2 2 2   2 2 2
D = Eq.(15)
c r c r
+  −  (1 + )
2  2 2 2
It is also possible to compute the duration of an entire portfolio of bonds; the
portfolio duration is only a weighted average of the durations of the individual
bonds. Using a computer, it is quite easy to determine the duration of any bond or
portfolio of bonds by employing the above formula.

I
An investor would regard a bond as risky if its duration is significantly different
from his desired holding period. He would, therefore, be willing to invest in such
FA
bonds only if they offer a higher YTM.
Short-Cut Formula for Computation of Duration
The formula given in equation (10) is cumbersome and time consuming to apply,
particularly for bonds with longer term to maturity. We provide two simplified
formulae for computing duration.
1. A simplified formula would be
rc  rc 
D= x PVIFArd,n x (1 + rd ) +  1 −  n Eq.(16)
rd  rd 
IC
Where,
rc = Current yield of the bond computed as coupon interest/bond price
rd = Yield to maturity
n = Term to maturity
In case of bond selling at par,
rc = rd
∴ Duration D = PVIFArd,n x (1 + rd) Eq.(17)
Illustration 23
A bond having Rs.1,000 face value and 8% coupon bond with 4 years to maturity
is priced to provide a yield to maturity of 10%.
Given that the bond has been priced to yield a YTM of 10%, the price P0 can be
computed as,
P0 = 80PVIFA10,4 + 1000 PVIF10,4
= (80 x 3.170) + (1000 x 0.683)
= Rs.937
The current yield rc will therefore be
rc 80
= = 854%
P0 937

238
 Bond Valuation

Substituting the values rd = 0.10, rc = 0.0854 and n = 4 years in equation (16), we get
0.0854   0.0854  
D = PVIFA10,4 x (1 + 0.1) + 1 −   x 4
0.10   0.1  
= 0.854 (3.170) (1.1) + (0.146) x 4 = 3.562 years
2. Equation (9) can also be expressed as follows:

i (1 + r) PVIFA r,n + n(r − i) PVIFr,n

D= Eq.(18)
i + (r − i)PVIFr,n
This simplication was derived by Prof. G Hawawini and provides a simpler
approach to computing duration.
Let us compute duration for the bond illustrated above using the short-cut equation (18).
The features of the bond are as follows:
Coupon interest rate (i) = 8%
Term to maturity (n) = 4 years
YTM (r) = 10%
Substituting the values in the above formula,

I
0.08(1 + 0.1)PVIFA10,4 + 4(0.1 − 0.08)PVIF10,4
D =
0.08 + (0.1 − 0.08)PVIF10,4
FA =
0.08(1.1) (3.170) + 4(0.02) (0.683)
0.08 + (0.02) (0.683)
D = 3.56 years
It should be noted that the short-cut formula can be applied only in case of bonds
redeemable at maturity. Duration of callable bonds, and bonds redeemable in
installments should be computed using equation (13), since in both these cases,
cash flows for each time period do not represent an annuity, but have to be defined
individually.
IC
The concept of duration can also be explained with the simple figure 6 without
resorting to mathematics.5
Figure 6

5 Frank J Fabozzi and Issuing M Pollack ‘The Hand book of Fixed Income Securities; Dow Jones – Iscoin,
PP88-89.

239
 Security Analysis

The blocks in the figure can be looked upon as containers resting on a board or
seesaw. The capacity of the containers represents the cash flow to be received at
each point of time. The shaded area represents the extent to which each is filled in
terms of the present value of the cash flow. If an investor has to evaluate the bond
on the date of acquisition, the first container is one period away, the second two
periods away, etc. Suppose the investor wants to balance the containers by placing
a fulcrum, duration is the distance from the investor to such a fulcrum.
Duration Wandering
In the real world, it does not suffice if we calculate the duration of a portfolio once
and hold that portfolio over the period of the duration. This is because, the
duration of a portfolio does not move in lockstep with the passage of time. Assume
that an investor has a liability maturing after eight years. Therefore, his portfolio
should have a duration of eight years. Now after one year, the remaining planning
period for the investor is seven years. At this stage the duration will not be seven
years. Recall that duration is always less than the time to maturity. Duration
“wanders” due to the passage of time.
It is quite common, that the investors design their portfolios in such a manner that the
returns from the portfolio are available on certain future dates so that they can act as
hedge against liabilities – like paying for a child’s education or paying an installment
on a loan. This makes it obligatory on the part of investors to monitor and adjust the
duration annually or at intervals suitable to them by rebalancing the portfolio.

I
Rebalancing a portfolio means that the investors have to sell a part or the whole of
their portfolio and buy other securities so that the duration of the new constructed
FA
portfolio coincides with the investors investment horizon.
By this method, an investor’s total realized yield will be equal to the yield
expected at the beginning of the investment horizon.
Illustration 24
An investor bought a 13% bond at par (Rs.1,000) that matures in five years.
Calculate the duration for this bond, if the interest rates are expected to remain the
same in the foreseeable future.
Solution
Year Cash PV of Re.1 PV of cash flow PVs of price (6)=(1).(5)
IC
flow at 13%
(1) (2) (3) (4) = (2).(3) (5) = (4) Σ (4)
1 130 0.885 115.05 0.115 0.115
2 130 0.783 101.79 0.102 0.204
3 130 0.693 90.09 0.090 0.270
4 130 0.613 79.69 0.079 0.316
5 1130 0.543 613.59 0.613 3.065
Total 1,000.21 3.970
We find that the duration is 3.97 years.
What will be the duration after one year? This is shown below:
Year Cash PV of Re.1 PV of cash PVs of price (6) =
flow at 13% flow (1).(5)
(1) (2) (3) (4) = (2).(3) (5) = (4)/ Σ (4)
1 130 0.885 115.05 0.115 0.115
2 130 0.783 101.79 0.102 0.204
3 130 0.693 90.09 0.090 0.270
4 1130 0.613 692.69 0.693 2.772
Total 999.62 3.361
We find that the calculated duration has changed to 3.361 years or say 3.36 years.

240
 Bond Valuation

We will find that the passage of time is one year while the change in duration is
3.97 – 3.36 = 0.61 years. This unequal change in the times lapsed and duration call
for rebalancing of portfolios built based on duration.
BOND PRICE VOLATILITY
So far we have looked at duration in two different ways:
1. We began by describing the duration as the holding period for which interest
rate risk disappeared.
2. We then presented a computational formula for the duration which showed
that duration was nothing but a weighted average time at which the present
value is received and is in this sense a (superior) alternative to maturity as a
measure of the term of the bond.
There is a third interpretation of duration which we now discuss.
3. Duration measures the sensitivity of the bond price to changes in interest
rates.
The sensitivity of bond price to changes in interest rates is called Bond Volatility.
We have seen that bond prices and YTM are inversely related. Therefore,
instantaneous changes in market yields cause prices to change in the opposite
direction. The extent of change in bond prices for a change in YTM measures the
interest rate risk of a bond. The interest rate risk is a function of the interest rate

I
elasticity. We shall discuss in this section, the concepts of interest rate elasticity
and interest rate risk.
FA
Interest Rate Elasticity
Interest Rate Elasticity (IEit) can be defined as

IEit Percentage change in price for bond in period t

=
Percentage change in yield to maturity for bond i
∆P0
P0
that is, IEit = Eq.(19)
∆ YTM
YTM
IC
Illustration 25
Consider a bond with the following features:
P0 = Rs.1,000; C = 10% p.a.; r = 10%; n = 10 years
For a change in r to 11%, the price would change to
100 PVIFA11,10 + 1000 PVIF11,10 = 940.9
The interest rate elasticity of the bond is
59.1
−
= 1000 = – 0.591
0.01
0.10
This means that for any percentage change in YTM, the simultaneous change in
price would be about six-tenths as large. In other words, a 10% change in YTM
would cause a 5.91% change in price of the bond in the opposite direction.
Interest rate elasticity is always a negative number, due to the inverse relationship
between YTM and bond prices.
Bond price elasticity can be computed directly as above, or with the help of the
following mathematical relation between duration and elasticity:
YTM
IE = Dit x Eq.(20)
1 + YTM

241
 Security Analysis

The above equation suggests that duration and interest rate elasticity of a bond are
directly related. Anything that causes duration of a bond to increase, will also
increase the bonds interest rate elasticity.
The duration of the bond (using equation (17))
D = PVIFA10,10 x (1 + 0.10)
= 6.145 x 1.1 = 6.76
The interest rate elasticity using Eq.(20) is
0.10
IE = 6.76 x = 0.6145
1.1
The equation (16) provides only an approximate measure of interest rate elasticity.
For very small changes in interest rates, it would provide a value identical to the
one derived using equation (19).
Interest Rate Risk
Interest rate risk, defined as price fluctuation caused by simultaneous change in
YTM, is determined by the interest rate elasticity of a bond. We may rewrite
equation (19) as given below.
 ∆P0   ∆YTM 
  = IEit   Eq.(21)

I
 P0   YTM 
Thus, a bond’s elasticity measures its interest rate risk.
FA
The bond, used as illustration in this section, would have an interest rate risk
0.01
= 0.591 x = 0.0591 or 5.91%
0.10
In other words, a 10% change in YTM would cause prices to fall by 5.91%. If we
use equation (19), the fall in prices would be predicted to be 6.15%. Using
duration itself as a measure of volatility would amount to further approximation of
the price change expected for a change in YTM.
Modified Duration as a Measure of Bond Volatility
IC
The modified duration of a bond is computed using the formula
D
DMod = Eq.(22)
1+ Y/f
Where,
D = Macaulay’s Duration
Y = YTM (in decimal form)
f = Discounting periods per year
The percentage price volatility is measured using DMod as
∆P
x 100 = –DMod . ∆Y
P
That is, Percentage Price Change = Modified duration x Change in yield
The DMod and volatility measures for the bond being used in this section as
illustration, would be
6.76
DMod = = 6.15%
1 + 0.01
∆P0
= 6.15 x 0.01 = 6.15%
P0

242
 Bond Valuation

PRINCIPLES OF BOND VOLATILITY

1. Bond price changes are an increasing function of maturity for any given
difference between coupon rate and YTM.
All other factors remaining constant, the volatility of a bond increases, the longer
the remaining term to maturity. For a 1% decrease in YTM = 9.9%, prices increase
by Rs.1.76 when 2 years remain to maturity, against Rs.14 for 60 years to
maturity. The principle holds good for an increase in YTM also.
An important implication of this property is that, if interest rates are expected to
increase, other things remaining constant, bond prices will decrease by a greater
percentage for long-term bonds, than for short-term bonds. An investor would
avoid long-term bonds under such a circumstance, from a purely capital loss
perspective. Conversely, when interest rates are projected to fall, long-term bonds
would be preferred to short-term bonds. (Note that this holds good from a capital
gain (loss) perspective only and that total return has other components.)
Illustration 26
Consider a 12% bond of Apple Products Company maturing after 5 years and a
12% bond of Banana Chips Company maturing after 10 years, both selling at par.
What would be the change in market price of these bonds if the market yield
change to 14% (assume semi-annual interest)?
Bond n Market Price Price Change
At 12% At 14% At 14%

I
Apple Products 5 1,000 930.96 69.04
Banana Chips 10 1,000 895.92 104.08
FA
The drop in price for the Banana Chips bond which has a longer maturity is larger.
2. The percentage change in the price of the bond (described in (1) above)
increases at a diminishing rate as ‘n’ increases.
Illustration 27
Consider three 10% bonds, A, B and C, the interest on all three bonds being
payable semi-annually. The three bonds will mature after 5, 10 and 15 years
respectively. If the market yield for the bonds of comparable risk changes to 12%,
what will be the marginal percentage change in their price? The three bonds have a
face value of Rs.1,000 and are currently selling at par.
Bond n Market price Percentage Marginal percentage
IC
change change in price
At 10% At 12%
A 5 years 1,000 926.0 7.30 7.30
B 10 years 1,000 885.0 11.47 4.17
C 15 years 1,000 862.0 13.77 2.30
This example shows that the percentage price change is larger, the longer the time
to maturity but the marginal percentage change diminishes as the maturity period
increases.
3. Given the term to maturity, the capital gains resulting from a decrease in
interest rates is always higher than the capital loss resulting from rise in
interest rates. This property is the result of the convex nature of the price-
yield curve.
Illustration 28
Consider the three bonds referred to the previous illustration, calculate their market
prices if the yield is 10%. Compare the capital gains arising from a 2% decline in
yield with the capital losses that will be sustained from a 2% increase in yield.
Market Price
Bond n Capital Gain Capital Loss
At 10% At 12% At 8%
A 5 Years 1,000 926.00 1,081.55 81.55 74.00
B 10 Years 1,000 885.00 1,135.50 135.50 115.00
C 15 Years 1,000 862.00 1,171.60 172.60 137.70

243
 Security Analysis

4. Higher the coupon rate, smaller the percentage change in price resulting from
a given change in yield. This principle is a corollary to the inverse
relationship between duration and coupon rates.
Illustration 29
Consider a 9% NCD of Blue Nose Company and a 14% NCD of White Elephant
Company which are currently yielding 12%. If the yield were to change to 10%,
what would be the percentage change in their prices? (Assume that both NCDs
will mature after 5 years and have a par value of Rs.1,000.)
Market Price Percentage
Bond n Coupon rate At 12% At 10% Change in
price
Blue Nose 5 9% 891.45 962.19 7.94
White 5 14% 1,071.70 1,154.74 7.47
Elephant
IMMUNIZATION
Interest rate risk is a real concern of bond investors. A change in interest rate has
two effects – 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 of interest will be higher. But
the rise in interest rate reduces the bond’s price and hence the investor incurs a

I
capital loss. Thus, a rise in interest rate has a positive reinvestment effect but a
negative price effect (converse is also true). But these opposite effects may not
FA
offset each other for a given bond. The positive effect can outweigh the negative
effect and vice versa. Consequently, the realized yield will be different from the
promised yield.
This indeed is a serious problem for investors like LIC, GIC, and Provident Funds
which have large known liabilities maturing in future and which would like to
ensure that their bond investment have predictable terminal values so that their
liabilities can be exactly met. If interest rate was to change, this purpose cannot be
served by holding a bond whose time to maturity exactly coincides with the
maturity of a known liability.
So, how can investors get around this problem? Investors can protect themselves
IC
from the interest rate risk by resorting the bond immunization. Bond immunization
is the strategy of matching the bond’s duration (and not the term-to-maturity) with
the time horizon of the investor. So assuming that an investor wants his investment
in a bond to yield 6% (YTM) in order to cover a known liability maturing after 10
years, he would be better off choosing a bond with a duration of 10 years rather
than a bond with a term to maturity of 10 years.
When the duration of a bond is set equal to the investment time horizon, any
unexpected change in the market value of the unmatured bond at the end of the
investment horizon (price effect) will be exactly equal in magnitude, but opposite
in direction, to any unexpected change in the reinvestment income (reinvestment
effect). Immunization will provide a compound rate of return over the period
immunized that equals the bond’s YTM, irrespective of changes in market rates.
Thus, the year can be locked in over the investment horizon.
Illustration 30
Suresh wants to realize a target rate of return (yield) of 9% on his bond investment
over 7 years (investment horizon). He has two options: (1) buy a 9% bond
maturing after 10 years which is selling at the par value of Rs.1,000; (2) buy a 9%
bond maturing after 7 years which is also selling at its par value of Rs.1,000. What
will be the terminal value and realized yield under each option if (a) interest rate
declines by 1% after the bond’s purchase (b) there is no change in interest rate, and
(c) interest increases by 1% after the bond’s purchase. Assume that the change in
interest rate occurs before the first interest payment.

244
 Bond Valuation

The duration of the first bond is given by PVIFA9,10 x 1.09 = 6.995 years = 7 years
(approx).
The realized yields under both these options are given in the following tables:
Table 8
Option: Purchase a 9%, 10 years bond with D = 7 years
Purchase Promised Reinvestment Coupon Interest on Price at the Terminal Realized
Price Yield Rate Amount Interest Rs. end of Value Rs. Yield
Rs. Year 7
(a) 1,000 0.09 0.08 630 173.05 1,025.93 1,828.98 0.09
(b) 1,000 0.09 0.09 630 198.04 1,000.00 1,828.04 0.09
(c) 1,000 0.09 0.10 630 223.85 975.12 1,828.97 0.09
Table 9
Option: Purchase a 9%, 7 years bond
Purchase Promised Reinvestment Coupon Interest on Price at the Terminal Realized
Price Yield Rate Amount Interest end of Year 7 Value Yield
Rs. Rs. Rs.
(a) 1,000 0.09 0.08 630 173.05 1,000 1,803.05 0.082
(b) 1,000 0.09 0.09 630 198.04 1,000 1,828.04 0.090

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(c) 1,000 0.09 0.10 630 223.85 1,000 1,853.85 0.092
From these tables, we find that under option (1) the bond is perfectly immunized
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against interest rate risk, whereas under option (2) the realized yield and terminal
value of the bond are susceptible to interest rate change. So Suresh has to choose
option (1).
Illustration 31
Coupon Rate : 13% p.a.
Face Value : Rs.200
Purchase Price : 191.5
Term to Maturity : 5 years
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YTM : 15%
Duration of the bond : (using equation (12))
0.136  0.136 
D = PVIFA15,5 x 1.15 + 1 −  x5
0.15  0.15 
= 0.907 (3.352) (1.15) + (0.093) x 5
= 3.496 + 0.465
= 3.96
We find that realized yield is equal to the promised YTM when the bond is held
for a period equal to its duration, namely 4 years, immunizing the investor from a
fall in interest rates from 15% to 12%.
Though we have so far suggested that bond immunization offers complete
protection against interest rate risk, it has to be noted that perfect immunization of
investment is possible only if the following conditions exist: (a) the investment is
made in a default-free bond or portifolio of bonds; (b) the buy-and-hold strategy is
adopted; (c) there is only a time change in interest rate during the investment
horizon; (d) the term structure is flat; and (e) the duration of bond or portifolio of
bonds is matched with the investment horizon.
These conditions hardly exist in reality. Frequent changes in interest rate is a
normal phenomenon rather than an exception. Term structure is normally upward

245
 Security Analysis

sloping or humped. Only government dated securities are default-free: other bonds
have varying degrees of default risk. So, complete immunization may not be
possible even if the investment horizon is matched with the bond’s duration and
the investor adopts a buy-and-hold strategy.
Convexity
A zero coupon bond has a duration equal to its maturity by definition since 100%
of its present value is received on the maturity date. Hence a 4-year zero coupon
bond has a duration of 4 years. The bond of illustration 17 also had a duration of 4
years. Is there no difference between these bonds as far as interest rate movements
are concerned? The answer is that the duration of the 4-year zero coupon remains
4 years whatever happens to the interest rate. On the other hand, the duration of the
coupon bearing bond does change as interest rates change. For some bonds, the
sensitivity of duration to interest rates is small (for the zero coupon it is zero)
while for others it can be quite large. Convexity measures this sensitivity. The
precise definition of convexity and its use are beyond the scope of this book.
ANALYSIS OF DEEP DISCOUNT BONDS
In November, 1992, the Small Industries Development Bank of India (SIDBI)
came out with an issue of deep discount bonds. Each bond having a face value of
Rs.1,00,000 was issued at a deep discounted price of Rs.2,500 with a maturity
period of 25 years from the date of allotment (i.e. February 1, 1993). The investor

I
as well as SIDBI have the option to withdraw or redeem the bond respectively at
the end of 5th or 9th or 12th or 15th or 20th year from the date of allotment. In the
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event of earlier withdrawal of redemption, the deemed face value of the bond
would be as under:
In the event of withdrawal/redemption Deemed face value Rs.
At the end of 5 years 5,300
At the end of 9 years 9,600
At the end of 12 years 15,300
At the end of 15 years 25,000
At the end of 20 years 50,000
In the offer document, SIDBI stated that it has been advised by its tax consultants
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that as per the present laws, the difference between the sale value (on transfer) or
the deemed face value (on redemption by SIDBI or withdrawal by the bondholder)
and the indexed cost of acquisition of the bond will be treated as capital gain. If the
bond is held for a continuous period of three years or more, then such difference
will be treated as long-term capital gain, and shall subject to income tax at a flat
rate of 20 percent for individuals and HUF, 40 percent for companies, and 30
percent in the case of all others.
Analyzing a bond like the SIDBI deep discount bond, which has a put feature (that
entitles the bondholder to sell the bond back to SIDBI at certain points of time) as
well as a call feature (that entitles SIDBI to redeem the bond at certain points of
time) is somewhat difficult.
The post-tax yield to maturity of such a bond is the value of r in the following
equation:
Cost of acquisition (1 + r)25 = Post-tax redemption value
2,500 (1 + r)25 = 821466
(1 + r)25 = 32.858
r = 15 percent

6 Post-tax redemption value can be calculated as follows:

Redemption value – [Redemption value – Indexed cost of acquisition] Tax rate
= 100000 – [100000 – 2500 (1.06)25] 0.2
= 100000 – 17854

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 Bond Valuation

ANALYSIS OF CONVERTIBLE BONDS

With the repeal of the Capital Issues Control Act and the enactment of SEBI Act in
1992, the rules of the game applicable to convertible bonds have changed. As per
SEBI guidelines issued in June, 1992, the provisions applicable to fully convertible
bonds and partially convertible bonds are as follows:
• The conversion premium and the conversion timing shall be pre-determined
and stated in the prospectus.
• Any conversion, partial or full, will be optional at the hands of the
bondholder, if the conversion takes place at or after 18 months but before
36 months from the date of allotment.
• A conversion period of more than 36 months will not be permitted unless
conversion is made optional with ‘put’ and ‘call’ options.
• Compulsory credit rating will be required if the conversion period for fully
convertible bonds exceeds 18 months.
From the SEBI guidelines it is clear that convertible bonds in India presently can
be of three types:
a. Compulsory convertible bonds which provide for conversion within 18 months.
b. Optionally convertible bonds which provide for conversion within 36 months.

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c. Bonds which provide for conversion after 36 months but which carry ‘call’
and ‘put’ features.
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Valuation of Compulsorily Convertible (Partly or Fully) Bonds
One who holds a compulsorily convertible (partly or fully) bond will receive:
• A certain number of equity shares on part/full conversion.
• A certain stream of interest and principal repayments.
Hence the value of such a bond is equal to the sum of
• The present value of equity shares receivable on conversion.
• The present value of interest and principal payments receivable on the bond.
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To illustrate the valuation of such a bond, let us consider an example.
Illustration 32
Kavya Alloys Limited has announced a rights issue of Partly Convertible
Debentures (PCDs) to part finance its Rs.11 crore vertical integration program. As
per the terms of this issue, 14% PCDs of Rs.100 each will be issued at par. The
convertible part of the debenture (Part A) of Rs.40 each will be converted into two
equity shares of Rs.10 each, 12 months from the date of allotment. The
non-convertible part (Part B) of Rs.60 each will be redeemed after seven years.
Interest will be paid semi-annually.
An equity investor of the company contemplating subscription to this issue seeks
your advice. You are provided with the following data:
Year March 31, March 31, March March
Ended 1998 1999 31, 2000 31, 2001
Panel A EPS (Rs.)Bonus 4 3.1 3.5 4.1
(Ratio) 1:3

Month Jan., Feb., Mar., Apr., May,

2001 2001 2001 2001 2001
Panel B Average 13 12.4 11.6 10.5 9.5
P/E ratio
The investor requires a rate of return of 24% p.a. compounded half-yearly.
The intrinsic value of the above PCD is calculated as under:

247
Security Analysis

A. Present value of interest payments

7 x PVIF(12,1) + 7 x PVIF(12,2)
+ 4.2 x PVIFA (12,12) x PVIF (12,2)
(7 x 0.893) + (7 x 0.797) + (4.2 x 6.194 x 0.797)
= 32.56
B.
Year Ended 1998 1999 2000 2001
Bonus Adjusted 4 4.13 4.67 5.47
Growth rate (g) implict in the bonus adjusted EPS can be obtained from the
equation
4 (1 + g)3 = 5.47
g = 0.11
Projected EPS (4.1 x 1.11) = 4.55
Average P/E ratio between (Jan. – May, 2001)
(13 + 12.4 + 11.6 + 10.5 + 9.5)
= = 11.4
5

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Projected market price after twelve months
= 4.55 x 11.4
FA = Rs.51.87
Present value of the market value of conversion after twelve months
= 103.74 x PVIF (12,2)
= 103.74 x 0.797
= Rs.82.68
C. Present value of the non-convertible portion redeemed after seven years
= 60 x PVIF (12,14)
= 60 x 0.205
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= Rs.12.3
D. Intrinsic value of the PCD =A+B+C
= Rs.127.54
= Rs.128
As intrinsic value is Rs.128, the investor can be advised to subscribe to the issue.
Assumptions
i. All coupon and principal payments are made on schedule.
ii. The non-convertible part of the PCD is held to maturity.
iii. The coupon payments are fully and immediately reinvested at the interest rate
equal to the coupon rate.
iv. The market price on the date of conversion is in line with the investor’s
expectation.
ANALYSIS OF TAX-SHELTERED FIXED INVESTMENT AVENUES
In addition to corporate bonds, a variety of other fixed income investment avenues
are available to investors in India. The tax advantages associated with these fixed
income avenues vary widely. At one end of the spectrum, we have provident fund
(as well as public provident fund) contributions that enjoy initial as well as
continuing tax advantages and at the other end of the spectrum, we have Indira
Vikas Patras, which like the debenture issues of private sector companies, offer no
tax advantage.

248
 Bond Valuation

The post-tax rate of return may be calculated as follows:

Step 1 Find the net investment made of every hundred rupees of gross
investment made. The net investment is simply100 – Tax saving on an
investment of 100.
Step 2 Calculate the post-tax amount that would be receivable by the investor
at the time of maturity of withdrawal after n years on every hundred
rupees of gross investment. This is equal to:
n
1 + Interest  1 − Tax rate applicable 
100 
 rate  
 on withdrawal 

Step 3 Compute the post-tax rate of return. This is equal to the value of r in the
following equation:
Net investment (1 + r)n = Post-tax amount receivable
at the time of maturity or
withdrawal. Eq.(23)
SUMMARY
• Coupon rate is the annual rate at which the interest is paid periodically at a
prespecified rate.
Basis point: It is simply one hundredth of one percent.

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•
• On the dimension of security the bonds are classified into secured and

•
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unsecured bonds.
Based on the dimension of transferability, debentures are classified into
registered and unregistered bonds. The unregistered or bearer debentures can
be transferred by simple endorsement whereas registered debentures can be
transferred only by executing a transfer deed.
• Based on the conversion feature, bonds are classified into convertible or non-
convertible bonds. Convertible bonds entitle the holder to acquire the equity
shares of the company at the agreed conversion rate.
• The process of financial engineering involves creating new instruments to
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suit the ever changing needs of the issuers and investors. Some of the
innovations are: Zero Interest Fully Convertible Debentures, Detachable
Equity Coupons/ Warrants, Secured Premium Notes, Triple Option
Convertible Debentures, Auction Rated Debentures, Third Party Convertible
Debentures, Floating Rate Bonds.
• Current Yield: It is measured by comparing the coupon interest with the
prevailing market price.
• Yield to Maturity: It is the discount rate that equates the present value of the
cash flows to its market value.
• Realized Yield: It is yield actually earned by the investor on the investment
and it depends on the reinvestment rate and the holding period chosen by the
investor.
The properties of the realized yield are
RI = RY = YTM
RI > RY > YTM
RI < RY < YTM
• The Bond Price Theorems state that
a. The market price of the bond will be equal to the par value of the bond
if the YTM equals its coupon rate.

249
Security Analysis

b. If YTM increases above the coupon rate, the market value drops below
the face value.
c. Inversely to the above principle, if the YTM of the bond falls to below
the coupon rate, the market value will be more than the face value of the
bond.
d. A bond’s price moves inversely to its yield to maturity.
e. For a given difference between YTM and coupon rate of the bonds, the
longer the term to maturity, the greater will be the change in price with
change in YTM.
f. The percentage price change described above increases at a diminishing
rate as the bond’s maturity time increases.
g. Given the maturity, the change in bond price will be greater with a
decrease in the bond’s YTM than the change in bond price with an
equal increase in the bond’s YTM.
h. The two theories which explain the determination of interest rates are
(i) Loanable Funds theory and (ii) the Liquidity Preference theory.
i. The holding period for which the interest rate risk disappears is known
as duration. It is a superior alternative to maturity as a measure of the
term of the bond. It also measures the sensitivity of the bond price to

I
changes in interest rates. Modified duration of a bond is used to measure the
volatility of bonds when the changes in YTM are known.
FA
j. The concept of duration of equity is still unfamiliar and the significance
is still under study. However there are three models developed to
measure the duration of equity:
i. Using Dividend Discount Model;
ii. Using Dividend Yield;
iii. Using Analytical Model: This model takes into account the real
rate of interest and the expected changes in the inflation and the impact
of such changes in the inflation rate on the growth rate of the dividends.
k. The value of a compulsorily convertible (partly or fully) bonds is equal
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to the sum of the present value of equity shares receivable on
conversion and the present value of interest and principal payments
receivable on the bond.
• Investors are mostly concerned about the right points for buying and selling
their securities. While fundamental analysis helps in selecting a security.
Technical analysis helps in deciding the right prints for buying & selling. The
next chapter focuses on the ‘Technical Analysis’.

250
Chapter X

Efficient Market Hypothesis

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•
FA
After reading this chapter, you will be conversant with:

Concept of Efficiency of the Stock Markets

• Forms of EMH
• Empirical Tests of EMH in the Indian Market
• Description of Tests of EMH
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Security Analysis

Introduction
Two commonly used approaches for decision-making on investments are
fundamental analysis and technical analysis. In fundamental analysis, the
investor’s decisions are based on the intrinsic value of a security which helps in
identifying the mispriced securities. In technical analysis, the decisions are based
on the price and volume of the stock as they are perceived to reflect the value of
the stock. Besides these two approaches, there are some qualitative factors which
also have a role in decision-making.
Investors are likely to make systematic errors which would push the stock prices
away from that determined by fundamental analysis. The psychological aspect of
the stock price movements forms a separate field of study termed “Behavioral
Finance”. The unexpected shocks in the stock markets can be explained by
behavioral finance, which has gained an upper hand over the traditional Efficient
Market Hypothesis (EMH). The theory that irrational behavior by some of the
investors leads to a distortion in the prices of securities, is seen to be gaining
increased importance over the EMH in the recent past. As research is still going on
in this field, EMH, however, still retains its hold in explaining stock movements.
Box 1: Behavioral Finance – An Introduction
Over the past decade, a different view of financial markets, broadly known as

I
“behavioral finance”, has emerged. Proponents say that investors can make
systematic errors in forecasting cash flows or in setting the discount rate, and
FA
these errors can push stock prices away from fundamental value for extended
periods of time.
The stratospheric rise in the value of the US equities and of the technology sector
in particular during the late 1990s has shaken many observers’ belief in efficient
markets, and drawn many to the behavioral finance view.
This raises the possibility that behavioral finance will replace the efficient
markets hypothesis as a dominant model, a prospect that strikes fear into the
hearts of financial economists who have built careers on the efficient markets
hypothesis.
Researchers in behavioral finance spend a good deal of time studying work by
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psychologists trying to understand the biases that affect decision-making.
Source: “Speculative Bubble, Irrationality and Chaos”, by Niamh Brodie,
Merrion-capital.com.

CONCEPT OF EFFICIENCY OF STOCK MARKETS

Market efficiency signifies how ‘quickly and accurately’ does relevant information
have its effect on the asset prices. Depending upon the degree of efficiency of a
market or a sector thereof, the return earned by an investor will vary from the
normal return (return appropriate to risk level).
Efficient Market Hypothesis (EMH)
According to EMH, successive absolute short run price changes are independent.
The hypothesis is based on the assumption that the market comprises rational
investors. The term ‘rational’ means that investors will select assets based on their
risk-return profile. If the behavior of the market participants, as revealed by
various empirical studies, towards various kinds of value relevant information is
compared with this term, we will see that the very assumption of EMH comes
under cloud. It must be noted that the empirical results existed well before
attempts were made to formulate a theory for explaining those results; therefore,
issues like competitive market, quicker adjustment to information, informed
market participants, easy access to markets, are not a part of EMH, but rather
explanations of empirical results.

252
 Efficient Market Hypothesis

Now, there is a need to explore how useful or redundant are the two approaches to
investing – fundamental and technical analysis.
The very phenomenon of market equilibrium brings to the fore the point that
mispricing is the basic feature of any market. Only the duration, speed and
frequency with which this mispricing disappears as a result of the action of various
market participants is something worth examining. Technical analysis, as an
approach, has been fairly useful in detecting trends and reversals of market
movement. A majority of the mutual funds which entered when the market was
ascending great heights are performing poorly even after several years, thus,
emphasizing the importance of time as a factor. The mere fact that technical
analysis will not fetch abnormal returns consistently does not render it redundant.
Technical analysis only gives an idea about the likely range of price movements
and reversals, and there is no serious attempt on its part to predict the future price.
Moreover, technical analysis is commonly used as a supplement to fundamental
analysis. Tests conducted to test trading strategies based on technical analysis do
not support its exclusive use. It is argued that the strategies are tested separately,
instead of testing them together and then arriving at a weighted result.
In fundamental analysis, EMH is entirely in agreement with upward or downward
change in trends since only the short run price changes are random and not the

I
price trends themselves. While discussing semi-strong form of EMH, we will see
that the market does not always react to value relevant information in an ‘accurate’
FA
manner. It is this inaccurate price adjustment, which increases the possibility of
developing trading strategies which might work and so the desirability of
fundamental analysis. The semi-strong form of Random Walk opines that analysts
who employ fundamental analysis should possess superior insight into companies’
future prospects using their own data rather than using merely publicly available
information and even inside information for consistently earning abnormal returns.
This is indeed a tougher proposition to achieve, but even on a simple plane,
analysts who employ fundamental analysis have their worth proved as far as
identifying securities in the risk-return framework is concerned. Even for a buy
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and hold strategy, one needs to pick securities which are at least priced equal to (if
not less than) their intrinsic value. According to Warren Buffett – What is
investing, if not the act of seeking value at least sufficient to justifying the amount
paid?

Box 2: The Efficient Market Hypothesis

Market efficiency infers that market prices reflect all publicly available
information. This includes information about confidence amongst investors and
consumers, as well as information regarding the likelihood of future events.
Prices react immediately and correctly to new information. Furthermore, changes
in share prices will be completely random unless new information is received and
assimilated. Speculative bubbles involve persistent deviations from a share’s
‘correct’ value and cannot be deemed random. Are efficient markets consistent
with Wall Street crashes? EMH implies that share prices should not increase on
the whims of the crowd. To examine how delusion in the stock market can occur,
we must thus assume that EMH does not always hold, and examine the basis
upon which investors value shares, the efficiency of their actions, and the role of
expectations.
Source: “Speculative Bubble, Irrationality and Chaos”, by Niamh Brodie,
Merrion-capital.com.

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Security Analysis

FORMS OF EMH
Depending upon the level of information considered, there are three forms of
EMH. They are:
a. Weak Form: Also known as random walk model, it says that current prices
fully reflect all historical information, hence, any attempt to predict prices
based on historical price or information is totally futile as future price
changes are independent of past price changes.
It is not surprising to note that the weak form holds good in any market, since
even the critics of EMH will admit that prices adjust to information albeit
with a lag.
b. Semi-strong Form: According to this form, current stock prices reflect all
publicly available information such as earnings, stock and cash dividends,
splits, mergers and takeovers, interest rate changes, etc. It also says that
prices adjust to such information ‘quickly and accurately’ so abnormal/superior
profits on a consistent basis cannot be earned.
c. Strong Form: According to the strong form, prices of securities fully reflect
all available information – both public and private. That is, if this form is
true, prices reflect the information that is available to only selected groups –
like the management, financiers and stock exchange officials. There are two
versions of the strong form – the near-strong form and the super-strong form.
As per the near-strong form, conclusions and opinions drawn by analysts

I
based on publicly available information are also reflected in the prices. The
super-strong form is more extreme and states that confidential information
FA available only to selected groups of people mentioned is also of no use in
obtaining abnormal returns, as the prices contain adjustment for that
information as well. As can be expected, the super-strong form has been
rejected by many while the near-strong form found some support.

EMPIRICAL TESTS OF EMH IN INDIAN MARKET

Market efficiency as a phenomenon certainly plays a great role in bringing
equilibrium in any market. With a variety of market participants at work and their
actions influenced by their respective opinion about prices or returns, the market
should at all times be in a state of dynamic equilibrium. In a nutshell, EMH states
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that successive absolute price changes are independent in the short run and subject
to the assumption that the market comprises rational investors. However, investors
are not always rational in that they consider factors other than risk and return for
selecting securities. It is extremely difficult, if not impossible, to segregate the
fractional influences of these factors. In the Indian stock market, sentiments play a
major role in price behavior at the counters.
Box 3: The Behavior of Investors and Security Analysts
Irrationality affects trading, expectations and prices in capital markets. Several
recent surveys summarize evidences about psychology of the individuals and its
relevance for financial and other economists. There are other possible reasons for
systematic decision errors. Most familiar psychological biases can be viewed as
outgrowths of heuristic simplification, self-deception, and emotion-based
judgments. Heuristic simplification helps explain many different documented
biases, such as salience and availability effects, framing effects, money illusion,
and mental accounting.
Investors
Investors Often do not Participate in Asset and Security Categories: Investors
invest only in stocks that are in limelight. Non-participation may also be related
to the extent of familiarity or “mere exposure” effects, for example, a perception
that what is familiar is more attractive and less risky. Even now, many investors
entirely neglect major asset classes (such as commodities, stocks, bonds, real
estate), and omit many individual securities within each class. Investors are
strongly biased toward home country stocks.

254
 Efficient Market Hypothesis

Individual Investors Exhibit Loss-averse Behavior: Owing to limited attention

and mental processing power, individuals engage in mental accounting, which
can lead them to confuse the unpleasantness of experiencing an economic loss
with the unpleasantness of realizing the loss. This is related to the notion of loss-
aversion in which individuals are concerned about gains and losses as measured
relative to an arbitrary reference point. Investors are more prone to realizing gains
than losses. Specifically, the individual investors trading through a large discount
brokerage firm tend to be more likely to sell their winners than their losers.
Investors use Past Performance as an Indicator of Future Performance in Mutual
Fund and Stock Purchase Decisions: Representativeness (a tendency to judge
likelihoods based upon naive comparison of characteristics of the event being
predicted with characteristics of the observed sample) suggests that investors will
sometimes extrapolate past price trends naively. Evidence suggests that investors
are naively extrapolating past mutual fund success, when empirical evidence
suggests that there is little or no persistence in performance. The fact that the
flows are concentrated among the top performing mutual funds in each category
is potentially consistent with limited attention/salience effects.
Investors Trade too Aggressively: It has been argued that the volume of trade in
speculative markets is too large, and overconfidence of traders has been advanced
as an explanation. Whether volume is too large or not is hard to establish without
a benchmark rational level of volume. Rational dynamic hedging strategies, in
principle, can generate enormous volume with moderate amounts of news.

I
Stronger support for overconfidence is provided by an evidence suggesting that
more active investors earn lower returns as a result of incurring higher transaction
FA
costs.
Investors do not always form Efficient Portfolios: More generally, there is an
evidence that investors sometimes fail to form efficient portfolios. Several
experimental studies examined portfolio allocation when there are two risky
assets and a risk-free asset and returns are distributed normally. People often
invest in inefficient portfolios that violate two-fund separation.
Certain Classes of Investors and their Agents Change their Behaviors in Parallel.
This phenomenon, called herding, is consistent with rational responses to new
information, agency problems or conformity bias. Herding behavior has been
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documented in the trading decisions of institutional investors in recommendation
decisions of stock analysts. Investors may form theories of how the market works
based upon irrelevant historical values and make decisions based upon mental
accounting with respect to arbitrary reference points.
Security Analysts
Analyst forecasts and recommendations are biased. Analyst forecasts and
recommendations have investment value. Nevertheless, there is a strong evidence
that analysts are biased in their forecasts and recommendations. It is likely that
agency problems, analyst misconceptions and investor gullibility play a role in
generating biases. Forecasts are generally optimistic especially at 12-month and
longer time horizons, both in the US and other countries.
Analyst Forecast Errors are Predictable Based upon Past Accruals, Past
Forecast Revisions and other Accounting Value Indicators: The presence of
systematic bias suggests inefficient forecasts and predictable forecast errors. Past
accounting accruals, the adjustments firms make for cash flows to obtain reported
earnings, predict forecast errors for new issue firms and more generally in firms
where earnings have been managed upward by taking high accruals. Analysts’
overoptimism about new issue firms, therefore, contributes to the new issue
anomaly. These findings suggest that investors are excessively credulous about
the motives of management, perhaps because of limited attention. It is not clear in
general whether analysts underreact or overreact to information.
Source: ICFAI Research Center.

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Security Analysis

Tests of Weak Form

The weak form enjoys a fair degree of chance to hold good even in a developing
market like India. The reason is the behavior of the market participants which is
driven by their sentiments rather than historical prices and returns.
Serial Correlation and Runs Test: Both the tests done by Obaidullah (1990)
taking weekly returns for the period 1985-88 do not contradict the weak form of
EMH. The correlation coefficients are not significantly different from zero.
Similarly, the actual number of runs too are not significantly different from runs
generated out of random numbers.
In another study, Chaudhary (1991) found the first order serial correlation
coefficients for 70 (out of 93) shares to be significantly different from 0 at 1%
level. However, the values of the correlation coefficients were very low. This indicates
that only 30% of the price changes are explained by previous day price changes.
Table 1: Serial Correlation Coefficients
Company Code (k) 1 2 3 4 5 6
1 0.040 –0.133 –0.163 0.066 0.007 –0.499
2 –0.038 0.013 0.042 –0.080 –0.479 0.016
3 0.133 –0.047 –0.304 –0.059 –0.049 0.011
4 0.091 –0.046 0.095 –0.062 0.132 –0.185
5 –0.100 –0.054 –0.057 –0.086 –0.035 0.356
6 –0.001 0.041 0.027 0.067 –0.066 –0.196

I
7 –0.030 0.065 –0.011 –0.102 0.064 0.019
8 –0.016 –0.074 0.053 0.269 0.035 –0.021
9
10
FA –0.022
–0.028
–0.095
0.101
–0.021
–0.112
0.004
–0.064
–0.006
0.067
0.015
0.007

Company Code (k) 7 8 9 10 11 12

1 –0.247 –0.134 –0.127 –0.151 0.127 –0.025
2 –0.130 –0.078 0.020 0.023 –0.028 0.014
3 0.194 –0.085 0.003 –0.077 –0.060 0.004
4 –0.100 0.043 –0.003 0.029 –0.178 0.045
5 –0.003 0.007 0.045 –0.103 –0.136 –0.003
6 0.024 0.201 –0.009 0.050 0.038 0.115
7 –0.029 0.035 –0.092 0.018 0.062 0.071
IC
8 0.102 –0.012 0.127 –0.046 0.066 0.081
9 0.058 –0.065 0.008 0.012 0.037 –0.083
10 –0.200 0.003 –0.033 –0.039 –0.104 0.057
Table 2: Runs Tests Results
Company Code Actual No. of Runs Expected No. of Runs Standardized Variable
1 111 104.41 1.038
2 110 113.51 –0.556
3 114 110.20 0.589
4 114 119.63 –0.888
5 118 107.79 –1.564
6 101 107.81 –1.051
7 129 121.21 1.222
8 120 110.64 1.493
9 113 107.92 0.793
10 113 112.41 0.094
11 96 107.58 –1.822
12 96 106.97 –1.711
Filter Tests: Unlike the serial correlation tests which assume linearity of relation
between prices (which may be an oversimplified assumption), here the strategy of
using filter rules for trading has been put to test. This has been done by comparing
the returns from different filter rules with that from a buy and hold strategy. The
test by Rao (1988) shows that the returns under buy and hold strategy are higher
than that under filter strategy without considering the transaction costs.

256
 Efficient Market Hypothesis

Table 3: Rates of Return Under Filter Techniques and Buy-and-Hold Strategy

Company 0.03 Rf Filter Rb 0.05 Rf Filter Rb 0.10 Rf Filter Rb
L&T –0.1415 0.3876 0.1050 0.3150 0.0021 0.2565
Bajaj Auto –0.0087 0.8450 0.0339 0.7708 0.0223 0.6235
HM –0.1050 0.1589 –0.6070 0.1634 –0.0800 0.0980
Spic –0.3150 0.5845 –0.1085 0.5044 –0.0046 0.5672
Colgate –0.0375 0.7640 –0.0053 0.7973 –0.0160 0.5725
Nocil –0.2150 0.4850 –0.2150 0.5350 –0.0117 0.4130
Grasim –0.9020 0.2700 –0.7500 0.2000 –0.0265 0.1895
Telco –0.1200 0.0079 –0.1375 0.0070 –0.0345 0.0080
Reliance –0.1203 0.0641 –0.0547 0.1068 –0.0659 0.1450
FSL –0.0620 0.6400 –0.1115 0.2750 –0.0440 0.3909
Notes: Rf – denotes the average annual rates of return under Filter Technique.
Rb – denotes the average annual rates of return under Buy-and-Hold
Strategy.
Thus, the significant support for ‘weak form’ is a direct rejection of past prices to
predict future prices. Technical analysis, if used as an independent trading tool, is
exposed to harsh criticism as a result of the above. However, this does not mean
that technical analysis can be ignored, considering its usefulness in conjunction
with fundamental analysis. Moreover, looking at the performance of the mutual

I
funds, it is more than evident that timing is an important factor that cannot be
overlooked.
FA
Tests for Semi-strong Form
These tests examine how ‘quickly and accurately’ the stock returns get revised
upwards or downwards as a result of release of information like earnings, stock
and cash dividends, splits, additional issues, mergers and takeovers, interest rate
changes, etc. While testing the semi-strong form, only changes in the residual
return in the equation Rit = ai + bi (Rmt) + eit that is, changes in eit are considered.
That is, by ignoring the changes in the other components of the return, the impact
of market movement on the returns is got rid of.
This return is computed in the form of Cumulative Average Abnormal Return
IC
(CAAR) for periods both before and after the zero date. The zero date is the date
on which price-sensitive information has been released.
Earnings Impact: In a study by Obaidullah (1991), the CAAR (computed over
1986-90) for both positive and negative unexpected earnings was found to move
up and down respectively in equal measure with no significant post release drift,
thus, indicating quick adjustment of returns to earnings information.
Figure 1: Behavior of CAAR (Impact of Earnings)

257
Security Analysis

Table 4: Returns/Earnings Correlation Coefficients

Window Residual Analysis Raw
–12, +6 0.179 (0.256) 0.168
–12, 0 0.163 0.226 (0.378)
–6, +6 0.152 0.093
–6, +3 0.156 0.143
–1, +1 0.049 0.066
Bonus Impact: Even though a bonus issue never brings any additional value to
investors, it does influence the expectations regarding future. As a result, the
adjustment which starts well before such announcement is less than accurate as
against the ideal ‘one to one’ adjustment with the bonus ratio. As before, the
CAAR after zero date does not drift significantly indicating fairly quick price
adjustment. However, there has been a significant upward drift before the zero
date, which means the market has anticipated the event. This is considered to be an
indication of the efficiency of the market.
Figure 2: Impact of Bonus Issue (All R)

I
FA
Table 5: Impact of Bonus Issues
Period all R R = 1:1 1:1 > R > 1:2 R = 1:2 R < 1:2
–12 –0.005 0.000 0.008 –0.038 0.022
IC
–11 0.008 0.029 –0.020 –0.007 0.004
–10 0.013 0.038 0.012 –0.012 –0.018
–9 0.018 0.042 0.015 –0.008 –0.004
–8 0.010 0.031 0.062 –0.056 –0.001
–7 0.048 0.045 0.055 0.098 –0.028
–6 0.076 0.082 0.066 0.144 –0.032
–5 0.098 0.117 0.083 0.158 –0.030
–4 0.106 0.131 0.053 0.188 –0.031
–3 0.122 0.155 0.062 0.194 –0.016
–2 0.147 0.193 0.055 0.215 0.011
–1 0.183 0.230 0.134 0.237 0.021
0 0.197 0.258 0.106 0.240 0.052
1 0.203 0.268 0.131 0.247 0.028
2 0.199 0.266 0.125 0.252 0.011
3 0.203 0.262 0.098 0.277 0.036
4 0.182 0.239 0.074 0.265 0.010
5 0.174 0.233 0.064 0.228 0.040
6 0.169 0.220 0.074 0.230 0.029
7 0.164 0.220 0.073 0.211 0.034
8 0.168 0.228 0.059 0.195 0.069
9 0.191 0.262 0.102 0.209 0.062
10 0.182 0.248 0.114 0.196 0.046
11 0.184 0.240 0.099 0.222 0.060
12 0.168 0.226 0.074 0.190 0.069

258
 Efficient Market Hypothesis

Tests of Strong Form

The studies done by Barua and Verma (1991) and Obaidullah and Ganeshan
(1991) show that mutual funds do provide abnormal returns thus contradicting the
near strong form EMH. As far as the super strong form is concerned, it does not
hold good even in developed markets.

DESCRIPTION OF TESTS OF EMH

Tests of Weak Form EMH
According to the weak form of EMH, investors cannot reap abnormal profits by
observing the historical data of stock prices as they follow a random path. That is,
the stock price on a particular day is not related to the stock price on any other day.
To prove the independent nature of share prices, analysts generally conduct the
tests described below.
AUTO-CORRELATION TEST
In this test, certain number of stocks are selected. For a particular period, the
changes in the prices of these stocks are observed. Then in another period, for the
same stocks the changes in the stock prices are noted. For these changes,
correlational analysis is conducted. If the correlation between these changes is near
or equal to zero, it implies that the price changes are independent of each other. First,
we calculate the coefficient of determination, ‘r square’ by the formula given below:

I
2
a ∑ Y + b ∑ XY − n.Y
r2 =
FA ∑ Y 2 − nY
2

∑ XY − n X Y
where ‘b’ is given by 2
and ‘a’ by Y − b X .
∑ X 2 − nX
If we compute the square root of ‘r’, we get the magnitude of correlation between
the price changes in two different periods. For the price changes to be independent,
the value of ‘r’ should be close to zero or statistically insignificant.
Illustration 1
The data given below relates to stock prices of Xylon Tech Ltd. during July 20x0,
IC
and July 20x2. Check whether these stock prices are independent or not.
Days on which trading Stock price Days on which trading took Stock price
took place in July, 20x0 place in July, 20x2
3 650.00 1 2507.00
4 665.00 2 2461.50
5 665.00 3 2363.75
6 685.00 4 2303.25
7 685.00 5 2080.25
10 705.00 8 1960.25
11 708.50 9 2151.00
12 707.00 10 2080.25
13 709.50 11 2252.25
14 707.00 12 2282.75
17 706.50 15 2055.00
18 718.25 16 2031.50
19 715.00 17 2229.00
20 710.00 18 2124.00
21 705.00 19 2063.50
24 698.00 22 1995.00
25 691.00 23 2110.75
26 705.00 24 2278.00
27 706.25 25 2281.00
28 709.00 26 2210.00
30 715.00 29 2292.00

259
Security Analysis

Price Changes Price Changes

X Y X2 Y2 XY
15.00 –45.50 225.0000 2070.2500 –682.500
0.00 –97.75 0.0000 9555.0625 0.000
20.00 –60.50 400.0000 3660.2500 –1210.000
0.00 –223.00 0.0000 49729.0000 0.000
20.00 –120.00 400.0000 14400.0000 –2400.000
3.50 190.75 12.2500 36385.5625 667.625
–1.50 –70.75 2.2500 5005.5625 106.125
2.50 172.00 6.2500 29584.0000 430.000
–2.50 30.50 6.2500 930.2500 –76.250
–0.50 –227.75 0.2500 51870.062500 113.875
11.75 –23.50 138.0625 552.2500 –276.125
–3.25 197.50 10.5625 39006.2500 –641.875
–5.00 –105.00 25.0000 11025.0000 525.000
–5.00 –60.50 25.0000 3660.2500 302.500
–7.00 –68.50 49.0000 4692.2500 479.500
–7.00 115.75 49.0000 13398.0625 –810.250
14.00 167.25 196.0000 27972.5625 2341.500

I
1.25 3.00 1.5625 9.0000 3.750
2.75 –71.00 7.5625 5041.0000 –195.250
6.00
Total
FA 82.00 36.0000
1590.0000
6724.0000
315270.6250
492.000
–830.375
∑X = 65 ∑ Y = –215
X = 3.25 Y = –10.75
2 2
X = 10.5625 Y = 115.5625

∑ XY − n X Y −830.375 − 20(3.25)(−10.75) −131.625

b = 2
= = = –0.095
2
∑ X − nX 1590 − 20(10.5625) 1378.75

a = Y − b X = –10.75 – (–0.095) (3.25) = –10.75 + 0.309 = –10.44

IC

2
a ∑ Y + b ∑ XY − n.Y
r2 =
∑ Y 2 − nV −2
( −10.44)( −215) + ( −0.095)( −830.375) − (20)(115.5625) 12.24
= =
315270.625 − (20)(115.5625) 312959.375

= 3.9 x 10 -5

r = 3.9 x 10 −5 = 0.0063

We observe that the correlation between the prices in two different periods is very
small and insignificant. Therefore, we conclude that prices moved in a random
fashion.
RUNS TEST
By this test, we test a sample for randomness of order. A run is defined as “a
sequence of identical occurrences preceded and followed by different occurrences
or by none at all.” For testing the randomness of share prices, we take a series of
stock prices. Starting with the first price, each price change is denoted by a plus
(+) or a minus (–) sign. Plus (+) sign indicates that the price under consideration
has increased compared to its preceding price and a minus (–) sign indicates that
the price under consideration has decreased compared to the preceding price. In
case the price under consideration is same as its preceding price, we indicate it by

260
 Efficient Market Hypothesis

a zero. In case the sign has changed from a plus to minus or from a minus to plus,
a new run is counted to have begun. To test the independence of the prices, we
require:
Total number of runs :r
Number of positive price changes : n1
Number of negative price changes : n2
Once we have this data, the mean and the standard deviation of the mean, are
calculated by using the formulae given below.
2.n1.n 2
µr = +1
n1 + n 2

2.n1.n 2 (2n1n 2 − n1 − n 2 )
and σr =
(n1 + n 2 ) 2 (n1 + n 2 − 1)
At a given level of significance, we calculate the upper and lower limits and check
whether the number of runs observed from the test falls within the limits or not. If
it is between the limits, we conclude that the prices are random or independent of
each other, otherwise not.
Illustration 2

I
Given below are the share prices of Laser Ltd. for the months of April, May, June
and July. For this data, conduct runs test and determine whether or not the prices
FA
are independent at 5%, 10% and 20% levels of significance.
Days on which Stock Price (X)
trading was done
20x2
April 1 881.50
2 856.50
3 859.75
4 918.50
IC
5 1010.25
8 1072.25
9 1074.50
10 1123.50
11 1203.50
12 1256.25
15 1341.50
16 1469.75
17 1450.25
18 1306.50
19 1258.00
22 1332.75
23 1315.75
24 1351.00
25 1407.50
26 1547.75
29 1521.00
30 1484.25

261
Security Analysis

Days on which Stock Price (X)

trading was done
May 1 1458.00
2 1425.00
3 1350.75
6 1447.50
7 1448.25
8 1505.25
9 1511.25
10 1588.25
13 1560.00
14 1576.00
15 1638.50
16 1648.50
17 1710.75
20 1703.00
21 1665.00
22 1665.75

I
23 1550.75
24 1508.00
FA 27
28
1460.00
1316.25
29 1229.00
30 1324.75
31 1205.75
June 3 1295.50
4 1292.25
5 1191.50
IC
6 1179.50
7 1279.00
10 1280.25
11 1247.50
12 1186.50
13 1207.75
14 1323.00
17 1366.75
18 1312.00
19 1412.75
20 1420.50
21 1375.50
24 1377.50
25 1304.50
26 1395.00
27 1498.75
28 1549.75
July 1 1520.00
2 1489.50
3 1397.75

262
 Efficient Market Hypothesis

Days on which Stock Price (X)

trading was done
4 1425.00
5 1487.50
8 1536.50
9 1500.50
10 1481.25
11 1437.25
12 1460.75
15 1385.50
16 1401.25
17 1381.25
18 1487.25
19 1471.25
22 1452.75
23 1442.50
Solution
For the given data, we mark the price changes. Negative sign denotes that the price

I
has decreased as compared to the price on the preceding day and a positive sign
denotes the opposite of this.
FA Days on which trading
was done
Stock price
(X)
Price change

April, 20x2 1 881.50

–
2 856.50
+
3 859.75
+
4 918.50
+
5 1010.25
IC
+
8 1072.25
+
9 1074.50
+
10 1123.50
+
11 1203.5
+
12 1256.25
+
15 1341.50
+
16 1469.75
–
17 1450.25
–
18 1306.50
–
19 1258.00
+
22 1332.75 –

263
Security Analysis

Days on which trading Stock price Price change

was done (X)
23 1315.75
+
24 1351.00
+
25 1407.50
+
26 1547.75
–
29 1521.00
–
30 1484.25
–
May 1 1458.00
–
2 1425.00
–
3 1350.75
+
6 1447.50
+
7 1448.25

I
+
8 1505.25
FA 9 1511.25
+

+
10 1588.25
–
13 1560.00
+
14 1576.00
+
15 1638.50
+
IC
16 1648.50
+
17 1710.75
–
20 1703.00
–
21 1665.00
+
22 1665.75
–
23 1550.75
–
24 1508.00
–
27 1460.00
–
28 1316.25
–
29 1229.00
+
30 1324.75
–
31 1205.75
+

264
 Efficient Market Hypothesis

Days on which trading Stock price Price change

was done (X)
June 3 1295.50
–
4 1292.25
–
5 1191.50
–
6 1179.50
+
7 1279.00
+
10 1280.25
–
11 1247.50
–
12 1186.50
+
13 1207.75
+
14 1323.00
+
17 1366.75

I
–
18 1312.00
FA 19 1412.75
+

+
20 1420.50
–
21 1375.50
+
24 1377.50
–
25 1304.50
IC
+
26 1395.00
+
27 1498.75
+
28 1549.75
–
July 1 1520.00
–
2 1489.50
–
3 1397.75
+
4 1425.00
+
5 1487.50
+
8 1536.50
–
9 1500.50
–
10 1481.25
–

265
 Security Analysis

Days on which trading Stock price Price change

was done (X)
11 1437.25
+
12 1460.75
–
15 1385.50
+
16 1401.25
–
17 1381.25
+
18 1487.25
–
19 1471.25
–
22 1452.75
–
23 1442.50

From above, the total number of runs : r = 35

Number of positive price changes : n1 = 43

I
Number of negative price changes : n2 = 38
FA
The mean for this data is given by µr =
2.n1.n 2
n1 + n 2
+1 =
2(43)(38)
43 + 38
+ 1 = 41.34

2n1n 2 (2n1n 2 − n1 − n 2 )
Standard error = σr =
(n1 + n 2 ) 2 (n1 + n 2 − 1)

2(43)(38) ((2)(43)(38) − 43 − 38) 10415116

= 2
= = 19.84 = 4.45
(43 + 38) (43 + 38 − 1) 524880

Since too many or too few runs would indicate that the movement of prices is not
IC
random, we employ a two-tailed test to test the randomness of prices.
Test at 5% Level of Significance
At α = 0.05, Z = 1.96
The lower limit: µr – Zσ r = 41.34 – 1.96(4.45) = 32.62
The upper limit: µ r + Zσ r = 41.34 + 1.96(4.45) = 50.06
Since the observed number of runs (35), falls within the lower and the upper
limits, we conclude that the prices are independent at 5% level of significance.
Test at 10% Level of Significance
At α = 0.10, Z = 1.65
The lower limit: µr – Zσr = 41.34 – 1.65(4.45) = 33.99
The upper limit: µr + Zσr = 41.34 + 1.65(4.45) = 48.68
Since the observed number of runs (35), falls within the lower and the upper
limits, we conclude that the prices are independent at 10% level of significance.
Test at 20% Level of Significance
At α = 0.20, Z = 1.28
The lower limit: µr – Zσr = 41.34 – 1.28(4.45) = 35.64
The upper limit: µr + Zσr = 41.34 + 1.28(4.45) = 47.036
Since the observed number of runs (35) does not fall within the lower and the
upper limits, we conclude that the prices are not independent but are affected by
some other factors.

266
 Efficient Market Hypothesis

Tests of Semi-strong Form of EMH

According to this form of EMH, investors will not be able to make abnormal
profits using the publicly available information. That is, the current stock prices
discount all the information which is common knowledge. To examine the validity
of this hypothesis, the tests conducted are (i) Residual Analysis and (ii) Event
Studies.
RESIDUAL ANALYSIS
In this test, to estimate the value of realized or normal return of a security, we
regress the security returns against the returns on market index. The normal return
is given by the relation,
rit = ai + βi rmt+ eit …(1)
where,
rit denotes the realized return on the i th stock in the period ‘t’
rmt denotes the realized return on the index
ai denotes the regression constant
eit denotes the error or the residual term
βi denotes the slope of the characteristic line.
Due to the fact that the deviations in the security’s returns from the estimating line

I
cancel each other, on average, the error term should be zero.
Therefore, the normal return is given by:
FA rit = ai + βi rmt …(2)
From the relation (1), if the normal returns (as given by (2)) are subtracted from
the realized return rit, we get the abnormal returns as,
eit = rit – (ai + βi rmt)
where eit denotes the abnormal returns.
Since, we happen to use the error or the residual term to calculate the abnormal
return, this analysis is referred to as Residual Analysis.
For the market to be efficient in the semi-strong form, the sum of the residual
IC
returns (abnormal returns) should be close to zero.
Illustration 3
South Indian Bearings Ltd. has announced a stock split in 20x0-x1. A fund
manager, in order to test the consistency of the semi-strong form of the market
efficiency, conducted regressional analysis taking into account the returns from
South Indian Bearings scrip and the market index for a period of three years on
monthly basis up to three months before the stock split decision was announced.
The characteristic line obtained by him was:
rSI,t = 1.33% + 1.1rmt
where rSI,t is the return on South India Bearings during period ‘t’ and rmt is the
market return during period ‘t’.
ADJUSTMENT FOR MARKET EFFECTS
For testing the alternative efficient market hypotheses, the security’s rate of return
should be adjusted for the rates of return of the overall market during the period
under consideration. Without knowing the performance of the market in terms of
returns, the performance of the stock in terms of returns does not convey any
meaning.
A need for adjustments to the stock returns was realized in the early 1970s for it
was assumed that the individual stocks should experience a change equal to the
aggregate stock market. So, it became imperative to subtract the return on the
market from the return on the stock to arrive at the abnormal rate of return.

267
 Security Analysis

ARa = Rit – Rmt

Where,
ARa = Abnormal rate of return on security ‘i’ during period ‘t’
Rit = Rate of return on security ‘i’ during period ‘t’
Rmt = Rate of return on a market index during period ‘t’.
If the return on the stock is 15% and the return on the market is 10%, then the
abnormal rate of return is 5%.
According to CAPM, different stocks move differently in relation to the
movements in the market. Hence, the above method of calculation of the abnormal
rate of return may not be suitable in such cases. Some stocks may be more volatile
and some less volatile. Therefore, the expected rate of return for the stock based on
the market rate of return and the stock’s relationship with the market should be
determined. The abnormal rate of return can then be computed as the difference
between the stock’s actual rate of return and its expected rate of return as follows:
ARa = Rit – E (Rit)
Where,
E(Rit) = Expected rate of return for stock ‘i’ during period ‘t’ based on the market
rate of return and the stock’s normal relationship with the market.
For example, suppose that a stock is 15% more volatile than the market. Then, if

I
the market experiences a 10 percent rate of return, one would expect this stock to
experience a 11.5 percent return. Now, if this stock has only 5 percent return, its
abnormal rate of return during the period would be minus 6.5 percent.
FA
Over the normal long run period, the returns on the stock and that on the market
tend to coincide, thus, making the abnormal rate of return to be zero. During one
period, the returns may exceed expectations, and in the next period they may fall
short of expectations.
There are two sets of tests of the semi-strong form of EMH. In the first set, the
future rates of return for individual stocks are predicted using public information,
such as the aggregate price-earnings ratio, dividend yield, or the risk premium
spread for bonds. Sometimes, analysts also seek information which would help
them to predict the cross-sectional distribution of risk adjusted rates of return. The
IC
second set of tests, known as event studies, involve examining abnormal rates of
return during the period immediately following the announcement of any
significant economic event to determine if it is possible for any investor to earn
above average risk adjusted rates of return.
Both sets of tests emphasize on the analysis of abnormal rates if returns deviate
from long-term expectations, or returns that are adjusted for a stock’s specific risk
characteristics and overall market rates of return during the period.
Illustration 4
Given below is the data regarding the actual and the market returns observed
during a seven-month period. Conduct residual analysis to test the semi-strong
form of market efficiency.
Months Actual Return (%) Market Return (%)
1 14.75 12.15
2 14.40 11.95
3 14.82 12.20
4 15.01 12.35
5 14.92 12.30
6 14.68 12.20
7 14.38 11.95
When rmt = 12.15,
Expected return (rSI,t) = 1.33% + 1.1(12.15) = 14.70
Abnormal return for the first month = Actual Return – Expected Return
= 14.75 – 14.70 = 0.05

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 Efficient Market Hypothesis

Solution
Months Actual Market Expected Abnormal
Return Return Return Return (%)
(%) (%) (%)
1 14.75 12.15 14.70 0.05
2 14.40 11.95 14.48 –0.08
3 14.82 12.20 14.75 0.07
4 15.01 12.35 14.92 0.09
5 14.92 12.30 14.86 0.06
6 14.68 12.20 14.75 –0.07
7 14.38 11.95 14.48 –0.10
0.02
From the table, we observe that the sum of abnormal returns is close to zero.
Therefore, we conclude that the market is efficient in the semi-strong form.
RESULTS OF RETURN PREDICTION STUDIES1
The time series tests of efficient market hypotheses are based on the assumption
that in an efficient market, the best estimate of future rates of return will be the
long run historical rates of return. The objective of the tests is to determine
whether there is any public information that will provide superior estimates of
returns for a short run horizon or a long run horizon.

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While the studies based on the returns are successful in predicting the long horizon
returns, they were less successful in predicting the returns for short horizons.
When the aggregate dividend yield (D/P) was taken as a proxy for the risk
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premium on stocks, a positive relationship is observed to exist between D/P and
future stock market returns. A further analysis of this relationship showed that the
predictive power increases with horizon. It was also found that the stock prices
need not follow a random walk and long run returns on stocks can be predicted as
long as aggregate output can be predicted.
Two commonly used variables in several studies are those that are related to the
term structure of interest rates viz., (i) the difference between yields on lower rated
bonds and higher rated bonds, the risk premium, (ii) the difference between yield
on long-term higher rated bonds and yield on short-term bonds referred to as the
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term structure of horizon spread. These variables can also be used to predict stock
returns and bond returns and for predicting returns for even foreign common
stocks.
High values of dividend yield and the default spread imply that a high return on
stocks and bonds is expected by the investors. This occurs when the economic
environment has been poor, indicating a low wealth environment wherein
investors perceive higher risk for investments, which means that the investors
require a high rate of return in order to invest and shift consumption from the
present to the future.
When a number of business cycle variables are considered, the predictive power of
various economic factors related to stock returns is found to change with time and
the volatility of returns. It was found that the predictability of returns was low in
the calm markets and the predictions were based on economic factors that could be
exploited in the volatile markets.
QUARTERLY EARNINGS STUDIES
The Quarterly Earnings Studies are a part of time-series analysis. These studies
aim at predicting future returns for a stock based on publicly available quarterly
earnings reports.

1 This section and the next three sections draw from “Investment Analysis and Portfolio Management” by
Frank K Reilly and Keith C Brown, 6th Edition, The Dryden Press.

269
 Security Analysis

Several studies were conducted by different groups to examine firms that

experienced unanticipated changes in quarterly earnings based on three categories
as to how actual earnings deviated from expectations i.e., (i) any deviation from
expectations, (ii) a deviation plus or minus 20 percent, and (iii) a deviation of at least
40 percent. The study examined the abnormal price movements for all the above
mentioned categories of deviations, and compared the post-announcement effects
on the stocks with the earnings surprise (the amount by which the actual earnings
is more than the expected results). The results of these studies suggested that
favorable information contained in quarterly earnings reports is not
instantaneously reflected in stock prices and a significant relationship exists
between the size of the earnings surprise and the post announcement stock price
change.
When the results of these studies were subsequently reviewed, it was found that
post-announcement risk-adjusted abnormal returns were consistently positive,
which is inconsistent with market efficiency. The abnormal returns could be due to
problems in the CAPM and not due to market inefficiencies.
Recent studies use the concept of Standardized Unexpected Earnings (SUE),
which normalizes the difference between actual and expected earnings for the
quarter by the standard error of estimate from the regression used to derive the
expected earnings figure, instead of just examining the percentage differences
between actual and expected results. The SUE can be defined as:

I
Reported EPSt − Predicted EPSt
Standard Error of Estimate for the Estimating Regression Equation
FA
The standard error of a statistic is the standard deviation of the sampling
distribution of that statistic. Standard errors are important because they reflect how
much sampling fluctuation a statistic will show. The standard error of a statistic
depends on the sample size. In general, the larger the sample size, the smaller the
standard error. The standard error of a statistic is usually designated by the Greek
letter sigma (σ) with a subscript indicating the statistic. For instance, the standard
error of the mean is indicated by the symbol: σM.
The predicted earnings are estimated by a time-series model that considers the
earnings during the prior 20 quarters and includes quarterly dummy variables that
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adjust for any seasonal factors. Therefore, the SUE indicates the number of
standard errors, which are above or below the predicted EPS figure.
Large SUEs were observed to be accompanied by significant abnormal stock price
changes. When the impact of different risk adjustments was analyzed, it was
concluded that the results were not sensitive to the risk adjustments.
The drift in the return following earnings announcements are examined and it was
found that over 80% of the stock price drift following announcements of the
earnings is brought about by the unexpected earnings. The results of many studies
indicate that the market has not adjusted stock prices to reflect the release of
quarterly earnings surprises as fast as expected by the semi-strong EMH. This may
lead to the use of earnings surprises to predict returns for individual stocks.
CALENDAR STUDIES
These attempted to predict rates of return during a calendar year and examine if
there is any particular observable pattern in the rates of return on the stocks that
would allow investors to predict returns on stocks in advance. They also test for
the presence of any irregularities. Besides “January Anomaly”, they also consider
a variety of other daily and weekly regularities.
The January Anomaly: This was proposed as a unique trading rule to make use
of tax selling. Most investors are observed to adopt tax selling at the end of the
year to establish losses on stocks that have declined and re-acquire the same shares
in the next year or buy other stocks that are attractive. This tendency of the
investors leads to a downward pressure on the stock prices during the end of the

270
 Efficient Market Hypothesis

year (November and December) and positive pressure during the beginning
(January) of the next year. This is termed as January Anomaly. The advocates of
the efficient markets believe that this kind of seasonal pattern does not last for a
longer period as it is likely to be eliminated by arbitrageurs’ action of buying in
December and selling in January of the next year.
Several studies conducted by different people at different points of time supported
this January Anomaly. December trading volume was found to be abnormally high
for the stocks that have declined during the previous year and the volume was low
for stocks that have experienced large gains.
Another observation confirmed that the price patterns on the last day of December
and the first four days of January support the anomaly. The presence of transaction
costs does not deter the arbitrageurs from engaging in the January tax selling anomaly.
One of the studies indicated the existence of a negative relationship between size
and abnormal returns. More than 50% of the January effect would be concentrated
in the first week of trading, particularly on the first day of the year. In addition, a
non-linear relationship is found to exist between dividend yields and stock returns
in January. A strong seasonal pattern was also observed because the dividend
yield-stock return relationship existed only during January. The year end effect
was also observed for small firms particularly during the last day of the year with
above normal trading activity continuing in January.
All the studies reveal that the January Anomaly is intriguing because it is

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pervasive. The seasonal impact also influences the dividend yield effect and trading
volume, and a tax-loss explanation of this anomaly has received a mixed support.
FA
Other Calendar Effects: Many other “calendar” effects like monthly effect, a
weekend/day-of-the-week effect, and an intraday effect have also been examined.
The weekend effect was documented by French, and Gibbons and Hess. While
mean return for Monday was observed to be significantly negative, the average
return for the other 4 days was positive. Returns were negative on Mondays for
both individual stocks and Treasury Bills. The Monday effect was the same for
different size firms and it remained the same irrespective of the nature of trading
of the stock.
The Monday effect was measured from Friday close to Monday close. When the
Monday effect was decomposed into weekend effect (Friday close to Monday
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open) and Monday trading effect (Monday open to Monday close), it was found
that the weekend effect was negative and the Monday trading effect was positive.
When the day-of-the-week returns were segmented into January and the rest of the
year, the Monday effect was positive in January and negative in all the other
months. The size effect also existed only in January.
The analysis of NYSE transactions data on trading and non-trading returns indicate
that for large firms, the negative Monday effect occurred before the market opened
whereas for smaller firms most of the negative Monday effect occurred during the
day on Monday.
PREDICTING CROSS-SECTIONAL RETURNS
If the market is assumed to be efficient, all securities should lie along the security
market line that relates the expected rate of return to an appropriate risk measure.
It is mandatory that all the securities have equal risk-adjusted returns because
security prices should reflect all public information that would influence the
security’s risk. Therefore, it is necessary to determine whether the future
distribution of risk-adjusted rates of return can be predicted (i.e., using public
information, the possibility of identifying the stocks which experience below-
average, risk-adjusted returns, and the stocks which experience above-average,
risk-adjusted returns).
The cross-sectional returns can be predicted by examining the usefulness of
alternative measures of size or quality as tools to rank stocks in terms of risk-adjusted
returns. The tests for predicting cross-sectional returns are dependent on the asset-
pricing model that provides the measure of risk used in the test as well as the
efficiency of the market.

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Security Analysis

Price-Earnings Ratios and Returns: EMH can be tested by examining the

relationship between the historical Price-Earnings (P/E) ratios for stocks and their
returns. There was an opinion that low P/E stocks outperform high P/E stocks
because growth companies enjoy high P/E ratios, but the market tends to
overestimate the growth potential and thus overvalues the growth companies while
undervaluing low-growth firms with low P/E ratios. A relationship between the
historical P/E ratios and subsequent risk-adjusted market performance would serve
as an evidence against the semi-strong EMH because it implies that investors can
use publicly available P/E ratios to predict future abnormal returns.
For testing purposes, the stocks were divided into five P/E classes and the risk and
return for portfolios of high and low P/E ratio stocks were determined. Measures
of risk-adjusted performance indicated that low P/E ratio stocks experienced
superior results relative to the market, whereas high P/E ratio stocks had
significantly inferior results. Therefore, it was concluded that publicly available
P/E ratios possess valuable information. But these results were not consistent with
semi-strong efficiency.
P/E ratios were also examined after making adjustments for firm size, industry
effects, and infrequent trading. With these adjustments it was found that the
risk-adjusted returns for stocks with low P/E ratios were superior to those with
high P/E ratios.
Price-Earnings/Growth Rate Ratios: The Price-Earnings/Growth Rate Ratio

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(referred to as PEG ratio) is used as a relative valuation tool, for stocks of growth
companies whose P/E ratios are relatively above average. An inverse relationship
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was observed to exist between the PEG ratio and subsequent rates of return, i.e.,
stocks with relatively low PEG ratios will have above average rates of return
whereas stocks with high PEG ratios experience below average rates of return. The
tests used to measure the PEG ratio do not support the EMH. When a sample of
stocks was examined by dividing it on the basis of a risk measure (beta), market
value size and expected growth rate, the results were not consistent with the
hypothesis of an inverse relationship between the PEG ratio and subsequent rates
of return except for stocks with low betas and those with very low expected
growth rates.
The Size Effect: An examination of the impact of size (as measured by total
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market value), on risk adjusted rates of return showed that small firms consistently
experienced significantly larger risk-adjusted returns than larger firms; and that it
was the size that influenced the risk-adjusted returns and not the P/E ratio as per
the earlier studies.
Inefficiency of the markets or the incorrect estimates of the expected returns
provided by the market model may give rise to abnormal returns. According to
Reinganum, abnormal returns were considered to be the result of the simple
one-period CAPM, which is perceived to be an inadequate description of the
real-world capital markets.
When betas were computed using two different models, Ordinary Least Squares
Model and the Aggregates Coefficients Model, a substantial difference was
observed in the estimated betas for smaller firms. The results demonstrated that
the risk for small firms was underestimated, but at the same time, the larger betas
could not explain the very large differences in rates of return. Several results imply
that most of the differences in size related returns can be explained by complete
measures of risk.
Since transaction costs vary inversely with price per share (because they include
both the dealer’s bid-ask spread and the broker’s commission), their impact on the
risk-return relationship of large and small firms cannot be ignored. Also, a
differential in transaction costs – with frequent trading – can have significant
impact on the results. These results imply that subsequent size effect studies must
consider realistic transaction costs and specify the holding period assumptions (if
any). If an annual rebalancing is assumed, it was found that small firms
outperformed the large ones after considering risk and transaction costs.

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 Efficient Market Hypothesis

Thus, we see that firm size seemed to influence future returns and had remained an
anomaly in the efficient market literature. In an attempt to explain the anomaly,
several attempts were made; however, no single study was able to explain the
unusual results. But the two strongest explanations were risk measurements and
the higher transaction costs.
Book Value-Market Value (BM/MV) Method: Another predictor of stock
returns identified is the ratio of a firm’s book value of equity to its market value. A
significant positive relationship is found to exist between a firm’s historical
BV/MV and the future stock returns. This result does not agree with the EMH.
The joint effects of market beta, size, E/P ratio, leverage and the BV/MV ratio on
the cross section average returns on the NYSE, AMEX and NASDAQ stocks
provide strong evidences in support of this ratio. Both size and BV/MV ratio are
significant when included together and dominate other ratios. Though leverage and
E/P ratio were significant by themselves or when considered with size, they
become insignificant when both size and the BV/MV ratio are considered. The
influence of the behavior of stock price to size and the BV/MV ratio on earnings
changes is also studied. The focus of the analysis is on the relationship of high and
low BV/MV stocks and profitability (measured as ROE). Low BV/MV stocks
(growth stocks) have high ROE prior to forming portfolios but lower ROE in
subsequent years. On the other hand, high BV/MV stocks (value stocks) experience
low ROE prior to the formation of portfolios, but high ROE after the formation.

I
Thus, size was found to play a major role in the small-stock portfolios, while the
BV/MV ratio is more important for firms with high BV/MV ratios.
FA
Following these studies, some more studies were conducted to test (i) the
relationship between beta and rates of return and (ii) the manner in which BV/MV
can be used to predict rates of return. Another opinion was that the relationship
between returns and the BV/MV ratio is periodic and is not significant over a
longer period.
The tests of publicly available ratios used to predict the cross-sectional returns
provided substantial evidence in conflict with the semi-strong EMH.
EVENT STUDIES
Event studies aimed at testing the EMH by examining how abnormal rates of
return react to significant economic information. Proponents of EMH opine that
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returns would adjust very quickly to announcements of new information. This
implies that it is not possible for investors to experience positive abnormal rates of
return by responding positively to the announcement. Some of the events that
bring out changes in the stock returns are stock splits, exchange listings, initial
public offerings, unexpected world or economic events, and the announcement of
significant accounting changes.
Stock split studies are used to analyze the effect of stock splits on the stock prices
and hence their returns. There is a general perception that a stock split will lead to
an increase in the price of the share as the demand for stocks increases after the
stock split. But proponents of EMH do not agree with this view as they do not
anticipate any change in the price of the stock after the announcement of the stock
split. One plausible reason in favor of increase in the stock price after the
announcement of a stock split is that the dividends tend to increase after the stock
is split. The dividend change, thus, has an information effect because it indicates
that management strongly expects a new higher level of earnings in future, which
in turn, influences the dividends. However, results of several studies on these lines
indicate that stock splits do not result in higher rates of return for stockholders
after the split thus supporting the semi-strong form of EMH, because they assert
that investors cannot gain from the information on a split after the public
announcement. Though the results of various studies in this aspect are not unique,
most of them conclude that stock splits do not have any short run or long run
impact on security returns.

273
 Security Analysis

In the event of initial public offering, the results showed that the price adjustment
takes place within one day after the offering. Abnormal returns are not possible for
the investors who acquire the stock after the initial adjustment. In the event of
exchange listing, the studies proved that the stocks’ prices increase before any
listing announcement, and they decline after the actual listing. The studies on
exchange listings do not indicate long run effects on value or risk. They provide
evidence of short run profit opportunities from public information and it does not
support the semi-strong EMH. There is a possibility of short run profits between
the period of announcement and the period of listing.
The studies on other major economic events in and around the world have
provided different results. Most of them conform to the view of stock price
movements as per semi-strong form. The stock prices were found to adjust to the
news before the market opened or before it reopened after the announcement. The
studies on the impact of announcement of accounting changes on the stock prices
revealed that in efficient markets, they should react quickly and predictably to the
announcements of accounting changes. If an accounting change brings about a
change in the economic value of a firm, a quick change in the stock prices is
expected. The results of the studies supported the EMH because there was no
indication of positive price changes following the change in the accounting policy.
Corporate events like mergers and acquisitions, reorganizations, and various

I
security offerings also have an impact on the market and the security prices.
Studies of these events unanimously support the semi-strong EMH.
FA
The semi-strong EMH has got a mixed support from numerous studies. It received
uniform support from almost all the event studies excepting the event of exchange
listing. However, studies on predicting rates of return over time or for a cross-
section of stocks presented evidence against the semi-strong hypothesis.
In this method, the average of the abnormal returns for a number of months before
and after the date of a particular event is computed. Mathematically, this may be
expressed as:
AARt = 1/n ∑AR
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where ‘n’ represents the number of securities under consideration.
Then the sum of Average Abnormal Returns (AAR) gives us the Cumulative
Average Abnormal Returns (CAAR).
That is, CAAR = ∑AARt
The value of CAAR will be close to zero if the markets are efficient.
Illustration 5
Four companies, Castle Bearings Ltd., Auto Spares Ltd., Mobiles Ltd., and Heavy
Vehicles Ltd., have increased their level of cash dividends for the year 20x0-x1. A
financial analyst at a mutual fund wanted to test the consistency of the semi-strong
form of market efficiency. He calculated the characteristic lines for a period of six
years on a monthly basis up to four months before the announcement took place.
The relationship between the returns on these four companies and the market are
given by:
rC,t = 1.70% + 1.05rm,t
rA,t = 1.53% + 1.08rm,t
rM,t = 1.92% + 1.02rm,t and
rHV,t = 1.42% + 1.09rm,t

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 Efficient Market Hypothesis

where rC,t, rA,t, rM,t, and rHV,t are the respective returns of the companies during
period “t” and rm,t is the market return during the same period. The following data
is given:
Period (months) Actual Return Market Return
rC,t rA,t rM,t rHV,t rm,t
4 13.47 13.61 13.35 13.60 11.00
3 11.90 12.04 11.82 12.03 10.00
2 13.50 13.67 13.42 13.71 11.15
1 12.97 13.12 12.88 13.13 10.88
0 13.43 13.60 13.31 13.59 10.90
1 12.50 12.62 12.41 12.63 10.05
2 13.09 13.25 12.99 13.27 11.05
3 14.51 14.71 14.37 14.76 12.15
4 14.80 14.99 14.65 15.02 12.67
Solution
Castle Bearings Ltd.
Period Actual Return Market Expected Abnormal Return
(%) Return (%) Return (%) (%)

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4 13.47 11.00 13.25 0.22
3 11.90 10.00 12.20 –0.30
FA 2
1
13.50
12.97
11.15
10.88
13.40
13.12
0.10
–0.15
0 13.43 10.90 13.15 0.28
1 12.50 10.05 12.25 0.25
2 13.09 11.05 13.30 –0.21
3 14.51 12.15 14.45 0.06
4 14.80 12.67 15.00 –0.20
Expected return is calculated by substituting market returns in the characteristic
line equation.
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For market return of 10.88%, the expected return is given by
rC,t = 1.70% + 1.05rm,t = 1.7% + 1.05(10.88) = 13.124%
The abnormal return is given by the difference between the actual return and the
expected return.
At an actual return of 11.90% and an expected return of 12.20%, the abnormal
return = 11.90 – 12.20 = –0.30%.
Auto Spares Ltd.
Period Actual Return Market Expected Abnormal Return
(%) Return (%) Return (%) (%)
4 13.61 11.00 13.41 0.20
3 12.04 10.00 12.33 –0.29
2 13.67 11.15 13.57 0.10
1 13.12 10.88 13.28 –0.16
0 13.60 10.90 13.30 0.30
1 12.62 10.05 12.38 0.24
2 13.25 11.05 13.46 –0.21
3 14.71 12.15 14.65 0.06
4 14.99 12.67 15.21 –0.22

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Security Analysis

Mobiles Ltd.
Period Actual Return Market Expected Abnormal Return
(%) Return (%) Return (%) (%)
4 13.35 11.00 13.14 0.21
3 11.82 10.00 12.12 –0.30
2 13.42 11.15 13.30 0.12
1 12.88 10.88 13.02 –0.14
0 13.31 10.90 13.04 0.27
1 12.41 10.05 12.17 0.24
2 12.99 11.05 13.20 –0.21
3 14.37 12.15 14.31 0.06
4 14.65 12.67 14.84 –0.19
Heavy Vehicles Ltd.
Period Actual Return Market Expected Abnormal Return
(%) Return (%) Return (%) (%)
4 13.60 11.00 13.41 0.19
3 12.03 10.00 12.32 –0.29
2 13.71 11.15 13.57 0.14
1 13.13 10.88 13.28 –0.15
0 13.59 10.90 13.30 0.29
1 12.63 10.05 12.37 0.26

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2 13.27 11.05 13.46 –0.19
3 14.76 12.15 14.66 0.10
FA 4 15.02 12.67
Now, we calculate the average abnormal returns
15.23 –0.21
for each of the weeks before and
after the dividend was announced.
Fourth week before the announcement of dividend
AAR = (1/4)(0.22 + 0.20 + 0.21 + 0.19) = 0.205
Third week before the announcement of dividend
AAR = (1/4)( –0.30 – 0.29 – 0.30 – 0.29) = –0.295
Second week before the announcement of dividend
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AAR = (1/4)(0.10 + 0.10 + 0.12 + 0.14) = 0.115
First week before the announcement of dividend
AAR = (1/4)(–0.15 – 0.16 – 0.14 – 0.15) = –0.15
Week zero during which the dividend was announced
AAR = (1/4)(0.28 + 0.30 + 0.27 + 0.29) = 0.285
First week after the announcement of dividend
AAR = (1/4)(0.25 + 0.24 + 0.24 + 0.26) = 0.2475
Second week after the announcement of dividend
AAR = (1/4)(–0.21 – 0.21 – 0.21 – 0.19) = –0.205
Third week after the announcement of dividend
AAR = (1/4)(0.06 + 0.06 + 0.06 + 0.10) = 0.07
Fourth week after the announcement of dividend
AAR = (1/4)(–0.20 – 0.22 – 0.19 – 0.21) = –0.205
Now, we compute the Cumulative Average Abnormal Returns for the period of
one month before and after the announcement of the dividend.
CAAR = 0.205 – 0.295 + 0.115 – 0.15 + 0.285 + 0.2475 – 0.205 + 0.07 – 0.205
= 0.0675

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 Efficient Market Hypothesis

Since the value of CAAR is close to zero, we conclude that markets are efficient in
the semi-strong form.
Box 4: Rational Pricing
Rational pricing of securities is of primary importance in economics not merely
to indicate the correct wealth of shareholders; it is also “of critical importance for
resource allocation,” and to ensure that prices eventually correspond to their long
run competitive equilibrium. Speculative bubbles indicate that the pricing of
securities is irrational. The obvious culprit for such irrationality is the role of
expectations in the pricing of securities. Eugene F Fama, in analyzing the 1987
crash from a rational pricing perspective saw that all explanations were “driven
by a change in expectations about conditions.” No reason has been found for
expectations to change initially.
In reality, investors are more concerned with the behavior of their colleagues
than with market fundamentals. “If an ordinary rational investor had good reason
to believe that other investors would not behave rationally, then it might well be
rational for him to adopt a strategy he would otherwise have rejected as
irrational.” Stock market crashes could easily result from similar behavior; if an
investor perceives panic, or impending hysteria, he himself will panic. If such
behavior occurs during the building and bursting of speculative bubbles, can we
have confidence in security prices in general? Is the determination of security
prices truly a ‘speculative and anticipatory phenomenon’? During the 1987 Wall

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Street crash, when $1 tn of paper money was wiped out in a day, The Economist
blamed the ‘madness of crowds’, and ‘mob psychology’ for the bull market and
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the subsequent crash. As for the belief in fundamental values – “Just before the
stock market crash, commodity analysts were saying that metal prices were rising
because of ‘market fundamentals’. Came the crash, they threw their
fundamentals out of the window and indulged in old fashioned panic instead.”
We must assume that the irrationality prevalent during speculative bubbles is
exceptional, despite the fact that one can construct simple and plausible models
of bubbles that never break. One of the greatest problems for economists is that
“there is no scientific way to show that security prices are rational or irrational.”
A fundamental assumption of economic theory is that all economic agents act
rationally. In case of speculative bubbles, (and perhaps in many other cases)
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rationality breaks down, and economic theory goes out the window. This is why
nobody will ever satisfactorily explain the Great Depression, Black Monday, or
the craze for tulip bulbs.
Chaos Theory
Is there any other theory that could possibly shed some light on the subject of
speculative bubbles? Chaos theory may be the answer. Chaotic models (despite
the name) have a pattern behind the chaos. These models are deterministic
mathematical models, (usually non-linear), which explain every nuance of the
behavior of the variables in question. The observations resulting from Chaotic
models have the following properties.
• They appear random (even when subject to sophisticated statistical analysis).
– No pattern repeats itself. Thus even with infinite data, no two patterns
will ever be exactly alike.
– The time series is subject to sharp and substantial breaks in the usual
pattern or trend, which are completely undetermined by what went
before. Thus, a series of observations with a high degree of volatility
and an upward trend can be suddenly replaced by a flat downward
trend.
– The qualitative behavior of a Chaotic time series is subject to complete
upheaval in response to the most microscopic change in the values of
the underlying parameters.

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Security Analysis

Despite the appearances conveyed by such properties, Chaotic models are non-
random, and (given the model) completely predictable. Let us examine the
explanatory power of such properties in relation to speculative bubbles:
– Stock market prices have been found in some empirical studies to be
completely random.
– Technical analysts cannot systematically beat the market, despite their in-
depth study of past patterns.
– ‘Sharp and substantive breaks’… : The events of 1929 and 1987 fall into
this category.
– ‘Microscopic changes’.... : This could well be the reason why a true cause
for Black Monday cannot be found. Could a farmer in New Zealand
increasing prices of his produce possibly be responsible for a crash in Wall
Street? Chaos theory suggests that this is possible.
– As we have seen, Chaos theory appears to have strong explanatory power
regarding the behavior of share prices. In applying this model to financial
markets, the parameters may be consistent with historical events, but too
complex to be of use in predictions of the future. These sentiments,
however, are as yet untested and further empirical research into this area is
necessary. In conclusion, behavior during speculative bubbles appears to be
outside the scope of traditional economic explanation. Although agents may

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have rational beliefs, they do not always behave in such a manner. To
understand the actions of economic agents during bubbles, psychological
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analysis appears to have greater explanatory power. Alternatively, perhaps
by replacing established economic models with a chaotic model, these
events will appear logical. These results portray an unkind picture of the
stock market; it is either irrational and inefficient, or ruled by chaos.
Source: “Speculative Bubble, Irrationality and Chaos”, by Niamh Brodie,
Merrion-capital.com.
Tests of Strong Form of EMH
According to this hypothesis, all the information, public as well as private, are
known to the investors and hence a particular investor cannot reap abnormal
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profits using this information. Since there are people who are privy to certain types
of information, to examine the validity of this hypothesis, we can divide this into
two groups: (i) the super-strong form consisting of Corporate Insiders and the
Specialists at the stock exchanges and (ii) the near-strong form consisting of
Mutual Fund Managers.
Trading by Exchange Officials: Top officials of the stock exchanges have access
to information on the overbought/oversold position of the market. If private
information is not of any use, it should not be possible for them to make profits
using the information. Analysis of profits or losses made by them in their trades
reveal whether they make profits or not, but this information is almost impossible
to get. However, studies carried out in the US on the profits made by ‘Specialists’
who have access to such information have shown that specialists consistently make
abnormal profits, which indicate that the super-strong form of EMH does not hold.
Trading by Mutual Fund Managers: Mutual fund managers are supposed to be
specialists in investment decision-making and are therefore, supposed to be able to
obtain such conclusions from publicly available information that is not accessible
to the common man not derivable by the common people. Therefore, if the near-
strong form holds good, mutual fund managers must be able to earn consistent
abnormal returns. Various studies have revealed that mutual fund managers have
not achieved consistent abnormal returns, which means that the near-strong form
of EMH does not hold good.

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 Efficient Market Hypothesis

INSIDER TRADING
Insider trading refers to dealing in securities by persons who are privy to specific
information of companies. This possession of confidential information gives those
persons undue advantage to either buy or sell the securities as the circumstances
warrant. This specific information is not disclosed to the investors in the general
course of business, and therefore, places them at a great disadvantage.
If the stock markets are to function efficiently, it is a prerequisite that the
regulatory authority be in a position to identify such instances and take corrective
measures. This also boosts the retail investors’ confidence in the impartial working
of the exchange.
SEBI amended the SEBI (Insider Trading) Regulations, 1992 in February 2002 to
provide for the following:
• The regulation would now cover subscription in the primary issue based on
inside information.
• A person, who is an intermediary, investment company, trust company, asset
management company or an employee or director thereof or an official of a
stock exchange or of a clearing house or corporation, would be deemed to be
a connected person.
• Price sensitive information would mean any information, which relates

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directly or indirectly to a company and which if published, is likely to
materially affect the price of securities of a company. Periodical financial
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results of the company, intended declaration of dividends (both interim and
final), issue of securities or buy-back of securities, any major expansion plans
or execution of new projects, amalgamation, mergers or takeovers, disposal
of the whole or substantial part of the undertaking, and any significant
changes in policies, plans or operations of the company would be deemed to
be price sensitive information.
• Speculative reports in print or electronic media would not be considered as
published information.
• Only dealing in securities based on unpublished price sensitive information is
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prohibited and communication of price sensitive information per se is not an
offense.
• Corporate dealing in securities of another company based on inside
information is specifically prohibited.
• All listed companies and organizations associated with securities market
including the intermediaries, asset management company, trustees of MFs,
self-regulatory organizations, stock exchanges, clearing house/corporations,
public financial institutions, professional firms such as auditors, accounting
firms, law firms, analysts, consultants, etc., assisting or advising listed
companies shall frame a code on internal procedure and conduct on lines of
model code specified in Regulations. These entities shall abide by the Code
for Corporate Disclosure Practices specified in the Regulations. They shall
adopt appropriate mechanisms and procedures to enforce these codes.
• Any person who holds more than 5% shares or voting rights in any listed
company shall disclose to the company, the number of shares or voting rights
held by such person, within four working days of the receipt of intimation of
allotment of shares, or the acquisition of shares or voting rights, as the case
may be. He shall also disclose to the company the change in shareholding or
voting rights, even if such change results in shareholding falling below 5%, if
there has been a change in such holdings from the last disclosure and such a
change exceeds 2% of total shareholding or voting rights held by such person
within four working days of becoming director or officer of the company. He

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Security Analysis

shall also disclose the change in shareholding or voting rights, if there has
been a change in such holdings from the last disclosure made and the change
exceeds Rs.5 lakh in value or 5,000 shares or 2% of total shareholding or
voting rights, whichever is lower. Every listed company, within 5 days of
receipts of these disclosures, shall disclose to all stock exchanges on which
the company is listed.
SEBI Regulations also prohibit the insider to communicate or counsel other
persons directly or indirectly about the confidential price-sensitive information. It
can appoint an officer to probe into allegations which come to its notice on its own
or when it possesses a written complaint from investors or intermediaries. During
the probe, the person against whom investigations are initiated (insider) is
expected to provide all the cooperation and assistance required by the investigating
officer. In the due course of the probe, SEBI appoints an auditor who examines the
relevant books to check their authenticity and appropriateness. After completion of
the probe, the investigating officer submits his report to SEBI, which then gives
the insider an opportunity to present his case.
If it finds evidence against the person, it imposes punishments. The punished
person can appeal to the Appellate Authority or the central government against the
order if he feels that the order is unjust.

SUMMARY

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• The hypothesis is based on the assumption that the market comprises rational
investors. In a nutshell, EMH states that successive absolute price changes
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are independent in the short run as per the assumption that the market
comprises rational investors. However, investors are not always rational in
that, they consider factors other than risk and returns for selecting securities.
• On the basis of the level of information considered, the EMH can be divided
into three forms namely, Weak Form, Semi-Strong Form and Strong Form.
• In developing market, the weak form enjoys a fair degree of chance to hold
good. The reason is the behavior of the market participants, which is driven
by their sentiments rather than historical prices and returns.
According to Semi-strong form of EMH, investors will not be able to make
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•
abnormal profits using the publicly available information. That is, the current
stock prices discount all the information, which is common knowledge.
• According to Strong form of EMH, the investors know all the information,
both public as well as private. Hence, a particular investor cannot reap
abnormal profits using this information, since there are people who are privy
to certain types of information.
• In the Indian stock market, sentiments play a major role in price behavior at
the counters.

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Chapter XI

Technical Analysis

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•
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After reading this chapter, you will be conversant with:
Concept of Technical Analysis
• The Dow Theory
• Types of Charts
• Price Patterns
• Trend Lines
• Advanced Technical Tools
Academic Perspective of Technical Analysis
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•
Security Analysis

Introduction
Investors may adopt two different approaches to equity investment. They may buy
stocks at a certain point of time and simply hold these stocks over a period of time,
without restructuring their portfolio. Such a passive approach to investment is also
called the ‘buy and hold’ policy. Alternatively, investors may adopt an active
investment strategy, constantly evaluating their holdings, and reshuffling the
stocks they hold. This approach requires constant evaluation of the market. It is a
well-established fact that stock markets also portray cyclical movements akin to
business cycle. An active investor who is able to identify the turns in the market
would be able to buy at bottoms (low prices) and sell at peaks (high prices) and
make substantial gains out of cyclical investments.
In practice, however, such gains can be registered only if an investor is able to
consistently buy and sell at turning points, and if the gains are substantial enough
to cover transaction costs and taxes. Suppose one assumes that an investor who
plans his strategies on the basis of his prediction of cyclical trends, would be able
to take an investment decision only after a 15% price movement from say a peak
or trough occurs, even then he may register substantial gains over the buy and hold
strategy.

CONCEPT OF TECHNICAL ANALYSIS

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Technical analysis is the study of technical characteristics which may be expected
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at major market turning points, and their objective assessment. According to
technical analysts, the cyclical trend visible in the movement of stock prices is due
to the changes in the attitude of investors, reflected in changes in the demand for
and supply of securities. The previous turning points are studied with a view to
develop some characteristics that would aid identification of major market tops
and bottoms. It is assumed that human reaction to similar situations is by and large
consistent and recurrence of a certain characteristic is expected to spur a similar,
though not identical, reaction. Technical analysts have developed tools and
techniques to study past patterns and predict future price. The basic assumptions
underlying technical analysis are as follows:
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• Market value is determined solely by the interaction of supply and demand.
• Supply and demand are governed by numerous factors, both rational and
irrational.
• Ignoring minor fluctuations in the market, stock prices tend to move in trends
which persist for an appreciable length of time.
• Changes in trend are caused by shifts in supply and demand.
• Shifts in supply and demand, no matter why they occur, can be detected
sooner or later in charts of market value.
• Some chart patterns tend to repeat themselves.
Unlike fundamental analysis where factors like earnings of the company, its
management, products, etc. are studied, technical analysis is based purely on study
of the behavior of past prices. The supply and demand for a security is supposed to
have incorporated not only the fundamental factors, but also psychological and
behavioral factors. While fundamental analysis is directed towards determining the
intrinsic value of a security, technical analysis is directed towards predicting the
price of a security. The price at which a buyer and seller settle a deal is considered
to be the ‘one precise figure’ which synthesizes, weighs and finally expresses all
factors, rational and irrational, quantifiable and non-quantifiable, and is the only
figure that counts. The spirit of technical analysis can be summed up thus: “The
going price as established by the market itself comprehends all the fundamental

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 Technical Analysis

information which the statistical analyst can hope to learn (plus some which is
perhaps secret to him, known only to a few insiders) and much else besides of
equal or even greater importance”.
Certain problems involved in using fundamental analysis for valuation, have
popularized technical analysis, the significant among them being:
• Fundamental analysis involves compilation and analysis of huge amount of
data, and is therefore complex and time consuming.
• Even if an analyst identifies an underpriced security, market may take time to
bid its price up. Gains, therefore, may be realized very late, before which
time, certain fundamental factors may undergo change.
• Financial statements, which provide the basic inputs for fundamental
analysis, are plagued by certain deficiencies like subjectivity, inadequate
disclosure, etc. These factors affect the quality of fundamental analysis.
Technical analysis is not based on a strong conceptual framework, but depends
fully on use of historical trends to predict future prices. Though technical and
fundamental analyses provide diagonally opposite approaches to valuation, in
practice a judicious blend of the two approaches is attempted, to arrive at better
results.
Technical analysis is done from four important points of view viz.,

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• Price: Changes in price reflect changes in investor attitude and demand for

•
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and supply of securities.
Time: The degree of movement in price is a function of time. The longer it
takes for a reversal in trend, the greater the price change that would follow.
• Volume: The intensity of price changes is reflected in the volume of
transactions that accompany the change. An increase in price accompanied
by a low volume implies that the change is not strong enough.
• Breadth: The quality of price change is measured by studying whether a
change in trend spreads across most sectors and industries or is concentrated
in few scrips. Study of the breadth of the market indicates the extent to which
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price changes have taken place in the market in accordance with a certain
overall trend.
We shall discuss in detail the tools and techniques of technical analysis in terms of
the above dimensions.

THE DOW THEORY

The Dow Theory, originally propounded by Charles Dow in 1900, is one of the
oldest methods of identifying trends in the stock market. The basic principles of
technical analysis originate from this theory. In a nutshell, this theory seeks to
study the major movements in the market with a view to establish trends. Until a
reversal occurs, a trend is assumed to exist. It should be noted that the Dow Theory
only describes the direction of market trends, and does not attempt to forecast
future movements or estimate either the duration or the size of such market trends.
[However, subsequent analysts like Robert Rheas who provided a formalized
account of the theory (‘The Dow Theory’, 1932) attempted to measure size and
duration of trends proposed by Dow.] The theory uses the behavior of the stock
market as a barometer of business conditions, rather than as a basis for forecasting
stock prices themselves. It is assumed that majority of the stocks follow the
underlying market trend, most of the times. Therefore, the postulates of the theory
were framed with reference to market indices, specifically constructed to measure
market trends. (The Dow Jones Industrial Average, one of the popular market
indicators in the United States, was one such index developed by Charles Dow).

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 Security Analysis

The six basic tenets of the Dow Theory are as follows:

THE AVERAGE DISCOUNTS EVERYTHING
The aggregate judgment of all stock market participants, regarding both the current
and potential changes in the demand-supply relationships of stocks, is reflected in
the share prices. In other words, the share prices that are determined in the market
evolve out of a discounting process, that takes all known and predictable factors
into account.
THE MARKET HAS THREE MOVEMENTS
The Dow Theory classifies the movements in stock prices into,
a. Primary movements.
b. Secondary reactions.
c. Minor movements.
Primary Movements
Primary movements, which last from about a year to several years, represent the
major market trends. It can either be a rising (bull) trend or a falling (bear) trend.
A primary bear market trend can be seen as a long decline, interrupted by some
rallies. (A rally is an increase in price that occurs after a falling trend in prices.) It
is important that, though few rallies have occurred, the long-term trend in prices is
bearish. A primary bull market trend is a broad upward movement, interrupted by

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some reversals. (A reversal is a decrease in price that occurs after a rise in prices.)
Primary trends are thus, long-term movements in prices, interrupted by swings in
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the opposite direction.
Secondary Reactions
A secondary or intermediate reaction is defined as ‘....an important decline in a
bull market, or advance in a bear market lasting from three weeks to as many
months, during which interval, the movement generally retraces from 33 to 66 percent
of the primary price change since the termination of the last preceding secondary
reaction’ (Robert Rheas, Dow Theory, 1932). Sometimes, a secondary reaction
almost wholly retraces the primary trend. Where the reaction is more than 50
percent of the preceding primary trend, technical analysts find it difficult to say
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whether the reaction is indeed secondary, or if it signals a new primary trend in the
opposite direction.
Minor Movements
Movements in prices daily that form only intradaily are called minor movements.
They have no implication for long-term forecasting, though short-term investors
tend to manipulate them to some extent.
Figure 1 provides an illustration of these three trends in prices
Figure 1

(Rupees in
Thousands)

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 Technical Analysis

PRICE ACTION DETERMINES THE TREND

A trend can be called primarily bullish, when successive rallies lead to peaks that
are higher than the preceding ones, and when troughs reached by the intervening
secondary reactions are above the preceding troughs. Similarly, a bearish trend is
marked by a series of descending peaks and troughs. A reversal in primary trend is
indicated when the above tenet does not hold.
Figure 2a

Figure 2b

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Figure 2a illustrates reversals implied by this tenet of the Dow Theory. Figure 2a
shows a bull market interrupted by reactions. A reversal occurs at point ‘a’ when
the rally does not surpass the previous peak. The reversal is confirmed by the next
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decline, as the trough lies at point ‘b’ much below the previous trough. A Dow
theorist considers penetration at point X to indicate a bear market. More
conservative analysts, however, await a rally or penetration of previous trough at
point Y.
Similarly figure 2b illustrates a change in a primarily bearish trend.
As was stated earlier, it is very important to distinguish between a secondary
reaction, and a reversal in primary trend. Technical analysts generally measure the
depth of the reaction to confirm if a reversal is actually a signal to a new trend. It is
also seen if the secondary reaction that is deep enough, lasts for at least 3 to 4
weeks, and is confirmed by vital changes in volume of shares traded.
LINES INDICATE MOVEMENT
In certain cases, price movements which initially look like secondary reactions,
persist within a narrow range, forming what is called in technical parlance as a
‘line’. A line is formed by price movements within a range of 5 percent of its mean
average (see figure 3). This is called an ‘accumulation’ (where a ‘line’ is formed in
between a primary bear trend) or a ‘distribution’ (where a line is formed in
between a primary bull trend). If prices advance above an accumulation, it marks a
reversal in the bearish trend; if prices continue to fall after an accumulation line, it
is only a consolidation of the bearish trend, and is only a horizontal secondary
movement. The converse is true for a distribution.

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 Security Analysis

Figure 3a

Figure 3b

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PRICE/VOLUME RELATIONSHIPS PROVIDE BACKGROUND
The relationship between share prices and volume of shares traded is very
important in technical analysis. Volume is normally expected to complement the
movement in prices. A reversal in trend is signaled if a dull volume accompanies a
rally, or a high volume, a reversal. This principle is further elaborated in the
section on volumes.
THE AVERAGES MUST CONFIRM
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Dow Theory was illustrated, as we noted earlier, with the help of few
indices/averages constructed for the purpose. An important tenet of the theory is
that the averages must confirm each other. If the market is truly a barometer of
future business conditions, the industry averages and market averages should by
and large move together. This principle has been tested in the United States where
averages that are industry specific (like the Transportation Average) exist. In the
Indian context, all indices that are widely used, measure the overall market trend.
This principle, therefore, is yet to be tested in India.
The Dow Theory is widely applied by technical analysts, and has stood the test of
time. However, one criticism against the theory is that it helps recognize reversals
in primary trends, a bit too late. It is estimated that the theory confirms a reversal
in trend often 20 to 25 percent after a peak or trough has occurred. The tenets of
the theory have, therefore, been supplemented by use of other information, the
most important of them being dividend yield. One rule of thumb widely used in the
Wall Street is that a 3% or higher fall in dividend yields indicates maturity of the
bull market, and a 6% or higher rise in the dividend yield is said to indicate end of
a bear market.
In brief it may be said that the Dow Theory concerns itself with determining the
direction of the primary trend of the market; the identification of the phases of the
trend, and any possible divergence in trend. Where the movement of share prices
provides inconclusive evidence, supplementary information is used to make
decisions.

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 Technical Analysis

TYPES OF CHARTS
The basic tool in technical analysis is movement in prices, measured by charts. It
is for this reason that the technical analyst is sometimes called the “Chartist”.
Three types of charts that are commonly used are:
a. Line Chart
b. Bar Chart
c. Point and Figure Chart.
Line Charts
Line charts are simple graphs drawn by plotting the closing price of the stock on a
given day and connecting the points thus plotted over a period of time. The charts
are easily drawn and widely used in technical analysis. The price is marked on the
Y-axis and the period of time on the X-axis. Line charts are helpful in easily
identifying price patterns.
(See Fig. 4 for a typical chart)
Figure 4

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Bar Charts
In order to draw a bar chart, the data on a day’s high, low and closing prices is
necessary. To plot a stock’s price movement, the high and low reached on a said
day is marked and connected by a vertical line. The closing price is indicated by a
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small horizontal tick on this line.
(See Fig. 5 for a typical bar chart)
Figure 5

Point and Figure Chart

Though the point and figure chart (hereinafter referred to as PFC) is not as
commonly used as the other two charts, it differs from the others in concept and
construction. We shall discuss the construction of the PFC in detail.
While the line and bar charts are plotted at specific time intervals, the PFC does
not have a time dimension. A PFC concerns itself only with the measurement of

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prices. Further, a PFC does not measure every movement in price. Unlike a bar
chart, PFC records changes in prices that are larger than a specific amount, called
points. For example, a PFC can be constructed to measure changes in prices over
and above Rs.2. Such a chart is called a 2-point chart. It is common practice to use
1-point charts for shares with face value of Rs.10, and 3-point charts for Rs.100
shares.
For plotting indices, a 10-point or 20-point chart may be constructed. As the size
of a point is decreased, the details of even minor fluctuations in the graph drawn is
increased and vice-versa. Some chartists chart graphs with varying point sizes for
the same stock for better analysis. The decision about the size of a point is
essentially based on price range and degree of volatility of the stock.
Construction of a PFC involves the use of 2 symbols – ‘X’ and ‘O’; while ‘X’
indicates increase in prices, ‘O’ indicates downward movement.
PFCs are plotted on cross-section paper that has arithmetically ruled squares.
Suppose that a 2-point PFC is to be plotted. The graph may begin by recording the
price at a chosen level. Across the price levels marked on the Y-axis, either ‘X’ or
‘O’ is marked for the beginning price. Subsequent change in price level is noted. If
the price increases, for every increase equal to, or over Rs.2, an ‘X’ is marked on
the same column if the chart began with an ‘X’ mark for the beginning price level.
A decrease in price equal to or above Rs.2, is treated as a change in direction. The

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chartist shifts to the next column and marks a series of ‘O’s to indicate the
magnitude of fall in prices. No marking is made if prices remain at the same level
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or if changes are less than Rs.2. Prices are marked in the same column irrespective
of the time period, as long as the direction of change remains unaltered.
Consider the following prices recorded for X & Co. Ltd. during a given period.
Figure 6 illustrates the PFC drawn for this price data using the above explained
rules.
X & Co. Ltd.
Day Price
(Rs.)
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1 700
2 690
3 700
4 690
5 700
6 710
7 710
8 720
9 690
10 725
11 710
12 720
13 725
14 730
15 705
16 710

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 Technical Analysis

Figure 6

PFCs do not include volume, or time. Therefore, price action alone is examined in
a PFC. Sometimes in order to indicate time, the year is recorded in the first column
at the left hand corner and the price recorded on the first day of the month is
indicated by the number of the month – 1 for January, 2 for February, so on.
A PFC is very useful in studying price swings. It also effectively emphasizes
support and resistance levels, about which we shall soon study. However, the main

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defect with PFCs is that formations like islands, gaps, etc., do not show on the
chart. While in bar chart the depth of information is used to measure the reliability,
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in a PFC, the width is used. This is because in a PFC the lateral and vertical
movements are proportional to each other.
It should be noted that there are certain pitfalls in interpreting the above described
charts. Let us see some of them.

Pitfalls in Interpretation of Charts

Several charting software are available in India, and charting is very extensively
used by operators in the market for their trading decisions. It appears so easy to
view a chart, just press a few keys on the keyboard and you have the chart you
want on the screen. Almost all software allows you to zoom in on to a small
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segment chosen by the user and some allow plotting of up to four charts on
separate windows simultaneously on the screen. How can there be any pitfalls in
such a simple process? Well, appearances, they say, can sometimes be very
deceptive. Let us see why that is particularly true of charting.
We have to understand a little bit about the computer screen to appreciate the
issues we shall raise on charting. The screen is made up of thousands of dots
(known as pixels). These dots are selectively lit up to form characters and other
impressions on the screen for the user. While the number of dots vary with the
kind of monitor used, we shall discuss the situation where the screen has 640 x 480
dots (that is, there are 640 columns and 480 rows of dots). Assuming that about
20% of these dots are used up in drawing and naming the axes and in naming the
chart, etc., we would have roughly a space of 400 x 380 dots for actual plotting.
That is, the chart can plot 400 distinct periods and 380 distinct prices at one time
on the screen. This physical dimension can pose difficulties in several situations.
Let us say we want to plot the price of TELCO shares for the last three years on
the screen. The total number of observations may be about 650. How do we
compress 650 observations into 400 columns available for plotting? We could use
two approaches: plot every alternate point or plot the average price of every pair of
successive observations, in both cases the number of observations would be
brought down to manageable level of 325. But either of the two procedures could
lead to serious distortions in the picture presented to us on the screen. And we
would not even know that such a distortion has taken place!

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Security Analysis

Let us take another situation. We should like to plot a share quoting below Rs.100
and the BSE Sensitive Index, which is say above 1000, on the same chart. What
kind of a scale shall we choose? Given that only 380 rows are available for
representing prices, each row may have to represent an increase of three points, so
that we can accommodate the Index. Therefore, a price series of 30, 32, 34, 37,
36, ..... may be altered to 30, 33, 33, 36, 36 (rounding on the actual price to the
nearest value that can be represented on the chart). And again we would not be
aware that the plot that is presented to us has suffered for the inherent limitations
of the display equipment.
The software designers are not to blame for this. They are constrained by the
limitations of the equipment. But what we must certainly do is to find out from
them, the manner in which data is being compressed whenever a need for such
compression arises. This would ensure that we are aware of the possible impact of
that compaction on the chart and therefore before reaching any conclusions, we
plot the data in all possible manner to overcome as best as possible, the limitations
of the display technology.
Another limitation of charting that an intelligent user must be aware of is the
optical illusion that is often created by the method of drawing the graphs. Let us
say we plot TISCO share price data from July 1 to December 31, 1990, which has
say 100 observations. Since the space available on the screen is for 400
observations, a point in every fourth column would be lit up and a line would be

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drawn through these points to give us the line chart. Now, let us say, to get a better
perspective about the price movement, we expand the period to one year, from
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January 1 to December 31, 1990, which has say 200 observations. A point in every
second column would now be lit up and joined with a line to produce the chart. To
make a comparison of price movement in a similar period last year, we further
expand the period to two years, from January 1, ’89 to December 31, ’90, which
has say 400 observations. This would light up one point in every column. What is
the impact of all this on the chart for the period of primary interest to us? From
being spread across 400 columns, it has got compressed to 100 columns. And more
often than not, we would notice that the pattern that we visualize when it is spread
across larger number of columns is different from the pattern we visualize when it
is spread across lesser number of columns. We would call this as optical illusion,
and we have to be vary of this all the time when we are interpreting charts. A
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simple example to drive home the point: examine the two graphs on sales below
(Fig. 7 and 8) and very quickly answer as to which case has the growth in sales
been higher? Our answer is likely to be: Case 2. Now let us look at the charts more
closely; in fact, the growth in sales is higher in Case 1. It is the choice of scale that
conveyed the wrong impression.
Figure 7 Case 1

In sum, charting may appear simple and yet is full of details which when ignored
would lead to erroneous conclusions. Therefore, before we firm up our
interpretation of a chart, it is advisable to plot it in several ways, for different time
periods, and examine it from all angles, before drawing inferences. Unless we do
that, it is likely that we would be as often wrong as right in our interpretation.

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Figure 8 Case 2

In the subsequent sections on Technical Analysis, we shall be using the bar and
line charts extensively, due to their simplicity in construction and interpretation.

PRICE PATTERNS
The cyclical trends in prices are of utmost interest to the technical analyst, who
looks at them with a view to forecast trend reversals preferably in advance, or at
least before the reversal is complete. It can be observed that share prices do not

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always switch from a bullish phase to a bearish phase, or vice-versa almost
overnight. The transitional period which lies in between the two trends, throws up
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indications as to the direction of price change. The concept of price patterns is
based on the invariable occurrence of a transitional phase, which shows up as an
intermediate trend, in between two major trends. In a rising market, prices increase
as the buyers’ optimism about the market outweighs the cautiousness of the sellers.
The uptrend subsequently slows down either because buyers are booking gains, or
because the balance tends to get even with the sellers exerting more pressure. At
the end of this exercise, the market either continues to surge ahead, or turns down
due to increased selling pressures. Sometimes, a highly emotional market changes
without warning. These instances however are only exceptions to the rule.
According to the technical analysts, the transitional phase is marked by clearly
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discernable price patterns which signal (a) The end of a bull/bear market, (b) The
reversal in trend, (c) The magnitude and direction of the new trend and (d)
Confirmation of the new trend.
In order to explain this concept of transition, Martin Pring1 likes the ‘battle’
between buyers and sellers to one fought by two armies engaged in trench warfare.
Figure 9 illustrates the behavior of prices in the transitional period, in terms of this
example.
Figure 9a

Figure 9b

1 Pring Martin J Technical Analysis Explained, McGraw-Hill, Page 42.

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In Fig. 9a, one finds armies A and B facing one another in position of attack. AA
and BB are lines of defence of the armies A and B respectively. The arrows
indicate attack on the opposite side’s line of defence. If army B, for instance,
manages to push through the line AA, army A is forced to retreat to line A2A2. In
the stock market, line AA represents selling resistance, which once overcome
signifies a change in balance between buyers and sellers, in favor of the buyers. If
the price line, after meeting resistance for a while, penetrates the line of defence, it
is most likely to advance quickly until a new line of defence is met.
Army B may penetrate defence A2 A2 also, but if it continues to advance without
waiting to consolidate its position, the possibility of receiving a serious setback is
high. In the stock market also, a rising trend arrested by reactions all along the way
is more dependable, than an unchecked rally.
The transitional period, as we already noted, may end either in reversal as
explained above, or mean a consolidation of the existing trend. In case the price
moves in the same direction after the transition, it is difficult to say during the
period of formation as to which direction the breakout would occur. The army B in
our example, may either advance after an attack on line A2A2 or may retreat when
army A breaks through the line of defense of army B. It is, therefore, assumed that
a prevailing trend continues to exist, until it is proved to be reversed.
The following are important principles to be borne in mind, while analyzing price

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patterns:
i. The significance of a pattern is a direct function of its size and depth. The
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longer a pattern takes to complete, and greater the price fluctuations within
the pattern, the more substantial the ensuing move is likely to be.
The fluctuations that occur indicate the combat between buyers and sellers.
The longer it takes for prices to break through a pattern, the greater is the
significance of the penetration.
ii. The longer it takes for prices to move out of the pattern, the stronger is the
base of the new trend. This is due to the presence of both uninformed
investors and professionals in the market.
When the prices hit a new low, uninformed investors panic, and start selling.
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Professionals would, however, accumulate stocks in anticipation of improved
conditions in the future. The stocks therefore move from weak to strong
hands. The reverse process occurs at the market tops. The professionals who
accumulated stocks at the bottom, sell to uninformed investors who are
attracted by the rising prices, and buy these stocks. Thus at market bottoms,
the base from which prices rise is strong, as most stock has moved into the
hands of professionals. At market tops, the reverse is true as most stock is in
the hands of less sophisticated investors, and triggers a sharp fall in prices.
iii. Price patterns offer certain forecasting possibilities, because the duration of a
trend can be measured, with a certain level of accuracy, on the price charts.
iv. A valid breakout can be confirmed, in most cases, if the penetration of the
boundaries of a pattern are marked by price change equal to or more than 3%.
v. The validity of a breakout should be confirmed by volume statistics. Volume
advances with rising prices and declines with falling prices. A divergence
from this relationship throws up important signals.
We shall now discuss some of the widely used price patterns.

Head and Shoulders

This pattern is by far the most reliable, and widely used, of all reversal patterns.
This pattern occurs at the end of a bull market and is characterized by two smaller
rallies flanking a higher rally just as the head lies in between two shoulders. A
typical head and shoulder formation is shown in figure 10.

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Figure 10

In reality, however, the shoulders are not always symmetrical. This does not, in
any way, alter the signals provided by the pattern. The important requirement is
that the shoulders should be at lower levels than the head. The left shoulder
signifies the penultimate rally in the bull market. The right shoulder confirms the
beginning of a bear market, as it fails to climb above the previous rally (the head).
The formation is easily discernible once the right shoulder is formed. The line that
joins the points from where the final rally (head) begins and ends is called the
neckline. A trend reversal almost always occurs when the neckline is penetrated by
the price line. The technical analyst sells when the price falls at least by 3% from
the point of penetration of neckline. The possibility of price line hovering around
the neckline, or rising after a penetration, are very rare, making this pattern the

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most reliable indicator of the onset of a bear market.
Volume characteristics have to confirm the reversal signalled by the head and
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shoulders formation. Volume is very heavy at the left shoulder, and continues to
rise, albeit at a lower rate at the head. The formation of the right shoulder is
accompanied by a noticeably low volume.
The formation also provides scope for measuring the extent of fall in prices. The prices
are expected to decline after the penetration at least as much as the distance between
the head and the neckline. The head and shoulders pattern may be formed over short
periods of a few weeks, or take even years to emerge. As noted earlier, longer the
period, greater the distribution of the pattern, and stronger the ensuing bear trend.
Figure 11
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The price chart in the Figure 11 illustrates a head and shoulder formation that
extended over four months. The neckline has been penetrated, after which, a sharp
fall in price is seen. Also, note that volumes confirm the pattern by reaching the
peak at the left shoulder formation and tapering off after right shoulder emerges.
Sometimes, one can see more than one shoulder on either side of the head.
Although these represent prolonging of the distribution at the end of a bull market,
reversal is signified once the right shoulder is clearly visible. Figure 12 of Replica
Industries Limited illustrates such a clustered head and shoulders pattern.

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Figure 12

Head and shoulders pattern occurring at market bottoms indicate a reversal and are
called ‘inverted head and shoulders’. Volume is high at the bottom of the left
shoulder and significantly contracts during the formation of a right shoulder. The
bull market is heralded when the neckline is penetrated. Figure 13 illustrates the
inverse head and shoulder pattern.
Figure 13

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Sometimes, a head and shoulder formation is seen, but the price line either fails to
penetrate the neckline, or rallies immediately after penetration. Though this pattern
called head and shoulders failure is very rare, it is followed by a very strong rally.
It is, therefore, advisable to wait for a decisive breakout, and see whether volume
characteristics confirm the pattern.

Double Tops and Bottoms

When prices are found to react after rallying up to a certain level, technical
analysts watch the rallies with caution. If subsequent rallies also fail to raise above
the previous highs, a level of resistance is found to be developing. A classic
pattern that indicates such a tendency is the Double Top formation.
A double top is formed when prices reach the previous high, and react
immediately, the two highs reached being almost at the same level. Two peaks at
comparable heights are seen, with a reaction forming a valley in between them.
The prices breakout into a bearish phase, once they penetrate the neckline drawn
across the bottom of the intervening reaction. The measuring implication is similar
as for the head and shoulder formation. If the price line falls from the neckline by a
distance equal to the distance between the peak and the trough the indication is to
sell. Volume is found to be distinctly low at the second top. A double bottom is
just the reverse of a double top and occurs at the end of a downtrend in prices.
(Fig. 14 is a typical example of a double top and a double bottom).

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Figure 14a

Figure 14b

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Sometimes the tops and bottoms are not found at exactly equal levels. All the
same, these formations provide valid reversal signals. Sometimes, the patterns
extend to form triple tops or triple bottoms.
While identifying double tops and bottoms, it must be remembered that longer it
takes for the second top (bottom) to appear, and deeper the intervening valley
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(peak), more reliable the reversal, sometimes a minor rally (reversal) can be seen
in between the peaks (troughs) of a double top (bottom) formation. This does not
hamper the signals given by the formation. See Figure 15 for a double top.
Figure 15

Triangles
Triangles are commonly used to identify reversals and consolidation but are not
very reliable formations. There are two types of triangle formations – symmetrical
and right-angled.

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A symmetrical triangle is formed when, in a series of rallies, each succeeding one

peaks at a lower level than the preceding peaks, and the bottoms of the intervening
relations is progressively higher. The lines joining the peaks and bottoms of such a
formation converge. When prices breakout of a symmetrical triangle, the reversal
is generally sharp. Volumes reduce as the triangle narrows towards the apex.
When the breakout occurs between the half and three-fourths of the distance
between the widest peak and rally, and the apex, the formation is said to be a
highly reliable indicator of a reversal (see Fig 16). It is, however, not known
before the breakout as to whether the triangle is a continuation pattern or a reversal
pattern.
Figure 16a

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A right-angled triangle is also formed when a series of rallies converge, but with
an important difference. One of the two boundaries of the series is horizontal to the
X-axis. In a right angled triangle, since the resistance or support level is implied in
its formation, the direction of breakout can be identified even before the actual
breakout. However, sometimes a right-angled triangle develops into a rectangle,
thus making such identification difficult. The validity of the breakout is measured
by drawing a line parallel to the sloping side of triangle (hypotenuse) through the
first rally or reaction. Figure 17 shows a right angle formation.
(see Fig. 18 for an illustration)
Figure 17a

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Figure 17b

Figure 18

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Rectangles
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A rectangle is an important consolidation pattern, which can be formed either
during an uptrend or in the course of a downtrend in prices. A series of minor
rallies and reactions, which have almost identical peaks and troughs signal the
formation of a rectangle. (Note that rectangles are formations indicated as ‘Lines’
in the Dow Theory.) A rectangle indicates equal pressure being exercised by
buyers and sellers, and the combat is indecisive until a breakout occurs. The price
line may breakout on either side. A rectangle therefore may be a consolidation
pattern or result in reversal. Just as in the case of the symmetrical triangle, one
cannot predict the course of prices when a rectangle is being formed, but has to
wait for the breakout.
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Volume is usually high when the rectangle begins to form, and tapers off
significantly as the rectangle extends. The breakout is definitely accompanied by a
high volume (Figure 19). The breakout from a rectangle is fairly reliable, as prices
generally do not return to the rectangle. Even if the prices subsequently touch the
boundary level, they generally do not penetrate the rectangle. These formations are
more commonly found at the market bottoms than at tops. The measuring
implication for a breakout is that prices should move out at least by a distance equal
to the maximum distance between the boundaries of the rectangle (breadthwise).
Figure 19

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Flags
If a vertical rally or decline is interrupted by a consolidation pattern akin to a
rectangle, such a formation is called a flag. After the flag formation prices move in
the same direction as before. Flags only represent a pause in a rally or reaction
before prices continue in their course. Flags may be horizontal, though it has been
found that flags in a rising market are formed with a slight downtrend, and flags in
a falling market have a slight uptrend.
Volume is generally very high as the flag begins to form and tapers off when the
formation is complete. When the prices breakout of the flag, a sudden increase in
volume can be noticed. In a rising market, bullish traders may pause to register
gains in the course of an uptrend that is particularly sharp, causing a flag formation
in prices.
A flag formation in a declining market is marked by falling volumes. Since a flag
in a downtrend in prices means a series of minor rallies, analysts who watch the
increase in prices accompanied by falling volumes, identify the ensuing bear
market. When prices breakout, the downtrend in prices continue. Volumes
accompanying a downward breakout are not very high as in the case of a flag
formed in an uptrend (see Fig. 20 for a typical flag formation).
Figure 20a

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Figure 20b

Since flags by definition are minor interruptions of a trend, a flag extending over
more than 4 weeks should be treated with caution. The price trend in such a case
may reverse. A flag takes 5 days to 2 weeks to form. If a flag formation is not
accompanied by contraction in volume, a reversal might occur. It is estimated that
flags occur somewhere near the mid-point of a trend. Therefore, the measuring
implication is continuance of the trend by a length equal to that which prevailed
before the flag was formed. Figure 21 illustrates a flag formation.

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Figure 21

Figure 22a

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Figure 22b
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A pennant is similar to a flag in all respects except that it looks like a triangle
rather than a rectangle. The volumes accompanying a pennant formation are much
smaller, and contract more than during a flag formation.
Figure 22 illustrates a typical pennant formation.

Saucers and Rounding Tops

A saucer generally occurs at market bottoms when investor interest in the share is
at its lowest ebb. The lows reached at the end of the market are all formed by
reactions that are small, and rallies are not marked enough due to lack of
enthusiasm. However, these minor fluctuations while continuing for sometime,
form a saucer-like pattern indicating that fluctuations have been occurring at
higher price levels, after a bottom was reached. This triggers increase in price as
well as volume, which explode at the end of the formation to a smart rally.
A saucer being formed during a period of near inaction in the market, volumes
almost dry up at the bottom of the saucer, and pick up once the upward movement
in prices begins. Saucers sometimes are formed when the rally in the beginning of
a bull market is sluggish, and have the same characteristics as described above. In
such cases, saucers confirm a reversal.

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Figure 23

Figure 24

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The price charts in figures 23 and 24 are provided as illustrations. (Figures 23 & 24)
Notice that volume moves along with the formation, picking up after the
formation.
A rounding top is exactly opposite to a saucer, but volume characteristics are same
for both the patterns. A rounding top is formed to indicate a slow change in the
demand-supply balance, and is an important reversal pattern.
The price volume relationship in a rounding top formation provides important tips.
The volume behaves just opposite to the price pattern, resulting in low volume
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when the price is at the highest level, and expanding volumes when prices begin to
fall. As we shall see in the section on volumes, both of these indicate a downtrend
in prices.
It is difficult to obtain support or resistance levels, or breakout levels for both
saucers and rounded tops. These patterns typically develop slowly and over a long
span of time. Interestingly these very characteristics are responsible for the
substantial moves that invariably follow these two formations.
Figure 25

Figure 25 illustrates a rounding top. Zeta Ltd. being a very volatile scrip, few
strong increases in volumes are noted. Otherwise, volumes have been low during
the rounded top formation. Note that the pattern extends over 6 months.

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Gaps
A gap refers to the occurrence of an empty space in a bar chart between the prices
of two consecutive trading periods. Typically, the lowest price of the period after
the gap is higher than the highest price of the preceding period or vice versa.
Figure 26a

Figure 26b

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By definition gaps can occur only in a bar chart where, for every period, the
lowest, highest and closing prices are plotted. (See Fig 26 for an illustration of a
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gap). Gaps which occur during the formation of a pattern, or gaps occurring when
a stock becomes ex-dividend, are of little significance and can be ignored.
Three types of gaps are generally analyzed by technicians – Runaway gaps,
Breakaway gaps and Exhaustion gaps. Runaway gaps occur when prices are on a
rapid uptrend or downtrend, they generally occur almost half way through a trend,
and are also called measuring gaps. Breakaway gaps are created when price breaks
out of a price pattern, and such breakouts are likely to be valid than those
occurring without a gap. The breakaway gap emphasizes the bullishness or
bearishness of the breakout. An upside breakout has to be accompanied by an
increase in volume, whether or not formed after a gap.
Exhaustion gaps represent gaps occurring before a trend ends, or gaps that precede
the last leg of a bullish or bearish trend. A series of runaway gaps indicate that an
exhaustion gap is round the corner, and that the trend could be expected to end
soon after. It is, however, not possible to say whether a gap, while it occurs,
signals a runaway or exhaustion gap. An exhaustion gap should normally be
treated as a sign of consolidation. Reversal may be confirmed by formation of
Islands. See Fig. 27 for an illustration. Notice the occurrence of breakaway gap at
the beginning of the reversal, runaway gaps in the middle of the trend and
exhaustion gap at the end of the move.

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Figure 27

Islands refer to the formation of an isolated price pattern, usually within a narrow
range, at the end of a price trend. The island is separated from the previous trend
by an exhaustion gap, and a breakaway gap (see Fig. 28 for an illustration of an
island). Islands signal price reversals which have to be confirmed by a noticeable
drop in volume occurring as the pattern forms, and an increase in volume after the
breakaway gap.
Figure 28

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Price patterns are widely used by technical analysts to discern trends. Conformation
of reversals, however, requires looking at patterns along with the supporting
volumes, momentum, etc. The subsequent sections deal with these topics.
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TREND LINES
A rising primary trend in prices, would be marked by a series of ascending rallies,
while a falling trend would be characterized by a series of descending rallies.
Trendlines are lines that are drawn to identify such trends and extend them into the
future. These lines typically connect the peaks of rallies and bottoms of reversals.
Sometimes an intermediate trend, that extends horizontally, is seen. Trendlines can
also be drawn to describe such patterns. The boundaries of a rectangle can be
called a horizontal trendline.
Figure 29

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Penetration of a trendline may either mean a reversal or a consolidation. In other

words, after a price chart breaksout of trendline, a reversal in the previous trend may
occur, or the same trend may be continued. Trendlines have to, therefore, be
analyzed along with the price patterns discernible on the chart. The neckline of head
and shoulder pattern can be seen as a horizontal trendline, while penetration signals
reversal. Similarly, penetration of a trendline that joins the troughs of a right-angled
triangle formation indicates a reversal. Trendline violation can be further analyzed
with the help of volume statistics that accompany it. A bullish trend can be
recognized to be near its end, if volumes at each successive rally are on the decrease.
A trendline penetration in such circumstances can signal a reversal.
The following principles have to be borne in mind while analyzing trendline
penetrations:
i. The larger the number of peaks/troughs that touch a trendline, the greater its
significance. When peaks of rallies reach the trendline, and return without
penetration, the recurrence of this tendency indicates that the trend ‘obeys’
the trendline. Further, the number of points contributing to a trendline,
determine the direction of the line. More the points, greater the accuracy of
the line.
ii. The length of a trendline indicates whether a penetration is significant.
Longer the time span covered by a trendline, greater the importance of a
violation.

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Figure 30a
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Figure 30b
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iii. A steep trendline is easily violated by small sideward movements in the price
chart, and is not particularly useful in identifying reversals (see Fig. 30a). A
flat trendline, on the other hand, might miss out certain key reversals. The
trendline in Fig. 30b violated at the end of the bull market while trendline
indicates reversal much earlier. Also note that is touched by 2 points only,
but covers a longer time span and is touched by more number of peaks but
covers a shorter time span. In reality, therefore, trendlines have to be drawn
exercising judgement, and balancing the factors that influence its predictive
ability.
iv. Penetration of a steep trendline generally results in a corrective movement,
after which the previous trend continues. Violation of a slower, sustainable
trend is an indication of a reversal.

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Just like price patterns, penetration of trendlines also has measuring implications.
For a rising trendline, the distance between the higher rally, before penetration,
and the trendline is measured. This distance is projected downward from the point
of penetration. (See Fig. 31. Distance AB is projected downward from point x, the
point of penetration.)
Figure 31a

Figure 31b

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When prices fall, the price objective (the level indicated by the measuring
implication), generally acts as a resistance level, beyond which subsequent rallies
do not rise (see Fig. 31b). The reverse is true in case of a falling trendline.
A trendline penetration should also be read along with other technical indicators
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like volume, momentum, etc. as there is no way of determining how long a certain
move would exist. Trendlines are commonly used as confirmation of reversals.

Trend Channels
Trendlines encompass rallies or reactions by joining successive tops or bottoms.
Sometimes, it is useful to ‘trap’ trends by drawing trendlines on both the sides of
an uptrend or downtrend. These parallel lines drawn to encompass trends from
both the sides, are called, channels. (see Fig. 32)
Figure 32a

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Figure 32b

Penetration of an upchannel indicates a reversal of at least a temporary proportion,

because it confirms that the price line not only fails to reach the previous rally, but
also reaches a new low, below the previous troughs. The reverse is true for
penetration of a down channel.

Support and Resistance

An important application of trendlines is in identification of support and resistance
levels. Resistance is defined by Edward and Magee as ‘Selling, actual or potential,
sufficient in volume to satisfy all bids and hence stop prices from going higher for
a time period’. Support is defined as ‘Buying, actual or potential, sufficient in

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volume to halt a downtrend in prices for an appreciable period’.
A support zone is formed when the demand supply balance tilts in favor of buyers,
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resulting in a concentration of demand. A resistance zone similarly represents a
concentration of supply. The concepts of support and resistance can be illustrated
with the help of an example. Consider figure 33 which shows the price chart.
Figure 33
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The behavior of prices during January-May does not throw up any price pattern,
but the range within which the prices are found to be fluctuating warrants
attention. On almost 6 occasions, prices have climbed to the level of Rs.122, and
returned. Prices can be observed to face resistance at this level, as every time they
reach there, they fail to climb further, but fall back. A trendline drawn to represent
this level is called a resistance line (designated RL1 in the figure).
Similarly, prices have not fallen beyond a level of Rs.110, most of the times they
returned from the resistance line. It can be said that a support level exists, at which
prices have shown a tendency to climb up again, rather than continue to fall. The
maximum fall registered is at Rs.106, represents the level at which support has
almost invariably occurred. Line SL1 represents this line of support.
Support and resistance lines are, therefore, trendlines drawn to indicate the ranges
a trend can be expected to take, using the past behavior as a reference point. These
lines throw up further interesting inferences. When the prices pierce the resistance
level RL1, it is an indication that buyers have succeeded in breaking the resistance,
and prices can be expected to climb up. The new high reached prices would
represent a new level of resistance (represented as RL2). Prices now are found to

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fluctuate between the old RL1, and the new RL2. The point to be noted is that the
old resistance line is the new support line, as prices receive support at a level
almost equal to RL1. Similarly prices can be observed to reach a new resistance
level RL3, and find support at the previous RL2.
The support and resistance levels are important tools in confirming a reversal, in
forecasting the course of prices, and in making appropriate price moves. The
following principles are to be applied while using support and resistance lines for
trend analysis:
i. Support and resistance lines are only approximations of the levels prices may
be expected to ‘obey’. They should therefore be drawn using judgment, and
clues from the past price behavior.
ii. Penetration of a support or resistance line, also confirmed by an underlying
price pattern, is a fairly sure indication of a strong ensuing move in the same
direction. New highs are reached after a resistance line is penetrated and new
lows follow penetration of a support line.
iii. Prices are said to remain in a ‘congestion zone’ as long as they fluctuate in
narrow ranges within a support and resistance level. The direction of
breakout from a congestion zone cannot be predicted in advance.
iv. The higher the volume accompanying the confirmation of a support or
resistance level, the more its significance.

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v. The speed and extent of the previous move determines the significance of a
support or resistance level. Prices penetrate support (resistance) level
FAgenerally after slowing down from a previous low (high) and hovering
around a level for sometime (see Figure 33).
vi. Support and resistance levels repeat their effectiveness time and again, even
if separated by many years.

Relative Strength Analysis

Stock prices tend to move more or less in tandem with the overall market trend,
represented by a market index. When the price chart of an industry, or an
individual stock diverts from the course chartered by an index, the concept of
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relative strength can be used to study such divergence. Relative Strength (RS)
refers to the ability of an industry or stock to outperform the market at turning
points. Relative strength arises out of inherent merit of an industry or stock to
recover from a bear market or to peak out earlier than most of the stocks trading in
the market.
Relative strength is obtained by dividing the price of the stock by the market
index. The divisor is always the measure of the trend that is expected to be out
performed. When computed in this manner, a rising RS index indicates that the
stock is doing better and vice-versa. RS index also follows trends, reversal of
which signifies changes in the relative strength of the stock. RS indexes are
normally used in stock selection.
Figure 34

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When a stock and its relative strength (in terms of the market) are plotted together
on a graph (see Fig. 34), the relative strength generally reverses ahead of the stock
prices. Analysts, however, also wait for the stock to reverse, before acting on the
basis of relative strength alone.

Moving Averages
While trends in share prices can be studied for possible patterns, sometimes it may
so happen that the prices appear to move rather haphazardly, and be very volatile.
Using moving averages can help under such circumstances. A moving average is a
summary measure of price movement which reduces the distortions to a minimum
by evening out the fluctuations in share prices. The underlying trend in prices is
thus clearly discernible when moving averages are used.
There are three basic types of moving averages:
a. Simple moving average
b. Weighted moving average
c. Exponential moving average.
SIMPLE MOVING AVERAGE (SMA)
A simple moving average is easy to construct and is widely used by technical
analysts. To construct a moving average the time span of the average has to be first

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determined. A 30-day moving average, averages out every fluctuation occurring
over all the possible 30-day time spans over the period under observation. To
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construct a 100-day SMA for instance, the prices observed over the first 100 days
are first summed up and divided by hundred to obtain a simple average. This is the
first value for constructing a 100-day SMA. To obtain the next value, the price
prevailing on the 1st day is excluded, while including the price on the 101st day.
This represents the next 100-day period. The average of these observations is the
next value of 100-day SMA. This process is repeated for the time period one
intends to cover. Table 1 illustrates the computation of SMA. A 100-day SMA of
the BSE Sensitive Index- is plotted in figure 33.
Table 1
Simple Moving Average
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Day BSE Sensex 100-day BSE Sensex 100 days

Total 100 days ago SMA
(1) (2) (3) (4)
1 3469.40 339796.80 3409.85 3397.968
2 3425.88 339812.70 3384.99 3398.127
3 3364.71 339792.60 3367.55 3397.926
4 3316.00 339741.60 3399.36 3397.416
5 3280.06 339623.50 3388.48 3396.235
6 3193.77 339430.70 3359.27 3394.307
The choice of time span is very important in constructing moving averages. If
prices move in cycles, say over 2 years, a 750-day moving average will smoothen
out all intermediate trends. A 10-day moving average will represent many minor
fluctuations present on the price line, and would be of little use in determining tops
and bottoms of a trend. Lesser the time span, more sensitive the moving average
and vice-versa. A moving average, therefore, should provide an optimum trade off
between oversensitivity and lateness in identifying reversals. A 200-day moving
average is widely used by analysts, and is believed to represent an optimum span.

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Figure 35

The importance of the choice of time span is illustrated in figure 35. Note that the
moving average with longer time span turns much later than those with shorter
spans.
Figure 36

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Technical analysts observe moving averages more for ‘crossovers’ (price chart
over the moving average or vice versa) than for the changes in direction and obtain
more clear-out buy-sell signals than those obtainable from use of trendlines. The
following are the important principles useful in this regard.
i. When the moving average rises above the price line, a reversal in bullish
trend is signalled. This is based on the simple logic that as long as price at the
end of a period is above the average that prevailed in the immediate past,
prices are on an uptrend. The converse is true for confirming the end of a
bear market. The price line in that case would crossover the moving average.
(See points A and B in figure 37.)
ii. The price line moving average crossover has to be examined cautiously when
the price line and moving average move in opposite directions before the
crossover. The price line that falls below a rising moving average only
indicates a secondary reaction and need not signal a trend reversal. Similarly,
a price line that rises above a falling moving average is an indication to sell.
(See point C in figure 37.)
iii. A moving average represents a smoothened trend and therefore, also acts as a
support/resistance line. A declining price line often finds support at the
moving average line and rallies without crossing the line. Similarly, a rally in
a bear market meets resistance at the moving average, and turns down.

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iv. If the moving average is flat or has already begun to change direction, a
crossover by the price line is a fairly reliable indicator of trend reversal.
v. The significance of a crossover signal depends, to a large extent, on the time
span covered by a moving average. A moving average covering a longer time
span is actually smoothening a long-term trend, and its crossover is more
significant than a crossover of an average of shorter time span.
Figure 37

Some technicians use more than one moving average to smoothen the same price
trend. This procedure smoothens the data twice, and provides warning signals for
trend reversals, comparatively more quickly after they have taken place. It is
common for analysts to use 100-day and 300-day averages simultaneously.
When the 100-day average moves below the declining 300-day average, a trend

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reversal is signalled. Multiple moving averages are useful because shorter-span
averages reach the turning points earlier than the longer-span averages, and are
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very useful in confirming a trend reversal. (See figure 36).
A point of caution is in order. Simple moving averages always invariably provide
signals to buy or sell, after the trend reversal has begun. They are neither lead
indicators, nor juncture points for change in trends. Simple moving averages,
therefore, should only be used along with other indicators. In an accumulation/
distribution phase, a series of crossovers can occur when the market is moving
sidewards, and provide misleading signals. (See Point D in Figure 37.)
WEIGHTED MOVING AVERAGES
Let us look at figure 35 once again. It can be observed that the moving average
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invariably changes direction after the price chart and lags the reversal in trend.
This is because the moving average line is so constructed as to plot the average of
a given period at its end (A 100-day moving average is plotted from the 100th day
onwards). This methodology leads to shifting the average, which can be assumed
to occur in the middle (50th day) to the end of the period. By plotting the average
for the period at the middle of the period, the moving average line would be
‘centered’ as shown in figure 38.
Figure 38: BSE Sensitive Index
100 Day Exponential Moving Average

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 Security Analysis

Such a technique of centering would not be of utility in stock price analysis

because if this technique is used, the analyst has to wait for the next half period
(50 days in case of a 100-day average) to ascertain if there is a trend reversal. Such
waiting can prove costly in terms of lost profitable opportunities as stock prices
fluctuate rapidly.
One way of overcoming this problem is to use weighted moving averages. A
weighted moving average is weighted in favor of the most recent observations, and
therefore, turns earlier than the simple moving average.
One of the simpler methods of weighing, which is also widely used, is to multiply
the first set of observations by 1, the next set by 2, the third by 3 and so on. The
values thus obtained are added, and the sum is divided not by the number of
observations, but by the total of the weights (see Table 2 for an illustration of this
method). This method, however, gets cumbersome and laborious when the time
span of the average is long.
Table 2
Weighted Moving Average
BSE 1 x col(1) 2 x col(1) 3 x col(1) 4 x col(1) 5 x col(1) 6 x col(1) Total of col. 8
Sensex 5 days ago 4 days 3 days 2 days 1 day current columns 21 days
Day value ago ago ago ago day 2 to 7
1 2 3 4 5 6 7 8 9
1 3469.40 — — — — — — — —
2 3425.88 — — — — — — — —

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3 3364.71 — — — — — — — —
4 3316.00 — — — — — — — —
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6
7
3280.06
3193.77
3138.79
—
3469.40
3425.88
—
6851.76
6729.42
—
10094.13
9948.00
—
13264.00
13120.00
—
16400.3
15968.85
—
19162.62
18832.74
—
69242.21
68024.89
—
3297.25
3239.28
8 3158.98 3364.71 6632.00 9840.00 12775.08 15693.95 18953.88 67259.62 3202.84
9 3143.18 3316.00 6561.20 9581.10 12555.16 15794.90 18859.08 66667.44 3174.64
10 3103.03 3280.06 6387.54 9416.37 12635.92 15715.94 18618.18 66054.01 3145.43

The table presents a 6-day weighted moving average for the BSE Sensex values. If
the method is to be used for a 100-day moving average, one has to turn to the
computer for determining the weighted moving average.
Another method is to double the weight of the last observation. For a 30-day
moving average, for instance, the price on the thirtieth day is doubled and the sum
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is divided only by 31. The weighted moving average being more sensitive than
that of a simple average, a change in its direction rather than a crossover confirms
a trend reversal.
EXPONENTIAL MOVING AVERAGE (EMA)
As noted earlier, averages constructed over a longer time span have higher utility in
technical analysis. But a simple moving average constructed over a long time span
lags the price trend, while construction of a weighted average on the lines just
discussed is time consuming. An exponential moving average provides a short cut
method of weighting. This method also provides more weightage to the recent data.
The procedure for computing the EMA can be explained with the help of an
example. 100-day EMA for the BSE Sensitive Index is computed in Table 3.
Table 3
100-day Exponential Moving Average
Day BSE Sensex EMA for previous day (1) – (2) (3) x 0.02 EMA = (2) ± (4)
(1) (2) (3) (4) (5)
1 3469.40 — — — 3397.793*
2 3425.88 3397.79 27.9120 0.55824 3398.526
3 3364.71 3398.52 –33.8162 –0.67632 3397.850
4 3316.00 3397.85 –81.8499 –1.6370 3396.213
5 3280.06 3396.21 –116.153 –2.3230 3393.890
6 3193.77 3393.89 –200.120 –4.0024 3389.887
* The 100-day SMA on day 1 is posted here.

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 Technical Analysis

To construct a 100-day moving average, the first step is to compute a simple

average for the first 100 days (the first value in column 5). The value is used as a
starting point at column 2. The index value for the 101st day is computed with this
value and the difference is shown in column 3. The exponent for the 100-day EMA
is calculated as 2 = 0.02. The difference obtained in column 3 is multiplied by the
exponential 0.02, and posted in column 4. The EMA value for the next 100 days
(excluding the first day and including the 101st day) would be the EMA value in
column 2 plus or minus the product obtained in column 4, depending upon
whether the difference in column 2 is negative or positive. The procedure is
repeated for each succeeding day. Figure 39 shows the 100-day EMA for the BSE
Sensitive Index (calculated as explained above)2.
Figure 39

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The EMA thus provides a smooth base for analyzing price trends. Since the
exponent is used, it should be remembered that a 100-day EMA would be thrice as
sensitive as a 300-day EMA, the exponent of the former being twice the exponent
of the latter. If it is found that the EMA is very sensitive, the time span can be
extended. Alternatively, the EMA can be further smoothened by constructing
another EMA for the values first obtained, using a further exponent.
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The Filter Rules

The filter rules, many a time, define the mechanical trading schemes. An x% filter
implies that a downtrend is indicated as soon as a stock moves down by x% from
the most recent peak, and uptrend is indicated whenever a stock moves up by x%
from the most recent low point. Let us apply a 4% filter rule to Tata Steel between
February 19 and February 23, 1998 (Table 4). The share touched a low of
Rs.120.70 on February 20. A 4% filter, that is, 120.70 (1 + 0.04) = 125.53, would
have given a buy signal on February 26, when the price touched Rs.126.20. Then
the scrip touched a peak of Rs.138.00. Therefore, the same filter that is, 138.00
(1 – 0.04) = 132.42 would give a signal to sell on March 3, when the price touched
Rs.132.10 (that is about 4% below the peak). The net gain to a person, before
transaction costs, and had he been able to transact precisely at the prices indicated
by the rule, would have been Rs.5.90 per share.

2 The exponent to be used depends on the time span of the moving average, and is calculated by dividing 2
by the time span. It is to be noted that an exponent of 0.067 holds for any time span of 30, irrespective of
whether it is 30 days, 30 weeks, or 30 months. The exponents for few time spans are provided below.
Time span Exponent
100 days 0.02
200 days 0.01
300 days 0.0067

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Security Analysis

Table 4
Price of Tisco Shares
Newspaper Date Tisco
Feb. 16, ‘98 124.50
17 123.20
18 121.60
19 122.20
20 120.70
23 122.80
24 122.80
26 126.20
27 132.30
March 2, ’98 138.00
3 132.10
4 136.00
5 133.90
6 133.90
9 137.90
10 141.00

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11 137.20
FA 12
16
135.20
139.20
17 145.60
18 146.90
19 145.70
20 149.90
23 156.00
24 153.90
25 153.60
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26 150.00
It is clear that smaller filters are likely to result in larger number of transactions
and therefore larger transaction costs. In general, these rules can be effectively
used in the market only if the transaction costs are very low. Since these rules can
be easily mechanized, they are widely used for computerized trading. In fact, the
October, ‘87 crash of Wall Street and the other developed capital markets has been
ascribed to such ‘mindless’ trading rules. It is also obvious that infinitely large
number of filter rules can be (and are) used by operators in the market. Do these
trading rules work? Do they indeed provide extra-normal returns to investors?
Envelopes
We have already noted that moving averages can be looked upon as smoothened
trendlines, which function as support and resistance feels for the prices. A moving
average with a longer time span would serve this purpose better.
On drawing envelopes, moving averages can also be looked upon as juncture
points around which stock prices fluctuate in cycles. We can draw parallel lines to
the moving average to envelop the cyclical movement around the average
(See figure 40). Envelopes represent moving averages as the center of a trend, with
the envelopes enclosing points of maximum and minimum divergence from that
trend. Depending upon the volatility of the chart being monitored, and the time
span of the moving average, the distance of the envelope from the moving average
is determined.

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 Technical Analysis

Figure 40 Envelopes

An envelope is useful in developing a ‘feel’ for the overall trend, and to discern
when a rally or reaction has over-extended. It cannot be said with certainty that the
envelopes would act as the eventual turning point, though a good probability of
reversal exists when the price chart breaches an envelope. The technical analyst
however, assesses the other technical characteristics before taking action.

Breadth of the Market

The extent of a trend is monitored by breadth. Breadth refers to the extent to which
share issues move along with the market trend and is generally measured in terms
of number of issues whose prices are advancing, declining, and remaining
unaltered in the period over which a trend persists. A reversal in trend is imminent
if the number of issues moving with the trend are fewer than those moving against.

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Breadth also measures the underlying strength of the market. If the index continues
to move up, when most listed shares are declining, a reversal can be read from the
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breadth of the market statistics. In other words, if a price trend does not receive a
follow up from the broad market, it is vulnerable, and may not persist for long.
Numerous methods exist for measuring the breadth of the market. One of the
simplest is to compare the number of issues whose prices advanced on a particular
day, to the number of issues whose prices declined on the same day. The net
advances or declines thus obtained, is cumulated over the period under
observation. The cumulated figures are also plotted on a graph, preferably along
with a market index. The Advance-Decline line (A-D line) and the index generally
move in tandem. However a divergence in the A-D line is indicative of a turning
point, and technical analysts look for such signals from the A-D line.
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For example, consider the following table showing net advances or declines for
issues traded on the Bombay Stock Exchange, during a certain period.
Table 5
Day Issues Advances Declines Net Cumulative
Traded Advances/Declines
(1) (2) (3) (4) (5)
25 Nov. ‘98 1318 454 686 –232 –232
26 1392 417 811 –394 –626
27 1403 344 841 –497 –1123
28 1392 417 811 –394 –1517
1 Dec. ‘98 1008 480 385 95 –1422
2 1219 538 483 55 –1367
3 1306 514 601 –87 –1454
4 1226 434 620 –186 –1640
5 1306 514 601 –87 –1727
8 1141 641 366 275 –1452
The breadth of the market statistics in the last column is simply the cumulative
value of net advances or declines. The value becomes negative when number of
declines exceed the number of advances. This in itself need not cause concern,
because the value of the cumulative advances/declines depend on the value

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Security Analysis

obtaining on the first data from which observations were made. However, the
change in direction of the breadth statistics is to be noted. It is the direction of the
statistics that is more important than the magnitude.
Figure 41 plots the A-D line for the period.
Figure 41

The A-D line drawn from a simple cumulation of the net advances or declines is
generally used to observe the breadth of the market over short periods of a month
or two. For long run observations, the A-D line is drawn after considering the
number of issues also whose prices remain unaltered. The A-D line is drawn by

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cumulating the value of A − D , where A = number of stocks whose prices are
u u
advancing; D = number of stocks whose prices are declining; and u = number of
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stocks whose prices remain unaltered. It is possible for the value D/u to be higher
than A/u when declines are more than advances. Such a tendency signals change in
direction of the A-D line. Therefore in such cases the value A −D is
u u
computed, and the resulting answer is subtracted from the cumulative total (note
that square root of a negative number cannot be mathematically computed). Table 6
illustrates this method for the issues traded on the Bombay Stock Exchange during
the above mentioned period.
Table 6
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Issues (2) (3) Cumulative
Day Advances Declines Unchanged x100 x100 (5)–(6) (7)
Traded (4) (4) A.D Line
(1) (2) (3) (4) (5) (6) (7) (8) (9)
1 1174 332 456 386 86.01 118.13 –32.12 –5.67 –5.67
2 1214 273 492 449 60.80 109.58 –48.78 –6.98 –12.65
3 1215 274 501 440 62.27 113.86 –51.59 –7.18 –19.83
4 1210 334 444 432 77.31 102.78 –25.47 –5.04 –24.87
5 1206 335 452 419 79.95 107.88 –27.93 –5.28 –30.15
6 1205 225 586 394 57.11 148.73 –91.62 –9.57 –39.72
7 1210 276 532 402 68.66 132.34 –63.68 –7.98 –47.70
8 1218 334 410 474 70.46 86.50 –16.04 –4.00 –51.70
9 1167 505 255 407 124.08 62.65 61.43 +7.83 –43.87
10 1190 370 341 479 77.24 71.19 6.05 +2.46 –41.41
Inclusion of the issues whose prices remain unaltered provides additional
information on the market following for a certain trend, and can also indicate in
advance, a trend reversal. If the trend to advance or decline is very strong, the
number of unchanged issue should diminish. By giving weightage to such stocks
in computing the A-D line, any slow down in the momentum of the A-D line can
be gauged earlier, because extreme movements would be restrained by an
increasing number of unchanged issues.
As already noted, breadth of the market is studied primarily to observe whether
price trends are supported by the issues trading in the market. The utility of the
A-D line in this context lies in its movement as compared to a market average. The
divergence of the A-D line from the market index provides vital clues on the future

314
 Technical Analysis

course the market is expected to take. Technical analysts, therefore, attach a lot of
value to the divergence of A-D line from the market index.
The following principles of divergence have been found to apply universally:
i. In a bull market the A-D line generally peaks ahead of the market index. Two
important reasons behind this phenomenon are:
Figure 42

a. The market, as a whole, discounts the business cycle, and generally

attains the peak at least 6 to 9 months before the economy peaks out.

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However, certain leading sectors like consumer durables peak out
earlier than the business cycle. Stocks representing such sectors,
FA therefore, will logically peak out ahead of the market.
b. At the end of a bull market, it is observed that the stocks of Blue Chip
companies are the last to be unloaded. Since most indices include many
Blue Chip stocks, it is natural for the A-D line to peak out before the
indices, which may continue to rise even after the broad market has
peaked out.
ii. The longer and greater the divergence, the implied reversal may be expected
to be deeper and more substantial. In the United States, for instance, the
weekly A-D line peaked almost 2 years ahead of the Dow Jones Industrial
Average in 1971. The ensuing bear market was the most severe one, after the
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depression of 1930. The converse of this principle is not always true. That is,
every bear market need not necessarily be preceded by a divergence.
iii. At market bottoms, the A-D line generally coincides with, or lags behind the
market index and has no forecasting significance until its downtrend reversal
is signalled by a breakout from a price pattern. However, where the A-D line
persistently refuses to confirm a new low in the market index, a downtrend
reversal is imminent.
Technical analysts always confirm whether the A-D line has made the final
advance by waiting for a downside trendline penetration or a moving average
crossover.
OTHER METHODS FOR ANALYZING MARKET BREADTH
Breadth of the market is popularly studied using A-D lines. Other techniques are
also used along with the A-D lines by technical analysts. The four popular
methods are
i. Stocks in positive trends
ii. Percentage of stocks over a moving average
iii. Diffusion indexes
iv. High-Low statistics

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 Security Analysis

Stocks in Positive Trends

A stock which rallies after a decline to reach a new high is said to be in an uptrend;
a stock that reacts to reach a new low is said to be in a downtrend. The percentage
of stock in an uptrend to the total stock traded is computed and plotted on a graph.
A rising market is expected to have an increasing percentage of uptrend stock.
Reversal is signalled when stock in positive trend begin to diminish.
Percentage of Stock Over a Moving Average
A specific moving average for a number of stocks is first computed, and the
percentage of the number that is above the average is ascertained. The percentage
of stocks over a moving average increases in a bull market, and generally moves
along with the positive trend index computed in (i) above. When the percentage of
stocks over a moving average reaches an extreme of 90-100 percent or 10-15
percent, it indicates that a substantial proportion of the prevailing move has taken
place and that reversal is imminent. When the percentage index reverses direction,
the reversal in market trend is almost immediate.
Diffusion Index
A diffusion index is computed by calculating the rate at which a certain group of
stocks change price over a given period of time. It is generally calculated on either
a wide number of stocks, or a number of industry indexes. Also called the

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momentum index, a rise in the index signals the onset of a bull market and vice
versa.
High-Low Statistics
FA
Technical analysts also study the high-low statistics to confirm market trends. A
rising market should be accompanied by a healthy number of net new highs. A
graph of net new highs can be plotted to be read along with a market index. If net
new highs trace a series of declining peaks while the index continues to rise, a
reversal is imminent. Similarly, a graph of net new lows can be expected to signal
the end of a bear market, when it does not confirm the new trough reached by the
market index. This is because, a declining number of stocks reaching new lows
implies that larger number of stocks are resisting the downtrend in the market
index, and thus signifies the end of a bear market.
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Breadth of the market, thus, is an important indicator of the depth of the prevailing
trend, and is of immense utility to the analyst in identifying trend reversals.

Volume
Technical analysts confirm a price reaction by looking at the volume of shares
traded. Volume generally moves along with price, and is indicative of the intensity
of a price reaction. Study of volumes also helps in forecasting reversals in trend. It
has been found by technical analysts that volume leads the trend of prices, and
indicates the trend reversals in advance. A study by William Gordo3 in the United
States found that between 1877 to 1966, in 84% of the bull markets, the volume
high did not occur at the price peak, but some months before. Of the 18 bull
markets during the period, 2 ended with volume and price reaching a peak
simultaneously, and in one uptrend, volume lagged by a month. The lead time of
volume in the remaining 15 cycles was from 2 months to 24 months. The average
for all cycles was 9 months. The volume curve has an almost consistent tendency
to peak out ahead of price, both during bull and bear phases.

3 William Gordon, The Stock Market Indicators, Investors Press, New York, 1968.

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 Technical Analysis

Figure 43a

Figure 43b

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Figure 43c
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Figure 43d

The following, in brief, are the principles to be borne in mind while studying
Price-Volume relationships:
i. A price rise that is accompanied by expanding volume is a normal market
tendency and therefore is not indicative of any potential trend reversal.

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Security Analysis

Figure 43e

Figure 43f

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Figure 43g
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Figure 43h

ii. A new high reached with a volume that is actually diminishing is a warning
to a reversal in price (Figure 43a)
iii. A rally which reaches a new high would also be accompanied by a volume
that is higher than that obtained at the preceding peak. If volumes obtained at
a new high are lower, a trend reversal is indicated. (Figure 43a)

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 Technical Analysis

iv. After a slow expansion over a period, sometimes both prices and volume
work into an exponential rise. This is indicative of heavy off-loading by bulls
and is called a ‘speculative blow off’ and marks the end of the bull market.
Price and volumes both fall sharply after this development. (Figure 43b)
v. When prices recover after a bearish phase and subsequently react to a level
equal to or slightly above the previous low, if the volume accompanying such
reaction is lower than that obtained at the previous low, a bullish trend is
indicated. Lower volumes accompanying such reactions is indicative of the
weakness of the reaction. (Figure 43c)
vi. A reversal in trend indicated by a downside breakout from a price pattern,
trendline or moving average, can be acted upon if accompanied by heavy
volume, which confirms the bearish sign. (Figure 43d)
vii. Termination of a bear market is often signalled by a ‘selling climax’. A
selling climax occurs when prices fall for a considerable time at an
accelerated pace and are accompanied by expanding volume. Price may be
expected to rise subsequently. (Figure 43e and 43f).
viii. An accumulation in the course of a bearish market, accompanied by high
volume, indicates persistent effort to push up prices, and would spark a
bullish phase. Similarly, a distribution accompanied by increased volume is a
bearish factor. However, where volumes do not increase at an accumulation
or distribution, the indication is that there is only a consolidation of the

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prevailing trend. (Figure 43g and 43h).

Momentum
FA
We have so far discussed the application of trendlines, moving averages and price
patterns to analyze the movement of share prices. In most cases, a trend reversal
can be identified with the help of these techniques only sometime after the reversal
has actually taken place. The concept of momentum is used to overcome this
weakness in technical analysis, by identifying a reversal much before a trend peaks
or bottoms out. Momentum measures the rate at which prices rise or fall and is
based on the principle that prices usually rise at the fastest pace well ahead of their
peak, and decline at their greatest speed before their trough.
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The concept of momentum can be explained with the help of an example. A ball
thrown into the air, generally shoots up with speed, but subsequently slows down
considerably before it turns to come down again. The loss of upward momentum
that occurs before the ball changes course can be seen in the stock market also.
Before peaking out, share prices register a noticeable decrease in momentum.
Similarly, the behavior of prices in a downtrend can be compared to the course of
a car that is pushed over the top of hill. Though the speed decreases, the car
continues to move, till it comes to a halt. Share prices behave in a similar manner
and the loss of momentum in a downtrend shows much before the final low is
reached. Momentum, thus, is an important lead indicator of the quality of price
movement.
There is, however, an exception to the above behavior of prices. Sometimes
momentum and price may peak simultaneously, just like a ball hitting the ceiling
even when its momentum is rising, and turning course with speed. When a ceiling
of selling resistance is met, or buying power is temporarily exhausted, momentum
does not provide any advance indications of the reversal, but peaks along with the
price. Similarly in a downtrend, when prices meet a major level of support,
momentum and price turn together. Despite these exceptions, momentum has been
found to lead price in most occasions, to be used as a reliable lead indicator of
trend reversals.
Momentum can be looked upon from two angles: As a measure of rate of change,
and as a measure of internal market vitality. Rate of change indices are widely
used to measure the speed of advance or decline of market indices and stock

319
 Security Analysis

prices. Measures of internal strength are generally applied to market indicators the
breadth of the market, and are known as oscillators. In order to determine the
quality of a certain price trend, momentum indices are used. We shall discuss the
construction and application of these indices in this section.
RATE OF CHANGE INDEX (ROC INDEX)
One of the simplest and widely used methods to measure momentum is to compute
the rate at which the price of a stock, or market index, changes over a certain
period of time. The ROC Index is an index constructed to measure such price
changes. Assume for instance that a ROC Index is to be constructed for measuring
50-day rate of change in prices. (See table 7). The price prevailing on a certain day
is compared to the price 50 days earlier. The resulting ratio is the ROC Index value
for that day.
Table 7
Computation of ROC Index Values
Day BSENI values BSENI 50 days ago ROC Index value
(1)
x100
(2)
(1) (2) (3)
1 382.60 377.19 101.43

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2 385.19 373.69 103.07
3 385.79 373.66 103.25
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5
381.27
378.79
380.79
383.00
100.13
98.90
6 378.45 383.28 98.74
7 379.62 383.27 99.05
8 384.19 389.83 98.55
9 383.16 393.81 97.30
10 385.24 375.28 102.65
The ROC Index value is computed as the ratio of the index on that date and
50 days earlier (382.6/377.19) x 100 (Note that index values are available only on
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the days trading actually took place in the market, and not for all days in a month.
The index computed is, therefore, for rate of change over 50 trading days and not
50 calendar days). The reading 101.43 means that the price has increased by 143
points since the level prevailing 50 trading days earlier. The ROC Index thus
oscillates around 100, which would be the index value if the price did not undergo
any change during the period under observation (see Figure. 44 for a graphical
presentation of the ROC Index).
Figure 44

A rising ROC Index indicates a growth in momentum (a bullish factor) and a

falling index a loss in momentum (a bearish factor). The line drawn at level 100

320
 Technical Analysis

functions as a reference line to study the movement of the index. When the ROC
Index is above the reference line, the market price is at a higher level than the
prevailing 50 days earlier. If the ROC Index is above the reference line and is also
raising, the rate at which price is increasing is growing. Any fall in the ROC
represents drop in momentum. If the index is falling but is still above reference
line, it indicates a slow down in the rate of increase in price.
When the index falls below the reference line, a future loss of momentum is
indicated. The point at which the momentum index crosses the reference line,
marks the onset of a trend reversal (Note that the ROC Index reaches its peak
much before it crosses the reference line).
When the index is below the reference line, but is rising, this is indicative of an
increase in upward momentum. The ROC Index turning upward, even while it lies
below the reference line, marks a reversal of bearish trend.
It is common practice to use a filter along with moving average curves to make
trading decisions.
MOVING AVERAGE CONVERGENCE AND DIVERGENCE (MACD)
MACD like ROC is an oscillator which measures momentum. This oscillator is
called as Moving Average Convergence and Divergence Oscillator, as it
continuously converges and diverges away from the horizontal reference line. It is
constructed by taking the difference or the ratio of short-term and the long-term

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moving average. The points obtained are plotted against a horizontal reference
line. The reference line represents the points, where the two EMAs have identical
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values. From the movement of the MACD indicator it can be known, whether the
shorter term moving average is above or below the longer term moving average.
This can be observed in the figures 45a and 45b below.
Figure 45a
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Figure 45b

The first figure shows the movement of 9-day and 20-day EMAs. The second
figure shows the movement of the MACD oscillator around the reference
horizontal line drawn at “1”. The graph has been drawn using the ratio of 9-day
EMA to the 20-day EMA. Points A, B, and C in figure 45a are points where the
two EMAs intersect. They can be seen as points of crossover in figure 45b, that is
points G, H and I.
The points of crossing between the oscillator and the reference line act as signals
to buy and sell the stock. In the figure, at the points ‘G’ and ‘H’, since the
indicator crosses the reference line from below, we interpret those points as signals

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Security Analysis

for buying the stock, whereas at point ‘K’ since the indicator crosses the reference
line from above, we interpret that point as a sell signal. In addition to this, we can
superimpose a third EMA or a moving average obtained from the oscillator itself.
This is referred to as a “Signal line” as it acts as a trigger which alerts the trader to
take an appropriate buy or sell decision. The other objective achieved by plotting
the third EMA is to get an overall view of the market trend.
In this technique, a buy signal will occur when the indicator moves above the
reference line and the signal line as at point ‘H’ and a sell signal when the
indicator crosses below the reference line and the signal line as at point “N”.
Relative Strength Index: Here we study about another oscillator which measures
momentum called Relative Strength Index (RSI). Opposed to what we have
studied above, this indicator measures the relative internal strength of a stock or a
market against itself. The RSI is calculated by the formula given below.
100
RSI = 100 –
1+ RS
where RS is the ratio of the average of X day’s up closes to the average of X day’s
down closes. For example, the closing prices of Excel Industries Ltd., on five
consecutive trading days are as follows:
Days Closing prices

I
0 120.00
FA 1
2
119.00
128.75
3 125.80
4 127.25
We require the first point (day 0) to decide whether the closing price following it
(that is, the price on the first day) is either greater or lower.
Since the closing price 119.00 on the first day is lower than the preceding closing
price, we count it as a down closing, whereas the price on the second day 128.75
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being higher than the closing price of 119.00 on the first day, we count it as
upclosing. Therefore, the prices 119.00 and 125.80 are considered to be
downclosing prices, and the prices 128.75 and 127.25 are considered as up closing
prices. In this case RSI will be calculated as follows:
(128.75 + 127.25) / 2
RS =
(119.00 + 125.80) / 2
256
= = 1.046
244.80
100
RSI = 100 –
1 + 1.046
= 100 – 48.87 = 51.13
From the formula it should be evident that the values of the RSI indicator fluctuate
between 0 and 100. A graph is plotted using the RSI values. On this graph, the
oversold and the overbought positions are drawn at 30 and 70 levels on a scale of
0 to 100. When the indicator crosses the overbought or oversold position line, it is
a warning signal to the trader. At this stage, it presents an opportunity to the trader
to consider either to buy or sell. When the indicator crosses the oversold position
at 30 from above, it signals that one should sell the stock, while at the same
position if the indicator crosses it from below it is taken as a signal for buying. At
the overbought position at 70, the opposite of this holds true. Though the RSI
indicates that a buy/sell action is required, the actual buying or selling should be

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 Technical Analysis

done only after the price line also shows a trend reversal. The oversold position is
defined as a situation when there are more buyers in the market who are willing to
take delivery than the number of shares available for delivery. In other words, the
demand for that stock outstrips its supply. This happens only when there is more of
speculative selling than speculative buying. The overbought position is exactly the
opposite of oversold position.

ADVANCED TECHNICAL TOOLS

The Confidence Index
The Confidence Index is supposed to reveal how willing investors are to take a
chance in the market. It is the ratio of high-grade bond yields to low-grade bond
yields. When bond investors grow more confident about the economy, they shift
their holding from high-grade to low-grade bonds in order to obtain the higher
yield. This change bids up the prices of low-grade bonds, lowers their yields
relative to high-grade bonds, and increases the confidence index.
Markets for bonds are frequented mostly by large institutional investors who are
believed to be less emotional about their portfolio decisions than many investors in
the market. In an effort to measure the market expectations some chartists study
the confidence index.
The Confidence Index, published weekly by Barron’s, attempts to measure

I
investor optimism and pessimism by examining investor actions in the bond
market. It is calculated as follows:
FA Confidence Index =
Yield on10 high-grade corporate bonds
Average yield on 40 Dow Jones bonds
Since high-grade bonds should always yield less than lower quality bonds, the
Confidence Index should always be less than 1.0. As investors become more
optimistic about the future, the difference between the two yields in the index
decreases (i.e., the default risk premium narrows and the ratio increases). As
investors become more pessimistic about the future, the difference between the
two yields increases (i.e., the default risk premium rises) and the ratio decreases.
Because the bond market tends to be dominated by institutional investors, the
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Confidence Index is viewed by some as a barometer of sophisticated investors’
expectations (and behavior).
Advocates of the Confidence Index believe that it should move in the same
direction as the stock market because increased confidence in the bond market
should lead to increased confidence in the stock market. Therefore, an increase
(decrease) in the index is a buy (sell) signal. If the Confidence Index leads the
market, it can be useful as an indicator. Because it is available weekly in Barron’s,
it is a convenient and accessible indicator.
Although the bond and stock markets generally move together, there is no
theoretical reason that confidence in the bond market should precede confidence in
the stock market. The latter is considered by most observers to be the preeminent
discounter of future events. In fact, the Confidence Index does not always lead the
market and has given a number of false signals. Thus, its record as a predictor is
mixed at best.

Contrary Opinion Theories

Several indicators are based on the theory of contrary opinion. The idea is to trade
contrary to most investors, who supposedly almost always lose – in other words, to
go against the crowd. This is an old idea on Wall Street, and over the years
technicians have developed several measures designed to capitalize on this
concept.

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 Security Analysis

ODD-LOT THEORY
According to the odd-lot theory small investors who often buy or sell odd lots (less
than 100 shares of stock) are usually wrong in their actions at market peaks and
troughs. Supposedly, such investors typically buy (sell) when the market is at or
close to a peak (bottom).
To take advantage of the (wrong) actions of these investors, an indicator must be
calculated. A commonly used Odd-lot index is defined as:
Odd-lot sales
Odd-lot index =
Odd-lot purchases
A decline in this index would indicate more purchases in relation to sales by small
investors, suggesting they are optimistic. According to contrary opinion, it is time
to sell – to go against the ‘man in the street.’ Conversely, a rise in this index would
indicate more sales relative to purchases, a sign of pessimism by small investors
but an opportune time for a contrarian to buy.
A variation of the odd-lot index is the odd-lot short sales ratio, defined as follows:
Odd-lot short sales
Odd-lot short sales ratio =
Total Odd-lot sales
As short sales by odd-lotters increase (decrease), these investors are becoming
more pessimistic (optimistic). For a contrarian, it is time to buy (sell). The

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rationale for this ratio is the same as before. Odd-lotters are expected to sell short
at precisely the wrong time; that is, prior to a rise in prices.
FA
Regardless of which odd-lot indicator is used, odd-lot theories have not been
particularly successful. Small investors have often been correct in their judgments,
particularly since the 1970s. This analysis seems to have proved incorrect at least
as often as it has proved accurate. Many market professionals today do not believe
in odd-lot theories.
MUTUAL FUND LIQUIDITY
It is interesting to note that mutual fund liquidity can be used as a contrary opinion
technique. Under this scenario, mutual funds are viewed in a manner similar to
odd-lotters – they are presumed to act incorrectly before a market turning point.
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Therefore, when mutual fund liquidity is low because the funds are fully invested,
contrarians believe that the market is at, or near, a peak. The funds should be
building up cash (liquidity); instead they are extremely bullish and are fully
invested. Conversely, when funds hold large liquid reserves, it suggests that they
are bearish; contrarians would consider this a good time to buy because the market
may be at, or near, its low point.

Oscillators
The Rate of Change (ROC) Index is widely used to measure the momentum of
price changes. In order to measure the momentum inherent in indicators of internal
market strength, like volume and breadth, oscillators are more widely used. The
ROC Index is also an oscillator in the sense that it is interpreted in terms of
oscillation around the reference line. But the ROC Index cannot be used to gauge
breadth of the market, which is measured from an arbitrary point, and can provide
both positive and negative values. The ROC Index, for instance, computed
between a negative and positive value of breadth statistics can provide a total
misleading impression of the prevailing momentum. It is for this reason that the
ROC Index constructed for measuring momentum of breadth of the market, does
not use the cumulative breadth statistics. We call it a momentum oscillator rather
than an index, for purposes of clarity.
Momentum of breadth is measured by dividing the total number of issues
advancing in a given period against the total number of issues declining in the
same period.

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 Technical Analysis

Computation of Momentum Oscillator

(Issues Traded on Bombay Stock Exchange)
Day No. of Issues 10-day Total No. of 10-day Total 10-day
Advancing of Advances Issues of Declines Momentum
Declining (2)
Index x100
(4)
(1) (2) (3) (4) (5)
1 332 - 456 - -
2 273 - 492 - -
3 274 - 501 - -
4 334 - 444 - -
5 335 - 452 - -
6 225 - 586 - -
7 276 - 532 - -
8 334 - 410 - -
9 505 - 255 - -
10 370 3258 341 4469 72.90
11 411 3337 310 4323 77.19

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12 324 3388 418 4249 79.74
13 398 3512 294 4042 86.89
Stochastics
FA
Stochastics is a price velocity technique based on the theory that as prices increase,
closing prices have a tendency to be ever nearer to the peaks reached during that
period. Similarly, as prices tend to fall, closing prices tend to be closer and closer
to the troughs reached during that period. This approach was developed by George C
Laire.
Calculation of Stochastics based on the simple formula that follows:
C−L
%K= x100
H−L
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where,
% K is Stochastics
C is the latest closing price
L is the low price during the last N periods
H is the high price during the last N periods
N can be any number of periods. Laire suggests 5 to 21 periods
% K is then smoothened to derive % D by using the simple moving average
technique.
When plotted, the resultant lines will show where the closing price is relative to
the range of prices for a given period of time (N).
Figure 46
Price Chart for Scrip Alpha

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Security Analysis

Figure 47
5%K 3%D Stochastic Chart

The principal method of interpreting Stochastics for buy and sell signals is through
divergence analysis.
A bearish divergence occurs when the security’s price makes a high then corrects
moving lower and subsequently reaches a higher high. At the same time,
corresponding dealers of the %D line make a high followed by a lower high.
A bullish divergence occurs when the security’s price makes a low, then corrects
moving higher, and subsequently, reaches a lower low. At the same time,
corresponding bottoms of the %D line makes a low followed by a higher bottom.
In the final analysis, in bearish divergence, a sell signal occurs when %K lines

I
move below %D line. Success rate will be high in the 85 to 90 percent range. In a
bullish divergence a high signal occurs when %K line moves above the %D line.
FA
Sometimes %K line might touch 0 or 100 percent. This only suggests great
weakness (0%) or great strength (100%) of the scrip.
Figure 48
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A warning signal: When %K line reverses direction sharply from the previous
direction say for 2 to 12 percent, the prices would be reversing their direction in
one or two periods (N).

Elliott Wave Theory

The Elliott Wave Principle is difficult to grasp and somewhat intimidating. The
principles behind the theory are actually relatively simple. You will notice that
many of the points covered sound very familiar. This is because much of the
Elliott material fits very nicely with the principles of the Dow theory and

326
 Technical Analysis

traditional charting techniques. Elliott Wave Theory, however, goes beyond

traditional charting by providing an overall perspective to market movement that
helps to explain why and where certain chart patterns develop and why they mean
what they do. It also helps the market analyst to determine where the market is in
its overall cycles. Much of technical analysis is trend-following in nature. Dow
Theory, despite all its merits, tends to give its signals well after trend has been
established. Elliott Wave Theory gives the analyst more advanced warning of tops
and bottoms, which can then be confirmed by the more traditional approaches.
We will cover the Elliott Wave Principle very briefly without going into all the
finer points.
BASIC TENETS
The most important element of wave theory is wave patterns or formations. The
other important aspect is ratio analysis which is useful in determining retracement
points and price objectives by measuring the relationships between the different
waves. Finally, time relationships also exist and can be used to confirm the wave
patterns and ratios, but are considered by some Elliotticians to be less reliable in
market forecasting.
Figure 49

I
FA
IC

Elliott Wave Theory, was originally applied to the major stock market averages,
particularly the Dow Jones Industrial Average. In its most basic form, the theory
says that the stock market follows a repetitive rhythm of a five-wave advance
followed by a three-wave decline. Shows one complete cycle. If you count the
waves, you will find that one complete cycle has eight waves – five up and three
down. In the advancing portion of the cycle, notice that each of the five waves are
numbered. Waves, 1, 3, and 5 – called impulse waves – are rising waves, while
waves 2 and 4 move against the uptrend. Waves 2 and 4 are called corrective
waves because they correct waves 1 and 3. After the five-wave numbered advance
has been completed, a three-wave correction begins. The three corrective waves
are identified by the letters a, b, and c.
Along with the constant form of the various waves, there is the important
consideration of degree. There are many different degrees of trend. Elliott, in fact,
categorized nine different degrees of trend (or magnitude) ranging from a Grand
Supercycle spanning two hundred years to a subminute degree covering only a few
hours. The point to remember is that the basic eight-wave cycle remains constant
no matter what degree of trend is being studied.
Each wave subdivides into waves of one lesser degree which, in turn, can also be
subdivided into waves of even lesser degree. It also follows that each wave is itself
part of the wave of the next higher degree.

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 Security Analysis

CONNECTION BETWEEN ELLIOTT WAVE AND DOW THEORY

In Elliott theory, three up waves, with two intervening corrections, fit nicely with
the Dow theory. While Elliott was no doubt influenced by Dow’s analysis, it also
seems clear that Elliott believed he had gone well beyond Dow’s theory and had in
fact improved on it. It’s also interesting to note the influence of the sea on both
men in the formulation of their theories. Dow compared the major, intermediate,
and minor trends in the market with the tides, waves, and ripples on the ocean.
Elliott referred to ‘ebbs and flows’ in the writing and named his theory the ‘wave’
principle.
WAVE PERSONALITIES
Another area where the two theories overlap to some extent is in the description of
the three phases of a bull market. A knowledge of these wave personalities can be
helpful, especially when wave counts are unclear. It’s also important to remember
that these wave personalities remain constant in all the different degrees of trend.
Wave 1
About half of the first waves are part of the basing process and often appear to be
nothing more than a rebound from very depressed levels. First waves are usually
the shortest of the five waves. These first waves can sometimes be dynamic,
especially if they occur from major base formations.
Wave 2

I
Second waves usually retrace or give back, all or most of wave 1. The ability of
wave 2, however, to hold above the bottom of wave 1 is what produces many of
FA
the traditional chart patterns, such as double or triple bottoms and inverse head and
shoulders bottoms.
Wave 3
The third wave is usually the longest and the most dynamic, at least in the
common stock area. The penetration of the top of wave 1 registers all kinds of
traditional breakouts and Dow Theory buy signals. Virtually, all technical trend
following systems have jumped on the bull bandwagon by this point. Volume is
usually the heaviest during this wave and gaps prevail. Not surprisingly, the third
wave is also the most likely to extend. Wave 3 can never be the shortest in a five-
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wave advance. By this time, even the fundamentals are looking good.
Wave 4
The fourth wave is usually a complex pattern. Like wave 2, it is a corrective or a
consolidation phase, but usually differs from wave 2 in its construction. Triangles
usually occur in the fourth wave. One cardinal rule of Elliott analysis is that the
bottom of wave 4 can never overlap the top of wave 1.
Wave 5
In stocks, wave 5 is usually much less dynamic than wave 3. In commodities, wave 5
is often the longest wave and the one most likely to extend. It is during wave 5 that
many of the confirming technical indicators, such as On Balance Volume (OBV),
being to lag behind the price action. It is also at this point that negative divergences
begin to develop on various oscillators, warning of a possible market top.
Wave A
Wave A of the corrective phase is usually misinterpreted as just a normal pull-back
in the uptrend. Having already spotted several oscillator divergences on the prior
advance, the alert technician may also notice a shift in the volume pattern at this
point. Heavier volume may now have shifted to the downside, although that is not
necessarily a requirement.
Wave B
Wave B, the bounce in the new downtrend, usually occurs on light volume and
usually represents the last chance to exit old long positions gracefully and a second

328
 Technical Analysis

chance to initiate new short sales. Depending on the type of correction taking
place, the rally may test the old highs (forming a double top) or even exceed the
old highs before turning back down.
Wave C
Wave C leaves little doubt that the uptrend has ended. Again, depending on the
type of correction in progress, wave C will often decline well below the bottom of
wave A, registering all kinds of traditional technical sell signals. In fact, by
drawing a trendline under the bottoms of wave 4 and wave A, the familiar head
and shoulders top sometimes appears.
RECENT DEVELOPMENTS
Technical analysis is by definition based on the assumption that past prices can be
used to predict future prices. But as a perceptive reader you would have noticed
something strange about the methods of technical analysis discussed so far. None
of these methods bear any resemblance to the standard statistical methods of
predicting the future from the past. If a technical analyst were to approach a
statistician for advice, the statistician in all likelihood would recommend
regression analysis, particularly auto-regressions and ARIMA (Box-Jenkins)
analysis. However, chartists do not use these techniques and the methods that they
do use would be totally alien to a statistician trained in classical prediction theory.
It is well known that the standard statistical methods are the best linear prediction

I
techniques possible. For charting techniques to make sense it is therefore,
necessary not merely that future prices depend on past prices but that they depend
FA
on past prices in a highly non-linear manner so as to make standard statistical
techniques irrelevant. In this section, we shall very briefly cover some recently
developed mathematical techniques for dealing with highly non-linear process
which have been used for charting.
Chaos theory has been proposed to study highly non-linear processes which
exhibit the following features:
a. The processes appear to be totally random and unpredictable.
b. The processes are in fact predictable using non-linear prediction techniques.
c. The accuracy of prediction drops rapidly as the prediction horizon is
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increased.
d. The processes are highly sensitive to initial conditions.
These features make chaos theory an attractive tool for technical analysts who
have powerful computers at their disposal to perform the complex calculations
required by the theory. These analysts hope to detect subtle patterns in price
movements which would not have been observed by people who employ less
sophisticated mathematics.
Neural network, originally designed on the basis of an analogy with the network of
neurons in the human brain, is another computer based technique for detecting
subtle patterns in voluminous data. Neural networks today do not attempt anything
as ambitious as imitating the human brain. They are instead highly versatile pattern
recognizers. Given large amounts of data to train on, a neural network can learn to
recognize highly complex patterns. The network learns the pattern by a
sophisticated form of trial and error known as back-propagation technique that has
led to the rapid growth of the neural network technology since the early 1980s.
As far as chartist is concerned, neural network is just another tool that allows him
to search for patterns in the prices and the success of the technique depends to a
great extent on the experience and ingenuity of the chartist himself. The neural
network has another major disadvantage in that it is a black box which gives no
reasons or explanation for its buy or sell recommendations. Just as you and I
would find it impossible to explain how we balance ourselves while walking, so
also the neural network is unable to explain how it works.

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Security Analysis

The use of these techniques in technical analysis dates back only to the 1980s and
it is still too early to say whether they are worthwhile charting techniques or
whether they are merely a passing fad.

ACADEMIC PERSPECTIVE OF TECHNICAL ANALYSIS

Academics have consistently been sceptical about Technical Analysis, as all their
attempts to unravel the golden rule that consistently provides extra-normal returns
have failed. A large number of studies, both in the Indian as well as markets the
world over, using a variety of statistical procedures and trading rules have
invariably concluded that no single rule can earn consistently above average
returns from the market over long periods of time. A rule may work very well for a
short time, but would fail miserably in the next time span, in which some other
rule would have yielded extra normal returns. No one has been able to predict with
certainty as to which rule is to be applied when for consistently out-performing the
market.
Academics also argue that even if knowledge for always earning superior returns
exists, it would never be disclosed as the one who possesses the knowledge could
use it profitably. The argument goes a step further: if the knowledge
(to out-perform the market) were to be made public, then that very act would
destroy its effectiveness because if everyone in the market were to act according to

I
that, no one will be able to make extra profits. Therefore, it is impossible that a
trading rule which yields extra normal profits with certainty would ever be known.
FA
Charting and Technical Analysis are, therefore, an attempt to build an edifice
without foundation.
These arguments comprise what is known as ‘market efficiency’. The thesis is that
the presence of large number of experts in the stock market, who are constantly
trying to outwit each other to make the extra buck, would ensure that the market is
very efficient in pricing of securities. In the long run, therefore, an investor would
earn the returns commensurate with the risks assumed, no more no less. The search
for patterns in the prices on the assumption that there is future in the history of
prices is meaningless. The view appears too fatalistic as it seems to do away with
the need to manage our portfolios. Well, that is not entirely true, because the risk
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one assumes in the market, which depends on the composition of the portfolio, is
still a decision that needs to be made and constantly reviewed by an investor. That
would necessitate transactions and reshuffle of portfolios.

SUMMARY
• Technical analysis is not based on a strong conceptual framework, but
depends fully on the use of historical trends to predict future prices. Though
technical and fundamental analyses provide diagonally opposite approaches
to valuation, in practice a judicious blend of the two approaches is attempted
to arrive at better results.
• The technical analysis is done from four important points of view namely,
price, time, volume and breadth.
• The DOW theory is one of the oldest methods of identifying trends and it has
six basic tenets:
a. The average discounts everything: which means that the aggregate
judgment of all stock market participants regarding both the current and
potential changes in the demand-supply relations of stock is reflected in
the share prices;
b. The market has three movements namely primary, secondary and minor
movements;

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 Technical Analysis

c. Price Action determines the trend: A trend is called primarily bullish,

when successive rallies lead to peaks that reorganize higher than the
preceding ones, and when troughs reached by the intervening secondary
reactions are above the preceding troughs. Similarly a bearish trend is
marked by a series of descending peaks and troughs;
d. Lines Indicate Movement: When the changes in prices occur within five
percent range, such range is called “line”;
e. Price/Volume relationships provide background: Volume is normally
expected to complement the movement in prices. A reversal in trend is
signaled if a dull volume accompanies a rally, or a high volume a
reversal;
f. The averages must confirm: An important tenet of the theory is that the
averages must confirm each other.
• The basic tool in technical analysis is movement in prices, measured by
charts. The analyst uses Line chart, Bar chart and Point and Figure chart. He
is also called “chartist”.
• Relative strength: Stock prices tend to move more or less in tandem with the
overall market trend, represented by a market index. Relative strength refers
to the ability of an industry or stock to outperform the market at turning
points. It arises on account of inherent strength in the industry.
Moving averages can help to determine the share prices when they appear to

I
•
move rather haphazardly and be very volatile. There are three basic types of
moving averages: (a) Simple Moving Average; (b) Weighted Moving

•
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Average; (c) Exponential moving average.
Filter rules: An x% filter implies that a downtrend is indicated as soon as a
stock moves down by x% from the most recent peak, and up trend is
indicated whenever a stock moves up by x% from the most recent low point.
• Oscillators: The Rate of Change Index (ROCI) is widely used to measure the
momentum of price changes. Momentum measures the rate at which prices
rise or fall and is based on the principle that prices usually rise at the fastest
pace well ahead of their peak, and decline at their greatest speed before their
trough.
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• Stochastics: It is a price velocity technique based on the theory that as prices
increase, closing prices have tendency to be ever nearer to the peaks reached
during that period.
• Lately a lot of derivative instruments are introduced in the Indian markets.
The next chapter deals with the general aspects of ‘options’.

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Chapter XII

Futures

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•
FA
After reading this chapter, you will be conversant with:

Forward Contracts
• Futures Contract
• Interpretation of Futures Price Quotations
• Trading Mechanism of Futures
• Basis and Spread
• Hedging with Futures
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• Clearing and Settlement of Futures
• Interest Rate Derivatives in India
Introduction
Futures on bonds started trading on stock exchanges in 1975 and futures on equity
were introduced in 1982. Prior to this, organized futures market in commodities
existed in Chicago Board of Trade since 1848. Over these years it experienced
rapid growth in terms of volume and turnover. Today, it is the oldest and largest
futures exchange in the world. It was established as a voluntary, non-profit
association by its members. Another exchange to reckon with is Chicago
Mercantile Exchange. These two exchanges between them account for about
80% of the total volume traded in future contracts in the US.
Futures, like options, possess certain characteristics which make them quite popular.
From farmers to financial institutions, all categories of people employ these
instruments to hedge their risks. A farmer, who produces wheat, in order to realize
a better price for his produce may go to an exchange and sell a futures contract.
Similarly, a baker who is uncertain about the future price of the wheat may also go
to an exchange and buy a futures contract. In these cases, neither the producer nor
the buyer possessed exact information about the price of wheat in future and faced
the risk of the price in future moving unfavorably. In order to reduce the
magnitude of this risk, a futures contract proves to be invaluable. A futures
contract also serves as an instrument, for some of the market participants to
speculate on.

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Futures contracts owe their origin to forward contracts. In other words, futures
contracts are refined forward contracts. Before we move on to the details of futures
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contracts, let us briefly study about forward contracts.

FORWARD CONTRACTS
Genesis
As with most of the phenomena, ambiguity exists as to where exactly these
contracts have seen the light of the day in their long history. Some authors suggest
that, it was India where these contracts took birth, while some others suggest that
Roman emperors employed forward contracts to procure foodgrains from Egypt.
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Irrespective of this fact, in the present age they are serving important social
objectives. It is estimated that forward contracts worth $500 billion are being
entered into every year.
Before the industrial revolution, it was not an easy task to transport commodities
from one country to another. The probability that the price could change
drastically during the period, the commodities were being transported was high.
Under these conditions, the traders required a mechanism where they could protect
their price and the profits. One of the viable methods to achieve this objective was
to enter into a forward contract with the other trader. That is, the trader has to
search for another trader who is willing to take position in the contract as a buyer.
This brings into picture, the first real problem. In the real world, it is quite difficult
to find another trader whose requirement coincides with our requirement.
In forwards, both the traders negotiate the details of the contract privately without
intervention of a third party. No doubt, this facilitates the traders to draw the
details of the contract according to their needs, but this also increases the
probability that one of the traders might default on fulfilling his obligation. This
characteristic of the forwards contract changes the very nature of risk, as the
fulfillment of the contract depends on the worth of the counterparty. This is the
second real problem that one has to put up with, if he wishes to deal in forwards.
In forward contracts, since the producers are not in direct contact with the
purchasers, they have to route their contracts through middlemen. Middlemen play
a crucial role in forward markets, as they purchase the products from the producer

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 by entering into a contract and then enter into a second contract with the other
purchaser regarding the supply of the same. They bear the risk and have to perform
the other part of the contract even when one of the parties default. Therefore, they
should not only be paid for their services, but also for credit risks they bear.
Although this may not be a problem on the face of it, the presence of an institution will
bring much more stability to the whole process. This is a prerequisite for the retail
investors to participate in forward markets. The other positive effect of this
arrangement will be that the transaction costs will be lowered to a great extent.
In the introduction part, we talked about a wheat farmer and a baker going to an
exchange to buy future contracts to hedge against the price risk. If we assume that
the same contract has been negotiated somewhere outside the exchange, without
any of the exchange rules regulating them, then it would have been a perfect
example of a forward contract.
Although forward markets have been serving the society at large, they are not
without their pitfalls as we have seen above. Now, we look at futures and how they
were structured to overcome these problems.

FUTURES CONTRACT
A futures contract is an agreement between two parties to exchange a commodity
or a financial asset for certain consideration after a specified period. As we have

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stated before, a futures contract is a refined forwards contract. The main
differences between forwards and futures contract are :
i.
FA
A futures contract is standardized in terms of Quantity, the Quality and terms
of delivery, etc.
ii. The futures contracts are traded in an organized exchange, where a large part
of the process is regulated.

Standardization of the Contracts

Standardization of contracts facilitates trading on the exchange. When a group of
traders come together they will be able to trade only if all of them know for sure
what a contract carries with it. The futures contracts traded in organized exchanges
are standardized in terms of features like Quantity, Quality, Expiration month,
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Delivery terms, Delivery dates, Minimum and Maximum Price Fluctuation, and
finally Trading days and hours.
We explain these in case of commodities traded at different exchanges.
QUANTITY
We know that commodities are usually in the form of solids or liquids. For these
obviously, the unit of measurement differs. We look at some of them in the table
given below.
Table 1
Commodity Unit Number of Units per Contract
Grains (wheat, corn, oats) Bushels 5000
Metals (silver) Troy Oz 1000
Meal (Soyabean meal) Tons 100
Meal (Soyabeans) Bushels 5000
Livestock (Pork Bellies) Pounds 40000
Sugar Pounds 112000
Cocoa Metric Tons 10
Coffee Pounds 37500

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QUALITY
At the Chicago Board of Trade, the quality of the grain contracts traded should be
one of the following types. They are as follows.
Table 2
Commodities Grades
Wheat grades No.2 Soft red, No.2 Hard red winter, No.2 Dark Northern Spring,
No.1 Northern Spring
Soyabeans No.2 Yellow
Corn No.2 Yellow
Sugar Raw centrifugal cane sugar
Cotton Strict low middling 1 1/16 inch US grown white cotton
Coffee Arabica coffee
Pork Bellies USDA approved frozen pork bellies, cut and trimmed
Oil Brent oil also described as North Sea oil and Gas oil.
EXPIRATION MONTH
The exchanges also specify the months in which the contracts should expire. These
months are so selected, that in case of some the traders insist on a physical delivery of
say wheat, the wheat harvested is ready for delivery.
Table 3

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Commodities Expiration months
Wheat July, September, December, March and May.
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Soyabean oil and Meal
Soyabean
Jan., Mar., May, July, Aug., Sept., Oct., Dec.
Jan., Mar., May, July, Aug., Sept., Dec.
Corn Mar., May, June, Sept., Dec.
Sugar Jan., Mar., May, July, Oct.
Cotton Mar., May, July, Oct., Dec.
Cocoa Mar., May, July, Sept., Dec.
Coffee Mar., May, July, Sept., Dec.
Pork Bellies Feb., Mar., May, July, Aug.
DELIVERY TERMS
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The exchange specifies the delivery details like the warehouse in which the trader
should store the physicals. For Chicago Board of Trade, the warehouses should be
in Chicago Switching district or the Toledo, Ohio Switching district.
DELIVERY DATES
The Chicago Board of Trade specifies that the contract can be delivered on any
business day of the expiration month.
MINIMUM PRICE FLUCTUATION
This is familiarly called as the tick size.
Table 4
Commodity Tick size per unit Tick size per contract
Wheat 1/4 cent $12.50
Soyabean oil 1/100 of a cent/pound $ 6.00
Soyabean meal 10 cents $10.00
Soyabean 1/4 cent $12.50
Corn 1/4 cent $12.50
Sugar 1/100 of a cent/pound $11.20
Cotton 1/100 of a cent/pound $ 5.00
Cocoa $1/Metric ton $10.00
Coffee 1/100 of a cent/pound $ 3.75
Pork Bellies $0.00025 per pound $10.00

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DAILY PRICE LIMIT
To restrict the price movement during the day, the exchange specifies a limit. That
is, in case of wheat contracts, the Chicago Board of Trade specifies that today’s
price should differ by the preceding day’s price by not more than 20 cents. For a
contract, this works out to be $1000. A particular point to remember is for the
contracts which are trading in their last month of their delivery these
specifications do not apply and for those contracts which are experiencing
excess volatility the price limits are expanded gradually till a stage where there is
no limit.
TRADING DAYS AND HOURS
The exchange also controls the days and the hours during which trading should be
carried out on business days. The wheat contracts at CBOT should trade from 9.30
A.M. to 1.15 P.M. on each trading day and on the last trading day, the trading
should cease by noon. The last trading day in case of wheat contract is seven
business days before the last business day of the delivery month. The last trading
day differs from commodity to commodity and also from exchange to exchange.
The level of standardization is so high, that all the participants know precisely
what is being offered for sale and the terms that accompany the transaction. This
has helped immensely to promote liquidity and stimulate trading.

Differences between Futures and Forward Contracts

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From what we have seen above, listing the differences should not be a problem.
They are as follows:
FA
Futures contracts Forward contracts
1. These are traded in organized No particular physical location as
location as exchange. such.
2. The terms of the contract are highly Terms are structured to suit both the
standardized. contracting parties.
3. Contracts are cleared by a separate No such facility exists.
clearing house.
4. Clearing house guarantees the No organization guarantees the
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performance of the contract. performance of the counterparty.
Depends on the worth of the
counterparty.
5. Traders have to deposit initial margin No compulsion to make such
irrespective of their trading position. deposits.
6. Traders have to pay daily settlement No such provisions are in vogue.
margin depending on movement in
the price of the underlying stock.
7. Future contracts can be easily closed. Quite difficult to do so.
8. Futures markets are monitored and Regulation is not as tight as in
regulated by special agencies. futures markets.
9. Marking to market is done at the end No such adjustements are carried
of every trading day. out.
Now, we look at some of the differences between options and futures.
i. In options, the obligation to honor the contract is on the writer of the option,
whereas in futures both the parties are equally responsible to honor their
obligations.
ii. In options, the buyer has to pay the premium to the writer of the option. In
futures, both the parties have to deposit the initial margin with the clearing
house and then have to pay variation margin depending on whether the price
fluctuation is favorable to them or not.

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 iii. American options can be exercised any time before the expiry day, while the
European options should be exercised on the last day of expiration period. In
futures, no such distinction exists and the parties are expected to honor the
contract on the settlement date.
iv. In options, the buyer limits the downside risk to the extent of premium paid.
He, however, retains the upside potential. In futures, the buyer is exposed to
the whole of the downside risk and has the potential for all the upside return.
v. The expiration period for options is nine months, while for futures it is twelve
months.
vi. Options are employed by both hedgers and speculators, while trading in
futures is by and large by speculators.

INTERPRETATION OF FUTURES PRICE QUOTATIONS

Futures prices are usually published briefly in leading newspapers and journals. A
sample of commodity futures contract price quotations is shown below:
Table 5
Thursday, October 18, XX
CORN (CBT) 5,000 Bushels; Cents per Bushel
Lifetime Open

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Open High Low Settle Change
High Low Interest
Dec. ’x1 229 1/2 229 3/4 227 3/4 228 –3/4 286 1/2 221 1/2 110,820
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Mar. ’x2 238 1/2 238 1/2 236 1/2
May
237
244 244 1/2 242 1/4 242 1/2 –1 1/4
–3/4 302 1/2 230 3/4 46,591
306 1/2 237 1/2 18,632
July 248 248 1/4 246 246 1/4 –1 1/4 308 1/4 241 1/2 19,956
Sept. 246 3/4 246 3/4 245 245 –1 1/4 287 1/2 240 1/4 2,578
Dec. 249 249 246 1/2 246 3/4 –1 3/4 275 242 1/2 9,454
Est Vol: 30,000; Vol Wed: 24,131; Open int 208,115, – 360.
OATS (CBT) 5,000 Bushels; Cents per Bushel.
Lifetime Open
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Open High Low Settle Change High Low Interest
Dec. ’x1 124 1/4 124 1/4 122 123 –1/4 194 1/4 110 10,493
Mar. ’x2 134 134 132 1/2 133 1/2 – 201 120 1/2 2,904
May 141 141 139 1/2 140 1/2 – 183 3/4 129 962
July 147 147 145 1/2 146 – 164 3/4 135 1/2 465
Est Vol: 1,000; Vol Wed: 1,345; Open int 14,839, +157.
To understand what these figures convey, we consider the first row of the
quotations for corn (Dec. xx, 229 1/2, 229 3/4, ....). The first column (Dec. xx)
gives the maturity of the contract (the month during which the contract will
expire). The second column, Open ($229 1/2) denotes the price for the day’s first
trade on that particular trading day. The third and fourth columns, High ($229 3/4)
and low ($227 3/4) denote the highest and lowest price at which a particular
contract has been traded during that day. The fifth column, ‘Settle’ stands for
settlement price ($228). The settlement price is determined by the settlement
committee, by using a formula which considers the prices at which trading took
place during the last few minutes of the closing time. That is, the settlement price
need not be last trading price of that day. The sixth column, change (–3/4) denotes
the difference between today’s settlement price and yesterday’s settlement price. It
can be positive or negative. The High and Low under the seventh column denotes
the highest and the lowest ever price at which the contract was traded till date. The
final column, open interest, denotes the cumulative number of contracts that are
due for delivery. In this case 110,820 contracts are open at the close of last trading
day, that is 17th October.

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 In the table, the contract which matures next (Mar., x1) is said to be a near-by
contract, while the contracts maturing after that (May, July) are known as Distant
or Deferred contracts.
In the last row of the corn quotations, we have estimated volume of trading in
contracts of all maturities as 30,000. This figure gives the volume traded on 18th
October and the figure 24,131 gives the actual volume traded on 17th October. It
also contains the figures open interest: 208,115 and –306. The first figure denotes,
the total open interest on all the contracts on 17th October and the figure 306
denotes the fall in the open interest position from the preceding day.
One should clearly distinguish between the Volume traded and the Open interest.
Volume traded is calculated by counting the number of contracts either bought or
sold and it gives definite idea about the trading activity in a period. Open interest
denotes the number of contracts that are “open” at the close of trading on the
preceding day.
More explicitly, if a trader ‘A’ has bought two contracts from trader ‘B’ and sold
one of them back to ‘B’ on the same day, the volume will be three contracts. This
is because, ‘A’ bought two contracts and ‘B’ bought one contract, which adds up
to three. For the same example, the open interest will be one contract. This is
because, trader ‘A’ bought two contracts and sold one of them and ‘B’ sold two
contracts and bought one of them. Therefore, traders ‘A’ and ‘B’ are left with one
contract each, which gives us the open interest.

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What would have been the open interest, if trader ‘A’ sold that one contract to
some other trader say ‘C’. In this case, as far as ‘A’ is concerned he did close his
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position in one of the contracts he bought, but that does not affect the open interest
as trader ‘C’ has taken his position. Therefore, the open interest would still remain
as ‘2’. Open interest is calculated from market point of view and not from an
individual point of view.

TRADING MECHANISM OF FUTURES

In this part, first we look at how a trade is initiated and then we elaborate on the
different players we come across and the different processes involved.
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Flow of the Order
Any person who wants to trade in futures has to contact a Futures Commission
Merchant (FCM) or a broker. First, let us look at an FCM. He is necessarily a
member of the clearing house. The next step is to open an account at his firm. You
will be assigned to one of the Accounts Executives, who will look after your
transactions. Whenever you place an order with the accounts executive, he will note
down the order specifications and immediately transmits it to one of the floor
brokers at the exchange. The floor broker will execute the order and reports the
transaction to the clearing house. Once he receives the confirmation from the
clearing house, he calls back the accounts executive giving him all the details about
the trade. The accounts executive, in turn, will pass these details to his client.
Other responsibilities of the FCM are maintaining all the records and reporting the
trading activity of all his clients to the clearing house and sending the clients
monthly statements about their position and account balances.

If you Open the Account at a Broker

The broker may or may not be a member of a clearing house. If he happens to be a
member of a clearing house, he notes down the specifications and transmits the
order to the floor broker who as studied above will execute it, confirms it from the
clearing house and sends back the details to the broker, who then conveys the same
to his client. In case, he does not happen to be a member of the clearing house, he
should necessarily route the order through a member. Once he does this, the
remaining procedure will be the same as above.

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 The investor who wants to trade futures can be a hedger or a speculator. We define
them as follows:
Hedgers
Hedgers deal in futures to offset a pre-existing risk. The commodity is usually that
which they produce or use in the course of their business.
Speculators
Speculators take long or short positions only with the intention of making profits
by getting out of the market when conditions favor them. As with the other
markets, speculators play an important role in futures market also. In the process,
they assume risk which is disproportionate to the returns they are expecting.

Futures Commission Merchant

By this time it should be clear as to what role does the FCM play. We note that its
role is similar to that of a brokerage house in stock market. Investors interested in
dealing in futures may also put through their deals through the contacting agents of
FCM. These agents do not accept money from the investors. The agents are also
called as ‘introducing brokers’.
The bulk of the business is carried out by FCMs only.

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Floor Brokers
These people have the responsibility of executing the trades forwarded from the
FA
FCMs on the floor of the exchange. They can also trade for their own account.
They work as individuals or associated with an FCM as their agents.
In addition to these brokers, we also have other types of brokers whose functions
are similar to what brokers in an option exchange does.
Pit
Now, the next logical question would be where does the floor brokers trade in the
exchange? The exchange floor is divided into several physical locations called as
Pits. According to the Federal law and the rules of the exchange, trading in futures
should take place only during official trading hours in a designated area (a physical
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location on the exchange floor) called as a Pit.

Open Outcry
To realize the fair price of the commodity, floor traders are required to make an
offer to all other traders present in the pit by openly shouting the bid or asked
prices. This method is referred to as Open Outcry System.

The Clearing House

In “Flow of the order” we mentioned that the floor broker will report back to the
account executive only after confirming the trade from the clearing house. Does
the clearing house function on similar lines to the one we have seen in options?
Yes. As in options, the futures contracts are also cleared by a clearing house. The
clearing house can be constituted separately or as a part of the futures exchange.
Nevertheless, each futures exchange is closely associated with the working of a
particular clearing house. The functions of the futures clearing house are very
much similar to those of the “Options Clearing Corporation”, the body which
we came across for the first time in Options. Therefore, as the clearing house is
well capitalized and since it holds a net zero position (it exists to facilitate trading
in futures for the participants and it does not trade on its own account) and finally
it being an integral part of the futures market, the traders place immense faith in
the institution.

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Margin and Daily Settlement
The first important point to note in this regard is that each clearing house
prescribes its own limits on initial, maintenance and variation margins. Therefore,
the margins we mention here cannot be applied universally.
One of the main differences between Options and Futures is that in futures both
the contracting parties are required to pay variation margins depending on the
price of the underlying asset in the market. But in case of options, the buyer of
contract after paying the premium does not bother about any other payments
irrespective of the underlying asset’s price in the market.
In futures trading, both the parties to the contract are required to deposit an initial
margin with the broker, which in turn will be deposited with the exchange.
This margin depends on the price volatility of the underlying asset. Exchanges
generally set this margin equal to µ + 3σ, where ‘µ’ is the average daily absolute
change in the value of the contract and ‘σ’ is the standard deviation of these
changes measured over a period of time.
Illustration 1
The average daily price change is $15 per ounce and the standard deviation of the
price changes is $4. Then the initial margin would be,

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(15 + 3 x 4) (100) = 2700.00.
FA
One can also deposit securities instead of cash with the brokerage firm and
simultaneously earn the interest on these. The initial margin is reinforced by
maintenance and variation margins.
Due to the fact that the price of the futures contract changes, gains or losses accrue
to the holder of the contract. The gains or losses are credited or debited to the
margin account. If the price movements are adverse, the balance in the
account falls. Under these circumstances, the trader is required to replenish
the margin, bringing it on par with the initial value whenever the level or
value of funds on deposit with the broker, reach a certain level. This level is
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referred to as the Maintenance margin. The additional amount, which the trader
deposits with the brokerage firm, is called as the “Variation margin”.
The maintenance margin is generally about 75% of the amount of the initial
margin.
In the US, most of the exchanges specify the initial and maintenance margins, for
the top ten futures contract.
Illustration 2
An investor buys a contract of Crude Oil on 13th November, x1. The settlement
price on ten consecutive trading days is shown below. The initial margin is $3000
the maintenance margin is $2100.00. For the following prices ($), prepare a table,
showing when the various margins were called. The contract is for 1000 barrels.
November 13 $ 26.25 November 18 $ 23.00 November 24 $ 26.50
November 14 $ 27.00 November 19 $ 23.55 November 25 $ 27.00
November 15 $ 25.79 November 20 $ 25.00
November 17 $ 24.12 November 21 $ 26.25
This problem will consist of two tables. One of them will show the daily gains and
losses along with cumulative trading profits and losses. The second table will show
equity and margin account.

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 Table 6
Daily Gains and Losses along with Cumulative Trading Profit and Losses
Day Trade Price Settlement Marked to Market Cumulative
Price/Barrel Cash flows Profit/Loss
($) ($) ($) ($)
November 13 26.25 26.25 – –
November 14 27.00 + 750.00 +750.00
November 15 25.79 –1210.00 –460.00
November 17 24.12 –1670.00 –2130.00
November 18 23.00 –1120.00 –3250.00
November 19 23.55 +550.00 –2700.00
November 20 25.00 +1450.00 –1250.00
November 21 26.25 +1250.00 0
November 24 26.50 +250.00 +250.00
November 25 27.00 27.00 +500.00 +750.00
Table 7
Equity and Margin Account
Equity Margin Account

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Transactions Beginning Cash flow Ending Margin call Deficiency Excess
($) ($) ($) ($) ($) ($)
FA
Deposits $2000
Nov.13 Bought a contract 2000.00
2000.00
–
2000.00
2000.00 1000.00 (I.M)
–
1000.00
– 2000.00

Nov. 14 Deposited $1000 3000.00 +750.00 3750.00 – – 750.00

Nov. 15 Withdraws $750 3000.00 –1210.00 1790.00 1210.00 (V.M) 1210.00 –
Nov. 17 Deposits $1210 3000.00 –1670.00 1330.00 1670.00 (V.M) 1670.00 –
Nov. 18 Deposits $1670 3000.00 –1120.00 1880.00 1120.00 (V.M) 1120.00 –
Nov. 19 Deposits $1120 3000.00 +550.00 3550.00 550.00
Nov. 20 Withdraws $550 3000.00 +1450.00 4450.00 1450.00
Nov. 21 Withdraws $1450 3000.00 +1250.00 4250.00 1250.00
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Nov. 24 Withdraws $1250 3000.00 +250.00 3250.00 250.00
Nov. 24 Withdraws $250 3000.00 +500.00 3500.00 500.00

Alternatively, if the investor does not withdraw any excess amount, then the equity
and margin account looks as under.
Table 8
Equity Margin Account

Transactions Beginning ($) Cash flow ($) Ending ($) Margin call ($) Deficiency ($) Excess ($)

Deposits $2000 2000.00 2000.00 – – 2000.00

Nov. 13 Brought a contract 2000.00 – 2000.00 1000.00 (I.M) 1000.00 –

Nov. 14 Deposited $1000 3000.00 +750 3750.00 – – 750.00

Nov. 15 3750.00 –1210.00 2540.00

Nov. 17 2540.00 –1670.00 870.00 2130.00 (V.M.) 2130.00 –

Nov. 18 Deposits $2130 3000.00 –1120.00 1880.00 1120.00 (V.M) 1120.00 –

Nov. 19 Deposits $1120 3000.00 +550 3550.00 – – 550.00

Nov. 20 3550.00 +1450.00 5000.00 – – 2000.00

Nov. 21 5000.00 +1250.00 6250.00 – – 3250.00

Nov. 21 6250.00 +250.00 6500.00 – – 3500.00

Nov. 25 6500.00 +500.00 7000.00 – – 4000.00

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 From the equity and margin account table we observe that on 17th November there
was only $870.00 in equity account (Trader’s account). This was lower than the
maintenance account of $2100.00. Therefore, the trader received a margin call and
has to deposit $2130.00 under the variation margin. On 18th November also, the
trader receives a margin call for $1120 which he deposits on the next day.
It is obvious that the traders wouldn’t like to get the margin calls often. To avoid
this, they can either deposit securities whose value is quite above that of the initial
margin or deposit the cash in excess of the initial margin into an interest bearing
account and use the proceeds towards margin amounts.
In case, the trader does not comply with the above discussed norms, the broker has
every right to close the futures position of the trader and return the balance after
deducting the loss and brokerage fees to the trader. This usually results in a loss
for the trader.
In the discussion till now, we have looked at various facets of buying futures. In
this part, we look at how futures position is closed.

Closing a Futures Position

A trader, who has entered into a futures contract, can close the contract in the
following three ways. He can:
1. either make delivery of the commodity or opt for a cash settlement

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2. enter into an offsetting or reversing trade
3. settle for exchange for physicals.
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The first two are similar to the methods studied in options. In case of entering into
an offsetting or a reversing trade, we have to remember that the contract should be
identical in terms of the commodity traded, the number of contracts and the
maturity to the one which is currently held.

Exchange for Physicals

A trader can also complete the futures contract by engaging in exchange for
physicals. In this method, the parties agree for an exchange of cash and the
commodity underlying the contract. A baker who genuinely requires wheat and a
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farmer who has wheat can mutually agree on a price for the wheat, so that the
exchange can take place, in the process facilitating both the traders to cancel their
complementary futures position against each other. The exchange notes their
positions and cancels their futures obligations.
This method is similar to the offsetting method, but differs from it in this manner:
i. the traders actually exchange physical goods;
ii. the transaction or the mutual agreement does not take place on the floor of
the exchange, and
iii. there may be no intermediaries to negotiate the deal.
Keeping in view, the above points an exchange for physicals transaction is also
called as “Ex-pit” transaction or “Against actuals” or “Versus cash” transaction
and is recognized by the Federal laws and Exchange rules.
In the discussion on margins, we looked at the manner in which the margins are
calculated for a futures contract. However, this was only for a single contract. In
the real world, traders seldom deal in single contracts. Since the objective of
margins is to protect the trader, the broker and the clearing house against losses,
will it not make sense to ask traders to pay margins depending on: (i) his
cumulative position and (ii) the risk he is exposed to in different markets?
Certainly, it will improve the liquidity position and also release the funds locked
up in margins.
Before we look at these margins let us learn a few more basics about futures.

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BASIS AND SPREAD
We define Basis as the difference between the current cash price of the commodity
and the futures price. That is,
Basis = Current Cash Price – Futures Price.
The spot price for a physical commodity can differ from location to location, since
for physical commodities transportation costs play an important role.
Correspondingly, basis calculated also differs from location to location. We know
that a single good cannot be sold at different prices at two different locations, as
the traders will actively exploit any arbitrage possibilities. Therefore, to avoid
arbitrage, the differences should be only to the extent of transportation costs.
Generally, basis is higher for contracts with longer maturity.
Futures markets can be either Normal or Inverted in nature. By normal markets,
we mean that the prices for distant futures are higher than for nearby contracts or
for which the basis gradually increases. The inverted futures market is quite
opposite of this.
The basis for normal markets usually exhibits “Convergence”. By “Convergence”
we understand that the spot and futures prices converge to a point, where the basis
would be zero towards the end of the life of the contract.
Basis is also a valuable indicator for predicting future spot prices of the
commodities that underlie the futures contracts and it is much more stable than the

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futures price or the cash price considered separately. The relatively low variability
of the basis aids in decision-making for traders interested in hedging and certain
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types of speculation.
Illustration 3
The spot price of Gold, say, on 7th November, ’98 was Rs.4,330.00. The price of
the futures contract expiring in August, ’99 is Rs.4,450.00. What is the basis for
this contract?
Solution
We know that,
Basis = Current cash price – Futures price
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= 4,330 – 4,450.00
= – 120.00

SPREAD
The difference between two prices of the futures contracts is called as a ‘Spread’.
Spread trading involves buying one futures contract and selling another.
In spreads, we have two types – intracommodity spread and intercommodity
spread. Intracommodity spread is a position with both futures contracts on the
same commodity, but with different expiration dates.
In intercommodity spread, the two future prices that form a spread belong to two
distinct but economically related commodities.
Spread relationships play important role and their thorough understanding is a
prerequisite for the speculators to earn profits. Also, one should have the ability to
identify economically unjustified spread relationships.
The intracommodity and intercommodity spreads require lower margins vis-a-vis
single contracts. The logic behind lower margins is that, the prices of futures
contracts in a spread are usually related and the initial margin which is deposited
for a spread covers both the contracts of the spread. As a result, the risk of a spread
is quite low as compared to the risk of a single contract and hence eligible for a
lower margin. Most of the exchanges recognize this and they collect lower
margins on the spreads.

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 In case of intercommodity spread, the pair of commodities in the futures contract
determine whether one can go for lower margin requirements on the spread or not.
Only those pairs of commodities which have close economic relationship between
them, say wheat and corn, are eligible for this treatment. Also, the contracts on
these commodities should be traded on the same exchange, since each exchange
establishes its own margins independently.
Intermarket spread is a variant of the intercommodity spread. The margin required
in this case is briefly discussed below.
INTERMARKET CROSS MARGINING
In this method of margining, a trader’s initial margin requirement would be
decided by considering his entire portfolio, even if the different constituents of the
portfolio happen to be with different exchanges. For example, the T-bill futures are
traded at Chicago Mercantile Exchange and Treasury bond futures at Chicago
Board of Trade. If a trader who holds a spread between T-bills and T-bonds
deposits the initial margin depending on the spread, it would be an example of
Intermarket Cross Margining. Intermarket Cross Margining depends on a trader’s
total holding in different markets.
The reasoning behind this method is that the trader’s portfolio risk is usually less than
the risk of the individual constituents. The other advantages of this method are:
1. The total amount of initial margin deposit would be lower for a given degree

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of risk protection, necessarily freeing capital for other purposes;
2. That a central clearing house, while serving various markets, reduces the
FA transfers of funds between different accounts increasing the overall efficiency
of the system;
3. It increases liquidity, as lower margins attract large number of traders.

HEDGING WITH FUTURES

We have seen in the introduction part, that in futures market all categories of
people try to hedge their risks. As an example, we looked at a farmer and a baker,
who in order to protect their price and the profits, went to a futures exchange to
buy futures contracts. The futures markets, thereby, perform an important social
function. While hedging, if the trader is thinking of acquiring any asset, he would
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buy a futures contract and therefore, become immune to any price rise in future
and if he is thinking of disposing an asset, he will sell a futures contract, also with
the sole aim of gaining immunity against falling prices. In the first case, it is
referred to as a long hedge and in the later part it is a short hedge.
In this part, we look at a couple of illustrations to understand the hedging process.
Illustration 4
A farmer knows that the soyabeans crop will be ready for harvest in the month of
September. He estimates that the crop would yield 50,000 bushels. The current price
for September futures contract is $7.50. He sells 10 contracts as the size of each
contract is 5,000 bushels. However, in September, the market price of the soyabeans
reaches $8.50. Would the farmer gain or lose and by how much amount?
Solution
On sale of 10 contracts, the cash inflows are:
= 7.50 x 10 x 5,000
= $375000
On selling the harvest at $8.50, the cash inflows would have been
= 8.50 x 50,000
= $425000
Subtracting these, we have $425000 – $375000 = $50000.
Thus, the farmer made a notional loss of $50000.

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 The point to be noted here is that the farmer is assured of a price of $7.50
irrespective of the actual market price. Even if the price turned out to be $6.50, the
buyer of the contract would have paid him $7.50 per bushel. Thus, the futures
contract has removed the uncertainty about the price the farmer may realize.
Illustration 5
The manager of Everest Photofilms requires 30000 troy ounces of silver after four
months. He buys six 5000 troy ounce silver future contracts maturing in five
months at $11.10 per ounce. After four months, if the spot price is $11.20 per
ounce and the basis is $0.05, does the manager gain or lose? In case he gains, what
will be the amount?
Solution
On buying the contracts, the outflow is
= 5000 x 11.10 x 6
= $333000
When he buys the silver in the market, his outflow will be:
= 5000 x 11.20 x 6
= $336000.
On sale of the futures contracts, he will realize:
$11.15 x 6 x 5000 = $334,500.

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Profit on futures contracts: $334,500 – $333,000 = $1500
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Loss on buying in the spot: $336,000 – $333,000 = $3,000.
The net loss is $1500. In this illustration, you may note that the manager, instead
of taking delivery of the silver under the contracts, has chosen to liquidate the
contracts and buy in the cash market. Deliveries of goods under futures contracts
are made at specified places. Generally, deliveries are not accepted because the
place of delivery may not be convenient for the holder of the contract. In such
cases, the buyer of the contract sells the contract and buys the commodity in the
spot market at his convenience. In this example, you should also observe that the
amounts gained and lost are not offsetting each other. There is a net loss of $1500.
Such a hedge which does not completely protect the holder from price changes is
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called an imperfect hedge. The hedge that offers complete protection is called a
perfect hedge.
We observe that profit made by Everest Photofilms is given by the difference of
$336000 – $333000 = $3000.

Futures Markets in India

Trading in the Futures commenced on June 12, 2000. National Securities Clearing
Corporation Limited (NSCCL) is the clearing and settlement agency for all deals
executed on the National Stock Exchange (NSE). NSCCL is the legal counterparty
to all deals on NSE’s Futures traders.
Admission to Clearing Members (CM) is distinct from NSE Trading Members
(TM) for the futures trading. This is in line with the 2 tier membership structure
stipulated by SEBI’s Dr. L C Gupta Committee to ease the constraint on
participation in the Futures and Options (F&O) segment due to high capital
adequacy requirements. All TMs of the NSE F&O segment are necessarily
required to appoint a CM of NSCCL for clearing and settlement of their deals,
before commencing trading.

Eligibility Norms for Clearing Members in F&O Segment

The clearing member should have a net worth of at least Rs.300 lakh, a deposit of
Rs.50 lakh to NSCCL, which forms the Base Capital (BC) of the member. The
clearing member should have an additional incremental deposits of Rs.10 lakh to
NSCCL for clearing and settlement of their deals, before commencing trading.

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 The following are the types of clearing members:
Trading Member-Clearing Member (TM-CM): A Clearing Member, who is
also a trading member may clear and settle his own proprietary trades and clients’
trades as well as those of other TMs.
Professional Clearing Member (PCM): A CM who is not a TM. Typically banks
or custodians could become a PCM and clear and settle for TMs.

Functions of a Clearing Member

A TM of NSE shall perform execution of an order on the trading system while the
CM of NSCCL shall clear and settle all deals. Primarily, the CM will perform the
following functions:
• Clearing: Computing obligations of all his TMs i.e., determining positions to
settle.
• Settlement: Performing actual settlement. Only funds settlement is allowed
in Nifty Index Futures and Options contracts.
• Risk Management: Setting position limits based on upfront deposits/
margins for each TM and monitoring positions on a continuous basis.
Box 1: Risk Containment Measures
Derivatives offer organizations the opportunity to break financial risks into

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smaller components and then to buy and sell those components to best meet
specific risk management objectives.
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SEBI has set-up a ‘Technical Group’ headed by Prof. J R Varma to prescribe
risk containment measures for new derivative products. The group has
recommended the introduction of Exchange Traded Options on Stocks, which
is also in conformity with the sequence of introduction of derivative products
recommended by Dr. L C Gupta Committee.
The following are the risk containment measures to be adopted by the
derivative exchange/segment and the Clearing House/Corporation for the
trading and settlement of Option Contracts on Stocks:
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The Stock Option Contracts to be traded on the derivative exchange/segments
shall have prior approval of SEBI. The Contract should comply with the
disclosure requirements, if any, laid down by SEBI.
The Exchanges shall introduce Premium Settled American Style Stock Options,
which shall be settled in cash at exercise, for an initial period of six months,
thereafter, the Stock Options, at exercise, shall be settled by delivery.
The Stock Option Contract shall have a minimum contract size of Rs.2 lakh at
the time of its introduction in the market.
The Stock Option Contract shall have a maximum maturity of 12 months and
shall have a minimum of 3 strikes (in-the-money, near the money and out-of-
the-money.)
The Initial Margin requirements shall be based on worst-case loss of a portfolio
of an individual client to cover 99 percent VaR over one day horizon. The
Initial Margin requirement shall be netted at individual client level and it shall
be on gross basis at the Trading/Clearing Member level. The Initial Margin
requirement for the proprietary position of Trading/Clearing member shall also
be on net basis.
A portfolio based margining approach shall be adopted which takes an
integrated view of the risk involved in the portfolio of each individual client
comprising of his positions in Derivative Contracts.

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 Enhancing confidence and knowledge among all market participants is a
necessary condition in order to guarantee the stability of the derivatives markets
besides information standardization and disclosure at all levels in the
derivatives trading industry. Also, the market value concept should always be
preferred in order to serve as a benchmark for the marking-to-market or
collateralization of the various risks exposures.
The kinds of risks associated with derivatives are no different from those
associated with traditional financial instruments, although they can be far more
complex i.e., credit, market, operational, and legal risk. However, it is
important that all users of derivatives, regardless of size, understand how their
contracts are structured, the unique price and risk characteristics of those
instruments, and how they will perform under stressful and volatile economic
conditions. To address those concerns, supervisory reforms should focus on
increasing disclosure of derivatives holdings and the strategies underlying their
use, appropriate capital adequacy standards, and sound risk management
guidelines.
Source: “Derivatives Trading: Where is it Headed?” by Dr. A S Harish, Portfolio
Organizer, November 2001.
Index and Stock Futures at NSE
NSE has introduced trading in Index based futures contracts with a cash market

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index as the underlying asset as well as futures on the underlying stocks.
Index Futures
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NSE will define the characteristics of a futures contract such as the underlying
index, market lot, and the maturity date of the contract. The contracts will be
available for trading from introduction to the maturity date.
Specifications of a contract
A futures contract is specified as follows:
Instrument Type: FUTIDX
Symbol: NIFTY
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Expiry Date: The expiry date identifies the date and month of expiry of the
contract, say December 26, 2002. The minimum lot size to be used for trading and
settlement of contracts will be 200. If NIFTY futures contract is traded at 1,000
and the lot size is 200, then the contract value would be Rs.2,00,000 (200 x 1,000).
The price step is Rs.0.05.
All NIFTY index futures contracts will expire on the last Thursday of the expiry
month. In the above example, NIFTY 26 DEC. 2002 futures contracts will expire
on December 26, it being the last Thursday of the month. This date is also known
as the maturity date of the contract. No further trading in this contract will be
permitted beyond this date. In case the last Thursday is a holiday, then the contract
shall expire on the preceding day.
NIFTY futures contract will have a 3-month expiration cycle. On expiry of a
contract, a new futures contract will be introduced on the trading day following the
expiry of a contract. The new contract will be introduced for a three-month
duration. This way, at any point in time, there will be 3 contracts available for
trading in the market, i.e., one near month, one mid month and one far month
duration respectively.
In the month of January 2004, three NIFTY futures contracts will be available for
trading viz. January, February and March respectively. On January 24, 2004, the
January contract will expire and hence the April contract would be introduced.
Hence, the three NIFTY futures contracts which will be available for trading are
February, March and April contracts.

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Futures on Individual Stocks
The security descriptor for the futures contracts is:
Market type :N
Instrument type : FUTSTK
Underlying : NIFTY
Expiry date : Date of contract expiry
Underlying symbol denotes the underlying security in the Capital Market
(equities) segment of the Exchange. Expiry date identifies the date of expiry of the
contract.
Underlying Instrument: Futures contracts are available on 29 securities
stipulated by the Securities and Exchange Board of India (SEBI). These securities
are traded in the Capital Market segment of the Exchange. Expiry day and trading
cycle are the same as that of Index futures.
Trading Parameters
The permitted lot size for the futures contracts on individual securities is stipulated
by the Exchange from time to time. The value of the option contracts on individual
securities may not be less than Rs.2 lakh at the time of introduction. The permitted
lot size for the options contracts on individual securities would be in multiples of
100 and fractions if any, shall be rounded off to the next higher multiple of 100.

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Base price of futures contracts on the first day of trading (i.e., on introduction)
would be the previous day’s closing value of the underlying security. The base
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price of the contracts on subsequent trading days would be the daily settlement
price of the futures contracts. There are no day minimum/maximum price ranges
applicable for futures contracts. However, in order to prevent erroneous order
entry by trading members, operating ranges are kept at +20%.

CLEARING AND SETTLEMENT OF FUTURES

Clearing Mechanism in NSE
The open position of a CM is calculated by taking the aggregate of the open
positions of all the Trading Members (TMs) clearing through them. A trading
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member’s open position is calculated by adding up his proprietary open positions
and client’s open positions. The proprietary positions will be calculated on net
basis (buy/sell) and client positions will be calculated on gross basis (i.e., a buy
open trade will be offset by a sell close trade and vice versa).
Margining Mechanism
NSCCL has developed a risk containment mechanism for the futures and options
segment. It has adopted a margining system to monitor the trading in the exchange.
The actual margining will be done on a daily basis while on-line position
monitoring will be done on an intra-day basis.
The initial margin is collected in advance for all the open positions of a clearing
member. A CM will collect the initial margin from the TMs and his respective
clients. When a trading member wishes to take additional positions, then the
clearing member is responsible for remitting additional base capital to NSCCL.
This base capital can be in the form of a liquid security, a bank guarantee, fixed
deposit receipt or cash in addition to the initial margin, the members are also
charged premium margin till the premium settlement is complete. Assignment
margin is to be paid on assigned positions of clearing members. This margin
would be charged as follows:
• Exercise Settlement Value up to Rs.100 lakh for an exercise settlement: 10%
of the exercise settlement value for that settlement.
• Exercise Settlement Value greater than Rs.100 lakh for an exercise
settlement: 15% of assignment margin would be released to the clearing
member after the scheduled pay-in day.

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 Box 2: Margining System in India
Indian capital markets have finally acquired an international flavor with the
market-wide rolling settlement coming into place on both the premier
exchanges (Bombay Stock Exchange and National Stock Exchange) and
volumes in the derivatives market slowly creeping up.
“Badla was an integrated product suited to Indian stockmarket conditions. Now,
with these (futures and options) successors, the product has simply bifurcated
into two variants for a different set of market participants,” says a former badla
financier who is now active in the derivatives segment.
In India (BLESS on BSE and ALBM on NSE), there was a financier who
stepped into fund the long (outstanding buy position) or lend securities to the
short (outstanding sell position). Therefore, there was always a cash market
settlement at the exchange linked to these transactions whereas stock futures is
currently being settled in cash and the settlements in futures and cash markets
are segregated. With identical trading terminals quoting both the spot and
futures market movement, the difference only being that a person can buy a
single share in cash market while one has to enter a minimum stipulated size for
a particular stock in the derivatives segment.
So, a trader buying a Satyam contract (minimum 1,200) would have to pay an
upfront margin of 15-20 percent to buy a contract of a Satyam futures or
options. He can shift his position from a one-month contract expiring at the end

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of that month, to a two-month contract at a slightly higher rate reflecting the
implied cost-of-carry for another month. Here the rate of interest, which is
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nothing but the implied Cost Of Carry (COC percent) is known to the investor
beforehand, while in badla the rates were decided by the trades in the badla
session, reflecting a level of transparency in derivatives. The margin is
collected by the broker on behalf of the exchange on a daily basis depending on
daily volatility on the ‘mark-to-market’ system in operation.
A contract bought by paying an upfront margin is calculated on Value-Added
Risk (VAR) basis, which traces the historic volatility (fluctuations in stock
price) of a particular stock and arrives at a margin which is reflective of this
volatility. This basically implies that a volatile stock, like a Sterlite Opticals or
a Satyam Computer, would attract higher margin requirement from an investor
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compared to the volatile stock like a Hindustan Lever or an ITC.
Source: “Indian Derivatives Market: Finally Catches on” by Abhishek Parekh,
Portfolio Organizer, April 2002.
Settlement Mechanism
Nifty index futures and option contracts are cash settled. All CMs are required to
open a separate bank account with NSCCL designated clearing banks.
The open positions in the index futures contracts are marked-to-market at the
settlement price of the contract at the end of each trading day. The members who
have a loss position should pay the loss amount to NSCCL which is then
transferred to the members who have made profits. This is known as daily mark-
to-market settlement. The daily settlement price of the Nifty index futures contract
is the closing price of the index futures contract which is computed by taking the
weighted average of the prices of the daily settlement price. The mark-to-market
losses and profits are directly debited and credited to the CM’s and clearing bank
account respectively.
On the expiry of the futures contract, NSCCL marks the open position of a
clearing member to the final settlement price and the resulting profit or loss is
settled in cash. The final settlement price is the closing value of the index price
on the expiration day of the relevant index futures contract. The final settlement
profit is the difference between the last mark-to-market price and the final
settlement price of the corresponding index futures contract. Final settlement
loss or profit is debited or credited to the relevant CM’s bank account on the
next day to the expiry day.

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 As the price of the futures contract changes, gains or losses accrue to the holder of
the contract. The gains or losses are credited or debited to the margin account. If
the price movements are adverse, the balance in the account falls. In these
circumstances, the trader is required to replenish the margin, bringing it on par
with the initial value whenever the level or value of funds on deposit with the
broker reach a certain level. This level is referred to as the Maintenance Margin.
The additional amount, which the trader deposits with the brokerage firm, is called
the “Variation Margin”.
The maintenance margin is generally about 75% of the amount of the initial
margin. In the US, most of the exchanges specify the initial and maintenance
margins, for the top ten futures contract. A typical futures quotations in Indian
exchanges are given below.
Table 9: Sensex Futures
Contract Prev. Close High Low Close Traded Value (in No. of Open Exp. Date
Qty. lakh) Contracts Interest

August 3100 – – 3114.20 0 0 0 0 29/08/02

2002

Sep. 2002 374.70 3165.00 3153 3187.7 30 945500 4 0 27/09/02

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Jan. 2003 3367.80 3365.90 3347 3353.9 83850 2815.91 1032 11 30/01/03
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Source: www.bseindia.com
Table 10: Nifty Futures
Contracts Open Price High Low Close Traded Traded Value (Rs. Open Interest Contracts
Volume Cr)

Jan. 2003 1079 1085 1078 1083 1310800 141.83 2188000

Feb. 2003 1090 1090 1080 1085 36600 3.97 240800

Mar. 2003 1085 1088 1082 1086 4000 0.43 24800

Source: Businessline.
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INTEREST RATE DERIVATIVES IN INDIA

India’s first trading on interest rate derivatives began in the National Stock
Exchange of India (NSE) in June 2003 with futures on 91-day treasury bills and a
10 year notional bond. Trading in the Mumbai Inter-Bank Offered Rate (MIBOR)
and other instruments would also be introduced subsequently. The first day of the
launch (June 24, 2003) started with 4 trades of Rs.25 crore each, involving two
deals on the 10-year zero-coupon bond and two others on a 91-day bill.
The list of securities on which futures contracts would be available and their
symbols for trading are as follows:

Symbol Description
NSETB91D Futures contract on notional 91-day T-bill

NSE10Y06 Futures contract on notional 10-year coupon bearing bond

NSE10YZC Futures contract notional 10-year zero-coupon bond

NSE defines the characteristics of the futures contract such as the underlying
security, market lot and the maturity date of the contract. Interest rate futures
contract shall be for a period of maturity of one year with three months
continuous contracts for the first three months and fixed quarterly contracts for
the entire year.

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 Minimum lot size for the interest rate futures contracts is fixed at 2000. To start
with, the minimum value of a interest rate futures contract would be Rs.2,00,000.
Base price of the interest rate future contracts on introduction of new contracts
would be theoretical futures price computed based on previous day’s closing price
of the notional underlying security. The base price of the contracts on subsequent
trading days will be the closing price of the futures contracts. There is no day
minimum/maximum price ranges applicable for the futures contracts. But for
practical purposes, operating ranges for interest rate futures contracts will be kept
at ±2% of the base price.
Product characteristics are summarized in the following table.
Table 11
Contract Notional 10 year Notional 10 year Notional 91 day
underlying bond (6% coupon) zero-coupon bond T-Bill
Contract N FUTINT N FUTINT N FUTINT
descriptor NSE10Y06 NSE10YZC NSETB91D
26JUN2003 26JUN2003 26JUN2003
Contract value Rs.2,00,000
Lot size 2000
Tick size Re.0.01
Expiry Date Last Thursday of the month

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Contract The contracts shall be for a period of a maturity of one year
months with three months continuous contracts for the first three
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Price limits
months and fixed quarterly contracts for the entire year.
Not applicable.
Settlement As may be stipulated by NSCCL in this regard from time to
Price time.
Source: www.nse-india.com
SUMMARY
• A futures contract is an agreement between two parties to exchange a
commodity or a financial asset for certain consideration after a specified
period. These are standardized in terms of quantity, the quality and terms of
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delivery, etc. And the futures contracts are traded in an organized exchange,
where a large part of the prices is regulated.
• Futures are used by hedgers to offset the pre-existing risk. The commodity is
usually that which they produce or use in the course of their business.
• In the case of futures both the parties to the contract are required to deposit
an initial margin with the broker who in turn deposits with the exchange.
The margin to be deposited depends upon the price volatility of the
underlying asset.
• Initial margin is the amount required to be deposited as margin initially, that
is, at the time of taking a position.
• Maintenance margin: The floor price below which the balance in the margin
account is not allowed to fall.
• Basis in futures is the difference between the current cash price of the
commodity and the futures price.
• Spread is the difference between the two prices of the futures contracts. It
involves buying one futures contract and selling another. There are
intracommodity spreads and intercommodity spreads.
• Apart from derivative instruments, many a time bonds/debentures are
attached with certain provisions. The next chapter focuses on such provisions
with special reference to warrants and convertibles.

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Chapter XIII

Options

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•
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After reading this chapter, you will be conversant with:

What Options Mean?

• Options Terminology
• Pay-off from Options
• Trading Process
• Options Market in India
• Settlement of Options Contracts
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 Options

Introduction
Man has always been innovative and ingenuous. His determination to improvize
and overcome the limitations of various processes has resulted in phenomenal and
epoch-making discoveries and inventions. To overcome the limitations of
proprietorship firms he discovered the limited companies concept, to limit his
dependence on term lending institutions he invented various types of instruments
to raise long-term as well as short-term finance like different types of debentures,
commercial paper and global depository receipts.

WHAT OPTIONS MEAN?

Options and Futures are also the result of this unrelenting search for better
financial instruments. They belong to a class of instruments referred to as
‘Derivatives’ because they derive their value from an underlying commodity or a
financial asset. The underlying commodities and financial assets can range from
mundane products like wheat and cotton to precious items like gold, silver,
petroleum, and financial assets like stocks, bonds and currencies. Options on
commodities have existed in different forms since 1860 for products as diverse as
gold, wheat and tulip bulbs in the USA. An active over-the-counter market in stock
options has also existed there for nearly a century. However, large-scale

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manipulations by intermediaries and the absence of standardized contracts resulted
in the investors incurring heavy losses due to which the commodity options
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disappeared from the listing of many exchanges by 1968. It was only in 1973 that
organized exchanges began trading options on equities. In 1982, futures on equity
and options on bonds made their appearance on stock exchanges.
For the success of innovative financial products, it is essential that the underlying
asset has a strong market presence. The features of equity stocks that have
contributed to the success of stock options are:
• In case of equities, the unsystematic risk component forms a large proportion
of the total risk of the security. On diversification this can be nullified.
Buying options on these equities is as good as buying equities themselves, if
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we do not take into consideration the premium (discussed later) paid.
Therefore, once the investor exercises the options he aims to achieve the
same objective of nullifying the unsystematic risk.
• Equities have high degree of liquidity, that is, they are traded in large
volumes. Therefore, purchases and sales by individuals or groups do not
cause wide fluctuations in the equity prices, assuring price continuity. This
helps the option holder in deciding the worth of the contract.
• Stocks are instruments with no maturity date. They remain on the exchanges
for long periods, which facilitate option contracts to be structured on them.
• In debt market, quite contrary to the stock market, a large proportion of the
total risk is systematic in nature and cannot be eliminated by diversification,
within the debt market. Also, the debt instruments have a finite life and
limited marketability as compared to stocks. Therefore, options on individual
debt instruments could not be successfully traded. However, options on debt
indices were introduced and traded.

Options Traded in Stock Exchanges

Options are traded on stocks, stock indices, foreign currency and futures. The table 1
gives some of the leading option exchanges in the United States and the
instruments on which options’ contracts are traded.

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 Security Analysis

Table 1
Exchange Name Assets on which Options are traded
Chicago Board Options Exchange Individual stocks, Stock indices, Treasury
securities
American Stock Exchange Individual stocks, Stock indices
Philadelphia Stock Exchange Individual stocks, Stock indices, Currencies
Pacific Stock Exchange Individual stocks, Stock indices
New York Stock Exchange Individual stocks, Stock indices
Chicago Mercantile Exchange Futures (on agricultural goods, stock indices,
debt instruments and currencies)
Chicago Board of Trade Futures (on agricultural goods, precious
metals, stock indices and debt instruments)
But the volumes traded differ from exchange to exchange. While CBOE leads in
equity and index options, Philadelphia Stock Exchange leads in foreign currency
options. In case of options on futures, Chicago Board of Trade and Chicago
Mercantile Exchange are the leaders.

OPTIONS TERMINOLOGY

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Option
An Option is a contract in which the seller of the option grants the buyer, the right
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to purchase from or sell to, the seller a designated instrument or an asset at a
specific price which is agreed upon at the time of entering into the contract. It is
important to note that the option buyer has the right but not an obligation to buy or
sell. But, if the buyer decides to exercise his right the seller of the option has an
obligation to deliver or take delivery of the underlying asset at the price agreed
upon. The seller of the option is also called the writer of the option.
Call Option
An option contract is called a ‘call option’, if the writer gives the buyer of the
option the right to purchase from him the underlying asset on or before expiry
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date.
Put Option
An option contract is said to be a ‘put option,’ if the writer gives the buyer of the
option the right to sell the underlying asset on or before expiry date.
EXERCISE PRICE
The exercise price of the options is determined by the exchange based on the
prices at which it is being traded. The underlying may be bought or sold at this
price. This price is referred to as the exercise price or the striking price. At this
price, the buyer of a call option can buy the asset from the seller and the buyer of a
put option can sell the asset to the writer of the option. This is regardless of the
market price of the asset at the time of exercising.

Expiration Period
At the time of introducing an option contract, the exchange specifies the period
(not more than nine months from the date of introduction of the contract in the
exchange) during which the option can be exercised or traded. This period is
referred to as the Expiration Period. An option can be exercised even on the last
day of the expiration period. Beyond this date the option contract expires.
Such options, which can be exercised on any day during the expiration period are
called American options. There is another class of options called European options.
European options can be exercised only on the last day of the expiration period. For
these options the expiration date is always the last day of the expiration period.

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 Options

Depending on the expiration period an option can be short-term or long-term in

nature. Warrants and convertibles belong to the later category and are often issued
by companies to finance their activities. (In our country, Reliance Petroleum Ltd.
has recently converted its warrants issued as a part of triple optional convertible
debentures into fully paid shares.)

Option Premium or Option Price

This is the amount which the buyer of the option (whether it be a call or a put
option) has to pay to the option writer to induce him to accept the risk associated
with the contract. It can also be viewed as the price paid to buy the option.
Consider the data given below. This is regarding the options trading at Chicago
Board Option Exchange.
Table 2
Expiry Date Sales Open Int. Week’s ($) Closing Net N.Y.
Strike Price Price ($) Change Close
($)
High Low
IBM Jan. 40 1172 3459 7 1/2 6 7 1/8 +1 3/8 45 7/8
IBM Jan. 40 p 2030 6479 1 1/2 7/8 15/16 –9/16 45 7/8

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IBM Jan 45 2410 10184 4 1/8 3 3 5/8 +11/16 45 7/8
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IBM Jan. 45 p 1827 8452 3 1/2 2 3/8 2 9/16 –1 3/16 45 7/8
IBM Jan. 50 4964 11862 1 1 1 11/16 +7/16 45 7/8
15/16 5/16
IBM Apr. 45 238 173 5 1/8 4 4 3/4 +7/8 45 7/8
IBM Apr. 50 755 676 2 7/8 2 1/8 2 11/16 +9/16 45 7/8
John Jn. Sep. 35 317 439 6 3/8 5 1/4 5 3/8 +1/4 39 7/8
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John Jn. Sep. 40 1146 2376 1 15/16 7/8 7/8 – 3/8 39 7/8
K Mart Oct. 25 222 327 3/16 1/8 1/8 – 3/6 22
Source: Barron’s – Dow Jones & Company, 1993.
For explanation, we consider the first row of quotations (IBM Jan. 40).
In the first column, the company’s name (IBM) on whose stock the option is being
traded, the month in which that particular option is going to expire (January), the
exercise price (40) and whether it is a call or a put option is given. All options that
are not indicated as put options are call options. The second column gives the
number of contracts that were traded on that day. Since each contract represents
100 shares of the company, trading 1172 contracts on that day involved a total of
117200 shares of IBM. The figure in the third column (3459) gives the aggregate
(cumulative) number of exercisable contracts that exist till date. It is referred to as
Open Interest. An opening writing transaction will add to the existing positions
and a closing writing transaction will reduce them.
The figures in the fourth column (7 1/2, 6), give the highest and the lowest prices
in dollars at which the contracts were traded. The figures in the fifth column give
the price of the last trade. The sixth column (1 3/8) gives the change between the closing
(last) trade of 7 1/8 and the prior week’s last trade of 6 6/8.
The last column gives the closing price of the underlying stock at the New York
Stock Exchange. This facilitates the comparison of the prices of the stocks and the
options.

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Security Analysis

Expiration Cycle
The options listed in the stock exchanges and introduced in certain months expire
in specific months of the year only. This is due to the fact that option contracts
have to expire within nine months from the date of their introduction. Exchanges
previously used to assign an issue to one of the three cycles. First is January, April,
July and October; other is February, May, August and November; third is March,
June, September and December. This has been modified now to include both the
current month and the following month, plus the next two months in the expiration
cycle so that the investors are always able to trade in the options. Therefore, now
the first cycle will be January, February, April and July, the second cycle will be
February, March, April and July and the final cycle will be March, April, July and
October.

PAY-OFF FROM OPTIONS

In this part, we will look at profit/loss made by an investor when he decides to
exercise the option.

Call Options
We know that in a call option if the investor decides to exercise his right, then he
will buy the shares of the company at the exercise price. Should he do so
irrespective of the current market price of the stock? No, he should not. The

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explanation for different market prices of the stock is given below.
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For a contract assume that the option premium was Rs.3, the exercise price Rs.25
and the current market price of the stock is Rs.23. This data remains the same for
all of the following three cases. Each contract stands for 100 shares.
Case 1
After three months assume that the market price of the stock rose to Rs.30. At this
point, should the investor exercise the option? Yes, he should. The pay-offs are
shown below.
Table 3
Premium Exercise price Total outgo Worth of stock at current Profit/(loss)
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price

300 2500 2800 3000 200

In this case, the trader made a profit of Rs.200. The explanation is as follows: The
trader by exercising the option has received the stock worth Rs.3,000 by paying
only Rs.2,500. That is, a profit of Rs.500. This lowered by the premium will be
Rs.200. Therefore, the trader will make a profit whenever the stock price exceeds
the sum of option premium and the exercise price. It is beneficial for him to
exercise the option as long as the stock price is greater than the exercise price.
Case 2
In this case, assume that the stock price has increased to Rs.28. Should he exercise
the option? He should. The pay-offs are shown in the following table.
Table 4
Premium Exercise price Total outgo Worth of stock at current Profit/(loss)
price
300 2500 2800 2800 0
In this case, the trader by exercising the option has made a profit of Rs.300.
However, this profit is negated by the option premium. Looking at it in another
angle, if the investor buys the stock in the market, he will have to pay Rs.28,
whereas he can get it for Rs.25 on exercising the option.

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 Options

Case 3
Now assume that the current stock price is Rs.21. Should the investor now exercise
his option and what would be the profit/loss if he exercises his option and if he
does not? The pay-offs are shown in the following table.
Table 5
Premium Exercise price Total outgo Worth of stock at current Profit/(loss)
price
300 2500 2800 2100 (700)
300 – 300 – (300)
We observe that if the trader exercises his option, he will incur a total loss of
Rs.700 and even if he does not exercise the option the loss will be equivalent to
premium. That is, if the stock price falls below the exercise price the investor loses
and his maximum loss is equal to the premium he pays.
Put Options
In case of put options, a buyer will make a profit if he exercises his option when
the stock’s current price is lower than the exercise price. In this situation, the
writer will take delivery of the stock whose worth is lower. We consider three

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cases as above. The option price (Rs.3) and the exercise price (Rs.25) remains the
same for all the three cases.
FA
Case 1
Assume that the current market price is Rs.21. Should the buyer of the option
exercise it? Yes, he should. The pay-offs are shown in the table:
Table 6

Premium Exercise price Total inflow Worth of stock at current Profit/(loss)

price

300 2500 2200 2100 100

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The explanation is as follows: On buying the option, the trader pays Rs.300. On
exercising the option, the trader could manage to make a profit of Rs.400 as the
price of the stock in the market is Rs.21. Therefore, Rs.400 reduced by Rs.300, he
has a total profit of Rs.100. Thus, when the current price of the stock is lower than
the exercise price less the premium, the trader makes a profit.
Case 2
Assume that the stock’s current market price is Rs.22. Should the buyer exercise
the option? Yes, he should. Pay-offs are shown in the table that follows:
Table 7

Premium Exercise price Total inflow Worth of stock at current Profit/(loss)

price

300 2500 2200 2200 0

In this case, the buyer paid Rs.300 as option premium. On exercising the option he
made a profit of Rs.300 as the market price of the stock is Rs.22. Therefore,
whatever profit was made on exercising the option was negated by the option
premium paid. As a result, there was no profit for the trader. Therefore, we
conclude that when the exercise price of the contract equals the sum of premium
paid and the current price of the stock, the trader just manages to recover his
investment.

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 Security Analysis

Case 3
Assume that the stock’s current market price is Rs.27. The pay-offs are shown in
the table.
Table 8
Premium Exercise price Total inflow Worth of stock at current Profit/(loss)
price
300 2500 2200 2700 (500)
300 – (300) 2700 (300)
In this case, the trader made loss. This is because the buyer already paid the
premium of Rs.300. As the price of the stock increased, it will be a wise decision
not to exercise the option. At least by selling the stock, in the exchange, the trader
can recover the premium and make profits as a part of capital appreciation.
Therefore, the trader makes a loss when the current market price of the stock is
greater than the exercise price. His maximum loss is, again, limited to the premium
paid as the option is allowed to lapse.
Note: In all these cases we have ignored the transaction costs.
INTRINSIC VALUE

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Intrinsic value of an option is the value of the profits that are likely from the
option. It consists of the profit that will accrue, if the option is exercised today (in
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the case of an American option) or the present value of the profit (in the case of a
European option).
TIME VALUE
7
The intrinsic value for first contract above is $5 . The difference between the
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intrinsic value and the option price is paid in the expectation that in future the price
of the stock may rise. This price is referred to as the Time Value. The option price
1 1 7
is $7 . The difference is 7 – 5 = 13/8 cents. This is the time value of the
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2 2 8
option.
‘OUT-OF-MONEY’ OPTIONS
An option contract is said to be ‘Out-of-Money’ if the buyer incurs a loss if he
exercises it now. An “Out-of-Money” call option will have an exercise price that
exceeds the current market price of the stock. In the table containing option
quotations, the fifth and the seventh contracts are examples of ‘Out-of-Money’
contracts.
These options have no intrinsic value, whatsoever, and the price quoted for these
options is for the perceived time value.
‘IN-THE-MONEY’ OPTIONS
An option contract is said to be ‘In-the-Money’ if the buyer makes a profit if he
exercises it now. An “In-the-Money” call option has an exercise price that is lower
than the current market price of the stock. In-the table of option quotations, the
option contracts: first, third and sixth are examples of “In-the-Money” contracts.
These options possess intrinsic value as well as time value.
‘AT-THE-MONEY’ OPTIONS
The contracts does not result either in gain or loss if the buyer exercises it now.
For ‘At-the-Money’ options, the exercise price of the option is equal to the current
market price of the stock.

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 Options

Note:
We have been defining the above concepts for ‘call options’. For put options
exactly the opposite of these have to be considered. These are shown in the
following table:
Table 9
Put options
Out-of-Money stock price > exercise price
In-the-Money stock price < exercise price
At-the-Money stock price = exercise price
TRADING PROCESS
We have already seen that options are traded on exchanges; and have already
discussed how to understand published quotations. Let us now learn the trading
mechanism, that is, the process through which trades take place on an options’
exchange.
Types of Traders
As in stock exchanges, we find different kinds of traders on the floor of the
exchange where options are traded. They are market makers, floor brokers and
order book officials.

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MARKET MAKERS
A trader who trades on his own account in order to make a profit is a market
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maker. Market makers have an obligation to make market for the investors by
standing ready to buy and sell options. Market makers can follow different
strategies in the options of the few stocks which he deals in by gauging the mood
of the investing public.
FLOOR BROKERS
The floor broker’s main job is to execute the order which he receives from outside
the exchange at the best possible price quickly. They usually belong to one of the
brokerage firms and receive salary or commissions. The brokerage firms also
engage in proprietary trading i.e., trading for their own account. Other staff
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members assist them.
ORDER BOOK OFFICIALS
The order book official is an employee of the exchange who participates in
trading. He cannot trade for his own account. His main task is to facilitate the flow
of orders. He does this by disclosing the best possible limit orders awaiting
execution. He is assisted by other staff members.
SPECIALISTS
These officials function as both dealers and brokers. As dealers, they have to
maintain inventory of the stocks they are assigned and deal in them by quoting the
prices in both ways. As brokers, they have the responsibility of maintaining the
limit order book and execute orders in it keeping in view the movement in the
market prices.
Specialists are employed by the American Stock Exchange, but in Chicago Board
Options Exchange, the function of the specialists is divided between market
makers and order book officials.
Types of Positions
Options trade fall into one of the four categories:
i. Open a position with a purchase.
ii. Open a position with a sale.
iii. Close a position with a purchase.
iv. Close a position with a sale.

359
 Security Analysis

OPEN A POSITION WITH A PURCHASE

An investor opens a position or establishes a position by buying an option. This
action on the part of the investor increases the existing long positions by a single
contract. An investor is said to be long when he buys an options’ contract – it
being either a call option or a put option.
OPEN A POSITION WITH A SALE
An investor can also open or establish a position by writing an option. This
increases the existing short positions by a single option. An investor is said to be
short when he writes an option, whether it is a call or a put option.
CLOSE A POSITION WITH A PURCHASE
An investor who has a short position as a result of writing an option can cancel it
by entering into a closing purchase transaction. This reduces the existing short
positions by one contract.
CLOSE A POSITION WITH A SALE
An investor who has a long position as a result of buying an option can offset it by
entering into a closing sale transaction. This reduces the existing long
positions by one contract.
When a trader closes an existing position – either long or short, that order is called
an offsetting order. Thus, an investor who is long cancels his position by a sale of

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an option which belongs to the same series (this is a necessary condition) and an
investor who is short can cancel his position by purchasing an option belonging to
the same series.
FA
In options trading also we have market order, limit order and stop limit order (along
with the specified periods). These are similar to what we have in case of stocks.

Process of Trading
An investor, who wishes to deal in options, has to open an account with the broker.
The broker may or may not be a member of a clearing house. First, we look at the
process when the broker happens to be a member of a clearing house. After
opening the account, the initial margin has to be deposited. One of the accounts
executive notes down the contract specifications and transmits the same to the
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floor brokers. The floor broker executes the order and intimates the clearing house
the details of the contract. After confirming these with the clearing house, he
passes back to the accounts executive the trade details which are then conveyed to
the investor.
When the broker does not happen to be a member of the clearing house: In
this case, the broker has to contact a member of the clearing house and route his
client’s trades through him. The remaining procedure is the same.

Options Clearing Corporation

The buyer of the call option has every right to purchase the shares of the company
at the exercise price. If the writer of the option does not honor his part of the
option contract, the buyer loses the benefit from buying the contract. Therefore, he
looks for a mechanism which would assure him that the contract will be honored
under all the circumstances. To overcome problems like these and to facilitate
smooth trading in options, a clearing house ‘Options clearing corporation’ has
been formed. In some instances this corporation is jointly owned by several
exchanges (the clearing members) while in some other instances it exists as an
autonomous body.
THE ROLE OF OCC
After the deal for an option contract is struck on the trading floor of the exchange,
the OCC steps in acting as a writer as far as the buyer is concerned and the buyer
as far as the seller is concerned. Thus, at this juncture, the link between the buyer
and the seller is severed. At the end of every trading day, the OCC examines the

360
 Options

contract notes submitted to it by its members. The paperwork submitted by both

the parties should match. If they agree they are called matched trade, if not
outtrade. The process of matching trades and tracking payments is called as
clearing. In case of outtrades, the exchange tries to reconcile the differences by
contacting the related traders.
The OCC maintains all these data in a computer system. It also maintains a record
of the outstanding position of all the investors involved in options trading. Thus,
whenever it receives an exercise notice from its members it checks the uncanceled
short position of other members in the same series and assigns it to one of them in
a random fashion.
After receiving the short notice, the trader with the short position will:
– Oblige the option holder, or
– Default.
When the Writer Obliges
This is quite a straight forward issue. The procedure is as follows:
When the buyer of a call option decides to exercise his right, he informs his
broker. The broker then delivers an exercise notice form to the OCC with
necessary details. When the OCC receives the exercise notice form from the
broker, it posts the same to one of the brokers whose account shows short

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uncanceled position in the same series. This is done on a random basis. The broker
house then reassigns the notice to one of its clients, and delivers the share
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certificates already deposited with it.
When the Writer Defaults
In case the short trader fails to oblige, the OCC performs the writer’s part of the
contract as usual and then initiates proceedings against the writer for default. We
will also see, how the OCC takes precautions to avoid such situations.
In addition to the above, the OCC makes it possible for buyers and writers to close
their positions at any time during the expiration period. When an option is sold, the
clearing corporation makes the entry for sale of the option in the account of the
holder maintained by it. At the same time, it enters a long position in the account
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of the writer of the option chosen randomly. The entry made will cancel out the
existing entry and the offsetting position of the two is reduced. From this, we
observe that whenever a buyer or a writer enters into an offsetting contract, he is
relieved from his obligation to pay or to deliver stock.
Margins
To relieve the OCC as well the broker of the legal complexities and the burden in
case the writer defaults, margin requirements have been set in place by the
exchanges where options are traded. This gives ample scope to brokers, to impose
even stricter requirements on their clients, as in the final arrangement of things the
brokers are responsible to the OCC for the actions of their clients. When a trader
buys an option, he will pay the price of the option to the writer on the next day.
Therefore, it can be said that in long positions, 100% margin is paid.
In case of option writers, margin requirements assume importance. When the
option buyer decides to exercise the option, the writer has to deliver or buy the
stock.
Margins are imposed on writers to make sure that there is no loss to the broker,
buyer or the clearing house. The writer of, say a call option, is asked to deposit an
amount calculated in accordance with the rules of the exchange. This amount is so
calculated that generally, the price fluctuation in the underlying stock in a day is
not more than the margin amount.

361
 Security Analysis

In case the price movement is adverse to the writer, the amount of loss is debited
to the margin account. If the balance in the margin account falls below the
maintenance margin amount, the writer is asked to make up the margin to the
original level. The margin to be paid initially is called initial margin and the
amount paid to make the margin up is called the variation margin.
If the option writer holds the stock on which he has written the option, he may
deposit it with the exchange instead of paying margins. If the stock is so deposited,
there is no risk of default by the writer. Therefore, he is exempted from margins.
The same has been elaborated below.
COVERED CALL WRITING
An option contract is said to be a Covered Call Option, when the option is covered
or protected by the writer by depositing the shares of the company on which the
option is written in an escrow account with the brokerage firm. Therefore, the
writer of a call option does not have to deposit any cash as such and whenever an
exercise notice is received from the OCC, the shares are delivered.
In case, the option expires or if the writer enters into an offsetting transaction he
can withdraw the stocks deposited.
NAKED CALL WRITING

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If a trader writes a call option without owning the underlying stock, it is called as
Naked Call Writing.
FA
When the writer does not own the underlying stock, he has to deposit the necessary
amount of margin with the brokerage firm who in turn deposits it with the exchange.
Sometimes, the deposit required by the broker may be higher than the deposit
required by the exchange.
NAKED PUT WRITING
In this situation, the brokerage firm does not have either the cash or the stock of
other companies as security deposited by the writer of the put option.
Calculation of the Initial Margin for Naked Options: The method of calculation
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of the margin differs from exchange to exchange.
We explain the method followed frequently with an example.
If the investor writes a naked call or put option which is ‘Out-of-money’, the
margin is calculated in two ways and the higher of these two is deposited as the
margin. In these cases, we apply the second method.
The first method
i. Calculate the option premium for 100 shares (each option contract is on 100
shares)
ii. Then compute 0.20(market value per share)(100)
iii. Then compute the amount by which the contract is ‘Out of money’
The margin amount is given by (i) + (ii) – (iii).
The second method
In this case, we calculate the margin as follows:
Margin = 100 x Option premium per share + 0.10(stock’s market price)(100)
Illustration 1
An option trader writes a single naked call option. The option premium is Rs.2.
The stock price and the exercise price are Rs.52 and Rs.55 respectively. Calculate
the margin required.

362
 Options

Solution
The option is Rs.3 out-of-money. We calculate the margin by both the methods.
First Method
Option premium for 100 shares is Rs.200. Substituting, in the formula: 100 x
Option premium per share + 0.20 (stock’s market price) (100) – the amount by
which the contract is ‘Out-of-money’.
We have
(2)(100) + 0.20(52)(100) – 100(55 – 52) = 940.00
Second Method
The formula is = 100 x Option premium + 0.10 (stock’s market price)(100)
= 200 + 0.10(52)(100)
= 720.00
The initial margin required is, therefore, the higher of two which is Rs.940.
Illustration 2
A trader writes a single put option at a premium of Rs.3.50. The stock’s exercise

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price and market price are Rs.32.00 and Rs.35.00 respectively. Calculate the
margin deposited by the trader at the brokerage firm.
Solution
FA
Margin is calculated by two methods, and highest of the two is deposited.
Method I
Margin = Option Premium x 100 + 0.20 (Market value of the share) (100) – 100
(Stock’s market price – Exercise price)
= 3.50 x 100 + 0.20(35.00) (100) – 100 (35 – 32)
= 350 + 700 – 300 = Rs.750.00
Method II
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Margin for single put option

= 100 x Option premium + 0.10(Stock’s market price) 100
= 350 + 0.10 (35) (100) = Rs.700.00
Therefore, margin to be deposited is the higher of these, which is Rs.750.
Calculation of Margin for Naked Put Option which is ‘In-the-money’.
For a naked put option, which is ‘In-the-money’, the margin is calculated as
follows:
i. calculate the option premium for 100 shares;
ii. calculate 0.20 (Stock’s market price) (100).
Then, the margin = (i) + (ii).
Illustration 3
An option trader writes a single naked put option. The option premium is Rs.2.
The stock price and the exercise price are Rs.36 and Rs.38 respectively. Calculate
the margin required.
Solution
We calculate the option premium which is 2 x 100 = Rs.200.
Then, we calculate 0.20(36)(100) = Rs.720
Margin to be deposited = 200 + 720 = Rs.920.

363
 Security Analysis

Calculation of Margin for Naked Call Option which is ‘In-the-Money’.

In this case, the margin is calculated as follows:
i. Compute the premium for 100 shares
ii. Compute 0.20(Stock’s market price)(100).
Then, the Margin = (i) + (ii).
We observe that, this method is similar to the method employed in calculation of
margin for naked put option which is ‘In-the-money’.
Illustration 4
An investor writes a naked call option at a premium of Rs.3. The current market
price of the stock is Rs.64 and the exercise price is Rs.60. Calculate the initial
margin.
Solution
In case of call option, Margin = Option premium + 0.20 (Stock’s market price)
= 100 x 3 + 0.20(64)(100)
= 300 + 1,280
= Rs.1,580.

OPTIONS MARKETS IN INDIA

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Options have been introduced in the Indian stock exchanges since July, 2001. But
the investors and the traders are still skeptical as these instruments are new to the
FA
Indian market and the derivatives market in the world is very dull after a few
scams in the derivatives dealing in the late nineties. From July 2002, stock options
were also introduced in December 2002, there is a proposal to introduce rupee
options in India.
Index options were already traded in the market. On July 2 the trading of stock
options started. An index option and a stock option are quoted as follows:
Details about the index and stock options traded at the NSE are given below.
Instrument Type : OPTIDX for index option and OPTSTK for stock option.
Symbol : NIFTY (in the case of index)/stock symbol in the case of stock
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say, XYZ.
Option Type : CE (to denote the option is a call of European type).
CA indicates the option is a call option and the style of the
option is American. Similarly, we have put options denoted as
PE and PA respectively.
Strike Prices : Generally there are five strike prices, two in-the-money, one at-the-
money and two out-of-the-money prices. In the case of stock
options, the strike price intervals are determined based on the
price of the underlying security. The strike-intervals are as
follows:
Table 10
Price of Underlying Strike Price Interval
Less than or equal to Rs.50 2.50
> Rs.50 to < Rs.150 5
> Rs.150 to < Rs.250 10
> Rs.250 to < Rs.500 20
> Rs.500 to < Rs.1,000 30
> Rs.1,000 to < Rs.2,500 50
> Rs.2,500 100

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 Options

Base price of the options contracts when introduced will be the theoretical value of
the option contract calculated as per the Black-Scholes model. The base price on
subsequent trading days will be the daily close price of the options contract. For
those options, whose orders could not be placed because of application of price
ranges, the base prices are modified at the discretion of the exchange and intimated
to its members. There is no day minimum or maximum price ranges applicable to
the options. The operating ranges and day minimum or maximum ranges of
options are kept at 99% of the base price. Hence, the members will not be able to
place orders at prices which are beyond 99% of the base price. Trading members
can enter into an index options contract (buy/sell) on NIFTY. Lot size in the case
of stock options will be Rs.2,00,000.
Expiry Period of the Contracts
The contracts in general expire on the last Thursday of the expiry month. If the last
Thursday is a holiday, then the previous working day will be considered as the
expiry date.
Liquidation of Options Contracts
Liquidation of options can be done in three ways. On the expiry date one can sell
or buy, abandon or exercise it. But buying and selling are most commonly
practised in the options market. When the premium is less than the transaction
costs of liquidating the options, the option is usually abandoned.

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Pricing of Options Contracts
Options are generally priced by the negotiations between buyers and sellers. Prices
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are influenced by the expectations of the future prices of the buyers and sellers and
the relationship between the option price and the price of the instrument. The price
step in respect of S&P CNX nifty options contracts is Rs.0.05.
Users of Options Markets
The choice of options for investment purposes will depend on financial goals and
investment objectives of the investors. The following types of investors may trade
in options:
– Those who want to trade in the market without holding a strong portfolio.
– Those who want to protect the value of their diversified portfolio of equities.
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– Those who have strong views on the market and its future movement and
would like to take advantage of the same.
– Those who observe the equities market closely.
Eligibility of Stocks for Options Trading
To be eligible for trading for options, the stocks should meet the following criteria:
– The stock should be one among the top 200 scrips on the basis of average
market capitalization during the last six months and the average free float
market capitalization should not be less than Rs.750 crore. The free float
market capitalization means the non-promoter holding in the stock.
– The stock should be amongst the top 200 scrips on the basis of average daily
volume (in value terms), during the last six months. Further the average daily
volume should not be less than Rs.5 crore in the underlying cash market.
– The stock should be traded in at least 90% of the trading days in the last
months, with the exception of cases in which a stock is unable to trade due to
corporate actions like demergers, etc.
– The non-promoter holding in the company should be at least 30%.
– The ratio of the daily volatility of the stock vis-à-vis the daily volatility of the
index (either BSE Sensex or S&P CNX Nifty) should not be more than 4, at
any time during the previous six months.

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Security Analysis

Options on Individual Securities

The following are the stocks on which options are traded.
Table 11
S.No. Security Name NSE Symbol
1. Associated Cement Co. Ltd. ACC
2. Bajaj Auto Ltd. BAJAJ AUTO
3. Bharat Heavy Electricals Ltd. BHEL
4. Bharat Petroleum Corporation Ltd. BPCL
5. BSES Ltd. BSES
6. Cipla Ltd. CIPLA
7. Digital Equipment (I) Ltd. DIGITALEQP
8. Dr. Reddy’s Laboratories DRREDDY
9. Grasim Industries Ltd. GRASIM
10. Gujarat Ambuja Cement Ltd. GUJAMBCEM
11. HDFC Ltd. HDFC
12. Hindalco Industries Ltd. HINDALCO

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13. Hindustan Lever Ltd. HINDLEVER
FA 14.
15.
Hindustan Petroleum Corporation Ltd.
Infosys Technologies Ltd.
HINDPETRO
INFOSYSTCH
16. ITC Ltd. ITC
17. Larsen & Toubro Ltd. L&T
18. Mahanagar Telephone Nigam Ltd. MTNL
19. Mahindra & Mahindra Ltd. M&M
20. Ranbaxy Laboratories Ltd. RANBAXY
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21. Reliance Industries Ltd. RELIANCE
22. Satyam Computer Services Ltd. SATYAMCOMP
23. State Bank of India SBIN
24. Sterlite Optical Technologies Ltd. STROPTICAL
25. Tata Iron and Steel Co. Ltd. TISCO
26. Tata Power Co. Ltd. TATAPOWER
27. Tata Tea Ltd. TATATEA
28. Telco Ltd. TELCO
29. Videsh Sanchar Nigam Ltd. VSNL

SETTLEMENT OF OPTIONS CONTRACTS

Settlement of the Index Options Contract
In the index options contract, the premium to be paid or to be received is
calculated for each CM after netting the positions at the end of each day. The CMs
who have to pay the premium pay them to NSCCL and this is adjusted with those
who have to receive the premium. This is known as daily premium settlement,
CMs are responsible for collecting and settling the premium amounts from the
TMs and their clients. The premium to be paid or received is directly debited or
credited respectively to the CM’s clearing bank account.

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 Options

On the expiry day of the options contract, NSCCL will determine the outstanding
in-the-money contracts based on the final settlement price, and the resulting profit
or loss will be settled in cash. The final settlement price is the closing value of the
underlying index price on the expiration day of the contract. The final settlement
profit or loss will be the difference between the stock price and the final settlement
price of the relevant index option contract. Final settlement profit or loss amount is
credited or debited to the relevant CM’s clearing bank account on the day
following the expiry day.

Settlement of Options Contracts on Individual Securities

The premium to be paid or received is netted across all option contracts on
individual securities at the client level to determine the net premium payable or
receivable at the end of each day. The settlement procedure is similar to that of the
index option contracts. Interim exercise settlement is effected for exercised option
positions at in-the-money strike prices, at the close of trading hours on the exercise
day. The interim exercise settlement price is the clearing price of the underlying
security on the exercise day. The settlement value is the difference between the
strike price and the exercise settlement price of the option contract. The exercise
settlement value is debited or credited to the CM’s clearing bank account on the
third day of the exercise day.
Final settlement is effected at in-the-money prices.

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Options quotations in the Indian exchanges are given as below.

Contract (Strike
FA Prev.
Table 12: Sensex Options
Close No. of No. of Value in Open
Price) Close Price Contracts Trades lakh Interest
BSXCFEB03300 414.09 406.33 100 1 374900 0
BSXPJAN03300 3311.03 3311.03 0 0 0 0
Source: www.bseindia.com.

Table 13: Stock Options on BSE

Stock Strike Premium No. of No. of Value in Open Exp. Date
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Price Contracts Trades lakh Interest
Call Option
Infosys 4900 61.26 – – – 100 30/01/2003
L&T 210 1.81 – – – 1000 30/01/2003
Sterlite Opt 65 0.12 – – – 600 30/01/2003
Put Option
HPCL 260 2.80 – – – 1300 30/01/2003
Infosys 4600 113.00 – – – 0 30/01/2003
Sterlite Opt 60 2.20 – – – 1200 30/01/2003
Source: Economic Times, 15th Jan., 2003.
Table 14: Nifty Options
Stock Exp. Strike Premium No. of Value in No. of Open
Date Price Trades lakh Contracts Interest
Call Open High Low
Options
Nifty 30/01/03 1050.00 35.00 39.25 34.25 10200 110.87 51 9000
Nifty 30/01/03 1060.00 28.00 29.00 25.00 3400 36.94 17 33000
Put Options
Nifty 30/01/03 930.00 1.00 1.00 1.00 200 1.86 1 2200
Nifty 30/01/03 930.00 0.25 0.25 0.25 200 1.98 1 200
Source: Economic Times, 15th Jan., 2003.

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 Security Analysis

Table 15: NSE Stock Options

Stock Exp. Strike Premium Settle No. of Value in No. of Open
Date Price Price Trades lakh Contracts Interest
Call Options High Low
ACC 27/02/03 130 15.30 15.30 58.55 6000 10.2 4 0
Bajaj Auto 30/01/03 450 30.50 30.50 49.75 1600 7.84 2 0
BHEL 27/02/03 170 9.00 9.00 9.00 1200 2.15 1 1200
BSES 30/01/03 200 11.35 11.35 23.90 4400 9.58 4 0
Cipla 30/01/03 900 40.00 40.00 43.00 600 5.65 3 7400
Digital 30/01/03 570 30 30 45 4800 29.24 12 4000
Global
Dr. Reddy’s 30/01/03 870 110.05 110.05 110.05 400 3.92 1 4400
Guj. Amb. 30/01/03 160 7.30 7.45 7.60 2200 3.68 2 55000
Cement

Source: Economic Times, 15th Jan., 2003

Box 1: Index Options
In view of strengthening the derivative markets SEBI allowed introduction of
options on indices. An option confers a right and does not constitute an
obligation. In India, index options are introduced based on two underlying
indices – S&P CNX Nifty in case of NSE options and BSE Sensex for BSE

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options. The multipliers for NSE and BSE are 200 and 100 respectively. Every
contract has a life cycle of three months.
FA
Therefore, if the NSE is at 1,000, the smallest possible contract on the NSE will
be of the size of Rs.0.2 million. If the BSE is at 3,000 then the smallest size of
the contract will be Rs.0.3 million.
At any point of time, three contracts will be available. One that will expire in the
current month, one that will expire in the near month and one that will expire in
the far month. For example, in June the contracts available are those expiring in
June (near month), July (next month) and August (far month). When the June
contract expires the September series will come into existence. Therefore, a
contract will have a life cycle of three months. The reasons for having contracts
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expiring in three different months are to provide the time intervals for which the
trader might take a view on the markets.
Underlying Index S&P CNX Nifty
Contract size Permitted lot size shall be 200 or multiples thereof
Price steps Rs.0.05
Price Bands Not applicable
Style European/American
Trading cycle The options contracts will have a maximum tenure of
three months – the near month (one), the next month
(two) and the far month (three)
New contracts will be introduced on the next
trading day following the expiry of near month
contract
Expiry day The last Thursday of the expiry month or the
previous trading day if the last Thursday is a
trading holiday
Settlement basis Cash settlement on a T + 1 basis
Settlement prices Based on expiration price as may be decided by the
Exchange
Source: NSE.
Source: Article on “Index Options” taken from Portfolio Organizer, July 2001.

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 Options

SUMMARY
• The option buyer has the right but not an obligation to buy or sell.
• An option is called a call option if the writer gives the buyer of the option the
right to purchase the underlying asset from him.
• An option contract is said to be a put option if the writer gives the buyer of
the option the right to sell the underlying asset.
• An European option is exercised only on the due date while an American
option can be exercised any day prior to the due date.
• The option premium is the amount which is paid by the buyer of the option to
the seller to induce him to undertake the risk associated with such contract.
• Out-of-Money: option is one in which the buyer incurs loss if the option is
exercised now.
• In-the-Money: option is one in which the buyer books profit if the option is
exercised now.
• At-the-Money: option does not result in loss or gain to the buyer if it is
exercised now.
• Options Clearing Corporation (OCC): It is a clearing house established to
ensure smooth trading in options. The process of matching trades and

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tracking payments is done by the OCC.
Covered Call Writing: When the option is covered or protected by the writer
•
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of the option by depositing the share of the company on which the option is
written in an escrow account with brokerage firm.
• Naked Call Writing: If a trader writes a call option without owning the
underlying asset, it is called Naked Call Writing.
• Naked Put Writing: Here the brokerage firm does not have either the cash or
the stock of other companies as security deposited by the writer of the put
option.
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Chapter XIV

Warrants and Convertibles

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•
FA
After reading this chapter, you will be conversant with:

Bonds with Warrants

• Convertible Bonds
• Callable Bonds
• Floating Rate Notes
• Dual Currency Bonds
• Equity Index-linked Notes
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• Commodity-linked Bull and Bear Bonds
• Swap-Linked Notes
 Warrants and Convertibles

Introduction
In the earlier chapters, we have discussed the bond market and its valuation
methodologies. We know that the price of a bond depends on various factors such
as existing interest rates, coupon rate, maturity, etc. In comparison to equities, a
bond at first sight appears less glamorous and exciting. But bonds too have their
subtleties and pitfalls for the investors. This is because, in general, there is less
uncertainty about the cash flows accruing to the bondholders as compared to the
shareholders. The emphasis is, therefore, more on fine tuned calculations and
analysis. Such careful computations may not be worthwhile in equities because
there is a greater uncertainty about the numbers one is working with. Typically,
bond prices fluctuate less than the equity prices and the investor who desires
superior performance has to be on the lookout for even small differentials in prices
and returns.
In this chapter, we shall discuss the various types of bonds which are offered in the
market along with other instruments. These instruments such as warrants, call
features, convertibility features attract the investors because of in-built diversity.
This diversity generates confidence among the investors to opt for the instruments.
The topics of discussion include, bonds with warrants, pricing, attractiveness to
investors, convertibles, callable bonds, dual currency bonds, equity index-linked
bonds and swap-linked notes. The popularity of these instruments has increased in
recent days as more and more companies are coming up with these instruments to

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attract the investors and financial institutions.
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BONDS WITH WARRANTS
Warrants are usually attached with the bonds or preference shares to attract the
investor. The objective is to induce the potential investors to subscribe to either
bonds or preferred stocks, which give less attractive returns. The investor commits
his funds with the expectation that he might be able to realize capital gains by
selling the underlying stock of the firm whenever the warrants are exercised and
exchanged for equity shares in some specified ratio.
Thus warrant is another variant of the call option wherein the holder has the right
to purchase shares of the company at some predetermined price. Warrants can be
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exercised within a certain time limit, which can be of some years. They entitle the
holders to subscribe to the shares of the company, which issued the warrants, at the
end of or within certain time period (ranging from 5-10 years). The number of
shares and the price at which these shares can be bought are determined at the time
of issuing the warrants. The price at which the shares can be subscribed to is called
exercise price. Warrants generally have a longer expiration period before they can
be exercised compared to exchange traded options.
Often warrants can be traded independent of the instrument along with which they
were issued. These warrants are called detachable warrants. Usually the exercise
price is fixed over the entire life of the instrument and is greater than the market
price of the stock at the time of issue. When bonds with detachable warrants are
offered, the investors purchase them as a bundle of securities.
Warrants are usually issued when a firm acquires another firm and new shares are
to be offered to the shareholders. These can also be issued when a company issues
new shares and the underwriters are to be suitably paid.
The purchaser of a warrant does not have equity rights in that company. He has no
voting rights and no dividends are paid for holding the warrant. Most of the
warrants have stocks on over the counter markets.
Investment Characteristics
As mentioned earlier, a warrant is a variant of a call option and gives the holder a
certain right to purchase shares of the company at a predetermined price within a

371
Security Analysis

certain time limit. But a warrant is different from a call option in the following
ways:
i. Investors design call or put options whereas corporates issue warrants.
ii. Warrants have longer shelf life (5–10 years) whereas call or put options have
much shorter life.
iii. Each warrant is different/unique in itself. But call or put options are
standardized.
The above mentioned characteristics of warrants provide the opportunity to the
investors to purchase them as they can be exercised at a later date in lieu of the
shares of the company. The investors expect to receive these shares at a lower
price than the market price. This speculative feature increases its investment
attractiveness. Moreover, the secondary market of warrants itself adds to the
investment opportunity of these instruments. Mostly, warrants are more traded in
the secondary market than exercised with an objective of capital gain. Thus the
in-built leverage feature existing in the warrants provides an opportunity to the
investors to make large gains (also losses) in future.

VALUE OF A WARRANT
The market price of a warrant fluctuates between minimum and maximum limits.

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When the current market price of the stock Ps is greater than the exercise price Pe,
the minimum value (Mv) is given by,
FA
Mv = (Ps – Pe) x N, where N is the number of shares.
When the current market price is lower than the exercise price, then the minimum
value is zero, as there is no gain from exercising it.
If the warrant price was lower than this value, any investor by arbitrage would
make risk-free profits. This is explained below.
Assume the market price of the share to be Rs.40, the warrant price Rs.4 and the
exercise price Rs.33. Under these conditions, the total investment by the trader
would be Rs.37 (to buy the warrants, exercise them and sell away the shares) and
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when he sells the underlying share he will realize Rs.40 ignoring the transaction
costs. On the whole, he makes a profit of Rs.3. Therefore, the market price of the
warrant should at least be equal to the minimum value.
The maximum value of the warrant is given by Ps x N. The warrant holders can
realize this maximum value as they do not receive any dividend on the underlying
stock during the period they hold the warrant.
Intrinsic Value
It is the minimum value of the warrant.
Warrant Premium
The difference between the warrant price and the minimum value of the warrant is
called the warrant premium. Usually, the magnitude of the premium over the
intrinsic value for a given change in the stock and the exercise price depends on
factors like the expiration period, variability in the stock price and the leverage
provided by the warrant.
Let us consider the leverage effect it provides. Assume the stock’s current market
price to be Rs.33 and the warrant price Rs.7. After one month assume that the
price of the stock increased to Rs.35 with a simultaneous increase in the warrant to
Rs.9. The percentage change in price of the share is given by (35 – 33)/33 = 5.71%.
And the percentage change in the warrant price is given by (9 – 7)/7 = 28.57%.
Therefore, a warrant holder will experience a rise of 28.57% for a similar absolute
change in the price of the share. The leverage effect acts in a reverse direction

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 Warrants and Convertibles

when the price of the underlying stock decreases. The leverage effect also has a
premium of the warrants for which the ratio of the stock and the warrant price is
high. This is explained as follows.
Table 1
Period
1 2 3 4
Stock Price 25 40 55.00 70.00
Increase in % 60 37.5 27.2
Warrant Price 5 20 35.00 50.00
Increase in % 300 75.0 42.8
Stock-warrant 5 2 1.57 1.40
ratio
We observe that the stock price increased by 60%, 37.5% and 27.2% in periods 2,
3 and 4 respectively. The corresponding changes in the warrant price were 300%,
75% and 42.8% respectively. Thus, during the first period, the warrant changed
300% corresponding to 60% change in the stock price, which is almost 5 times.
In the second period, the stock and the warrant changed 37.5% and 75%,
respectively. Change in the price of the warrant is two times that of the stock.
We observe that the leverage, which was quite high in the beginning, started
decreasing gradually. This process is also indicated by the Stock-Warrant ratio.

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As the ratio decreases, the leverage effect also decreases.
Also the premium on the warrant of companies which experience wide fluctuations
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in their earnings is generally high. The dividend pay-out ratio has an inverse
relation with the warrant premium. We also observe that more the expiration
period, more the chance for the stock price to exceed the exercise price, therefore
more the premium.
Thus warrants are expiring assets and their value decreases with the decrease in
their maturity value. In other words, as a warrant approaches its maturity, its time
value takes a downward turn.
In order to avoid arbitrage possibilities, the minimum value of the warrant should
not exceed the market price of the common stock. Mathematically expressing:
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Pm = 0 if Ps < Pe
Pm = (Ps – Pe) x N, if Ps > Pe
Where,
Pm = Minimum price of the warrant
Ps = Existing market price of the stock
Pe = Exercise price of the warrant
N = Number of shares which can be purchased per warrant.
The above equation determines the theoretical price of the warrant. But in practice,
the warrants usually sell above their theoretical prices. The difference between the
theoretical price and the actual price of the warrant is known as premium.
Premium = Market price of the warrant – Minimum price of the warrant.
The market price of the warrant and the premium have an inverse relationship i.e.,
as the market price of the share increases, the premium of the warrant decreases.
As the investors purchase warrants for speculative purposes, the following factors
determine the premium on the warrant.
i. Maturity Period of Warrant: The longer the period of maturity, the greater
will be the premium of warrant. This is because the maturity period increases
the attractive potential of the warrant. The underlying cause of this is that
chances of increase in the price of the stock reduce as the maturity period of
warrant decreases.

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Security Analysis

ii. Price Volatility of the Share: As the price volatility of the underlying share
increases, the premium of the warrant also increases. Because the investors
are ready to pay extra for such warrants due to speculative reasons, their
expectancy of increase in prices of underlying stock also increases, which
lures them to purchase such warrants.
iii. Dividend on the Stock: As the holders of warrants do not receive any
dividends, declaration of dividends on the share makes them skeptical about
the price. This results in a fall in the premium of the warrant.
iv. Potential Leverage on the Warrant: The greater the leverage on the
warrant, the greater the premium it will attract from the investors. This is
again because of the expectation of greater return (coupled with losses too)
from the warrant.
The present day financial market has grown to a greater extent. Introduction of
better financial instruments such as options, futures, swaps, etc., has reduced the
popularity of warrants. However, large scale companies having better market
capitalization are still coming up with warrant issues for the investors.
Advantages to the Company
1. Growth-oriented companies with a good track record will be in a position to
issue a Non-Convertible Debenture (NCD) with an attractive equity warrant
directly to the public and reduce their dependence on the financial institutions

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and mutual funds.
2. Warrants provide a mechanism for raising additional capital depending on the
FA cash flow requirements of the company. They give a reasonable flexibility to
the company to plan its cash inflows from exercise of warrant options
depending on its requirements.
3. Warrants reduce the overall cost of a debt issue as the investor may accept a
lower yield in anticipation of a profit on the exercise of the warrant option.
Advantages to the Investors
1. The warrant acts as a sweetener and ensures a better subscription to the
NCDs, especially for companies with good track record. NCDs with warrant
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option may also be offered to the investors with offer for buy-back, so that
the investors are required to retain only the equity warrant and are not
required to retain the NCD.
2. NCD with warrant is preferred by many investors because they can expect
steady rate of return and capital appreciation on the NCD and can also obtain
capital appreciation by subscribing to the equity shares on exercise of the
warrant option.
3. Warrants confer a high degree of leverage to the investor. The investor has
the option to sell the warrant in the market, subscribe to equity shares by
surrendering the warrant and paying the exercise price or allowing the
warrant to lapse.
4. Warrants are listed and are traded independently on the stock exchanges. The
investor has the option to dispose off the warrant before the right to allotment
of equity shares becomes exercisable. However, in practice, warrants have
very limited liquidity in India.
5. The investor limits his downside risk to the amount paid for the warrants, but
the upside potential of capital appreciation in the event of favorable price
movements is large.
6. Warrants are highly geared instruments with tremendous potential for capital
appreciation and are attractive speculative tools for investors.

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 Warrants and Convertibles

Types of Warrants
DETACHABLE WARRANTS
These warrants are issued with most debentures, like convertible or non-
convertible or equity, and are immediately detachable. They are traded in the
secondary market as separate instruments.
Example: M/s. Patron Engineering Construction Co. Ltd. has issued, during
March 20x3, Rs.5,00,000 – 14% secured non-convertible debentures, with
detachable warrants, aggregating to Rs.500 lakh.
M/s. Malavika Steel Ltd. has announced a 5.70 crore equity shares of Rs.10 each
for cash at a premium of Rs.30 attached with optional tradeable warrants.
PUTTABLE WARRANTS
These warrants confer a right on the investor to sell the warrant back to the
company at a fixed price before the expiry of a fixed period thereby limiting his risk.
WEDDING WARRANTS
These warrants are attached to the host debentures and can be exercised only if the
host debenture is surrendered.
NAKED WARRANTS
These warrants are issued separately and not as a part of a bond or a debenture
issue. The holder has the option of converting the warrant into debt or equity or

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some other asset of the issuer.

CONVERTIBLE BONDS
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Basics of Convertible Bonds
The provision of conversion in a corporate bond entitles the bondholder the right
to convert the bond into a predetermined number of shares of common stock of the
issuer. Put differently, one can say that a convertible bond is a corporate bond with
a call option to buy common stock of the issuer.
The number of shares of common stock that the bondholder can receive from
exercising the call option of the convertible bond is called the conversion ratio.
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The strike price or the exercise price at which the investor exchanges the bond for
the share is called conversion price.
More often than not, most of the convertible bonds are callable at the option of the
issuer. Some of the convertible bonds are puttable. The put options are further
classified into hard puts and soft puts. If the convertible bond is redeemable by the
issuer only for cash it is known as hard put. If the issuer has the option to redeem
the convertible security for cash, common stock, subordinated notes, or for a
combination of the three, then it is called a soft put.
Let us analyze a convertible bond with the following example.
Illustration 1
A hypothetical bond XYZ has maturity = 10 years; coupon rate = 10%; conversion
ratio = 50; par value = Rs.1,000; current market price of XYZ bond = Rs.950;
current market price of XYZ common stock = Rs.17; dividend per share = Re.1.
The conversion price for XYZ bond is = Rs.1,000/50 = Rs.20
The value obtained by multiplying the current market price of the stock and the
conversion rate or the number of shares that are allotted on conversion is called the
conversion value or the stock value of the bond.
Due to the inverse relationship between the interest rates and the bond prices, we
know that when the interest rate increases, the price of the bond declines. In these
situations, the intrinsic value of the bond acts as a support value (floor) for the
convertible bonds, although the intrinsic value itself would fall. Since the

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 Security Analysis

conversion also takes place in case of preferred stock, the theoretical or intrinsic
value of a preferred stock is a recent value of the future dividends of perpetuity,
discounted at a rate equivalent to the required rate of return or the rate realized on
identical securities without the conversion clause.
The minimum price of a convertible bond is the greater of:
1. Its conversion value, or
2. Its value as a corporate bond without the conversion option, the straight value
referred to above.
If a convertible bond is sold for a price less than the minimum price of the
convertible bond, then arbitrage profits could be realized. Let us suppose that a
convertible bond has a conversion value greater than the intrinsic value and the bond
trades at its intrinsic value. It is beneficial for an investor to buy the convertible bond
at the intrinsic value and convert it since he gets profit equal to the difference
between the conversion value and the intrinsic value. Let us see the other possibility.
The intrinsic value is greater than the conversion value and the bond is trading at its
conversion value. Then by buying the convertible at the conversion value, the
investor will realize a higher yield than that on comparable straight bond.
In our Illustration 1, the conversion value is equal to = Rs.17 x 50 = Rs.850.
To determine the intrinsic value, we need to determine the prices of comparable
bonds in the market. Suppose the YTM of such bonds is 15%. The intrinsic value

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is Rs.788. Since the conversion value is Rs.850, and the straight value Rs.788, the
minimum price for the XYZ bond is Rs.850 being the greater of the two. If the
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bond is selling at Rs.788, an investor purchases it and sells the converted shares at
Rs.850 to book a profit of Rs.62 per bond. So this arbitrage profit can only be
avoided by selling the convertible bond at Rs.850.
Similarly if the yield on comparable non-convertible bonds is 11.8%, the intrinsic
value of the bond will be Rs.896 and the minimum price of the bond Rs.896 itself
would be greater than Rs.850, the conversion value. When the convertible bond is
selling at Rs.850 the YTM will be 12.7%, 90 basis points higher than on comparable
non-convertible bonds. Hence investors would like to purchase XYZ bond.
DOWNSIDE RISK OF CONVERTIBLE BONDS
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When the underlying stock becomes worthless, the percentage price decline
experienced by the investors is given by,
Percentage of Downside Risk
(Market price of convertible − Intrinsic value of right) x 100
=
Intrinsic value
It is also called premium over intrinsic value. The higher the premium over the
intrinsic value, all other factors remaining constant, the less attractive the
convertible bond.
INVESTMENT CHARACTERISTICS OF A CONVERTIBLE BOND
The market price of the stock decides the investment characteristics of a convertible
bond. When the stock price is low, the straight value is considerably higher than the
conversion value. Then the bond will sell just like a straight bond. The convertible
bond in such cases is referred to as a bond equivalent or a busted convertible.
If the market price of the stock is such that the conversion value is considerably
higher than the straight value, then the convertible bond will trade as if it were an
equity instrument; in this case it is said to be an equity equivalent. In such cases,
the market conversion premium per share will be low.
VALUE OF CONVERSION BENEFITS
Having seen the measure used to analyze the convertible bonds, let us now
examine the merits and demerits of convertible bonds and why or why not an
investor chooses a convertible bond.

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 Warrants and Convertibles

In our hypothetical bond XYZ, the market value of the stock is Rs.17. Suppose it
rises to Rs.34 in one month period. If an investor purchases the stock at Rs.17, a
profit of Rs.17 i.e., 100% can be booked. On the other hand, in bonds the
conversion value = Rs.34 x 50 = Rs.1,700. Since the market value of the bond is
Rs.950, the investor in bond books a profit of Rs.750 i.e., 79%. The reason for
lowering of the return in bond is due to investing Rs.2 additionally (over and
above Rs.17) per share more for the stock. The investor realizes a gain based on a
stock price of Rs.19 rather than Rs.17.
Let us consider the other possibility. If the stock prices drop to Rs.7 in one month
period, the investor who invests in the stock will book a loss of Rs.10 per share
i.e., return of 59%. The conversion value of the bond also drops to Rs.350 (Rs.7 x 50).
The bond price will not fall to that level. We know that the minimum price of the
bond is greater than its conversion value or its straight value, assuming that the
straight value is Rs.788. This shows that the investor realizes a loss of 17%. The
loss would be even less in fact because the convertible bond would trade at a
premium to its straight value.
The analysis made so far is based on the assumption that the straight value of the
bond does not change although it can change due to various reasons. When the
rates of interest in the economy grow, the bond values decline and hence the
straight value. Even if the interest rates remain constant, due to deterioration of the
perceived creditworthiness of the issuer the bond rate may fall. When the price of
the stock drops precipitously, like in the above example, the perceived
creditworthiness of the issuer may decline, causing a decline in the straight value.

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In any case although the straight value may decline, it is still a floor price for the
convertible bond price (albeit a moving floor). We can observe from our example
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that it has dropped from Rs.950 to Rs.390.
From the above discussion, it is clear that there are both advantages and
disadvantages of investing in convertible bonds. The disadvantage is that we have
to pay premium for shares. An advantage is the reduction in downside risk (as
determined by the straight value) with an opportunity to recoup the premium per
share through the higher current income from owning the convertible bond.
MARKET VALUES
Premium
The amount by which the market price exceeds the conversion value or the
investment value is called as the premium. When expressed as a percentage, it is
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given by,
Market Price − Conversion Value
Conversion premium = x 100
Conversion Value
The conversion value can be lower than or greater than the investment value.
Irrespective of this, the premium exists. This may be due to the investor’s
expectations that in future, the underlying stock may experience a price rise. These
relationships can be better understood by Figure 1.
Figure 1

From Figure 1, we observe that the investment value serves as a floor for the price
of the convertible security, in the scenario of decline in the price of the underlying
stock. When the market price of the stock exceeds certain value, the conversion
value exceeds the investment value. The market value of the convertible security

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 Security Analysis

on most of the occasions exceeds its conversion value and investment value. The
market premium is greatest at the point of intersection of the investment value and
the conversion value.
In the above figure, we could understand the changes in the market price of the
convertible with respect to conversion and investment values figuratively. If we
express these relationships in relative terms, we have the following ratios.
Bond Price − Conversion Value
Premium over Conversion Value =
Conversion Value
Bond Price − Investment Value
Premium over Investment Value =
Bond Price
Illustration 2
For the data given below, calculate the premium over the conversion and the
investment value.
Market Prices
Rs.
Stock 11
Bond 117

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Conversion rate 10
Conversion value 110
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Investment value 100
Solution
Bond Price − Conversion Value
Premium over Conversion Value =
Conversion Value
117 − 110
= = 0.0636 = 6.36%
110
Bond Price − Investment Value
Premium over Investment Value =
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Bond Price
117 − 100 17
= = = 14.53%
117 117
Conversion Parity Price
We defined the conversion premium as the difference between the market price of
the convertible and the conversion value. The conversion premium ratio tells us
about the magnitude of appreciation in the price that the stock should experience
so that a parity price relationship is reached between the convertible bond and the
underlying share. Expressed in another way, the profit/loss, if an investor buys a
convertible bond, exercises it and sells the equity shares, his position should not
change. That is a situation wherein the investor does not experience either profit or
loss. This situation is referred to as conversion parity price relationship. The
amount of appreciation that the common stock would undergo is also given by,
Bond Price
Conversion parity price of stock =
Number of shares on conversion per warrant
117
For the above example, this will be, = Rs.11.70.
10
This ratio indicates that the price should rise by about Rs.0.70 (6.36% of 11), so
that parity is reached.

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 Warrants and Convertibles

In no circumstances, will the market price of the convertible be lower than the
conversion price, because the investors may make risk-free profits through
arbitrage.
BREAK EVEN PERIOD
It is also important to compare the returns from the equity stock and the bond to
determine the profitability of both investments. Assume that the dividend paid on
equity we have seen above is Rs.0.75. That is, a current yield of 0.75/11 = 0.06818
or 6.82%. The bond, at 10%, will yield 10/117 = 0.08547 or 8.55%.
We note that holding the bond gives us a better return than the outright purchase of
the common stock. Under these conditions, we try to calculate the number of years
required to recover the conversion premium, which results due to different cash
flows from the instruments. This period is referred to as the Break Even Period. It
is calculated by the formula given below.
Conversion Premium
Break Even Period =
Interest Income − Dividends
For our example, it is given by,
7
Break Even Period = = 2.8 years.
10 − 7.50
Till now we have been looking at a well-known model called the “Traditional

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Valuation Model”. In a more systematic manner,
Annual cash flow differential = Face amount x Coupon rate – Conversion
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value x Dividend yield, and the payback period is,
%Premium
1 + %Premium
Payback period =
Dividend Yield
Current Yield −
1 + %Premium
We should notice that this method is only an adaptation of the method used in
capital budgeting and has its own drawbacks.
CALL RISK
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We have seen earlier that there are callable bonds. This is a valuable feature for the
issuers who consider that their stock is undervalued enough so that selling the
stock directly would dilute the equity of current stockholders. The company will
set the conversion ratio based on a stock price it regards as acceptable. When the
market price reaches the conversion point, the issuer will want to see the
conversion happen in view of the risk that the price may drop in future. This
motivates the company to go for conversion even though this is not in the interest
of the owners of the security whose price is likely to be adversely affected by the call.
TAKEOVER RISK
If the issuer company is taken over, then the bondholders are likely to suffer. It is
due to lowering of the stock prices in the market as a post takeover effect. As the
stock of the acquired company may no longer trade after a takeover, the investor
can be let with a bond that pays a lower coupon rate than comparable risk
corporate bonds.

CALLABLE BONDS
Basics of Callable Bonds
A callable bond is a convertible bond with a favorable feature of call option
available to the issuer. When the firm feels that its stock is undervalued in such a
way that selling stock directly would dilute the equity of current stockholders and
if the firm does not prefer the route of debentures/debt, then it issues a convertible

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Security Analysis

bond duly setting the conversion ratio on the basis of a stock price acceptable to
the firm. Once the market price reaches the conversion point, the firm will want to
see the conversion happen in view of the risk that the price may drop in the future.
The holder of a callable bond thus gives the issuer the right to call the issue prior
to the expiration date. In fact the bondholder is put to two disadvantages. First, the
bondholders are exposed to the reinvestment risk, since an issuer will call the bond
when the yield on bonds in the market is lower than the issue’s coupon rate. Let us
try to understand this concept with the help of an example. Suppose a firm has
issued a callable bond with a coupon rate of 13%. Subsequently the market rates
come down to 7%. When funds are available at 7% in the market, why should the
firm pay interest at 13% to the bondholders? Since it has the option to call it
utilizes the opportunity, pays cash to the bondholder by going for the 7% issue.
The second disadvantage is that, the price appreciation potential for the callable
bond in a declining interest rate regime is limited. This happens because the
investors can reasonably expect that the firm would prefer off-loading the bonds
by redeeming at the call price since the market rates of interest have fallen. This
phenomenon of a callable bond is called price compression.
In view of the two disadvantages associated with callable bonds and in order to
make them attractive, the issuer often provides a call protection for an initial

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period, akin to the lock-in-period during which the bond may not be called.
Despite this why would any investor prefer this at all with inherent reinvestment
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risk and price compression unless otherwise sufficient potential compensation in
the form of a higher potential yield is explicitly provided?
The yield associated with a callable bond is simply the interest rate at which all the
coupon payments (generally semi-annual) and the call price are discounted to
equate with the price of the bond. Put differently,
n
C M
P = ∑ (1 + y) t + (1 + y) n
t =1

Where M = call price in rupees, n = number of periods until the first call date. The
discount rate ‘y’ in this equation represents the yield to call and ‘C’ is coupon.
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The yield to call assumes that (1) the investor will hold the bond to the assumed
call date, and (2) the issuer will call the bond on the date. But these assumptions
are unrealistic in the sense that they do not take into account the rate at which the
investor can reinvest the proceeds after the issue is called. For example, for a five
year bond, the investor intends to hold the bond for five years, but when the bond
is called at the end of the third year, the total return for five years will depend
upon the interest at which the proceeds are reinvested from the call date to the
end of the fifth year. Thus it is not possible to calculate the yield to maturity for
such callable bonds.
Price-Yield Relationship of a Callable Bond
The price-yield relationship of a non-callable or a non-puttable bond is convex
because price and yield are inversely proportional. Figure 2 shows the price-yield
relationship of a bond when it is callable and non-callable. The non-convex nature
of a callable bond can be explained as follows.
From the definition of the callable bond, we know that a bond becomes callable
only when the prevailing market yield is less than the coupon rate on comparable
bonds. The price-yield curve of a bond is unaffected till the time it becomes
callable. Investors may not be willing to pay the same price for a bond even when
the coupon rate on the bond is just lower than the market yield as what would have
been its price if it were a callable bond, for there is a possibility of a further drop in
the market yield and the issuer may call the bond. As yields decline, there is an

380
 Warrants and Convertibles

increasing possibility of the issuer calling the bond. Though the exact yield level at
which the bond would be called may not be known, but the existence of such a
level is certain. In Figure 2, for yield levels below y*, the price-yield relationship
of a callable bond differs from that of a non-callable bond. For instance, the
market yield is such that a bond would be selling for 107. But if it is a callable
bond then it might be called at 105 and hence the investors will not be willing to
pay 107. Even if the investors purchase at 107 and if the bond is called, then they
get only 105 and hence there is a loss of 2 units per bond. For a range of yields
below y*, there is price compression. Hereby price compression we mean that as
yields decline price appreciation is limited. This portion of the price-yield
relationship of a callable bond below y* is termed negatively convex because of
the following reason. Increase in yields by a given number of basis points will
result in a greater price decline compared to the price appreciation if yields decline
by the same number of basis points.
Figure 2

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Yield
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Components of a Callable Bond
A callable bond can be thought of as the sale of a call option by the investor to the
issuer as it allows the issuer to repurchase the bond from the time it becomes
callable until the maturity date. The purchaser of a callable bond effectively enters
into two transactions.
i. Purchase of a non-callable bond for which they pay some price.
ii. Sale of a call option to the issuer for which they receive the option price from
him.
The net price paid by callable bondholder is given by,
Price of the callable bond = Price of the non-callable bond – Price of the call option.
It can be seen in Figure 2 that the difference between the price of the non-callable
bond and the callable bond is the price of the embedded call option. Though we
have simplified the situation for explanatory purposes, in practice it is not easy to
define the price of a callable bond like this. The issuer may call the bond at the
first call date or any time thereafter or any subsequent coupon anniversary. Thus
the investor has sold a strip of call options to the issuer. The price of the call
option may vary with the date the option is exercised by the issuer. But it is always
easier to describe the investor’s position as a combination of a long position in
non-callable bond and a short call option.

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Security Analysis

Components of a Puttable Bond

In the case of a puttable bond, the investor acquires a right to exercise his option at
a predetermined price and time. Thus a puttable bond can also be described as
involving two transactions.
i. Purchase of a non-puttable bond;
ii. Purchase of a put option on the bond.
The put option allows the investor to sell the bond to the issuer. An investor will
exercise the put option when the market yield is greater than the coupon rate on the
bond. The price of the puttable bond is given by,
Price of the puttable bond = Price of the non-puttable bond + Price of the put option.
Effective Duration and Convexity
The modified duration is a measure of the sensitivity of a bond’s price to interest
rate changes; the assumption made here is that the expected cash flow does not
change with the interest rates. In the case of a callable bond, the cash flow does
change with the interest rates. Then modified duration may not be appropriate to
measure the price volatility of such bonds. If the rate of interest falls, the expected
cash flow for a callable bond may change. Thus it may be concluded that modified
duration is not an appropriate measure of price sensitivity to interest rate changes.

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If P0 is the initial price and P1 is the price level to which it is reduced on account of
a small increase in the yield (∆y) and the price increases to a level of P2 on account
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of a small decrease in the yield (∆y) then the approximate duration is given by the
formula,
P2 − P1
Approximate duration =
2.P0. (∆y) 2
where y is used in the decimal form. It can be observed that the formula measures
the average percentage price change relative to the initial price per basis point
change in the yield.
When this formula is used for a non-callable bond, it gives the modified duration
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since there is no change in the cash flow due to change in the yield. But when this
formula is used for a callable bond, i.e., a bond embedded with an option, the new
prices at the higher and lower yield levels should reflect the value from the
valuation model. Duration calculated in this method is called effective duration or
option-adjusted duration.
We may summarize the relationships among the duration, modified duration and
the effective duration on the following lines:
• Duration is a generic concept that indicates a bond’s response to a change in
interest rates.
• Modified duration is a measure of duration in which it is assumed that the
cash flows do not change with change in the yield.
• Effective duration measures the sensitivity of the bond’s price considering
that the expected cash flows change on account of changes in the yield due to
the option available with it.
Another measure that is normally studied along with duration is convexity. The
standard convexity measure may be inappropriate for a bond with embedded
options as it does not consider the effect of a change in interest rates on the bond’s
cash flow. The formula for calculating the approximate convexity of any bond is,
P1 + P2 − 2.P0
P0 .y

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 Warrants and Convertibles

When the prices used in this formula are calculated assuming that the cash flows
do not change when yields have changed, the resulting convexity becomes a good
approximation of standard convexity. On the other hand, if prices are calculated
under the assumption that the cash flows have undergone a change due to changes
in the yield in respect of a callable bond, then it is called effective convexity.

FLOATING RATE NOTES

When interest rates are high and the general outlook is either stable or indicating
the possibility of a downward trend in return, then an investor would obviously
consider purchasing a long-term fixed rate bond. The rationale behind such a
strategy is simply to secure the prevailing high returns and also to benefit from any
appreciation of capital that may occur when the expected future scenario is of
declining rates of interest. If the present rates of interest are discouragingly low
and if interest rates are expected to increase in future, then the investor cannot
choose to go for long-term or medium-term investments whose coupon rates are
based on the prevailing lower interest rates. He naturally looks for instruments
which would pay interest that varies with the trend prevailing in the future years.
This need of the investor led to the innovation of Floating Rate Notes. From the
point of view of issuers, it should be noted that there are no conditions attached to
the use of funds and therefore, the borrowers are free to use them for their general
corporate needs. However, since many of these issues are unsecured, sovereign
borrowers in developing countries are required to obtain a state guarantee while

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corporate entities require a bank guarantee.
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Definition and Mechanism
A Floating Rate Note (FRN) is a bond issued for medium to long-term, which pays
coupons that are pegged to the level of a certain floating index, which is called
reference index. Let us consider a five-year FRN with coupons referenced to the
six-month LIBOR (London Inter-bank Offer Rate) paying coupon semi-annually
and the default risk premium set at 0.125%. This implies that during the five-year
tenure of the bond, the coupon interest paid will be varying according to the
LIBOR. For example, if the LIBOR is 6.6% the next coupon payment on a $1000
FRN will be equal to 0.5 (0.066 + 0.00125) (1000) = $33,625. If, on the other
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hand, for the next reset date the six month LIBOR comes down to 5.7%, then the
coupon payment will be equal to 0.5 (0.057 + 0.00125) (1000) = $29,125.
In a basic floating rate note, the following are the five important features:
1. Reference Index
2. Quoted Margin to Reference Rate
3. Reset Frequency
4. Observation Date
5. Maturity Date.
REFERENCE INDEX
Every FRN chooses its own reference index upon which the calculation of each
successive new coupon is based. The most commonly used reference index is
LIBOR. It is a European market rate, used when European banks negotiate loan
agreements. The British Banks Association which has a consortium of 24 British
banks publishes it. Other reference indices are US 90-day Treasury Bill rates,
Prime rates, Commercial Paper rates, etc. In India, MIBOR (Mumbai Inter-bank
Offer Rate), 10-year Government Bond rate, 3-year Fixed Deposit rate of State
Bank of India, etc., are some of the reference indices.

383
Security Analysis

QUOTED MARGIN TO REFERENCE RATE

This is also called default risk premium. This indicates the additional rate paid
over and above the reference rate. It is the compensation for the credit risk of the
issuer. The spread over the indexed rate could be fixed or varying. This spread
depends mainly on the security offered by the issuer and his creditworthiness.
Companies which claim good reputation in the market like Reliance and Tata
would be able to issue FRNs with very thin premium.
RESET FREQUENCY
Normally periodicity of coupon payments and the reset dates go together. That is,
they are identical. However, on some FRNs, the coupon resets faster than it pays.
For example, the coupon rate might be reset monthly but the coupon interest might
be paid quarterly. In such cases, the interest payable on the bond will be revised
three times between two consecutive interest payments if the reference rate
undergoes change in all the three months.
OBSERVATION DATE
The rules for determining the dates upon which the value of the reference index is
observed for the purpose of setting the next coupon change from one issue to the
other. The rule for specifying the observation date generally includes not only a

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specific time, but also a specific place. To quote an example, the observation date
for three month LIBOR might be specified as the average offered rate for three
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month Eurodollar deposits at a list of reference banks in London at 12 Noon on the
second business day preceding the reset date.
MATURITY DATE
This is simply the due date of the bond on which the principal of the bond and the
last coupon payment become payable.
Types of FRNs
In an era of innovations, while changing needs and preferences of the investors
trigger introduction of newer FRNs, the borrowers’ funding specifications also
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necessitate the sprouting of new varieties of FRNs. Some of the important varieties
are listed hereunder:
1. Flip-flop FRNs
2. Mismatch FRNs
3. Mini-max FRNs
4. Capped FRNs
5. Structured FRNs
6. Perpetual FRNs
7. Deleveraged FRNs
8. Inverse FRNs.
Flip-Flop FRNs
The World Bank came out with an issue of FRNs in 1985, with a spread of 50
basis points over the three-month US Treasury Rate and a perpetual life. It also
provided the note holder an option of converting the FRN into a three month flat
yield at the end of every sixth months. The investor could again go back to floating
rate with perpetual maturity if he desires so.

384
 Warrants and Convertibles

Mismatch FRNs
These are also called rolling rate FRNs.
Mini-Max FRNs
These FRNs consist of minimum and maximum coupons. Investors benefit in
terms of high spread (over the LIBOR), but have to agree to a minimum rate as
well as a maximum rate on their notes, the differential between the two being very
small. These are also referred to as Collared FRNs. For example, a bond with
5-year maturity and coupon interest payable six monthly at LIBOR – 0.50%
subject to a cap of 8.25% and a floor of 5.5%.
Capped FRNs
Under capping arrangements, the FRNs issued are pegged to an interest rate cap.
This means that the issuer need not pay interest beyond the ceiling level even if the
LIBOR shoots up to more than that level. In order to protect the interests of the
investors and make the bond attractive, normally higher margins are offered on
such FRNs.
Structured FRNs (Variable Rate Notes)
This is one of the latest innovations which is issued for longer terms (sometimes
perpetual also) with variable interest spreads with margins over LIBOR going up
for later maturities. Margins for the subsequent dates in this regard are fixed either

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by auctioning or through a mutual agreement.
Perpetual FRNs
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These are also called irredeemable or unrated FRNs and are akin to a form of
capital.
Deleveraged FRNs
The reference rate is adopted as a percentage of the value of reference index. For
example, the coupon will be determined as 75% of LIBOR + 0.7%. It may be
noted that the reference rate is not taken as the full value of LIBOR.
Inverse Floating RATEs
The coupon rate increases when the LIBOR rate decreases and vice versa. This
benefits the investors when the rate of interest in the market is in the declining trend.
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Risks Associated with FRNs

Basically there are two risks associated with FRNs. One is the interest rate risk and
other default risk.
Interest Rate Risk: Normally short-term interest rates have higher volatility than
long-term interest rates. So an FRN holder may hedge against such risk by taking
positions in Eurodollar futures contracts or interest rate swaps. The risk in
institutions holding a portfolio of FRNs with different reset dates, is very similar to
a portfolio of short-term paper issued by the respective companies with maturity
dates coinciding with various reset dates.
Default Risk: This risk arises if the FRN is traded at discount.
Advantages of FRNs
We know that the coupon rate is fixed for fixed rate bonds and that throughout its
tenure the investor receives coupons at a predetermined interest rate irrespective of
the changes in the interest rates in the market. Further, bonds experience inverse
price changes when the market rates of interest change. That is, the price of a bond
decreases when there is an increase in the market rates and increases when there is
a decrease in the market rates. It has been observed that FRNs will experience only
mild price changes between reset dates, the reason being that the reference rate
normally moves in tandem with the market rates and the coupon of the FRN is
pegged to the reference rate.

385
Security Analysis

It is to be appreciated that FRNs make attractive investment for the investors with
a strong need to preserve the principal value of the investment if they desire to
withdraw the investment prior to the maturity date of the bond. The reason is very
simple; the rate of interest paid as coupon rate is almost the same as the market
rate at any given point of time.
FRNs are equally advantageous to the issuers because they need not borrow long-
term debt at historically high rates of interest particularly when there is a declining
trend in the interest rates. During 1993, MRPL issued partly convertible debentures
at 16.5% rate and had to keep on paying interest on the debt portion at the same rate
even after five or six years when the market rate of interest had considerably come
down. Similarly, the Hyderabad Urban Development Authority (HUDA) also issued
bonds at 15% interest whereas the market rate subsequently came down drastically.
HUDA is still paying interest at 15% to fulfill its original commitment.
Box 1: Floating Rate Notes Issues
The Power Finance Corporation had accessed the market with a $100 mn
floating rate note issue to raise funds for financing various power projects. ABN
Amro was the lead manager of the issue. The issue was launched on June 28
and closed on July 9, 1999. The issue carried a coupon of 145 basis points over
LIBOR and came with a green-shoe option for $50 mn. The seven-year issue

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due to mature in 2006 carries a call and a put option at the end of five years.
Road shows were held in Singapore, Mumbai, Dubai, London and three other
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European cities to promote the issue. The Bank of Baroda, Natexis Banque,
Bank of India and Rabobank were appointed as the senior co-lead managers on
the issue that was underwritten by ABN Amro.
PFC was accorded the same long-term foreign currency debt rating as the
Indian sovereign by Moody’s and S&P: Amro was targeting banks and
institutional investors mainly in Europe and Asia.
Sterlite had raised $80 mn through a floating rate note issued in 1998, lead-
managed by UBS. Most of the funds (Rs.287.51 crore) were still lying locked
up in Merrill Lynch’s International Bank in London when sterilite had made an
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open offer for INDAL.
IRFC (Indian Railway Finance Corporation) has raised $150 mn (Rs.540 crore)
through floating rate notes sold in the US, Europe and Southeast Asia in August
1997 at an extremely cheap rate of 75 basis points above the London inter-bank
offer rate.
Arvind Mills Ltd. has also issued Floating Rate Notes (FRNs) of $125 mn in the
overseas market.
Spic Electric Power Corporation, a company promoted by Tamilnadu
Petroproducts Ltd., issued during 1996-97, FRN (floating rate convertible notes)
for Swiss France 45 mn, to be repaid at par on December 9, 2003. These notes
were convertible at the option of investors at Rs.21.03 per share at any time
during the period April 1, 1997 to maturity date.
The Chennai-based fertilizer major SPIC also retired through market operations
with its $120 mn FRN. The buy-back was done by borrowing money in the
local markets in rupees and buying out the FRN, which was being quoted at a
heavy discount.
Industrial Development Bank of India floated bonds outside India, which include
dollar denominated FRN maturing in 2002 and a similar dollar denominated FRN
maturing in 2004. The outstanding FRN maturing on 2002 and FRN maturing on
2004 stood at Rs.987.37 crore and Rs.582.17 crore, respectively.
Source:www.thehindubusinessonline.com

386
 Warrants and Convertibles

SUMMARY
• Warrants are usually attached with the bonds or preference shares to attract
the investor. The objective is to induce the potential investors to subscribe to
either bonds or preferred stocks, which give less attractive returns.
• Warrants are of different types, namely, Detachable Warrants, Puttable
Warrants, Wedding Warrants and Naked Warrants.
• Convertible bond is a corporate bond with a call option to buy common stock
of the issuer. The number of shares of common stock that the bondholder can
receive from exercising the call option of the convertible bond is called the
conversion ratio.
• Convertible bonds are also of different types such as callable bonds and
puttable bonds. A callable bond is a convertible bond with a favorable feature
of call option available to the issuer. In the case of a puttable bond, the
investor acquires a right to exercise his option at a predetermined price and
time.
• A Floating Rate Note (FRN) is a bond issued for medium to long-term, which
pays coupons that are pegged to the level of a certain floating index, which is
called reference index.

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387
Chapter XV
Real Assets

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•
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After reading this chapter, you will be conversant with:

Real Assets
• Appraisal of Real Assets
• Approaches to Estimate the Market Value
• Methods to Calculate the Capitalization Rate
• Subjective Factors Affecting the Value of Real Estate
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 Real Assets

Introduction
In the previous chapter, we discussed about the financial markets and their
functions. In a broad framework we covered the scope and development of
financial markets. In this chapter, we would discuss about the components of
financial markets which require special coverage because of their nature and
contribution to the functioning of the financial system. We would deal with
currency markets, commodity markets and the property markets and their vital role
in the development of any financial system.
REAL ASSETS
Real estate is not easily exchangeable or transferable. Three types of real estate are
identified. They are industrial buildings, commercial buildings and residential
complexes. But, however, such a classification is also not unique. While considering
an investment in a property, the investor looks into these parameters: location,
design, potential for appreciation in value, etc. Of these, location is more important
than any other parameter because it determines the value of a property the most. In
the beginning of the seventies, operating in the real estate markets was not so
difficult as it is today. The sources of funds were limited to equity and mortgage
lending during that period. But now the situation has changed with more sources
of funds available in the market. The banks, financial institutions and the insurance
companies have a variety of schemes to fund real estate investment.
Reasons for opting for real estate investment:

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The choice of real estate for investment could be any of the following:
1. Diversification
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2. High risk-adjusted returns
3. Inflation adjusted returns
4. Low volatility.
Real estate investment has its own limitations too:
1. Lack of liquidity
2. Real estate market is less efficient than other markets
3. Insufficient historical data available on real estate
4. Diversification is possible only for large investors and not for small investors.
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The influence of inflation on the value of a property is more pronounced in the
case of emerging markets. When low inflation rates are accompanied by lower
interest rates, the capitalization rates tend to be lower. The cash flows and residual
values rise gradually. Because of this, low internal rate of return will be accepted.
In periods of higher inflation rates, cash flows and terminal values increase more
rapidly. The cash flows related to property ownership in response to inflation is
more predictable than that with the ownership of any other asset. This is because
with rising inflation the property appreciates in value more than the appreciation
that occurs with any other type of asset. Thus the real estate is said to be more
stable in value.
The real estate cycle is depicted below.
Figure 1: The Real Estate Cycle

389
Security Analysis

Each stage of the above cycle lasts for about 5 to 8 years. But the period of the
cycle varies from country to country and within a country from city to city and
within a city from area to area.
Characteristics of Real Estate/Property Markets
Valuation of real estate portfolio is different from that of bonds or stocks because
of the following characteristics:
a. Each Packet is Unique: No two real estate investments can be the same, at
least if they are located in different places. This difference may not be very
significant but the price of one of them may not give any clue about the price
of another. Thus the principle of pricing of similar products cannot be applied
to real estate pricing.
b. Relatively Fewer Players in the Market: While there are a large number of
players in the stock market or bond market, there are a very few players in
the property market. This is because the amount required for investment in
property markets is comparatively higher than that required in other asset
markets.
c. The Price of a Property is Influential: In a perfectly competitive market,
buyers cannot determine the price. Buyers have no choice. But the situation is

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different in the case of real estate markets because a buyer who can bid for a
much higher price than the second bidder will definitely influence the price
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of the property. Real estate does not have a market mechanism which allows
short selling.
d. Real Estate Investments are Large Economic Units: Property investments
cannot be divided into smaller units like equity shares. This may be
overcome to a certain extent by way of securitization of real estate
investments. But still a property investment must be made as a single unit.
e. Extensive Government Controls: Property markets are subject to several
regulations such as tax laws, building codes, environmental norms to be
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adhered to, etc. These act as detrimental factors to the development of real
estate. Frequent changes in government regulations may cause change in
ownership position of a real estate which poses an additional risk.
f. Slow Reaction of Supply to Demand: Supply and demand in real estate do
not balance. This is because it takes time for conversion of a property from
one use to another use. This adds to the complication of the valuation of an
investment.
g. Unorganized Market: There is no regulated market available for real estate.
So the price of the real estate becomes difficult to be estimated. Though the
shares in Real Estate Investment Trusts (REITS) are traded, they do assume
the properties of a share rather than those of a real estate.
h. Insufficient Data about Market Prices: Absence of an organized market and
indivisible nature of real estate investment are the reasons for the availability of
reliable information about the prices of real estate. Even the buyers and sellers
are not willing to disburse the price information. Unless a lease agreement is
signed, it is not possible to estimate the price of a vacant space in any building.
Thus, price information about the property is difficult to obtain.
i. Illiquid Nature: Very few transactions occur in real estate over a period of
time. So a definite trend of the prices over time is difficult to determine. The
risk and return characteristics are also difficult to estimate.

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 Real Assets

Efficiency of Property Markets

Because of lack of information available about the price of the real estate, high
price is to be paid to obtain useful information. Buyers, sellers, lenders and others
are ready prey to the intermediary who provides relevant information about the
market.
The buyers who have access to more information tend to be benefited more. In an
efficient market, additional returns cannot be obtained by trying to derive more
information from the existing reports. But since the real estate market is
inefficient, additional returns are possible. Because of this advantage, more
investors besides institutional investors are exploring the real estate market. Many
analysts take advantage of the lack of efficiency in the market and sell
information. The developers in the real estate market adopt strategies like
securitization to make available more real estate investments. These approaches
will tend to bring about efficiency in the real estate markets.
Appraisal
An appraisal is the first important step towards estimating the real worth (value) of
the asset. For it to be objective and authentic, it should be carried out by an
impartial person who has the expertise in the relevant field.
LAND AND HOUSE PROPERTY

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Whenever we talk of value of a theoretical concept, we try to know the market
price of the asset to get an estimate of value. Also, it gives the expectant buyers
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and sellers an estimate of the price at which they can transact. This is important as
most of the time they have their own subjective views. Therefore, we may define
market value as,
i. The price at which the asset is most likely to be disposed off, in cash,
ii. The value at which the goods and services are exchangeable for a property,
and
iii. The present value of future claim to the income realized on that property.
The market value also plays a crucial role in the estimation of the following.
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TRANSFER OF OWNERSHIP
The market values serve as a benchmark at which the transacting parties can
negotiate with each other on reasonable terms. Often the price at which the deal is
finalized is based on the market value. It forms the basis on which the rent of the
house is usually fixed. In case of distribution of property among multiple
claimants, it serves as a fair value.
FINANCING A PROPERTY INTEREST
Whenever land property (real estate) is forwarded as a collateral, the lender checks
whether the market value of the property is more than the principal amount of the
loan or not. The extra value serves as a buffer in case of default.
PAYING TAXES ON PROPERTY
The proper estimate of the market value by the assessor is necessary for paying the
correct amount of property tax.
FOR COMPENSATION IN CASE OF LOSS OR DAMAGE
Most of the owners insure the real assets they possess in order to make good the
losses and damage caused by natural calamities and accidents.
In some cases, where the government takes over the private property for public
use, the compensation to the owner depends on the market value of the property.
PROPERTY UTILIZATION
The property is said to be utilized in the best possible (highest and best use)
manner if it yields the greatest present value for that use.

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 Security Analysis

PRINCIPLES OF APPRAISAL
While appraising, these principles play an important role. We discuss them briefly.
Principle of Substitution
According to this principle, a rational buyer will not spend more than the amount it
is going to cost him if he buys another similar property with same utility. Also, the
buyer while making a decision has three alternatives. They are:
1. The buyer can opt for an existing one with same utility as the one in question,
2. Buy a clear site and develop it to that extent, where it equally serves his
purpose, or
3. Buy a property whose risk-return characteristics are similar to that of the
subject property.
We will look at various methods, which are appropriate for valuation under these
three circumstances later.
Principle of Change
According to this principle, price is a function of demand and supply and as price
fluctuates, the value also fluctuates. This may be due to existing political, social
and economic environment in the country. Therefore, the appraiser has to take into
account these factors and evaluate their effects on the value of the property.

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Principle of Marginal Productivity
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According to this principle, the value of any factor of production or a component
of a property can add to or lower the value of the asset.
Principle of the Highest and Best Use
This principle states that a rational owner will try to gain the maximum out of the
resources he possesses.
THE APPRAISAL PROCESS
The various steps are:
1. Defining the problem
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2. Making a survey and a plan
3. Collecting the relevant data
4. Applying the most suitable approach to estimate the market value
5. Writing a report.
Defining the Problem
In this step, the appraiser and the owner together, discuss in detail about the
property to be valued, the purpose of valuation, the date for which the valuation is
desired and the specific value to be evaluated (market value/assessed value).
Making a Survey and a Plan
After getting the necessary details from the owner, the appraiser then estimates the
scope, character and the exact amount of work to be carried out. At this stage, he
may have to collect information from a host of people like brokers, lenders and
other appraisers. As the work involved varies from method to method, the
appraiser at this stage decides the approach to be used and the corresponding fee.
Only after the owner agrees does he begin his work.
Collecting and Organizing Data
At this stage, the appraiser will make an on-site inspection of the said property and
collect data regarding the topographic, environmental, demographic and social
factors. He also has to collect the relevant regional, community and the
neighborhood data to serve as a background for the appraisal plan.

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 Real Assets

Applying the Best Approach to Estimate the Market Value

A buyer can acquire property by opting for any one of the three alternatives. There
are several ways of appraising the real estate information and arriving at a value.
Some of them are:
a. Cost approach
b. Comparison of sales approach
c. Income approach.
The appropriate method to calculate the market value in these three cases is given
below.
Table 1
Alternative Method
1. Buy an existing one Market or direct sales comparison
approach
2. Buy a clear site and develop it Cost approach
3. Buy a property with same Risk- Income approach
Return characteristics
COST APPROACH
According to this approach, value of a property is equal to the sum of the land
value and the replacement cost of the building. From the value thus obtained, the

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cost of repairs to be done, and the cost associated with obsolescence of its utility if
any (functional or others) are deducted to arrive at the net value. The rationale
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behind this approach is that any rational investor would not be ready to pay more
than the cost of replacing the same building with an equivalent property.
When the existing building cannot be put to the best use, its value is assumed to be
diminished.
The steps involved in the Cost Approach are:
1.
Estimating the market value of the site,
2.
Estimating the improvization or development charges,
3.
Estimation of depreciation charges and deducting them from development
charges, and
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4. Estimating the market value of the property in question.
The drawbacks of cost approach are:
a. It is difficult to quantify the functional and external obsolescence.
b. A developer would not raise any building without any expectation of return.
This profit motive has not been considered in arriving at a value under the
cost approach.
c. It always assumes that the owner has the first right to the property. If the
owner has leased the property, then he would have partial ownership only.
Adjustments have to be made in arriving at a value for a building when it is
leased.
COMPARISON OF SALES APPROACH
In this approach, the value of a property is determined based on the sales of similar
properties. The appraiser should be able to get enough information to adjust for the
difference in prices between the properties. The factors that are considered for
comparison purposes are similar:
1. Location, type of property
2. Ability to generate identical income
3. Lease structure
4. Risk
5. Ability to finance
6. Rights associated with them.

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 Security Analysis

Assigning a value of the property under consideration based on the value of similar
property is a difficult task. This cannot be done without making any adjustments,
for we cannot find a hundred percent identical property. The second problem is
that this approach ignores market changes. If the comparable property has been
sold a few months earlier or a year earlier the same price may not be valid now and
using that value without any adjustment does not make any sense.
The steps in Market or Direct Sales Comparison Approach are:
1. Select properties which have similar characteristics to that of the subject
property,
2. Then subdivide them into units so that it would aid us in comparing and
performing calculations,
3. Then adjust the sales figures with that of the subject property, and
4. Estimating the market value of the subject property.
INCOME APPROACH
Based on the ability to generate income, the value of a property is determined
according to this approach. The present value of the future benefits that would
arise out of holding the property is determined to assign a value to it. This method
also relies on market related data such as market rent for a similar property,
expenses that would be incurred on the property, etc. The rate that should be used
for arriving at the present value is more important and more difficult to estimate.

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The crude way of arriving at a capitalization rate is to divide the net operating
income on a comparable property by its sale price. This capitalization rate is then
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used to arrive at a price for the property being evaluated.
The income approach, has two methods. They are gross income multiplier method
and direct income capitalization method.
Gross Income Multiplier Method
The steps involved are:
1. Ascertaining the gross market earnings of the subject,
2. Calculating the gross income multiplier, and
3. Estimating the value of the said property.
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Illustration 1
Given below is the data of two similar residential properties.
Property Sales Price (Rs.) Gross Annual Income (Rs.)
House No. 1 310,000 21,000
House No. 2 305,000 20,800
Compute the indicated market value of the third property which is similar in
characteristics to the above two properties. The gross annual income of the third
property is Rs.20,500.
Solution
First, we calculate the gross income multiplier for these two units.
Gross Income Multiplier (GIM) = Sales Price
Gross Annual Income
For House No. 1: GIM = 3,10,000/21,000 = 14.76
For House No. 2: GIM = 3,05,000/20,800 = 14.66
By observing these two ratios, 14.71, the average of these two, will reflect the
market sentiment in an appropriate way.
Therefore, the indicated market value of the third unit is
= Gross annual income of third unit x Gross income multiplier derived from the
market
= 20,500 x 14.71 = Rs.3,01,555

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 Real Assets

Direct Income Capitalization Method

The steps involved are:
1. The calculation of the net operating income of the subject,
2. Deriving the income capitalization rate from the market, and
3. Estimating the market value of the subject.
Now, we look at the application part of this method.
Estimation of Market Value for Income Producing Property
For a property which gives us regular returns, the market value is calculated in a
similar way as we calculate net present value of cash flows from a financial asset.
The formula is
n NOI MVn
t
MV0 = ∑ t
+ n
t =1 (1 + r) (1+r)
where,
MV0 is the current market price of the property
MVn is the expected sales price of the property at time n
NOIt is the annual cash inflows or the net operating income at time t, and
R is the required rate of return.
If we assume that this property changes hands infinite number of times, then the
market value of the property is given by
NOI t

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MV0 = ∑
(1 + r) t
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If the net operating income grows at a rate of “g” annually, then
MV0 =
NOI
r−g
Where NOI is the net operating income growing at a constant rate of “g”.
The term (r – g) is the capitalization rate “R0”. When the rate of inflation is high,
one would find a very low value of capitalization rate. Capitalization rates are net
of appreciation or depreciation.
Illustration 2
The net operating income from a property is Rs.35,000. The required rate of return
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is 14%. Since past two years, the NOI is growing at a rate of 1.5%. Calculate the
market value of this property.
Solution
NOI 35,000
MV = = = Rs.2,80,000
r − g 0.14 − 0.015

ISSUES IN REAL ESTATE VALUATION

Real estate markets have evolved over the years and have now become an
alternative investment strategy for many of the investors who were erstwhile only
inclined towards stock market investments. The changes in the market scenario
have made the valuation of real estate a difficult task.
With international capital flowing into the real estate market in the United States,
the values of the real estate have become more influenced. If there is a sufficient
number of investors to bid for a particular property, they will constitute a market
and if they are genuine investors then the price they are ready to pay will reflect
the true value. But one should not ignore the fact that the value of the real estate
may change in a short notice.
Institutional investors like pension funds are showing interest in real estate investments
because they perceive such investments as means of diversification. They make a
serious attempt to analyze the real estate markets and structure the deals in a different
way. They use modern portfolio theory for valuing the real estate or make an attempt to
securitize the same so that it can be traded like stocks or bonds.

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Security Analysis

Another factor of importance is the effect of environmental hazards on the

properties. So a low premium has to be placed on the properties that are exposed to
environmental hazards while valuing the property. This factor has to be
incorporated in arriving at a value of a property. For example, Bhuj was a
flourishing town in Saurashtra, Gujarat before the earthquake struck on January
26, 2001. Now, the price of real estate has fallen to about 20% of the original
price. This is a typical case of low premium being put on high risk of
environmental hazard properties.
The regulatory aspects should not be overlooked when valuating real estate. The
economic policies of the government, the tax laws, etc. play a role in determining
the real estate value.
Approximate indicative rate per sq.ft. rates (builtup/super builtup area) of Residential
and commercial areas (including shopping) in Mumbai and Navi Mumbai. Rates
may vary depending on location, amenities, etc.
Table 2: Real Estate Prices in Mumbai in 2002-03
Location Residential Rates Commercial Rates
(per sq. foot) (per sq. foot)
Bandra (East) 3000-4500 5000-17000
Bandra (West) 4000-7500 4500-12000
Khar (East) 2500-3000 4000-5000

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Khar (West) 3000-7000 4000-9000
Santacruz (East) 2200-3000 4000-5500
FA Santacruz (West) 4200-7000 4500-9000
Vile Parle (East) 3000-5000 5000-7000
Vile Parle (West) 3500-5000 5000-7000
Andheri (East) 2200-3500 3000-5000
Andheri (West) 2800-3500 3500-5000
Jogeshwari 1800-2500 2200-3000
Goregaon 2000-2200 2000-3000
Malad 1900-2200 3000-4000
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Kandivali (East) 1450-2100 2500-4000

Kandivali (West) 1900-2000 3000-4000
Borivali (East) 1600-2100 3000-4000
Borivali (West) 1600-2800 3500-5000
Dahisar 1500-1800 2200-3300
Mira Road 650-800 700-1200
Bhayandar 600-900 800-1200
Naigam 450-800 700-1000
Vasai Road 650-1000 1500-2200
Nalasopara 600-900 1000-1500
Virar 600-1100 1000-3000
Wadala 3000-3700 3000-4100
KingsCircle 3000-3500 4000-5200
Sion 3500-4500 3500-5200
Kurla 2000-2500 2000-2800
Chembur 2500-4500 2500-3500
Ghatkopar 3000-6000 4000-7000
Vikhroli 1500-2000 1500-2000

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 Real Assets

Location Residential Rates Commercial Rates

(per sq. foot) (per sq. foot)
Bhandup 2200-2000 2000-2500
Mulund 1800-3000 2500-4000
Thane 1200-2200 2500-4000
Mumbra 650-800 1000-1500
Dombivali 700-950 1000-2000
Kalyan 900-1200 1500-3000
Ambernath 200-800 1000-1500
Badalapur 700-800 1000-1500
Titwala 700 1000-1200
Asangaon 700 900-1000
Vashi 900-1800 1600-2500
Koparkhairaine 800-1000 1200-1800
Airoli 600-1200 1800-2200
Sanpada 800-1100 1500-2000
Nerul 1000-1300 1500-1800
Konkan Bhavan (CBD) 1000-1300 750-1300

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Kharghar 750-1000 600-900
Kalamboli 800-950 1000-1200
FA Panvel 850-1200 1600-2200

How to Derive the Capitalization Rate

To derive this rate, the following methods are employed. They are:
1. Market extraction method,
2. Band of investment method, and
3. Built-up method.
Market Extraction Method
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In this method, we select comparable properties. For these properties, we require
net operating income and current market price. The net operating income divided
by the sales price, gives the capitalization ratios. From these ratios, we choose a
rate which reflects the market sentiment.
Illustration 1
Given below is the data regarding four similar residential properties.
Property NOI (Rs.) Market Value (Rs.)
House No. 1 20,000 345,000
House No. 2 18,000 330,000
House No. 3 21,000 350,000
House No. 4 19,000 335,000
Calculate the capitalization rate.
Solution
Property NOI (Rs.) Market NOI/Market
Value (Rs.) Value (%)
(1) (2) (3) (4)
House No. 1 20,000 345,000 5.80
House No. 2 18,000 330,000 5.45
House No. 3 21,000 350,000 6.00
House No. 4 19,000 335,000 5.67
After observing the ratios in column (4), the average capitalization rate would be 5.73%.

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 Security Analysis

Band of Investment Method

In this method, the rates on equity as well as debt financing are weighted
according to their proportions to calculate the capitalization rate.
Illustration 4
Construction of a trade center complex is financed by using 55% of bonds (first charge)
bearing a coupon of 9% and maturing in 12 years. The interest will be compounded
annually. The rest is financed by issuing equity, whose required rate of return is 14%. To
redeem the bonds, a sinking fund is established. Calculate the capitalization rate.
Solution
The total payments required to be made to the bondholder consists of interest
payments and contribution to the sinking fund.
i 0.09
Amount contributed to the sinking fund = = = 0.0496
n
(1 + i) − 1 (1 + 0.09)12 − 1
Interest rate on the bonds = 0.09
Therefore, total payments for a bond = 0.09 + 0.0496 = 0.1396 = 13.96%
Calculation of Capitalization Rate.
Instruments % Employed Required Rate (%) Weighted Rates (%)
(1) (2) (3) (4) = (2) x (3)

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Bonds 55 13.96 7.68
Equity 45 14.00 6.30
Total 13.98
FA
Therefore, the capitalization rate is 13.98%.
Built-Up Method
In this method, the capitalization (built-up) rate is the sum of the following rates:
i. Rate on an asset being non-liquid,
ii. Risk premium,
iii. Pure interest or the risk-free rate, and
iv. Recapture premium (a return of investment).
Illustration 5
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Consider the following data.
Risk-free rate = 9.2%
Rate for non-liquidity = 2%
Recapture premium = 4%
Risk premium = 3%
NOI = Rs.30,000.
Compute the capitalization rate and the market value.
Solution
Capitalization rate = Risk-free Rate + Rate for Non-liquidity + Recapture premium
+ Risk premium
= 9.2% + 2% + 4% + 3% = 18.20%
The capitalized value of NOI is, therefore, given by
NOI 30,000
MV = = = Rs.1,64,835.
R 0.182

FACTOR AFFECTING THE VALUE OF REAL ESTATE

Business Cycle
The existing stage of the business cycle affects the cash flows into and from the
real estate market, which has a bearing on the valuation. During the boom period,
there will be a natural increase in the economic activity and as a consequence, the
demand for real estate also increases, resulting in higher valuations.

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 Real Assets

Interest Rates and Inflation

Any sector in the economy can attract and retain funds only when it gives more
value for the investors’ money as compared to returns from other sectors.
Therefore, the investors will park their funds in real estate only when they realize
more returns from this sector.
During the periods of high inflation, real estate acts as a hedge against price rise.
Population Demographics
The regions, which are densely populated, usually experience high real estate
prices as compared to regions which are sparsely populated.
Legal Environment
Lack of uniformity and the presence of multiple laws and regulations with respect
to land holdings, act as impediments in frequent turnover of real estate, thereby
affecting valuation process.
Taste and Preference for Real Estate
The investors’ inclination and their outlook to invest in real estate are determined
by their respective tastes and preferences which, in turn, are shaped by a host of
factors like being averse to risk, social environment and the purpose of investment.
The micro factors are as follows:
Physical Characteristics like Size, Age and Quality

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The measure of the plot, age and quality of construction in case of existing
properties and the quality of land (for example, the fertility of the soil in case of

Location
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farm lands) play an important role in determining the value of the land.

The location of the plot at elite or down market areas or the plot being in a
residential or industrial zone, determines the value of the land.
Leasehold/Freehold (Ownership Rights)
In case of inheritance, it is general that the property is passed onto the
heirs/successors. This may not be possible in every case, as at the end of the lease
period, one has to give up the ownership of the property in question. This may
alter the cost structure of the property.
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Regulatory Restrictions like Zoning, Floor Space Index and Laws
with respect to Easement Rights
Laws and regulations regarding zoning, floor space index and easement rights alter
the cost structure of the real estate.
Bullion
Silver or Gold existing in the form of bars are called as bullion or ingots. Most of
these private holdings are dealt by few banks and dealers. The bars are of different
sizes. The disadvantages of holding in this form is that the investor will not be able
to realize any current income. Small bars are usually purchased at a premium and
sold at a discount. The difference is the wholesaler’s profit or spread. If we
analyze them as a percentage of the total cost, we will realize that the wholesaler
will make handsome profits on smaller quantities. Therefore the investor, to realize
average profits, have to buy large amounts at a single time. In addition to the loss
of current income, the high transaction and the storing costs, the price of the
bullion should rise substantially for breaking even. The possibility of fraud in case
the investor not dealing with reputed dealers adds another dimension to this.
Art Objects
We have seen the definition of this in the avenues of investment. There are
different types of participants in every market. This market consists of creative and
imaginative artists, a selective and minority group of investors and collectors, agents,
auctioneers, dealers and finally museums and art galleries. The investor will do good if

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he consults an expert and visit art exhibitions to find out about the authenticity, historic
appeal, fashion and the origin of the objects that appeal to him, and at the same
time making sound investment sense. It is also advised that an investor who does
not possess the requisite skill to identify the genuineness of the object should buy
it in an auction. It has been observed that the demand for paintings has been rising
in the past decade.

SUMMARY
• Real Assets are physical assets like real estate, diamonds, oil paintings and
other investments in physical things. In the case of some real assets the
investor enjoys non-financial income called Psychic Income. Investing in real
assets differs from investing in securities in the type of income derived, the
manner in which the asset is valued and the way inflation affects the value of
real assets.
• Real assets are valued using quantitative or qualitative methods. Income
Approach, Direct Income Capitalization method, Band of Investment
method, Built-up method are quantitative methods. The qualitative methods
are further classified into macro and micro factors. Under macro factors,
business cycle, interest rates and inflation, population demographics, legal
environment, taste and preference for real estate are classified. The micro
factors are identified as physical characteristics like size, age and quality and

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location and leasehold/freehold.
•
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Most of the times, investors like knowledge about the intricacies of the
securities and end up doing mistakes. Therefore mutual funds have come to
their rescue them. The next chapter focuses on Mutual Funds.
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 Chapter XVI

Mutual Funds

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•
FA
After reading this chapter, you will be conversant with:

The Concept and Objectives of a Mutual Fund

• Types of Mutual Funds
• Advantages of Mutual Funds
• Mutual Fund Services
• Organization and Management of Mutual Funds
• The Mutual Fund Scene in India
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 Security Analysis

Introduction
The concept of Mutual Funds is not new. Originating in the USA and moving on
to the UK in the 1930s, this culture started in India only in 1960s, with the setting
up of UTI in 1964. Mutual Funds are financial intermediaries in the investment
business. In a Mutual Fund, the resources of many investors are pooled and
invested to create a diversified portfolio. Thus, in a mutual fund the savings of
many investors are combined to form a fairly large and well diversified portfolio
of investments.

OBJECTIVES OF A MUTUAL FUND

The objectives sought to be achieved by Mutual Funds are as follows:
• To provide an opportunity for lower income groups to acquire property
without much difficulty in the form of shares.
• To cater mainly to the need of individual investors whose means are small.
• To manage investors’ portfolios in a manner that provides regular income,
growth, safety, liquidity and diversification.

TYPES OF MUTUAL FUNDS

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Mutual Funds can be classified into the following three broad categories:
1. Portfolio classification of Mutual Funds.
2.
3.
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Functional classification of Mutual Funds.
Geographical classification of Mutual Funds.

Portfolio Classification of Mutual Funds

Mutual Funds differ with reference to the type of instruments in which the money
has been invested as per the requirements of the investors. These are specified
Mutual Funds structured for feeding a particular investible purpose. Therefore,
different Mutual Funds are designed to meet the objectives of different types of
savers and are named as such. For example:
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BOND FUNDS
Bond Funds provide fixed return for those who desire safety. The savings of
investors are invested in various kinds of bonds in which investment is made
primarily with the investment objective of safety. Bond funds are more liquid,
diversified and conservative investments with modest capital gains. Price of bond
Mutual Funds fluctuates with changing interest rates. In India, Mutual Funds
income is tax exempt and as such no such classified Mutual Funds have come to
exist as in the USA where tax-free income in municipal bond funds or other fixed
income bearing securities is an attractive investment.
STOCK FUNDS
Stock Funds are established for those who are willing to accept significant risks in
the hope of very high returns. These are called common stock funds. The assets
held in the fund are entirely the common stocks of diversified list of industrial
corporations. These may be further classified as ‘growth funds’ which assume high
risk to obtain stocks expected to yield high return. When these funds are invested
in stocks which pay consistently high dividend like Blue-Chip companies, then it
is known as Income Funds.
INCOME FUND
Income Fund is established to maximize the current income (i.e. interest and
dividend) of investors. There are two aspects of Income Funds viz., low
investment risk, generating constant income and high investment risk generating
maximum income. Investment is made in various combinations of high yielding

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 Mutual Funds

common stocks and bonds with a view to extract income on regular basis with
safety of the principal amount of investment. Conservative investment strategy
dominates the Income Funds with modest amount of risk.
MONEY MARKET FUNDS
Money Market Funds are used in short-term liquid assets like Certificate of
Deposits [CD(s)] or commercial papers and for them capital is raised by selling
shares to the investing public at a price equal to the asset value of the then existing
shares outstanding plus a loading fee or service charge. This is known as high
liquid asset funds with very low risk and virtually no capital loss. Interest income
fluctuates because of volatile interest rates, but investors get better yield than
available from pass book saving accounts. In the USA, Money Market Mutual
Funds were set up in November, 1972 and have been a very successful vehicle of
savings mobilization. In India, Government has only recently taken a decision to
allow establishment of MMMFs.
SPECIALIZED FUNDS
Specialized Mutual Funds envisage to specialize investment in securities of firms
of certain industries or specific income producing securities. Such funds carry
more risk for lack of diversification approach.
LEVERAGED FUNDS

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Leveraged Funds or borrowed funds are used in order to increase the size of the
value of the portfolio and benefit the shareholders by gains exceeding the cost of
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the borrowed funds. Such funds are used in speculative and risky investments like
short sale to take advantage of declining market to realize gains in the portfolio
short sales.
BALANCED FUNDS
Some Mutual Funds are called ‘Balanced Funds’ where assets are a judicious
mixture of industrial stocks and bonds. With a view to embrace modest risk of
investment and secure reasonable rate of return the funds are employed in high
grade common stock with 25% to 40% investment in conservative fixed income
securities like debentures, bonds and preference shares.
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GROWTH FUNDS
Growth funds have the principal objective of capital appreciation of the investment
over a period of time. The investment is made in equity stock which has above
average growth potential. This is a high risk investment fund with high capital gain
potential and low current income assurance.
PERFORMANCE FUNDS
Performance Funds were set up in the USA in 1960s to seek large profits from
investments in high-flying common stocks. The investment is made in buying
equity shares of small unseasoned companies with relatively high price-earnings
ratio and higher price volatility.
SPECIALTY FUNDS
These funds, as the name goes, are invested in equity shares of good track record
companies which offer long-term capital growth and provide handsome dividend
income. In the USA the companies which fall in the group of specialty companies
are electronics, chemicals or the foreign securities like Japanese stocks, etc.
Sometimes, Specialty Mutual Funds are established for catering financial
equipments of one particular type of industry or unit within it, for example,
commodity funds, offshore drilling funds, etc. These are highly risky investment
funds and require deep knowledge and expertise and extensive experience to
handle such funds.

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 Security Analysis

DUAL PURPOSE FUNDS

Income and growth are two objectives which are achieved by offering half of the
amount of funds to those investors who wish regular income and half to those who
wish growth. The funds thus received are pooled together and used for investment.
Any income derived from the portfolio goes to the investors who hold income
shares. The investors who hold capital shares receive no income. Instead they
receive capital gains or losses that result from investments of total portfolio.
REAL ESTATE FUNDS
Real Estate Fund is of close-ended type. The fund is named so because of primary
investment in real estate ventures. Such funds are of various types depending upon
real estate transactions.
Thus, the type of Mutual Funds depends upon the nature of securities they issue or
sell and purchase. In this way, it is observed that a mutual fund can be named
keeping in view the immediate objective behind its creation.

Functional Classification of Mutual Funds

Functional classification of Mutual Funds is based on the basic characteristics of
the mutual fund schemes opened for the public for subscription. Mutual Funds on
this account are classified into two broad types viz.,
• Open-ended Mutual Fund.

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• Closed-ended Mutual Fund.
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OPEN-ENDED MUTUAL FUND
The holders of the shares in the fund can resell them to the issuing mutual fund
company at any time. They receive in turn the Net Assets Value (NAV) of the
shares at the time of resale. Such mutual fund companies place their funds in the
secondary securities market. Thus, they influence market price of corporate
securities. Open-end investment companies can sell an unlimited number of shares
and thus keep growing larger. The open-end mutual fund company buy or sell their
own shares. These companies sell new shares at NAV plus a loading or management
fee and redeem shares at NAV. In other words, the target amount and the period both
are indefinite in such funds. UTI’s Unit Scheme, 1964 and CANCIGO and
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CANGILT are few examples of such funds. For open ended schemes, Mutual Fund
Units are sold and bought at NAV with or without loading charges.
NET ASSET VALUE
It is the actual value of the investments made by the mutual fund for each unit
issued by it. It changes almost on a daily basis as the market prices of individual
securities in its portfolio fluctuate. It is computed by the formulae given below.
Assets − Liabilities
NAV =
Number of units outstanding
More specifically, it will be
Value of Investments + Receivables + Accrued Income + Other Current Assets − Liabilities − Accrued Expenses
NAV =
Number of Units Outstanding
Consider the following data of a Mutual Fund Trust (all figures in Rs. millions)
Value of Investments = 10.00
Receivables = 0.75
Accrued Income = 0.25
Other Current Assets = 3.00
Liabilities = 2.25
Accrued expenses = 0.50
Number of Outstanding Units = 2.00 million

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 Mutual Funds

Given this data the NAV is calculated as shown below:

The formula to calculate NAV is
Value of Investments + Receivables + Accrued Income + Other Current Assets − Liabilities − Accrued Expenses
NAV =
Number of Units Outstanding

10 + 0.75 + 0.25 + 3 − 2.25 − 0.50

=
2
= Rs.5.625
We know that the value of the mutual fund varies with the value of the portfolio,
as the prices of the securities which constitute the portfolio fluctuate day to day.
As the intrinsic value of the security represents the fair value of the security, the
NAV represents the fair value of a unit in a mutual fund.
Usually, the fund units at the time of application are sold at Public Offering Price
(POP). The difference between the NAV and the public offering price is the sales
charge recovered by the Asset Management Company from the scheme to cover
costs of raising funds on a continuous basis. The public offering price is generally
calculated as follows:
NAV
POP =
1 − Sales charge

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Example: If the maximum sales charge is 3% on the NAV of Rs.13.50, the public
offering price is given as,
FA POP =
NAV
1 − Sales charge
=
13.50
1 − 0.03
13.50
= 13.50 = = Rs.13.92
0.097
CLOSE-ENDED MUTUAL FUND
Close-ended Mutual Funds are different from the open-ended Mutual Funds in the
following respects:
i. Close-ended fund investment company has a definite target amount for the funds
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and cannot sell more shares after its initial offering. Its growth in terms of
number of shares is limited. Its shares are issued like any other company’s
new issues listed and quoted at stock exchange.
ii. The shares of close-ended funds are not redeemable at their NAV as are
open-ended funds. On the other hand, these shares are traded in secondary
market on stock exchanges at market prices that may be above or below their
NAV.
iii. Close-ended funds channelize funds in secondary market in acquisition of
corporate securities.
iv. The NAV and the price at which units of Mutual Funds are traded in the
market need not always be equal: the units may sell for the current NAV per
share, for more (at a premium), or for less (at a discount). Financial papers
like The Economic Times and magazines like Business Today regularly
report the NAVs of closed-ended funds and present a comparison of the
current price with the NAV. The reasons for the current market price being
less than the NAV can be as follows:
– Investors’ doubts about the abilities of the fund’s management
– Lack of sales effort (brokers earn less commission on closed-ended
schemes than on open-ended schemes)
– Riskiness of the fund
– Lack of marketability of the fund’s units.

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 Security Analysis

The examples of close-ended Mutual Funds include Canstock, Canshare

Mastershare, Magnum, Can 80CC, Dhanashree, etc., which have the above
features. It is to be noted that unlike in foreign countries where closed-ended and
open-ended Mutual Funds are totally separate schemes, in India, this difference is
not clearly demarcated for eg.: UTI as Mutual Fund Manager has floated both
closed-ended schemes (Master share, Master plus, GMIS ‘92, etc.) and open-ended
schemes (Unit Scheme ‘64, ULIP ‘71, Omni Unit Plan, etc.).

Geographical Classification of Mutual Funds

Nations’ boundaries provide territorial restrictions on the sale and purchase of
mutual fund units or shares as is the case in commodity trade or services. In view
of this, Mutual Funds which operate within the nations’ boundaries are different
from those which are meant for subscription of foreigners or the country’s
nationals living away from its shores. This classification is broadly of two types
viz.,
• Domestic Mutual Funds.
• Offshore Mutual Funds.
DOMESTIC MUTUAL FUNDS
Domestic Mutual Funds are the saving schemes which are opened for mobilizing
savings of the nationals within the country. These schemes may be of different

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types as discussed above under the portfolio classification and functional
classification. All the schemes in vogue in the country by the existing Mutual
FA
Funds viz., UTI, GIC Mutual Fund, LIC Mutual Fund, SBI Mutual Fund, Canbank
Mutual Fund, BOI Mutual Fund, PNB Mutual Fund and Indbank Mutual Fund are
the domestic schemes.
OFFSHORE MUTUAL FUNDS
The basic objective of opening offshore mutual fund scheme is to attract foreign
capital for investment purposes in the country of the issuing company. Offshore
Mutual Funds, thus facilitate cross-border fund flow which is a direct route for
getting foreign currency without political strings or domination on the issuer
country. From investment point of view too, offshore Mutual Funds open up
domestic capital markets to the international investors and global portfolios
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investments.
The major point of difference between the offshore Mutual Funds and domestic
Mutual Funds is the currency and country risk for the global investors as the
source of fund is from abroad. Because of the high risk higher return in the
invested funds can be expected.
Like domestic Mutual Funds, the offshore Mutual Funds could also be functionally
classified into close-ended or open-ended funds.
The major offshore Mutual Funds opened so far comprised of close-ended
schemes providing redemption of the units for individual investors only at the end
of the specified period specified in the scheme. UTI’s India Fund 1986, India
Growth Fund, SBI’s India Magnum 1989, Canbank’s Indo-Swiz Himalayan Fund
1990 and Commonwealth Equity Fund were all close-ended offshore funds.

ADVANTAGES OF MUTUAL FUNDS

Mutual Funds are advantageous to individual investors in relation to their direct
involvement in investment portfolio activity covering the following aspects:

Reduced Risk
Mutual fund provides small investors access to reduced investment risk resulting
from diversification, economies of scale in transaction cost and professional
finance management.

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 Mutual Funds

Diversified Investment
Small investors participate in larger basket of securities and share the benefits of
efficiently managed portfolio by experts, and are freed of keeping any records of
share certificates, etc. of various companies, tax rules, etc.

Botheration-free Investment
Investors get freedom from emotional stress involved in buying or selling
securities. Mutual Funds relieve them from such stress as it is managed by experts
who act scientifically with right innings in buying and selling for their clients.

Revolving Type of Investment

Automatic reinvestment of dividends and capital gains provides relief to the
members of Mutual Funds.

Selection and Timings of Investment

Expertize in stock selection and timing is made available to investors so that
invested funds generate higher returns to them.

Wide Investment Opportunities

Availment of wider investment opportunities that create an increased level of
liquidity for the funds holders become possible because of package of more liquid

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securities in the portfolio of Mutual Funds. These securities could be converted
into cash without any loss of time.
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Investment Care
Care for securities is available through mutual fund to the investors relieving them
of various rules and regulations.

Tax Benefits
Income tax exemption has been ensured for Mutual Funds. While originally, only
such Mutual Funds as are set up by public sector banks or a public financial
institution were exempt from tax, now the benefit of tax exemption has been
extended to all Mutual Funds. Investors are eligible for deduction under Section 80L of
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the Income Tax Act in respect of the dividends from units or shares of Mutual
Funds and under Section 88 in respect of contributions made by investors to unit-
linked insurance plan of UTI and LIC Mutual Fund.
The above advantages are only illustrative and not exhaustive as there is scope of
more to be added to the list in the light of individuals own experience(s).

MUTUAL FUND SERVICES

Financial Mutual Funds, to cater to the need of the different categories of
investors, launch schemes involving services to the investors. These are special
services in addition to the returns which Mutual Funds offer to the investors, these
services are vulnerable to investors and attract them to invest their savings in those
Mutual Funds which have such plans to meet their various needs, for example,
regular income plan, savings and reinvestment plans, health insurance schemes,
equity-linked savings plans for tax exemption purposes, etc.
Some of the important services offered by Mutual Funds globally are discussed
below:

Saving Scheme
This is one of the inherent objective of investors to accumulate their savings,
voluntary saving plan can be added to Mutual Funds through which an investor
can save on monthly or quarterly basis and thus the amount so saved will be added
to purchase the units in the Mutual Funds.

407
Security Analysis

The important features of such plans are,

a. Savings could be made through voluntary saving plans which are at the
option and free will of the investor to contribute any sum at any time on
regular or irregular basis.
b. Alternatively, savings could be made through contractual saving plans
pursuant to some agreement envisaging a long-term investment plan binding
upon the investor.
In the USA, these plans are quite in vogue and are under regulation of
Securities Exchange Commission. These plans charge investors with
substantially high front-end loads. An investor is required to pay commissions
over the life of the contract which are recovered in advance in the initial year of
the contract from initial installments in the form of front-end loads.
c. The investors who drop out from the contractual plans as stated in (b) above,
remain at a disadvantage as the prepaid commission is not refunded to them.
Securities Exchange Commission has made rules requiring Mutual Funds to
refund the full amount of prepaid commission to investors if the investor
cancels the plan within 45 days and 85% of the amount, if the investor
cancels within 18 months of joining the saving plan. Those who cancel the
commitment after 18 months get no refund.

Automatic Reinvestment Plan

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The UTI, in India, has also started this plan where like in the USA, the amount of
dividend and other income accrued on mutual fund investments is automatically
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reinvested in purchasing additional units or shares in the open-ended funds. Other
Mutual Funds in the public sector have followed suit.

Regular Income Plan

Systematic withdrawal is allowed to investors of their money locked in mutual
fund investments in the form of regular income by way of monthly or quarterly
installments to meet their regular financial needs. Initial investment in such plans
is stipulated which carries interest at the specified rate. The repayment installments
are so formulated as to pay out the earnings first and then the principal amount.
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Shifting Advantage or Conversion Privileges
Many mutual fund companies offer different investment plans for investors and
many provide the facility to investors within the family of the plans to shift or
convert or exchange them afterwards from one plan to another at nominal costs or
at no costs subject to tax advantages, if any, available to the investors.

Retirement Pension Plans

Mutual Funds are now very much linked with retirement pension plans. They
facilitate setting up by individuals and companies, the tax deferred retirement plans
for self or their employees respectively. Regular monthly income plans in India
offered by UTI and other Mutual Funds established by nationalized banks are alike.

Insurance Plan
Mutual Funds offer in the USA a relatively new service in the form of insurance
program that protects an investment in mutual fund against a long-term loss. The
insurance cover is available for a period ranging from 10 to 15 years, for the
amounts ranging from $3,000 to $2,00,000 at a premium of about 6% of the
insured sum for a period of 10 years. In dollar terms the insurance of a sum of
$1,00,000 will cost $600 for a period of 10 years. One has to assess the loss on the
insured sum. In the case of capital loss accruing $10,000 then this loss will be
completely met by insurance company to cover up the insurance sum of $1,00,000.
LIC Mutual Fund and UTI have come out with schemes providing life insurance
covers to the investors.

408
 Mutual Funds

Cheque-writing Facilities
In the USA, all Mutual Funds offer to the investors the facility of drawing cheques
on the Mutual Funds to draw the money invested in Mutual Funds. These cheques
are drawn and paid through the funds’ banks. This service is rendered frequently
by all the Mutual Funds in the USA. In India, Mutual Funds have yet to conceive
such noval and innovative schemes.
To conclude, real service to investors is done by Mutual Funds by offering the
schemes which directly offer income, capital gains and solutions to their personal
individual problems. For this purpose, Mutual Funds should maintain marketing
research wing which should always remain on toes looking for new opportunities
and conceiving innovative schemes to meet the other conceptual needs of the
investors than income and gains in money terms.

ORGANIZATION AND MANAGEMENT OF MUTUAL FUNDS

Structural Pattern
In Mutual Funds, usually formed as trusts, three parties are generally involved viz.,
• Settler of the trust or the sponsoring organization.
• The trust formed under the Indian Trust Act, 1882 or the trust company
registered under the Indian Companies Act, 1956.

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• Fund managers or the merchant banking unit.
•
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Custodians.
While in the USA and other countries an “arms length” distance is maintained
between settlers, trustees and fund managers, whereas in India, very often, there is
an overlapping of roles. For example, in the case of Canbank Mutual Fund, Canara
Bank is the settler or sponsor, members of Canara Bank’s board form the trust
company as trustees and the subsidiary of Canara Bank Canbank Financial
Services Ltd. serves as fund managers.
Let us take a look at the organization and management pattern of UTI vis-a-vis the
organization and management pattern of some other Mutual Funds established by
IC
banks or insurance companies.

Organization and Management Pattern of UTI

UTI has a full-time Chairman with an Executive Trustee reporting to him. The
Executive Trustee looks after the Corporate Office, Zonal Offices and 32 Branch
Offices. Mutual Funds are managed through various well organized and staffed
departments viz.,
• Business Development and Marketing Department which formulates in
markets schemes and manages the network of branches and agents;
• Operations and Vigilance Department which divides the scheme-wise
responsibilities of branches, organizes the computer network for investor
services, issues certificates and repurchases units;
• Investment Department which makes investments in short-term and long-term debt
securities;
• Market Operations Department which invests in equity shares, convertible
securities and engages in secondary market operations;
• International Department which looks after the offshore funds;
• Support departments like Accounts, Research and Planning, Personnel and
Administration, etc.

409
Security Analysis

UTI has a well planned and fully developed market network involving 32 branches,
over 300 representatives serving over 150 lakh investors throughout the country. UTI
represents nearly 60% of the total savings mobilization done by Mutual Funds and
holds nearly 80% of the investible funds of Mutual Funds. UTI is responsible
directly to the Department of Economic Affairs, Ministry of Finance, Government
of India and is not regulated by SEBI.
Organization and management pattern of Mutual Funds established by banks
or insurance companies
These Mutual Funds have been established under the Indian Trust Act, 1882, as
trusts for the benefits of investors.

Parties to Mutual Fund Trust

As is common to any trust covered under the Indian Trust Act, the parties involved
in a mutual fund trust are the sponsor or settler, the trustees, the investor as
beneficiary and the trust property. In a mutual fund trust, subscription made by the
investor to the scheme, investments made by the mutual fund of the moneys
received into capital market or money market instruments, the income received
from such investments after incurring expenses incurred by the trust and any other
assets bought by the mutual fund out of the investors money are trust property and
the investors are entitled to all these properties as per the terms of the scheme and
the provisions of the trust deed.

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Table 1
Existing Organization of some Public Sector Mutual Funds
Sponsor/
FA
Name of the Fund Trustee Fund Managers Custodians
Settler
SBI SBI Mutual Fund SBI Cap Markets SBI SBI
Ltd.
Canara Canbank MF Canara Bank Canbank Mutual Canbank Mutual
Bank Fund Fund
LIC LIC Mutual Fund SHCI LIC MF SHCI
Indian Bank Ind Bank MF Indian Bank Ind Bank Indian Bank
IC
Bank of BOI MF BOI BOI Finance Ltd. BOI Finance Ltd.
India
Punjab PNB MF PNB PNB Capital PNB Capital
National Services Ltd. Services Ltd.
Bank
GIC GIC MF Own Board of GIC SHCI
Trustees
UTI UTI -do- UTI SHCI/Citibank.
Till recently, in all the Mutual Funds including UTI, the sponsors, trustees, fund
managers and custodians were the same persons with no difference of organization
and management. But after the issue of certain guidelines by the Government of
India on 14.2.1992, sponsors, trustees, custodians and fund managers are to be
separate entities with independent legal standing. This has been done with a view
to eliminate mismanagement of Mutual Funds.
Let us take a closer look at the 4 constituents of Mutual Funds i.e. sponsors,
trustees, fund managers and custodians.
SPONSORS
The sponsor of a mutual fund can be a public limited or private limited company
registered under the Companies Act, 1956. One or more public and private limited
companies can join to sponsor a mutual fund. The following are the requirements
of a competent sponsor.

410
 Mutual Funds

Track Record
The sponsor company should have a track record of 5 years established through its
audited final accounts exhibiting consistency in operating profits, dividend
payments, rising cash accruals, etc.
General Reputation
The sponsor should have a good general reputation having directors with clean
business records.
Fairness in all Business Transactions
The sponsor company should have good credit record, default-free dealings with
suppliers of material, good and tension-free personal relations and should not have
any outstanding dues with bankers, creditors, income tax or sales tax authorities.
The sponsor should contribute atleast 40% to the networth of the asset
management company.
ROLE OF SPONSOR
In the establishment of mutual fund trust, the main role is played by the sponsors.
Both the trustees and the fund managers or the asset management company have to
be located and appointed by the sponsor. Alternatively, the sponsor has to appoint
Board of Trustees and incorporate an asset management company. It has to submit

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to SEBI the drafts of the Trust Deed for creation of mutual fund trust with
particulars of the persons consenting to be the Trustees both from the sponsor
company and the outsiders. It has also to submit draft Memorandum and Articles
FA
of Association of Asset Management Company to SEBI with particulars of
Directors i.e. the persons to be appointed from the sponsors’ Board and those to be
taken from outside. It has also to suggest the name and particulars of the
custodians to be engaged for the mutual fund. Once the mutual fund trust is
authorized by SEBI, the role of sponsor diminishes as it is the Trust that will
interact with SEBI.

Mutual Fund Trust

Mutual Fund Trust is created by the sponsors under the Indian Trust Act, 1882
IC
which is the main body in the creation of Mutual Fund Trust.
The main functions of Mutual Fund Trust are as follows:
• Planning and formulating mutual fund schemes.
• Seeking SEBI’s approval and authorization to these schemes.
• Marketing the schemes for public subscription.
• Seeking RBI approval in case NRIs’ subscription to mutual fund is invited.
• Attending to trusteeship functions. This function as per guidelines can be
assigned to separately established trust companies too.
In the absence of such companies, existing debenture trustees, banks and financial
institutions may be contracted to act as mutual fund trustees with approval of
SEBI. Alternatively, a separate Board of Trustees consisting of individuals of
sufficient repute and experience may act as mutual fund trustees. Two third of the
trustees shall be independent persons and shall not be associated with the sponsors
or be associated with them in any manner whatsoever. The trust company,
companies as aforesaid or the Board of trustees including the eligibility of each
member shall be intimated to SEBI as per the Guidelines.
Each trustee shall file the details of his transactions of dealing in securities with
Mutual Fund on a quarterly basis. Trustees are also required to submit an annual
report to the investors in the fund.

411
 Security Analysis

Fund Managers or the Asset Management Company (AMC)

The role of fund managers is highly significant in the mutual fund operations. So
far, this role is being played by the Mutual Funds through the subsidiary company
of the sponsoring bank or inside the banks through department or division. Under
the Guidelines fund managers will have to be a separate company specialized and
skilled in the investment activities.
AMC has to discharge mainly three functions as given below:
• Taking investment decisions and making investments of the funds through
market dealer/brokers in the secondary market securities or directly in the
primary capital market or money market instruments;
• Realize fund position by taking account of all receivables and realizations,
moving corporate actions involving declaration of dividends, etc. to
compensate investors for their investments in units; and
• Maintaining proper accounting and information for pricing the units and
arriving at Net Assets Value (NAV), the information about the listed schemes
and the transactions of units in the secondary market. AMC has to feedback
the trustees about its fund management operations and has to maintain a
perfect information system.
FORMATION OF BOARD OF AMC AND RESTRICTIONS ON DIRECTORS

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Having regard to the significant role of the Board of Directors of the AMC in
rendering the company’s operations efficiently, the Government has prescribed
FA
stringent qualifications for the members of the Board. According to the Guidelines,
AMC should have persons on its Board of high repute and adequate professional
experience in the relevant fields such as portfolio management, investment analysis,
financial administration, etc. At least 50% of the directors on its Board should be
independent persons not connected with the sponsoring organizations. The names of
the directors and any subsequent changes must be intimated to SEBI. A director on
the Board of AMC shall not be director on the Board of any other AMC. Further, a
person who is a director of an AMC shall not hold the position of a trustee or
director in a trust company of a fund operated by the same AMC. No person should
be a Director/Trustee of more than one Trust Company/Board of Trustees.
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SBI Mutual Funds and Canara Bank Mutual Funds have already incorporated their
respective asset management companies. The asset management should have a
networth of not less than Rs.10 crore.

Custodians for Mutual Funds

Mutual Funds run by the subsidiaries of the nationalized banks had their respective
sponsor banks as custodians like Canara Bank, SBI, PNB, etc. Foreign banks with
higher degree of automation in handling the securities had assumed the role of
custodians for Mutual Funds. Citibank has been a very prominent bank in this
regard which acts as custodian for UTI and SBI’s funds. With the establishment of
Stock Holding Corporation of India, the work of custodian for Mutual Funds is
now being handled by it for various Mutual Funds. A few other foreign banks are
also eager to act as custodians as they are well equipped with a network of
telecommunication facilities and software support systems essential for efficient
discharge of the role of the custodian. It is only because of this quality, the Indian
Growth Fund (promoted by UTI Merrill Lynch) was shifted from SHCI to
Citibank. Now SHCI is also fully equipped with the software support system and
acts as Custodian for Mutual Funds for SBI and other Mutual Funds schemes.
Automation eliminates manual handling and reduces requisition and delivery time
and brings efficiency in operations of a custodian.
Besides, Industrial Investment Trust Company acts as sub-custodian for SHCI for
domestic schemes of UTI, BOIMF, LICMF, etc.

412
 Mutual Funds

ROLE OF CUSTODIANS
The Securities and Exchange Board of India on 5th May, 1996, through its
notification No. S.O.344 (E) has issued the SEBI (Custodian of Securities)
Regulations, 1996. If any person, wishes to act as custodian of securities on or
after the regulations have come into vogue; he has to obtain a certificate to that
effect from SEBI. Generally, custodian services are availed of in-house by the
Mutual Funds. However, the institutions which are acting as professional
custodians are Stock Holding Corporation of India (SHCI), Citibank, Industrial
Investment Trust Ltd (IITL); Hong Kong Bank and BOI Shareholdings Ltd. SHCI
has not so far decided to extend their services as custodian to private sector Mutual
Funds. The capacity of IITL is not specified to cater the needs of private sector
Mutual Funds, only Citibank and Hong Kong Bank are in the limelight which
could be contacted by the aspirant mutual fund sponsors.
Responsibilities to be discharged by the custodians on behalf of Mutual Funds
include receipt and delivery of securities, holding of securities, collecting income,
holding and processing cost, corporate actions, etc.
Functions of custodians widely cover safe keeping of securities bid settlements,
corporate actions and transfer agents. Salient features of each of these functions
are given below:

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SAFE CUSTODY
FA
Safe keeping of securities covers a wider range of services rendered to the
customer viz. scheme-wise segregation of assets and regular checking and
verification of securities, registration of securities for proper verification, regular
reconciliation of assets to accounting records.

TRADE SETTLEMENT
Trade transactions take place at the instance of fund managers, but settlements
are done at the instance of the custodian which is responsible for the timely
IC
receipt and delivery of cash and securities i.e. securities will be delivered on
receipt of cash and payment will be made only on receipt of securities. Any
discrepancies arising out of the trade settlements are resolved at the end of the
custodian.

CORPORATE ACTION
Custodian also assists the corporate actions viz. dividend declarations, exercise the
rights of equity holders, collection of dividends, rights, etc.

TRANSFER AGENTS
There are four important functions which are attended to by the custodians in
addition to the above, viz. firstly attending to shareholders transactional
activities viz. to issue, transfer, exchange, redeem, maintain detailed records of
transactions, receipt of dividends, reimbursement of dividend and purchase of
securities, etc. Secondly, maintaining records of confirmations of transactions,
cheque registers, certificates, files, commission reports, tax reporting, etc.
To sum up, the consolidated activities of sponsors, trustees, AMC and
custodians form the basis of the organization and management of the mutual
fund.

413
Security Analysis

Figure 1 presents a compact representation of the organization and management of

Mutual Funds.
Figure 1

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Advantages of Private Mutual Funds
FA
It is felt that the entry of private Mutual Funds would encourage competitiveness
in the financial sector and promote the existing investment climate. At present,
many of the leading industrial houses, through their investment companies are
already providing financial support to their group companies besides deploying
their investible funds in a profitable manner. Thus, many of these private corporate
investment companies have already carved a niche for themselves by registering
excellent performance in deployment of their funds through their rich experience
in portfolio management. Therefore, many of the private sector companies that
have applied for setting up Mutual Funds are already proven companies and are
ready for playing the game. The entry of private Mutual Funds could also lead to a
IC
lot of accountability about the transparency of their transactions, which had till
now not been published by a few existing Mutual Funds. With the government
stressing more emphasis on the private corporate sector and mass mobilization of
funds by the private sector in the Eighth Plan, the entry of private mutual fund will
certainly fill up the slot.

Money Market Mutual Fund

Even as the Mutual Funds show a promise of becoming a major instrument of
household savings, another concept which is being talked about and which is
waiting to make an entry into the Indian capital market is money market Mutual
Funds (MMMFs). Though MMMF has taken a foothold in the West, almost a
couple of decades ago, owing to a widespread and well-knit infrastructure and
communications network, its arrival in India is fraught with procedural delays and
conceptual difficulties.
Basically, the idea is to take advantage of the surplus funds lying with the Mutual
Funds’ institutions (LIC, UTI, banks, etc.) by investing them in the money market.
This might serve two important purposes: one it might open the access of the
individual saver’s to the short-term capital market. Two, the MMMF may exercise
its stabilizing influence on the volatile interest rates, particularly when liquidity
pressure is high. In 1990, for instance, call money market rates had zoomed
through the roofs owing to tight money conditions in the market.

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 Mutual Funds

Presently, Mutual Funds operate in the money market only to a limited extent
owing to a number of restrictions imposed on them. They just manage to invest
around 20 percent of their funds in Money Market. A separate mutual fund to
participate exclusively in the money market was hence thought of. This would help
to increase the size of the mutual fund’s investible resources in the money market
and also allow an individual investor who hitherto stayed away from the money
market to indirectly participate in the money market through MMMF.

THE MUTUAL FUND SCENE IN INDIA

Mutual Funds made their entry in India in 1964 with the setting up of UTI.
However, their progress has not been encouraging in the past 30 years by way of
offering investor friendly products and features.
In November, 1993, India’s first private sector mutual fund was launched in the
form of Kothari Pioneer mutual fund. This started a spate of other private sector
Mutual Funds.
The present trend in the industry is in favor of open-ended scheme as all close-ended
schemes have disappointed the investors by continuously quoting at a discount to
their NAV’s. The promoters of some recent issues have reacted to this
development by coming out with open-ended schemes. These schemes also are

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innovative and cater to different segments of the market. This change has come
about with growing awareness among investors about the functioning of Mutual
FA
Funds. Also, the individual investor is increasingly getting alienated from the
primary and secondary markets, which makes Mutual Funds an attractive avenue
for investments. The concept of mutual fund rating too has caught on with the
market, and thus an individual investor can ask for unbiased source of information
on the performance of various funds. The emergence of industry specific funds is a
good sign for the choosy investor to enter the mutual fund industry. It will only be
a matter of time before the Mutual Funds really dominate the market, though at
present they are not very strong.

Performance of Mutual Funds

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The performance of Mutual Funds can be evaluated by calculating the rate of
return earned during the relevant comparison period. The return will include
changes in the value of the fund during the performance period plus any income
from contributions to the fund minus any outgoing fund due to withdrawal from
the fund.

Guidelines for Mutual Funds

The Securities and Exchange Board of India on 9th December, 1996 through its
notification No. S.O. 856 (E) has issued a set of comprehensive guidelines
applicable to Mutual Funds. In January, 1998 some amendments were made by
SEBI in these regulations. The highlights of the regulations are given below.
FORMATION AND REGULATIONS
i. Mutual Funds are to be established in the form of trusts under the Indian
Trusts Act and are to be operated by separate Asset Management Companies
(AMCs);
ii. AMCs shall have a minimum net worth of Rs.10 crore;
iii. AMCs and trustees of Mutual Funds are to be two separate legal entities and
that an AMC or its affiliate cannot act as a manager in any other fund;
iv. All the schemes launched by the Asset Management Company should be
approved by the trustees and a copy of the offer document should be filed
with SEBI.

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Security Analysis

SCHEMES
i. The AMC should mention in the offer document,
a. The minimum amount it wishes to raise under the scheme and
b. The amount of funds it may retain in case of oversubscription. In this
case, all the applicants who apply for five thousand units or less should
be given full allotment keeping in view the oversubscription levels.
ii. The mutual fund as well as the AMC are liable to refund the application
money back wholly or in part if
a. The Mutual Funds does not receive the minimum amount which it
mentions in the prospectus and
b. If the amount received for units is in excess of subscription referred in i(b).
iii. Every close-ended scheme launched by the AMC should be listed on a
recognized stock exchange within a period of six months from the date of
closure of the subscription.
However, this is not mandatory in cases where
a. There is a provision in the scheme for periodic repurchase facility to all
the unitholders;

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b. The scheme provides for monthly income or if it takes into account the
needs of certain classes of persons like senior citizens, women, widows
FA or physically handicapped and children with a provision for periodic
repurchase of units;
c. The details of the repurchase facility are disclosed in the offer
document;
d. The scheme opens for repurchase within a period of six months from the
date of closure of the subscription.
iv. The AMC at its discretion can repurchase or reissue the units repurchased
under the close-ended scheme.
v. The units of a close-ended scheme can be converted into an open-ended
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scheme provided that:
a. The offer document discloses the option and the period of such
conversion or
b. The unitholders are provided with an option to redeem their units in full.
vi. The close-ended scheme should be redeemed completely at the end of its
maturity period. However, a close-ended scheme may be allowed to be
roll-over if the purpose, period and other terms of the roll-over and all other
material details of the scheme including the composition of assets
immediately before the roll-over, the net assets and net asset value of the
scheme, are disclosed to the unitholders and a copy of the same has been
filed with the Board. However, further that such roll-over will be permitted
only in case of those unit holders who express their consent in writing and the
unit holders who do not opt for the roll-over or have not given written
consent shall be allowed to redeem their holdings in full at net asset value
based price.

Restrictions on Investments
A mutual fund scheme shall not invest more than 15% of its NAV in debt
instruments issued by a single issuer, which are rated not below investment grade
by a credit rating agency authorized to carry out such activity under the Act. Such
investment limit may be extended to 20% of the NAV of the scheme with the prior
approval of the Board of Trustees and the Board of Asset Management Company.

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 Mutual Funds

Provided that such limit shall not be applicable for investments in government
securities and money market instruments. Provided further that investment within
such limit can be made in mortgaged backed securitised debt, which are rated not
below investment grade by a credit rating agency, registered with the Board.
A mutual fund scheme shall not invest more than 10% of its NAV in unrated debt
instruments issued by a single issuer and the total investment in such instruments
shall not exceed 25% of the NAV of the scheme. All such investments shall be
made with the prior approval of the Board of Trustees and the Board of Asset
Management Company.
No mutual fund under all its schemes should own more than 10% of any
company’s paid up capital carrying voting rights. Transfers of investments from
one scheme to another scheme in the same mutual fund shall be allowed only if, –
a. Such transfers are done at the prevailing market price for quoted instruments
on spot basis.
Explanation – “spot basis” shall have same meaning as specified by stock
exchange for spot transactions.
b. The securities so transferred shall be in conformity with the investment
objective of the scheme to which such transfer has been made.
A scheme may invest in another scheme under the same asset management
company or any other mutual fund without charging any fees, provided that

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aggregate interscheme investment made by all schemes under the same
management or in schemes under the management of any other Asset Management
FA
Company shall not exceed 5% of the net asset value of the mutual fund.
The initial issue expenses in respect of any scheme may not exceed six percent of
the funds raised under that scheme.
Every mutual fund shall buy and sell securities on the basis of deliveries and shall
in all cases of purchases, take delivery of relative securities and in all cases of sale,
deliver the securities and shall in no case put itself in a position whereby it has to
make short sale or carry forward transaction or engage in bad finance. Provided
that Mutual Funds shall enter into derivatives transactions in a recognized stock
exchange for the purpose of hedging and portfolio balancing, in accordance with
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the guidelines issued by the Board.
Every mutual fund shall, get the securities purchased or transferred in the name of
the mutual fund on account of the concerned scheme, wherever investments are
intended to be of long-term nature.
Pending deployment of funds of a scheme in securities in terms of investment
objectives of the scheme a mutual fund can invest the funds of the scheme in short-term
deposits of scheduled commercial banks.
No mutual fund scheme shall make any investment in:
a. Any unlisted security of an associate or group company of the sponsor; or
b. Any security issued by way of private placement by an associate or group
company of the sponsor; or
c. The listed securities of group companies of the sponsor which is in excess of
25% of the net assets.
No mutual fund scheme shall invest more than 10 percent of its NAV in the equity
shares or equity related instruments of any company. Provided that, the limit of 10
percent shall not be applicable for investments in case of index fund or sector or
industry specific scheme.
A mutual fund scheme shall not invest more than 5% of its NAV in the unlisted
equity shares or equity related instruments in case of open ended scheme and 10%
of its NAV in case of close ended scheme.

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 Security Analysis

Rights of Investors
CERTIFICATES
An investor is entitled to receive shares/unit certificates allotted to him within a
period of 6 weeks from the date of closure of the subscription.
TRANSFER
An investor is entitled to get the unit/share certificates transferred within a period
of 30 days from the date of lodgment for transfer.
REFUND
If the total collection of the funds by a mutual fund is less than the minimum
amount of subscription planned to be raised, as mentioned in the prospectus, the
applicants are entitled to receive the entire application money as refund, within a
period of six weeks from the date of closure of subscription. Should the refund be
delayed beyond this period, the applicants are entitled to receive, along with the
application money, interest at the rate of 15% p.a. for the period of delay.
DISCLOSURES
a. An investor under a mutual fund scheme is entitled to receive information
about the ‘Net Asset Value’ at intervals not exceeding one week. This
information should be published in at least two daily newspapers.
b. Every mutual fund is required to publish the audited annual report and

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unaudited half-yearly report, through prominent newspapers in respect of
each of its schemes, within six months and two months respectively of the

c.
FA
date of closure of accounts.
A mutual fund shall before the expiry of one month from the close of each
half year sent to all unitholders a complete statement of its scheme portfolio.
However, the statement of scheme portfolio may not be sent to the unit
holders if the statement is published, by way of an advertisement in one
English daily circulating in the whole of India and in a newspaper published
in the language of the region where the head office of mutual fund is situated.
This set of guidelines will go a long way in providing a level playing field to all
Mutual Funds.
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Conclusion
Mutual Funds are subject to market risks and past performance is not necessarily
an indication for the future. A general depression in the stock markets will bring
down the NAV. But depressions are only temporary phases. Good fund
management is the only solution and the investors have realized it as is indicated
by the growing popularity of existing schemes as well as the new schemes that are
cropping up.

SUMMARY
• The main objectives of Mutual Funds are to provide an opportunity to small
investor to acquire property in the form of shares without much difficulty, to
cater mainly to the needs of small individual investors and to manage
investors’ portfolio in a manner that provides regular income, growth, safety,
liquidity and diversification.
• The mutual funds can be divided into the main categories: portfolio
classification, functional classification and geographical classification.
• Portfolio classification: Based on the security in which the funds are invested,
the mutual funds are divided into bond funds, stock funds, income funds,
money market funds, specialized funds, leveraged funds, balanced funds,
growth funds, performance funds, specialty funds, dual purpose funds and
real estate funds.

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 Mutual Funds

• Functional classification: Open-ended mutual funds and close-ended mutual

funds come under this category.
• Geographical classification: Domestic mutual funds and offshore mutual
funds.
• Net Asset Value: It is the difference between assets and liabilities of a mutual
fund divided by the number of units outstanding.
• Advantages of Mutual Funds: Reduced risk, diversified investment,
botheration-free investment, automatic reinvestment of dividends, tax
benefits such as Section 80L and Section 88 exemptions.
• Mutual funds can be sponsored by either public or private limited companies.
The sponsors will appoint the trustees and the funds managers or asset
management company. A mutual fund is created by the sponsors under the
Indian Trust Act.

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FA
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 Glossary
Accrued Interest : The interest that has been earned by an investor but that has not yet
been paid to the investor. Bond buyers pay bond sellers accrued
interest whenever a bond is purchased on a date that is not a
scheduled coupon interest payment date. Thus, if a bond were sold
between its semi-annual interest payment dates, the purchaser should
pay the market price of the bond plus the appropriate fraction of the
accrued coupon interest earned but not yet received by the party
selling the bond.

Active Stocks : These are shares which are actively traded in the stock exchange, i.e.
those for which the highest number of bargains are recorded. These
are reported separately as ‘A’ class shares in the business section of
newspapers and magazines.

Adjusted Futures : The cash price equivalent reflected in the current futures price. This
Price is calculated by taking the futures price times the conversion factor
for the particular financial instrument (for example, bond or note)
being delivered.

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A-D Index or : A tool used for detecting bullish or bearish trend in the stock market
Advance-Decline wherein one divides the number of traded shares which have risen in
Index
FA price by those which have fallen. For example, if 400 shares have
advanced and 100 declined on a particular day the A-D index is 4. If
the A-D index is more than 1, it indicates a bullish trend and if it is
less than 1, it indicates a bearish trend.

A-Group Securities : Most widely traded shares, usually of large, well-established

(also known as companies where forward trading is allowed.
specified shares,
cleared securities,
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alpha shares)

Aggregate Exercise : The exercise price of an option contract multiplied by the number of
Price units of underlying covered by the option contract.

Alligator Spread : Any spread in the options market that ‘eats the investor alive’ because
of its high commission costs. The term may be used when a broker
advocates or arranges a combination of calls and puts that generate so
much commission that the client is unlikely or unable to obtain a profit
net of commission even if the markets move as anticipated.

All-or-nothing : Digital options that pay out a set amount if the underlying asset is
Options above or below the strike price at expiry. (The amount the option is
in-the-money is irrelevant since it is a fixed amount that is paid out.)

Allotment Letter : A communication sent by a company (or its issue house) stating the
number and value of the securities allotted to the investor in
response to his application.

Allotment of Shares : After a company has issued prospectus and application forms, it
receives applications from investing community for varying number
of shares. If the number of shares applied for exceeds the number
available i.e., oversubscription, allotment is made by a random draw
or by a proportional allocation.
Alpha Factor : It measures the inherent volatility of a share. A share with an alpha
factor of, say, 1.25 is expected to rise in price by 25% in a year on its
inherent strength, such as growth in earnings per share, irrespective
of the behavior of the market.

American Option : An option that can be exercised at any time prior to expiry.

Amortization : Writing-off of the assets of a company over a number of years, not

necessarily depending on the life of the assets, for the purpose of
their replacement or renewal.

Annuity : An equal amount paid every year in lieu of a lump sum payment for
a certain fixed period or for life. Some investment schemes offered
by banks, Life Insurance Corporation, Unit Trust, etc., offer annuity
payments.

Ante-Date : To date a document before the date on which it is drawn up.

Application Money : The amount an investor is asked to pay with the application for new
issues, usually less than the full value of the shares, the remainder
being either fully or partly collected on actual allotment.

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Appreciation : Increase usually in the price of share, or the value of capital assets
which is called capital appreciation.

Arbitrage
FA : Making use of the difference in the price of the same commodity
(for instance, shares) traded in different markets to make profit, by
buying in the lower market and selling in the higher market. It is
non-speculative because an arbitrager will only switch from one
market to another if the prices in both the markets are known and if
the profit to be gained outweighs the cost of the operation.

Arbitration : The settlement of disputes between brokers, clients, authorized

assistants, and sub-brokers through arbitrators.
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Ascending Tops : It is a tool used in Technical Analysis. Ascending Tops are formed
when price movement of a particular share traces a number of peaks,
each higher than the preceding one, indicating a bullish trend.

Asked Price : The price at which a share is offered for sale on the floor of the stock
exchange. It is the price at which the Jobber sells for a small
difference in price. This is responded by the bid price.

Assign : To make options, sellers perform their obligations in assuming short

futures positions or selling the underlying cash market (as sellers of
call options) or long futures positions or buying the underlying cash
market (as sellers of a put option).

At Best : An instruction to a broker to buy or sell shares, stocks, commodities,

currencies, etc., as specified, at the best possible price. It must be
executed immediately irrespective of market movements.

At Call : Denoting secured money that has been lent on a short-term basis and
must be repaid immediately on demand.

At Limit : An instruction to a broker to buy or sell shares, stocks, commodities,

currencies, etc., as specified at a stated limiting price. When issuing
such an instruction the principal should also state for how long the
instruction stands for example, for a day, a week, etc.

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At Par : A price equal to the face value of a share or other security for
example, if the face value of a share is Rs.10 or Rs.100 it is being
issued or sold at Rs.10 or Rs.100. If the market value of a share
exceeds the par value it is said to be above par; if it falls below the
par value it is below par. It is not the market price.

At Premium : A price higher than the face value, i.e. above par. When a well-
established company issues new shares, either as rights or to the
public, it may ask for a higher price.

At a Premium : A currency which is more expensive to purchase forward than for

(Foreign Exchange spot delivery.
and Currency
Deposit Markets)

At-the-Money : A call or put option in which the exercise price is approximately the
Option same as the current market price of the underlying security.

Authorized Share : The total amount of capital that a company is authorized to raise
Capital according to its articles of association.

: It is also known as ‘Ulta Badla’ or ‘Undha Badla’. The payment to

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Backwardation
be made by a seller to a buyer for the loan of securities for which the
seller wishes to defer deliveries. When a bear sells in anticipation of
FA a fall in prices in the immediate future but the fall doesn’t happen
within the accounting period, he has to have his sales carried over to
the next accounting period on payment of ‘undha badla’ or
backwardation charges to the buyer.

Backspreads : Calls and puts can be combined on the basis of a ratio whereby the
number of calls (or puts) purchased exceeds the number of calls (or
puts) written. This is achieved by reversing the call ratio spread (or
put ratio spread) thereby creating backspreads.
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Bad Delivery : A delivery of a share certificate together with a deed of transfer
considered defective.

Badla : Permitted only in specified securities, badla involves carrying

forward of a transaction from one settlement period to the next. The
carry forward is done at the making-up price, which is usually the
closing price of the last day of settlement. A badla transaction
attracts the following payments/charges: (a) ‘margin money’
specified by the stock exchange board; and (b) contango or badla
charges (interest charges) determined on the basis of demand and
supply forces.

Bar Charts : A tool of Technical Analysis, wherein vertical bars represent each
day’s price movement. Each bar covers the distance between the
day’s highest price to the day’s lowest price, with an ‘X’ to mark the
closing price.

Bargain : The transaction between two members of an exchange. Other terms

which have the same meaning are ‘dealing’ and ‘contract’.

Basis : The difference between the spot price of a commodity and it futures
price.

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Basis Grade : The grade of a commodity used as the standard of the futures
contract.
Basis Point : 1/100th of one percentage point.

Basis Price : Agreed price between buyer and seller of an option at which the
option may be taken up. Also called a strike (or striking) price, or an
exercise price.
Basis Quote : Offer/sale of cash commodity as a difference above or below a
futures price.
Basket Option : An option that gives the holder the right to buy or sell a basket of
assets (usually currencies) against a base asset (currency).
Bear : A dealer on a stock exchange, currency market, or commodity
market who expects prices to fall. A bear market is one in which
prices are falling or expected to fall, for example, a market in which
a dealer is, more likely to sell securities, currency, or goods than to
buy them. A bear may even sell securities, currency or goods
without having them. This is known as selling short or establishing a
bear position. The bear hopes to close (or cover) a short position by

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buying at a lower price the securities, currency or goods previously
sold. The difference between the purchase price and the original sale
FA price represents the successful bear’s profit. A concerted attempt to
force prices down by one or more bears by sustained selling is called
a bear raid. A successful bear raid will produce a sharply falling
market, known as bear slide. In a bear squeeze, sellers force prices
up against someone known to have a bear position to cover.
Bearer Bond : A bond which does not have the owners name on it and is redeemed
at maturity to anyone who presents it.
Bear Spread : In most commodities and financial instruments, the term refers to
(Futures) selling the nearby contract month, and buying the deferred contract,
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to profit from a change in the price relationship.
Bear Spread : This strategy offers profits if the market falls slightly. If it is thought
(Options) that the market is more likely to fall than to rise it offers profits at
lower cost than a put option.
Best Price : The price which a stockbroker thinks is the most advantageous to his
client. A best price order to buy or sell gives the stockbroker the free
option to buy or sell at his discretion.
Beta : A measure of a security’s performance in relation to the general
movement of the market. A share with a beta of 1 rises and falls
corresponding exactly to the market. The rise or fall in a security
with a beta higher than 1 is more than that of the market and the rise
or fall in a security with a beta less than 1 is less than the rise or fall
in the market index.
Beta Shares : Shares of listed companies which are not frequently traded because
of low equity base.
Bid : An indication of willingness, made at a given moment, to buy a
futures or options contract, or other asset, at a specific price.

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Bid-offer Spread : The amount by which the offer price exceeds the bid price. Also
called bid-ask spread.

Bid Price : A price which a prospective buyer of a share is prepared to pay on

the floor of the stock exchange at a particular auction. This is in
response to the jobber’s ‘Asked Price’.

Black Options : A model for evaluating European options on futures contracts.

Pricing Model

Black-Scholes : A model for evaluating European options on non-dividend paying

Options Pricing equity.
Model

Blank Transfer : A share transfer form in which the name of the transferee is left
blank. A person depositing shares with a stockbroker for immediate
or eventual sale signs a blank transfer form. The form is signed by
the registered holder of the shares so that the holder of the blank
transfer has only to fill in the missing details to become the
registered owner of the shares.

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Blue Chips : Shares of well-established, financially sound companies with good
future prospects.

Bond
FA : An instrument of loan raised by the government or a company,
against a specified interest rate and a promised date of repayment.
Debentures are bonds secured by mortgage against company assets
as distinguished from fixed deposits which are unsecured.

Bond Volatility : It is the absolute value of the percentage change in bond price for a
given change in yield to maturity.

Book Value : In general, it is the value at which an asset is carried on a balance

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sheet. The book value of a share is given by dividing the equity
reserves of the company by the number of shares issued.

Boom : The height of a favorable trade cycle, represented by upward

movement of share prices. Booms often tend to end suddenly.

Bottom Line : The net profit or loss figures in an analysis of a company’s performance.

Bourse : The Bourse usually refers to the stock exchange in Paris (see Paris
Bourse), but other continental stock markets are also known by this
name.

Breadth of the : It is the percentage of shares involved in an upward or downward

Market movement of the stock market. If two-thirds of the shares listed in a
stock exchange participate during a trading session, the trend it
shows is said to be representative, and is not influenced by the price
of a few heavily traded shares.

Break out : When shares move between the Support Level and the Resistance
Level for some time and then move upwards or downwards beyond
the line, they make a break out from their price limits.

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Broker : A stock exchange member licensed to buy or sell shares on his own
or on his clients’ behalf. Commission brokers just execute buy or
sell orders against a commission whereas full service brokers offer
facilities such as offering investment advice, safe keeping of
securities, managing portfolios, etc.
Bull : A person who holds an optimistic view of the market and expects the
prices to rise. A bull with a long position hopes to sell his purchases
at a higher price after the market has risen.
Bull Market : A strong or rising market in which a dealer is more likely to be a
buyer than a seller, even to the extent of buying without having
made a corresponding sale, thereby establishing a bull position or a
long position.

Bull Spread : In most commodities and financial instruments, the term refers to
(Futures) buying the nearby month, and selling the deferred month, to
profit from the change in the price relationship.
Bull Spread : The most popular bullish trade, it offers profits if the underlying
(Options) asset rises slightly. If it is thought that the market is more likely to rise

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than to fall it offers profits at lower cost than a call option.
Buy-Back
FA : Repurchase of convertible or non-convertible debentures or the non-
convertible part of partly convertible debentures before the
stipulated period, at par or at a discount, by companies or banks.

Buying In : When a seller on the stock exchange fails to deliver shares ordered
by a buyer in due time, the buyer may buy in wherever he can get
the shares and the seller is responsible for the additional cost.
Buy In : Making a purchase to cover a previous sale, often called covering.

Buy on Margin : An investor buys on margin when he borrows money from the
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stockbroker for the purpose of investment.
Buy on the Bad : A contrarian investment strategy which involves buying shares of a
News company which has posted bad results or which is in trouble,
thinking that the share price has reached the bottom and will
appreciate as conditions improve. If the adverse conditions are
temporary the buyer gains when the situation improves.
Buy Order : An order to the stockbroker to buy a share or shares either at the Best
Price, or within a particular price limit.

Buy-Sell Decision : Rule 1: If the market price of share is lower than its intrinsic value, buy.
Rules Rule 2: If the market price of a share is higher than its intrinsic
value, sell.
Rule 3: If the market price of a share equals its intrinsic value, hold.

Call : A period at the opening and the close of some futures markets in
which the price for each futures contract is established by auction.
Call Feature : The ability of the issuer of a bond or other instrument to redeem it
prior to maturity. This will occur with dual-dated bonds, where they
may be redeemed at any time between the two dates.

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Call Option : An option that gives the holder the right (but not the obligation) in
exchange for payment of a premium, to buy the underlying asset at a
specific price, and obligates the seller to sell the underlying asset at a
specific price, should the option be exercised. If the option is an
option on a future the holder will obtain a long futures if exercise
takes place and the writer a short futures position, both at the
exercise price.
Call Over : A meeting of commodity brokers and dealers at fixed times during
the day in order to form a market in that commodity. The call over is
usually used for trading in futures, in fixed quantities on a standard
contract, payments usually being settled by differences through a
clearing house. Because traders usually form a ring around the
person calling out the prices, this form of market is often called ring
trading. This method of trading is also called open outcry, as bids
and offers are shouted out during the course of the call over.
Call Spread : A call purchase reduced by the sale of another call at a higher
(Options) exercise price. This is a long bull spread. Advantageous if the
purchaser thinks that there is only limited upside potential.
Capital Appreciation : As the price of a share increases over a period of time, there is an

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increase in the capital value of the share which is the most obvious
reason for investing in them. Generally, the price of shares always
FA moves upwards, barring periodic corrections.
Capitalization of : The accumulated undistributed profits of a company which are put
Reserves aside as reserves can be converted into share capital by issuing
bonus shares.
Capital Loss : The loss incurred when investments are sold at a price below the
purchase price. If the sale is within a year of the purchase, it is a short-
term capital loss; if it is after a year long-term capital loss is sustained.
Long-term capital losses can only be set-off against long-term capital
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gains, whereas short-term capital losses can be set-off against short-
term capital gains or against current income from other sources.
Capital Market : It is a source of long-term capital raised for the development of
companies. The stock exchange is a part of the capital market and
helps investors to trade in their shares and thus maintain the liquidity
of their investments. The capital market is distinct from money
market – banks and lending institutions provide short-term finance.
Capital Reserves : It is different from Free Reserves or reserves distributable
through dividends or bonus shares. The capital reserves of the
company are retained indefinitely as part of the capital of a
company. These reserves arise out of share premium, capital
redemption reserve, and revaluation of assets.
Carry Basis : The difference between the cash price and the fair futures price. It
reflects the net carrying cost. Actual basis is the sum of carry basis
and value basis.
Carrying : General term covering both borrowing and lending.

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Cash and Carry : An arbitrage where the simultaneous purchase of a cash instrument
or commodity is made with borrowed money, and the item sold
through a futures contract. An arbitrage profit is made if the futures
price is higher than its theoretical price, that is, if the premium of
futures over spot price exceeds the cost of carry.
Cash Commodity : An actual physical commodity someone is buying or selling, for
example, soyabeans, corn, gold, silver, etc. Also referred to as
actuals or physicals.
Cash Contract : A sales agreement for either immediate or future delivery of the
actual product.
Cash Settlement : The delivery of securities against payment where the settlement date is
the same as the ‘trade date’. The term is typically used in the US money
markets. Known as ‘same-day settlement’ in the UK.
Carry Over Margin : The amount which operators must deposit in order to carry over their
transactions from one settlement period to another. Stock exchange
authorities periodically impose such margins in order to curb
excessive speculation.

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Cartel : A restrictive trade association of a number of persons grouping
together to monopolize a market by entering into agreements
FA amongst themselves with respect to price, supplies, etc. so as to
make unfair profits.
Cash Cow : An investment which yields a consistently high rate of current
income but which does not have bright growth prospects and is
therefore used to fund other enterprises.
Cash List : Group B securities, Unspecified shares, Non-cleared securities.

Cash Ratio : The ratio of cash and marketable securities to a company’s current
liabilities. The ratio indicates how soon a company can pay back its
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creditors.
Cash Shares : See Non-cleared Securities.
CB or Cum-Bonus : The buyers of such shares receive the bonus shares distributed by a
company on registration of their shares before the record date.
CD or Cum-Dividend : The buyer of a share is entitled to the dividend declared if he buys
the share before the closure of the company’s books. CD shares are
usually sold at a slightly higher price than XD shares, reflecting the
value of the dividend to the buyer.
Clearing House : The clearing house of the stock exchange is the agency for effecting
delivery and settlement of contracts between the members.
Clearing Member : A member of an exchange who is also a member of the clearing
house. A member who is not a member of the clearing house is
called a non-clearing member.
Closing a Market : It involves reducing the spread between the asked price and the bid
price by a jobber.
Closing a Position : Taking a long or short position that offsets a pre-existing position.

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Closure of Lists : This is the date up to which applications from the public for an issue
of shares/debentures would be accepted.
Collar : Two interest-rate options combined to protect an investor against
wide fluctuations in interest rates. One, the cap, covers the investor
if the interest rate rises against him or her, the other, the floor, covers
the investor if the rate of interest falls too far.
Collateral : Collateral is the security given to secure a loan. Debentures and
other loans taken by companies are often collateralized (secured) by
stocks or fixed assets of the company.
Commission : Commission is the amount paid to a broker for the purchase or sale
of shares and is usually a percentage of the purchase/sale price of the
share.
Common Stock : Term used in the USA for ordinary shares to differentiate from
preference or redeemable stock.
Commodity Warrant : A warrant giving the holder the right to purchase a commodity. See
warrant.
: An option on an option. These are so far based mostly on interest

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Compound Option
rate option products such as caps and floors, and also on currencies.
They provide hedging opportunities for corporates with contingent
FA interest rate or currency exposures. Premiums are priced off the
underlying asset and not the underlying option, and if exercised can
add as much as 50% to the overall premium cost. They are relatively
expensive because their volatility is magnified by that of the
underlying option. Consequently, they are also used by speculators,
since downside risk is limited to the premium whilst high volatility
means very sharp price movements.
Consortium : A combination of two or more large companies formed on a
temporary basis to quote for a large project, such as a new power
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station or dam. The companies would then work together on agreed
terms, if they were successful in obtaining the work. The purpose of
forming a consortium may be to eliminate competition between the
members or to pool skills, not all of which may be available to the
individual companies.
Contango : The consideration or interest charge paid by the buyer to carry over a
transaction from one settlement period to the next.
Contingent Option : An option where the premium, while higher than usual, is only paid
if the value of the underlying asset reaches a specified level. Also
known as a contingent premium option.
Contract Note : Given by the stockbroker to the buyer of shares, embodying an
agreement reached between them to buy or sell the specified shares
at the stated price. The broker sends the note after executing the
customer’s order as an agreement of delivery. The contract note
must be preserved carefully, as it is a document providing evidence
to the income tax authorities in the computation of short-term capital
gains or losses.

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Contrarian : An investor who follows the Theory of Contrary Opinion, doing just
the opposite of what others are doing, for example, buying shares
when everyone is trying to get out of the market and selling when
others are buying. The contrarian believes that the market does the
opposite of what investors assume and hence acts against the
majority opinion.
Conversion : Allotting a fixed number of shares, at their par value or at a
premium, in exchange for a debenture or its convertible part. On
conversion, shares issuing out of debentures rank pari passu with the
other shares of the company.
Convertible : Fixed interest secured loan certificates which carry a provision of
Debenture conversion into a certain number of shares at par or at a premium on
a certain date. When only a part of the loan is converted the
certificate is called a partly convertible debenture, and when the
entire amount is converted it is called a fully-convertible debenture.
Cornering Shares or : It involves buying a share in large numbers so that its price can be
Cornering the manipulated. A speculator who has short sold has then to pay a high
Market price to cover his position.

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Correction : A short and sharp reversal usually downwards, in share prices.
Corrections usually occur during any long-term move upwards or
FA downwards as share prices generally do not move straight up or
down.
Coupon : The interest payment on a bond or debenture.

Covered Call Option : This is a short call option position where the writer holds the
underlying asset. If the option is exercised, the asset is surrendered
to fulfill the contract. This reduces the risk of the position and
changes the expiry profile to that of a short put option. Income is
made if the underlying asset rises in price equivalent to the premium
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income. If the asset rises spectacularly it will be surrendered through
exercise and such gains foregone. If the asset falls in value the option
will not be exercised and the premium income retained, but since the
asset itself is held it must be marked down in value. This is a strategy
that can be followed by persons holding the underlying asset long-term
and believing that the market will not rise, as a means of adding extra
income to a portfolio. Also called a buy write.
Covered Option : A written option is said to be covered if it is matched by an opposing
cash or futures position in the underlying asset, or by an opposing
option position in the underlying asset, or by an opposing position of
specific characteristics.
Covered Warrant : A warrant issued by a company or securities house that enables the
holder to buy shares in another company. It is referred to as covered
because the issuer should have made arrangements to hold or obtain
the underlying shares when the warrant is exercised.
Credit Risk : The risk that a loss may be experienced because of a default by the
counterparty.

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Cross-currency Cap : A cap where the pay-out to the holder is spread between two
currency base rates (say sterling Libor and dollar Libor) minus a
strike spread, where this exceeds zero. It can thus be considered as a
strip of options on forward spread agreements.

Currency Contract : A futures or options contract for a currency, quoted in terms of

another.

Currency : A bond that includes a put feature together with a currency option.
Convertible The currency option gives the holder the right to convert the
currency of issue into another currency at a fixed exchange rate at
redemption.

Currency Option : The option to buy or sell a specified amount of a given currency at a
stated rate at or by a specified date in the future.

Currency Warrant : A warrant giving the holder the right to purchase a currency.

Current Yield : Dividend or interest received calculated as a percentage of a share’s

or debenture’s current market price.

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Cyclical Shares : Share whose price movements are dependant on the state of the
FA national and international economy and also affected by natural
phenomena.

Daily Margin : The amount which members must deposit with the stock exchange
authorities in case they exceed their prescribed level of trading. Like
Carry Over Margin, daily margin is another method used by the
stock exchange authorities to curb excessive speculation.

Dalal Street : Popular name of the Bombay Stock Exchange, which is located
there. The BSE is housed in Jeejeebhoy Towers.
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Day Order : An order given to a stockbroker to buy or sell particular shares,

which holds good only for that particular day the order is placed.

Day Trade : A trade that is entered into and closed on the same day.

Dealer Option : A put or call on a physical commodity, not originating on or subject

to the rules of an exchange, in which the obligation for performance
rests with the writer of the option.

Debt Warrant : Warrant enabling the holder to buy a bond or debt at a fixed price
over a given period of time.

Defensive Shares : Shares providing a safe return on the investor’s money and
comparatively more stable than others.

Deferred Futures : The futures, of those currently traded, that expire during the most
distant months; also called forward months.

Delivery : This is the actual handing over of the share certificates and the
transfer form duly signed and witnessed.

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Delta : A measure of how much an option premium changes, given a unit
change in the underlying futures or cash price.

Derivatives : Instruments derived from securities or physical markets, essentially

futures and options. Thus, options on equities or futures on
commodities are derived from the underlying cash markets and
hence may be termed derivatives.

Descending Top : A share price chart pattern indicating a bearish trend with each new
high price of a share at a lower level than the preceding high.

Dividend : Dividend is the portion of the company’s profit that is distributed to

the shareholders. This is usually declared as a percentage of the face
value of the share and is in effect the income the shareholder earns
on his investment.

Dividend Cover : The number of times a company’s dividends to ordinary

shareholders could be paid out of its net profits after tax in the same
period. For example, a net dividend of Rs.40,000 paid by a company
showing a net profit of Rs.1,00,000 is said to be converted 2 1/2
times.

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Double Bottom : A share price chart pattern which shows a drop in price, a
FA subsequent recovery and another drop and recovery. The double
bottom level is regarded as the support level and if the price falls
again and penetrates this level it is likely to fall further.

Double Top : A share price chart pattern which shows two successive tops (high
price) after declines, indicating that the price has met with its
resistance level. If, at the next rise the price penetrates this level, it is
likely to continue to rise.

Double Option : An option which gives the buyer or person taking the option the
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right either to buy from or sell to the writer of the option or the
person who gives it the underlying instrument at the strike price.

Dual-currency Bond : A bond where the coupon interest is payable in one currency, but it
is redeemed in another currency.

Dual-currency : An option that allows the holder to buy either of two currencies.
Option

Dual Listing : The listing of a share on more than one stock exchange, increasing
the share’s liquidity and volume of trading.

Duration : The alternative measure of the length of a bond which represents the
weighted average of the time periods to maturity.

EPS or Earnings Per : A widely used indicator reflecting a company’s earnings on its
Share shares. It is a ratio arrived at by dividing the net profit after tax by
the number of shares. Preference dividends, if any, are to be
deducted from net profit after tax.

Earnings to Equity : A ratio indicating how profitably a company is making use of its
Ratio capital and is arrived at by dividing the net profit after tax (less
preference dividends) by net worth.

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Economic : The trends in the national economy which influence share prices, are
Indicators shown by indicators such as GNP (or Gross National Product, the
sum total of goods and services produced in a country in a year),
employment figures, agricultural production, industrial production,
bank deposits, imports and exports, money supply, index of
wholesale prices, and interest rates.

Efficient Market : The hypothesis that holds that the financial market is in possession
Hypothesis of all available information influencing the price of a share or
financial security, which results in perfect competition in the
financial market. Perfect competition in the stock market context
implies that buyers and sellers have perfect knowledge and neither
are in possession of any information unknown to others.

Eligible Securities : Shares, debentures and bonds which banks are ready to accept as
collateral for loans. Only listed shares are eligible, although banks
tend to make their own rules about what they place in the category of
eligible securities.

: Shares in companies, unlike other kinds of investment, such as gold,

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Equities
real estate, debentures, fixed deposits, units in mutual funds,
government bonds, etc.

Equity Shares
FA : Equity or ordinary shares are the shares that have the right to the
profits of a company after preferential shareholders have been paid
and between which the assets of a company are distributed after all
other claims have been satisfied.

Equity Warrant : A warrant, usually attached to a bond but capable of being separated
and/or trading separately, entitling the holder to purchase shares. The
shares are usually those of the warrant issuing company but not
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always.

Euro-commercial : A generic term applied to the market for Euronotes issued on a non-
Paper underwritten basis. Euro-commercial paper is commonly issued on a
continuous tap basis by one or more dealers. See Eurosecurity.

Euro-dollars : US dollars on deposit with a bank outside of the US and,

consequently, outside the jurisdiction of the US. The bank could be
either a foreign bank or a subsidiary of a US bank.

Euronote : A short-term fully-negotiable bearer promissory note typically of up

to six months maturity. Euronotes are commonly distributed by an
auction between members of a tender panel. See Eurosecurity.

European Option : An option that can be exercised only on the expiry date.

Eurosecurity : A security denominated in a currency other than that of the market in

which it is issued, for example, a dollar-denominated bond issued in
the UK or Germany.

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Eurobond : A bond issued in a Eurocurrency, which is now one of the largest
markets for raising money. The reason for the popularity of the
eurobond market is that secondary market investors can remain
anonymous, usually for the purpose of avoiding tax. For this reason
it is difficult to ascertain the exact size and scope of operation of the
market. There are various kinds of eurobonds. An ordinary bond,
called a straight, is a fixed-interest loan of 3 to 8 years duration;
others include floating-rate notes, which carry a variable interest rate
based on the London Inter Bank Offered Rate; and perpetuals.
Eurocurrency : A currency held in European country other than its country of origin.
For example, dollars deposited in a bank in Switzerland are
eurodollars, yen deposited in Germany are euroyen, etc.
Eurodeposit : A deposit using the currency of another country, for example, a
transaction in the eurocurrency market.
Ex : “Ex” means without and shares are sometimes quoted as “ex bonus”
or “ex dividend” or “ex right”. This occurs when shares are
purchased after the books are closed but before the actual dividend
or rights or bonus is paid. Investors purchasing shares at this time
purchase them without a right to the dividend or bonus or right as the

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case may be.
Exchange Rate
FA : The domestic price of one unit of foreign currency. For example, if it
takes Rs.31.50 to purchase one American dollar, the dollar-rupee
exchange rate is 31.50.
Exchange Rate : Futures contracts for currencies.
Futures

Exercise : To ‘exercise an option’ is to use the right to buy or sell the

underlying asset at the strike price.
Exercise Notice : A notice in writing delivered to a clearing house on or by a specific
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time giving notice of intent from an option holder (buyer) that they
wish to make or take delivery of the underlying instrument or
commodity.
Exercise Price : In the case of a call option, the exercise price is the price at which
the buyer of the option has the right to purchase the underlying
securities. For put options, it refers to the price at which the option
buyer has the right to sell the underlying securities.
Expiration Date : This is the date at which the option expires. If an option has not been
exercised before the expiration date, it ceases to exist. Options on
different underlying securities normally have different expiration
dates and expire according to different cycles – monthly, quarterly, etc.
These features are determined by the conditions in the market in
which the options are traded.
Extinguishable : An option where the holder’s right to exercise is canceled if the
Option value of the underlying passes a specified level.
Face Value (FV) : The nominal value printed on the face of a share, debenture or bond.
This is also known as the par value. It may be more or less than the
market value.

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Fair Futures Price : The theoretical price of a future calculated such that there is no cash
and carry arbitrage opportunity.
Financial Year : It begins on 1st April and ends on March 31st for income tax
purposes, although previously companies could choose one-year
periods of their convenience.
Fixed Income : Investments such as fixed deposits, non-convertible debentures,
Investments monthly income plans, or any other government bonds or certificates
which yield a fixed rate of interest. When the rate of inflation is low,
these may provide a steady and adequate return. With high inflation,
both their capital value and yield value are eroded.
Flag : A share price chart pattern wherein the share prices move up and
down in a narrow range, forming sort of a parallelogram, with a
sharply rising or a falling mast at the beginning. A flag formation at
the top of the mast indicates a sharp rise; at the bottom of a mast it
indicates a sharp fall.
Floating Stock : The fraction of a company’s paid-up capital which normally
participates in day-to-day trading.

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Floor Broker : A person who actually does the buying and selling of shares on
behalf of a member of the stock exchange for a small share of the

Floor Trader
FA commission charged by a broker.
: A member of the stock exchange who trades on the floor of the
exchange on his own account. He buys neither for the public, nor for
the broker, but looks for profitable buying or selling opportunities
for himself.
Forward Contract : A contract in which a seller agrees to deliver to a buyer sometime in
the future. Forward contracts, in contrast to futures contracts, are
privately negotiated and are not exchange traded or standardized.
There is no margin paid over between the counterparties, only a
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settlement on the agreed date.
Forward Dealing : Contracts to buy or sell specific quantities of goods, currency, or
freight at a stated price and a stated time in the future. These
contracts are made in trade, by buyers who wish to cover themselves
against price fluctuations, and sellers who wish to benefit from them.
Forward Purchase : A forward purchase is when one agrees to purchase shares at a future
period at a certain price. He does this in the belief that the prices will
fall in future.
Forward Rate : Discount rate for a future time period.

Forward Rate : A contract to provide a given interest rate, for a given maturity, from
Agreement (FRA) a date in the future. FRAs are both purchased and sold. Quotations
are made on the basis of bid and offer yield levels for the period of
the FRA. They are labelled on the basis of the number of months to
the start and end of the FRA.
Forward Start : An option that provides the purchaser the right, after a contracted
Option period of time, to hold a standard put or call option with an at-the-
money exercise price at the time the option is granted rather than
when it is activated.

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Fully Paid Shares : Fully paid shares are those shares which have been fully paid for
(the face value).

Fundamental : A method of anticipating future price movement using supply and

Analysis demand information.

Futures : A term used to designate all contracts covering the purchase and sale
of physical commodities or financial instruments for future delivery
on a commodity exchange.

Futures at Discount : A backwardation in the market. Futures prices are lower than the
to Cash current market price.

Futures at Premium : A contango or carrying charge market where futures prices are
to Cash higher than the current market price.

Futures Market : A market where contracts for future delivery of commodities and
certain financial instruments are traded.

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Gaps : Price patterns on charts where the highest (lowest) price of one day
is followed by the lowest (highest) price of the next day being
FA significantly higher (lower) leaving a gap in the chart.

Gilt-Edged : Usually government securities and bonds; a very safe asset to hold,
as the government is responsible for the payment of interest and
refund.

Globalization : The process that has enabled investment in financial markets to be

carried out on an international basis. It has come about as a result of
improvements in technology and deregulation; as a result of
globalization, for example, investors in London can buy shares or
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bonds directly from Japanese brokers in Tokyo rather than passing
through intermediaries.

Good Delivery : A share certificate together with its transfer form meeting all the
necessary requirements of a transfer. The buying broker is obliged to
accept such a delivery.

Growth Fund : A mutual fund which invests only in securities which have scope of
good capital growth, rather than current income.

Growth Shares : These are shares of companies which show increasing and higher
than average earnings per share than the industry. Although the
current yield of such shares is negligible.

Growth Rate : The growth rate is measured by the increased earning of a company
over its previous achievement, expressed in percentage and
determines the price of a share.

Hand Delivery : A transaction in shares wherein delivery by the seller must be made
on the date stipulated in the contract, or on another date not
exceeding fourteen days after the contract.

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Hawala : The rate fixed by the stock exchange for the purpose of working out
the liabilities between member-brokers at the end of the settlement
period in respect of unfulfilled contracts in specified securities which
are to be carried to the subsequent period. For determining the
liabilities of members vis-a-vis the unfulfilled contracts, the stock
exchange decides a rate for each specified share, known as the
hawala rate, generally fixed at the level of the closing price of the
share on the last working day of the settlement period.
Head and Shoulders : A share price chart pattern with two short peaks on either side of a
large peak resembling the head and shoulders of a person. As the
price moves down from the head to the right shoulder, it is regarded
as a signal for a further fall in prices. In the reverse pattern, the head
and shoulders forming below the line, when the price in the right
shoulder has touched the baseline, it is a signal for a continued rise.
Hedge : Protecting the price of a financial instrument or commodity at a date
in the future by undertaking an offsetting position using futures,
options or another instrument. If the move in the cash market is
adverse to the needs of the investor, producer or consumer, then
opposite moves in the derivatives market position will eliminate or

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reduce the risk and loss.
Hedging : Offsetting or guarding against investment risk. A perfect hedge is a
FA no-risk-no-gain precaution.
Hedge Ratio : The number of contracts required to hedge the value of the asset that
(Futures) underlies one contract.
Hedge Ratio : The delta of an option derived from an option valuation model. It
(Options) tells the proportion of options and underlying assets that will create a
theoretically riskless hedge.
Holding Period : The rate of return for the period of holding of an investment.
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Return (HPR)
Horizontal Price : A share price movement with a narrow range of ups and downs over
Movement an extended period, say six months.
Illiquid Investments : Any form of investment which cannot be readily converted into
cash, which are not regularly traded remained inactive most of the
time, so that the investor may not find a ready buyer, or has to sell at
a disadvantage.
Immunization : Immunization is the process of constructing a bond portfolio so that
the realized return will always at least equal the promised return.
Inactive Shares : Shares which are seldom bought and sold in the stock exchange,
although they are listed. A share which is transacted less than four
times a year may be called inactive or dead. It is quite difficult to
find a buyer or a seller for such shares. The Spread between buying
and selling prices can be large.
Income Fund : A mutual fund with investments mostly in debentures, bonds and
high dividend shares. This type of fund attracts investors interested
in income rather than growth of their investment.

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Income Shares : Income shares usually have a low P/E and a low price. Yet these
yield fairly good dividends, sometimes equalling or exceeding the
rate of return from fixed deposits, etc. The companies follow a
policy of high payouts and as a result have low reserves for growth.
Index Futures : Futures contracts on an index, example, stock index futures.

Inflation Risk : The risk arising from decline in purchasing power on account of
inflation.
Initial Margin : The amount required to be deposited as margin initially, that is, at
the time of taking a position.
Insider : A person working in a particular company in an important position
in possession of crucial facts about the company such as contracts
won, takeover bids, current results, etc., which the public are
unaware of. Insiders include owners, executives and consultants of a
firm. It is illegal for an insider to indulge in speculative trading in
the company’s shares.
Insider Trading : An illegal activity in which persons in a company have unpublished
price sensitive information, such as expansion plans, financial

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results, takeover bids, etc., take advantage of such information to
make a profit on the stock exchange by buying or selling shares.
Institutional
Investor
FA : Mutual funds, Unit Trust, Life Insurance Corporation of India,
banks, and other institutions which invest their members’ money in
shares and bonds, are institutional investors. They trade in large
volumes, and often play a supportive role in a falling market.
Interest Rate Option : Option to pay, or receive, a specified rate of interest on or from a
predetermined date.
Interest Rate Risk : The changes in the relative yields of debentures and equity shares due to
changes in interest rates.
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Inter-market Spread : The sale of a given delivery month of a futures contract on one
exchange and the simultaneous purchase of the same delivery month
and a related futures contract on another exchange.
Interval : The standard differential or interval between the exercise or strike
prices of traded options contracts.
Interim Dividend : An advance installment of the dividend finally declared. It is
generally paid once but sometimes, two such payments are made.
The final dividend is often at least equal and sometimes more. The
interim dividend gives an idea of a company’s profitability during
the year.
Inverted Market : Market in which futures prices decrease with increasing maturity.
Jobbers : Members of a stock exchange who stand ready to buy and sell shares
in which they specialize are called jobbers. A jobber quotes his ‘bid’
price (the price at which he is willing to buy) and ‘ask’ price (the
price at which he is willing to sell). The difference between the two
is known as the jobber’s spread.

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Kerb Dealings : Transactions done among members after the closing of the
official trading hours, eventhough such trading among the
members is not strictly legal. Such an unofficial trading carried
out outside the stock exchange premises is known as ‘Kerb
Trading’. Kerb trading accounts for a sizeable percentage of total
trading in the Indian stock exchanges.
Ladder (Options) : A table top, i.e., buy a call, sell a higher strike call and sell an
equally higher strike call, or sell a put, sell a higher strike put and buy
an equally higher strike put.
Lagging Indicators : Market indicators showing the general direction of the economy and
confirming, or denying the trend, implied by the leading indicators.
Lambs : A stock market slang for gullible investors, looking for quick,
illusory gains.
Leading Indicators : Market indicators that signal the state of the economy for the coming
months. Some of the leading indicators include average
manufacturing work-week, lay-off rate of manufacturing workers,
inflation-adjusted new orders for consumer goods and material,
speed of delivery of new goods, rate of net business formation,

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contracts for plant and equipment, change in inventories on hand,
change in crude material prices, prices of stocks, change in total

Letter of Regret
FA liquid assets, change in money supply.
: A letter of regret is a communication received from a company
informing one of the company not allotting him any shares.
Letter of : A document issued by a company to a shareholder in a rights issue,
Renunciation by means of which the shareholder can renounce, in part or in full,
his right to additional shares in favor of a third party. These letters of
renunciation can be sold in the market, if the company’s shares are
sought after and the terms of the rights offer are attractive.
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Leverage : A company’s long-term debt in relation to equity in its Capital
Structure. The larger the long-term debt, the higher the leverage.
Libor : The London inter bank offered rate, or the rate at which banks will
offer funds. Rates exist for overnight, 1-month, 3-months, 6-months,
etc., out to 5 years, and for euro-currency deposits. Libid-Libor is the
bid-offer spread. It is widely used as a reference rate for payments
on floating-rate instruments.
Limit Order : When a client gives the stockbroker a price limit above which he
cannot buy or below which he cannot sell it is called a limit order.
Limit Price : Largest permitted price fluctuation in a futures contract during a
trading session, as fixed by the contract market’s rules. Also known
as maximum price fluctuation.
Line Charts : Line charts simply connect successive days’ closing prices unlike
bar charts which show daily price movements.
Listed Shares : Shares which are registered by a stock exchange for trading on its
floor. Listed shares are very liquid whose prices are determined
fairly in a fair market place. There is a continuous reporting of their
prices with strict regulation for the protection of investors trading in
such shares.

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Lot : A fixed minimum number in which shares are bought and sold.
Trading lots are in 5, 10, 50 or 100 shares, depending on the face
value of shares. Such numbers make round lots, anything less makes
odd lots.
Lyons Range : A common name for the Calcutta Stock Exchange.

Maintenance Margin : The floor below which the balance in margin account is not allowed
to fall. When the balance falls below the maintenance margin
amount, a margin call is made on the holder of the account to make
up the balance to the level of the initial margin.
Margin : The amount collected from people who trade in securities, whether
shares and debentures or derivatives like futures by exchanges. It is
generally based on the maximum daily price fluctuation of the
security.
Marketable : An item appearing in company balance sheets, denoting assets which
Securities can be easily converted into cash; for example, government
securities, short-term investments, and other money market instruments.
These are shown at the lower of cost or current market value.

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Market : The total market value at the current prices of the total number of
Capitalization equity shares issued by a company.
Market Indices
FA : There are five stock market indices widely used by investors in
India: The Bombay Stock Exchange (BSE) Sensitive Index, BSE
National Index, the Economic Times Index, the Financial Express
Index and Business Standard Index.
Market-maker : An individual or organization which, in exchange for reduced
dealing fees and other concessions, commits in certain securities,
contracts or markets to continuously make two-way prices (i.e. bids
and offers) at an agreed minimum spread differential and for an
agreed minimum volume, during market hours.
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Markowitz Model : A method of selecting the optimum investment portfolio, devised by

H M Markowitz. It makes use of the concepts of a market portfolio
(containing all available investments in amounts proportional to the
total market value of each individual security) and a graph (the
capital market line) of alternative combinations of risk and return,
resulting from investing fixed sums in the market portfolio.
Maturity : i. Period within which a futures contract can be settled by delivery
of the actual commodity.
ii. The period between the first notice day and the last trading day of
a commodity futures contract.
iii. The due date of a loan, note, bond, or, in the USA a mortgage-
backed security
Merchant Bank : Merchant banks, have been concerned with import and export trade,
although they have recently expanded their activities by raising
finance, at home and abroad, for industry, including high-risk hire-
purchase financing. These banks also float shares on behalf of
companies or underwrite them. They are increasingly involved in
takeover bids and mergers, offering specialized advice to the
bidders.

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Money-back Option : An option guaranteed to repay at least the original option premium at
expiry. This results in the gearing being greatly reduced compared
with a standard option.

Moving Average : An average of share prices for specified periods showing trends of
price movements, rather than daily fluctuations. A monthly moving
average will take a month’s prices till yesterday and for tomorrow’s
average it will drop the earliest day and include today in its place.

Multi-index Option : An option that gives the holder the right to buy the asset that
performs best out of a number of assets, i.e., a call on the best
performing index. The indices would all be rebased for comparison
and the currency may or may not have a fixed exchange rate. This
product was introduced by Mitsubishi Finance.

Mutual Funds : Investment companies and banks, which collect money from
shareholders and invest in a large variety of securities like shares,
debentures, bonds set-up for a limited period, or with no winding-up
date. The investors thus have the advantage of owning a truly
diversified portfolio which offers attractive annual dividends and a

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reasonable price appreciation with minimum risk involved.

Naked Option
FA : A Call Option wherein the seller does not own shares but hopes to buy
from the market, expecting the price to fall. If it does, he makes a
profit on the difference; if it doesn’t and rises, the seller is caught in a
naked position and must sustain a loss by buying at the higher price.

Net Asset Value : Term used by mutual funds, Master shares and other investment
(NAV) trusts to indicate the net tangible asset value of each share on a
particular date. It can also mean the total market price of all the
shares held by a mutual fund less any liabilities, divided by the total
number of outstanding shares on a particular date. With every
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change in share prices the NAV of mutual funds shares changes.

Net Change : The difference in the last trading price and the next day’s closing
price of a share.

Net Dividend : The dividend paid by a company to its shareholders, after

excluding the tax credit received by the shareholders.

Net Worth : It is the total of equity share capital and reserves. It is also the value
of total assets minus total liabilities.

Nominal Price : Price quotations for a futures period in which no actual trading took
place, usually an average of bid and asked prices.

Nominal Value : The nominal value is the face value of share. If the face value of a share
is Rs.10 then it may also be stated that its nominal value is Rs.10.

Non-Cleared : Shares which are traded directly between brokers, and not cleared
Securities through the stock exchange clearing house. They are also known as
Non-specified Securities, B-group Securities, or Cash Shares.

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Odd Lots : An odd lot is a small number of shares one may get as a result of a
bonus or rights issue or on the conversion of debentures. They are
not in marketable lots (there is a minimum quantum of shares that is
usually traded which is known as marketable lot – 50 or 100 shares).
They are usually difficult to sell. On Saturdays in the major stock
markets odd lots are traded. The price is, however, lower than the
normal price of the share (about 10%). The small investors more
often than not buy fewer than 100 shares of a given stock i.e., an odd
lot and such buyers and sellers are called ‘odd lotters’.
Odd Lot Dealer : Brokers specializing in buying and selling of odd lots, pay less than
the market price for buying and charge more for selling, the difference
constituting their profit. They also put together the odd lots into
market lots or help investors to make up their own market lots.
Offer : Indicates a willingness to sell a futures or options contract, or other
asset, at a given price.
Off-Balance Sheet : The use of company funds to hire or lease an expensive piece of
Finance equipment rather than purchasing it. This enables a company to
make use of the equipment without having to invest capital. The
item does not appear on the balance sheet as an asset and therefore

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the capital employed will be understated, although the profit and loss
account will show the rental payments.
Official List
FA : The list of share prices published by the stock exchange at the end of
the day’s trading. It is different from stock prices reported in
newspaper and financial journals, which are sometimes erroneous.
Offshore Fund : A fund held outside the country of residence of the holder.

Open Contracts : Contracts which have been bought or sold without the transaction being
closed or completed by subsequent sale or purchase, or by making or
taking actual delivery of the commodity, or exercising the option.
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Open-end Fund : A form of unit trust in which the managers of the trust may vary the
(Mutual Fund) investments held without notifying the unitholders.
Open Interest : The total number of long or short positions outstanding in a market.

Opening a Position : Taking a long or short position in a security without any pre-existing
position in it.
Option : A legally binding agreement that confers the right, but not the
obligation, to the holder to buy (in the case of a call option) or sell
(in the case of a put option) an underlying asset (which may be a
financial instrument, commodity, or futures contract) at a price
agreed now (the exercise or strike price) by a specified expiry date in
the future (if it is an American-style option) or on a specified date in
the future (if it is a European-style option). The writer or seller of the
option has the obligation to fulfill the contract if the holder wishes to
exercise the option (take up the rights). This option is obtained in
exchange for payment of a premium. There are exchange traded
options available as well as over-the-counter varieties.
Option Buyer : A person who obtains the right conveyed by the option. Sometimes
he is referred to as the holder. Only the option buyer has the right to
exercise an option.

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Option-dated : A forward foreign exchange contract with an option to select the
Forward Contract date of the exchange.
Option Group : Options in the same three-month interval and with the same exercise
price.
Option Holder : Someone who has bought an option.

Option on a Future : An option, the exercise of which results in a futures position rather
than a claim directly on an underlying security or asset. The exercise
of a call results in a long futures position for the buyer (a short
position for the seller or writer). The exercise of a put results in a
short futures position for the buyer (a long position for the writer).
Option Premium : The going (market) price for an option.

Option Spread : The simultaneous purchase and sale of one or more option contracts,
futures, and/or cash positions.
Option Writer : The writer of an option is obligated – if and when he is assigned an
exercise – to perform according to the terms of the option. The
option writer is sometimes referred to as option seller.

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Over the COUNTER : Market for shares outside the control of the official stock exchange.
or OTC
Oversubscribed
FA : A company may offer for sale a certain number of shares. If
applications are received for sha res in excess of the number
offered, the issue is termed to be oversubscribed.
Overvalued Shares : The shares which impress investors and who therefore are willing to
pay a price for them which is not justified by their EPS or P/E ratio.
Paper Market : A market in forwards, futures or options as distinct from the physical
cash commodity market.
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Par : Par is another term for the face or nominal value of the share. When
an issue of Rs.10 shares are offered at par it means that the Rs.10
shares are being offered at Rs.10 per share.
Partial Delivery : A situation in which the broker does not deliver the entire quantity
of shares ordered by an investor.
Partly Active Shares : These are shares which are not traded very frequently and on an
average are partly active. They are not easy to buy and sell and the
spread between buying and selling prices can be large.
Partly Paid : Partly paid shares are those whose nominal value has not been fully
paid-up. If only Rs.5 has been paid on a Rs.10 share it is termed as
partly paid-up.
Participating Option : An option where the buyer foregoes a certain percentage of potential
profits in return for a reduced premium.
P/D Ratio or Price- : The current market price of a company share divided by the dividend
Dividend Ratio per share for the previous year. It is a measure of the investment
value of the share.
P/E Ratio or Price- : An indicator of how highly a share is valued in the market. Arrived
Earnings Ratio at by dividing the price of a share by the Earnings Per Share (EPS).

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Pennant : A share price chart pattern resembling a pointed triangular flag. It
emerges when successive peaks and rallies almost disappear. Not
only are price fluctuations less pronounced, the volume of
business also falls. A pennant formation signals an imminent rise
or fall which cannot be predicted.

Perpetual Bond : A bond with no pre-determined redemption date. Many have a date
after which they may be redeemed by the issuer, such as UK
government 2% Consols (1923 and after). Effectively, they have an
open-ended issuers’ call.

Pivotal Shares : Shares of some blue chip companies act as a pivot on which the
market is balanced. If they turn bearish the market follows; if they
turn bullish, the market looks up.

Point : i. Minimum price unit in which a commodity price is quoted, or

minimum price movement of a future.

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ii. One percent of the nominal value of a security; for example, one
hundred basis points.

Point and Figure

FA : A Technical Analysis graph which records the share price
Chart movements disregarding the element of time. Every time a share
price moves up an X is put on the graph above the previous point.
Every time the share price moves down an O is placed on square
down in the next column. This chart helps one to study the trend of
movement of a share price for a period of time.

Portfolio : The combined holding of many kinds of financial securities – shares,

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debentures, government bonds, Unit Trust certificates, and other
financial assets. The object of forming a portfolio is to reduce risk by
diversification and maximize gains.

Portfolio Manager : A professional who manages investment portfolios with the

objectives of profitability, growth and risk minimization. He is
expected to manage the investor’s assets prudently and chooses
particular investment avenues, with a view to maximize profits.

Position : A market commitment. A buyer of a futures or options contract is

said to have a long position and, conversely, a seller of futures or
options contract is said to have a short position. A position is having
an exposure in the market by either buying or selling derivatives or
the cash market asset or commodity.

Position Limit : The maximum position a trader is allowed to hold.

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Premium : i. The excess of one futures contract price over that of another, or
over the cash market price.
ii. The amount a price would be increased to purchase a better
quality commodity.
iii. A futures delivery month selling at a higher price than another, as
in ‘July is at a premium over May’. See contango and
backwardation.
iv. Cash prices that are above the future, such as in foreign
exchange. If the forward rate for Italian lira is at a premium to
spot lira, it is selling above the spot price.
v. The money the buyer pays to the writer for granting an option
contract
Primary Market : i. A market for new issues of shares, debentures and bonds, where
investors apply directly to the issuer for allotment and pay
application money to the issuer’s account. It is different from the
secondary market where investors trade in shares on the stock
exchange through brokers.
ii. The market in which securities are first issued to investors. See

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secondary market.
Principal : A market-maker or dealer who is committed to giving a price (rate)
FA for a deal or trade which is readily available to be taken.
Put-option : An option to sell is called a put-option and is bought in the
expectation of a falling price or to protect a profit on an investment.
Put Spread : A purchased put where the purchase cost is offset by the sale of
another put at a lower exercise price. This results in a long bear
spread. Advantageous if a market fall is expected.
Quick Ratio (Acid- : A measure of the liquidity of a company, showing whether the
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Test Ratio) company can meet its obligations from the current assets. It is
arrived at by subtracting inventory from current assets and divide the
remainder by current liabilities. Ratios below 1:1 are considered low.
However, high ratios may simply mean that although the company is
cash rich, it is not using its assets effectively.
Quote : The highest bid and lowest offer for a share.

Quoted Price : The price at which a share was last bought and sold on the stock
exchange.
Quoted Shares : The shares of a company which are officially registered on a stock
exchange, and whose prices are quoted on the official list.
Quotation : The current price available on the market at which purchases or sales
may be executed.
Rally : A strong raise in the price of a share, or in the share market index,
after a period of stagnancy or declining trend.
Random Walk : This hypothesis states that in a perfectly competitive market,
investors take stock of all the factors influencing share price
movements and hence further changes are caused randomly and no
systematic prediction can be made. The risk of random walk can be
reduced by diversification of one’s portfolio.

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Range (Price) : The price span during a given trading session, day, week, month, year, etc.
Rate of Return : It is calculated as the dividend received divided by the price of the
share, multiplied by a hundred. The total return on an investment is the
sum of dividend received and the increase in the price of one’s shares.
Rating : The evaluation of credit risk of fixed income securities.

Reaction : A drop in share prices for poor performance of the company, equity
dilution, profit taking, etc.
Real Assets : Land, houses, gems, gold appreciate in value faster than equity
shares, although their acquisition is difficult due to the large size of
investment, storage cost and insurance. It is not easy to acquire them
while there are a hundred ways of being dispossessed.
Real Interest Rate : Current interest rate less the rate of inflation.

Realized Return : The actual return earned on a bond which may differ from the
promised YTM if the assumptions underlying the YTM are violated.
Real Rate of Return : Return on an investment adjusted for inflation.

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Redemption : The repayment at maturity of a bond or other document certifying a
loan by the borrower to the lender. In the case of debentures or
FA preference shares, redemption means paying back the investor, either
in cash, or through equity shares. Thus, the redemption date specifies
when repayment takes place and is usually printed on the bond
certificate itself.
Redemption Date : Date on which loan instruments like debentures are due to be paid-off.
Reinvestment Rate : The rate at which the interest payments are reinvested.

Relative Strength : The comparison of a share with other shares or the share price index
based on its price.
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Relative Strength : A charting measure that indicates a market is overbought or

Indicator (RSI) oversold.
Resistance Level : A term in technical analysis indicating the level at which the
increase in the price of a share has repeatedly halted as there are
more sellers at that particular price than buyers. If at a subsequent
rise the price penetrates the line, it is supposed to signify a bull
phase, taking the price upwards.
Return on Capital : The profits of an organization expressed as a percentage of the capital
Employed (ROCE; employed. This is an important indicator of the efficiency with which
Return on Imputed the assets of the organization are used; it provides a useful comparison
Capital) of companies in the same industry or, for the investor, a comparison
between various industrial sectors. However, it is important to know
what is meant by capital. Frequently, return on capital is calculated by
comparing the profits with the book value of the net assets. This tends to
undervalue the assets, so that a capital figure based on market value
would be more helpful, although not as readily obtainable. It is also
important to know whether the profit given is before or after tax and
whether or not adequate provision has been made for any bad debts.
Return on Equity : The net income of an organization expressed as a percentage of its
(ROE) equity capital.

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Reversal : A continuous fall of share prices from a peak.
Rigging : The manipulation of share prices in order to attract gullible investors
to buy or sell shares.
Rights Issue : The issue of additional equity shares to the existing shareholders on
a pre-emptive basis. Typically, the subscription price of a rights
issue is significantly below the market price of the old shares.
Risk : The chance of an outcome not occurring as planned. This may be due
to an actual return differing from a previously predicted return. The
variability of such predicted returns can be estimated using statistical
tools such as standard deviations and probability distributions. In
addition, risk may arise from interest rate or foreign exchange rate
changes, counterparty failure, issuer default and many other causes.
Risk Factors : A measurement of an option position or premium in relation to the
underlying instrument.
Risk Management : The practice of continuously assessing and controlling all known
exposures and hedging such risks to a sustainable level or where
applicable maximizing profitable returns.

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Return on : The profits of an organization on its investment. For instance, an
Investment (ROI) investment yielding a 5% yearly dividend and 3% in the form of
FA increased market value in the year of investment would have
returned 8% provided that investment had been turned back into
cash at the end of a year.
Round Lot : The minimum number of shares in a trading lot; 100 or 50 in the case of
Rs.10 shares and 10 or 5 for Rs.100 shares. Any number less than the
trading lot is called an odd lot, for which the selling price for the
investor is lower than normal, but the buying price is higher.
Saucer : A share price chart pattern forming a saucer-like bottom and moving
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up, indicating further rise. If the chart pattern is an upside down
saucer, the signal is for a further fall.
Scrip : This is another term for ‘share’ or ‘stock’.
Secondary Market : It is a place where shares already issued are traded. It is different
from the primary market wherein the issuer sells shares directly to
the investor.
Secured Debt : A debt instrument, like a bond or a debenture, whose principal amount is
secured by tangible assets as collateral. The creditor can lay a claim on
the assets in the event of default by the issuer.
Securitization : The process that enables borrowing and lending by banks to be replaced
by the issue of such securities as eurobonds. A bank borrows money
from savers (investors) and lends to borrowers, charging fees to both for
its service as well as making a turn on the interest payments. If a
borrower can borrow directly from an investor, by issuing them with a
bond (or equity), the costs to both borrower and lender can be reduced.
Securitization has occurred increasingly in the 1980s as technology has
improved and investors have become more sophisticated.

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Security : A security is a document that gives its owner, specific claim of
ownership of particular assets. The two main types of securities are
bonds and shares. The bondholder gets an assured interest only for
the period of holding, while the shareholder is part-owner of the
company and has invested in its future with a corresponding share in
its profits or losses.
Seller’s Market : A market characterized by a shortage of shares in the market
considering their demand and consequent high prices, indicating a
Bull Market.
Settlement Period : For administrative purposes, stock exchanges divide the year into a
number of settlement periods which are usually of two weeks
duration.
Settlement Price : The official price for a financial or commodity derivative at which
all open positions on an exchange are revalued for the purposes of
profit and loss and subsequent margin calculation at the end of each
business day. The settlement price is a calculated value that takes
into consideration the closing offer and bid price, the last actual
traded price and a weighted average of prices traded during the last
few minutes of the close of trading.

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Shake-out : If there are many companies trying to market the same class of
FA goods or services and there are more sellers than buyers, there will
be a shake-out and many companies will be eliminated. Many
leasing companies, were shaken out in the mid-eighties when there
were too many of them.
Share Certificates : Share certificates are the documents proving a person’s ownership of
shares in a company. It states the number and class of shares owned
by the shareholder and the serial number of the shares.
Share Splitting : The division of the share capital of a company into smaller units.
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The effect of a share split is the same as a scrip issue although the
technicalities differ. Share splits are usually carried out when the
existing shares reach such a high price that trading in them becomes
difficult.
Share Transfer : An investor purchasing shares from the broker will receive the
certificates along with share transfer forms having the transferor’s
attested signature. The buyer of the shares, the transferee, will fill in
these forms, affix share transfer stamps and send the certificates for
registration in his name.
Short Covering : A short seller borrows shares from others for his operation; when he
actually buys them to replace what he had borrowed at the time of
short sale, he is covering his short position.
Short Position : Shares which a person has sold short, by delivering borrowed
certificates, but which he has not yet covered by actually buying
shares to repay the loan as on a particular date.
Short Sale : A short sale occurs when a person believing that the prices of shares
will fall, sells shares that he does not own with the intention of
purchasing the shares at a lower price at the time delivery has to be
made. This is also known as forward sale.

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Stop Loss Order : An order placed with a broker in a security or commodity market to
(SLO) close an open position at a specified price in order to limit a loss. It
may be used in a volatile market, as a means of reducing one’s loss,
while waiting for the market to recover.

Slump : The bottom of a trade cycle when prices and employment are at their
lowest, reflected in the downward movement of share prices.

Small Investor : An investor trading in small quantities and although he may be a part
of a very large crowd, his individual importance to the company or
to the stockbroker is near non-existent.

Specified Shares : The most widely traded shares, also known as group securities,
cleared securities, transactions made through the clearing house of
the stock exchange.

Speculation : An activity, in which a person assumes high risks, not bothered

about the safety of his invested principal, to achieve large capital
gains. The time span in which the gain is sought to be made is
usually very short.

: This occurs when the shares are divided into shares of smaller

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Split
denomination. Rs.100 shares may be split into ten Rs.10 shares. It
usually happens when the price becomes unwieldy.

Spot
FA : Spot purchase or sale implies that the deal is for immediate cash and
the shares are to be delivered immediately.

Spot Commodity : The actual commodity as distinguished from futures. Same as

actuals or cash commodity.

Spot Delivery : When the payment for the delivery of shares is done on the same day
or on the following day, it is called a spot delivery.
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Spot Rate : It is the discount rate or required return quoted for the current period.
The actual commodity as distinguished from futures. Same as
actuals or cash commodity.

Spread : Another type of combination position that an option buyer can take.
This involves being both the buyer and the writer of the same type of
option – put or call – on the same underlying security with the
options having different exercise prices and/or expiration dates.

Spread (Futures) : Refers to a simultaneous purchase and sale of futures contracts for
the same commodity or financial instrument for delivery in different
months or in different but related markets.

Spread (Options) : The purchase and sale of different series of options by the same
principal.

Spread Margin : The margin required for a spread. Because a spread reduces risk, the
margin requirement may be lower than for each contract involved
separately.

Stock Dividend : The distribution of additional shares to current shareholders in lieu

of cash dividends with a view to conserving cash within the
company.

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Stock Exchange : A market place where shares are traded. It is usually a building
where members of the exchange, acting as brokers or dealing on
their own, buy and sell shares, sometimes as bulls and sometimes as
bears.
Stock Index : An indicator used to measure and report value changes in a
selected group of stocks. How a particular stock index tracks the
market depends on its composition, the sampling of stocks, the
weighting of individual stocks, and the method of averaging used
to establish an index.
Stock Option : It is the right to buy or sell a share at a particular price within a
particular period, in order to hedge the investment.
Strongly Efficient : A market in which all information (and not just publicly available
Market information) about a share is reflected in its price. Such a market is
hypothetical as all information about a share’s price is hardly ever
accessible. However, if the hypothesis of a strongly efficient market
is accepted, it follows that expectations of future price changes will
be revised randomly and share prices will take a random walk,
upwards or downwards.

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Support Line : A trendline drawn on a price chart through the troughs of an upward
price movement in a market. It indicates the points where the market

SWOT Analysis
FA is finding support.
: A type of fundamental analysis of the health of a company by
examining its strengths (S), weaknesses (W), business opportunities
(O) and any threats (T) or dangers it might be exposed to.
Systematic Risk : An investment risk which applies to all securities of the same class,
which cannot be avoided by diversifying one’s portfolio. Economic,
social or political factors will cause price fluctuations of all shares
alike. Hence, the prices of shares in the market tend to rise and fall
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together.
Target Price : An investor while buying a share has a price in mind which he thinks
the share will reach. This price is the target price. It is wise to have a
target price for every share bought, so that it can be sold at that
price.
Technical Analysis : A method of forecasting share price movements based on a study of
price charts on the assumption that share price trends are repetitive,
that seems investor psychology follows certain pattern, what is seen
to have happened before is likely to be repeated. The technical
analyst is only concerned about investor and price behavior.
Theoretical Value : Option value generated by an option valuation model.
Trading Pattern : It helps in identifying the long-term direction of a share price. A line
is drawn connecting the peaks and the lows and the direction of the
trend gives the trading pattern.
Transfer Deed : A transfer deed is the document that records the transfer of shares
and debentures. It should be remembered that the validity of a
transfer deed is only up to the date of the book closure of the
company.

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Treasury Bill : A short-term government debt instrument with a maturity of one
year or less. Bills are sold at a discount to face value (or par value)
with the interest earned being the difference between the face value
received at maturity and the price paid.
Trend : The general direction in which prices are moving.

Trendline : A straight line drawn to connect the highest or lowest prices of a

share over a period. If there is a price reversal, for example, if the
price rises above a downward trendline or drops below an upward
trendline, technical analysts conclude that a new direction is
emerging.
Triangle : A share price chart pattern wherein there are two base points and an
apex on the left. If the apex is on the right, it makes a reverse
triangle. If a share’s price breaks out of the triangle formation, it
indicates that the rise or fall (depending whether the formation is
upwards or downwards) will continue for sometime.

Turnaround : A change for the better in a company’s performance. Turnaround

situations in companies is a good opportunity for investors to pick up
shares when their price is still low.

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Undersubscribed : This is used to describe an issue when all the shares offered by a
FA company for sale are not subscribed for.

Undervalued Shares : These shares sell below their book value or the price earning ratio
which they deserve. The reasons would be that the industry is out of
favor, or the company has current labor trouble. Fundamental
analysts often identify and recommend such shares before they
become fully priced. Companies with undervalued shares are often
targets of takeovers as their shares can be acquired cheaply.

Underwrite : Underwriting is effectively a guarantee wherein the underwriter

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(usually a bank, broker or financial institution) agrees to purchase a
certain number of shares in the event the issue is undersubscribed for
a certain fee.

Undha Badla : See Backwardation.

Unlisted Share : Shares in companies that are not on an official stock exchange list.
They are, therefore, not required to satisfy the standard set for
listing.

Unsystematic Risk : Risk that can be diversified away.

Uptick : An increase in price.

Value of an Option : The value of any option is made up of two parts i.e. the intrinsic and the
time values. Intrinsic value reflects the amount, if any, by which the
price of an option differs from that of the underlying security. Time
value is whatever value the option has in addition to its intrinsic value
and reflects what a buyer would be willing to pay for the option in the
hope that at sometime prior to expiration, its value will increase because
of a favorable change in the price of the underlying securities.

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Variability of Return : The degree to which the return on an investment varies
unpredictably. An investment whose holding period return varies
widely from period to period is a riskier investment than one whose
holding period return does not vary much.

Variation Margin : The amount to be paid in to bring up the balance in a margin account
to the level of initial margin.

Venture Capital : Capital invested in a project in which there is a substantial element

of risk (but with above average prospect of reward), especially
money invested in a new business in exchange for share in the
business.

Vertical Line : The charting of the movement of the price of a share with a vertical
Charting line representing the high and the low, and a horizontal bar across
the point where the day’s trading has closed. There is a line for each
day or each week or each month depending on the breadth of
analysis. The chart gives an idea, not only of the trend of price
movements, but also the range of fluctuation of the share’s price.

: A chart pattern which forms a V, indicating that the share price has

I
V Formation
bottomed out and is on an upward course. A reverse V will indicate
the opposite trend.

Volatile
FA : A share subject to frequent and violent fluctuations is said to be
volatile. If the volatility of a share is due to inherent factors like
variability in its earnings, smallness of the issue, it is measured by
the alpha factor. But, if the volatility is market related, it is measured
by the Beta Factor.

Volatility : A measurement of the variability rate (but not the direction) of the
change in price over a given time period.
IC
Volume : The number of contracts executed for a given period (usually a day)
in any given instrument or market.

Wall Street : A popular name for New York Stock Exchange, which is located at
the corner of Board Street and Wall Street.

Warrant : A stock market security with a market price of its own that can be
converted into a specific share at a predetermined price and date.
The value of the warrant is thus determined by the premium (if any)
of the share price over the conversion price of the warrant. There are
also warrants available on gold and oil, where they are convertible
into these commodities.

Weak Market : A market in which there are more sellers than buyers, resulting in a
decline in prices.

Wedge : A share price chart pattern like a triangle, with a difference. In a

triangle one line rises while the other falls, whereas in a wedge both
the lines move in the same direction, for example, both rise or fall
until the distance between the peaks and the trough closes. A wedge
indicates a temporary interruption in the rising or falling trend.

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W Formation : A share price chart pattern, forming a W, showing that a share’s
price has hit the support level (the two bottoms of a W) twice, and is
now likely to move up.

Writing an Option : Selling an option.

Yield : Yield is the return earned by the investor or shareholder on his

investment.

Yield Curve : The curve that depicts the yields of bonds with differing maturities.

Yield Gap : The difference between the average annual dividend yield on
equities and the average annual yield on long-dated gilt-edged
securities. Before the 1960s equity yields usually exceeded gilt
yields, reflecting the greater degree of risk involved in an investment
in equities. In the 1960s, rising equity prices led to falling dividend
yields causing a reverse yield gap. This was accepted as equities
were seen to provide a better hedge against inflation than fixed-
interest securities; thus their greater risk element is compensated by
the possibility of higher capital gains.

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Yield-to-call : The discount rate that equates the present value of the cash flow to first
call of a callable bond to its market value.
FA
Yield-to-maturity : i. The return obtained on holding a bond to maturity. The yield-to-
maturity assumes that any coupon payments received before
redemption can be reinvested at this yield. This implies a flat
yield curve and is hence not a realistic assumption.
ii. The discount rate that equates the PV of the cash flow to its
market value.

Zero-Coupon Bond : A bond that has no coupon payments, just a single maturity payment.
IC
It will be sold at a discount to face value and will be more volatile
than a coupon carrying bond of the same maturity or yield.

Zero Interest : A new type of security permitted to be issued by the companies.

Bonds/Debentures These bonds or debentures offers no interest payments and the same
will be either fully or partly convertible into equity shares of the
company at the choice of the bond/debentureholder or they will be
redeemable debentures/bonds.

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