FMG304 Security Analysis and Portfolio Managment

FMG 304
Yashwantrao
Chavan
Maharashtra
Open University
MBA : SECOND YEAR

SEMESTER III
FINANCE GROUP
SECURITY ANALYSIS & PORTFOLIO MANAGEMENT

Unit 1 : Introduction to Security Analysis & Portfolio Management 01
Unit 2 : Financial Markets & Institutions 23
Unit 3 : Investment Avenues in India 42
Unit 4 : Analysis of Risk And Return 58
Unit 5 : Fundamental Analysis Part A : Economic Analysis 81
Unit 6 : Fundamental Analysis Part B : Industry Analysis 102
Unit 7 : Fundamental Analysis Part C : Company Analysis 121
Unit 8 : Technical Analysis 151
Unit 9 : Behavioural Finance Anomalies 174
Unit 10 : Valuation of Shares and Business 193
Unit 11 : Fixed Income Securities Valuation 215
Unit 12 : Portfolio Management :Analysis selection Revision & Evaluation 236
Unit 13 : Theories of Portfolio Management 257
Unit 14 : Derivatives 277
Unit 15 : Investments And Tax Planning 303
Unit 16 : Mutual Funds, Insurance & Commodities 331

YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
VICE-CHANCELLOR : Prof. E. Vayunandan
DIRECTOR, SCHOOL OF COMMERCE & MANAGEMENT : Dr. Pandit Palande
NATIONAL ADVISORY BOARD
Dr. Pandit Palande Prof. Devanath Tirupati, Dr. Surendra Patole
Former Vice Chancellor Dean Academics, Assistant Professor,
Director, School of Commerce Indian Institute of Management (IIM) School of Commerce &
& Management, Bangalore. Management,
Yashwantrao Chavan Maharashtra Yashwantrao Chavan Maharashtra
Open University, Nashik Open University, Nashik
Prof. Sudhir. K. Jain Prof. Karuna Jain, Dr. Latika Ajitkumar Ajbani
Former Vice Chancellor Director, Assistant Professor,
Professor & Former Head N I T I E, Vihar Lake, School of Commerce &
Dept. of Management Studies Mumbai Management,
Indian Institute of Technology (IIT) Yashwantrao Chavan Maharashtra
Delhi Open University, Nashik
Prof. Vinay. K. Nangia

Professor & Former Head
Department of Business Studies,
Indian Institute of Technology (IIT)
Roorkee
Authors Editor
Dr. Meghana Chotaliya Dr. Varadraj Bapat
National College, Mumbai SJM School of Management
Indian Institute of Technology
Prof. Dinesh Rajput Mumbai
Thakur Management Institutue, Mumbai
Instructional Technology Editing & Programme Co-ordinator

Dr. Latika Ajitkumar Ajbani
Assistant Professor
School of Commerce & Management
Yashwantrao Chavan Maharashtra
Open University, Nashik
Production
Shri. Anand Yadav
Manager, Print Production Centre, Y. C. M. Open University, Nashik- 422 222
Copyright © Yashwantrao Chavan Maharashtra Open University, Nashik.
(First edition developed under DEB development grant)
q First Publication : October 2017 q Publication No. 2248
q Cover Design : Shri. Avinash Bharne
q Printed by : Shri. Narendra Shaligram, M/s. Relica Printers, 2, Chitko Centre, Vakilwadi, Nashik - 422 001
q Publisher : Dr. Dinesh Bhonde, Registrar, Y. C. M. Open University, Nashik- 422 222
ISBN : 978-81-8055-432-2
FMG 304
Introduction
We are very pleased in placing the first edition of this study material on Security Analysis
and Portfolio Management ‘ to the students and practitioners of this subject. This book is
designed as per the revised syllabus prescribed by the YCMOU Nashik from August 2015.
It gives equal importance to the theoretical aspects as well as to the practical case studies.
Hence this edition will be an ideal companion not only to the scholars but also to the average
students. I am sure that this work would subserve the genuine interest of all the students
concerned in enriching their knowledge of this ever-growing Security Analysis and Portfolio
Management discipline.
We have made a sincere attempt to make the subject easy to understand. For this
purpose the theory on each topic is written in a simple and lucid language to enable the
students to grasp the essence of subject.
Any suggestions will be appreciated.
I am confident, that students will welcome new edition of this book.
With knowledge, hard work, marvelous success is just around the corner.
All The Best!
Dr. Varadraj Bapat

Dr. Meghana Chotaliya
Prof. Dinesh Rajput
Copyright © Yashwantrao Chavan Maharashtra Open University, Nashik.
All rights reserved. No part of this publication which is material protected by this copyright
notice may be reproduced or transmitted or utilized or stored in any form or by any means now
known or hereinafter invented, electronic, digital or mechanical, including photocopying, scan-
ning, recording or by any information storage or retrieval system, without prior written permis-
sion from the Publisher.
The information contained in this book has been obtained by authors from sources believed to
be reliable and are correct to the best of their knowledge. However, the publisher and its
authors shall in no event be liable for any errors, omissions or damage arising out of use of this
information and specially disclaim any implied warranties or merchantability or fitness for any
particular use.
Message from the Vice-Chancellor
Dear Students,
Greetings!!!
I offer cordial welcome to all of you for the Master’s degree programme of
Yashwantrao Chavan Maharashtra Open University.
As a post graduate student, you must have autonomy to learn, have information
and knowledge regarding different dimensions in the field of Commerce & Manage-
ment and at the same time intellectual development is necessary for application of
knowledge wisely. The process of learning includes appropriate thinking, understand-
ing important points, describing these points on the basis of experience and observa-
tion, explaining them to others by speaking or writing about them. The science of
Education today accepts the principle that it is possible to achieve excellence and
knowledge in this regard.
The syllabus of this course has been structured in this book in such a way, to
give you autonomy to study easily without stirring from home. During the counseling
sessions, scheduled at your respective study centre, all your doubts will be clarified
about the course and you will get guidance from some experienced and expert
professors. This guidance will not only be based on lectures, but it will also include
various techniques such as question-answers, doubt clarification. We expect your
active participation in the contact sessions at the study centre. Our emphasis is on
‘self study’. If a student learns how to study, he will become independent in learning
throughout life. This course book has been written with the objective of helping in
self-study and giving you autonomy to learn at your convenience.
During this academic year, you have to give assignments and complete the
Project work wherever required. You have to opt for specialization as per
programme structure. You will get experience and joy in personally doing above
activities. This will enable you to assess your own progress and thereby achieve a
larger educational objective.
We wish that you will enjoy the courses of Yashwantrao Chavan Maharashtra
Open University, emerge successful and very soon become a knowledgeable and
honorable Master’s degree holder of this university.
Best Wishes!
- Vice-Chancellor
Security Analysis and Protfolio Management
SYLLABUS
UNIT 1 INTRODUCTION TO SECURITY ANALYSIS AND PORTFOLIO

MANAGEMENT
The Investment Process, Investment versus Financing , Investor Life Cycle, Guidelines for
Investment Decisions
UNIT 2 FINANCIAL MARKETS AND INSTITUTIONS

Structure of the Indian Financial System, Financial Markets, Money Markets, Financial
Services
UNIT 3 INVESTMENT AVENUES IN INDIA

Objectives of Investment, Investment Attributes, Analysis of different Investment Avenues.
UNIT 4 ANALYSIS OF RISK AND RETURN

Types of Risks, Relationship between Risk and Return, Measurement and Diversification
of Risk, Risk Adjusted Models
UNIT 5 FUNDAMENTAL ANALYSIS PART A : ECONOMIC ANALYSIS

Application of Fundamental Analysis, Phases of Fundamental Analysis, Economic Indicators,
Economic Forecasting Techniques
UNIT 6 FUNDAMENTAL ANALYSIS PART B: INDUSTRY ANALYSIS

The Industry Analysis Process, Industry Life Cycle and Business Cycles, Financial Aspect
of Industrial Analysis, Porter’s Five Forces Model, Industry Classification,
UNIT 7 FUNDAMENTAL ANALYSIS PART C: COMPANY ANALYSIS

Need and Significance of Company Analysis, Study of Financial Statements, Ratio analysis
and other Techniques of Company Analysis ,Measures of Value Addition,
UNIT 8 TECHNICAL ANALYSIS

Fundamental V/s Technical Analysis, Tools of Technical Analysis, Trend Analysis, Charting
Techniques and Modern Development in Technical Analysis
UNIT 9 BEHAVIORAL FINANCE ANOMALIES

Differences between Traditional Finance and Behavioural Finance, Investor Biases,
Taxonomy of Behavioural Risk, Behavioural Portfolio, Applications of Behavioural Finance
Theory, Behavioural Finance and Market Efficiency and Critiques of Behavioural Finance.
UNIT 10 VALUATION OF SHARES AND BUSINESS

Techniques of Valuation of Shares, Asset Based Valuation, Dividend Yield, Earnings Yield,
Fair Value, Discounted cash Flow Techniques and Theoretical Techniques of Valuation.
UNIT 11 FIXED INCOME SECURITIES VALUATION

Components of Debt Market, Valuation of Debt and Bonds, Bond Risk Analysis and
Credit Rating Process of Bonds.
UNIT 12 PORTFOLIO MANAGEMENT: ANALYSIS, SELECTION, REVISION AND
EVALUATION
Phases, Notions and Principles of Portfolio Management
UNIT 13 THEORIES OF PORTFOLIO MANAGEMENT

Modern Portfolio Theory-Markowitz Model , Efficient Portfolio ,Sharpe and Treynor’s
Ratio
UNIT 14 DERIVATIVES
Options, Futures, Black Scholes , Binomial Distribution Models and other Option Pricing
Models, Index Futures and Swaps.
UNIT 15 INVESTMENTS AND TAX PLANNING

Tax Aspects of Investments, Deductions u/s 80, Securities Transaction Tax (STT), Capital
Gains Tax, and Capital Gain Bonds.
UNIT 16 MUTUAL FUNDS, INSURANCE AND COMMODITIES

Classification of Mutual Funds, Performance Evaluation of Managed Portfolio by empirical
Tests,Mutual Fund Ratings, Commodities, Real Estate and Insurance.
nnnn
Introduction to Security
Unit 1 Introduction to Security Analysis and Analysis & Portfolio
Management
Porfolio Management
NOTES
Structure
1.0 Introduction
1.1 Unit Objectives
1.2 Security analysis
1.3 Portfolio Management
1.4 The Investment Process
1.5 Investment versus Financing
1.6 Types of investments
1.7 Guidelines for Investment Decisions\
1.8 Classification of Investors
1.9 Summary
1.10 Key Terms
1.11 Questions and Exercises
1.11.1 Multiple Choice Questions
1.11.2 Theory Questions
1.11.3 Assignments
1.12 Further Readings and References
1.0 Introduction
Security Analysis and Portfolio Management is of relative significance in the
light of the contemporary investment climate characterized by the emergence of a

number of specialized institutions and the streamlining of regulatory investment
mechanisms. There exists different investment mediums which can be availed by
investors according to their requirements and categories

Security Analysis and
Portfolio Management: 1
Analysis & Portfolio 1.1 Unit Objectives
Management
After studying this unit, you will be able to
NOTES
Ø Understand the concept of Security Analysis
Ø Understand the concept of Portfolio Management
Ø Learn the Investment Process
Ø Know the differences between Investment and Financing
Ø Analyse the types of Investments
Ø Study the Guidelines for Investment Decisions
Ø Learn the Classification of Investors
1.2 Security Analysis
To understand the meaning of security analysis, we first need to understand the

meaning of the term “Security”. Securities are assets with some financial values.
Broadly speaking, Securities are tradable and carry some financial value. Securities
are fungible. It can also be said to be an investment instrument, other than an insurance
policy or fixed annuity that is issued by a corporation, government, or other organization
which offers evidence of debt or equity. The definition of security from the Securities
Exchange Act of 1934, is: “Any note, stock, treasury, bond, debenture, certificate of
interest or participation in any profit-sharing agreement or in any oil, gas, or other
mineral royalty or lease, any collateral trust certificate, pre-organisation certificate or
subscription , transferable share, investment contract, voting-trust certificate, certificate
of deposit, for a security, any put, call, straddle, option, or privilege on any security,
certificate of deposit, or group or index of securities (including any interest therein or
based on the value thereof), or any put, call, straddle, option, or privilege entered into
on a national securities exchange relating to foreign currency, or in general, any instrument
commonly known as a ‘security’; or any certificate of interest or participation in,
temporary or interim certificate for, receipt for, or warrant or right to subscribe to or
purchase, any of the foregoing; but shall not include currency or any note, draft, bill of
exchange, or bankers acceptance which has a maturity at the time of issuance of not
Security Analysis and exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity
Portfolio Management: 2 of which is likewise limited.”
This book which is based on a study of Security Analysis and Portfolio Mangement Introduction to Security
Analysis & Portfolio
is divided into 16 units which are given hereunder: Management
Unit 1 Introduction
NOTES
Unit 2 Financial Markets and Institutions
Unit 3 Investment Avenues in India
Unit 4 Analysis of Risk and Return
Unit 5 Fundamental Analysis Part A Economic Analysis
Unit 6 Fundamental Analysis Part B Industry Analysis
Unit 7 Fundamental Analysis Part C: Company Analysis
Unit 8 Technical Analysis
Unit 9 Behavioral Finance- Anomalies
Unit 10 Valuation of Shares and Business
Unit 11 Fixed Income Securities Valuation
Unit 12 Portfolio Management: Analysis, Selection, Revision and Evaluation
Unit 13 Theories of Portfolio Management
Unit 14 Derivatives
Unit 15 Investments and tax planning
Unit 16 Mutual Funds, Insurance and Commodities
Classification of Securities
Securities can be classified into the following categories which are inclusive not
exhaustive:
a. Debt Securities: Tradable assets which have clearly defined terms and
conditions are called debt securities. Financial instruments sold and purchased
between parties with clearly mentioned interest rate, principal amount, maturity
date as well as rate of returns are called debt securities.
b. Equity Securities: Financial instruments signifying the ownership of an

individual in an organization are called equity securities. An individual buying
equities has an ownership in the company’s profits and assets.
c. Derivatives: Derivatives are financial instruments with specific conditions

under which payments need to be made between two parties.
Introduction to Security The analysis of various tradable financial instruments is called security analysis.
Management Security analysis helps a financial expert or a security analyst to determine the value
of assets in a portfolio. Security analysis is a method which helps to calculate the value
NOTES
of various assets and also find out the effect of various market fluctuations on the
value of tradable financial instruments (also called securities).
Security Analysis is broadly classified into three categories:
a. Fundamental Analysis
b. Technical Analysis
c. Quantitative Analysis
Fundamental Analysis refers to the Evaluation of securities with the help of certain
fundamental business factors such as financial statements, current interest rates as

well as competitor’s products and financial market. Financial statements are nothing
but proofs or written records of various financial transactions of an investor or company.
Financial statements are used by financial experts to study and analyze the profits,
liabilities, assets of an organization or an individual. Technical analysis refers to the
analysis of securities and helps the finance professionals to forecast the price trends
through past price trends and market data.Quantitative analysis refers to the analysis
of securities using quantitative data.
Difference between Fundamental Analysis and Quantitative Analysis
Fundamental analysis is done with the help of financial statements, competitor’s
market, market data and other relevant facts and figures whereas technical analysis is
more to do with the price trends of securities. Portfolio management refers to the art
Check Your Progress of selecting the best investment plans for an individual concerned which guarantees
Explain the concept of
maximum returns with minimum risks involved. Portfolio management is generally
“Security Analysis” and
the classification of done with the help of portfolio managers who after understanding the client’s
securities.
requirements and his ability to undertake risks design a portfolio with a mix of financial
instruments with maximum returns for a secure future
1.3 Portfolio Management
Portfolio Management is the art and science of making decisions about investment
Portfolio Management: 4 mix and policy, matching investments to objectives, asset allocation for individuals and
institutions, and balancing risk against performance. The art of selecting the right Introduction to Security
investment policy for the individuals in terms of minimum risk and maximum return is Management
called as portfolio management. It also refers to managing an individual’s investments
NOTES
in the form of bonds, shares, cash, mutual funds etc so that he earns the maximum
profits within the specific time frame. Portfolio management refers to managing money
of an individual under the expert guidance of portfolio managers. It is done by analyzing
Check Your Progress
the strengths, weaknesses, opportunities and threats in different investment alternatives
Discuss the need and
to have a risk return trade off. Portfolio management is all about strengths, weaknesses, significance of Company
opportunities and threats in the choice of debt vs. equity, domestic vs. international, Analysis.
growth vs. safety, and many other tradeoffs encountered in the attempt to maximize
return at a given appetite for risk. Portfolio is nothing but the combination of various
stocks in it. Understanding the dynamics of Market is the essence of Portfolio
Management. This means Portfolio Management basically deals with three critical
questions of investment planning.
1. Where to Invest?
2. When to Invest?
3. How much to Invest?
Portfolio is the combination of assets. It refers to a collection of investment tools

such as stocks, shares, mutual funds, bonds, and cash and so on depending on the
investor’s income, budget and convenient time frame.
Following are the two types of Portfolio:
• Market Portfolio
• Zero Investment Portfolio
Need for Portfolio Management
Portfolio management presents the best investment plan to the individuals

as per their income, budget, age and ability to undertake risks. Portfolio
management minimizes the risks involved in investing and also increases the
chance of making profits. Portfolio managers understand the client’s financial
needs and suggest the best and unique investment policy for them with
minimum risks involved. Portfolio management enables the portfolio managers
to provide customized investment solutions to clients as per their needs and Security Analysis and
requirements. Portfolio Management: 5
Introduction to Security Modern Portfolio Management
Management There are differences between Traditional and Modern Security Analysis.
NOTES In traditional form of security analysis greater emphasis is placed on analyzing

Risk Return relationship and in modern security analysis the intrinsic value
is given more significance. Another point of difference is the effect of
personal needs, desires and wants forming the basis of portfolio selection
but in modern security analysis, greater emphasis is laid on scientific approach
to security analysis in terms of estimating risk and return of portfolio and the
risk return trade off estimated by the investors.
Types of Portfolio Management
Portfolio Management is further of the following types:
Ø Active Portfolio Management:

Check Your Progress
As the name suggests, in an active portfolio management service, the portfolio
Briefly discuss the
managers are actively involved in buying and selling of securities to ensure
structure and framework
of Company analysis. maximum profits to individuals. The aim of Active Portfolio Management is
to outperform the benchmark (for example, BSE Sensex, NIFTY 50 etc.).
Ø Passive Portfolio Management:
In a passive portfolio management, the portfolio manager deals with a fixed
portfolio designed to match the current market scenario. Discretionary

Portfolio management services an individual authorizes a portfolio manager
to take care of his/her financial needs on his/her behalf. The individual issues
money to the portfolio manager who in turn takes care of all his investment
needs, paper work, documentation, filing and so on. In discretionary portfolio
management, the portfolio manager has full rights to take decisions on his
client’s behalf. Non-Discretionary Portfolio management services: In non-

discretionary portfolio management services, the portfolio manager can merely
advise the client what is good and bad for him but the client reserves full
right to take his own decisions.

Area of comparisons Active investment Passive investment Introduction to Security
management management Management
Results and Performance Above Average Average NOTES
Strategies Short term , quick & Long term positions, slow

more risky decisions decisions
Taxes and turnover of High taxes, relatively Low taxes, small turnover
investment portfolio high turnover of portfolio of portfolio
Analytical methods Qualitative, risk averse, Quantitative, risk
forecasts, emotions, management,
intuition, success, long term statistical

speculation, gambling analysis & fundamental
analysis
Elements of Portfolio Management
Ø Proper Asset Allocation: The key to effective portfolio management is
the long-term mix of assets. Asset allocation is based on the understanding

that different types of assets do not move in concert, and some are more
volatile than others. Asset allocation seeks to optimize the risk/return profile
of an investor by investing in a mix of assets that have low correlation to
each other. Investors with a more aggressive profile can weight their portfolio
toward more volatile investments. Investors with a more conservative profile

can weight their portfolio toward more stable investments.
Ø Diversification: The only certainty in investing is it is impossible to
consistently predict the winners and losers, so the prudent approach is to

create a basket of investments that provide broad exposure within an asset
class. Diversification is the spreading of risk and reward within an asset
class. Because it is difficult to know which particular subset of an asset

Check Your Progress
class or sector is likely to outperform another, diversification seeks to capture
State the differences
the returns of all of the sectors over time but with less volatility at any one between Investment and
time. Proper diversification takes place across different classes of securities, Financing.
sectors of the economy and geographical regions. Security Analysis and

Introduction to Security Ø Rebalancing and Restructuring: It is used to return a portfolio to its original
Management target allocation at annual intervals. It is important for retaining the asset
mix that best reflects an investor’s risk/return profile. Otherwise, the

NOTES
movements of the markets could expose the portfolio to greater risk or
reduced return opportunities. For example, a portfolio that starts out with a
70% equity and 30% fixed-income allocation could, through an extended
market rally, shift to an 80/20 allocation that exposes the portfolio to more
risk than the investor can tolerate. Rebalancing almost always results in the
sale of high-priced/low-value securities and the redeployment of the proceeds
into low-priced/high-value or out-of-favor securities. This annual exercise

enables investors to capture gains and expand the opportunity for growth in
high potential sectors while keeping the portfolio aligned with the investor’s
risk/return profile.
1.4 The Investment Process

The steps in the investment process are explained below :
1. Framing the Investment Policy with reference to the objectives, quantum of
investment, attributes of assets and allocating wealth to each category of
Check Your Progress investment
Discuss the steps in the 2. Valuation of Investment

Investment Process.
3. Investment Analysis
4. Analysis of the economy , industry and company where investment is to be
made
5. Quantiative analysis of investment
6. Portfolio Construction and feedback
1.5 Investment versus Financing
The term ‘investing” could be associated with different activities, but the common
point in these activities is to employ the money seeking to enhance the investor’s
wealth. Funds to be invested come from assets already owned, borrowed money and
savings. By foregoing consumption and use of money today and investing their savings,
investors expect to enhance their future consumption possibilities by increasing their Introduction to Security
wealth. Here it would be useful to make a distinction between real and financial Management
investments. Real investments generally involve some kind of tangible asset, such as
NOTES
land, machinery, factories, etc. Financial investments involve contracts in securities
such as stocks, bonds, etc.
Corporate finance typically covers such issues as capital structure, short-term

and long-term financing, project analysis, current asset management. Capital structure
addresses the question of what type of long-term financing is the best for the company
under current and forecasted market conditions; project analysis is concerned with the
determining whether a project should be undertaken. Current assets and current liabilities
management also known as Working Capital Management addresses how to manage
the day-by-day cash flows of the firm. Corporate finance is also concerned with how
to allocate the profit of the firm among shareholders through the dividend payments,
the government through tax payments and the business itself through retained earnings.
These securities are traded in the financial markets and the investors have possibility
to buy or to sell securities issued by the companies. Thus, the investors and companies,
searching for financing, realize their interest in the same place – in financial markets.
At the same time both Finance and Investments are built upon a common set of principles,
such as the present value, the future value, the cost of capital.
There are two types of investors:
Ø Individual investors;
Ø Institutional investors.
Individual investors are individuals who are investing on their own. Sometimes
individual investors are called retail investors. Institutional investors are entities such
as investment companies, commercial banks, insurance companies, pension funds and
other financial institutions. In recent years the process of institutionalization of investors
can be observed. As the main reasons for this can be mentioned the fact, that institutional
investors can achieve economies of scale, demographic pressure on social security,
the changing role of banks. One of the important preconditions for successful investing
both for individual and institutional investors is the favourable investment environment
Our focus in developing this course is on the management of individual investors’
portfolios. But the basic principles of investment management are applicable both for
individual and institutional investors. Portfolio Management: 9
Introduction to Security Common Errors in Investment Management are:
Management • Having High and Unrealistic expectation of returns
NOTES • Linking financial planning to tax planning
• Having uncertain investment goals

Check Your Progress • Improper financial and investment planning
State the differences
• Investing only in adversity
between Investment and
Financing. • No Evaluation of Financial Plans regularly
1.6 Types of Investment
Investments may be classified as financial investments or economic investments.
In Finance investment money is put into something with the expectation of gain that
upon thorough analysis has a high degree of security for the principal amount, as well
as security of return, within an expected period of time. In contrast putting money into
something with an expectation of gain without thorough analysis, without security of

principal, and without security of return is speculation or gambling. Investment is related
to saving or deferring consumption. Investment is involved in many areas of the
economy, such as business management and finance whether for households, firms, or
governments.
Economic investments are undertaken with an expectation of increasing the current
economy’s capital stock that consists of goods and services. Capital stock is used in
the production of other goods and services desired by the society. Investment in this
sense implies the expectation of formation of new and productive capital in the form of
new constructions, plant and machinery, inventories, and so on. Such investments
generate physical assets and also industrial activity. These activities are undertaken by
corporate entities that participate in the capital market.
Financial investments and economic investments are, however, related and
dependent. The money invested in financial investments is ultimately converted into
physical assets. Thus, all investments result in the acquisition of some asset, either
financial or physical. In this sense, markets are also closely related to each other.
Hence, the perfect financial market should reflect the progress pattern of the real
Portfolio Management: 10 market since, in reality, financial markets exist only as a support to the real market.
India’s Average Savings Rates over the Five-Year Plans Introduction to Security
Five-Year Plan Gross Domestic Savings Average annual rate of Management
Rate (per cent) change in the savings NOTES
rate (percentage points)
First Plan (1951-56) 9.2
Second Plan (1956-61) 10.6 0.3
Third Plan (1961-66) 12.1 0.3
Fourth Plan (1969-74) 14.7 0.5
Fifth Plan (1974-79) 18.5 0.8
Sixth Plan (1980-85) 17.9 -0.1
Seventh Plan (1985-90) 20.0 0.4

Check Your Progress
Eighth Plan (1992-1997) 22.9 0.6 Explain the different
Types of Investments.
Ninth Plan (1997-2002) 23.6 0.1
Tenth Plan (2002-2007) 31.3 1.5
Eleventh Plan (2007-2012) 33.7 0.6

Source: Central Statistics Office
1.7 Guideline for Investment Decisions

• Diversification should be the key word
• Adequate insurance cover and Cash Reserve
• Start early and save regularly
• Avail of maximum tax benefits
• Revise and Review your investments periodically
Investment Preferences and Investor Life Cycle
The investor life cycle and the risk return preference comprises of four stages:
1. Early Life Career: At the beginning of career, a person’s net worth is

lower and sometimes there are debts due to loan taken for education or
other purposes. At this stage, there is high risk and low or very low Portfolio Management: 11
Introduction to Security return. Consequently the risk is also high with expectation of high returns
Management in the future.
2. Mid Life Career: This stage is characterized by some growth in the

NOTES
wealth and income of a person and in some cases there is a good base
built for investments and a high risk and high return. However the extent
of risk is moderate due to the objective of capital acquisition holding
priority.
3. Late Life Career: This stage is characterized by capital appreciation

as the main objective with a reasonably existing base of assets and
investments in hand. Savings level are high due to an expansion of
income and reduction of expenses . At this stage, the debt or loans are
repaid making the individual free from the burden of debts.
4. Retirement Career : This stage is predominantly characterized by

unpredictable expenses and high inflation and investment is the main
source of income and sustenance. Risk is reduced considerably even at
the cost of low returns since a stable income source becomes a priority.
It can be said that the risk taking capacity of an individual diminishes
with age and time as a result it would make sense in increasing the debt
proportion in investments and lower the equity component with
advancement of age making this a thumb rule in majority of cases. It
means that with advancement in age, a person should shift his portfolio
towards debt. This strategy is set to change if there are other factors
like more dependent children or affordability .
Sources of Investment Information in India are:
• Business India
• Business Standard
• Business Today
• Business World
• Financial Express
• The Economic Times
• Bombay Stock Exchange Official Directory

Portfolio Management: 12 • Websites of India Info line, Value Notes and others
1.8 Classification of Investors Analysis & Portfolio
Management
There exists the following types of investors :
NOTES
1. The Common Path Follower
2. The Unknown Path Follower
3. The Conservative Hedgers
4. The Calculated Risk Taker

Check Your Progress
5. The Competitor
What are the Guidelines
Characteristics of each types of investors are as follows: for effective investment
decisions ? Explain the
1. The Common Path Follower :
Investors Life Cycle.
• Conservative Approach Mention the sources of
Investment Information in
• Low risk and low return approach preferred
India.
• Less Innovative
2. The Unknown Path Follower :
• Buys and Sells contrary to the common Trend
• Moderate Risk Taker
• Moderate Returns
3. The Conservative Hedger :
• High Return expectation with low risk
• Usually invests in safe mode
• Government Bonds and Government Investments are the preferred mode

of investment
4. The Calculated Risk Taker :
• Regular Investment Done Check Your Progress

• Invests in a hybrid of securities rather than a single investment medium What are the different
types of investors and
• Rebalancing Portfolios frequently their expectations
5. The Competitor : according to their income
group ?
• Invests early and regularly
• Puts maximum money in investment

• Confidence about the future investment scenario Portfolio Management: 13
Introduction to Security Expectation of Investors according to income groups
Management Income Group Return Risk Tax Benefits
NOTES High High Low Nil or Negligible
Medium High Medium or High Maximum
Low High High Maximum
1.9 Summary
• Securities are assets with some financial values. Broadly speaking, Securities
are tradable and carry some financial value. Securities are fungible.
• Securities can be classified into Debt Securities, Equity Securities and

Derivatives
• Security Analysis is broadly classified into three categories: Fundamental

Analysis ,Technical Analysis ,Quantitative Analysis
• Fundamental Analysis refers to the Evaluation of securities with the help of

certain fundamental business factors such as financial statements, current
interest rates as well as competitor’s products and financial market.
• Technical analysis refers to the analysis of securities and helps the finance
professionals to forecast the price trends through past price trends and market
data.
• Quantitative analysis refers to the analysis of securities using quantitative

data.
• Portfolio Management is the art and science of making decisions about

investment mix and policy, matching investments to objectives, asset allocation
for individuals and institutions, and balancing risk against performance.
• It also refers to managing an individual’s investments in the form of bonds,

shares, cash, mutual funds etc so that he/she earns the maximum profits
within the specific time frame
• Portfolio is the combination of assets. It refers to a collection of investment
Security Analysis and tools such as stocks, shares, mutual funds, bonds, and cash and so on depending
Portfolio Management: 14 on the investor’s income, budget, risk appetite and convenient time frame.
• There are differences between Traditional and Modern Security Analysis. Introduction to Security
In traditional form of security analysis greater emphasis is placed on analyzing Management
Risk Return relationship and in modern security analysis the intrinsic value
NOTES
is given more significance.
• The elements of Portfolio Management include Proper Asset Allocation,
Diversification: Rebalancing and Restructuring
• The term ‘investing” could be associated with different activities, but the
common point in these activities is to employ the money seeking to enhance
the investor’s wealth.
• Corporate finance typically covers issues such as capital structure, short-
term and long-term financing, project analysis, current asset management.
• Corporate finance is also concerned with how to allocate the profit of the
firm among shareholders through the dividend payments, the government
through tax payments and the business itself through retained earnings.
• Investments may be classified as financial investments or economic
investments. In Finance investment is putting money into something with the
expectation of gain that upon thorough analysis has a high degree of security
for the principal amount, as well as security of return and Economic
investments are undertaken with an expectation of increasing the current
economy’s capital stock that consists of goods and services.
• Capital stock is used in the production of other goods and services desired
by the society. Investment in this sense implies the expectation of formation

of new and productive capital in the form of new constructions, plant and
machinery, inventories, and so on. Such investments generate physical assets
and also industrial activity.
• There exists the following types of investors :the Common Path Follower,
the Unknown Path Follower, the Conservative Hedgers ,the Calculated Risk
Taker and the Competitor.

Analysis & Portfolio 1.10 Key Terms
Management
1. Security : It means any note, stock, treasury, bond, debenture, certificate of
NOTES
interest or participation in any profit-sharing agreement or in any oil, gas, or
other mineral royalty or lease, any collateral trust certificate, pre-organization
certificate or subscription , transferable share, investment contract, voting-
trust certificate, certificate of deposit, for a security, any put, call, straddle,
option, or privilege on any security, certificate of deposit, or group or index
of securities or in general, any instrument commonly known as a ‘security’.
2. Debt Securities: Tradable assets which have clearly defined terms and
conditions are called debt securities. Financial instruments sold and purchased
between parties with clearly mentioned interest rate, principal amount, maturity
date as well as rate of returns are called debt securities.
3. Equity Securities: Financial instruments signifying the ownership of an
individual in an organization are called equity securities. An individual buying

equities has an ownership in the company’s profits and assets.
4. Derivatives: Derivatives are financial instruments with specific conditions

under which payments need to be made between two parties.
5. Fundamental Analysis: It refers to the Evaluation of securities with the
help of certain fundamental business factors such as financial statements,

current interest rates as well as competitor’s products and financial market.
6. Technical analysis : It refers to the analysis of securities and helps the
finance professionals to forecast the price trends through past price trends
and market data.
7. Quantitative analysis : It refers to the analysis of securities using

quantitative data.
8. Portfolio management : It refers to managing money of an individual under
the expert guidance of portfolio managers. It is done by analyzing the

strengths, weaknesses, opportunities and threats in different investment
alternatives to have a risk return trade off.

9. Active Portfolio Management: In this the portfolio managers are actively Introduction to Security
involved in buying and selling of securities to ensure maximum profits to Management
individuals.
NOTES
10. Passive Portfolio Management: In this , the portfolio manager deals with
a fixed portfolio designed to match the current market scenario. Discretionary
Portfolio management services an individual authorizes a portfolio manager

to take care of his/her financial needs on his/her behalf.
11. Early Life Career: It is that stage of Investors Life Cycle which is the
beginning of career, a person’s net worth is lower and sometimes there are
debts due to loan taken for education or other purposes with high risk and
low or very low return.
12. Mid Life Career: This stage is characterized by some growth in the wealth
and income of a person and in some cases there is a good base built for
investments and a high risk and high return .
13. Late Life Career: This stage is characterized by capital appreciation as
the main objective with a reasonably existing base of assets and investments
in hand. Savings level are high due to an expansion of income and reduction
of expenses
14. Retirement Career: This stage is predominantly characterized by
unpredictable expenses and high inflation and investment is the main source
of income and sustenance. Risk is reduced considerably even at the cost of
low returns since a stable income source becomes a priority. It would make
sense in increasing the debt proportion in investments and lower the equity
component with advancement of age making this a thumb rule in majority of
cases.

Analysis & Portfolio 1.11Questions and Exercises
Management
1.11.1Multiple Choice Questions
NOTES
1. The definition of security from the Securities Exchange Act of 1934 covers
the following:
a. Treasury,
b. Bond,
c. certificate of interest or participation in any profit-sharing agreement
d. All the above
2. Securities can be classified into the following
a. Debt Securities
b. Equity Securities
c. Derivatives
d. All the above
3. Fundamental analysis is done with the help of the following:
a. Technical Data
b. Financial statements
c. Stock market Data and share prices
d. All the above
4. In this form of security analysis greater emphasis is placed on analyzing

Risk Return relationship
a. Traditional
b. Liberal
c. Modern
Check Your Progress
Enlist the important d. None of the above
Financial Ratios for
5. In this form of security analysis the intrinsic value is given more significance.
Company Analysis and
their computation. a. Traditional
b. Liberal
c. Modern
Portfolio Management: 18 d. None of the above
6. Active Portfolio Management entails the following Introduction to Security
a. Above average performance Management
b. Below average performance NOTES
c. Peak Performance
d. Poor Performance
7. Passive Portfolio Management involves following strategies
a. Slow Decisions
b. Quick Decisions
c. Risky Decisions
d. None of the above
8. Corporate finance typically covers such issues
a. Project Analysis
b. Capital Structure
c. Short-term and long-term financing
d. All the above
9. This addresses the question of what type of long-term financing is the best
for the company under current and forecasted market conditions
a. Project Analysis
b. Capital Structure Planning
c. Working Capital Management
d. All the above
10. It is also concerned with how to allocate the profit of the firm among
shareholders through the dividend payments, the government through tax

payments and the business itself through retained earnings.
a. Investment Planning
b. Portfolio Management
c. Project Financing
d. Corporate Finance
Introduction to Security 11. Putting money into something with an expectation of gain without thorough
Management analysis, without security of principal, and without security of return is known
as
NOTES
a. Portfolio Management
b. Security Analysis
c. Speculation or gambling.
d. All the above
12. This stage of Investor Life Cycle is characterized by some growth in the
wealth and income of a person and in some cases there is a good base built
for investments and a high risk and high return
a. Early Life Career
b. Mid Life Career
c. Late Life Career
d. Retirement
13. This stage is characterized by capital appreciation as the main objective

with a reasonably existing base of assets and investments in hand
b. Mid Life Career
c. Late Life Career
d. Retirement
14. This stage is predominantly characterized by unpredictable expenses and
high inflation and investment is the main source of income and sustenance.
b. Mid Life Career
c. Late Life Career
d. Retirement

15. This type of investor does Regular Investment , invests in a hybrid of securities Introduction to Security
rather than a single investment medium and does Rebalancing Portfolios Management
frequently
NOTES
a. The Calculated Risk Taker
b. The Competitor
c. The Common Path Follower
d. The Uncommon Path Follower

1. Explain the concept of “Security Analysis” and the classification of securities
2. Explain the concept, need and Types of “Portfolio Management”
3. Discuss the steps in the Investment Process.
4. State the differences between Investment and Financing.
5. Explain the concept different Types of Investments
6. What are the Guidelines for effective investment decisions.
7. Explain the Investors Life Cycle.
8. Mention the sources of Investment Information in India.
9. What are the different types of investors and their expectations according to
their income group?
1.11.3 Assignments
1. Establish asset/sector allocation and start to construct and trade your
portfolios.
2. Construct a trial portfolio based on your individual and Group (if any)
investment based on the guidelines and strategies and rebalance it monthly.
3. Identify absolute risk and relative risk of your portfolio versus benchmark.
4. Measure return of your portfolio and its benchmark monthly.
5. Devise a performance attribution methodology for your portfolio and

benchmark and apply it on monthly basis. Security Analysis and
Introduction to Security 6. Prepare monthly summary report including discussions on the following:
Management a) Market outlook updates,
NOTES b) Portfolio actions,
c) Portfolio absolute and relative risks to its benchmark,
d) Weekly and cumulative performance of portfolio and benchmark and

their attribution.
7. Reconcile Monthly reports to be turned in with the final project report.
1.12 Further Reading and References
“Investment Management”, Dr. Preeti Singh, Himalaya Publishing House, 2008

Financial Markets &
Unit 2 Financial Markets & Institutions Institution
Structure NOTES
2.0 Introduction
2.1 Unit Objectives
2.2 Indian Financial System
2.3 Financial Markets
2.3.1 Capital Markets
2.3.1.1 Primary Market
2.3.1.2 Secondary Markets
2.3.2 Money Markets
2.4 Financial Institutions
2.4.1 Banks
2.4.2 Regulatory Institutions
2.4.3 Non-Banking Finance Companies (NBFC)
2.4.4 Mutual Funds
2.4.5 Others
2.5 Financial Services
2.5.1 Hire Purchase:
2.5.2 Lease Financing:
2.5.3 Installment Sale
2.5.4 Merchant Banking
2.5.5 Factoring
2.6 Regulation of Financial Markets
2.7 Summary
2.8 Key Terms

Security analysis &
Portfolio management 23
Financial Markets &
Institutions 2.0 Introduction
The financial system of a country is an important tool of economic development

NOTES
which is done through wealth creation by facilitating investments. It serves as a link
between savings and investment and enables lenders and borrowers to exchange funds.
2.1 Unit Objectives
After studying this Unit, you will be able to :

Ø Understand the Indian Financial System and its structure
Ø Understand the Financial Markets and its components
Ø Understand the different financial services in India and understand its
features.
The financial system of a country plays a significant role in the growth and
development of an economy and both are interdependent on each other. The constituents
of the financial system act as a catalyst for its growth The structure of the Indian
Financial System is explained in the table below:
INDIAN FINANCIAL SYSTEM
Financial Markets Capital Market

Money Market
Financial Institutions Banks
Regulatory Institutions
NBFCs
Mutual Funds
Others
Financial Instruments Long Term
Medium Term
Short Term
Check Your Progress Financial Services Hire Purchase
Explain the structure of the Lease Financing
Indian Financial System. Instalment Sale
Merchant Banking
Security analysis &
Portfolio management 24 Factoring
Financial Markets &
2.3 Financial Markets Institution
Financial Markets are the life blood of an economy as they are the mobilisers of
NOTES
financial resources which help in growth and development. Financial market is
a market in which people trade financial securities, commodities and other items of
value at prices that reflect supply and demand. Securities include stocks and bonds,
and commodities include precious metals or agricultural products.
Financial markets are composed of the following :
2.3.1 Capital Markets

It is a financial market for long term loanable funds as opposed to the money
market which deals with short term funds. Capital markets ideally provide funds for a
period exceeding one year. The corporates directly raise funds from the investors in
Capital Markets. It functions under the regulatory supervision of SEBI. (Securities

and Exchange Board of India). Capital markets can be either primary markets or
secondary markets.
2.3.1.1 Primary Market

Primary market is a segment of capital markets where new issues are made and
hence it is also known as new Issue Market. It is a dynamic market which is a Financial
Reservoir. This market is mostly useful to newly established businesses. In Primary
markets, new securities are issued in the form of :

l Public Issue, Rights Issue
l Private Placement
l Book Building
l Buy – Out Deals.
The functions of the Primary Market can be categorized into :
a. Investigation
b. Underwriting
c. Distribution
Security analysis &

Financial Markets & The Investigation function entails a research on the financial resources available
Institutions
at a low rate of cost in the form of interest which comprises technical, economic,
financial and legal aspects in the study so as to have the best quality of capital issues.
NOTES
The Underwriting function consists of a guarantee about the public issue which
is done through an agreement with the underwriters in return for a commission.
Distribution is an important function which consists of the wide distribution of
share applications to an unlimited geographic area which is usually done by brokers.

Brokers are specialists in dealing with securities who can influence the buying decisions
of the investors.
2.3.1.1 Secondary Market

In the secondary markets, existing securities are sold and bought among the
investors mainly through the Stock Exchange. Another division of capital markets can
be based on the classification into stock markets where shares are traded and Bond
Markets where investors become creditors by dealing with Bonds. Stock market or
stock exchange is an organized place for trading in securities. However, it is to be
noted that primary markets and secondary markets are inter-dependent as the growth
of one is dependent on the other. A strong secondary market creates a high demand
for the primary market.
Stock Exchanges
There are 21 Stock Exchanges in India. Most of the trading in the Indian stock
market takes place on its two stock exchanges: the Bombay Stock Exchange (BSE)
and the National Stock Exchange (NSE). The BSE is the oldest stock exchange in
Asia and has been in existence since 1875. The NSE, on the other hand, was founded
in 1992 and started trading in 1994. However, both exchanges follow the same trading
mechanism, trading hours, settlement process, etc. The two prominent Indian market
indexes are Sensex and Nifty. Sensex is the oldest market index for equities and the
other is the S & P CNX Nifty. The overall responsibility of development, regulation
and supervision of the stock market rests with the Securities & Exchange Board of
India (SEBI), which was formed in 1992 as an independent authority. Since then, SEBI
has consistently tried to lay down market rules in line with the best market practices.
Security analysis &

Year (No. of Listed Companies in BSE) Financial Markets &
Institution
2010-2011 5067
2011-2012 5133 NOTES
2012-2013 5211
2013-2014 5336
2014-2015 5624
2015-2016 5911
2016-2017 5834
Source : BSE Website
2.3.2 Money Market

It is a financial market in India for funds ranging from overnight to one year.
Financial Instruments which are close substitutes for money are traded in money mar-
ket. The Indian money market is a platform for dealings in various money market
instruments such as Treasury Bills, call money, Commercial Paper, Certificate of De-
posits and many other instruments which will be dealt with later in detail. It is a focal
point of Central Bank’s intervention as it is mostly regulated by the (RBI) Reserve
Bank of India and SEBI. Banks deal in this market to fulfill their CRR (Cash Reserve
Ratio) and SLR (Statutory Liquidity Ration)requirements as per RBI norms. The money
market in India is composed of Organized Sector comprised of the Central Bank i.e.
Reserve Bank of India, Development Banks, and NBFCs etc. In India, the money
market is still undeveloped and is characterized by a small number of large players.
Participants in the Financial Market

The major participants in a financial market are the buyers and sellers of
investments and securities. There are the financial intermediaries who are also
participants of the financial markets. These intermediaries are those who intervene
between the buyer and seller for matching the duration and timings of settlement.
Check Your Progress
Financial intermediaries are again of two types: Banking Financial Intermediaries and
Explain the components
Non-Banking Financial Intermediaries mainly consisting of Investment companies, trusts, of the financial markets in
Housing finance and Insurance agents and companies. However, nowadays due to the India.
concept of Universal Banking, this line of distinction between banking and non-banking
Security analysis &
Financial Markets & financial companies is disappearing. Further we have other participants in the financial
Institutions
markets such as brokers, lead managers, share transfer agents, registrars and merchant
bankers.
NOTES
2.4 Financial Institutions
A Financial Institution conducts transactions such as loans, deposits and invest-
ments. These act as an intermediary between the Capital market and debt market.
Financial Institutions are categorized into Banks, Regulatory Institutions, NBFCs, Mutual
Funds and other Institutions. These are elaborated as under:
2.4.1 Bank
The operations of all the banks in India are controlled by the Reserve Bank of
India which was established in April 1935, but was nationalized on 1 January 1949.
The Reserve Bank of India is the official Central Banking Authority for the smooth
supervision of the banking industry in India. State Bank of India (SBI) is the largest
and the oldest bank. Banks in India are classified into two broad categories namely,
Public sector banks and Private sector banks. A detailed list of the types of Banks is
explained in the table below:
Central Scheduled Banks Non Specialized
Bank Scheduled
Commercial Cooperative Banks Banks
Public Private Foreign Regional 1.Central
Sector Sector Banks Rural Co-operative
Banks Banks
1.State 2.State 1.Development
Bank of Co-operative
India & Banks Banks
Associates
2.Other 2.Investment
Nationalized Banks
Banks
Security analysis &
3.Other 3.Industrial Financial Markets &
Institution
Public Banks
Sector
NOTES
Banks
4.Land
Mortgage
Banks
5. Exchange
Banks
6.EXIM
(Export
Import)
Banks
7.Retail
Banks
2.4.2 Regulatory Institution

There are various financial regulators in India governing different aspects of
the Financial System:
a. Securities and Exchange Board of India (SEBI)
It is the securities market regulator established in 1992 and is formed with
the aim of protecting the interest of investors in securities and to promote

the development of and to regulate the securities market. It caters to the
needs of issuers, investors and market intermediaries.
b. Reserve Bank of India (RBI)
It is the Central Apex Bank in India which controls the monetary policy of
the rupee Its aim is to undertake supervision of the financial sector mainly
commercial banks, financial institutions and NBFCs.
c. Ministry of Finance
It is an important ministry of the Government of India concerned with financial
aspects such as financial legislation, financial institutions, Government

Finances and the Union Budget.
Security analysis &
Financial Markets & d. Ministry of Corporate Affairs
Institutions
This ministry of the Government of India is concerned with the administration
and functioning of the Corporate Law namely the Companies Act 2013
NOTES
(previously the Companies Act, 1956); The Limited Liability Partnership
Act, 2008; The Competition Act 2002; The Partnership Act 1932 and other
allied laws.
e. Insurance Regulatory and Development Authority of India (IRDA)
It is an autonomous agency entrusted with the task of regulating and promoting

the insurance industry in India and it performs a wide array of functions
ranging from protecting the policyholders interest, laying down the code of
conduct for intermediaries and agents and regulating different matters

connected there with.
2.4.3 Non-Banking Finance Companies (NBFC)

Non-Banking Finance Company (NBFC) is a business entity which includes a
loan company or an investment company or a Hire Purchase Finance Company or an

Equipment Leasing Company. These are regulated by the RBI. It is defined as a
company registered under the Companies Act 2013 of India, engaged in the business
of loans and advances, acquisition of shares, stock, bonds, hire purchase, insurance
business or chit business but does not include any institution whose principal business
includes agriculture, industrial activity or the sale, purchase or construction of immoveable
property.
2.4.4 Mutual Funds

A mutual fund is a professionally managed investment fund that pools money
from many investors to purchase securities. It allows its investors to go for a diversified
selection of securities. Mutual funds are generally classified by their principal
investments. The four main categories of funds are:- money market funds, bond or
fixed income funds, stock or equity funds, and hybrid funds. Funds may also be
categorized as index (or passively managed) or actively managed. These will be
discussed in detail in the later part of this book.
Security analysis &

2.4.5 Others Financial Markets &
Institution
Development Financial Institutions:
These were formed with a view to carry out the task of funding and assisting NOTES
developmental activities such infrastructure development, rural area development, risk
capital etc. These institutions mobilize funds by issuing securities in the primary market
and by loans. They do not accept deposits from the public. IDBI, IFCI, ICICI (now Check Your Progress
merged with ICICI Bank), NHB are some the Development Financial Institutions in Explain the different
India. categories of Financial

Institutions in India.
2.5 Financial Services

Financial services are one of the important components of a financial system.
These are provided by Banks and Financial Institutions in the form of economic services
encompassing a wide range of services. They are provided through various credit
instruments and financial products and enable the user to obtain any asset on credit
according to his convenience and at reasonable rates of interest. The significance of
financial services are highlighted through different points like promotion of savings
and investments, minimizing risks, maximizing returns, economic growth and
development, promoting domestic and foreign trade and ensuring a balanced regional
development. The different types of financial services available in the Indian Financial
Market are discussed hereunder:
2.5.1 Hire Purchase

A system by which a buyer pays for a product by regular instalments while
enjoying the use of it. During the repayment period, ownership (title) of the item does
not pass to the buyer. Upon the full payment of the loan, the title passes to the buyer.
Hire purchase is a method of financing of the fixed asset to be purchased on future
date. Under this method of financing, the purchase price is paid in installments.
Ownership of the asset is transferred after the payment of the last installment.
Features of Hire Purchase:
i. The hire purchaser becomes the owner of the asset after paying the last
installment.
ii. Every installment is treated as hire charge for using the asset. Security analysis &
Financial Markets & iii. Hire purchaser can use the asset right after making the agreement with the
Institutions
hire vendor.
iv. The hire vendor has the right to repossess the asset in case of difficulties in
NOTES
obtaining the payment of installment.
2.5.2 Lease Financing:

Lease financing is a source of medium- and long-term financing where the owner
of an asset gives another person, the right to use that asset against periodical payments.
The owner of the asset is known as lessor and the user is called lessee. The periodical
payment made by the lessee to the lessor is known as lease rental. Under lease financing,
lessee is given the right to use the asset but the ownership lies with the lessor and at
the end of the lease contract, the asset is returned to the lessor or an option is given to
the lessee either to purchase the asset or to renew the lease agreement.
Different Types of Lease:

Depending upon the transfer of risk and rewards to the lessee, the period of
lease and the number of parties to the transaction, lease financing can be classified
into two categories: Finance lease and operating lease.
Finance Lease:
It is the lease where the lessor transfers substantially all the risks and rewards of
ownership of assets to the lessee for lease rentals. In other words, it puts the lessee in
the same con-dition as he/she would have been if he/she had purchased the asset.
Finance lease has two phases: The first one is called primary period. This is non-
cancellable period and in this period, the lessor recovers his total investment through
lease rental. The primary period may last for indefinite period of time. The lease rental
for the secondary period is much smaller than that of primary period.
Operating Lease:
Lease other than finance lease is called operating lease. Here risks and rewards
incidental to the ownership of asset are not transferred by the lessor to the lessee. The
term of such lease is much less than the economic life of the asset and thus the total
investment of the lessor is not recovered through lease rental during the primary period
of lease. In case of operating lease, the lessor usually provides advice to the lessee for
Security analysis &
repair, maintenance and technical knowhow of the leased asset and that is why this Financial Markets &
Institution
type of lease is also known as service lease.
2.5.3 Installment Sale NOTES

An installment sale is a type of financial transaction in which a buyer makes
regular payments to the seller in order to repay the debt that is owed. This can be used
on many different types of property but it is most commonly used in the real estate
market. With an installment sale, the buyer agrees to make regular payments to the
seller for a certain amount of time. The total price of the purchase will be divided over
the number of years of the term. In addition to that, interest will be added onto the
installment sale payments. Even though it might seem advantageous to get a lump sum
of money when you are selling a piece of property, using the installment sale method
can provide you with some benefits as a seller. With this type of arrangement, the
seller can also benefit from this transaction. One of the biggest benefits is that they do
not have to come up with all of the cash at once.
2.5.4 Merchant Banking

A merchant bank is an institution or an organization which provides a number of
services including management of securities issues, portfolio services, underwriting of
capital issues, insurance, credit syndication, financial advices, project counseling etc.
There is a distinction between a commercial bank and a merchant bank. The merchant
banks mainly offer financial services for a fee while commercial banks accept deposits
and grant loans. The merchant banks do not act as repositories for savings of the
individuals. The basic function of a merchant banker is marketing corporate and other
securities. Now they are required to take up some allied functions also which are
elaborated hereunder:
Ø Promotional Activities
Ø Issue Management
Ø Credit Syndication
Ø Portfolio Management
Ø Leasing and Finance
Ø Servicing of Issues
Security analysis &

Financial Markets & 2.5.5 Factoring
Institutions
Factoring is defined as an outright purchase of credit approved accounts
receivables, with the factor assuming bad debt losses. The modern factoring involves
NOTES
a continuing arrangement under which a financing institution assumes the credit control/
protection and collection functions for its client, purchases his receivables as they arise
(with or without recourse to him for credit losses, i.e., customer’s financial inability to
pay), maintains the sales ledger, attends to other book-keeping duties relates to such
accounts receivables and performs other auxiliary functions. Factoring is an asset
based method of financing as well as specialized service being the purchase of book
debts of a company by the factor, thus realizing the capital tied up in accounts receivables
and providing financial accommodation to the company. The book debts are assigned
to the factor who collects them when due for which he charges an amount as discount
or rebate deducted from the bills. Thus, the factor is an intermediary between the
supplier and customers who performs financing and debt collection services.Factoring
can be both domestic and for exports. In domestic factoring, the client sells goods and
services to the customer and delivers the invoices, order documents, etc. to the factor
and inform the customer of the same.In return, the factor makes a cash advance and
a statement to the client. The factor then sends a copy of all the statements of accounts,
remittances, receipts, etc. to the customer, on receiving them, the customer sends the
payment to the factor.In case of export factoring two ‘factors’ are involved. The
factor in the customer’s country is called “Import Factor” while the one in the client’s
country is called the “Export Factor”. All the transactions remain similar in the case of
international factoring, the only difference being that the export factor has to send the
shipping documents to the import factor and the import factor has to pass on the
ultimate collection to the export factor.
Types of Factoring :
(i) In Recourse factoring the credit risk remains with the client though the debt
is assigned to the factor, i.e., the factor can have recourse to the client in the
event of non-payment by the customer.
(ii) The Non-Recourse Factoring also called as ‘Old-line factoring’. It is an
arrangement whereby the factor has no recourse to the client when the bill
remains unpaid by the customer. Thus, the risk of bad debt is absorbed by
Security analysis &
Portfolio management 34 the factor.
(iii) Where the payment is made by the factor immediately is called Advance Financial Markets &
Institution
Factoring. Under this type of factoring, the factor provides financial
accommodation apart from non-financial services rendered by him.

NOTES
(iv) In confidential and undisclosed factoring the arrangement between the factor
and the client are left un-notified to the customers and the client collects the
bills from the customers without intimating them to the factoring arrangements.
(v) In maturity factoring method, the factor may agree to pay an amount to the
client for the bills purchased by him either immediately or on maturity. The
latter refers to a date agreed upon on which the factor pays the client.
(vi) Supplier Guarantee Factoring is also known as ‘drop shipment factoring’.

This happens when the client is a mediator between supplier and customer.
When the client is a distributor, the factor guarantees the supplier against
the invoices raised by the supplier upon the client and the goods may be
delivered to the customer. The client thereafter raises bills on the customer
and assigns them to the factor. The factor thus enables the client to make a Check Your Progress
Discuss the various
gross profit with no financial involvement at all.
financial Services available
(vii) In bank participation factoring the bank takes a floating charge on the client’s in the Indian Financial
system.
equity i.e., the amount payable by the factor to the client in respect of his
receivables. On this basis, the bank lends to the client and enables him / her
to have double financing.
2.6 Regulation of Financial Markets

The securities market in India comprising mainly of primary markets and secondary
markets i.e. the stock exchange was highly unregulated in the 1850’s when they
originated. In 1947, the Capital Issues (Control) Act, 1947 was passed for administering
control over the securities issue and it was administered by the Office of the Controller
of Capital Issues. Later on, in 1956, the Securities Contract (Regulation) Act was
passed which brought the stock exchanges under the administration and control of
the Ministry of Finance. The companies in India were regulated by the Companies
Act 1956 (now 2013) which was administered by the Department of Company Affairs
(DCA). Thereafter, in 1990’s, in the post liberalization scenario, with the entry of
Security analysis &
foreign multinationals, there was a need felt for a single regulatory body to supervise Portfolio management 35
Financial Markets & and regulate the securities market. This resulted in the setting up of Securities and
Institutions
Exchange Board of India (SEBI) which was later on given statutory powers apart
from its regulatory powers. The major responsibility of SEBI was to:
NOTES
a. Protect the interests of investors in securities
b. Promote the development of the securities market
c. Regulate the Securities Market.
Table showing number of Intermediaries registered with SEBI as on 9th June

2017.
Type of Intermediary Number
1. Banker to an Issue 64
2. Debenture Trustee 30
3. Depository Participants 18
4. Merchant Bankers 187
5. Registrars to an issue and Share Transfer Agent 69
6. Underwriters 2
7. Venture Capital Funds 92
8. Mutual Funds 45
9. Portfolio Managers 244
Source : SEBI Website.
2.7 Summary
• The financial system plays a significant role in the growth and Development
of an economy
• Financial market is a market in which people trade financial securities,

commodities and other items of value at prices that reflect supply and
demand.
• Capital Market is a financial market for long term loanable funds as opposed
to the money market which deals with short term funds.
Security analysis & • Primary market is a segment of capital markets where ne issues are made
• In the secondary markets, existing securities are sold and bought among the Financial Markets &
Institution
investors mainly through the Stock Exchange.
• Money market is a financial market in India for funds ranging from overnight
NOTES
to one year.
• A Financial Institution conducts transactions such as loans, deposits and

investments. These act as an intermediary between the Capital market and
debt market.
• The Reserve Bank of India is the official Central Banking Authority for the
smooth supervision of the banking industry in India.
• Non-Banking Finance Company (NBFC) is a business entity which includes

a loan company or an investment company or a Hire Purchase Finance
Company or an Equipment Leasing Company.
• A mutual fund is a professionally managed investment fund that pools money

from many investors to purchase securities.
• Under lease financing, lessee is given the right to use the asset but the
ownership lies with the lessor and at the end of the lease contract, the asset
is returned to the lessor .
• An installment sale is a type of financial transaction in which a buyer makes

regular payments to the seller in order to repay the debt that is owed.
• A merchant bank is an institution or an organization which provides a number

of services including management of securities issues, portfolio services,
underwriting of capital issues, insurance, credit syndication, financial advices,
project counseling etc.
• Factoring is defined as an outright purchase of credit approved accounts

receivables, with the factor assuming bad debt losses.
2.8 Key Terms
• Financial market : It is a market in which people trade financial securities,

commodities and other items of value at prices that reflect supply and demand.
• Capital Market : It is a financial market for long term loanable funds as

opposed to the money market which deals with short term funds.
• Money Markets: It is a financial market in India for funds ranging from

overnight to one year. Financial Instruments which are close substitutes for Security analysis &
money are traded in money market. Portfolio management 37
Financial Markets &
• Non-Banking Finance Company (NBFC) : It is a business entity which
Institutions
includes a loan company or an investment company or a Hire Purchase
Finance Company or an Equipment Leasing Company.
NOTES
• Mutual fund : It is a professionally managed investment fund that pools
money from many investors to purchase securities.
• Development Financial Institutions : These institutions mobilize funds

by issuing securities in the primary market and by loans. They do not accept
deposits from the public.
• Hire Purchase : It is a system by which a buyer pays for a thing in regular

installments while enjoying the use of it. During the repayment period,
ownership (title) of the item does not pass to the buyer.
• Lease financing : It is a method of financing wherein lessee is given the

right to use the asset but the ownership lies with the lessor and at the end of
the lease contract, the asset is returned to the lessor or an option is given to
the lessee either to purchase the asset or to renew the lease agreement.
• Merchant bank : It is an institution or an organization which provides a

number of services including management of securities issues, portfolio
services, underwriting of capital issues, insurance, credit syndication, financial
advices, project counseling etc.
• Factoring : It is defined as an outright purchase of credit approved accounts

receivables, with the factor assuming bad debt losses.

1. The market in which people trade financial securities, commodities and other
items of value at prices
a. Capital
b. Money
c. Financial
Security analysis &
Portfolio management 38 d. Stock
2. The markets ideally provide funds for a period exceeding one year. Financial Markets &
Institution
a. Capital
b. Money NOTES
c. Financial
d. Stock
3. This market is a segment of capital markets where new issues are made
and hence it is also known as new Issue Market.
a. Financial
b. Capital
c. Primary
d. Secondary
4. An organized place for trading in securities.
a. Primary Market
b. Capital Market
c. Stock Exchange
d. Money Market
5. This is the oldest market index for equities
a. S & P Nifty Index
b. BSE Sensex
c. Dow Jones Index
d. None of the Above
6. It is a platform for dealings in instruments such as Treasury Bills, call money,
Commercial Paper and Certificate of Deposits
a. Money Market
b. Capital Market
c. Primary Market
d. Banks
Security analysis &

Financial Markets & 7. It is the securities market regulator formed with the aim of protecting the
Institutions
interest of investors in securities and to promote the development of and to
regulate the securities market.
NOTES
a. Reserve Bank of India
b. SEBI
c. Ministry of Corporate Affairs
d. IRDA
8. In this system, the ownership of the asset is transferred after the payment of
the last installment.
a. Factoring
b. Installment Sale
c. Hire Purchase
d. Leasing
9. This is an asset based method of financing as well as specialized service by

the purchase of book debts of a company realizing the capital tied up in
accounts receivables and providing financial accommodation to the company.
a. Factoring
b. Installment
c. Hire Purchase
d. Leasing
10. The major responsibility of SEBI was
a. To protect the interests of investors in securities
b. To promote the development of the securities market
c. To regulate the Securities Market.
d. All the above
1. Explain the structure of the Indian Financial System
2. Explain the components of the financial markets in India.

Security analysis &
Portfolio management 40 3. What are the different types of Capital markets in India?
4. What are the different types of banks in India? Financial Markets &
Institution
5. Write a note on:
a. Capital market NOTES
b. Money market
c. New Issue market
d. Stock Exchanges
e. Development Financial Institutions
f. SEBI
h. Ministry of Corporate Affairs
i. Hire Purchase
i. Leasing
j. Factoring
6. Explain the different categories of Financial Institutions in India.
7. Discuss the various financial Services available in the Indian Financial system

“Security Analysis and Portfolio Management”, M. Ranganatham and R.
Madhumati, Pearsons, New Delhi, 2012.
Security analysis &

Investment Avenues in India
Unit 3 Investment Avenues in India
NOTES Structure
3.0 Introduction
3.1 Unit Objectives
3.2 Investment: Meaning and Objectives
3.3 Investment versus Speculation and Gambling
3.4 Factors affecting investment decisions
3.5 Investment Attributes
3.6 Equity
3.7 Bonds and Debt
3.8 Deposits
3.9 Government Schemes
3.10 Post office savings schemes
3.11 Mutual Funds
3.12 Insurance Schemes
3.13 Real Estate
3.14 Venture Capital
3.15 Commodities
3.16 Public Provident Fund (PPF)
3.17 Summary
3.18 Key Terms

Security Analysis &
3.0 Introduction
Investments are done with the aim of earning returns over a period of time
NOTES
which can be in the form of either capital appreciation or regular income. Risk and
return go hand in hand and there are investments which are risky and some are not.
There are multiple investment avenues available in India and each avenue has its pros
and cons which needs to be evaluated by an investor in terms of his/her requirements
in terms of liquidity, safety, return and other factors.
3.1 Unit Objectives
Ø Understand the meaning of investment and its objectives
Ø Know the differences between investment, gambling and speculation

Ø Study the factors affecting investment decisions
Ø Analyze the Investment Attributes affecting the investment decision
Ø Understand the different investment avenues in India
3.2 Investment: Meaning and Objectives
To invest refers to the act of an individual to deploy money in securities or assets

issued by financial institutions with a view to obtain returns over a period of time. This
return can be in the form of increase in the value of the concerned security or asset
called capital gain and/or it can include a regular income generated from the security
or asset. In a nutshell, to invest means to apply money to earn more money. Investments
can also mean the utilization of resources in order to increase income or production in
the future. It includes any physical or tangible asset such as building, machinery,
equipment or financial assets such as stocks, bonds, bullion and precious stones.
Investment is the act of buying a financial product or items of value with anticipated
positive returns in the future. Investments are of different types such as financial
investments or economic investments , though these two terms have different meanings,
they are related and interdependent. Financial investments are usually converted into
physical assets and these investments reflect the pattern of the real market and the Security Analysis &
economy and these financial markets act as a support to the real market and economy. Portfolio Management: 43
Investment Avenues in India The objectives of investments depend upon the characteristics of investments
which include safety, income and growth. i.e. safety of capital, current income, or
capital appreciation . These objectives depend on a person’s age, stage/position in life,

NOTES
and personal circumstances. Investment in India can be broadly classified into two
categories- Risky asset class and Risk – free asset class.
Investments can also be classified as below:

Check Your Progress
Explain the meaning and Ø Financial Investment
objectives of Investments.
Ø Fixed Income Investment
Ø Variable Income Investment
Ø Real Investment
3.3 Investment Versus Speculation And Gambling
Investment is done with a motive of gain done with analysis of security, return
and other factors; where as speculation or gambling is done by putting money with
expectation of gain without detailed analysis regarding the security and return. Investing
is different from gambling. Gambling is putting money at risk by betting on an uncertain
outcome with the hope of winning money. It is defined as an act of betting on an
uncertain outcome. An investor does not put his money at any random investment; but
Check Your Progress only after doing a thorough analysis and commits capital only when there is a reasonable
What is the difference
between Investment, expectation of profit. Like gambling, there is risk, and there are no guarantees, but
Speculation and investing is more than considering the luck factor.
Gambling?
3.4 Factor affecting Investment Decisions
The investment decision is based on an analysis of certain key factors which

differs from individual to individual:
Ø Risk Profile: The investment decision is based on the risk profile of the
investor say for eg. A low risk investor should not invest into equities. He/
she should look for the safe investment option.
Ø Liquidity: Liquidity is also an important criterion for selection of Investment

Security Analysis &
Portfolio Management: 44 Avenue. E.g. an investor should not invest into PPF, if the need of money is
arising in 3- 4 years’ time frame because PPF has minimum lock in of 5 Investment Avenues in India
Years.
Ø Time Frame: Investment in any of the asset class should be done with NOTES
specific time horizons. E.g. for short term investment debt mutual fund or
Fix deposit could be a good option, whereas for long term horizon, real estate
and regular investment into equities could be a good option. Check Your Progress
What are the factors
Ø Taxation: Taxation kills the real returns of investment, investor should always affecting the Investment
look at the tax treatment of any investment before investing into it. E.g. an Decisions?
investment into fixed deposit at 9% by an investor who fall under 30% tax
bracket will yield 6.22% which is equivalent to current inflation rate.

Eventually investor is not earning any returns post inflation.
3.5 Investment Attributes
The below chart showing investment attributes enable an investor to evaluate the
various investment avenues which are discussed as under :
Security Analysis &

Investment Avenues in India 1. Risk and Return:The rate of return on different investments would vary
widely and it is the sum total of the annual income accruing and the price
changes during the year. Risk refers to the variability of the rate of return.
NOTES
It arises due to the deviation to the actual value of investment as compared
to the expected outcome. Risk factor arises due to the uncertainty element
of the futurity which cannot be avoided.
2. Liquidity: To ensure liquidity, it is desirable that the investment is marketable.
An investment can be said to be marketable when it can be transacted and

the price changes between transactions are negligible. Also other factors
are to be considered such as facility to make withdrawal without penalty
and taking a loan against the accumulated amount at lower interest rates.
3. Tax benefits: Taxes benefits are of different types such as initial tax benefits,
continuing tax benefits and terminal tax benefits. The investment should
have tax shelter or advantage and some investments are attractive even if it
gives low return since they have tax advantage.
4. Convenience: It is an important attribute in investment decision making.

It refers to the ease with the day to day management of the investment and
also the procedural ease. For eg. It is easier to invest in NSC as compared
to equity shares and it is easier to invest in equity shares than in real estate
because of factors like documentation and legal work.
Investors avail of the potential investment opportunities by the means of effective

investment strategies such as:
Ø Leveraging on the capability to analyse market trends and make appropriate

investments
Ø Investing in innovative products which lead to value enhancement

Check Your Progress
Ø Diversifying across various assets from the pool of assets
Explain the components of
the financial markets in Ø Investing across emerging geographies
India.
Ø Consolidating financial information
Security Analysis & As a general rule, the shorter your time horizon, the more conservative you should
Portfolio Management: 46 be. If your investment is for a long-term objective like retirement planning and you are
still in your 20s, then you still have time to make up for losses and can therefore invest Investment Avenues in India
in aggressive investment vehicles like stocks. At the same time, if you start when you
are young, you have the power of compounding on your side.

NOTES
On the other hand, if you are about to retire, then the opportunity to recover
losses on your investments is limited and therefore it is critical to invest your assets
conservatively.
The core factors that define your risk tolerance are:
Ø Investment Objectives
Check Your Progress
Evaluate the different
Ø Timeframe
Investment Attributes used
Ø Your personality by investors before taking
an investment decision.
3.6 Equity
Equities are a type of security that represents the ownership in a company.
Investments in equity is generally done for the long term ( more than 5 years) to earn
decent returns. Risk of investing in equities is high and so the returns are also high.
Investing in Indian equities can be done by participating in primary markets (applying
for IPO’s) and also by purchasing securities from secondary markets (stock exchanges).
Direct Equities is a type of securities where the investor buys the ownership of company.
This entitles you to vote at the shareholder’s meeting and allows you to receive any
profits that the company allocates to its owners–these profits are referred to as
dividends. While bonds provide a steady stream of income, stocks are volatile. That is,
they fluctuate in value on a daily basis. When you buy a stock, you aren’t guaranteed
anything. Many stocks don’t even pay dividends, making you any money only by
increasing in value and going up in price–which might not happen. As compared to

bonds, stocks provide relatively high potential returns. Of course, there is a price for
this potential: you must assume the risk of losing some or all of your investments.
Equities are tradable (bought & sold) in the Stock Exchanges. Equities can be a good
investment option for a long term horizons as it beats all the asset class in terms of
returns over longer time frame. This can be considered as one of the riskiest asset
class as well. Equities are highly risky. The risk of loss of capital is very high. Investing Security Analysis &
Investment Avenues in India in direct equity is termed risky and one needs to diversify the risk by investing in
multiple securities from various sectors. We have different types of equity shares
which are known in investors terminology such as growth stocks, Blue chips, value
NOTES
Stocks, Cyclical stocks, turnaround stocks etc.
Investors can invest in the stock market broadly in three ways.
1. Directly by buying and selling shares on the stock exchanges BSE/NSE
2. Investing through the Mutual Fund route where different options available
Check Your Progress are equity diversified, balanced, tax saving ELSS funds, thematic, exchange
Discuss Equity and Stock traded or index funds
as an Investment Avenue.
3. Investing in ULIPs (unit linked insurance plans) via their equity funds.
3.7 Bonds and Debt
Ø Bonds
The term ‘bond’ is commonly used to refer to any instrument founded on debt.
Bond is a form of lending money to government or company. In exchange, government
or company pays fix amount of interest on principal. Corporate bonds offer higher
returns compare to government bonds, because of the risk factor. Before investing
into bonds, investor should always look for the rating and the interest rate offered by
the bond. The main attraction of bonds is their relative safety. Bonds are fixed income
instruments which are issued for the purpose of raising capital. Both private entities,
such as companies, financial institutions, and the central or state government and other
government institutions use this instrument as a means of raising funds. Bonds issued
by the Government carry the lowest level of risk but could deliver fair returns.
Ø Debt
Check Your Progress Debt investment can be done for the short term as well as the long term . Risk
Discuss the
here is very low and so return is low as well. Investing in debt can be done by the
characteristics of Bonds
and Debt as an following ways.
Investment Avenue.
1. Fixed Deposits, NSC, PPF, NPS, Bonds, , Senior Citizen Saving Schemes
2. Debt mutual funds (balanced, floating rate, gilt, liquid etc ) also offer another
way to do so.
Security Analysis &
Portfolio Management: 48 3. Traditional insurance policies (money back, whole life, endowment)
3.8 Deposits
Deposits are considered as one of the traditional ways of Investing. Fixed Deposits
NOTES
(FD) offer a fixed return at the end of the specified period. A fixed deposit allows
investors to deposit money into bank/corporate for a specific period of time, which in
return earns an interest. Rate of returns in fixed deposits are higher than bank saving
account. An investment into 5 year fixed deposit is eligible for tax benefit under section
80 C. maximum of Rs. 1, 00,000. Currently bank FD’s offer somewhere around 8% to
9% returns annually. Bank Deposits are of different types such as Fixed Deposits,
Recurring Deposits, Public Provident Fund and Savings Deposits Scheme. On the
other hand, Corporate Fixed Deposits are just like bank FD’s they only difference is Check Your Progress
that they are issued by corporations and are a bit riskier compared to bank FD’s as What are characteristics
most of these corporate deposits are unsecured an hence offer higher interest rate.
of Real Estate as an
Investment Avenue?
They offer interest rates as high as 12% to 13% p.a.
3.9 Government Schemes
Government Securities include the following:
Ø Government Securities (Bonds): These are issued by Central or State
government. These bonds are the safest investment instruments in India.
These securities carry least amount of credit risk as they are backed by the
Government of India.
Ø Bills: These are short term money market instruments issued by the RBI
on behalf of the Government. They are issued to meet short term requirements
of the Government and the maximum tenure is one year. No Tax is deducted
at source and there is minimal default risk.

Check Your Progress
Explain different
Ø Other Government Securities: Include dated securities, Zero Coupon Government Schemes as
an Investment Avenue.
Bonds, Floating Rate Bonds, partly paid stock etc.
Security Analysis &

3.10 Post Office Saving Schemes
These saving schemes by post offices are considered as a reliable source of

NOTES
investment. It attracts decent returns and the investments can be done starting with as
low as Rs. 100 per month. Post office monthly income Scheme is specially made for
the purpose of providing regular pension to the investors offering 8% per annum, paid
Check Your Progress
Explain the different Post on monthly basis with the maximum limit for investment is Rs. 4.5 lakh and maturity
Office Schemes in India. period is 6 years. It can be prematurely enchased after 1 year but before 3 years at the
discount of 2% and after 3 years at the discount of 1%.
3.11 Mutual Fund
Mutual fund is a financial instrument created with pool of investments from many
investors and is a collection of stocks and bonds. These are professionally managed
and they invest in equity, debt, gold, foreign equity, etc. on behalf of the investor.
Mutual funds are all set up with a specific strategy in mind, and their distinct focus can
be nearly anything: large stocks, small stocks, bonds from governments, bonds from
companies, stocks and bonds, stocks in certain industries, stocks in certain countries,
and so on. The main advantage of a mutual fund is that you can invest your money
without needing the time or the experience in choosing investments. It is one of the
best way to diversify your portfolio. SIP’s are a form of Mutual fund where one tends
to invest systematically i.e. once a month or once in three months, etc. They offer
Check Your Progress moderate returns but are less risky compared to equity. This investment avenue is
Explain Mutual Funds as
popular because of its cost-efficiency, risk-diversification, professional management
and sound regulation.
3.12 Insurance Schemes
Insurance is one of the most important investment avenues in India. Insurance
companies provide different types of policies having benefits such as savings, assured
return, life cover, health cover, tax benefit and social security. Insurance companies
are regulated by IRDA (Insurance Regulatory and Development Authority) . Insurance
Security Analysis &
Portfolio Management: 50 companies offer policies such as Endowment plans, Whole Life policies, Pension plan,
Equity Linked Insurance Schemes and many other schemes. Unit Linked Insurance Investment Avenues in India
Plans are very popular in India besides the traditional endowment policies. ULIP gives
the benefit of risk cover as well as the returns of equity market as it invests the
NOTES
premium into equity linked instruments.
Insurance policies are either life insurance or general insurance policies. Life
insurance is a contract between a buyer and insurance company. Insurance company
Check Your Progress
pays a predominant amount to the nominee in case of death of a buyer. The primary
Explain Insurance as an
purpose of insurance is to protect the family in case of an event of death of the earning Investment Avenue.
member of the family.
3.13 Real Estate
Real Estate investment as an asset provides limited liquidity and is capital intensive
and a risky investment. Investing in property can be done by buying apartments and
Check Your Progress
What are characteristics
plots in either residential or commercial areas or buying Real Estate Mutual Funds.In of Real Estate as an
India investing in real estate is considered as the best form of investment but only after Investment Avenue?
gold. It can be a residential or commercial property. Returns are also higher .It also
requires time for managing them.
3.14 Venture Capital
Venture Capital is provided to start-up companies and small businesses having

long term growth potential.It is particularly useful to start ups not having access to
capital markets. It is like investing in someone’s business idea at an early stage of the
venture. In return , the capitalists get equity for the amount invested and one can exit
the investment when the business is acquired by some other company or when the
company gets listed. These investments are highly ill-liquid and carry huge risk. The
Check Your Progress
potential for above average returns is higher.It can be either in monetary form or in the Explain Venture Capital as
form of technical or managerial expertise.
Security Analysis &

3.15 Commodities
Ø Gold:
NOTES
Gold is the most appropriate investment avenue for small investors. The risk
is moderate in this class of investment and it is highly volatile as well.Investors
could buy gold and silver bars/coins or jewellery and/ or Invest in Gold
exchange traded mutual funds.It is a very traditional form of investment in

India. Commonly known as the ‘yellow metal’, it is a preferred investment
option, particularly when markets are volatile. Today, beyond physical gold,
a number of products which derive their value from the price of gold are
available for investment. These include gold futures and gold exchange traded
funds.
Ø Other commodities:
Commodity has emerged as one of the important asset classes in recent

time. Government has allowed investment into listed commodities. Investor
needs to open an account with the broker to trade in a commodity market,

Check Your Progress
Explain the features of MCX (Multi Commodity Exchange) in India. Commodity market is very
Commodities as an risky. Investor with sound knowledge should only invest in commodities.
Investment Avenue.
3.16 Public Provindent Fund (PPF)
The PPF is a government backed, long-term small savings scheme of the Central
Government started with the objective of providing income security to the workers in
the unorganized sector and self-employed individuals.The minimum amount which can
be invested in PPF is Rs. 500 andd the maximum amount is Rs. 60,000.Interest is paid
annually at the rate determined by the Central Government. The interest on PPF is tax
free under Section 10 of the Income Tax Act, 1961. It is meant to provide old age
Check Your Progress
security.PPF offers tax benefit under section 80 C and it has a lock in of 15 Yrs.
Elaborate the features and
advantages of PPF as an However, it allows withdrawing 50% of the balance at the end of the fourth year,
Investment Avenue.
proceeding the year in which the amount is withdrawn or the end of the preceding year
Security Analysis & whichever is lower. It has the following advantages:

• Flexibility in making either lump sum contribution or in instalments. Investment Avenues in India
• Provides liquidity as there is facility of loans or withdrawals allowed.
• The credit balance in PPF is not subject to attachment under an order or NOTES
decree of the court.
• Nomination facility is available
Investment Liquidity Risk Yield Tax Capital
Avenue Benefit Appreciation
Equity High High Low High High
Debentures Low Low High No Low
PPF Low No No Moderate Low
Insurance Low No No Moderate Low
Bank Deposits High Low Low No No Check Your Progress

Discuss the various
Real Estate Moderate Low Low As per rates High financial Services available
in the Indian Financial
Gold High Low Low No High
system.
Commodities High Low Low No High
3.17 Summary
• Investments can also mean the utilization of resources in order to increase

income or production in the future.
• The objectives of investments depend upon the characteristics of investments

which include safety, income and growth.
• Investment is done with a motive of gain done with analysis of security,

return and other factors; whereas speculation or gambling is done by putting
money with expectation of gain without detailed analysis regarding the
security and return.
• There are different investment attributes such as risk and return, liquidity, Security Analysis &
tax benefits and convenience based on which investment decisions. Portfolio Management: 53
Investment Avenues in India • Equities are a type of security that represents the ownership in a company
and is generally done for the long term (more than 5 years) to earn decent
returns.
NOTES
• Bonds are fixed income instruments which are issued for the purpose of
raising capital.
• A fixed deposit allows investors to deposit money into bank/corporate for a
specific period of time, which in return earns an interest.
• Government Securities include Bondsissued by Central or State government
and these are the safest investment instruments in India carrying least amount
of credit risk as they are backed by the Government of India.
• Mutual fund is a financial instrument created with pool of investments from
many investors and is a collection of stocks and bonds.
• Insurance companies provide different types of policies having benefits such
as savings, assured return, life cover, health cover, tax benefit and social
security.
• Venture Capital is provided to startup companies and small businesses having

long term growth potential.
• Gold is the most appropriate investment avenue for small investors where
the risk is moderate and it is highly volatile as well.
3.18 Key Terms
• Equity :Equities are a type of security that represents the ownership in a
company.
• Bonds:Bond is a form of lending money to government or company. In
exchange, government or company pays fix amount of interest on principal.
• Fixed Deposits: A fixed deposit allows investors to deposit money into
bank/corporate for a specific period of time, which in return earns an interest.
• Treasury Bills :These are short term money market instruments issued by
Security Analysis &
Portfolio Management: 54 the RBI on behalf of the Government
• Mutual Funds: Mutual fund is a financial instrument created with pool of Investment Avenues in India
investments from many investors and is a collection of stocks and bonds.
• Venture Capital: Venture Capital is provided to start-up companies and NOTES

small businesses having long term growth potential. It is particularly useful
to start ups not having access to capital markets.
3.19 Questions

1. The objectives of investments depend upon the characteristics of investments
which include
a. Safety
b. Income
c. Growth
d. All the above
2. The rate of return on different investments would vary widely and is the
sum total of this ___________
a. Income and price changes
b. Income changes only
c. price changes
3. ________are a type of security that represents the ownership in a company
a. Debt
b. Bonds
c. Equity
d. Government Securities
4. Government Securities include the following______
a. Government Securities
b. Treasury Bills
c. Zero Coupon Bonds

Security Analysis &
d. All the above Portfolio Management: 55
Investment Avenues in India 5. In _______, the investments can be done starting with as low as Rs. 100
per month.
a. Equity
NOTES
b. Bonds
c. Government Securities
d. Post Office Savings Bank Account
6. __________ gives the benefit of risk cover as well as the returns of equity
market as it invest the premium into equity linked instruments.
a. Equity
b. Debt
c. Gold
d. Unit Linked Insurance Plan
7. Investing in property can be done by buying apartments and plots in either

residential or commercial areas or buying this
a. Real Estate Mutual Funds
b. Gold Bonds
c. Equities in those companies
d. All the above
8. _____ capital provided to start-up companies and small businesses having

long term growth potential and not having access to capital markets.
a. Equity
b. Debt
c. Venture
d. Real Estate
9. _____commonly known as the yellow metal is a preferred investment

option particularly when markets are volatile.
a. Silver
b. Gold
c. Copper
Security Analysis &
Portfolio Management: 56 d. Steel
10. _____ is meant to provide old age security offers tax benefit under section Investment Avenues in India
80 C and it has a lock in of 15 Yrs.
a. Post Office Savings Bank Account

NOTES
b. Insurance
c. Public Provident Fund
d. Government Bonds

1. What do you mean by the term Investment? What are its objectives?
2. What are the investments attributes which are considered by an investor

before making an investment decision?
3. Evaluate the factors affecting the investment decisions.
4. Discuss Equity and Stock as an Investment Avenue.
5. Discuss the characteristics of Bonds and Debt as an Investment Avenue
6. Discuss Fixed Deposits as an Investment Avenue
7. Explain the different Post Office Schemes in India
8. Explain Mutual Funds as an Investment Avenue
9. Explain Insurance as an Investment Avenue
10. What are characteristics of Real Estate as an Investment Avenue?
11. Discuss Fixed Deposits as an Investment Avenue
12. Explain the different Post Office Schemes in India
13. Explain Mutual Funds as an Investment Avenue
14. Explain Insurance as an Investment Avenue
15. What are characteristics of Real Estate as an Investment Avenue?
16. Explain Venture Capital as an Investment Avenue
17. Explain the features of Commodities as an Investment Avenue
18. Elaborate the features and advantages of PPF as an Investment Avenue.
“Securities Analysis and Portfolio Management” Sudhindra Bhat, Excel

Books, New Delhi, 2015 Security Analysis &
Analysis of Risk & Return
Unit 4 Analysis of Risk And Return
NOTES Structure
4.0 Introduction
4.1 Unit Objectives
4.2 Concept of Risk and Return
4.3 Types of Risks
4.4 Relationship between risk and return
4.5 Quantification of risk and return
4.6 Diversification of Risk
4.7 Portfolio Risk
4.8 Beta
4.9 Risk-Adjusted Models
4.10 Summary
4.11 Key Terms
4.0 Introduction
Risk and return go hand in hand and are two sides of the same coin. Every
investment exposes an investor to a risk which differs from investment to
investment.Risks are of different types and there are different techniques, tools, methods
and models to measure, evaluate and compute the risk and return.Risk can be diversified
by different ways and means so as to optimize the returns on investment.

4.1 Unit Objectives

NOTES
Ø Understand the concept of Risk and Return
Ø Analyze the specific types of Risk in portfolios and securities
Ø Study the relation between risk and return

Ø Understand the process of measuring risk and return
Ø Understand how risk can be diversified
Ø Analyze and learn the different techniques/models/methods of portfolio analysis

Ø Study the concept of Beta and its importance in portfolio management
Ø Understand the risk adjusted methods of measuring risk and return in a portfolio
Almost all investments carry risk and yield return.Risk and return are said to be
two sides of the same coin. Risk and return go hand in hand. Usually, higher the risk
higher the return, lower the risk lower the return. Risk refers to the dispersion or
deviation of returns from the average return of such investment. Risk is measured by
calculating Standard Deviation and other measures.The quantifiable analysis is done

by use of simple arithmetic and statistics to analyze the relationship. A return from any
investment can be calculated simply by subtracting the amount invested from the final
amount realized. The figure of return thus obtained is a relative figure. Comparison of
two such investments can be made by taking out the absolute value of returns from
such investments. The Profit or loss on investments is a measure of the difference
between the amount invested and the amount actually realized. The absolute value of
returns is the return percentage. The return obtained (profit or loss) multiplied by 100
and divided by the amount invested. Profit / Loss Percentage = Profit / Loss * 100 /
Amount Invested
Risk is the uncertainty that an investment will earn its expected rate of
return.However, since risky assets generate negative surprises as well as positive
ones, defining risk as the uncertainty of the rate of return is reasonable. Greater
uncertainty results in greater likelihood that the investment will generate larger gains, Security Analysis and
as well as greater likelihood that the investment will generate larger losses in the short Portfolio Management: 59
Analysis of Risk & Return term and in higher or lower accumulated value in the long term.In financial planning,
the investment goal must be considered in defining risk. If your goal is to provide an
acceptable amount of retirement income, you should make an investment portfolio to
NOTES
generate an expected return that is sufficient to meet your investment goal. But because
there is uncertainty that the portfolio will earn its expected long-term return, the long-
Check Your Progress term realized return may fall short of the expected return. This raises the possibility
Explain the concept of Risk that available retirement funds fall short of needs - that is, the investor might outlive the
and Return in portfolio investment portfolio. Since the uncertainty of return could also result in a realized
management Return.
return that is higher than the expected return, the investment portfolio might “outlive”
the investor. Therefore, considerations of shortfall risk are subsumed by considering
risk as the uncertainty of investment return.
4.3 Types of Risks
The distinction between different types of risks is elaborated as under :
• Unsystematic risk : Also known as specific risk, it is a measure of risk

associated with a particular security; also known as diversifiable risk. It is
the type of uncertainty that comes with the company with which you invest
or the industry where you invest. This risk can be mitigated by holding a
diversified portfolio of many different stocks in many different industries.
• Systematic risk/ market risk : It is a risk faced by all investors due to

market volatility and this risk cannot be diversified away. This is the type of
risk most people are referring to when they casually use the term “risk”
when discussing investments.
• Political risk : It is the risk to an investment due to changes in the law or

political regime. Potential changes in tax law or changes in a country’s
structure of governance are sources of political risk.
• Inflation risk : Stocks, bonds and cash are all subject to the risk that one’s
investment will not keep pace with inflation. This risk can be mitigated by
investing in inflation-protected Treasury bonds.
Security Analysis and • Financial risk : This risk is due to the capital structure of a firm. Corporate
Portfolio Management: 60 debt magnifies financial risk to a company’s stocks and bonds.
• Management risk : Investors using actively managed funds are exposed Analysis of Risk & Return
to the risk that fund or portfolio managers will under-perform benchmarks
due to their management decisions or style. Investors can avoid this risk by
NOTES
selecting passively-managed index funds.
• Interest rate risk : It is the risk associated with changes in asset price due
to changes in interest rates. Bonds and bond funds face this type of risk. As
interest rates rise, prices on existing bonds decline and vice versa. Interest
rate risk is greater for bonds with longer maturities, and vice versa.
• Credit risk : It is the risk of default on account of non- payment. Holders
of corporate and municipal bonds face this risk.
• Call risk : It is the risk that a bond issuer, after a decline in interest rates,
may redeem a bond early, forcing the bond holder to find a replacement
investment that may not pay as well as the original bond.
• Reinvestment risk : the risk that earnings from current investments will
not be reinvested at the same rate of return as current investment yields.
Coupon payments from a bond may suffer reinvestment risk if they cannot
be reinvested at the same rate as the bond’s yield.
• Currency risk : investors in international stocks and bonds are also exposed
to the risk caused from changes in currency exchange rates. Investments in
currencies other than the one in which the investor purchases most goods
and services are subject to currency risks.
• Longevity risk : It is the risk an investor will outlive his/her money.
• Shortfall risk : It is the risk the portfolio will not provide sufficient returns
to meet the investor’s goal
• Diversifiable Risk : This risk is Company Specific or Non Systematic and
is connected with the random events of respective company whose stocks

are being purchased. Diversification can reduce diversifiable risk. The good
random events influencing one stock will be cancel out by the bad random
events that influence another stock of the portfolio.

Analysis of Risk & Return • Market Risk : This risk is also called Beta Risk or Non-Diversifiable Risk
and is connected with Socio-political & Macroeconomic events that occur
on global basis such as Macro Market Interest Rates, Inflation, War and
NOTES
Recession etc. Market risk can never reduce through diversification.
Total Risk of Stock = General Risk + Specific Risk
= Market Risk + Issuer Risk
= Systemic Risk + Non Systemic Risk
4.4 Relationship between risk and return

The risk and return relationship form the entire basis of investment decisions.
Investors are risk averse; i.e., given the same expected return, they will choose the
investment for which that return is more certain. Therefore, investors demand a higher
expected return for riskier assets. Note that a higher expected return does not guarantee
a higher realized return. Because by definition returns on risky assets are uncertain,
an investment may not earn its expected return. The risk in holding deviates from
actual return from the expected return maybe upward or downside. The mean (average)
annual return increases as the dispersion of returns increases.
4.5 Measurement of Risk and Return

Risk is the uncertainty of future returns.Risk can be measured as the difference
between expected return and actual return. Expected returns are the anticipated returns
for a future period. Risk is measured as the difference between expected return and
actual realized return. There are different techniques/tools of measuring risk as discussed
below
1. Volatility
Volatility is the range of price fluctuations as compared to the expected
Check Your Progress
level of return. The more the changes in price the more volatile a stock is.
Explain the relationship
between risk and return. Volatility brings uncertainty and hence greater risk. The past volatility data
provides an insight into the risk of a stock.
2. Standard Deviation
Security Analysis and This is the most common measure of risk in investments in terms of variance
Portfolio Management: 62 or standard deviation. Standard Deviation indicates the likely volatility in the
returns from the mean value of returns. It can be either in the form of an Analysis of Risk & Return
increase or a decrease from the mean.

Where ,
NOTES
S = StandardDeviation
rk = SpecificReturn
n = Number of Returns (sample size)

n – 1 = number of degrees of freedom, which, in statistics, is used for small
sample sizes
3. Probability Distribution
Probabilities indicate the likelihood of different outcomes and are in the form Check Your Progress
Explain the different types
of decimals. Past occurrences are taken to estimate the probability with
of Risk.
consideration for any changes expected in the future. To determine the
single most outcomes from a specific probability distribution, the expected
value is computed.Expected return or Ex-ante return is the mean return

found by using probability distribution of expected return.
Annual Return and Annualised Return

The two terms Annual Return and Annualised Return should not be taken to be
synonymous. An annual return is a return over a period of one year whereas annualized
return is measured over a period which is either longer or shorter than a year which is
annualized for comparison with a one year return. It does not necessarily have to be
one year. The annualisation also depends on whether the returns are reinvested or
not. In other words, annualized return is the geometric average of the money earned
from an investment each year if the annual return is compounded. It is calculated as:
Annualised return = ( (1 + r1) x (1+ r2) x (1+r3) x …x(1+r(n))) 1/n -1
In case of Cumulative returns , it is calculated as :
(365/number of days held)

Annualised Return = ( 1 + Cumulative Return) -1 Security Analysis and
Analysis of Risk & Return Illustration 1 :
An investor hold a mutual fund whose annual returns over a five year period is
NOTES as follows. Calculate its annualized return.
Year Mutual Fund A Birla Returns

1 3%
2 7%
3 2%
4 12%
5 8%
Solution :
Annualized Return for Mutual Fund A = ((1+0.03) x(1+0.07) x(1+0.02) x(1+0.12)
x(1+0.08)) ^ (1/5) -1 = 135.97% v(0.20) -1 = 106. 33% -1 = 6.33%
Illustration 2 :
The Nifty 50(NSEI) and the return from 2006 to 2016 (as at December end) is given
Year Nifty 50 Value of Rs. 1 Lakh at the end of 2016
2006 3966 2,06,379
2007 6139 1,33,350
2008 2959 2,76,627
2009 5201 1,57,387
2010 6135 1,33,439
2011 4624 177,017
2012 5905 1,38,623
2013 6304 1,29,851
2014 8283 98,830
2015 7946 1,03,013
2016 8186 -
Source : NSE Website

4.6 Diversification of Risk
Risk can be reduced through diversification.
NOTES
• The risk of investing in a single risky security, such as a stock or corporate
bond, is very high due to the company-specific risks. Any number of
unfortunate events could impact the rate of return. In the worst possible
case, the company could go bankrupt, and the investor could lose the entire
value of the investment.
• Company-specific risk is generally referred to as unsystematic risk or
nonsystematic risk. Other names are unique-risk, firm-specific risk, or

diversifiable risk.
• Unsystematic risk can be eliminated by holding a broad portfolio of risky
assets; e.g., many different securities in many different industries. This is

easy to accomplish by owning a total market stock or bond index fund.
Unsystematic risk is risk that can be “diversified away.
• The risk that remains after diversifying away unsystematic risk is systematic
risk. Other names are market risk or non-diversifiable risk. A total stock or
bond market fund has systematic risk. In an efficient market, assets with
known systematic risks will be priced lower and thereby compensate

investors through higher expected returns. This expected relationship only
applies to systematic risks. There is no reward for incurring unsystematic

Check Your Progress
risk, and investors may therefore seek broad diversification without reducing How can diversification
the expected return of their portfolio.After diversification, the next step in lead to reduction in risk?
managing portfolio risk is asset allocation.This part will be dealt with in later
part of this book.
4.7 Portfolio Analysis
At some time in the future, the actual return will be one of many possible outcomes.
The various outcomes have some probability of occurring. The expected return is just
the average of these possible returns weighted (multiplied) by the respective probabilities
of occurring.Standard deviation of annual returns is most useful for measuring risk

over shorter time periods. For measuring risk over longer time periods, the dispersion Portfolio Management: 65
Analysis of Risk & Return of possible cumulative returns is a better measure of risk. This is because over many
years, a relatively small difference in annualized rate of return can result in a large
difference in cumulative returns. The cumulative return on your investments at a specified
NOTES
future time is referred to as terminal wealth. The dispersion of possible terminal wealth
is referred to as terminal wealth dispersion.
Portfolio analysis
• The collection of multiple investments is referred to as portfolio. Mostly
large size organizations and also some individuals maintain a portfolio of
their different investments and hence the risk and return is considered as
the entire portfolio risk and return. Portfolio may be composed of two or
more bonds, stocks, securities and investments or combination of all.
The value of a portfolio constrains your choices at later stages.
• This is because trading individual securities creates costs - brokerage costs,
bid-ask spreads and price impact
• There is a critical mass value, below which it does not pay to actively manage
a portfolio - it is far better to invest in funds.
• The larger a portfolio, the more choices become available in terms of assets
- this is largely because some components of trading costs - the brokerage
costs and the spread - may get smaller for larger portfolios.
• If a portfolio becomes too large, it might start creating a price impact which
might cause trading costs to start increasing again.
The different models /techniques for portfolio analysis and selection for measuring
risk and return are discussed in detail here under :
1. Measuring historical return
The return on an investment for a given period is done as follows :

Cash Pyment Received during the Period +
Price changes over the Period
Total Return =
Price of the investment at the beginning of the Period
In other words, it is measured as
R = C + (PE – PB )
PB
This may be further divided into two components i.e. Current yield in the form of
dividend and capital return which is as follows
Security Analysis and Cash Payment Ending Price – Beginning Price
+
Portfolio Management: 66 Beginning Price Beginning Price
The first part of the equation represents current return and the other part depicts Analysis of Risk & Return
capital return.
Illustration 3 NOTES
From the following details for an equity stock, compute the total return on the
stock
1. Price at the beginning of the year Rs. 120
2. Dividend paid at the end of the year Rs.4.80
3. Price at the end of the year Rs. 138.00
Solution
4.80 + (138.00 – 120.00)
Total Return on the stock = = 19 percent
120.00
2. Cumulative Index
Total return is reflected in the changes in the wealth level for which we need to
measure the cumulative effects of returns over time. It is cumulative effect which is
measured as under.
CWIn= WI 0 (1 + R1) (!+ R2 ) ….(1+ Rn)
Where CWI is the cumulative wealth index at the end of n years, WI 0

is the
beginning index value which is typically a rupee and R1 is the total return of the year.
3. Measuring historical risk
Risk is a measure of variability or dispersion . The risk in a security say equity

can be measured over a time period by different measures and the common ones are
variance and Standard Deviation.
4. Portfolio’s Expected Rate of Return (rP) :
The weighted average of expected returns of every single investment in the

portfolio is referred to as portfolio’s expected rate of return. The formula as given
below which is similar to the expected return for single investment but its interpretation
is quite different.
rP* = r1 x 1 + r2 x 2 + r3 x 3 + . . . + rn x n
In case there are “n” no of various investments in the portfolio then r1 corresponds
Analysis of Risk & Return to the expected return (in % age) on investment no.1 and x1 corresponds to the weight
of investment no.1 (fraction of the Rupee value of total portfolio represented by
investment no.1).
NOTES
Illustration 4
Mr. Amir an investor have portfolio of the following 2 stock investments.

Stock Value of Investment ($) Expected Return
Stock A 40 15
Stock B 60 20
Total Value = 100
The expected rate of return of the portfolio is calculated as follows where r is the
return of a stock in a portfolio.

rP* = rA x A + rB x B
rP* = 20% x (40/100) + 15% x (60/100)
rP* = 8% + 9%
rP* = 17%
5. Portfolio Risk of two Stock Investments

The portfolio risk is not the weighted average risk of the singles investments and
more specifically it is less than weighted average risk of single investments. Following
is formula of portfolio risk of 2 stocks.

p = XA2 óA2 + XB2 óB2 + 2 (XA XB óA óB) AB
The investment A’s weight in total value of portfolio is represented by XAand
investment A’s single risk (Standard deviation) is represented by óA. AB

represents
correlation coefficient called covariance term which evaluates the correlation in the
returns of two investments.
Illustration 5
Following is the data of portfolio of two stocks
Stock: Value Expected Return Risk (Std.dev)

Stock A 40 20 20%
Stock B 60 15 10%
Total Value = 100 Correlation coefficient = +0.6

Security Analysis and Compute the portfolio risk.
Solution Analysis of Risk & Return
Portfolio risk is calculated by using following formula
p = XA2 óA2 + XB2 óB2 + 2 (XA XB óA óB AB NOTES

2 2 2 2
p = {(40/100) (20%) + (60/100) (15%) + 2 [(40/100) (60/100) (20%) (15%)
(0.6)]}0.5
p = {(0.16) (0.04) + (0.36) (0.0025) + 2 [(0.4) (0.6) (0.2) (0.15) (0.6)]} 0.5
p = {(0.0073) + 2 [(0.00432)]} 0.5
p = {0.01594}0.5
6. Sharpe Ratio
This model was conceptualized by Bill Sharpe closely based on the Capital Asset
Pricing model(CAPM) and it uses total risk to compare portfolios to the capital market
line. The risk measure is the standard deviation of the portfolio instead of onlyonly
systematic risk, represented by Beta. Sharpe Ratio is a measure of

(Portfolio return – Risk Free Rate) / Standard Deviation.
Illustration 6
Determine Sharpe Ratio for the following portfolio managers. Assume that the
S& P had a standard deviation of 18% over a 10 year period.
Manager Annual return Portfolio Standard Deviation
Manager A 15 0.11
Manager B 19 0.20
Manager C 16 0.27
Solution Check Your Progress

Discuss the different
S (Manager A) = (0.15-0.05)/0.11. = 0.909 models/techniques for
measuring portfolio risk
S (Manager B) = (0.19-0.05)/0.20 =0.70
and return.
S (Manager C) = (0.16-0.05)/0.27 = 0.407
4.8 Beta
Beta is a measure of systematic risk of a security which is unavoidable.It is a

measure of non-diversifiable risk. It is a relative measure of the individual stock as Portfolio Management: 69
Analysis of Risk & Return compared to the market portfolio risk.Beta measures the security’s volatility or
fluctuations in price and is useful for measuring the systematic risk of different stocks
and investors rank stocks based on their beta. Stocks with high betas are said to be
NOTES
more risky and vice versa. Higher the responsiveness of a price of a security to changes
in market,higher the beta and vice-versa Beta is used in Capital asset pricing model
Check Your Progress (CAPM) to link between risk and return. This will be seen in detail in the later part of
Wirte a note on Beta. this book.
4.9 Risk-Adjusted Models
1. The Capital Asset Pricing Model (CAPM): The capital asset pricing
model provides a simple and intuitive measure for measuring performance.
It compares the actual returns made by a portfolio manager with the returns
he should have made, given both market performance during the period and
the beta of the portfolio created by the manager.
Abnormal Return = Actual Return – Expected Return
> 0: Outperformed
< 0: Underperformed
where,
Actual Return = Returns on the portfolio (including dividends)
Expected Return = Risk - free rate at the start of the period + Beta of portfolio *
(Actual return on market during the period-Risk-free Rate)
2. The APT: The arbitrage pricing theory defines the expected return in terms
of statistical factors (instead of just the market as in the CAPM). A beta is
defined relative to each factor.
3. Multi-Index Models: Multi-index models allow the performance evaluator

to bring in economic factors that may influence expected returns.
4. Markowitz Risk-Return Analysis: Harry Markowitz invented portfolio
analysis According to him , portfolio is the total collection of all investments
Security Analysis and held by an individual or institution, including stocks, bonds, real
Portfolio Management: 70 estate, options, futures, and alternative investments, such as gold
or partnerships. Most portfolios are diversified to protect against the risk of Analysis of Risk & Return
single securities or class of securities. Hence, portfolio analysis consists of
analyzing the portfolio as a whole rather than relying exclusively on security

NOTES
analysis, which is the analysis of specific types of securities. While the risk-
return profile of a security depends mostly on the security itself, the risk-
return profile of a portfolio depends not only on the component securities,
but also on their mixture or allocation, and on their degree of correlation. As

with securities, the objective of a portfolio may be for capital gains or for
income, or a mixture of both. A growth-oriented portfolio is a collection of
investments selected for their price appreciation potential, while an income-

oriented portfolio consists of investments selected for their current income
of dividends or interest. Theselection of investments will depend on one’s
tax bracket, need for current income, and the ability to bear risk, but regardless
of the risk-return objectives of the investor, it is natural to want to minimize
risk for a given level of return. The efficient portfolio consists of investments
that provide the greatest return for the risk, or—alternatively stated—the
least risk for a given return. To assemble an efficient portfolio, one needs to
know how to calculate the returns and risks of a portfolio, and how to minimize
risks through diversification.
As per this model, a portfolio that gives maximum return for a given risk or
minimum risk for a given return is an efficient portfolio. Among portfolios having
similar return, investors will prefer those portfolios where risk is lower. These portfolios
are considered efficient, because they maximize expected returns given the standard
deviation, and the entire set of portfolios is referred to as the Efficient Frontier.
Since the return of a portfolio is commensurate with the returns of its individual
assets, the return of a portfolio is the weighted average of the returns of its component
assets.
n
Amount of Asset
Portfolio Return = ∑ Amount of Portfolio X Return Assets
k=1
The amount of an asset divided by the amount of the portfolio is the weighted
average of the asset and the sum of all weighted averages must equal 100%.
Analysis of Risk & Return Illustration 7
Calculating the Expected Return of a Portfolio of 2 Assets given below
NOTES Portfolio
Asset Weightings
Asset A 30%
Asset B 70%
Expected Returnsfor each Asset
E (rA) 13.9%
E (rB) 9.7%
Solution
The expected return of this portfolio is calculated thus:
Portfolio Expected Return = .3 × .139 + .7 × .097 = .109 = 10.9%
5. Covariance: It is a statistical measure of how one investment moves in

relation to another. If two investments tend to be up or down during the
same time periods, then they have positive covariance. If the highs and lows
of one investment move in perfect coincidence to that of another investment,
then the two investments have perfect positive covariance. If one investment
Check Your Progress tends to be up while the other is down, then they have negative covariance.
Discuss in detail the Risk
If the high of one investment coincides with the low of the other, then the
Adjusted models for
measuring risk and return two investments have perfect negative covariance. The risk of a portfolio
of stock and portfolio. composed of these assets can be reduced to zero. If there is no discernible
pattern to the up and down cycles of one investment compared to another,
then the two investments have no covariance.

Illustration 8 Analysis of Risk & Return
From the following details of price and dividend of KRC ltd. for the 6 years ,
calculate the average rate of return.
NOTES
Year Average market price Dividend per share
2015 95 3
2014 80 2.6
2013 62 2.0
2012 65 2.5
2011 55 2.0
2010 50 1.8
Solution
Year Average Market Capital gain Dividend Dividend Rate
price per share (%) per share Yield of Return
2010 50 - 1.8 3.6 -
2011 55 10 2.0 3.63 13.63
2012 65 18.18 2.5 3.85 22.03
2013 62 (4.62) 2.0 3.22 (1.4)
2014 80 5.26 2.6 3.25 8.51
2015 95 18.75 3 3.16 21.91
R = 1/5 [13.63 + 22.03 + (1.4) + 8.51 + 21.91] = 12.936
Illustration 9
S.Singh holds a two stock portfolio. Stock A has a standard Deviation of returns
of 0.6 and Stock B has a standard deviation of 0.1. The correlation coefficient of the
two stock returns is 0.25. He holds equal amount of each stock. Calculate the portfolio
standard deviation for the two stock portfolio.
Solution
0.52 ×0.62 +2×0.5×0.6×0.4×25+52 ×0.4

0.16 = 0.4 Portfolio Management: 73
4.10 Summary
• Risk and return are said to be two sides of the same coin. Risk and return go
NOTES
hand in hand.
• Higher the risk higher the return, lower the risk lower the return.
• Risk refers to the dispersion or deviation of returns from the average return
of such investment.
• Unsystematic risk: The measure of risk associated with a particular security;
also known as diversifiable risk.
• It is a risk faced by all investors due to market volatility and this risk cannot
be diversified away.
• It is the risk associated with changes in asset price due to changes in interest
rates. Bonds and bond funds face this type of risk.
• This risk is Company Specific or Non Systematic and is connected with the
random events of respective Company whose stocks are being purchased.
• This risk is also called Beta Risk or Non-Diversifiable Risk and is connected
with Socio-political & Macroeconomic events that occur on global basis
• Volatility is the range of price fluctuations as compared to the expected level
of return.
• Standard Deviation indicates the likely volatility in the returns from the mean
value of returns.
• Probabilities indicate the likelihood of different outcomes and are in the form
of decimals. Past occurrences are taken to estimate the probability with
consideration for any changes expected in the future.
• The collection of multiple investments is referred to as portfolio. Mostly
large size organizations maintains portfolio of their different investments and

hence the risk and return is considered as the entire portfolio risk and return.
Portfolio may be composed of 2 or more bonds, stocks, securities and
investments or combination of all.
Security Analysis and • The weighted average of expected returns of every single investment in the
Portfolio Management: 74 portfolio is referred to as portfolio’s expected rate of return.
• This model was conceptualized by Bill Sharpe closely based on the Capital Analysis of Risk & Return
Asset Pricing model (CAPM) and it uses total risk to compare portfolios to
the capital market line. This model was conceptualized by Bill Sharpe closely
NOTES
based on the Capital Asset Pricing model (CAPM) and it uses total risk to
compare portfolios to the capital market line.
• Beta is a measure of systematic risk of a security which is unavoidable. It is

a measure of non-diversifiable risk. It is a relative measure of the individual
stock as compared to the market portfolio risk.
• Expected Return = Risk-free rate at the start of the period + Beta of portfolio
(Actual return on market during the period - Risk-free Rate)
• Markowitz model states that a portfolio that gives maximum return for a
given risk or minimum risk for a given return is an efficient portfolio. Among
portfolios having similar return, investors will prefer those portfolios where
risk is lower.
4.11 Key Terms
1. Risk: It refers to the dispersion or deviation of returns from the average

return of such investment andis the uncertainty that an investment will earn
its expected rate of return. Risk is the uncertainty that an investment will
earn its expected rate of return.
2. Systemic Risk: It is the type of uncertainty that comes with the company
with which you invest or the industry where you invest.
3. Unsystematic Risk: It is a risk faced by all investors due to market volatility
and this risk cannot be diversified away.
4. Inflation Risk: Stocks, bonds and cash are all subject to the risk that one’s
investment will not keep pace with inflation and can be mitigated by investing
in inflation-protected Treasury bonds.
5. Financial risk: This risk is due to the capital structure of a firm. Corporate
debt magnifies financial risk to a company’s stocks and bonds.

Analysis of Risk & Return 6. Management risk: Investors using actively managed funds are exposed
to the risk that fund or portfolio managers will under-perform benchmarks
due to their management decisions or style.
NOTES
7. Interest rate risk: It is the risk associated with changes in asset price due
to changes in interest rates. Bonds and bond funds face this type of risk.
8. Currency risk: Investors in international stocks and bonds are also exposed
to the risk caused from changes in currency exchange rates.
9. Market Risk: This risk is also called Beta Risk or Non-Diversifiable Risk
and is connected with Socio-political & Macroeconomic events that occur
on global basis.
10. Standard Deviation: This is the most common measure of risk in investments
in terms of variance or standard deviation.It indicates the likely volatility in
the returns from the mean value of returns. It can be either in the form of an
increase or a decrease from the mean.
11. Probability Distribution:Probabilities indicate the likelihood of different

outcomes and are in the form of decimals. Past occurrences are taken to
estimate the probability with consideration for any changes expected in the
future. To determine the single most outcomes from a specific probability
distribution, the expected value is computed. Expected return or Ex-ante
return is the mean return found by using
12. Cumulative Index: Total return is reflected in the changes in the wealth
level for which we need to measure the cumulative effects of returns over
time. It is cumulative effect which is measured as under
13. Beta: Itis a measure of systematic risk of a security which is unavoidable

and is a measure of non-diversifiable risk. It is a relative measure of the
individual stock as compared to the market portfolio risk.
14. The Capital Asset Pricing Model (CAPM): The capital asset pricing
model provides a simple and intuitive measure for measuring performance.
It compares the actual returns made by a portfolio manager with the returns
he should have made, given both market performance during the period and
Portfolio Management: 76 the beta of the portfolio created by the manager.
15. Covariance: It is a statistical measure of how one investment moves in Analysis of Risk & Return
relation to another. If two investments tend to be up or down during the

same time periods, then they have positive covariance.
NOTES

1. It refers to the dispersion or deviation of returns from the average return of
such investment
a. Risk
b. Return
c. Standard Deviation
d. Covariance
2. This can be calculated simply by subtracting the amount invested from the
final amount realized.
a. Risk
b. Return
c. Profit/loss
d. Variance
3. It is a risk faced by all investors due to market volatility and this risk cannot
be diversified away.
a. Systematic Risk
b. Unsystematic Risk
c. Credit Risk
d. Currency Risk
4. This risk is also called Beta Risk or Non-Diversifiable Risk and is connected
with Socio-political & Macroeconomic events
a. Credit risk
b. Market Risk
c. Currency Risk
d. Political Risk Portfolio Management: 77
Analysis of Risk & Return 5. It is the range of price fluctuations as compared to the expected level of
return.
a. Standard Deviation
NOTES
b. Covariance
c. Volatility
6. In an efficient market, assets with this risk will be priced lower and thereby
compensate investors through higher expected returns.
a. Credit Risk
b. Currency Risk
c. Systematic Risk
d. Unsystematic Risk
7. This may be further divided into two components i.e Current yield in the
form of dividend and capital return which is as follows
a. Risk
b. Return
c. Portfolio
d. Variance
8. The weighted average of expected returns of every single investment in the

portfolio is referred to as portfolio’s
a. Return
b. Expected Rate of Return
c. Volatility
d. Price changes
9. It is a measure of systematic risk of a security which is unavoidable and

measures non-diversifiable risk.
a. Sharpe Model
b. Beta
c. Markowitz Model
Portfolio Management: 78 d. Cumulative Index
10. This is closely based on the Capital Asset Pricing Model (CAPM) and it Analysis of Risk & Return
uses total risk to compare portfolios to the capital market line.
a. Sharpes Model NOTES

b. Markotwitz Model
c. Cumulative Index
d. Beta

1. Define Risk
2. Define Return
3. What are the different types of risks affecting investment decision
4. Define Beta.
5. Explain the concept of Risk and Return in portfolio management
6. Explain the relationship between risk and return
7. Discuss the different techniques of measuring risk and return.
8. How can diversification lead to reduction in risk?
9. Discuss in detail the Risk Adjusted models for measuring risk and return of
stock and portfolio.
4.12.3 Further Reading and References
Ex.1. Mr. Sonu holds a mutual fund with the following returns. Compute the
annualized return for the period of five years.
Year Mutual Fund B Returns
1 4%
2 5%
3 7%
4 6%
5 9%

Analysis of Risk & Return Ex.2 From the following data related to three different stocks ofa listed company,
compute the returns of each stock.
NOTES Stock Investment (Rs.) Expected Return Weight
A 15,000 8% 0.15
B 50,000 12% 0.50
C 35,000 14% 0.35
Ex. 3 The S & P BSE SENSEX 50 Index for the month of June 2017 is given
below. Compute the annualized returns.
Date BSE Date BSE
SENSEX SENSEX
02-June-2017 10001.50 16-June-2017 9936.29
05-June-2017 10030.70 19-June-2017 10004.03
06-June-2017 9990.69 20-June-2017 10007.39
07-June-2017 10014.05 21-June-2017 9988.90
08-June-2017 9996.75 22-June-2017 9989.79
09-June-2017 10011.06 23-June-2017 9933.69
12-June-2017 9958.31 27-June-2017 9873.17
13-June-2017 9954.33 28-June-2017 9848.15
14-June-2017 9963.66 29-June-2017 9859.83
15-June-2017 9932.52 30-June-2017 9882.20

“Security Analysis and Portfolio Management”, S. Kevin, PHI Publishers, June 2006.

Economic Ananlysis Part A
Unit 5 Economic Analysis Part A : : Fundamental Analysis
Fundamental Analysis
NOTES
Structure
5.0 Introduction
5.1 Unit Objectives
5.2 Fundamental analysis
5.3 The Basics of Fundamental Analysis
5.4 Fundamental Analysis – Applications
5.5 Economic Analysis
5.6 Economic Indicators: a Currency’s Vital Sign
5.7 Economic Indicators
5.8 Why Fundamental Economic Analysis
5.9 Economic Forecasting techniques
5.10 Summary
5.11 Key Words
5.0 Introduction
Investment Analysis and decisions are based on two major analysis –Fundamental
Analyis and Technical Analysis and both of these are the opposite sides of the spectrum
with the common objective of investment decisions. Fundamental Analysis is used to
evaluate the securities by their Intrinsic Values by studying the economy, industry and
Company Position. Technical Analysis is more concerned with a study of past prices,
volume and other statistics by means of charts, graphs, and other tools to identify
stock patterns and trends to attempting to find the stock behavior in the future Portfolio Management:81
: Fundamental Analysis 5.1 Unit Objectives
After studying this Unit, you should be able to :

NOTES
Ø To learn the concept of fundamental analysis
Ø To understand the concept of Economic analysis
Ø To know the applications of Fundamental Analysis
Ø To study the Economic Indicators as a Currency’s Vital Signs
Ø To analyze the various Economic Forecasting techniques
5.2 Fundamental Analysis
There are two broad approaches to the analysis of investment decisions wherein
the objective of the analysis is to determine what stock to buy and at what price:
1. Fundamental Analysis
2. Technical Analysis
1. Fundamental analysis maintains that markets may misprice a security in the
short run but that the “correct” price will eventually be reached. Profits can
be made by purchasing the mispriced security and then waiting for the market
to recognize its “mistake” and reprice the security.
2. Technical analysis maintains that all information is reflected already in the
price of a security. Technical analysts analyze trends and believe that
sentiment changes predate and predict trend changes. Investors’ emotional

responses to price movements lead to recognizable price chart patterns.
Technical analysts also analyze historical trends to predict future price
movement.
3. Stock markets are concerned with eitherpurely fundamental or purely
technical analysis Practically; there is no small amount of overlap between

the two methods. However when it comes to selection of one method over
the other, technical method has always preceded the economic analysis as
seen by most of the largest market trends occurring throughout the past.
Portfolio Management:82
Fundamental analysis is a method of evaluating a security by measuring its intrinsic Economic Ananlysis Part A
: Fundamental Analysis
value, with the aid of related economic, financial and other qualitative and quantitative
factors. Fundamental analysis incorporates a study of all factors that can affect the
NOTES
security’s value, including macroeconomic factors such as the overall economy and
industry conditions, and microeconomic factors such as financial conditions and internal
management. The end goal of fundamental analysis is to produce a quantitative value
that an investor can compare with a security’s current price,indicating whether the
security is undervalued or overvalued.It determines the health and performance of an
Check Your Progress
underlying company by looking at economic indicators and other factors. The purpose
Explain the Concept of
is to identify fundamentally strong companies or industries and fundamentally weak
Fundamental Analysis.
companies or industries. This method of security analysis is considered to be the opposite
of technical analysis.
5.3 Financial Markets
Fundamental analysis although used by most analysts to value stocks, it can be
used valuation of any type of security. For example, an investor can while performing
fundamental analysis on a bond’s value by looking at economic factors such as interest

rates and the overall state of the economy;can also look at information about the bond
issuer, such as potential changes in ratings. For stocks and equity instruments, this
method uses revenues, earnings, future growth, return on equity, profit margins and
other data to determine a company’s underlying value and potential for future growth.
In terms of stocks, fundamental analysis focuses on the financial statements of the
company being evaluated. In a nutshell, fundamental analysis attempts to predict the

intrinsic value of an investment. This is based on the theory that the market price of an
asset typically tends to gravitate towards its ‘real value’ or ‘intrinsic value’.
Fundamental analysis, in accounting and finance, is the analysis of a
business’s financial statements by analyzing the business’s assets, liabilities,

and earnings; health, its competitors and markets.Fundamental analysis is performed
on historical and present data, but with the goal of making financial forecasts. There
are several possible objectives:

Economic Ananlysis Part A • to conduct a company stock valuation and predict its probable price evolution;
• to make a projection on its business performance;
NOTES • to evaluate its management and make internal business decisions;
• to calculate its credit risk.
• to find out the intrinsic value of the share.
Fundamental analysis is an analysis of factors such as economy aggregates,

Industry aggregates and company aggregates. It covers an analysis of various
fundamental factors. Technical analysis, on the other hand is based on an analysis of
factors like demand and supply of securities and the share prices reflecting the various,
market indices in the stock market.
Fundamental analysis aims to arrive at the intrinsic value of shares. Intrinsic

value is useful for investment decisions by making comparison of intrinsic value with
the market value of shares to arrive at buy or sell decisions.
If Intrinsic Value > Market Price then BUY
If Intrinsic Value < Market Price then SELL

Check Your Progress
Discuss the Basics of The intrinsic value of the shares is determined based upon these three analyses.
Fundamental Analysis This value is considered the true value of the share. If the intrinsic value is higher than
used to analyse the
the market price, it is recommended to buy the share. If it is equal to market price, it is
Intrinsic Value of Shares.
recommended to hold the share; if it is less than the market price, then one should sell
the shares.
5.4 Fundamental Analysis – Applications
Investors may also use fundamental analysis strategies.
• Buy and hold investors believe that latching onto good businesses allows the
investor’s asset to grow with the business. Fundamental analysis lets them
find ‘good’ companies, so they lower their risk and probability of wipe-out.
• Value investors restrict their attention to under-valued companies, believing

that ‘it’s hard to fall out of a ditch’. The values they follow come from
fundamental analysis.
• Managers may use fundamental analysis to correctly value ‘good’ and ‘bad’
Security Analysis and companies. ‘Bad’ companies’ stock price will eventually fluctuate, creating
opportunities for profit.
• Managers may also consider the economic cycle in determining whether Economic Ananlysis Part A
conditions are ‘right’ to buy fundamentally suitable companies.
• Contrarian investors hold that “in the short run, the market is a voting machine, NOTES
not a weighing machine”.Fundamental analysis allows a broker to make his
or her own decision on value, while ignoring the opinions of the market.
• In addition, managers may use fundamental analysis to determine future

growth rates for buying high priced growth stocks.
• Lastly, managers may include fundamental factors along with technical factors
in computer models (quantitative analysis).
Phases of fundamental analysis
There are three phases of fundamental analysis as follows:
I. Economic Analysis
II. Technical Analysis
III. Company Analysis
Fundamental analysis is useful to investors for decision making and helps to assess Check Your Progress
the risk and return of an investment. The most significant part of fundamental analysis What are the different
phases of Fundamental
is the economic analysis which is dealt hereunder, whereas the other phases will be
Analysis.
covered later in this book.
In this part of fundamental analysis, different economic aggregates are analyzed

so as to take investment decisions. The economic set up is made up of individuals as
well as institutions undertaking investments. The economy is studied at the macro level
to analyse its performance and also the performance of its sectors.Economic growth
determines the stock prices which reflects the economic activities. Higher the economic
growth higher the stock prices and vice versa. Economic indicators have a considerable
potential to generate volume and move prices. It might seem like you need an advanced
economics degree to parse all this data accurately. All economic indicators do not
impact the markets. The market may pay attention to different indicators under different
conditions. That focus can change over time and from one currency to another. Portfolio Management:85
Economic Ananlysis Part A Macroeconomic indicators are statistics that indicate the current status of the economy
of a state depending on a particular area of the economy (industry, labor market, trade,
etc.). They are published periodically by governmental agencies and private agencies.
NOTES
After the publication of these indicators you can observe volatility of the market (the
volatility degree is determined as per the indicator importance).
Check Your Progress
Explain the meaning and In truth, these statistics help CFD traders monitor the economy’s pulse; thus it is
concept of Economic
not surprising that these are religiously followed by almost everyone in the financial
Analysis.
markets. Top macroeconomic indicators are analyzed as per the following procedure:
Macro Economic Indicators
5.6 Economic Indicators : a Capital Currency’s Vital Signs
Traders can measure the economic health of a given country (and its currency)
through its economic indicators - but, just like a doctor monitoring a patient’s vital signs,
not all stats count equally. Here’s a primer of the key economic indicators that often
impact currency traders.
Economic indicators have a considerable potential to generate volume and move
prices. It might seem like you need an advanced economics degree to parse all this
data accurately. All economic indicators do not impact the markets. The market may
pay attention to different indicators under different conditions. That focus can change
over time and from one currency to another. For example, if prices (inflation) are not
a crucial issue for a given country, but its economic growth is problematic, traders may
pay less attention to inflation data and focus on employment data or GDP reports.Often
the data itself may not be as important as whether or not it falls within market
expectations. If a given report differs widely and unexpectedly from what economists
and market pundits were anticipating, market volatility and potential trading opportunities
Security Analysis and may result. At the same time, be careful of pulling the trigger too quickly when an
Portfolio Management:86 indicator falls outside expectations. Each new economic indicator release contains
revisions to previously released data.Similarly, PPI measures changes in producer prices Economic Ananlysis Part A
generally - but traders tend to watch PPI excluding food and energy as a market
driver. Food and energy data tend to be much too volatile and subject to revisions to
NOTES
provide an accurate reading on producer price changes. Macroeconomic indicators
are statistics that indicate the current status of the economy of a state depending on a
particular area of the economy (industry, labor market, trade, etc.). They are published
periodically by governmental agencies and private agencies. After the publication of

these indicators you can observe volatility of the market (the volatility degree is
determined as per the indicator importance).
Top macroeconomic indicators are:
Stock prices react favorably to the low inflation, earnings growth, a better balance
of trade, increasing gross national product and other positive macroeconomic news.
Indications that unemployment is rising, inflation is picking up or earnings estimates are

being revised downward will negatively affect the stock prices. This relationship is
reasonably reliable that the US economy is better represented by the Standard & Poor
500 stock index, which is famous market indicator. The stock market will forecast an
economic boom or recession properly from the signs in front of average citizen. The
implications of market risk should be clear to the investor. When there is recession in
the economy, the prices of stocks moves downward. All the companiessuffer the effects
of recession despite of the fact that these are high performing companies or low
performing ones. Similarly the stock prices are positively affected by the boom period
of the economy.Traders can measure the economic health of a given country (and its
Check Your Progress
currency) through its economic indicators - but, just like a doctor monitoring a patient’s
Explain the relevance of
vital signs, not all stats count equally. Here’s a primer of the key economic indicators economic indicators as a
that often impact currency traders. currency’s vital sign.
Different economic factors which affect investment decisions in terms of its risk
and return broadly include
v Money Supply
v Employment Portfolio Management:87
Economic Ananlysis Part A v Inflation
v Gross Domestic Product (GDP)
NOTES v Interest Rates
v Stock Prices
v Fiscal Deficit
v Infrastructure
v Foreign Trade
v Balance of Payment
v Business Cycle
v Industrial Wages
v Foreign Investments
v Technological Developments
v Factors of Production
v Cost of Living Index
v Standard of Living
v Fiscal policies
v Economic policies
v Industrial policies
v Industrial production
v Monsoons and Agriculture
The list above is inclusive and not exhaustive. In a global economy, there are
other factors which also come into play while taking investment decisions.Economic
indicators divide into leading and lagging indicators:
Leading indicators are economic factors that change before the economy starts
to follow a particular trend. They’re used to predict changes in the economy. A leading
indicator is generally slow and smooth moving, usually gives fruitful results, has low
default rate. These indicators are also useful in predicting the overall development of
the industry by comparing each industry with the overall industrial growth or with the
growth of the country. They include
a. Monsoon Economic Ananlysis Part A
b. Per Capita Income
c. Industrial Growth NOTES
d. Infrastructure
e. Government policies
f. Inflation
g, Interest rates
Lagging indicators are economic factors that change after the economy has
already begun to follow a particular trend. They’re used to confirm changes in the
economy.These are of theoretical significance only and maybe useful for decisions on
future developmental growth and its planning.For eg. Regional disparities in growth
and development, sector wise studies etc.
A few leading economic indicators which impact investment decisions are
discussed hereunder:
Money Supply:
Money supply is mainly controlled through monetary policy .It is concerned with
the changes in money supply in the economy mainly through impact on interest rates.
Various tools are deployed to implement monetary policy such as Open Market
Operations, Bank Rate, Reserve requirements in the form of Statutory Liquidity Ratio
and Cash Reserve Ratio, Credit Controls, Repo Rate, etc.
Fiscal Policy:
It is concerned with the tax initiatives and spending of the Government. It is a
tool used to stimulate the economy or dampen it. An increase in government spending
stimulates demand and a decrease of it reduces demand. Similarly an increase in tax
rates decreases consumption of goods and a decrease in tax rates increase consumption.
Monsoons and Agriculture:
Agriculture production has a direct and significant bearing on the industrial
production and corporate profits of those companies which use agricultural produce as
an input and also indirectly other corporates. Monsoons also have an impact on the
industrial production and performance which affects the stock market also.
Economic Ananlysis Part A Gross Domestic Product (GDP):
GDP is the average of the growth rates of agriculture, industrial sector and service
sector. However, the industrial sector impacts the stock market more as compared to
NOTES
the other sector which is reflected in the overall industrial growth as well as growth of
different industries. This is analyses through the index of Industrial Production.
Inflation
Inflation is measured by the price level changes as compared to the growth rate
in GDP and inflation has different effects on different industries wherein some
companies stand to gain whereas the others lose and hence the stock market prices
vary with stocks of those companies with a strong market stand to gain from inflation
and as a result their stock prices rise.
Balance of Payments (BOP):

Balance of Payment is measured as :
Balance in capital account + Balance in current account
Capital account comprises of external borrowings, repayment of external
borrowings investments and disinvestments. Current account consists of trade in goods
and invisibles. Invisibles comprise of international payment on account of payment of
items other than export and imports of goods. Examples of invisibles are software,
travel, interest and dividend payments.
Balance of payments has an impact on the forex reserves and the exchange
rates.
Foreign Investment:
This can be in two forms i.e. Foreign Direct Investment (FDI) and Foreign
Institutional Investments (FII). FDI is for starting new projects and for a long term
whereas FII is for purchase of outstanding securities in the Indian Capital markets and
can be easily encashed. India has received more of FII than FDI which has had an
impact on the stock markets. However at the same time, too much of FIIs inflow has
raised concerns specially related to forex reserves and due to specific companies
stocks being preferred more by FIIs as compared to others leading to liquidity issues.
Infrastructure
Infrastructural facilties influence industrial performance specifically in relation
Portfolio Management:90 to certain facilities such as supply of electric power, an efficient transportation and
communication system, supply of basic raw materials and financial support for capital Economic Ananlysis Part A
assets and working capital. Lack of an adequate supply of infrastructure inputs have
hampered the growth of many industries in India.

NOTES
Measures total receipts of retail stores from samples representing all sizes and
kinds of business in retail trade throughout the nation. It is the timeliest indicator of
broad consumer spending patterns and is adjusted for normal seasonal variation, holidays,
and trading-day differences. Retail sales include durable and nondurable merchandise
sold, and services and excise taxes incidental to the sale of merchandise. It doesn’t
include sales taxes collected directly from the customer.
Purchasing Managers Index (PMI)
The National Association of Purchasing Managers (NAPM), now called the

Institute for Supply Management, releases a monthly composite index of national
manufacturing conditions. The index includes data on new orders, production, supplier
delivery times, backlogs, inventories, prices, employment, export and import orders. It
is divided into manufacturing and non-manufacturing sub-indices.
Industrial Production
A chain-weighted measure of the change in the production of the nation’s
factories, mines and utilities, industrial production also measures the country’s industrial
capacity and how fully it’s being used (capacity utilization).The manufacturing sector
accounts for one-quarter of the major currencies’ economies, so it’s critical to watch
the health of factories and whether their capacity is being maximized.
Gross Domestic Product (GDP)
The sum of all goods and services produced either by domestic or foreign
companies. GDP indicates the pace at which a country’s economy is growing (or
shrinking) and is considered the broadest indicator of economic output and growth.
Producer Price Index (PPI)
Measures average changes in selling prices received by domestic producers

in the manufacturing, mining, agriculture, and electric utility industries.
The PPIs most often used for economic analysis are those for finished goods,
intermediate goods, and crude goods.
Economic Ananlysis Part A Consumer Price Index (CPI)
Measures the average price level paid by urban consumers (80% of the population
in major currency countries) for a fixed basket of goods and services. It reports price
NOTES
changes in over 200 categories.
The CPI also includes various user fees and taxes directly associated with the
prices of specific goods and services.
Interest Rates
As the institutions that set interest rates, central banks are therefore the most
influential actors. Interest rates dictate flows of investment. Since currencies are the
representations of a country’s economy, differences in interest rates affect the relative
worth of currencies in relation to one another. When central banks change interest
rates they cause the forex market to experience movement and volatility. In the realm
of Forex trading, accurate speculation of central banks’ actions can enhance the trader’s
chances for a successful trade.
Gross Domestic Product (GDP)
The GDP is the broadest measure of a country’s economy, and it represents the
total market value of all goods and services produced in a country during a given year.
Since the GDP figure itself is often considered a lagging indicator, most traders focus
on the two reports that are issued in the months before the final GDP figures: the
advance report and the preliminary report. Significant revisions between these reports
can cause considerable volatility.
Consumer Price Index
The Consumer Price Index (CPI) is probably the most crucial indicator of inflation.
It represents changes in the level of retail prices for the basic consumer basket. Inflation
is tied directly to the purchasing power of a currency within its borders and affects its
standing on the international markets. If the economy develops in normal conditions,
the increase in CPI can lead to an increase in basic interest rates. This, in turn, leads to
an increase in the attractiveness of a currency.
Employment Indicators
Employment indicators reflect the overall health of an economy or business cycle.
Security Analysis and In order to understand how an economy is functioning, it is important to know how
many jobs are being created or destructed, what percentage of the work force is
actively working, and how many new people are claiming unemployment. For inflation Economic Ananlysis Part A
measurement, it is also important to monitor the speed at which wages are growing.
Retail Sales
NOTES
The retail sales indicator is released on a monthly basis and is important to the
foreign exchange trader because it shows the overall strength of consumer spending
and the success of retail stores. The report is particularly useful because it is a timely
indicator of broad consumer spending patterns that is adjusted for seasonal variables.
It can be used to predict the performance of more important lagging indicators, and to
assess the immediate direction of an economy.
Balance of Payments
The Balance of Payments represents the ratio between the amount of payments
received from abroad and the amount of payments going abroad. In other words, it
shows the total foreign trade operations, trade balance, and balance between export
and import, transfer payments. If coming payment exceeds payments to other countries
and international organizations the balance of payments is positive. The surplus is a
favorable factor for growth of the national currency.
Government Fiscal and Monetary Policy
Stabilization of the economy (e.g., full employment, control of inflation, and an
equitable balance of payments) is one of the goals that governments attempt to achieve
through manipulation of fiscal and monetary policies. Fiscal policy relates to taxes and
expenditures, monetary policy to financial markets and the supply of credit, money,
and other financial assets.
There are many economic indicators, and even more private reports that can be Check Your Progress
Discuss the various
used to evaluate the fundamentals of forex. It’s important to take the time to not only
economic indicators used
look at the numbers, but also understand what they mean and how they affect a nation’s in economic analysis for
economy. investment decisions.
5.8 Why Fundamental Economic Analysis?
First and foremost fundamental analysis is the most common technique used by
the public. Since a large enough number of people adopt it, it will operate on the basis
of economic data which is reliable. Also, a systematic approach is followed in which
Economic Ananlysis Part A economists and other professionals estimate the economic environment and its strengths
and weaknesses. Economic analysis plays an important role in the the decision making
of manufacturers/ service providers/ investors in a market. Economic analysis takes

NOTES
into account the opportunity costs of resources employed and attempts to measure in
monetary terms the private and social costs and benefits of a project to the community
or economy.
5.9 Economic Forecasting techniques
Forecasting for a business begins with forecasting for the entire industry involved.
For undertaking the forecasting, an analysis of factors affecting the company’s shares
needs to be done by employing appropriate market research techniques. Few techniques
which can be effectively used for economic analysis are elaborated hereunder:
A. Anticipatory Surveys: Periodic surveys undertaken by government as well
as private organizationsto obtain information from different experts so as to
learn about their opinions ,attitudes, beliefs, behavior towards different facets
of the economy. Care has to be taken while relying on the information
gathered through surveys as these cannot be regarded as forecasts and
there is no surety of the reliability which can be placed on the intentions

surveyed as they may not materialize.Surveys are very common for short
term forecasting.
B. Barometric approach: In this approaches, different indicators are studied

for finding out meaningful economic behavior and trends which are interpreted
and classified into different indicators such as leading or lagging indicators.
C. CompositeIndexes: Composite indices such as DiffusionIndex can also
be used to measure the statistical sets of variables for analyzing data about
the economy. A Diffusion Index is an indicator of thee extensiveness or

spread or expansion. A diffusion Index summarizes the common tendency
of a group of statistical series of variables. It combines several indicators
into a single variable so as to measure the movements of a time series data.

If as greater number of the series isrising the index will be above 50 and it
will be below 50, iffew numbers in the series are rising. Diffusion index
measures the degree of strength of an economy and the resultant inflation or Economic Ananlysis Part A
recession as a result of the performance of an industry and the group of
industries. There are two types of Diffusion Index i.e. Composite or

NOTES
Consensus Index as explained in thepreceding sentence wherein different
leading indicators are combined into a single measure and the other is
Component Evaluation Index which is a narrow measure examining a
particular series considering its components showing the breadth of movement

within a series.
D. Money and Stock Prices: Money Supply determines the Gross Domestic
Product, profits, interest rates, stock prices among other things. While making
forecasts, the growth rate of money supply should be taken into consideration
as also the stock market leads to changes in money supply. An effective

monetary policy is necessary for economic growth and steady prices.
C. Econometric Model Building: Econometrics is the field of study which
applies mathematical and statistical techniques to economic theory. A

mathematical model can be constructed using mathematical equations for
expressing relations between economic factors. The precise relationship
between dependent and independentvariables are formed. This method gives

direction as well as the magnitude of the changes in economic variables.
Econometric forecasting is used to forecast the overall economicactivities
with the aid of econometric model building which includes hundreds of

complex mathematical equations. However, the problem with econometric
models is the need for large scale programming and clerical support, collection
and processing a large amount of data and possibility of the out datedness of
results due to time gap in collection of data, analysis and interpretation.
Check Your Progress
D. Opportunistic Model Building: Opportunistic Model Building or GNP
Discuss the various
Model Building also known as sectoral analysis is a very widely used method Economic Forecasting
using national accounting framework wherein the total demands and total Techniques used for
forecasting in economic
income is hypothesized assuming certain decisions impacting the economy
analysis.
such as inflation, interest rates, war or peace etc. Thereafter, the forecast
of various components of GNP is done leading to an estimate of the GNP
figure which is tested for consistency. Data from government sources such Portfolio Management:95
Economic Ananlysis Part A as budgets, reports etc. can be utilized for this model building exercise. This
technique involves a vast amount of judgmenthowever; this can be eliminated
through selective combination
NOTES
5.10 Summary
• Fundamental analysis is a method of evaluating a security by measuring

its intrinsic value, with the aid of related economic, financial and other
qualitative and quantitative factors.
• Technical analysis is based on an analysis of factors like demand and supply

of securities and the share prices reflecting the various ,market indices in
the stock market.
• There are three phases of fundamental analysis as follows: .Economic

Analysis, Industry Analysis and Company Analysis
• In fundamental analysis, the investment decision is made as follows
If Intrinsic Value < Market Price then SELL
• Leading indicators are economic factors that change before the economy
starts to follow a particular trend.
• Lagging indicators are economic factors that change after the economy has
already begun to follow a particular trend.
• Money supply is mainly controlled through monetary policy and is concerned

with the changes in money supply in the economy mainly through impact on
interest rates.
• GDP is the broadest measure of a country’s economy, and it represents the

total market value of all goods and services produced in a country during a
given year.
• The balance of payments represents the ratio between the amount of payments
received from abroad and the amount of payments going abroad
• Balance of payment also shows the total foreign trade operations, trade
balance, and balance between export and import, transfer payments.
• In Barometric approach of forecasting, different indicators are studied for

Portfolio Management:96 finding out meaningful economic behavior and trends
• A Diffusion Index is an indicator of thee extensiveness or spread or expansion Economic Ananlysis Part A
which summarizes the common tendency of a group of statistical series of
variables by combines several indicators into a single variable to measure

NOTES
the movements of a time series data.
• Econometrics is the field of study which applies mathematical and statistical
techniques to economic theory in which mathematical model can be

constructed using mathematical equations for expressing relations between
economic factors.
5.11 Key Terms
1. Fundamental analysis: It is a method of evaluating a security by measuring
its intrinsic value, with the aid of related economic, financial and other
qualitative and quantitative factors.
2. Leading indicators: These are economic factors that change before the
economy starts to follow a particular trend and are used to predict changes
in the economy.
3. Lagging indicators: These are economic factors that change after the
economy has already begun to follow a particular trend.
4. Gross Domestic Product (GDP): It is the average of the growth rates of
agriculture, industrial sector and service sector.
5. Balance of Payments (BOP): It is measured as balance in capital account
+ balance in current account
6. Gross Domestic Product (GDP): It is the sum of all goods and services
produced either by domestic or foreign companies.
7. A Diffusion Index: It is an indicator of thee extensiveness or spread or

expansion and summarizes the common tendency of a group of statistical
series of variables.
8. Econometrics: It is a field of study which applies mathematical and statistical
techniques to economic theory. Security Analysis and

: Fundamental Analysis 5.12 Questions and Exercises

NOTES
1. This maintains that markets may misprice a security in the short run but that
the “correct” price will eventually be reached.
a. Technical Analysis
b. Fundamental Analysis
c. Economic Analysis
d. Financial Analysis
2. This is used to analyze historical trends to predict future price movement.
3. It is a method of evaluating a security by measuring its intrinsic value, with
the aid of related economic, financial and other qualitative and quantitative
factors.
4. These are generally slow and smooth moving and are also useful in predicting
the overall development of the industry by comparing each industry with the
overall industrial growth or with the growth of the country.
a. Leading Indicators
b. Lagging Indicators
c. Combined Indicators
d. All the above

5. These are economic factors that change after the economy has already Economic Ananlysis Part A
begun to follow a particular trend and are used to confirm changes in the
economy.
NOTES
a. Leading Indicators
b. Lagging Indicators
c. Combined Indicators
d. All the above
6. It is concerned with the tax initiatives and spending of the Government
a. Monetary Policy
b. Fiscal Policy
c. Trade Policy
d. Foreign Policy
7. It is measured by the price level changes as compared to the growth rate in

GDP
a. Gross National Product
b. Balance of Payments
c. Producers Production Index
d. Inflation
8. It comprises of external borrowings, repayment of external borrowings

investments and disinvestments.
a. Capital Account
b. Current Account
c. Balance of Payment
d. Invisibles
9. It comprise of international payment on account of payment of items other

than export and import of goods.
a. Capital Account
b. Current Account
d. Invisibles Portfolio Management:99
Economic Ananlysis Part A 10. It shows the total foreign trade operations, trade balance, and balance between
export and import, transfer payments.
NOTES a. Capital Account
b. Current Account
d. Invisibles
11. It combines several indicators into a single variable so as to measure the
movements of a time series data.
a. Diffusion Index
b. Composite Index
c. Consumer Price Index
d. Human Development Index
12. It is the field of study which applies mathematical and statistical techniques
to economic theory by constructing a mathematical model using mathematical
equations for expressing relations between economic factors.
a. Economics
b. Statistics
c. Mathematics
d. Econometrics

1. Explain the Concept of Fundamental Analysis
2. Discuss the Basics of Fundamental Analysis
3. Discuss the Basics of Fundamental Analysis used to analyse the Intrinsic

Value of Shares
4. What are the different phases of Fundamental Analysis
5. Explain the meaning and concept of Economic Analysis
6. Explain the relevance of economic indicators as a currency’s vital sign
7. Discuss the various economic indicators used in economic analysis for

investment decisions
8. Discuss the various Economic Forecasting Techniques used for forecasting Economic Ananlysis Part A
in economic analysis
NOTES
1. “Fundamental Analysis for Investors: 4th Edition”, Raghu Palat, Vision Books,
New Delhi, 2015
2. “Security Analysis and Portfolio Management”, Priyanka Singh and Raj
Kumar Singh, Thakur Publishers, Chennai, 2016.

Fundamental Analysis part
B : Industry Analysis Unit 6 Fundamental Analysis Part B:
Industry Analysis
NOTES
Structure
6.0 Introduction
6.1 Unit Objectives
6.2 The concept of Industry
6.3 Why Industry Analysis?
6.4 The Industry Analysis Process
6.5 Industry Life Cycle
6.6 Industry Classification according to Business Cycle
6.7 Financial aspects of Industrial analysis
6.8 Industry Competition Analysis – Porter’s Five Forces Model
6.9 Summary
6.10 Key Terms
6.0 Introduction
Industry analysis is done to assesss the prospects of various industrial groups. It
gives an idea of which industry will prosper and which industry will suffer in terms of
growth. Industry analysis provides an insight into the key sectors of an economy
influencing a particular industry or group of industries and the relative strength or
weakness of an industry or group of industries based on a set of assumptions. It is the
second phase of fundamental analysis.

6.1 Unit Objectives B : Industry Analysis

NOTES
Ø Understand the concept of industry
Ø Study the need for industry analysis
Ø Analyse the Industry Life Cycle
Ø Study the financial aspect of Industrial Analysis
Ø Understand Industry Competition Analysis
6.2 The Concept of Industry
Industry is a group of firms producing similar goods and it consists of a number of
companies.There may be industries which are on the rising point of the cycle called
sunshine industries and those which are on the decline called sunset industries. Industry
analysis takes into account various factors which influence the performance of the
company whose stocks are analyzed such as product line, Raw material inputs, Capacity
utilized, characteristics of industry concerned, demand of the product, Government
policy,labouravailability, future potential etc. Companies are classified as per their
production of goods. Industries can be classified on different basis, one of which is laid
down by the Reserve Bank of India as per the following groups:
• Food and Food Products.
• Textiles.
• Beverages and Tobacco.
• Wood and Wooden Products
• Rubber and Plastic Goods.
• Transport Equipment.
• Basic Metals and Alloys. Check Your Progress

• Machinery and Machine tools and Components. Industry and the
• Non Metallic Mineral Products. classification of industries.
• Chemical and Chemical Products.

B : Industry Analysis 6.3 Why Industry Analysis?
Although overall economy has got its own cycle of ups and downs, all industries
NOTES
in the economy need not necessarily move in tandem with the economy. Some industries
lag the economy, some might lead. At the same time, the performance of different
industries varies. Hence the need for industry analysis. Different industries have got
different risk-return characteristics during a particular time period. The stages of the
industries can also be different. Some might be mature while some industries might be
at agrowth stage of development. In a particular industry also, different companies

Check Your Progress
Explain the need for vary in their performance and stage of development. Hence for the analyst it might be
Industry Analysis. opportune to make buy or sell recommendation based on industry.
6.4 The Industry Analysis Process
Industry classification is the first and foremost step to be carried out. Because of
continuous development in product and process technologies, innovation and
technological changes, the structure of different industries change from time to time.
Hence it is difficult to categorize the economy into different industries for all the time
at once. This keeps changing at some interval. There are different ways in which
industry classification is done. The industry analysis process comprises of different
elements viz. business cycle vs. industry sectors, structural economic changes vs.
alternate industries, industry life cycle and industry competition analysis , the business
cycle and industrial sectors: Business cycle denotes the ups and downs in the
economy.Industry performance is related to these movements in the economy. However
all the industries do not move in tandem with the economy and this is point of challenge
for the analyst to choose an industry for investment. The investors should be prudent
to switch from one industry to another at opportune time.This is known as industry or

sector rotation. Investors should be able to identify the industry that is likely to do
better than others in a particular stage of the business cycle. This can be done by
monitoring relevant economic trends and industry characteristics. Structural Economic
Changes vs. Alternate Industries besides cyclical changes, the structural changeslike
Security Analysis and those in demographics, technology, lifestyles and regulatory environment also affect
Portfolio Management:104 differentindustries differently. Demographics includes growth in population, age
distribution, geographicdistribution of people, income distribution and changes in all Fundamental Analysis part
B : Industry Analysis
such attributes over time.Industry analysis is a complex process and to analyze a
particular industry, the past trends, demand supply mechanics, future potential and
NOTES
other industry dynamics needs to be analyzed.
A study of each industry is done at the micro level by analyzing the industry wide
factors with the objective to provide information about the best industry in which
investments can be made. Industry analysis comprises of a two- stage study.
Ø Industry Life Cycle. Check Your Progress

Discuss the Industry
Ø Study of other industry related factors. Analysis process.
Every industry has a life cycle similar to a product lifecycle. At a given point of
time, different industries perform differently. While one reason could be because ofthe
business cycle prevailing then another reason is the stage of the particular industry.
Industries gothrough different stages. In the initial stage, very high growth is observed
and lot of investment takesplace. At this time the players have got fist mover advantage
and protect and subsequently very high rateof returns are earned by the players in the
industry, which attracts new entities into the industry andsubsequently because of this
the initial players loose the advantages or superiority over others.
v Preliminary or Introduction Stage
v Growth Stage
v Stability
v Decline Stage
v Preliminary or Introduction Stage
In this stage, the manufacturer try to develop their brand name and it is the initial
stage for new companies. Demand is created for the product and there is stiff
competition as there are many producers producing the same or similar type of goods.
It is a survival of the fittest. The major portion of the market is occupied by the company
known as Market Leader. The primary aim of any business at this stage is survival
and for this firms may need to spend heavily on advertising to push the sale of the Security Analysis and
Fundamental Analysis part product. This stage is full of risk and uncertainty which needs to be countered by the
businessman to ensure survival.
NOTES The key features of this stage are:
• Modest Sales.
• Low or negative profit margin.
• Major Development Costs.
• Rapid Accelerating Growth.
• High sales growth.
• Limited number of competitors.
• Very high profit margin.
v Growth Stage
This stage is a significant stage in the life cycle and only the companies which
survive the preliminary stage can reach this stage. Strategies need to be made and
implemented at this stage to capture the market at this stage
Key Features of this stage are:
• Mature Growth
• Higher than normal sales growth
• More number of competitors
• High but declining profit margin
• Stabilization and Market Maturity
• Longest phase
• Normal sales growth
• Lower profit margin

v Stabilization or maturity stage
After enjoying rapid growth during the previous stage, the industry achieves
stabilization and maturity when the industry is more or less fully developed. In the
introduction or start up stage, one sees a rapid and increasing sales growth that becomes
stable in consolidation phase. In maturity stage, the sales growth declines and during
decline stage sales growth becomes negative.
Key features of this stage are: Fundamental Analysis part
• Longest phase
• Normal sales growth NOTES
• Lower profit margin
v Declining performance
The duration of different phases of industry life cycle varies from one industry
toanother. For industries where technological obsolescence is high, the duration becomes
shorter. Oneshould find the securities of firms that are able to capitalize on technological
change.An alternate way of analyzing the industry life cycle is to divide the same into
five stages with uniquefeatures in each stage.
Key Features of this stage are: Check Your Progress

Explain the components
• Declining sales growth
of the financial markets in
• Low or negative profit margin India.
• Very low rate of return on capital
Table showing Indian Industries at different stages of Life Cycle
Life Cycle Stage Industries
Preliminary or Introduction Stage v Biotech
v Bioinformatics
v Cyber Media
v Drugs
v Entertainment
v EcoFriendly Goods
v Organic Foods
Growth Stage v Information
Technology
products/services
v Mobile
v Automobile
v Pharmaceutical Portfolio Management:107
Fundamental Analysis part v Basic Education
v Retailing
NOTES v Medical and Healthcare
Stability v Textile
v Steel
v Oil and Gas
v Manufacturing
v Business Process Outsourcing
Decline Stage v Print Media
v Cotton Textile
v Paper
v Mining
Check Your Progress
Explain Industry Life v Agriculture
Cycle.
v Metallurgical
v Personal Computers
6.6 Industry Classification according to Business Cycle
The duration of a Business Cycle is not of the same length but varies for a period
ranging between two years to ten years which depends on the fluctuations in output
and other economic indicators. The trends in the cycle also differ. The duration of a
Business Cycle is not of the same length but varies for a period ranging between two
years to ten years which depends on the fluctuations in output and other economic
indicators. The trends in the cycle also differ.
Features of Business Cycles are:
« Business cycles occur periodically but not at regular and fixed intervals.
« They have distinct phases such as expansion , peak, contraction or depression

and trough.
« They have impact on more than one industry or sector and in all embracing
in nature.
« The impact is felt not only on the output and production levels but also other Fundamental Analysis part
factors such as employment, investment, consumption ,interest rates and
general price level.

NOTES
« Consumption of durables such as cars, houses, etc. affected more by business
cycles since its consumption can be postponed.
« The major impact of business cycles is on the inventories of goods due to

changes in output and production.
« Business cycles are global in nature since it spreads from one country to
other as inflation or recession affects imports and exports.
The classification of industries according to this framework is
1. Growth Industries
2. Cyclical Industries
3. Defensive Industries and
4. Cyclical growth industries.
Growth industries are those which feature abnormally high growth rates by
expansion and growth of earnings.This may be on account of a major change in the
state of technology or an innovative technique. Cyclical industries are those which
are impacted by the trade cycles and usually benefit during economic prosperity and
suffer from an economic recession. For example products like refrigerators and other
consumer durables. Defensive industries are those which are least impacted during
economic downswings. Investors hold securities in such defensive industries for income
purpose and not capital appreciation. Cyclical growth industries are those which
have the combined characteristics of both a cyclical as well as a growth industry. For
instance technological industries which grow tremendously at some point of time and Check Your Progress
then after going through periods of stagnation or decline also, they again resume their Explain Industry
Classification according to
growth.
Business Cycle.
Where are we in the business cycle?

B : Industry Analysis 6.7 Financial aspect of Industrial analysis
The financial performance of industries varies over time as well as among industries
NOTES
at a particular point of time. Industry performance is related to these movements in the
economy. However all the industries do not move in tandem with the economy –
where lies the challenge for the analyst to choose an industry for investment. The
investors should be prudent to switch from one industry to another at opportune time
known as industry or sector rotation. Investors should be able to identify the industry
that is likely to do better than others in a particular stage of the business cycle. This
can be done by monitoring relevant economic trends and industry characteristics. It

also suggests which industry is likely to do better at a particular stage of business
cycle, so that one can rotate the investment from one industry to another. When the
business cycle is at its peak, the basic materials industries like oil, metals etc. should
become investor favorites. Inflation, which is high at the time of peak have little effect
on these industries and these industries can increase prices thus showing higher profit
margins. During recession, some industries perform better than others. Although the
aggregate spending of people decline during recession, the spending on necessities
remain almost unchanged. Hence consumer staples like pharmaceuticals, food and
beverages outperform other sectors during a recession. Cyclical industries like consumer
durables, luxury items benefit the most at the time of expansion. The firms with high
financial graphs, technology, lifestyles and regulatory environment also affect different
industries differently. Demographics includes growth in population, age distribution,

geographic distribution of people, income distribution and changes in all such attributes
over time. In India, industries like retail, lifestyle products, fashion etc. are likely to do
better. The industries like information technology - IT and IT enabled services also do
better because of availability of brainpower. Lifestyles, the living standards, consumption
Check Your Progress pattern, education level etc. keep changing from time to time. Technology affects how
Explain the significance of
analysis of financial products are produced and delivered. This makes some industries redundant and new
performance for the industries come to the fore. Besides the above, the life cycle of industry and level of
purpose of Industrial
competition in a particular industry also affect the industry performance.
Analysis.

6.8 Industry Competition Analysis – Porter’s Five Forces B : Industry Analysis
Model
NOTES
Besides forecasting growth in sales and earnings in different stages of industry
and identifying the opportunities to invest, one should analyze the competitive structure
for the industry. MichaelPorter has provided five competitive forces that determine
the competitive structure of the industry. Those are explained as below.There are a
number of different frameworks available for industryanalysis; one of the most
recognized of these frameworks is called Porter’s Five Forces which is used to analyze
the five forces that determine the competitiveness and attractiveness of a particular
industry, to identify the major players in the industry, and to summarize the interaction
amongst all the players. This framework can also be a useful tool for investors evaluating
the attractiveness of investing in a particular company’s stock and to identify the
opportunities and risks the company will face in its industry.
There are two basic approaches to equity investing:
a. Bottom-up: Bottom up investing typically entails a quantitative screen that

identifies companies meeting certain criteria, such as a return on equity above
15%, or revenue growth of at least 20%, or a price/earnings multiple less
than 10. Once a list of stocks is identified, the analysis focuses on the specific
situation of the company, including its financial stability, market strategy,
valuation, etc. While a macro or industry analysis will be relevant, investors
that use a bottom up approach may in fact invest in industries with poor
prospects, if they feel that a particular company will still do well.
b. Top-down: On the other hand, there is a top-down approach, which starts
with a macro economic analysis to identify industries poised to perform well

in the current environment. Once these industries are identified, individual
companies are analyzed to determine the best positioned company to
outperform within those industries.

Fundamental Analysis part The Porter’s Five Forces Model
NOTES
The Porter’s five forces model can be depicted quite simply with the diagram
above. The following few paragraphs attempt to provide additional insight into the
application and use of the framework.
1. Competitive Rivalry among existing firms
If there are several players in the market, there will be very highcompletion for
price and profit margins are likely to be lower. If firms are of similar size, the rivalry
becomes more severe. Firms tend to price the products very low. Because of exit
barrierslike existing agreements with input suppliers, firms might operate with below-
average or negativereturn. In a slow growth industry the rivalry becomes worse because
expansion for a particularfirm will come at the cost of an existing player. This will lead
to further price wars.Competition exists on account of price, quality, after sales service,
promotion, guarantees, warrantees and other factors. Rivalry among firms in an industry,
competitive moves and countermoves impact the profitability of firms. The intensity
and form of competitive rivalry can have a huge impact on the dynamics within an
industry. On the other hand, it could inspire innovation and product improvements that
spur profits for all industry participants and hence, new entrants.Some of the factors
that impact the competitive rivalry of an industry are the number of firms in the industry,
the level of fixed costs, and the level of exit barriers. The larger the number of firms
Portfolio Management:112 competing in an industry, the more likely there will be intense competition for the same
customers. The same could be said for industries where fixed costs are high and or Fundamental Analysis part
exit barriers are costly. For instance, when fixed costs are high, companies tend to stay
back and fight to try to recover those costs. The same is applicable to industries with
NOTES
high exit barriers. It is also important to determine how easily a customer can switch
from one product/service to another. The lower the switching cost for a customer, the
more intense will be the rivalry to keep current customers while the competition tries
to steal them away.
2. Threat of New Entrants:
While existing firms in a particular industry compete among themselves,there are
always possibilities of new firms entering the market. If the barriers to entry are high
or strong then the existing players can benefit. The barriers to entry can take different
forms. Certain industries require very high investment in technology and other resources
thus limiting the number of players. New players may have to abandon their existing
facility and technology to enter a new market. Existing players might have got good
relationship with suppliers and customers in the supply chain. This might be difficult for
the new entrants to emulate. There are also regulatory constraints that prohibit other
players entering a market. Entry barriers exist for firms from other countries. Existing
firms might have cost advantage because of experience and scale of activity which
might be difficult to achieve for new players.An industry with high profit margins can
be expected to attract many new entrants. This results in an influx of new entrants,
which eventually will decrease profitability for all firms in the industry. Unless the
entry of new firms can be prevented, the unusually high profit margins decline to a
level considered equilibrium.New entrants add capacity; inflate costs, lower prices of
products thereby lowering the profitability.The existence of barriers to entry can be a
deterrent for outsiders Barriers to entry may include patents, capital expenditures,
product expertise, technological capabilities, economies of scale, to name a few. The
most attractive industry therefore, is one in which entry barriers are high and exit
barriers are low.
3. Bargaining power of buyers
Buyers can impose restrictions for the firms by asking for lowerprices and superior
quality. This is possible for buyers who are very large in size. The players in passenger
Fundamental Analysis part car or commercial vehicles industry have considerableinfluence on suppliers of
automobile components. This can lead to lower profitability for autocomponents
industry.As an investor, one has to analyse all the above factors to assess the intensity
NOTES
of competition in aparticular industry its impact on the long run profitability of the
industry.The bargaining power of customers can best be described as the terms that
customers can demand of companies. Buyers are a competitive force. In general, the
higher the number of customers a company has the less bargaining power each customer
will have. For instance, a company with a majority of sales to one large customer will
often have to provide that customer with favorable terms. Another factor in determining
the level of bargaining power of a customer is the size and frequency of orders placed
by that customer. A customer placing one small order will have less bargaining power
than a company placing many small orders over a longer period of time. In general, ask
yourself, who needs who more? And that should lead you in the right direction.
4. Bargaining power of suppliers
If suppliers are limited in number, they can pose threat to the industry in terms of
high input costs. The firms will be always on their toes. It becomes furtherdifficult if
the number of players is relative large compared to suppliers’ industry. Suppliersinclude
labor which can be organized and critical input for the firms. Availability of substitutesfor
inputs make the suppliers weak. The bargaining power of suppliers is determined by
the uniqueness of supplier’s products or services as well as a company’s ability to
switch suppliers. Suppliers of raw materials with very little differentiation among the
quality of material will have less power than a supplier with a comparatively higher
quality of product that is difficult to substitute. It’s important to evaluate supplier
capabilities within the context of what customers demand. The fact there could be a
high number of suppliers means the company can potentially switch if the need arises.
On the other hand, if there exists only one supplier of a particular input needed for a
company’s products, it would be difficult, costly, and/or impossible to switch.Powerful
suppliers can harm the profitability prospects of a buyer.
5. Threat of substitute products
Substitute products pose threat in terms of keeping theprice lower in a particular

industry. However the substitute has to be close in its functionality andutility. In food
industry, one can see lot of substitutes. In cooking appliances industry, inductioncookers Fundamental Analysis part
are very close substitute for gas burners. Thus, there is likely to be limited rise in price
ofgas burners. All industries face the threat of substitute products. These aren’t the
NOTES
same products offered by other companies, but rather, different products that satisfy
the same need as the product being offered by the company being analyzed. Substitute Check Your Progress
products hamper the profitability of a business by the imposition of a ceiling on the Explain Industry
Competition Analysis with
prices that can be charged from the customers. Examples of substitute products are
the help of Porter’s Five
Tablets as a substitute for computers to surf the internet, Smart phones as a substitute Forces Model.
for landlines to communicate. It should be remembered that the cost of changing products
is a key factor and when the cost is negligible and the perceived level of differentiation
is low, the substitution risk is high.
6.9 Summary
• Industry analysis provides an insight into the key sectors of an economy

influencing a particular industry or group of industries and the relative strength
or weakness of an industry or group of industries.
• Industry is a group of firms producing similar goods and it consists of a

number of companies.
• Industry analysis takes into account factors influencing the performance of

the company such as product line, Raw material inputs, Capacity utilized,
characteristics of industry concerned, demand of the product, Government
policy,labouravailability, future potential etc.
• Some industries lag the economy, some might lead and different industries
have got different risk-return characteristics during a particular time period.
• Investors should be able to identify the industry that is likely to do better than
others in a particular stage of the business cycle by monitoring relevant
economic trends and industry characteristics.
• Every industry has a life cycle similar to a product life cycle with different
stages namely Preliminary or Introduction Stage, GrowthStage, Stability stage,
Decline Stage.
Fundamental Analysis part • The classification of industries according to the business cycle framework is
growth, cyclical, defensive and cyclical growth industries.
NOTES • Growth industries are those which feature abnormally high growth rates by
expansion and growth of earnings on account of a major change in the state
of technology or an innovative technique.
• Cyclical industries are those which are impacted by the trade cycles and
usually benefit during economic prosperity and suffer from an economic
recession.
• Defensive industries are those which are least impacted during economic
downswings.
• Cyclical growth industries are those which have the combined characteristics
of both a cyclical as well as a growth industry.
• Michael Porter’s Five Forces Model has provided five competitive forces
that determine the competitive structure of the industry which is used to
analyze the five forces that determine the competitiveness and attractiveness
of a particular industry.
6.10 Key Terms
1. Industry: It is a group of firms producing similar goods and it consists of a

number of companies.
2 Industry analysis: It aims to assess the prospects of various industrial

groups.
3. Industry Life Cycle: It can be separated into Preliminary or Introduction

Stage,GrowthStage, Stability stage, Decline Stage and it describes the stages
through which an industry passes through
4. Growth industries: These are thoseindustries which feature abnormally

high growth rates by expansion and growth of earnings on account of a
major change in the state of technology or an innovative technique.
5. Cyclical industries: These are those which are impacted by the trade cycles
Security Analysis and and usually benefit during economic prosperity and suffer from an economic
recession.
6. Defensive industries: Theseare those which are least impacted during Fundamental Analysis part
economic downswings.
7. Cyclical growth industries: These are those which have the combined NOTES
characteristics of both a cyclical as well as a growth industry.
8. Industry Rotation: Investors should be prudent to switch from one industry

to another at opportune time. This is known as industry or sector rotation.
6.11Questions and Exercises

1. It gives an idea of which industry will prosper and which industry will suffer
in terms of growth.
a. Product Lifecycle
b. Industry Lifecycle
c. Industry analysis
d. Fundamental Analysis
2. The investors should be prudent to switch from one industry to another at

opportune time known as
a. Industry Analysis
b. Industry Rotation
c. Cycle Rotation
d. Switching
3. This includes growth in population, age distribution, geographic distribution

of people, income distribution and changes in all such attributes over time.
a. Industry Analysis
b. Industry Rotation
c. Demographics
d. Sector Rotation
4. This is a complex process and is used to analyze a particular industry, the

past trends , demand supply mechanics, future potential and other industry
dynamics needs to be analyzed.
a. Industry Life Cycle Security Analysis and

b. Industry Analysis Portfolio Management:117
Fundamental Analysis part c. Company Analysis
d. All the above
5. In this stage, the manufacturer try to develop their brand name and demand
NOTES
is created for the product
a. Preliminary Stage
b. Growth Stage
c. Stability stage
d. Decline Stage.
6. Strategies need to be made and implemented at this stage to capture the

market at this stage
b. Growth Stage
c. Stability stage
d. Decline Stage
7. Strategies need to be made and implemented at this stage to capture the

market at this stage
b. Growth Stage
c. Stability stage
d. Decline Stage
8. The key features of this stage areNormal sales growth and Lower profit
margin.
b. Growth Stage
c. Stability stage
d. Decline Stage
9. The key features of this stage are declining sales growth, low or negative
profit margin and low rate of return.
b. Growth Stage
c. Stability stage
Security Analysis and d. Decline Stage
10. These industries are those which feature abnormally high growth rates by Fundamental Analysis part
expansion and growth of earnings.
a. Cyclical
NOTES
b. Defensive
c. Growth
d. Cyclical Growth
11. These industries are those which are impacted by the trade cycles and usually
benefit during economic prosperity and suffer from an economic recession.
a. Cyclical
b. Defensive
c. Growth
d. Cyclical Growth
12. Investors hold securities in such industries for income purpose and not capital
appreciation
a. Cyclical
b. Defensive
c. Growth
d. Cyclical Growth
13. These industries are those which are least impacted during economic
downswings wherein investors hold securities for income purpose and not
capital appreciation
a. Cyclical
b. Defensive
c. Growth
d. Cyclical Growth
14. These industrieshave the combined characteristics of both a cyclical as well
as a growth industry.
a. Cyclical
b. Defensive
c. Growth
d. Cyclical Growth Portfolio Management:119
Fundamental Analysis part 15. This could inspire innovation and product improvements that spur profits for
all industry participants and hence, new entrants.
a. Competitive Rivalry between existing firms

NOTES
b. Threat from substitutes
c. Threats from new entrants
d. All the above

1. What do you mean by Industrial Analysis?
2. Explain the Industry Analysis process.
3. Explain the process of Industrial Life Cycle
4. Elaborate the classification of industries according to Business Cycles
5. Discuss the financial aspects of Industrial Analysis
6. Discuss Industry Competition Analysis with the help of Porter’s Five Forces
Model
“Security Analysis and Portfolio Management: Second Edition”, S.Kevin,

PHI learning Private Limited, Delhi, 2015

Unit 7 Fundamental Analysis Part C : part C : Company Analysis
Company Analysis
NOTES
Structure
7.0 Introduction
7.1 Unit Objectives
7.2 Need and Significance of Company Analysis
7.3 Company Analysis – Structure and Framework
7.4 Applications of Company Analysis: The Study of Financials Statements
7.5 Techniques of Financial Analysis
7.6 Important Financial Ratios for Company Analysis
7.7 Estimating Intrinsic Value
7.8 Economic Value Added (EVA) –A measure of Value Addition
7.9 Summary
7.10 Key Words
7.0 Introduction
An industry has more than one company. After industrial analysis , the next step
is to undertake company analysis in which an analysis of a company’s performance
enables an investor to take decisions on investment in that company’s stock from the
Check Your Progress
selected industry. It involves a company wide analysis of different factors which will
result in decisions whether to invest in a company or not.This is because all companies Company Analysis.
in a selected industry do not perform well. Hence, company analysis results in a decision
on selecting the best company from among the selected industry for investment. Security Analysis and
part C : Company Analysis 7.1 Unit Objectives
After studying this unit, you will be able to:

NOTES
Ø Understand the meaning and concept of Company Analysis
Ø Understand the need for Company Analysis and its significance
Ø Know the structure and framework of Company Analysis
Ø Understand the applications of company analysis through the study of
Financials Statements
Ø Learn the different techniques of Financial Analysis
Ø Know the important Financial Ratios for Company Analysis and understand
its computation
Ø Understand the meaning and relevance of Intrinsic Value for Company
Analysis
Ø Know the relevance of Economic Value Added and Market Value Added as
a measure of value addition
7.2 Need And Significance Of Company Analysis
Company Analysis is more of practical relevance as compared to economic and

industry analysis as it has direct relevance to the investment decision of invresting in a
specific company’s stock and securities.For this, a proper Evaluation of company’s
quantitative and qualitative factors is essential. The results of economic analysis provide
an idea when the economical conditions favour an investment, whereas the industry
analysis provides answers as to in which industry to invest, however the final decision
as to selection of the company in which investment can be done is taken only after a
relevant and useful company analysis. The objective of company analysis is to identify
those companies for investments based on factors like growth potential, profitability
prospects and risk averse. Company Analysis covers management analysis and financial
analysis. Management analysis would consider the performance of CEOs and top
managers, the past record and performance of the CEO and the corporate work ethic.
Security Analysis and Financial Analysis would consider revenue, costs, earnings of the company and the
company’s capital structure as reflected by its debt to equity ratio. Financial Analysis Fundamental Analysis
part C : Company Analysis
in the form of financial ratio analysis compares the company’s current stock price to
its earnings, dividends, and assets. Theses financial valuation ratios and then compared
NOTES
the financial valuation of other companies in the same industry to identify overvalued
and undervalued companies in terms of earnings, dividends and assets.
Warren Buffet has suggested four tenets of investing, viz. Business Tenets;
Management Tenets; Financial Tenets; Market Tenets.
1. Business Tenets:
• Is the business simple and understandable?
• Does the business have a consistent operating history?
• Does the business have favorable long-term prospects?
2. Management Tenets:
• Is management rational?
• Is management candid with its shareholders?
3. Financial Tenets:
• Focus on return on equity, not earnings per share
• Calculate “owner earnings”
• Look for companies with high profit margins
• For every dollar retained, make sure the company has created at least
one dollar of market value
4. Market Tenets:
• What is the intrinsic value of the business?
• Can the business be purchased at a significant discount to its fundamental

intrinsic value?
5. Financial Analysis
Shareholders, creditors, managers and other stakeholders seek answers to

questions about a business such as:
What is the Financial Position of a company during a given time period?
• How is the Financial Performance of a company during a given time

period? Portfolio Management:123
Fundamental Analysis • What are the sources and applications of cash over a given time period?
The answer to these questions lies in the preparation of statements like
NOTES Ø Balance Sheet
Ø Profit/ Loss Statement
Ø Cash Flow Statement
The Companies Act ,1956 (now 2013) mandates the preparation of Balance Sheet
and Profit/ Loss Account, the preparation of Cash Flow Statement is mandated by
Accounting Standard 3 issued by the ICAI (Institute of Chartered Accountant of India)

when the turnover of a company exceeds Rs.50 crores or its debt or equity is listed on
a stock exchange. The historical Financial Analysis includes an analysis of financial
reports is one of the intricate part of security analysis. Financial statements are supposed
to depict a true and fair view of the company. One has to analyze the company
performance for profitability, efficiency, liquidity, solvency and capital .market standing.
As part of financial statement analysis, normalization and adjustments need to be done

so that the statements are comparable across the companies in a particular group.
Since financial statements are the outputs of financial accounting/ reporting system,
subjectivity creeps into such reports because of accounting policies being followed by
a particular company. Hence one should look at the notes to accounts which are part
of financial statements. Financial statement analysis may not reveal the possible frauds
or misrepresentation in financial reporting strategy by the companies.
Some of the indications about frauds/ misrepresentation in the financial statements
are discussed hereunder:
• Assets utilization ratios that provide early warning signal.
• Unexplained changes are reasons for suspicious activities
• Unreasonable growth goals that cannot be financed easily
• Unexplained changes in policies & estimates especially in doom days
• Unexplained transactions to boost profit
• Very consistent margin, growth rate and stable or consistent increasing

cash and bank balance
• Unusual increase in debtors and inventories in relation to sales

Portfolio Management:124 • Unusual increase in intangible assets
• Reduction in managed cost- like advertisement to boost cost Fundamental Analysis
• One time profit from non-operating assets
• Unexplained focus or shift towards non-core business NOTES

• Significant changes in segment revenue & margin
• Improper method adopt in asset valuation
• Increasing gap between accounting income and taxable income
• Increasing gap between reputed income and cash from operation
• Unexplained write-off Check Your Progress

Discuss the need and
• Presence of special purpose vehicles/ enterprises (SPVs/ SPEs)
significance of Company
• Weak governance structure Analysis.
• Complex financial structure
7.3 Why Industry Analysis?
Company Analysis is composed of:
1. Financial Analysis
2. Non- Financial Analysis
Both the components have its relevance in its own unique way and a balance
should be achieved between both these components so as to make a sound investment
decision based on the company analysis. Financial analysis is a study of financial
indicators concerning the value of equity shares of a company and it is based on
factors such as assets, liabilities, cash flow, and revenue and price earnings ratio.
Financial Analysis broadly involves an analysis of:
a. Profitability
b. Financial Position
This will be dealt separately in the later part of this unit.
Non Financial/ Qualitative Analysis
Non Financial Analysis is done to evaluate the qualitative information about a

company which is available from other sources such as reports, prospectus, and other
non financial reports. It studies important non- financial aspects which do affect the
investment choice of investing in a company. An inclusive list of qualitative factors is
given below: Portfolio Management:125
Fundamental Analysis v Organization Structure
v Product range
NOTES v History and business of the company
v Company’s market share
v Industrial Relations
v Government Policies
v Industry Life Cycle
v Business Life Cycle

Check Your Progress
v Environment Protection
Briefly discuss the
structure and framework v Trade Unions
of Company analysis.
v Statutory Controls
7.4 Application of Company Analysis: The Study of

Financial Statements
Financial statements are a gold mine of information. Financial statements are the
medium by which a company discloses information concerning its financial performance.

Fundamental analysis use the quantitative information gathered from financial statements
to make investment decisions. The three most important financial statements – income
statements, balance sheets and cash flow statements are discussed hereunder:
a. Balance Sheet: The level, trends, and stability of earnings are powerful
forces in the determination of security prices. Balance sheet shows the assets,
liabilities and owner’s equity in a company. It is the analyst’s primary source
of information on the financial strength of a company. Accounting principles
dictate the basis for assigning values to assets. Liability values are set by
Check Your Progress contracts. When assets are reduced by liabilities, the book value of share
Highlight the Applications holder’s equity can be ascertained. The book value differs from current
of Company Analysis
value in the market place, since market value is dependent upon the earnings
with reference to Financial
Statements. power of assets and not their cost of values in the accounts.
b. Profit and Loss account: It is also called as income statement. It expresses

the results of financial operations during an accounting year i.e. with the
help of this statement we can find out how much profit or loss has taken Fundamental Analysis
place from the operation of the business during a period of time. It also helps
to ascertain how the changes in the owner’s interest in a given period have
NOTES
taken place due to business operations.
The main techniques of financial analysis are:
a) Comparative Financial Statements
b) Trend Analysis
c) Common Size Statement
d) Fund Flow Statement
e) Cash Flow Statement
f) Ratio Analysis
a) Comparative Financial Statements: Financial statements of two or more

firms may be compared for drawing inferences. This is known as inter-firm
comparison. Similarly, there may be inter-period comparison which involves
a, comparison of the financial statements of the same firm over a period of

years known as trend analysis. This is also known as horizontal analysis,
since each accounting variable for two or more years is analyzed horizontally.
Inter-firm or inter-period comparisons are very much facilitated by the

preparation of comparative statements. In preparing these statements, the
items are placed in the rows and the firms of years are shown in the columns.
Such arrangement facilitates finding the difference and brings out the
significance of such differences. The statement also provides for columns
to indicate the change form one year to another in absolute terms and also in
percentage form. In calculating percentages, there is one difficulty, namely,

if the figure is negative, percentages cannot be calculated. Likewise, if the
change is from or to a zero balance in account, it is not possible to calculate
the percentage. These statements indicate trends in sales, cost of production,

profits, etc., helping the analyst to evaluate the performance, efficiency and
financial condition of the undertaking. Comparative statements can also be Portfolio Management:127
Fundamental Analysis used to compare the position of the firm with the performance of the industry
or with other firms. Such a comparison facilitates the identification of
weaknesses.
NOTES
At times, Inter-firm comparison may be misleading if the firms are not of
the same age and size, follow different accounting policies and do not cater
to the same market. Inter-period comparison will also be misleading if the

period has witnessed frequent changes in accounting policies.
b) Trend Analysis: For analyzing the trend of data shown in the financial
statements it is necessary to have statements for a number of years. This

method involves the calculation of percentage relationship that each statement
item bears to the same item in the “base year”. Trend percentages disclose
changes in the financial and operating data between specific periods and
make possible for the analyst to form an opinion as to whether favorable or
unfavorable tendencies are reflected by the data.
c) Common Size Statement: Financial statements when read with absolute

figures are not easily understandable, sometimes they are even misleading.
It is, therefore, necessary that figures reported in these statements, should
be converted into percentage to some common base. In this technique, the

profit and loss account sales figure is assumed to be equal to 100 and all
other figures are expressed as percentage of sales. Similarly, in balance
sheet the total of assets or liabilities is taken as 100 and all the figures are
expressed as percentage of the total. This type of analysis is called vertical
analysis. This is a static relationship because it is a study of relationship
existing at a particular date. The statements so prepared are called common-

size statements.
d) Fund Flow Statement: Income Statement or Profit or Loss Account helps

in ascertainment of profit or loss for a fixed period. Balance Sheet shows
the financial position of business on a particular date at the close of year.
Income statement does not fully explain funds from operations of business
because various non-fund items are shown in Profit or Loss Account. Balance
Security Analysis and Sheet shows only static financial position of business and financial changes
Portfolio Management:128 occurred during a year can’t be known from the financial statement of a
particular date. Thus, Fund Flow Statement is prepared to find out financial Fundamental Analysis
changes between two dates. It is a technique of analyzing financial
statements. With the help of this statement, the amount of change in the
NOTES
funds of a business between two dates and reasons thereof can be
ascertained. The investor could see clearly the amount of funds generated
or lost in operations. These reveal the real picture of the financial position of
the company.
e) Cash Flow Statement: The cash flow statement shows how much cash
comes in and goes out of the company over the quarter or the year. At first
glance, that sounds a lot like the income statement in that it records financial
performance over a specified period. But there is a big difference between
the two. What distinguishes the two is accrual accounting, which is found on
the income statement. Accrual accounting requires companies to record
revenues and expenses when transactions occur, not when cash is exchanged.
At the same time, the income statement, on the other hand, often includes
non-cash revenues or expenses, which the statement of cash flows does not
include. Indeed, one of the most important features you should look for in a
potential investment is the company’s ability to produce cash. Just because

a company shows a profit on the income statement doesn’t mean it cannot
get into trouble later because of insufficient cash flows. A close examination
of the cash flow statement can give investors a better sense of how the
company will perform.
f) Ratio Analysis: Ratio is a relationship between two figures expressed
mathematically. It is quantitative relationship between two items for the

Check Your Progress
Explain the different
purpose of comparison. Ratio analysis is a technique of analyzing financial
techniques of Financial
statements. The ratios are studied in detail in the forthcoming part in detail. Analysis.
7.6 Important Financial Ratios for Company Analysis
A. Investment Valuation Ratios
1. Dividend Payout Ratio : Dividends paid divided by company earnings

over some period of time, expressed as a percentage. Security Analysis and
Fundamental Analysis 2. Dividend Yield: The yield a company pays out to its shareholders in
the form of dividends. It is calculated by taking the amount of dividends
paid per share over the course of a year and dividing by the stock’s
NOTES
price.
3. Price to Earnings Ratio: The most common measure of how expensive

a stock is. The P/E ratio is equal to a stock’s market capitalization divided
by its after-tax earnings over a 12-month period, usually the trailing period
but occasionally the current or forward period. The value is the same
whether the calculation is done for the whole company or on a per-
share basis. Companies with high P/E ratios are more likely to be
considered “risky” investments than those with low P/E ratios, since a
high P/E ratio signifies high expectations. Comparing P/E ratios is most
valuable for companies within the same industry. The last year’s price/
earnings ratio (P/E ratio) would be actual, while current year and forward
year price/earnings ratio (P/E ratio) would be estimates, but in each
case, the “P” in the equation is the current price. Companies that are not
currently profitable (that is, ones which have negative earnings) don’t
have a P/E ratio at all. It is also called earnings multiple.
4. Price Earnings Growth Ratio (PEG Ratio): A stock’s price/earnings

ratio divided by its year-over-year earnings growth rate. In general, the
lower the PEG, the better the value, because the investor would be paying
less for each unit of earnings growth.
B. The Liquidity Ratios
Liquidity of a company is an important indicator of its health. It measures the

ability of a company to convert its assets into cash quickly without any price compromise.
Liquidity ratios provide information about a firm’s ability to meet its short-term financial
obligations. They are of particular interest to those extending short-term credit to the
firm. The most common liquidity ratios are:
1. Current Ratio: The current ratio is the ratio of current assets to current
liabilities. Short-term creditors prefer a high current ratio since it reduces
their risk. Shareholders may prefer a lower current ratio so that more of
Portfolio Management:130 the firm’s assets are working to grow the business. The higher the ratio,
the more liquid the company is. If the current assets of a company are Fundamental Analysis
more than twice the current liabilities, then that company is generally
considered to have good short-term financial strength. If current
NOTES
liabilities exceed current assets, then the company may have problems
meeting its short-term obligations.
2. Quick Ratio: The quick ratio is an alternative measure of liquidity that

does not include inventory in the current assets. The current assets used
in the quick ratio are cash, accounts receivable, and notes receivable.
These assets essentially are current assets less inventory. The quick
ratio often is referred to as the acid test. Finally, the cash ratio is the
most conservative liquidity ratio. It excludes all current assets except
the most liquid: cash and cash equivalents. A measure of a company’s
liquidity and ability to meet its obligations. Quick ratio, often referred to
as acid-test ratio, is obtained by subtracting inventories from current
assets and then dividing by current liabilities. Quick ratio is viewed as a
sign of company’s financial strength or weakness (higher number means
stronger, lower number means weaker).
3. Cash Ratio: The total value of cash and marketable securities divided
by current liabilities. The cash ratio measures the extent to which
a company can quickly liquidate assets and cover short-term liabilities,
and therefore is of interest to short-term creditors. Also called Liquidity
Ratio or Cash Asset Ratio.
C. Profitability
In general, you want to invest in companies that are profitable. Profitability

ratios offer several different measures of the success of the firm at generating profits.
The gross profit margin is a measure of the gross profit earned on sales. The gross
profit margin considers the firm’s cost of goods sold, but does not include other costs.
1. Return on assets: It is a measure of how effectively the firm’s assets

are being used to generate profits. A measure of a company’s profitability,
equal to a fiscal year’s earnings divided by its total assets, expressed as
a percentage.
2. Return on equity: It is the bottom line measure for the shareholders, Portfolio Management:131
Fundamental Analysis measuring the profits earned for each dollar invested in the firm’s stock.
It is a measure of how well a company used reinvested earnings to
generate additional earnings, equal to a fiscal year’s after-tax income
NOTES
divided by book value, expressed as a percentage. It is used as a general
indication of the company’s efficiency; in other words, how much profit
it is able to generate given the resources provided by its stockholders.
investors usually look for companies with returns on equity that are high
and growing
3. Profit Margin: Net profit after taxes divided by sales for a given 12-
month period, expressed as a percentage.
4. Return on Capital Employed (ROCE): A measure of the returns

that a company is realizing from its capital. It is calculated as profit
before interest and tax divided by the difference between total assets
and current liabilities. The resulting ratio represents the efficiency with
which capital is being utilized to generate revenue.
D. Debt
Some debt is good, but too much debt could be bad. In general, you want to invest
in companies that can manage its debt well and can effectively leverage debt to its
advantage. Capitalization Ratio analyze debt in which each component of a
firm’s capital (common stock or ordinary share, preferred stock or preference shares,
other equities, and debt) as a percentage of its total capitalization is analyzed. These
ratios are used in analyzing the firm’s capital structure.
1. Debt to Asset Ratio: Debt capital divided by total assets. It shows the
company’s reliance on debt to finance assets. When calculating this
ratio, both current and non-current debt and assets are considered. In
general, the lower the company’s reliance on debt for asset formation,
the less risky the company is since excessive debt can lead to a very
heavy interest and principal repayment burden. However, when a
company chooses to forgo debt and rely largely on equity, they are also
giving up the tax reduction effect of interest payments. Thus, a company
will have to consider both risk and tax issues when deciding on an optimal
debt ratio.
3. Debt to Equity Ratio: A measure of a company’s financial leverage. Fundamental Analysis
Debt to equity ratio is equal to long-term debt divided by common
shareholders’ equity. Typically the data from the prior fiscal year is used
NOTES
in the calculation. Investing in a company with a higher debt to equity
ratio may be riskier, especially in times of rising interest rates, due to the
additional interest that has to be paid out for the debt. It is important to
realize that if the ratio is greater than 1, the majority of assets are financed
through debt. If it is smaller than 1, assets are primarily financed through
equity.
4. Interest Coverage Ratio: A calculation of a company’s ability to meet
its interest payments on outstanding debt Interest coverage ratio is equal
to earnings before interest and taxes for a time period, often one year,
divided by interest expenses for the same time period. The lower the
interest coverage ratio, the larger the debt burden is on the company.
E. Productivity
1. Asset Turnover Ratios: Asset turnover ratios indicate of how
efficiently the firm utilizes its assets. They sometimes are referred to as
efficiency ratios, asset utilization ratios, or asset management ratios.
Two commonly used asset turnover ratios are receivables turnover and
inventory turnover. Receivables turnover is an indication of how quickly

the firm collects its accounts receivables. The receivables turnover often
is reported in terms of the number of days that credit sales remain in
accounts receivable before they are collected. This number is known as

the collection period. It is the accounts receivable balance divided by the
average daily credit sales, calculated as follows:
2. Inventory Turnover Ratios: Another major asset turnover ratio is

inventory turnover. It is the cost of goods sold in a time period divided by
the average inventory level during that period. The inventory turnover
often is reported as the inventory period, which is the number of days

worth of inventory on hand, calculated by dividing the inventory by the
average daily cost of goods sold:

Fundamental Analysis 3. Fixed Asset Turnover Ratio: A way of determining the productivity of
a business, expressed as the ratio between money spent on fixed assets
and the total amount of revenue generated from sales. The less money
NOTES
spent on fixed assets for any given amount of sales revenue, the
more efficiently the business is operating.
F. Cash Flow
In business, you want to invest in companies with good cash flow. Operating
Cash Flow Ratio - This is a determination of whether current cash flow can
support the amount of expenses the company has generated.
1. Sales to Cash Flow Ratio: An indicator of the financial strength of
a company. This ratio looks at sales in relation to cash flow. The higher
the value of this ratio, the stronger the company. Formula: sales per
share divided by cash flow per share (or equivalently, total sales divided
by total cash flow).When investing in individual stocks, there are a lot of
information to consider when doing your due diligence. Understanding

these ratios can help you better understand the company you are looking
at and how it compares to its peer group.
G. Earnings:
There is strong evidence that earnings have a direct and powerful effect
upon dividends and share prices. So the importance of forecasting earnings

cannot be overstated. These ratios are generally known as ‘Return on
Investment Ratios’. These ratio help in evaluating whether the business is
earning adequate return on the capital invested or not. With the help of the
following ratios the performance of the business can be measured. The
earnings forecasting ratios are:
1. Return on Total Assets: A ratio that measures a company’s earnings
before interest and taxes (EBIT) against its total net assets. The ratio is
considered an indicator of how effectively a company is using its assets

to generate earnings before contractual obligations must be paid. To
calculate ROTA.
Where EBIT = Net Income + Interest Expense + taxes
The greater a company’s earnings in proportion to its assets (and the Fundamental Analysis
greater the coefficient from this calculation), the more effectively that
company is said to be using its assets. To calculate ROTA, you must

NOTES
obtain the net income figure from a company’s income statement, and
then add back interest and/or taxes that were paid during the year. The
resulting number will be the company’s EBIT. The EBIT number should
then be divided by the company’s total net assets.
2. Return on Equity: The amount of net income returned as a percentage
of shareholders equity. Return on equity measures a corporation’s

profitability by revealing how much profit a company generates with the
money shareholders have invested.Net income is taken for the full fiscal
year (before dividends paid to equity shareholders but after dividends to

preference shareholders) Shareholder’s equity does not include
preference shares. Also known as “return on net worth” (RONW). The
ROE is useful for comparing the profitability of a company to that of

other firms in the same industry. There are several variations on the
formula that investors may use. Investors wishing to see the return on
common equity may modify the formula above by subtracting preferred

dividends from net income and subtracting preferred equity from
shareholders’ equity, giving the following: return on common equity
(ROCE) = net income - preferred dividends / common equity.Return on

equity may also be calculated by dividing net income by average
shareholders’ equity. Average shareholders’ equity is calculated by adding
the shareholders’ equity at the beginning of a period to the shareholders’

equity at period’s end and dividing the result by two. Investors may also
calculate the change in ROE for a period by first using the shareholders’
equity figure from the beginning of a period as a denominator to determine

the beginning ROE. Then, the end-of-period shareholders’ equity can be
used as the denominator to determine the ending ROE. Calculating both
beginning and ending ROEs allows an investor to determine the change

in profitability over the period.
Fundamental Analysis H. Leverage
Borrowing of money at a fixed cost and the use of these funds to earn return
on assets is known as employing leverage. If one can earn more on borrowed

NOTES
money than you have to pay for it, the leverage is to firm’s advantage.
However, leverage should be used within reasonable limits because excessive
use of debt relative to equity increases borrowing costs and also the cost of
equity funds. The volatility of share holders returns increases with the
expansion of the degree of financial leverage. The greater volatility of earnings
owing to increased leverage can, at certain levels of debt financing, cause

the market to pay less per rupee of earnings. Further with the use of more
debts it may become progressively difficult to maintainor improve the rate of
return on assets. One of the best ways of measuring the proportions of debt
and equity financing is:
1. Debt to asset ratio = Total Debt / Total Assets
Valuation Ratios: A measure used by owners of common shares in a firm
to determine the level of safety associated with each individual share after
all debts are paid accordingly.
1. Earnings per share (EPS): The portion of a company’s profit allocated
to each outstanding share of common stock. Earnings per share serve as an
indicator of a company’s profitability. When calculating, it is more accurate

to use a weighted average number of shares outstanding over the reporting
term, because the number of shares outstanding can change over time.
However, data sources sometimes simplify the calculation by using the number
of shares outstanding at the end of the period.
Diluted EPS expands on basic EPS by including the shares of convertibles

or warrants outstanding in the outstanding shares number
2. Dividend per Share (DPS): The sum of declared dividends for every
ordinary share issued. Dividend per share (DPS) is the total dividends paid
out over an entire year (including interim dividends but not including special
dividends) divided by the number of outstanding ordinary shares issued.
Security Analysis and DPS can be calculated by using the following formula:
Formulae for Ratios Fundamental Analysis
Ratio Formula
1. Dividend Payout Ratio Dividend per share Earnings per share NOTES
2. Dividend Yield Dividend per share / market price per share
3. Price to Earnings Ratio Market Price per share Earnings per share
4. Price Earnings Growth Ratio Price / Earnings growth rate.
5. Current Ratio Current Assets / Current Liabilities
6. Quick Ratio Quick Assets / Quick Liabilities
7. Cash Ratio Cash + Marketable securities / Current
Liabilities.
8. Return on assets Earnings / Profit after tax / Total assets,
9. Return on equity Net Income / Shareholder’s Equity
10. Profit Margin Profit after tax × 100 / Net sales
11. Return on Capital Employed Profit before interest & tax /

(ROCE) Capital Employed
12. Debt to Asset Ratio Total Debt / Total Assets
13. Debt to Equity Ratio Total Debt / Net Worth
14. Interest Coverage Ratio Earnings before interest & taxes /
Interest Expenses
15. Asset Turnover Ratios Turnover / Total Assets
16. Inventory Turnover Ratios : Cost of goods Sold / Average Inventory
17. Fixed Asset Turnover Ratio Turnover / Sales / Fixed Assets
18. Sales to Cash Flow Ratio Sales per share / Cash Flow per share
19. Debt to asset ratio Debt / Total Assets
20. Earnings per share (EPS) : Earnings Available for Equity

Shareholders / Number of Equity Shares
21. Dividend per Share (DPS) : Total Dividend / Number of Equity Shares

Fundamental Analysis Case study
Study the financial performance and analyze its position with the help of the
financials as provided hereunder:

NOTES
Nestle India Ltd.
Standalone Balance Sheet in Rs. Crores
Dec ‘16 Dec ‘15 Dec ‘14 Dec ‘13 Dec ‘12
12 mths 12 mths 12 mths 12 mths 12 mths
Sources Of Funds
Total Share Capital 96.42 96.42 96.42 96.42 96.42
Equity Share Capital 96.42 96.42 96.42 96.42 96.42
Reserves 2,917.28 2,721.42 2,740.79 2,272.33 1,701.99
Networth 3,013.70 2,817.84 2,837.21 2,368.75 1,798.41
Secured Loans 0.00 0.90 4.11 0.01 0.24
Unsecured Loans 33.15 16.83 15.46 1,189.48 1,049.95
Total Debt 33.15 17.73 19.57 1,189.49 1,050.19
Total Liabilities 3,046.85 2,835.57 2,856.78 3,558.24 2,848.60
Application of Funds
Gross Block 5,201.10 5,058.48 4,950.10 4,844.28 4,368.68
Less: Accum. Depreciation 2,471.64 2,160.63 1,773.46 1,474.97 1,164.41
Net Block 2,729.46 2,897.85 3,176.64 3,369.31 3,204.27
Capital Work in Progress 188.17 230.79 244.78 294.71 344.08
Investments 1,749.35 1,324.92 811.82 851.08 364.86
Inventories 943.18 820.81 844.10 735.93 745.58
Sundry Debtors 97.93 78.42 99.10 84.27 87.57
Cash and Bank Balance 880.00 499.55 445.82 749.36 236.96
Total Current Assets 1,921.11 1,398.78 1,389.02 1,569.56 1,070.11
Loans and Advances 217.88 228.12 197.24 229.61 180.60
Total CA, Loans

Portfolio Management:138 & Advances 2,138.99 1,626.90 1,586.26 1,799.17 1,250.71
Dec‘16 Dec‘15 Dec‘14 Dec‘13 Dec‘12 Fundamental Analysis
12 mths 12 mths 12 mths 12 mths 12 mths
Current Liabilities 1,466.21 1,382.40 1,361.00 1,348.76 1,259.51 NOTES
Provisions 2,292.91 1,862.49 1,601.72 1,407.27 1,055.81
Total CL & Provisions 3,759.12 3,244.89 2,962.72 2,756.03 2,315.32
Net Current Assets -1,620.13 -1,617.99 -1,376.46 - 956.86 - 1,064.61 Check Your Progress
Total Assets 3,046.85 2,835.57 2,856.78 3,558.24 2,848.60 Enlist the important
Financial Ratios for
Contingent Liabilities 81.44 111.92 43.53 72.68 103.86 Company Analysis and
their computation.
Book Value (Rs) 312.57 292.26 294.27 245.68 186.53
Source: Nestle India Ltd. Website
7.7 Estimating Intrinsic Value
Intrinsic Value means the value of shares backed by asset quality, earning
capacity, risk, potential for performance and other factors. Ultimately, the market price
will be more or less equal to intrinsic value. Intrinsic value is calaulated by first estimating
the expected EPS of the company and expected risk and thereafter estimating the P/
E Multiplier.
Intrinsic Value is found as Expected EPS multiplied by the P/E Multiplier. It can
also be done as under.
After selecting a group of companies, one has to value the company or stock.
A. Present value of cash flows (PVCF)
1. Present value of dividends (DDM)
2. Present value of free cash flow to equity (FCFE)
3. Present value of free cash flow to firm (FCFF)
B. Relative valuation techniques
1. Price earnings ratio (P/E)
2. Price cash flow ratios (P/CF)
3. Price book value ratios (P/BV)
4. Price sales ratio (P/S) Security Analysis and

Fundamental Analysis Also one should also be able to find the stocks that are available cheap, i.e. the
market price is more that the intrinsic value. For estimating the intrinsic value of the
company one has to look at two major aspects: the company’s business in terms of
NOTES
products, services, capabilities, competitiveness etc. and corresponding business strategy
& the resultant financial performance.
If Intrinsic Value< Market Price then SELL
7.8 Industry Competition Analysis – Porter’s Five Forces

Model
Stern and Stewart of New York have suggested two new measures for measuring
value addition namely:
Check Your Progress a. Economic Value-Added (EVA)

Explain how the intrinsic
b. Market Value Added(MVA)
value is estimated?
These are alternatives to traditionals financial ratios.
a. Economic Value Added: It is the difference of net operating profit less

adjusted taxes (NOPLAT) and firm’s total cost of capital in rupee terms,
including the cost of equity. Traditional measures like return on equity or
return on investment do not consider the cost of capital. A company earning

a profit more than its cost of capital is supposed to be creating additional
wealth for the investors. This is propagated by Stern and Stewart of New
York as a better measure compared to accounting profit since it captures

cost of capital. In its base form, it can be called as economic profit i.e. the
profit earned over above the expectations of investors in terms of cost of
capital.
b. Market Value-Added: It is also suggested by Stern and Stewart for
measuring the performance of a company. It is measure of external

performance and it shows, how the market has evaluated the firm’s
performance in terms of market value of debt and market value of equity
Security Analysis and compared to the capital invested in the firm. Market value added is the
difference between market value and book value of the firm. It is suggested
that high EVA firms are likely to have high MVA. Similarly it is also suggested Fundamental Analysis
that MVA is the present value of future stream of EVA of a firm over the
years.
NOTES
These values are affected by the following factors:
• Competitive Edge: Another business consideration for investors is
competitive advantage. A company’s long-term success is driven largely
by its ability to maintain a competitive advantage and keep it. A company

with competitive advantage, would reward its shareholders well for
decades.
• Market share: The market share of the company helps to determine a
company’s relative position within the industry. If the market share is
high, the company would be able to meet the competition successfully.

The size of the company also matters since smaller companies may find
it difficult to survive in the future.
• Stability and Growth of annual sales: Investor generally prefers to
study the growth in sales because the larger size companies may be able
to withstand the business cycle rather than the smaller companies. The
rapid growth keeps the investor in better position as growth in sales is
followed by growth in profit. If a firm has stable sales revenue, other

things being remaining constant, will have more stable earnings. Wide
variation in sales leads to variation in capacity utilization, financial planning
and dividends.
• Earnings: The earning of the company should also be analyzed along
with the sales level. The income of the company is generated through
the operating and non-operating income. The investor should analyze
the sources of income properly. The impact of various factors on the
earnings of the company may be analyzed so as to improvise on the

same.

NOTES
• Capital Structure: Capital structure is combination of owned capital
and debt capital which enables to maximize the value of the firm. With
this we decide the proportion in which the capital should be raised from
the different securities. The owned capital includes share capital and
Preference shares Preference shares are those shares which have

preferential rights regarding the payment of dividend and repayment of
capital over the equity shareholders.
• Debt: It is an important source of finance as it has the specific benefit

of low cost of capital because interest is tax deductible. The leverage
effect of debt is highly advantageous to the equity shareholders.
• Management: A company relies upon management to steer it towards
financial success. Management is the most important aspect for investing
in a company. Even the best business plan is doomed if the leaders of

the company fail to deliver the results.
• Management Discussion and Analysis (MD&A): The management
discussion and analysis is found at the beginning of the annual report. In

theory, the MD & A is supposed to be frank commentary on the
management’s outlook. .

Past Performance Fundamental Analysis
Another good way to get a feel for management capability is to check and see
the performance in the past. Identify the companies they worked at in the past and do NOTES
a search on those companies and their performance.
• Operating Efficiency: Corporate governance describes the policies in
place within an organization denoting the relationships and responsibilities

between management, directors and stakeholders. These policies are
defined and determined in the company charter and its bye laws, along
with corporate laws and regulations. The purpose of corporate governance

policies is to ensure that proper checks and balances are in place, thereby
regulating unethical and illegal activities. Good corporate governance is
a situation in which a company complies with all of its governance policies

and applicable government regulations in order to look out for the interests
of the company’s investors and other stakeholders.
• Transparency: This aspect of governance relates to the quality and

timeliness of a company’s financial disclosers and operations. Sufficient
transparency means that a company’s financial discluses are written in
a manner that stakeholders can follow what management is doing so as

to have a clear understanding of the company’s current financial
situation.
• Stakeholder Rights: This aspect of corporate governance examines
the extent that a company’s policies are benefiting stakeholder interests,
especially shareholder interests. Ultimately, as owners of the company,

shareholders should have some access to the board of directors if they
have concerns. Therefore companies with good governance give
shareholders a certain amount of ownership voting rights to call meetings Check Your Progress
to discuss pressing issues with the board. Discuss Economic Value
Added and Market Value
• Composition of the Board of Directors: The board of directors is
Added as a measure of
composed of representatives from the company and representatives from Value Addition and
outside of the company. The combination of inside and outside directors factors affecting the same.
attempts to provide an independent assessment of management’s Security Analysis and

performance, making sure that the interests of shareholders are
Fundamental Analysis represented. The key word when looking at the board of directors is
independence.
NOTES
7.9 Summary
• Company analysis is an analysis of a company’s performance enables an
investor to take decisions on investment in that company’s stock from the
selected industry
• Financial analysis is a study of financial indicators concerning the value of
equity shares of a company based on factors such as assets, liabilities, cash
flow, revenue and price earnings ratio.
• Non Financial Analysis is done to evaluate the qualitative information about
a company which is available from other sources such as reports, prospectus,

and other non financial reports.
• The Companies Act ,1956 (now 2013) mandates the preparation of Balance
Sheet and Profit/ Loss Account, the preparation of Cash Flow Statement is
mandated by Accounting Standard 3 issued by the ICAI when the turnover
of a company exceeds Rs. 50 crores or its debt or equity is listed on a stock
exchange.
• Economic Value Added is the difference of net operating profit less adjusted
taxes (NOPLAT) and firm’s total cost of capital in rupee terms, including
the cost of equity.
• Market Value-Added is also suggested by Stern and Stewart for measuring
the performance of a company. It is measure of external performance and it

shows, how the market has evaluated the firm’s performance in terms of
market value of debt and market value of equity compared to the capital
invested in the firm. Market value added is the difference between market
• Capital structure is combination of owned capital and debt capital which
enables to maximize the value of the firm.
• The board of directors is composed of representatives from the company
and representatives from outside of the company. The combination of inside

Security Analysis and and outside directors attempts to provide an independent assessment of
management’s performance, making sure that the interests of shareholders Fundamental Analysis
are represented.
• The three most important financial statements – income statements, balance

NOTES
sheets and cash flow statements are discussed hereunder:
• Balance sheet shows the assets, liabilities and owner’s equity in a company.
It is the analyst’s primary source of information on the financial strength of

a company.
• Profit and Loss account also called as income statement expresses the results
of financial operations during an accounting year
• Comparative Financial Statements are financial statements of two or more
firms may be compared for drawing inferences known as inter-firm

comparison and inter-period comparison involves a, comparison of the
financial statements of the same firm over a period of years known as trend
analysis.
• Fund Flow Statement is prepared to find out financial changes between two
dates which helps us to know the amount of change in the funds of a business
between two dates and reasons thereof can be ascertained.
• The cash flow statement shows how much cash comes in and goes out of
the company over the quarter or the year.
• Ratio is a relationship between two figures expressed mathematically and it
shows the quantitative relationship between two items for the purpose of
comparison.
• Ratio analysis is a technique of analyzing financial statements.
• Liquidity of a company is an important indicator of its health which measures

the ability of a company to convert its assets into cash quickly without any
price compromise.
• Liquidity ratios provide information about a firm’s ability to meet its short-
term financial obligations.
• Profitability ratios offer several different measures of the success of the

firm at generating profits.
Fundamental Analysis • Borrowing of money at a fixed cost and the use of these funds to earn return
on assets is known as employing leverage.
NOTES • For estimating the intrinsic value of the company, the company’s business in
terms of products, services, capabilities, competitiveness etc. and
corresponding business strategy and the resultant financial performance is
to be seen
7.10 Key Terms
1. Financial Analysis: This would consider revenue, costs, earnings of the
company and the company’s capital structure as reflected by its debt to

equity ratio.
2. Financial statements: These are the medium by which a company discloses
information concerning its financial performance. The three most important

financial statements – income statements, balance sheets and Cash Flow
Statements.
3. Balance sheet: It shows the assets, liabilities and owner’s equity in a
company. It is the analyst’s primary source of information on the financial
strength of a company.
4. Profit and Loss account: It is also called as income statement and it
expresses the results of financial operations during an accounting year.
5. Comparative Statements: It is a technique of Financial Analysis wherein

financial statements of two or more firms may be compared for drawing
inferences known as inter-firm comparison. Similarly, there may be inter-
period comparison which involves a, comparison of the financial statements

of the same firm over a period of years known as trend analysis.
6. Trend Statements: These are prepared by finding trend percentage which

discloses changes in the financial and operating data between specific periods
and to form an opinion as to whether favorable or unfavorable tendencies
are reflected by the data.

7. Fund Flow Statement: It is a technique of analyzing financial statements. Fundamental Analysis
With the help of this statement, the amount of change in the funds of a
business between two dates and reasons thereof can be ascertained.

NOTES
8. Cash Flow Statement: These statements show how much cash comes in
and goes out of the company over the quarter or the year.
9. Ratio: It is a relationship between two figures expressed mathematically. It

is quantitative relationship between two items for the purpose of comparison.
10. Economic value added: It is the difference between net operating profit
adjusted for tax and cost of capital (in absolute value).
11. Market value added: It is the difference between market value and book
value of the firm. It is combination of owned capital and debt capital which
enables to maximize the value of the firm. With this we decide the proportion
in which the capital should be raised from the different securities.

1. Company Analysis covers
a. Management analysis
b. Financial analysis
c. Industry analysis
d. All the above
2. The Companies Act ,1956 (now 2013) mandates the preparation of
a. Balance Sheet
b. Profit/ Loss Account
c. Cash Flow Statement
d. All the above
3. Some of the indications about frauds/ misrepresentation are
a. Assets utilization ratios that provide early warning signal.

Fundamental Analysis b. Unexplained transactions to boost profit
c. Very consistent margin, growth rate and stable or consistent increasing
cash and bank balance

NOTES
d. All the above
4. It is done to evaluate the qualitative information about a company which is

available from other sources such as reports, prospectus, and reports.
a. Financial Statements
b. Non Financial Statements
c. Management Reports
d. All the above
5. It involves the calculation of percentage relationship that each statement
item bears to the same item in the base year
a. Trend Statements
b. Comparative Statements
c. Common size Statements
6. It measures the ability of a company to convert its assets into cash quickly
without any price compromise.
a. Liquidity
b. Solvency
c. Profitability
7. It is an alternative measure of liquidity that does not include inventory in the
current assets.
a. Current Ratio
b. Quick Ratio
c. Inventory Turnover Ratio
d. Cash Ratio

8. It is equal to earnings before interest and taxes for a time period, often one Fundamental Analysis
year, divided by interest expenses for the same time period.
a. Debt Coverage Ratio

NOTES
b. Interest Coverage Ratio
c. Earnings per Share
d. Dividend payout Ratio
9. This term is propagated by Stern and Stewart of New York as a better

measure compared to accounting profit since it captures cost of capital.
a. Leverage
b. Economic Value Added
c. Market Value Added
10. It is the difference of net operating profit less adjusted taxes (NOPLAT)
and firm’s total cost of capital in rupee terms, including the cost of equity.
a. Leverage
c. Market Value Added
11. It is the difference between market value and book value of the firm.
a. Leverage
c. Book Value Added
d. Market Value Added
12. It is combination of owned capital and debt capital which enables to maximize
the value of the firm.
a. Leverage
b. Capital Structure
c. Debt Equity Ratio
d. Intrinsic Value Security Analysis and

Fundamental Analysis 7.11.2 Theory Questions
1. Explain the need and significance of Company Analysis.
NOTES 2. Discuss with reference to Company Analysis – Structure and Framework.
3. What are the applications of Company Analysis with reference to the study
of financial Statements?
4. Explain the different techniques of Financial Analysis in detail.
5. List down the Important Financial Ratios for Company Analysis and its
computation.
6. Explain the Estimation of Intrinsic Value with reference to company analysis.
7. Discuss the relevance of Economic Value Added (EVA) as a measure of
Value Addition.
V.A.Avdhani, “Investment Analysis and Portfolio Management” , Himayala
Publishing House, 2011.

Technical Analysis
Unit 8 Technical Analysis
Structure NOTES
8.0 Introduction
8.1 Unit Objectives
8.2 Technical Analysis: Concept and Framework
8.3 Fundamental Analysis v/s Technical Analysis
8.4 Tools of Technical Analysis
8.5 Trends as tools of Technical Analysis
8.6 Charting Techniques
8.7 Modern Developments in Technical Analysis
8.8 Summary
8.9 Key Words
8.0 Introduction
Technical analysis is an analysis of share prices and traded volumes used to

predict the future price movements. It is done with the help of charts and other tools
which suggest some future movements. Technical Analysts believe that the stock prices
depend upon the demand and supply in the market and are worked out by the price and
volume statistics.

Technical Analysis
8.1 Unit Objectives

NOTES
« Know the meaning of Technical Analysis
« Distinguish Between Technical Analysis and Fundamental Analysis
« Use Charting and other techniques to take investment decisions
« Use Breadth and other indicators to assess the technical conditions of the
market and market sentiment
8.2 Technical Analysis: Concept & framework
Technical analysis is the Evaluation of securities by means of studying statistics
generated by market activity, such as past prices and volume. Technical analysts do
not attempt to measure a security’s intrinsic value but instead use stock charts to
identify patterns and trends that may suggest what a stock will do in the future.
Basic Premises underlying Technical Analysis
« The forces of Demand and Supply determine the market prices
« On the other hand, demand and supply are influenced by various fundamental,
psychological and other factors.
« Stock prices generally tend to move in a consistent trend with a few

exceptions
Check Your Progress
What do you mean by « The shifts in demand and supply can be identified with the help of charts of
Technical Analysis?
market trends.
Explain its concept and
framework. « Analysis of past market data aids in the process of predicting future price
behaviour.
8.3 Fundamental Analysis v/s Technical Analysis
Stock market is a volatile and uncertain market. For analyzing the stock market
prices and taking investment decisions, there are broadly two approaches. Fundamental
analysis (as seen in the previous units) and Technical Analysis. Fundamental Analysis
which is primarily focused on ascertaining the Intrinsic Value of shares for making Technical Analysis
investment decisions, Technical Analysis is radically different as it is concerned with
analyzing the price movements of a security and the studying the market trend and
NOTES
other market data with the help of graphs and chart. Technicians (also called chartists)
are only interested in the price movements in the market. In technical analysis it is
believed that the market is 90 percent psychological and 10 percent logical while the
reverse is assumed in fundamental analysis. Fundamentalists make their decisions on

quality and value and the yield or growth potential, concerning more with the financial
strength, turnover and profitability growth and other related factors. Technicians have
a belief that the stock market is dominated by institutional investors and the performance
of a stock is relevant rather than the company whose stocks are traded. Technicians
are of the view that the forces of demand and supply are reflected in the patterns of
price and trading volume through which he predicts whether prices are moving higher
or lower. Despite all the different tools it employs, technical analysis really just studies
and demand in a market in an attempt to determine what direction, or trend, will continue Check Your Progress
in the future. In the world of stock analysis, fundamental and technical analysis are on What are the differences
between Fundamental
completely opposite sides of the spectrum. Earnings, expenses, assets and liabilities
Analysis and Technical
are all important characteristics to fundamental analysts, whereas technical analysts Analysis?
could not care less about these numbers.
8.4 Tools of Technical Analysis
The various tools available for technical analysis are explained in detail below:
8.4.1 Charting Techniques

Technical Analysis uses different charting techniques to analyze the data. The
most common and popular ones are the Dow Theory, Bar and line charts, point and
figure charts, moving average and relative strength. Some of these technical tools
used to analyze the market data are elaborated hereunder:
a. Dow Theory: It originated in the late nineteenth century and formulated by
Charles H. Dow from a series of Wall Street Journal editorials which reflected
Dow’s beliefs on how the stock market behaved and how the market could
be used to measure the health of the business environment. Dow believed Security Analysis and
Technical Analysis that the stock market as a whole was a reliable measure of overall business
conditions within the economy and that by analyzing the overall market, one
could accurately gauge those conditions and identify the direction of major
NOTES
market trends and the likely direction of individual stocks. He used this theory
to create two averages namely
« Dow Jones Industrial Index(DJIA)
« Dow Jones Transportation Index (DJTA),
These two indexes were considered
to be representative of the economy

because they covered two major
economic segments: industrial and rail
transportation. Jones identified that the

share prices show three types of price
movements moving at the same time. An
important part of Dow Theory is

distinguishing the overall direction of the
market.
To do this, the theory uses trend analysis. The market tends to move in a general
direction, or trend, it doesn’t do so in a straight line. The market will rally up to a high
(peak) and then sell off to a low (trough), but will generally move in one direction. An
upward trend is broken up into several rallies, where each rally has a high and a low.
For a market to be considered in an uptrend, each peak in the rally must reach a higher
level than the previous rally’s peak, and each low in the rally must be higher than the
previous rally’s low. A downward trend is broken up into several sell-offs, in which
each sell-off also has a high and a low. To be considered a downtrend in Dow terms,
each new low in the sell-off must be lower than the previous sell-offs low and the peak
in the sell-off must be lower than the peak in the previous sell-off.
Now that we understand how Dow Theory defines a trend, we can look at the
finer points of trend analysis. Dow Theory identifies three trends within the market:

1. Primary Trend: Primary Trends representing bull and bear Phases of the Technical Analysis
market which continue for about a year or more and are quite significant in the application
of Dow Theory. A primary trend is the largest trend lasting for more than a year,
NOTES
while a secondary trend is an
intermediate trend that lasts three

weeks to three months and is often
associated with a movement against
the primary trend. Finally, the minor

trend often lasts less than three
weeks and is associated with the
movements in the intermediate

trend. In Dow Theory, the primary
trend is the major trend of the
market.
which makes it the most
important one to determine. This is

because the overriding trend is the
one that affects the movements in
stock prices. The primary trend will

also impact the secondary and minor
trends within the market. Dow
determined that a primary trend will

generally last between one and
three years but could vary in some
instances.
When reviewing trends, one of the most difficult things to determine is how long
the price movement within a primary trend will last before it reverses. The most important
aspect is to identify the direction of this trend and to trade with it, and not against it,
until the weight of evidence suggests that the primary trend has reversed.

Technical Analysis 2. Secondary or Intermediate Trend
Secondary movements or technical corrections which move against the primary
NOTES trend and last for a few weeks to a few months and they represent adjustments to the
excesses occurring in the primary movements. In Dow Theory, a primary trend is the
main direction in which the market is moving. Conversely, a secondary trend moves in
the opposite direction of the primary trend, or as a correction to the primary trend. For
example, an upward primary trend will be composed of secondary downward trends.
This is the movement from a consecutively higher high to a consecutively lower high.
In a primary downward trend
the secondary trend will be an

upward move, or a rally. This is the
movement from a consecutively
lower low to a consecutively higher

low. Below is a diagram of a
secondary trend within a primary
uptrend. Here the short-term highs

shown by the horizontal lines fail to
create successively higher peaks, suggesting that a short-term downtrend is present.
Since the retracement does not fall below the low, traders would use this to
confirm the validity of the correction within a primary uptrend. In general, a secondary,
or intermediate, trend typically lasts between three weeks and three months, while the
retracement of the secondary trend generally ranges between one-third and two-thirds
of the primary trend’s movement. Another important characteristic of a secondary
trend is that its moves are often more volatile than those of the primary move.
3. Minor Trend/ Daily Movements
Daily Movements also called minor trends which last for about a few hours to a
few days. These are of less significance and are random day to day wiggles. The last
of the three trend types in Dow Theory is the minor trend, which is defined as a market
movement lasting less than three weeks. The minor trend is generally the corrective
moves within a secondary move, or those moves that go against the direction of the
Portfolio Management:156 secondary trend. Due to its short-term nature and the longer-term focus of Dow Theory,
the minor trend is not of major concern to Dow Theory followers. However, the minor Technical Analysis
trend is analyzed with the large picture in mind, as these short-term price movements
are a part of both the primary and secondary trends. Most proponents of Dow Theory
NOTES
focus their attention on the primary and secondary trends, as minor trends tend to
include a considerable amount of noise.
Support and Resistance Level
The concepts of support and

resistance are undoubtedly two of the
most highly discussed attributes of
technical analysis and they are often

regarded as a subject that is complex by
those who are just learning to trade.
These terms are used by traders to refer

to price levels on charts that tend to act
as barriers from preventing the price of an asset from getting pushed in a certain
direction.
The explanation and idea behind identifying these levels seems easy, but as you’ll
find out, support and resistance can come in various forms and it is much more difficult
to master than it first appears. Even most experienced traders will be able to tell many
reasons about how certain price levels tend to prevent traders from pushing the certain
direction. Resistance levels are also regarded as a ceiling because these price levels
prevent the market from moving prices upward. On the other side, we have price
levels that are known as support. This terminology refers to prices on a chart that tend
to act as a floor by preventing the price of an asset from being pushed downward. As
you can see from the chart above, the ability to identify a level of support can also
coincide with a good buying opportunity because this is generally the area where market
participants see good value and start to push prices higher again
Volume of Trade
Dow gave special emphasis to volume. Technical analysts use volume as an
excellent method of identifying the trend. Therefore, the analyst looks for a price
increase on heavy volume relative to the stock’s normal trading volume as an indication Portfolio Management:157
Technical Analysis of bullish activity. Conversely, a price decline with heavy volume is bearish. A generally
bullish pattern would be when price increase are accompanied by heavy volume and
the small price increase reversals occur with the light trading volume, indicating limited
NOTES
interest in selling and taking profits and vice-versa.
8.4.2 Breadth of the market

The breadth of the market is the term often used to study the advances and
declines that have occurred in the stock market. Advances mean the number of shares
whose prices have increased from the previous day’s trading. Decline indicates the
number of shares whose prices have fallen from the previous day’s trading. This is
easy to plot and watch indicator because data are available in all business dailies. The
net difference between the number of stocks advanced and declined during the same
period is the breadth of market. A cumulative index of net differences measures the
net breadth. An illustrative calculation of the breadth of the market is shown in table
below.
Day Advances Declines Net Breadth
Advances (Cumulative of
Net Advances)
Monday 630 527 103 103
Tuesday 690 475 215 318
Wednesday 746 424 322 640
Thursday 492 630 -138 502
Friday 366 701 -335 167
Saturday 404 698 -294 -127
To analyze the breadth of the market, it is compared with one or two market
indices. Ordinarily, the breadth of the market is expected to move in tandem with
market indices. However, if there is a divergence between the two, the technical
analysts believe that it signals something. It means, if the market index is moving
upwards whereas the breadth of the market is moving downwards, it indicates that the
market is likely to turn bearish. Likewise, if the market index is moving downwards but
the breadth of the market is moving upwards, then it signals that the market may turn
Security Analysis and bullish.
Short Selling Technical Analysis
The selling of a security which the seller does not own, or any sale that is completed
by the delivery of a security borrowed by the seller is called shortselling. Short sellers NOTES
assume that they will be able to buy the stock at a lower amount than the price at
which they sold short. Selling short is the opposite of going long. That is, short sellers
make money if the stock goes down in price.
Odd Lot Trading
An odd lot is an order amount for a security that is less than the normal unit of
trading for that particular asset. Odd lots are considered to be anything less than the
standard 100 shares for stocks. Commissions on trading for odd lots are generally
higher on a percentage basis than those for standard lots, since most brokerage firms
have a fixed minimum commission level for undertaking such transactions. Odd lots
may inadvertently arise in an investor’s portfolio through reverse splits or dividend
reinvestment plans. The popularity of online trading platforms and the consequent
plunge in brokerage commissions means that it is no longer as difficult or expensive for

investors to dispose of odd lots as it was in the past.
8.4.3 Moving Average

Most technical traders incorporate the power of various technical indicators, such
as moving averages, to aid in predicting future short-term momentum, but these traders
never fully realize the ability these tools have for identifying levels of support and
resistance. A moving average is a constantly changing line that smooths out past price
data while also allowing the trader to identify support and resistance. Notice how the
price of the asset finds support at the moving average when the trend is up, and how it
acts as resistance when the trend is down. Most traders will experiment with different
time periods in their moving averages so that they can find the one that works best for
this specific task A five-day moving average of daily closing prices is calculated as
follows:

Technical Analysis Trading Day Closing price Sum of the recent Moving
closing prices Average
NOTES (5 latest days)
1 25 - -
2 26 - -
3 25.5 - -
4 24.5 - -
5 26 127 25.4
6 26 128 25.6
7 26.5 128.5 25.7
8 26.5 129.5 29.9
9 26 131 26
10 27 132 26.4
The moving averages are used to study the movement of the market as well as
the individual security prices. These moving averages are used along with the price of
a stock. The stock prices may intersect the moving average at a particular point and
give the buy and sell signal. The moving average analysis recommends buying a stock
when stock prices line rises through the moving average line when graph of the moving
average line is flattening out. Stock price line falls below the moving average line,
which is rising. Stock price line, which is above the moving average line, falls but
begins to rise again before reaching the moving average line. Moving average analysis
recommends selling a stock when stock price lines falls through the moving average
line when graph of the moving average line is flattening out. Stock prices line rise
above the moving average line, which is falling. Stock price line, which is below the
moving average line, rises but begins to fall again before reaching the moving average
line. The buy and sell signals initiated by a moving average trading system vary with
the length of time over which the moving average is calculated.

8.4.4 Relative Strength Analysis Technical Analysis
Relative Strength is a technical analysis strategy to help investors sort through all
of the various recommendations. It starts with identification of individual stock trends NOTES
and when the upward trends of stocks are identified early enough, the stocks may be
purchased and a profit may be realized by a continuance of the trend. Although past
performance is not necessarily a determining factor in the future performance of a
stock, using Relative Strength Analysis for stock selection has proven to be a profitable
strategy over time. This selection, which is used to compare all of the stocks that are
being followed, will sort them by their strength rating of the previous week placing a
rank on them and then sorting them by the current week’s strength rating. This report
is one of the most valuable tools of this system which will show you which stocks are
stronger and how much they are stronger than the previous. It provides you with a
means of analyzing hundreds of issues without having to look at each of the individual
charts to make comparisons. This tool has provided superior returns in testing and in Check Your Progress
Discuss in detail the
practice. The idea is to buy stocks that are experiencing strong upward momentum
various tools used for
with the expectations that the stocks will continue to be strong. These can be found Technical Analysis.
within the top 10 or 20 issues. It is important to look for issues that are experiencing a
steady upward momentum.
8.4.5 Mutual Fund Liquidity

A ratio called the mutual fund liquidity ratio compares the amount of cash relative
to total assets held by a mutual fund. Equity investors use the mutual fund liquidity ratio
to gauge the demand for shares and to know the bullish or bearish trend of stocks in a
portfolio. For instance, if a mutual fund is sitting on a large amount of cash, the
fundamental is that it is doing so because it is hard pressed to find quality investment

opportunities; therefore, it has a bearish sentiment toward the market. On the contrary,
if a mutual fund is highly invested and has a very small amount of cash on hand, the
logic is that it has found some excellent investing opportunities and is taking advantage
of these opportunities by being nearly fully invested - that is to say, it is bullish.

Technical Analysis 8.4.6 Put/Call Ratio
It is a ratio of the trading volume of put options to call options. The put-call ratio
NOTES has long been viewed as an indicator of investor sentiment in the markets. Times
where the number of traded call options outpaces the number of traded put options
would signal a bullish sentiment, and vice versa.

Number of Puts purchased
Put / Call Ratio is exp ressed as :
Number of Calls purchased
Technical Analysts have used the put call ratio for years as an indicator of the
market. Most importantly, changes or swings in the ratio are seen as instances of great
importance as this is viewed as a change in the tide of overall market sentiment. By
getting ahead of the tide, traders may be able to reap the rewards of taking positions at
prices below future projections.
8.5 Trends as tools of technical analysis
Tools of technical analysis that help in identifying these trends early are helpful
aids in investment decision making.Shifts in demand and supply are gradual rather than
instantaneous. Technical analysis helps in detecting these shifts rather early and hence
provides clues to future price movements.Fundamental information about a company
is absorbed and assimilated by the market over a period of time. Hence, the price
movement tends to continue in more or less the same direction till the information is
fully assimilated in the stock price.Charts provide a picture of what has happened in
the past and hence give a sense of volatility that can be expected from the stock.
Further, the information on trading volume which is ordinarily provided at the bottom of
a bar chart gives a fair idea of the extent of public interest in the stock.Most technical
analysts are not able to offer convincing explanations for the tools employed by them.By
the time an uptrend or downtrend may have been signaled by technical analysis, it may
already have taken place.Ultimately, technical analysis must be a self-defeating
proposition. Despite these limitations, technical analysis is very popular. It is only in the
rational, efficient and well-ordered market where technical analysis has no use. But
given the imperfections, inefficiencies and irrationalities that characterize real markets,
technical analysis can be helpful. Hence, it can be concluded that technical analysis
may be used, although to a limited extent, in conjunction with fundamental analysis to
Security Analysis and guide investment decision-making, as it is supplementary to fundamental analysis rather
than substitute for it.Technical analysis is all about trends. Here is a simplified chart Technical Analysis
showing the movement of a stock price over 18 months, as well as a trend line.Technical
analysis searches not only for trends, but also for reversals of trends. Using a polynomial
NOTES
trend curve, a technician may see a different pattern emerge, as shown on Figure
below.
Saucer
As you can see above, the data line is exactly the same, but at this point a technician
might see a saucer shape, which suggests a trend reversal. A saucer bottom indicates
the stock price has reached its support level, the lowest price at which it is likely to
trade, and it has nowhere to go but up. A saucer top signals exactly the opposite: the
stock has reached its resistance level, the highest price at which it is likely to trade.
The band between the support and resistance levels is called the trading channel.
Head and Shoulders
Another sign of a trend reversal is the head-and-shoulders pattern.. Technicians

consider this a bearish chart. Inverted head-and-shoulders would be bullish.
Take a closer look at the head and shoulders pattern, how to spot it and when to
buy.

Technical Analysis Breakout
The end that is signalled by a breakout,happens when a stock penetrates through
a support or resistance level. If a stock price breaks out through a resistance level and
NOTES
is accompanied by higher-than-usual trading volumes, technicians consider this a bullish
indicator. It means, according to technical analysis, that the stock is now looking for a
new resistance level, and it may be able to continue climbing on momentum for quite
some time.
Moving Average
One other type of trend line that technicians consider is the moving average,
which shows changes in the average share price over a given period. Technicians
believe that a stock price is likely to regress back to that average - good news to
anyone who bought the stock below that line
Accumulation/Distribution Line
Stock price is just one component of technical analysis. Volume is also important
because, according to technicians, changes in volume precede changes in price. Right
before a stock price gains, there may be a period of increased volume. One key volume
indicator is the accumulation/distribution line, which identifies divergences between
Check Your Progress stock price and volume flow.
of trends used for • If the price is declining but the volume is increasing, it is a bullish sign.
technical analysis.
• When price gains while volumes decrease, it is bearish.
8.6 Charting Techniques
Charts are the valuable and easiest tools in the technical analysis as they represent
a key activity for them. The graphic presentation of the data helps the investor to find
out the trend of the price without any difficulty by providing visual assistance to him in
detecting changing patterns of price behaviour. A large number of charts are used to
analyze the trend of the market. Several patterns are indicated by a chart which is
made by plotting the prices of individual shares. These charts are used to predict the
future price movements. The bar and line chart is the simplest and most commonly
used tool of a technical analyst. Bar charts contain measures on both axis: price on the
Portfolio Management:164 vertical axis and time on the horizontal axis. On bar charts, the analysts plot a vertical
line to represent the range of prices of the stock during the period that may be a day, Technical Analysis
week or month etc. thus the top of the vertical line would represent the highest price of
the stock during the day and the bottom of the line would represent the low price of the
NOTES
stock during the same day. A small horizontal line is drawn across the bar to denote the
closing price at the end of the time period. Technical Analysis all comes down to the
reading and interpretation of charts in the quest to identify a high probability entry into
a trade. The three most widely used types of charts are the Line chart, the Bar chart,
and the Candlestick chart Below you will find examples of each.
Line Chart
Of the three, the Line Chart is the most basic. It is created by connecting a series
of data points such as the closing price of the currency pair together with a line. In the
below chart, the line simply follows the price action so the trader can make a
determination as to the direction of the trend based on the past data points shown.
More often than not, a line chart is used on longer time frames to make a simple and
quick judgment about how the pair has been moving over the designated time frame.
Bar Chart
A Bar Chart provides additional information that can be valuable to a trader. The
daily chart having bars with each bar representing how the price for the pair traded
over 24 hours of time. The bar will show us the price at which this pair opened trading,
the high and the low price that it reached during the time frame, and the last price the
pair traded at that day. These details are noted in the chart below. Portfolio Management:165
Technical Analysis The additional details provided here can greatly assist the trader. The trader can
tell that during this time frame the pair continued its bullish upward move, since the
closing price was above the opening price.
NOTES
The Bar Chart represents categorical data in rectangular bars. The rectangular
bars can be horizontal or vertical. In the chart below, the data is represented by vertical
bars.
Candlestick Chart
At the first glance of this Daily Candlestick Chart one can see the benefits of
using this type of chart over the line chart and the bar chart straightaway. Based on the
shades of the candles –the dark shade is for a bullish candle that closes higher than it
opened, and light for a bearish candle that closes lower than it opened — it is readily
apparent which days were days of upward momentum and which days had downward
momentum.
The information provided by the candlestick chart (high, low, opening and closing
prices) is the same information provided by the Bar Chart. However, the information
is much more readily discernible in candlestick chart, because of the colours of the
candles. When looking at any candlestick, a bullish candle or a bearish candle, the top
of the wick and the bottom of the wick represent the highest and lowest price to which
the pair traded during that time frame. In using candlestick charts, keep in mind that as
you move among the various time frames, each candlestick will represent that time
frame. So, if you are looking at a Daily chart, each candle represents one day (24
Security Analysis and hours). In a 4 hour chart, each candle will represent 4 hours of time and so forth.
The Candlestick chart is a type of financial chart that is used by traders to keep Technical Analysis
a track of price movements. High Price, Low Price, and Close Price are represented
by candlestick chart. Other details like: Volume and Open Price can also be charted
NOTES
using Candlestick chart. A hypothetical data set is used an example to show the candle-
stick chart.
Particulars High Price Low Price Closing Price
Stock 1 156.26 151.76 153.99
Stock 2 138.97 135.76 137.45
Stock 3 148.34 144.14 146.67
Stock 4 150.25 145.75 147.87
Check Your Progress

Elaborate the different
types of Charts and
Charting techniques used
for technical analysis.
8.7 Modern Developments in Technical Analysis
Ø Elliot Wave Principle

Elliot Wave Principle (EWP) is a theory that attempts to develop a long term
pattern in the movements of stock prices according to which major moves take place
in five successive steps similar to tidal waves. For instance in a bullish market phase,
the first move is upward , second downward ,third upward, fourth downward and the
fifth and last stage upward. Whereas in a bearish market, the reverse flow is observed.

Technical Analysis Ø Chaos Theory
Chaos Theory in physics is used to examine some behaviour though random is
actually quite systematic. This theory is applied to weather prediction, fisheries, and
NOTES
population estimates. This helps in predicting stock Market behaviour by showing the
random changes in stock Prices to be non-random thus requiring revision in the theories
of finance.
Ø Kondratiev Wave Theory

This theory developed by Nikolai Kondratiev, a Russian Economist who helped
in the development of the First Soviet Union Five Year Plan. This theory is used to
Predict significant macro-economic changes such as floating exchange rates, elimination
of Gold Standard, reduction in free trade barriers among others making the decision
cycle less predictable.
Ø Neural Networks
It is a trading system which is used to build a forecasting model to find out a
desired output from the past financials and trading data. A pattern is developed by
repeatedly cycling through the data eventually leading to the expected outcome. Till
the desired output is achieved, more and more data is included. These are used to
extract patterns and trends that are complex and cant be noticed by humans or other
computer techniques. Neural Network also has a feedback mechanism incorporating
experience based on past errors. Sometimes a genetic algorithm is built into the network
Check Your Progress
to adapt against the changing flow of data. In technical analysis this can be used to
Discuss the modern
developments in Technical predict the future price of a financial instrument through a model, with the help of
Analysis. technical and fundamental data and other inputs such as current price, percentage gain
etc.
8.8 Summary
• Technical analysis is the Evaluation of securities by means of studying

statistics generated by market activity, such as past prices and volume.
• Fundamental and technical analysis is on completely opposite sides of the

spectrum. With Earnings, expenses, assets and liabilities being important
characteristics to fundamental analysts, whereas technical analysts could
not care less about these numbers.
• Technical Analysis uses different techniques to analyse the data such as the Technical Analysis
Dow Theory, Bar and line charts, point and figure charts, moving average
and relative strength.
NOTES
• Dow theory states that the stock market as a whole was a reliable measure
of overall business conditions within the economy and that by analyzing the
overall market, one could accurately gauge those conditions and identify the
direction of major market trends and the likely direction of individual stocks.
• In Dow Theory, the primary trend is the major trend of the market which
will generally last between one and three years.
• In Dow Theory, secondary movements or technical corrections move against

the primary trend and last for a few weeks to a few months representing
adjustments to the excesses occurring in the primary movements.
• In Dow Theory, Daily Movements also called minor trends which last for
about a few hours to a few days and are random day to day wiggles.
• Support and Resistance Level are concepts of technical analysis used by

traders to refer to price levels on charts that tend to act as barriers from
preventing the price of an asset from getting pushed in
• The breadth of the market is used to study the advances and declines that
have occurred in the stock market where advances mean the number of
shares whose prices have increased from the previous day’s trading and
decline indicates the number of shares whose prices have fallen from the
previous day’s trading.
• The moving averages are used to study the movement of the market as well
as the individual security prices and are used along with the price of a stock.
• The put-call ratio is a ratio of the trading volume of put options to call options
and viewed as an indicator of investor sentiment in the markets.
• Charts are the valuable and easiest tools in the technical analysis as they
represent a key activity for them through a graphic presentation of the data
helping the investor to find out the trend of the price
• Line Chart is created by connecting a series of data points such as the

closing price of the currency pair together with a line. Portfolio Management:169
Technical Analysis • A Bar Chartof the daily chart type has bars with each bar representing how
the price for the pair traded over 24 hours of time.
NOTES • In a candlestickchart the information is much more readily discernible asa

bullish candle or a bearish candle, the top of the wick and the bottom of the
wick represent the highest and lowest price to which the pair traded during
that time frame.
8.9 Key Terms
1. Technical analysis: It is the Evaluation of securities by studying statistics

generated by market activity, such as past prices and volume.
2. Dow Theory: Dow’s theory is based on a study on how the stock market
behaved and how the market could be used to measure the health of the
business environment.
3. Primary Trend: It represents bull and bear Phases of the market which
continue for about a year or more and are quite significant in the application
of Dow Theory.
4. Secondary Trend: Itis an intermediate trend that lasts three weeks to three
months and is often associated with a movement against the primary trend.
5. Minor Trend: It often lasts less than three weeks and is associated with
the movements in the intermediate trend.
6. Support and Resistance: These refer to price levels on charts that tend to
act as barriers from preventing the price of an asset from getting pushed in
a certain direction.
7. Breadth: The breadth of the market is the term often used to study the
advances and declines that have occurred in the stock market.
8. Short Selling: The selling of a security that the seller does not own, or any
sale that is completed by the delivery of a security borrowed by the seller is
called short selling.
9. Odd lot: It is an order amount for a security that is less than the normal unit
Security Analysis and of trading for that particular asset and is considered to be anything less than
the standard 100 shares for stocks.
10. Moving averages: These are used to study the movement of the market Technical Analysis
as well as the individual security prices and they recommend buying a stock
when stock prices line rises through the moving average line
NOTES
11. Put/Call Ratio: It is a ratio of the trading volume of put options to call
options and it has long been viewed as an indicator of investor sentiment in
the markets.:

1. It is an analysis of share prices and traded volumes used to predict the
future price movements.
a. Fundamental Analysis
b. Technical Analysis
c. Dow Theory
d. Chaos Theory
2. In technical analysis it is believed that the market is
a. 10 percent psychological and 90 percent logical
b. 80 percent psychological and 20 percent logical
c. 90 percent psychological and 10 percent logical
3. Technical analysts are of the view that these are reflected in the patterns of
price and trading volume through which he predicts whether prices are moving
higher or lower.
a. The forces of demand and supply
b. The stock price movements
c. The market performance
d. All the above
4. The most common and popular technical tools are
a. The Dow Theory
b. Bar and line charts
c. Point and figure charts Security Analysis and

d. All the above Portfolio Management:171
Technical Analysis 5. Dow believed that it is a reliable measure of overall business conditions
within the economy and that by analyzing the overall market; one could
accurately gauge those conditions and identify the direction of major market
NOTES
trends
a. Trends
b. Stock Markets
c. Company statistics
d. All the above
6. These represent bull and bear Phases of the market which continue for
about a year or more and are quite significant in the application of Dow
Theory.
a. Primary trend
b. Secondary Trend
c. Minor Trend
7. It is an intermediate trend that lasts three weeks to three months and is

often associated with a movement against the primary trend.
a. Primary trend
b. Secondary Trend
c. Minor Trend
8. This often lasts less than three weeks and is associated with the movements
in the intermediate trend.
a. Primary trend
b. Secondary Trend
c. Minor Trend
9. This term is often used to study the advances and declines that have occurred
in the stock market.
a. Breadth of the market
b. Length of the market
c. Resistance
Portfolio Management:172 d. None of the Above
10. It is an order amount for a security that is less than the normal unit of trading Technical Analysis
for that particular asset.
a. Averages
NOTES
b. Length
c. Breadth
d. Odd lot
11. It is a constantly changing line that smooths out past price data while also
allowing the trader to identify support and resistance.
a. Moving Averages
b. Length
c. Breadth
d. Odd lot
12. This ratio compares the amount of cash relative to total assets held by a
mutual fund.
a. Debt Equity Ratio
b. Moving Average
c. Mutual Fund Equity Ratio
d. Mutual Fund Liquidity Ratio
8.10.2 Theory questions
1. What do you mean by Technical Analysis? Explain its concept and
framework.
2. What are the differences between Technical Analysis and Fundamental
Analysis?
3. Discuss in detail the various tools used for Technical Analysis.
4. Explain the different types of trends used for technical analysis.
5. Elaborate the different types of Charts and Charting techniques used for
technical analysis.
1. Security Analysis and Portfolio Management - Second Edition, Punithavathy

Pandian, Vikas Publishing House, New Delhi.
2. Investment Management(Security Analysis and Portfolio Management),Jay

M. Desai and Nisarg Joshi, Wiley. Portfolio Management:173
Behavioural Finance
Anomalies Unit 9 Behavioural Finance Anomalies
NOTES Structure
9.0 Introduction
9.1 Unit Objectives
9.2 Behavioural Finance: Concept and Framework
9.3 Key Differences between traditional finance and Behavioural finance
9.4 Investor Biases
9.5 Taxonomy of behavioural risk
9.6 Observations in behavioral finance
9.7 Behavioural portfolio
9.8 Applications of Behavioural Finance Theory
9.9 Investor Psychology Cycle
9.10 Behavioural Finance and market efficiency
9.11 Critiques of behavioural finance
9.12 Summary
9.13 Key Words

Behavioural Finance
9.0 Introduction Anomalies
Behavioural Finance is the study of the impact of psychology on the behavior of

NOTES
financial decision makers and practitioners and its effects on the market behavior. It is
a combination of two different areas economics and psychology which is jointly used
to assess the behavior of people on spending, saving, borrowing money and other
financial transactions.
9.1 Unit Objectives
After studying this Unit, you will be able to:
Ø Understand the concept and framework of behavioural Finance
Ø Know the differences between Traditional Finance and behavioural Finance
Ø Study the different types of investor biases
Ø Understand the Taxonomy of behavioural risk
Ø Oversee the different observations in Behavioural Finance
Ø Study the common behavioural portfolio
Ø Study the applications of Behavioural Finance Theory
Ø Learn the Investor Psychology Cycle
Ø Understand the relation between Behavioural Finance and Market Efficiency
9.2 Behavioural Finance: Concept and Framework
Behavioral finance is a combination social and psychological theory with financial

theory as a means of understanding how price movements in the securities markets
happen independent of any corporate actions. In financial market there are numerous
variables that affect prices in the securities markets. Investors’ decisions to buy or sell
may have a more distinct margin affect impact on market value than
favorable earnings or profitable products. The role of behavioral finance is to
help market analysts and investors understand price movements in the absence of any
intrinsic changes on the part of companies or sectors. Behavioral finance is a theory
that attempts to explain how investors process events and formulate decisions. Security Analysis and
Behavioural Finance Theoretically, understanding behavioral finance allows other investors to predict market
Anomalies
movements and profit from them. While consumers tend to make a lot of the same
mistakes investors do, there is a definite focus among financial behaviorists on the
NOTES
psychology of investing in particular. This is most likely due to the fascination with the
activity of financial markets. In addition to sometimes making poor decisions, consumers
and investors have a tendency to follow each other into significant financial situations.
Behavioral finance theorists try to track the wrong decisions they make, as well as
their impact on markets as a whole. They can use this information to either help guide
investors into making sounder decisions when investing in the stock market, or to profit
from it. These concepts contradict the efficient market hypothesis, and may not really
give investors the opportunity to profit from subsequent market movements, but they
can act as a guide to investors into making better investing decisions. There are different
theories of behavioural finance such as Prospect Theory and it is believed the net
effect of the gains and losses involved with each choice are combined to present an
overall Evaluation of whether a choice is desirable. The prospect theory can be used
to explain quite a few illogical financial behaviors. Prospect theory also explains the
occurrence of the disposition effect, which is the tendency for investors to hold on to
losing stocks for too long and sell winning stocks too soon. The most logical course of
action would be to hold on to winning stocks in order to further gains and to sell losing
stocks in order to prevent escalating losses. By avoiding the Disposition Effect It is
Check Your Progress
Explain the concept and possible to minimize the disposition effect by using a concept called hedonic framing to
Framework of Behavioural change your mental approach.
Finance.
9.3 Key Differences between Traditional Finance and

Behavioural Finance
Traditional Finance theories exist and predominantly followed since 1950s, based
on the financial model developed by economists at the University of Chicago. Traditional
Finance theories are based on the assumption that investors act rationally while taking
investment decisions and evaluate all the available information. Psychologists challenged
this view and argued that people suffer from cognitive and emotional biases and
sometimes act in an irrational manner. Though this theory called behavioural finance
was not accepted by financial experts, it started gaining wider acceptance with larger
Portfolio Management:176 availability of evidences on the influence of psychology on financial decisions.
Traditional Finance and Behavioural Finance can be differentiated on the following Behavioural Finance
Anomalies
grounds:
« Traditional Finance recognizes the correct and complete data processing by

NOTES
the people, whereas behavioural finance believes in employment of improper
rules to process data thereby inducing biases in decisions and thereby resulting
into commitment of errors.
« The basic proposition of Traditional Finance is that all finance decision is

taken with the objective of risk and return with the form used to describe the
problem being inconsequential. In behavioural finance perceives risk and
return as being influenced by the manner in which decision problem is framed.
« Traditional Finance decisions are guided by reasoning, logic and judgment.

Behavioural finance is more guided by emotions and instincts which play a
lead role in investment decision making.
« Traditional Finance assumes markets to be efficient making the security

prices an unbiased estimate of its intrinsic value, whereas behavioural finance
contends heuristic based biases and errors and effect of emotions and social
Check Your Progress
influences leading to differences between fundamental value and security What are the key
prices. differences between
Traditional Finance and
Behavioural Finance?
9.4 Investor Biases
Investors suffer from biases which result into lack of learning from mistakes and
economists assume that people learn from their mistakes. The most common biases
are over optimism and over confidence. The different types of biases are –
Ø Self-Attribution Bias: It happens when people attribute success to their

own efforts whereas unsuccessful results are said to be the result of bad
luck.
Ø Cognitive Bias: Cognitive errors result from incomplete information or

lack of analytical ability to understand the available information. Cognitive
study is a study of cognition which is concerned with the mental process
underlying a behavior. For instance, reasoning, thinking, decision making,
motivation and different emotion impacting behavior. Cognitive psychology
includes a wide array of topics concerning aspects like reasoning, creativity,
perception, attention etc. Portfolio Management:177
Behavioural Finance Ø Confirmation Bias: It is a human tendency to rely on evidences which
Anomalies
may act as an explanation to a behavior. It is a psychological concept which
seeks to explain why people tend to search information to confirm their
NOTES
opinion and overlook information which refutes their beliefs. This bias occurs
as a result when people filter out useful facts which don’t support their
belief .This can create problems resulting from a poor investment decision
due to overconfidence and due to which bulls tend to remain bullish and
bears remain bearish regardless of reality.
Ø Heuristic Driven Biases: Heuristic Driven Bias results into an investment

decision based on rules on thumb derived from personal experiences or
Trial and Error or simple beliefs. There are different heuristic drive biases
which impair a fair and proper judgement such as
i. Representativeness: This is all about forming opinion based on past

performance and stereotypes. It may or may not be a good basis to take
decisions.There are instances when this may not work, say when behavior
patterns are formed from random data, estimating future growth based on
past growth statistics which may or may not occur in the future, becoming
optimistic about future based on past or otherwise becoming too pessimistic
about it and so also when investors link a company and its reputation to its
profits and vice versa.
ii. Over Confidence: The information available may not be adequate enough
to form an opinion of a company. Overconfidence in the correctness of their
decision so also their illusion of control which may sometimes may not
correct leading to failures and wrong decisions.
iii. Anchoring: It results in a so called post returns announcement drift which

results in a company having reported unexpectedly good earnings to earn
exceptionally high profits and vice versa. Anchoring also results in the non
movement of stock prices on the announcement of profits/earnings since
investors stick to their belief about a company’s performance whether good
or bad. It means that once an opinion is formed by an investor ,they are
reluctant to change it inspite of hearing news of changes.

iv. Responsiveness to ambiguity: There is always a fear factor in people Behavioural Finance
Anomalies
which makes them wary of uncertain and fearful situations .They always
have comfort zone when it comes to investment decisions since there is less
NOTES
risk factor involved of losing their money. This results in local company
Bias, own company Bias or country bias which seeks to avoid unknown
investment avenues.
v. Mathematical Illiteracy: Not all people are mathematically literate since

many have problem in understanding maths. This leads to a monetary illusion
as there is a difference between nominal and real changes. Many a times,
people have problem in understanding probability. For example, in a lottery,
what will be the probability that a selected number out of 50 will be either 1,
2, 3, 4 or 5.There is a lot of improbability involved in this .This leads to a
great amount of uncertainty. Also people have a tendency to attach more
significance to large numbers than smaller ones. Similarly base rates are Check Your Progress
ignored while doing computations ignoring case to case rates. All these and
of investor biases affecting
many more problems are associated with mathematical computations and investment decisions.
literacy.
9.5 Taxonomy of Behavioural Risk
Psychologists and finance professionals have identified over a hundred biases

and heuristics which result in investors making poor investment decisions. It may
broadly be classified into Ego Bias, Information Bias, Emotion Bias, Attention Bias, or
Conservation Bias. A few illustrative examples of the different types of biases are
• Confirmation Bias
• Hindsight Bias
• Choice Supportive Bias
• Experimenter’s Bias
• Over Confidence
• Endowment Effect
• False Consensus
• Base Rate Fallacy Portfolio Management:179
Behavioural Finance • Information Bias
Anomalies
• Triviality
NOTES • Gambler’s Fallacy
• Blind Spot Bias
• Normalcy Bias
• Outcome Bias
• Negativity Bias
• Empathy Bias
• Optimism Bias
• Risk Compensation
• Restraint Bias
• Anchoring
• Availability Bias
• Focusing Effect
• Framing Effect
• Home Bias
• Attention Bias
• Loss Aversion
• Status Quo Bias
• Disposition Effect
• Sunk Cost Fallacy
• Zero risk Bias
• Availability Bias
• Social Biases
This list is not exhaustive but only illustrative; however the most common biases
are over optimism and over confidence.

Behavioural Finance
9.6 Observations in Behavioral Finance Anomalies
There are some of the most commonly recorded phenomena in behavioral finance
NOTES
which have been observed over periods of years. Behavioural Finance seeks to explain
various complex processes of traditional finance based on past experience and studies
depicting the following indicators of future behavior:

1. Investors are motivated by the fear of lossmore than the rewards of
investment: This is because investors put their money into assets so that
they can make money and once they’ve invested, the fear of losing their
money predominating. Even when the asset continues to give negative returns,
they are do not accept the fact that they made a poor investing decision and
continue to hold it, hoping to get their money back. This may or may not
happen and they end up incurring even greater losses.
2. Investors are often overconfident due to limited information: Generally
it is assumed that investors would be less confident when less information is

available. However, they have been easily assured by good news and when
the stock market performs well, they believe that it was possible to make a
lot of money with little effort. When the stock market recovers, this bias will
probably become evident again.
3. Detailed descriptions have greater influence on investors than
routine and more relevant facts: People have a tendency to be more

influenced by a colourfulsmall five page report than a set of hard data. Those
few pieces of data may be more relevant and beneficial in making a decision,
but lengthy and elaborate reports seem to have a stronger effect on many
people. This is also the case when they aren’t looking for something specific,
or have no preconceived notions about what they expect.
4. Random Decision making amongst choices: At the time of purchasing

almost identical products at similar prices, consumers are often confused
when it comes to making a decision. Many times, they make random choices
rather than an informed decision.

5. Using an arbitrary metrics to assign values to a security: Investors
usually come up with a random way to determine the value of a security
Behavioural Finance known as anchoring. For instance when investors look at the high and low
Anomalies
price of a security for a year and assume that the security is always going to
be trading in that price range. Whereas, if it is trading on the low side, they
NOTES
will buy the security with the expectation of increase in value which may
actually happen or may not happen. It can possible always move into new
low value resulting into a significant loss to the investors.
6. Gambler’s fallacy: Humans tend to be overconfident and end up being
completely illogical when predicting random, future events. They make
assumptions usually based on past events having no connection to the future.
Same is the case of viewing trading strategies that are based on random
price movements. It also shows for the difficult time people have profiting
from technical analysis trading strategies and according to them, the market
has no memory and that attempts to predict if based off of prior price
movements is a wasted exercise . However, there is a good probability that
they are right.
7. Placing more emphasis on recent events: People assume that recent
and relevant events go hand in hand and rationale doesn’t make any sense.
Investors will often look at the most current report from a group of analysts
who, from the same set of information, assumed that it is the correct one.
They often fail to look at the fact that all the analysts before them looked at
the same data, over the same time frame, but came up with different findings.
It is as if the events or studies that came before were statistically insignificant
and didn’t merit being included in the sample.
Check Your Progress 8. Conform to others’ beliefs: People go with the flow and make the same
What are the common mistakes that others have already made. This may be either due to a need
observations in the field of
for acceptance or the inability to accept that large groups can possibly be
behavioural finance?
incorrect.
9.7 Behavioural portfolio
A well balanced and appropriate portfolio developed on the lines of Harry

Markowitz’s Portfolio Theory needs to be developed so as to have well diversified
portfolio. The psychological basis of forming a portfolio in the form of a pyramid is built
Portfolio Management:182 based on the following points:
Ø Safety, Income and Growth is the order in which the needs of investments Behavioural Finance
Anomalies
are analyzed
Ø Each asset and each part of the pyramid is meant for a specific purpose.
NOTES
Ø Each investor has different investment needs and hence assume different
levels of risk for different goals
Ø The monetary allocation determines asset allocation in the portfolio
Ø Goal Diversification leads to investment diversification and the level of return
is determined by the level of risk taken by the investor.
Check Your Progress

Define an appropriate and
well balanced
behaviouralportfolio.
9.8 Applications of Behavioral Finance Theory
There are several ways that financial experts can use the lessons of behavioral
finance to their advantage
1. Recognizing mistakes and rectifying them:
There are a number of mistakes that investors and consumers make time and
time again. Understanding behavioral finance thoroughly allows them to notice their
mistakes and rectify them. Quite often, investors might realize that they constantly
make decisions based on limited knowledge. After they are made aware of this common
heuristic, they may notice it and take steps to fix it.
2. Adapting to other people’s decision making processes.
Apart from recognizing people’s mistakes, it is sometimes important just to

understand people and their thinking level. Portfolio Management:183
Behavioural Finance 3. Evaluating market trends.
Anomalies
Behavioral finance is the concept behind understanding markets trends, because
NOTES these are the basis of significant financial decisions. One application is through the use
of technical analysis, which involves using charts and graphs to predict future price
movements. The principle behind this is that humans rely on both conscious and
subconscious patterns when investing. Those patterns can be followed and used to
predict other future behavior.
4. Facilitating the planning process.
Forecasters are able to predict significant variables affecting investment decisions

and this is the key to understanding financial models. In many cases, they find their
numbers are erroneously assumed such as consumers’ or investors’ behaviour is
assumed to be rational. Predicting how consumers and investors will behave rather
than how they should behave will lead to more accurate forecasts and models.
5. Impacts of events on the market.
Typically, following long standing trends (such as price patterns over the course
of a month or more) is a popular idea among traders and technical analysts, but financial
planners can track security prices based on one-time events as well. Human beings
are expected to react in a certain way after an event and this information can be used
to their advantage.
6. Promoting products to consumers.
In a lot of ways, behavioral finance overlaps with marketing. They both rely
on the psychology of individuals and groups, and how it can be influenced through
strategically influencing others. While it could be considered unethical, companies
regularly study the decision-making errors of consumers to find out how they can be
exploited to convince consumers to purchase their products.
Some of these concepts contradict the efficient market hypothesis, which should
Check Your Progress
Discuss the applications of not necessarily be completely discounted. There is evidence to suggest that concepts
Behavioural Finance such as technical analysis are valid trading tools. They are based off of the logical
Theory.
concept that human beings tend to follow behavioral patterns not always to the majority
Security Analysis and of investors. Therefore, it may still be possible to profit from them.
Behavioural Finance
9.9 Investor Psychology Cycle Anomalies
Investors generally behave in any of the two ways

NOTES
i. During Bull markets, they become over enthusiastic
ii. During Bear Markets, they become over cautious
A rational investor takes his decisions based on an objective analysis of the markets
and other factors rather than going with the crowd. The typical investor behavior is
linked to the cycle known as Investor Psychology Cycle which is elaborated below:
1. Contempt: According to the cycle, a bull market begins at the point when
the markets are low and investors avoid investments in stocks, which however,
at the same time, provides the best opportunity to buy as valuations are high
in comparison to prices.
2. Doubt: At this stage, investors are to decide whether to invest in a safe

avenue as they have already experienced the worst investment losses and
decide never to invest again.
3. Caution: At this point, the markets witness recovery, however, investors
are cautious but some prudent investors are looking at the possibility of
profits.
4. Confidence: With the rising prices, investors gain confidence in the markets
which ultimately turn into enthusiasm and many investors pick up buying
more and more stocks with the hope of earnings better returns.
5. Enthusiasm: At this stage, investors have already started making profits
and make a move out of the stock markets due to the realization that the bull
market is likely to end soon.
6. Greed: The enthusiasm of investors in the previous stage is followed by

greed as a result of the different IPOs available in the market.
7. Indifference: Investors go beyond high price earnings ratio leading to

pressure to sell stocks whereas there is a reduction in buying pressure which
results in a steep fall in the markets.

Behavioural Finance 8. Dismissal: Dismissal signs begin to show as markets decline so as the
Anomalies
stock prices as investors reject different asset classes not worth investing.
NOTES 9. Denial: This is that stage where there is a belief that there cannot be a
further fall in the markets.
10. Fear, panic and Contempt: There are investor concerns as to whether to
hold and fear followed by panic and despair. At this juncture, investors are
frustrated and decide never to invest ever again as markets are at their
Check Your Progress
Write a note on Investor lowest and losses are at the maximum. This cycle goes on repeating again
Psychology Cycle. and again.
9.10 Behavioural Finance and Market Efficiency
Behavioural Finance theorists argue that there are variances between market
price and intrinsic value as a result of behavioural influence. This is founded on two
assumptions as given below:
1. All investors are not rational and are influenced by other factors like belief,
sentiments etc while making investment decisions.
2. Investors are wary and careful and when dealing with arbitrage operations
due to their risky nature. These type of investors also termed as noise traders
traderandomly and not based on an informed and rational analysis. These

traders suffer from judgmental bias and have common strategies to make
investment decisions. These investors have characteristics such as
overconfidence in trading, overreliance on trends, lesser weightage to base

rates and over reliance on new market information and followers of market
forecasts. This investment behavior results in an aggregate shift in demand.
3. Arbitrageursare immune to sentiments and guided by fundamentals. They

Check Your Progress usually face two types of risks fundamental risk which is the risk of going
Explain the relation
for undervalued stocks and fear of losses leading to further losses and making
between Behavioural
Finance and Market them avoid taking long positions pushing price to confirm to fundamentals
Theory. and the other is Resale price risk due to the limit on arbitrageurs due to
limited horizons. This is because they usually run their trades on borrowed
Portfolio Management:186 funds and can’t keep an open position for an infinite period. Further, given
the market conditions, these arbitrageurs are in a position to influence prices Behavioural Finance
Anomalies
more than what is expected from fundamentals enhancing price volatility. In
such situations, the option would be to either expect returns spread over a
NOTES
few months’ time period or otherwise expecting a negative correlation over
return over a few years’ time resulting in prices returning to fundamentals.
9.11 Critiques of Behavioural Finance
The critics of behavioural finance attribute the imperfections in the markets due
to the existence of bias and human errors in judgment and information processing and
have claimed that there is a larger amount of risk involved in loss making portfolio as
compared to the winning portfolios. This is in contrast to the empirical evidence in

which loser portfolios perform better than winner portfolios even after considering risk
adjustment. Also, these critics argue that behavioural finance is a mere collection of
anomalies and that underpricing or overpricing happens rarely in practice and is

temporary and when conditions normalize, the stock prices will be again equalized to
intrinsic value once the phase of mispricing is over so also market forces will drive
back the prices back to normal as claimed by economists. As a result, the irrational
behavior of investors doesn’t generally have a significant impact on the prices. The
biggest critique of behavioural finance is that it is more of theoretical relevance than of

practice. Another criticism of behavioural finance is that it is condemned as a theory
Check Your Progress
which shifts the failures of society and markets to the individuals used to confront Discuss the critiques of
economic, political and social problems. The micro level behavioural biases do not Behavioural Theory.
carry into the macro level markets.
9.12 Summary
• Behavioural Finance is the study of the impact of psychology on the behavior

of financial decision makers and practitioners and its effects on the market
behavior.
• Behavioural Finance is a combination of two different areas economics and

psychology which is jointly used to assess the behavior of people on spending,
saving, borrowing money and other financial transactions. Security Analysis and
Behavioural Finance • The role of behavioral finance is to help market analysts and investors
Anomalies
understand price movements in the absence of any intrinsic changes on the
part of companies or sectors.
NOTES
• Traditional Finance theories are based on the assumption that investors act
rationally while taking investment decisions and evaluate all the available
information
• Investors suffer from biases which result into lack of learning from mistakes
and economists assume that people learn from their mistakes and the most
common biases are over optimism and over confidence.
• Self-Attribution Bias results when people attribute success to their own efforts
whereas unsuccessful results are said to be the result of bad luck.
• Cognitive study is a study of cognition which is concerned with the mental

process underlying a behavior.
• Heuristic Driven Bias results into an investment decision based on rules on

thumb derived from personal experiences or Trial and Error or simple beliefs.
• Psychologists and finance professionals have identified over a hundred biases

and heuristics which result in investors making poor investment decisions
which may broadly be classified into Ego Bias, Information Bias, Emotion
Bias, Attention Bias, or Conservation Bias.
• A well balanced and appropriate portfolio developed on the lines of Harry

Markowitz’s Portfolio Theory needs to be developed so as to have well
diversified portfolio.
• Safety, Income and Growth is the order in which the needs of investments
are analysed
• Goal Diversification leads to investment diversification and the level of return

is determined by the level of risk taken by the investor.
• A rational investor takes his decisions based on an objective analysis of the

markets and other factors rather than going with the crowd.
• Arbitrageurs are immune to sentiments and guided by fundamental
• The critics of behavioural finance attribute the imperfections in the markets
due to the existence of bias and human errors in judgement and information
Security Analysis and processing.
Behavioural Finance
9.13 Key Terms Anomalies
1. Behavioral finance: It is a combination social and psychological theory

NOTES
with financial theory as a means of understanding how price movements in
the securities markets happen independent of any corporate actions.
2. Self-Attribution Bias: It is the result of people attributing success to their

own efforts whereas unsuccessful results are said to be the result of bad
luck.
3. Cognitive Bias: It emerges from Cognitive errors resulting from incomplete

information or lack of analytical ability to understand the available information.
4. Confirmation Bias: It is a psychological concept which seeks to explain

why people tend to search information to confirm their opinion and overlook
information which refutes their beliefs.
5. Heuristic Driven Bias: It results into an investment decision based on

rules on thumb derived from personal experiences or Trial and Error or
simple beliefs.

1. These theories are based on the assumption that investors act rationally
while taking investment decisions and evaluate all the available information.
a. Behavioural Finance
b. Traditional Finance
c. Psychological
2. Behavioural finance is more guided by these factors which play a lead role
in investment decision making.
a. Emotions
b. Instincts
c. Opinions
Behavioural Finance 3 These biases result from incomplete information or lack of analytical ability
Anomalies
to understand the available information.
NOTES a. Heuristic
b. Confirmation
c. Cognitive
d. Anchoring
4. This bias is due to the human tendency to rely on evidences which may act
as an explanation to a behavior
a. Heuristic
b. Confirmation
c. Cognitive
d. Anchoring
5. These bias result into an investment decision based on rules on thumb
derived from personal experiences or Trial and Error or simple beliefs.
a. Heuristic
b. Confirmation
c. Cognitive
d. Anchoring
6. It results in a so called post returns announcement drift which results in a

company having reported unexpectedly good earnings to earn exceptionally
high profits
a. Gamblers Fallacy
b. Heuristic Bias
c. Anchoring
d. All the above
7. A well balanced and appropriate portfolio developed is built based on the

following points:
a. Safety
Security Analysis and b. Income

c. Growth Behavioural Finance
Anomalies
d. All the above
8. Behavioural Finance theorists argue that there are variances between these NOTES
as a result of behavioural influence.
a. Market Price and Cost Price
b. Market Price and Intrinsic Value
c. Book Value and Market Value
d. All the above
9. They are immune to sentiments and guided by fundamentals and usually run
their trades on borrowed funds and can’t keep an open position for an infinite
period.
a. Fundamentalists
b. Behaviourists
c. Hedgers
d. Arbitrageurs
10. The critics of behavioural finance attribute the imperfections in the markets
due to the existence of these in judgment and information processing and

have claimed that there is a larger amount of risk involved in loss making
portfolio as compared to the winning portfolios.
a. Errors
b. Bias
c. Risk
d. All the above

1. Explain the concept and Framework of Behavioural Finance.
2. Explain the different types of investor biases affecting investment decisions.
3. What are the key differences between Traditional Finance and Behavioural
Finance?
4. Discuss the taxonomy of Behavioural Risk.
Behavioural Finance 5. What are the common observations in the field of behavioural finance?
Anomalies
6. Define an appropriate and well balanced behavioural portfolio.
NOTES 7. Discuss the applications of Behavioural Finance Theory.
8. Write a note on Investor Psychology Cycle.
9. Explain the relation between Behavioural Finance and Market Theory.
10. Discuss the Critiques of Behavioural Theory.
“Security Analysis and Portfolio Management”, Suyash Bhatt, Biztantra,

New Delhi , 2015

Valuation of Shares &
Unit 10 Valuation of Shares and Business Business
Structure NOTES
10.0 Introduction
10.1 Unit Objectives
10.2 Process of Valuation of Shares and Business
10.3 Value of a Business
10.4 Valuation of Equity shares- Techniques and Methods
10.4.1 Asset Based Valuation
10.4.2 Dividend Yield Method
10.4.3 Earnings Yield Method
10.4.4 Fair Value Method
10.4.5 Return on Capital Employed Method
10.4.6 Discounted Cash Flow Valuation Methods
10.4.7 Theoretical Techniques of Valuation
10.4.8 Valuations based on Fundamentals
10.5 Summary
10.6 Key words
10.7.2 Exercises

Business 10.0 Introduction
Valuation of shares and business is an integral aspect of any corporate business.

NOTES
The value of an equity share and business is resorted when mergers, acquisitions,
takeover, reconstruction and other business purchases options are under consideration.
These are reflected in two broad parameters namely Dividend and Earnings. Dividend
is a function of profits and earnings of a company .Other factors which decide the
value of an equity share are market price, performance of company, asset quality etc.
After studying this unit you will be able to:
Ø Understand the valuation of shares and business.
Ø Learn about the basis of valuation for listed and unlisted shares
Ø Understand the different business valuation methods and techniques for

valuation of shares
Ø Understand the valuation methods and techniques for valuation of business
10.2 Process of Valuation of Shares and Business
The process of valuation comprises the transfer of the data about the company
fundamentals into a set of market variables. The results of the valuation become the
basis of portfolio analysis. Share valuation is a process of assigning the rupee value of
an equity share. There are various share valuation models with each one being unique
in its own way. It can be said that
Shareholders Equity
Value of share =
Number of Outs tanding Equity Share
This is based on the idea that the value of an equity share equals the shareholders
claims in the company.This is for unlisted shares whereas in case of listed and publicly
traded shares,
Check Your Progress
Explain the process of Value of Equity = Market Capitalization
valuation of shares.
Apart from this, there are other methods of share valuation which will be
Security Analysis and deliberated in the forthcoming sections.

10.3 Value of a Business Business
The valuation of a business is determined with reference to its assets. This is

NOTES
done by experts using fundamental as well as industry analysis unlike valuation of
equity shares which is done with only fundamental analysis. The concept of fair value
of a business is taken into consideration since it is not possible to ascertain the exact
accurate value of a business.
Ø Value of Business = Value per share x Number of equity equal to the market
capitalization
Ø Value of a business = Value of Equity + Value of Debt + Minority Interests

+ Pension and other claims
Check Your Progress
Ø Value of Business = Value per share (as per dividend yield method) x Number Explain the process of
of equity shares valuation of Business.
10.4 Valuation of Equity shares - Techniques and Methods
There are different valuation methods for finding the value of equity share. These
are (categorized into)
10.4.1 .Asset Based Valuation

This method is also known as Intrinsic Value Method. In this, the intrinsic value
of an equity share is computed according to the net assets available to each individual
shareholder.
Net Assets available to Equity Shareholders
Intrinsic Value of an Equity Share =
Number of Equity Shares
Ø Important points to be remembered in this method while computing intrinsic
value of shares.
Ø Net asset value is based on the historical value of an asset. This is equal to
the Cost price less depreciation.
Ø Net Asset equals to the difference between assets and liabilities
Ø The assets are adjusted for some transactions as per the accounting principles.
Ø Only External Liabilities are to be taken in the computation of net assets.
These are those values of liabilities which are payable on the date of valuation.
Ø Other adjustments to be made are for arrears of dividend, tax provision and
provision for bad and doubtful debts. Portfolio Management:195
Valuation of Shares & Ø The preference shareholders claim is to be deducted from the net assets to
Business
arrive at the net assets available to equity shareholders.
Ø The value of intangibles is ignored while computing net asset value. Eg.
NOTES
Goodwill, trademarks, patents, know how, human resources, quality of
products etc.
Illustration 1 :
The Balance sheet of Jet Ltd. as on 31st March 2016 is given below:
Particulars Amount (Rs.)
Liabilities
Equity Shares of Rs. 10 each 8,00,000
General Reserve 10,00,000
Profit/ Loss Account 6,00,000
9% Debentures 7,00,000
Creditors 4,00,000
Bills Payable 1,00,000
Assets
Fixed Assets 15,00,000
Investment 10,00,000
Current Assets 12,00,000
The Board of Directors decided to amalgamate the company with Kaypee Ltd..
Find the Intrinsic Value of shares on the basis of book values.
Solution
Computation of Intrinsic Value

Particulars Amount (Rs.) Valuation of Shares &
Business
Fixed assets 15,00,000
Investments 10,00,000 NOTES
Current Asset 12,00,000
Total Assets (a) 37,00,000
Less : Current Liabilities
Bills Payable 1,00,000
Creditors 4,00,000
Total External Liabilities (b) 5,00,000
Net Assets (a-b) 32,00,000
Number of shares 80,000
Intrinsic Value per share 40
10.4.2 Dividend Yield Method

Dividend is the return earned by shareholders on the value of their shares. This is
an alternative to another approach called Earnings which is also used to find the value
of shares. The relationship between the level of dividend and the share prices helps
determine the value of shares.

Dividend per share
Value of Share = × Normal value of company’s share
Industry average dividend per share
Illustration 2:
Fatima ltd. has issued and paid up capital of 5, 00,000 shares of Rs. 10 each. The
company declares a dividend of Rs. 12 Lakhs during the last 3 years. The average
dividend yield for listed companies in similar lines of business is 18%. Compute the
value of 6,000 shares in the company.
Solution:
Dividend per share = Rs. 12, 00,000 / 5, 00,000 = Rs. 24
Industry’s normal rate of dividend = 18 %

Dividend per Share Security Analysis and
Value per share =
Industry's Normal Rate of Dividend Portfolio Management:197
Valuation of Shares & = 24 = Rs. 133.33
Business 0.18
Value of shares = 3,000 x Rs. 133 = Rs. 3, 99,000
NOTES Illustration 3:
Tarika Ltd. has declared dividend during the last five as follows:
Year Rate of Dividend (% )

Check Your Progress
2011 8
Explain the asset based
valuation techniques for 2012 10
valuation of shares.
2013 12
2014 14
2015 16
The industry average rate of dividend in the same industry is 15%
Calculate the value per share of Rs. 10 of Tarika Ltd. as per Dividend Yield
Method.
Solution
Year Rate of Dividend Weights Product
2011 8 1 8
2012 10 2 20
2013 12 3 36
2014 14 4 56
2015 16 5 80
Total 15 200
Weighted Average rate of dividend = 200/15= Rs. 13 % (Approx)
Check Your Progress 10.4.3 Earnings Yield Method

Write a note on Dividend
This is an alternate approach to dividend yield. It takes into consideration the
Yield Method for valuation
of shares. total profits of the company which actually belongs to the equity shareholders whether
Security Analysis and distributed as dividend or not. This undistributed profit is used for growth and expansion
Portfolio Management:198 of a business which in turn leads to an increase in the value of shares. This is also a
return to the shareholders on their investment as good as dividend. For calculating the Valuation of Shares &
Business
value of shares, the profits or earnings generated by the business is considered.
Expected Future Maintainable profits
Value per share = NOTES
Number of Equity shares
Future Maintainable profits are computed taking into consideration the changes
in future profits based on past estimates. Adjustments are made in past normal profits
for fluctuations due to various unexpected reasons.
Illustration 4:
Jogi Industries Ltd. expects to have future profits Rs. 25,00,000 .What will be
the value of shares if the company has 1,00,000 equity shares.
Solution
Value of shares = Future Maintainable profits

Number of Equity shares
5400000
=
100000
= Rs. 54 per share
10.4.4 Fair Value Method Check Your Progress

Explain Earnings Yield
Fair Value is the average of the value obtained under Net Asset method and
Method for share
Dividend Yield Method. It is calculated by the following formula: valuation.
Net asset value of share + Dividend Yield value of share
Fair Value =
2
10.4.5 Return on Capital Employed Method
This method involves return on capital employed which is normally expected Check Your Progress
considering the industry rate of return. It takes into account the future maintainable What is Fair Value
Method for Share
profits of the company and also the capital required to earn the industry rate of return
Valuation?
Rate of Return
Value of share = Market Expected Rate of Return × Normal Value of share
Illustration 5:
The following details of Joita Ltd. are provided. Calculate the Value of Equity
Shares based on return on capital employed.

Valuation of Shares & (Rs.in thousands)
Business
Year 2012 2013 2014 2015 2016
NOTES Capital Employed 40 52 66 70 82
Profit 6 10 12 16 22
Market rate of return is 12%
Solution
Year Capital Employed Profit (Rs.) Return on Weight Product
(Rs. In lakhs) Capital
Employed
(%)
2012 40 6 15 1 15
2013 52 10 19 2 38
2014 66 12 18 3 54
2015 70 16 22 4 88
2016 82 22 27 5 135
15 330
The weighted average rate of return on capital employed is 330/15 = 22% or
0.22. Whereas the expected market rate of return is 12 %.

Check Your Progress
Rate of Return
Write a note on: Return Value of share = × Normal value of share
Market Rate of Return
on Capital Employed 22
Method. = × 10
16
= Rs. 13.75
10.4.6 Discounted Cash Flow Valuation Methods

These models are based on the valuation in terms of net present values of the
cash flows generated. It is a more reliable and commonly used model for valuation of
shares and business since cash flows determine the shareholder value more accurately.
The different techniques used under this model are:
i. Discounted Cash Flow Valuation of Shares &
Business
ii. Discounted Dividend
iii. Discounted Internal Rate of return NOTES
iii. Discounted Economic Value
These techniques are discussed in detail hereunder:
i. Discounted Cash Flow technique (DCF)
In this technique, the discounted future cash flows using the cost of capital are
discounted back to today. The weighted average (WACC) and not simple average is
used to weigh the cost of equity and the cost of debt.
The value is calculated as under:

CF1 + CF2 CFn + TV
Value of Business = 2
+
(1+K 0 ) (1+K 0 ) (1+K 0 ) n (1+K 0 ) n
CFn+1
TV = K –g
0
Where
CF = Cash Flow for the future
K O = Weighted Average Cost of Capital
TV = Terminal Value
n = Number of years
g = Constant Growth Rate
The investment proposals are evaluated using this method by estimating the future
incremental cash flows which are discounted into the present value by the cost of
capital.
i. Discounted Dividend method
This technique equates the share value based on the value of equity equal to all
future dividend discounted today. The future dividends of the company are forecasted
for an estimated period called explicit period and thereafter discounted so as to get the
value of equity. The long term growth in dividend and corresponding long term cost of
capital is estimated to find the terminal value of equity after the explicit period to Security Analysis and
Valuation of Shares & infinity. This terminal value is also discounted to the present value as on today. The
Business
cost of capital shows the risk in the cash flow.
D1 D2 Dn TV
NOTES Value of equity = + 2
+ n
+
1 + K e (1 + K e ) (1 + K e ) (1 + K e ) n
D n +1
Terminal Value (TV) = (K – g)
e
g = growth rate in dividend
ii. Discounted Internal Rate of Return Technique
In this technique the future cash flows are discounted using the weighted average
internal rate of return of all the projects with the cash investment. The gross cash
investment is the total inflation adjusted annual cash flow
CF1 + CF2 CFn + TV
Value of share = 1 2
+
(1+IRR) (1+IRR) (1+IRR) n1 (1+IRR) n
Where,
TV = Inflation adjusted terminal value of all future cash inflows from
year ‘n’ to infinity.
N = Average economic life of the business assets
IRR = Inflation adjusted average internal rate of return of all projects.
iii. Discounted Economic Value added technique
Economic Value added (EVA) is a measure of the profitability and a variant

of economic profit determined as per accounting principles. The value of a
business is a measure of the capital stock plus the present value of all future
EVA discounted to the present. The value of a business equals the present
value of all future EVA plus the capital stock investment. The aggregate
EVA is called Market Value Added (MVA).

EVA1 + EVA 2 EVA n + TV
Value of Business = 1 2
+
(1+WACC) (1+WACC) (1+WACC) n (1+WACC) n
Check Your Progress
Discuss Discounted Cash
In other words, Value of Business = Capital invested + Present Value of
Flow Valuation Methods.
future EVAs
Security Analysis and EVA can be computed in accounting terms as

EVA = NOPAT – (K X WACC) Valuation of Shares &
Business
Where, NOPAT = Net Operating Profit after tax but before interest and
depreciation NOTES
WACC = Weighted Average Cost of Capital
K = Long term funds in terms of debt and equity
Alternatively, EVA can be computed as:
EVA = (ROCE – WACC) x K
Where, ROCE = Return on capital employed (NOPAT / K)
10.4.7 Theoretical Techniques of Valuation

i. Dividend Growth Technique
ii. Walters Share Valuation Model
iii. Modigliani and Millers Dividend Irrelevancy Model
iv. Capital Asset Pricing Model
These techniques are explained hereunder:
i. Dividend Growth Technique
This method takes into consideration the dividend growth and the value of
shares are based on dividend growth which is expected to happen perpetually.
The share price rises when the rate of return is greater than the discount
rate and vice versa. Companies which do not pay dividend inspite of earning
profits witness an increase in share prices due to the retention policy.

D 0 (1+g)
Value of share (Pe) =
Ke – g
Where,
P0 = Market Price per share (ex – dividend)
D 0 = Constant annual growth rate of dividend
K e = Cost of Equity
This model is based on certain assumptions such as:
Ø Rate of return is constant
Ø Cost of Capital is constant

Ø Absence of taxes Portfolio Management:203
Valuation of Shares & Ø Retained earnings are the only source of earnings
Business
Ø Cost of capital is higher than the growth rate.
NOTES ii. Walter’s Valuation Model :
James Walter model is based on the views of Walter that in the long run the share
prices are impacted by the expected dividends. According to him, dividend policies and
investment policies are interconnected and can’t be considered separately. Dividend

policy decisions are framed in a manner so as to optimize the shareholders’ value
which results in wealth maximization.
P = {[D+ ((Ra/Rc) (E-D))]/RC}
Where,
P = Market Price of equity share
E = Earnings per share
D = Dividend per share
(E-D) = Retained Earnings per share
Ra = Internal Rate of return on investment
Rc = Cost of Capital
Assumptions:
Ø Retained Earnings is the only source of finance
Ø The cost of capital and IRR is constant
Ø The business is a going concern
Ø All profits are either distributed as dividend fully or otherwise fully retained
Ø EPS and DPS remains constant
In other words, this model is based on the idea that shareholders would be ready
to accept low or no dividend when the return expected by investors is higher than
market capitalization. The converse is true when the return on investment is less than
the market capitalization where shareholders prefer high dividend which can be invested
elsewhere in more profitable avenues.
iii. Modigliani and Miller’s Dividend Irrelevancy Model
Security Analysis and Modigliani Millers model (MM model) asserts that the value of a business is
determined by its investment decisions and that the dividend policy of a firm has no
influence on its share value or share price. This model holds good only in absence of Valuation of Shares &
Business
uncertainties and under conditions of market asymmetry. The market price of a share
as per MM approach is determined as under:

NOTES
Po = (P1+D 1) / (1+Ke)
Where,
P 0 = Prevailing Market price of share
P 1 = Market Price of a share at the end of period one
D 1 = Dividend at the end of period one
K e = Cost of equity.
iv. Capital Asset Pricing Model (CAPM)
This model is used to determine the required rates of return on different assets.
It is done by evaluating the risk – return relationship. It is based on an understanding of
the fact that the risk in a portfolio is a combination of systematic and unsystematic
risks. Systematic risk arises due to the variations in returns caused by market forces
and cannot be eliminated by diversification. Unsystematic risk is firm specific and can
be eliminated by diversifying the portfolio. This model shows the risk return relationship:
E (R1) = RF+â (Rm – RF)
Where,
E (R1) = Expected Rate of Return on Individual Share or portfolio
RF = Risk Free Return
Rm = Expected Rate of Return on Market Portfolio
R F+â = Beta of investment
Beta is a measure of risk and volatility of a security’s return relative to the market
portfolio return measured by m. As per this model, the risk premium is proportional to
unsystematic risk which determines the share prices as reflected by the beta coefficient.
Illustration 6
Gama Ltd. is intending to sell its business to Alpha Ltd. The beta factor of
Check Your Progress
Elaborate all theoretical
Gama Ltd.’s share is Rs. 1.50 and its current market price is Rs. 1.50. The company techniques of share
is consistently paying a dividend of Rs. 50 p.a. The risk free market rate of interest is valuation.
12 % and the expected rate of return on such security in the market is 18%, Find the
value of shares of Gama Ltd. as per Capital Asset pricing model. Portfolio Management:205
Valuation of Shares & Solution:
Business
E (R1) = RF+â (Rm – Rf)
NOTES E (R1) = 12 + 1.5(18 – 12)
= 12 + 1.5(6)
= 12+ 9 = 21 %
10.4.8 Valuation based on Fundamentals

These techniques give significance to a company’s financials for valuation. Also
called standalone valuation, the financial information is given prime consideration and
weightage to evaluate the performance of the company and the resulting value of
shares. Different measures of valuation are:
i. Operating profit Multiple
ii. Operating free Cash Flow Multiple
iii. Revenue or sales Multiple
iv. Price/ Book Value Multiple
i. Operating Profit Multiple:
It measures the value in terms of cash flow taken from the income statement
more so from the audited financial statements, to increase reliability. This is a better
measure of value compared to other approaches considering company financials.

EV (ROCE–g) × (1–T)
Value of share = = × (1 – D)
EBIDT ROCE × (Ko – g)
Where,
D = Depreciation as a percentage of EBDIT
ROCE = Return on Capital Employed
g = Growth Rate
EV = Enterprise Value
Ko = Weighted Average Cost of Capital
T = Tax rate

ii. Operating free Cash Flow Multiple : Valuation of Shares &
Business
This multiple considers free cash flow to find value of share and business. Free
cash flow will be EBDIT reduced by extraordinary items and Capital Expenditure NOTES
(yearly).
(ROCE–g) × (1–T)
Value of Share = EV = ROCE × (Ko – g)
Where,
OPFCF = EBDIT – Estimated Annual Reinvestment – inflation on working capital
ROCE = OPFCF / Capital stock
iii. Revenue or sales Multiple:
It helps to measure both, the value of business as well as value of shares. These
are commonly applied to loss making businesses. The fundamental multiples are
computed as under:
EV (ROCE–g) × (1–T) × M
Value of shares = =
Sales ROCE × (Ko – g)
Where,
Check Your Progress
M = EBDIT margin Explain techniques of
share valuation based on
ROCE = Return on Capital Employed
company fundamentals.
g = Growth Rate
EV = Enterprise Value
Ko = Weighted Average Cost of Capital
T = Tax rate
iv. Price /Book Value Multiple:
It shows the market value of equity in relation to the company’s book value.
Book Value is the adjusted book value of total assets less adjusted book value of
liabilities. It is also called P/BV ratio (Price to Book value ratio).
P / BV ratio = Current Market Price of equity / Earnings per share
10.5 Summary
• The value of a share is reflected in two broad parameters namely Dividend
and Earnings.
Valuation of Shares & • The process of valuation comprises the transfer of the data about the company
Business
fundamentals into a set of market variables. The results of the valuation
become the basis of portfolio analysis.
NOTES
• Share valuation is a process of assigning the rupee value of an equity share.
• In case of listed and publicly traded shares, Value of Equity = Market
Capitalization in case of listed and publicly traded shares, Value of Equity =
Market Capitalization
• The valuation of a business is determined with reference to its assets and is
done by experts using fundamental as well as industry analysis unlike valuation
of equity shares which is done with only fundamental analysis.
• Asset Based Valuation method also known as Intrinsic Value Method
considers the intrinsic value of an equity share is computed according to the
net assets available to each individual shareholder.
• Earnings Yield Method is an alternate approach to dividend yield considering
the total profits of the company which actually belongs to the equity
shareholders whether distributed as dividend or not.
• Fair Value is the average of the value obtained under Net Asset method and
Dividend Yield Method.
• Return on Capital Methodinvolves return on capital employed which is
normally expected considering the industry rate of return taking into account
the future maintainable profits of the company and also the capital required
to earn the industry rate of return
• Discounted Cash Flow Valuation Methods are based on the valuation in

terms of net present values of the cash flows generated.
• Discounted Cash Flow technique (DCF) are those where the discounted
future cash flows using the cost of capital are discounted back to today by
weighted average (WACC) to weigh the cost of equity and the cost of debt.
• Discounted Dividend method equates the share value based on the value of
equity equal to all future dividend discounted today.
• Discounted Internal Rate of Return technique uses the future cash flows
which are discounted using the weighted average internal rate of return of
Security Analysis and all the projects with the cash investment.
• Economic Value added (EVA) is a measure of the profitability and a variant Valuation of Shares &
Business
of economic profit determined as per accounting principles and the value of
a business is a measure of the capital stock plus the present value of all
NOTES
future EVA discounted to the present.
• Dividend Growth Technique takes into consideration the dividend growth
and the value of shares are based on dividend growth which is expected to
happen perpetually.
• Walter’s Valuation Model is based on the view that in the long run the share
prices are impacted by the expected dividends
• Modigliani Millers model (MM model) asserts that the value of a business is
determined by its investment decisions and that the dividend policy of a firm
has no influence on its share value or share price.
• Capital Asset Pricing Model (CAPM) is used to determine the required

rates of return on different assets by evaluating the risk – return relationships
and is based on a combination of systematic and unsystematic risks.
• Beta is a measure of risk and volatility of a security’s return relative to the

market portfolio return measured by m.
• Valuations based on Fundamentals give significance to a company’s financials

for valuation which are based on valuation measures like Operating profit
Multiple, Operating free Cash Flow Multiple, Revenue or sales Multiple or
Price/ Book Value Multiple.
10.6 Key Terms
1. Valuation: The process of valuation comprises the transfer of the data about
the company fundamentals into a set of market variables. The results of the
valuation become the basis of portfolio analysis.
2. Share valuation: It is a process of assigning the rupee value of an equity

share where the intrinsic value of an equity share is computed according to
the net assets available to each individual shareholder.
3. Net asset value: It is based on the historical value of an asset and equals Security Analysis and
the Cost price less depreciation. Portfolio Management:209
Valuation of Shares & 4. Net Asset: It is the difference between assets and liabilities
Business
5. Dividend: It is the return earned by shareholders on the value of their
shares.
NOTES
6. Fair Value: It is the average of the value obtained under Net Asset method
and Dividend Yield Method.
7. Return on Capital Method: This method involves return on capital

employed which is normally expected considering the industry rate of return
taking into account the future maintainable profits of the company and also
the capital required to earn the industry rate of return.
8. Economic Value added (EVA): It is a measure of the profitability and a

variant of economic profit determined as per accounting principles and the
value of a business is a measure of the capital stock plus the present value
of all future EVA discounted to the present.
9. Beta: It is a measure of risk and volatility of a security’s return relative to

the market portfolio return measured by m.

1. Value of shares is reflected in
a. Dividend
b. Earnings
c. Asset quality
d. All the above
2. In case of publicly traded shares, value of equity is equal to
a. Dividend
b. Earnings
c. Market price
d. Market Capitalization
3. The valuation of a business is done by experts using
a. Fundamental analysis
Portfolio Management:210 b. Industry analysis
c. Technical Analysis Valuation of Shares &
Business
d. Both a and b above
4. The intrinsic value of an equity share is computed by NOTES

a. Net assets available to equity shareholder/ Number of Equity shares
b. Net assets only
c. Total Assets
d. Total Assets less external liabilities
5. Dividend Yield Method of share valuation considers
a. The relationship between the level of dividend and the share prices
b. The dividend growth
c. The dividend and earnings
6. Future Maintainable profits are computed taking into consideration
a. the changes in future profits based on past estimates.
b. Adjustments are made in past normal profits for fluctuations due to various
unexpected reasons.
c. Abnormal items
d. All the above
7. Economic Value added (EVA) is a measure of
a. Economic profit
b. A variant of economic profit determined as per accounting principles
c. Accounting profit
d. None of the above.
8. As per Economic value added approach, Value of Business is equal to
a. Market value
b. Capital invested + Present Value of future EVAs
c. Economic value
d. All the above

Valuation of Shares & 9. Walter’s Valuation Model is based on the views of Walter that
Business
a. In the long run the share prices are impacted by the expected dividends.
NOTES b. Dividend policies and investment policies are interconnected and can’t
be considered separately.
c. Dividend policy decisions are framed in a manner so as to optimize the

shareholders’ value which results in wealth maximization.
d. All the above
10. Modigliani Millers modelasserts that the value of a business is determined
by its investment decisions and holds that that
a. The dividend policy of a firm has influence on its share value
b. The dividend policy of a firm has no influence on its share value or share
price.
c. The market forces have an impact on share value
d. The market forces do not have an impact on share value
11. Capital Asset Pricing Model is used to determine the required rates of
return on different assets by
a. Evaluating the risk – return relationship.
b. Understanding of the fact that the risk in a portfolio is a combination of
systematic and unsystematic risks.
c. Systematic risk arises due to the variations in returns caused by market
forces and cannot be eliminated by diversification.
d. All the above
12. Beta is a measure of
a. Risk premium
b. Market risk
c. Risk and volatility of a security’s return relative to the market portfolio
return
13. Operating Profit Multiple measures the value in terms of
a. Risk Premium
Portfolio Management:212 b. Dividend and Price
c. Earnings Valuation of Shares &
Business
d. Cash flow
10.7.2 Exercises NOTES
Ex.1. Tony Ltd. has outstanding 1, 00,000 equity shares of Rs. 10 each selling
at Rs. 25 per share. It is expected that it will earn a net income of Rs. 5,
00,000 during the year ended 31st March 2016. It is proposing a dividend
off Rs. 2 per share at the end of the current year. The capitalization rate
for risk class of the firm is estimated to be 14%. Assuming no taxes,
value the share price at the end of 31st March 2016 on the basis of
Modigliani Miller model assuming:
a. If dividend is paid
b. If dividend is not paid
Ex. 2. TVS ltd. provides the following details:
a. Earnings per share Rs 5
b. Dividend per share Rs. 2.5
c. Cost of capital 15%
d. Internal Rate of return 17 %
Calculate the market price of shares and value of shares as per Walter’s
Model.
Ex.3. From the following details, of Gilet Ltd. which is going to be acquired by
Yen Ltd. based on the capitalization of the last three years profits, at an
earnings yield of 21% calculate the value of business on earnings Yield
basis.
Year Profits (Rs. In ‘000)
2014 65
2015 78
2016 90
Valuation of Shares & Ex.4. Dolly Ltd. paid a dividend of Rs. 4 per share for the year ending 31st
Business
March 2017. A constant growth of income at 5 % has been estimated
for an indefinite future period. The required rate of return is estimated at

NOTES
12%. You want to buy the share at a market price quoted on 1st September
2017 at Rs.80. What would be your decision?
Ex.5. Telsa Ltd. is paying a dividend on its equity shares at Rs. 10 per share
and expects to pay it for an indefinite long period in the future The
current price at which equity is sold is Rs. 75 and the investors required
rate of return is 10. Determine the pricing and value of shares of Telsa
Ltd. using P/E Approach.

1. Explain the process of valuation of shares.
2. Explain the process of valuation of Business.
3. Explain the asset based valuation techniques for valuation of shares
4. Write a note on Dividend Yield Method for valuation of shares
5. Explain Earnings Yield Method for share valuation
6. What is Fair Value Method for Share Valuation?
7. Discuss Discounted Cash Flow Valuation Methods.
8. Elaborate all theoretical techniques of share valuation.
9. Explain techniques of share valuation based on company fundamentals.
“Investment Analysis and Portfolio Management: Second Edition”,S. Kevin,

PHI Learning Private Ltd., Delhi ,2015.

Fixed Income Securities
Unit 11 Fixed Income Securities Valuation Valuation
Structure NOTES
11.0 Introduction
11.2 Debt Instruments: Classification
11.3 Bond/ Debt market in India
11.4 Components of Debt Market
11.5 Valuation of Debt/ Bonds
11.6 Bond Risk Analysis
11.7 Credit Rating of Bonds by Independent Agencies
11.7.1 Features of Credit Ratings
11.7.2 Areas to be investigated in the Bond Rating Process
11.8 Interest Rate Determinants
11.9 Summary
11.10 Key Words
11.11.3 Exercises
11.0 Introduction
Bonds and Debentures are fixed income securities offering regular returns to its
holders. The issuer has a legal obligation to pay the interest at regular intervals and
also the principal portion on maturity. Legal proceedings can be initiated by the holder
of such bond or debenture if the issuer fails to pay the same. They are traded in the Security Analysis and
debt market segment in capital market or in money markets.
Fixed Income Securities Debentures/Bonds have the following features:
Valuation
Ø A form of loan or debt capital or borrowed capital
Ø Fixed return in the form of interest
NOTES
Ø No voting rights in general meeting
Ø Have conversion or redemption option
Ø Preference in repayment at the time of winding up
Ø Understand the various categories of debt instruments in India
Ø Know the advantages of bond market in India and its components
Ø Study the Valuation of Bonds/ Debts
Ø Understand the risk associated with bonds/ debt
Ø Evaluate the credit rating of bonds by Independent rating agencies
Ø Understand the theories of interest rate determinants
11.2 Debt Instruments: Classification
Debt instruments can be classified into different categories are under:
1. Redeemable and Irredeemable
2. Convertible and Non- Convertible
3. Secured and Unsecured
4. Floating Rate Debentures
5. Index linked Debentures
6. Zero Coupon Bonds

Check Your Progress
State the different 7. Deep Discount Bonds
categories of debt
8. Mortgage Backed securities
instruments in India.
These have been already discussed in the preceding units on investment avenues
Portfolio Management:216 in India.
11.3 Bond/ Debt market in India Valuation
Bond market which is a part of the debt market is also known as Fixed Income
NOTES
Securities Market. The advantages of investing in bond market are:
• Security of return as well as safety of investment and therefore a reduced
risk of loss
• Low volatility of prices as compared to equity and hence ensures better
safety.
• Relatively risk free investment mode due to low default risk on investments
done in government securities
• Enables wide portfolio diversification and managing portfolio risk efficiently
• Credit rating assigned by different credit rating agencies help investors make Check Your Progress
What are the advantages
an informed investment choice based on the risk and return analysis.
of investing in Bond/ Debt
• Bonds enable the duration adjustment in portfolio management. Market?
11.4 Components of Debt Market
Debt markets have three major components namely:
a. Government Securities or bonds
b. Corporate securities such as debentures and bonds
These are explained as under:
a. Government Bonds: The Government of India issues bonds called
Government Securities or Gilt edged securities (G-secs). These are medium
to long term issued by Reserve Bank of India on behalf of the Government.

Usually interest accrual on these bonds is semi-annual. Also, many
government agencies issue bonds guaranteed by the Central Government
and a few State Governments.
b. Corporate Securities: Public Sector as well as Private sector companies
issue Bonds and Debentures. These are issued in the form of different types
of instruments such as Security Analysis and
Fixed Income Securities Ø Straight Bonds / Plain Vanilla Bonds: These have a fixed periodic
Valuation
return over their life and return of principal on maturity.
NOTES Ø Floating Rate Bonds: These bonds have an interest rate linked to a
benchmark rate such as Treasury Bill interest rate.
Ø Zero Coupon Bonds: These do not carry a fixed interest payment;
however they are issued at a steep discount over its face value and
redeemed at face value on maturity.
Ø Convertible Bonds: These bonds give both regular income as well as
capital appreciation. It gives the holder, the option to convert the bond
into a predetermined number of shares or common stock.
Ø Participating Bonds: They have a guaranteed rate of interest and also
an additional specified percentage of earnings.
Ø Sinking Fund Bonds: In these types of bonds, a certain specified
amount is kept aside each year to retire the bond issue. The fixed amount
or percentage of amount is paid to the sinking fund agent who acts as a
trustee for the same.
Ø Mortgage or Secured Bonds: These are bonds covered by security
of assets and may be of different types such as Open ended, Closed

Check Your Progress
What are the major ended, limited open end etc.
components of Bond Ø Commodity Linked Bonds: The return on these bonds depends on
market in India?
the price of the underlying commodity like derivatives.
11.5 Valuation of Debts/ Bonds
The value of a Bond is based on its intrinsic value which is equal to the present
value of its expected cash flows. The value of bonds depends on various factors such
as default risk associated with the bonds, and return in terms of the net cash flows and
other variables influencing the value. Generally discounting and compounding techniques
are used to find the value of money at a future date or to find the value of money
today. The valuation models for bonds and debts are explained hereunder:

a. Bonds with maturity period : Fixed Income Securities
Valuation
Bonds having maturity date will be valued by taking annual interest payments
and terminal value using present value and thereafter by computing the discounted NOTES
values of cash flows as follows:
I1 + I2 In + P
Value of Bond(V) = 2
+
(1 + i) (1 + i) (1 + i) n (1 + i)n
In + PN
= n-1(1+i) n(1+i) N
Where,
V = Value of bond
I = Annual interest (Rs.)
I = Required Rate of interest (%)
P = Principal Value on maturity
N = Number of years to maturity
Illustration 1:
If Mr. A purchases a 5-year value bond at nominal interest rate of 7%, how
much should he pay now to get a required rate of 10% % to purchase the bond if he
will receive on maturity, the bond value at par.
Solution:
Year Annual P.V.Factor Present Value
Interest (Rs.) @10 %
1 70 .909 63.63
2 70 .826 57.82
3 70 .751 52.57
4 70 .683 47.81
5 70 .621 43.47
Present Value
of Inflows 265.3
% years maturity
Value 1,000 x .621 621

Value of Bond 886.3
Fixed Income Securities The value of bond is Rs. 886.3. This shows that the bond of Rs .1, 000 is worth
Valuation
Rs. 886.3 today, if the required rate of return is 10 %. The investor should be willing to
pay maximum Rs. 886.3 for purchasing it today. The Present value on maturity is Rs.
NOTES
621 & Rs. 886.3 is the composite of the Present value of interest payments Rs. 265.3.
b. Bonds with Perpetuity:
In India, such bonds are very rarely issued by companies. In such type of bonds
there is no maturity value. The formula for calculating the value of such bonds is:
I1 + I 2 + I
V = (1 + i)1 (1 + i) 2 (1 + i)
I I
N = I (I + i) =
n i
Where,
V = Value of Bond
I = Annual Interest
I = Required Rate of Return
The value of perpetual bond is the discounted sum of the infinite series. The
discount rate depends upon the riskiness of the bond. It is usually the rate or yield on
bonds of similar type of risk.
Illustration 2:
Mr. X pays Rs. 90 interest annually on a perpetual bond, what would be the value
if the current yield is 9%?
Solution:
The value of the bond is determined as follows:
I 90
= = 1,000
i 09
If the rate of interest is 9% currently, the value of the bond is Rs. 1,000 and if it
is 8 % it will be Rs. 1125 and if it is 10 %, the value is Rs. 900. The value of the bond
will decrease as the interest rate starts increasing.

Value of Perpetual Bond at different discount rates
Valuation
Discount Rate (%) Value of Bond
NOTES
5 1800
6 1500
7 1285
8 1125
9 1000
10 900
c. Yield to maturity:
The Yield to maturity of a bond is the interest rate which makes the present value
of cash flows receivable from the bond equal to the price of the bond .It is a trial and
error method. It is that interest rate which satisfies the equation of
C+ C+C+M
P=
(1+r) (1+r)2 (1+r)n (1+r)n
Where,
P = Price of the Bond
C = the annual interest in rupees
M = Maturity value in rupees
n = number of years left to maturity
Illustration 3:
An investor is considering investment in a bond currently selling for Rs. 8750.

The bond has four years to maturity, a Rs. 10,000 face value and an 8 percent coupon
rate. The next annual interest payment is due after one year. The discount factor for
investments of similar risk is 10 %.
1. Find the Intrinsic Value of the bond. Based on this computation, should the
investor invest in the bond?

Fixed Income Securities 2. Calculate the Yield to Maturity (YTM) of the bond. Based on this computation,
Valuation
should the investor invest in the bond?
NOTES Solution:
1. The Intrinsic value will be equal to the discounted value of the cash flows
i.e.
V = Rs. 800 / (1 + 10)1 + 800 (1 + 10)2 + 800 (1 + 10)3 800 (1 + 10)4
= 727.27 + 661.16 + 601.05 + 7376.55
= Rs. 9366.03
The bond is actually sold for Rs. 8750, and since it is underpriced, the investor
should invest in it.
2. The YTM is the interest rate that equates the price of the bond to the
discounted value of the cash flows.
Rs. 8750 = Rs 800 (1 + YTM)1 + Rs 800 (1 + YTM) 2 + Rs 800 (1 + YTM)3
+ Rs 800(1 + YTM)4
By solving this, we get, YTM = 12% approx.
Since the YTM at 12% is higher than the discount rate (10 %), the investor
should invest it.
d. Yield to Call:
Bonds having a call feature entitling the issuer to call the bond before the
aforementioned maturity date stated in the bond as per a call schedule which mentions
Check Your Progress a call price for each call date. It is usual to find YTM or YTC for bonds. Yield to Call
Explain the different represented by r, C represents Interest amount, M being the Call Price in rupees and n
methods of Valuation of is the number of years till the call date . It is computed in the same manner as Yield to
Bonds/ Debt Instruments.
maturity as under :
C+M
P =
t – 1 (1 + r) t (1 + r) n

11.6 Bond Risk Analysis Valuation
Bonds should be analyzed in terms of risk and return. Returns are always viewed
NOTES
in terms of risk involved. Bonds are subject to different types of risks which are
discussed as follows:
Ø Interest rate risk
Ø Inflation risk
Ø Default risk
Ø Liquidity risk
Ø Reinvestment risk
Ø Real Interest Rate risk
Ø Interest rate risk: Interest rate risk also called market risk shows the
percentage change in the bond value due to the change in interest rate. It is
a systematic risk associated with fixed income securities. It is a measure of
the maturity period of the bond and its coupon interest rate. Interest rate and
market prices are inversely related as a rise in the interest rates will lead to
a reduction in the market prices of bonds and vice versa. Longer the maturity
time, greater is the sensitivity of price to changes in the interest rate and
larger the interest payment, lower is the sensitivity of price to changes in
interest rates.
Market Price of a Bond = Present value of interest payments + Principal

Repayment.
Ø Inflation Risk: Inflation risk is a measure of the rate of exchange between

current value of rupee and its future value. The real rate of exchange between
current and future goods is what is to be actually considered. If inflation is
higher than expected than there is a gain and vice versa. The relationship
between the nominal rate ( r) , the real rate (a) and the expected inflation
rate (á) as per Fischer’ s effect is
(1 + r) = (1 + a) (1 + á)
Ø Default Risk: In the event of bankruptcy of the borrower who is unable to Security Analysis and
pay his debts, this risk arises. The Principal as well as interest payment is Portfolio Management:223
Fixed Income Securities lost or there is a delay in payment with no eventual loss, still the value of
Valuation
debt in terms of present value will be reduced substantially. Also called Credit
upcoming sections of this unit).Higher the default risk, lower the credit rating
NOTES
resulting into trading at a higher yield to maturity. The perceived risk of
default is higher than the actual default which may or may not happen.
Ø Liquidity Risk: Debt instruments generally have low liquidity since debt
market activities occur in the primary market. This leads to liquidity problems
to the investors in debt since it is difficult for them to trade these debt
instruments.
Ø Real interest Rate risk: There is always a risk in change in real interest
rates due to the shifts in demand and supply for funds. Other factors affecting
real interest rates are taxation laws, competition etc. It is very difficult to
predict such changes in real interest rates. It may result into borrowers
ending up paying a higher interest on its borrowings as compared to its returns
on the assets invested.
11.7 Credit Rating of Bonds by Independent Agencies

Credit ratings of bonds and debt instruments enable to gauge the credit risk. In
India, (on the lines of other countries), there are independent rating agencies to assess
the credit risk. There are five rating agencies in India namely:
• CRISIL
• CARE
Check Your Progress
• ICRA
Bonds are subject to
different types of risks. • Fitch
Elaborate.
• Brickworks
These agencies have their own rating procedure; however the common feature
of credit ratings is that the debt rating is essentially a reflection of the timeliness of
interest and principal repayment by the borrowers. The higher the likelihood of
repayment, higher the credit rating and vice versa.

11.7.1 Features of Credit Ratings Fixed Income Securities
Valuation
a. They provide up to date and recent information on the debt instruments.
b. They offer low cost and real time information to the lenders and borrowers NOTES
c. They offer credibility to the financial representativeness.
d. They act as a disciplinarian force on the corporate borrowers.
e. Ratings are neither recommendations nor guidelines for investment decisions.
f. They do not provide an Evaluation and analysis of the performance of the
debt issuing organizations and companies since these ratings are security
specific.
g. Ratings are not a basis for creating a legal relationship between the rating
agencies and investors relying on these ratings.
h. Debt ratings are not one time but a continuous process of the Evaluation of
the debt instruments based on changes in the real world affecting the value
and other factors related to these instruments.
11.7.2 Areas to be investigated in the Bond Rating Process

The following factors are areas which need to be investigated in a bond rating
process:
a. Earnings Capacity
b. Leverage
c. Liquidity
d. Indenture
a. Earnings Capacity :
Earnings are the indicators of financial health of an organization and a basis
for assessing the future growth in terms of the return from the efforts of Check Your Progress
What are the features of
management. Before assessing the earnings capacity we have to take into
credit ratings for Bonds?
consideration factors like sustainability of the returns by looking at the track
record, legal and political environment affecting the business functioning,

Fixed Income Securities returns and margins on sales. Competitive trends etc. Some basic questions
Valuation
need to be answered such as:
• Does the business have sufficient cash and marketable over and above
NOTES
its operating requirements?
• Are the fixed assets and inventories valued properly and adequately to
reflect earnings power and reflect replacement values?
• Are the profit margins increasing or decreasing ?
b. Leverage :
Leverage is measured in terms of the business’ earning capacity and risk

involved in the expected earnings which may or may not occur and also the
interest coverage from the returns on assets. For instance, a business having
70% assets financed by debt and 30 % by equity, having 21% return on
assets and interest cost is assumed to be 10%. This means that it will
cover its interest charges 3 times enabling greater protection from risk to its
creditors.
c. Liquidity :
Liquidity is measured in terms of cash and cash equivalents showing access

to cash.
Cash can be generated from sources like:
• Sale of Equity
• Debt raising
• Sale of fixed Assets
• Turnover of current Assets
• Internal cash via net income add depreciation and deferred taxes.
A firm having adequate liquidity shows the ability to meet cash requirements for
expansion, growth and debt coverage in terms of interest and principal repayments.
d. Indenture :
Indentures are legal agreements between the lender and borrower specifying
the rights and obligations and liabilities. It also contains the conditions requiring
Portfolio Management:226 the borrower to maintain certain levels of earnings, working capital and assets
etc. It sometimes restricts the creation of further debts and also restrictions Fixed Income Securities
Valuation
on leasing or sale of assets and other aspects of financing. These are meant
for protecting the interest of both the parties to a debt agreement. Indentures
NOTES
specify all the important features such as timings and rate of interest, maturity
period, convertible features etc. They contain the financial covenants
governing the issue. Indentures serve as a reference in case off conflict
resolution between the parties.
Rating Symbols
The following table shows the credit rating symbols used by different credit rating
agencies in India. Check Your Progress

What are the areas to be
Level of Risk CRISIL CARE ICRA FITCH
investigated in the Bond
Highest Safety AAA CARE AAA LAAA AAA Credit Rating Process?
High Safety AA CARE AA LAA AA
Adequate Safety A CARE A LA A
Moderate Safety BBB CARE BB LBBB BBB
Inadequate Safety BB CARE BB LBB BB
Risk Prone B CARE B LB B
Substantial Risk C CARE C LC C
Default D CARE D LD D
11.8 Interest Rate Determinants
There are two theories which explain the level and changes of interest rates
namely
I. Liquidity Preference Theory
II.Loanable Funds Theory
Liquidity Preference Theory
This theory derives the interest rate at a point of equilibrium in the demand and
supply of money at a given point of time. The demand for money being determined by
the income of the holder of debt wherein greater the income greater the demand for Security Analysis and
money. There is an inverse relation between the interest rate and quantity of money Portfolio Management:227
demanded. On the other hand, the supply of money is determined by the Reserve
Valuation
Bank’s monetary policy and norms like CRR and SLR and other measures to control
money supply resorted from time to time. Hence Demand for money is a function of
NOTES
interest rates (i) and Gross national Product (Y)
It can be expressed as DM = f (I, Y)
Supply on the other hand is a function of money supply (M)
SM= M
Loanable Funds Theory
This theory gives significance to the demand and supply of loanable funds. These
Check Your Progress funds are raised from households, businesses and Government Surplus where the
What are the determinants spending is less than the income. This again depends on the interest rates. Higher the
of interest rate level and
interest rates, higher will be the motivation to save and vice- versa. On the other hand,
changes?
the demand for the loanable funds arises from the households, business which prefers
to spend more than the income and the Government expenditure. This leads to
borrowings leads to issue of primary securities. It leads to more creation of deficit
spending units. There is an inverse relation between the demand for loanable funds
and interest rates. It can be said that
Demand for Loanable funds = Supply of Securities.
This point is the equilibrium point of Interest where demand is equal to supply.
This theory is useful to predict interest rates in financial sectors of the economy
11.9 Summary
• Bonds and Debentures are fixed income securities offering regular returns
to its holders. The issuer has a legal obligation to pay the interest at regular
intervals and also the principal portion on maturity.
• Debentures/Bonds are in the form of loan or debt capital having fixed return
in the form of interest and no voting rights in general meeting with preference
in repayment at the time of winding up
• Debt markets have three major components namely Government Securities

or bonds Corporate securities and money market instruments
• The Government of India issues bonds called Government Securities or Gilt Fixed Income Securities
Valuation
edged securities which are medium to long term issued by Reserve Bank of
India on behalf of the Government.
NOTES
• The value of a Bond is based on its intrinsic value which is equal to the
present value of its expected cash flows.
• Bonds having maturity date will be valued by taking annual interest payments
and terminal value using present value and thereafter by computing the
discounted values of cash flows
• The value of perpetual bond is the discounted sum of the infinite series. The
discount rate depends upon the riskiness of the bond. It is usually the rate or
yield on bonds of similar type of risk.
• The Yield to maturity of a bond is the interest rate which makes the present
value of cash flows receivable from the bond equal to the price of the bond.
• Bonds having a call feature entitling the issuer to call the bond before the
maturity date stated in the bond as per a call schedule which mentions a call
price for each call known as Yield to call.
• Returns are always viewed in terms of risk involved and bonds are subject
to different types of risks such as Interest rate risk, Inflation risk, Default
risk, Liquidity risk, Reinvestment risk and Real Interest Rate risk
• Interest rate risk also called market risk shows the percentage change in the
bond value due to the change in interest rate.
• Inflation risk is a measure of the rate of exchange between current value of

rupee and its future value.
• Credit risk arises in the event of bankruptcy of the borrower who is unable
to pay his debts.
• Liquidity risk arises due to low liquidity of debt market instruments leading
to liquidity problems to the investors in debt since it’s difficult for them to
trade off these debt instruments.
• Reinvestment risk arises when a bond or debt instrument pays periodic interest
and the interest payments are reinvested at a lower interest rate.
• Credit ratings of bonds and debt instruments enable to gauge the credit risk.
• There are five credit rating agencies in India namely CRISIL, CARE, ICRA,
Valuation
Fitch and Brickworks.
NOTES • Areas which need to be investigated in a bond rating process are Earnings
Capacity, Leverage, Liquidity and Indenture
• Indentures are legal agreements between the lender and borrower specifying
the rights and obligations and liabilities.
• There are two theories which explain the level and changes of interest rates
namely Liquidity Preference Theory and Loanable Funds Theory.
11.10 Key Words
1. Government Bonds : These are issued by the Government of India also
called Government Securities or Gilt edged securities (G-secs) on a medium
to long term issued by Reserve Bank of India on behalf of the Government
2. Interest rate risk: Also called market risk, it shows the percentage change
in the bond value due to the change in interest rate and is a measure of the
maturity period of the bond and its coupon interest rate.
3. Inflation risk: It is a measure of the rate of exchange between current
value of rupee and its future value.
4. Credit Risk: This risk arises when the principal as well as interest payment
is lost or there is a delay in payment with no eventual loss, still the value of
debt in terms of present value will be reduced substantially.
5. Liquidity Risk: It is generally due to debt instruments having low liquidity

since debt market activities occur in the primary market leading to liquidity
problems to the investors in debt since it is difficult for them to trade these
debt instruments.
6. Reinvestment Risk:This risk arises when a bond or debt instrument pays
periodic interest and the interest payments are reinvested at a lower interest
rate.
Security Analysis and 7. Real interest Rate risk :This risk is due to change in real interest rates
Portfolio Management:230 due to the shifts in demand and supply for funds.
8. Leverage: It is measured in terms of the business’ earning capacity and Fixed Income Securities
Valuation
risk involved in the expected earnings which may or may not occur and also
the interest coverage from the returns on assets.

NOTES
9. Indentures: These are legal agreements between the lender and borrower
specifying the rights and obligations and liabilities containing the conditions
requiring the borrower to maintain certain levels of earnings, working capital
and assets etc

1. Bonds and Debentures are fixed income securities
a. offering regular returns to its holders.
b. creating a legal obligation to pay the interest at regular intervals and also
the principal portion on maturity.
c. giving preference for repayment on winding up
d. All the above
2. Debentures/Bonds have the following features:
a. form of loan or debt capital or borrowed capital
b. Fixed return in the form of interest
c. No voting rights in general meeting
d. All the above
3. The advantages of investing in bond market are:
a. Security of return only but no safety of investment
b. High volatility of prices as compared to equity
c. Relatively risk free investment mode due to high default risk on

investments done in government securities
d. Enables wide portfolio diversification and managing portfolio risk

efficiently

Fixed Income Securities 4. The components of debt market are
Valuation
a. Government Securities or bonds and Corporate securities
b. Derivatives
NOTES
c. Foreign Direct Investment
d. All the above
5. The value of a Bond is based on this value which is equal to the present
value of its expected cash flows.
a. Yield
b. Intrinsic
c. Coupon
d. Market
6. Generally these techniques are used to find the value of money at a future
date or to find the value of money today.
a. Yield to call
b. Yield to market
c. Realized to market
d. Discounting and Compounding
7. These will be valued by taking annual interest payments and terminal value
using present value and thereafter by computing the discounted values of
cash flows as follows
a. Bonds with maturity dates
b. Bonds with perpetuity
c. Stock with warrants
d. Bonds with coupon rates
8. This is taken as the interest rate which makes the present value of cash
flows receivable from the bond equal to the price of the bond.
a. Yield to market
b. Yield to Call
c. Yield to maturity

9. It is also called market risk shows the percentage change in the bond value Fixed Income Securities
Valuation
due to the change in interest rate.
a. Interest rate risk

NOTES
b. Default risk
c. Reinvestment risk
d. Liquidity risk
10. The following factors are areas which need to be investigated in a bond
rating process:
a. Earnings Capacity
b. Leverage
c. Indenture
d. All the above
11. It is measured in terms of the earning capacity and risk involved in the
expected earnings which may or may not occur
a. Indenture
b. Leverage
c. Credit rating
d. Liquidity
12. These are legal agreements between the lender and borrower specifying
the rights and obligations and liabilities
a. Indenture
b. Bonds
c. Derivatives
d. All the above
13. This theory derives the interest rate at a point of equilibrium in the demand
and supply of money at a given point of time.
a. Liquidity Preference Theory
b. Loanable Funds Theory
c. Preferred Habitat Theory Security Analysis and

Fixed Income Securities 14. This theory gives significance to the demand and supply of loanable funds.
Valuation
a. Liquidity Preference Theory
NOTES b. Loanable Funds Theory
c. Preferred Habitat Theory
d. All the above
15. These funds are raised from households, businesses and Government Surplus
where the spending is less than the income.
a. Liquid funds
b. Hybrid Funds
c. Loanable funds

1. State the different categories of debt instruments in India.
2. What are the advantages of investing in Bond/ Debt Market?
3. What are the major components of the Bond market in India?
4. Explain the different methods of Valuation of Bonds/ Debt Instruments
5. What are the different types of risks which bonds are subject to?
6. What are the features of credit ratings for Bonds?

7. What are the areas to be investigated in the Bond Rating Process?
8. What are the determinants of interest rate level and changes?
11.11.3 Exercises
Ex.1 The market value of a Rs.500 par value bond carrying coupon rate of
14% and maturing after 5 years is Rs. 525.What is the Yield to Maturity
(YTM) on this bond? What will be the realized yield to maturity if the
reinvestment rate is 12%.
Ex.2 What would be the value of a bond of Rs. 2000 issued with a maturity
of 5 years at par to yield 12%? Interest is to be paid annually and the
bond is newly issued.
Ex.3 An 8 % debentures with Rs. 100 face value to be redeemed at a premium

of 5% at the end of the 5th year is being traded in the market from the
first day of its issue. The expected rate of return is 15%. At what price Fixed Income Securities
Valuation
should he buy the debenture?
Ex.4 Joy ltd. has a 12 % debenture with a face value of Rs. 100 maturing in
NOTES
12 years. The debenture is callable in five years at Rs. 115. It currently
sells for Rs. 105. Calculate the Yield to call and Yield to maturity.
Ex.5 A Bond pays annual interest and sells for Rs. 915. It has six years left to
maturity with a par value of Rs. 1,000. What is the coupon rate if its
expected Yield to Maturity is 12%?
“Investment Analysis and Portfolio Management”, “V.A. Avadhani, Himalaya

Publishing House, Mumbai, 2011.

Portfolio Management:
Analysis, Selection, Unit 12 Portfolio Management: Analysis,
Revision & Evalution
Selection, Revision and Evaluation
NOTES
Structure
12.0 Introduction
12.2 Phases of Portfolio Management
12.3 Portfolio Notion and Principles
12.5 Portfolio Selection
12.5.1 Efficient Portfolio
12.5.2 Modern Portfolio Theory - Efficient Frontier (Harry Markowitz Model)
12.5.3 Market Portfolio
12.6 Portfolio Revision
12.7 Portfolio Evaluation
12.7.1 Risk Adjusted Return
12.7.2 Differential Return
12.8 Summary
12.9 Key words
12.10.3 Exercises

Portfolio Management:
12.0 Introduction Analysis, Selection,
Portfolio Management is a decision on investments in terms of what investments
NOTES
to buy and sell so as to manage the basket of securities to yield highest possible return
with the lowest risk. In India, the concept of Portfolio management gained prominence
with Mutual funds having success in managing the funds of clients by proper portfolio
management. However, SEBI’s license is required in India to practice as a professional
portfolio manager.
Ø Learn the phases of portfolio management
Ø Understand the portfolio notions and principles
Ø Learn the Portfolio analysis process
Ø Learn the Portfolio Selection process
Ø Understand the meaning of Portfolio Revision
Ø Understand the meaning of Portfolio Evaluation
12.2 Phases of Portfolio management
The typical portfolio management process entails the following phases:
Ø Security Analysis
Ø Portfolio Analysis
Ø Portfolio Selection
Ø Portfolio Revision
Ø Portfolio Evaluation
Each phase is significant in its own way and managing each phase efficiently
results in an optimum portfolio.
Ø Security Analysis: There are various securities available for investment

and there are shares of over 7008 companies listed on the stock exchanges Security Analysis and
Portfolio Management: in India. As seen earlier, the securities are classified into ownership basis
Analysis, Selection,
Revision & Evalution into equity shares and preference shares and creditorship basis into debentures
and bonds. Apart from these traditional securities there are a variety of new
NOTES
securities with innovative features being introduced in the recent past such
as Deep discount bonds, Zero Coupon bonds, Flexi Bonds, Floating Rate
Bonds, Euro Currency Bonds, Global Depository Receipts, American
Depository Receipts, etc. To choose from this variety of securities required

an in depth analysis of each of them in terms of their features. Securities
analysis is the starting point of portfolio management wherein each available
alternative investment is evaluated in terms of risk and return. Usually it is a

practice to buy underpriced securities and sell overpriced securities. Security
analysis is all about analysis of the prices of securities. As we have seen
before, there are two practical approaches to security analysis i.e.

Fundamental Analysis and Technical Analysis which is discussed in detail in
the preceding sections. Another recent approach to security analysis is
Efficient Market Hypothesis which is based on the idea that financial markets
are efficient in pricing securities. It also assumes that the market price of
securities is a reflection of all information about the securities and this market
value is always equal to its intrinsic value. Efficient market hypothesis is a

direct result of fundamental analysis and technical analysis.
Ø Portfolio Analysis: Portfolio is a group of securities which an investor

invests in. It is always preferred by investors to invest in a portfolio consisting
of a basket of securities rather than a single security due to the benefit of
risk aversion. In portfolio analysis, each security in the portfolio is analyzed

by measuring the risk – return characteristics. Portfolio analysis is as a
phase of portfolio management seeks to identify the possible range of
securities in which investments can be made so as to decide on the optimum

portfolio in which investment can be made.
Ø Portfolio Selection: This is the next stage in portfolio management in which
the inputs received from the previous phase of portfolio management is

utilized so as to take a decision on selection of the best portfolio from among
Portfolio Management:238 the set of selected and shortlisted portfolio known as efficient portfolio. Harry
Markowitz portfolio theory provides the basis for analyzing and evaluating Portfolio Management:
the portfolio known as efficient portfolio from amongst the available options Revision & Evalution
in an objective manner through a proper framework.
NOTES
Ø Portfolio Revision: As time passes by, there needs to be made a revision
in the portfolio mix. This is done to ensure that the portfolio selected is
optimal. There may be dynamic changes in the economy and the financial
and capital markets, hence the need to reorganize the portfolio as per the
needs of the environment. To make this revision, there is a need to buy some
new securities which offer better return with lower risk and sell existing
securities which have stopped yielding higher returns as compared to new
ones available in the market.
Ø Portfolio Evaluation: It is a process of assessing the performance of a

portfolio in terms of risk and return over a period of time. The relative
performance of the portfolio is measured as per the benchmarks established
by the investors as per their expectations. It identifies the weaknesses in the

portfolio management process and also gives feedback on the weaknesses
so as to take steps for its improvement. By making this Evaluation process a

Check Your Progress
continuous one, superior performance is ensured and the optimal portfolio Explain the different
results from the entire process starting from portfolio construction, revision phases of Portfolio
Management.
and Evaluation.
12.3 Portfolio Notions & Principles
Portfolio is a collection of two or more securities held at a specific point of time
with the aim of fulfillment of investment objectives. There are some fundamental
principles on the basis of which portfolio is created with the objective of either risk
minimization. These principles also called notion of portfolio are as under:
Ø Notion of Portfolio Construction
This can be further bifurcated into:

a. Notion of Diversification:
It is based on the fundamental of having a manageable portfolio. The more Security Analysis and
the number of securities in a portfolio, the lesser will be the unsystematic Portfolio Management:239
Portfolio Management: risk in the portfolio. It is based on the notion that the bad performance of one
Revision & Evalution security in a portfolio may be diversified by gaining on some other security
in the same portfolio performing better. Due to the spread of the risk due to
NOTES
diversification, there is less risk of loss on account of one or two securities
giving low returns.
b. Notion of Negative Correlation:
This notion states that the securities to be included in a portfolio should be
negatively correlated as far as possible. Due to the negative correlation, the

variance in the portfolio returns will be minimized due to the nullifying effect.
Check Your Progress
Discuss the Portfolio Negative correlation will lead to minimal or no risk whereas in case of positive
Notions and Principles. correlation, the risk will be multifold.
Portfolio analysis consists of a series of steps by determining the expected risk
and return of different portfolios and the securities in each portfolio. To begin with, the
securities that needs to be included in portfolio needs identification. Thereafter, the risk
– return expectations are set in terms of standards which are expressed as the expected
rate of return (mean) and the variance or standard deviation of the return.
Expected Return of a Portfolio: The expected return of a portfolio is

measured as :
n
= Xri t =1
rp
where,
rp = Expected Return of the portfolio
Xi = Proportion of funds invested in security i.
ri = Expected return of security i.
n = Number of securities in portfolio
Expected Risk of a Portfolio
Risk of a portfolio can be measured by measures such as Variance and Standard
deviation. It is measured in terms of the variability of returns in a portfolio. Covariance

Portfolio Management:240 is a statistical tool measuring the interactive risk of a security in relation to other securities
in the portfolio. Co-variance also measures the movements of two securities. A negative Portfolio Management:
covariance would show two securities moving in opposite direction and a positive Revision & Evalution
covariance would indicate the securities moving in the same direction. The covariance
NOTES
between two securities is measured by the formula:
 N 
 R x – R x   R y – R y 
 i =1 
Covxy =
N
Where,
Cov xy = Covariance between security x and y
Rx = Return of Security x
Ry = Return of Security y
Rx = Expected or mean return of security x
Rx = Expected or mean return of security x
Ry = Expected or mean return of security y
N = Number of observations
Illustration 1
Year Rx Rx - R x Ry Ry – R y Product of
Deviation
1 12 -4 18 6 -24
2 14 0 14 2 0
3 18 2 9 -3 -6
4 20 4 7 -5 -20
64 48
Rx = = 16 Ry = = 12 -50
4 4
 N 
 R x – R x   R y – R y 
 i =1 
Covxy =
N
–50
= = –12.5
4
Illustration 2
The coefficient of correlation is obtained by dividing the covariance by the product
of the standard deviation of each security. The values of coefficient of correlation can
Portfolio Management: range anything between –1 and 1 ranging between perfect negative correlation and
Revision & Evalution perfect positive correlation. This is expressed as:
Cov xy
R xy =
NOTES σx σ y
Where,
r xy
= Coefficient of correlation between x and y
Covxy = Covariance between x and y
óx = Standard Deviation of x
óy = Standard Deviation of y
It can also be seen that:
Covxy = rxyó x óy
Portfolio with two securities
The variance of a portfolio with 2 securities only may be computed by the following
formula:
ó p 2 = x i2 ó i 2 + x22 ó 2 + 2 x1 x2 (r12 ó1ó 2 )
Where,
óp 2 = Portfolio Variance
x1 = Proportion of funds invested in first security
x 2
= Proportion of funds invested in second security
ó 2
= Variance of first security
Check Your Progress 1
What do you mean by ó 2

= Variance of second security
2
Portfolio Analysis? What
is the difference between ó 1
= Standard Deviation off first security
the Portfolio analysis of a ó = Standard Deviation second security
2
Portfolio with one security
and with two securities? r1 = Correlation Coefficient between the returns of the first and second
security
12.5 Portfolio Selection
Portfolio Selection is the process of finding out the optimal portfolio which would
be one generating highest return with the lowest risk. This is done with the objective of
Portfolio Management:242 maximizing the investor’s return. Diversification is done for reducing the risk in a
portfolio. The investor usually combines a limited number of securities thereby creating Portfolio Management:
a large number of portfolios and in different proportions. This is known as portfolio
opportunity set. Every portfolio in the opportunity set is characterized by an expected
NOTES
return and some risk in terms of variance or standard deviation. Some portfolios in a
portfolio opportunity set are of interest to an investor depending upon the risk and
return as measured by standard deviation. A portfolio will dominate over others if it has Check Your Progress
a lower standard deviation. These portfolios which are dominated by other portfolios How is Portfolio Selection
done?
are known as inefficient portfolios. Efficient portfolios are the ones in which the investor
is interested to invest.
12.5.1 Efficient Portfolio

An Efficient portfolio is the one which yields maximum return at minimum risk at
a given level of return. The Dominance Principle is used as a base to identify the
efficient portfolio. A portfolio having maximum return for a specific level of risk is
preferred over other portfolios having similar risk. Investors maximize their terminal
wealth by going for high yielding securities at a given risk level. Only efficient portfolios
are feasible in the long run which fulfills this need of the investors. The expected
returns and risk measured by standard deviation of portfolio returns can be estimated
as done in the table below.
Portfolio Number Expected Return in % Standard Deviation(Risk)
1 5 4.5
2 7 5.6
3 9 7.8
4 11 7.8
5 13 11.3
6 13 12.8
7 15 13.1
8 17 14.5
9 18 16.4
10 20 17.2
11 22 18.9
12 25 19.1 Portfolio Management:243
Portfolio Management: By comparing the portfolios at the given risk and return, if we compare portfolio
Analysis, Selection, 5 and 6 with the same return at 13 %, an investor would select Portfolio 5 since the
Revision & Evalution risk is low at 11.3 as compared to portfolio 6. Similarly, if we compare portfolio 3 and
NOTES 4, having similar risk depicted by standard deviation of 7.8, an investor would choose
portfolio 4 since it yield at higher return at 11 % compared to portfolio 3. Thus we can
lay down general criteria for portfolio selection as:
1. Between two portfolios having the same risk , an investor would choose
the one with higher expected return
2. Between two portfolios having the same return, an investor would choose
Check Your Progress the one with lower risk.
What do you mean by an
This is because of the rational natures of the investors who is risk averse and
Efficient Portfolio?
want more returns.
12.5.2 Modern Portfolio Theory - Efficient Frontier (Harry

Markowitz Model)
• Introduction
The concept of Efficient Frontier or Portfolio Frontier was introduced by Harry
Markowitz in 1952. Efficient Frontier is a Modern Portfolio Theory tool. Modern
Portfolio Theory also known as Portfolio Theory of Portfolio Management Theory is
an investment theory that is developed with an idea to help investors to build a portfolio
which will generate maximum expected return at a given level of market risk. It is a
tool that emphasizes on the best possible returns that the investors can expect at a
given level of market risk.
The theory also focuses on the benefits of diversifying the portfolio i.e. investing
in different asset classes like stocks, bonds, real estate, gold etc. It is based on the
underlying fact of “Do not put all your eggs in one basket”.

l Meaning Portfolio Management:
Efficient Market Frontier represents the set of portfolios that yield the highest
expected return fora given level of market risk or the lowest possible level of market
risk. The portfolios that lie towards the right end of the efficient frontier are characterized NOTES
by high risk and high returns, on the other hand, the portfolios tending towards the left
end of the efficient frontier are associated with low risk and low returns. The risk
seeking investors invest in the portfolios on the right end, whereas the risk averse
investors select the portfolios on the left end of the efficient frontier.
The portfolio that maintains the perfect balance between the risk and return is
called as the optimal portfolio. An optimal portfolio is the one that maximizes investors’
utility with respect to risk and reward. A perfect balance between risk and return is
ensured while selecting an optimal portfolio.
The portfolios that lie below the efficient frontier are known as the sub-optimal
portfolios. These sub-optimal portfolios fail to maintain the perfect balance between
the risk and reward. These sub-optimal investments do not yield adequate returns for
the degree of risk associated with them.
The table below shows the optimal and sub-optimal portfolios with the help of
certain risk and return numbers:
Nature of Risk Returns Risk Positionon the Type of
and Return (%) (%) Efficient Frontier Portfolio
Efficient Risk & Return 15% 10% On the Frontier Optimal
Less Return, Same Risk 12% 10% Below the Frontier Sub-Optimal
Same Return, Less Risk 15% 12% Below the Frontier Sub-Optimal
• Assumptions
The Markowitz’s Efficient Market Frontier is based on the following assumptions:
Ø The portfolio returns are normally distributed.
Ø The investors are rational.
Ø There are no restrictions or limits for the investors on borrowing or lending
of money at risk free rate.
• Limitations
Based on the above assumptions, the limitations of Efficient Market Frontier
can be inferred as below:
Ø The portfolio returns are not normally distributed but are heavily skewed on
the tails.
Ø The investors are irrational. They believe in risk taking, expecting that higher
the risk, higher the returns.
Ø In reality, the investors in the market have limited access to borrowing or
lending of money at risk free rate.
Portfolio Management: 12.5.3 Market Portfolio
This represents such a portfolio in which all the securities traded in the market
have exactly the same proportion in which these represent themselves in the market
NOTES capitalization. It results in producing equilibrium market prices. It means that the prices
of shares are at equilibrium as and when they yield the expected return which sufficiently
Check Your Progress compensates for the risk involved. An investor choosing the market portfolio as his
What do you mean by investment portfolio must hold shares in all the companies quoted on the stock market
Efficient Frontier? OR as a proportion to their market value. The portfolio so created is allocated in all the
Explain the Modern risky securities in the ratio of their representation in the overall market. Beta of the
Portfolio Theory. portfolio is that which has the effect of aligning the risk and return of the investment
with the overall market.
12.6 Portfolio Revision
Portfolio Revision may not be as important as portfolio analysis and selection;

however it has its own significance in constructing an optimal portfolio. Portfolio revision
is required due to the changing dynamic markets which lead to a situation where a
change in Portfolio is done as per the market conditions. The reasons leading to a
change or revision in a portfolio may be:
Ø Changes in the Risk level
Ø Changes in the investment objective
Ø Changes in the funds available for investment
A portfolio revision entails changes in two factors which determine the composition
of a portfolio i.e. the securities which form a part of the portfolio and the other is the
proportion of total funds invested in each security. It entails a change or a revision in
the mix of securities. Though the objective of portfolio revision and portfolio selection
is same i.e. maximization of returns and minimizing risks, the difference is that portfolio
revision leads to purchase and sale of securities. Revision can be done either by portfolio
rebalancing or portfolio upgrading.
Portfolio Rebalancing consists of reviewing and revising the mix of securities in

the portfolio by different policies such as buy and hold policy wherein the original
portfolio is left undisturbed and no changes are made in the composition of securities in
the portfolio. There is a constant mix policy which seeks to maintain the proportion of
stocks and bonds when their relative values change. Then there is a portfolio insurance
policy which needs an increase in the exposure to stocks as and when there is an
Check Your Progress
appreciation in its value and decrease in the same on depreciation in its value. This
What do you mean by
Market Portfolio? policy aims to maintain the portfolio value at a floor level below which it should not fall.
Portfolio upgrading is done by reassessing the risk- return characteristics of securities
Security Analysis and and is done by selling overpriced securities and buying underpriced ones. It may be
noted that investors are reluctant to go for upgrading the portfolio as it entails costs like Portfolio Management:
cost of trading, commission, taxes, etc.
NOTES
12.7 Portfolio Evaluation
Portfolio Evaluation which is the last stage in portfolio management is the stage
where the investor evaluates the performance of the portfolio selected. It consists not
only of risk return computations but a much detailed analysis of the risk and return
relationship and its impact on the portfolio performance. The performance of portfolio
is evaluated by carrying out a performance appraisal which can be done either by the
individual investor or by professionals such as mutual funds or investment companies.
Portfolio Evaluation can be done with specific purpose such as Self Evaluation of
investor’s investment activity and portfolio selection and also portfolio performance so
as to locate the weakness in the whole process of portfolio management done by the
investor. Secondly, Evaluation of portfolio also enables an investor to know the
performance of the portfolio managers through the portfolio performance.
The portfolio Evaluation process essentially consists of two functions namely:
Ø Performance Measurement
Ø Performance Evaluation
Performance measurement is a function which measures the return on investment

in financial terms and performance Evaluation is a means of finding out whether the
performance was as expected and whether performance was better or not as compared
to benchmarks. This can be done by evaluating the return earned by the Portfolio with
the risk involved in earning the returns. Another way to evaluate the Performance Check Your Progress
would be identify the risk class of each portfolio and then compare the returns within Explain the process of
Portfolio Revision.
each risk class. It can also be evaluated by adjusting the return for the risk and developing
the risk adjusted return measures for evaluating the portfolios.
12.7.1 Risk Adjusted Return

Risk free rate of interest is the return which an investor earns on a risk-free
security. The return actually earned by the investor is the premium or reward for the
risk borne called Risk Premium. To measure the risk of portfolios, two models are
made by William Sharpe called Sharpe Ratio and the other one by Jack Treynor. These
are given below:
Portfolio Management: 1. Sharpe Ratio
Revision & Evalution This ratio also called reward to variability ratio is the ratio of reward or risk
NOTES premium to the variability of return or risk measured by standard deviation. It is calculated
as follows:
rp – rf
Sharpe Ratio =
σp
Where,
rp = Return realized on the portfolio
rf = Risk free rate of return
ó p
= Standard Deviation of the portfolio return
2. Treynor Ratio
This ratio also called reward to volatility ratio developed by Jack Treynor called
Treynor Ratio is ratio of the reward or risk premium to the volatility of the return
indicated by beta. It is calculated as follows:

rp – rf
Treynor Ratio =
βp
Where,
rp = Return realized on the portfolio
rf = Risk free rate of return
â p = Portfolio Beta
Illustration 3:
The following data of 2 funds managed by Etica Asset Management Co.Ltd. is
given. You are being asked to evaluate the performance of each fund in the portfolio
using Sharpe Ratio and Treynor ratio:
Fund Return (%) Standard Deviation (%) Beta
Check Your Progress Ace 14 15 0.6

Explain the Portfolio
Evaluation Phase of Joy 16 22 1.5
Portfolio Management.
Maxx(Market Index) 21 25 1.2
Security Analysis and The risk free rate of return is 8 percent.

Solution: Portfolio Management:
Sharpe Ratio : Revision & Evalution
14 – 8 NOTES
Ace = = 0.4
5
16 – 8
Joy = = 0.36
22
21 – 8
Maxx = = 0.52
25
As per Sharpe’s performance measure, Fund Maxx has performed better than
the market index whereas fund Joy has performed worse than the market index.
Treynor’s Ratio:
14 – 8
Ace = = 0.67
0.6
16 – 8
Joy = = 5.33 Check Your Progress
1.5
What do you understand
21 – 8
Maxx = = 10.83 by Risk Adjusted Return?
1.5
According to Treynor’s performance measure, Fund Maxx has performed better

and Fund Ace has performed worse than the index.
12.7.2 Differential Return

Michael Jensen developed another type of risk adjusted performance measure
known as Jensen Ratio or Jensen Alpha which is based on Capital Asset pricing model.
It is the difference between the actual return earned on a portfolio and the expected
return on the portfolio given its beta as per capital asset pricing model. The expected
return on the portfolio is calculated as:
E (Rp) = Rf + âp (Rm – Rf)
Where,
E (Rp) = Expected portfolio return
Rf = Risk Free rate
Rm = Return on market index
Âp = Systematic Risk of the portfolio

Check Your Progress
What do you mean by
The differential return is calculated as: Differential Return?
áp = Rp– E (Rp) Security Analysis and
Portfolio Management: Where,
Revision & Evalution áp = Differential Return earned
NOTES Rp =Actual Return earned
E (Rp) = Expected Return
12.8 Summary
• The typical portfolio management process entails the phases of Security
Analysis, Portfolio Analysis, Portfolio Selection,Portfolio Revision and
Portfolio Evaluation
• Securities analysis is the starting point of portfolio management wherein
each available alternative investment is evaluated in terms of risk and return.
• There are two practical approaches to security analysis namely Fundamental
Analysis and Technical Analysis.
• Portfolio analysis is as a phase of portfolio management seeks to identify the

possible range of securities in which investments can be made so as to
decide on the optimum portfolio in which investment can be made.
• Portfolio Selection is that stage in portfolio management in which the inputs

received from the previous phase of portfolio management is utilized so as
to take a decision on selection of the best portfolio from among the set of
selected and shortlisted portfolio known as efficient portfolio.
• In Portfolio Revision, there is a need to buy some new securities which offer
better return with lower risk and sell existing securities which have stopped
yielding higher returns as compared to new ones available in the market.
• Portfolio Evaluation is a process of assessing the performance of a portfolio
in terms of risk and return over a period of time.
• The Notion of Diversification is based on the fundamental of having a
manageable portfolio and is based on the notion that the bad performance of
one security in a portfolio may be diversified by gaining on some other security
in the same portfolio performing better.
• The Notion of Negative Correlation states that the securities to be included

in a portfolio should be negatively correlated as far as possible.
• Portfolio analysis consists of a series of steps by determining the expected Portfolio Management:
risk and return of different portfolios and the securities in each portfolio. Revision & Evalution
• Risk of a portfolio can be measured by measures such as Variance and NOTES
Standard deviation and is measured in terms of the variability of returns in a
portfolio.
• Covariance is a statistical tool measuring the interactive risk of a security in

relation to other securities in the portfolio.
• Portfolio Selection is the process of finding out the optimal portfolio which
would be one generating highest return with the lowest risk.
• The investor usually combines a limited number of securities thereby creating
a large number of portfolios and in different proportions known as portfolio

opportunity set.
• An Efficient portfolio is the one which yields maximum return at minimum
risk at a given level of return for which the Dominance Principle is used as
a base to identify the efficient portfolio.
• Harry Markowitz has formalized the risk return relationship in the concept
of Efficient Frontier and Modern Portfolio theory which favours this efficient
frontier model which describes that portfolio which produces highest return
for a given level of risk.
• Portfolio Revision is required due to the changing dynamic markets which
lead to a situation where a change in Portfolio is done as per the market
conditions.
• Portfolio Evaluation which is the last stage in portfolio management is the
stage where the investor evaluates the performance of the portfolio selected
consisting not only of risk return computations but a much detailed analysis
of the risk and return relationship and its impact on the portfolio performance.
• Portfolio Evaluation can be done with specific purpose such as Self

Evaluation of investor’s investment activity and portfolio selection and also
portfolio performance so as to locate the weakness in the whole process of
portfolio management done by the investor.

Portfolio Management: • Sharpe Ratio also called reward to variability ratio is the ratio of reward or
Revision & Evalution risk premium to the variability of return or risk measured by standard deviation.
• Treynor Ratio also called reward to volatility ratio is the ratio of the reward
NOTES
or risk premium to the volatility of the return indicated by beta.
• Differential Return is another type of risk adjusted performance measure

known as Jensen Ratio or Jensen Alpha which is based on Capital Asset
pricing model which is the difference between the actual return earned on
a portfolio and the expected return on the portfolio given its beta as per
capital asset pricing model.
12.9 Key Terms
1. Portfolio Management: It is a decision on investments in terms of what

investments to buy and sell so as to manage the basket of securities to yield
highest possible return with the lowest risk.
2. Securities analysis: It is the starting point of portfolio management wherein

each available alternative investment is evaluated in terms of risk and return.
3. Portfolio analysis: It is a phase of portfolio management seeks to identify

the possible range of securities in which investments can be made so as to
decide on the optimum portfolio in which investment can be made.
4. Portfolio Selection: This is that stage where the inputs received from the
previous phase of portfolio management is utilized so as to take a decision
on selection of the best portfolio from among the set of selected.
5. Portfolio Revision: In this process, there is a need to buy some new

securities which offer better return with lower risk and sell existing securities
which have stopped yielding higher returns as compared to new ones available
in the market.
6. Portfolio Evaluation: It is a process where relative performance of the

portfolio is measured as per the benchmarks established by the investors as
per their expectations.
7. Efficient portfolio: It is the one which yields maximum return at minimum
Security Analysis and risk at a given level of return and only efficient portfolios are feasible in the
Portfolio Management:252 long run which fulfills this need of the investors.
8. Efficient frontier: It is a line representing all the efficient portfolios on a Portfolio Management:
risk return graph. Revision & Evalution
9. Market Portfolio: It represents such a portfolio in which all the securities
NOTES
traded in the market have exactly the same proportion in which these represent
themselves in the market capitalization.

1. Its license is required in India to practice as a professional portfolio manager.
a. RBI
b. SEBI
c. UTI
d. Stock Exchange
2. The typical portfolio management process entails the following phases :
a. Security Analysis
b. Portfolio Analysis
c. Portfolio Selection
d. All the above
3. It is the starting point of portfolio management wherein each available

alternative investment is evaluated in terms of risk and return.
a. Securities Analysis
c. Portfolio Analysis
4. It is a phase of portfolio management seeks to identify the possible range of

securities in which investments can be made so as to decide on the optimum
portfolio in which investment can be made.
c. Portfolio Analysis Security Analysis and

d. None of the above Portfolio Management:253
Portfolio Management: 5. It is that stage in portfolio management in which the inputs received from
the previous phase of portfolio management is utilized so as to take a decision
on selection of the best portfolio known as efficient portfolio.
NOTES
c. Portfolio Selection
d. Portfolio Analysis
6. This portfolio theory provides the basis for analyzing and evaluating the
portfolio known as efficient portfolio from amongst the available options in
an objective manner through a proper framework.
a. Sharpe
b. Treynor
c. Harry Markowitz
d. Jensen
7. It represents such a portfolio in which all the securities traded in the market
have exactly the same proportion in which these represent themselves in the
market capitalization producing equilibrium market prices..
a. Efficient Portfolio
b. Efficient Frontier
c. Market Portfolio
8. A portfolio revision entails changes in the securities which form a part of the
portfolio and the other is the proportion of total funds invested in each security.
a. Portfolio Revision
b. Portfolio upgrading
c. Portfolio Rebalancing
d. Portfolio Evaluation
9. It consists of reviewing and revising the mix of securities in the portfolio by
different policies such as buy and hold policy wherein the original portfolio is
left undisturbed.
a. Portfolio Revision
b. Portfolio upgrading
Security Analysis and c. Portfolio Rebalancing

Portfolio Management:254 d. Portfolio Evaluation
10. Michael Jensen developed this risk adjusted performance measure which is Portfolio Management:
based on Capital Asset pricing model.
a. Jensen Alpha
NOTES
b. Jensen Measure
c. Jensen Model
d. Jensen Risk Ratio

1. Explain the different phases of Portfolio Management.
2. Discuss the Portfolio Notions and Principles.
3. What do you mean by Portfolio Analysis?
4. What is the difference between the Portfolio analysis of a Portfolio with one
security and with two securities?
5. How is Portfolio Selection done?
6. What do you mean by an Efficient Portfolio?
7. What do you mean by Efficient Frontier?
8. Explain the Modern Portfolio Theory.
9. What do you mean by Market Portfolio?
10. Explain the process of Portfolio Revision.
11. Explain the Portfolio Evaluation Phase of Portfolio Management.
12. What do understand by Risk Adjusted Return?
13. What do you mean by Differential Return?
12.10.3 Exercises
Ex.1 Following data on performance on a mutual fund and capital market is
given. Calculate the following measures for the mutual fund:
A. Reward to variability ratio
B. Reward to volatility ratio

Portfolio Management: Year Mutual Fund Mutual Fund Return on Return on Govt.
Revision & Evalution beta return (%) market index (%) Securities (%)
NOTES 1 0.50 – 4.00 – 7.50 5.50
2 0.55 1.80 6.00 5.50
3 0.60 15.00 12.00 5.00
4 0.60 18.00 16.50 5.00
5 0.70 9.00 6.50 4.25
6 0.72 7.00 1.80 4.25
7 0.85 19.00 14.00 8.00
8 0.94 21.00 19.00 6.50
9 1.10 16.00 11.00 4.50
10 0.82 – 2.00 9.00 7.00
Ex.2 Consider the following information for three mutual funds P, Q and R
and the market.
Mutual Fund Mean Return (%) Standard Deviation (%) Beta
P 14 16 1.2
Q 12 14 0.7
R 10 18 1.5
12 16 1.0
The mean risk – free rate was 8 Percent. Calculate Treynor Ratio, Sharpe Ratio
and Jensen Ratio for the three mutual funds and the market index.
12.11Further Reading and References
“Security Analysis and Portfolio Management”, Donald E. Fischer and Ronald

J. Jordan, Pearson, South Asia, 2016.

Theories of Portfolio
Unit 13 Theories of Portfolio Management Management
Structure NOTES
13.0 Introduction
13.2 Efficient Market Theory
13.2.1 Efficient Market
13.2.2 Efficient Market Hypothesis (EMH)
13.3 Capital Market Theory – Capital Asset Pricing Model
13.4 Multiple Factor Model and Arbitrage Pricing Theory
13.5 Summary
13.6 Key Words
13.7.3 Exercises
13.0 Introduction
Portfolio Theories are frameworks for assembling asset portfolios to maximize

returns for a given level of risk which is measured in terms of variance. Risk and
Return are not the only factors to be analyzed for individual assets but for the overall
portfolio performance is to be assessed to have a broader view of the performance.

Different theories of portfolio management are studied to measure the portfolio
performance so as to optimize the same.

Management 13.1 Unit Objectives
After studying this Unit, you will be able to:

NOTES
Ø Learn Efficient Market Theory, Efficient Markets and Efficient Market
Hypothesis
Ø Understand the different forms of Efficient Market Hypothesis and tests for
the same.
Ø Know the Capital Market Theory and Capital Asset Pricing Model
Ø Understand Overvalued and Undervalued Portfolios and its identification
Ø Understand the Multiple Factor Theory or Arbitrage Pricing Theory
13.2 The Concept of Industry
13.2.1 Efficient Market Theory

The stock markets in India are characterized by an inefficient market. There
was nothing called a circuit breaker as such to control the movement of share prices in
a trading day. It was only after major scams like Harshad Mehta’s case, where there
were sharp declines in the scrip prices without any circuit filter. Later on major changes
were introduced post 1995- 96 such as Automated Online Trading System , Depository
System, Ban on Badla, Derivatives, Insider Trading Regulations, Corporatization of
Stock Exchanges and other changes to make the markets more efficient. Efficient
Markets are those markets where share prices have an independent path and are
independent of previous prices. Demand and Supply influences stock prices in an
independent efficient market. There are various factors on which market efficiency
depends such as
Ø Free flow of ideas and information.
Ø Perfect knowledge of investors about all the market information.
Ø No single investor has any influence on the market.
Ø Presence of a large number of investors.
Ø Equilibrium of demand and supply.

Ø Price changes only in response to new market information.
An efficient market is one in which the market price of a security is an estimate Theories of Portfolio
Management
of the intrinsic value. In most of the efficient markets, this holds true, however deviations
from the intrinsic value are only random and not correlated to any observable variable.
NOTES
The following three conditions will result into market efficiency:
1. Rational Investor: A rational investor will result in the stock prices adjust
rationally to the flow of new information. Any change in the company’s
policy or for that matter, any major move by the company will make the
investor react which; in turn will be reflected in the stock prices.
2. Independent Deviations: Any major moves by the company will result in

either an extreme optimistic reaction or an extreme negative reaction. Any
such reactions which result into deviations from rationality are independent
and not correlated. This will make the market price a real reflection of the
intrinsic value.
3. Effective Arbitrage: When a market has more rational investors and

Professionals, there will be less mispricing of securities and the value of
securities will be as per the value of the company which will be fair, objective
and unbiased. They will analyze the information and then take actions on
buying or selling the stocks and this will nullify the effect of mispricing of
securities by irrational investors.
13.2.2 Efficient Market Hypothesis (EMH)

Efficient Market Hypothesis is based on the fact that markets are efficient and
prices are independent of any movement in the markets. This hypothesis is also called
Random Walk Hypothesis since the prices are independent of previous prices and
indicate random movements. A major shift or changes in the stock prices are only due
to disequilibrium in the demand and supply. It also assumes that all price sensitive
information is available to the investors.
13.2.3 Forms of Efficient Market Hypothesis (EMH):

Random Walk Hypothesis was the focus of capital markets long ago. Thereafter,
in 1970, Eugene Fama introduced a theory in terms of a Fair Game Model based on the
empirical evidence available. This model reflects the fact that the current price of a
stock fully reflects all the available information. As a result, the expected risk and
return would be consistent with each other. Portfolio Management:259
Theories of Portfolio Efficient Market Hypothesis assumes three forms of efficiency:
Management
a. Weak Form Efficient Market Hypothesis (EMH): In weak form, a
NOTES market is considered efficient when the subsequent price is independent of

the previous prices. There is always a random walk and demand supply
position affects prices. Technical analysis will not be of benefit to the investors
in decision making since the past trends affect future prices and trends. It is
a direct repudiation of technical analysis. It asserts that the security prices
fully reflect all market information relating to volumes, prices, rate of return
etc.
b. Semi Strong Form Efficient Market Hypothesis (EMH): The Semi-

Strong form EMH asserts that the security prices reflect all public information.
It includes market information as well as non–market information like
economic data, industry statistics, corporate data, ratios etc. There is full
disclosure and transparency and all kind of price sensitive information is
reflected in the prices. Fundamental analysis will be of no benefit in such a
market.
c. Strong Form Efficient Market Hypothesis (EMH): This form of EMH

reflects all information public as well as private information in the stock
prices. It assumes that no single group of investors has any access to
information which enables it to earn greater risk adjusted returns. No insider
will have any information which will give him an upper hand in the knowledge
of the security prices. This can be achieved by means of regular and strict
disclosure by companies.

Empirical Tests of Weak Form Market Efficiency Theories of Portfolio
Management
There are various tests of the Weak form Efficient Market Hypothesis. These
tests help to test the market efficiency level with the help of qualitative as well as NOTES
quantitative measures. There are qualitative methods such as “Observation about the
disclosure and transparency measurements” and there are quantitative methods such
as “Run test” and “Serial Correlation test” and “Filter Test”. Some of these are
discussed below:
a. Serial Correlation Tests: These tests are used to determine if price changes
in future are related to the preceding period. They show a very low correlation
coefficient indicating that a price rise did not show tendency to price fall or
the other way round. In the past, researchers like Moore and Fame tested
the movements of stock prices through serial correlation tests. Moore used
the test to measure the association of one series of security prices with a
series in the past and measured the correlation coefficient of price changes
of one week with those a week later and so on. Fame also did the same
tests on daily price changes of the companies in the Dow Jones Industrial
average and his studies showed low correlation between price changes in
the successive periods. This test showed price movements in an independent
manner and the stock movements. It showed the correlation between price
changes in one period and changes in the same stock for another period.
b. Run Tests: This test is useful to test the randomness in stock price
movements. Only direction of price changes is seen and the absolute price
changes are not considered. An increase in price is represented by + sign
whereas a decrease is represented by – sign. When there is no change in
the prices, it is shown by ‘0’. A run is a set of consecutive price changes in
one direction. This rest is used to test the randomness in the stock price
movements. A run represents a consecutive sequence of the same sign. For
instance, the sequence +++—+++ has two runs with each run showing a
change in signs. Similarly the sequence ++—0 — ++ has five runs etc.
In a run test, the actual number of runs in a series of stock price movements
is compared with the number of runs in a randomly generated number series.
If differences are minimal or there is no difference, the price changes are
said to be random. Portfolio Management:261
Theories of Portfolio c. Filter Tests: These tests are direct tests of specific mechanical trading
Management
strategies to test the validity. A certain X percent of filter is stated as follows:
If the stock prices of a stock increases say by X percent, then buy and hold
NOTES
it till its price decreases by at least x percent. When price decreases by at
least x percent or more, then sell it. The difficulty arises when the stock
price movements are random and filter rules should not be applied over a
buy and hold strategy. It is a belief that till that is no new information entering
the markets, the price movements are random within two barriers i.e. the
lower and the higher. A new equilibrium price will be formed when new
information enters the markets. The movements in the equilibrium whether

positive or negative depends upon whether the news or information is
favourable or unfavourable. Technicians as well as investors decide on the
trading strategies based on such patterns to earn more returns.
d. Returns over Long Horizon: Returns over the long horizon are
characterized by negative serial correlation. Returns over the short horizon

are characterized by minor positive serial correlation. As per a concept of
‘Fad Hypothesis’, stock prices tend to overreact to such news. This reaction
results in positive correlation over short horizons and negative correlation

over long horizons. Prices shoot up in the short run but correct in the long
run.
e. Distribution Patterns: Usually it happens statistically that the distribution

of random occurrences will confirm to a normal distribution. These distribution
patterns can be used to study the randomness of stock prices. The Efficient
market theory which was previously known as The Random Walk Theory
was used to test the share prices movement to show whether it followed a
Random Walk or not. Robert and Osborne conducted a study to test this
Random Walk Theory by taking the movements in the Dow Jones Industrial
Average with that of a variable created out of the Random Walk Process.
His findings also showed that the price movements and patterns generated
by Random Walk Theory were more or less same to those of the Dow
Jones Index.
Empirical Tests of Semi Strong Form Market Efficiency: Theories of Portfolio
Management
The semi strong form of Efficient Market Hypothesis shows that the stock prices
reflect not only the information of the historical prices but also all publicly available
NOTES
information about the company. Such publicly available information may be available
from company annual reports, press releases, corporate announcements such as stock
splits and dividend declaration etc. This form of EMH assumes that the stock prices
absorb and reflect the full public information. There is an instanteneous absorption of
all the available public information. It can be said that this form of EMH repudiates the
fundamental analysis since these fundamentalists cannot make any additional gain by
their analysis as the stock prices absorb all the market information. Studies conducted
by Fama, Fischer and Jensen reflect the methodology used in Semi Strong EMH to
test their variables. According to their findings, there have been refinements in the
testing procedure of this form of market efficiency. These studies have taken into
consideration the economic event and have measured its impact on share prices. The
difference between the actual return and expected return is measured. The single
index model given by William Sharpe is used to estimate the expected return. The
expected returns are estimated using the following formula also known as Residual
Analysis:
Ri =ai + bi Rm+ei
Where,
Ri = Return on Security i.
Rm = Return on a market index
a i and bi = constants
ei = Random error
The return will be positive, if the actual return is more than the expected return.
Apart from this, other techniques are used to study the stock price change in reaction
to events. Hence an event study can be conducted to find out the market reactions to
an event such as dividend declaration or stock splits etc. Here, there are a few steps
involved in an event study such as:
Ø Identifying the event to be studied and the date on which it was

announced.
Ø Collect data around the announcement date. Portfolio Management:263
Theories of Portfolio Ø Calculate abnormal returns period wise and around the announcement
Management
date for each business
Ø Calculate the average and the standard error of abnormal returns across
NOTES
all the firms.
Ø Check whether the excess returns around the announcement date is

different from zero.
A study by Fama, Fischer and Jensen by which they sought to examine the effect
of stock split on returns for approx. 900 stock splits by the companies listed on the
New York Stock Exchange from 1927 to 1959 and it was found that the stocks earned
greater returns before the splits than expected returns. However, after the split the
stocks earned returns mostly in conformity with the market model. Such events and
other events like changes in accounting policies and corporate events like Scams and
also World Events and Economical events impact the stock prices. These events support
the semi- strong form of EMH.Other techniques such as Time Series and Portfolio
Study can also be used to test the semi-strong form of EMH.
Empirical Tests of Strong Form Market Efficiency:
This form of EMH is based on the view that all the available information- public
as well as private is reflected in the stock prices. This is a case of an extreme level of
market efficiency. Insider information which is available only to the Directors and
other persons at top managerial positions cannot be used to earn superior profits. Even
security analysts who have expertise in investment matters and have the information
edge of insiders and stock exchange information will not be able to provide information
which is helpful for earning a better risk adjusted rate of return. There are basically
two types of tests for strong form of market efficiency. The first test will be to find out
if those who have access to inside information which is not generally available to
general public, have been able to use that information profitably or not to earn superior
returns. The other type of test is to review the performance of professional investment
Check Your Progress
What are the different managers and mutual funds and other professionals to see if they are able to achieve
forms of Efficient Market superior performance and better returns with their private information.
Hypothesis? Discuss
various empirical tests for Studies conducted by Jaffe and Lorie have also shown that the markets are not
different forms of EMH. efficient in the strong form. Such studies found that Insider information can be used to
Security Analysis and earn a bit higher returns than average and that mutual funds and other professional are
Portfolio Management:264 able to earn better returns by using their expertise and private information.
13.3 Capital Market Theory - Capital Asset Pricing Model Management
The Capital Asset Pricing Model (CAPM) was developed by researchers like
NOTES
William Sharpe, John Lintner and Jan Mossin and hence it is also known as Sharpe-
Lintner-Mossin Model. This model is an extension of the Markowitz Portfolio Theory.
The CAPM Model predicts the risk – return relationship. Investors base their investment
decisions on these two factors i.e. Risk and Return of a security. Risk is a measure of
the variability of returns. The variability of risk can be reduced through diversification.
Some risks are not diversifiable known as systematic risk or market risk. This risk is
measured by Beta coefficient. This model gives the relationship between such risk and
its expected returns.
Basic Assumptions of CAPM:
Ø The transactions in securities can be undertaken in infinitely divisible units.
Ø Investors are risk – averse
Ø Investors have various homogenous expectations and their estimates of

means, variances and covariances of returns are subjective. They have
identical expectations about the holding period and other inputs.
Ø There are no transaction costs
Ø There are no personal income taxes
Ø Investors can freely lend or borrow of the desired amount at the riskless
rate.
The Capital Market Line (CML): Portfolios that have returns which are
perfectly positive correlation also called Efficient Portfolios are those which
lie on the linear segment. Accordingly all investors will face the same efficient
frontier. Every investor will seek to combine the same risky portfolio with
different levels of lending or borrowing. This will be decided as per his
tolerable risk. This portfolio of all risky securities is called Market Portfolio.
All investors will hold securities only in two combinations of assets i.e. market
portfolio and riskless security.
The slope of the CML (ë) can be found as:

E(R m ) – R f
λ= Security Analysis and
σm Portfolio Management:265
Theories of Portfolio Security Market Line (SML): There is a simple relationship between the
Management
expected return and standard deviation. The expected return and standard
deviation for securities will be below CML showing the inefficiency of the
NOTES
undiversified portfolio. The expected return should be related to the risk of a
security as shown by beta (â). This shows the sensitivity to changes in the
market rate of return. There is a linear relationship between the expected
return of a security and beta. The Security Market Line (SML) shows the
relationship between the expected return and beta which is expressed as:
Ri = Rf + β(Rm – Rf)
Expected return on a security = Risk free return + (Beta x Risk premium of
market)
The difference between the SML and CML is that, in CML the risk is the
total risk measured by standard deviation whereas in SML the risk is the
systematic risk measured by beta â. CML is the foundation of Capital market
theory while SML is the basis of the Capital Asset Pricing Model.
Overvalued or Undervalued Portfolio: In actual practice, the CAPM
doesn’t assign values to the portfolios but identifies which portfolios are
overvalued and which ones are undervalued. This is done with the help of
efficient frontier.
Undervalued Portfolio: When the actual returns generated are more than
the expected returns (ex-ante) at a given risk level, the portfolio is said to be
undervalued. This is due to the fact that other portfolios with a similar risk
are generating lower returns resulting in outperforming efficient portfolios.

These portfolios get reflected above the efficient frontier (CML). Such
portfolios are always preferred by risk averse investors.
Overvalued Portfolios: When the actual returns generated from a portfolio
Check Your Progress are less than the expected returns (ex-ante) at a given risk level, the portfolio
Explain Capital Asset is said to be overvalued. All overvalued portfolios are reflected below the
Pricing Model. CML. As soon as investors get the knowledge of this overvaluation, they
tend to switch over to efficient or undervalued portfolios

Illustration 1: Theories of Portfolio
Management
Risk free return is 5% and returns of market portfolio is 16% with standard
deviation (σm) is 2.5%.Find out the position of the following portfolios on CML and give
NOTES
your judgment on these portfolios:
a. Portfolio A with 20% returns and standard deviation 3%
b. Portfolio B with 22% returns and standard deviation 4%
c. Portfolio C with 10% returns and standard deviation 5%

d. Portfolio D with 10% returns and standard deviation 5%
e. Portfolio E with 15 % returns and standard deviation 3%
Solution:
(ER m – R f )
Using the formula ERp = × σp
σm
Portfolio Actual Returns ER p Judgment
σ p)
(Rp) and Risk (σ
A Rp= 20 % σp = 3% = 5 + (16 – 5) × 3 Actual Returns < Expected

18.2
= 2.5 Returns,
Therefore Overvalued
(16 – 5)
B Rp= 22% σp = 4% =5+ ×4 Actual Returns < Expected
2.5
= 13 Returns,
Therefore Overvalued
(16 – 5)
C Rp= 10 % σp = 5% =5+ ×5 Actual Returns > Expected
2.5
= 11 Returns,
Therefore Undervalued
(16 – 5)
D Rp= 10 % σp = 5% =5+ ×5 Actual Returns > Expected
2.5
= 11 Returns,
Therefore Undervalued
(16 – 5)
E Rp= 15 % σp = 3% =5+ ×3 Actual Returns = Expected
2.5
= 15 Returns,
Therefore Efficient

Management 13.4 Multiple Factor Model and Arbitrage Pricing Theory
The Arbitrage Pricing Theory (APT) was developed by Stephen Ross as an
NOTES
alternative model to the CAPM. This was to remove the deficiencies of the CAPM. It
is an approach used to determine asset prices. It says that the security returns are not
based on a single market factor but on multiple factors. These multiple factors include
interest rates, Wholesale Price Index and Consumer Price Index, bank rates, inflation
etc. The Arbitrage Pricing Theory is also called multiple factor theory. APT is one of
the modern portfolio theories based on investors’ rationality. This theory is formed on
the basis of the fundamental of ‘a single price’. According to this one price opinion,
two similar securities with similar level of risk must have the same return. In the event
of dissimilar returns due to market conditions of short term disequilibrium, there will be
arbitrage and it will result into safe returns. Investors will sell that security with the low
returns and buy those with high returns.
There will be two resulting outcomes of APT by assigning prices to securities by
identifying portfolios which are Underpriced, Overprices and efficiently priced. The
portfolio or individual securities associated with the multiple factors are done with the
help of sensitivity factor called beta (â). Unlike CAPM where each share has only one
beta for a security, in APT there are more than one beta value fir a security. For
example, if a particular security is impacted by eight factors, then that security will
have eight beta values, each one of them showing the relationship of the returns with
that factor. Hence it is called Multiple Factor Model.
Basic assumptions underlying APT:
1. Presence of Perfect market conditions
2. Presence of the Dominance principle.
3. Markets are in equilibrium
4. Efficient Frontier
5. Homogenous Beliefs of the investors
6. Risk averse investors
Check Your Progress Return Generating Model:
Explain Industry
The general assumption in this model is that the security returns are related to an
Competition Analysis with
unknown number of unknown factors called Risk Factors. The asset returns are
the help of Porter’s Five
Forces Model. created by a stochastic process expressed as a linear function of a set of a certain n
number of risk factors or indices. This linear function can be expressed as:
Portfolio Management:268 E = a+ b1F1 + b2F2 + b n Fn + e
Where, Theories of Portfolio
Management
E = Return on stock
a = expected return on stock where all factors have zero value

NOTES
F1 F2 Fn = factors affecting stock return
b1 b2 bn = sensitivity of stock return to the factors
e = random error with mean equal to zero
According to this, the multiple factors affecting the return of securities are
considered. This model estimates return expected which is generated by a multi –
index model taking into consideration the sensitivity to changes in each factor represented
by beta coefficient.
Illustration 2:
A Portfolio manager has given the following data about four portfolios managed
by him and also estimated the APT equation for all these portfolios as:
= 3 + 2 b1 + 3 b2
Using this equation, find out whether an opportunity exists or not.
Portfolio Expected Returns E (%) b1 b2

P 9 0.75 1
Q 10 2 1
R 13 1 1
S 7 1 1
Solution:
This table shows the expected return for all Portfolios using the APT equation:
Portfolio E (%) b1 b2 R = 3 + 2b1 + 3b2 Identification
P 9 0.75 1 (3 + 2 × 0.75 + 3 × 1) Undervalued
= 7.5 (E>R)
Q 10 2 1 (3 + 2 × 2 + 3 × 1) Efficient (E=R)
= 10
R 13 1 1 (3 + 2 × 1 + 3 × 1) Undervalued (E>R)
=8
S 7 1 1 (3 + 2 × 1+3 × 1) Overvalued (E<R)
=8
Theories of Portfolio Asset Pricing and Arbitrage:
Management
When there is a mispricing of assets in the market APT Model will initiate arbitrage
NOTES operations by the market participants. This model will generate return commensurate
with the risk of an asset or security. Hence, the security price should be equal to the
sum of all future cash flows discounted at the expected rate. If the current market
Check Your Progress price differs from the price generated by APT, then the security is said to be mispriced.
Discuss in detail This mispricing will result into investors selling the overpriced security and buying the
‘Arbitrage Pricing
underpriced ones. These steps will ultimately lead to correcting the pricing of securities.
Theory’.
13.5 Summary
• Efficient Markets are those markets where share prices have an independent
path and are independent of previous prices and where demand and supply
influences stock prices.

• An efficient market is one in which the market price of a security is an
estimate of the intrinsic value, however deviations from the intrinsic value
are only random and not correlated to any observable variable.
• Efficient Market Hypothesis is based on the fact that markets are efficient
and prices are independent of any movement in the markets.

• Efficient Market Hypothesis assumes three forms of efficiency: Weak ,Semi
Strong and Strong Form Efficient Market Hypothesis
• In weak form, a market is considered efficient when the subsequent price is

independent of the previous prices as there is always a random walk and
demand supply position affects prices.
• Technical analysis will not be of benefit to the investors in decision making

on a Weak form of EMH, since the past trends affect future prices and
trends.
• Semi Strong Form Efficient Market Hypothesis (EMH):

• The Semi- Strong form EMH asserts that the security prices reflect all public
information and includes market information as well as non – market
information like economic data, industry statistics, corporate data, ratios etc.
Security Analysis and • Strong Form Efficient Market Hypothesis (EMH) reflects all information
public as well as private information in the stock prices.
• Serial Correlation Tests are used to determine if price changes in future are Theories of Portfolio
Management
related to the preceding period and they show a very low correlation
coefficient indicating that a price rise did not show tendency to price fall or
NOTES
the other way round.
• Run Tests are useful to test the randomness in stock price movements and
only direction of price changes are seen and the absolute price changes are
not considered. An increase in price is represented by + sign whereas a
decrease is represented by – sign and when there is no change in the prices;
it is shown by ‘0’.
• Filter Tests are direct tests of specific mechanical trading strategies to test
the validity of stock price movements and a new equilibrium price will be
formed when new information enters the markets.
• Returns over the long horizon are characterized by negative serial correlation
and Returns over the short horizon are characterized by minor positive serial
correlation.
• The CAPM Model predicts the risk – return relationship and investors base
their investment decisions on these two factors i.e. Risk and Return of a
security.
• Risk is a measure of the variability of returns which can be reduced through
diversification.
• Some risks are not diversifiable known as systematic risk or market risk
measured by Beta coefficient.
• The Arbitrage Pricing Model (APT) is an alternative model to the CAPM
and is an approach used to determine asset prices.
• APT Model states the security returns are not based on a single market
factor but on multiple factors such as interest rates, Wholesale Price Index
and Consumer Price Index, bank rates, inflation etc.
• Return Generating Model holds that the security returns are related to an
unknown number of unknown factors called Risk Factors and the asset
returns are created by a stochastic process expressed as a linear function of
a set of a certain number of risk factors or indices.
• When there is a mispricing of assets in the market APT Model will initiate
arbitrage operations by the market participants and this will generate return Security Analysis and
commensurate with the risk of an asset or security. Portfolio Management:271
Management 13.6 Key Words
1. Efficient Markets: These are those markets where share prices have an
NOTES
independent path and are independent of previous prices.
2. Efficient Market Hypothesis: It is based on the factor that markets are
efficient and prices are independent of any movement in the markets and it
is also called Random Walk Hypothesis since the prices are independent of
previous prices and indicate random movements.
3. Serial Correlation Tests: These tests are used to determine if price changes
in future are related to the preceding period.
4. Run Test: This test is useful to test the randomness in stock price movements
and only direction of price changes are seen and the absolute price changes
are not considered.
5. Filter Tests: These tests are direct tests of specific mechanical trading
strategies to test the validity.
6. Returns over Long Horizon: These are characterized by negative serial
correlation. Whereas returns over the short horizon are characterized by

minor positive serial correlation.
7. Distribution Patterns: These patterns can be used to study the randomness

of stock prices.
8. Undervalued Portfolio: When the actual returns generated are more than
the expected returns (ex-ante) at a given risk level, the portfolio is said to be
undervalued.
9. Overvalued Portfolios: When the actual returns generated from a portfolio
are less than the expected returns (ex-ante) at a given risk level, the portfolio
is said to be overvalued.
10. The Arbitrage Pricing Model: This model was developed as an alternative
model to the CAPM to remove the deficiencies of the CAPM and is used to
determine asset prices not based on a single market factor but on multiple
factors.
13.7 Questions and Exercises Management
13.7.1 Multiple Choice Questions NOTES
1. These factors influence stock prices in an independent efficient market.
a. Perfect knowledge of investors about all the market information
b. No single investor has any influence on the market
c. Presence of a large number of investors
d. All the above
2. An efficient market is one in which the market price of a security is
a. an estimate of Fair Value
b. an estimate of Market Value
c. an estimate of Intrinsic Value
d. an estimate of Book Value
3. Efficient Market Hypothesis is also known as
a. Arbitrage Pricing Theory
b. Multiple Factor Theory
c. Capital Asset Pricing Theory
d. Random Walk Theory
4. It is a direct repudiation of technical analysis.
a. Strong Form of Market Efficiency
b. Semi Strong Form of Market Efficiency
c. Weak Form of Market Efficiency
5. Fundamental analysis will be of no benefit in such a market efficiency
d. None of the above Security Analysis and

Theories of Portfolio 6. No insider will have any information which will give him an upper hand in
Management
the knowledge of the security prices in case of existence of

NOTES
7. Quantitative methods of measuring Weak Form of EMH include all except
a. Run test
b. Serial Correlation test
c. Filter Test
d. Observation about disclosure and transparency measures
8. This test showed price movements in an independent manner and the

connection between price changes in one period and changes in the same
stock for another period.
a. Filter Test
b. Run Test
c. Serial Correlation Test
9. This test is useful to test the randomness in stock price movements and only
direction of price changes are seen and not the absolute price changes
a. Filter Test
b. Run Test
c. Serial Correlation Test
10. This is a case of an extreme level of market efficiency where insider

information available only to the Directors and other persons at top managerial
positions also cannot be used to earn superior profits.

Portfolio Management:274 d. None of the above
11. This is also known as Sharpe-Lintner-Mossin Model. Theories of Portfolio
Management
a. Multiple pricing Model
b. Sharpe’s Model NOTES

c. Arbitage Pricing Model
d. Capital Asset Pricing Model
12. These portfolios have returns which are perfectly positive correlation and
which lie on the linear segment.
a. Efficient
b. Inefficient
c. Dominant
13. All overvalued portfolios are reflected below this
a. Security Market Line
b. Capital Market Line
c. Asset Pricing Line
d. All the above
14. This theory is formed on the basis of the fundamental of ‘a single price’.
a. Efficient Market Theory
b. Sharpe’s single index theory
c. Arbitage Pricing Model
d. Random Walk Theory

1. What do you mean by Efficient Markets?
2. What are the different forms of Efficient Market Hypothesis? Discuss various
empirical tests for different forms of EMH.
3. Explain Capital Asset Pricing Model
4. What do you mean by Capital Market Line and Security Market Line?
5. Discuss in detail ‘Arbitrage Pricing Theory’
6. What is Return Generating Model?

Theories of Portfolio 7. What do you mean by Overvalued and Undervalued Portfolios?
Management
8. What is Asset Pricing and Arbitrage?
NOTES
13.7.3 Exercises
Ex. 1 Two securities Alpha and Beta with expected returns of 12.55 % and
16.32 % respectively have a current market price of Rs. 30 each. These
prices are expected to increase to Rs. 320 and Rs. 345 respectively by
the year end. Assume no dividend distribution on these securities during

the year.
“Security Analysis and Portfolio Management”, Mohammed Arif Pasha,

Vrinda Publications, 2010.

Derivatives
Unit 14 Derivatives
Structure NOTES
14.0 Introduction
14.2 Derivatives: Meaning, Features and Types
14.3 Option Contracts
14.3.1 Features of Option Contracts
14.3.2 Call Option and Put Option
14.3.3 Option Pricing Models
14.3.3.1 Black Scholes Model
14.3.3.2 Binomial Model for Options Valuation
14.4 Futures
14.5 Index Futures
14.6 Uses of Futures Contract
14.7 Differences between Futures and Options
14.8 Swaps
14.9 Swaptions
14.10 Summary
14.11 Key words
14.12.3 Exercises

Derivatives
14.0 Introduction
The financial markets are volatile in nature. There is always a risk of price changes
NOTES
which can be transferred by locking in asset prices which also minimizes the losses
due to price fluctuations and the profitability and liquidity of risk averse investors.
Derivatives are a part of the financial system and derivatives trading has been growing
by leaps and bounds during the past few years.
After studying this unit you will be able to:
Ø Understand the meaning, features and types of derivatives
Ø Learn the meaning and features of Option Contracts
Ø Understand Call and Put Options and its valuation
Ø Know the different Options Pricing Models
Ø Know the meaning, features and types of Futures Contract
Ø Understand the meaning, types and valuation of Index Futures
Ø Know the uses of Futures Contract
Ø Understand the differences between Futures and Options contract
Ø Understand the differences between Futures and Forward contract
14.2 Derivatives: Meaning, Features and Types
Derivatives emerged as a hedging device against fluctuations in commodity prices.
Financial derivatives were introduced later in the 1970’s as a result of instability in the
financial markets. Financial derivatives accounted for one third of the total derivative
products. There are various factors contributing to the growth of the derivatives segment
of the financial markets such as increased volatility in the markets with increased
risks, availability of better risk management tools, globalization of business resulting
into multinationals operating in the country, etc. Derivatives are instruments, the value
of which depends upon the underlying asset on which it is created. The underlying
Portfolio Management:278 assets may be a commodity, currency, shares, debentures or index. For instance if a
farmer wishes to sell his harvest of rice at a future date to avoid the risk in price Derivatives
changes by that date, it is a derivative where rice is the underlying commodity.
Equity Derivative is defined under the Securities Contract (Regulation) Act, 1956 NOTES
as “A security derived from a debt instrument, share, loan, whether secured or
unsecured, risk instrument or contract or any other form of security”. Derivatives do

not have their own intrinsic value.
Types of Derivative Instruments:
• Option contracts
• Future contracts
• Forward contracts
• Index futures
Salient Features of Derivative Instruments:
1. Derivatives can be traded on the stock exchanges which provide liquidity
to it
2. They have low transaction cost
3. There is a close relation between the value of derivatives and the value
of the underlying asset.
4. They possess unique characteristics not common to other assets Check Your Progress
What do you mean by
5. Low credit risk as the margin requirements for exchange traded
Derivatives? Explain the
derivatives is low types and features of
6. They can be altered as per portfolio requirements Derivative Instruments?
14.3 Option Contracts
An option is a contractual agreement between two parties that gives the buyer
the right , but not the obligation, to purchase (in case of a call option) or to sell (in case
of a put option) ,a specified instrument at a specified price at any time of the buyer’s
choosing by or before a fixed date in the future. And upon exercising of the right by the
option holder, a seller is thereby obliged to deliver the specified instrument at the specified
price. The terms and conditions are decided mutually by both the parties on the
Derivatives transaction date. In case of options traded on the stock exchange, the terms and
conditions relating to the following are regulated by the exchange:
NOTES • Lot size
• Underlying asset
• Strike date
• Expiration date
• Margins
14.3.1 Features of Option Contracts:

Ø Limited Liability of buyer
Ø Exercisable only by buyer who is the owner of the option
Ø No rights of buyers similar to ownership rights of shareholders such as

voting rights and rights as to dividend
Ø High degree of risk.
Ø Buying Counter positions by the option seller
Ø No certificates to be issued by the company
Ø Affords flexibility in case of exchange traded options
Important terms used in Options Contract:

1. Strike Price
2. Premium
3. American Option versus European option
4. Expiration of the option
5. Margin Deposit
6. Declaration Day
7. Traded Options
8. Double Options
9. Gearing
1. Strike Price: It is the fixed price at which the option may be exercised
which is based on the current market price. With a Put Option the striking
Portfolio Management:280 price is the lower quoted price whereas in call option the striking price is the
higher quoted price and a further small sum called the Contago to Derivatives
recompensate the option dealer. In put option there is no Contago money
involved. Options with three types of strike prices are available;

NOTES
At one price option is in – the – money, second is out – of – money and the
third is at – the – money. The first one creates positive cash flow for the
investor, the second one results in a zero cash flow and the third one results
in a negative cash flow.
2. Premium: It is the price paid upfront by the buyer of the option to the seller
which is mutually decided amongst them on the date of the contract. Premium
is always over and above the strike price.
3. American Option versus European Option: In an American Option, a
buyer has a right to exercise his option any time before the expiration date
but in an European Option, the buyer can exercise this right only after the
expiration date.
4. Expiration of the option: When the buyer fails to exercise his option to
buy/sell the underlying asset, the option expires. Also in case of option out –
of – money, it will expire since the buyer does not exercise the option.
5. Margin Deposit: The margin deposit is the initial margin which the seller is
required to deposit to protect the buyer against losses on account of default
as the seller is likely to default in an option when it is exercised by the buyer.

This margin amount differs as per the rules of exchange. It is only deposited
by the seller always and never by the buyer since there cannot be any
default by the buyer.
6. Declaration day: It is the second last day in the account before the final
account day on which completion of the option may take place. At the end
of the option period, the holder of the option either abandons the option or
claims rights under it.
7. Traded options: These are those options which are traded on the stock
exchanges and are publicly traded like any other stock quoted on the exchange.
Traded options are more flexible in terms of transferability.

Derivatives 8. Double options: A double option has a combination of both call and put
option, The holder of option has a right either to buy or to sell the shares
subject to the option at the strike price which will be something around the
NOTES
middle of the current quoted price. The option money is twice the current
Check Your Progress
quoted price.
by Options Contract? 9. Gearing: The risk is higher in an option however the rewards are also
What are its unique
equally higher in relation to the amount of investment. The price movements
features?
of an exchange traded option are higher than the underlying share
14.3.2 Call Option and Put Option

a. Call Option
A Call Option provides the right to buy the specified shares on or before the
specified price known as strike price or exercise price and on or before a specified
date known as the maturity or expiry date. In other words, a call option gives the buyer
the right to buy a specified number of shares and the seller of the option is known as
the writer. The writer has no choice for fulfillment of the obligation and if the buyer
wants to exercise his right, the writer must comply with it. For this, the buyer must pay
the write the option price called premium.
In call option,
ATM (at-the- money) : Exercise Price = Market Price

Check Your Progress
Explain meaning of Call ITM (in-the-money) : Exercise Price < Market Price
option.
OTM (out-the-money) : Exercise Price > Market Price
Illustration 1:
An Investor buys one share of Wipro Ltd. at a premium of Rs.2 per share on 31st
July 2016. The Strike Price is Rs55 and the contract matures on 31st October 2016.
The payoff is computed based on the spot prices fluctuating from time to time. The
loss made by the investor would be maximum Rs. 3 per share paid towards the premium.

Stock Price ‘S’ Exercise Price Call Option Pay off Net Derivatives
‘X’ at time ‘t’ Premium ‘c’ Profit
50 55 3 0 -3 NOTES
52 55 3 0 -3
54 55 3 0 -3
55 55 3 0 -3
57 55 3 2 -1
59 55 3 4 1
60 55 3 5 2
62 55 3 7 4
65 55 3 10 7
67 55 3 12 9
Payoff for the buyer will be: max(S-X, 0)
Payoff for the seller will be: max(S-X, 0) or min (X-S, 0)

Derivatives b. Put Option
In Put Option, which is the opposite of Call Option, the holder of the option i.e.
the buyer gets the right but not an obligation to sell a given quantity of an underlying
NOTES
asset at a given price on or before a given date. The seller of the option is called the
writer and he has no choice for fulfillment of the obligation. In other words, if the
buyer wants to exercise his right under the put option, the writer must purchase at the
exercise price. The buyer must pay the writer of the option, the option price called
premium.
In a put option,
ATM (at-the- money): Exercise Price = Market Price
ITM (in-the-money): Exercise Price > Market Price
OTM (out-the-money): Exercise Price< Market Price
Illustration 2:
An investor buys a Put option on one share of Reliance Ltd. at a premium of Rs

.3 per share .The Strike Price is Rs. 55 and the contract matures on 31st October 2016.
The payoff is computed based on the spot prices fluctuating from time to time. The
loss made by the investor would be maximum Rs. 3 per share paid towards the premium.
Stock Price ‘S’ Exercise Price Call Option Pay off Net Profit
‘X’ at time ‘t’ Premium ‘c’
45 55 3 10 7
48 55 3 7 4
50 55 3 5 2
53 55 3 2 -1
55 55 3 0 -3
58 55 3 0 -3
61 55 3 0 -3
Check Your Progress
63 55 3 0 -3
Explain Put Option and its
features.
65 55 3 0 -3
Portfolio Management:284 68 55 3 0 -3
Payoff for the buyer will be: max(X-S, 0) Derivatives
Payoff for the seller will be: max(X-S, 0) or min (X-S, 0)
Ø Intrinsic Value of an Option

NOTES
Intrinsic Value forms the basis of fixing premium and also the demand for
the option is created. The difference between the spot price and strike price
is the intrinsic value. Intrinsic value is created only when it is ITM (In the
money) otherwise it will be zero.
Intrinsic Value of Call Option = Spot Price – Strike Price Check Your Progress
Intrinsic Value of Put Option = Strike Price – Spot Price How do you measure
Intrinsic Value of an
Ø Time Value of Option
Option?
The excess of the market price of an option over its intrinsic value is the
time value of the option. It represents net gain/loss for the buyer. If it is
positive for the buyer it will be negative for the seller and vice versa. It is the
amount which the seller of the option is ready to pay for the timing differences
between the current time and exercise date.
Ø Parameters of Option Value and its impact on the option prices
There are various factors which affect the option prices. These factors are:
1. Spot Price
2. Strike Price
3. Expiration Date
4. Volatility
5. Risk Free interest Rates
6. Dividend
Parameter American European
Option Option
Call Put Call Put
Spot Price F A F A
Strike Price A F A F Check Your Progress

Expiration Date ? ? F F Elaborate different factors
affecting Option Prices.
Volatility F F F F
Risk free interest rates F A F A

Dividends A F A F Portfolio Management:285
Derivatives F = Favorable
A = Adverse
NOTES 14.3.3 Option Pricing Models

There are models used for determining the theoretical values for options. They
are used for making bids and prices from time to time. The Black Scholes Model and
Rubinsten Binomial Distribution Model are basic primary pricing models. The inputs
required for these models are:
• Spot Price
• Strike Price
• Expiration Date
• Volatility
• Risk free interest rates
• Dividends
14.3.3.1 Black Scholes Model

This model is used to calculate a theoretical call price based on five determinants
of the price of an option namely stock price, strike price, volatility, time to expiration
and risk free interest rate. The calculation of the value of an option and the resultant
value of a portfolio is done by the following steps:
1. Compute d1
In (S0 IE) + (r +0.5 × σ2 ) × t
d1 =
σ t
Where,
In = log normal
S0 = Spot Price of the underlying share
E = Exercise Price
r = Risk free rate of return
ó = Standard Deviation of the return of underlying share showing risk
t = time period till expiration
Security Analysis and 2. Compute d2

d 2 = d1 – σ t Derivatives
3. Compute C0
E NOTES
C0 = S0 N (d1) – N (d2 )
En
Where,
C0 is the equilibrium value of a call option, S0 is the stock price, E is the
Exercise Price, e is the base of natural logarithm, r is the annualized
compounded risk free interest rate, t is the length of time in years to the
expiration date and N (d) is the value of the cumulative density function.
This model is based on the following assumptions
1. It is based on the European Option. (the model applies to American
option also)
2. Absence of transaction costs involved
3. Absence of Taxation
4. No restrictions on short selling
5. Stock prices have normal distribution
6. No dividend paid on stocks
7. The interest rates are risk free and known and also constant
Illustration 3:
Assume that the price of Hindalco’s stock is Rs. 450 on 1stJanuary having a put
option with maturity of 90 days and exercise price of Rs. 510. The contract size for
Hindalco put option is 820. Calculate the gains of the put option for different prices of
Hindalco’s shares on the option expiration date

Derivatives Solution:
Stock Price(Sr) Option Value Option Premium Gain Max
NOTES (Sx– Sr, 0) (P 0) (– P0, Sx – Sr – P0)
350 -160 74.8 -85.2
380 -130 74.8 -55.2
400 -110 74.8 -35.2
410 -100 74.8 -25.2
450 -60 74.8 14.8
470 -40 74.8 34.8
510 0 74.8 74.8
530 0 74.8 74.8
550 0 74.8 74.8
570 0 74.8 74.8
600 0 74.8 74.8
14.3.3.2 Binomial Model for Options Valuation

This model developed by Cox, Ross and Rubinstein breaks down the time to
expiration into a large number of time intervals. It is based on the concept of the
Binomial Tree. The stock price may follow different paths which are represented by a
diagram known as binomial tree of future stock prices. Say for instance, if the current
market price of a stock is Rs.100 which is expected to either move up say by 20

percent or move down by 20 percent. This may be in the form of a one-step binomial
tree. On the other hand, if the stock price is Rs.105 or Rs.97, then the probability of the
upward or downward movement may be different. Here the probability of upward

movement is 0.5 and that of downward movement is 0.3.
In another example where the stock price of a stock is Rs.55 and the exercise
price is Rs.60 then the option will have a value of Rs.5 (Rs.60-55) and here if the stock
price is Rs.48 then the call option will have no value since the exercise price exceeds
Security Analysis and the stock price.
In a two - step binomial distribution tree, the stock prices may either move up by Derivatives
say 20 percent or down by 20 percent. This type of binomial distribution maybe extended
by even three or more steps or time intervals. In Binomial distribution trees with more
NOTES
than one step, the option values at the final nodes are seen first and the current value
of option is computed by working backwards and hence it is known as backward
induction.
In this model the current option price is taken as that value of the option which is
the discounted weighted average of possible future option values.
Black Scholes Model and Binomial Distribution Model –

Differences
Black Scholes Model is the most commonly used option pricing model and is
hence popular as it gives the solution after a thorough analysis and a formula. It can
also be done by a computer by giving the inputs for the formula. This model is more
appropriate for valuing European style Options and less suitable for American Style
Options.
On the other hand, the Binomial Model does not permit an analytical approach to Check Your Progress
the solution of finding the option price with the help of a formula, rather an iterative Explain with illustrations,
different Options Pricing
process is involved which is done step by step. It is more suitable for valuing American
Models.
Style Options which may be exercised early. This model is comparatively more flexible
asit provides for variations in interest rates and stock volatility.
14.4 Futures
Futures are important instruments for hedging the risk in commodities and financial
markets for managing price fluctuations in the markets. A futures contract like a Forward
Contract, is an agreement between two parties to buy or sell an asset at a certain time
at a certain price in the future. Futures are normally traded on organized or regulated
exchanges but forwards are negotiated between the parties. Futures are similar to
options in that they specify the terms of purchase and sale of the underlying security at
a future date. The differences between these two are that in case of a future or
forward contract there is a firm obligation to buy or sell. Future contracts are
standardized agreements to exchange specific types of goods in specific amounts at a
specific future delivery date. Portfolio Management:289
Derivatives The underlying asset in futures contract may be any commodity such as wheat,
sugar, gold, copper etc. or financial assets like stocks, stock indices, foreign currencies
etc. Accordingly, future contracts can be of two types:

NOTES
1. Commodity futures
2. Financial futures.
Standardized items in Futures
The following items are standardized in a futures contract :
• Quantity of the underlying
• Quality of the underlying(only in case of commodity futures)
• Date and month of delivery
• Settlement Place
• Units of quotation
Features of Futures Contract
1. Standardization: Each Futures contract is standardized in terms of quantity,
grade, coupon rate, maturity etc. This increases the marketability of the
contracts and also gives liquidity.
2. Clearing House: The clearing house for futures contract is called “Future
Exchanges” and this clearing house fulfills the contract between the buyer
and the seller thereby eliminating the default risk. Each Future has a clearing
house which arranges the delivery of the asset and payment of money. In
other words, the clearing house becomes the counter party to the buyer to
deliver the asset and the also to the seller to make the payment for the asset.
3. Margins: Margin Money consists of cash or cash equivalent and it is kept

in order to ensure that the traders will honor their obligations in the future
contract. This margin money has to be provided by both the parties to the
contract so as to protect both the parties from the loss. There are three
types of margins: Initial margin, Maintenance margin and variation margin.
Initial margin is deposited by the buyer and the seller at the time of execution
of the future contract which is fixed as a percentage of the base value of the
Security Analysis and contract. It may range anywhere between 5 percent and 25 percent.
Maintenance margin is the minimum balance which the buyer and the seller Derivatives
are expected to maintain in their margin accounts throughout the contract
duration. This is because the balance in the margin account keeps on changing
NOTES
as the futures contract is marked-to-market on a daily basis. This margin
may be a certain percentage fixed on the initial margin and when the balance
in the margin account falls below the maintenance level, a margin call may
be issued by the exchange to the concerned part. Variation margin is applicable

when additional funds are to be deposited on the basis of margin call.
4. Time spread: There is a relationship between the spot price and the futures
price. The difference between the prices of two future contracts which are Check Your Progress
on the same commodity or instrument and different expiry dates is known as What is a Futures
Time spread. Contract? Explain are its
characteristics?
14.5 Index Future
Equity futures are of two types: stock index futures and futures on individual
securities. A stock index shows the general stock price levels. It is taken on the basis
of the stock prices of representative group of stocks traded in the stock market. Index
futures are used to create such stock market indices as underlying assets for creating
future contracts. There are many stock indices available in different countries across
the globe such as Nikkei 225 in Japan, FTSE in UK, S&P 100 and S&P 500 in USA
and DAX in Germany. Futures trading are available on Bombay Stock Exchange (BSE)
and National Stock Exchange (NSE) based on domestic indices such as S&P CNX
Nifty and Sensex respectively. The Nifty Futures are traded on the NSE F&O segment.
In case of index futures, only a cash settlement is possible and not by physical delivery
of the index. Index futures are used by investors for hedging against the risk and also
for making gains from the movement of the stock indices.

Derivatives Stock Index Futures
A few of the most actively traded stock index futures across the globe are:
NOTES India BSE SENSEX, NSE CNX NIFTY
USA DJIA, S & P 500, NYSE,
RUSSELL 2000 NASDAQ 100
UK PTSE 100
Japan NIKKEI
Germany DAX
France CAC 40
Canada TSE 35
Malaysia KUALALUMPUR
Spain IBEX 35
Switzerland SMI
Valuation of Stock Index Futures Contracts:

The valuation of Stock Index Futures is a simple process. The Price of an index
(Ie) will equal the price of futures (Fe) on expiration. Today’s futures Price will equate
the index Price plus the interest obtainable on a risk free basis over the life of the
contract less the dividend to be received on that index over the contract duration.
FB = IB +(RF – D)
Return to Index = Index Price at Expiration – Current Index Price + Dividend

Check Your Progress
What is an Index Futures? i.e. IE - I B
+ D
How are stock index Return to Futures = Futures price at expiration – Current Futures Price + Interest
futures valued?
i.e. FE – F B + R F
14.6 Uses of Futures Contract

Hedging:
An investor is always facing a risk of loss due to fall in share prices which
might lead to a reduction in the portfolio value. He can effectively hedge the
Security Analysis and risk by taking a position in the stock index futures resulting in a gain to the
Portfolio Management:292 investor in the event of a fall in the share prices. By virtue of their position in
the instrument specified in the futures contract, these hedgers are exposed Derivatives
to risk. By taking an opposite position, parties who are at risk can hedge
their position. There are two basic hedge positions:

NOTES
• Short sell hedge: A party who wants to liquidate his holdings in the
future and who has a long cash position (currently or in the future may
sell short the futures.
• Long buy hedge: A party who is not in cash position currently but
anticipates being in cash in the future may buy a futures contract to face
uncertainty in the prices.
Speculation:
Speculators may take short or long positions in index futures so as to earn

profits from the stock market movements. Unlike hedgers, they don’t have
a prior cash position that they want to hedge against the price changes. In
fact they hope to profit from price changes. Practically speaking, the futures
market functioning is improvised due to speculators since they absorb the
excess of either demand or supply and absorb the risk which is avoided by
hedgers. They create liquidity in the market and reduce the variability in
prices from time to time.
Arbitrageurs:
An arbitrageur is one who uses futures contracts to take advantage of the
pricing differences between the different markets. Arbitrage transactions Check Your Progress
Discuss the uses of Future
can be of two types: A futures- futures arbitrage wherein a dealer exploits
Contracts.
the price differences between two futures market and a cash- futures arbitrage
where a dealer exploits the price misalignment or mismatch between the
cash market and the futures market.

Derivatives
14.7 Differences between Futures and Options
Futures Contract Option Contract

NOTES
Obligations created for both Only sellers’ obligation to perform
the parties to the contract the contract is created
No premium payment Buyer pays a premium
involved by either parties to the seller
No obligation to perform the Buyer can exercise option at
contract before settlement date any time before expiry date
14.8 Differences between Forward and Futures
Forward Contract Futures Contract
Not traded on the stock exchange Traded on the stock exchange
The contract specifications differ as The contract specifications
per trade practices and is tailor made are standardized
There is counterparty risk involved Counterparty risk is assumed
by Clearing House
Low Liquidity due to non- High liquidity due to
standardized contracts standardized contracts

Check Your Progress
What are the differences Low Price discovery due Better Price discovery as markets
between Futures and
Options? Differentiate to market fragmentation have a common platform.
between Futures and
They end with deliveries They end with settlement of differences
Forwards.
Settlement on daily basis Settlement on ‘marked to market basis’.

Derivatives
14.9 Swaps
A swap means any exchange of one stream of cash flows with another stream of
NOTES
cash flows with different features and characteristics. It is usually in the form of an
agreement between two people for the exchange, there are two types of swaps viz.
Currency Swaps and Interest rate swaps.
Currency swaps are agreements wherein currencies are exchanged at specific

exchange rates and at specific intervals. This is to safeguard against the currency rate
changes.
Interest rate swaps are agreements whereby one party exchanges a set of interest
Check Your Progress
rate payments for another set. Fixed interest rate payments are usually exchanged
over a time period. Interest rate swaps are also between fixed and floating interest
by Swaps?
rates. Apart from these, we also have credit swaps, commodity swaps and equity
swaps.
14.10 Swaption
A swaption is an option granting its owner the right but not the obligation to enter
into an underlying swap. There are two types of swaption agreements namely
• A payer swaption where the owner is given the right to enter into a
swap by paying a fixed leg and receiving the floating leg.
• A receiver swaption where the owner is given the right to enter into a
swap by receiving the fixed leg and paying the floating leg
Generally in a swaption agreement, the buyer and seller agree upon the terms
relating to the strike rate, the premium, the length of the option period, the term of the
underlying, the notional amount, and settlement frequency. Swaptions are used by
banks and corporates to manage the interest rate risk arising from their core business
Check Your Progress
or financing arrangements. The swaption market is over – the – counter and not Explain the meanings and
exchange traded. Swaptions not only act as a hedge against the downside risk but also types of Swaps.
gives gain to the buyer of upside benefits. There are three types/styles of swaptions:
1. American Swaption where the owner can enter the swap on any day
that falls within a range of two dates, Portfolio Management:295
Derivatives 2. European Swaption where the owner is allowed to enter the swap only
on the maturity date
3. Bermudan Swaption where the owner can enter the swap only on certain
NOTES
dates falling within a range of the start date and end date.
14.11 Summary
• Derivatives are hedging instruments, the value of which depends upon the
underlying asset on which it is created and the underlying assets may be a

commodity, currency, shares, debentures or index.
• An option is a contractual agreement between two parties that gives the

buyer the right, but not the obligation, to purchase or to sell, a specified
instrument at a specified price at any time of the buyer’s choosing by or
before a fixed date in the future.
• Strike Price: is the fixed price at which the option may be exercised which is
based on the current market price.
• A Call Option provides the right to buy the specified shares on or before the
specified price known as strike price or exercise price and on or before a
specified date known as the maturity or expiry date.
• In a Put Option, the holder of the option gets the right but not an obligation to
sell a given quantity of an underlying asset at a given price on or before a
given date.
• The difference between the spot price and strike price is the intrinsic value
which is created only when it is ITM (In – the – money) otherwise it will be
zero.
• The excess of the market price of an option over its intrinsic value is the
time value of the option. representing net gain/loss for the buyer.
• A futures contract like a Forward Contract is an agreement between two
parties to buy or sell an asset at a certain time at a certain price in the future.

• The clearing house for futures contract is called “Future Exchanges” and Derivatives
this clearing house fulfills the contract between the buyer and the seller
thereby eliminating the default risk.

NOTES
• Margin Money consists of cash or cash equivalent and it is kept in order to
ensure that the traders will honour their obligations in the future contract.
• Stock index shows the general stock price levels and is taken on the basis of
the stock prices of representative group of stocks traded in the stock market.
• Speculators may take short or long positions in index futures so as to earn

profits from the stock market movements and they don’t have a prior cash
position that they want to hedge against the price changes.
14.12 Key Terms
1. Equity Derivative: A security derived from a debt instrument, share, loan,

whether secured or unsecured, risk instrument or contract or any other form
of security.
2. Option: It is a contractual agreement between two parties that gives the

buyer the right , but not the obligation ,to purchase (in case of a call option)
or to sell (in case of a put option) ,a specified instrument at a specified price
at any time of the buyer’s choosing by or before a fixed date in the future.
3. Strike Price: It is the fixed price at which the option may be exercised
which is based on the current market price.
4. Premium: It is the price paid upfront by the buyer of the option to the seller
which is mutually decided amongst them on the date of the contract. Premium
is always over and above the strike price.
5. Expiration of the option: When the buyer fails to exercise his option to
buy/sell the underlying asset, the option expires.
6. Declaration day: It is the second last day in the account before the final
account day on which completion of the option may take place.

Derivatives

NOTES
1. Derivatives are instruments, the value of which depends upon
a. Futures
b. Underlying asset
c. Options
d. Interest rates
2. In case of options traded on the stock exchange, the terms and conditions
relating to the following are regulated by
a. Buyer
b. Seller
c. Exchange
3. All the following are features of Option Contracts except
a. Limited Liability of buyer
b. Low degree of risk
c. Exercisable only by buyer who is the owner of the option.
d. No rights of buyers similar to ownership rights
4. It is the fixed price at which the option may be exercised which is based on
the current market price.
a. Exercise price
b. Strike price
c. Option price
d. Exchange price
5. It is the price paid upfront by the buyer of the option to the seller which is
mutually decided amongst them on the date of the contract.
a. Strike price
b. Exercise price
c. Premium
Portfolio Management:298 d. Exchange price
6. In an this Option a buyer has a right to exercise his option any time before Derivatives
the expiration date
a. American option
NOTES
b. European Option
c. Bermudan Option
7. In this option, the buyer can exercise this right only after the expiration date.
a. American option
b. European Option
c. Bermudan Option
8. It is the second last day in the account before the final account day on which
completion of the option may take place.
a. Declaration Day
b. Exercise Day
c. Strike Day
9. A Call Option provides the right to buy the specified shares on or before the
specified price known as
a. strike price
b. exercise price
c. Either a or b
10. In this, the holder of the option i.e. the buyer gets the right but not an
obligation to sell a given quantity of an underlying asset at a given price on
or before a given date.
a. Call
b. Put
c. Futures
d. Forwards Security Analysis and

Derivatives 11. He is called the writer and he has no choice for fulfillment of the obligation
as he must purchase it at the exercise price.
a. Buyer
NOTES
b. Seller
c. Agent
12. The buyer must pay the writer of the difference between the spot price and
strike price known as
a. Market Value
b. Book Value
c. Intrinsic value.
d. Time Value
13. This is created only when it is ITM (In –the-money) otherwise it will be
zero.
a. Market Value
b. Book Value
c. Intrinsic value.
d. Time Value
14. The excess of the market price of an option over its intrinsic value is this
a. Market Value
b. Book Value
c. Intrinsic value.
d. Time Value
15. This model is used to calculate a call price based on five determinants of the
price of an option namely stock price, strike price, volatility, time to expiration
and risk free interest rate.
a. Black Scholes Model
b. Binomial Model
c. Logarithmic Model

16. This model breaks down the time to expiration into a large number of time Derivatives
intervals where the stock price may follow different paths
a. Black Scholes Model

NOTES
b. Binomial Model
c. Logarithmic Model

17. All the following items are standardized in a futures contract except
a. Quantity of the underlying
b. Quality of the underlying
c. Settlement Place
d. Settlement
18. This means any exchange of one stream of cash flows with another stream
of cash flows with different features and characteristics.
a. Futures
b. Swaps
c. Options
d. Swaptions
19. It is an option granting its owner the right but not the obligation to enter into
an underlying a
a. Futures
b. Swaps
c. Options
d. Swaptions
20. Each Future has a clearing house which arranges this
a. Delivery of the asset
b. Payment of money
c. Both a and b
1. What do you mean by Derivatives? Explain the types and features of
Derivative Instruments?
2. What do you understand by Options Contract? What are its features? Security Analysis and
Derivatives 3. Explain meaning of Call option.
4. Explain Put Option and its features.
NOTES 5. How do you measure Intrinsic Value of an Option?
6. What are the different factors affecting Option Prices.
7. Explain the different Options Pricing Models.
8. What is a Futures Contract? Explain are its characteristics?
9. What is an Index Future? How are stock index futures valued?
10. Discuss the uses of Futures Contract.
11. Explain the differences between Futures and Options?
12. Explain the differences between Futures and Forwards.
13. What do you understand by Swaps?
14. Explain the meanings and types of Swaps.
14.13.3 Exercises
Ex.1 A stock is currently trading at Rs.72. Call options and put options on this
stock are available with maturity in 3 months. The exercise price of the
call as well as that of the put is Rs.75. The price of the call option is Rs.
4 and that of the put option is Rs.2.52. Compute the gain from buying a
put and writing a call if the terminal stock price is Rs. 65, 67, 70, 72, 75
and 78 respectively.
Ex.2 Telco Ltd. stock sells for Rs. 50 per share. There are four options trade
on a particular day: 45 call at Rs.5.5, 50 call at Rs.0.60, 45 put at Rs.0.50

and 50 put at Rs.5.20. What are the Intrinsic Value and time Premium
for each Option?
“Options, Futures, and other Derivatives”: Ninth Edition, John C. Hull and
SankarshanBasu, Pearson, Delhi, 2015.

Investments & Tax Planning
Unit 15 Investments and Tax Planning
Structure NOTES
15.0 Introduction
15.2 Tax aspects of investment
15.3 Computation of Total Income and Tax Liability
15.4 Deductions under Section 80
15.5 Mutual Fund Taxation
15.6 Security Transaction Tax (STT)
15.7 Capital Gains Tax – CGT
15.8 Capital Gains Tax
15.9 Computation of Capital Gains Tax
15.10 Capital Gain Index
15.11 Capital Gains Tax Exemption
15.12 Summary
15.13 Key Words
15.14.3 Exercises

15.0 Introduction
Investments are affected by tax liabilities and an investor has to take into
NOTES
consideration the tax implications while making his investment decisions. Taxation
impacts liquidity and risk and return and hence its effect on individual investment decision
is to be analyzed before making investment
Ø Know the Taxation aspects of Investments
Ø Understand the Computation of Total Income and Tax liability
Ø Learn how to find the Residential Status of an Individual Assessee
Ø Know the Income tax Slabs of Individuals, Senior Citizens and Super Senior
Citizens
Ø Understand the different aspects of Mutual Fund Taxation
Ø Analyze the different aspects of the levy of Securities Transaction Tax

(STT)
Ø Learn the tax provisions of Capital Gains Taxation
Ø Understand the computation of Capital Gains Tax
Ø Understand the meaning and application of Cost Inflation Index (CII)
Know the exemptions from Capital Gains Tax
15.2 Tax Aspects of Investment
Investors focus is often on the risk return relationship of their portfolios, ignoring
the tax impact of any investment decision. As a result, their decisions are incomplete
Check Your Progress and ineffective since taxes can have an impact on their overall returns and wealth by
Discuss the taxation
affecting growth compounds and sometimes also wiping off the extra returns gained.
aspects of investment and
investment planning. Every investment decision has a different tax exposure. These are discussed at length
hereunder in the forthcoming sections.

15.3 Computation of Total Income and Tax Liability
At the time of filing return in the income tax department a statement showing
NOTES
computation of total income is to be submitted. The table hereunder gives an idea of
Computation of Total Income
Particulars Rs. Rs.
a) Income from Salaries

Basic Salary xx
Taxable Allowances xx
Taxable Value of Perquisites xx

Gross Salary xx
Less : Professional Tax xx XX
b) Income From House Property

Gross Annual Value xx
Less : Municipal Taxes paid xx
Net Annual Value xx

Less : Deduction u/s 24 xx XX
c) Profits and Gains of Business or Profession
Net Profit as per P/L A/c xx

Add : Amount shown as expenses but not allowed xx
Less : Expenses allowed but not claimed. xx
Add : Incomes not shown in the P/L A/c but taxable xx

Less : Incomes shown in the P/L A/c but not taxable xx XX
d) Income from Capital Gains
Sale Consideration xx
Less :Expenses on transfer xx
Net Sale Consideration xx
Less : Cost of acquisition/improve xx

Capital Gains xx XX
e ) Income From Other Sources XX
Gross Total Income XX

Less : Deduction u/s 80CCC to 80U
Investments & Tax Planning Total Income (taxable)
Tax on taxable income to be computed by
applying the applicable rates
NOTES
Less: Rebate under section 87A
Tax Liability after Rebate
Add: Surcharge
Tax Liability After Surcharge
Add: Education cess @ 2% on tax liability
after surcharge
Add: Secondary and higher education cess
@ 1% on tax liability after surcharge
Tax liability before rebate
under sections 86, section 89, sections 90,
90A and 91 (if any)
Less: Rebate under sections 86, section 89,
sections 90, 90A and 91 (if any)
Tax Liability for the Year Before Pre-paid Taxes
Less: Prepaid taxes in the form of TDS
Tax payable / Refundable

Check Your Progress
Note: Inter source losses, inter head losses, brought forward losses, unabsorbed
Explain the Computation
depreciation, etc., (if any) will have to be adjusted (as per the Income-tax Law) while
of total income and Tax
liability. computing the gross total income
15.4 Deductions under Section.80
• Section 80C
Under section 80C, a deduction of Rs 1, 50,000 can be claimed from your total
income. In simple terms, you can reduce up to Rs 1, 50,000 from your total taxable
income through section 80C. This deduction is allowed to an Individual or an HUF. A
maximum of Rs 1, 50,000 can be claimed for the financial year 2016-17. The limit for
the financial year 2017-18 is also Rs 1, 50,000.If you have paid excess taxes, but have
Security Analysis and invested in LIC, PPF, Mediclaim etc., you can file your Income Tax Return and get a
refund.
• Section 80CCC: Deduction for Premium Paid for Annuity Plan of Investments & Tax Planning
LIC or Other Insurer
This section provides a deduction to an Individual for any amount paid or deposited
NOTES
in any annuity plan of LIC or any other insurer. The plan must be for receiving a
pension from a fund referred to in Section 10(23AAB).If the annuity is surrendered
before the date of its maturity, the surrender value is taxable in the year of receipt.
• Section 80CCD: Deduction for Contribution to Pension Account
Employee’s contribution – Section 80CCD (1):
Allowed to an individual who makes deposits to his/her pension account? Maximum

deduction allowed is 10% of salary (in case the taxpayer is an employee) or 10% of
gross total income (in case the taxpayer being self-employed) or Rs 1, 50,000, whichever
is less.
Note: From FY 2017-18 – In the case of a self-employed individual, maximum

deduction allowed is 20% of gross salary instead of 10% (earlier subject to a maximum
of Rs1, 50,000).However, the combined maximum limit for section 80C, 80CCC and
sec 80CCD (1) deduction is Rs 1, 50,000, which can be availed.
• Deduction for self-contribution to NPS – section 80CCD (1B) :
This is a new section 80CCD (1B) has been introduced for an additional
deduction of up to Rs 50,000 for the amount deposited by a taxpayer to their NPS
account. Contributions to Atal Pension Yojana are also eligible.
• Employer’s contribution to NPS – Section 80CCD (2) :
It is an additional deduction is allowed for employer’s contribution to employee’s

pension account of up to 10% of the salary of the employee. There is no monetary
ceiling on this deduction.
• Deductions on Interest on Savings Account
Section 80 TTA: Deduction from Gross Total Income for Interest on

Savings Bank Account
A deduction of maximum Rs 10,000 can be claimed against interest income from

a savings bank account. Interest from savings bank account should be first included in
other income and deduction can be claimed of the total interest earned or Rs 10,000,
whichever is less. This deduction is allowed to an individual or an HUF. And it can be
claimed for interest on deposits in savings account with a bank, co-operative society,
or post office. Section 80TTA deduction is not available on interest income from fixed Security Analysis and
deposits, recurring deposits, or interest income from corporate bonds. Portfolio Management:307
Investments & Tax Planning • Deductions on Rajiv Gandhi Equity Saving Scheme (RGESS)
Section 80CCG: Rajiv Gandhi Equity Saving Scheme (RGESS)
NOTES The Rajiv Gandhi Equity Saving Scheme (RGESS) was launched after the 2012
Budget. Investors whose gross total income is less than Rs. 12 lakhs can invest in this
scheme. Upon fulfillment of conditions laid down in the section, the deduction is lower
of, 50% of the amount invested in equity shares or Rs 25,000 for three consecutive
Assessment Years. Rajiv Gandhi Equity Scheme has been discontinued starting from
April 1, 2017. Therefore, no deduction under section 80CCG will be allowed from
AY 2018-19.However, if you have invested in the RGESS scheme in FY 2016-17 (AY

2017-18), then you can claim deduction under Section 80CCG until AY 2019-20.
• Deductions on Medical Insurance
Section 80D: Deduction for premium paid for Medical Insurance
Deduction is available up to Rs. 25,000/- to a taxpayer for insurance of self,
spouse and dependent children. If individual or spouse is more than 60 years old the
deduction available is Rs 30,000. An additional deduction for insurance of parents (father
or mother or both) is available to the extent of Rs. 25,000/– if less than 60 years old
and Rs 30,000 if parents are more than 60 years old. For uninsured super senior citizens
(more than 80 years old) medical expenditure incurred up to Rs 30,000 shall be allowed
as a deduction under section 80D. Therefore, the maximum deduction available under
this section is to the extent of Rs. 60,000/-. (From AY 2016-17, within the existing limit
a deduction of up to Rs. 5,000 for preventive health check-up is available).
• Deduction for donations towards Social Causes
Section 80G: Deduction for donations towards Social Causes
The various donations specified in Sec. 80G are eligible for deduction up to
either 100% or 50% with or without restriction as provided in Sec. 80G. 80G deduction
not applicable in case donation is done in form of cash for amount over Rs 10,000.
From Financial Year 2017-18 onwards – Any donations made in cash

exceeding Rs 2000 will not be allowed as deduction. The donations above Rs 2000
should be made in any mode other than cash to qualify as deduction u/s 80G.

Donations with 100% deduction without any qualifying limit: Investments & Tax Planning
• National Defense Fund set up by the Central Government
• Prime Minister’s National Relief Fund

NOTES
• National Foundation for Communal Harmony
• An approved university/educational institution of National eminence
• Zila Saksharta Samiti constituted in any district under the chairmanship of
the Collector of that district

• Fund set up by a State Government for the medical relief to the poor
• National Illness Assistance Fund
• National Blood Transfusion Council or to any State Blood Transfusion Council

• National Trust for Welfare of Persons with Autism, Cerebral Palsy, Mental
Retardation and Multiple Disabilities
• National Sports Fund

• National Cultural Fund
• Fund for Technology Development and Application
• National Children’s Fund

• Chief Minister’s Relief Fund or Lieutenant Governor’s Relief Fund with
respect to any State or Union Territory
• The Army Central Welfare Fund or the Indian Naval Benevolent Fund or
the Air Force Central Welfare Fund, Andhra Pradesh Chief Minister’s
Cyclone Relief Fund, 1996
• The Maharashtra Chief Minister’s Relief Fund during October 1, 1993 and
October 6, 1993.
• Chief Minister’s Earthquake Relief Fund, Maharashtra
• Any fund set up by the State Government of Gujarat exclusively for providing
relief to the victims of earthquake in Gujarat
• Any trust, institution or fund to which Section 80G(5C) applies for providing
relief to the victims of earthquake in Gujarat (contribution made during January
26, 2001 and September 30, 2001) or
• Prime Minister’s Armenia Earthquake Relief Fund
• Africa (Public Contributions — India) Fund Security Analysis and

Investments & Tax Planning • Swachh Bharat Kosh (applicable from financial year 2014-15)
• Clean Ganga Fund (applicable from financial year 2014-15)
NOTES • National Fund for Control of Drug Abuse (applicable from financial year
2015-16
Donations with 50% deduction without any qualifying limit.
• Jawaharlal Nehru Memorial Fund
• Prime Minister’s Drought Relief Fund
• Indira Gandhi Memorial Trust
• The Rajiv Gandhi Foundation
Donations to the following are eligible for 100% deduction subject to

10% of adjusted gross total income
• Government or any approved local authority, institution or association to be
utilized for the purpose of promoting family planning
• Donation by a Company to the Indian Olympic Association or to any other
notified association or institution established in India for the development of

infrastructure for sports and games in India or the sponsorship of sports and
games in India.
§ Donations to the following are eligible for 50% deduction subject to 10%
of adjusted gross total income
Section 80 Deduction Table
– Section Deduction on FY 2016-17
Section 80C • Investment in PPF Rs. 1,50,000
• Employee’s share of PF
contribution
• NSCs
• Life Insurance Premium
payment
• Children’s Tuition Fee

• Principal Repayment Investments & Tax Planning
of home loan
• Investment in Sukanya NOTES
Samridhi Account
• ULIPS
• ELSS
• Sum paid to purchase
deferred annuity
• Five year deposit scheme
• Senior Citizens savings
scheme
• Subscription to notified
securities / notified
deposits scheme
• Contribution to notified
Pension Fund set up by
Mutual Fund or UTI.
• Subscription to Home
Loan Account Scheme
of the National Housing
Bank
• Subscription to deposit
scheme of a public sector
or company engaged in
providing housing finance

Investments & Tax Planning • Contribution to notified
annuity Plan of LIC
NOTES • Subscription to equity shares
/ debentures of an approved
eligible issue
• Subscription to notified bonds
of NABARD
80CC For amount deposited in annuity plan
of LIC or any other insurer for
pension from a fund referred to in
Section 10(23AAB). –
80CCD (1) Employee’s contribution to NPS
account (maximum up to Rs 1,50,000) –
80CCD (2) Employer’s contribution to NPS Maximum up to
account 10 % of salary
80CCD (1B) Additional contribution to NPS Rs. 50,000
80TTA (1) Interest Income from Savings
account Maximum up to 10,000
80GG For rent paid when HRA is not
received from employer Least of rent paid
minus 10% of
total income Rs.
5000/- per month
25% of total
income
80E Interest on education loan Interest paid for a

Security Analysis and period of 8 years
80EE Interest on home loan for first Investments & Tax Planning
time home owners Rs. 50,000
80CCG Rajiv Gandhi Equity Scheme for NOTES
investments in Equities Lower of – 50%
of amount
invested in equity
shares or Rs
25,000
80D Medical Insurance – Self, spouse, Rs. 25,000
children Medical Insurance – Rs. 30,000
Parents more than 60 years
old or (from FY 2015-16)
uninsured parents more than
80 years old.
80DD Medical treatment for handicapped Rs. 75,000
dependent or payment to specified Rs. 1,25,000
scheme for maintenance of
handicapped dependent
• Disability is 40% or more but
less than 80%
• Disability is 80% or more
80DDB Medical Expenditure on Self or • Lower of Rs

Dependent Relative for diseases 40,000 or the
specified in Rule 11DD amount actually

• For less than 60 years old paid
• For more than 60 years old • Lower of Rs

• For more than 80 years old 60,000 or the Security Analysis and
Investments & Tax Planning amount actually
paid
NOTES • Lower of Rs
80,000 or the
amount actually
paid
80U Self-suffering from disability Rs. 75,000
:• Individual suffering from Rs. 1,25,000
a physical disability
(including blindness) or
mental retardation.
• Individual suffering from
severe disability
80GGB Contribution by companies to
political parties Amount contributed

(not allowed in cash)
80GGC Contribution by individuals to
political parties Amount contributed

(not allowed in cash)
80RRB Deductions on Income by
way of Royalty of a Patent Lower of Rs 3,00,000

or income received
Check Your Progress Note: The deduction under section 80CCG i.e. Rajiv Gandhi Equity Savings Scheme
Discuss the various
available under Chapter 6A has been discontinued starting from 1st April
deductions under Section
80. 2017.

15.5 Mutual Fund Taxation
15.5.1 Factors determining Mutual Fund Taxation NOTES

The factors that determine the Mutual Fund Taxation are divided into three
major parts:
1. Residential Status-Resident or Non-Resident (NRI)

Taxation is based on the residential status of an individual. If he is a resident
then the taxation rules will be different and if nonresident then again it differs.
Hence, first, the residential status has to be ascertained.
2. Types of Funds-Equity Funds or Non-Equity Funds

Any fund which invests 65% or more in equity is called as Equity Fund. For
example, large-cap funds, multi-cap funds, small and mid-cap funds or equity-
oriented balanced funds (where the equity exposure is 65% or more) are all
called equity oriented funds. If the equity portion is less than that, then they
are all treated as debt funds or non-equity funds. For example liquid funds,
ultra-short term funds, short-term funds, income funds, gilt funds, debt-oriented
balanced funds, gold funds, fund of funds or money market funds.
3. Holding periods of Investment

The holding period for Equity and Debt Funds will be different for taxation
purpose. For equity funds, if the holding period more than a year, then it is
called long term. If the holding period is less than a year, then such equity
mutual funds holding period is considered as short term. Whereas in the
case of debt funds, holding period more than 3 years is considered as long
term. If holding period of debt funds is less than 3 years, then it is considered
as short-term and taxed accordingly.
4. Taxation aspects:
The income of mutual fund is received in two forms one is by dividend and
other is by capital appreciation. For example, Mr. A will receive dividend
and capital appreciation on mutual fund invested. If he purchased it for Rs.
100. Then during the year he may Rs. 10 as dividend and at the year end the
value of one unit may go up to Rs. 150 which gives him capital appreciation Security Analysis and
of Rs. 540.As we know there are two types of benefits Portfolio Management:315
Investments & Tax Planning 1) Income received on such units as dividend or by any other name.
2) Capital appreciation on such units on sale/redemption.
NOTES Income received on such units as dividend or by any other name during the
year
Any income received on such units as specified under clause 10(23D) are
exempt from income tax under section 10(35).
Section 10(23D) covers all mutual funds registered under SEBI, set up by
public sector bank, public financial institutions, RBI and are subject to
conditions of central Govt.
So any income you receive on mutual fund during the year is exempt.
Capital appreciation on such units on sale/redemption.
If you receive any money for increase in value of units at the time of sale/
redemption of such units, then it will liable for capital gain taxation. Capital gain may be
long term or short term. If you hold the units for more than a year then it is long term
investment. Otherwise it is short term investment. We divide it into long term and short
term since we have tax treatment/rate is different of both.
There are various types of mutual fund in income tax. It is Equity oriented mutual
fund and other funds.
Capital Gains on Mutual Funds:
Payee Equity-oriented Debt oriented schemes/
schemes Money Market and Liquid
Schemes
Individual /HUF Nil 28.84% (25% + 12%Surcharge +

3%Cess)
Domestic
Companies/Firms Nil 34.608% (30% + 12%Surcharge
+ 3%Cess)
Non Resident Indians Nil 28.84% (25% + 12%Surcharge +
Security Analysis and 3%Cess)

Security Transaction Tax : Investments & Tax Planning
Sale of units of Equity Oriented Mutual Fund 0.001%
NOTES
Sale of units Other than Equity Oriented Mutual Fund Nil
Check Your Progress

Purchase of units of equity oriented mutual funds on stock exchange Nil
What are the factors
determining Mutual Fund
Sale of units of equity oriented mutual funds on stock exchange 0.001%
Taxation? Explain the
Mutual Funds will also pay securities transaction tax wherever applicable on the taxation aspects of Mutual
Fund Investments.
securities bought or sold at 0.10%
15.6 Security Transaction Tax (STT)

Securities transaction tax or STT was introduced in the year 2004 by the then
Finance Minister, P. Chindambaram. This tax was introduced to avoid tax evasion in
case of capital gains. Securities transaction tax is levied on the value of securities
(except commodities and currency). Securities transaction tax is a type of tax levied
on gains from securities. This includes mainly equities and futures and options. The
rate of taxation is different for different types of securities. STT can basically be
understood as a type of tax levied on transactions done in the domestic stock exchange.
Securities transaction tax is a direct tax and is levied and collected by the Central
Government of India. The most notable point about securities transaction tax is that
STT is applicable only on share transactions made through a recognized stock exchange
in the country. Off-market share transactions are not covered under STT.
Salient Features of Securities Transaction Tax:

STT is a simple direct tax and is not very complicated to calculate or levy. Some
of the most significant features of STT are as listed below.
• Security Transaction Charges or STT is the charges or tax when you buy or
sell securities (excluding commodities and currency) through a recognized
stock exchange.
• STT is levied on all sell transactions for both options as well as futures
• For purpose of STT calculation, each future trade is valued at the actual
traded price while each option trade is valued at premium Security Analysis and
Investments & Tax Planning • The amount STT that a clearing member has to pay is the sum total of all the
STT taxes of trading members under him
NOTES • The definition of securities covers:

1. Shares, scrips, stocks, bonds, debentures, debenture stock or other
marketable securities of a like nature in or of any incorporated company
or other body corporate;

2. Derivatives;
3. units or any other instrument issued by any collective investment scheme
to the investors in such schemes;

4. Security receipt as defined in section 2(zg) of the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest
Act, 2002;
Check Your Progress 5. Government securities of equity nature;
What do you mean by
6. Rights or interest in securities;
Securities Transaction Tax
(STT)? What are its 7. Equity-oriented mutual funds
Salient Features? Whenever you buy and sell these securities through a recognized stock exchange,
then you have to pay this STT.
Securities Transaction Tax Rate in India:
The table below depicts the rate at which various securities are taxed. The rate
of taxation for STT is set by the government and depends upon the type of security
and also on the fact that the transaction is sale or purchase. Apart from all the advantages
that STT offers with respect to transparent and timely payment of tax on trading
instruments, STT also ensures that inflow of speculative cash in reduced in any market.
Sr.No. Taxable Securities Rate of taxation Payable By
Transaction
1 Sale of an option in securities 0.017 per cent Seller
2 Sale of an option in securities,
where option is exercised 0.125 per cent Purchaser
3 Sale of a futures in securities 0.01 per cent Seller

This table can further be refined to include details about the type of securities Investments & Tax Planning
and then list down the corresponding rates of taxation. This is explained in the table
below.
NOTES
S.No. Type of Taxable Type of Applicable STT
Securities Transaction
1 Delivery-based Purchase 0.125 % on

equity shares total value
2 Equity oriented Redemption of units 0.25 %
mutual funds
3 Equity shares, equity Purchase Nil
mutual fund units &
intra-day traded shares
4 Derivative- sale of option Sale 0.017 %
5 Derivative sale of futures Sale 0.017 %
Securities on which STT is Applicable:
Securities transaction tax is levied on various types of transactions made on the
domestic stock exchanges in India. According to the Securities Contract Act, 1956,
following are the transactions covered under the same.
• Shares, bonds, debentures or any such marketable security which is traded
at the stock market
• Derivatives traded in the market
• Units issued by any collective investment scheme to customers

Check Your Progress
• Government securities that are of the nature of equity
What are the Securities
• Rights or interests in securities Transaction Tax (STT)
rates in India for different
• Mutual funds that are based on equity trading
types of transactions?
Securities Transaction Tax and Income Tax:
Taxation on the money made via share market trading depends largely on the
purpose for which share transactions are done. An individual can trade shares for
Investments & Tax Planning business purposes or as an investment activity. In both the cases the STT that is levied
by the government, varies. Depending upon this factor, following two heads can be
differentiated.
NOTES
• Income from Capital Gains:
Income from capital gains is applicable when the assessee is a salaried or self-
employed person who deals in stock transactions only for investment purposes and
trading in securities is not what he does as his main line of profession. Gains of losses
in such cases can be grouped as short-term capital gains or long-term capital gains
depending upon the period for which the stocks are held. If the holding period is less
than a year, then the gains are classified as short-term capital gains whereas for share
holdings with a holding period more than one year, the term long-term capital gains is
applicable.
• Income from Share Trading as a Profession:
This case arises when the income from trading of stocks is being made as a
professional choice and is being carried out from business point of view. In such cases
the losses as well as gains from share trading is classified as business income. This is
then taxed at the regular income tax rates set by the government. Securities transaction
tax paid on income from taxes can then be claimed as deduction under section 36 of
the income tax act
• When is Securities Transaction Tax levied?

Securities transaction tax is levied on each purchase and sale of equity listed on
a domestic and recognized stock market. The rate of taxation is determined by the
government. All stock market transactions that involve equity or equity derivatives like
futures and options are liable to be taxed under the STT act. STT is charged as soon as
a share transaction is completed. This makes STT fast, transparent and effective.
Since the tax is levied as soon as the transaction arises, instances of non-payment,
wrong payment etc. is reduced to minimum. The net result of this however, is that it
Check Your Progress
What are the securities on pushes up the cost of the transactions.
which STT is levied? Example of STT:
When is it ?
Suppose a trader buys 500 shares worth Rs.10000 at Rs.20 each and sells it at
Rs.30 each. If the trader sells the shares the same day then intraday STT rate will
Portfolio Management:320 apply which is 0.025%.
So, STT = 0.025 × 30 × 500 = Rs.375 Investments & Tax Planning
Similarly, for futures and options, STT applicable is 0.01%. Suppose a trader
buys 5 lots of Nifty futures at Rs.5000 and sells it at Rs.5010, The lots size of nifty is
NOTES
50 then STT is calculated as,
STT = 0.01 × 5010 × 50 × 5 = Rs.125.25
15.7 Capital Gains Tax (CGT)

Capital gains are the profits that the investor realizes when he sells the capital
asset for a price higher than its purchase price. This is taxable under the head ‘Capital
Gains’ and there must exist a capital asset, transfer of the capital asset and profit or
gains arising from the transfer.
Capital Asset includes any property held by the assessee except the following:
• Stock in trade.
• Consumable stores or raw materials held for the purpose of business or
profession.
• Personal effects that are movable except jewellery, archaeological
collections, drawings, paintings, sculptures or any art work held for

personal use.
• Agricultural land. The land must not be located within 8kms from a
municipality, Municipal Corporation, notified area committee, town

committee or a cantonment board with a minimum population of 10,000. Check Your Progress
What do you mean by
• 6.5 percent Gold Bonds, National Defence Gold Bonds and Special Bearer
Capital Gains Tax?
Bonds. Discuss the provisions for
levy of Capital Gains Tax?
• Gold Deposit bonds under Gold Deposit Scheme.
15.8 Capital Gains Tax
Capital gains tax is a tax that is charged on the profits that he has made by selling
his capital asset. In India, the long-term capital gains on stocks and equity mutual funds
are not taxed. But, the short term gains will be taxed at 15 percent. In case of debt
mutual funds, both short and long term capital gains are taxed. The short-term capital
gain on debt mutual fund is added to the income and taxed as per the individual’s Portfolio Management:321
Investments & Tax Planning Income tax slab and the long-term capital gains on debt mutual funds are taxed at 20
percent with indexation and 10 percent without indexation. Indexation is adjusting the
purchase value for inflation. The indexation increases the purchase cost and lowers
NOTES
the gain.
For making it easy for taxation, the capital assets are classified to ‘Short-Term
Capital Asset; and ‘Long-Term Capital Asset’.
• Short-Term Capital Asset: If the shares and securities are held by the
taxpayer for a period not more than 36 months preceding the date of its
transfer will be treated as a short-term capital asset.
• Long- Term Capital Asset: If the taxpayer holds the shares and securities
for a period exceeding 36 months before the transfer will be treated as a

long-term capital asset. Equity shares which are listed in a recognized stock
Check Your Progress exchange, units of equity oriented mutual funds, listed debentures and
Government securities, units of UTI and Zero Coupon Bonds’ period of
by Short term and Long
term Capital Asset? holding will be considered for 12 months instead of 36 months. Transfer is
giving up your right on an asset it includes sale, exchange, compulsory
acquisition under any law and relinquishment.
15.9 Computation of Capital Gains Tax
Computation of Capital Gains:
The computations for the capital gains are as follows:
• Short-term capital gain = Full value consideration- (cost of acquisition + cost
of improvement + cost of transfer)
• Long-term capital gain = Full value of consideration received or accruing –
(indexed cost of acquisition + indexed cost of improvement + cost of transfer).

Where;
Check Your Progress Note:

How are short term and
1. Indexed cost of acquisition = Cost of acquisition X cost inflation index of the
long term capital gains
computed? year of transfer/ cost inflation index of the year of acquisition
2. Indexed cost of improvement = cost of improvement X cost inflation index

Portfolio Management:322 of the year of transfer / cost inflation index of the year of improvement
3 Cost of transfer is a brokerage paid for arranging the deal, legal expenses Investments & Tax Planning
incurred, cost of advertising, etc.
Illustration 1:
NOTES
Mr. Harish is a resident individual and he sells a residential house on 12/4/
2016 for Rs.25,00,000. He had purchased the house on 5/7/2014 for
Rs.5,00,000 and spent Rs.1,00,000 on its improvement during May 2015.
During the previous year, 2016-2017, his income under all heads excluding
capital gains was NIL.
Solution:
Since the asset was held for less than 36 months, it is a short term capital
asset and the
Short-term capital gain = 25,00,000 – 5,00,000 – 1,00,000= 19,00,000\
15.10 Capital Gain Index

It is important to know about the cost inflation index when you are calculating the
long-term capital gains. The long-term capital gain is computed by deducting the indexed
cost of acquisition and indexed cost of improvement.The concept of indexation was
introduced as the value of a rupee keeps changing due to inflation. Indexation lets you
show a higher purchase cost of the capital asset bought, and this helps lower your
overall profit. The acquisition price is indexed by a factor called the Cost Inflation
Index (CII). CII is the CII for year in which the asset is transferred divided by the year
in which the asset was acquired. The CII is then multiplied with the purchase price to
arrive at the indexed acquisition cost.
Year CII Year CII Year CII Year CII Year CII
1981-82 100 1988-89 161 1995-96 281 2002-03 447 2009-10 632
1982-83 109 1989-90 172 1996-97 305 2003-04 463 2010-11 711
1983-84 116 1990 -91 182 1997-98 331 2004-05 480 2011-12 785
Check Your Progress
1984-85 125 1991-92 199 1998-99 351 2005-06 497 2012-13 852 What do you understand
by Cost Inflation Index
1985-86 133 1992-93 223 1999-2000 389 2006-07 519 2013-14 939
(CII)?
1986-87 140 1993-94 244 2000-01 406 2007-08 551 2014-15 1024
1987-88 150 1994-95 259 2001-02 426 2008-09 582 2015-16 1081
2016-17 1125 Portfolio Management:323
15.11Capital Gains Tax Exemption
The following assets are exempt from levy of Capital Gains Tax:
NOTES
• Agricultural land in rural area in India is not considered as a capital asset
and therefore no capital gains will be applicable on its sale.
• You will not be taxed if you use the entire sale proceed of your capital asset
to buy a house property. The following conditions have to be satisfied to
avail exemption under Section 54F:
• The purchase of house should be made 1 year before or 2 years after the
sale.
• Under construction properties must be completed within 3 years from the

date of transfer of the original house.
• The house must not be sold within 3 years of the purchase or construction.
• The new house must be situated in India.
• The assessee must not own more than 1 residential house other than the
new one on the date of transfer.
• The assessee should not purchase a new house apart from the new one
within 2 years or construct a residential house within a period of 3 years.
• When an assessee satisfies these conditions and when he invests the entire
sale proceeds towards the new house, there will be no tax on capital gain.
• Investment made in Capital Gains Account Scheme, will not attract tax on
the capital gains. However the investment of money should be for a specified
period as specified by the bank. If the money is not kept invested for the
specified period, then it will be treated as capital gain.

Check Your Progress
Discuss the exemptions • By purchasing Capital Gains Bonds, he will be exempted from tax. This is
from Capital gains Tax. applicable only if it is a long-term capital asset and the exemption is under
Section 54EC.
Capital Gains Bonds

As per Section 54EC, one can claim tax relief by investing the capital gains
Security Analysis and earned from long-term capital assets in bonds issued by National Highway Authority
of India or by the Rural Electrification Corporation Limited. The investment in bonds
must be done within a period of 6 months. These will not be redeemable before 3 Investments & Tax Planning
years. You can earn a guaranteed rate of interest on the bond. The maximum amount
that can be invested in capital gain bonds is Rs.50, 00,000 during a financial year. The
NOTES
same benefit cannot be availed for a short-term capital gain. The long-term capital
gains on stocks and equity mutual funds are not taxed whereas the short term gains
are taxed at 15 percent. The short-term capital gain on debt mutual fund is added to
Check Your Progress
the income and taxed as per the individual’s income tax slab and the long-term capital
Discuss the taxability of
gains on debt mutual funds are taxed at 20 percent with indexation and 10 percent Capital Gains Bond under
without indexation. Section 54 EC?
15.12 Summary
• Taxation impacts liquidity and risk and return and hence its effect on individual
investment decision is to be analyzed before making investment.
• Total income is arrived after making various deductions from gross total
income under section 80 C to 80 U and is computed on the basis of residential
status of an Assessee.
• Income tax is charged on total income earned by an Assessee during the

previous year, but at the rate applicable to the assessment year
• There is basic and additional condition for determining the residential status
of an Individual Assessee.
• Taxation is based on the residential status of an individual. If he is a resident

then the taxation rules will be different and if nonresident then again it
differs
• Any fund which invests 65% or more in equity is called as Equity Fun but if
the equity portion is less than that, then they are all treated as debt funds or
non-equity funds.
• For equity funds, if the holding period more than a year, then it is called long
term and if the holding period is less than a year, then such equity mutual
funds holding period is considered as short term.
• In the case of debt funds, holding period more than 3 years is considered as
long term and if holding period of debt funds is less than 3 years, then it is
considered as short-term and taxed accordingly. Portfolio Management:325
Investments & Tax Planning • Securities transaction tax is levied on the value of securities except
commodities and currency and it is a type of tax levied on gains from securities.
• Securities transaction tax is a direct tax and is levied and collected by the
NOTES
central government of India.
• STT is applicable only on share transactions made through a recognized

stock exchange in the country.
• Security Transaction Charges or STT is the charges or tax when you buy or
sell securities (excluding commodities and currency) through a recognized
stock exchange.
• Income from capital gains is applicable when the assessee is a salaried or

self-employed person who deals in stock transactions only for investment
purposes and trading in securities is not what he does as his main line of
profession.
• Income from Share Trading as a Profession arises when the income from
trading of stocks is being made as a professional choice and is being carried
out from business point of view. In such cases the losses as well as gains
from share trading is classified as business income.
• Capital gains is the profit that the investor realizes when he sells the capital
asset for a price higher than its purchase price which is taxable under the
head ‘Capital Gains’ and there must exist a capital asset, transfer of the
capital asset and profit or gains arising from the transfer.
• If the shares and securities are held by the taxpayer for a period not more
than 36 months preceding the date of its transfer will be treated as a short-
term capital asset.
• If the taxpayer holds the shares and securities for a period exceeding 36
months before the transfer will be treated as a long-term capital asset.
• The long-term capital gain is computed by deducting the indexed cost of

acquisition and indexed cost of improvement. Indexation lets you show a
higher purchase cost of the capital asset bought, and this helps lower your
overall profit.
• As per Section 54EC, one can claim tax relief by investing the capital gains
earned from long-term capital assets in bonds issued by National Highway
Portfolio Management:326 Authority of India or by the Rural Electrification Corporation Limited.
15.13 Key Words
1. Equity Funds: Any fund which invests 65% or more in equity is called as
NOTES
Equity Fund.
2. Debt Funds: If the equity portion is less than that, then they are all treated
as debt funds or non-equity funds
3. Securities Transaction Tax (STT): It is a type of tax levied on transactions
done in the domestic stock exchange and is a direct tax and is levied and
collected by the central government of India and is applicable only on share

transactions made through a recognized stock exchange in the country
3. Securities : It covers shares, scrips, stocks, bonds, debentures, debenture

stock or other marketable securities of a like nature in or of any incorporated
company or other body corporate.
4. Capital gains: It is the profit that the investor realizes when he sells the
capital asset for a price higher than its purchase price and there must exist
a capital asset, transfer of the capital asset and profit or gains arising from
the transfer.
5. Capital gains tax: It is a tax that is charged on the profits that he has made
by selling his capital asset for a price higher than its purchase price.
6. Short-Term Capital Asset: If the shares and securities are held by the
taxpayer for a period not more than 36 months preceding the date of its
transfer will be treated as a short-term capital asset.
7. Long- Term Capital Asset: If the taxpayer holds the shares and securities
for a period exceeding 36 months before the transfer will be treated as a
long-term capital asset.
8. Indexation: lets you show a higher purchase cost of the capital asset
bought, and this helps lower your overall profit. The acquisition price is indexed
by a factor called the Cost Inflation Index (CII).


NOTES
1. Total income is arrived after making various deductions from gross total
income under I this section
a. 80
b. 85
c. 10
d. 3
2. These factors determine the Mutual Fund Taxation
a. Residential Status-Resident or Non-Resident (NRI)
b. Types of Funds-Equity Funds or Non-Equity Funds
c. Holding periods of Investment
d. All the above.
3. Securities transaction tax is levied on the value of securities except
a. Commodities and currency
b. Foreign Exchange
c. Shares
d. Bonds
4. The most notable point about securities transaction tax is that STT is applicable
only on share transactions
a. made through a registered broker
b. made through a share transfer agent
c. made through a recognized stock exchange in the country.
5. Securities include all of the following except:
a. Shares
b. Bonds
c. Debentures
d. Chit Funds
6. Sale of an option in securities is taxable in the hands of the seller at Investments & Tax Planning
a. 0.10 percent
b. 0.15 percent NOTES
c. 0.17 percent
d. d.0.25 percent
7. Equity Oriented Mutual Funds are taxable at 0.25 percent on
a. Issue
b. Conversion
c. Endorsement
d. Redemption
8. The gains are classified as short-term capital gains where the holding period
is
a. More than one year
b. Less than one year
c. Equal to one year
9. Transfer is giving up your right on an asset it includes
a. Sale
b. Exchange
c. Compulsory acquisition under any law
d. All the above
10. As per Section 54EC, one can claim tax relief by investing the capital gains
earned from long-term capital assets in bonds issued by
a. National Highway Authority of India or by the Rural Electrification
Corporation Limited.
b. Government of India
c. SEBI
d. Reserve Bank of India

Investments & Tax Planning 15.14.2 Theory Questions
1. Discuss the taxation aspects of investment and investment planning.
NOTES 2. Explain the Computation of total income and Tax liability.

3. Discuss the different deductions available under Section 80?
4. What are the factors determining Mutual Fund Taxation?
5. What do you mean by Securities Transaction Tax (STT)? What are its Salient
Features
6. What are the Securities Transaction Tax (STT) rates in India for different
types of transactions?
7. What are the securities on which STT is levied? When is it levied?
8. What do you mean by Capital Gains Tax? Discuss the provisions for levy of
Capital Gains Tax?
9. What do you mean by Capital Gains Tax? Discuss the provisions for levy of
Capital Gains Tax?
10. What do you understand by Short term and Long term Capital Asset?
11. How is Short term and long term capital Gain computed?
12. What do you understand by Cost Inflation Index (CII)?
13. Discuss the exemptions from Capital gains Tax.
14. Discuss the taxability of Capital Gains Bond under Section 54 EC?
15.14.3 Exercises
Ex.1 Mr. Sharma bought 1,000 shares of TCS Ltd. for Rs. 10 each in the year
2010. After 5 years, in January 2016, he sold off 500 shares for Rs.
7,500. CII for 2010-11 is 711 and for 2016-17 it is 1125. Compute his
Capital Gains for the Assessment year 016-17 in the year of sale.
Ex.2 A trader buys 1000 shares of Rs. 1, 00,000 at Rs. 100 each. If he sells
the shares on the same day, then what rate of STT will be applicable
and find the amount of STT to be payable
“Investment Principles and Practices”, Badger Tigerson Guthman,
Security Analysis and PrenticeHall, USA.

Mutual Funds, Insurance &
Unit 16 Mutual Funds, Insurance & Commodities
Commodities
NOTES
Structure
16.0 Introduction
16.2 Mutual Funds as an Investment Medium
16.3 Bottom of Form
Classification of Mutual Funds
16.4 Evaluation of the performance of Managed portfolio
16.5 Empirical Tests of Performance Evaluation of Managed Portfolio
16.6 Mutual Fund Ratings
16.7 Investment in Commodities
16.8 Real Estate
16.9 Insurance
16.10 Summary
16.11 Key Terms
16.12.3 Exercises
16.12.4 Assignment

Commodities 16.0 Introduction
Mutual Funds are financial intermediaries in the investment process. In a mutual

NOTES
fund, the resources of investors are pooled together and invested in diversified portfolio.
These are managed by Asset Management Companies which operate under SEBI
guidelines. The Asset Management Companies broadly comprises of open ended and
closed ended investment companies.
Ø Understand the features of Mutual Funds as an Investment Medium.
Ø Know the Constituents of Mutual Funds.
Ø Learn the categories of Mutual Funds operating in India
Ø Study the Analysis of different techniques and tools for evaluating managed
portfolios/ Mutual Funds
Ø Learn the Empirical Tests for Evaluating the Performance of Managed
Portfolio.
Ø Know the different Mutual Fund Rating Agencies in India
Ø Discuss Commodities as an investment Avenue
Ø Know the Principles of investing in Real estate
Ø Understand and analyze insurance as an investment medium
Ø Know the different types of Insurance policies.
16.2 Mutual Funds as an Investment Medium
Mutual Funds are collective investment vehicles which are based on the
“Trusteeship” Principle. It means that the fund is managed on behalf of other individuals
for their benefit and seeks to provide protection to the person on whose behalf it is
managed. Until up to 1986 the mutual fund industry was monopolized by the Unit
Trust of India (UTI) and thereafter banks and insurance companies were also allowed
Security Analysis and to do mutual fund business. This resulted into multiplayers in the mutual fund industry
such as State Bank of India, LIC, GIC and private players such as DSP Merrill Mutual Funds, Insurance &
Commodities
Lynch, HDFC Mutual Fund, IDBI Principal Mutual Fund, Kotak Mahindra and others
have been set up into the mutual fund business.

NOTES
The common features of a Mutual Fund are as explained below:
1. Liquidity: It means the investors in a mutual fund can easily and conveniently
redeem their shares at the Current Net Asset Value (NAV) and additionally
the fees or charges on redemption. There is no need for the investor to
locate or find another seller to buy his shares in a mutual fund like shares on
a stock exchange.
2. Diversification : In order to reduce the risks involved in shares and stocks
due to uncertainty in price movements, investment in mutual funds are made

since mutual funds invest in a variety of different schemes and in different
stocks of different companies. Also there is a constant monitoring and review
of the managed portfolio of a mutual fund and these results in diversification

and reduction of risk.
3. Professional Management : The mutual funds are usually managed by

professional managers and a team of experts who do research, select and
review and also constantly reconstruct the portfolio of a mutual fund which
results in a higher return to the investors. SEBI is the regulatory authority of

mutual funds in India which governs all mutual funds by the same set of
rules and regulations. This also results in efficient management .
4. Risk Sharing : Investors in a mutual fund get their portfolio risk shared
with the fund managers and the asset management companies and hence it
is a stress free investment compared to others investment modes.
5. Tax Benefits : Investments in Mutual Funds offer tax benefits such as the
dividend which is received from Mutual Funds is exempt in the hands of the
unit holders, wealth tax is not to be levied on the units held under mutual
fund investments, long term capital gains tax is exempt on sale of mutual
fund units and short term capital gains tax is levied at 15% depending on the
holding period of mutual fund units subject to payment of Securities

Transaction Tax (STT).
Mutual Funds, Insurance & Constituents of a Mutual Fund
Commodities
The entities in a mutual fund include the following:
NOTES 1. Sponsor: The sponsor is like the promoter which may be a bank or financial
institution. SEBI license is required to operate as a Sponsor for which certain
terms and conditions are to be met for capital, profits, performance etc.
2. Mutual Fund Trustees: It is somewhat like a trust formed under the

Indian Trust Act, 1881 and it should be registered with SEBI. The functioning
of mutual fund trust is very similar to that of a trust which enters into
contracts on behalf of its beneficiaries and the trustees decide on the Asset
Management Company (AMC) to secure permissions and to monitor the
activities of the trust.
3. Asset Management Company (AMC): The AMC acts as an investment
manager which is appointed by trustees oversee the activities of the trust. It
usually consists of a team of experts who are responsible for the investment
of the funds collected. The AMCs should also have a certificate from SEBI
to function as a Portfolio Manager and hence all SEBI rules and regulations
of a Portfolio Manager are applicable. Such AMCs are paid the investment
management fees according to the scheme size and composition subject to
limits set up by SEBI in this behalf.
4. Custodian: The back office operations are handled by the Custodian which
oversees the delivery of securities, collection of revenue, dividend and
deciding the asset composition. This allows the control to stay safely in the
hands of a person other than the sponsor.
5. Registrar and Share Transfer Agents: They manage the investor related
matters like issuing and redeeming units, preparing and circulating annual
reports etc. Sometimes the functions of Registrar and Share Transfer agents
are given to outside agents registered with SEBI.

Assets under Mutual Fund Schemes operating as on 31st March 2017 \ Mutual Funds, Insurance &
Commodities
Scheme Returns for the last one
year as on August 2017 (%)
NOTES
ABSL Top 100 54.82
Kotak Select Focus Fund Regular 31.17
SBI Blue Chip Fund 35.78
L&T Emerging Businesses Fund 23.95
L&T Midcap Fund 130.43
Mirae Emerging Blue chip Fund 45.73
ABSL India GenNext 73.66
Motilal Focused Multicap 25.40
Principal Emerging Blue chip 97.53
Sundaram Rural India Fund 40.21
Tata Equity P/E Fund 126.51
DSP-BR Natural Resources 33.11
IDFC Infrastructure Plan A 16.31
Tata India Tax Savings Fund 70.81 Check Your Progress

HDFC Balanced Fund 98.63 Explain the Features of
Mutual Funds as an
SBI Dynamic Bond Fund 140.67
Investment Medium and
UTI Dynamic Bond Fund 21.43 what are its constituents?
16.3 Bottom of Form Classification of Mutual Funds
The following are the broad categories of Mutual Fund schemes operated
by Mutual funds in India:
1. Open Ended fund
2. Closed Ended fund
3. Growth fund
4. Equity fund
5. Balanced fund
6. Infrastructure fund Portfolio Management:335
Mutual Funds, Insurance & 7. Debt fund
Commodities
8. Income fund
9. Income & growth fund

NOTES
10. Index fund
11. Equity linked fund
12. Money Market fund

13. Load funds
14. Tax saving schemes
Apart from the above types of mutual funds, the objective, income potential
and stability measures of different funds are enlisted below :
Type of Mutual Investment Current Income Stability of Principal

Fund Objective Potential portion of Investment
Taxable bonds Regular Income Moderate Low
Tax-exempt bonds Tax free Income Moderate to high Low to moderate
Balanced Regular Income & High Low

Check Your Progress Capital Appreciation
What are the different types
Equity Income Growth in Dividend Moderate Low
of Mutual Funds based on
Investment Objective, Growth Funds Growing Income Low Low to Moderate
Current Income Potential
and stability of Principal Aggressive Funds Aggressive Capital Very low Very Low
amount of investment?
Growth
Small Cap Diversified Growth Very low Very low
16.4 Evaluation of the performance of Managed portfolio
Managed portfolio consists of Mutual funds, Portfolio Management Schemes
and Individual portfolios. There are various parameters or variables which are used to
measure the performance of managed portfolio:

a. Risk: It is measured by the variations of returns over a period of time
either by standard deviation or by other techniques. Risks are of two types
Security Analysis and namely Systematic Risk and Unsystematic Risk.

a. Systematic Risk is due to generic market forces and arises on account Mutual Funds, Insurance &
Commodities
of system variables. For instance Market Risk, Inflation Risk, Interest
Rate risk, Political risk, etc. Beta is the measure of non diversifiable
NOTES
risk which cannot be avoided.
b. Non Systematic Risk is due to the individual companies whose
performance is evaluated and also on account of the strategies of the
mutual fund. These risks can be eliminated by different risk management

techniques and it is measured by Apha, Beta, etc .Such risk arises due
to business risk, financial risk, disputes and strategies of the AMCs
concerned.
b. Return: There are different tools and techniques to measure the return of
a managed portfolio. The return on investment in a mutual fund is found in
two ways.
a. Capital Appreciation: This is the profit earned on the sale of units at
a greater NAV as compared to original cost of investment.
b. Income or Dividend: Dividend or income is distributed to the investor

when there is a profit which can be either reinvested or retained in the
business in cash.
However the most common measure is Net Asset Value (NAV) which shows
the value of assets held against the value of liabilities held by a mutual fund. The
returns are measured by the changes in NAV which is calculated by the following
formula:
(NAVt – NAVt–1 ) + 1t + G x 100
Returns of a Managed Portfolio =
NAVt–1
Where,
NAV t = NAV at the end of the year one
NAV t-1 = NAV at the beginning of the year one.
It = Income during the period “t”
Gt = Capital gains during the period “t”
Illustration 1:
The Net Asset Value of a Mutual fund of Rs. 20 at the beginning of July had
income and capital gains of Re. 0.1 and Re. 0.08 per share respectively Portfolio Management:337
Mutual Funds, Insurance & during July. The month end Net Asset Value of the Fund was Rs. 20.06.
Commodities
Compute the monthly Return of the fund for the month of July.
NOTES Solution:
(NAVt – NAVt–1 ) + 1t + G x 100
Returns of Mutual Fund (r) =
NAVt–1
(20.06 – 20) + 0.1+ 0.08
=
20
= 16%
Other measures for Evaluation of Mutual Funds:
The following are the other measures used for Evaluation of the performance
of a mutual fund:
• Net Asset Value (NAV) : It is the actual value if a share on a specific day,
which is computed as follows :
Fair Market Value of investments + Receivables + Accrued Income +

Other assets Accrued expenses – Payables – Other Liabilities
NAV =
Number of shares or units outstanding
The computation of NAV is shown with the help of the following illustration.
Illustration 2:
Scheme Size: Rs. 10 crore
Face Value of share: Rs. 10 each
Number of Outstanding shares: 1 crore

Market Value of investments of the fund: Rs. 18 crore
Receivables: Rs. 0.1 crore
Accrued Income: Rs. 0.1 crore

Liabilities: Rs.0.05 crore
Accrued Expenses: Rs. 0.05 crore
Compute Net Asset Value of the Fund.
Solution :
18 + 0.1 + 0.1 – 0.05 – 0.05
Net Asset Value (NAV) =
10
= Rs. 18.15
Entry Load and Exit Load:
Load Funds charge a certain percentage of NAV for entry or exit from the fund.
Portfolio Management:338 Entry Load also known as Front End load is charged on the investor on purchases of
mutual fund units and exit load also known as Back End load is charged on the investor Mutual Funds, Insurance &
Commodities
at the time of redeeming the mutual fund units.
Front End load is computed with the help of the following Formula: NOTES
Net Asset Value
Public Offer Price =
1 – Front end load
Back End Load is computed with the help of the following Formula:
Net Asset Value
Redemption or Sale Price =
1 – Back end load
Illustration 3:
The unit price of DSP Scheme of a mutual fund is Rs. 10. The Public Offer
Price (POP) is Rs. 10.45 and the redemption price is Rs. 9.75. Calculate:
1. Front end load
2. Back end load
Solution:
Net Asset Value
Public Offer Price =
1 – Front end load
Public Offer Price is Rs. 10.45 and Net Asset Value is Rs. 10.
1. To find Front end load(F), we substitute the values;

10
10.45 = (1 – F)
10.45 (1-F) = 10
10.45- 10.45 F = 10
10.45 F = 10.45-10
0.45
F =
10.45
= 0.043
2. To find Back end Load(B), we substitute the values in the following formula:
Net Asset Value
Redemption Price =
1 – Back end load
10
9.75 =
(1 – B)
9.75 (1 – B) = 10
9.75 – 9.75 B = 10
– 9.75 B = 10 – 9.75 B
B = 0.25/ 9.75 = 2.56%

Back End Load = 2.56% Portfolio Management:339
Mutual Funds, Insurance & • Standard Deviation: It is a measure of dispersion which is the square root
Commodities
of the mean of the square of deviations around the average. It is usually
calculated on monthly returns for a time range of 3-5 years.
NOTES
• Beta: It is a measure of the Price Volatility of a fund relative the stock
market index. It is a risk measure providing statistical information of portfolios
as compared to individual stocks. Betas fall in the range of 0.80 to 1.05 for
normal stocks.
• Alpha: It is a measure of the extra return earned on a scheme based on

risk adjusted return.
• Portfolio Turnover Ratio: It is a measure of the turnover churned in a

portfolio. It is measured by the following formula:
Portfolio Turnover Ratio =

Purchase or sales (whichever is lower) during a period
Average Daily Net Assets
• Expense Ratio: It refers to the annual costs as a percentage of net assets
of a mutual fund.
16.5 Empirical Tests of Performance Evaluation of

Managed Portfolio
1. Sharpe’s Model
2. Jensen Model
3. Treynor’s Model
These models are elaborated below:
1. Sharpe’s Model: Sharpe’s index or Model is based on the fact that the
performance of a mutual fund is indicated in the returns which are in excess
of the risk free returns for a period. It assumes that the non systematic risk
is zero in a managed portfolio. And hence the standard deviation of returns
will be representative of the market or systematic risk. The excess returns
are weighed against the risk as measured by the standard deviation of the
returns. That portfolio which has the higher standard deviation is terms
better as compared to others. Sharpe’s Index is created by these excess
Portfolio Management:340 returns as follows :
Rp – T
Sp = Commodities
S.D.
Where,
NOTES
Rp = Mean returns of a Portfolio over a time period based on
NAV or market prices.
T = Risk Free return on Treasury Bills
S.D. = Standard Deviation of the returns
Sp = Sharpe’s Index
2. Jensen’s Measure: It is also known by Reward to risk ratio which is

based on the Capital Asset pricing (Model CAPM). The fundamentals of
CAPM are applicable while calculating returns. This theory states that
investors have an option to either create their own combined portfolio with
risk free assets and market portfolio or invest in a managed portfolio. The
returns of a managed portfolio should be similar to the returns generated
through CAPM Model.
Expected Returns are calculated as under:
Erp = T + B p x (Erm– T)
Where,
E rp = Expected Return from a managed portfolio
Erm = Mean return of the market portfolio
T = Risk free Return
Bp = Beta of the portfolio
The portfolio having mean return more than the expected return is better for
investment and vice versa.
3. Treynor’s Index: It is a measure of Reward to Variability. It is done by

measuring the excess returns over the risk free returns. Beta is the measure
of risk in a portfolio which indicates systematic or market risk since non
systematic risk is absent in a managed portfolio. Beta is used as a sensitivity
measure showing volatility in returns. The portfolio having beta one is
considered to be the best portfolio with the best correlation. The formula
used to calculate returns is :
Rp – T
Commodities Tp =
Bp
NOTES Where,
R p = Mean returns of portfolio either based on market prices or Net

asset values (NAV)
T = Risk free return
Bp = Beta of portfolio
Tp = Treynor’s Measure
The portfolio with the highest index is taken to be the best portfolio and vice
versa and ranking can also be done as per this index.
16.6 Mutual Fund Ratings
There are various independent rating agencies which evaluate the performance
of mutual funds periodically. In India, the various rating agencies are:

• CRISIL
• Economic Times
• Value Research India

• Morning Star Style Boxes
Style Boxes
A style box is a tool for characterizing Portfolio Risk as per the market
Check Your Progress capitalization and value added growth. This is useful since it is difficult to compare the
What are the different
performance of mutual funds with different investment objectives and strategies and
techniques for Evaluation of
Managed Portfolios? Show at different levels. This is a technique articulated by Morning Star which has classified
with necessary illustrations. fund portfolios into 9 types based on market capitalization and value growth. All the
companies are classified into one of the three categories Viz. Large Cap, Mid Cap and
Small Cap. The top 250 companies are of Large Cap Category, next 750 companies
are of Mid Cap type and the remaining companies are of Small Cap Category.

16.7 Investment in Commodities Commodities
There are other commodities which are an investment avenue for investors. These
NOTES
options are analyzed hereunder:
1. Gold and Bullion: Gold is an attractive Investment Medium and a favorite
one among investors for years. The US Dollar was also put on a Gold Standard
by the United States in 1792 by passing the Coinage Act. It means the price
of Gold was fixed on US Dollars. Slowly when the dollar was taken off the
gold standard, it was used as an Investment avenue. The gold prices since
then have skyrocketed as a result of the price bubble in prices. It resulted

into a poor investment performance. However, inspite of this, Gold still
continues to be a preferred choice of investment due to the non correlation
of gold prices and common stock prices. There are various forms in which
gold can be invested such as Gold Coins or Bullion, Gold Mining Stocks and
Gold Focused Mutual Funds. Gold Bars are bought by investors who invest
large amounts in gold.
2. Other Precious Metals and Mining Stocks: Other Precious Metals like
Platinum and Silver are also a popular investment medium but not as much
common as Gold. Platinum as well as Silver is bought in bars or coins.
The precious metals market isn’t really all about metals. Mining stocks are a
significant part of the market and one that is very much interesting for gold
and silver investors. Mining stocks is the general name for the stocks of
companies extracting metals. A precious metals investor might be interested
in mining stocks for a variety of reasons such as, mining stocks are readily
available and buying them is easy and the commissions on these transactions
are not very high. Secondly, it’s not only easy to buy mining stocks, it’s also Check Your Progress
relatively easy to sell them, meaning that there usually is a wide range of Discuss briefly the different
possible buyers and sellers so you can close out your positions very quickly. commodities as an
Investment avenue.
This would result in a high liquidity for the investors. Thirdly, unlike buying
physical gold, buying mining stocks doesn’t incur specific types of storage
costs which might be quite significant. From that stems the second subtle Security Analysis and
Mutual Funds, Insurance & point. If the leverage of gold miners at any moment is negative, this would
Commodities
mean that a move up in gold could correspond to the stock moving down.
While this might not look very attractive at first, think about times when gold
NOTES
plunges. In such periods of negative returns on gold, stocks with negative
leverage could actually go up. This would be far from certain, but it seems
that some miners can appreciate even in prolonged periods of falling gold
prices.
16.8 Real Estate
Real estate stands for Land and House Property. The primary objective of
investing in real estate is to hedge against the fluctuating prices. Various factors
determine the choice of investment in real estate such as availability of large sums of
money for investment, geographical transfer or settlement at a place, care and

maintenance of landed property and risk factor.
There are some principles to be taken into consideration while investing in Real
estate.
Principles of Investing in Real Estate:
• Price: This is the most significant factor to be considered by an investor in
relation to the use and position of the property. i.e. whether the property is to
be used as residential premises or for business or for farms etc.
• Tax: Sale of land and profit made on it is subject to Capital Gains Tax and
also property which is to be taken into consideration. Tax on purchase of

property is also to be counted to see its impact on the investors finances.
The annual value of the rented property is to be evaluated for tax impact.
• Collateral: For those investors who want to invest in real estate by taking
a loan by giving the land collateral, banks lend as a good collateral but lending
is restricted to the Market value of the collateral.
• Demand and Supply of land: The demand and supply of land depends on
the area and location and market value which in turn depends on factors like
Security Analysis and population, area, affluence, purchasing power etc.
Valuation of Real Estate: Mutual Funds, Insurance &
Commodities
The Valuation of Real Estate is done by any of the four techniques considering
Intrinsic Value namely: NOTES

1. Cost Technique: This technique consider cost to replace the property in
present form which is equal to the estimate of the land value add replacement
cost. However other factors which significantly affect the prices are ignored
in this techniques such as location, construction cost , rent income etc.
which is
2. Sales Comparison Technique: The market value of a property is estimated

relative to a benchmark. This benchmark can be the market value of the
property or Average or median Prices of the similar properties recently
bought or sold. This benchmark has to be representative of the market

conditions so as to make it a reliable source of price estimates.
3. Income Technique: The Net Operating Income (NOI) of the property

generated is considered in this method. The NOI is an estimate of the Gross
income less expenses on account of taxes, insurance, maintenance charges
etc. The discount rate is taken to convert income into present value figures.
4. Discounted Post – Tax Cash Flow Approach: In this technique, the
stream of post tax equity cash flows are taken which is discounted to find
the present value of the investment. Factors like amortization, rental income,
salvage value and required rate of return and total cost of property financed
by equity and borrowings is to be taken into consideration while calculating
the Discounted Post Tax Cash Flow.
16.9 Insurance
Insurance is a contract between the insurance company and a person for a specific
time period for protecting the life or goods or assets of the person. Accordingly insurance
contracts are of two broad categories such as :
1. Life Insurance
2. General Insurance Security Analysis and

Mutual Funds, Insurance & There are various reasons for life insurance to be considered as an
Commodities
investment medium. Due to various reasons, it is an investment mode
protection of life against risk of early death, use as a collateral for taking
NOTES
loans from banks, and recovery of a certain sum of money at the end of the
contract.
Types of Life Insurance policies:
• Whole Life Policy
• Endowment Policy
• Term Policy
1. Whole Life Policies: This type of policy is for the full life of the insurer
and the amount will be paid on death of the insured. The family of the insured
will get benefit only after his death. This policy can be of Single Premium,
Limited Premium and Continuous Premium plan.
2. Endowment Policy: This type of policy gives benefits to the investors in
the form of savings in income, life cover and tax benefits. Under this policy,
the insured is paid a certain sum of money to the beneficiary on death of the
insured during the policy period or paid to the insurer if he survives the
period. There are again different variants of this policy such as Ordinary
Endowment, Double Endowment, Anticipated Endowment, Educational
Endowment etc.
3. Term Policy: In Term Policy, there is a contract for payment of the sum
insured on the event of death of the insured during the term specified in the
policy. If the insured survives the term mentioned then the contract expires
and is treated as cancelled. The different types of term policies are Straight
Term Policy, Convertible Policy, Decreasing Term Policy, Renewable Term

Policy etc.

16.10 Summary Commodities
• Mutual Funds are financial intermediaries in the investment process. In a

NOTES
mutual fund, the resources of investors are pooled together and invested in
diversified portfolio. These are managed by Asset Management Companies
which operate under SEBI guidelines. The Asset
• Mutual Funds are collective investment vehicles which are based on the
“Trusteeship” Principle. It means that the fund is managed on behalf of
other individuals for their benefit and seeks to provide protection to the person
on whose behalf it is managed.

• The common features of a Mutual Fund are Liquidity, Diversification,
Professional Management, Risk Sharing and Tax Benefits
• The sponsor is like the promoter which may be a bank or financial institution,
Mutual Fund Trustees are like a trust formed under the Indian Trust Act,
1881 and it should be registered with SEBI, Asset Management Company
(AMC) acts as an investment manager which is appointed by trustees

oversee the activities of the trust, Custodians are the ones who handle back
office operations and oversees the delivery of securities, collection of
revenue, dividend and deciding the asset composition.

• Managed portfolio consists of Mutual funds, Portfolio Management Schemes
and Individual portfolios.
• The measures used for Evaluation of the performance of a mutual fund are
Net Asset Value (NAV), Standard Deviation, Beta, Alpha , Portfolio Turnover
Ratio and Expense Ratio
• The Empirical Tests of Performance Evaluation of Managed Portfolio are

Sharpe’s Model, Jensen Model and Treynor’s Model
• There are various rating agencies which evaluate the performance of mutual
funds periodically such as CRISIL, Economic Times, Value Research India

and Morning Star Style Boxes (in the US)
• A style box is a tool for characterizing Portfolio Risk as per the market
capitalization and value added growth.

Mutual Funds, Insurance & • There are other commodities which are an investment avenue for investors
Commodities
such as Gold and Bullion , Other Precious Metals and Mining Stocks such
as Platinum and Silver.

NOTES
• Real estate stands for Land and House Property and the primary objective
of investing in real estate is to hedge against the fluctuating prices.
• Insurance is a contract between the insurance company and a person for a
specific time period for protecting the life or goods or assets of the person.
• Insurance contracts are of two broad categories: such as Life Insurance
and General Insurance.
16.11 Key Terms
1. Alpha: It is a measure of the difference between the fund’s actual returns
and expected returns.
2. Beta: It is a measure of the sensitivity of a fund to the market movements.
3. Sponsor: The sponsor is like the promoter which may be a bank or financial
institution. SEBI license is required to operate as a Sponsor for which certain

terms and conditions are to be met for capital, profits, performance etc.
4. Asset Management Company (AMC): The AMC acts as an investment

manager which is appointed by trustees oversee the activities of the trust
consisting of a team of experts who are responsible for the investment of
the funds collected.
5. Registrar and Share Transfer Agents: They manage the investor related
matters like issuing and redeeming units, preparing and circulating annual
reports etc.
6. Net Asset Value (NAV) : It is the actual value if a share on a specific day,
which is computed by adding the Fair Market Value of investments,
Receivables, Accrued Income, Other assets & deducting Accrued expenses

- Payables - Other Liabilities divide by the number of shares or units
outstanding
7. Entry Load : It also known as Front End load is charged on the investor on
Portfolio Management:348 purchases of mutual fund units
8. Exit load: It is also known as Back End load is charged on the investor at Mutual Funds, Insurance &
Commodities
the time of redeeming the mutual fund units.
9. Standard Deviation: It is a measure of dispersion which is the square root

NOTES
of the mean of the square of deviations around the average.
10. Portfolio Turnover Ratio: It is a measure of the turnover churned in a
portfolio. It is measured by the following formula:
11. Expense Ratio: It refers to the annual costs as a percentage of net assets
of a mutual fund.
12. Sharpe’s Model: This Model is based on the fact that the performance of
a mutual fund is indicated in the returns which are in excess of the risk free
returns for a period.
13. Jensen’s Measure: It is also known by Reward to risk ratio which is
based on the Capital Asset pricing Model (CAPM).
14. Treynor’s Index: It is a measure of Reward to Variability by measuring
the excess returns over the risk free returns.
15. Style Box : It is a tool for characterizing Portfolio Risk as per the market
capitalization and value added growth and is used to compare the
performance of mutual funds with different investment objectives and

strategies and at different levels.

1. Mutual Funds are collective investment vehicles which are based on this
principle.
a. Custodian
b. Trusteeship
c. Agency

Mutual Funds, Insurance & 2. Until up to 1986 the mutual fund industry was monopolized by
Commodities
a. Unit Trust of India (UTI)
NOTES b. Banks
c. RBI
d. Government
3. It is measured by the variations of returns over a period of time either by
standard deviation or by other techniques.
a. Return
b. Standard Deviation
c. Beta
d. Risk
4. This risk is due to generic market forces arises on account of system
variables:
a. Market Rate Risk
b. Interest Rate Risk
c. Inflation Risk
d. All the above
5. Entry Load also known as this is charged on the investor on purchases of
mutual fund units
a. Front End Load
b. Back End Load
c. Exit Load
6. This is also known as Back End load is charged on the investor at the time of
redeeming the mutual fund units.
a. Front End Load
b. Back End Load
c. Exit Load

7. It is a measure of dispersion which is the square root of the mean of the Mutual Funds, Insurance &
Commodities
square of deviations around the average.
a. Mean
NOTES
b. Standard deviation
c. Alpha
d. Beta
8. It is a measure of the Price Volatility of a fund relative the stock market

index.
a. Mean
b. Standard deviation
c. Alpha
d. Beta
9. The primary objective of investing in real estate is to
a. Have diversification in investments
b. Earn Voluminous returns
c. Hedge against the fluctuating prices.
d. Tax Benefits
10. This type of policy is for the full life of the insurer and the amount will be
paid on death of the insured.
a. Whole Life Policy
d. Endowment Policy
c. Term Policy
11. This type of policy gives benefits to the investors in the form of savings in
income, life cover and tax benefits.
a. Whole Life Policy
b. Endowment Policy
c. Term Policy

Mutual Funds, Insurance & 12. In this Policy, there is a contract for payment of the sum insured on the
Commodities
event of death of the insured during the term specified in the policy.
NOTES a. Whole Life Policy
b. Endowment Policy
c. Term Policy

1. Explain the Features of Mutual Funds as an Investment Medium and what
are its constituents?
2. What are the different types of Mutual Funds based on Investment Objective,
Current Income Potential and stability of Principal amount of investment?
3. What are the different techniques for Evaluation of Managed Portfolios? .
4. What are the different commodities available as a viable Investment avenue.
16.12.3 Exercises
Ex. 1 The units of a mutual fund had a unit price of Rs. 25. The public Offer
Price is Rs. 24.50 and the redemption price is Rs. 26.25. Calculate the
Front end load and Back end load.
Ex. 2 A mutual fund has Rs. 10 crores of Portfolio assets and Rs. 4 crores in
short term liabilities. If the number of shares outstanding is 1.5 crores,
what is the Net Asset Value of the Fund?
16.12.4 Assignment
1. Visit the Morning Star website- www.morningstar.com
2. Select a mutual fund and evaluate its performance from the Fund Menu
Link as on today.
3. Compare and analyze that fund’s performance year wise taking current
year, previous year and preceding three years.
4. Make use of Mutual Fund Screener by which you can search for mutual
Security Analysis and funds as per your desired style

5. Repeat for other Mutual Fund Categories and decide on your investment Mutual Funds, Insurance &
Commodities
decision to invest in which fund.
NOTES
“ Investment Analysis and Portfolio Management: Fourth Edition” Prasanna

Chandra, Mc Graw Hill, New Delhi 2015.


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FMG 304

MBA : SECOND YEAR

SECURITY ANALYSIS & PORTFOLIO MANAGEMENT

Unit 2 : Financial Markets & Institutions 23

Unit 3 : Investment Avenues in India 42

Unit 4 : Analysis of Risk And Return 58

Unit 5 : Fundamental Analysis Part A : Economic Analysis 81

Unit 6 : Fundamental Analysis Part B : Industry Analysis 102

Unit 7 : Fundamental Analysis Part C : Company Analysis 121

Unit 8 : Technical Analysis 151

Unit 9 : Behavioural Finance Anomalies 174

Unit 10 : Valuation of Shares and Business 193

Unit 11 : Fixed Income Securities Valuation 215

Unit 12 : Portfolio Management :Analysis selection Revision & Evaluation 236

Unit 13 : Theories of Portfolio Management 257

Unit 14 : Derivatives 277

Unit 15 : Investments And Tax Planning 303

Unit 16 : Mutual Funds, Insurance & Commodities 331

Prof. Vinay. K. Nangia

Instructional Technology Editing & Programme Co-ordinator

Dr. Varadraj Bapat

UNIT 1 INTRODUCTION TO SECURITY ANALYSIS AND PORTFOLIO

UNIT 2 FINANCIAL MARKETS AND INSTITUTIONS

UNIT 3 INVESTMENT AVENUES IN INDIA

UNIT 4 ANALYSIS OF RISK AND RETURN

UNIT 5 FUNDAMENTAL ANALYSIS PART A : ECONOMIC ANALYSIS

UNIT 6 FUNDAMENTAL ANALYSIS PART B: INDUSTRY ANALYSIS

UNIT 7 FUNDAMENTAL ANALYSIS PART C: COMPANY ANALYSIS

UNIT 8 TECHNICAL ANALYSIS

UNIT 9 BEHAVIORAL FINANCE ANOMALIES

UNIT 10 VALUATION OF SHARES AND BUSINESS

UNIT 11 FIXED INCOME SECURITIES VALUATION

UNIT 13 THEORIES OF PORTFOLIO MANAGEMENT

UNIT 15 INVESTMENTS AND TAX PLANNING

UNIT 16 MUTUAL FUNDS, INSURANCE AND COMMODITIES

1.1 Unit Objectives

1.2 Security analysis

1.3 Portfolio Management

1.4 The Investment Process

1.5 Investment versus Financing

1.6 Types of investments

1.7 Guidelines for Investment Decisions\

1.8 Classification of Investors

1.10 Key Terms

1.11 Questions and Exercises

1.11.1 Multiple Choice Questions

1.11.2 Theory Questions

1.12 Further Readings and References

Security Analysis and Portfolio Management is of relative significance in the

light of the contemporary investment climate characterized by the emergence of a

mechanisms. There exists different investment mediums which can be availed by

investors according to their requirements and categories

Ø Understand the concept of Portfolio Management

Ø Learn the Investment Process

Ø Know the differences between Investment and Financing

Ø Analyse the types of Investments

Ø Study the Guidelines for Investment Decisions

Ø Learn the Classification of Investors

1.2 Security Analysis