MMPF-004

Indira Gandhi
Security Analysis and
National Open University Portfolio Management
School of Management Studies

Block

1
AN OVERVIEW
UNIT 1 7
Introduction to Investment

UNIT 2 28
Securities Market

UNIT 3 46
Risk and Return

UNIT 4 69
Investment Theories
COURSE DESIGN AND PREPARATION TEAM
Prof M S S Raju Prof. M.S Narasimhan
Director, Indian Institute of Management
School of Management Studies,
Bangalore
IGNOU, New Delhi
Prof. Braj Kishor
Prof Peeush Ranjan Agrawal
Deptt. of Business Management
Former Vice Chancellor
Osmania University
APS University, Rewa
Hyderabad
Madhya Pradesh
Prof. Rattan K. Sharma
Prof Niti Nandini Chatnani
Indian Institute of Management
Indian Institute of Foreign Trade
Lucknow
New Delhi
Ms. Hemalatha Chandrahasan
Prof. P. V. Rajeev
UTI Institute of Capital Markets
Banaras Hindu University
Bombay
Varanasi
Dr. Suresh N. Kulkarni
Prof. Tanuj Nandan
Institute of Peace Research and Action
MNNIT, Prayagraj
New Delhi
Prof Shveta Singh
Prof. S.K. Choudhari
IIT, New Delhi
Management Development Institute,
Prof. K Ravi Sankar Gurgaon
School of Management Studies,
Prof. U. Damodaran
IGNOU, New Delhi
Xavier Institute of Management
Prof Anjali Ramteke Bhubaneshwar
School of Management Studies,
Mr. Bimal Aggarwal
IGNOU, New Delhi
Project Executive
Prof. Kamal Vagrecha PNB Mutual Fund, New Delhi
School of Management Studies,
Prof. R.K. Grover
IGNOU, New Delhi
School of Management Studies
Prof Rajeev Kumar Shukla IGNOU, New Delhi
School of Management Studies,
Dr S.P. Parashar
IGNOU, New Delhi
School of Management Studies
Dr. Leena Singh IGNOU, New Delhi
School of Management Studies,
Prof. B.B. Khanna
IGNOU, New Delhi
School of Management Studies
Mr. Saurabh Jain IGNOU, New Delhi
School of Management Studies,
IGNOU, New Delhi

COURSE COORDINATOR AND EDITOR

Prof. Neeti Agrawal
School of Management Studies
IGNOU, New Delhi
Acknowledgement: Parts of this course have been adapted and updated from the course MMPF-004: security
Analysis and Porttolio Management, SOMS, IGNOU. The names and the profile of the experts involved in
the preparation of course MMPF-004 are as on the year of initial print are mentioned in italics.

MATERIAL PRODUCTION
Mr. Tilak Raj
Assistant Registrar, MPDD, IGNOU, New Delhi
April, 2023
© Indira Gandhi National Open University, 2023
ISBN: 978-93-5568-814-9
All rights reserved. No part of this work may be reproduced in any form, by mimeograph or any other means, without
permission in writing from the Indira Gandhi National Open University.
Further information on the Indira Gandhi National Open University courses may be obtained from the University’s
office at MaidanGarhi, New Delhi-110 068.
Printed and published on behalf of the Indira Gandhi National Open University, New Delhi, by the Registrar,
MPDD, IGNOU.
Laser typeset by
Printed at:Nutan Printers, Okhla Industrial Area, Phase I, New Delhi-20
MMPC 004: SECURITY ANALYSIS AND
PORTFOLIO MANAGEMENT
Dear learners,
Security analysis and portfolio management are two interconnected fields of study that
deal with investment decision-making. Security analysis involves the process of
evaluating financial instruments or securities, such as stocks, bonds, and derivatives, to
determine their investment value. The aim of security analysis is to identify securities
that are undervalued or overvalued in the market and make informed investment decisions
based on this analysis.
Portfolio management, on the other hand, is the process of selecting and managing a
group of securities, known as a portfolio, that meets the investment objectives and risk
tolerance of an investor. The primary goal of portfolio management is to maximize
returns while minimizing risk by diversifying investments across different asset classes,
sectors, and geographic regions.
Effective security analysis and portfolio management require a deep understanding of
financial markets, economic trends, and risk management strategies. It involves analyzing
financial statements, market trends, and macroeconomic factors to identify attractive
investment opportunities and create a well-diversified portfolio. Security analysis and
portfolio management are critical components of investment decision-making that can
help investors achieve their long-term financial goals while managing risk.
The course is divided into four blocks and has 15 units in all. The course outline is given
below.
BLOCK 1 AN OVERVIEW
Unit 1 Introduction to Investment
Unit 2 Securities Market
Unit 3 Risk and Return
Unit 4 Investment Theories
BLOCK 2 SECURITY ANALYSIS
Unit 5 Economy Analysis
Unit 6 Industry Analysis
Unit 7 Company Analysis
Unit 8
Unit 9 Valuation of Securities
BLOCK 3 PORTFOLIO MANAGEMENT
Unit 10 Portfolio Analysis
Unit11 Portfolio Selection
Unit12 Capital Market Theory
Unit 13
BLOCK 4
Unit14 Mutual Funds
Unit 15 Performance Evaluation of Managed Portfolio
An Overview The primary objectives of learning security analysis and portfolio management are as
follows:
1. To understand the fundamental concepts and principles of investment analysis and
portfolio management, including the various types of securities, financial markets,
and investment strategies.
2. To learn the techniques and tools used to evaluate the intrinsic value of securities
and identify undervalued or overvalued securities, such as ratio analysis, financial
statement analysis, and cash flow analysis.
3. To develop an understanding of different types of risk and how to measure and
manage them, including market risk, credit risk, liquidity risk, and operational risk.
4. To gain knowledge of the various approaches to portfolio management, including
passive and active management, strategic and tactical asset allocation, and factor-
based investing.
5. To learn how to construct a diversified portfolio by selecting securities that
complement each other and balance risk and return.
6. To develop critical thinking and analytical skills to make informed investment
decisions and manage a portfolio over time.

4
 Introduction to
BLOCK 1 AN OVERVIEW Investment

This block comprises of four units and aims to provide a general backdrop to
security analysis and portfolio management.
In Unit 1: Introduction to Investment discusses the nature and scope of
Investment Decisions. The unit also defines the term ‘investment’ and discusses
the investment process and investment alternatives available in securities markets.
Unit 2: Securities Market discusses the different types of markets. It discusses
the regulation aspects of securities market. The unit also covers the different
types of stock exchanges operating in the country.
Unit 3: Risk and Return covers components of Investment Risk, and stresses
on ‘risk’ as a crucial factor in all investment decisions. It attempts to discuss the
overall investment risk into recognized elements and then regroups them into
broad terrains of systematic and unsystematic or diversifiable risk categories.
Unit 4: Investment Theories discusses the concept of investment theories and
various forms of efficiency and their anomalies and limitations. , ‘Efficient Market
Hypothesis’, highlights various aspects of the hypothesis that markets are efficient.
It describes various forms of market efficiency. It also highlights the implications
of EMH for security analysis and portfolio management.

5
An Overview

6
 Introduction to
UNIT 1 INTRODUCTION TO INVESTMENT Investment

Objectives
After reading this unit, you should be able to:
x Explain the concept of investment;
x Understand the difference between speculation and gambling;
x Explain the investment environment;
x Know different types of investment.
Structure
1.1 Introduction
1.2 Concept of investment
1.3 Speculation and Gambling
1.4 Investment Objectives
1.5 Investment Environment
1.6 Types of Investments
1.7 Investment Process
1.8 Summary
1.9 Key words
1.10 Self Assessment Questions
1.11 Further Readings

1.1 INTRODUCTION
Individuals like you invest money for various reasons. It could be:
x You or your family may be earning more than what is required for monthly
expenses and thus would like to keep the money in a safe place and also
allow the savings to earn a return during the period.
x You may not have regular surplus but may get occasional one-time surplus
earnings such as annual bonus from your employer or sale of some family
property. You would like to keep such money for some time, when you
don’t required, in some safe place and also allow such savings to earn a
return during the period.
We also invest money on education of our children like our parents did. Just
as individuals do, organizations too invest to increase revenue. For example,
you might have read news items like X Industries investing `1000 Cr. for
expansion of its petrochemical division.

7
An Overview The above examples underline the following characteristics of an ‘investment’
decision: One, it involves the commitment of funds available with you or that
you would be getting in the future. Two, the investment leads to acquisition
of a plot, house, or shares and debentures. Three, the physical or financial
assets you have acquired is expected to give certain benefits in the future
periods. The benefits may be in the form of regular revenue over a period of
time like interest or dividend or sales or appreciation after some point of time
as normally happens in the case of investments in land or precious metals.
The investment decisions relate to financial assets bulk of which comprises
pieces of paper evidencing a claim of the holder (i.e., investor) over the issuer
(i.e., user of funds). For example, when you buy shares of, say, A or B
organization, the share certificate that is handed over to you is a piece of
paper which testifies your ownership of the number of shares stated in the
certificate. It represents your financial claim (as a holder of the said shares)
over A or B, (as issuers of the shares). The same can be said for any security
like a debenture, a warrant a convertible, etc., of an organization. Unlike
promoters of organizations, several buyers of these securities hold them for
limited period and then sell them. The reasons for selling the financial assets
could vary from person to person. If an investor needs money for other
expenditure like marriage or education, s/he could sell some of the financial
assets like shares/ bonds. Similarly, if an investor finds that her/his expected
return for the financial asset is realized, s/he can sell the same and use the
money to buy some other securities. It is also possible that some of these
high-risk takers speculate in financial securities. Investors of different kinds
look out for investments, which can be sold in organized markets with ease
and at best obtainable prices. Financial assets, which are tradable with ease
and at best prices in organized markets, are known as ‘marketable securities’.
In this unit we are going to study various aspects of investment.

1.2 CONCEPT OF INVESTMENT

It may be appropriate at this juncture to define the term ‘investment’ in a
general sense. Investment takes place when an investor postpones her/his
consumption, which is initially converted into savings and subsequently into
investments. By not spending the entire amount of your salary, you are saving
a part of your salary income for the future needs. Savings of this kind run into
risk of loss of value because of inflation. In order to prevent erosion of value
of your savings, the amount saved has to be invested at least by depositing
the amount in savings bank account. You have several options if the money
you are saving is not required in the near future and the number of options
increases further, if you are willing to assume a bit of risk in your investment.
Remember without taking risk, it is not possible to expect a higher return.
Some of the investment options available to you are time deposit (fixed
deposit) of bank, bonds and debenture of financial institutions or organizations,
mutual funds, futures, options, etc.
It is interesting to observe that all investment decisions arise from a ‘trade-
off’ between current and future consumption. An example would make this
8 idea clear. We can assume an individual who has ` 50,000, which s/he can
either spend on current consumption or invest, say, for one year at 11 per cent Introduction to
interest. This person’s current consumption (Co) can range from ` zero (when Investment
s/he invests the whole of ` 50,000) to ` 50,000 (when s/he does not invest a
single rupee).

Figure 1.1: Trade-off between present and future consumption

Similarly, her/his future consumption (CI) can be as high as ` 55,500 (when

s/he invests the whole of ` 50,000 at 11 per cent per annum and ends up with
a total wealth of ` 50,000 + ` 5,500 = ` 55,500 at the end of the year, ` 5,500
being interest earnings on ` 50,000 at 11 per cent) to as low as ` zero (when
s/he consumes the whole of ` 50,000 right now).
In most such cases, individuals would consume a part and invest the rest.
Such a situation is called a ‘trade-off’ between current and future possibilities
for our hypothetical individual on the trade-off function. Our investor is on
point `X’ which suggests that ‘s/he spends ` 30,000 today and invests the
balance ` 20,000 to get a total sum of ` 22,000, which includes interest of
` 2,000, at 11 per cent after one year.

Having defined ‘investment’ in terms of ‘postponed consumption’ we must

get ready to answer an inescapable question viz., why should a person postpone
her/his present consumption? This question acquires added significance
because we know that individuals generally prefer current consumption to
future consumption. And if they are required to invest or postpone current
consumption there must be commensurate inducement. This underlines the
need for a positive rate of return on all potential investment without which a
person would prefer to consume all her/his income today rather than tomorrow.
Such an investment /consumption behaviour is based on an important concept
known as ‘time value of money’. This concept signifies ‘a rupee today is
worth more than tomorrow’. The ‘tomorrow’ must promise a larger wealth to
give incentive to forego current consumption. The next natural question is
how much the return should s/he larger to attract investment?
9
An Overview You will readily notice that a nominal rate of return may well be fully
swallowed away by the inflation. For example, if you earn an interest rate
(nominal) of 11 per cent for one year on your investment and face the threat
of 11 per cent price rise (inflation) too during that year, where do you stand in
terms of purchasing power of your money? What happens in a situation like
this is that the 11 per cent nominal return is neutralized by 11 per cent inflation
and you remain after one year where you were a year ago. It is, therefore,
natural that an investor would be induced to postpone consumption today
only if her/his command over goods and services does not get diluted over
time. Thus, if s/he gets 11 per cent nominal interest and 11 per cent is the rate
of inflation, her/his real rate of return would be zero. In the event of inflation
what induce investors to postpone current consumption are the real rate of
return and not just the monetary rate of return. There is yet another dimension
to the rate of return as an incentive to invest. For example, if a person buys,
say, government securities s/he is completely assured of all payments viz.,
interest and principal. In such cases, a relatively lower rate of return is adequate
as an incentive. But if the avenue of investment is an organization’s debenture,
the probability of default does exist even if the rate of interest and the
repayment schedules are known in advance. The investor here perceives some
risk and would insist upon an additional compensation. In other words, the
investor requires a risk premium over and above the risk free rate.
This extra reward or risk premium would have to be substantially greater in
the case of shares of organizations where the dividend rates are not
ascertainable in advance and where payment of such dividends and invested
sums are not at all assured. What we are trying to underline through these
examples is the ‘risk’ factor which affects the expected rates of return by
investors. In all these cases, investors demand a risk premium. It would thus
be seen that the investor’s required rate of return would be an aggregate of
the risk-free real rate, expected rate of inflation, and risk premium.
Investments in securities on average offer adequate return to compensate the
risk assumed by the investors. But one has to wait for a longer period to
realize such extra return for the additional risk assumed particularly in case
of investments in stocks. In other words, if the holding period of an investment
is short, then high-risk securities may not offer adequate return to compensate
the risk, you have assumed. You might have recognized the existence of
‘speculators’ in the securities markets. They invest in high risk securities for
a short period and hence exposed to high level of risk.

1.3 SPECULATION AND GAMBLING

Speculation and gambling are two distinct ways of increasing wealth in the
face of risk or uncertainty. However, in the world of investing, these two
terms are very different. Gambling is the act of putting money into an event
with an uncertain outcome in the hope of winning more money, whereas
speculation is the act of taking a calculated risk in an uncertain outcome.
Speculation involves some sort of expected positive return on investment,
even if the end result is a loss. While the expected return on gambling is
10 negative for the player, some people may be fortunate and win.
Speculation Introduction to
Investment
Before engaging in a financial transaction, speculators calculate risk and
conduct research. A speculator buys or sells assets in the hope of making a
larger profit than he risks. A speculator takes risks, knowing that the more
risk they take, the greater is their potential gain. They are also aware that
they may lose more than they gain.
An investor, for example, may speculate that a market index will rise due to
strong economic data by purchasing one contract in one market futures
contract. If their analysis is correct, they may be able to sell the futures contract
for a higher price than they paid in the short to medium term. However, if
they are incorrect, the investor may suffer a loss greater than expected.
Speculator vs Investor
Speculators may lose their entire wealth or become rich in a short period of
time. How are they different from that of normal investors? We can distinguish
the two operators as follows:
i) The time-horizon of a speculator is short while that of the investor is
long.
ii) The investor expects a ‘good’ return and a consistent performance over
time but the speculator expects abnormal returns earned quickly over
short periods.
iii) The investor generally sticks to her/his investment, but the speculator
makes rapid shifts to greener pastures. S/he moves from one stock to
other for a small profit.
iv) The investor is risk-averse but the speculator takes greater risks. Often,
speculators take risk by entering into margin trading (i.e. use borrowed
funds) to increase the volume and her/his exposure in the market.
If speculation is high-risk game, why do exchanges allow such trading? They
essentially provide liquidity for the securities and often match the demand
and supply of the market.
For example, positive news on an organization may attract a large demand
for the stock. In the absence of any sellers, the price will shoot up. Some
speculators may take a different view and are willing to sell the stock to meet
the excess demand of the market. Similarly, a mutual fund may wants to sell
1 lakh shares of an organization. If there are limited buyers for the stock, the
stock price would crash. Again, speculators would buy the stock in anticipation
of selling the same at a small profit once the demand for the stock picks up in
the market.
Gambling
Gambling, in contrast to speculation, is a game of chance. The odds are
generally stacked against gamblers. When gambling, the chances of losing an
investment are usually greater than the chances of winning more than the
investment. Gambling, as opposed to speculation, carries a higher risk of loss.
11
An Overview For example, a gambler opts to play a game of American roulette instead of
speculating in the stock market. Only single numbers are bet on by the gambler.
The payout, however, is only 35 to 1, while the odds against them winning
are 37 to 1. So, if a gambler bets $2 on a single number, their potential gambling
income is $160 (80*$2), but their chances of winning are about 1/37.
Key Differences
Although there are some superficial similarities between the two concepts, a
strict definition of both speculation and gambling reveals the fundamental
differences. A standard dictionary defines speculation as a risky type of
investment, whereas investing means to invest money in something that offers
profitable returns, particularly interest or income. According to the same
dictionary, gambling is defined as participating in any stakes game. To stake
or risk money or anything of value on the outcome of something involving
chance; bet; wager is gambling.
The act of conducting a financial transaction that has a significant risk of
losing value but also holds the expectation of a significant gain or other major
value is referred to as speculation. The risk of loss in speculation is more than
offset by the possibility of a large gain or other recompense. Some market
professionals regard speculators as gamblers, but a healthy market includes
not only hedgers and arbitrageurs, but also speculators. A hedger is a risk-
averse investor who purchases positions that are diametrically opposed to
those already held. If a hedger owned 500 shares of Marathon Oil and was
concerned that the price of oil would soon fall significantly, they could short
sell the stock, purchase a put option, or use one of the other options of hedging
strategies.
While speculation is risky, it frequently has a positive expected return, even
if that return never materialises. Gambling, on the other hand, always has a
negative expected return—the house always wins. Gambling tendencies go
much deeper than most people realise and far beyond the standard definitions.
Gambling can take the form of feeling the need to socially prove oneself or
acting in a way to be socially accepted, which leads to action in a field one
knows little about.
Market gambling is frequently seen in people who do it primarily for the
emotional high they get from the excitement and action of the markets. Finally,
relying on emotion or a must-win attitude to generate profits rather than trading
in a methodical and tested system indicates that the individual is gambling in
the markets and is unlikely to succeed over a long period of time.
Activity 1
i) A young couple buys a flat for ` 30 lakh with a 25 per cent down payment
and the balance in 100 equal monthly instalments. Would you consider
the investment a case of postponed consumption? Justify.
.............................................................................................................
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12
 ............................................................................................................. Introduction to
Investment
.............................................................................................................
ii) Distinguish between a speculator and an investor.
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1.4 INVESTMENT OBJECTIVES

Asset managers use investment objectives to determine the best portfolio mix
for a client. The investment objective guides the selection of investments. An
investor questionnaire frequently defines financial goals and objectives and
determines portfolio asset allocation based on an individual’s time horizon,
risk tolerance, and financial situation. Features of investment goals are as
follows:
x A set of goals that determines an investor’s financial portfolio is known
as an investment objective.
x Using an investment objective, a financial advisor determines the best
strategy for achieving the client’s objectives.
x The risk tolerance and time horizon of an investor aid in determining an
investment goal.
Understanding an Investment Goal
An individual’s investment objective, which is typically based on one of
four strategies that include income, growth, and income, growth, or
trading, clarifies investment ideas to help achieve an individual’s financial
goals.
Individuals may provide information such as annual income and net worth,
average annual expenses, timeline for withdrawing funds, and the
maximum decrease in the value of the portfolio with which the investor
is comfortable. The portfolio is tailored based on the answers to these
questions, and a strategy is defined as an investment goal.
Tolerance for Risk
Risk tolerance is the level of risk that an investor is willing to accept
given the volatility of an investment’s value. A client with a high risk
tolerance who is looking for growth may have a short-term aggressive
portfolio comprised of stocks and trading opportunities. A balanced
portfolio of growth and income instruments, including stocks and bonds,
may be appropriate for a moderate-risk investor. A conservative investor
with a low risk tolerance may concentrate on an income-producing
portfolio comprised of dividends and bonds. 13
An Overview Factors Influencing a Person’s Investment Goal
Other factors that influence an individual’s investment decisions, in
addition to time horizon and risk profile, include income, capital gains
tax, dividend tax, commission and fees for actively managed portfolios,
and total wealth, which may include assets such as Social Security benefits,
expected inheritance, and pension value.
Questionnaire on Investment Objectives
Investors can find a variety of free questionnaires on brokerage websites.
When deciding not to use a personal advisor, however, it is critical to
review the questionnaire’s assumptions and limitations as well as accept
the organization’s terms and conditions. Because the information that will
be provided is highly sensitive, an investment objective is typically not
formally completed until a client has decided to use the services of a
financial planner or advisor.
When an investor’s financial circumstances or goals change, it may be
beneficial to re-complete an investment objective questionnaire and
reallocate investments in a portfolio.
Types of investment objectives
There are two types of investiment objectives viz.a.viz. primary and
secondary investment objectives. There are discussed below.
Primary Investment Objectives
Safety
Everyone wants their money to be safe and secure. If you are a conservative
investor who wants to receive their initial capital investment on time and
without losses, then the safety objective is critical to you. However, you
should be aware that no investment is completely risk-free. However, if
your primary goal is safety, you can make investments with low or reduced
risks. Naturally, the returns on these investments will be low and may not
keep pace with rising inflation. Government bonds, bank securities, and
money market instruments are examples of safe investment objectives.
Capital Gain
When you want to grow your wealth, capital gain or capital appreciation
is an important investment goal. While safety is critical, many people
invest heavily in order for it to grow. Capital gains can be obtained through
conservative growth, aggressive growth, or speculation.
Conservative growth refers to the process by which investors construct
an investment portfolio that will generate wealth over time. When investors
make a risky investment in stocks, they are looking for both short and
long-term gains. Speculation occurs when investors attempt to maximise
returns by trading shares and securities through share price speculation.
Capital gains necessitate a great deal of forecasting and determining which
stock to buy when. They also attract taxes.
14
 Income Introduction to
Investment
The income investment objective, as the name implies, means investing
to generate a source of income for you. Dividends, interest, and yields are
all forms of income. These investment goals have a high level of risk and
low stability, but they also have higher returns. Income objectives are
popular among conservative investors due to their attractive returns and
ability to keep up with inflation. The stock market is an example of an
income investment objective; it has high risks and high returns.
Secondary Investment Objectives
Liquidity
Another investment goal is the liquidity of the investment you make. The
ability to instantly trade/sell/convert assets into cash with ease in the market
and with minimal risk of loss is referred to as liquidity. While some
securities are easier to liquidate than others, this is not always the case.
Most investors prefer to invest in securities that are easy to liquidate and
use in an emergency. They try to keep a portion of their total investments
in readily marketable securities, if not entirely. If liquidity is one of your
primary goals, you should consider investing in such securities as well.
Tax Savings
Did you know that capital gains income is taxed differently than ordinary
income? Yes, taxes on such income are lower than taxes on interest or
salary-based income. As a result, tax savings are a popular investment
goal for many people. Tax-free savings accounts and the National Pension
Scheme are two examples of tax-saving investments. Furthermore, life
insurance policies and tax-saving mutual funds are popular ways to save
taxes while earning good returns. Actual returns on investment are after-
tax returns. As a result, before making an investment decision, it is best to
research and learn about all tax considerations and exemptions available
to you in order to reduce your tax burden.

1.5 INVESTMENT ENVIRONMENT

A reading of the earlier sections has provided some understanding on the
basic principles of investment. Suppose you are able to frame your investment
objective and also identified securities that are to be purchased. Now you
need to deal with the market for the purchase and sale of securities. An
understanding of the operational details of the market would be useful.
Investment decisions to buy/sell securities taken by individuals and institutions
are carried through a set of rules and regulations. There are markets - money
and capital - that function subject to such rules and established procedures
and are, in turn, regulated by legally constituted authority. Then there are
securities or financial instruments which are the objects of purchase and sale.
Finally, the mechanism, which expedites transfers from one owner to another,
comprises a host of intermediaries. All these elements comprise the investment
environment. Investors have to be fully aware of this environment for making
optimal investment decisions. 15
An Overview The three elements of the investment environment are as follows:
FINANCIAL INSTRUMENTS
Financial assets or instruments can be classified in a variety of ways. We will
classify them into creditorship and ownership securities on the basis of the
nature of the buyer’s commitment. The description will then be split into
public and private issues differentiating the two major forms of issuance.
Creditorship Securities
Debt instruments furnish an evidence of indebtedness of the issuer to the
buyer. Periodic payments on such instruments are generally mandatory and
all of them provide for the eventual repayment at maturity of the principal
amount. Securities may also be sold at a price below the eventual redemption
price, the difference between the redemption price and the sale price
constituting the interest. For example, a buyer of a ` 100 bond/debenture may
receive an interest at 6 per cent for one year in one of the following ways:
a) s/he pays ` 100 at the time of investment and receives ` 106 at the end of
one year, or
b) s/he pays ` 94:30 at the beginning and receives ` 100 at maturity i.e.,
s/he receives 6 per cent of ` 94.30 that is equal to the difference between
` 100 (redemption price) and ` 94.30 (issue price).

The latter arrangements are known as zero-interest bonds. The interest amount
in rupees measured as a percent of the par value of a debt instrument is known
as nominal or coupon rate of interest. For example, ` 28 payable per year on
a debenture whose face/par value is ` 200 yields a coupon rate of 14 per cent
per annum.
Debt instruments can be issued by public bodies and governments and also
by private business organizations.
Public Debt Instruments: Government issues debt instruments for long and
short periods. They are rated the best in terms of quality and are risk-free. A
common term used to designate them is ‘gilt-edged-securities’. The 182-day
treasury bills issued by the Government of India are examples of short-term
instruments. State governments and local bodies also issue series of loans
and bonds. Banks, insurance, pension and provident funds, and several other
organizations buy government debt instruments in compliance with their
statutory obligations. Such debt instruments are usually over-subscribed. You
can refer money market page of any one of the financial dailies, where you
can find the list of short-term and long-term securities that were bought and
sold on a particular day.
Private Debt Instruments: These are issued by private business organizations,
which are incorporated as organizations under the Organizations Act, 1956.
Generally these instruments are secured by a mortgage on the fixed assets of
a organization. In addition to plain debt instruments, there are several
variations. A very popular variety of such debentures are‘convertible’ whereby
either the whole or a part of the par value of a debenture is convertible (either
16
automatically or at the option of investors) on the expiry of a stipulated period Introduction to
after issue. The terms of conversion are stated in advance. There may be a Investment
series of conversions and conversion price may differ from period to period.
The PSU bonds are issued to the general public and financial institutions by
public sector undertakings, usually with tax incentive. It is interesting to note
that a large proportion of PSU bonds are privately placed with banks, their
subsidiaries, and financial institutions. Certificates of Deposits (CDs) were
introduced in June 1989. Commercial banks are permitted to issue CDs within
a ceiling equal to 2 per cent of their fortnightly average outstanding aggregate
deposits. The maturity of 3 months at the short-end and one-year at the longer
end was generally popular with investors. Interest rates for CDs are normally
higher than the interest rate offered by the bank for similar maturity period
deposits.
Ownership Securities: These instruments are called ‘equities’ because
investors who invest in them get a right to share residual profits. Equity
investment may be acquired indirectly or directly or even through a hybrid
instrument known as preference shares. They are discussed in this order.
Indirect Equities: The investor acquires special instruments of institutions,
who take the buy-sell decisions on behalf of investors. Such institutions are
Unit Trust or Mutual Funds. An individual who buys Units gets a dividend
from the income of the Trust/Mutual Fund after meeting all expenses of
management. The Units can be bought from and sold to the institution at sale
and repurchase prices announced from time to time (on a daily basis). Many
mutual funds schemes are also listed in stock exchanges and investors can
also sell and purchase the Units through secondary markets. The objective of
Trusts and Mutual Funds is to use their professional expertise in portfolio
construction and pass on the benefits to the small investor who cannot repeat
such a performance if left alone to subscribe to equity shares directly.
Direct Equities: The investor can subscribe directly to the equity issues placed
on the market by the new organizations or by the existing organizations. If
s/he is already a shareholder of an existing organization, which enters the
capital market for additional issue of equity shares, such an investor would
get a pro rata right to subscribe, on a pre- emptive basis, to the new issue.
Such offerings are known as ‘rights shares’. Established organizations reward
their shareholders in the form of ‘bonus shares’ also. They are given out of
the accumulated reserves and shareholders need not pay any cash consideration
as happens in the case of `right shares’. For example, an organization may
announce a bonus issue on a one-for-one basis. This amounts to a 100 per
cent bonus issue (or, loosely stock dividend) so that the number of shares
held by a shareholder after the bonus would be doubled. The chances for an
increase in the potential dividend income become very bright and this would
happen unless the organization imposes a proportionate cut in future dividends.
Thus, a shareholder, who held 100 shares of ` 100 each in an organization,
got a dividend income of ` 2000, the dividend announced being 20 per cent.
His shareholding after a 100 per cent bonus now increases to 200. Now, if the
organization maintaining the same rate of dividend as last year viz., 20 per
17
An Overview cent, the dividend income of the shareholder would go up to ` 4000.
A less popular instrument is called ‘preference share’. It is neither full debt
nor full equity and is, therefore, recognized as a ‘hybrid security’. Such a
shareholder would have certain preference over equity shareholder. They may
relate to dividends, redemption, participation, and conversion, etc. The most
common is with regard to dividends which, when not paid for any particular
year, get accumulated and no equity dividend would be payable in future
until such accumulated areas of preference dividend are cleared. The dividend
rate on these shares is normally less than the one on equity shares but greater
than interest rate.
Activity 2
Study the main trends and conclusions with regard to the size and
relative popularity of various instrument of finance from different
sources. Note down top 20 stocks in term of trading volume in NSE
from the NSE website for a day. Collect data with regard to the
dividend and earnings record of any 10 organizations.
..........................................................................................................
..........................................................................................................
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FINANCIAL INTERMEDIARIES
Financial intermediaries perform the intermediary function i.e., they bring
the users of funds and the suppliers of funds together. Many of them issue
financial claims against themselves and use cash proceeds to purchase the
financial assets of others. The Unit Trust of India and other mutual funds
belong to this category.
Most financial institutions underwrite issues of capital by non-governmental
public limited organizations in addition to directly subscribing to such capital
either under a public issue or under a private placement.
The financial institutions engaged in intermediary activities include the
Industrial Development Bank of India, Industrial Finance Corporation of India,
Industrial Credit and Investment Corporation of India, Unit Trust of India,
Life Insurance Corporation, and General Insurance Corporation. Two
institutions, which have broadened financial services activities in India,
deserve a special mention. They are: The Credit Rating Information Services
of India Ltd., (CRIS1L) and other credit rating agencies, and the Stockholding
Corporation of India Ltd. (SHCIL).
CRISIL, the first credit rating agency of the country, was set up jointly by
ICICI, UTI, LIC, GIC, and Asian Development Bank. It started operations in
January 1988 and has rated a large number of debt instruments and public
deposits of organizations. CRISIL ratings provide a guide to investors as to
18 the risk of timely payment of interest and principal on a particular debt
instruments and preference shares on receipt of request from a organization. Introduction to
Investment
Ratings relate to a specific instrument and not to the organization as a whole.
They are based on factors like industry risk, market position and operating
efficiency of the organization, track record of management, planning and
control system, accounting, quality and financial flexibility, profitability and
financial position of the organization, and its liquidity management.
The SHCIL was sponsored by IDBI, IFCI, ICICI, UTI, LIC, GIC and IRBI to
introduce a book entry system for the transfer of shares and other types of
scripts replacing the present system that involves voluminous paper work.
The corporation commenced its operations in August 1988.
FINANCIAL MARKETS
Securities markets can be seen as primary and secondary. The primary market
or the new issues market is an informal forum with national and even
international boundaries. Anybody who has funds and the inclination to invest
in securities would be considered a part of this market. Individuals, trusts,
banks, mutual funds, financial institutions, pension funds, and for that matter
any entity can participate in such markets. Organizations enter this market
with initial and subsequent issues of capital. They are required to follow the
guideline prescribed by the regulating agencies like SEBI from time to time
unless they are expressly exempted from doing so. A prospectus or a statement-
in-lieu of prospectus is a necessary requirement because this contains all
material information on the basis of which the investor would form judgment
to put or not to put his money. Concealment and misrepresentations in these
documents have serious legal implications including the annulment of the
issue.
Some organizations would use the primary market by using their ‘in house’
skill but most of them would employ brokers, broking and underwriting
organizations, issue managers, lead managers for planning and monitoring
the new issue. New guidelines are periodically issued by the Securities &
Exchange Board of India (SEBI).
Secondary markets or stock exchanges are set up under the Securities Contracts
(Regulation) Act, 1956. They are known as recognized exchanges and operate
within precincts that possess networks of communication, automatic
information scans, and other mechanized systems. Members are admitted
against purchase of a membership card whose official prices vary according
to the size and seniority of the exchange. Membership cards generally
command high unofficial premia because the number of members is not easily
expandable. Business was earlier transacted on the trading floor within official
working hours under the open bid system. Today, all exchanges in India have
introduced screen-based trading where the members of the exchange transact
the business (purchase and sale of securities) through computer terminals.

1.6 TYPE OF INVESTMENTS

You have a lot of options for where to put your money as an investor. It is
critical to carefully consider the various types of investments. Within each
19
An Overview bucket, there are numerous investment options.
Here are six types of investments to consider for long-term growth, along
with information about each. We won’t discuss cash equivalents, such as
money markets, certificates of deposit, or savings accounts, because those
types of investment accounts are more concerned with keeping your money
safe than with growing it.
x Stocks
x Bonds
x Mutual funds
x Index funds
x Exchange-traded funds (ETFs)
x Options
Stocks
A stock is a financial investment in a particular organization. When you buy
a stock, you are purchasing a share — a small portion of the organization’s
earnings and assets. Organizations sell shares of stock in their businesses to
raise cash; investors can then buy and sell those shares among themselves.
Stocks can produce high returns, but they also carry a higher level of risk
than other investments. Organizations’ values can fall or they can go out of
business. Read our complete stock explanation.
How investors profit: Stock investors profit when the value of the stock they
own rises and they can sell it for a profit. Some stocks also pay dividends,
which are regular distributions of profits to shareholders.
Bonds
Bonds are loans made to organizations or governments. When you buy a bond,
you are giving the bond issuer permission to borrow your money and pay you
back with interest.
Bonds are considered less risky than stocks, but they may provide lower returns.
As with any loan, the primary risk is that the issuer will default. Government
bonds issued by the United States are backed by the country’s “full faith and
credit,” effectively eliminating that risk. State and local government bonds are
generally thought to be the least risky option, followed by corporate bonds. In
general, the lower the interest rate, the less risky is the bond.
Investors anticipate regular income payments. Investors typically receive
interest in regular installments, typically once or twice a year ,and the total
principal is paid off when the bond matures.
Mutual funds
If picking and choosing individual bonds and stocks doesn’t appeal to you,
you are not alone. In fact, there is an investment specifically designed for
20 people like you: the mutual fund.
Mutual funds enable investors to buy a diverse range of investments in a Introduction to
single transaction. These funds pool money from multiple investors and then Investment
hire a professional manager to invest it in stocks, bonds, or other assets.
Mutual funds adhere to a specific strategy — for example, a fund may invest
in a specific type of stock or bond, such as international stocks or government
bonds. Some mutual funds hold both stocks and bonds. The mutual fund’s
risk level is determined by the investments it holds. Learn more about mutual
funds and how they work.
How investors make money: When a mutual fund earns money, such as through
stock dividends or bond interest, a portion of it is distributed to investors.
When the value of the fund’s investments rises, the value of the fund rises as
well, implying that you could sell it for a profit. To invest in a mutual fund,
you must pay an annual fee known as an expense ratio. the investments within
the fund. Learn more about mutual funds and how they work.
ETFs are short for exchange-traded funds.
ETFs are index funds that track a benchmark index and attempt to replicate
its performance. They, like index funds, are less expensive than mutual funds
because they are not actively managed.
The major difference between index funds and ETFs is how ETFs are
purchased. They trade on an exchange like stocks, so you can buy and sell
ETFs at any time, and their prices fluctuate throughout the day. Mutual funds
and index funds, on the other hand, are priced once per trading day and remain
the same regardless of when you buy or sell. Bottom line: For many investors,
this distinction is insignificant, but if you want more control over the fund’s
price, an ETF may be preferable. Here’s more information on ETFs.
How investors make money: As with mutual funds and index funds, your
hope as an investor is that the fund’s value will rise and you will be able to
sell it for a profit. Investors may also receive dividends and interest from
ETFs.
Options
An option is a contract to buy or sell a stock at a predetermined price and by
a predetermined date. Because the contract does not obligate you to buy or
sell the stock, options provide flexibility. As the name suggests, this is an
option. The majority of option contracts are for 100 shares of a stock.
When you purchase an option, you are purchasing the contract rather than the
stock. You can then buy or sell the stock at the agreed-upon price and time;
sell the options contract to another investor; or let the contract expire.

1.7 INVESTMENT PROCESS

A lot of planning is required while investing your hard-earned money in
securities. Often investors lose money when they make investments without
any planning. They make hasty investment decision when the market and
economy was at its peak based on some recommendation. Many investors 21
An Overview who invested before the stock market crash are yet to recover their losses.
This is a result of lack of planning and to an extent greed. Both are not good
for making a decent return on investment. A typical investment decision
undergoes a five-step procedure, which in turn forms the basis of the
investment process. These steps are:
1) Determine the investment objectives and policy
2) Undertake security analysis
3) Construct a portfolio
4) Review the portfolio
5) Evaluate the performance of the portfolio
You may note at the very outset that this five-step procedure is relevant not
only for an individual who is on the threshold of taking his own investment
decisions but also for individuals and institutions who have to aid and work
out investment decisions for others i.e., for their clients. The investment
process is a key-process entailing the whole body of security analysis and
portfolio management. Let us, now, discuss the steps involved in the
investment process in detail:
1. Investment objectives and Policy
The investor will have to work out her/his investment objectives first and
then evolve a policy with the amount of investible wealth at her/his command.
An investor might say that his objective is to have ‘large money’. You will
agree that this would be a wrong way of stating the objective. You would
recall that the pursuit of ‘large-money’ is not possible without the risk of
‘large losses’. The objective should be in clear and specific terms. It can be
expressed in terms of expected return or expected risk. Suppose, an investor
can aim to earn 12% return against the risk-free rate of 9%. It means the
investor is willing to assume some amount of risk while making investment.
Alternatively, the investor can set her or his preference on risk by stating that
the risk of investment should be below market risk. In specific terms, she or
he can say that beta of the portfolio has to be 0.80. If the investor defines one
of the two parameters of investment (return or risk), it is possible to find the
other one because a definite relationship exists between the two in the market.
It may not be possible for you to define both return and risk because it may
not be achievable. For example, if you want to earn a return of 12% with zero
risk when government securities offer a return of 9%, it would not be possible
to develop an investment for you. Thus, it is desirable to set one of the two
parameters (risk or return) and find the other one from the market. If necessary,
an investor can revise the objective if sheik finds the risk is too high for her/
him to bear a desired return. Though setting an investment objective is good,
many investors fail to do the same and blindly invest their money without
bothering the risk associated with such investments. Investments are bound
to fail if an investor ignores this point.
The next step in formulating the investment policy of an investor would be
22 the identification of categories of financial assets he/she would be interested
in. It is obvious that this in turn, would depend on the objectives, amount of Introduction to
Investment
wealth and the tax status of the investor. For example, a tax-exempt investor
with large investible wealth like a pension/provident fund would invest in
anything but tax-exempt securities unless compelled by law to do so. Some
investors may entirely avoid derivatives because of high risk associated with
such investments. Some investors may invest more in equities to earn higher
return but use derivatives to reduce additional risk. As in consumer products,
financial products also come With different colours and flavors and one has
to be highly knowledgeable before selecting appropriate securities.
2. Security Analysis
After defining the investment objective and broadly setting the proportion of
wealth to be invested under different categories, the next step is selecting
individual securities under each category. For instance, if an investor sets
50% of her/his wealth to be invested in government securities, the next
question is which of the government securities that the investments should be
made. It should be noted that not all government securities are one and the
same. A long-term government bond is much riskier than short-term bonds.
Similarly, investment in equities requires identification of organizations stocks,
in which the investment can be made. Security analysis is often performed in
two or three stages. The first stage, called economic analysis, would be useful
to set broad investment objective. If the economy is expected to do well,
investor can invest more in stocks. On the other hand, if the economic
slowdown is expected to continue, investor can invest less in stocks and more
in bonds. In stage two, investors typically examine the industries and identify
the industries, in which investment can be made. There are several
classifications of industry, which we will discuss in a separate unit. Investments
need not be made in any one specific industry because many of the stocks
may be overpriced in a growth industry. It is better to look for three to five
industries and it depends on individual’s choice. The issue is an analysis of
broad trends of industry and future outlook is essential to proceed further on
security analysis.
As the last step, one has to look into the fundamentals of specific organizations
and find whether the stock is desirable for investment. At this stage, investors
need to match the risk-return objective she/he has set in the previous stage.
Organization specific analysis includes examination of historical financial
information as well as future outlook. Using historical performance and future
outlook, specifically the future cash flows are projected and discounted to
present value. Through such analysis, analysts quantify the intrinsic value of
the stock and compare the same with current market price. If the intrinsic
value is greater than the current market price, the stock qualifies for investment.
3. Portfolio Construction
In the previous stage, bonds and stocks, which fulfill certain conditions, are
identified for investments. Under portfolio construction stage, the investor
has to allocate the wealth to different stocks. A couple of principles guide
such allocation of wealth. Investors need to appreciate that the risk of portfolio
comes down if the portfolio is diversified. Diversification here doesn’t mean
23
An Overview more than one stock but stocks whose future performance is not highly
correlated. Further, too much diversification or too many stocks may also
create problem in terms of monitoring. For example, if the investor decides
to invest 10% of the wealth in software sector, it would be desirable to restrict
the investment in two or three stocks based on the amount of investment. On
the other hand, if s/he invests in 20 software stocks, the portfolio will become
too large and create practical problem of monitoring. While including stocks
in the portfolio, the investor has to watch its impact on the overall portfolio
return and risk and also examine whether it is consistent with the initial
investment objective.
Portfolio construction is not done once for all. Since investors saving take
place over a period of time, portfolios are also constructed over a period of
time. It is a continuous exercise. Sometime, timing of investment may be
critical. For instance, if an investor saves ` 30,000 during the first quarter and
the desired portfolio includes both bonds and stocks, the issue before the
investor is whether the amount has to be used for bonds or stocks or both. It
requires some further analysis at that point of time. However, over the years,
when the accumulated investments grow to certain level, subsequent yearly
investments as a proportion of total investments will become smaller and
hence the timing issue will become minor decision.
4. Portfolio Revision
Under portfolio construction, investor is matching the risk-return
characteristics of securities with the risk-return of investment objective. In
two conditions, the securities, in which investment was made earlier, require
liquidation and investing the amount in a new security. The risk or expected
return of the security might have changed over a period of time when the
business environment changes. The stock might also become less risky but
offer lower return. That is, when the risk-return characteristics of securities
change, it will affect the desired risk-return characteristics of portfolio and
hence calls for a revision of portfolio of stocks. Another reason for selling
some of the securities in the portfolio and buying a new one in its place is a
change in investment objective. For instance, when you are young and have
less family commitments, then your investment objective may aim for higher
return even if it amounts to higher risk. You may invest more of your savings
in equity stocks and derivatives. When your family grows, you might want to
reduce the risk and change the investment objective. Portfolio of securities
has to be revised to reflect your new investment objective. There is yet another
reason for revision, which we discussed earlier. When the macro-economic
condition changes, you may want to shift part of your investment from equity
to debt or vice versa depending on the future economic outlook.
5. Portfolio Performance Evaluation
The value of your investment changes over a period of time and it reflects the
current market value of the securities in the portfolio. For instance, if you
have made some investment in A some 10 years back, when you first started
investing, the value of A today is several times more than its value some 10
years back. Few stocks could have resulted in a loss and it would be difficult
24
to construct a portfolio of stocks only with winner stocks. Portfolio return Introduction to
reflects the net impact of positive and negative returns of individual securities Investment
in the portfolio. At the end of each period, you may like to compute the
portfolio return and risk and compare the same with your investment objective
as well as certain benchmark risk-return. The objective of this exercise is to
evaluate the efficiency in construction and management of portfolio.

1.8 SUMMARY
Individuals save a part of their earnings to meet their future cash flow needs.
Such savings are often invested in securities since money has a time value.
Investments normally offer a positive return, which often is more than rate of
inflation. Such a positive return is an incentive for individuals to increase the
level of savings and help the country by creating new capital. Individuals
before making investments need to understand the basic principles of
investments.
x Securities are of different types and the expected return from such
securities differs considerably. Government securities offer lowest return
but they are also risk- free. Equities offer maximum return but they are
too risky. Risk and return of securities go together.
x The starting point of investment process is clearly defining the investment
objectives. Investment objectives are expressed in terms of expected return
or risk and period of holding.
x Security analysis is performed to identify securities, which qualify for
investments. Following the principles of portfolio management, securities
are combined to achieve diversification. Portfolios are periodically revised
and performance of managing the portfolio is also periodically evaluated.
x In addition to knowing the basic principles of investments, an investor is
also required to know the operations of securities market. Different types
of securities are traded in the market and they are broadly classified into
debt and equity instruments. They are bought and sold through a set of
intermediaries, which include brokers, stock exchanges, etc. All stock
market intermediaries are regulated by the SEBI to ensure orderly
functioning of the market.

1.9 KEY WORDS

Financial Assets : Documentary evidence of financial claim of
the holder, say of shares on debentures, over
the issuer.
Financial intermediation : A function, which brings the savers and users
of funds together, usually performed by
specialized agencies and institutions like
banks and underwriters for art agreed/
stipulated commission.

25
An Overview Investment : Commitment of funds for a period usually
exceeding one year in expectation of a required
rate of return.
Investment decision : The decision to acquire, hold, or dispose asset
by rational and risk-averse individuals/
organizations.
Marketable securities : Financial claims, which are tradable in
organized markets at the best prices.
Portfolio : A collection of two or more assets, generally
employed in the context of financial assets.
Portfolio construction : Building up a portfolio of financial assets with
consideration of selectivity, timing, and
diversification or raising a portfolio with
rational selection criteria, at the right time, and
in a way that the risk is reduced to the
minimum for a given level of expected return.
Portfolio revision : A review of an existing portfolio in the light
of changes in risk- return dimensions.
Portfolio evaluation : Assessing the performance of a portfolio on
the basis of some aptly developed norms or
yardsticks.
Real assets : Physical assets held to perform an activity with
an expected income/pay off profile.
Risk : The probability that the realized return would
be different from the anticipated return of an
investment.
Securities market : Organized and recognized trading centres,
where financial claims are bought and sold as
per established rules and procedures.
Zero-interest bonds : Creditorship securities on which a coupon rate
is not made explicit but the compensation is
provided through a discount on the purchase
price or a premium on redemption.

1.10 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. Define investment.
2. Describe the steps involved in the investment process.
3. What do you understand by investment environment
4. Explain different types of investment.

26
 Introduction to
1.11 FURTHER READINGS Investment

Chandra, P. (2018). Investment Analysis & Portfolio Management (5e). Tata

McGraw Hill.
D Ambrosio, Charles A.(1976). Principles of Modern Investments, Chicago :
SRA, Inc.
Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis
Portfolio Management (7th ed.). Pearson Education.
Frank K. (1979) Investment Analysis & Portfolio Management, Hinsdale,
Illinois : The Dryden Press.
Fuller, Russell J., and Farrell, James L. (1987). Modern Investments and
Security Analysis, New York : McGraw-Hill Book Co. Reilly,
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-01 Introduction to Investment
Management [Video]. YouTube. https://www.youtube.com/watch?v=ope5Y3Mrsaw
Jones, Charles P., Futtle, Donald L., and Heaton, Cherill P. (1977). Essentials
of Modem Investments, New York Ronald Press.
Kevin S.( 2000)., Portfolio Management, Prentice-Hall of lndia Pvt. Ltd.,
NewDelhi.
Pandian Punithavathy.( 2001). Security Analysis and Portfolio Management,
Vikas Publishing House Pvt. Ltd., New Delhi.
Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., &Elston, F. (2019).
Investment Analysis & Portfolio Management. Cengage AU.
Rustagi, R. (2021). Investment Analysis & Portfolio Management. Sultan
Chand & Sons.
Tripathi, V. (2023). Taxmann’s Fundamentals of Investments. Taxmann
Publications Private Limited.

27
An Overview
UNIT 2 SECURITIES MARKET
Objectives
After reading this unit you should be able to:
x Distinguish between primary and secondary markets;
x Understand the concept of Initial Public Offerings (IPOs);
x Discuss the evolution of Indian stock Market;
x Understand different types of stock markets;
x Understand the role of SEBI as a regulating body.
Structure
2.1 Introduction
2.2 Primary Markets
2.3 Initial Public Offerings (IPOs)
2.4 Secondary Markets
2.5 Indian Stock Market
2.6 Different Stock Markets
2.7 Securities Exchange Board of India (SEBI)
2.8 Summary
2.9 Key Words
2.10 Self Assessment Questions
2.11 Further Readings

2.1 INTRODUCTION
Market is a place where buyers and sellers meet and exchange products. This
definition is universal and applies to all markets. In this course, we will discuss
more about the market called capital market. It is a place, where capital of
different types is exchanged. Often individuals, like you, are the lenders or
the suppliers of capital. Companies and various other institutions are the
borrowers or the receivers of capital. The market is organized or divided into
different ways. At a very broad level, the market is divided into (a) Short-
term Capital Market (money market) and (b) Long term capital market (also,
called stock market). Another way of classifying the market is (a) Institutional
Market and (b) Direct Market. As an investor you can deal with the market in
different ways. Let us understand the market from individual’s perspective.
If the surplus money you have can be spared only for a short period, you have
to look for savings of short-duration. Since the amount available is fairly
small in such cases, you have to look for some institutional support for such
savings. In other words, individuals don’t directly deal with the money market,
which specialize in short-term capital.
28
Often, individuals approach an institution for this purpose. You can save your Securities Market
short-term surplus in a bank deposit or a mutual fund, which offer money
market schemes. If the surplus money you have can be spared for a long-
term, you have to look for investments of longer duration. Again, you can go
to an institution, which offers long- term products or you can directly
participate in the market. That is, you can deposit your money in a long-term
fixed deposit or invest in a mutual funds scheme or directly buy securities in
the market. When you intend to deal with the market on your own, you can
deal with the market in two ways. The markets are accordingly classified into
primary and secondary market.
Primary market is the one in which the organization approaches investors to
raise capital. They can approach for debt capital or equity capital or
combination of both. Dealing in primary market is fairly simple today. Like
fixed deposit opening, you have to take up an application form of the issue
and deposit the amount after filling up the form. Brokers and sub-brokers
will normally help you to get forms and guide you to fill up the forms. What
is important is you have to make sure that investments fit with your objective.
The uncertainty of getting allotment forces many investors, who are directly
willing to deal with the market, to turn into secondary market. It is a place
where an investor sells to another investor. Since there are large number of
sellers and buyers, the market is dynamic. Securities prices change depending
on the demand and supply of the securities.
Secondary market exists for different types of securities like debt, equity and
others. Investment in secondary market has also become easy, thanks to
developments in Information and Computing Technologies. You have to open
an account with the members of any stock exchanges of your choice. The
procedure to open an account is fairly simple and it is somewhat similar to
opening a Savings Bank Account with your banker. You can place your buying
and selling orders over phone and often you get immediate confirmation of
your purchase or sale. Today, it is also possible for you to buy and sell securities
through internet. In this Unit, we will discuss more on how the stock market
is organized and how investors can transact in buying and selling of securities
in the market.

2.2 PRIMARY MARKETS

Primary market is the segment in which new issues are made whereas
secondary market is the segment in which outstanding issues are traded. It is
for this reason that the Primary Market is also called New Issues Market and
the Secondary Market is called Stock Market. In the primary market, new
issues May be made in three ways, namely, public issue, rights issue, and
private placement. Public Issues involves sale of securities to members of
public. Rights issue involves sale of securities to the existing shareholders/
debenture holders. Private placement involves selling securities privately to
a selected group of investors. In the primary market, equity shares, fully
convertible debentures (FCD), partially convertible debentures (PCD), and
non- convertible debentures (NCD) are the securities commonly issued by
non-government public limited companies. Government companies issue 29
An Overview equity shares and bonds. In the primary market, issues are made either ‘at
par’ or `at premium’. Pricing the new Issues is regulated under `Guidelines
on Capital Issues’ or what are also known as “Guidelines for Disclosure and
Investors Protection” issued by the Securities and Exchange Board of India
(SERI). The SEBI guidelines on Disclosure and Investor Protection is now
available in the SEBI website, www.sebi.gov.in.

2.3 INITIAL PUBLIC OFFERINGS (IPOS)

Concept
IPO stands for Initial Public Offering. It is the process by which a private
organization offers shares of its stock to the public for the first time. The
purpose of an IPO is to raise capital from public investors, allowing the
organization to grow and expand its business operations.
The process of going public through an IPO involves several steps, including
selecting an investment bank to lead the offering, preparing a prospectus that
outlines the organization’s business and financials, and setting an initial
offering price for the shares. The organization also needs to meet various
regulatory requirements before the IPO can take place.
Once the IPO is complete, the organization’s shares are listed on a stock exchange,
and they can be bought and sold by members of the public. The price of the
shares is determined by supply and demand, and can fluctuate based on various
factors, including the organization’s financial performance and market conditions.
IPOs can be a significant opportunity for investors to participate in the growth
of a promising organization, but they also come with risks. Investors need to
carefully evaluate the organization’s financials and business prospects before
investing, and they should be aware that the value of their shares can go up or
down depending on market conditions.
There have been many IPOs over the years, and some of the most high-profile
examples include:
Facebook: The social media giant went public in 2012, raising $16 billion in
one of the largest IPOs in history.
Alibaba: The Chinese e-commerce organization raised $25 billion in its 2014
IPO, which was the largest in history at the time.
Uber: The ride-hailing organization went public in 2019, raising $8.1 billion
in one of the most highly anticipated IPOs of the year.
Snowflake: The cloud-based data warehousing organization went public in
2020, raising $3.4 billion in the largest software IPO ever.
Airbnb: The online marketplace for vacation rentals went public in 2020,
raising $3.5 billion in one of the biggest IPOs of the year.
These are just a few examples of the many successful IPOs that have taken
place over the years, but it’s important to remember that not all IPOs are
30 successful, and investing in an IPO can be risky.
Eligibility for an IPO Securities Market

In India, eligibility for an Initial Public Offering (IPO) is regulated by the

Securities and Exchange Board of India (SEBI). To be eligible for an IPO, an
organization must fulfill certain criteria set by SEBI. The eligibility is amended
from time to time. As of now the eligibility for an IPO in India is as follows:
x Minimum net tangible assets of at least ` 3 crores for the preceding three
full years.
x The organization must have a minimum operating profit of at least `15
crores in each of the preceding three years.
x The organization must have a net worth of at least ` 1 crore in each of the
preceding three years.
x The organization must have a minimum of 1,000 shareholders and a
minimum public float of 25% of the issued capital.
x The organization must have a track record of distributable profits for at
least three out of the immediately preceding five years.
These are some of the broad eligibility criteria for an IPO in India, and there
may be additional requirements depending on the specific regulations and
guidelines issued by SEBI from time to time. It is recommended that students
refer to SEBI and other regulatory bodies to update themselves about the
eligibility of IPO.
IPO Process
The IPO process has evolved significantly over time, as markets, regulations,
and technology have changed. Here are a few key ways in which the IPO
process has evolved:
x Increased regulation: The IPO process has become more heavily
regulated over time, with requirements for financial reporting, disclosure,
and transparency. The Sarbanes-Oxley Act of 2002, for example, increased
the regulatory burden on public companies, making it more costly and
time-consuming to go public.
x Online investing: The rise of online brokerages and trading platforms
has made it easier for individual investors to participate in IPOs. In the
past, IPOs were typically only available to institutional investors and
high net worth individuals, but now anyone with an online brokerage
account can invest in an IPO.
x Direct listings: In a direct listing, a company goes public by selling its
existing shares directly to the public, rather than issuing new shares
through an investment bank. This approach has become more popular in
recent years, with companies like Spotify and Slack opting for direct
listings.
x Special purpose acquisition companies (SPACs): SPACs are companies
that are created specifically to acquire other companies and take them
public. They raise money through an IPO, and then use the proceeds to 31
An Overview identify and acquire a target company. SPACs have become increasingly
popular in recent years as a way for companies to go public without going
through the traditional IPO process.
The IPO process has become more complex and more diverse over time, with
organizations having a range of options for going public.
SEBI Guidelines for IPO’s
SEBI (Securities and Exchange Board of India) issues guidelines for Initial
Public Offerings (IPOs) in India to ensure that the process of raising capital
through the primary market is fair, transparent and efficient. Some of the key
SEBI guidelines for IPOs are:
Eligibility criteria: The issuer organization must meet certain eligibility
criteria to be able to issue shares through an IPO. The organization must have
a minimum net worth, a track record of profitability for a certain period, and
must not be undergoing any regulatory or legal action.
Disclosure requirements: The issuer organization is required to provide
complete and accurate disclosures in the prospectus. The disclosures must
include details about the organization’s financial performance, risk factors,
management structure, and other relevant information that can help investors
make an informed decision.
Pricing guidelines: SEBI guidelines provide a framework for determining
the price at which shares can be issued. The issuer organization is required to
disclose the rationale behind the price and the factors that have been taken
into consideration.
Use of proceeds: The issuer organization must disclose how the proceeds
from the IPO will be utilized. The disclosures must provide a clear
understanding of how the organization plans to use the funds and the expected
benefits to the organization and its stakeholders.
Book building process: SEBI guidelines provide a framework for the book
building process, which is used to determine the demand for the shares being
offered. The issuer organization can use either the fixed price method or the
book building method to determine the price of the shares.
Underwriting and merchant banking guidelines: SEBI guidelines also cover
the role of merchant bankers and underwriters in the IPO process. The
merchant bankers are responsible for preparing the prospectus and ensuring
that the issuer organization complies with all the regulatory requirements.
The underwriters are responsible for subscribing to the shares that are not
taken up by the public.
These guidelines are regularly updated by SEBI to ensure that the process of
raising capital through IPOs remains fair and transparent for all stakeholders
involved.

32
 Securities Market
2.4 SECONDARY MARKETS
The secondary market is the segment in which outstanding issues are traded
and thus provide liquidity. Investors, who seek both profitability and liquidity,
need both primary and secondary markets. There is thus a direct and
complementary interface between the primary and secondary markets.
Secondary market exists both for short- term (money market) securities and
long-term securities. It exists for debt, equity and a variety of hybrid securities.
While the secondary market activities in money market securities are
conducted over phone or through market makers, the trading is more organized
for long-term securities and conducted through stock exchanges. Buying and
selling securities in secondary market is fairly simple. Investors have to open
an account with a member of stock exchange and then place orders through
the member.
For an orderly functioning of market, a set of institutions is required. The
role of institutions assumes importance in securities market because the market
deals with high value financial assets. Institutions connected with securities
markets are Stock Exchanges (http:// www.bseindia.com and http://
www.bseindia.com), Members of Stocks Exchanges (popularly called brokers),
Clearing Corporation, Depository (http://www.nsdl.co.in and http://
www.centraldepository.com) Transfer Agents and Securities and Exchange
Board of India (SEBI) (http://www.sebi.gov.in).
Technology has converted stock exchanges into a virtual institution. Earlier,
there was an importance for the physical location of stock exchange because
it was a place where brokers or their assistants negotiate the prices (outsiders
can hear only some noise but brokers understand the meaning) and enter into
transactions on behalf of their client-investors. Since the telecommunication
was very poor in India, one or two stock exchanges have been opened up in
every state to cater to the needs of the investors of the region. India is one of
the few countries with a large number of stock exchanges. Thanks to
development in telecommunication and information technology, the physical
constraint was removed during the last few years. National Stock Exchange
today has its presence everywhere in the country. Bombay Stock Exchange
has also expanded its network. Many other stock exchanges are finding it
difficult to compete with these two principal stock exchanges and trying to
come together and create new business. This new development has improved
transparency of operations and brought down the cost. Today, stockbrokers
are operating from their office through computer network and investors can
see the price at which the transactions are settled.Competition has brought
down the brokerage from 2% to in India around 0.5% and today the brokerage
rate in India is one of the lowest in the world. This transformation has taken
place in a matter of few months.
Members of stock exchanges, called stock brokers, are intermediary between
buyers and sellers. Buying and selling securities through members of stock
exchange is beneficial, legally and functionally. Entry of major institutions
like ICICI, Kotak Mahindra, into brokerage services and development in
technology including intenet based broking service have improved the quality
33
An Overview of service. Many of these brokerage houses offer a number of facilities to the
investors at no extra cost.
Clearing corporation enables the members to settle the transactions entered
among themselves on behalf of their client-investors. It operates something
similar to cheque clearing service offered by RBI for the banks. Earlier when
securities are traded in physical form, a large number of securities have to be
exchanged between members and clearing corporation had a major work on
this part. Today, after depository facility was introduced, the workload of the
clearing corporations has come down significantly. Clearing corporation today
facilitates the members to transfer (or receive) securities to (or from)
depositories and also settle monetary part of the transactions. It is an institution
exclusively serving the brokers.
Depository service is another major development in the Indian stock market.
It allows investors to hold securities in electronic form (like you are holding
cash in your bank account) and transfers electronically when they sell the
shares. The operation is fairly simple. Investors have to open a depository
account with a member of depository service provider (we have two depository
service providers in India - National Securities Depository Ltd and Central
Depository Services (India) Limited). Investors can give physical securities
that they are holding for cancellation (provided depository facility is available
for the securities/company) and convert them in to electronic holding. A large
number of companies have depository holding facility and SEBI has put it
compulsory to trade certain stocks only under depository mode. When an
investor apply new shares next time in the primary market, they can ask the
issuer to credit the depository account in the event of successful allotment.
Any new purchases in the secondary market can also be credited in the
depository account. Investors will get periodical statement on their holding
from the member with whom the depository account is maintained. Many
depository participants allow the investors to see their account through
Internet. There was some resistance from retail investors for this change but
today everyone started seeing the benefit of this service. A significant part of
volume traded today is settled through depository mode.
Apart from holding the stocks electronically, there are other benefits from
depository services.- There is no need to apply for transfer of shares after the
purchase of shares. If an investor buys securities in physical form and desire
to transfer the shares in her/his name, s/he has to fill-up the transfer deed,
affix transfer fee (0.5% of market value of stock) and then send the same to
transfer agent. There is a cost, time and uncertainty involved in the transfer.
Under depository mode, the shares are transferred in a short period of time
without any further action from your side. For more details about depository,
visit one of the web sites (http://www.nsdl.co.in or http://
www.centraldepository.com) of depository service providers or the members
of depository service providers.
Transfer agents maintains the members register of the companies. On the
instructions of the company, they transfer the shares from the existing members
to new member. When an investor buys a share in a physical mode and intend
34 to transfer the share in her/his name, s/he has to send the transfer deed along
with share certificate to the Transfer Agent. There are many transfer agents Securities Market
like Karvy Consultants Ltd (http://www.karvy.com) and MCS Ltd. After initial
verification, they will place the shares received for transfer for the approval
of company’s Board. The shares are transferred in the name of investors after
the approval of the Board and investor will receive communication to this
effect along with share certificates from the Transfer Agent. Some companies
perform this transfer of shares internally whereas many leading companies
have outsourced this service by appointing one of these transfer agents. The
process of verification and other formalities connected with transfer has been
simplified after the introduction of depository services.
Activity 1
i) Write brief note on a recent public issue of a company. The note may
include the size of the issue, type of security offered, price, justification
of premium, registrar, banker to issue, underwriter, etc.
...........................................................................................................
...........................................................................................................
...........................................................................................................
...........................................................................................................
ii) Visit any one or more of the web sites and describe your additional
learning on the regulation of Primary and Secondary Markets.
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2.5 INDIAN STOCK MARKET

Evolution
Organizations and institutions, whether they are economic, social or political,
are products of historical events and exigencies. The events continually replace
and/or reform the existing organizations, so as to make them relevant and
operational in contemporary situations. It is, therefore, useful to briefly
acquaint ourselves with the evolution of the stock market in India. The Indian
stock market has undergone significant changes and evolved over the years.
Stock exchanges of India in a rudimentary form originated in 1800 and since
that time have developed through different stages.
Pre-independence era
1800-1865 (Pre-independence era: The East India Company and few
commercial banks floated shares sporadically, through a very small group of
brokers. According to a newspaper in 1850, in Bombay during 1840-1850
there were only half a dozen recognised brokers. The year 1850 marked a 35
An Overview watershed. A wave of company flotations took over the market ; the number
of brokers spurted to 60. The backbone of industrial growth and the resulting
boom in share flotation was the legendary personality of the financial world,
PremchandRoychand.
In 1860 the stock market created a unique history. The entire market was
gripped by what is known as ‘share mania’. The American Civil War created
cotton famine. Indian cotton manufacturers exploited this situation and
exported large quantities of cotton. The resulting increase in export earnings
opened opportunities for share investments. New companies started to come
up. Excessive speculation and reckless buying became the order of the day.
This mania lasted upto 1865. It marks the end of the first phase in the Indian
stock exchange history because with the cessation of the Civil War, demand
for Indian cotton slumped abruptly. The share became worthless pieces of
paper. To be exact, on July 1, 1865 all shares ceased to exist because all time
bargains which had matured could not be fulfilled.
1866-1900: We find another distinct phase during 1866-1900. The mania effect
haunted the stock exchange of Bombay during these 25 years. Above
everything else, it led to foundation of a regular market for securities. Since
the market was established in Bombay, it soon became and still is the leading
and the most organized stock exchange in India. A number of stock brokers
who geared up themselves, set up a voluntary organization in 1887, called
Native Share and Stockbrokers Association. The brokers drew up codes of
conduct for brokerage business and mobilized private funds for industrial
growth. It also mobilized funds for government securities (gilt edged
securities), especially of the Bombay Port Trust and the Bombay Municipality.
A similar organization was started at Ahmedabad in 1894.
1901-1913: Political developments gave a big flip to share investment. The
Swadeshi Movement led by Mahatma Gandhi encouraged the indigenous
trading and business class to start industrial enterprises. As a result, Calcutta
(Kolkata) became another major centre of share trading. The trading was
prompted by the coal boom of 1904- 1908. Thus the third stock exchange was
started by Calcutta stock brokers. During Inter-war years demand for industrial
goods kept increasing due to British involvement in the World Wars. Existing
enterprises in steel and cotton textiles, woolen textiles, tea and engineering
goods expanded and new ventures were floated. Yet another stock exchange
was started at Madras in 1920. The period 1935-1965 can be considered as
the period of development of the existing stock exchanges in India. In this
period industrial development planning played the pivotal role of expanding
the industrial and commercial base of the country. Post-independence era
At the time of Independence seven stock exchanges were functioning located
in the major cities of the country. Between 1946 and 1990, 12 more stock
exchanges were set up trading the shares of 4843 additional listed companies.
After independence in 1947, the government took steps to regulate the stock
market. In 1956, the Securities Contracts (Regulation) Act was passed to
regulate stock exchanges.

36
1990s liberalization Securities Market

In the 1990s, India started opening up its economy and embracing economic
reforms. This led to a surge in foreign investments in the stock market, and
the government introduced measures to encourage more participation in the
stock market.
Introduction of NSE
In 1994, the National Stock Exchange (NSE) was established, which
introduced electronic trading in India. This helped to bring more transparency
and efficiency to the stock market.
Dematerialization
In 1996, the process of dematerialization of shares was introduced, which
allowed investors to hold and trade shares in electronic form, eliminating the
need for physical share certificates.
Online trading
In the late 1990s and early 2000s, online trading platforms were introduced,
which made it easier for investors to trade in the stock market from anywhere
in the world.
Derivatives trading
In 2000, the government allowed derivatives trading in the stock market, which
provided investors with more investment options and helped to increase
liquidity in the market.
Introduction of SEBI
The Securities and Exchange Board of India (SEBI) was established in 1992
as the regulator of the Indian securities market. SEBI has been instrumental
in regulating and developing the Indian stock market.
The Indian stock market has evolved significantly over the years, with the
introduction of new technologies and regulatory measures to ensure
transparency and efficiency in the market. The stock market has become an
important avenue for investment and wealth creation for millions of investors
in India.
There are several stock exchanges in India, but the major ones are:
National Stock Exchange of India (NSE): It is the largest stock exchange in
India in terms of market capitalization and trading volumes. It is located in
Mumbai and offers trading in equities, derivatives, mutual funds, and currency
futures.
Bombay Stock Exchange (BSE): It is the oldest stock exchange in Asia and
the first in India, established in 1875. It is also located in Mumbai and offers
trading in equities, derivatives, mutual funds, and currency futures.
Metropolitan Stock Exchange of India (MSEI): It is the third-largest stock
37
An Overview exchange in India and is located in Mumbai. It offers trading in equities,
currency derivatives, and debt instruments.
Indian Commodity Exchange (ICEX): It is a commodity futures exchange
and is located in Mumbai. It offers trading in commodity futures such as
gold, silver, and crude oil.
Multi Commodity Exchange (MCX): It is another commodity futures
exchange located in Mumbai. It offers trading in commodity futures such as
gold, silver, and crude oil.
National Commodity and Derivatives Exchange (NCDEX): It is a
commodity futures exchange located in Mumbai. It offers trading in
commodity futures such as agricultural products, metals, and energy.
These are some of the major stock exchanges in India.
Role and Functions
Stock exchanges play a crucial role in modern economies by providing a
platform for buying and selling securities, such as stocks, bonds, and
derivatives. Some of the key roles of stock exchanges include:
Facilitating trading: Stock exchanges provide a centralized marketplace
where buyers and sellers can come together to trade securities in a
transparent and regulated manner.
Price discovery: The stock market helps to determine the price of securities
through the forces of supply and demand. The prices of securities on the
exchange reflect the collective judgment of all the buyers and sellers
participating in the market.
Liquidity: By providing a platform for trading, stock exchanges enhance
the liquidity of securities. This means that investors can easily buy and
sell securities at any time, making it easier for them to manage their
portfolios and adjust their positions as needed.
Transparency: Stock exchanges provide transparent pricing and reporting
of trades, which helps to promote market efficiency and fairness.
Capital formation: Stock exchanges play a critical role in raising capital
for companies by facilitating the initial public offerings (IPOs) of new
companies and providing a platform for companies to issue additional
shares or bonds to raise more capital.
The stock exchanges are essential to the functioning of modern economies,
providing a vital platform for trading securities, setting prices, and
promoting transparency and liquidity in the market.
Market Types
NEAT system
NEAT stands for National Exchange for Automated Trading, which is a

38
 fully automated screen-based trading system that was introduced by the Securities Market
National Stock Exchange of India (NSE) in 1994. The NEAT system has
several different market types that are used for trading different types of
securities. These market types include:
Normal Market: This is the most commonly used market type, where
securities are traded in a regular manner based on their market price.
Odd Lot Market: This market type is used for trading securities in lots
that are less than the standard trading lot. This market is designed to
facilitate trading for small investors who cannot afford to buy or sell in
the standard trading lot.
Retail Debt Market: This market type is used for trading debt securities
such as bonds, debentures, and government securities.
Wholesale Debt Market: This market type is used for trading debt
securities in large quantities. It is primarily used by institutional investors
such as banks, mutual funds, and insurance companies.
Call Auction Market: This market type is used for trading securities at a
predetermined price. Orders are collected for a specific period, and the
system matches the buy and sell orders at the predetermined price.
Block Deal Market: This market type is used for trading large quantities
of securities. It is primarily used by institutional investors to trade in large
blocks of shares.
Overall, the NEAT system of market types provides a range of options for
investors to trade securities in a manner that suits their specific needs and
preferences.
Stock Market Information System
A stock market information system is a computer-based system that
provides investors and traders with real-time information about the stock
market. It allows users to access a variety of data, such as stock prices,
trading volumes, news articles, financial statements, and other market-
related information. Some of the key features of a stock market information
system include:
Real-time data: The system provides real-time information about the stock
market, allowing investors and traders to make informed decisions in a
timely manner.
Customizable dashboards: Users can customize their dashboards to
display the information that is most relevant to their needs, such as stock
prices, news headlines, and financial ratios.
Charting and technical analysis: The system provides advanced charting
and technical analysis tools that allow users to analyze market trends and
patterns, and make informed trading decisions.
News and analysis: The system provides access to news articles and
39
An Overview market analysis from a variety of sources, allowing users to stay up-to-
date on market developments and make informed decisions.
Portfolio management: The system allows users to manage their
investment portfolios, track their holdings, and monitor their performance
over time.
A stock market information system is a powerful tool for investors and
traders, providing them with the real-time data, analysis, and insights they
need to make informed decisions in the stock market.
Activity 2
1) Take a look at the Bombay Stock Exchange quotations published in
Economic Times and write out hereunder price quotations for five
Shares and five Debentures.
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2.6 DIFFERENT STOCK MARKETS

National Stock Exchange of India (NSE):It is the leading stock exchange in
India in terms of market capitalization and trading volumes. NSE was founded
in 1992 and is headquartered in Mumbai, India.
NSE offers a platform for trading in equities, equity derivatives, debt
instruments, currencies, and exchange-traded funds (ETFs). The exchange
operates on an electronic trading platform, which enables investors to trade
securities from anywhere in India through a network of brokers.
NSE has played a significant role in the development of the Indian capital
markets, introducing new products and services, and adopting best practices
in technology and regulation. NSE has also been instrumental in popularizing
equity investments among retail investors in India through initiatives like the
National Stock Exchange’s Certification in Financial Markets (NCFM)
program, which provides education and training in financial markets.
NSE is regulated by the Securities and Exchange Board of India (SEBI), which
sets the rules and regulations governing the exchange. The exchange is also a
member of the World Federation of Exchanges (WFE), which represents the
interests of the global exchange industry.
NSE is an important platform for investors to participate in the Indian capital
markets, providing a secure and transparent environment for trading in a wide
range of securities.
Bombay Stock Exchange (BSE) :It is one of the oldest and the first stock
exchanges in Asia, established in 1875 in Mumbai, India. BSE offers a platform
40 for trading in equities, equity derivatives, debt instruments, currencies, and
mutual funds. Securities Market

BSE operates on an electronic trading platform, similar to NSE, which enables

investors to trade securities from anywhere in India through a network of
brokers. BSE is also home to several prominent indices, including the BSE
Sensex, which is a benchmark index of the top 30 companies listed on the
exchange. BSE has played an important role in the development of the Indian
capital markets, introducing new products and services, and adopting best
practices in technology and regulation. BSE is also known for its initiatives
in investor education and protection, including setting up the Investor
Protection Fund to compensate investors in case of default by trading members.
BSE is regulated by the Securities and Exchange Board of India (SEBI), which
sets the rules and regulations governing the exchange. The exchange is also a
member of the World Federation of Exchanges (WFE), which represents the
interests of the global exchange industry.
Overall, BSE is an important platform for investors to participate in the Indian
capital markets, providing a secure and transparent environment for trading
in a wide range of securities.
Metropolitan Stock Exchange of India (MSEI): It is a stock exchange in
India that was founded in 2008 and received recognition as a stock exchange
in 2012. It is headquartered in Mumbai, India.
MSEI offers a platform for trading in equities, equity derivatives, and currency
derivatives. The exchange uses an electronic trading platform, similar to NSE
and BSE, which enables investors to trade securities from anywhere in India
through a network of brokers.
MSEI has been known for its innovative products, including its flagship
product, the Multi Commodity Exchange (MCX) Currency Futures, which
enables trading in currency derivatives. It has also been active in promoting
investor education and awareness programs to increase the participation of
retail investors in the Indian capital markets.
MSEI is regulated by the Securities and Exchange Board of India (SEBI),
which sets the rules and regulations governing the exchange. However, in
2019, MSEI was placed under a surveillance mechanism by SEBI due to
concerns over its financial viability and governance issues.
The MSEI is a relatively new player in the Indian stock exchange market,
and it has faced some challenges in gaining market share and maintaining
financial stability. However, it continues to offer a platform for trading in
equities and derivatives, and it has been active in promoting investor education
and awareness programs.
Indian Commodity Exchange Limited (ICEX): It is a national-level
commodity futures exchange in India that was launched in 2009. The exchange
offers a platform for trading in a wide range of commodities, including precious
metals, base metals, energy, and agricultural commodities.
ICEX uses an electronic trading platform, which enables investors to trade
41
An Overview commodities from anywhere in India through a network of brokers. The
exchange operates on a transparent and regulated marketplace, with
standardized contracts, price discovery mechanisms, and risk management
systems. ICEX is known for its flagship product, the Diamond Futures
Contract, which enables trading in diamonds as a commodity. This product is
unique in the Indian commodity futures market and has helped to increase the
transparency and efficiency of the diamond trade in India.
ICEX is regulated by the Securities and Exchange Board of India (SEBI),
which sets the rules and regulations governing the exchange. The exchange
is also a member of the World Federation of Diamond Bourses (WFDB), which
represents the interests of the global diamond industry.
ICEX is an important platform for investors to participate in the Indian
commodity futures market, providing a secure and transparent environment
for trading in a wide range of commodities. The exchange has been innovative
in introducing new products and services, and it has played a significant role
in the development of the Indian commodity futures market.
National Commodity and Derivatives Exchange Limited (NCDEX): It is
a national-level commodity futures exchange in India that was launched in
2003. The exchange offers a platform for trading in a wide range of
commodities, including agricultural commodities, metals, energy, and other
raw materials.
NCDEX uses an electronic trading platform, which enables investors to trade
commodities from anywhere in India through a network of brokers. The
exchange operates on a transparent and regulated marketplace, with
standardized contracts, price discovery mechanisms, and risk management
systems. NCDEX is known for its flagship products, including futures
contracts for agricultural commodities like wheat, soybean, chana, and castor
seed. The exchange has been instrumental in improving the efficiency and
transparency of agricultural commodity trading in India, enabling farmers
and other stakeholders to hedge their price risks and access better prices.
NCDEX is regulated by the Securities and Exchange Board of India (SEBI),
which sets the rules and regulations governing the exchange. The exchange
is also a member of the World Federation of Exchanges (WFE), which
represents the interests of the global exchange industry.
The NCDEX is an important platform for investors to participate in the Indian
commodity futures market, providing a secure and transparent environment
for trading in a wide range of commodities. The exchange has played a
significant role in the development of the Indian commodity futures market,
particularly in the agricultural sector.
Multi Commodity Exchange of India Ltd. (MCX):It is India’s largest
commodity derivatives exchange, with a market share of over 90%. MCX
facilitates online trading of a wide range of commodities, including metals,
energy, agricultural commodities, and bullion. MCX was established in 2003
and has since become a leading player in the Indian commodities market.
42
The exchange offers a range of futures contracts with different expiry dates, Securities Market
which allow market participants to hedge their price risk or speculate on the
price movements of various commodities. MCX operates through a network
of over 500,000 terminals, spread across more than 1,000 cities and towns in
India. The exchange has a state-of-the-art trading platform that provides real-
time price information, market news, and analysis to market participants. MCX
is regulated by the Securities and Exchange Board of India (SEBI), which
sets the rules and regulations governing the exchange. The exchange is also a
member of the Federation of Indian Commodity Exchanges (FICE), which
represents the interests of the commodity exchanges in India.
MCX plays an important role in the Indian commodities market, providing a
platform for price discovery and risk management for market participants.
MCX offers trading in a wide range of commodities, including metals, energy,
agricultural commodities, and bullion. Here are a few examples of the
commodities that are traded on MCX:
Gold: MCX is a major platform for trading in gold futures, with contracts for
different delivery months. The gold traded on MCX is 24 karat, and the
minimum contract size is one kilogram.
Crude oil: MCX also offers trading in crude oil futures, with contracts for
different delivery months. The crude oil traded on MCX is of the WTI (West
Texas Intermediate) variety, and the minimum contract size is 100 barrels.
Copper: MCX is a leading platform for trading in copper futures, with
contracts for different delivery months. Copper is a widely used metal in
construction and manufacturing, and its price movements are closely watched
by traders and investors.
Natural gas: MCX also offers trading in natural gas futures, with contracts
for different delivery months. Natural gas is a key source of energy, and its
price movements are influenced by factors such as supply and demand, weather
conditions, and geopolitical events.
The exchange offers a range of other commodities as well, such as silver,
zinc, lead, and agricultural products like cotton, soybean, and crude palm oil.

2.7 SECURITIES EXCHANGE BOARD OF INDIA

(SEBI)
SEBI (Securities and Exchange Board of India) is the regulatory body for the
securities market in India. It is responsible for regulating and supervising the
securities market in India and ensuring its proper functioning. SEBI issues
various guidelines from time to time to ensure that the market operates in a
fair and transparent manner. Some of the important SEBI guidelines are:
1. Insider Trading: SEBI has issued guidelines to prevent insider trading
in the stock market. Insider trading refers to the practice of buying or
selling securities by people who have access to non-public information
about the organization.
43
An Overview 2. Takeover Code: SEBI has also issued guidelines for the takeover of
companies. The takeover code provides a framework for the acquisition
of shares and control of companies.
3. Listing Agreement: SEBI has mandated certain rules for companies that
are listed on the stock exchanges. These rules are included in the Listing
Agreement and cover areas such as financial reporting, shareholder
communication, and corporate governance.
4. Mutual Funds: SEBI has also issued guidelines for mutual funds. These
guidelines cover areas such as investment restrictions, disclosure
requirements, and management fees.
5. Primary Market: SEBI regulates the primary market through its
guidelines for initial public offerings (IPOs). These guidelines cover areas
such as the eligibility criteria for companies to go public, the process of
issuing shares to the public, and the disclosures required.
These are just a few examples of the guidelines issued by SEBI. SEBI
continuously updates and revises its guidelines to ensure that the securities
market in India operates in a fair and transparent manner.

2.8 SUMMARY
In this Unit, we have discussed two segments of Indian securities market
namely primary market or new issues market and secondary market or stock
market. We have highlighted recent trends in the primary market and discussed
various types of market players and trading arrangements which exist in the
Indian stock market. Different aspects of the Indian stock market and stock
market information system have been explained so that you are able to clearly
visualise the environment in which investment and portfolio management
decisions are made. The unit also discusses various types of stock markets
and the role of SEBI as a regulatory body.

2.9 KEY WORDS

Initial Public Offering (IPO) : It is the process by which a private
organization offers shares of its stock to
the public for the first time
Multi Commodity Exchange : It is India’s largest commodity derivatives
of India Ltd. (MCX) exchange.
National Stock Exchange : It is the largest stock exchange in India in
of India (NSE) terms of market capitalization and trading
volumes.
Primary Market : Are markets where companies can raise
capital by issuing new securities to the
public for the first time.

44
Secondary Market : The secondary market is the segment in Securities Market
which outstanding issues are traded and
thus provide liquidity.

2.10 SELF ASSESSMENT QUESTIONS

1. What are the basic constituents of the securities market?
2. What are the different types of securities markets? What are their role
and functions?
3. What are different categories of players operating in primary and
secondary markets?
4. Write a brief note on the management of stock exchanges in India.
5. Briefly discuss recent trends in the development of the primary market
in India.
6. Describe NSE?

2.11 FURTHER READINGS

BSE (2023). https://www.bseindia.com/
Chandra, P. (2018). Investment Analysis & Portfolio Management (5e). Tata
McGraw Hill.
Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis
Portfolio Management (7th ed.). Pearson Education.
Gupta, L.C. (1992). Stock Exchange Trading in India-Agenda For Reform,
Society For Capital Market Research and Development, New Delhi.
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-02 Markets for Investment
[Video]. YouTube. https://www.youtube.com/watch?v=bp76hNEIjAs
National Stock Exchange (2023). https://www.nseindia.com/
Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., &Elston, F. (2019).
Investment Analysis & Portfolio Management. Cengage AU.
Rustagi, R. (2021). Investment Analysis & Portfolio Management. Sultan
Chand & Sons.
SEBI guidelines (2023) . https://www.sebi.gov.in/sebiweb/home/
HomeAction.do?doListing=yes&sid=1&ssid=5&smid=0
Tripathi, V. (2023). Taxmann’s Fundamentals of Investments. Taxmann
Publications Private Limited.

45
An Overview
UNIT 3 RISK AND RETURN
Objectives
After reading this unit you will be able to:
x understand the concept of risk and return;
x differentiate between systematic and unsystematic risk;
x discuss different techniques to measure risk;
x discuss the concept of risk and return trade-off.
Structure
3.1 Introduction
3.2 Concept of risk
3.3 Systematic risk
3.4 Unsystematic risk
3.5 Risk measurement
3.6 Risk and return trade-off
3.7 Summary
3.8 Key words
3.9 Self Assessment Questions
3.10 Further readings

3.1 INTRODUCTION
In this unit, the concept of risk is discussed in detail because no investment
decision can be taken without understanding the risk associated with the
investment. The importance of risk in investment decision can be appreciated
if you ask the investors why they invest one part of their savings in bonds and
the other part in equity. If risk is not a relevant factor in investment decision,
investor should bet all their savings only in equity stocks, which offer on
average higher return than debt instruments. Investors not only like return
but they also dislike risk. Many investors may be willing to take some amount
of risk since it is the only way to earn higher return but they need compensation
for taking such additional risk. Thus, investment decision not only requires
an estimation of return but also an assessment of risk to find whether the
return from a risky asset is adequate for the risk assumed by the investors.

3.2 CONCEPT OF RISK

The word ‘risk’ is common vocabulary and is widely used in the world of
investments. In normal life, the term risk often means a negative outcome. If
46 you say that it is risky to drive vehicle in a particular road, you actually mean
that driving in that road may cause an accident. However, the term risk in Risk and Return
investments has a different meaning. It not only refers to a scope of negative
occurrence but also implies the chance of positive return. For example, that
investment in stocks is riskier than investments in bond. It doesn’t mean that
investments in stocks will yield a negative return or it will be lower than
bond return. It simply means that investments in stocks may offer a high return
or also a huge loss. Risk captures variation in expected return and such
uncertainty of return is invest in risky investments, the expected return needs
to be higher. When such higher expected return is used for discounting the
future cash flows, the security value tends to move downward. This way you
can see a link between risk and return.
Since investment decisions are made based on the expected future outcome,
we can broadly classify our understanding and knowledge on future into four
categories. These are:
x Knowledge
x Ignorance
x Possible Outcomes
x Uncertainty
Knowledge: At one extreme, we have certain knowledge. If an investor invests
in government security, it is almost certain that the government pays interest
and principal on the due date. Only in extreme conditions, the government
may fail to honour the commitment.
Ignorance: At the other extreme, we have no idea on the future and we can
call this as our ignorance. Suppose an organization comes out with a public
issue stating that they will take up a research to develop a process that will
convert iron into gold. Many of us may not be able to judge the outcome
because we may not have any idea on the feasibility. No rational investment
decision is feasible when we are ignorant of possible outcome.
Possible outcomes: The third one is a situation where we know the possible
outcomes and its range. Suppose we are able to estimate that A’s earning will
grow by 30% if the economy does well and will decline by 10% if the economy
fails. If we are able to know the probability of the economy doing well or
failing, then the situation is called risky. For example, in the above case, if
we know the probability of economy doing well next year is 70% and the
probability of economy failing is 30%, then we can estimate A’s earnings in a
better way. Under this condition, the earnings of A will increase by 30% with
70% probability and decline by 10% with 30% probability.
Uncertainty: If we don’t know anything beyond a certain point, then the
situation is called as uncertain. It is again difficult to take a rational investment
decision in a situation of uncertainty. In other words, a situation pertaining to
future is considered as risky if we know the range of outcome and its
probability distribution.
Two elements in the concept of risk as applied to the world of investment and
finance deserve attention. One, risk in the investment sense is associated with 47
An Overview return. A person buys a financial asset with expectations of a return. The
investment decision would be premised on an ‘expected return’, which may
or may not actually be realized. The chance of an `unexpected’ or ‘adverse’
return would be the risk carried by an investment decision. For example, you
buy a share at ` 370 expecting a dividend of ` 6 per share in the coming year
and expecting the price to rise to ` 450 in a year’s time. You are basing your
decision to buy on a return of
(450 - 370) + 6.0 = 23.2 percent
370
Now, the price may rise only to ` 380 in which case the actual return downs to
a mere 4.2 percent, if the organization comes out with a dividend of ` 6 per
share on a ` 10 equity share. Should the dividend be pruned to ` 4 per share, the
return would further fall to 3.3 per cent. The other point to be stressed about
investment risk is that it is generally considered synonymous with uncertainty.
The investor is most of the time dealing with uncertainty and yet figuring out
his subjective probabilities for the expected return. The risk-zone in which the
investor moves is characterized by ‘stochastic knowledge’ and his beliefs about
the expected return enable him to work out a probability distribution of possible
outcomes. This is illustrated in the paragraph that follows.
Assume that you are interested in buying 1000 equity shares of an organization.
The market price of a ten-rupee share is ` 200. The highest prices were (2020-
21): ` 135; (2021-22) : ` 146; and (2022-23): ` 235. You expect the price to
go up to ` 250 within a year of your purchase. The organization paid the
following dividends (2020-21): 23%; (2021-22): 30% and (2022-23): 32%.
There has been a liberal record of five bonuses in the past, the last bonus
being in 2019-2020 in the ratio of 1:1. This information enables you to figure
an expected return of 26.6% assuming that the organization will maintain the
dividend of 32% in 2021-23 and that the price at the time of your sale will be
` 250. The expected return of 26.6% was derived as follows. The investor
gets a dividend of ` 3.20 and a capital gain of ` 50 when s/he sells the stock at
` 250. The net gain of ` 53.20 for an investment of ` 200 works out to 26.6%.

The figure you have estimated above is a single estimate of expected return.
Since future is uncertain, you may have to examine the probability of several
other possible returns. Thus, the expected return may be 20%, 30%, 35% or
10%. Now, you will have to assign the chances of occurrence of these
alternative possible returns on the basis of your information and subjective
beliefs. For example, you expect as shown in table 3.1
Table 3.1: Probability Distribution
Possible return (Xi) Probability Occurrence (P (Xi)
10% 0.10
20% 0.20
26.6% 0.40
30% 0.20
48 35% 0.10
You are clearly now not working on a point estimate. The earlier estimate of Risk and Return
26.6% is one of the five sets of outcomes you have generated. The table above
is known as a probability distribution and you can use it to have an insight
into the riskiness of your proposal to buy 1000 shares. The procedure would
be as follows:
i) Estimate the expected value of the five possible outcomes. If the possible
returns are denoted by Xi and the related probabilities by P(Xi), the
expected value (EV) is
EV =

In other words, it is the sum of products of possible returns with their respective
probabilities.
ii) You will be in a position to have some idea of risk by estimating the
variability of possible outcomes from the expected value of outcomes that
you have estimated in (i) above. A statistical procedure used for the purpose
is the calculation of standard deviation which is given as follows:

σ=

Where ‘σ ’ denotes standard deviation and all other terms as in (i) above. The
table 3.2 provides the required calculations:
Table 3.2: Calculation of Standard Deviation
Possible Probability Products Deviations Deviation (Xi -EV)2
Return (Xi) (P (Xi)) (Xi -EV) Squared x P(Xi)

(1) (2) (3)= (4) (5) = (4)2 (6)

(1) x (2)

10.0% 0.1 0.0100 -0.15 0.0229 0.0023

20.0% 0.2 0.0400 -0.05 0.0026 0.0005

26.6% 0.4 0.1064 0.01 0.0002 0.0001

30.0% 0.2 0.0600 0.05 0.0024 0.0005

35.0% 0.1 0.0350 0.10 0.0097 0.0010

EV 0.2514 σ2 0.0044
σ= = 0.0660

iii) The above calculations can be repeated for several stocks and if the
investor’s objective is to minimize risk, the one with minimum standard
deviation can be selected. Suppose there is another stock which offers
same expected return if 25.14% but the standard deviation of return is
lower than 0.0660. Then investors will prefer the new stock, which offer
lower risk with same return. You may note that squared standard deviation
(σ 2) is known as ‘variance’ and is an equally useful measure of risk.

49
An Overview
Activity 1
1. a) How many possible return outcomes could be estimated for a
Government security?
.......................................................................................................
.......................................................................................................
.......................................................................................................
b) What would be the probability of occurrence of the ‘outcome(s)’ in
(a) above?
.......................................................................................................
.......................................................................................................
.......................................................................................................
c) State how would you figure the one-period return on a risky security?
.......................................................................................................
.......................................................................................................
.......................................................................................................
d) What does the standard deviation of possible return show?
.......................................................................................................
.......................................................................................................
.......................................................................................................
e) Define risk.
.......................................................................................................
.......................................................................................................
.......................................................................................................
f) Can risk of an investment be considered without reference to return?
.......................................................................................................
.......................................................................................................
.......................................................................................................

3.3 SYSTEMATIC RISK

Systematic risk also known as refers to the overall risk that is inherent in the
entire market or an entire asset class, rather than being specific to a particular
company or industry. It is also known as “market risk” or “non-diversifiable
risk”. This type of risk cannot be eliminated through diversification, as it
affects the entire market or asset class. Examples of systematic risk include
economic recessions, political instability, inflation, interest rate fluctuations,
50 and natural disasters. These factors can cause widespread market fluctuations
that affect a large number of investments. Investors can manage systematic Risk and Return
risk through asset allocation and diversification. By investing in a variety of
assets across different sectors and industries, investors can minimize the impact
of market fluctuations on their overall portfolio. However, they cannot
completely eliminate systematic risk.
TYPES OF SYSTEMATIC RISK
There are several reasons for the future return varying from the expected
return and we grouped them under two broad categories. Our discussion was
more on measuring different components of risk and now we will discuss
more on understanding different sources of risk. There are different types of
systematic risk. These are as follows:
Interest Rate Risk
Market Risk
Inflation Risk (Purchasing power risk)
INTEREST RATE RISK
To start with, we will discuss an important source of risk namely interest rate
risk, which affects every sector in the economy. Often government through
RBI uses interest rates to push the economy forward or cool down the heated
economy. Interest rate risk arises from variations in such rates, which cause
changes in market prices. It can be seen that a rise in market interest rates
causes a decline in market prices of securities and vice versa. There are
different ways through which the interest rate affects the securities return. It
affects the expected or required rate of return because investors always
compare risk-free return with the expected return of an investment. An increase
in interest rate will cause an increase in expected or required rate of return of
other investments.
Illustration
Assume a 14% secured non-convertible debenture of ` 200 for five years. As
long as the market interest rate remains at 14%, the value of debenture will be
equal to ` 200. Suppose the interest rate in the market increases to 20%, it affects
the prices of debenture because an investor, who is willing to buy the debenture
would expect a return of 20% and hence discount the cash flows at 20%.
Solution
Year-end Cash Flow(` ) Present Value at 20%
28 23.33
28 19.44
28 16.20
28 13.50
228 91.63
Total 164.11
The debenture price will decline from ` 200 to 164.11. 51
An Overview Interest rate risk affects largely the securities with longer duration. For
instance, if there is another non-convertible debenture with 10 year maturity,
its price would decline to ` 149.69 from ` 200 if the interest rate increases
from 14% to 20%. The workings are as follows:
Year-end Cash Flow (`) Present Value at 20%

28 23.33

28 19.44

28 16.20

28 13.50

28 11.25

28 9.38

28 7.81

28 6.51

28 5.43

10 228 36.82

Total 149.69

Now let us know, how the interest rate risk affects stock price? Since stocks
have no maturity, the interest rate changes affect the stock prices more than
bonds. Secondly, increase in interest rates also reduces the profit of the
companies and hence securities prices are negatively affected. It can now be
stated that the market prices (or present values) of securities would be
inversely related both to market interest rates (or yield to maturity) and
duration. You will recognize that the interest rate risk is the price fluctuation
risk, which the investor is likely to face when interest rates change.
With a view to avoid the interest rate and duration risk, the investor, may like
to invest in short-term securities. Rather than buying a 5-year debenture, s/he
may buy a one-year security every time the earlier one-year security matures.
This strategy, though successful in reducing the interest rate or the price
fluctuation, would possibly expose the investor to another risk. Even the
coupon rates in successive short-term securities may vary and the range of
variation may be wide too.
MARKET RISK
You would have observed that the market moves upward at some point of
time and then moves downward at some other point of time. Such movements
may happen despite the good or bad performance of the companies. Often,
organization’s management and its employees will be puzzled why the market
fluctuates like this. Irrespective of our understanding, the reality is the market
move in one of the two directions (upward or downward) and once such trend
starts, it exists for a time. There are several reasons behind such movements.
52
These can be: Risk and Return

x Changes in economy or expectation about the future of the economy may

cause such widespread movement.
x Organization specific news may also cause such movement and if the
organization is a major one like any of the blue chip organizations, a
positive or negative development may generally affect several other stocks
in the market. Similarly, a shock in the U.S. market may have an impact
on domestic stock prices.
x Investors’ psychology also often contributes to the market risk. For
instance, negative news may create a panic in the market and everyone
would like to sell the stock without any buyer in the market. In this process,
the market will decline more than the desired level.
Market risk is demonstrated by the increased variability of investor returns
due to alternating bouts to bull and bear phases. Efforts to minimize this
component of total investment risk require a fair anticipation of a particular
phase. This needs an understanding of the basic cause for the two market
phases. It has been found that business cycles are a major determinant of
the timing and extent of the bull and bear market phases. This would
suggest that the ups and downs in securities markets would follow the
cycle of expansion and recession in the economy. A bear market triggers
pessimism and price falls on an extensive scale. There is empirical
evidence, which suggests that it is difficult for investors to avoid losing
in bear markets barring exceptions.
The question of protection against market risk naturally arises. Investors can
protect their portfolios by withdrawing invested funds before the onset of the
bear market. A simple rule to follow would be: ‘buy just before the security
prices rise in a bull market and sell just before the onset of the bear market’,
that is, buy low and sell high. This is called good investment timing but often
difficult to practice.
Market risk as pointed out earlier is also classified as systematic and non-
systematic. When combinations of systematic forces cause the majority of
shares to rise during a bull market and fall during a bear market, a situation
called systematic market risk is created. As already noted, a minority of
securities would be negatively correlated to the prevailing market trend. These
unsystematic securities face diversifiable market risk. For example,
organizations granted a valuable patent of obtaining a profitable additional
market share might find its share prices rising even when overall gloom
prevails in the market. Such unsystematic price fluctuations are diversifiable
and the securities facing them can be combined with some other shares so
that the resulting diversified portfolio offsets the non-systematic losses by
gains from other -systematic securities.
INFLATION RISK (PURCHASING POWER RISK)
Inflation risk is the variability in the total purchasing power of an asset. It
arises from the rising general price level. The interest rate on bonds and
53
An Overview debentures and dividend rates on equity and preference shares are stated in
money terms and if the general price level rises during some future period,
the buying power of the cash interest/dividend income is likely to be received
for that period would decline. And if the rate of inflation is equal to the money
rate of return, the investor does not add anything to his existing wealth since
he obtains a zero rate of return.
Many investors believe that if the market prices of their financial assets
increase, they are financially better off in spite of inflation. Their argument is
‘after all money is increasing’. This is nothing but ‘money illusion’. Consider,
for instance, a situation when the market price of a security you are holding,
doubles and the general price level increases four-fold. Would you say that
you are richer simply because your command over money doubles by selling
the security? True, you get more money than what you had earlier but you
can buy less with that money. You can’t dismiss the fact that your command
over goods and services (which is the eventual objective of all investment
decisions) has declined due to a four-fold rise in prices in general.
The money illusion is partly rectified by obtaining real rates of return (interest/
dividend cash income + capital gains) that is equivalent to the inflation-
adjusted monetary or nominal rates of return. If the real rate of return is denoted
by Rr, inflation rate by q, coupon rate by ‘r’ and nominal rate of return by R,
then:
= - 1
For example, a ` 500 debenture earns a coupon rate of 15% per annum.
Inflation rate expected in the coming one-year period is 12%. Then the real
rate of return would be:
= - 1 = 1.027 – 1 = 0.027 or 2.7%
You may notice the drastic fall in the real rate of return to 2.27% from the coupon
rate of 15% due to inflation rate of 12%.

Again, an equity share of `10 promises a dividend of 20% and you expect the
price of the share to rise from the current level of ` 60 to ` 80 in a year’s time.
Inflation during the next year is estimated at 14%.The rea lrateof return would
be:

Nominal rate {R} = = 36.7%

Real rate of Return {R} = - 1 = - 1 = 1.199 – 1 = 0.199 or 19.9 %.
The above examples clearly highlight the effects of purchasing power risk on
the wealth and returns of an investor.
A question is sometimes asked about negative real rates of returns, that is, a
situation where the inflation rate exceeds the nominal rate. Should an investor
stop investing in such situations? The answer would depend on what other
alternatives the investor would have in the event of not investing. If the money
withheld from investment is kept as idle cash with zero nominal return then
investing even with negative real returns, may be advisable because, as shown
54 in the example below, non-investment would yield a larger negative real return
than investing. And even though normal investment objectives would be to Risk and Return
earn positive real rates, in abnormal situations like the one stated above, the
objective would be to reduce the negative real rate of return.
Assume that a security is expected to yield a nominal rate of return of 12%
and the rate of inflation is expected to be 15%. We have now to work out the
choices of the investor, further assuming that if he does not invest; her/his
cash will have to remain idle.
Now, if our hypothetical investor decides to invest, her/his real rate of return
would be :
= - 1= - 1 = 0.974 – 1.0 = - 0.026
It works out to a negative 2.6% return. Should the investor decide to keep
idle cash, the real rate of return would be;
= - 1 = - 1 = 0.869 - 1.0 = -0.131
It would be better to have a negative return of 2.6 than to end with a negative
return of 13.1% by keeping cash idle.
You have seen that the purchasing power risk arises even if the market prices
of assets rise. Likewise, this risk may emerge even if the asset prices do not
fluctuate. The reason for these relationships is that the purchasing power risk
arises from fluctuations in the purchasing power of real income and/or real
price of assets and not from fluctuations in buying power of their nominal
income and/or nominal prices.
It has already been stated that investment assets are real assets like land, real
estate, gold, diamonds and financial or monetary assets like shares, bonds,
and debentures. It has been observed that prices of real assets move with
inflation and are positively correlated with it. In contrast, prices of monetary
assets are relatively rigid and are negatively correlated with inflation. In
consequence, real assets do not lose purchasing power, as do the monetary
assets in periods of inflation. In other words, real assets are good inflation
hedges but monetary assets are not. Hence, monetary assets cannot form part
of a portfolio, which already has got a high degree of purchasing power risk.
Such a portfolio can be diversified with real assets.
Activity 2
Collect monthly data of movements in the BSE-100 Index for the last few
years. Plot them on a graph with months and years on the horizontal scale
and Index levels on the vertical scale. Read the resulting graph and point
out.
a) No. of peaks
b) No. of troughs
c) Duration of all peaks and troughs
d) Average duration of all peaks and troughs.
55
An Overview
Also prepare a brief comment on the information of ‘bull’ and ‘bear’
markets from the information that you obtained.
..................................................................................................................
..................................................................................................................
..................................................................................................................
..................................................................................................................

3.4 UNSYSTEMATIC RISK

Unsystematic risk, also known as “specific risk or diversifiable risk” refers
to the risk that is specific to a particular company, industry, or asset. It is the
opposite of systematic risk, which affects the entire market or asset class.
Examples of unsystematic risk include company management issues, supply
chain disruptions, labor strikes, product recalls, and legal liabilities. These
factors can affect the performance of a specific company or industry, without
necessarily impacting the broader market.
Investors can reduce unsystematic risk through diversification. By investing
in a range of assets across different companies and industries, investors can
spread their risk and reduce their exposure to any single company or industry’s
specific risk. This helps to minimize the impact of negative events on an
investor’s overall portfolio.
TYPES OF UNSYSTEMATIC RISK
There are different types of unsystematic risks. These include:
x Financial Risk
x Business Risk
x Management Risk
FINANCIAL RISK
The default risk arises from a deterioration of financial strength of the
organization that issues securities. Holders of such securities have to
experience greater variability of returns when financial strength begins to
worsen. Since the basic parameter is‘financial health’, default risk is also
known as financial risk.
Financial risk arises when the organization uses debt in its capital structure.
Debt brings fixed liability and hence increases the variability of income
available to the equity shareholders. Use of debt is not always bad. It will
increase the profitability when the organization performs well and equity
holders get a return more than what is available otherwise. Debt creates
problem in bad times because of the fixed liability. If the organization fails to
meet the debt obligation, the managers need to spend a lot of time in convincing
the lenders to accept delayed payment and in meanwhile loose valuable
56 managerial time. Default easily spread bad words about the organization and
the organization faces problem from several fronts. It may not be able to get Risk and Return
credit from suppliers and some of the good workers may leave the organization.
Customers will also prefer companies with sound financials to avoid
uncertainty in supply.
The impact of financial risk up to a limit is restricted only to the equity holders.
But too much of debt creates problems even to existing debt security holders
unless the debt is fully secured. Even in such cases, it is difficult to take
charge of the assets and sell it to meet their liability in view of lengthy legal
process.
If not handled properly, the default episodes of a organization may as well
finally end up in bankruptcy. This would, however, not be quite a swift process
and one may notice warning signals before the final disaster strikes. For
example, an organization may begin stopping payment of its bills, accumulate
arrears of cumulative preference dividends and accrued interest on loans,
default on debenture interest, incur persistent losses, slash the equity dividend,
and finally skip it, and so on. In more objective terms, adverse movements in
financial ratios like the current ratio, the acid-test ratio, the cash to operating
expense ratio, the net-worth to total assets ratio and so on can be put on the
watch. The point is that bankruptcy will not be a bolt from the blue except
when an act of nature destroys all assets, which are not insured.
Organizations operating in the financial services sector like CRISlL, CARE
and ICRA undertake an ongoing exercise to provide quality-ratings to the
debt instruments of issuing companies. They are at present being solicited in
India by companies who want to raise funds from the capital market. In Western
countries, the rating programme is a voluntary and continual exercise
performed by eminent organizations like Standard & Poor. Ratings as given
by these agencies are a significant aid to the investor in estimating the
probabilities of default in a particular debt issue.
When the first sign of a weakening financial health of a organization is noticed,
market price of its security reacts and takes a deep dip. The price decline will
be equal to the estimated loss when the organization goes into bankruptcy.
The immediate target groups would be lenders and loan creditors but ultimately
even shareholders would suffer. In fact, if the worst happens, losses of equity
holders could be total and they may end up with share prices nearly dropping
to zero. Also, even at such abysmally low levels, there may not be any takers.
As with other risk factors, there may be diversifiable and non-diversifiable
components of default risk. Thus, tight credit conditions created by Reserve
Bank of India would push up interest rates and financially weak companies
may not be able to borrow. Similarly, a recession may curtail order position
of the organizations and organizations that are already weak may start
defaulting when their sales and income decline. These are examples of
systematic forces that affect all organizations simultaneously and
systematically push them towards default. You should note that these are
extraordinary circumstances and would push up the normal default rate of
organizations. The systematic element in default risk is more harmful to the
investor than the diversifiable element. The latter can be anticipated and
57
An Overview managed. For example, a government security can be added to the portfolio
unless securities exposed to normal default risk themselves are yielding an
average return that is very much in excess of the default-free securities.
Liquidity risk
Liquidity risk is a type of financial risk. Liquidity risk of securities results
from the inability of a seller to dispose them off except by offering price
discounts and commissions. It is easy to rank assets according to liquidity.
The currency unit of a country is immediately saleable at par and no discount,
etc., need be given. Government securities and blue chip shares are the next
highly liquid group of assets. Debt securities and equity shares of some small
and less known companies are less liquid or even illiquid. Lack of liquidity
forces investors to sell the securities at a price below to the existing price,
particularly when the quantity to be sold is large. Investors must consider the
liquidity risk factor while selecting securities.
BUSINESS RISK
Organizations operate in an environment, which often changes and such
changes causes variation in expected income. For example, a change in
government policy on fertilizer subsidy may affect a group of companies in
the fertilizer industry. Similarly, an action by a competitor, domestic or from
outside may also affect other companies. While the above changes in the
environment are caused by certain entities, there are several factors, which
change the operating environment but can’t be attributed to anyone. For
instance, many organizations are exposed to business cycle and the income
of such organizations significantly differs from period to period. Companies
in steel, auto and shipping industries are exposed to such business cycles. It
is difficult to assess whether the business risk is systematic or non-systematic.
A diversified portfolio consisting of securities of several industries can
diversify such business risk to a great extent. On the other hand, portfolios
with few stocks or stock drawn from select industries would be exposed to
such business risk if all sectors of the portfolio were affected by changes in
the environment.
MANAGEMENT RISK
Management risk is that part of total variability of return which is caused by
managerial decisions in organizations where owners are not managers. However
qualified and capable the management team, there are chances for judgmental
errors and wrong decisions. Owners-investors are rightly aggrieved when
executives are paid high salaries and perks and are allowed ego-bolstering non-
income consumption like luxury cars, lavishly furnished offices and yet they
plunge the organization in severe difficulties by their inept decisions.
Management errors are the main reasons, which give rise to management risk
component of total investor risk. The errors are so numerous that it is difficult
to either list them or even to classify them. Nevertheless, some potential areas
of management errors can be highlighted. The one great blunder that
management might commit is to ignore product obsolescence. In fact, adequate
58 expenditure must be made on R & D and alternative products are promoted
before the life cycle of existing ones comes to an end. Single product Risk and Return
organizations will be more exposed to this risk than organizations with
diversified product lines. Another risk is the dependence of a organization on
a single large customer. Management must adequately diversify customer
groups. Many organizations supplying military equipment have been found
caught up in deep financial distress when the Government announces cuts in
military spending. Many software companies are also facing this problem
and making effort to diversify customers as well as country exposure. Yet one
more area of management errors could be the wrong handling of a correct
decision when it is subjected to unfair criticism and is even fought out in a
court. For example, an automobile manufacturer develops a fuel-efficient small
car much ahead of times. Some ardent consumer protection group brings a
lawsuit on the grounds of user-safety being threatened. The organization then
announces abandonment of the product, forcing investors to bear the loss of
investments and lost revenues in future. You should note that these cases are
only illustrative and the list may go to an infinite number of factors.
Agency Theory and Management Risk
A recent development in the area of explaining management risks is concerned
with research that seeks to explain the basic motivations of owners and
managers. It has been stated that owners work harder than managers, who do
not have ownership interest in a organization. Moreover, non-owner managers
have strong incentives to consume non-pecuniary benefits since they are hired
employees. The emerging theory hypothesizes that owner-non-managers
delegate all authority to non-owner- managers, who then operate under a
principal-agent relationship. Since ex-post rewards and punishments are not
perfect and just, hired executives may not make, as much ex ante effort to
generate profitable investment opportunities than they would if they owned
the organization. Thus, there is a conflict of interest between owners and
managers and the latter may abuse the authority delegated to them much to
the detriment of owners. In consequence, investors, who are rational
individuals, would pay a higher price for shares of owner-managed
organizations than for shares of employee- managed organizations. The
difference between the two sets of prices has been termed as ‘agency cost’. It
must be observed that the theory has not gone without criticism but the view
is getting increasingly accepted.
Evaluating Management
Investors and security analysts must attempt to evaluate the management team
of an organization for its strengths and deficiencies. The task, though difficult
and highly subjective, must be done using some vital checkpoints, which are
briefly stated below:
1) Age, health, and experience profile of executives
2) Growth-orientation and aggressiveness of management
3) Composition of Board of Directors and the number of outside directors;
Effectiveness of the Board.
4) Management depth of the organization i.e., extent of delegation and 59
An Overview decentralization and development of managers at all levels with a strong
middle-management team.
5) Dynamism and flexibility of management.
6) Dividend payout policy and cash dividend record.
7) The depth and transparency of annual reports to shareholders (corporate
disclosure practices).
8) Compensation to managers including special arrangements like stock
option plans.
9) Compliance record of environmental, consumer protection, and fair trade
practices.
10) Extent of implementing corporate governance codes.
Diversifiable and Non-diversifiable Elements
Management errors are instances of management weaknesses. During normal
periods, they go unnoticed but during periods of difficulty, not only are these
errors conspicuously observed but also the responses of weak management
become very poor.
Difficulties crop up when stresses are built up for all organizations irrespective
of the quality of management. For example, a shortage of petroleum products
or emergence of a strong global competitor would aggravate problems and
increase their number manifold. Since all organizations would be affected,
the investor would have no choice to diversify. Of course, s/he would sell off
shares of organizations with weaker management because they would be more
prone to committing management errors during such stresses or systematic
pressures. This would lower security prices of such organizations and investors
would hold them only if higher rates of return are offered. But while this may
happen, there is no escape for the investor. If s/he moves from a weaker
organization to a organization that is not so weak, systematic pressures would
still work. Hence, this component of management risk is known as systematic
or non-diversifiable risk.
It must be observed that even best managers can commit errors during normal
periods. This would be a case of diversifiable management risk. Normal
management errors occur randomly and investors can diversify by shifting
their investments across companies.
Activity 3
Select a small and a medium-sized/large-sized organization and visit
their web site. Write a note on your experience after browsing the web
site. Are you happy with the kind of information provided for investors
in the web site? You can also visit a web site of foreign organization
and compare the contents provided in the web site of the organization
with Indian organizations.
...........................................................................................................
...........................................................................................................
60
 Risk and Return
3.5 RISK MEASUREMENT
You would have also come across a statement in this unit that the standard
deviation measures the total risk of an investment. The later developments,
in the theory of investment risk decompose this ‘total’ into several of its
components. And this can be done in two ways.
x One, dividing total risk into systematic and unsystematic risk and two,
dividing total risk into parts such that each of which has an origin in
some causal force. Obviously, the first part of the decomposition exercise
is broad and has relation to the market.
x The second part of the exercise relates to the factors or causes which
produce risk in investments.
The division of total risk into ‘systematic’ and ‘unsystematic’ or ‘non-
systematic’ owes its origin to developments in the area of portfolio theory.
Sources of risk that cause variability of returns may be perceived as belonging
to two general classes- those that are pervasive and affect all securities though
in varying degrees e.g., inflation, interest rates, market sentiment, etc., and
those that are specific to a particular security e.g., financial risk and business
risk. When variability of returns moves with the market, it is recognized as
‘systematic’. Organizations cannot eliminate such a risk and they are of major
concern to the investor. For example, when prices rise, all organizations would
be affected in terms of their costs and realizations, which in turn would affect
variability of returns. This will be a market phenomenon and would tend to
stay for all. The investor would demand compensation for this risk component
in figuring out his expected rate of return. On the other hand, when variability
of returns occurs because of organization-specific factors like the failure to
obtain a prestigious overseas contract, or a higher exposure to the risk of
default in payment of interest charges and debt obligations, the risk is termed
‘non-systematic’. Since this part of risk can be reduced through a diversified
portfolio, it is not considered while computing the expected or required rate
of return.
Total Risk
The two components of total risk are additive and hence total risk is equal to
Systematic risk plus Non-systematic risk. Systematic risk is normally measured
by comparing the stock’s performance vis-a-vis market’s performance under
different conditions. For example, in a good period, if the stock appreciates
more than other stocks in the market and in a bad period, it depreciates more
than other stocks in the market; the systematic risk of the stock is more than
the market risk. The systematic risk of the market (normally widespread market
index like BSE-100 or NIFTY-50 index) is equal to 1 and systematic risk of
all stocks is expressed in terms of systematic risk of market index.
Beta Calculation
Beta factor, also known as beta coefficient, is a measure of the volatility, or
systematic risk, of a security or a portfolio in relation to the overall market.
The beta factor indicates how much the price of a security is expected to 61
An Overview move relative to the movement of the overall market.
The formula for calculating beta is:
Beta = Covariance of the security’s returns with the market’s returns / Variance
of the market’s returns
The steps to calculate beta are as foloows:
Gather data: Collect historical data for the security’s returns and the market’s
returns for a given period. The market return can be represented by a
benchmark index, such as the S&P 500.
Calculate the average return for both the security and the market for the
given period.
Calculate the covariance between the security’s returns and the market’s
returns. Covariance measures the degree to which two variables move together.
A positive covariance indicates that the two variables move in the same
direction, while a negative covariance indicates that they move in opposite
directions.
Calculate the variance of the market’s returns. Variance measures the degree
of dispersion of a set of data points around their average. It represents the
overall volatility of the market.
Divide the covariance by the variance to get the beta coefficient.
The beta of the stock is equal to beta of the regression coefficient when stock’s
of returns are regressed on return of market - index. If the beta of stock is
1.50, then the stock is expected to show a price increase of 1.5 times of stock
returns in a good period. At the same time, if the market declines by some
percentage in a bad period, the stock is expected to decline 1.5 times more
than market’s negative returns.
For illustrative purpose, the weekly price and return data BSE-100 index,
‘A’, ‘B’ and ‘C’ Industries are taken for a period of six months (July, 2022 to
December 2022). Using the return data and regression, the beta values of the
three individual stocks are computed. A’s beta shows the lowest value and is
0.49. The stock is less volatile during the period. The market as a whole
(measured through BSE-100 index) has reported a net loss of 32% during the
six months period, whereas A has suffered a net loss of 27.60% during the
same period. A week-to-week comparison shows that A suffered less or posted
profit when the market was reporting loss during the week.
On the other hand, C Industries reported a gain of 8.30% against the market
loss of 32%. Again a week to week comparison shows the C Industries weekly
return are closely moving in line with BSE-100 and hence got a beta value of
0.96, which is close to market’s beta of 1. B showed wide variation during the
period. Against a market loss of 32%, B reported a net loss of 54.79% and
also showed high volatility in the returns. The beta of 1.82 reflected the
volatility. Thus, the systematic risk of A is the lowest and B is highest whereas
C Industries has shown a moderate systematic risk. The unsystematic risk of
62
the stock is equal to total risk less systematic risk. It is computed as follows: Risk and Return

Unsystematic Risk = Variance of the stock - [β2 x Variance of the Market

Index]
Sometime, the unsystematic risk is expressed as a standard deviation. For the
three illustrative stocks, the systematic and unsystematic measures are as
follows:
BSE-100 A B C

Total Risk(variance) 0.0024 0.0029 0.0111 0.0037

Beta (β) 1.0000 -0.0444 -0.8528 -0.1588

Systematic Risk (variance) 0.00024 0.0011 0.0043 0.0023

Unsystematic Risk (variance) 0.0017 0.0069 0.0014

Unsystematic Risk (SD) 4.13% 8.28% 3.73%

3.7 RISK AND RETURN TRADE-OFF

An individual invests ‘postpones consumption’ only in response to a rate of
return, which must be suitably adjusted for inflation and risk. This basic
postulate, in fact, unfolds the nature of investment decisions. Let us understand
it:
Cash has an opportunity cost and when you decide to invest it you are deprived
of this opportunity to earn a return on that cash. Also, when the general price
level rises the purchasing power of cash declines - larger the increase in
inflation, the greater the depletion in the buying power of cash. This explains
the reason why individuals require a ‘real rate of return’ on their investments.
Now, within the large body of investors, some buy government securities or
deposit their money in bank accounts that are adequately secured. In contrast,
some others prefer to buy, hold, and sell equity shares even when they know
that they get exposed to the risk of losing their much more than those investing
in government securities. You will find that this latter group of investors is
working towards the goal of getting larger returns than the first group and, in
the process, does not mind assuming greater risk. Investors, in general, want
to earn as large returns as possible subject, of course, to the level of risk they
can possibly bear.
The risk factor gets fully manifested in the purchase and sale of financial
assets, especially equity shares. It is common knowledge that some investors
lose even when the securities markets boom. So there lies the risk.You know
risk, as the probability that the actual return on an investment will be different
from its expected return. Using this definition of risk, you may classify various
investments into risk categories.
Thus, government securities would be seen as risk-free investments because
the probability of actual return diverging from expected return is zero. In the
case of debentures of an organization the probability of the actual return being
63
An Overview different from the expected return would be very little because the chance of
the organization defaulting on stipulated interest and principal repayments is
quite low. You would obviously put equity shares in the category of ‘high
risk’ investment for the simple reason that the actual return has a great chance
of differing from the expected return over the holding period of the investor,
which may range from one day to a year or more.
Investment decisions are premised on an important assumption that investors
are rational and hence prefer certainty to uncertainty. They are risk-averse
which implies that they would be unwilling to take risk just for the sake of
risk. They would assume risk only if an adequate compensation is forthcoming.
And the dictum of ‘rationality’ combined with the attitude of ‘risk aversion’
imparts to investments their basic nature.
The question to be answered is: how best to increase returns with a given
level of risk? Or, how best to reduce risk for a given level of return? Obviously,
there would be several different levels of risks and different associated
expectations of return. The basic investment decision would be a trade-off
between risk and return.
Figure 3.1 depicts the risk-return trade-off available to rational investors.The
line RfM shows the risk-return function i.e., a trade-off between expected
return and risk that exists for all investors interested in financial assets. You
may notice that the RfM line always slopes upward because it is plotted against
expected return, which has to increase as risk rises. No rational investor would
assume additional risk unless there is extra compensation for it. This is how
his expectations are built.
This is, however, not the same thing as the actual return always rising in
response to increasing risk. The risk-return trade-off is figured on ‘expected
or anticipated (i.e., ex-ante) return’ and not on actual or realized (ex-post)
return’. Actual return will also be higher for high-risk securities, if you plot
long-term return of these investments. It is relatively easier to show evidence
for this in debt instruments. For example, Treasury Bills offers lowest return
among the government securities because of their short-term nature.

64 Figure 3.1: The Expected Return-Risk trade-off functions

Government bonds with a long-term maturity offer a return higher than treasury Risk and Return
bills because they are exposed to interest rate risk. We will discuss more when
we cover bond analysis. Corporate bonds offer a return more than government
bonds because of default risk. The return ranges from 12% to 18% depending
on the credit rating of the bond. The returns of all these securities are less
volatile compared to equity return. The long-term return of BSE Sensitive
Index is around 18%.
You may now look at figure 3.1 to understand the relative positioning of
different financial assets on the risk-return map. The point Rf is the expected
return on government securities where risk is zero and is recognized as the
risk-free rate. As you move on the Rf_M line, you find successive points,
which show the increase in expected return as risk increase. Thus, equity
shares, which carry lot more of risk than government securities and
organization debentures are plotted higher on the line. Organization debentures
are less risky than equity because of the mortgages and assurances made
available to the investor but more risky than government securities where the
default risk is zero because government generally does not fail. They are placed
between the two securities viz., government securities and equity shares.
Warrants, options and financial futures are other specialized financial assets
ranked in order of rising risk. We shall know more about these investments in
a latter unit.
An important point deserves attention while interpreting the risk-return trade-
off of the type presented in figure 3.1. It shows a simple fact. Financial
securities are of different types and they offer different risk-return combination.
The risk and return also move together. Thus, if an investor is not willing to
assume any risk, s/he will have to be satisfied with the risk-free rate i.e., Rf
by investing the wealth in government securities. If you are not happy with
8% or 9% return of government securities, you can move to next security that
offers higher return. But there is a cost associated with such higher return.
Investors in corporate bonds have to bear additional risk compared to investors
of government securities. One of the important sources of additional risk is
default risk since companies may fail to honour the interest and principal
liability. As you move on the ladder, you can expect a higher return but your
risk also increases. Investors need to strike a balance when they allocate their
wealth under various investments. If someone invests their entire savings only
in government securities or only in high- risk securities like equity or
derivatives, it may not yield desired result. Investors need to balance the
investments by partly investing in equities and partly in government securities.
The proportion of investment can be changed depending on the economic
outlook. Allocation of wealth on different securities and periodical revision
should be an integral part of your investment strategy. We will discuss more
on this strategy in the next section as well as in a separate unit.

3.7 SUMMARY
Considerations of risk are vital for investments. A potential investor looks at
some expected return, which occurs in future. And what is certain about future
is its uncertainty. A decision today for a tomorrow, which is uncertain, is the 65
An Overview kind of topography on which an investor has to walk. The path is rugged and
the journey full of risk. An intelligent investor would want to make his journey
as smooth as possible. S/he would attempt to anticipate the kind of risks she
is likely to face and also the vast number of factors that probably produce
these risks. Even though s/he understands that he task is highly subjective,
she makes her best efforts to remain anchored to cannons of rationality.
The two-step procedure that an investor follows in accomplishment of the
objective is to get some specific insights into the total investment risk and
then to familiarize with, various elements and factors that sum up to such
total risk. For estimating the total risk, the investor uses past experience and
modifies it appropriately for the expected changes, in the future and then
develops a subjective probability distribution of possible returns from the
proposed investment. This probability distribution is then employed to estimate
the expected value of the return and its variability. The ‘mean’ gives the
expected value and ‘variance’ or ‘standard deviation ‘gives the variability or
the measure of risk. The widely used procedure for assessing risk is known as
the mean-variance approach.
The ‘variance’ or ‘standard deviation’ provides an overview of risk. It measures
‘total risk’. In actual practice, various factors produce this total risk. A
decomposition of total risk would be necessary to gain knowledge of the
influence of these factors individually. Recognizing some recent developments
in the theory of risk measurement, especially the portfolio aspects, a first step
in reaching out to the components of total risk are to divide it into systematic
or market-related risk and non-systematic or diversifiable risk.
When it comes to specifying the factors influencing total risk, one may group
them into two broad classes, viz., factors, which produce non-diversifiable or
systematic risk and factors which cause non-systematic or diversifiable risk.
The former category comprises causes like interest rate variations, inflation,
or market sentiment (or bull-bear market) which would affect all organizations
and their measurement will be useful in estimating required rate of return.
The latter category would, on the other hand, include causes like business
environment, financial leverage, management quality, liquidity, and chance
of default. They affect some organizations but no others. These sources of
risk are expected to have minimum impact on a diversified portfolio and hence
one need not be concerned with them too much.

3.8 KEY WORDS

Agency Theory : Documents that view that managers have incentives
to consume as against owners who have motivation
to work hard. Agency theory postulates non-owner
managers to be more susceptible to management
errors.
Bear Market : A period (measured generally in months) during which
the market indexes and prices of most shares decline
in a given market. This phase is characterized by
66 pessimism and low volume.
Bull Market : A period during which the market indexes and prices Risk and Return
of most shares rise in value in a given market and
when optimism prevails.
Diversifiable Risk : Variability of return caused by factors that are unique
to one or afew securities. Such variability is averaged
out to zero in diversified portfolio and can, therefore,
be eliminated.
Default Risk : The variability of returns to investors caused by
changes in the probability that the company issuing
securities might default. Also known as financial risk
and/or bankruptcy risk.
Illiquid Assets : Assets including securities, which cannot be readily
sold unless deepprice discounts and/or commissions
are given.
Liquidity Risk : The probability that securities will not be sold out for
cash without price discounts and/or commission.
Management : An assessment of an organization’s management and
Evaluation its aggressiveness, growth-orientation, research and
development plans, utilization of board of directors
depth, flexibility, ability to earn profits and stay
abreast of modern developments, experience,
education, and compensation plans.
Non-Diversifiable : Variability in the investor’s rates of return arising out
Risk of common and macro-level factors like an economic
downturn, general rise in prices. Increase in interest
rates, and bull/bear phases of the securities market.
All returns of securities are systematically affected
by these factors. Hence, the risk is also known as
‘systematic risk’.

3.9 SELF-ASSESSMENT QUESTIONS

1) Which of the following concepts of ‘risk’ would you consider better and
why?
a) Margin of Safety
b) Debt Ratio
c) Standard deviation
2) Explain the following terms :
a) Diversifiable interest rate risk
b) Liquidity risk
c) Real rate of return
67
An Overview d) Peaks and troughs of business activity
e) Duration
3) Distinguish between
a) Financial risk and business risk
b) Diversifiable risk and Non-diversifiable risk
c) Nominal rate of return and Real rate of return
d) Market interest rate risk and coupon rate risk
e) Individual security risk and portfolio risk.

3.10 FURTHER READINGS

Altman,Edward I. (1983) Corporate Financial Distress, New York: Wiley.

Chandra, P. (2018). Investment Analysis & Portfolio Management (5e). Tata

McGraw Hill.
Curley, Anthony J.,and Bear,Robert M.. (1979).,Investment Analysis and
Management, New York: Harper & Row.

Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis

Portfolio Management (7th ed.). Pearson Education.
Harlow,J.Henemen. (1970) ,Reading in Financial Analysis, Ind. Ed .Homewood III
: Richard D. Irwin.

Henderson, Richard.(1980). Performance Appraisal.,Reston,VaReston Publishing.

IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-03 Risk and Return [Video].
YouTube. https://www.youtube.com/watch?v=fGrS8fRilS4
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-04 Risk and Return (Contd.)
[Video]. YouTube. https://www.youtube.com/watch?v=H9hvDKLI-hQ
Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., &Elston, F. (2019).
Investment Analysis & Portfolio Management. Cengage AU.
Rustagi, R. (2021). Investment Analysis & Portfolio Management. Sultan
Chand & Sons.
Sprinckel,Bery W. (1964) Money and Stock Prices.,Homewood III.:RichardD. Irwin.

Tripathi, V. (2023). Taxmann’s Fundamentals of Investments. Taxmann

Publications Private Limited.

68
 Risk and Return
UNIT 4 INVESTMENT THEORIES
Objectives
After reading this unit, you should be able to:
• Explain the concept of market efficiency;
• Differentiate various forms/degrees of market efficiency;
• Undertake various empirical tests of market efficiency;
• Discuss the implications of Efficient Market Hypothesis (EMH).
Structure
4.1 Introduction
4.2 Investment Theories
4.3 Basic concept of Market Efficiency
4.4 Forms of Market Efficiency
4.5 Empirical tests of EMH
4.6 Anomalies in EMH
4.7 Implications of EMH
4.8 Random Walk Theory
4.9 Summary
4.10 Key words
4.11 Self Assessment Questions
4.12 Further Readings

4.1 INTRODUCTION
The validity of the assumption that the market price is not equal to the intrinsic
value is questionable. The approach, called ‘Efficient Market Hypothesis’, is
based on the premise that current market price is a true reflection of the value
of the securities (stocks) and hence it is futile to expect that fundamental or
technical analysis will yield a superior return by identifying under-priced or
over-priced stocks. Under efficient market hypothesis, investors can expect a
return commensurate with the risk associated with such investments.
Efficient Market Hypothesis was an issue that was the subject of intense debate
among Academics and Finance Professionals during the last five decades.
The Efficient Market Hypothesis states that at any given time, security prices
fully reflect all available information. The implications of the efficient market
hypothesis are truly profound. Most individuals who buy and sell securities
(stocks in particular), do so under the assumption that the securities they are
buying are worth more than the price that they are paying, while efficient and 69
An Overview current prices fully reflect all information, then buying and selling securities
in an attempt to outperform the market will effectively be a game of chance
rather than skill.
Under efficient investors cannot outperform the market since there are
numerous knowledgeable analysts and investors who would not allow the
market price to deviate from the intrinsic value due to their active buying and
selling. The current market price therefore reflects the intrinsic value at all
time and hence, there is no need for fundamental analysis or technical analysis.
Empirically also market prices have been observed to move randomly or
independently. A net outcome of all this had been a good deal of confused
surroundings of the efficient market model or random walk model. It is perhaps
for the same reason that we still talk of efficient market hypothesis and not
efficient market approach to equity investment decision.
In this unit, you will learn the concepts and forms of market efficiency, some
empirical tests of EMH and also the anomalies in EMH and the implications
of EMH for security analysis and portfolio management.

4.2 INVESTMENT THEORIES

There are several investment theories that have been developed over time to
guide investors in making investment decisions. Here are some of the most
prominent ones:
1. Efficient Market Hypothesis (EMH): EMH was developed by Eugene
Fama in the 1960s. It suggests that financial markets are efficient, meaning
that prices reflect all available information about a security. According to
EMH, it is impossible to consistently outperform the market because all
relevant information is already reflected in the stock price.
2. Random Walk Theory: The random walk theory is a mathematical model
used to describe the behavior of financial markets, which suggests that
the price movements of stocks, bonds, and other securities are random
and unpredictable.
3. Modern Portfolio Theory (MPT): MPT was introduced by Harry
Markowitz in 1952. It is based on the principle of diversification, which
means that investors can reduce their portfolio risk by holding a mix of
assets that are not perfectly correlated with each other. MPT suggests
that investors should allocate their portfolio among different asset classes,
such as stocks, bonds, and cash, based on their risk tolerance and return
objectives.
4. Value Investing: Value investing is an investment approach popularized
by Benjamin Graham and Warren Buffett. It involves buying undervalued
stocks that are trading at a price lower than their intrinsic value. This
approach requires a thorough analysis of a company’s financial statements,
balance sheet, and income statement.
5. Growth Investing: Growth investing involves investing in companies
that have high growth potential, but may not be profitable yet. This
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 approach is popular among investors who are willing to take on more risk Investment Theories
in the hope of earning higher returns.
6. Behavioral Finance: Behavioral finance is a relatively new field that
combines finance and psychology. It suggests that investors are not always
rational and can be influenced by biases and emotions. Behavioral finance
tries to understand how these biases affect investment decisions and how
to mitigate their effects.
These are just a few of the many investment theories out there. Each theory
has its own strengths and weaknesses, and investors should carefully consider
which approach is best for their individual needs and goals. In this unit we
will concentrate on EMH and Random Walk Theory.

4.3 BASIC CONCEPT OF MARKET EFFICIENCY

The Efficient Market Hypotheisis was discovered by chance, in 1953, by
Maurice Kendell Lu, a distinguished statistician. Kendell had been looking
for regular price cycles, but to his surprise he could not find any. He came to
a finding that there exists no pattern in the movement of share prices and that
the change in prices is a random event. Initially, this result disturbed many
economists because they interpreted the random behaviour of stock prices as
an outcome of erratic market psychology and it follows no logical rules.
However, over a period of time, they started appreciating that in a well
functioning or efficient market, prices will indeed change randomly reflecting
the impact of new information.
The Efficient Market Hypothesis slowly evolved in the 1960s. Eugene Fama
persuasively made the argument that in an active market that includes many
well-informed and intelligent investors, securities will be appropriately priced
and reflect all available information. If a market is efficient, no information
or analysis can be expected to result in out performance of an appropriate
benchmark.
An efficient market is defined as a market where there are large numbers of
rational, profit-maximizers actively competing, with each trying to predict
future market values of individual securities, and where important current
information is almost freely available to all participants. In an efficient market,
competition among the many intelligent participants leads to a situation where,
at any point in time, actual prices of individual securities already reflect the
effects of information based both on events that have already occurred and on
events which, as of now, the market expects to take place in the future. In
other words, in an efficient market at any point in time the actual price of a
security will be a good estimate of its intrinsic value.
William Sharpe stated that “a perfectly efficient market is one in which every
security price equals its market value at all times”. An efficient capital market
is a market that is efficient in processing information. The prices of securities
observed at any time are based on “correct” evaluation of all information
available at that time. In an efficient market, prices fully reflect all available
information.
71
An Overview The random walk theory asserts that price movements will not follow any
patterns or trends and that past price movements cannot be used to predict
future price movements. Much of the theory on these subjects can be owed to
French mathematician Louis Bachelier. Bachelier came to the conclusion that
“ The mathematical expectation of the speculator is zero” and he described
this condition as a “fair game.”
Market efficiency has implications for corporate managers as well as for
investors. This takes a lot of the “gamesmanship” out of corporate
management. If a market is efficient, it is difficult to fool the public for long.
For instance, only genuine “news” can move the stock price. It is hard to
pump-up the stock price by claims that are not verifiable by investors. “Fake”
news will not move the price, or if it does, the price will quickly revert to the
pre-announcement value when the news proves hollow. Publicly available
information is probably already impounded in the price. This is hard for some
managers to believe.
Rational investors seek to maximize returns at a given level of risk. If a security
is underpriced, investors will quickly identify it and rush to pick it up.
Competition for the underpriced security drives the price up. Hence it would
be difficult to consistently achieve superior performance. Most securities are
correctly priced and it should be possible to earn a normal return by randomly
choosing securities of a given risk level.
Notion of financial market efficiency is infact akin to the concept of profit in
a perfectly competitive market. Abnormal or excess profits, in such a market
are competed away. In an efficient market new information is discounted as it
arrives. Price instantaneously adjusts to a new and correct level. An investor
cannot consistently earn abnormal profits by undertaking fundamental analysis
(to identify undervalued/overvalued securities) or by studying the behaviour
of share prices with a view to discerning definite patterns. Isolated instance
of windfall gains from the stock market does not negate the theory that markets
are efficient.
Paradox of the efficient market is that it is efficient because of the organized
and systematic efforts of thousands of analyst to evaluate intrinsic values. It
ceases to be efficient the moment such efforts are abandoned by the investing
community and analyst firms. Market prices will promptly and fully reflect
what is known about the companies whose shares are traded only if investors
seek superior returns and analyze information promptly and perceptively. If
the efforts were abandoned, the efficiency of the market would diminish
rapidly. In order for EMH to be true, it is necessary for many investors to
disbelieve it.

4.4 FORMS OF MARKET EFFICIENCY

Eugene Fama gave three flavours to market efficiency and subsequently all
empirical testing has proceeded on these lines. These three forms have been
discussed in detail as follows:

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a) Weak form of Efficiency Investment Theories

The weak form means that the current prices of stock fully reflect all the
information that is contained in the historical sequence of prices. Hence
abnormal profits cannot be earned by studying the past behaviour of share
prices. In other words, weak form of efficiency implies that you cannot make
excess profits by trading on past trends. You may be surprised to note that a
lot of people do exactly just that. They are called technical analysts, or
chartists. By implication, technical analysis that relies on charts of prices,
moving averages and momentum and volume of trading is not a meaningful
analysis for making abnormal trading profits if the markets are efficient in
weak form. What would you do if your securities that they are selling are
worth less than the selling price? What would you do if you notice that every
time the market went down by 1%, the next day on average, it went down
again by 1/2 %? If your answer is that you would buy on an up day and sell on
a down day, you have the makings of an active technical trader and you are
using a trading rule.
Academics have been testing trading rules like this for almost five decades
now, and traders have been exploiting them for even longer. The concept
behind the simple rule described above is momentum. Although it is a widely
used concept for technical investing, there is no evidence that any short-term
market-timing rule actually makes money. The reason for this is the following:
What if everyone followed the same strategy? Wouldn’t the opportunity go
away? Further, you have to buy and sell stocks every day, and in doing so,
you have to pay brokerage fees. Thus, while major patterns in stock prices
should not exist, weak patterns that are too costly to arbitrage may persist. If
these simple trends are arbitraged away, then the market will follow a random
walk, i.e. past deviation from expected returns tell you nothing about future
deviations from expected returns.
A weak-form efficient market is one in which past security prices are
impounded into current prices. Since past prices are deemed public
information, weak form of efficiency implies semi-strong form of efficiency
and semi-strong form efficiency implies strong form efficiency.
b) Semi-Strong form of Efficiency
How about all public information? That is, all information available in annual
reports, news clippings, gossip columns and so on? If the market price
impounds all of this information, the market is then called Semi-Strong Form
Efficient. Most people believe that the U.S. equity markets by and large reflect
publicly available information. But one has to consider certain things. Whether
the information placed on the Internet is public? Are government files available
under the freedom of information act public? There must be subtle shades of
semi-strong market efficiency, but they are not typically differentiated. Each
new piece of information an analyst gathers should be carefully considered
with regard to whether it is already impounded in the stock price. The easier
it was to get, the more likely it is to have already been traded upon.
Semi-strong form strikes at the very heart of the analyst profession. Tests of
73
An Overview semi- strong have dealt with the speed at which market participants react to
public releases of new information. Empirical evidence generally supports
the contention that the public reacts quickly to information; but there is also
some evidence that the market does not always digest new information
correctly.
c) Strong Form of Efficiency
This represents the extreme case of market efficiency. What kind of information
is impounded in the stock price? It turns out that there are lots of different
levels of market efficiency, depending upon the source or the information
being impounded. The best way to illustrate this is through example. Suppose
you had a hyper-efficient market that impounded a all private information.
This means that even a personal note passed between the CEO and the CFO
regarding a major financial decision would suddenly impacts the stock price.
If so, this is called Strong-Form Efficiency. Few people believe that the market
is strong-form efficient, but it is nice to have this benchmark.
To test the strong form three groups of investors having potential access to
private information can be examined. These are:
a) Corporate Insiders
b) Stock Exchange Specialists
c) Mutual Funds

4.5 EMPIRICAL TESTS OF EMH

What is the degree of efficiency witnessed in, the stock market? Is it efficient
of the weak form or semi-strong form or strong form? In order to be able to
answer these questions, certain empirical tests have been devised. This section
would discuss in detail some of the tests used:
Tests of Weak Form
Weak form efficiency should be the simplest type of efficiency to prove, and
for a time it was widely accepted that the U.S. stock market was at least weak
form efficient. Recall that weak form efficiency only requires that you cannot
make money using past price history of a stock (or index) to make excess
profits. Recall the intuition that, if people know that the price will rise
tomorrow, then they will bid the price up today in order to capture the profit.
Researchers have been testing weak form of efficiency using daily information
since the 1950’s and typically they have found some daily price patterns, e.g.
momentum. However, it appears difficult to exploit these short-term patterns
to make money. Interestingly, as you increase the horizon of the return, there
seems to be evidence of profits through trading. Buying stocks that went down
over the last two weeks and selling those that went up appears to have been
profitable. When you really increase the horizons, stock returns look even
more predictable. Eugene Fama and Ken French for instance, found some
evidence that 4-year returns tend to revert towards the mean. Unfortunately,
this is a difficult rule to trade on with any confidence, since the cycles are so
74
long that in fact, they are as long as the patterns conjectured by Charles Henry Investment Theories
Dow some 100 years ago.
Does this all lend credence to the chartists, who look for cryptic patterns in
security prices - perhaps. But in all likelihood there is no easy money in
charting, either. Prices for widely trades securities are pretty close to a random
walk, and if they were not, then they would quickly become so, as arbitrageurs
moved in to buy the stock when it is underpriced and short (sell) it when it is
overpriced. But who knows. May be a retired rocket scientist playing around
with fractal geometry and artificial intelligence will hit upon something. Of
course, if s/he did, it wouldn’t become common knowledge, at least for a
while. There have been empirical tests of weak-form market efficiency for
equities, bonds and futures contracts. Random walk hypothesis suggests that
even bond price changes should be essentially random or unpredictable.
Tests of Weak form efficiency
Two groups of tests have been formulated by researchers to test the weak
form of EMH. One approach looks for statistically significant patterns in
security price changes. Another approach searches for profitable short-term
trading rules. Serial independence, filter rules, run tests and distribution pattern
test for weak form are described below:
a) Statistical tests of independence
EMH contends that security returns over time should be independent of one
another because new information comes to market in a random, independent
fashion and security prices adjust rapidly to this new information. Does return
of day t correlate with day t-1, t-n? Three major statistical tests have been
used to verify this independence. One is the Autocorrelation test the other is
the Run test and the third is the distribution pattern.
(i) Serial Independence (Autocorrelation): Autocorrelation measures the
significance of the positive or negative correlation in return over time.
Does the rate of return on day correlate with the rate of return on day t-
1 or t-2 or t-3? If the capital market is believed to be efficient then one
should expect insignificant correlation for all combinations. Randomness
in stock price movements can be tested by calculating the correlation
between price changes in one period and changes for the same stock in
another period.
If the autocorrelation is close to zero, the price changes are said to be
serially independent. This is tested for over-short periods (1 to 4 days,
even 9-16 days). Fama, for instance, calculated the autocorrelation for
the period 1958-1962 for US stock prices. The autocorrelation was found
to be insignificant. A similar analysis is done for the BSE Sensitive Index
(Sensex) and few other stocks for the period from April 1997 to March
2001 using the daily index value and the results show that the serial or
auto correlation values between the returns of various lags are very low
and statistically insignificant except in a few cases. A very low
autocorrelation provides some evidence that Indian market is also
showing efficiency at weak form and hence any analysis on historical 75
An Overview price data is of little use. One of the main reasons for achieving weak
form of efficiency is creating an environment for active trading and
reducing the transaction cost. These two actions will attract a large
number of investors to trade and bring some level of efficiency in the
market.
(ii) Runs tests confirm efficiency: Price changes may be random most of
the time, but occasionally become serially correlated for varying period
of time. Further serial correlation coefficients can be affected by extreme
values. To overcome these problems, the run test is used. Run tests ignore
the absolute values of the numbers in the series and observe only their
signs. Given a series of price changes, each price change is either
designated a plus (+) if it is an increase in price or a minus (-) if it is a
decrease in price. The result is a set of pluses and minuses just like this
- + + + - + - + + + - + - + +. A run occurs when two consecutive price
changes are the same, two or more consecutive positive or negative price
changes constitute one run. For example, + + + - - +- + - has three runs.
When the price changes in a different direction then, such as a negative
price change is followed by a positive price change, the run ends and a
new run begins.
The actual number of runs observed is compared with the number that
are expected from a series of randomly generated price changes. If no
significant differences are found, then price changes are random in
character. Studies that have examined the stock price runs have confirmed
the independence of stock price changes over time. The actual number
of runs for stock price series consistently fell over the range expected
for a random series.
(iii) Distribution Pattern: The sum or the distribution of random occurrences
will statistically conform to a normal distribution. If proportionate price
changes are randomly generated events, then their distribution should
be approximately normal. Fama has tested for normal distribution and
found only slight difference from the normal. Studies have also been
undertaken on technical trading strategies based on information other
than historical prices, such as odd-lot figures, volume of short sales,
advance-decline ratios, chart pattern, etc. The general conclusion is that
such strategies have failed to outperform a naive buy-and-hold strategy.
b) Tests of Trading Rules
The statistical tests of independence were too rigid to identify the intricate
price patterns examined by technical analysis. Technical analysis do not accept
a set number of positive or negative price changes as a signal of a move to a
new equilibrium in the market. They typically look for a general consistency
in the price and volume trends over time. Such a trend might include both
positive and negative changes. For this reason technical analysts felt that their
trading rules were too sophisticated and complicated to be simulated by rigid
statistical tests. Advocates of EMH, hypothesized that investors could not
derive profit above a buy and hold policy or abnormal profits using any trading
rule that depended solely on any past market information about factors such
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as price, volume, odd lot shares or specialist activity. Investment Theories

Filters can be prescribed for trading as follows:

A share price is increasing and a 20 per cent filter has been set. Suppose it
starts declining and when it reaches a level 20 per cent below its peak, it is a
sell signal. Similarly, if the share is declining in price and it reverses its trend
and level, then it is a buy signal. By using such buy and sell signals, using
filters ranging from 1 to 50 per cent several studies found that it was not
possible to earn abnormal returns.
Studies of this trading rule have a range of filters from 0.5 percent to 50
percent. The results indicated that small filters would yield above average
profits before taking account of trading commissions. However, some filters
generate numerous trades and therefore substantial trading costs. When these
trading commissions were considered all the trading profits turned to losses.
Alternatively, larger filters did not yield returns above those of a simple buy
and hold strategy.
On a before transaction cost basis these trading rules do appear to work, but
there is no evidence that you can profitably trade on this - when transaction
costs are included the profitability disappears.
Researchers have generated other trading rules that used past market data
other than stock prices. Trading rules have been devised that use odd-lot
figures, advanced- decline ratios, short sales, short positions and specialist
activities. These simulation tests have generated mixed results. Most of the
early studies suggested that these trading rules generally would not outperform
a buy and hold policy on a risk-adjusted basis after taking account of
commissions , while a couple of studies have indicated support for the specific
trading rules . Therefore, most evidence from simulation of specific trading
rules indicate that these trading rules have not been able to beat a buy and
hold policy. These results support the weak form of EMH.
Tests of Semi-Strong Form
Semi-Strong form contends that all public information is fully reflected in
security prices. Public information includes company financial statements,
earnings and dividends, bonus announcements and macro-economic data.
The most obvious indication that the market is not always and everywhere
semi- strong form efficient is that money managers frequently use public
information to take positions in stocks. While there is no evidence that they
beat the market on a risk-adjusted basis, it is hard to believe that an entire
industry of information production and analysis is for naught. It seems likely
that there is value to publicly available information, however there are probably
degrees to which information really is public knowledge. What is surprising
is that recent studies have shown some evidence that excess returns can be
made by trading upon very public information. These tests usually take the
form of “back testing” trading strategies. That is, you play a “what-if’ game
with past stock prices, and pretend you followed some rule, using information
available only at the time of the pretend trade. One common rule that seems
77
An Overview to perform well historically is to buy stocks when the dividend yield is high.
This apparently has made money in the past, even though the information
about which of the stocks have high yields and which of them have low yields
is widely available. Another rule that generates positive excess returns in
back-tests is to buy stocks when the earnings announcement is higher than
expected. This seems simple, since current announcements and even forecasts
are widely available as well.
Does this mean that it is easy to become rich in stock market? Hardly! The
profitability of these simple trading rules depends upon the liquidity of the
stocks involved and trading costs (“frictions”). Sometimes the costs outweigh
the benefits. While many investment managers explain that they pursue a
strategy of buying “Value” stocks (such as low Public Interest entity firms)
few of these managers have consistently superior track records.
The assumption of semi-strong form efficiency is a good first approximation
for a market with as many sharp traders and with as much publicly available
information as the U.S. equity market. Fama, Fischer, Jensen and Roll have
tested the speed of the market’s reaction to a company’s announcements of a
stock split and with respect to a change in dividend policy. They estimated
the abnormal returns using ‘residual analysis”. Security returns were regressed
against the returns on a market index and the error term in the following
linear equation represented the residual or abnormal return.
Tests of Strong Form
Strong form argues that all information is fully reflected in security prices.
The top management has access to corporate and financing strategies. In the
same way specialists have access to the book limit orders for any share.
Knowledge of the price and quantities of the limit order represent private
information. Professional portfolio managers who have large research database
and also access to top management may also have access to private information
on a new company that has not yet been disclosed to the public. To disprove
strong form EMH, one has to find an insider who has profited from inside
information.
The strong form of EMH is of two types:
a) Super-strong form which includes insiders and specialists (who possess
monopolistic information).
b) Near-strong form which includes private estimates developed by (who
possess information) financial analysts, portfolio managers, etc.
Under the Insiders Trading Regulation, 1992 (last amended November 24,
2022), the Securities and Exchange Board of India defined an, insider as “a
person who, is or was connected with the company or is deemed to have been
connected with the company, and who is reasonably expected to have access,
by virtue of such connection, to unpublished price sensitive information in
respect of securities of the company, or who has received or has had access to
such unpublished price sensitive information”. Hence an insider could be the
company promoter, director, executive, auditor, a lawyer, stock broker, a fund
78
manager or even a newspaper correspondent who may be privy to a certain Investment Theories
critical development in the company which could affect the company’s share
prices, before the general public come to know of the development.
The regulation has also given an illustrative list of information that may be
construed upon as price sensitive information. It includes financial results
(both half yearly and annual), declaration of dividends (both half yearly and
annual), issue of shares by way of public, rights or bonus, any major expansion
or execution of new projects, amalgamation, mergers and takeovers, taxation
charges, extra-ordinary events like strikes, etc.
Further the regulation says that a person guilty of insider trading based on
reports submitted by the inspection of SEBI is liable to be punished with a
civic penalty not exceeding three times of the profit gained or loss avoided as
a result of dealing, subject to a specific minimum or punishable with rigorous
imprisonment. (More information on the regulation could be obtained from
the SEBI web site: www.sebi.gov.in). With the implementation of the
regulation to curb insider trading, it is hoped that stock market would become
more efficient and devoid of malpractice.
A simple test for Strong Form of Efficiency is based upon price changes close
to an event Acts of nature may move prices, but if private information release
does not, then we know that the information is already in the stock price. For
example, consider a merger between two firms. Normally, a merger or an
acquisition is known about by an “inner circle” of lawyers, investment bankers
and the firm managers before the public release of the information. When
these insiders violate the law by trading on this private information, they may
make money. They also make it to the SEBI’s wall of shame.
Unfortunately, stock prices typically move up before a merger, indicating that
someone is acting dishonestly. The early move indicates that the market has a
tendency towards strong-form of efficiency, i.e. even private information is
incorporated into prices. However, the public announcement of a merger/
takeover is typically met with a large price response, suggesting that the market
it not strong-form efficient (figure 4.1). Leakage, even if illegal, does occur,
but it is not fully impounded in stock price.
The efficient market theory is a first and good approximation for characterizing
how price is liquid and free market react to the disclosure of information. In
a word, “Quickly!” If they did not, then the market is lacking in the
opportunism we have come to expect from an economy with arbitrageurs
constantly collecting, processing and trading upon information about
individual firms. The fact that information is impounded quickly in stock
prices and that the windows of investment opportunity are fleeting, is one of
the best arguments for keeping the markets free of excessive trading costs,
and for removing the penalties for honest speculation. Speculators keep market
prices close to economic values, and this is good, not bad.

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An Overview

Figure 4.1: Stock price movement before and after public announcement

Activity 1
a) List out three forms of market efficiency.
………………………………………………………………………...
…………………………………………………………………………
…………………………………………………………………………
b) List out tests of weak form of market efficiency and point which of the
them are statistical in nature?
………………………………………………………………………...
…………………………………………………………………………
…………………………………………………………………………

4.6 ANOMALIES IN EMH

Securities markets are flooded with thousands of intelligent, well-paid, and
well- educated investors seeking under and over-valued securities to buy and
sell. The more participants and the faster the dissemination of information,
the more efficient a market should be. The debate about efficient markets has
resulted in hundreds and thousands of empirical studies attempting to
determine whether specific markets are in fact “efficient” and if so to what
degree. Many novice investors are surprised to learn that a tremendous amount
of evidence supports the efficient market hypothesis. Early tests of the EMH
focused on technical analysis and it is chartists whose very existence seems
most challenged by the EMH. And in fact, the vast majority of studies of
80 technical theories have found the strategies to be completely useless in
predicting securities prices. However, researchers have documented some Investment Theories
technical anomalies that may offer some hope for technicians, although
transaction costs may reduce or eliminate the advantage.
a) Technical Anomalies
A question that has been subject to extensive research and debate is whether
past prices and charts can be used to predict future prices. “Technical Analysis”
is a general term for a number of investing techniques that attempt to forecast
securities prices by studying past prices and related statistics. Common
techniques include strategies based on relative strength, moving averages, as
well as support and resistance. The majority of researchers that have tested
technical trading systems (and the weak-form efficient market hypothesis)
have found that prices adjust rapidly to stock market information and that
technical analysis techniques are not likely to provide any advantage to
investors who use them. However, others argue that there is validity to some
technical strategies.
Ball and Brown analyzed annual earnings; Joy, Litzenberger and McEnally
tested the impact of quarterly earnings announcement on stock prices. They
found that favorable information published in quarterly reports is not
instantaneously reflected in stock prices. Researchers have also uncovered
numerous other stock market anomalies that seem to contradict the EMH.
The search for anomalies is effectively the search for systems or patterns that
can be used to outperform passive and/or buy- and-hold strategies.
Theoretically though, once an anomaly is discovered, investors attempting to
profit by exploiting the inefficiency should result its disappearance. In fact,
numerous anomalies that have been documented via back testing have
subsequently disappeared or proven to be impossible to exploit because of
transactions costs.
b) Stock Market Anomalies
The stock market related anomalies include:
(i) Fundamental anomalies:
Value investing is probably the most publicized anomaly of the
fundamental anomalies and is frequently touted as the best strategy
for investing. There is a large body of evidence documenting the fact
that historically, investors mistakenly overestimate the prospects of
growth companies and underestimate value companies.
(ii) Calendar Anomalies:
These includes anomalies like the January effect, turn of the month
effect, the Monday effect and Year ending in 5 effect.
January Effect: According to Robert Haugen and Philippe Jorion, “The
January effect is, perhaps the best-known example of anomalous behaviour
in security markets throughout the world.” The January Effect is particularly
intriguing because it doesn’t appear to be diminishing despite being well
known and publicized for nearly two decades. Theoretically an anomaly should
81
An Overview disappear as traders’ attempt to take advantage of it in advance. The bottom
line is that January has historically been the best month to be invested in
stocks.
The effect is usually attributed to small stocks rebounding following year-
end tax selling. Individual stocks depressed near year-end are more likely to
be sold for tax- loss recognition while stocks that have run up are often held
until after the new year. Many believe the January effect has moved into
November and December as a result of mutual funds being required to report
holdings at the end of October and from investors buying in anticipation of
gains in January. Some studies of foreign countries have found that returns in
January were greater than the average return for the whole year. Interestingly,
the January effect has also been observed in many foreign countries including
countries like Great Britain and Australia that do not use December 31 as the
tax year-end. This implies that there is more to the January effect than just
tax effects.
Empirical study has also established that over one-half of the small firm effect
occurs in January and most of the abnormal return associated with January
takes place during the first 5 days of trading.
Turn of the Month Effect: Stocks consistently show higher returns on the
last day and first four days of the month. Chris R. Hensel and William T.
Ziemba presented the theory that the effect results from cash flows at the end
of the month (salaries, interest payments, etc.). The authors found returns for
the turn of the month were significantly above average from 1928 through
1993 and “that the total return from the S&P 500 over this sixty-five-year
period was received mostly during the turn of the month.” The study implies
that investors making regular purchases may benefit by scheduling to make
those purchases prior to the turn of the month.
The Monday Effect: Monday tends to be the worst day to be invested in
stocks. The first study documenting a weekend effect was by M. J. Fields in
1931 at a time when stocks traded on Saturdays. Several studies have shown
that returns on Monday are worse than other days of the week. Interestingly,
Lawrence Harris has studied intraday trading and found that the weekend
effect tends to occur in the first 45 minutes of trading as prices fall but on all
other days’ prices rise during the first 45 minutes. This anomaly presents the
interesting question: Could the effect be caused by the moods of market
participants? People are generally in better moods on Fridays and before
holidays, but are generally grumpy on Mondays (in fact, suicides are more
common on Monday than on any other day). Investors should however, keep
in mind that the difference is small and virtually impossible to take advantage
of because of trading costs.
c) Other Anomalies
The Size Effect: Some studies have shown that small firms (capitalization or
assets) tend to outperform. The small stock affect was first documented by
Rolf W. Banz. He divided the stocks on the NYSE into quintiles based on

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market capitalization. The returns from 1926 to 1980 for the smallest quintile Investment Theories
outperformed the other quintiles and other indexes. Others have argued that
it is ‘not size that matters, it is the attention and the number of analysts that
follow the stock.
Stocks with positive surprises tend to drift upward, those with negative
surprises tend to drift downward. Some refer to the likelihood of positive
earnings surprises to be followed by several more earnings surprises as the
“cockroach” theory because when you find one, there are likely to be more in
hiding. Robert Haugen argued that the evidence implies investors initially
underestimate firms showing strong performance and then overreact. Haugen
concluded that “The market overreacts-with a lag” and that “ we apparently
have a market that is slow to overreact.”
IPOs, Seasoned Equity Offerings, and Stock Buybacks: Numerous studies
have concluded that Initial Public Offerings (IPOs) in aggregate underperform
the market and there is also evidence that secondary offerings also
underperform. Several recent studies have also documented arguably related
market inefficiencies.
Stock repurchases, on the other hand, can be viewed as the opposite of stock
issues, and studies have shown that firms announcing stock repurchases
outperform in the following years . This evidence seems to confirm the theory
that managers tend to have inside information regarding the value of their
company’s stock and their decisions whether to issue or buy back their stock
may signal over or undervaluation. The implication of these studies seems to
be that investors may do better buying stocks of firms that are repurchasing
their own stock rather than from firms that are selling or issuing more of their
own stock.
Insider transactions: There have been many studies that have documented a
relationship between transactions by executives and directors in their firm’s
stock and the stock’s performance. Insider buying by more than one insider is
considered by many to be a signal that the insiders believe the stock is
significantly undervalued and their belief that the stock will outperform
accordingly in the future. However, many researchers question whether the
gains are significant and whether they will occur in the future.
The S&P Game: “The S&P Game” involves buying stocks that will be added
to the S&P 500 index (after the announcement but before the stock is added
several days later). The fact that stocks rise immediately after being added to
S&P 500 was originally documented by Andrei Shleifer as well as Lawrence
Harris and Eitan Gurel in 1986 .Opportunities may also exist with other
indexes.

4.7 IMPLICATIONS OF EMH

Since you are now a lot familiar with the subject a question arises “Is it possible
to outperform the market?” This is one of the most important questions any
investor should ask. This question is relevant for you as an investor and also
for the fund managers, who invest in securities promising the naive investors
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An Overview to pay a handsome return on their investment. This they could do only by
outperforming the market. If your answer is no and if you believe the market
is efficient, then passive investing or indexing - buying diversified portfolios
of all the securities in an asset class - is probably the way to go. The arguments
for such an approach include reduced costs, tax efficiency and the fact that,
historically, passive funds have outperformed the majority of active funds
But if your answer is yes, it is possible to beat the market, then you should pursue
active portfolio management. Among the arguments for this approach are the
possibility that there are a variety of anomalies in securities markets (that we
have discussed in the earlier sections) that can be exploited to outperform passive
investments the likelihood that some companies can be pressured by investors to
improve their performance and the fact that many investors and managers have
outperformed passive investing for long periods of time.
But the active investor must still face the challenge of outperforming a passive
strategy. Essentially, there are two sets of decisions. The first is asset allocation,
where you carve up your portfolio into different proportions of equities, bonds
and other instruments decisions, often referred to as market timing as investors
try to reallocate between equities and bonds in response to their expectations
of better relative returns in the tow market, tend to require macro forecasts of
broad-based market movements. The second set of decisions includes security
selection - picking particular stocks or bonds. These decisions require micro
forecasts of individual securities underpriced by the market and hence offering
the opportunity for better than average returns.
Active investing involves being ‘overweight’ in securities and sectors that
you believe to be undervalued and `underweight’ in assets you believe to be
overvalued. Buying a stock, for example, is effectively an active investment
that can be measured against the performance of the overall market. Compared
to passive investing in a stock index, buying an individual stock combines an
asset allocation to stocks and an active investment in that stock in the belief
that it will outperform the stock index. In both market timing and security
selection decisions, investors may use either technical or fundamental analysis
and growth investing. And you can be right in your asset allocation and wrong
in your active security selection and vice versa
There could be two important implications of EMH for portfolio selection.
These are:
1. Even simple random selection leads to portfolio, which approximates the
market very closely when 15-20 stocks are held.
2. Index Funds are an outgrowth of the increasing awareness and
acknowledgement of market efficiency.
Nobel Laureate William Sharpe makes a simple yet powerful case against
active management in his article ‘The Arithmetic of Active Management’: “If
active and passive management styles are defined in sensible ways, it must
be the case that: (1) before costs, the return on the average actively managed
dollar will equal the return on the average passively managed dollar; and (2)
84 after costs, the return on the average actively managed dollar will be less
than the return on the average passively managed dollar These assertions will Investment Theories
hold for any time period”.
Ambitious investors and investment managers almost all want to beat the
market, but it is worth asking why should they want to beat it for you. Why
should precious insights into the nature of the market be available for sale to
the general public, either directly through a fund or indirectly, perhaps through
a book advocating a particular investment technique as the route to out-
performance? If an investment technique is so good, it would seem to make
more sense to keep its secrets to yourself.
Activity 2
a) Distinguish between active and passive management of portfolio?
Briefly explain the process involved in the active management of the
portfolios.
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
b) List out the implications of EMH for security analysis and portfolio
management in India.
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………

4.8 RANDOM WALK THEORY

According to the random walk theory, asset price changes are unpredictable.
This indicates that because stock values fluctuate erratically, it is impossible
to reliably anticipate future prices using data from the past. The stock market
is said to be efficient and reflect all available information, according to the
random walk theory. The notion that traders can time he market or use technical
analysis to spot and capitalize on patterns or trends in stock prices is challenged
by a random walk. Some traders and analysts who think that stock values
may be forecasted using different techniques, like technical analysis, have
criticized random walk.
Features of Random Walk Theory
According to the random walk theory,
x stock prices are arbitrary and as a result, a stock price’s or a market’s
historical movement or trend cannot be used to forecast its future
movement.
x Markets cannot be outperformed without additional risk;
x Fundamental analysis is deemed unreliable because of the frequently subpar
information gathered and its susceptibility to misunderstanding. 85
An Overview x investment advisers don’t significantly improve an investor’s portfolio.
Concept
Since the beginning of time, economists have maintained that asset prices are
largely random and unpredictable, and that historical price movements have
little to no bearing on future changes. In fact, this was a foundational tenet of
the efficient market hypothesis (EMH). According to the random walk theory,
stock prices accurately reflect all information that is currently accessible and
swiftly adapt to new knowledge, making it hard to act on it.
The semi-strong efficient hypothesis, which contends that it is hard to
continually outperform the market, is congruent with economist Burton
Malkiel’s idea. The idea has significant ramifications for investors in that it
suggests that the greatest long-term investing strategy may be to buy and
hold a diverse portfolio. Malkiel’s 1973 book, ‘A Random Walk Down Wall
Street’, popularised the random walk hypothesis. Malkiel contends in the
book that trying to timing or beat the market or predicting stock prices using
fundamental or technical research is a waste of time and can result in
underperformance. Instead, he contends that buyers and holders of wide index
funds would be better off.
The random walk theory is still a widely accepted concept in the field of
financial economics, despite opposition from those who think there are
practical ways to predict stock values and beat them. Investors can concentrate
on long-term planning and avoid making snap judgements based on short-
term market fluctuations by acknowledging that stock prices are unpredictable
and efficient. In the end, random walk theory serves as a reminder to investors
of the value of maintaining discipline, patience, and concentration on their
long-term investment objectives.

4.9 SUMMARY
In this Unit, we have discussed various dimensions of the hypothesis that the
stock markets are efficient. We have highlighted the concept and forms of
market efficiently viz., weak form, semi-strong form and strong form. We
have also described various empirical tests of EMH. The Unit also discusses
the implications of EMH for security analysis and portfolio management, &
‘investing by dart’ can still not be recommended as superior equity investment
strategy in the context of most of the stock markets of the world. Most of the
world stock markets are still less than efficient and hold scope for abnormal
returns by following active security analysis and portfolio management
strategies. The unit also discusses in brief one more investment theory i.e.
random walk theory which describes the financial markets through a
mathematical model.

4.10 KEY WORDS

Investment theories : guide investors in making investment
decisions.
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Weak form efficiency : means that the current prices of stock Investment Theories
already fully reflect all the information that
is contained in the historical sequence of
prices.
Strong Form of Efficiency : This represents the extreme case of market
efficiency.
Efficient Market : It suggests that financial markets are
Hypothesis (EMH) efficient, meaning that prices reflect all
available information about a security.
Random Walk Theory : The random walk theory is a mathematical
model used to describe the behavior of
financial markets, which suggests that the
price movements of stocks, bonds, and other
securities are random and unpredictable.

4.11 SELF ASSESSMENT QUESTIONS

1. What do you mean by capital markets are efficient? And why capital
market should be efficient?
2. Define market efficiency?
3. Describe the differences in various forms of market efficiency.
4. Describe the different tests of the weak form of EMH.
5. What are the implications of EMH for technical analysis?
6. What factors can act as signaling devices for stock price movements?
Explain, how these factors would affect market efficiency?
8. What are some of the anomalies in efficient market hypothesis?
9. What are the implications of EMH for security analysis and portfolio
management?
10. What do you understand by random walk theory?

4.12 FURTHER READINGS

Albright, Christian S (1987). Statistics for Business and Economics, New York,
Macmillan Publishing, 515-517.
Arora, R. and Natarajan P. (1997); Social Dynamics Influences Towards
Equilibrium Decisions as regards Investment Opportunities in the Light of
Multiple Goals Finance India 10: 941-950.
Basu, S. (1977), ‘‘Investment Performance of Common Stocks in Relation to
their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis’’.
Journal of Finance.

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An Overview Brown, S and Warner, J. (1980). ‘‘Measuring Security Price Performance’’.
Journal of Financial Economics.
Brush, John S. (1986); Eight Relative Strength Models Compared Journal of
Portfolio Management 13 (1), (Fall): 21-28.
Chandra, P. (2018). Investment Analysis & Portfolio Management (5e). Tata
McGraw Hill.
Duna Abhijit (2001); Investors Reaction to Good and Bad News in Secondary
Market: A Study Relating to Investor Behaviour Finance India 15 (2), (June):
567-576.
Fama, Eugene and Blume, Marshal (1966); Filter Rules and Stock Market
Trading Rules, Journal of Finance 39 (1), (January): 226-241.
Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis
Portfolio Management (7th ed.). Pearson Education.
Hagerman, Robert K. and Richmond, Richard D. (1973); Random Walks,
Martingales and the OTC, Journal of Finance 28 (4), September, 897-909.
Maiti, M. H. (1997); Indian Capital Market: Some Emerging Trends Finance
India 11: 609- 618.
Pinches, George (1970); The Random Walk Hypotheses and Technical Analysis,
Financial Analysts Journal 26 (2), (March - April): 104-110.
Pruitt, Stephen W. and White, Richard E. (1988); Who Says Technical Analysis
Cannot Beat the Market, Journal of Portfolio Management 14 (3), (Spring):
55-58.
Ramasastri, A. S. (2001); Stock Market Efficiency - Spectral Analysis Finance
India 15 (3), (September): 885-990.
Rao, S. V. D. and Nageswara (1997); Response of Stock Price to Macro Events
Finance India 10: 881-918.
Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., &Elston, F. (2019).
Investment Analysis & Portfolio Management. Cengage AU.
Rustagi, R. (2021). Investment Analysis & Portfolio Management. Sultan
Chand & Sons.
William F. Sharpe, (1991). The Arithmetic ofActive Asset Management;
Financial Analysis Journal 47 (1), January / February.
Tripathi, V. (2023). Taxmann’s Fundamentals of Investments. Taxmann
Publications Private Limited.

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