SAPM NOTES

MODULE 1: INVESTMENT
Meaning of Investment
Investment refers to a tool used by people for allocating their funds with the aim of generating
revenue. It is the one through which profit is created out of ideal lying resources by deploying
them into financial assets. Investment simply refers to the purchase of assets by people not
meant for immediate consumption but for future use that is wealth creation.
Importance of Investment
1. Generates Income
Investment serves as an efficient tool for providing periodic and regular income to people.
Earning return in the form of interest and dividends is one of the important objectives of the
investment process. Investors analyses and invest in those that provide a better rate of return at
lower risk.
2. Wealth Creation
Creation of wealth is another important role played by an investment activity. It helps investors
in wealth creation through appreciation of their capital over the time. Investment helps in
accumulating large funds by selling assets at a much higher price than the initial purchase price.
3. Tax Benefits
It enables peoples in availing various tax benefits and saving their incomes. Under section 80C
of income tax act, individuals can save up to a maximum limit of Rs. 1,50,000. Many peoples
prefer to go for an investment for taking numerous tax exemptions.
4. Economic Development
Investment activities have an efficient role in the overall development of the economy. It helps
in efficient mobilization of ideal lying resources of peoples into productive means. Investment
serves as a mean for bringing together those who have sufficient funds and one who are in need
of funds. It enables in capital creation and leads to economic development of the country.
5. Meet Financial Goals
Investment activities support peoples in attaining their long term financial goals. Individuals
can easily grow their funds by investing their money in long term assets. It serves mainly the
purpose of providing financial stability, growing wealth and keeping people on track at their
retirement by providing them with large funds.
Dimensions of investment

1. Growth Investing:

• Focuses on companies that are expected to grow at an above-average rate compared to

other companies.
• Growth investors look for companies with strong earnings growth potential, often
reinvesting profits back into the business.
 • These investments tend to have higher price-to-earnings (P/E) ratios.

2. Value Investing:

• Involves selecting stocks that appear to be undervalued based on fundamental

analysis.
• Value investors look for stocks with low P/E ratios, high dividend yields, or other
indications that they are undervalued.
• The goal is to buy undervalued stocks and hold them until the market corrects their
price.

3. Income Investing:

• Focuses on generating regular income from investments, typically through dividends

or interest payments.
• Common investments include dividend-paying stocks, bonds, and real estate
investment trusts (REITs).
• Suitable for investors seeking steady cash flow, such as retirees.

4. Index Investing:

• Involves investing in a portfolio that replicates the components of a market index,

such as the S&P 500.
• It is a passive investment strategy that aims to match the performance of the index.
• Typically involves lower fees and expenses compared to actively managed funds.

5. Active Investing:

• Involves actively buying and selling securities to outperform the market.

• Active investors use research, analysis, and judgment to make investment decisions.
• This style often incurs higher fees and requires more time and effort compared to
passive investing.

6. Passive Investing:

• Seeks to replicate the performance of a specific index or benchmark.

• Involves buying and holding investments for the long term with minimal trading.
• Passive investing typically results in lower fees and is less time-consuming.

7. Small-Cap, Mid-Cap, and Large-Cap Investing:

• Small-cap investing focuses on companies with smaller market capitalizations, often

with higher growth potential but more risk.
• Mid-cap investing targets companies with medium-sized market capitalizations,
offering a balance between growth and stability.
• Large-cap investing involves companies with large market capitalizations, generally
providing more stability and steady returns.
Investment process (2021)
Step 1: Setting financial goals
Setting clear financial goals is the cornerstone of any successful Investment journey. Short-
term goals like purchasing a car and long-term objectives such as retirement planning must be
defined and prioritised. These goals act as guiding stars, shaping your Investment strategies
and providing direction.
Through meticulous goal-setting, individuals create a roadmap, ensuring that
their Investments align with their aspirations, whether it's funding a dream holiday or securing
a comfortable retirement. Clear goals provide the purpose and motivation needed to navigate
the intricate world of Investments, turning dreams into tangible financial achievements.
Example: Jane wants to save $50,000 for a down payment on a house in five years.

Step 2: Assessing risk tolerance

Understanding your risk tolerance is pivotal in making Investment decisions. It refers to your
ability to endure fluctuations in the value of your Investments. Assessing your risk tolerance
involves evaluating your comfort level with market uncertainties.
Are you conservative, moderate, or aggressive in your risk appetite? By gauging your
psychological and financial resilience, you can tailor your Investment portfolio accordingly.
Conservative Investors prefer stability, while aggressive ones seek high returns despite higher
risks. This step ensures that your Investments align with your temperament, making your
financial journey not just profitable but also emotionally secure.
Example: Jane takes a risk tolerance questionnaire and finds she is moderately risk-averse.

Step 3: Creating a budget and emergency fund

A strong financial foundation starts with disciplined budgeting and building an emergency
fund. Budgeting helps in tracking income and expenses, ensuring surplus funds
for Investments. Simultaneously, having an emergency fund safeguards Investments from
unexpected events such as medical emergencies or sudden job loss.
The emergency fund acts as a safety net, preventing the need to liquidate Investments during
crises, thus preserving long-term goals. Creating a budget cultivates financial discipline,
enabling systematic Investments, while an emergency fund provides:
1) Financial security
2) Reinforcement in your ability to stay invested during market fluctuations
3) Surety that your Investments stay on course to meet your goals
Example: Jane creates a monthly budget that includes $500 for investing and sets aside $10,000
in a high-yield savings account as an emergency fund.
Step 4: Diversifying Investment portfolio
Diversification is the golden rule of Investments. It refers to spreading Investments across
different asset classes, such as stocks, bonds, mutual funds, and real estate. This strategy
mitigates risks by reducing the impact of poor performance in any single Investment.
Diversifying ensures that a downturn in one sector doesn’t devastate your entire portfolio,
balancing potential losses.
For instance, when stocks underperform, bonds might flourish, maintaining overall stability.
Diversification aligns Investments with risk tolerance and financial goals, ensuring a resilient
portfolio. By not putting all your financial resources into one category, you safeguard
your Investments, enhancing your chances of steady, long-term growth.
Example: Jane invests in a mix of stocks, bonds, and real estate funds.
Step 5: Conducting research and analysis
Informed decisions are the bedrock of successful investing. Conducting thorough research and
analysis is imperative before making Investment choices. Fundamental analysis delves into a
company's financial health, while technical analysis studies market trends. Staying updated on
economic indicators and market dynamics enables anticipation of trends.
Informed Investors can identify promising opportunities, avoiding impulsive decisions.
Research ensures an understanding of potential risks and rewards, leading to prudent choices.
Continuous analysis aids in tracking Investments, ensuring they align with goals. With
comprehensive knowledge, Investors can navigate the ever-changing market landscape,
making well-informed decisions that pave the way for sustainable financial growth.
Example: Jane researches different companies, analyzes their financial statements, and reads
market reports.
Step 6: Making informed Investment decisions
Professional guidance and continuous monitoring are pivotal in making informed Investment
decisions. Seeking advice from financial experts provides nuanced insights tailored to your
specific needs. Regularly monitoring Investment performance is essential, ensuring they align
with your goals. Adapting strategies to market changes and evolving life goals is critical.
Whether it’s seeking expert advice or using online tools, informed decisions are the result of
meticulous evaluation and adaptation. By staying vigilant and flexible, Investors can respond
to market dynamics, ensuring that their Investments remain aligned with their objectives, even
amidst economic fluctuations, securing their financial future.
Example: Jane decides to buy shares in a technology company with strong growth potential
and invests in a government bond for stability.
Step 7: Regularly reviewing and rebalancing the portfolio
Investment strategies need periodic review and adjustment. Regular portfolio reviews help
gauge performance against goals. Rebalancing involves adjusting asset allocation to maintain
the desired risk and return levels. Life events like marriage or nearing retirement may
necessitate changes in the Investment approach.
Adapting the portfolio ensures it remains effective in fulfilling objectives. By responding to
changing circumstances, Investors maximise opportunities and minimise risks. Regular
reviews and rebalancing not only safeguard Investments against market volatility but also
optimise their potential. This step ensures that Investments remain relevant, aligning with
evolving goals, ultimately securing a stable and prosperous financial future.
Example: Every six months, Jane reviews her portfolio's performance and adjusts her
investments to maintain her desired asset allocation.
Difference between speculation and gambling
Stock market indices
Stock market indices are statistical measures that track the performance of a specific group of
stocks. These indices provide a snapshot of market trends and can be used as benchmarks for
comparing individual stock performance.
Types

Sensex (BSE 30):

• Comprises 30 of the largest and most liquid companies on the Bombay Stock
Exchange (BSE).
• Often considered the benchmark index for the Indian stock market.
• Includes companies like Reliance Industries, Tata Consultancy Services, and HDFC
Bank.

Nifty 50:

• Includes 50 of the largest and most liquid companies on the National Stock Exchange
(NSE).
• Widely used as a benchmark for the Indian equity market.
• Features companies such as HDFC Bank, Reliance Industries, Infosys, and ICICI
Bank.

Nifty Midcap 100:

• Comprises the top 100 mid-cap companies listed on the NSE.

• Focuses on companies with moderate market capitalization.
• Features companies like Muthoot Finance, Max Financial Services, and Zee
Entertainment Enterprises.

Nifty Smallcap 100:

• Represents the top 100 small-cap companies listed on the NSE.

• Highlights the performance of smaller, high-growth potential companies.
• Includes companies such as Dilip Buildcon, Alok Industries, and Minda Industries.

BSE Midcap:

• Tracks the performance of mid-cap companies listed on the BSE.

• Provides insight into the performance of mid-sized companies.
• Includes companies like Godrej Properties, Apollo Hospitals, and LIC Housing
Finance.

BSE Smallcap:

• Tracks the performance of small-cap companies listed on the BSE.

• Focuses on smaller companies with potential for high growth.
• Includes companies like TCI Express, Caplin Point Laboratories, and Tanla Solutions.
Nifty IT:

• A sector-specific index tracking the performance of the IT sector.

• Includes major IT companies like Infosys, Tata Consultancy Services, and Wipro.

Nifty Bank:

• A sector-specific index tracking the performance of the banking sector.

• Features major banks such as HDFC Bank, ICICI Bank, State Bank of India, and
Kotak Mahindra Bank.

Nifty FMCG:

• A sector-specific index tracking the performance of the Fast-Moving Consumer

Goods sector.
• Includes companies like Hindustan Unilever, ITC, Nestlé India, and Britannia
Industries.

Nifty Pharma:

• A sector-specific index tracking the performance of the pharmaceutical sector.

• Features companies like Dr. Reddy's Laboratories, Sun Pharmaceutical Industries, and
Cipla.

Construction of stock market index

2. Market Capitalization-Weighted Index

Definition: In a market capitalization-weighted index, each stock's weight is proportional to

its total market capitalization (i.e., the stock price multiplied by the number of outstanding
shares).
Calculation: The index value is the total market capitalization of the included stocks divided
by a base value.

MODULE 2: SECURITY RISK, RETURN & VALUATION

Risk refers to the possibility that an investment's actual returns will differ from the expected
returns, and it encompasses the potential for losing some or all of the original investment.
Understanding risk is crucial for investors because it affects investment decisions and portfolio
management.
Difference between systematic and unsystematic risk
Definition of Systematic Risk
By the term ‘systematic risk’, we mean the variation in the returns on securities, arising due to
macroeconomic factors of business such as social, political or economic factors. Such
fluctuations are related to the changes in the return of the entire market. Systematic risk is
caused by the changes in government policy, the act of nature such as natural disaster, changes
in the nation’s economy, international economic components, etc.
Definition of Unsystematic Risk
The risk arising due to the fluctuations in returns of a company’s security due to the micro-
economic factors, i.e. factors existing in the organization, is known as unsystematic risk. The
factors that cause such risk relates to a particular security of a company or industry so
influences a particular organization only. The risk can be avoided by the organization if
necessary actions are taken in this regard.

Analyzing risk
1. Types of Risks:
• Market Risk (Systematic Risk): The risk of losses due to overall market movements,
including economic factors like recessions, interest rate changes, and geopolitical
events. It affects all securities to some extent and cannot be diversified away.
• Specific Risk (Unsystematic Risk): Risks specific to individual securities or sectors,
such as company-specific factors (e.g., management changes, competitive pressures,
regulatory changes) or industry-specific events (e.g., technological disruptions, supply
chain issues). This risk can be mitigated through diversification.
2. Quantitative Analysis:
• Beta Coefficient: Measures a stock's volatility relative to the market. A beta greater than
1 indicates higher volatility compared to the market, while less than 1 indicates lower
volatility.
• Standard Deviation: Measures the historical volatility of a stock's returns. Higher
standard deviation implies greater risk.
• Value at Risk (VaR): Estimates the maximum potential loss in value of an investment
over a given time period and confidence level.
3. Qualitative Analysis:
• Industry and Sector Analysis: Understanding the economic environment and industry-
specific factors that could affect the security.
• Company Analysis: Evaluating financial statements, management quality, competitive
positioning, and growth prospects.
• Management Quality: Assessing the competence and integrity of company management
in handling risks and making strategic decisions.
4. Risk Management Strategies:
• Diversification: Spreading investments across different securities, sectors, and asset
classes to reduce unsystematic risk.
• Hedging: Using derivatives or other instruments to offset potential losses from adverse
price movements.
• Asset Allocation: Balancing investments across different types of assets based on risk
tolerance and investment objectives.
5. Risk Measurement Tools:
• Risk Models: Statistical models that estimate the potential range of outcomes for
securities based on historical data and assumptions.
• Scenario Analysis: Evaluating how different scenarios (e.g., economic downturn,
regulatory changes) could impact securities and their values.
• Sensitivity Analysis: Assessing how changes in key variables (e.g., interest rates,
commodity prices) affect the securities' returns and prices.
6. Monitoring and Adjusting:
• Continuously monitoring market conditions, economic trends, and company-specific
developments to reassess risks and adjust investment strategies as needed.
• Regularly reviewing and updating risk assessments based on new information and
changes in the investment landscape.
The dividend discount model (DDM)
is a valuation method used to estimate the intrinsic value of a stock based on its expected future
dividends. There are primarily two versions of the DDM: the single-period DDM and the multi-
period DDM.
Single-Period Dividend Discount Model (SPDDM):
Assumptions:
Constant Dividends: Assumes dividends paid by the company remain constant throughout the
single period.
Zero Growth: Assumes dividends do not grow over time; they remain the same in perpetuity.
Multi-Period Dividend Discount Model (MPDDM):
Assumptions:
Dividend Growth: Assumes dividends grow at a constant rate 𝑔 indefinitely.
Discount Rate: Assumes a constant required rate of return 𝑟 throughout the valuation period.
What is beta? Discuss its relevance in investment risk-return analysis. (2023)
Beta, in the context of investment risk-return analysis, is a measure of the volatility or
systematic risk of a security or a portfolio in comparison to the overall market. It quantifies the
relationship between the price movements of a security and the market as a whole
Definition of Beta:
Beta Coefficient: It is a numerical value that indicates the sensitivity of a stock's returns to
changes in the market returns.
Calculation: Beta is calculated using regression analysis, where historical returns of the stock
are regressed against the returns of a market index (such as the S&P 500 for US stocks).
Interpretation:
Beta = 1: The stock moves in line with the market.
Beta > 1: The stock is more volatile than the market (it tends to amplify market movements).
Beta < 1: The stock is less volatile than the market (it tends to move less than the market).
Relevance of Beta in Investment Risk-Return Analysis:
1. Risk Measurement:
Systematic Risk: Beta primarily measures systematic risk, which is the risk inherent to the
entire market or a market segment. It indicates how much of a stock's risk is attributable to
market risk factors.
Diversification: Beta helps investors understand how adding a particular stock to their portfolio
will affect the overall portfolio risk. Stocks with low beta provide diversification benefits as
they may move differently than the market.
2. Portfolio Construction:
Risk Management: Investors can use beta to manage the overall risk of their portfolios. By
combining assets with different betas (positive, negative, or zero), investors can potentially
reduce the portfolio’s volatility.
Capital Allocation: Beta helps in allocating capital efficiently by balancing risk and return.
Stocks with higher betas may offer higher potential returns but also come with higher risk.
3. Return Expectations:
Expected Return: According to the Capital Asset Pricing Model (CAPM), which uses beta, the
expected return of a stock is influenced by its beta relative to the risk-free rate and the market
risk premium. Stocks with higher betas are expected to have higher returns to compensate for
their higher risk.
4. Comparative Analysis:
Benchmarking: Beta allows investors to compare the risk of a stock against the market or other
stocks within the same industry. It provides a standardized measure to assess relative riskiness.
5. Investment Strategy:
Strategic Asset Allocation: Investors with a growth-oriented strategy might prefer stocks with
higher betas, expecting higher returns during bullish market conditions.
Defensive Strategy: Investors seeking stability may prefer stocks with lower betas, which tend
to be less volatile and offer more predictable returns.
What is standard deviation? How it is calculated? Illustrate with an example. (2022)
Standard deviation is a statistical measure of the dispersion or variability of a set of data points
from the mean (average). In finance and investment analysis, it is used to quantify the volatility
or risk of a security or portfolio of securities.
Explain the different statistical tools used to measure the risk of the securities return.
(2023)

1. Standard Deviation (SD):

• What it measures: The degree to which a security's return fluctuates around its
average return.
• Interpretation: A higher standard deviation indicates a higher risk, as the price is
more volatile. However, SD doesn't tell you if the deviations are positive or negative,
just the overall spread.

2. Beta (β):

• What it measures: The relative volatility of a security compared to the overall market
(often represented by an index like the S&P 500).
• Interpretation: A beta of 1 indicates the security moves exactly in line with the market.
A beta greater than 1 (beta > 1) suggests the security is more volatile than the market, and
vice versa (beta < 1) means it's less volatile. Beta helps understand how a security might
react to broader market movements.

3. R-Squared (R²):

• What it measures: The proportion of a security's return that can be explained by the
movement of a benchmark index.
• Interpretation: An R² closer to 1 indicates the security's returns are highly correlated
with the benchmark, while a value closer to 0 suggests the returns are less influenced
by the market. This helps assess diversification benefits - ideally, some securities in
your portfolio won't move in lockstep with the market.

4. Sharpe Ratio:

• What it measures: The amount of excess return (return above the risk-free rate) an
investment generates per unit of risk (measured by standard deviation).
 • Interpretation: A higher Sharpe Ratio indicates better risk-adjusted performance. A
negative value suggests the investment isn't providing enough return to compensate
for the risk taken.

5. Value at Risk (VaR):

• What it measures: The potential maximum loss for a portfolio over a specific time
period at a given confidence level.
• Interpretation: VaR helps investors understand the worst-case scenario for potential
losses within a set timeframe. It's a more complex tool often used by professional risk
managers.

6. Alpha (α)

• What it measures: Investment's performance relative to a benchmark, specifically its

ability to outperform the expected return based on its risk level.

• Interpretation:
o Positive Alpha: A positive alpha indicates the investment has outperformed the
market after adjusting for risk. This suggests the investment manager has added
value through active management strategies like stock picking or market timing.
o Zero Alpha: An alpha of zero means the investment's return matched the
expected return based on its beta, essentially mirroring the market performance.
o Negative Alpha: A negative alpha indicates the investment has underperformed
the market after adjusting for risk. This could be due to various factors, like poor
investment decisions or high fees.

MODULE 3: VALUATION OF BONDS

What Is a Bond?
A bond is a fixed-income instrument and investment product where individuals lend money to
a government or company at a certain interest rate for an amount of time. The entity repays
individuals with interest in addition to the original face value of the bond.
Bonds are used by companies, municipalities, states, and sovereign governments to finance
projects and operations. Owners of bonds are debtholders, or creditors, of the issuer.
Bond Components
1. Face Value
The face value, or par value, of a bond, is the amount that the issuer will repay the bondholder
at maturity. It is the principal amount on which the periodic interest payments are calculated.
2. Coupon Rate
The coupon rate is the annual interest rate paid on a bond, expressed as a percentage of the
bond's face value. This rate determines the periodic interest payments made to the bondholder
throughout the life of the bond.
3. Maturity Date
The maturity date is the date when the bond's principal amount is due to be repaid to the
bondholder. Bonds can have short-term, medium-term, or long-term maturities, typically
ranging from a few months to 30 years or more.
4. Issuer's Credit Rating
The issuer's credit rating is an assessment of the issuer's creditworthiness and likelihood of
defaulting on its debt obligations.
Credit rating agencies, such as Standard & Poor's, Moody's, and Fitch, assign ratings based on
their evaluation of the issuer's financial strength and stability.
Bond Valuation Theories and Concepts
1. Present Value and Discounting
Present value is the concept of determining the value of future cash flows in today's terms.
Discounting is the process of converting future cash flows to their present value by applying a
discount rate, which accounts for the time value of money and the inherent risk associated with
the cash flows.
2. Yield to Maturity (YTM)
Yield to maturity (YTM) is the total return an investor can expect to receive if a bond is held
until its maturity date. It takes into account the bond's current market price, face value, coupon
rate, and time to maturity. YTM is a widely used metric for bond valuation and comparison.
3. Duration and Modified Duration
Duration is a measure of a bond's price sensitivity to changes in interest rates. It estimates the
weighted average time until the bond's cash flows are received.
Modified duration adjusts the duration to account for the bond's price change due to a one
percent change in yield, making it a useful risk management tool.
4. Convexity
Convexity is a measure of the curvature of a bond's price-yield relationship, providing an
estimate of how the bond's price will change as interest rates move.
A higher convexity indicates greater price changes for a given change in interest rates, making
it an essential tool for managing interest rate risk in a bond portfolio.
Types of bonds

• Fixed-Rate: These instruments have coupon rates that remain constant throughout their
life.
• Floating Rate: The coupon rates of these securities are linked to a reference interest rate,
such as the LIBOR (London Interbank Offered Rate) or U.S. Treasury Bill rate. Since these
are volatile, they are classified as floating. For example, the interest rate may be defined as
U.S. Treasury Bill rate + 0.25%. It gets recomputed on a periodical basis.
• Corporate: These are debt securities issued by the companies and sold to various investors.
They can be secured or unsecured. The backing for them depends on the payment ability
of the company, which in turn is linked to possible future earnings of the company from its
operations. These are the aspects looked in by the credit rating agencies before giving in
their confirmation.
• Government: These are issued by the national government promising to make regular
payments and repay the face value on maturity. The terms on which the government can
sell such securities depend on its creditworthiness in the market.
• Municipal: These debt instruments are released by the nation, state, or cities to raise
finances for their upcoming or running projects. The income from such securities is
exempted from the state and federal tax liabilities.
• Zero-Coupon: They do not pay any periodical interest during their life. Instead, they are
usually issued at a discount to the par value, making it an attractive investment. This
difference is then rolled up, and the entire principal amount (par value) is paid on
maturity. Financial institutions can also issue them by stripping off the coupons from the
principal amount.
• High Yield: Such debt securities, also known as junk bonds, are rated below investment
grade by the credit rating authorities. So, to attract investors, the issuers offer a higher rate
of return. Since these are lower-grade instruments, they are expected to offer a larger yield.
Investors willing to take a risk for higher yield opt for them.
• Convertible: It allows the holders to exchange them for specific equity shares. These are
considered hybrid securities since they possess combined features of equity as well as debt.
• Inflation-indexed: These debt instruments link the principal and the interest amount to the
inflation indexes like the consumer price index. Thus, they protect investors from inflation
prevailing in the economy, thereby securing their investments.
• Callable Bond: When the issuer of the bond calls out his right to redeem the bond even
before it reaches its maturity is called a Callable Bond. Through this type of bonds, the
issuer can convert a high debt bond into a low debt bond.
Factors Affecting Bond Valuation
1. Interest Rate Changes
Interest rate fluctuations directly impact bond prices, as they influence the discount rate used
in bond valuation. When interest rates rise, bond prices tend to fall, and vice versa. Investors
must monitor interest rate movements to adjust their bond investment strategies accordingly.
2. Inflation Expectations
Inflation expectations can affect bond valuation, as they influence the real return on investment.
Higher inflation expectations may lead to higher interest rates and lower bond prices, while
lower inflation expectations can result in lower interest rates and higher bond prices.
3. Credit Rating Changes
Credit rating changes can significantly impact a bond's valuation, as they alter the perceived
risk associated with the investment.
An upgrade in credit rating may result in a narrower credit spread and higher bond prices,
whereas a downgrade can lead to a wider credit spread and lower bond prices.
4. Economic Conditions
Economic conditions, including GDP growth, employment, and consumer sentiment, can
influence bond valuation by affecting interest rates, inflation expectations, and credit risk.
A strong economy may lead to higher interest rates and lower bond prices, while a weaker
economy can result in lower interest rates and higher bond prices.
5. Market Liquidity
Market liquidity refers to the ease with which a bond can be bought or sold in the market
without affecting its price.
A liquid bond market generally leads to more accurate bond valuations and narrower bid-ask
spreads, while an illiquid market can result in wider spreads and greater price volatility,
potentially affecting the bond's perceived value.
6. Issuer's Financial Health
The financial health of the bond issuer plays a critical role in bond valuation, as it directly
impacts the issuer's creditworthiness and ability to meet its debt obligations.
Strong financial performance and low debt levels can lead to higher bond prices, while financial
distress or high debt levels can result in lower bond prices.

MODULE 4: FUNDAMENTAL ANALYSIS

Explain the role of fundamental analysis (2023)
Fundamental analysis is a method used by investors and financial analysts to evaluate the
intrinsic value of a security. The goal is to assess whether a stock is overvalued, undervalued,
or fairly valued by examining various financial, economic, and qualitative factors.
Key Components of Fundamental Analysis:
Economic Analysis:
Macroeconomic Factors: Includes GDP growth, inflation, interest rates, and unemployment
rates, which impact a company's performance.
Economic Indicators: Examines data such as consumer confidence, industrial production, and
retail sales to understand the economic environment.
Industry Analysis:
Industry Trends: Looks at market demand, technological advancements, regulatory changes,
and competitive dynamics.
Industry Positioning: Evaluates the company's position within the industry, including market
share, competitive advantages, and barriers to entry.
Company Analysis:
Financial Statements: Analyzes the income statement, balance sheet, and cash flow statement
to assess profitability, liquidity, and financial health.
Qualitative Factors: Considers the quality of management, business model, brand strength,
corporate governance, and overall company strategy.
Role of Fundamental Analysis:
1. Valuation:
o Intrinsic Value: Fundamental analysis helps estimate the intrinsic value of a security
by evaluating the underlying financial health and prospects of the issuing company.
This intrinsic value is compared to the current market price to determine if the stock is
overvalued, undervalued, or fairly valued.
2. Investment Decisions:
o Buy, Hold, or Sell: Investors use fundamental analysis to make informed decisions on
whether to buy, hold, or sell a security. If a stock is undervalued, it might be a good
buy; if overvalued, it might be a good sell.
3. Risk Assessment:
o Financial Health: By analyzing financial statements, investors can assess the financial
stability and risk profile of a company. Companies with strong balance sheets,
consistent earnings, and positive cash flows are generally considered lower risk.
4. Long-term Perspective:
o Growth Potential: Fundamental analysis provides insights into a company’s long-
term growth potential by examining factors like revenue growth, market expansion,
and innovation. This is crucial for long-term investors who are more interested in
sustained growth rather than short-term gains.
5. Market Comparison:
o Relative Valuation: Investors can compare a company’s financial metrics with those
of its peers and industry averages. Metrics like P/E ratio, P/B ratio, and EV/EBITDA
are commonly used for comparative analysis.
6. Economic Insight:
o Macroeconomic Impact: Understanding how broader economic conditions affect a
company helps investors anticipate potential risks and opportunities related to
economic cycles, interest rate changes, and regulatory shifts.
As an investor, what are the aspects you would consider when conducting an operational
analysis of a company. Explain (2022)
1. Management Quality:
• Experience and Track Record: Assess the management team's experience, past
performance, and ability to execute the company's strategy.
• Leadership Style: Evaluate the leadership style and how it influences company culture
and employee morale.
• Corporate Governance: Examine the structure of the board of directors, their
independence, and the effectiveness of their oversight.
2. Business Model and Strategy:
• Revenue Streams: Identify the company's primary sources of revenue and their
sustainability.
• Competitive Advantage: Determine the company's unique selling propositions
(USPs), market position, and competitive edge.
• Growth Strategy: Evaluate the company's plans for growth, such as market expansion,
product development, and mergers/acquisitions.
3. Operational Efficiency:
• Production Processes: Analyze the efficiency of the production processes, including
cost management, quality control, and innovation.
• Supply Chain Management: Assess the reliability, flexibility, and cost-effectiveness
of the supply chain.
• Operational Metrics: Review key performance indicators (KPIs) like inventory
turnover, production cycle time, and capacity utilization.
4. Financial Health:
• Profit Margins: Examine gross, operating, and net profit margins to understand the
company's profitability.
• Cost Structure: Analyze fixed and variable costs and their impact on profitability.
• Cash Flow: Review operating cash flow to ensure the company can meet its short-term
obligations and invest in growth.
5. Market Position and Competition:
• Market Share: Assess the company's market share in its industry and its potential for
growth.
• Competitive Landscape: Identify key competitors and evaluate the company’s relative
strengths and weaknesses.
• Industry Trends: Understand industry trends, regulatory changes, and technological
advancements that could impact the company.
6. Product and Innovation:
• Product Portfolio: Evaluate the diversity, quality, and market acceptance of the
company's products or services.
• R&D and Innovation: Assess the company's investment in research and development
(R&D) and its ability to innovate and adapt to market changes.
• Lifecycle Management: Consider the stage of the product lifecycle and plans for future
product introductions or updates.
7. Customer and Market Insights:
• Customer Base: Analyze the diversity, loyalty, and purchasing behavior of the
customer base.
• Market Demand: Evaluate the current and projected demand for the company’s
products or services.
• Brand Strength: Assess brand recognition, reputation, and the effectiveness of
marketing strategies.
8. Operational Risks:
• Supply Chain Risks: Identify potential disruptions in the supply chain and the
company's contingency plans.
• Regulatory Risks: Understand the regulatory environment and compliance risks
associated with the company's operations.
• Operational Resilience: Evaluate the company's ability to respond to operational
disruptions, such as natural disasters, cyber-attacks, or other emergencies.
9. Human Resources:
• Workforce Quality: Assess the skill level, experience, and motivation of the
workforce.
• Employee Turnover: Analyze employee turnover rates and their impact on operations
and company culture.
• Training and Development: Evaluate the company’s investment in employee training
and development programs.
10. Technology and Systems:
• IT Infrastructure: Assess the robustness and efficiency of the company's IT
infrastructure.
• Automation and Innovation: Evaluate the use of technology and automation in
operations to improve efficiency and reduce costs.
• Cybersecurity: Examine the company's cybersecurity measures to protect against data
breaches and cyber threats.
What factors should the analyst examine to determine whether a firm is likely to gaim
competitive advantage? (2021)
To determine whether a firm is likely to gain a competitive advantage, analysts typically
examine a combination of internal and external factors that contribute to a company's ability to
outperform its competitors and sustain superior profitability over the long term. Here are key
factors analysts consider:
1. Industry Analysis
• Market Structure: Evaluate the industry's competitiveness, including the presence of
barriers to entry (e.g., economies of scale, capital requirements, regulatory barriers)
that can protect existing firms.
• Industry Growth: Industries with higher growth rates offer opportunities for firms to
expand and gain market share.
• Competitive Rivalry: Assess the intensity of competition among existing firms, which
can impact pricing power and profitability.
2. Company-Specific Factors
• Unique Value Proposition: Identify whether the firm offers a unique product or service
that provides superior value to customers compared to competitors.
• Brand Strength: Evaluate the strength of the firm's brand and its ability to influence
customer perceptions and loyalty.
• Intellectual Property: Assess the presence of patents, trademarks, or proprietary
technology that provides a competitive edge.
• Innovation Capabilities: Analyze the firm's track record and investments in research
and development (R&D) to develop new products or improve existing ones.
• Operational Efficiency: Review cost structure, supply chain management, and
operational processes that contribute to lower costs or higher quality compared to
rivals.
• Management Quality: Evaluate the effectiveness of leadership in strategic decision-
making, resource allocation, and adapting to market changes.
3. Financial Performance
• Profitability: Analyze historical and projected financial performance, including
margins, return on investment (ROI), and return on assets (ROA) compared to industry
benchmarks.
• Financial Stability: Assess the firm's ability to manage financial risk, debt levels, and
liquidity.
• Cash Flow Management: Evaluate the firm's ability to generate and effectively utilize
cash flow to fund growth initiatives and withstand economic downturns.
4. Market Position and Growth Strategy
• Market Share: Determine the firm's current market share and its ability to increase
market penetration.
• Expansion Plans: Assess strategic initiatives such as geographic expansion,
diversification into new products or services, or acquisitions that contribute to
sustainable growth.
 • Customer Base: Understand the firm's relationship with its customers and strategies
for customer acquisition, retention, and satisfaction.
5. External Environment
• Regulatory Environment: Consider regulatory changes or government policies that
may impact the firm's operations and competitive position.
• Economic Conditions: Evaluate macroeconomic factors such as interest rates,
inflation, and consumer confidence that can influence market demand and competitive
dynamics.
• Technological Advancements: Monitor technological trends and disruptions that could
affect industry norms and create opportunities for innovation.
6. SWOT Analysis (Strengths, Weaknesses, Opportunities, Threats)
• Strengths: Internal factors that contribute to competitive advantage.
• Weaknesses: Areas where the firm may be vulnerable or lagging behind competitors.
• Opportunities: External factors that the firm can leverage to grow and gain market
share.
• Threats: External factors that pose risks to the firm's competitive position

MODULE 5: TECHNICAL ANALYSIS

What do technical analysts mean when they say that market is 90% psychological and
10% logical? (2019)
When technical analysts say that the market is 90% psychological and 10% logical, they are
emphasizing the significant influence of human emotions and behavior on market movements
compared to purely rational or logical factors. Here’s a deeper explanation of this perspective:
Psychological (90%):
1. Investor Sentiment:
o Fear and Greed: These two powerful emotions often drive market trends. Fear can lead
to panic selling, while greed can lead to excessive buying.
o Herd Behavior: Investors often follow the actions of others, leading to trends and
bubbles. This herd mentality can cause market overreactions.
2. Market Psychology:
o Market Cycles: Bull and bear markets are often driven by collective investor optimism
or pessimism, rather than fundamental changes.
o Psychological Levels: Certain price levels, such as round numbers or previous
highs/lows, can act as psychological support or resistance levels.
3. Cognitive Biases:
o Overconfidence: Investors might overestimate their knowledge or ability to predict
market movements, leading to excessive risk-taking.
 o Anchoring: Relying heavily on the first piece of information (e.g., initial stock price)
and making decisions based on that reference point.
4. News and Rumors:
o Media Influence: News stories, headlines, and social media can greatly influence
investor perceptions and decisions, often causing short-term market volatility.
o Rumors: Unverified information can lead to significant market movements as investors
react emotionally.
Logical (10%):
1. Fundamental Analysis:
o Earnings Reports: Company performance, profitability, and financial health are logical
factors that can influence stock prices.
o Economic Indicators: Data such as GDP growth, unemployment rates, and inflation
can logically affect market expectations
2. Technical Analysis:
o Charts and Patterns: Identifying trends, support and resistance levels, and other
technical patterns are logical approaches to predicting future price movements.
o Volume and Momentum Indicators: Analyzing trading volume, moving averages, and
other indicators provide logical insights into market dynamics.
3. Quantitative Models:
o Valuation Models: Discounted Cash Flow (DCF), Price/Earnings (P/E) ratio, and other
valuation models are logical methods to assess stock value.
o Statistical Analysis: Using historical data and statistical techniques to forecast future
prices is a logical approach.
Technical analysis
is a method used to evaluate and predict the future price movements of securities, such as
stocks, commodities, or currencies, by analyzing past market data, primarily price and volume.
Unlike fundamental analysis, which focuses on a company's financial health and economic
factors, technical analysis primarily relies on charts, patterns, and technical indicators to
identify trends and potential trading opportunities.
Explain Dow theory (2021)
The Dow theory is a financial theory founded on a set of ideas derived from Charles H. Dow’s
editorials. It fundamentally states that a significant shift between bear and bull sentiment in a
stock market will occur when multiple indices confirm it.
The identified trend is accepted when it is backed by solid proof. The theory explains that if
two indices move in the same direction, the identified primary trend is real. Whereas if the two
indices do not match, then there is no clear trend. It focuses on price movements, trade volumes,
capturing the trends with the help of pictorial representations and comparison of indices.
There are six main components to the Dow Theory.
1. The Market Discounts Everything
The Dow Theory operates on the efficient market hypothesis (EMH), which states that asset
prices incorporate all available information.
Earnings potential, competitive advantage, management competence—all these factors and
more are priced into the market, even if not everyone knows all or any of these details. In more
strict readings of this theory, even future events are discounted in the form of risk.
2. There Are Three Primary Kinds of Market Trends
Markets experience primary trends which can last a year or more, such as a bull or bear market.
Within the broader trends, secondary trends make smaller movements, such as a pullback
within a bull market or a rally within a bear market; these secondary trends can last a few weeks
to a few months. Finally, minor trends can last a few days to a few weeks. These small
fluctuations are considered market noise.
3. Primary Trends Have 3 Phases
According to the Dow Theory, the primary bull and bear trends pass through three phases.
A bull market's phases are the:
Accumulation phase: Prices rise alongside an increase in volume.
Public participation (or big move) phase: Retail and average investors begin to notice the
upward trend and join in—generally, this is the longest phase.
Excess phase: The market reaches a point where experienced investors and traders begin
exiting their positions while the larger average investing population continues to add to their
positions.
A bear market's phases are the:
Distribution phase, where news of a decline begins to be distributed throughout the investing
community via various channels.
Public participation phase: Opposes that of a bull market participation phase—average and
retail investors are selling stocks and exiting positions to reduce losses. Again, this is generally
the longest phase.
Panic (or despair) phase: Investors have lost all hopes of a correction or full reversal and
continue selling at scale.
4. Indices Must Confirm Each Other
For a trend to be established, Dow postulated indices or market averages must confirm each
other. This means that the signals that occur on one index must match or correspond with the
signals on the other. If one index, such as the Dow Jones Industrial Average, shows a new
primary uptrend, but another remains in a primary downward trend, traders should not assume
that a new trend has begun.
Dow used the two indices that he and his partners invented, the Dow Jones Industrial Average
(DJIA) and the Dow Jones Transportation Average (DJTA), on the assumption that if business
conditions were healthy—as a rise in the DJIA might suggest—the railroads would be profiting
from moving the freight this business activity required; thus, the DJTA would also be rising.
5. Volume Must Confirm the Trend
Trading volume generally increases if the price moves in the direction of the primary trend and
decreases if it moves against it. Low volume signals a weakness in the trend. For example, in
a bull market, buying volume should increase as the price rises and falls during secondary
pullbacks because traders still believe in the primary bullish trend. If selling volume picks up
during a pullback, it could be a sign that more market participants are turning bearish.
6. Trends Persist Until a Clear Reversal Occurs
Reversals in primary trends can be confused with secondary trends. It is difficult to determine
whether an upswing in a bear market is a reversal or a short-lived rally followed by still lower
lows. The Dow Theory advocates caution, insisting that a possible reversal be confirmed by
comparing indexes.
“Charts patterns are helpful in predicting the stock price movement”. Comment (2022)
Chart Patterns and Stock Price Prediction
Chart patterns are graphical representations of historical price movements in securities and are
used extensively in technical analysis to predict future price movements. The assertion that
"Chart patterns are helpful in predicting stock price movement" is widely accepted among
technical analysts. Here are some key points to consider:
The Role of Chart Patterns in Technical Analysis
1. Visual Representation of Market Sentiment:
o Chart patterns reflect the collective psychology of market participants. Patterns form
as a result of the actions of buyers and sellers, which are driven by human emotions
such as fear, greed, and hope.
2. Identification of Trends and Reversals:
o Chart patterns can help identify ongoing trends and potential reversals. Patterns like
head and shoulders, double tops, and double bottoms are often used to signal trend
reversals.
o Continuation patterns, such as flags, pennants, and triangles, indicate that the
prevailing trend is likely to continue after a brief consolidation.
3. Support and Resistance Levels:
o Patterns often highlight important support and resistance levels, which are critical for
making trading decisions. For example, the neckline in a head and shoulders pattern
acts as a support or resistance level.
4. Predictive Power:
o Historical analysis shows that certain chart patterns can statistically lead to predictable
outcomes. For instance, a breakout from a triangle pattern often results in a significant
price movement in the direction of the breakout.
Common Chart Patterns and Their Implications
1. Head and Shoulders:
o Description: This pattern has three peaks, with the middle peak (head) being higher
than the two side peaks (shoulders).
o Implication: It signals a potential reversal from a bullish to a bearish trend. The
opposite, an inverted head and shoulders, signals a reversal from bearish to bullish.
2. Double Top and Double Bottom:
o Description: A double top consists of two peaks at roughly the same price level, while
a double bottom consists of two troughs.
o Implication: Double tops indicate a potential bearish reversal, while double bottoms
indicate a potential bullish reversal.
3. Triangles:
o Description: Triangles form when price movements become progressively narrower,
creating a shape like a triangle. There are ascending, descending, and symmetrical
triangles.
o Implication: Ascending triangles typically signal a bullish continuation, descending
triangles signal a bearish continuation, and symmetrical triangles can signal
continuation or reversal, depending on the breakout direction.
4. Flags and Pennants:
o Description: Flags are small rectangles that slope against the prevailing trend, and
pennants are small symmetrical triangles.
o Implication: Both patterns indicate a continuation of the prevailing trend after a brief
consolidation.
Support and resistance levels
Support Levels
Support is a price level at which a security tends to find buying interest as it falls. It is a price
point where demand is strong enough to prevent the price from declining further.
• Key Characteristics:
o Buying Interest: At support levels, buyers typically outnumber sellers, causing the
price to hold steady or bounce back up.
o Previous Lows: Often, support levels are identified by looking at previous price lows.
 o Psychological Levels: Round numbers or significant price points can act as support
due to the psychological impact on traders.
• Example:
o If a stock's price has dropped to $50 several times and then rebounded, $50 is a support
level.
Resistance Levels
Resistance is a price level at which a security tends to find selling interest as it rises. It is a
price point where supply is strong enough to prevent the price from climbing further.
• Key Characteristics:
o Selling Interest: At resistance levels, sellers typically outnumber buyers, causing the
price to halt its rise or turn downwards.
o Previous Highs: Resistance levels are often identified by looking at previous price
highs.
o Psychological Levels: Similar to support, round numbers or significant price points
can act as resistance due to psychological factors.
• Example:
o If a stock’s price has risen to $100 several times but failed to break through, $100 is a
resistance level.
Indicators: Volume Of Trade, Simple Moving Average, MACD
1. Volume of Trade
• Definition: Volume refers to the total number of shares or contracts traded for a
particular security during a specified period (e.g., day, week, month).
• Use in Technical Analysis:
o Confirmation of Price Trends: Volume is used to confirm the strength of a price
trend. For example, increasing volume during an uptrend suggests strong buying
interest, while decreasing volume could signal weakening momentum.
o Breakout Confirmation: High volume during a breakout (price moving above
resistance or below support) suggests conviction behind the move.
o Reversal Signals: Unusual volume spikes can indicate potential trend reversals or
significant market events.
• Interpretation:
o High Volume: Indicates strong investor interest and potential continuation of the
current trend.
o Low Volume: Suggests indecision or lack of interest, potentially signaling a
reversal or consolidation.
2. Simple Moving Average (SMA)
• Definition: The Simple Moving Average is a technical indicator that calculates the
average price of a security over a specified number of periods (e.g., 20 days, 50 days,
200 days).
• Interpretation:
o Upward Sloping SMA: Indicates an uptrend.
o Downward Sloping SMA: Indicates a downtrend.
o Flat SMA: Suggests a ranging or consolidating market.
3. Moving Average Convergence Divergence (MACD)
• Definition: The MACD is a trend-following momentum indicator that shows the
relationship between two moving averages of a security’s price.
• Interpretation:
o MACD Line Above Signal Line: Bullish signal.
o MACD Line Below Signal Line: Bearish signal.
o Histogram Moving Up: Indicates increasing momentum.
o Histogram Moving Down: Indicates decreasing momentum.

Oscillators: RSI, ROC, Stochastic oscillator

Oscillators are a category of technical indicators that fluctuate within a bounded range,
typically overbought to oversold conditions, to provide insights into a security's price
momentum and potential reversal points.
1. Relative Strength Index (RSI)
• Definition: The Relative Strength Index (RSI) is a momentum oscillator that measures the
speed and change of price movements. It oscillates between 0 and 100 and is typically
calculated over a 14-period timeframe.
• Interpretation:
o RSI above 70: Overbought, potential reversal downwards.
o RSI below 30: Oversold, potential reversal upwards.
o Divergence with price: Signals potential trend reversal.
2. Rate of Change (ROC or Price Rate of Change)
• Definition: The Rate of Change (ROC) is a momentum oscillator that measures the
percentage change in price over a specified period, typically 12 or 14 periods.
• Interpretation:
 o Positive ROC: Indicates upward momentum.
o Negative ROC: Indicates downward momentum.
o Extreme Values: High ROC may indicate overbought conditions, while low ROC may
indicate oversold conditions.
3. Stochastic Oscillator
• Definition: The Stochastic Oscillator is a momentum indicator that compares a security's
closing price to its price range over a specified period. It oscillates between 0 and 100.
• Interpretation:
o %K above 80: Overbought, potential reversal downwards.
o %K below 20: Oversold, potential reversal upwards.
o %K crossing %D: Signals potential changes in momentum.

MODULE 6: EFFICIENT MARKET HYPOTHESIS (EMH)

The efficient market hypothesis (EMH), alternatively known as the efficient market theory,
is a hypothesis that states that share prices reflect all available information and consistent alpha
generation is impossible.
According to the EMH, stocks always trade at their fair value on exchanges, making it
impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.
Therefore, it should be impossible to outperform the overall market through expert stock
selection or market timing, and the only way an investor can obtain higher returns is by
purchasing riskier investments.
Types/Forms of Efficient Market Hypothesis
Weak Form EMH
The weak form of EMH posits that all past market prices and data are fully reflected in current
stock prices.
Therefore, technical analysis methods, which rely on historical data, are deemed useless as they
cannot provide investors with a competitive edge. However, this form doesn't deny the potential
value of fundamental analysis.
Semi-strong Form EMH
The semi-strong form of EMH extends beyond historical prices and suggests that all publicly
available information is instantly priced into the market.
This includes financial statements, news releases, economic indicators, and other public
disclosures. Therefore, neither technical analysis nor fundamental analysis can yield superior
returns consistently.
Strong Form EMH
The most extreme version of EMH, the strong form, asserts that all information, both public
and private, is fully reflected in stock prices.
Even insiders with privileged information cannot consistently achieve higher-than-average
market returns. This form, however, is widely criticized as it conflicts with securities
regulations that prohibit insider trading.
What are the arguments against EMH? (2022)
1. Market Anomalies and Empirical Evidence
• Market Anomalies: Numerous anomalies and patterns in financial markets suggest that
prices do not always fully reflect all available information in an efficient manner. Examples
include:
➢ Stock Market Bubbles and Crashes: Instances like the dot-com bubble and the financial
crisis of 2007-2008 demonstrate periods where asset prices deviated significantly from
their fundamental values.
➢ Calendar Effects: Seasonal patterns and anomalies (such as the January Effect) that
persist despite being well-documented.
➢ Long-term Return Predictability: Some studies find evidence of long-term return
predictability based on factors like value, size, and momentum, which are inconsistent
with EMH's predictions of random price movements.
• Behavioral Biases: Behavioral finance suggests that investors are not always rational and
can exhibit biases such as overreaction, herding behavior, and loss aversion, leading to
market inefficiencies.
2. Limits to Arbitrage
• Transaction Costs: Trading and information costs can prevent arbitrageurs from fully
correcting mispricings, especially in less liquid markets or with small price
discrepancies.
• Short-selling Constraints: Constraints on short-selling can limit arbitrage opportunities,
preventing prices from adjusting efficiently to new information.
3. Information Asymmetry and Insider Trading
• Insider Trading: While illegal, instances of insider trading indicate that not all market
participants have equal access to information. If insiders possess material non-public
information, they can potentially profit, contradicting EMH's assumption that all
information is immediately reflected in prices.
4. Adaptive Market Hypothesis
• Adaptive Markets: The Adaptive Market Hypothesis (AMH) proposes that markets are
not fully efficient at all times but instead adapt and evolve as new information becomes
available and as market participants learn and react to changing conditions. This
 hypothesis incorporates elements of behavioral finance and suggests that market
efficiency can vary over time and across different market conditions.
5. Practical Observations and Investor Behavior
• Fundamental Analysis Success: Successful investors and fund managers who
consistently outperform the market through fundamental analysis challenge the idea
that markets are perfectly efficient.
• Market Inefficiencies: Real-world examples of mispricings, anomalies, and investor
behavior suggest that markets can exhibit inefficiencies, even if they may tend towards
efficiency over the long term.
Evidences for EMH
1. Random Walk Theory
• Definition: Prices in an efficient market follow a random walk pattern, meaning that
future price movements cannot be predicted based on past prices.
• Evidence:
o Statistical Tests: Studies have applied statistical tests like autocorrelation and runs
tests to stock price data and found no significant evidence of predictable patterns or
serial correlation in price movements over time.
o Efficient Price Adjustments: Prices adjust rapidly to new information, suggesting
that markets incorporate new information efficiently without persistent deviations
from equilibrium.
2. Efficient Market Anomalies
• Definition: Anomalies are deviations from the Efficient Market Hypothesis that may
appear temporarily but are not consistently exploitable after accounting for transaction
costs and risks.
• Evidence:
o Small and Microcap Stocks: While small stocks tend to have higher average returns
(the small-cap premium), these returns are often attributed to higher risk rather than
market inefficiency.
o Value and Growth Stocks: The value premium (higher returns from value stocks
compared to growth stocks) has been observed, but explanations often involve risk
factors or investor behavior rather than market inefficiency.
 MODULE 7: PORTFOLIO MODELS/THEORIES
Markowitz theory
The Markowitz model is an investment technique. It is used to create a portfolio that would
yield maximized returns. In 1952, Harry Markowitz published his model in the Journal of
Finance. Markowitz is an American economist. He is considered the creator of the modern
portfolio theory. The theory is also known as the Markowitz Mean Variance Model.
The Markowitz model of portfolio suggests that the risks can be minimized through
diversification. Simultaneously, the model assures maximization of overall portfolio returns.
Investors are presented with two types of stocks—low-risk, low-return, and high-risk, high-
return stocks. Risks are also divided into two—systematic risk and unsystematic risk. The
Harry Markowitz model uses mathematical calculations to reduce risks; it builds an ideal
portfolio.
Nonetheless, real-world investments cannot eliminate a certain level of risk. Thus, investors
must possess some risk appetite. New investors especially benefit from this theory—the
Markowitz model of portfolio popularized diversification. Not to mention the importance of
understanding and avoiding systematic portfolio risks.
Formula of Markowitz Model
RP = IRF + (RM – IRF)σP/σM
Here,
RP = Expected Portfolio Return
RM = Market Portfolio Return
IRF = Risk-free Rate of Interest
σM = Market’s Standard Deviation
σP = Standard Deviation of Portfolio
Efficient frontier
The efficient frontier is a concept from modern portfolio theory (MPT) introduced by Harry
Markowitz in 1952. It represents a set of optimal portfolios that offer the highest expected
return for a given level of risk or the lowest risk for a given level of expected return. These
portfolios are considered efficient because no other portfolio provides a better combination of
risk and return.
Corner portfolio
A corner portfolio is a concept in modern portfolio theory related to the efficient frontier. It
refers to a portfolio that lies at the "corners" or "vertices" of the efficient frontier when graphed
in the risk-return space. Corner portfolios are particularly important in practical applications of
portfolio optimization because they are the building blocks from which any portfolio on the
efficient frontier can be constructed through linear combinations.
Sharpe index model

Capital asset pricing theory

Capital Asset Pricing Theory (CAPT), often referred to as the Capital Asset Pricing Model
(CAPM), is a foundational concept in finance that describes the relationship between
systematic risk and expected return for assets, particularly stocks. Developed by William F.
Sharpe, John Lintner, and Jan Mossin in the 1960s, CAPM is widely used for pricing risky
securities and generating expected returns for assets given the risk of those assets and the cost
of capital.
SML
The Security Market Line (SML) is a graphical representation of the Capital Asset Pricing
Model (CAPM). It illustrates the relationship between the expected return of a security and its
systematic risk, measured by beta (β). The SML provides a benchmark for evaluating the
performance of individual securities relative to the overall market.
CML
The Capital Market Line (CML) is another key concept in modern portfolio theory. It represents
the risk-return trade-off in the market for efficient portfolios that combine the risk-free asset
and the market portfolio. The CML is derived from the Capital Asset Pricing Model (CAPM)
and provides a benchmark for evaluating the performance of risky portfolios.

Arbitrage pricing theory

Arbitrage Pricing Theory (APT) is an asset pricing model that aims to determine the expected
return of an asset based on its exposure to multiple macroeconomic factors, rather than a single
market index as in the Capital Asset Pricing Model (CAPM). Developed by economist Stephen
Ross in the 1970s, APT provides a more flexible and nuanced approach to asset pricing,
accommodating a variety of systematic risks.
 MODULE 8: PORTFOLIO EVALUATION AND REVISION
Explain the modern approach to the construction of an investment portfolio (2023)
The modern approach to constructing an investment portfolio, often referred to as Modern
Portfolio Theory (MPT), was introduced by Harry Markowitz in the 1950s. This approach
emphasizes diversification to optimize the trade-off between risk and return. Here are the key
steps and concepts involved in the modern approach to portfolio construction:
Key Concepts
1. Diversification:
Spreading investments across various asset classes, sectors, and geographies to reduce risk.
The idea is that different assets will react differently to the same economic event.
2. Risk and Return:
Understanding the expected return of an asset and the risk associated with it. In MPT, risk is
typically measured by the standard deviation of returns.
3. Correlation:
A measure of how two securities move in relation to each other. Diversification benefits are
maximized when assets have low or negative correlations.
4. Efficient Frontier:
A set of optimal portfolios that offer the highest expected return for a given level of risk.
Portfolios on the efficient frontier are considered well-diversified and efficient.
5. Risk-Free Asset:
An asset with zero risk, typically represented by government securities like Treasury bills. It
provides a baseline return that is risk-free.
6. Capital Market Line (CML):
A line that represents portfolios that optimally combine the risk-free asset and the market
portfolio. It shows the best possible return for a given level of risk.
Steps to Constructing an Investment Portfolio
1. Determine Investment Objectives and Constraints:
Define the investment goals, risk tolerance, time horizon, liquidity needs, and any legal or
regulatory constraints. These factors will shape the overall strategy.
2. Asset Allocation:
Decide on the mix of asset classes (e.g., stocks, bonds, real estate, commodities) based on the
investor's risk tolerance and investment objectives. This step is crucial as asset allocation is a
primary determinant of portfolio performance.
3. Security Selection:
Choose specific securities within each asset class. This involves analyzing the expected returns,
risks, and correlations of individual securities to build a diversified portfolio.
4. Optimization:
Use mathematical models to construct the portfolio that lies on the efficient frontier. This
involves calculating the expected return, variance, and covariance of all possible portfolios to
find the optimal mix.
5. Implementation:
Execute the investment strategy by purchasing the selected securities in the appropriate
proportions.
6. Rebalancing:
Periodically review and adjust the portfolio to maintain the desired asset allocation. This
involves selling over-performing assets and buying under-performing ones to stay aligned with
the target allocation.
7. Monitoring and Evaluation:
Continuously monitor the portfolio’s performance against benchmarks and objectives. Evaluate
whether the portfolio is achieving the desired risk-return profile and make adjustments as
necessary.
Advanced Techniques
1. Factor Investing:
Investing based on specific factors that drive returns, such as value, growth, momentum, and
quality. Factor models, like the Fama-French three-factor model, can help identify these
factors.
2. Smart Beta:
Combining elements of passive and active investing by using alternative index construction
rules based on factors like volatility, dividends, or momentum.
3. Alternative Investments:
Including non-traditional assets like hedge funds, private equity, commodities, and real estate
to enhance diversification and potentially improve returns.
4. Use of Derivatives:
Employing options, futures, and other derivatives for hedging, income generation, or
leveraging positions to enhance portfolio performance.
5. Risk Management Techniques:
Implementing risk management strategies such as value at risk (VaR), stress testing, and
scenario analysis to understand and mitigate potential risks.
How is portfolio managed? How it is revised? (2019)
Portfolio management involves the ongoing process of managing and adjusting an investment
portfolio to achieve specific objectives while considering factors such as risk tolerance, return
expectations, and market conditions. Here’s how portfolio management is typically approached
and how portfolios are revised over time:
Portfolio Management Process
1. Establishing Objectives and Constraints:
o Objectives: Define the goals of the portfolio (e.g., growth, income, capital
preservation).
o Constraints: Consider factors such as risk tolerance, time horizon, liquidity needs, legal
and regulatory requirements, and any ethical considerations.
2. Asset Allocation:
o Determine the mix of asset classes (e.g., stocks, bonds, cash equivalents, alternative
investments) based on the investor’s objectives and constraints.
o Asset allocation is a primary driver of portfolio performance and risk.
3. Security Selection:
o Select specific securities or investments within each asset class. This involves
researching individual stocks, bonds, mutual funds, ETFs, or alternative investments
that fit within the portfolio strategy.
4. Portfolio Construction:
o Construct the portfolio based on the chosen asset allocation and security selection. This
step involves allocating funds to different investments in accordance with the desired
risk-return profile.
5. Monitoring and Reviewing:
o Regularly monitor the portfolio’s performance against benchmarks and objectives.
This includes tracking returns, volatility, and other key metrics.
o Review holdings to ensure they continue to align with the investment thesis and
economic outlook.
6. Rebalancing:
o Adjust the portfolio periodically to maintain the desired asset allocation. Rebalancing
involves selling assets that have appreciated (and may now be overweight) and buying
assets that have underperformed (and may now be underweight) to bring the portfolio
back to its target allocation.
o Rebalancing can be triggered by predefined thresholds (e.g., deviations of more than
5% from the target allocation) or scheduled on a regular basis (e.g., annually, semi-
annually).
7. Risk Management:
o Implement strategies to manage risk, such as diversification, hedging, and use of
derivatives.
o Monitor and analyze risks using techniques like value at risk (VaR), stress testing, and
scenario analysis.
8. Performance Evaluation:
o Assess portfolio performance relative to benchmarks and objectives. Evaluate whether
the portfolio is meeting its goals and whether adjustments are needed based on
performance and market conditions.
How Portfolios are Revised Over Time
Portfolios are revised and adjusted based on various factors, including:
• Market Conditions: Changes in economic conditions, interest rates, inflation, and
geopolitical events can impact asset prices and the performance of different sectors.
• Investment Goals: Changes in an investor’s financial goals, risk tolerance, time horizon,
or liquidity needs may necessitate adjustments to the portfolio strategy.
• Performance: Regular monitoring reveals whether the portfolio is achieving expected
returns and whether adjustments are needed to improve performance or manage risk.
• Rebalancing: As mentioned earlier, rebalancing ensures that the portfolio maintains its
target asset allocation. This process helps control risk and ensure the portfolio remains
aligned with the investor’s objectives.
• New Opportunities: Opportunities arise for new investments or changes in asset classes
due to market developments, new products, or evolving investor preferences.
• Tax Considerations: Changes in tax laws or personal tax situations may influence portfolio
decisions, such as realizing gains or losses to manage tax liabilities.
Discuss the following measures of portfolio performance: Treynor Measure, Sharpe
Measure, Jensen Measure And M2 Measure. (2021)

1. Treynor Measure

Definition: The Treynor Measure, developed by Jack Treynor, evaluates the performance of a
portfolio per unit of systematic risk (beta).

Interpretation:

• The Treynor Ratio indicates how much excess return the portfolio earns for each unit
of systematic risk it takes on.
• A higher Treynor Ratio suggests better risk-adjusted performance, as the portfolio is
earning more return per unit of systematic risk.
2.Sharpe Measure (Sharpe Ratio)

Definition: The Sharpe Ratio, developed by William Sharpe, evaluates the performance of a
portfolio adjusted for its total risk (standard deviation).

Interpretation:

• The Sharpe Ratio measures the excess return of the portfolio per unit of total risk (both
systematic and unsystematic).
• A higher Sharpe Ratio indicates better risk-adjusted performance, as the portfolio is
generating more return for the amount of risk taken.

3. Jensen Measure (Jensen's Alpha)

Definition: Jensen's Alpha, developed by Michael Jensen, measures the portfolio's excess
return relative to its expected return based on its beta and the market's risk premium.

Interpretation:

• Jensen's Alpha indicates whether the portfolio manager has added value relative to the
market (positive alpha) or underperformed (negative alpha) after adjusting for
systematic risk.
• A positive alpha suggests the portfolio has outperformed the expected return based on
its risk exposure.
4. M2 Measure

Definition: The M2 Measure, also known as the Modigliani-Modigliani Measure, evaluates

the performance of a portfolio by comparing its return to a benchmark portfolio, adjusting for
risk.

Interpretation:

• The M2 Measure assesses the risk-adjusted return of the portfolio relative to a specified
benchmark.
• A higher M2 Measure indicates that the portfolio has outperformed the benchmark on
a risk-adjusted basis.

Strategies for International Portfolio Investment

1. Diversification:
Spread investments across different countries and regions to reduce overall portfolio risk.
International diversification helps mitigate country-specific risks and economic fluctuations
that may affect domestic investments.
2. Sector and Industry Exposure:
Gain exposure to sectors and industries that may not be well-represented or are
underrepresented in the domestic market. This allows for a broader investment opportunity set
and potential for higher returns.
3. Currency Exposure:
Take advantage of currency movements to enhance returns. Investing in assets denominated in
different currencies can provide opportunities for currency appreciation and diversify currency
risk.
4. Emerging Markets Growth:
Allocate funds to emerging markets with high growth potential. These economies often offer
opportunities for rapid economic expansion, leading to potentially higher investment returns.
5. Risk Management:
Hedge against geopolitical risks, regulatory changes, and economic downturns by diversifying
internationally. Different countries may have varying economic cycles and political stability,
reducing overall portfolio volatility.
Portfolio Revision Techniques
1. Periodic Review:
Regularly assess the performance of international investments relative to their benchmarks and
objectives. Adjust asset allocations based on changing market conditions, economic forecasts,
and geopolitical developments.
2. Rebalancing:
Maintain the desired international exposure by periodically rebalancing the portfolio. Sell
overperforming assets and purchase underperforming assets to realign with target allocations
and risk tolerances.
3. Currency Risk Management:
Hedge currency risk using derivatives or currency-hedged funds to mitigate the impact of
adverse exchange rate movements on international investments.
4. Strategic Asset Allocation:
Adjust asset class weights based on long-term investment goals and market expectations.
Consider shifts in global economic trends and sectoral performance when revising the portfolio.
5. Tax Considerations:
Understand the tax implications of international investments, including withholding taxes,
foreign tax credits, and reporting requirements. Optimize tax efficiency through proper
planning and compliance.
Benefits of International Portfolio Investment
1. Diversification Benefits:
Reduce portfolio risk by spreading investments across different countries, regions, and
currencies. International diversification can lower overall volatility and enhance risk-adjusted
returns.
2. Enhanced Return Potential:
Access global markets with higher growth potential, emerging industries, and innovative
companies that may not be available domestically. This can lead to higher investment returns
over the long term.
3. Currency Opportunities:
Capitalize on currency fluctuations to potentially enhance returns. Investing in countries with
strong currencies or anticipating currency appreciation can add value to the portfolio.
4. Access to Global Markets:
Gain exposure to global economic cycles and diverse market conditions. International
investments provide access to a broader range of investment opportunities and economic
trends.
5. Portfolio Optimization:
Optimize risk-adjusted returns by combining domestic and international assets. International
portfolio investments offer opportunities for portfolio diversification and asset allocation
strategies.
Risks of International Portfolio Investment
1. Currency Risk:
Fluctuations in exchange rates can impact the value of international investments. Currency
depreciation can erode returns when converted back into the investor's home currency.
2. Political and Regulatory Risks:
Political instability, changes in government policies, and regulatory environments in foreign
countries can affect investment returns and market stability.
3. Market Volatility:
International markets may experience higher volatility compared to domestic markets due to
geopolitical events, economic uncertainties, and regional factors.
4. Liquidity Risk:
Some international markets may have lower liquidity levels, making it challenging to buy or
sell assets at desired prices. This can affect portfolio performance and execution.
5. Legal and Operational Risks:
Different legal systems, accounting standards, and operational practices in foreign countries
can pose challenges for international investors. Understanding local laws and regulations is
crucial to managing risks effectively.
Asset management companies
Asset management companies (also known as investment management firms or asset
managers) are financial institutions that manage investment funds on behalf of their clients,
which can include individual investors, institutional investors, corporations, and governments.
These companies specialize in creating and managing portfolios of various assets to achieve
specific investment objectives and goals.
Functions of Asset Management Companies
1. Portfolio Management:
The primary function of asset management companies is to manage investment portfolios on
behalf of clients. This involves selecting and allocating assets across different asset classes
(such as stocks, bonds, commodities, real estate, and alternative investments) to achieve
optimal risk-adjusted returns.
2. Investment Research and Analysis:
Asset managers conduct extensive research and analysis to identify investment opportunities,
assess market trends, and evaluate potential risks. This research informs their investment
decisions and strategies.
3. Asset Allocation:
Asset management companies develop asset allocation strategies based on client objectives,
risk tolerance, and market conditions. They aim to diversify portfolios effectively to manage
risk and optimize returns.
4. Risk Management:
Managing risk is a critical aspect of asset management. Asset managers use various risk
management techniques, such as diversification, hedging, and portfolio rebalancing, to mitigate
potential losses and protect client assets.
5. Client Services:
Asset managers provide personalized investment advice, portfolio monitoring, and reporting
to clients. They offer insights into market developments, performance reviews, and
recommendations for portfolio adjustments.
6. Compliance and Regulation:
Asset management companies adhere to regulatory requirements and compliance standards
governing the financial industry. They ensure transparency, fiduciary responsibility, and ethical
practices in managing client investments.
Types of Asset Management Companies
1. Mutual Fund Companies:
These companies pool funds from multiple investors to invest in a diversified portfolio of
securities. Investors purchase shares in the mutual fund, and professional managers handle the
investment decisions.
2. Pension Funds:
Pension funds manage retirement savings on behalf of employees or members. They invest in
a mix of assets to generate returns and fund future pension obligations.
3. Insurance Companies:
Insurance companies manage investment portfolios to support policyholder obligations and
generate investment income. They invest in various asset classes, including bonds, equities,
and real estate.
4. Private Equity Firms:
Private equity firms raise capital from institutional investors and high-net-worth individuals to
invest in private companies. They aim to achieve capital appreciation through strategic
investments and operational improvements.
5. Hedge Funds:
Hedge funds are alternative investment vehicles that pool capital from accredited investors.
They employ a range of investment strategies, including long/short equity, arbitrage, and
derivatives trading, to generate returns.
6. Wealth Management Firms:
Wealth management firms provide comprehensive financial planning and investment
management services to high-net-worth individuals and families. They offer customized
portfolio management, estate planning, and tax advisory services.