INVESTMENT MANAGEMENT

INTRODUCTION
PRIMARY MARKET OR NEW ISSUE MARKET:

Companies issue securities from time to time to raise funds in order to meet their financial
requirements for promotion, modernization, expansion, and diversification or for regular working
capital programs. These securities are issued directly to the investors (both individual as well as
institutional) through the mechanism called primary market or new issue market. The primary
market refers to the set-up which helps the industry to raise funds by issuing different types of
securities.

Primary versus Secondary Markets:

Primary markets are securities markets in which newly issued securities are offered for sale to
buyers.
Secondary markets are securities markets in which existing securities that have previously been
issued are resold. The initial issuer raises funds only through the primary market.

The primary market is that part of the capital markets that deals with the issue of new securities.
Companies, governments or public sector institutions can obtain funding through the sale of a new
stock or bond issue. This is typically done through a syndicate of securities dealers. The process
of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale
is an initial public offering (IPO). Dealers earn a commission that is built into the price of the
security offering, though it can be found in the prospectus. Primary markets create long term
instruments through which corporate entities borrow from capital market.

Features of primary markets are:

 This is the market for new long term equity capital. The primary market is the market where
the securities are sold for the first time. Therefore it is also called the new issue market
(NIM).

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  In a primary issue, the securities are issued by the company directly to investors.
 The company receives the money and issues new security certificates to the investors.
 Primary issues are used by companies for the purpose of setting up new business or for
expanding or modernizing the existing business. 
 The primary market performs the crucial function of facilitating capital formation in the
economy.
 The new issue market does not include certain other sources of new long term external
finance, such as loans from financial institutions. Borrowers in the new issue market may
be raising capital for converting private capital into public capital; this is known as "going
public."
 The financial assets sold can only be redeemed by the original holder.

Methods of issuing securities in the primary market are:

 Initial public offering;

An initial public offering (IPO) referred to simply as an "offering" or "flotation," is when a
company (called the issuer) issues common stock or shares to the public for the first time.
An Initial Public Offer (IPO) is the selling of securities to the public in the primary market. It is
when an unlisted company makes either a fresh issue of securities or an offer for sale of its existing
securities or both for the first time to the public. This paves way for listing and trading of the
issuer's securities. The sale of securities can be either through book building or through normal
public issue.

 Rights issue (for existing companies);

A rights issue is an option that a company can opt for to raise capital under a secondary market
offering or seasoned equity offering of shares to raise money. The rights issue is a special form of
shelf offering or shelf registration. With the issued rights, existing shareholders have the privilege
to buy a specified number of new shares from the firm at a specified price within a specified time.[1]
A rights issue is in contrast to an initial public offering (primary market offering), where shares
are issued to the general public through market exchanges. Companies

2
usually opt for a rights issue either when having problems raising capital through traditional
means or to avoid interest charges on loans.

 Preferential issue.
An issue of shares set aside for designated buyers, for example, the employees of the issuing
company.

SOME OF THE IMPORTANT TERMINOLOGY:

Stock
The stock or capital stock of a business entity represents the original capital paid into or
invested in the business by its founders.

Shares
The stock of a business is divided into shares, the total of which must be stated at the time of
business formation. Given the total amount of money invested in the business, a share has a certain
declared face value, commonly known as the par value of a share.

Stock certificate
Ownership of shares is documented by issuance of a stock certificate. A stock certificate is a legal
document that specifies the amount of shares owned by the shareholder, and other specifics of the
shares, such as the par value, if any, or the class of the shares.

Dematerialization
Dematerialization is the process by which physical certificates of an investor are converted to an
equivalent number of securities in electronic form and credited to the investor s account with his
Depository Participant (DP).

Listing of Securities:
Listing means admission of securities of an issuer to trading privileges (dealings) on a stock
exchange through a formal agreement. The prime objective of admission to dealings on the

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Exchange is to provide liquidity and marketability to securities, as also to provide a mechanism
for effective control and supervision of trading.

Stock Exchange
Stocks (Shares, equity) are traded in stock exchange. India has two big stock Exchanges (Bombay
Stock Exchange - BSE and National Stock Exchange - NSE) and few small exchanges like Jaipur
Stock Exchange etc. Click here to see the list of Stock Exchanges in India Investor can trade stocks
in any of the stock exchange in India.

Stock Broker
Investor requires a Stock Broker to buy and sell shares in stock exchanges (BSE, NSE etc.). Stock
Broker are registered member of stock exchange. A stock broker can register to one or more stock
exchanges.

Only stock brokers can directly buy and sell shares in Stock Market. An investor must contact a
stock broker to trade stocks. Broker charge commissions (brokerages) for their service. Brokerage
is usually a percent of total amount of trade and varies from broker to broker.

Stock Trading
Traditionally stock trading is done through stock brokers, personally or through telephones. As
number of people trading in stock market increase enormously in last few years, some issues like
location constrains, busy phone lines, miss communication etc start growing in stock broker
offices. Information technology (Stock Market Software) helps stock brokers in solving these
problems with Online Stock Trading.

INVESTMENT AND CAPITAL MARKET:

Investment and Capital Market are corollary to each other. For efficient investment process,
existence of healthy capital market is a pre-requisite. Capital Market in India has witnessed growth
and structural changes, during the last two decades. The capital market of a country is the
barometer of that country’s economy and provides a mechanism for capital formation. The Indian
economy is growing at a fast pace due to the liberalization of the Indian economy and the

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Policies being adopted by the Government of India. This raised the interest in the Indian capital
market not only from investors in India but also from the Foreign Institutional Investors. This also
has resulted in the growth of the stock exchange system in India.
The capital market works as a mechanism to facilitate the transfer of funds from the savers
(investors) to the borrowers (issuers of securities). The transfer of funds will be optimum if the
capital market is efficient.
The history of Indian capital markets spans back 200 years, around the end of the 18th century. It
was at this time that India was under the rule of the East India Company. The capital market of
India initially developed around Mumbai; with around 200 to 250 securities brokers participating
in active trade during the second half of the 19th century.

SCOPE OF THE INDIAN FINANCIAL MARKET

The financial market in India at present is more advanced than many other sectors as it became
organized as early as the 19th century with the securities exchanges in Mumbai, Ahmedabad and
Kolkata. In the early 1960s, the number of securities exchanges in India became eight - including
Mumbai, Ahmedabad and Kolkata. Apart from these three exchanges, there was the Madras,
Kanpur, Delhi, Bangalore and Pune exchanges as well. Today there are 23 regional securities
exchanges in India.

The Indian stock markets till date have remained stagnant due to the rigid economic controls. It
was only in 1991, after the liberalization process that the India securities market witnessed a flurry
of IPOs serially. The market saw many new companies spanning across different industry
segments and business began to flourish.

The launch of the NSE (National Stock Exchange) and the OTCEI (Over the Counter Exchange
of India) in the mid-1990s helped in regulating a smooth and transparent form of securities trading.

The regulatory body for the Indian capital markets was the SEBI (Securities and Exchange Board
of India). The capital markets in India experienced turbulence after which the SEBI came into
prominence. The market loopholes had to be bridged by taking drastic measures.

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FEATURES OF FINANCIAL MARKET IN INDIA:
 India Financial Indices - BSE 30 Index, various sector indexes, stock quotes, Sensex charts,
bond prices, foreign exchange, Rupee & Dollar Chart
 Indian Financial market news
 Stock News - Bombay Stock Exchange, BSE Sensex 30 index, S&P CNX-Nifty, company
information, issues on market capitalization, corporate earning statements
 Fixed Income - Corporate Bond Prices, Corporate Debt details, Debt trading activities,
Interest Rates, Money Market, Government Securities, Public Sector Debt, External Debt
Service
 Foreign Investment - Foreign Debt Database composed by BIS, IMF, OECD,& World
Bank, Investments in India & Abroad
 Global Equity Indexes - Dow Jones Global indexes, Morgan Stanley Equity Indexes
 Currency Indexes - FX & Gold Chart Plotter, J. P. Morgan Currency Indexes
 National and Global Market Relations
 Mutual Funds
 Insurance
 Loans
 Forex and Bullion

The capital market has two interdependent segments: the Primary Market and the Secondary
Market.

PRIMARY MARKET OR NEW ISSUE MARKET:

Companies issue securities from time to time to raise funds in order to meet their financial
requirements for promotion, modernization, expansion, and diversification or for regular working
capital programs. These securities are issued directly to the investors (both individual as well as
institutional) through the mechanism called primary market or new issue market. The primary
market refers to the set-up which helps the industry to raise funds by issuing different types of
securities.

6
The primary market is that part of the capital markets that deals with the issue of new securities.
Companies, governments or public sector institutions can obtain funding through the sale of a new
stock or bond issue. This is typically done through a syndicate of securities dealers. The process
of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale
is an initial public offering (IPO). Dealers earn a commission that is built into the price of the
security offering, though it can be found in the prospectus. Primary markets creates long term
instruments through which corporate entities borrow from capital market.

Features of primary markets are:

 This is the market for new long term equity capital. The primary market is the market where
the securities are sold for the first time. Therefore it is also called the new issue market
(NIM).
 In a primary issue, the securities are issued by the company directly to investors.
 The company receives the money and issues new security certificates to the investors.
 Primary issues are used by companies for the purpose of setting up new business or for
expanding or modernizing the existing business.
 The primary market performs the crucial function of facilitating capital formation in the
economy.
 The new issue market does not include certain other sources of new long term external
finance, such as loans from financial institutions. Borrowers in the new issue market may
be raising capital for converting private capital into public capital; this is known as "going
public."
 The financial assets sold can only be redeemed by the original holder.

Methods of issuing securities in the primary market are:

 Initial public offering

An initial public offering (IPO) referred to simply as an "offering" or "flotation," is when a
company (called the issuer) issues common stock or shares to the public for the first time.

7
An Initial Public Offer (IPO) is the selling of securities to the public in the primary market. It is
when an unlisted company makes either a fresh issue of securities or an offer for sale of its existing
securities or both for the first time to the public. This paves way for listing and trading of the
issuer's securities. The sale of securities can be either through book building or through normal
public issue.

 Rights issue (for existing companies);

A rights issue is an option that a company can opt for to raise capital under a secondary market
offering or seasoned equity offering of shares to raise money. The rights issue is a special form of
shelf offering or shelf registration. With the issued rights, existing shareholders have the privilege
to buy a specified number of new shares from the firm at a specified price within a specified time. [1]
A rights issue is in contrast to an initial public offering (primary market offering), where shares
are issued to the general public through market exchanges. Companies usually opt for a rights issue
either when having problems raising capital through traditional means or to avoid interest charges
on loans.

 Preferential issue.
An issue of shares set aside for designated buyers, for example, the employees of the issuing
company.

Primary versus Secondary Markets:

Primary markets are securities markets in which newly issued securities are offered for sale to
buyers. Secondary markets are securities markets in which existing securities that have previously
been issued are resold. The initial issuer raises funds only through the primary market.

SECONDARY MARKET:

With primary issuances of securities or financial instruments, or the primary market, investors
purchase these securities directly from issuers such as corporations issuing shares in an IPO or

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Private placement, or directly from the federal government in the case of treasuries. After the initial
issuance, investors can purchase from other investors in the secondary market

Meaning of Stock Exchange:

Stock Exchanges are the organized securities markets regulating the trading in shares, debentures
and other securities in the interest of the investors.

Definition of Stock Exchanges:

The Securities Contracts (Regulation) Act, 1956 defines a stock exchange as "an association,
organization or body of individuals, whether incorporate or not, established for the purpose of
assisting, regulating and controlling the business in buying, selling and dealing in securities".

Functions of Stock Exchanges:

The role of a stock exchange in a capital market is as follows:-

(1) Ready and Continuous Market: The stock exchange provides a ready and continuous market
for the sale and purchase of securities.
(2) Bank Borrowing Facility: Securities listed on a stock exchange serve as a collateral security
when an investor needs funds from a bank.
(3) Promotes Capital Formation: Stock Exchanges promote capital formation as they
encourage investors to invest need funds from a bank.
(4) Safety and Fair Dealing: The Stock Exchange operates under rules and regulations framed
by the Central Government. The rules and regulations framed by the Central Government are in
the interest to ensure safety to the investors and whatever be their dealings, it should a fair one.
(5) Government F u n d i n g : Stock E x c h a n g e s h e l p s t h e g o v e r n m e n t t o raise
funds by selling shares and debentures.
(6) Creation of Employment Opportunities: Stock Exchange creates a number of employment
opportunities to a number of brokers, sub brokers as they are the intermediaries through which
shares are being sold.
(7) Evaluation of Securities: Stock Exchanges helps to evaluate the worth of securities, as
securities are traded at a certain price on the stock market. Investors are able to determine the

9
real worth of their holdings in the form of shares and debentures which are listed on the stock
exchange.
(8) Industrial Development: The capital collected through shares and debentures can be put to
industrial use. With the capital, new industries can be started, existing ones can be expanded and
modernized and thereby enhancing the industrial development of a country.
(9) Clearing House of Securities: The Stock Exchanges acts as a clearing house of securities. It
facilitates easy and quick clearance of transactions of securities between the buyers and the sellers.
(10) Facilitates Flow of Capital: Stock Exchange facilitate the flow of capital to companies who
have a high potential to raise substantial funds.

Role of SEBI in monitoring the Stock Exchange

SEBI stands for Securities and Exchange Board of India. It was set up in April, 1988, as a strong
need was felt to protect the interest of the investors and to have a systematic and organized working
of the securities market.
It started actually functioning when the SEBI Act was passed in 1992. The Act empowered SEBI
with necessary powers to regulate the activities connected with marketing of securities and
investment of Stock Exchanges, Portfolio Management, Stock Brokers, and Merchant Banking etc.

Objectives of Securities & Exchange Board of India

There are three basic objectives of SEBI. They are as follows:-

(1) Towards Investors: To protect the interest of the investors.

(2) Towards Capital Issuers: It aims at creating a good market environment where capital
issuers can raise necessary funds.
(3) Towards Intermediaries: It wants to bring about professionalism among the brokers,
stokers and sub – brokers.

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Powers and Functions of SEBI

(1) To protect investors Interest: SEBI is formed to protect the interest of the investors. It
monitors whether issuing companies, brokers, mutual funds are following the rules and
regulations. It also gives a hearing to the investor's complaints and grievances, if any, against the
issuing companies brokers etc.

(2) Regulating Working of Mutual Funds: SEBI regulates the working of mutual funds. It has
laid down certain rules and regulations that are needed to be followed. Failure to follow the
regulations may lead to cancellation of the registration of a mutual fund.

(3) Regulates Merchant Banking: SEBI has laid down certain regulations in respect
of registration, submission of half yearly results, code of conduct in respect of merchant banking,
etc.

(4) Take over and Mergers: SEBI has issued guidelines to protect the interest of the investors in
case of take over and mergers.

(5) Restriction on Insider Trading: SEBI restricts insider trading activity. Its regulation states
that, no insider shall either on his own behalf or on behalf of any other person may deal in securities
of a company listed on any stock exchange on the basis of any unpublished price sensitive
information.

(6) Regulates Stock Brokers Activities: SEBI has laid down the regulations in respect of brokers
and sub-brokers. Without being a registered member of SEBI, no broker or sub-broker can buy,
sell or deal in securities.

(7) Research and Publicity SEBI conducts survey and research in respect of investments and
opportunities. It also undertakes to publish two monthly bulletins called SEBI market review and
SEBI news letter.

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(8) Guidelines on Capital Issues: SEBI has framed certain guidelines on capital issues which are
applicable to first public issue of new companies, first public issue by existing private held
companies, public issue by existing listed companies.

(9) Portfolio Management: SEBI has laid down certain regulations regarding portfolio
management. Without proper registration with SEBI, no person or institution can work as a
portfolio manager.
(10) Other functions: There are some other functions also which are as follows:-
(i) It p r e v e n t s unfair trade practices relating to the securities market.
(ii) It gives training to intermediaries in the securities market.
(iii) It promotes investor's education.
(iv) It conducts audits of the stock exchanges.
(v) It also conducts inquiries, and inspections.
Online Stock Market Trading is an internet based stock trading facility. Investor can trade shares
through a website without any manual intervention from Stock Broker.
In this case these Online Stock Trading companies are stock broker for the investor. They are
registered with one or more Stock Exchanges. Mostly Online Trading Websites in India trades in
BSE and NSE.
There are two different type of trading environments available for online equity trading.
Installable software based Stock Trading Terminals: These trading environment requires
software to be installed on investor’s computer. These software are provided by the stock broker.
These software’s require high speed internet connection. This kind of trading terminals are used
by high volume intraday equity traders.
Advantages:
 Orders directly send to stock exchanges rather then stock broker. This makes order
execution very fast.
 It provides almost each and every information which is required to a trader on a single
screen including stock market charts, live data, alerts, stock market news etc.
Disadvantages:
 Location constrain - You cannot trade if you are not on the computer where you have
installed trading terminal software.

12
  It requires high speed internet connection.
 These trading terminals are not easily available for low volumn share traders.

Web (Internet) based trading application: These kind of trading environment doesn't require
any additional software installation. They are like other internet websites which investor can access
from around the world through normal internet connection.
Below are few advantages and disadvantages of Online Stock Market Trading :-
Advantages of Online Stock Trading (Website based):
Real time stock trading without calling or visiting broker's office.
Display real time market watch, historical datas, graphs etc.
Investment in IPOs, Mutual Funds and Bonds.
 Check the trading history; demat account balance and bank account balance at any
time.
 Provide online tools like market watch, graphs and recommendations to do analysis
of stocks.
 Place offline orders for buying or selling stocks.
 Set alert to inform you certain activity on the stock through email or sms.
 Customer service through Email or Chat.
 Secure transactions.
Disadvantages of Online Stock Trading (Website based):
 Website performance - sometime the website is too slow or not enough user friendly.
 Little long learning curve especially for people who don’t know much about
computer and internet.
 Brokerages are little high

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 INTRODUCTION:

The money a person earns is partly spent and the rest saved for meeting future expenses. Instead
of keeping the savings idle he may like to use savings in order to get return on it in the future.
This is called Investment.

The term investment refers to exchange of money wealth into some tangible wealth. The money
wealth here refers to the money (savings) which an investor has and the term tangible wealth
refers to the assets the investor acquires by sacrificing the money wealth. By investing, an
investor commits the present funds to one or more assets to be held for some time in expectation
of some future return in terms of interest or dividend and capital gain.

Definition:
“Investment may be defined as an activity that commits funds in any financial/marketable or
physical form in the present with an expectation of receiving additional return in the future.”
For example, a Bank deposit is a financial asset, the purchase of gold is a physical asset and the
purchase of bonds and shares is marketable asset.
“Investment is the commitment of current funds in anticipation of receiving larger inflow of funds
in future, the difference being the income”. An investor hopes to be compensated for (i) forgoing
present consumption, (ii) for the effects of inflation, and (iii) for taking a risk.
Features:
There are three basic features common to all types of investment:
1. There is a commitment of present funds.
2. There is an expectation of some return or benefits from such commitment in
future, and
3. There is always some risk involved in respect of return and the principal
amount invested.

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OBJECTIVES OF INVESTMENT:

1. RETURN:

Investors expect a good rate of return from their investments. Return from investment may be
in terms of revenue return or income (interest or dividend) and/or in terms of capital return
(capital gain i.e. difference between the selling price and the purchasing price). The net return
is the sum of revenue return and capital return.
For example, an investor purchases a share (Face Value FV Rs.10) for Rs.130. After one year,
he receives a dividend of Rs.3 (i.e. 30% on FV of Rs.10) from the company and sells it for
Rs.138. His total return is Rs.11, i.e., Rs.3 + Rs.8. The normal rate of return is Rs.11 divided
by Rs.130 i.e., 8.46%.
In the same case, if he is able to sell the share only for Rs.128, then his net return is Re.1 (i.e.,
Rs.3 – Rs.2) only. The annual rate of return in this case is 0.77% (i.e., 1/130)

a) Expected Return:
The expected return refers to the anticipated return for some future period. The
expected return is estimated on the basis of actual returns in the past periods.
b) Realised Returns:
The realized return is the net actual return earned by the investor over the holding
period.It refers to the actual return over some past period.

2. RISK:
Variation in return i.e., the chance that the actual return from an investment would differ
from its expected return is referred to as the risk. Measuring risk is important because
minimizing risk and maximizing return are interrelated objectives. There are two types of risk
i.e. Systematic Risk and Unsystematic Risk which is discussed in detail later in this chapter.

3. LIQUIDITY:
Liquidity, with reference to investments, means that the investment is saleable or

15
convertible into cash without loss of money and without loss of time. Different types of
investments offer different type of liquidity. Most of financial assets provide a high degree of
liquidity. Shares and mutual fund units can be easily sold at the prevailing prices. An investor
has to build a portfolio containing a good proportion of investments which have relatively high
degree of liquidity.Cash and money market instruments are more liquid than the capital market
instruments which in turn are more liquid than the real estate investments. For ex, money
deposited in savings a/c and fixed deposit a/c in a bank is more liquid than the investment made
in shares or debentures of a company.

4. SAFETY:
An investor should take care that the amount of investment is safe. The safety of an
investment depends upon several factors such as the economic conditions, organization where
investment is made, earnings stability of that organization, etc. Guarantee or collateral
available against the investment should also be taken care of. For ex,
 Bonds issued by RBI are completely safe investments as compared with the bonds of
a private sector company.
 Like wise it is more safer to invest in debenture than of preference shares of a company
 Accordingly, it is more safer to invest in preference shares than of equity shares of a
company, the reason being that in case of company liquidation, order of payment is
debenture holders, preference share holds and then equity share holders.

5. TAX BENEFITS:
Investments differ with respect to tax treatment of initial investment, return from
investment and redemption proceeds. For example, investment in Public Provident Fund (PPF)
has tax benefits in respect of all the three characteristics. Equity Shares entails exemption from
taxability of dividend income but the transactions of sale and purchase are subject to Securities
Transaction Tax or Tax on Capital gains. Sometimes, the tax treatment depends upon the type
of the investor.

The performance of any investment decision should be measured by its after tax rate of

16
return. For example, between 8.5% PPF and 8.5% Debentures, PPF should be preferred as it is
exempt from tax while debenture is subject to tax in the hands of the investors.

6. REGULARITY OF INCOME:

The prime objective of making every investment is to earn a stable return. If returns are not
stable, then the investment is termed as risky. For example, return (i.e. interest) from Savings
a/c, Fixed deposit a/c, Bonds & Debentures are stable but the expected dividends from equity
share are not stable. The rate of dividend on equity shares may fluctuate depending upon the
earnings of the company.

CHARACTERISTICS OF INVESTMENT:
1. RETURN
2. RISK
3. SAFETY
4. LIQUIDITY
5. TIME HORIZON
(Refer objectives of investment topic notes)

INVESTMENT & SPECULATION:

In speculation, there is an investment of funds with an expectation of some return in the form
of capital profit resulting from the price change and sale of investment. Speculation is relatively
a short term investment. The degree of uncertainty of future return is definitely higher in case
of speculation than in investment.
In case of investment, the investor has an intention of keeping the investment for some period
whereas in speculation, the investor looks for an opportunity of making a profit and “exit- out”
by selling the investment.

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 DIFFERENCES IN INVESTMENT & SPECULATION:

FACTOR INVESTEMENT SPECULATION

1. Degree of risk Relatively lesser Relatively higher

2.Basis of return Income and capital gain Change in market price

3. Basis for decision Analysis of fundamentals Rumors, tips, etc

4.Position of investor Ownership Party of an agreement

5.Investment period Long term Short term

INVESTMENT ALTERNATIVES

One may invest in:

Physical assets like real estate, gold/jewellery, commodities etc. and/or

Financial assets such as fixed deposits with banks, small saving instruments with post offices,
insurance/provident/pension fund etc. or
Marketable assets - securities market related instruments like shares, bonds, debentures,
derivatives, mutual fund etc.

CLASSIFICATIONS OF INVESTMENT ACTIVITIES:

1. DIRECT INVESTING:
Direct investing involves the buying and selling of securities by investors themselves.
The securities may be capital market securities such as shares, debentures or derivative
products, or money market instruments such as Treasury Bills, Commercial Bills,
Commercial Papers, Certificates of Deposits, or real assets such as land and building,
house, etc or non-financial assets such as gold, silver, art, antiques, etc.

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2. INDIRECT INVESTING:
Investors may not directly invest and manage the portfolio, rather they buy the units of
funds that hold various types of securities on behalf of the investors example, Mutual funds,
Public Provident fund (PPF), National Savings Scheme (NSS), National Savings
Certificate (NSC), and investment in Insurance Company schemes.

INVESTMENT PROCESS

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 Investment process of securities as follows:

1. Investment Policy:

The government or the investor before proceeding into investment, formulates the policy for the
systematic functioning. The essential ingredients of the policy are the investible funds,
objectives and the knowledge about the investment alternatives and market.

a) Investible funds: The entire investment procedure revolves around the availability of
investible funds. The fund may be generated through savings or borrowings. If the funds are
borrowed, the investor has to be extra careful in the selection of investment alternatives. The
return should be higher than the interest he pays. Mutual funds invest their owner’s money in
securities.

b) Objectives: The objectives are framed on the premises of the required rate of return, need
for regularity of income, risk perception and the need for liquidity. The risk taker’s objective is
to earn high rate of return in the form of capital appreciation, whereas the primary objective of
the risk averse (person not interested in taking risk) is the safety of the principal.

c) Knowledge: The knowledge about the investment alternatives and markets plays a key
role in the policy formulation. The investment alternatives range from security to real estate.
The risk and return associated with investment alternative differ from each other. Investment in
equity is high yielding but has more risk than in fixed income securities.

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 2. Security Analysis:

After formulating the investment policy, the securities to be bought have to be scrutinized through
the market, industry and company analysis.

Market Analysis: The general economic scenario is reflected in the stock market. The growth in
gross domestic product and inflation are reflected in the stock prices. The recession in the
economy results in a bear market. The stock prices may be fluctuating in the short run but in the
long run they move in trends i.e. either upwards or downwards.

Industry Analysis: The industries that contribute to the output of the major segments of the
economy vary in their growth rates and their overall contribution to economic activity. Some
industries grow faster than the GDP and are expected to continue in their growth. For example,
IT industry has higher growth rate than the GDP in 1998. The economic significance and the
growth potential of the industry have to be analysed.

Company Analysis: The Company’s earnings, profitability, operating efficiency, capital

structure and management have to be analysed. These factors have direct bearing on the stock
prices and the return of the investors. Appreciation of the stock value is a function of the
performance of the company. Company with high product market share is able to create wealth
to the investors in the form of the capital appreciation.

3. Valuation:

The valuation helps the investor to determine the return and risk expected from an investment in
the common stock.
Intrinsic Value: Intrinsic value is the present value of securities of all future cash inflows by
using simple discounting models.
Future Value: Future value of the securities could be estimated by using a simple statistical
technique like trend analysis. The analysis of the historical behaviour of the price enables the
investor to predict the future value.

21
Construction of Portfolio:
A portfolio is a combination of securities. The portfolio is constructed in such a manner to meet
the investor’s goals and objectives.

Diversification: The main objective of diversification is the reduction of risk in the loss of capital
and income. A diversified portfolio is comparatively less risky than holding a single portfolio.
Various types of diversification are:
1) Debt – equity diversification

2) Industry diversification

3) Company diversification
Selection: Based on the diversification level, industry and company analyses the securities have
to be selected. Funds are allocated for the selected securities.

Evaluation:
The portfolio has to be managed efficiently. The efficient management calls for evaluation of
the portfolio.

Appraisal: The return and risk performance of the security vary from time to time. The
variability in returns of the securities is measured and compared. The developments in the
economy, industry and relevant companies from which the stocks are bought have to be
appraised. The appraisal warns the loss and steps can be taken to avoid such losses.

Revision: Revision depends on the results of the appraisal. The low yielding securities with high
risk are replaced with high yielding securities with low risk factor. To keep the return at a
particular level necessitates the investor to revise the components of the portfolio periodically.

RISK
Investors invest for anticipated future returns, but these returns can be rarely predicted. The
difference between the expected return and the realized return and latter may deviate from the

22
former. This deviation is defined as risk.

All investors generally prefer investment with higher returns, he has to pay the price in terms of
accepting higher risk too. Investors usually prefer less risky investments than riskier investments.
The government bonds are known as risk-free investments, while other investments are risky
investments.
RISK

Systematic Unsystematic
Or Or

Uncontrollable controllable

1. Market risk 1. Business risk

2. Interest rate risk 2. Financial risk

3. Purchasing power risk

SYSTEMATIC RISK
It affects the entire market. It indicates that the entire market is moving in particular direction.
It affects the economic, political, sociological changes. This risk is further subdivided into:

1. Market risk
2. Interest rate risk
3. Purchasing power risk

23
1. Market risk:
Jack Clark Francis defined market risk as “portion of total variability in return caused by the
alternating forces of bull and bear markets. When the security index moves upward for a
significant period of time, it is bull market and if the index declines from the peak to market
low point is called troughs i.e. bearish for significant period of time.

The forces that affect the stock market are tangible and intangible events. The tangible events
such as earthquake, war, political uncertainty and fall in the value of currency. Intangible
events are related to market psychology.

For example – In 1996, the political turmoil and recession in the economy resulted in the fall
of share prices and the small investors lost faith in market. There was a rush to sell the shares
and stocks that were floated in primary market were not received well.

2. Interest rate risk:

It is the variation in single period rates of return caused by the fluctuations in the market interest
rate. Mostly it affects the price of the bonds, debentures and stocks. The fluctuations in the
interest rates are caused by the changes in the government monetary policy and changes in
treasury bills and the government bonds.

Interest rates not only affect the security traders but also the corporate bodies who carry their
business with borrowed funds. The cost of borrowing would increase and a heavy outflow of
profit would take place in the form of interest to the capital borrowed. This would lead to
reduction in earnings per share and consequent fall in price of shares.

EXAMPLE –In April 1996, most of the initial public offerings of many companies remained
under subscribed, but IDBI & IFC bonds were over subscribed. The assured rate of return
attracted the investors from the stock market to the bond market.

24
 3. Purchasing power risk:
Variations in returns are due to loss of purchasing power of currency. Inflation is the reason behind
the loss of purchasing power. The inflation may be, “demand-pull or cost-push “.

Demand pull inflation, the demand for goods and services are in excess of their supply. The
supply cannot be increased unless there is an expansion of labour force or machinery for
production. The equilibrium between demand and supply is attained at a higher price level.

Cost-push inflation, the rise in price is caused by the increase in the cost. The increase in cost of
raw material, labour, etc makes the cost of production high and ends in high price level. The
working force tries to make the corporate to share the increase in the cost of living by demanding
higher wages. Hence, Cost-push inflation has a spiraling effect on price level.

UNSYSTEMATIC RISK

Unsystematic risk stems from managerial inefficiency, technological change in production

process, availability of raw materials, change in consumer preference and labour problems.
They have to be analysed by each and every firm separately. All these factors form
Unsystematic risk. They are
1. Business risk
2. Financial risk

1. BUISNESS RISK:

It is caused by the operating environment of the business. It arises from the inability of a firm
to maintain its competitive edge and the growth or stability of the earnings. The variation in
the expected operating income indicates the business risk. It is concerned with difference
between revenue and earnings before interest and tax. It can be further divided into:

 Internal business risk

 External business risk

25
Internal business risk - it is associated with the operational efficiency of the firm. The
efficiency of operation is reflected on the company’s achievement of its goals and their
promises to its investors. The internal business risks are:

 Fluctuation in sales
 Research and development
 Personal management
 Fixed cost
 Single product

External business risk –It is the result of operating conditions imposed on the firm by
circumstances beyond its control. The external business risk are,
 Social and regulatory factors
 Political risk
 Business cycle.

2. FINANCIAL RISK:

It is the variability of the income to the equity capital due to the debt capital. Financial risk is
associated with the capital structure of the firm. Capital structure of firm consists of equity
bonds and borrowed funds. The interest payment affects the payments that are due to the equity
investors. The use of debt with the owned funds to increase the return to the shareholders is
known as financial leverage.

The financial risk considers the difference between EBIT and EBT. The business risk causes
the variation between revenue and EBIT. The financial risk is an avoidable risk because it is
the management which has to decide how much has to be funded with equity capital and
borrowed capital.

26
 BUY-SELL DECISION RULES FOR INVESTORS

The intrinsic value working with the demand and supply forces determine the price of security
in market. The actual investment decision be made on the basic of comparison of intrinsic value
with the price. The rules are as follows,

BUY RULE: If the market price of a security is less than its value, it is an undervalued security
and it should be bought and held. Then, when price increases then it may be sold to make profit.

SELL RULE: If the market price of a security is more than its value, it is an over priced and it
should be sold .Then, when price falls at later stage, it may be sold to make profit.

NO BUY-SELL: If the price is equal to its value then equilibrium exists. The security is
correctly priced and an investor may not make any profit from buying or selling.

VALUATION OF SECURITIES

I. BOND YIELD

Yield is a commonly used parameter in investment process. It is a common bench mark for
evaluating different investment instruments. It refers to the percentage rate of return on the
amount invested in buying one bond. Bond yield may or may not be same as the coupon rate.
There are various factors which it depends on,

1. Par value
2. Coupon rate
3. Maturity
4. Market price

PAR VALUE: It is also called as face value or normal value. The par value of the bond is the
principal amount of a bond and is stated on the face of the bond security. The issue price may

27
be less than or more than or equal to par value.
COUPON RATE: It is the rate at which interest on par value of bond is payable as per payment
schedule. It represents a fixed annual monetary amount payable by borrower to lender. It may be
paid annually, semi-annually or even monthly. It is also called as Nominal Yield.

MATURITY: The maturity of bond refers to the period from date of issue, after the expiry of
which the redemption repayment will be made to the investor by the borrower firm. In India few
firms have issued unsecured bonds of maturity period 179 days. In International bank markets,
the maturity period will be 50 years or 100years.

MARKET PRICE: An investor bys a bond from market, then the return depends upon the price
paid for the debt.

TYPES OF YIELD
Yield on investment may be calculated in different ways for different purpose.

BOND YIELD PURPOSE

Nominal yield Measures only coupon rate

Current yield Measures the current year rate of return

Yield to maturity Measures annual rate of return, if bond is held till maturity

Yield to call Measures annual rate of return, if bond is held till call

Realised yield Measures the total return over the holding period.

28
 DURATION OF THE BOND

Duration can be defined as, weighted average of lengths of time until the remaining cash flows
are received. Duration is the measure of the length of the time at the end of which investor
would get his investment returned. It is different from maturity of the bond. Maturity refers to
the time when the redemption value will be paid.

Duration is a measure of interest rate risk of bond. It is a relative change in prices with respect
to changes in interest rates. There are two basic measures of duration,

1. Macaulay Duration
2. ModifiedDuration

a. MACAULAY DURATION:

Duration may be defined as the weighted average of the lengths of time until the remaining
cash flows are received.

Duration is a measure of the length of time at the end of which the investor would get his
investment returned. It may be noted that duration is different from the maturity of the bond.
The maturity refers to the time when the redemption value will be paid. Duration depends not
only on the maturity or the term over which cash flows are received, but also on the time-
pattern of interim cash flows. The coupon payments made prior to maturity make the effective
maturity to be less than actual time to maturity. Duration considers the interest and part
payments through the holding period.

Each time period is weighted by the present value of cash flow at that time. The present values
are calculated by discounting the cash flows at the discount rate equal to YTM of the bond.

29
 n (PV x Time)
Duration D = ∑

i=1 B0

b. MODIFIED DURATIOIN:

Modified duration is defined as Macaulay Duration divided by (1+YTM)

Modified duration MD = D/(1+YTM)

II. PREFERENCE SHARES

Preference shares which entitles the shareholder to receive in preference over equity
shareholders:
i. A dividend at a fixed rate for a given period
ii. A redemption amount at the time of redemption of preference shares
Bond being type of loan always matures, but preference shares may or may not mature.
They are different from equity shares because,
a. The dividend on preference shares is payable in priority over the dividend to
equity share holders.
b. In case of winding up of company, the preference shareholders will be repaid
their capital amount in priority over equity share holders.
Hence preference shares may be considered as a security containing features of both bonds
and the share ownership.

ASSUMPTIONS:

1. The dividend on preference shares is received once a year and that the first dividend is
received at the end of one year from the date of acquisition or purchase.

30
 2. The company always intends to pay the preference dividend so that the stream of
preference dividend is considered to be known with certainty.

III. VALUATION OF EQUITY SHARES

Investors, individual as well as institutional, do invest in equity shares. The motive for
investment in equity shares is twofold: To get a dividend income and to earn a capital profit at
the time of sale.
Assumptions:
1. Equity shares do not have any redemption date.
2. Equity shares do not have any given redemption or liquidating value. In
case of liquidation of the company, their claim is residual in nature and arises in the
last.
3. Dividends on equity shares are neither guaranteed nor compulsory. Further, neither the
rate nor the timing of dividend is specified. So, the dividend can vary in any direction.

Valuation:
1. Zero Growth Model
2. Constant Growth Model
3. Two Growth Model
4. Three Growth Model

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FUNDAMENTAL ANALYSIS:

Fundamental analysis is the study of economic factors, industrial environment and the factors
related to the company. The earnings of the company, the growth rate and the risk exposure of the
company have a direct bearing on the price of the share. These factors in turn rely on the host of
other factors like economic development in which they function, the industry belongs to, and
finally companies’ own performance. The fundamental school of thought appraised the intrinsic
value of shares through

 Economic Analysis
 Industry Analysis
 Company Analysis

ECONOMIC ANALYSIS:

The state of the economy determines the growth of gross domestic product and investment
opportunities. An economy with favorable savings, investments, stable prices, balance of
payments, and infrastructure facilities provides a best environment for common stock investment.
If the company grows rapidly, the industry can also be expected to show rapidly growth and vice
versa. When the level of economic activity is low, stock prices are low, and when the level of
economic activity is high, stock prices are high reflecting the prosperous outlook for sales and
profits of the firms. The analysis of macro economic environment is essential to understand the
behaviour of the stock prices.
The commonly analyzed macro economic factors are as follows:

 Gross domestic product (GDP):

GDP represents the aggregate value of goods and services produced in the economy. It consists of
personal consumption expenditure, gross private domestic investment and government
expenditure on goods & services and net export of goods & services. It indicates rate of growth of
economy. The estimate on GDP available on annual basis.

 Business Cycle:
Business cycles refer to cyclical movement in the economic activity in a country as a whole. An
economy marching towards prosperity passes through different phases, each known as a
component of a business cycle. These phases are:
a. Depression: Demand level in the economy is very low. Interest rates and Inflation rates
are high. These affect profitability and dividend pay out and reinvestment activities.
b. Recovery: Demand level starts picking up. Fresh investment by corporate firms shows
increasing trend.
c. Boom: After a consistent recovery for a number of years, the economy starts showing signs
of boom which is characterized by high level of economic activities such as demand,
production and profits.
d. Recession: The boom period is generally not able to sustain for a long period. It slows
down and results in the recession.

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 Savings & investment:
The growth requires investment which in turn requires substantial amount of domestic savings.
Stock market is a channel through which the savings of investors are made available to the
corporate bodies. Savings are distributed over various assets like equity shares, deposits, mutual
fund unit, real estate and bullion. The saving and investment pattern of the public effect the stock
to great extent.

 Inflation:
The inflation is raise in price, where its rate increases, than the real rate of growth would be very
little. The demand is the consumer product industry is significantly affected. The industry which
comes under the government price control policy may lose the market. If the mild level of inflation,
it is good to the stock market but high rate of inflation is harmful to the stock market.

 Interest rates:
The interest rate affects the cost of financing to the firms. Higher interest rates increase the cost of
funds and lower interest rates reduce the cost of funds resulting in higher profit. There are several
reasons for change in interest rates such as monetary policy, fiscal policy, inflation rate, etc,

 Monetary Policy, Money supply and Liquidity:

The liquidity in the economy depends upon the money supply which is regulated by the monetary
policy of the government. RBI regulate the money supply and liquidity in the economy. Business
firms require funds for expansion projects. The capacity to raise funds from the market is affected
by the liquidity position in the economy. The monetary policy is designed with an objective to
maintain a balance in liquidity position. Neither the excess liquidity nor the shortage are desirable.
The shortage of liquidity will tend to increase the interest rates while the excess will result in
inflation.

 Budget:
The budget draft provides an elaborate account of the government revenues and expenditures. A
deficit budget may lead to high rate of inflation and adversely affect the cost of production. Surplus
budget may result in deflation. Hence, balanced budget is highly favourable to the stock market.

 Tax structure:
Every year in March, the business community eagerly awaits the government’s announcement
regarding the tax policy. Concessions and incentives given to the certain industry encourage
investment in particular industry. Tax relief given to savings encourages savings. The minimum
alternative tax (MAT) levied by finance minister in 1996 adversely affected the stock market. Ten
years of tax holiday for all industries to be set up in the northeast is provided in the 1999 budget.
The type of tax exemption has impact on the profitability of the industries.

 Monsoon and agriculture:

33
Agriculture is directly and indirectly linked with the industries. For example, sugar, cotton, textile
and food processing industries depend upon agriculture for raw material. Fertilizer and insectide
industries are supplying inputs to agriculture. A good monsoon leads to higher demand for input
and results in bumper crop. This would lead to buoyancy in the stock market. When the monsoon
is bad, agricultural and hydro power production would suffer. They cast a shadow on a share
market.

 Infrastructure facilities:
Infrastructure facilities are essential for the growth of industrial and agricultural sector. A wide
network of communication system is a must for the growth of the economy. Good infrastructure
facilities affect the stock market favourably. The government are liberalized its policy regarding
the communication, transport and power sector.

 Demographic factors:
The Demographic data provides details about the population by age, occupation, literacy and
geographic location. This is needed to forecast the demand of customer goods. The population by
age indicates the availability of able work force.

 Economic forecasting:
To estimate the stock price changes, an analyst the macro economic environment and the factor
peculiar to industry concerned to it. The economic activities affect the corporate profits, Investors,
attitude and share prices.

 Economic indicators:
The economic indicators are factors that indicate the present status, progress or slow down of the
economy. They are capital investment, business profits, money supply, GNP, interest rate,
unemployment rate, etc. The economic indicators are grouped into leading, coincidental and
lagging indicators. The indicators are selected on the following criteria
Economic significance,
Statistical adequacy,
Timing, conformity.

 Diffusion index:
Diffusion index is a composite index or consensus index. The diffusion index consist of leading,
coincidental and lagging indicators. This type of index has been constructed by the National
Bureau of Economic Research in USA. But it is complex in nature to calculate and the irregular
movements that occur in individual indicators cannot be completely eliminated.

 Econometric model building:

For model building several economic variables are taken into consideration. The assumptions
underlying the analysis are specified. The relationship between the independent and dependent
variables is given mathematically. While using the model, the analyst has to think clearly all inter-
relationship between the variables. This model use simultaneous equations.

Other factors:
a. Industrial growth rate

34
 b. Fiscal policy of the Government
c. Foreign exchange reserves
d. Growth of infrastructural facilities
e. Global economic scenario and confidence
f. Economic and political stability.

INDUSTRY ANALYSIS

An industry is a group of firms that have similar technological structure of production and produce
similar products. E.g.: food products, textiles, beverages and tobacco products, etc. These
industries can be classified on the business cycle i.e. classified according to their relations to the
different phases of the business cycle. They are classified into
 Growth industry
 Cyclical industry
 Defensive industry
 Cyclical Growth industry

 Growth industry:
The growth industry has special features of high rate of earnings and growth in expansion,
independent of the business cycle. The expansion of the expansion of the industry mainly depends
upon the technological change.

 Cyclical industry:
The growth and the profitability of industry move along with the business cycle. During the
boom period they enjoy the growth and during depression they suffer set back.

 Defensive industry:
Defensive industry defies the movement of business cycle. The stock of defensive industries can
be held by the investor for income earning purpose. They expand and earn income in the depression
period too, under the government’s of production and are counter-cyclical in nature.

 Cyclical Growth industry

This is a new type of industry that is cyclical and at the same time growing. The changes in technology
and introduction of new models help the automobile industry to resume their growth path.

INDUSTRY LIFE CYCLE

The life cycle of the industry is separated into four well defined stages such as
o Pioneering stage
o Rapid growth stage
o Maturity and stabilization stage
o Declining stage

35
Pioneering stage:

The prospective demand for the product is promising in this stage and the technology of the product
is low. The demand for the product attracts many producers to produce the particular product. There
would be severe competition and only fittest companies this stage. The producers try to develop brand
name, differentiate the product and create a product image. This would lead to non-price competition
too. The severe competition often leads to the change of position of the firms in terms of market shares
and profit. In this situation, it is difficult to select companies for investment because the survival rate
is unknown.

36
Rapid growth stage:

This stage starts with the appearance

of surviving firms from the pioneering stage. The companies that have withstood the competition
grow strongly in market share and financial performance. The technology of the production would
have improved resulting in low cost of productions and good quality products. The companies have
stable growth rate in this stage and they declare dividend to the share-holders. It is advisable to invest
in the shares of these companies.

Maturity and stabilization stage:

In the stabilization stage, the growth rate tends to moderate and the rate of growth would be more or
less equal to the industrial growth rate or the gross domestic product growth rate. Symptoms of
obsolescence may appear in the technology. To keep going, technological innovations in the
production process and products should be introduced. The investors have to closely monitor the
events that take place in the maturity stage of the industry.

Declining stage:

In this stage, Demand for the particular product and the earnings of the companies in the industry
decline. The specific feature of the declining stage is that even in the boom period; the growth of the
industry would be low and decline at a higher rate during the recession. It is better to avoid investing
in the shares of the low growth industry even in the boom period. Investment in the shares of these
types of companies leads to erosion of capital.

KEY FACTORS IN INDUSTRY ANALYSIS:

1. The past performance of the industry.

2. The performance of the product and technology of the industry.
3. Role of government in the industry.
4. Labour conditions relating to the industry.
5. Competitive conditions in the market
6. Inter-linkages with other industries

DETERMINING THE SENSITIVITY OF THE INDUSTRY:

1. Sensitivity to sales.
2. Operating leverage
3. Financial leverage.

SWOT ANALYSIS FOR THE INDUSTRY

Strength: Strength of the industry refers to its capacity and comparative advantage in the economy.
For example, the existing research and development facilities and greater dependence on allopathic
drugs are two elements of strength to the pharmaceutical industry in India.

37
Weakness: Weakness refers to the restrictions and inherent limitations in the industry, which keep
the industry away from meeting its target. For example, Lack of infrastructure facility, rail-road links,
etc., are weakness of the tourism industry in India.

Opportunities: Opportunities refers to the expectation of favourable situation for an industry. For
example, with increase in purchasing power with the people, demand for pharmaceutical industry will
increase and likewise, changing preference from gold to diamond jewellary has brought a lot of
opportunities for the diamond industry.

Threats: Threat refers to an unfavourable situation that has a potential to endanger the existence of
an industry. For example, after liberalization of import policy in India, import of Chinese goods has
threatened many industries in India, such as toys, novelties, etc.

III. COMPANY ANALYSIS

Effect of a business cycle on an individual company may be different from one industry to another.
Here, the main point is the relationship between revenues and expenses of the firm and the economic
and industry changes. The basic objective of company analysis is to identify better performing
companies in an industry .These companies would be identified for investment. The processes that
may be taken up to attain the objective are as follows:

a. Analysis of management of the company to evaluate its trust-worthiness, capacity and

efficiency.
b. Analyse the financial performance of the company to forecast its future expected earnings.
c. Evaluation of long-term vision and strategies of company in terms of organizational strength
and resources of company.
d. Analysis of key success factor for particular industry.

SOURCES OF INFORMATION:

Information and data required for analysis of earnings of a firm are primarily available in the annual
financial statements of the firm. It include,
 Balance sheet or Position statement
 Income statement or Profit & Loss account.
 Financial statement analysis (Ratio analysis)
 Cash flow statement, the statement of sources and uses of cash and also
 Top level management people in the company.

I. BALANCE SHEET (BS):

It is the most significant and basic financial statement of any firm. It is prepared by a firm to present
a summary of financial position at a given point of time, usually at the end of financial year. It
shows the state of affairs of the firm at a point of time. In fact, the total assets must be equal to the
total claim against the firm and this can be stated as,
Total assets =Total claim (Debt +Share holders)
=Liabilities +Share holders equity

38
 The different items contained in BS can be grouped into,
1. Assets
2. Liabilities
3. Shareholder’s funds.

a. ASSETS: An asset of the firm represents the investments made by the firm in order to
generate earnings. It can be classified into (a).Fixed Asset (b).Current assets.

FIXED ASSET – Those which are intended to be for a longer period .These are permanent in nature,
relatively less liquid and are not easily converted into cash in short run. Fixed asset include, plant &
machinery, furniture & fixtures, buildings, etc. The value of fixed asset is known as book value, which
may be different from market value or replacement cost of the assets. The amount of depreciation is
anon-cash expense and does not involve cash out flow. It is taken as an expense item and is included
in the cost of goods sold or indirect expense.

CURENT ASSET - It is the liquid asset of the firm and is convertible into cash within a period of one
year. It includes cash and bank balance, receivables, inventory (raw material, finished goods, etc),
prepaid expenses, loan, etc.

LIABILITIES: It is also called as debts. It is claimed by the outsiders against the assets of the firm.
The liabilities refer to the amount payable by the firm to the claim holders. The liabilities are classified
into long term and short term liabilities.

LONG TERM LIABILITIES: It is the debt incurred by the firm, which is not payable during the
period of next one year. It represents the long term borrowings of the firm.

CURRENT LIABILITITES: It is the debt which the firm expects to pay within a period of one year.
It is related to the current assets of the firm in the sense that current liabilities are paid out of the
realization of current assets.

SHAREHOLDERS EQUITY (SE): It represents the ownership interest in the firm and reflects the
obligations of the firm towards its owners. It the direct contribution of the shareholders to the firm.The
retained earnings on the other hand reflects the accumulated effect of the firms earnings. SE is also
called as net worth. The liabilities and the SE must be equal to the total assets of the firm.

II. INCOME STATEMENT OR PROFIT & LOSS ACCOUNT (IS):

It shows the result of the operations of the firm during a period. It gives detail sources of income and
expenses; Income statement is a flow report against the balance sheet which is a stock report or status
report. It helps in understanding the performance of the firm during the period under consideration. It
can be grouped into three classes. (i) Revenues (ii) Expenses & (iii) Net profit or loss

REVENUES- It is the inflow of resources\cash that arise because of operation of the firm. The revenue
arises from the sale of goods and services to the customer and other non-operating incomes. The firm
may also get revenue from the use of its economic resources elsewhere. E.g. – some of the

39
funds might have been invested in some other firm. The income by way of interest or dividend is also
a revenue.

EXPENSES- The cost incurred in the earning the revenues is called the expenses. Expenses like,
salaries, general expenses, repairs, etc. It occurs when there is a decrease in assets or increase in
liabilities

III. CASH FLOW STATEMENT AND FUND FLOW STATEMENT:

The balance sheet and the income statement are the two common financial statements and are
also known as traditional financial statements. It is essential to know the movement of cash
during the period. It is a historical record of where the cash came from and how was it used.

IV. FINANCIAL STATEMENT ANALYSIS:

Financial statement analyses are ratio like:
a. Profitability ratios
b. Liquidity ratios
c. Solvency ratios

TECHNICAL ANALYSIS

It is a process of identifying trend reversal at earlier stages to formulate the buying and selling
strategy. With the help of various indicators they analyse the relationship between price& volume,
supply & demand, etc. An investor who does this analysis is called technician.

ASSUMPTIONS:

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

2. The market discounts everything. The information regarding the issuing of bonus shares and
right issues may support the prices. These are some of the factors which cause shift in demand &
supply and change in direction of trends.
3. The market always moves in trend, except for certain minor deviations. The trend may either
be increasing or decreasing. It may continue in same manner or reverse.
4. In the rising market, many purchase shares in greater volume. When the market moves down,
people are interested in selling it. The market technicians assume that past prices predict the future.

THEORIES USED IN THIS ANALYSIS:

1. Dow theory
2. Elliot wave theory

DOW THEORY:

This theory was developed by Charles H Dow. He did research and published in journal in 1984
mainly for trend analysis. According to his theory, the price patterns do not move just like that and
it follows some trend. There are 3 types of trend.

40
  Primary trend – It is broad upward or downward movement which last for a year or two.
 Secondary trend or Correction trend – It last for 3 weeks to some months.
 Minor trend. –It refers to the day to day price. Its also knows as fluctuations

These 3 trends are compared to tide, waves and ripples of the sea. Diagrammatic representations
of these trends are depicted below:

PRIMARY TREND:

The security price may be either increasing or decresing.When market exhibits increasing trend,
its called bull market.The graph below show three clear cut peaks.

Each peak is higher than the previous peak.The revival period encourages more and more investors
to buy scripts,their expectation about the future is high.In the next phase, increased profits or
corporate would result in further price rise.In the final phase,the price advance due to inflation and
speculation.

41
the above graph depicts bear market.The contrary of bull market happens here .In the first phase
,the prices are coming down,this would result in lowering of profit in second phase.The final phase
is characrterised by distress sale of share.

SECONDARY TREND

In the bull market the secondary trend results in fall of about 33-66% of earlier rise. In bear market,
it carries the price upward and corrects the main trend. It provides breathing space to market.

MINOR TREND :
Its also called as random wiggles. They are the daily price fluctuations. It tries to carry the
secondary trend movement. It’s better for the investors to carry primary or secondary than this
trend.

42
ELLIOT WAVE THEORY-

The above graph depicts bullish wave,

1,3,5 – impulsive waves
2,4 - correction waves
In starting wave, only few people invest and the waves keep moving high. It indicates the prices
of shares are moving high and hence they sell it. As they get more profit they will again invest in
the same company and there will be few more investors. This makes the wave to move higher.
Same process keeps going everyday. In the 5th wave investors will be more interested in investing
and to gain profit. Since people buy lot of shares here, it is called as buying wave.
After these five waves get over A,B,C waves or correction waves will occur. It these 8 waves get
over and if the same trend occur, again we may face bully’s wave or else we have beary’s wave.

43
 TYPES OF PRICES

1. The open price.

2. The close price.
3. The high price.
4. The low price.

TOOLS AND TECHNIQUES USED IN TECHNICAL ANLYSIS

CHARTS
What are stock charts

It is a graphical representation of how a stock’s price or trading volumes have changed over time. This
relationship can be presented in a number of ways, through the use of different types of charts. It is
your job, as a technical analyst, to identify the type that will bring out a hidden trend most effectively.

Stock charts, like all other charts, have two axis—the vertical axis and the horizontal axis. The
horizontal axis represents the historical time periods for which a technical chart has been constructed.
The vertical axis displays the stock price or the trading volume corresponding to each period.

There are many types of charts that are used for technical analysis. However, the four types that are
most common are—line chart, bar chart, point and figure chart and candlestick chart. We will discuss
these technical charts extensively later. However, we have illustrated three types of stock charts below.
The bar chart looks a lot like the candlestick chart. All the charts displayed below are stock price
charts. The nature of the input may, however, have to be altered when you move from one chart type
to another.

Line charts: A line chart is the figure that, perhaps, automatically comes to mind when you think of
a chart. The line chart has the stock price or trading volume information on the vertical or y-axis and
the corresponding time period on the horizontal or x-axis). Trading volumes refer to the number of
stocks of a company that were bought and sold in the market on a particular day. The closing stock
price is commonly used for the construction of a line chart.

Once the two axes have been labelled, preparation of a line chart is a two-step process. In the first step,
you take a particular date and plot the closing stock price as on that date on the graph. For this, you’ll
put a dot on the chart in such a way that it is above the concerned date and alongside the corresponding
stock price.

Let’s suppose that the closing stock price on December 31, 2014 was Rs 120. For plotting it, you’ll
put a dot in such a way that it is simultaneously above the marking for that date on the x-axis, and
alongside the mark that says Rs 120 on the y-axis. You will do this for all dates. In the second step,
you will connect all the dots plotted with a line. That’s it! You have your line chart below:

44
 Fig. Line Chart

Point and figure charts:

A point and figure chart essentially displays the volatility in a stock’s price over a chosen period
of time. On the vertical axis, it displays the number of times stock prices rose or fell to a particular
extent. On the horizontal axis, it marks time intervals. Markings on the chart are exclusively in the
form of X’s and O’s. X’s represent the number of times the stock rose by the specified limit, while
O’s represent the number of times it fell by it. The specified amount used is called box size. It is
directly related to the difference between markings on the y-axis.

Fig. Point and Figure Chart

 Bar charts: A bar chart is similar to a line chart. However, it is much more informative. Instead
of a dot, each marking on a bar chart is in the shape of a vertical line with two horizontal lines
protruding out of it, on either side. The top end of each vertical line signifies the highest price the
stock traded at during a day while the bottom point signifies the lowest price at which it traded at
during a day. The horizontal line to the left signifies the price at which the stock opened the

45
trading day. The one on the right signifies the price at which it closed the trading day. As such,
each mark on a bar chart tells you four things. An illustration of the marks used on a bar chart is
given below:

A bar chart is more advantageous than a line chart because in addition to prices, it also reflects
price volatility. Charts that show what kind of trading happened that day are called Intraday charts.
The longer a line is, the higher is the difference between opening and closing prices. This means
higher volatility. You should be interested in knowing about volatility because high volatility
means high risk. After all, how comfortable would you be about investing in a stock whose price
changes frequently and sharply?

Fig. Bar Chart

Candlestick charts: Candlestick charts give the same information as bar charts. They only offer
it in a better way. Like a bar chart is made up of different vertical lines, a candlestick chart is made
up of rectangular blocks with lines coming out of it on both sides. The line at the upper end signifies
the day’s highest trading price. The line at the lower end signifies the day’s lowest trading price.
The day’s trading can be shown in Intraday charts. As for the block itself (called the body), the
upper and the lower ends signify the day’s opening and closing price. The one that is higher of the
two, is at the top, while the other one is at the bottom of the body.

What makes candlestick charts an improvement over bar charts is that they give information about
volatility throughout the period under consideration. Bar charts only display volatility that occurs
within each trading day. Candles on a candlestick chart are of two shades-light and dark. On days
when the opening price was greater than the closing price, they are of a lighter shade
46
(normally white). On days when the closing price was higher than the opening price, they are of a
darker shade (normally black).A single day’s trading is represented by Intraday charts. Higher the
variation in colour, more volatile was the price during the period. The appearance of candles on a
candlestick chart is as follows:

Fig. Candle stick chart

PRICE PATTERNS

Price Patterns are formations which appear on stock with the help of charts which have shown to
have a certain degree of predictive value. Some of the most common patterns include: Head &
Shoulders (bearish), Inverse Head & Shoulders (bullish), Double Top (bearish), Double Bottom
(bullish), Triangles, Flags.

CONTINUATION PATTERNS

A price pattern that denotes a temporary interruption of an existing trend is known as a continuation
pattern. A continuation pattern can be thought of as a pause during a prevailing trend – a time
during which the bulls catch their breath during an uptrend, or when the bears relax for a moment
during a downtrend. While a price pattern is forming, there is no way to tell if the trend will
continue or reverse. As such, careful attention must be placed on the trendlines used to draw the
price pattern and whether price breaks above or below the continuation zone. Technical analysts
typically recommend assuming a trend will continue until it is confirmed that it has reversed. In
general, the longer the price pattern takes to develop, and the larger the price movement within the
pattern, the more significant the move once price breaks above or below the area of continuation.
(See also: Continuation Patterns – An Introduction.)
If price continues on its trend, the price pattern is known as a continuation pattern. Common
continuation patterns include:

47
  Pennants, constructed using two converging trendlines
 Flags, drawn with two parallel trendlines
 Wedges, constructed with two converging trendlines, where both are angled either up or
down

FLAGS & PENNANTS

Flags and Pennants are short-term continuation patterns that represent a consolidation following a
sharp price movement before a continuation of the prevailing trend. Flag patterns are characterized
by a small rectangular pattern that slopes against the prevailing trend, while pennants are small
symmetrical triangles that look very similar.

Figure – Pennant Example – Source: StockCharts.com

The short-term price target for a flag or pennant pattern is simply the length of the ‘flagpole’ or
the left vertical side of the pattern applied to the point of the breakout, as with the triangle patterns.
These patterns typically last no longer than a few weeks, since they would then be classified as
rectangle patterns or symmetrical triangle patterns.

48
TRIANGLES

Triangles are among the most popular chart patterns used in technical analysis since they occur
frequently compared to other patterns. The three most common types of triangles are
symmetrical triangles, ascending triangles, and descending triangles. These chart patterns can last
anywhere from a couple weeks to several months.

49
 Figure Symmetrical Triangle Example – Source: StockCharts.com

Symmetrical triangles occur when two trend lines converge toward each other and signal only that
a breakout is likely to occur – not the direction. Ascending triangles are characterized by a flat
upper trend line and a rising lower trend line and suggest a breakout higher is likely, while
descending triangles have a flat lower trend line and a descending upper trend line that suggests a
breakdown is likely to occur. The magnitude of the breakouts or breakdowns is typically the same
as the height of the left vertical side of the triangle.

REVERSAL PATTERNS

A price pattern that signals a change in the prevailing trend is known as a reversal pattern. These
patterns signify periods where either the bulls or the bears have run out of steam. The established
trend will pause and then head in a new direction as new energy emerges from the other side (bull
or bear). For example, an uptrend supported by enthusiasm from the bulls can pause, signifying
even pressure from both the bulls and bears, then eventually giving way to the bears. This results
in a change in trend to the downside. Reversals that occur at market tops are known as distribution
patterns, where the trading instrument becomes more enthusiastically sold than bought.
Conversely, reversals that occur at market bottoms are known as accumulation patterns, where the
trading instrument becomes more actively bought than sold. As with continuation patterns, the
longer the pattern takes to develop and the larger the price movement within the pattern, the larger
the expected move once price breaks out.
When price reverses after a pause, the price pattern is known as a reversal pattern. Examples of
common reversal patterns include:
 Head and Shoulders, signaling two smaller price movements surrounding one larger
movement
 Double Tops, representing a short-term swing high, followed by a subsequent failed
attempt to break above the same resistance level
 Double Bottoms, showing a short-term swing low, followed by another failed attempt to
break below the same support level

50
HEAD AND SHOULDERS

The Head and Shoulders is a reversal chart pattern that indicates a likely reversal of the trend once
it’s completed. A Head and Shoulder Top is characterized by three peaks with the middle peak
being the highest peak (head) and the two others being lower and roughly equal (shoulders). The
lows between these peaks are connected with a trend line (neckline) that represents the key support
level to watch for a breakdown and trend reversal. A Head and Shoulder Bottom – or Inverse
Head and Shoulders – is simply the inverse of the Head and Shoulders Top with the neckline being
a resistance level to watch for a breakout higher.

Figure Head and Shoulders – Source: StockCharts.com

DOUBLE TOPS AND BOTTOMS

The Double Top or Double Bottom pattern are both easy to recognize and one of the most
reliable chart patterns, making them a favorite for many technically-orientated traders. The pattern
is formed after a sustained trend when a price tests the same support or resistance level twice
without a breakthrough. The pattern signals the start of a trend reversal over the intermediate- or
long-term.

Figure – Double Top Example – Source: StockCharts.com

51
MARKET INDICATORS

Market indicators are a subset of technical indicators used to predict the direction of major
financial indexes or groups of securities. Most market indicators are created by analyzing the
number of companies that have reached new highs relative to the number that created new
lows, known as market breadth, since it shows where the overall trend is headed.

 Market Breadth indicators compare the number of stocks moving in the same direction
as a larger trend. For example, the Advance-Decline Line looks at the number of advancing
stocks versus the number of declining stocks.

 Market Sentiment indicators compare price and volume to determine whether investors
are bullish or bearish on the overall market. For example, the Put Call Ratio looks at the
number of put options versus call options during a given period.

MOVING AVERAGES

Moving averages "smooth" price data by creating a single flowing line. The line represents the
average price over a period of time. Which moving average the trader decides to use is determined
by the time frame in which he or she trades. For investors and long-term trend followers, the 200-
day, 100-day and 50-day simple moving average are popular choices.

There are several ways to utilize the moving average. The first is to look at the angle of the moving
average. If it is mostly moving horizontally for an extended amount of time, then the price isn't
trending, it is ranging. If the moving average line is angled up, an uptrend is underway. Moving
averages don't predict though; they simply show what the price is doing, on average, over a period
of time.

Crossovers are another way to utilize moving averages. By plotting a 200-day and 50-day moving
average on your chart, a buy signal occurs when the 50-day crosses above the 200-day. A sell
signal occurs when the 50-day drops below the 200-day. The time frames can be altered to suit
your individual trading time frame.

52
When the price crosses above a moving average, it can also be used as a buy signal, and when the
price crosses below a moving average, it can be used as a sell signal. Since price is more volatile
than the moving average, this method is prone to more false signals, as the chart above shows.

Moving averages can also provide support or resistance to the price. The chart below shows a 100-
day moving average acting as support (i.e., price bounces off of it).

53
 PORTFOLIO MANAGEMENT

INTRODUCTION

“Never put all your eggs in one basket” is what is meant by diversification. Instead of investing
all funds in one asset, the funds be invested in a group of assets.

Diversification helps in reducing the risk of investing. Total risk of one investment is the sum of
the impact of all the factors that might affect the return from that investment. However, investors
need not suffer risk inherent with individual investments as it could be reduced by holding a
diversity of investments.

For example, return from a single investment in a cold drink company is subject to weather
conditions. This investment is a risky investment. However, if a second investment can be made
in an umbrella company, which is also subject to weather changes, but in an opposite way, the
return from the portfolio of two investments will have a reduced risk-level. This process is known
as diversification.

Portfolio is the combination of securities or diversified investment in securities.

Diversification may be Random or Efficient diversification.
In Random diversification, an investor may randomly select the portfolio without analyzing the
risk and return of the securities.
In Efficient diversification, an investor may construct a portfolio by carefully studying and
analyzing the risk and return of individual securities and also of its portfolio.

APPROACHES IN PORTFOLIO CONSTRUCTION:

 Traditional Approach
 Modern Approach

54
 1. STEPS IN TRADITIONAL APPROACH:

 Analysis of constraints: Analysing the constraints like, income needs, liquidity, time
horizon, safety, tax consideration and risk temperament of an investor.
 Determination of objectives: The objective of the portfolio range from income to capital
appreciation. Investor has to decide upon the return which he gets from the portfolio like,
current income, growth in income, capital appreciation and so on.
 Selection of Portfolio: a) Selecting the type of securities for investment i.e. Shares and
Bonds or Bonds or Shares, b) Calculating the risk and return of the securities and c)
Diversifying the investment by selecting the securities combination and its proportion of
investment in that securities.

2. MODERN APPROACH:

The traditional approach is a comprehensive job for the individual. In modern approach, gives
more attention on selecting the portfolio i.e. Markowitz Model as well as CAPM. (These are
discussed in Unit IV).

PORTFOLIO MANAGEMENT:

Portfolio management may be defined as the process of construction, maintenance, revision and
evaluation of a portfolio.

The objective of portfolio management is to build a portfolio which gives a return commensurate
with the risk preference of the investor.

Portfolio management specifically deals with security analysis, analysis and selection of portfolio,
revision of portfolio and evaluation of portfolio.

POINTS TO BE CONSIDERED:

55
  Deciding the number and type of security in the portfolio.
 Deciding on the proportionate amount of investment in each security.
 Develop the various combinations of portfolio based on risk and return of portfolio.
 Select one combination using Markowitz Model or Capital Asset Pricing Model (CAPM).
 Evaluate the performance of the portfolio using Treynor’s, Sharpe’s or Jensen’s Model.
 Periodical revision of the portfolio in order to maximize the portfolio returns.

PORTFOLIO SELECTION

INTRODUCTION

Risk and return are two basic factors for construction of a portfolio. While constructing a portfolio,
an investor wants to maximize the return and to minimize the risk. The risk can be reduced by
diversification. A portfolio which has highest return and lowest risk is termed as an optimal
portfolio. The process of finding an optimal portfolio is known as the portfolio selection.

If the investments can be made with certainty of returns, then the returns from different investments
would be the only consideration for making portfolio. However, in case of uncertainty, decision
regarding investments cannot be made only on the basis of returns. Risk (uncertainty) should also
be considered. The following are the theoretical relationship between the risk and return and can
be used to construct a portfolio.

 MARKOWITZ MODEL or PORTFOLIO THEORY

 CAPITAL ASSET PRICING MODEL

MARKOWITZ MODEL or PORTFOLIO THEORY

In order to select the best portfolio, an investor can use the Markowitz Portfolio Model.

56
The development of Portfolio theory is given by Harry Markowitz (HM) in1952 in Journal of
Finance. He has provided a conceptual framework and analytical tool for selection of an optimal
portfolio. As the HM Model is based on the expected returns (mean) and standard deviation
(variance) of different portfolios, this model is also called as Mean-Variance Model.

ASSUMPTIONS:

1. The investor should invest only in risky securities; this means no investment should be
made in risk-free securities.

2. The investor should use his own funds. Borrowed funds are not allowed for investments.

3. The decision of the investor regarding selection of the portfolio is made on the basis of
expected returns and risk of the portfolio:
Return:
n _
Rp = ∑ Ri Wi
i=1
Risk:

SDp = √ (Prop x)2 (SD)2+(Prop y)2(SD)2 + 2 (Prop x)(Prop y)(Covariancexy)

4. For a given level of risk, an investor prefers maximum return than lower return and
likewise, for a given level of return, the investor prefers lower risk than higher risk.

Harry Markowitz Model is presented in 3 steps:

I. Setting the Risk-Return opportunity set:

57
The process of selection of optimum portfolio starts with the identification or construction of the
opportunity set of various portfolios in terms of risk and return of each portfolio. For example, ‘x’
number of securities are available in which an investor can invest his funds and infinite number of
combinations of all or a few of these securities are possible. Each such combination has an
expected average rate of return and risk. All these portfolios with a relative set of risk and return,
when plotted on graph, may look like as below:

RISK-RETURN OF NUMBER OF POSSIBLE PORTFOLIOS

R H
E L E
T
U M
R G R
N r2 N
A RISK
0 r1 r3

The Shaded area AEHA includes all possible combinations of risk and return of portfolios and a
particular combination can be identified with a set of risk and return e.g., combination R represents
a risk level of r1, and the return level of r2.

Now the investor has to identify the best portfolio for which he has to identify the efficient set.

58
II. Determining the Efficient Set:

Efficient Portfolio is one which provides the maximum expected return for any particular degree
of risk. Thus, setting the Efficient Set will be subject to two prepositions:

a) Out of the portfolios with the equal expected return, an investor would prefer that
which has lowest risk; and
b) Out of the portfolios that have same degree of risk, and investor would prefer that
which has highest expected return.

As the investors are rational and risk averse, they would prefer more return and lesser risk. In the
above diagram, the portfolios which lie along the boundary AGEH are efficient portfolios and it
is also called as Efficient Frontier.

For e.g., given level of risk r3, there are three portfolios L, M and N. But the portfolio L is an
efficient portfolio because for a given level of risk r3, it has the highest return and it lies on the
boundary AGEH.

Out of these three portfolios, L, M and N, the portfolio L is called the dominating portfolio
because it is having maximum expected return. Dominance is a situation in which investors prefers
a portfolio for investment that dominates all others. Portfolios lying on the efficient frontier are
all dominating portfolios.

III. Selecting the Optimal portfolio:

In order to select the best portfolio or the optimal portfolio, the risk-return preferences of the
investor are to be analysed.

59
A highly risk averse investor will hold a portfolio on the lower left-hand segment of the efficient
frontier. However, risk taker investor will hold a portfolio on the upper position on the right- hand
side.

Risk taker

Risk averse
HM Model does not specify one optimum portfolio. To select the expected risk-return combination
that will satisfy investor’s preferences, indifference curves or utility curves are used. All the
investors’ satisfaction level is not same. An investor is indifferent to various combinations of risk
and return and hence, the name indifference curve. The following figure shows the risk-return
indifference curves or for the investors.

C3

S6 C2
R
E S5 S4 C1
T
U S3 S2
R
N S1
0 RISKS
Risk- Return Indifference Curves

60
All points lying on a particular indifference curve represent different combinations of risk and
return which provide same level of utility or satisfaction to the investors. The indifference curves
show the investor’s risk-return trade-off. The steeper the slope, the more risk averse the investor
is.

An investor may have, at present, a satisfaction level represented by the indifference curve C1, but
if the satisfaction level increases, then the investor will move to indifference curve C2 or C3. Thus,
an investor at any particular point of time, will be indifferent between combinations S1 and S2 or
S3 and S4 or S5 and S6.
The indifference curves never intersect each other and the shape of the curves may vary depending
on the risk preferences of the investors.

Once the shape of investor’s indifference curve is determined, an investor should match his risk-
return preference (indifference curve) with the best portfolios available (efficient frontier). Given
the efficient frontier and risk-return indifference curves, the investor’s optimal portfolio is found
at the tangency point of efficient frontier with the indifference curve. This tangency point marks
the highest level of satisfaction, the investor can attain is shown below:

EFFICIENT FRONTIER AND OPTIMAL PORTFOLIO

(Unattainable)
C3
C2
R C1 (Inferior)

61
 E
T R
U X
R Y
N

0 RISK

R is the tangency point and also the efficient portfolio. At this portfolio, the investor will be able
to get best possible level of satisfaction and also the best combination of risk and return.
Combinations ‘X’ and ‘Y’ are not optimal because they lie outside and inside the region.

Limitations of Harry Markowitz Model:

1. Risky securities alone taken for investment.

2. It requires large amount of input data. An investor must obtain estimates of return, variance
of return and covariance of returns for each pair of securities included in the portfolio. For
ex. If there are ‘N’ number of securities in the portfolio, then ‘N’ estimates of return,
variances and (N2-N)/2 estimates of covariances are required. For ex. For 4 securities 42-
4/2 i.e. 6 covariances are estimated and for 10 securities 102-10/2 i.e. 45 covariances are
estimated.
3. HM Model complex and ‘N’ number of computations are required.

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CAPITAL ASSET PRICING MODEL (CAPM)

CAPM is an extended version of Markowitz Model. In the HM Model we assume that the investor
invests in risk-free securities and investors not use borrowed funds. The CAPM overlook these 2
assumptions. That means CAPM studies the nature of risk and return of a portfolio when an
investor uses borrowed funds and also invests in risk-free securities.

The total CAPM Model explained under two broad segments:

I. Capital Market Line (CML)
II. Security Market Line (SML)

Assumptions:

1. The investors are basically risk averse and diversification is needed to reduce the risk.
2. All investors want to maximize the return and choose a portfolio solely on the basis of
risk and return assessment.
3. All investors can borrow or lend an unlimited amount of funds at risk-free rate of interest
(risk-free lending and risk-free borrowing).
4. All investors have same estimates of risk and return of all securities.
5. All securities are perfectly divisible and liquid and there is no transaction cost or tax.
6. There is a perfect competition in the market.
7. All investor are efficiently diversified and have eliminated the unsystematic risk. Thus,
only the systematic risk is relevant in determining the estimated return.

I. Capital Market Line (CML):

The introduction of risk-free investment and borrowing creates a new set of expected risk-
return possibilities which did not exist earlier. This new trade-off is represented by the
straight line IRFN in the following diagram. This line IRFN is called the CML.

63
 N
CML

R
E R2 M
T U Borrowing
R IRF R1
N Lending
(Rp) 0 σ1 RISK (SD)

For example, the investor has Rs.100 for investment, which he invests in on risk-free
securities (10% rate of return) and risky securities (), the Risk-free lending and risk-free
borrowing rates are:

Portfolio % of investment in % of investment in Total Money Portfolio

risk-free securities Risky securities Return
A 100 0 100 10
B 90 10 100 11
C 75 25 100 12.5
D 60 40 100 14
E 25 75 100 17.5
F 10 90 100 19
G 0 100 100 20
H -10 110 100 21
I -20 120 100 22
J -50 150 100 25

 When an investor invests the total money in risk-free securities, the portfolio
return is equal to the risk-free rate of return.

64
 On the other hand, if the total investment is made in risky securities, the portfolio
return is equal to the risky rate of return.

 This line is tangent to the efficient frontier at portfolio M and has a vertical intercept
IRF. If the investor has risky portfolio, then the investor will hold portfolio M as
optimal risky portfolio.

 The part of CML from IRF to M is Lending portfolio (Defensive) i.e. the investor
invests own fund for investment and beyond M is known as borrowing portfolio
(Aggressive) i.e. the investor uses borrowed fund also for investment. 

 For a given risk of σ1, when an investor sticks to efficient frontier, then his return
would be R1, whereas he introduces risk-free lending, then his return is R2 more than
the return he gets from efficient frontier portfolio.

 Hence, The CML shows that by borrowing or lending at risk-free rate IRF, an
investor can create different portfolios along the CML in such a way that for a given
level of risk, the particular combination offers a return higher than the return
available on the efficient frontier. 

65
II. Security Market Line (SML):

SML is an extension of CML. In CML Standard Deviation σ includes the Systematic and
Unsystematic Risk. But Unsystematic Risks are diversifiable and can be eliminated by
efficient diversification. Systematic risks are non-diversifiable and can be measured by β,
the beta factor.

Interpretation of β value:

R β>1
E T β=1
U
R
N β<1
(Rs)

0 MARKET RETURN (RM)

1. β value less than 0 (Negative β):

It indicates a negative (inverse) relationship between stock return and market return.
Negative β means that if market goes up, the prices of that security are likely to go
down. It is possible but quite unlikely.

2. β value zero:

It means that there is no systematic risk and the share prices have no relationship with
the market. It is very unlikely. Total investment is made in risk-free securities.

66
3. β value between 0 and 1:

The investment is made out of own funds (i.e. defensive portfolio). Particular stock
has less volatility than the market. In case of rise or fall, share price will show lesser
fluctuations than market.

4. β value 1:

It means that volatility in share price and market is equal. Total investment is made in
risky securities.

5. β value more than 1:

It means that the stock has a higher volatility than the market. Fluctuation in share
price will be more than the fluctuation in the market index. Investment is made out of
borrowed funds (i.e. aggressive portfolio) also.

The line which shows the values of risk and return combinations of the defensive and
aggressive portfolio is called Security Market Line which is depicted below:

RS = IRF + (RM – IRF) β

67
 N
SML
R
E R2 M
T
U Borrowing
R IRF R1
N Lending
(RS)

0 β RISK (β)

The portfolio that contains all the securities in the economy is called the market
portfolio. The CAPM model depicts that the expected rate of return of a security
consists of two parts i.e. 1) the risk-free interest rate IRF and 2) the risk premium (RM
– IRF) β. The risk premium is equal to the difference between the expected market
return and the risk-free interest rate multiplied by the beta factor, β. The higher the beta
factor, the greater is the expected rate of return RS and vice-versa.
(Calculations refer class notes)

Limitations of CAPM:

1. Beta calculation difficult (tedious).

2. Assumptions are hypothetical and are impractical.
3. Required rate of return is only a rough approximation.

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 PORTFOLIO EVALUATION

Portfolio evaluation is the process of measuring and comparing the returns (actually) earned on a
portfolio with returns (estimates) for a benchmarks.

Evaluation factors:

1. Risk-return Trade-off:

The performance evaluation should be based on risk and return not on either of them. Risk
without return and return without risk level are impossible to be interpreted. Investors are
risk-averse. But it does not mean that they are not ready to assume risk. They are ready to
take risk provided the return is commensurate. So, in the portfolio performance evaluation,
risk-return trade-off be taken care of.

2. Appropriate Market Index:

The performance of one portfolio is benchmarked either against some other portfolio (for
comparative position) or against some market index.

3. Common Investment Time Horizon:

Investment period horizon of the portfolio being evaluated and the time horizon of the
benchmark must be same. Suppose, a mutual fund scheme announces that it has earned the
highest return, it must be verified before accepting whether the highest return has been
earned during current year or during last 3 years or 5 years, etc.

4. Objectives or Constraints of Portfolio:

The objectives for which the portfolio has been created has to be evaluated.

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Measures of Portfolio Performance:

There are several measures for evaluation of portfolio performance. They are

I. Return per unit of risk:

The return earned over and above the risk-free return is the risk-premium and is earned for
bearing risk. The risk-premium may be divided by risk factor to find out the reward per
unit of risk undertaken. This is also known as reward to risk ratio. There are two methods
of measuring reward to risk ratio:

a) Sharpe Ratio (Reward to Variability Ratio) :

The Sharpe Index measures the risk premium of the portfolio relative to the total amount
of risk in the portfolio. The larger the index value, the better the portfolio has performed.

RP – IRF
Sharpe Ratio = ------------
σP

b) Treynor Ratio(Reward to Volatility Ratio):

The Treynor Index measures the risk premium of the portfolio related to the amount of
systematic risk present in the portfolio.

RP – IRF
Treynor Ratio = -----------
βP

70
II. Differential Return:

c) Jensen Ratio:

Michel Jensen has developed another method for evaluation of performance of a portfolio.
This measure is based on differential returns. The Jensen’s Ratio is based on the difference
between the actual return of a portfolio and required return of a portfolio in view of the risk
of the portfolio.

α
Jensen’s Index = -----
β
αP = RP - RS

RP = Acutal Return on portfolio

RS = Expected Return on portfolio

RS = IRF + (RM – IRF) β

(Note: Caln. refer class work)

71
 PORTFOLIO REVISION

The care taken in the construction of portfolio should be extended to review and revision of the
portfolio. Volatility (fluctuation) that occur in the equity prices cause substantial gain/loss to the
investors. The investor should have competence and skill in the revision of portfolio. There are 3
important plans for revising the portfolio. They are:

 Constant rupee plan

 Constant ratio plan
 Variable ratio plan
1. Constant rupee plan:

The constant rupee plan enables the shift of investment ftrom bonds to stock and vice versa,
by maintaining a constant amount invested in stock portion of portfolio. The constant rupee
plan starts from fixed amount of money invested in selected stocks and bonds. When price
of stocks increases, the investor sells sufficient amount of stock to return to the original
amount of investment in stock. By keeping the value of aggressive portfolio constant,
remainder (balance) is invested in the conservative portfolios. The plan force the investor
to sell when the price rise and purchase as price falls.

Qn.1) Revise the portfolio using constant rupee method from a tolerance level of 20%.
The total money available from the investor is Rs.20,000 planning to invest in bonds and
shares equally. The market value of share is Rs. 25, 23, 20, 22, 24, 28, 24, 26, 27 and 29.

72
 2. C
Port Investmen Investment Mkt No of Total remarks
o
folio t in bonds in shares value of shares money
shares invested n
s
1 10000 10000 25 400 20000 -
t
2 10000 9200 23 400 19200 -
a
3 10000 8000 20 400 18000 -
n
8000 10000 20 500 18000 Purchase of share
t
100 @ Rs.20
4 8000 11000 22 500 19000 -
r
5 8000 12000 24 500 20000 -
a
10000 10000 24 417 20000 Sell 83 shares @
t
Rs.24/each
i
6 10000 11676 28 417 21676 -
o
7 10000 10008 24 417 20008 -
8 10000 10842 26 417 20842 -
p
10 10000 12093 29 417 22093 -
l
12093 10000 29 345 22093 Sell 72 shares @
a
Rs.29/each
n
:
Under this method, a predetermined ratio is fixed under aggressive and defensive
investment. Wherever the ratio is exceeding the tolerance limit the remedial action should
be taken by restoring the predetermine ratio.

Qn) An investor is planning to have 1:1 investment ratio in aggressive and defensive
investment. The tolerance level is 10% or 0.1. To start with the total money invested by
the investor is Rs 20,000. The market values of the shares are Rs.25, 23, 19, 21, 24, 26,
28, and 25.

73
Port Investments Investments Mkt Ratio No of Total remarks
folio in Bonds in shares price shares investment
1 10000 10000 25 1:1 400 20000 -
2 10000 9200 23 0.92:1 400 19200 -
3 10000 7600 19 0.76:1 400 17600 -
8800 8800 19 1:1 463 17600 Pur 63 share @
Rs.19
4 8800 9723 21 1.10:1 463 18523 -
9261.5 9261.5 21 1:1 441 18523 Sold 22 shares
@ Rs.21
5 9261.5 10584 24 1.14:1 441 19845.5 -

9923 9923 24 1:1 413 19846 Sold 28 shares

@ Rs.24
6 9923 10738 26 1.08:1 413 20661 -

7 9923 11564 28 1.16:1 413 21487 -

10743.5 10743.5 28 1:1 384 21487 Sold 29 shares
@ Rs.28
8 10743.5 9600 25 0.89:1 384 20334 -
10172 10172 25 1:1 407 20334 Pur 23 shares
@ Rs.25

74
 3. Variable Ratio Plan:

Instead of maintaining a constant rupee amount in stock or constant ratio of stock is to

bonds, the variable ratio plan steadily lowers (by selling) the aggressive portion of the total
portfolio as stock price increases and steadily increases (by purchasing) the aggressive
portion when stock price falls and new ratio is adopted.

Qn. An investor is planning to have an equal investment of Rs.5000 in both bonds and
shares. The tolerance level is 20% and market value of the shares are Rs.50, 45, 40, 45,
50 and 60.

Port Investments Investments Mkt Ratio No of Total remarks

folio in Bonds in shares price shares investment
1 5000 5000 50 0.5:1 100 10000 -
2 5000 4500 45 0.47:1 100 9500 -
3 5000 4000 40 0.44:1 100 9000 -
2700 6300 40 0.7:1 158 9000 Pur 58 share
@ Rs.40
4 2700 7110 45 0.72:1 158 9810 -
5 2700 7900 50 0.74:1 158 10600 -

5300 5300 50 0.5:1 106 10600 Sold 52 shares

@ Rs.50
6 5300 6360 60 0.54:1 106 11660 -

8162 3498 60 0.3:1 58 11660 Sold 48 shares

@ Rs.60

75
76