INVESTMENT MANAGEMENT

Module 1: Investment
INVESTMENT
 Investment is the employment of funds on assets to earn income or capital
appreciation.
 The individual who makes an investment is known as the investor.
 In economic terms, investment is defined as the net addition made to the capital stock
of the country.
 In financial terms, investment is defined as allocating money to assets with a view to
gain profit over a period of time.
 Investments in economic and financial terms are inter-related where an individual's
savings flow into the capital market as financial investment, which are further used as
economic investment.
OBJECTIVES OF INVESTMENT.
The main investment objectives are increasing the rate of return and reducing the risk.
Other objectives like safety, liquidity and hedge against inflation can be considered as
subsidiary objectives.
Return – investors always expect a good rate of return from their investments. The rate of
return could be defined as the total income the investor receives during the holding period
stated as a percentage of purchasing price at the beginning of the holding period.
𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑒𝑛𝑑 𝑝𝑒𝑟𝑖𝑜𝑑 𝑣𝑎𝑙𝑢𝑒 − 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑣𝑎𝑙𝑢𝑒 + 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 × 100
Beginning period value
Rate of return is stated semiannual or annual to help comparison among the different
investment alternatives. If it is a stock, the investor gets the dividend as well as the capital
appreciation as returns.
Risk - risk of holding securities is related with the probability of actual return becoming less
than the expected returns. The word risk is synonymous with the phase variability of the
return. Investments’ risk is just as important as measuring its expected rate of return because
minimizing risk and maximize the rate of return are the interrelated objectives in the
investment management. Every investor likes to reduce the risk of his investment by proper
combination of different securities.
Liquidity – marketability of the investment provides liquidity to the investment. The liquidity
depends upon the marketing and trading facility. If a portion of the investment could be
converted into cash without much loss of time, it would help the investors meet the
emergencies. Stocks are liquid only if they command good market by providing adequate
return through dividends and capital appreciation.
Hedge against inflation- since there is inflation in almost all the economy, the rate of return
should ensure a cover against the inflation. The return rate should be higher than the rate of
inflation; otherwise, the investors will have loss in real terms. Growth stocks would
appreciate in their values over time and provide a protection against inflation. The return thus
earned should assure the safety of the principal amount, regular flow of income and be a
hedge against inflation.
Safety - The selected investment avenue should be under the legal and regulatory frame
work. If it is not under the legal frame work, it is difficult to represent the grievances, if any.
Approval of the law itself adds a favor of safety. Ex: Bank deposits, LIC
SPECULATION
Speculation means taking business risks with the anticipation of acquiring short term gain. It
also involves the practice of buying and selling activities in order to profit from the price
fluctuations. An individual who undertakes the activity of speculation is known as speculator.
DIFFERENCE BETWEEN INVESTOR AND SPECULATOR

Factors Investor Speculator

Time Plans for a longer time horizon. Holding Plans for a very short period. Holding period
horizon period varies from one year to few years. varies from few days to months

Risk Assumes moderate risk. Willing to undertake high risk

Return Likes to have moderate rate of return Like to have high returns for assuming high
associated with limited risk. risk.

Considers fundamental factors and evaluates Considers inside information, hearsays and
Decision the performance of the company regularly. market behaviour.
Funds Uses his own funds and avoids borrowed Uses borrowed funds to supplement his
funds. personal resources.

GAMBLING

Gambling is usually a very short term investment in a game or chance. The roll of dice or the
turn of a card determines the results. People gamble as a way to entertain themselves, earning
 incomes would be the secondary factor. Gambling enjoys artificial risks whereas commercial
risks present in the investment activity

Difference between gambling and investment

Gambling Investment

It is a short time investment in a game or chance. It is a long term employment of funds on assets.

Gambling is a way of entertainment and earning is Present consumption is foregone for future return.
a secondary factor.
Commercial risks are present in investment activity.
The risk in gambling is different from investment.
Its artificial risk in gambling. There is an analysis of risk and return and positive
returns are expected by the investors.
There is no risk and return trade off in gambling
and the negative outcomes are expected.

FEATURES OF A GOOD INVESTMENT

Objective fulfillment
An investment should fulfill the objective of the savers. Every individual has a definite
objective in making an investment. When the investment objective is contrasted with the
uncertainty involved with investments, the fulfillment of the objectives through the chosen
investment avenue could become complex.
Safety
The first and foremost concern of any ordinary investor is that his investment should be safe.
That is he should get back the principal at the end of the maturity period of the investment.
There is no absolute safety in any investment, except probably with investment in
government securities or such instruments where the repayment of interest and principal is
guaranteed by the government.

Return
The return from any investment is expectedly consistent with the extent of risk assumed by
the investor. Risk and return go together. Higher the risk, higher the chances of getting higher
return. An investment in a low risk - high safety investment such as investment in
government securities will obviously get the investor only low returns.
Liquidity
Given a choice, investors would prefer a liquid investment than a higher return investment.
Because the investment climate and market conditions may change or investor may be
confronted by an urgent unforeseen commitment for which he might need funds, and if he
can dispose of his investment without suffering unduly in terms of loss of returns, he would
prefer the liquid investment.
Hedge against inflation
The purchasing power of money deteriorates heavily in a country which is not efficient or not
well endowed, in relation to another country. Investors, who save for the long term, look for
hedge against inflation so that their investments are not unduly eroded; rather they look for a
capital gain which neutralizes the erosion in purchasing power and still gives a return.
Concealability
If not from the taxman, investors would like to keep their investments rather confidential
from their own kith and kin so that the investments made for their old age/ uncertain future
does not become a hunting ground for their own lives. Safeguarding of financial instruments
representing the investments may be easier than investment made in real estate. Moreover,
the real estate may be prone to encroachment and other such hazards.
Tax shield
Investment decisions are highly influenced by the tax system in the country. Investors look
for front-end tax incentives while making an investment and also rear-end tax reliefs while
earning the benefit of their investments. As against tax incentives and reliefs, if investors
were to pay taxes on the income earned from investments, they look for higher return in such
investments so that their after tax income is comparable to the pre-tax equivalent level with
some other income which is free of tax, but is more risky.

ECONOMIC Vs FINANCIAL INVESTMENT

Financial Investment
A financial investment allocates resources into a financial asset, such as a bank account,
stocks, mutual funds, foreign currency and derivatives. Financial investments are purchases
of financial claims. This type of investment may or may not yield a return. However,
businesses gain from placing money into financial investments because many safe assets,
such as an interest-bearing savings account, may yield enough of a return to protect it from
inflation. Essentially, some financial investments offer protection against rising prices.
Economic Investment
An economic investment puts resources in something that may yield benefits in excess of its
initial cost. Though these resources still include money, investments can also be made in
time, assistance and mentoring. Likewise, assets are not limited to financial instruments. An
economic investment may include buying or upgrading machinery and equipment or adding
to a labor force.
Measuring the return of an economic investment is not as straightforward as a financial
investment. While a financial investment provides concrete data regarding the asset's past
performance and its day-to-day growth or decline, assessing economic investments is not as
direct because the return of an economic investment is not always apparent.

INVESTMENT PROCESS
Investment policy: The government or investor before proceeding into investment
formulates the policy for the systematic proceeding. The essential ingredients are:
Investible funds: It is the core of investment policy. 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 alternatives. The return should be higher than the interest rate.
Objectives: the objectives are framed on the premises of required rate of return, need for
regularity of income, risk perception and need for liquidity. The risk taker’s objective is to
earn high rate of return or vice versa
Knowledge: The knowledge about the investment alternatives and markets plays an important
role. The risk and the return associated with each alternative differ from each other.
Ex: investment in equity yields high return but has more risk than fixed income securities.
The investor should be aware of stock market and functions of brokers. The knowledge about
the stock exchanges enables to trade the stock intelligently.
Security analysis: After formulating the policy the securities to be bought have to be
scrutinized through the market, industry, company analysis.
Market analysis: the stock market mirrors the general economic condition. The growth in the
GDP is reflected in the stock prices. The stock prices may be fluctuating in the short run but
in the long run they may move in trends i.e. either upwards or downwards. The investor can
fix his entry and exit points through technical points
Industry analysis: the industries that contribute to the economy vary in their growth rates and
their overall contribution to the economy. Some industries grow faster than the GDP and are
expected to grow. The economic significance and the growth potential of the industry have to
be analyzed.
Company analysis: the company earnings, profitability, operating efficiency, capital structure
and the management have to be screened. These factors have direct bearing on the stock
prices and returns.
Valuation
The valuation helps the investor to determine the return and risk expected from an
investment.
The intrinsic value of the share is measured through the book value of the share and price
earnings ratio. The real worth of the share is compared with the market price and then the
investment decisions are made.
Future value: Future value of the securities could be estimated by using a simple statistical
technique like trend analysis. The analysis of the historical behavior of the price enables the
investor to predict the future value.
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. The investor tries to attain maximum return with the
minimum risk. Toward this end he diversifies his portfolio and allocates funds among the
securities.
Diversification: the main objective of diversification is the reduction of risk in the loss of
capital and income. It can be
Debt equity diversification: debt instruments provide assured return with limited capital
appreciation. Common stock provide income and capital gain but with high degree of risk.
Both debt and equity are combined to complement each other.
Industry diversification: Industries growth and their reaction to the government policies differ
from each other.
Ex: banking industry shares provide regular income with less capital appreciation. The IT
stock yields high return and capital appreciation but their growth rate after 2002 is
unpredictable. Thus, industry diversification is needed and it reduces the risk.
Company diversification: securities from different companies are purchases to reduce the
risk. Technical analyst suggests to buy based on the price movement. Fundamental analysts
suggest the selection of financially sound and investor friendly companies
Selection: Based on the diversification level, industry and company analyses the securities
have to be purchased. Funds are allocated for selected securities.
Evaluation:
The efficient management of portfolio calls for the evaluation. This process consists of
Appraisal: The return and the risk performance of the security vary from time to time. The
variability in the returns are compared and measured. The developments in the economy,
industry and relevant companies 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 portfolio periodically.
INVESTMENT ALTERNATIVES.

1 CORPORATE SECURITIES

EQUITY SHARES
Equity share are commonly referred to common stock or ordinary share. Even though the
words shares and stocks are interchangeable used, there is a difference between them. Share
capital of company is divided into a number of small units of equal value called shares.
Equity share have the following rights according to section 85(2) of the companies Act
1956
1. Right to vote at the general body meeting of the company.
2. Right to control the management of the company.
3. Right to share in the profits in the form of dividends and bonus share.
4. Right to claim on the residual after repayment of all the claims in the case of
winding up of the company.
5. Right to pre-emption in the matter of issue of new capital.
SWEAT EQUITY
Sweat equity is a new equity instrument introduced in the companies (amendment)
ordinance, 1988. Newly inserted section 79A of Companies Act, 1956 allows issue of sweat
equity. However is should be issued out of a class of equity share s already issued by the
company. It cannot form a new class of equity shares. Section 79A (2) explains that all
limitations, restriction and provisions applicable to equity shares are applicable equity shares
are applicable to sweat equity. Thus, sweat equity forms a part of equity share capital.
The definition of sweat equity has two different dimensions
1. Shares issued at a discount to employees and directors.
2. Shares issued for consideration other than cash for providing know-how or making
available rights in the nature of intellectual property rights or value additions, by
whatever name called.
NON-VOTING SHARES
Non-voting shares carry no voting right, they carry additional dividends instead of the
voting rights even though the idea was widely discussed in 1987, and it was only in the year
1994 that the finance minister announced certain board guidelines for the issue of non-voting
shares.
They have rights to participate in the bonus issue. The non-voting shares also can be listed
and traded in the stock exchanges. If non-voting shares were not paid dividend for 2 years,
the shares would automatically get the non-voting rights. The company can issue this to a
max of 25% of voting stock. The dividend on non-voting shares would have to be 20% higher
than the dividend on voting shares. All rights and bonus shares for the non-voting shares have
to be received in the form of non-voting shares only.
RIGHT SHARES
Shares offered to the existing shareholders at a price by the company are called the
right shares. They are offered to the shareholders as a matter of legal right. If a public,
company wants to increase its subscribed capital by way of issuing shares after 2 years from
its formation date. The right shares may be partly paid. Minimum subscription limit is
prescribed for right issues. In the event of company failing to receive 90% subscription, the
company shall have to return the entire money received. At present, SEBI has removed this
limit. Right issues are regulated under the provisions of the company’s act.
BONUS SHARES
Bonus shares are the distribution of shares in addition to the cash dividends to the
existing shareholders. Bonus shares are issued to the existing shareholders without any
payment of cash. The aim bonus share is to capitalize the free reserves. The bonus issue is
made out of the free reserves built out of genuine profit or share premium collected in cash
only. The bonus issue could be made only when all the partly paid shares, if any, existing are
made fully paid up.
They take it as an indication of higher future profits. Bonus shares are declared by the
directors only when they expect a rise in the profitability of the concern. The issue of bonus
shares enables the shareholders to sell the shares and get capital gains while retaining their
original shares.
PREFERENCE SHARES
Some of its features resemble the bond and others equity shares. Like the bonds, their
claims on the company’s income are limited and receive fixed dividend. The dividend
received by the preferred stock is treated on par with the dividend received from the equity
share for the tax purposes. These shareholders do not enjoy any of the voting powers except
when any resolution affects their rights.
Cumulative preference shares
Here, the cumulative total of all unpaid preferred dividends must be paid before
dividends are paid on the common equity. The unpaid dividends are known as arrears.
Generally three years of arrears accrue and the cumulative feature ceases after three years.
But the dividends in arrears continue if there is no such provision in the articles of
association.
Non-cumulative shares
As the name suggests, the dividend does not accumulate if there is no profit in the
company in a particular year, the company does not pay it. In the wind up of a company if the
preference and equity shares are fully paid, they have no further rights to have claims in the
surplus. If there is a provision in the articles of association for such claims, then they have the
rights to claim.
Convertible preference shares
The convertibility feature makes the preference shares a more attractive investment
security. The conversion feature is almost identical with that of the bonds. These preference
shares are convertible as equity shares at the end of the specified period and are quasi equity
shares.
Redeemable preference shares
If there is a provision in the Article of association, redeemable preference shares can be
issued. But redemption of the shares can be done only when
a) The partly paid up shares are made fully paid up.
b) The fund for redemption is created is created from the profits, which would otherwise
be available for distribution of dividends or out of the proceeds of a fresh issue of shares
for the purpose.
c) If any premium has to be paid on redemption, it should be paid out of the profits or out
of the company’s share premium account.
d) When redemption is made out of profits, a sum equal to the nominal value of the
nominal value of the redeemed shares should be transferred to the capital redemption
reserve account.
Irredeemable preference shares
 This type of shares is not redeemable is not redeemable except on occasions like
winding up the business. In India, this type of shares was permitted till 15 th June 1988. The
introduction of section 80A in the Companies Act 1956 put an end to it.
Cumulative convertible preference share
This CCPS was introduced by the government in 1984. This preference share gives a
regular return of 10% during the gestation period from three years to five years and then
converted into equity as per the agreement.

DEBENTURE
According to the Company’s act 1956 “Debenture includes Debenture stock, bonds
and any other securities of the company, whether constituting a charge on the assets of the
company or not”. Debentures are generally issued by the private sector. Companies have a
long term promissory note for raising loan capital. Public sector companies and financial
institutes issue bonds.
Characteristic feature of debenture
1. Form It is given in the form of certificate of indebtedness by the company specifying
the date of redemption and interest rate.
2. Interest the rate of interest is fixed at the time of issue itself which is known as
contractual or coupon rate of interest. Interest is paid as a percentage of the par value
of the debenture and may be paid annually, semi-annually or quarterly. The company
has the legal binding to pay the interest rate.
3. Redemption as stated earlier, the redemption date would be specified in the issue
itself. The maturity period may range from 5 years to 10 years in India. They may be
redeemed in instalments. Redemption is done through a creation of sinking fund by
the company.
Buy back provisions help the company to redeem the debentures at a special price
before the maturity date. Usually the special price is higher than the par value of the
debenture.
4. Indenture is a trust deed between the company issuing debenture and the debenture
trustee who represents the debenture holders. The trustee takes the responsibility of
protecting the interest of the debenture holders and ensures that the company fulfils
the contractual obligations. Financial institutes, banks, insurance companies are firm
attorneys act as trustees to the investors.
Types of debenture
 Debentures are classified on the basis of security and convertibility.
1. Secured or unsecured
It is secured by a company’s specific asset. In case of default the trustee can take hold of the
asset on behalf of the debenture holders.
2. Fully convertible debenture
This type of debenture is converted into equity shares of the company on expiry of specific
period according to the guidelines issued by the SEBI.
3. Partly convertible debenture
This debenture consists of two parts namely convertible and non-convertible. The convertible
portion can be converted into shares after a specific period. Ex: Proctor and Gamble had
issued PCD of Rs. 200 each to its existing shareholders. The investor can get a share for Rs.
65 with the face value of Rs.10 after 18 months from allotment.
4. Non-convertible debenture
Holders cannot convert the debentures into equity shares and are redeemed at the expiry of
the specific period.
BONDS
Bonds represent long term debt instruments. The issuer of the bond promises to pay a
stipulated stream of cash flow. A bond is a debt security issued by the government, quasi-
government, public sector enterprises and financial institutions.
Various features of a bond are:
 The interest rate is generally fixed
 It is traded in the securities market
 At the time of issue of bonds, maturity date is specified
Some of the types of bonds that a company can issue are:
Secured bonds and unsecured bonds
The secure bond is secured by the assets of the issuer. If it is not secured it is called
unsecured bond, but it should be issued by one who has highest credit rating.
Perpetual bonds and redeemable bonds
Bonds do not mature or never mature are called perpetual bonds. The interest rate alone
would be paid.
Fixed interest rate bonds and floating interest rate bonds
In the fixed interest rate bonds, the interest rate is fixed at the time of issue. Whereas in the
floating rate bonds, the interest changes according to the benchmark rate.
Zero coupon bonds
 These bonds sell at a discount and the face value is repaid at maturity. For example, a zero-
coupon bond that matures in 15 years with the face of Rs. 40000 would be sold at Rs.6500 to
give a return of 12% per annum.

Deep discount bonds

A bond that sells at a significant discount from par value. A bond that is selling at a discount
from par value and has a coupon rate significantly less than the prevailing rates of fixed-
income securities with a similar risk profile. These low-coupon bonds are typically long term
and issued with call provisions. Investors are attracted to these discounted bonds because of
their high return or minimal chance of being called before maturity.
Capital indexed bonds
The principal amount of the bond is adjusted for inflation for every year. The befit of the
bond is that it gives the investor an increase in return by taking inflation into account. The
investor enjoys the benefit of a return on his principal, which is equal to the average inflation
between issue (purchase) and maturity period of the instrument.
2 MONEY MARKET INSTRUMENTS
Debt instrument which have a maturity of less than 1 year at the time of issue are called
Money market instruments. It refers to a mechanism whereby on the one hand borrowers
manage to obtain short-term loanable funds and on the other, lenders succeed in getting
creditworthy borrowers for their money.
Types of money market
 The unorganized market
 The organized market
Unorganized sector
 Unregulated no-banking financial intermediaries: Finance companies, chit funds.
 Indigenous bankers
 Money lenders
Organized sector
It comprises the reserve bank of India, commercial banks, foreign banks, cooperative banks,
finance corporations, mutual funds and the finance house of India limited (DFHI)
The important money market instruments are;
i. Call Money Market
The call money market is an integral part of the Indian Money Market, where the day-to-day
surplus funds (mostly of banks) are traded. The loans are of short-term duration varying from
 1 to 14 days. The money that is lent for one day in this market is known as "Call Money", and
if it exceeds one day (but less than 15 days) it is referred to as "Notice Money".
ii. Certificate of Deposit
CDs are negotiable money market instruments and are issued in dematerialized form or a
promissory note, for funds deposited at a bank or other eligible financial institution for a
specified time period. They are like bank term deposits accounts. Unlike traditional time
deposits these are freely negotiable instruments and are often referred to as Negotiable
Certificate of Deposits.
iii. Commercial Paper
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a
promissory note. Only highly rated corporate borrowers, primary dealers (PDs) and all-India
financial institutions (FIs) can issue CP.
 Denomination: min. of 5 lakhs and multiple thereof.
 Maturity: min. of 7 days and a maximum of upto one year from the date of issue
iv. Treasury Bills
Treasury bills, commonly referred to as T-Bills are issued by Government of India against
their short term borrowing requirements with maturities ranging between 14 to 364 days.
All these are issued at a discount-to-face value. For example a Treasury bill of Rs. 100.00
face value issued for Rs. 91.50 gets redeemed at the end of its tenure at Rs. 100.00.
Who can invest in T-Bill?
Banks, Primary Dealers, State Governments, Provident Funds, Financial Institutions,
Insurance Companies, NBFCs, FIIs (as per prescribed norms), NRIs & OCBs can invest in T-
Bills.
v. Repos
It is a transaction in which two parties agree to sell and repurchase the same security. Under
such an agreement the seller sells specified securities with an agreement to repurchase the
same at a mutually decided future date and a price. The Repo/Reverse Repo transaction can
only be done at Mumbai between parties approved by RBI and in securities as approved by
RBI (Treasury Bills, Central/State Govt securities).
3 MUTUAL FUNDS
Instead of directly buying equity shares or other securities, investor can participate in various
schemes floated by mutual funds, which in turn invest in equity shares and fixed income
securities. These can be classified into;
i. Open ended scheme
An open-ended Mutual fund is one that is available for subscription and repurchase on a
continuous basis. These Funds do not have a fixed maturity period. Investors can
conveniently buy and sell units at Net Asset Value (NAV) related prices which are declared
on a daily basis. The key feature of open-end schemes is liquidity
ii. close ended scheme
A close-ended Mutual fund has a stipulated maturity period e.g. 5-7 years. The fund is open
for subscription only during a specified period at the time of launch of the scheme.
iii. Income scheme
The aim of income funds is to provide regular and steady income to investors. Such schemes
generally invest in fixed income securities such as bonds, corporate debentures, Government
securities and money market instruments. Such funds are less risky compared to equity
schemes.
iv. Growth scheme
Growth funds are those mutual funds that aim to achieve capital appreciation by investing in
growth stocks.
v. Balanced scheme
The aim of balanced funds is to provide both growth and regular income as such schemes
invest both in equities and fixed income securities in the proportion indicated in their offer
documents. These are appropriate for investors looking for moderate growth. They generally
invest 40-60% in equity and debt instruments. These funds are also affected because of
fluctuations in share prices in the stock markets.
vi. Tax saving scheme
These schemes offer tax rebates to the investors under specific provisions of the Indian
Income Tax laws as the Government offers tax incentives for investment in specified
avenues. Investments made in Equity Linked Savings Schemes (ELSS) and Pension Schemes
are allowed as deduction u/s 88 of the Income Tax Act, 1961.
vii. Money market scheme
A money market fund is a mutual fund that invests solely in money market instruments.
Money market instruments are forms of debt that mature in less than one year and are very
liquid.

4 LIFE INSURANCE
The basic customer needs met by life insurance policies are, protection and savings. Policies
that provide protection benefits are designed to protect the policy holder from the uncertain
events such as death, disability, etc. In practice, many policies provide a mixture of saving
and protection benefit. The common type of life insurance policies are;
Endowment plan
Combining risk cover with financial savings, endowment policies are among the popular life
insurance policies. Policy holders benefit in two ways from a pure endowment insurance
policy. In case of death during the tenure, the beneficiary gets the sum assured. If the
individual survives the policy tenure, he gets back the premiums paid with other investment
returns and benefits like bonuses.

Money back plan

This life insurance policy is favored by many people because it gives periodic payments
during the term of policy. In other words, a portion of the sum assured is paid out at regular
intervals. If the policy holder survives the term, he gets the balance sum assured. In case of
death during the policy term, the beneficiary gets the full sum assured.

Unit linked plan

ULIPs are market-linked life insurance products that provide a combination of life cover and
wealth creation options. A part of the amount that people invest in a ULIP goes toward
providing life cover, while the rest is invested in the equity & debt instruments for
maximizing returns. They provide the flexibility of choosing from a variety of fund options
depending on the customers risk appetite. One can opt from aggressive funds (invested
largely in the equity market with the objective of high capital appreciation) to conservative
funds (invested in debt markets, cash, bank deposits and other instruments, with the aim of
preserving capital while providing steady returns). ULIPs can be usefull for achieving various
long term financial goals such as planning for retirement, child’s education, marriage etc.
Term assurance
A term insurance policy is a pure risk cover policy that protects the person insured for a
specific period of time. In such type of a life insurance policy, a fixed sum of money called
the Sum Assured is paid to the beneficiaries (family) if the policyholder expires within the
policy term. For instance, if a person buys a Rs 2 lakh policy for 15 years, his family is
entitled to the sum of Rs 2 Lakh if he dies within that 15-year period.
Immediate Annuity
A plan that gives you the benefit of life time income. With this unique plan, one can start
getting their annuity immediately after paying the premium.
Deferred Annuity
A deferred annuity is a type of annuity contract that allows for periodic contributions to the
plan, but does not allow any withdrawals from the plan until either an appointed time is
reached or a specific event takes place. For example, a deferred annuity plan may be put is
place early in life and receive payments on a regular basis until the point of retirement. At
that point, contributions cease and the holder of the annuity account begins to receive regular
income payments that are funded from the balance in the plan.
Riders
Riders are the additional benefits that you may buy and add to your policy. They are options
that allow you to enhance your insurance cover, qualitatively and quantitatively. Riders can
be mixed and matched based on one’s preferences for a small additional cost. Ex: life
insurance policy with the mediclaim.
NON-MARKETABLE FINANCIAL ASSETS: a good portion of financial assets of
individual investors is held in the form of non-marketable financial assets, they represent
personal transactions between the investor and the issuer. These can be classified into;
5 BANK DEPOSITS
Savings account
Allows save money for the future, this popular account type also helps to gain an interest
Savings bank account allows its users to draw money in form of cheques or through
Automatic Teller Machines (ATM) in India. However, in countries like the United States,
cannot issue a cheque with savings account.

Current Bank Accounts

A current bank account is a non-interest bearing account which is used mainly for
transactions. This cheque-operated account is opened by businessmen, companies and firms
purely for business purposes. Deposits and withdrawals can be made infinitely, but a
comparatively higher minimum balance has to be maintained.

Fixed Deposit Accounts

Customers deposit in a fixed deposit account for a fixed period of time at a fixed rate of
interest. Money cannot be withdrawn from such accounts before the time period ends, though
some banks allow withdrawal by paying a penalty fee.
6 POST OFFICE DEPOSITS
Post office saving account
Post office saving account is similar to a savings account in a bank. The account can be
opened at any post office with a minimum balance of Rs. 20. Maximum of Rs. one lakh for
single account holder and Rs. two lakhs for joint account holders can be deposited. There is
no lock-in or maturity period. Rate of interest is decided by the Central Government from
time to time. Interest is calculated on monthly balances and credited annually. Income tax
relief is available on the amount of interest under the provisions of section 80L of Income
Tax Act.

Post office monthly income account

The maturity of an account is six years. Only one deposit can be made in an account.
Minimum deposit limit is Rs 1000. Maximum deposit limit is Rs. 3 lakhs in case of single
account and Rs. 6 lakhs in case of joint account. Interest @ 8% per annum is payable
monthly. In addition, bonus equal to 10% of the deposited amount is payable at the time of
repayment on maturity. Premature closure facility is available after one year subject to
condition. Income tax relief is available on the interest earned as per limits fixed vide section
80L of Income Tax, as amended from time to time.
Post office time deposit account
Post office time deposit account is just like the bank fixed deposit account. These time
deposits are meant for those investors who want to deposit a lump sum for a fixed period.
Time deposit account can be opened at any post office with a minimum deposit of Rs. 200.
There is no maximum limit for the account. The amount can be deposited for 1year, 2year,
3year, and 5years. The deposited amount is repayable after expiry of the period for which it is
made viz: 1 year, 2 years, 3 years or 5 years. Interest is calculated on quarterly compounding
basis, and is payable annually. Rate of interest varies according to the period of the deposit
and is decided by the central government from time to time. Income tax relief is available on
the amount of interest under the provisions of section 80l of income tax act.
National Savings Certificate
National Savings Certificate, popularly known as NSC, is a time-tested tax saving instrument
that combines adequate returns with high safety. National Savings Certificates are available
in the denominations of Rs. 100, Rs 500, Rs. 1000, Rs. 5000, & Rs. 10,000. There is no
maximum limit on the purchase of the certificates. Income tax relief is also available on the
interest earned as per limits fixed vide section 80L of Income Tax, as amended from time to
time.
Public Provident Fund
Public Provident Fund, popularly known as PPF, is a savings cum tax saving instrument. It
also serves as a retirement planning tool for many of those who do not have any structured
pension plan covering them. Public Provident Fund account can be opened at designated post
offices throughout the country and at designated branches of Public Sector Banks throughout
the country. Minimum deposit required in a PPF account is Rs. 500 in a financial year.
Maximum deposit limit is Rs. 70,000 in a financial year. Maximum number of deposits is
twelve in a financial year. The account matures for closure after 15 years. Income Tax rebate
is available "on the deposits made", under Section 88 of Income Tax Act, as amended from
time to time. Interest credited every year is tax-free.
Kisan Vikas Patra
Kisan Vikas Patra (KVP) is a saving instrument that provides interest income similar to
bonds. Amount invested in Kisan Vikas Patra doubles on maturity after 8 years & 7 months.
Kisan Vikas Patra is available in the denominations of Rs 100, Rs 500, Rs 1000, Rs 5000, Rs.
10,000 & Rs. 50,000. There is no maximum limit on purchase of KVPs. Premature
encashment of the certificate is not permissible except at a discount in the case of death of the
holder(s), can be pledeged. No income tax benefit is available under the Kisan Vikas Patra
scheme.
7 COMPANY DEPOSITS
Company fixed deposit (CFD) is a deposit with financial institutes and NBFCs for a fixed
rate of return over a fixed period of time. The rate of interest is determined by the tenure of
the deposit as well as other factors. The deposit made in a CFD is governed by section 58A of
the Companies Act. CFDs are a good option for investment as they provide higher rate of
interest compared to bank deposits. They are a good source of regular income by means of
monthly, quarterly, half-yearly, or yearly interest incomes. However, these deposits are not
secured like those in the bank. In case of default by a company, the investor cannot sell the
deposit documents to recover his amount. The investor has no claim over the assets of the
company in case the company is wound-up. This makes CFD a risky option.
8 NON-FINANCIAL INVESTMENT
Real estate
For the bulk of the investors the most important asset in their portfolio is a residential
house, in additional to the residential house, the more affluent investors are likely to be
interested in the following types;
1. Agriculture land
2. Semi urban land
3. Commercial property

Precious objects
These are items that are generally small in size but highly valuable in monetary terms.
Some important precious objects are Gold and Silver.
1. Gold and silver
2. Precious stones
3. Art objects
9 FINANCIAL DERIVATIVES
A financial derivative is an instrument whose value is derived from the value of an
underlying asset. It may be viewed as a side bet on the asset. The important financial
derivatives are;
1. Options
An option is a derivative financial instrument that specifies a contract between two parties
for a future transaction on an asset at a reference price (the strike).The buyer of the option
gains the right, but not the obligation, to engage in that transaction, while the seller incurs the
corresponding obligation to fulfill the transaction. The price of an option derives from the
difference between the reference price and the value of the underlying asset (commonly a
stock, a bond, a currency or a futures contract) plus a premium based on the time remaining
until the expiration of the option. Other types of options exist, and options can in principle be
created for any type of valuable asset.
2. Futures
A futures contract is a standardized contract between two parties to buy or sell a specified
asset of standardized quantity and quality for a price agreed today (the futures price or strike
price) with delivery and payment occurring at a specified future date, the delivery date. The
contracts are negotiated at a futures exchange, which acts as an intermediary between the two
parties. The party agreeing to buy the underlying asset in the future, the "buyer" of the
contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller"
of the contract, is said to be "short".
MUTUAL FUND: Functions of Investment companies
An investment company is a financial services firm that holds securities of other companies
purely for investment purposes. Investment companies come in different forms: exchange-
traded funds, mutual funds, money-market funds, and index funds. Investment companies
collect funds from institutional and retail investors, and are assigned with making
investments in financial instruments according to the objectives of the investors.
Collect Investments
Investment companies collect funds by issuing and selling shares to investors. There are
basically two types of investment companies: close-end and open-end companies. Close-end
companies issue a limited amount of shares that can then be traded in the secondary market--
on a stock exchange--whereas open-end company funds, e.g. mutual funds, issue new shares
every time an investor wants to buy its stocks.
Invest in Financial Instruments
Investment companies invest in financial instruments according to the strategy of which that
they made investors aware. There are a wide range of strategies and financial instruments that
investment companies use, offering investors different exposures to risks. Investment
companies invest in equities (stocks), fixed-income (bonds), currencies, commodities and
other assets.

INTRODUCTION TO MUTUAL FUND

A Mutual Fund is a trust that pools the savings of a number of investors who share a common
financial goal. The money thus collected is then invested in capital market instruments such
as shares, debentures and other securities. The income earned through these investments and
the capital appreciations realized are shared by its unit holders in proportion to the number of
units owned by them. Thus a Mutual Fund is the most suitable investment for the common
man as it offers an opportunity to invest in a diversified, professionally managed basket of
securities at a relatively low cost.
Every Mutual Fund is managed by a fund manager, who using his investment management
skills and necessary research works ensures much better return than what an investor can
manage on his own.
When an investor subscribes for the units of a mutual fund, he becomes part owner of the
assets of the fund in the same proportion as his contribution amount put up with the corpus
(the total amount of the fund). Mutual Fund investor is also known as a mutual fund
shareholder or a unit holder. Any change in the value of the investments made into capital
market instruments (such as shares, debentures etc) is reflected in the Net Asset Value
(NAV) of the scheme.
Pay Out the Profits
The profits and losses that an investment company makes are shared among its shareholders.
Depending on the type--close-end or open-end--and the structure of the investment company,
investors can redeem their shares for cash from the company, sell the shares to another firm
or individual, or receive capital distributions when assets held by the investment company are
sold.

ADVANTAGES OF INVESTING MUTUAL FUNDS

1. Professional Management - The basic advantage of funds is that, they are professional
managed, by well qualified professional. Investors purchase funds because they do not have
the time or the expertise to manage their own portfolio. A mutual fund is considered to be
relatively less expensive way to make and monitor their investments.
2. Diversification - Purchasing units in a mutual fund instead of buying individual stocks or
bonds, the investors risk is spread out and minimized up to certain extent. The idea behind
diversification is to invest in a large number of assets so that a loss in any particular
investment is minimized by gains in others.
3. Economies of Scale - Mutual fund buy and sell large amounts of securities at a time, thus
help to reducing transaction costs, and help to bring down the average cost of the unit for
their investors.
4. Liquidity - Just like an individual stock, mutual fund also allows investors to liquidate
their holdings as and when they want.
5. Simplicity - Investments in mutual fund is considered to be easy, compare to other
available instruments in the market, and the minimum investment is small. Most AMC also
have automatic purchase plans whereby as little as Rs. 2000, where SIP start with just Rs.50
per month basis.

DISADVANTAGES OF INVESTING MUTUAL FUNDS:

1. Professional Management- Some funds don’t perform in neither the market, as their
management is not dynamic enough to explore the available opportunity in the market, thus
many investors debate over whether or not the so-called professionals are any better than
mutual fund or investor himself, for picking up stocks.
2. Costs – The biggest source of AMC income is generally from the entry & exit load which
they charge from investors, at the time of purchase. The mutual fund industries are thus
charging extra cost under layers of jargon.
3. Dilution - Because funds have small holdings across different companies, high returns
from a few investments often don't make much difference on the overall return. Dilution is
also the result of a successful fund getting too big. When money pours into funds that have
had strong success, the manager often has trouble finding a good investment for all the new
money.
4. Taxes - when making decisions about your money, fund managers don't consider your
personal tax situation. For example, when a fund manager sells a security, a capital-gain tax
is triggered, which affects how profitable the individual is from the sale. It might have been
more advantageous for the individual to defer the capital gains liability.
TYPE OF MUTUAL FUND SCHEMES
Open Ended Schemes
An open-end fund is one that is available for subscription all through the year. These do not
have a fixed maturity. Investors can conveniently buy and sell units at Net Asset Value
("NAV") related prices. The key feature of open-end schemes is liquidity.
Close Ended Schemes
A closed-end fund has a stipulated maturity period which generally ranging from 3 to 15
years. The fund is open for subscription only during a specified period. Investors can invest
in the scheme at the time of the initial public issue and thereafter they can buy or sell the
units of the scheme on the stock exchanges where they are listed. In order to provide an exit
route to the investors, some close-ended funds give an option of selling back the units to the
Mutual Fund through periodic repurchase at NAV related prices. SEBI Regulations stipulate
that at least one of the two exit routes is provided to the investor.

Interval Schemes
Interval Schemes are that scheme, which combines the features of open-ended and close-
ended schemes. The units may be traded on the stock exchange or may be open for sale or
redemption during pre-determined intervals at NAV related prices.
Based on their investment objective:
Equity funds: These funds invest in equities and equity related instruments. With fluctuating
share prices, such funds show volatile performance, even losses. However, short term
fluctuations in the market, generally smoothens out in the long term, thereby offering higher
returns at relatively lower volatility. At the same time, such funds can yield great capital
appreciation as, historically, equities have outperformed all asset classes in the long term.
Hence, investment in equity funds should be considered for a period of at least 3-5 years. It
can be further classified as:
Index funds- In this case a key stock market index, like BSE Sensex or Nifty is tracked.
Their portfolio mirrors the benchmark index both in terms of composition and individual
stock weightages.
Equity diversified funds- 100% of the capital is invested in equities spreading across
different sectors and stocks.
Dividend yield funds- it is similar to the equity diversified funds except that they invest in
companies offering high dividend yields.
Thematic funds- Invest 100% of the assets in sectors which are related through some theme.
e.g. -An infrastructure fund invests in power, construction, cements sectors etc.
Sector funds- Invest 100% of the capital in a specific sector. e.g. - A banking sector fund
will invest in banking stocks.
ELSS- Equity Linked Saving Scheme provides tax benefit to the investors.
Balanced fund: Their investment portfolio includes both debt and equity. As a result, on the
risk-return ladder, they fall between equity and debt funds. Balanced funds are the ideal
mutual funds vehicle for investors who prefer spreading their risk across various instruments.
Following are balanced funds classes:
Debt-oriented funds -Investment below 65% in equities.
Equity-oriented funds -Invest at least 65% in equities, remaining in debt.
Debt fund: They invest only in debt instruments, and are a good option for investors averse
to idea of taking risk associated with equities. Therefore, they invest exclusively in fixed-
income instruments like bonds, debentures, Government of India securities; and money
market instruments such as certificates of deposit (CD), commercial paper (CP) and call
money. Put your money into any of these debt funds depending on your investment horizon
and needs.
Liquid funds- These funds invest 100% in money market instruments, a large portion being
invested in call money market.
Gilt funds - They invest 100% of their portfolio in government securities of and T-bills.
Floating rate funds - Invest in short-term debt papers. Floaters invest in debt instruments
which have variable coupon rate.
MIPs- Monthly Income Plans have an exposure of 70%-90% to debt and an exposure of
10%-30% to equities.
Capital Protection Oriented Schemes
Capital Protection Oriented Schemes are schemes that endeavor to protect the capital as the
primary objective by investing in high quality fixed income securities and generate capital
appreciation by investing in equity / equity related instruments as a secondary objective. The
first Capital Protection Oriented Fund in India, Franklin Templeton Capital Protection
Oriented Fund opened for subscription on October 31, 2006.
Gold Exchange Traded Funds
It offers investors an innovative, cost-efficient and secure way to access the gold market.
Gold ETFs are intended to offer investors a means of participating in the gold bullion market
by buying and selling units on the Stock Exchanges, without taking physical delivery of gold.
The first Gold ETF in India, Benchmark GETF, opened for subscription on February 15,
2007 and listed on the NSE on April 17, 2007.
Fund of Funds (FOFs)
Fund of Funds are schemes that invest in other mutual fund schemes. The portfolio of these
schemes comprises only of units of other mutual fund schemes and cash / money market
securities/ short term deposits pending deployment. The first FOF was launched by Franklin
Templeton Mutual Fund on October 17, 2003. Fund of Funds can be Sector specific e.g. Real
Estate FOFs, Theme specific e.g. Equity FOFs, Objective specific e.g. Life Stages FOFs or
Style specific e.g.Aggressive/ Cautious FOFs etc. Please bear in mind that any one scheme
may not meet all your requirements for all time. You need to place your money judiciously in
different schemes to be able to get the combination of growth, income and stability that is
right for you. Remember, as always, higher the return you seek higher the risk you should be
prepared to take.
INVESTMENT STRATEGIES
1. Systematic Investment Plan: under this a fixed sum is invested each month on a fixed
date of a month. Payment is made through postdated cheques or direct debit facilities. The
investor gets fewer units when the NAV is high and more units when the NAV is low. This is
called as the benefit of Rupee Cost Averaging (RCA)
2. Systematic Transfer Plan: under this an investor invest in debt oriented fund and give
instructions to transfer a fixed sum, at a fixed interval, to an equity scheme of the same
mutual fund.
3. Systematic Withdrawal Plan: if someone wishes to withdraw from a mutual fund then he
can withdraw a fixed amount each month.
MUTUAL FUND EVALUATION
Key Financial Numbers
As a participant in a mutual fund scheme, you should understand the following
 Asset mix
 Net asset value
 Market price, -repurchase price, and reissue price
 Discount
 Rate of return
 Standard deviation
2
 Ex-Mark (or R )
 Beta
 Gross yield
 Portfolio turnover ratio
 Expense ratio
 Alpha
Asset Mix: The asset-mix of a scheme refers to the allocation of the corpus of a scheme
across three broad asset categories, viz., stocks, bonds, and cash. An asset mix of 60:30:10
means that 60 percent of the corpus is invested in stocks, 30 percent in bonds, and 10 percent
in cash.
Net Asset Value: The net asset value (NAV) is the actual value of a share/unit on any
business day. It is computed as follows:
NAV= Market value of the fund's investments + Receivables + Accrued income -Liabilities -
Accrued expenses/ Number of shares or units outstanding.
Entry and Exit Loads: Entry load is the load imposed when the investor purchases the units
and exit load is the load imposed when the investor redeems the units.
Market Price, Repurchase Price, and Reissue Price: A closed-ended scheme has to be
necessarily listed on a recognized stock exchange to ensure that its participants enjoy
liquidity. Generally, the market price of a closed-ended scheme tends to be lower than its
NAV. If the market price is lower than the NAV, the scheme is said to be selling at a
discount; if it is higher, the scheme is said to be selling at a premium. In addition to listing,
the mutual fund may also offer the facility of repurchase. The repurchase price is usually
linked to the NAV.
Unlike a closed-ended scheme, an open-ended scheme is not ordinarily listed on the stock
exchange. Hence, the mutual fund has to stand ready to repurchase and issue its units or
shares on a continuing basis. The repurchase and reissue prices are, of course, closely linked
to the NAV.
Discount: Closed-ended schemes typically sell at a discount} which may sometimes be very
steep, over their NAV. Why? According to Benjamin Graham, the reason lies in the structure,
not the performance, of such schemes. They are perhaps not well-suited for any important
group of investors. The small and naive investors are allured towards the open-ended
schemes as they are sold more aggressively; the large and sophisticated investors may find
mutual funds, in general, not very appealing; the speculators also have little interest in the
ordinary closed-ended scheme as it lacks the excitement of a specific scrip.
Rate of Return: The periodic (the period may be one month, one quarter, one year, or any
other) rate of return on a mutual fund scheme.
Standard Deviation: The standard deviation of returns, a measure of dispersion, is the
square root of the mean of the square of deviations around the arithmetic average. Generally,
standard deviation, Ex-Mark, and beta are computed taking monthly returns into account for
a period of three to five years.
Ex-Mark: This is a term coined by John C. Bogle to define the extent to which a return of a
mutual fund is explained by a particular financial Market. This concept is designated in
statistics as R-squared. The Ex-Mark of a typical mainstream equity fund is 80-90 percent.
Beta: Beta of a fund measures its past price volatility relative to a particular stock market
index. It is a measure of risk that provides useful statistical information particularly when
applied to portfolios (as distinct from individual stocks). Most mainstream equity funds have
betas in the range of 0.85 to 1.05.
Alpha: Alpha measures the extra return earned on a scheme on a risk-adjusted basis.
Gross Dividend Yield: The gross dividend yield is an important indicator of the investment
characteristics of a mutual fund. Among equity funds, value-oriented funds tend to have a
higher gross dividend yield and growth-oriented funds tend to have a lower gross dividend
yield. The gross dividend yield is a reliable differentiator of a fund's investment philosophy.
Portfolio Turnover Ratio: Portfolio turnover represents the churn in the portfolio. It is
measured as follows:
Portfolio turnover ratio = Lower of purchase or sales during a given period Average daily net
assets
Expense Ratio: Expense ratio refers to the annual recurring costs as a percentage of the net
assets of the scheme. These are discussed fully in the next section.
SECURITIES MARKET
It is the market for equity, debt and derivatives.
Stock exchanges
 Stock market” is a term used to describe the physical location where the buying and
selling of stocks take place.
 The correct term to be used in pertaining to the physical location for trading stocks is
“stock exchange.”
 The Stock market in India consists of about approximately twenty two stock
exchanges.
 The stock exchanges constitute a market where securities issued by the Central &
State Govt., Public bodies & Joint Stock companies are traded.
PARTICIPANTS IN THE SECURITY MARKET
Regulators
The key agencies that have a significant regulatory influence, direct or indirect, over the
securities market are currently: The company law board, the reserve bank of India,
Securities exchange board of India, The department of economic affairs, the department
of company affairs.
Stock exchanges
It is an institution where securities that have already issued are bought and sold.
Listed securities
Securities that are listed on various stock exchanges and eligible for being traded there are
called listed securities. Presently about 10,000 securities are listed on all the stock
exchange.
Depositories
It is an Institution which dematerializes physical certificates and effects transfer of
ownership by electronic book entries. They are NSDL and CSDL.
Brokers
These are registered members of the stock exchanges through whom investors transact.
FII’s
Institutional investors from abroad who are registered with SEBI to operate in the Indian
capital market are called FII’s.There are about 600 of them.
 Merchant bankers
Firms that specialize in managing the issue of securities. They have to register with SEBI.
Mutual funds
It is a vehicle for collective investment. It pools and manages the funds of investors.
Custodians
It looks after the investment back office of a mutual fund. It receives and delivers
securities, collects income, distributes dividends and segregates the assets between the
schemes.
Underwriters
An underwriter agrees to subscribe to a given number of shares in the event the public
subscription is inadequate.
Bankers to an issue
Collects money on behalf of the company from the applicants.
Credit rating agencies
Assigns ratings primarily to debt securities.
Debenture trustees
Ensures that the borrowing firm fulfills its contractual obligations.
Venture capital funds
It is a pool of capital which is essentially invested in equity shares or equity linked
instruments
PRIMARY MARKET
It is a market where companies issue the share freshly.
Features of primary market
 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.
 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.
Objectives of new issues
 To promote a new company
 To expand an existing company
 To diversify the production
 To meet the regular working capital requirements
 To capitalize the reserves
ISSUE MANAGEMENT
Management of issue involves marketing of corporate securities, that is, equity shares,
preference shares, debentures or bonds by offering them to public. Merchant banks act as
intermediaries whose job is to transfer capital from those who own it to those who need it.
The issue function may be broadly classified into pre-issue management and post issue
management. In both the stages, legal requirements have to be complied with and several
activities connected with the issue have to be co-ordinated.
The pre issue management is divided into:
(i) Issue through prospectus, offer for sale and private placement.
(ii) Marketing and underwriting.
(iii) Pricing of issues.
a. Public Issue through Prospectus
(a) The most common method of public issue is through prospectus.
(b) Offers for sale are offers through the intermediary of issue house or firm of stock
broker. The company sells the entire issue of shares or debentures to the issue house
at an agreed price which is generally below the par value.
(c) The direct sale of securities by a company to investors is called private placement.
The investors include LIC, UTI, GIC, SFC, etc.
To bring out a public issue, Merchant bankers have to coordinate the activities relating to
issue with different government and public bodies, professionals and private agencies. They
have to ensure that the information required by the Companies ACT and SEBI are furnished
in the prospectus and get it vetted by a reputed solicitor.
The copies of consent of experts, legal advisors, attorney, and solicitor, bankers to the issue,
brokers and underwriters are to be obtained from the company making the issue to be filed
along with prospectus to the Registrar of Companies.
Brokers to the Issue canvass subscription by mailing the literature to the clients and
undertaking wide publicity. Members’ of stock exchange are appointed as brokers to issue.
Bankers to issue accept application along with subscriptions tendered at their designated
branches and forward them to the Registrar.
b. Marketing
After dispatch of prospectus to SEBI, the Merchant bankers arrange a meeting with company
representatives and advertising agents to finalize arrangements relating to date of opening and
closing of issue, registration of prospectus, launching publicity campaign and fixing date of
board meeting to approve and sign prospectus and pas the necessary resolutions.
Publicity campaign covers the preparation of all publicity material and brochures, prospectus,
announcement, advertisement in the press, radio, T.V., investor conference, etc. the merchant
bankers help choosing the media, determining the size and publication in which the
advertisement should appear.
The merchant banker’s role is limited to deciding the number of copies to be printed,
checking accuracy of statements made and ensures that the size of the application form and
prospectus confirmed to the standard prescribed by the stock exchange. The merchant banker
has to ensure that the material is delivered to the stock exchange atleast 21 days before the
issue opens and to brokers to the issue, branches of brokers to the issue and underwriters on
time.
Security issues are underwritten to ensure that incase of undersubscription the issues are
taken up by the underwriters. SEBI has made underwriting mandatory for issues to the public.
The underwriting arrangement should be filed with the stock exchange. Particulars of
underwriting arrangement should be mentioned in the prospectus.
The various activities connected with pre-issue management are a time bound programme
which has to be promptly attended to. The execution of the activities with clock work
efficiency would lead to a successful issue.

c. Pricing of Issues
The SEBI guidelines 1992 for capital issues have opened the capital market to free pricing of
issues. Pricing of issues is done by companies themselves in consultation with the merchant
bankers. Pricing of the issue is part of pre-issue management.
An existing listed company and a new company set by an existing company with a five year
track record and existing private closely held company and existing unlisted company going
in for public issues for the first time with a two and a half years track record of constant
profitability can freely price the issue. The premium has to be decided after taking into
account net asset value, profit earning capacity and market price. Justification of price has to
be stated and included in the prospectus.
POST ISSUE MANAGEMENT
The post issue management consists of collection of application forms and statement of
amount received from bankers screening applications, deciding allotment procedure, mailing
of allotment letters, share certificates and refund orders.
Registrars to the issue play a major role in post issue management. They receive the
applications, verify them and submit the basis of allotment to the stock exchange. After the
basis of allotment is approved by the stock exchange and allotted by the Board, the
auditor/company secretary has to certify that the allotment has been made by the company as
per the basis of allotment approved by the exchange. Registrars have to ensure that the
applications are processed and the allotment/refund orders are sent within 70 days of the
closure of the issue. The time limit of 70 days has proved difficult to adhere and applicants
have to wait for anytime between 90 to 180 days. Merchant bankers assist the company by
co-ordinating the above activities.
Underwriting of Public Issue
Underwriting is a guarantee given by the underwriter that in the event of under subscription
the amount underwritten would be subscribed by him. It is insurance to the company which
proposes to make public offer against risk of under subscription. The issues backed by well-
known underwriters generally receive a higher premium from the public. This enables the
issuing company to sell the securities quickly.
All public issues have to be fully underwritten. Only category I, II, and III merchant bankers
are permitted to underwrite an issue subject to the limit that the outstanding commitments of
any such individual merchant banker at any point of time do not exceed five times of his net
worth (paid-up and free reserves excluding revaluation reserves). This criteria is applicable to
brokers also. Lead managers have to underwrite mandatorily 5% of the issue or 2.5 lakhs
whichever is less. Banks/ Merchant banker subsidiaries cannot underwrite more than 15% of
any issue.
By ensuring a direct in the underwriting, the merchant bankers make raising money from
external resources easy.
MODES OF RAISING FUNDS
 Public issue
 Rights issue
 Preferential allotment
Public Issue
It involves sale of securities to the public at large. Public issues in India are governed by the
provisions of the companies act, 1956, SEBI guidelines on investors protection, and the
listing agreement between the issuing company and the stock exchanges.
The issue of securities to members of the public involves the following steps:
 Approval of the board of directors
 Approval of shareholders
 Appointment of the lead manager
 Due diligence by the lead manager
 Appointment of other intermediaries like co-managers, advisors, underwriters,
bankers, brokers and registrars.
 Preparation of the draft prospectus
 Filling of the draft prospectus
 Application for listing in stock exchanges
 Filing of the prospectus
 Promotion of the issue
 Printing and distribution of applications
 Statutory announcement
 Collection of applications
 Processing of applications
 Determination of the liability of underwriters
 Finalization of allotment
 Giving of demat credit and refund orders
 Listing of the issue.
An investor should be familiar with the following aspects of public issues:
  A company informs the public
 If the issue is oversubscribed the pattern of allotment should be decided
 The balance amount to be called by one or two calls
 If the investor fails to pay the shares are liable to be forfeited
 The shares are entitled for dividend from the date of allotment
 Public issue prices may be determined at predetermined price or on the basis of bids
Book building: The pricing mechanism in public issue
Book Building is essentially a process used by companies raising capital through Public
Offerings-either Initial Public Offers (IPOs) or Follow-on Public Offers (FPOs) to aid price
and demand discovery. It is a mechanism where, during the period for which the book for the
offer is open, the bids are collected from investors at various prices, which are within the
price band specified by the issuer. The process is directed towards both the institutional as
well as the retail investors. The issue price is determined after the bid closure based on the
demand generated in the process.
The Process:
 The Issuer who is planning an offer nominates lead merchant banker(s) as 'book
runners'.
 The Issuer specifies the number of securities to be issued and the price band for the
bids.
 The Issuer also appoints syndicate members with whom orders are to be placed by the
investors.
 The syndicate members input the orders into an 'electronic book'. This process is
called 'bidding' and is similar to open auction.
 The book normally remains open for a period of 5 days.
 Bids have to be entered within the specified price band.
 Bids can be revised by the bidders before the book closes.
 On the close of the book building period, the book runners evaluate the bids on the
basis of the demand at various price levels.
 The book runners and the Issuer decide the final price at which the securities shall be
issued.
 Generally, the numbers of shares are fixed; the issue size gets frozen based on the
final price per share.
 Allocation of securities is made to the successful bidders. The rest get refund orders.
Rights issue
A rights issue involves selling securities in the primary market by issuing rights to the
existing shareholders. When a company issues additional equity capital, it has to be offered in
the first instance to the existing shareholders on a pro rata basis. This is required under sec 81
of the companies’ act 1956. The procedure for rights issue as follows
 A company sends a ‘letter of offer 'A B C D
 A is for acceptance of the rights and application for additional shares
 B is for the shareholders wants to renounce the rights in favor of someone else
 C is meant for rights have been renounced by the original allottee
 D is to be used to make a request for split forms
Preferential allotment
An issue of equity by a listed company to selected investors at a price which may or may not
be related to the prevailing market price. An issue can be made only when the shareholders
pass a special resolution (75% of voting rights).It is given mainly to promoters or friendly
investors. Very popular means of raising fresh equity capital. The cost and uncertainty
associated with the public issue is high. Sophisticated investors like mutual funds and private
equity investors likely to pay a higher price. The price at which a preferential allotment of
shares is made should not be lower than the higher of the average of the weekly high and low
of the closing prices of the shares quoted on the stock exchange during the six months period
before the relevant date or during the two weeks period before the relevant date.
Parties involved in the new issue
 Managers to the issue
 Registrar to the issue
 Underwriters
 Bankers to the issue
 Advertising agents
 The financial institutions

SECONDARY MARKET
Secondary market refers to a market where securities are traded after being initially offered to
the public in the primary market and or listed on the stock exchange. Majority of the trading
is done in the secondary market. This consists of equity market and debt market. It is nothing
but stock exchanges. We have two major stock exchanges in India. They are
 National stock exchange (NSE)
  Bombay stock exchange (BSE)
National stock exchange (NSE)
It established in the year 1994. It is a ringless, national, computerised exchange. It has two
segments: the whole sale debt market & capital market segment. The capital market segment
covers equities, convertible debentures, and retail trade in non- convertible debentures. The
wholesale debt market segment is a market for high value transactions in government
securities, commercial papers and other debt instruments. NSE is the first exchange in the
world to employ the satellite technology. A satellite link up is called VSAT (Very small
aperture terminal). All trades on NSE are guaranteed by the National securities clearing
corporation.
The S&P CNX Nifty (Nifty 50 or simply Nifty) is a composite of the top 50 stocks listed on
the National Stock Exchange (NSE), representing 24 different sectors of the economy. Nifty
was developed by the economists Ajay Shah and Susan Thomas, then at IGIDR. Later on, it
came to be owned and managed by India Index Services and Products Ltd. (IISL), which is a
joint venture between NSE and CRISIL. IISL is India’s first specialized company focused
upon the index as a core product. IISL have a consulting and licensing agreement with
Standard & Poor’s (who are world leaders in index services. CNX stands for CRISIL NSE
Indices. CNX ensures common branding of indices, to reflect the identities of both the
promoters, i.e. NSE and CRISIL. Thus, ‘C’ stands for CRISIL, ‘N’ stands for NSE and X
stands for Exchange or Index. The S&P prefix belongs to the US-based Standard & Poor’s
Financial Information Services. It is calculated as a weighted average, so changes in the share
price of larger companies have more effect. The base is defined as 1000 at the price level of
November 3, 1994.
BOMBAY STOCK EXCHANGE (BSE)
Established as "The Native Share & Stock Brokers' Association" in 1875. Oldest stock
exchange in Asia. Today, BSE is the world's number 1 exchange in terms of the number of
listed companies & worlds 5th in transaction numbers. BSE has two of world's best
exchanges, Deutsche Börse and Singapore Exchange, as its strategic partners. The BSE
Index, SENSEX, is India's first stock market index that enjoys an iconic stature, and is
tracked worldwide. BSE Sensex is a value-weighted index composed of 30 stocks. It consists
of the 30 largest and most actively traded stocks, representative of various sectors. SENSEX
is calculated using the "Free-float Market Capitalization" methodology. The base period of
SENSEX is 1978-79 and the base value is 100 index points. SENSEX is calculated every 15
seconds. The BSE switched from the open outcry system to the screen based system in 1995
which is called BOLT (BSE on line trading).
TRADING AND SETTLEMENT
Each stock exchange has certain listed securities and permitted securities which are traded on
it. Investors interested in buying and selling securities should place their orders with the
members (also called brokers) of the exchange. There are two ways of organizing the trading
activity: open outcry system and the screen based system
Open outcry system
Traders shout and resort to signals on the trading floor of the exchange which consists of
several ‘notional’ trading posts for different securities. A member wishing to buy or sell a
certain security reaches the trading post where the security is traded. Here, he comes in
contact with others interested in transacting in that security. Buyers make their bids and
sellers make their offers and bargains are closed at mutually agreed-upon prices.
Screen based system
The trading ring is replaced by the computer screen and distant participants can trade with
each other through the computer network. A large number of participants, geographically
separated, can trade simultaneously at high speeds.
Buyers and sellers place their orders on the computer. These orders may be limit orders or
market orders. A limit order pre specifies the price limit. For example, a limit order to buy at
a price of Rs.90 means that the trader wants to buy at a price not greater than Rs.90.
Likewise, a limit order to sell at a price of Rs.95 means that the trader wants to sell at a price
not less than Rs.95. A market order is an order to buy or sell at the best prevailing price. A
market order to sell will be executed at the highest bid price whereas a market order to buy
will be executed as the lowest ask price. The computer constantly tries to match mutually
compatible orders. The matching is done on a price-time priority; implying that price is given
preference over time in the process of matching.

SETTLEMENT
To mitigate the costs and risks associated with physical delivery, security transactions in
developed markets are settled mainly through electronic delivery facilitated by depositories.
A depository is an institution which dematerializes physical certificates and effects transfer of
ownership by electronic book entries. The national securities depository limited, India’s first
depository, was set up in 1996. It was followed by the central securities depositories limited.
 Every depository required to register with SEBI.
  Investors required to register with the agents of the depositories.
 Shares in the depository mode will be fungible.
 Ownership changes in the depository system will be made automatically on the basis
of delivery against payment
 Any loss caused by the depository to the investors due to negligence will be
indemnified by the depository
Shifting to rolling settlement
The weekly settlement system along with the badla system of carrying forward transactions
from one account period to the next, according to many informed observers of the Indian
stock market, led to unbridled speculative activity and periodic market crises. So SEBI
decided to introduce rolling settlement in a phased manner from 2002. Under compulsory
rolling system now in vogue, every day represents a new settlement period. The trading cycle
which was earlier one week has been reduced to one day. This means that you have to square
an open position the same day; otherwise, you have to take or give delivery, depending on
your position. Presently, the settlement of all trades is on a T+2 basis and the settlement cycle
is as follows.
 T Trade
 T+1 custodial confirmation final obligation
 T+2 Pay in/Pay-out of funds& shares
 T+3 Auction for shortages
 T+4 -
 T+5 Pay-in/Pay-out of funds & securities for auction

TRANSACTION COSTS
Transaction costs may be divided into three broad categories: Trading costs, clearing costs,
and settlement costs.
Trading costs
It consists of brokerage cost, market impact cost, and securities transaction tax. A brokerage
cost is the brokerage paid to the broker. Due to high competition in stock broking, brokerage
costs have fallen significantly. Market impact cost is the difference between the actual
transaction price and the ideal price, the latter being defined as the price at which the trade
will occur if the market for the stock were perfectly liquid or infinitely deep. Suppose a stock
trades at bid 99 and ask 101. We say the "ideal" price is Rs. 100. Now, suppose a buy order
for 1000 shares goes through at Rs.102. Then we say the market impact cost is 2%.
Securities Transaction Tax (STT) is a tax being levied on all transactions done on the stock
exchanges. Securities Transaction Tax is applicable on purchase or sale of equity shares,
derivatives, equity oriented funds and equity oriented Mutual Funds. Currently for delivery
based trades in equity the levy is 0.25% and the same is to be split equally between the buyer
and the seller.
Clearing costs
When a negotiated trade takes place, the counterparty may default or when a trade takes place
on an exchange, the exchange may default in its payout. Clearing costs are costs experienced
in resolving such defaults.
Settlement costs
Costs associated with transfer of funds and securities. With the advent of dematerialization,
elimination of stamp duty on dematerialized trades, and improvement of banking technology,
settlement costs have come down substantially. As of mid-1993, the total transaction cost in
Indian market was 5%; presently it is around 0.5%.
BUYING AND SELLING OF SHARES
Buying shares involves the following steps:
Locating a broker
Shares are bought through a stock broker, who is a licensed member of a stock exchange. So
when we want to buy shares, we should locate a broker. The broker we select can render
prompt and efficient service and protect your interest. We have to submit a client registration
form as well as a member – constituent form.
Placement of order
After locating a suitable broker, place your order to buy. Your order should clearly specify
the name of the company and the type of securities (equity shares, preference shares, or
debentures). All the transactions through a stock exchange are now settled through the
depositories. So we must have a demat account with an authorized depository before we
place an order. We can place a limit order or market order. A limit order specifies the
quantity to be traded, the highest price (limit price) that the buyer willing to accept and the
length of time the order is valid. Whether it is a day order, month order or week order. When
we submit a limit order, we run the risk of delayed execution as well as the risk that the order
will not be executed. When you submit a market order, the order will get executed
immediately at price what prevailing in the market.
Execution of order
On receiving our order, the broker will feed the same on his terminal. Once the order is
executed, the broker will inform us and send a contract note specifies the details of
transaction. After we make the payment for the purchases the broker will transfer the shares
electronically to our depository account.
Procedure for selling
Once we locate a broker, the steps involved in selling shares are as follows:
Placement of order
We have to place a sale order with our broker. We may place a limit order wherein we
specify the minimum price acceptable to us or we may place a market order, which means
that we instruct our broker to sell at the best available market price.
Execution order
On receiving sale order the broker will feed the same in his terminal. Once the order is
executed the broker will inform and the contract note. The seller has to issue a depository
participant cheque for the share that he has sold in favor of the broker. This cheque transfers
the shares from the depository account to the brokers depository account. The seller will
receive payment from the broker in a few days.
BUYING ON MARGIN
We can buy shares on margin. This means that we provide a portion of the purchase value as
margin and the rest is given by the broker as a loan to us. For example if we have a margin
account with ICICI securities we can get a loan up to 75% of the purchase value. So the
margin account has a balance of Rs.25, 000 and he can buy shares up to Rs.1, 00000.This is
called as initial percentage margin.
There may be a chance that the margin account balance turns negative. To guard against such
thing, the broker prescribes a maintenance margin, if the maintenance margin falls below the
maintenance margin, the broker will issue a margin call asking to deposit a difference amount
in the margin account.
Short sale
It is a sale of shares that one does not have. A short seller expects the price of the shares to
fall in future so that he can square his position at a profit. If the price rise, inflicting a loss on
the short seller. A short sale is arranged by the broker who borrows shares from another
customer or broker so that the short seller can affect delivery. The short seller has to buy back
the shares in future to replace the borrowed shares and repay any dividend that may have
been paid on the shares.
INDEX CALCULATION
Price weighted index: it is an index reflecting the sum of the prices of the sample stocks on a
certain date in relation to a base date. The price weighted index assumes that the investor
buys one share of each stock included in the index.
Equal weighted index: it is an index reflecting the simple arithmetic average of the price
relatives of the sample stocks on a certain date in relation to a base date. It assumes that the
investor invests an equal amount of money in each stock included in the index.
Value weighted index: It is an index reflecting the aggregate market capitalization of the
sample stocks on a certain date in relation to a base date. It assumes that the investor allocates
money across various stocks included in the index in such a way that the weights assigned to
various stocks are proportional to their market capitalization.

STOCK MARKET INDICES AROUND THE WORLD

 The Dow Jones industrial average (DJIA) is based on 30 large, “blue chip”
corporations in the US. It is a price weighted Index.
 The Standard and Poor’s composite 500 (S&P 500) stock index is a broad based index
of 500 US stocks. It is a market value weighted index.
 The Nikkei 225 is based on the largest 225 stocks of Tokyo stock exchange. It is a
price weighted index.
 FTSE published by the financial times of London is based on 100 large stock
exchange stocks. It is a value weighted index.
STOCK MARKET ABROAD
The two largest stock exchanges in the US, as well as the world, are the New york stock
exchange and the NASDAQ.
New York stock exchange
World’s biggest stock exchange in terms of market capitalization. Only large, financially
strong companies get listed.
NASDAQ
It is a short form for national association of securities dealers automated quotation system. It
is the biggest stock exchange of the world in terms of turnover. Technology heavy weights
like Cisco, Intel, and Microsoft have their listing only on NASDAQ.
Stock market in the UK
Amalgamation of all the stock exchanges in UK had led to the emergence of single exchange
is called “big bang”. Equities are traded on this market using the stock exchange quotation
system (SEAQ), a quote-driven system or the stock exchange automatic execution facility
(SEAF), an order-driven system.
Stock market in Japan
The Tokyo stock exchange (TSE) is the dominant exchange in Japan, accounting for about
1200 most actively traded stocks; Second section consists of about less actively traded stocks.
Emerging stock markets
The first group represents markets in Africa (Kenya, Zimbabwe), Eastern Europe (Hungary,
Poland). These markets are in the early stages of development. The second group markets in
countries like Brazil, India, Philippines and China. These markets are fairly developed with a
large number of listed companies. The third group represents more mature markets like Hong
Kong, Korea, and Singapore.
REFORMS IN THE INDIAN CAPITAL MARKET
Freedom in designing and pricing Instruments
Companies now enjoy freedom in designing the instruments of financing as long as they fully
disclose the character of the same.

Ban on badla
To rectify the defects in trading practices, the badla system has been banned
Screen based trading
The competition posed by the NSE and the insistence done by SEBI, all the stock exchanges
have switched to screen based trading.
Electronic transfer
The shares and the money is transferred electronically by the depositories
Risk management
A comprehensive risk management system that covers capital adequacy, limits on exposure
and turnover, margins based on VAR(Value at risk), client level gross margining, and online
monitoring has been introduced.
Rolling settlement
The trading cycle has been reduced from one week to one day and the system of rolling
settlement has been introduced.
Registration and regulation of intermediaries
Intermediaries such as merchant bankers, underwriters, bankers, registrars are required to be
registered with SEBI.
Redressal of investor Grievances
The steps taken by the SEBI the redressal ratio (the ratio of complaints resolved to
complaints received) has improved.
Regulation of mutual funds
Mutual funds have been brought under the purview of SEBI and SEBI has issued the
regulatory guidelines for this purposes.
Regulation of foreign portfolio investment
SEBI has formulated guidelines to permit the investment through broad based funds (such as
mutual funds, pension funds, and country funds) referred to as foreign institutional investors.
Introduction of equity derivatives
SEBI has allowed the introduction of equity derivatives like stock index futures, stock index
options etc.

Integrated market surveillance system.

SEBI has launched an IMSS from December 2006. IMSS integrates data from stock
exchanges, depositories and clearing corporation’s and comes up with alerts, based on certain
pre specified parameters. Such integration of data has been done for the first time in any
market in the world.SEBI can detect capital market offences like market domination and
control, artificial rigging, and creation of false market.
IMPORTANT POINTS TO REMEMBER
Companies Close its transfer books only once in a year at the time of annual general meeting
and to have record dates for the purpose of bonus issues, rights issues etc. Have uniform dates
of book closing and record dates either on 1st or 6th of any month and to give to the
exchange notice in advance of at least 42 days. Issue letters of allotment or letters of rights
within six weeks of the record date.
On the stock market, the shares become ex-dividend (or ex-bonus or ex-rights) several days
before the book closure date. This is indicated by the abbreviation ‘xd’ affixed after the price
of the share. If we buy the ‘xd’ we are not entitled to dividend for which books are about to
be closed.
Block deals
It is a deal involving a minimum quantity of five lakh shares or a minimum value of Rs.
5crore.There is a separate window for block deals on BSE and NSE. These deals can take
place only between 9.55 am and 10.25 am. It involves simultaneous large scale buy and sell
transactions at a predetermined price.
Demutualization
Till early 1990s almost all stock exchanges were mutual ventures, owned cooperatively by
members who enjoyed trading privileges. From 1993, a number of smaller exchanges
resorted to demutualization. They transformed themselves into profit making companies, and
issued shares to outsiders.
Red herring prospectus
The firm files a preliminary registration statement (preliminary prospectus) with SEC. It is
also called as red herring as it includes statement printed in red stating that the company is
not attempting to sell the security before SEC approves its registration statement.

RISK AND RETURN

Risk and Return: Two Sides of the Investment Coin

Investment decisions, involve a tradeoff between risk and return and central to investment
decisions.
RETURN
Return is the primary motivating force that derives investment. It represents the reward for
undertaking investment.
Components of returns are current return and capital return
Current return is the periodic income, such as divided or interest, generated by the
investment. It is measured as the periodic income in relation to the beginning price of the
investment.
Capital return is reflected in the price change it is simply the price appreciation (or
depreciation) divided by the beginning price of the asset.
Total return = Current return + Capital return
RISK
Risk refers to the possibility that the actual outcome of an investment will deviate from its
expected outcome.
 Possibility of loss or injury
 Variability of return
 The degree or probability of loss
Components of risk
• Systematic risk: Caused by factors external to the company and uncontrollable by the
company. Interest rates, recession and wars all represent sources of systematic risk
because they affect the entire market and cannot be avoided through diversification.
Whereas this type of risk affects a broad range of securities, unsystematic risk affects
a very specific group of securities or an individual security. Systematic risk can be
mitigated only by being hedged.
• Unsystematic risk: Factors are specific, unique and related to the particular industry
or company. Company or industry specific risk that is inherent in each
investment. The amount of unsystematic risk can be reduced through appropriate
diversification.
Also known as "specific risk", "diversifiable risk" or "residual risk".
Systematic risk
 Market risk: The portion of total variability of return caused by the alternative forces of
bull and bear markets. When the index moves upward halting for a significant period of
time is known as bull market. In bull market index moves from a low level to the peak. In
bear market index declines from the peak to a market low point called trough. During the
bull and bear market more than 80% of the price rise or fall with the stock market indices.
The forces that affect the stock market are tangible and intangible events. The tangible
events are real events such as earth quake, war and fall in the value of currency.
Intangible events are related to market psychology.
 Interest rate risk: Interest rate risk is the risk that an investment's value will change as a
result of a change in interest rates. This risk affects the value of bonds more directly than
stocks. As interest rates rise, bond prices fall and vice versa. The rationale is that as
interest rates increase, the opportunity cost of holding a bond decreases since investors
are able to realize greater yields by switching to other investments that reflect the higher
interest rate. For example, a 5% bond is worth more if interest rates decrease since the
bondholder receives a fixed rate of return relative to the market, which is offering a lower
rate of return as a result of the decrease in rates.
 Purchasing power risk: The risk that unexpected changes in consumer prices will
penalize an investor's real return from holding an investment. Because investments from
gold to bonds and stock are priced to include expected inflation rates, it is the unexpected
changes that produce this risk. Fixed income securities, such as bonds and preferred
stock, subject investors to the greatest amount of purchasing power risk since their
payments are set at the time of issue and remain unchanged regardless of the inflation rate
 Default risk: The event in which companies or individuals will be unable to make the
required payments on their debt obligations. Lenders and investors are exposed to default
risk in virtually all forms of credit extensions. To mitigate the impact of default risk,
lenders often charge rates of return that correspond the debtor's level of default risk. The
higher the risk, the higher the required return, and vice versa.
Unsystematic risk
Business risk: it is the portion of the risk 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 business risk is concerned with the difference between
revenue and earnings before interest and tax. It can be divided into external and internal
business risk.
Internal business risk
It is associated with the operational efficiency of the firm. The efficiency is depends on the
company’s achievement of its goals and the fulllfilment of the promises to its investors.
1. Fluctuations in sales: The sales level has to be maintained. Loss of customers will
lead to a loss of operating income. Diversified sales force may help to tide over this
problem. Big corporate bodies have long chain of distribution channel. Smaller firms
often lack this diversified customer base.
2. Research and development: Sometimes the product goes out style or become
outdated. The company has to overcome this problem by concentrating on in-house
research and development. New product has to be introduced to replace the old one.
3. Personnel management: it also contributes to the operational efficiency of the firm.
Frequent strikes and lock outs result in loss of production and high fixed capital cost.
The labor productivity also will come down. Encouragement given to the laborers at
the floor level would boost morale of the labor force and lead to high productivity and
proper utilization of resources.
4. Fixed cost: During the period of recession or low demand for product, the company
cannot reduce the fixed cost. The higher the fixed cost in a firm would become a
 burden to the firm. Thus the fixed cost has to be kept always reasonable so that it may
not affect the profitability of the company.
5. Single product: The internal business risk is higher in the case of firm producing a
single product. The fall in the demand for a single product would be critical for the
firm. Hence the company has to diversify the products if it has to face the competition
and the business cycle successfully.
6. Management risk: The risks associated with ineffective, destructive or
underperforming management, which hurts shareholders and the company or
fund being managed. This term refers to the risk of the situation in which the
company and shareholders would have been better off without the choices made by
management.
7. Default risk: The event in which companies or individuals will be unable to make the
required payments on their debt obligations. Lenders and investors are exposed to
default risk in virtually all forms of credit extensions. To mitigate the impact of
default risk, lenders often charge rates of return that correspond the debtor's level of
default risk. The higher the risk, the higher the required return, and vice versa.
External business risk
It is the result of operating conditions imposed on the firm beyond its control
1. Social and regulatory factors: harsh regulatory and legal restriction against the
business may degradation the profitability of the firm. Price control, volume control,
import/export control and environment control reduce the profitability of the firm. For
example the pollution control board has asked to close most of the tanneries in Tamil
Nadu, which has affected the leather industry.
2. Political risk: It arises out of the change in the government policy. With a change in
the ruling party, the policy also changes. Political risk arises mainly in the case of
foreign investment.
3. Business cycle: The fluctuations of the business cycle lead to fluctuations in the
earnings of the company. Recession in the economy leads to a drop in the output of
many industries. During the boom period, the earnings of the industries go up.
Financial risk: Financial risk is the additional risk a shareholder bears when a company uses
debt in addition to equity financing. Companies that issue more debt instruments would have
higher financial risk than companies financed mostly or entirely by equity. Capital structure
of the company consists of equity and debt funds. The presence of debt results in a
commitment of paying interest. 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.
Debt financing enable the corporate to have funds at a low cost and financial leverage to the
shareholders. As long as the earnings of a company are higher than the cost of borrowed
funds, shareholders earnings are increased. At the same time when the earnings are low, it
may lead to bankruptcy.
MINIMIZING RISK EXPOSURE
Market risk exposure
 Study the Price behavior of the stock
 Gauge the risk factor to make wise decision
 Hold the stock for a long period of time
Protection against interest rate risk
 Hold investment to maturity
 Reinvestment of interest
 Maturity Diversification can yield the best results
Protection against inflation
 Increase the bond yield
 Investment in short term securities
 Diversify the investment
Protection against business risk and financial risk
 Analyze strength and weakness of the industry
 Profitability trend of the company
 Analyze the Capital structure of the company
 MODULE 2: INVESTMENT ANALYSIS

FUNDAMENTAL ANALYSIS
The intrinsic value of an equity share depends on a multitude of factors. The earnings of the
company, the growth rate & the risk exposure of the company have a direct on the price of
the share. These factors in turn rely on the host of other factors like economic environment in
which they function, the industry they belong to & 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 level of economic activity has an impact on investment in many ways. If the
economy grows rapidly, the industry can also be expected to show rapid growth & vice versa.
When the level of economic activity is low, stock prices are low & when the economic
activity is high, stock prices are high reflecting the prosperous outlook for sales & profits of
the firms.
Global economy
In a globalized business environment, the top – down analysis of the prospects of a firm must
begin with the global economy. The global economy has a bearing on the export prospects of
the firm, the competition it faces from international competitors, and the profitability of its
overseas investment.
Global economic scene

2000 – 2010 – Rise of Developing and Emerging Economies

2000 – 2006 – United States still leads, but China is catching up

At exchange rates, the economic output of 176 markets expanded by $17.4 trillion from 2000
to 2006. The five largest contributors to global output expansion are the United States at
20%, China at 9%, Germany at 6%, the United Kingdom at 6%, and France at 5%. The
economic output of 4 markets contracted by $94.2 billion from 2000 to 2006. The three
largest contributors to global output contraction are Japan at 80%, Argentina at 19%, and
Uruguay at 1%.
At purchasing power parity, the economic output of 180 markets expanded by $19.2 trillion
from 2000 to 2006. The five largest contributors to global output expansion are the United
States at 18%, China at 17%, India at 6%, Japan at 5%, and Russia at 4%.
2007 – China leads expansion
The economic output by nominal GDP of 183 markets expanded by $6.4 trillion during 2007.
China accounted for 12% while the United States accounted for 10%, Germany accounted for
6%, and the United Kingdom accounted for 6% of the global output expansion.
2008 – Credit crisis begins
The economic output of 171 markets expanded by $5.8 trillion during 2008. China accounted
for one-sixth of the global output expansion. The economic output of 11 markets contracted
by $267 billion during 2008. The United Kingdom accounted for one-half while South Korea
accounted for two-fifth of the global output contraction. Though the crisis first affected most
countries in 2008, it was not yet deep enough to reverse growth.
2009 – Credit crisis spreads
At exchange rates, the economic output of 127 markets contracted by $4.1 trillion during
2009. The United Kingdom was the largest victim accounting for 12% while Russia
accounted for 11% and Germany accounted for 8% of the global output contraction. The
economic output of 56 markets expanded by $767.1 billion during 2009. China accounted for
61% while Japan accounted for 20% and Indonesia accounted for 4% of the global output
expansion.
At purchasing power parity, the economic output of 79 markets contracted by $1.4 trillion
during 2009. The United States was the largest victim accounting for 18% while Japan
accounted for 17% and Russia accounted for 10% of the global output contraction. The
economic output of 104 markets expanded by $1.5 trillion during 2009. China accounted for
56% while India accounted for 17% and Indonesia accounted for 3% of the global output
expansion.
2010 – Recovery
At exchange rates, the economic output of 148 markets expanded by $5.3 trillion during
2010. The five largest contributors to global output expansion are China at 17%, the United
States at 10%, Brazil at 9%, Japan at 8%, and India at 5%. The economic output of 35
markets contracted by $338.5 billion during 2010. The five largest contributors to global
output contraction are France at 22%, Italy at 18%, Spain at 17%, Venezuela at 10%, and
Germany at 7%.
At purchasing power parity, the economic output of 169 markets expanded by $4.2 trillion
during 2010. The five largest contributors to global output expansion are China at 25%, the
United States at 13%, India at 10%, Japan at 5%, and Brazil at 4%. The economic output of
14 markets contracted by $17.8 billion during 2010. The five largest contributors to global
output contraction are Greece at 67%, Venezuela at 19%, Romania at 5%, Haiti at 3%, and
Croatia at 2%.
IMF's economic outlook for 2010 noted that banks faced a "wall" of maturing debt, which
presents important risks for the normalization of credit conditions. There has been little
progress in lengthening the maturity of their funding and, as a result, over $4 trillion in debt
is due to be refinanced in the next 2 years.
While there have been some encouraging signs of economic recovery, especially in the
United States, the global economic growth seems to be losing momentum. According to the
IMF's World Economic Outlook report published in April 2012, "global growth is projected
to drop from about 4 percent in 2011 to about 3½ percent in 2012 because of weak activity
during the second half of 2011 and the first half of 2012.”
The commonly analyzed macro-economic factors are:-
 Gross domestic product
 Savings & investment
 Inflation
 Interest rates
 Budget
 Tax structure
 Balance of payment
 Monsoon & agriculture
 Infrastructure facilities
 Demographic factors
 Economic forecasting
 Economic indicators
 Diffusion index
 Econometric model building
Gross domestic product (GDP)
GDP indicates the rate of growth of the economy. GDP represents the aggregate value
of the goods & services produced in the economy. GDP consist of personal consumption
expenditure, gross private domestic investment & government expenditure on goods &
services & net export of goods & services. The GDP estimates are available on an annual
basis. The rate of growth of GDP is 6.5% in 2009.
Savings & investment
It is obvious that growth requires investment which in turn requires substantial
amount of domestic savings. Stock market is a channel through which the savings of the
investors are made available to corporate bodies. Savings are distributed over various assets
like equity shares, deposits, mutual fund units, real estate & bullion. The savings &
investment patterns of the public affect the stock to a great extent.
Inflation
Along with the growth of GDP, if the inflation rate also increases, then the real rate of
growth would be very little. The demand in the consumer product industry is significantly
affected. The industries which come under the government price control policy may lose the
market, for example sugar. The government control over this industry, affects the price of
sugar & thereby the profitability of the industry itself.
Interest rates
The interest rates affect the cost of financing the firms. A decrease in the interest rate
implies lower cost of finance for firms & more profitability. More money is available at a
lower interest rate for the brokers who are doing business with borrowed money. Availability
of cheap fund encourages speculation & rise in the price of shares.
Budget
The budget draft provides an elaborate account of the government revenues &
expenditures. A deficit budget may lead to high rate of inflation & adversely affect the cost of
production. Surplus budget may result in deflation. Hence, balanced budget is highly
favorable to the stock market.
The tax structures
Every year in March, the business community eagerly awaits the government's
announcement regarding the tax policy. Concessions & incentives given to a certain industry
encourage investment in that particular industry. Tax relieves are given to encourage savings.
The type of tax exemption has impact on the profitability of the industries.
The balance of payment
The balance of payment is a record of a country’s money receipts from & payments
abroad. The difference between receipts & payments may be surplus or deficit. Balance of
payment is a measure of the strength of rupee on external accounts. If the deficit increases,
the rupee may depreciate against other currencies, thereby, affecting the cost of imports. A
favorable balance of payment renders a positive effect on the stock market.
Monsoon & agriculture
Agriculture is directly & indirectly linked with industries. For example, sugar, cotton,
textile and food processing industries depend upon agriculture for raw material. Fertilizer &
insecticide industries are supplying inputs to the agriculture. A good monsoon leads to a
higher demand for input and results in the bumper crop.
Infrastructure facilities
Infrastructure facilities are essentials for growth of the industrial and agriculture
sector. A wide network of communication system is a must for the growth of the economy.
Regular supply of power without any power cut would boost the production. Banking and
financial sectors also should be sound enough to provide adequate support to the industry and
agriculture. Good infrastructure facilities affect the stock favorably. In India even though
infrastructure facilities have been developed, still they are not adequate. The government has
liberalized its policy regarding the communication, transport and the power sector.

Demographic factors
The demographic factors provide details about the popularity by age, occupation,
literacy and geographic location. This is needed to forecast the demand for the consumer
goods. The population by age indicates the availability of able work force.

THE BUSINESS CYCLE

Recession
The recession stage is described as the bottom stage of the cycle. It is characterized as the
stage ahead of recovery. In this stage, the Fed will expand the money supply in order to
stimulate growth. Attractive investment opportunities in this stage include investments such
as commodities and stocks.
Recovery
The recovery stage is characterized as the stage after recovery. The economy is starting to
"recover" after the recession; the Federal Government's moves to stimulate the economy
begin to have an effect. In this stage, attractive investment opportunities include investments
such as cyclical investments and commodities.
Expansion
The early expansion stage is a continuation of the recovery stage, where the recovery begins
to gain momentum. In this stage, attractive investment opportunities include investments in
the overall stock market and real estate.
The late expansion stage continues on after the early expansion stage. In this stage the
expansion momentum continues and investor confidence is strong. Attractive investment
opportunities in the late expansion stage include investments in bonds and interest sensitive
investments.
Slowing into Recession
This stage occurs after the expansion phase and is the stage where the economy begins to
show signs of slowing down and even turning negative. In this stage, attractive investment
opportunities include investments in bonds and interest sensitive investments.

INDUSTRY ANALYSIS
 An industry is a group of firms that have similar technological structure of production
& produce similar products. For the convenience of the investors, the broad classification of
the industry is given in financial dailies & magazines. Companies are distinctly classified to
give a clear picture about their manufacturing process & products. These industries can be
classified on the basis of the business cycle. They are:
 Growth industry
 Cyclical industry
 Defensive industry
 Cyclical growth industry
a) Growth industry: the growth industries have special features of high rate of earnings and
growth in expansion, independent of the business cycle. The expansion of the industry
mainly depends on the technological changes. For instance, in spite of the recession in the
Indian economy in 1997-98, there was a spurt in growth of information technology
industry. It defied the business cycle and continued to grow.
b) Cyclical industry: the growth and the profitability of the industry move along with the
business cycle. During the boom period they enjoy growth and during depression they
suffer a setback. For example, the white goods like fridge, washing machine and kitchen
range products command a good market in the boom period and the demand for them
slackens during the recession.
c) Defensive industry: defensive industry defines the movement of the business cycle. For
example shelter is the basic requirements of humanity. The food industry withstands
recession and depression. The stocks of the 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 umbrella of protection and are counter-cyclical in
nature.
d) Cyclical growth industry: this is a new type of industry that is cyclical and at the same
time growing. For example, the automobile industry experiences periods of stagnation,
decline but they grow tremendously. The changes in technology and introduction of new
models help the automobile industry to remain their growth path.
Industry life cycle
The industry life cycle theory is separated into 4stages such as:
 Pioneering stage
 Rapid growth stage
 Maturity & stabilization stage
 Declining stage
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 survive this
stage. The producers try to develop brand name, differentiate the product and create a product
image. 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.
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 &
financial performance. The technology of the production would have improved resulting in
low cost of production & good quality products. The companies have stable growth rate in
this stage & they declare dividend to the shareholders. It is advisable to invest in the shares of
these companies. In this stage the growth rate is more than the industry’s average growth rate.
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 & 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 & the earnings of the companies in the
industry decline. Innovation of new products & changes in consumer preferences lead to this
stage. The specific feature of the declining stage is that even in the boom period; the growth
of the industry would be low & 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.
Factors to be considered
Apart from industry life cycle analysis, the investor has to consider some other factors also.
They are
i. Growth of the industry
ii. Cost structure and profitability
iii. Nature of the product
iv. Nature of the competition
v. Government policy
vi. Labor
vii. R&D
Company Analysis
In the company analysis the investor assimilates the several bits of information related
to the company & evaluates the present & future values of the stock. The risk & return
associated with the purchase of the stock is analyzed to take better investment decisions. The
valuation process depends upon the investor’s ability to elicit information from the
relationship & inter-relationship among the company related variables. The present & future
values are affected by a number of factors & they are given below-

Factors Share value

Competitive edge Historic price of stock
Earnings P/E ratio
Capital structure Economic condition
Management Stock market condition
Financial performance
Operating efficiency
Future Price

Future price Present price

 Competitive edge of the company: major industries in India are composed of hundreds of
individual companies. In the information technology industry even though the number of
companies is large, few companies like Tata InfoTech, Infosys, NIIT etc., control the
 major market share. Once the companies obtain the leadership position in the market,
they seldom to lose it. Over the time they would have proved their ability to withstand
competition and to have a sizeable share in the market. The competitiveness of the
company can be studied with the help of
 The market share
 The growth of annual sales
 The stability of annual sales
 Earnings of the company: sales alone do not increase the earnings but the costs and
expenses of the company also influence the earnings of the company. Even though there
is a relationship between sales and earnings, it is not a perfect one. Sometimes, the
volume of sales mat decline but the earnings may improve due to the rise in the unit price
of the article. Hence, the investor should not depend only on the sales, but should analyze
the earnings of the company.
 Capital structure: the equity holder’s return can be increased manifold with the help of
financial leverage, i.e., using debt financing along with equity financing. The effect of
financial leverage is measured by computing leverage ratios.
 Management: good and capable management generates profit to the investors. The
management of the firm should efficiently plan, organize, actuate and control the
activities of the company. The basic objective of management is to attain the stated
objectives of company for the good of the equity holders, the public and the employees.
 Operating efficiency: the operating efficiency of a company directly affects the earnings
of a company. An expanding company that maintains high operating efficiency with a
low break-even point earns more than the company with high break-even point. Efficient
use of fixed assets with raw materials, labor and management would lead to more income
from sales. This leads to internal fund generation for the expansion of the firm. A
growing company should have low operating ratio to meet the growing demand for its
product.
 Financial performance: the best source to analyze the company’s financial performance
is its own financial statements. Financial statement analysis is the study of a company’s
financial statement from various viewpoints. The statement gives the historical and
current information about the company’s operations; historical financial statement helps
to predict the future. The current information aids to analyze the present status of the
company. The two main statements used in the analysis are:
  Balance sheet
It shows all the company’s sources of funds (liabilities and stockholder’s equity) and
uses of funds at a given point of time. The balance sheet can be either in the
horizontal form or vertical form
 Profit and loss account.
The income statement reports the flow of funds from business operations that take
place in between two points of time. It lists down the items of income and
expenditure.
ANALYSIS OF FINANCIAL STATEMENTS
Comparative financial statements: The annual data are compared with similar data of
previous years, either in absolute terms or in percentages.
Trend analysis: Here percentages are calculated with a base year. This would provide insight
into the growth or decline of the sale or profit over the years.
Common size statement: Common size statements can be made between two different size
firms belonging to the same industry.
Fund flow analysis: It is a statement of the sources and application of funds. It highlights the
changes in the financial condition of a business enterprise between two balance sheet dates.
Cash flow statement: The investor interested in knowing the cash inflow and outflow of the
enterprise. It is prepared with the help of balance sheet, income statement and some
additional information.
Ratio analysis
Ratio is a relationship between two figures expressed mathematically. Financial ratios are
calculated from the balance sheet and profit and loss account.
 Liquidity ratio
 Turnover ratio
 Leverage ratio
 Profit margin ratio
 Return on investment ratio
 Valuation ratio

TECHNICAL ANALYSIS
It is a process of identifying trend reversals at an earlier stage to formulate the buying
and selling strategy. With the help of several indicators they analyze the relationship between
price-volume and supply-demand for the overall market and the individual stock. Volume is
favorable on the upswing i.e., the number of shares traded is greater than before and on the
downside the number of shares traded dwindles. If it is the other way round, trend reversals
can be expected.
The assumptions of technical analysis are as follows:-
a) The market value of the script is determined by the interaction of supply and demand.
b) The market discounts everything. The price of the security quoted represents the hopes,
fears and inside information received by the market players. Insider information regarding
the issuing of bonus shares and right issues may support the prices. These factors may
cause a shift in demand and supply, changing the direction of trends.
c) The market always moves in trend. Except for minor deviations, the stock prices move in
trends. The price may create definite patterns too. The trend may be either increasing or
decreasing. The trend continues for some time & then it reverses.
d) In the rising market investors psychology has up beats and they purchase the shares in
greater volumes, driving the prices higher. At the same time, in the down trend they may
be very eager to get out of the market by selling them & thus plunging the share price
further. The market technicians assume that past prices predict the future.
Contrary-Opinion Rules
 Many analysts rely on rules developed from the premise that the majority of investors
are wrong as the market approaches peaks and troughs
 Technicians try to determine whether investors are strongly bullish or bearish and
then trade in the opposite direction
 These positions have various indicators
DOW THEORY
Dow developed his theory to explain the movement of the indices of Dow Jones
Averages. He developed he theory on the basis of certain hypothesis. The first hypothesis is
that, no individual buyer can influence the major trend of the market. However; an
individual investor can affect the daily price movement by buying or selling huge quantum of
particular scrip. The intermediate price movement also can be affected to a lesser degree by
an investor.
His second hypothesis is that the market discounted in the market. The pokhran blast
affected the share market for a short while and the market returned back to normalcy
His third hypothesis is that theory is not infallible. It is not a tool to beat the market
but provides a way to understand it better.
 According to Dow Theory the trend is divided into primary, Intermediate and short
term trend. The primary trend may be the broad upward or downward movement that may
last for a year or two. The intermediate trends are corrective movements, which may last for
three weeks to three weeks to three months. The primary trend may be interrupted by the
intermediate trend. The short term refers to the day to day price movement. It is also known
as oscillations or fluctuations. These three types of trends are compared to tide, waves and
ripples of the sea.
Trend is the direction of movement. The share price can either increase or fall or
remain flat. The three direction of the share price movements are called as rising, falling and
flat trend. The point to be remembered is that share prices do not fall or rise in a straight line
every rise or fall in price experiences a counter move.
If a share price is increasing, the counter moves. If a share price is increasing, the counter
move will be a fall in price and vice-versa. The share price move in zigzag manner.
The trend lines are straight line drawn connecting either the tops or bottoms of the
share price movement to draw a trend line, the technical analyst should have at least or
bottoms. The following figures shows the trend lines

Dow Theory Trends

The rise or fall in share price cannot go on forever. The share price cannot go on forever. The
share price movement may reverse its direction. Before the change of direction, certain patter
in price movement emerges. The change in the direction of the trend is shown by violation of
the trend line from above; it is a violation of trend line and signals the possibility of fall in
price. Like-wise if the scrip pierces the trend line from below, this signals the rise in price.
Support and resistance level
A support level exists at a price where considerable demand for that stock is expected to
prevent further fall in the price level.
 In the resistance level, the supply of scrip would be greater than the demand and
further rise in price is prevented.
For ex: if a scrip price hovers around Rs 150 for some weeks, then it may rise and reach Rs
210. At this point the price halts and then falls back. The scrip keeps on falling back to
around its original price Rs 150 and halts. Then it moves upward. In this case Rs 150
becomes the support level. At this point, the scrip is cheap and investors buy it and demand
makes the price move upward. Whereas Rs 210 become the resistance level, the price is high
and there would be selling pressures resulting in the decline of the price.
The support level and resistance level differ in the following way:

Support level Resistance level

 When the stock touches a certain level  If the stock reaches down to a certain
and then drops, this is called resistance. level and then rises there exists a
 The fall in the price may be halted for the support.
time being or it may result even in price  The selling price is greater and the
reversal. In the support level, demand for increase in price is halted for the time
the particular scrip is expected. being.
 If the scrip price reverses the support  If the scrip penetrates the previous top
level and moves downward, it means that and moves above, it is the violation of
the selling pressure has overcome the resistance level. At this point, buying
potential buying pressure, signalling the pressure would be more than the selling
possibility of a further fall in the value of pressure. If the scrip was to move above
the scrip. It indicates the violation of the the double top or triple top formation, it
support level and bearish market. indicates bullish market.

The support and resistance level need not be formed only on tops or bottoms. They can be on
the trend lines or gaps of the chart. Gaps are defined as those points or price levels where the
scrip has not changed hands. In the rising or falling price level gaps are formed. If the prices
are in the upward move and the high of any day is lower than the next day’s low, the gap is
said to have occurred.
INDICATORS
Volume of trade
Volume expands with the bull market and narrows down in the bear market. Large rise in
price or large fall in price leads to large increase in volume.
The breath of the market
It is a method often used to study the advances and declines that have occurred in the stock
market. Advances mean the number of shares whose prices have increased from the previous
day’s trading. Declines indicate the number of shares whose prices have fallen from the
previous day trading.
Short sales
Short sale refers to the selling of shares that are not owned. The bears are the short sellers
who sell now in the hope of purchasing at a lower price in the future to make profits.
Odd lot trading
Shares, sold in smaller lots, fewer than 100 are called odd lot. Such buyers and sellers are
called odd lotters. Odd lot purchases to odd lot sales are the odd lot to index. The increase in
the odd lot purchases results in an increase in the index. Relatively more selling leads to fall
in the index.
Moving average
The market indices do not rise or fall in straight line. The word moving means that the body
of data moves ahead to include the recent observation. It is the five day moving average, on
the sixth day the body of data moves to include the sixth day observation eliminating the first
day’s observation. In moving average closing price of the stock is used.
Oscillators
Oscillators indicate the market momentum or scrip momentum. It shows the share price
movement across a reference point from one extreme to another. The momentum indicates:
- Over bought and oversold conditions of the scrip or the market.
- Signalling the possible trend reversal
- Rise or decline in the momentum.
Relative Strength Index (RSI)
Relative Strength Index (RSI) was developed by wells wilder. It is an oscillator used to
identify the inherent technical strength and weakness of a particular scrip or market. RSI can
be calculated for scrip by adopting the following formula.
RS = 100 – [100/ 1 + Rs]
Rs = average gain per day / average loss per day
The RSI can be calculated foe any number of days depending on the wish of the
technical analyst and the time frame of trading adopted in a particular stock market. RSI is
calculated for 5, 7, 9 and 14 days. If the time period taken for calculation is more, the
possibility of getting wrong signals is reduced. Reactionary or sustained rise or fall in the
price of the scrip is foretold by the RSI.
The broad rule is, if the RSI crosses seventy three mat be downturn and it is time to
sell. If the RSI falls thirty it is time to pick up the scrip.
Rate of change
ROC measures the rate of change between current price and the price ‘n’ number of
days in the past. ROC helps to find out the overbought and oversold positions in scrip. It is
also useful in identifying the trend reversal. Closing prices are used to calculate the ROC.
Calculation of ROC for 12 week or 12 month is so popular. Suppose the price of AB
company’s share is Rs.12 and price twelve days ago was Rs.10 then the ROC is obtained by
using: 12/10*100 = 120%. In the second method, the % variation between the current price
and the price twelve days in the past is calculated. It is nothing but 12/10*100-100=20%.
CHARTING PATTERNS
Charts are the valuable and easier tools in the technical analysis. The graphic
presentation of the data helps in the investors to find out trend of the price without any
difficulty. The charts also have the following uses-
-Sports the current trend for the buying and selling.
- Indicates the probable future action of the market by projection.
- Shows the past historic movements.
- Indicates the important areas of the support and resistance.

Point & Figure charts

Technical analyst to predict the extent & direction of the price movement of a
particular stock or the stock market indices uses point & figure charts. This PF charts are of
one-dimensional & there is no indication of time or volume. The price changes in relation to
previous prices are shown. The change of direction can be interpreted. The charts are drawn
in the ruled paper.

X
X
X XO
X XO
XO O
XO O
X

Bar charts
The bar chart is the simplest & most commonly used tool of a technical analyst. To
build a bar a dot is entered to represent the highest price at which the stock is traded on that
day, week or month. Then another dot is entered to indicate the lowest price on that particular
date. A line is drawn to connect both the points a horizontal nub is drawn to mark the closing
price. Line charts are used to indicate the price movements. The line chart is a simplification
of the bar chart. Here a line is drawn to connect the successive closing prices.

Double top & bottom

This type of formation signals the end of one trend & the beginning of another. If the
double top is formed when a stock price rises to a certain level, falls rapidly, again rises to the
same height or more & turns down. The double top may indicate the onset of the bear market.
 In a double bottom, the price of the stock falls to a certain level & increase with
diminishing activity. Then it falls again to the same or to a lower price & turns up to a higher
level. Technical analysts view double bottom as a sign for bull market.
Double Top

Target
Target

Double Bottom

Head & shoulders

This pattern is easy to identify & the signal generated by this pattern is considered to
be reliable. In the head & shoulder pattern there are three rallies resembling the left shoulder,
a head 7 a right shoulder. A neckline is drawn connecting the lows of the tops. When the
stock price cuts the neckline from above, it signals the bear market.
H&S Top
Head

Left Shoulder Right Shoulder

Neckline

H&S Bottom
Neckline

Left Shoulder Right Shoulder

Head
Symmetrical triangle
This pattern is made up of series of fluctuations, each fluctuation smaller than the
previous one. Tops do not attain the height of the previous tops. Likewise booms are higher
than the previous bottoms. Connecting the lower tops that are slanting downward forms a
symmetrical triangle. Connecting the rising bottom, which is slanting upward, becomes the
lower trend line. It is not easy to predict the breakaway either way. The symmetrical triangle
does not have any bias towards the bull and bear operators. It indicates the slow down or
temporary halt in the direction of the original trend. A probability of the original trend to
continue after the completion of the triangle is always there .
Triangles
The triangle formation is easy to identify & popular in technical analysis. The
triangles are of ascending and descending triangle.
a) Ascending triangle
b) Descending triangle
c) symmetrical
Ascending

Symmetrical

Symmetrical

Flags Descending

Flag pattern is commonly seen on the price charts. These patterns emerge either
before a fall or rise in the value of the scrip’s. These patterns show the market corrections of
the overbought or oversold situations.
Pennant
Pennant looks like a symmetrical triangle. Here also there are bullish & bearish
pennants. In the bullish pennant, the lower tops form the upper trend line. The lower trend
line connects the rising bottoms. The bullish trend occurs when the value of scrip moves
above the upward trend line. Likewise in the bearish pennant, upward trend line is falling and
the lower trend line is rising.

Japanese candlesticks
• Been around for hundreds of years
• Often referred to as “Japanese Candles” because the Japanese would use them to
analyze the price of rice contracts
• Similar to bar chart, but uses color to show if stock was up (green) or down (red) over
the day
• More than 20 patterns are used by technicians for candlestick charting. Some of the
most popular include the following.
• Green is an example of a bullish pattern, the stock opened at (or near) its low and
closed near its high

• Red is an example of a bearish pattern. The stock opened at (or near) its high and
dropped substantially to close near its low

• Top example is called a hammer and is a bullish pattern only if it occurs after the
stock price has dropped for several days.
– Theory is that pattern indicates a reversal
 • Bottom is an example of a star, typically indicating a reversal and/or indecision.

Elliott Wave Theory

Ralph Nelson Elliott developed the Elliott Wave Theory in the late 1920s by discovering that
stock markets, thought to behave in a somewhat chaotic manner, in fact traded in repetitive
cycles.
Elliott discovered that these market cycles resulted from investors' reactions to outside
influences, or predominant psychology of the masses at the time. He found that the upward
and downward swings of the mass psychology always showed up in the same repetitive
patterns, which were then divided further into patterns he termed "waves".
Elliott's theory is somewhat based on the Dow Theory in that stock prices move in waves.
Because of the "fractal" nature of markets, however, Elliott was able to break down and
analyze them in much greater detail. Fractals are mathematical structures, which on an ever-
smaller scale infinitely repeat themselves. Elliott discovered stock-trading patterns were
structured in the same way.

Market Predictions Based on Wave Patterns

Elliott made detailed stock market predictions based on unique characteristics he discovered
in the wave patterns. An impulsive wave, which goes with the main trend, always shows five
waves in its pattern. On a smaller scale, within each of the impulsive waves, five waves can
again be found. In this smaller pattern, the same pattern repeats itself ad infinitum. These
ever-smaller patterns are labeled as different wave degrees in the Elliott Wave Principle.
Only much later were fractals recognized by scientists.
In the financial markets we know that "every action creates an equal and opposite reaction" as
a price movement up or down must be followed by a contrary movement. Price action is
divided into trends and corrections or sideways movements. Trends show the main direction
of prices while corrections move against the trend. Elliott labeled these "impulsive" and
"corrective" waves.
Theory Interpretation
The Elliott Wave Theory is interpreted as follows:
 Every action is followed by a reaction.
 Five waves move in the direction of the main trend followed by three corrective
waves (a 5-3 move).
 A 5-3 move completes a cycle.
 This 5-3 move then becomes two subdivisions of the next higher 5-3 wave.
 The underlying 5-3 pattern remains constant, though the time span of each may vary.
Let's have a look at the following chart made up of eight waves (five up and three down)
labeled 1, 2, 3, 4, 5, A, B and C.

You can see that the three waves in the direction of the trend are impulses, so these waves
also have five waves within them. The waves against the trend are corrections and are
composed of three waves.

The major difference between technical and fundamental analysis is:

Fundamental analysis Technical analysis

1. Fundamental analyst’s analyses the stock 1. The technical analysts mainly focus the
based on the specific goals of the attention on the past history of prices.
investors. They study the financial Generally technical analysts choose to
 strength of corporate, growth of sales, study two basic market data-price and
earnings and profitability. They also take volume.
account the general industry and 2. Compared to fundamental analysts,
economic conditions. technical analysts mainly predict the short
2. The fundamental analysts estimate the term price movement rather than long
intrinsic value of the shares and purchase term movement. They are not committed
them when they are undervalued. They to buy and hold policy.
dispose the shares when they are cover 3. Technicians opine that they can forecasts
priced and earn profits. They try to find supply and demand by studying the prices
out the long term value of shares. and volume of trading.
3. Fundamentals are of the opinion that
supply and demand for stocks depend on
the underlying factors. The forecasts of
supply and demand depend on various
factors.
In both the approaches supply and demand factors are considered to be critical.
Business, economic, social and political concern affects the supply and demand for securities.
These underlying factors in the form of supply and demand come together in the securities
market to determine security prices.

EFFICIENT MARKET THEORY

BASIC CONCEPTS
Before understanding the theory certain concepts and phrases like market efficiency, liquidity
traders and information traders should be understood.
Market efficiency The expectations of the investors regarding the future cash flows are
translated or reflected on the share prices. The accuracy and the quickness in which the
market translates the expectation into prices are termed as market efficiency. There are two
types of market efficiencies:
-Operational efficiency
-Informational efficiency
Operational efficiency At stock exchange operational efficiency is measured by factors like
time taken to execute the order and the number of bad deliveries. Investors are concerned
with the operational efficiency of the market. But efficient market hypothesis does not deal
with this efficiency.
Informational efficiency It is a measure of the swiftness or the market's reaction to new
information. New information in the form of economic reports, company analysis, political
statements and announcement of new industrial policy is received by the market frequently.
How does the market react to this? Security prices adjust themselves very rapidly and
accurately. They never take a long time to adjust to the new information. For instance the
announcement of bonus shares of any company would result in a hike in price of that stock.
Like-wise major changes in the policy decisions of the Government are also reflected in the
stock index movement.
Liquidity traders These traders investments and resale of shares depend upon their individual
fortune. Liquidity traders may sell their shares to pay their bills. They do not investigate
before they invest.
Information traders Information traders analyze before adopting any buy or sell strategy.
They estimate the intrinsic value of shares. The deviation between the intrinsic value and the
market value makes them enter the market. They sell if the market value is higher than the
intrinsic value and vice -versa. The buying and selling of the shares through the demand and
supply forces bring the market price back to its intrinsic value.

THE RANDOM-WALK THEORY

In 1900, a French mathematician named Louis Bachelier wrote a paper suggesting that
security price fluctuations were random. In 1953, Maurice Kendall in his paper reported that
stock price series is a wandering. They appeared to be random; each successive change is
independent of the previous one. In 1970, Fama said that efficient markets fully reflect the
available information. If markets are efficient, securities' prices, reflect normal returns for
their level of risk. Fama suggested that efficient market hypothesis can be divided into three
categories. They are "weak form", the "semi-strong form" and the "strong form". The level of
information being considered in the market is the basis for this segregation.
WEAK FORM OF EMH
The type of information used in the weak form of EMH is the historical prices. According to
it, current prices reflect all information found in the past prices and traded volumes. Future
prices cannot be predicted by analyzing the prices from the past. Everyone has the access to
the past prices, even though some people can get these more conveniently than others.
Liquidity traders may sell their stocks without considering the intrinsic value of the shares
and cause price fluctuations. Buying and selling activities of the information trader’s lead the
market price to align with the intrinsic value.
In the weak efficient market short term traders may earn a positive return. On an average,
short term traders will not outperform the blind folded investor picking the stock with a dart.
That is traders may earn by the naive buy and hold strategy while some may incur loss, the
average buy and hold strategy cannot be beaten by the chartist. Many studies of the market
analysts have proved the weak form of the EMH. Empirical tests of the weak form are
presented here.
Filter rule To earn returns technical trading strategies based on historical prices have been
used. Filter rule is one among such strategies. According to this strategy if a price of a
security rises by at least x per cent, investor should buy and hold the stock until its price
declines by at least x per cent from a subsequent high. Short sellers can use the filter to earn
profits by liquidating their holdings when the price decreases from a peak level by x per cent.
They can take up short position as the price declines till the price reaches a new low and then
increases by 'x' percentage. Different filter rules are used by different traders. It ranges from
as small as.5 per cent to as large as 50 per cent.
The filter rule can be explained with the help of an example. Take a hypothetical company
XY and assume me filter to be 10 per cent. The price fluctuates between Rs 20 to 30. Assume
the starting point to be Rs 20. When there is an increase in the price of the share to Rs 22 Le.
,(10 per cent rise) one has to buy it. The rally may continue up to Rs 30 and decline. If the
price falls the sell signal is given at Rs 27 i.e. 10% of Rs 30 and me trader can take up the
short position till it reaches its low level. When there is a rise in price the same exercises have
to be followed.
Runs Test
Runs test is used to find out whether the series of price movements have occurred by chance.
A run is an uninterrupted sequence of the same observation. If a coin is tossed the following
sequence may occur
HHTTTHHHTHH
Here occurrence of H H is a run and T T is another run. When the sequences of the
observations change we count it as a run.
Serial correlation
To test the independence between successive price changes serial correlation technique is
used. Serial correlation or auto-correlation measures the correlation co-efficient in a series of
numbers with the lagging values of the same series. Price changes in period t + 1 (or t + any
number) are correlated with the price changes of the preceding period. Scatter diagrams can
be used to find out the correlation. If there is correlation between the price of t and t + 1
period, the points plotted in the graph would form a straight line. If the price rise (or fall) in
period t is followed by price rise (or fall) in period t + 1 then the correlation co-efficient
would be +1. But many studies conducted on the security price changes have failed to show
any significant correlations. Fama computed serial correlations for 30 stocks for the period
1958 -62 with varying t periods from t + 1to t + 10. The results of the autocorrelations were
generally found to be insignificant, with most falling within the range of +. 10 to -. 10. If
there is little correlation between stock price over time, chart analyses cannot be of much use
in predicting the future.
SEMI-STRONG FORM
The semi-strong form of the efficient market hypothesis states that the security price adjusts
rapidly to all publicly available information. In the semi-strongly efficient markets, security
prices fully reflect all publically available information. The prices not only reflect the past
price data, but also the available information regarding the earnings of the corporate,
dividend, bonus issue, right issue, mergers, acquisitions and so on. In the semi-strongly
efficient market a few insiders can earn a profit on a short run price changes rather than the
investors who adopt the naive buy and hold policy. In the case of a competitive market, price
is fixed by the supply and demand force. The price at the equilibrium level of the supply and
demand represents the consensus opinion of the market. The intrinsic value of the stock and
the equilibrium price are the same. Whenever a new information arrives at the market, the
supply and the demand factors react to it. If the market processes the new information
quickly, a new price would come out of it. If the market has to be semi-strongly efficient,
timely and correct dissemination of information and assimilation of news are needed. Only
then, the market can reflect all the relevant information quickly. It is stated that the stock
markets in US strongly supports the semi-strong hypothesis because the prices adjust rapidly
to the new information.
Empirical evidence Fama, Fisher, Jensen and Roll were the fore runners in examining the
semi strong form of EMH. They analyzed the effect of stock split on share prices. Their study
was important because (a) it provided evidence to semi-strong form of markets (b) it analyzed
whether the stock splits increase the wealth of the shareholders and (c) they developed a
research method to test the market efficiency.
STRONG FORM
The strong form EMH states that all information is fully reflected on security prices. It
represents an extreme hypothesis which most observers do not expect it to be literally true.
The strong form of the efficient market hypothesis maintains that not only the publicly
available information is useless to the investor or analyst but all information is useless.
Information whether it is public or inside cannot be used consistently to earn superior
investors' return in the strong form. This implies that security analysts and portfolio managers
who have access to information more quickly than the ordinary investors would not be able to
use it to earn more profits
Empirical evidence Many of the tests of the strong form of the efficient market hypothesis
deal with mutual fund performances. Financial analysts have studied the risk adjusted rates of
return from hundreds of mutual funds and found out that the professionally managed funds
are not able to outperform the naïve- buy hold strategy. Jensen had studied 115 funds over a
decade. He concluded that even though the analysts are well endowed with wide ranging
contacts and associations in both the business and financial committees, they are unable to
forecast returns accurately enough to recover the research and transaction costs. He holds this
as a striking piece of evidence for the strong form of the efficient market hypothesis.
THE ESSENCE OF THE THEORY
According to the theory, the successive price changes or changes in return are independent
and these successive price changes are randomly distributed. Random Walk Model argues
that all publicly available information fully reflected on the stock prices and further the stock
prices instantaneously adjust themselves to the available new information. The theory mainly
deals with the successive changes rather than the price or return levels.
The investors should note that the random theory says nothing about the relative price change
that is the changes that are occurring across the securities. Some securities may outperform
others. Again, it does not make any remark on the decomposing of price into market, industry
or firm factors. All these factors are concerned with the relative prices but not with the
absolute price changes. The random walk hypothesis deals with the absolute price changes
and not with the relative prices.
The prices may move at random but this does not indicate that there would not be any upward
or downward movement in the price. The random walk hypothesis is entirely consistent with
the upward and downward movements of the stock prices.
MARKET INEFFICIENCIES
Many studies have proved the prevalence of the market efficiency. At the same time, several
study results contradict the concept of market efficiency. For example, the studies conducted
Joy, Litzenberger and Mr. Enally over the period of 1963-1968 gave different results. The
authors have examined the quarterly earnings of the stock prices. The earning of one quarter
was compared with the same quarter of the previous year. If the current year's earnings were
40% or more high than the earnings for the same quarter in the previous year, the earnings
were classified as good earnings than anticipated. If the current quarter's earnings were below
40% of the previous year's earnings, they are classified as bad than expected.
LOW PE effect Many studies have provided evidences that stocks with low' price earnings
ratios yield higher returns than stocks with higher PEs. This is known as low PE effect. A
study made by Basu in 1977 was risk adjusted return and even after the adjustment there was
excess return in the low price-earnings stocks. If historical information of PE ratios is useful
to the investor in obtaining superior stock returns, the validity of the semi-strong form of
market hypothesis is questioned. His results stated that low PE portfolio experienced superior
returns relative to the market and high PE portfolio performed in an inferior manner relative
to the overall market. Since his result directly contradicts semi-strong form of efficient
market hypothesis, it is considered to be important.
Small firm effect The theory of the small firm effect maintains that investing in small firms
(those with low capitalization) provides superior risk adjusted returns. Banz found that the
size of the firm has been highly correlated with returns. Banz examined historical monthly
returns of NYSE common stocks for the period 1931-1975. He formed portfolios consisting
of 10 smallest firms and the 10 largest firms and computed the average return for these
portfolios. The small firm portfolio has outperformed the large firm portfolio.
Several other studies have confirmed the existence of a small firm effect. The size effects
have given rise to the doubts regarding the risk associated with small firms. The risk
associated with them is underestimated and they do not trade as frequently as those of the
large firms. Correct measurement of risk and return of small portfolios tends to eliminate at
least 50% of the small firm effect.
The weekend effect French in his study had examined the returns generated by the, Standard
and Poor Index for each day of the week. Stock prices tend to rise all week long to a peak on
Fridays. The stocks are traded on Monday at reduced prices, before they begin the next
week's price rise. Buying on Monday and selling on Friday from 1953 to1977 would have
generated average annual return of 13.4% while simple buy and hold would have
yielded 5.5% annual return.
 MODULE 3: VALUATION OF BONDS AND SHARES
BOND
Promise to pay a stipulated stream of cash flows. It is a contract that requires the borrower to
pay the interest income to the lender. It resembles the promissory note and issued by the
government and corporate. The par value of the bond indicates the face value of the bond.
Bond characteristics
 To make specified payments
 It described in terms of par value, coupon rate and maturity date.
 Bond indenture: Agreement between bond issuer, bond holder and intermediary who
give guarantee to the bond holder and ensure that the bond issuer pays interest and
principal on time.
TYPES OF BONDS
 Government bonds
The borrowers are central and state governments. The government of India periodically
issues bonds which are called government securities or gilt edged securities. These are
medium or long term bonds issued by the RBI on behalf of the government. Interest
payments usually on semiannual. Apart from governments, a number of government agencies
issue bonds that are guaranteed by the government.
 Corporate bonds
Companies issue bonds to borrow money called corporate bond. A secured corporate debt
instrument is called a corporate bond where as an unsecured corporate debt instrument is
called a corporate debenture.
 Straight bonds
It is also called plain vanilla bond and pays a fixed periodic semi-annual coupon over its life
and returns the principal on maturity date.
 Zero coupon bonds
It does not carry any regular interest payment. It is issued at a steep discount over its face
value and redeemed at face value on maturity. For example, the IDBI issued deep discount
bonds in 1996 which had a face value of Rs. 200,000 and a maturity period of 25 years. The
bonds were issued at Rs. 5,300.

 Floating rate bonds

It pays an interest rate that is linked to a benchmark rate such as the Treasury bill interest
rate. For example, in 1993 the SBI came out with the first issue of floating rate bonds in
India.
 Bonds with embedded options
Bonds may have options embedded in them. These options give certain rights to investors or
issuers. Convertible bonds give the issuer the right to convert them into equity shares.
Callable bonds give the issuer the right to redeem them prematurely on certain terms.
Puttable bonds give the investor the right to prematurely sell them back to the issuer on
certain terms.
 Commodity-linked bonds
The payoff from a commodity linked bond depends to a certain extent on the price of a
certain commodity. For example the payoff of the bond will be based on the price per
barrel of crude oil.
BOND PRICES
The value of the bond or any asset is equal to the present value of the cash flows expected
from it. The value of a bond requires:
 Expected cash flows
 The required rate of return
The assumptions of bond valuation
 The coupon interest rate is fixed for the term of the bond
 The coupon payments are made annually
 The bond will be redeemed at par on maturity
PRICE YIELD RELATIONSHIP
The bond price varies inversely with yield. As the required yield increases, the present value
of the cash flow decreases, hence the price decreases. Conversely when the yield decreases,
the present value of the cash flow increases, hence the price increases.
Relationship between bond price and time
Since the price of a bond must equal its par value at maturity, the bond prices changes with
time. For example a bond redeemable for Rs.1000 after five years when its matures, if the
current price is 1000 it is said to be premium bond. If the current price is Rs. 900 the bond
said to be discount bond. The premium and discount will disappear when it’s near to the
maturity period. If the current price of the bond is equal to the maturity value then it is called
par value bond.
BOND YIELDS
Bonds are generally traded on the basis of their prices. They are typically compared in terms
of yields. The commonly employed yield measures are: current yield, yield to maturity, yield
to call and realized yield to maturity
Current yield
It relates the annual coupon rate to the market price
Current yield = Annual interest/price
Yield to maturity
Purchasing a bond depends on bond price, maturity date and coupon payments which help to
figure out rate of return offered by the bond over its life. It is referred as Yield to Maturity
(YTM)
Assumptions
 There should not be any default. Coupon and principal amount should be paid as per
schedule.
 The investor has to hold the bond till maturity.
 All the coupon payments should be reinvested immediately
Yield to call
Some bonds carry a call feature that entitles the issuer to call (buy back) the bond prior to the
stated maturity date, such bonds, it is a practice to calculate the yield to call (YTC)

P = price of the bond

n = number of periods
C = coupon payment
r = required rate of return on this investment
F = principal at maturity
t = time period when payment is to be received
Realized yield to maturity
The YTM assumes that the cash flows received through the life of a bond are reinvested at
rate equal to the yield to maturity. This assumption may not be valid as reinvestment rates
applicable to future cash flows may be different. It is necessary to define the future
reinvestment rate which is nothing but realized yield to maturity. The value of r * is
Present market price (1+r*) n = Future value
RISKS IN BONDS
  Interest rate risk: it tends to vary over time, causing fluctuations in bond prices. A
rise in interest rates will decrease the market price, whereas a fall in interest rates will
increase the market price.
 Default risk: it is the risk that a borrower may not pay interest or principal on time.
Bonds carry a high default risk which carries low credit rating and they sell at a lower
price.
 Marketability risk: The poor liquidity in the debt market, investors face difficulty in
trading debt instruments, particularly when the quantity is large. In this case bonds
will sell at a discount and purchase at a premium.
 Callability risk: A bond may have a call provision that gives the issuer the option to
redeem the bond before its maturity. The issuer would generally exercise the call
option when the interest rate decline. This is attractive from the investor’s point of
view and it exposes to call risk.
 Reinvestment risk: A bond pays periodic interest there is a risk that the interest
payments may have to be reinvested at a lower interest rate. This is called
reinvestment risk.
BOND VALUE THEOREMS
Theorem 1
• The value of the bonds depends upon three factors, the coupon rate, YTM and the
expected yield to maturity
• If the market price of the bond increases, the yield would decline and vice versa.

Example…
Bond A Bond B
Par value Rs.1000 Rs.1000
Coupon rate 10% 10%
Maturity period 2yrs 2yrs
Market price Rs.874.75 Rs.1035
Yield 18% 8%

Theorem 2
 If the bond’s yield remains the same over its life, the discount or premium depends on
the maturity period.
  The bond with a short term to maturity sells at a lower discount than the bond with a
long term to maturity.
Example….
bond A bond B
Par value Rs.1000 Rs.1000
Coupon 10% 10%
Yield 15% 15%
Maturity 2 3
M.Price 918.71 885.86
Discount Rs.81.29 Rs.114.14
Theorem 3
If a bond’s yield remains constant over its life, the discount or premium amount will decrease
at an increasing as its life gets shorter.
Example….
Years to maturity The present value
5 620.9
4 683.0
3 751.3
2 826.4
1 909.1

Theorem 4
A rise in the bond’s price for a decline in the bond’s yield is greater than the fall in the bond’s
price for a raise in the yield.
Example…
 Take a bond of 10% coupon rate, maturity period of five years with the face value of
Rs 1000. if the yield declines by 2%, that is to 8% then the bond price will be Rs
1079.87
 If the yield increases by 2% then, the bond price will be Rs.927.88
Theorem 5
The change in the price will be lesser for a percentage change in bond’s yield if its coupon
rate is higher.
Example…
bond A bond B
Coupon 10% 8%
Yield 8% 8%
Maturity 3 3
Price Rs.105.15 Rs.100
FV Rs.100 Rs.100
Y.Raise 1% 1%
Price after Rs.103 Rs.97.47
Yield rises
% change 2.15% 2.53%
in price
YIELD CURVE (TERM STRUCTURE INTEREST RATE THEORY)
 The level of interest rate and the term structure of interest rate
 The relationship between the yield and time is called term structure.
 It is also known as yield curve.
 Other influences held constant except yield.
 Pure discount bonds are selected.
 The bonds do not have early redemption.
Expectations theory
 Based on the expectations of the investors about the future interest rate.
 There are three reasons to anticipate the fall in the interest rate.
1. Fall in the inflation rate
2. Balanced budget or cut in the fiscal deficit
3. Recession in the economy
Yield curve Explanation
Ascending short term rates are expected to rise in future
Descending short term rates are expected to fall in future
Flat short term rates are expected to remain
unchanged
Liquidity preference theory
 It would be more desirable for the investors to invest in short term bonds than on long
term bonds because of their liquidity
 The bond issuing corporate or contributor pay premium to motivate the investors to
buy long term bond.
  The exponents of the liquidity preference theory believe that the investors prefer short
term rather than long term. Hence they would like to invest in long term bonds
Segmentation theory
 Life insurance companies prefer to invest in a long term bond.
 The commercial banks and corporate may prefer liquidity to meet their short term
requirements.
 Supply and demand for fund are segmented in sub markets because of their preferred
habitats of the individual.
 The yield is determined by the demand and supply of the funds.
 For example life insurance companies offer insurance policies that do not require any
payment for a long time. If the insurance company invests the funds in a long term
bond, the interest rate bond would earn interest rate is higher than the promised
interest rate, the company stands to gain and its risk is also reduced. On the other
hand, commercial banks and corporate may prefer liquidity to meet their short term
requirements, they prefer short term issues. Therefore supply and demand for fund are
segmented based on the preference of the individuals.
Convexity
 Bond price and yield are inversely related.
 The rise in bond price would cause a fall in yield and vice-versa.
 According to theorem 4 the relationship is not linear.
The quantum increase in the bond’s price for a given decline in the yield is higher than the
decline in bond’s price for a amount of increase in yield.

BOND DURATION
It measures the time structure of a bond and the bond’s interest rate risk. It is to measure the
average time until all interest coupons and the principal is recovered. This is called
Macaulay’s duration. It is defined as the weighted average of time periods to maturity.
BOND MANAGEMENT STRATEGIES
i. Passive strategy
ii. Quasi – passive strategy
iii. Immunization strategy
iv. Active strategy
PASSIVE STRATEGY
• It simply involve buying a bond & holding it until maturity
• A manager selects a portfolio of bonds based on the objectives of the client with the
intent of holding these bonds to maturity
• Investors don’t trade actively to maximize the return
• Hold the bond with a maturity or duration which is close to their investment horizon
• Examine factor such as quality rating, coupon level, terms to maturity, call features
etc.
• Only default-free or very high quality securities should be held
• Also, those securities that are callable by firm (allows the issuer to buy back the bond
at a particular price and time) or puttable by holder (allows bondholder to sell the
bond to issuer at a specified price and time) should not be included
• The buy-and-hold strategy minimizes transaction costs
• Suitable for income maximizing investor with low level of risk
QUASI – PASSIVE STRATEGY
The main techniques of quasi – passive bond management are detailed here.
Ladders
It refers to a portfolio of individual bonds with various maturity dates. The portfolio is
divided into equal parts and invested in bonds with staggered maturity over the investor time
horizon.
Rungs
By taking the total investment amount that you are planning to invest and dividing it equally
by the total number of years for which you wish to have a ladder, you will arrive at the
number of bonds for this portfolio, or the number of rungs on your ladder. The greater the
number of rungs, the more diversified your portfolio will be and the better protected you will
be from any one company defaulting on bond payments.
Height of the ladder - The distance between the rungs is determined by the duration between
the maturity of the respective bonds. This can range anywhere from every few months to a
few years. Obviously, the longer you make your ladder, the higher the average return should
be in your portfolio since bond yields generally increase with time.
Materials - Just like real ladders, bond ladders can be made of different materials. One
straightforward approach to reducing exposure to risk is investing in different companies, but
investments in products other than bonds are sometimes more advantageous depending on
your needs. Debentures, government bonds, municipal bonds, Treasuries and certificates of
deposit - each having different strengths and weaknesses - are all different products that you
can use to make the ladder. One important thing to remember is that the products in your
ladder should not be redeemable (or callable) by the issuer. This would be the equivalent to
owning a ladder with collapsible rungs.
Bullets
It refers to the staggered purchase of several bonds that mature at the same time. This is also
known as maturity matching strategy. Staggering the purchase date minimizes the interest
risk. This approach is effective when the investor wants the proceeds from the bonds at a
specific time to meet expenses such as child’s higher education fees.
Barbells
A Barbell strategy is formed when a Trader invests in Long and Short duration bonds, but
does not invest in the intermediate duration bonds. This results in a bond portfolio of medium
– term average weighted maturity. This strategy is useful when interest rates are rising; as the
short term maturities are rolled over they receive a higher interest rate, raising the value.
Indexing
The investor buys the bonds that are in the index, to replicate the return and risk of a bond
index. It tracks the index and to a certain extent it resembles the buy and hold strategy. Either
CRISIL Composite index or iBEX.
IMMUNIZATION STRATEGY
A strategy that matches the durations of assets and liabilities thereby minimizing the impact
of interest rates on the net worth. Bonds are typically stable from day to day, but they are
exposed to interest rate risk. Without immunization, rising interest rates send bond values
down. Bond immunization can reduce the price sensitivity of a bond portfolio to rising
interest rates.
You adjust the duration of a portfolio to match your investment horizon. Duration, expressed
as a number of years, is a multiple that approximates individual bond or bond portfolio
sensitivity to interest rate changes. A bond with a duration of four will see a decline in value
that is roughly four times the increase in interest rates. For example, a 0.5 percent increase in
interest rates would cause a bond with a duration of four to drop in value about 2 percent, or
four times 0.5 percent.
ACTIVE STRATEGIES
The main type of active strategies are valuation strategy and bond swap strategy.
Valuation Strategy
The basic premise of valuation is based on the portfolio manager's ability to identify and
purchase undervalued securities and avoid those that appear to be overvalued. For example,
take five bonds of the exact same credit rating, maturity, industry and liquidity. Using
a required yield to discount the future cash flows, all else being equal, one bond may be
pricing out lower than its intrinsic value.
Bond-Swap Strategies
The key to a bond-swap strategy is to simultaneously sell one bond and purchase another for
the sole purpose of improving the portfolio's return. This involves simultaneously swapping
out of a lower-coupon bond for a higher-coupon bond.
Yield Spread Strategy
Yield spreads are determined by the pricing of bonds in various segments of the market. The
unique characteristics of the bonds relate to the varying prices and related yields.
Different coupons across segments can also carry different prices due to their demand and
liquidity.
Interest Rate Anticipation
Interest rate anticipation is one of the most common - and probably riskiest - strategies, since
it relies on forecasting. Since duration is a more accurate metric to measure volatility, it is
used to adjust the portfolio. Duration is lengthened in an effort to capture an increase in value
when the prediction is that interest rates will fall. Conversely, if interest rates are expected to
rise, the move would be to shorten the duration of the portfolio to preserve capital and
potentially reinvest in shorter-term bonds when rates are presumed to be higher.
BOND IMMUNIZATION
 It is a technique that makes the bond portfolio holder to be relatively certain about the
promised stream of cash flows.
 The bond interest rate risk arises from the changes in the market interest rate.
 The market rate affects the coupon rate and the price of the bond.
 The coupon rate risk and the prices risk can be made offset each other.
 Whenever there is an increase in the market interest rate, the prices of the bonds fall.
 At the same time newly issued bonds offer higher interest rate.
 The coupon can be reinvested in the bonds offering higher interest rate and losses that
occur due to the fall in the price of bond can be offset and the portfolio is said to be
immunized.
PREFERENCE SHARES
Company stock with dividends that are paid to shareholders before common stock dividends
are paid out. In the event of a company bankruptcy, preferred stock shareholders have a right
to be paid company assets first. Preference shares typically pay a fixed dividend, whereas
common stocks do not. And unlike common shareholders, preference share shareholders
usually do not have voting rights.
There are four types of preference shares: Cumulative preferred, for which dividends must be
paid including skipped dividends; non-cumulative preferred, for which skipped dividends are
not included; participating preferred, which give the holder dividends plus extra earnings
based on certain conditions; and convertible, which can be exchanged for a specified number
of shares of common stock.
Features of Preference Shares
Return on Investment: It is in the form of dividend and rate of dividend is prefixed and pre
communicated to the investors.
Not Owners: Investors in preference shares are not the owners of the company.
Return of Capital: Capital raised by the company by way of preference shares are required
to be repaid during the existence of the company.
Non participation in management: Preference shareholders do not participate in the affairs
of the company.
Risk: The risk is more on the part of the company.

EQUITY SHARES
Meaning: Equity shares are those shares which are ordinary in the course of company's
business. They are also called as ordinary shares. These shareholders do not enjoy preference
regarding payment of dividend and repayment of capital. Equity shareholders are paid
dividend out of the profits made by a company. Higher the profits, higher will be the dividend
and lower the profits, lower will be the dividend.
Features of Equity Shares
(1) Owned capital: Equity share capital is owned capital because it is the money of the
shareholders who are actually the owners of the company.
(2)Fixed value or nominal value: Every share has fixed value or a nominal value. For
example, the price of a share is Rs. 10/- which indicates a fixed value or a nominal value.
(3) Distinctive number: Every share is given a distinct number just like a roll number for the
purpose of identification.
(4) Attached rights: A share gives its owner the right to receive dividend, the right to vote,
the right to attend meetings, the right to inspect the books of accounts.
(5) Return on shares: Every shareholder is entitled to a return on shares which is known as
dividend. Dividend depends on the profits made by a company. Higher the profits, higher will
be the dividend and vice versa.
(6) Transfer of shares: Equity shares are easily transferable, that is if a person buys shares
of a particular company and he does not want them, he can sell them to any one, thereby
transferring the shares in the name of that person.
(7) Benefit of right issue: When a company makes fresh issue of shares, the equity
shareholders are given certain rights in the company. The company has to offer the new
shares first to the equity shareholders in the proportion to their existing shareholding. In case
they do not take up the shares offered to them, the same can be issue to others. Thus, equity
shareholders get the benefits of the right issue.
(8) Benefit of Bonus shares: Joint stock companies which make huge profits, issue bonus
shares to their ordinary shareholders out of the accumulated profits. These shares are issued
free of cost in proportion to the number of existing equity share holding. In case they do not
take up the shares offered to them, the same can be issued to others. Thus, equity
shareholders get the benefits of the right issue.
(9) Irredeemable: Equity shares are always irredeemable. This means equity capital is not
returnable during the life time of a company.
(10)Capital appreciation: The nominal or par value of equity shares is fixed but the market
value fluctuates. The market value mainly depends upon profitability and prosperity of the
company. High rate of dividend is paid with high rate of profit, the shareholders capital is
appreciated through an appreciation in the market value of shares. (i.e. higher the rate of
dividend, higher the market value of the shares.)
 MODULE 4: PORTFOLIO CONSTRUCTION

Portfolio is a combination of securities such as stocks, bonds and money market instruments.
The process of blending together the broad asset classes so as to obtain optimum return with
minimum risk is called portfolio construction. Diversification of investments helps tp spread
risk over many assets.
Approaches in portfolio construction or portfolio management process
There are two approaches in the construction of the portfolio of securities - traditional
approach and modern approach (Markowitz efficient frontier approach). In the traditional
approach investor’s needs in terms of income and capital appreciation are evaluated and
appropriate securities are selected to meet the needs of the investor. The common practice in
the traditional approach is to evaluate the entire financial plan of the individual. In the
modern approach, portfolios are constructed to maximize the expected return for a given level
of risk.
Traditional approach
It deals with two dimensions
 Determining the objectives of the portfolio
 Selection of securities to be included in the portfolio

Analysis of constraints

Determination of
objectives

Selection of portfolio

Assessment of risk and

return
 Diversification

ANALYSIS OF CONSTRAINTS
Income needs: The income needs depends on the need for income in constant rupees and
current rupees.
Need for current income: The investor should construct the income which portfolio should
generate. After knowing the expenditure of a person, it is possible to construct the portfolio to
earn income to meet the standard of living.
Need for constant income: Inflation reduces the purchasing power of the money. Based on
the fluctuations of the inflation, tries to build a portfolio that offers income and increase at the
rate that would offset the inflation.
Liquidity: If the investors prefer to have high liquidity, then funds should be invested in short
term securities such as money market instruments and shares.
Safety of the principal: Investing bonds and debentures is safer than investing in the stocks.
Investing money in the unregistered finance companies may not provide adequate safety.
Time horizon: It is the investment planning period of the individuals. Individuals risk and
return preferences are often described in terms of his” Life cycle”. The stage of the life cycle
determines the nature of investment. During early career investments may be in the form of
savings for liquidity purposes. In the mid-career would like to invest in medium term assets
and reduce the risk exposure. The final stage is the late career or the retirement stage. The
time horizon of the investment is very much limited and shifts his investment to low return
and low risk category investments, because safety of the principal is given priority.
Tax consideration: Investors in the income tax paying group consider the tax concessions
they could get from their investments. Investments in government bonds and NSC can avoid
taxation. This constraint makes the investor to include the items which will reduce the tax.
Temperament: Some investors are risk lovers who would like to take high risk even for a
low return. While some investors are risk averse, who may not be willing to undertake higher
level risk. The risk neutral investors match the return and the risk. Risk adverse investors do
not have the temperament to invest in the stock.

DETERMINATION OF OBJECTIVES
The return that the investor requires and the degree of risk he is willing to take depend upon
the constraints.
 Current income
 Growth in income
 Capital appreciation
 Preservation of capital
SELECTION OF PORTFOLIO
 Objectives and asset mix
If the main objective is getting adequate amount of current income, 60% of the
investment is made on debts and 40% on equities. The proportions of investments on debt
and equity differ according to the individual preferences. Money is invested in short term
debt and fixed income securities.
 Growth of income and asset mix
Here the investor requires a certain percentage of growth in the income received from
his investment. The investor’s portfolio may consist of 60% to 100% in equities. The
debt portion of the portfolio may consist of concession regarding tax concession.
 Capital appreciation and asset mix
 Investment in real estate’s like land and house may provide a faster rate of capital
appreciation but they lack liquidity. In the capital market, the values of the shares are
much higher than their original prices. Hence next to real assets, the stock markets
provide best opportunity for capital appreciation.
 Safety of the principal and asset mix
The risk averse investors are very particular about the stability of principal. According
to the life cycle theory, people in the third stage of life also give more importance to
the safety of the principal. Hence the investor’s portfolio consists more of debt
instruments.
RISK AND RETURN ANALYSIS
The ability to achieve high returns is dependent upon his ability to judge risk and his ability
to specific risks. The risks are namely interest rate risk, purchasing power risk, financial risk
and market risk. The investor analyses the varying degrees of risk and constructs his
portfolio.
DIVERSIFICATION: Once the asset mix is determined and the risk and return are
analyzed, the final step is the diversification of portfolio. Financial risk can be minimized by
commitments to top quality bonds, but these securities offer poor resistance to inflation.
Stocks provide better inflation protection than bonds but are more vulnerable to financial
risks. According to the investor’s need for income and risk tolerance level portfolio is
diversified. In the bond portfolio, the investor has to strike a balance between the short term
and long term bonds. Short term fixed income securities offer more risk to income and long
term fixed income securities offer more risk to principal. In the stock portfolio, he has to
adopt the following steps which are shown in the following figure.

Selection of industries

Selection of companies in the

industry

Determining the size of participation

The investor has to select the industries appropriate to his investment objectives. Each
industry corresponds to specific goals of the investor. The sales of some industries like two
wheelers and steel tend to move in tandem with the business cycle, the housing industry sales
move counter cyclically. If regular income is the criterion then industries, which resist the
trade cycle should be selected. Likewise, the investor has to select one or two companies
from each industry. The selection of the company depends upon its growth, yield, expected
earnings, past earnings, expected price earnings ratio, dividend and the amount spent on
research and development. Selecting the best company is widely followed by all the investors
but this depends upon the investor’s knowledge and perceptions regarding the company. The
final step in this process is to determine the number of shares of each stock to be purchased.
This involves determining the number of different stocks that is required to give adequate
diversification.
MODERN APPROACH: The traditional approach is a comprehensive financial plan for the
individual. It takes into account the individual needs such as housing, life insurance and
pension plans. But these types of financial approaches are not done in the Markowitz
approach. Markowitz gives more attention to the process of selecting the portfolio. His
planning can be applied more in the selection of common stocks portfolio than the bond
portfolio. The stocks are not selected on the basis of need for income or appreciation. But the
selection is based on the risk and return analysis. Return includes the market return and
dividend. The investor needs return and it may be either in the form of market return or
dividend.
In the modern approach, the final step is asset allocation process that is to choose the
portfolio that meets the requirement of the investor. The risk taker i.e. who are willing to
accept a higher probability of risk for getting the expected return would choose high risk
portfolio. Investor with lower tolerance for risk would choose low level risk portfolio. The
risk neutral investor would choose the medium level risk portfolio.
PORTFOLIO-MARKOWITZ MODEL
Harry Markowitz opened new vistas to modern portfolio selection by publishing an article in
the Journal of Finance in March 1952. His publication indicated the importance of correlation
among the different stocks’ returns in the construction of a stock portfolio. Markowitz also
showed that for a given level of expected return in a group of securities, one security
dominates the other. To find out this, the knowledge of the correlation coefficients between
all possible securities combinations is required.
Simple diversification
Portfolio risk can be reduced by the simplest kind of diversification. Portfolio means the
group of assets an investor owns. They may vary from stocks to different types of bonds.
Sometimes the portfolio may consist of securities of different industries. When different
assets are added to the portfolio, the total risk tends to decrease. In the case of common
stocks, diversification reduces the unsystematic risk or unique risk. Analysts opine that if 15
stocks are added in a portfolio of the investor, the unsystematic risk can be reduced to zero.
But at the same time if the number exceeds 15, additional risk reduction cannot be gained.
But diversification cannot reduce systematic or undiversifiable risk.
In the case of simple diversification, securities are selected at random and no analytical
procedure is used.
Total risk of the portfolio consists of systematic and unsystematic risk and this total risk is
measured by the variance of the rates of returns overtime. Many studies have shown that the
systematic risk forms one quarter of the total risk.
The simple random diversification reduces the total risk. The reason behind this is that the
unsystematic price fluctuations are not correlated with the market’s systematic fluctuations.
The figure shows how the simple diversification reduces the risk. The standard deviations of
the portfolios are given in Y axis and the number of randomly selected portfolio securities in
the X axis.
The standard deviation was calculated for each portfolio and plotted. As the portfolio size
increases, the total risk line starts declining. It flattens out after a certain point. Beyond that
limit, risk cannot be reduced. This indicates that spreading out the assets beyond certain level
cannot be expected to reduce the portfolio’s total risk below the level of undiversifiable risk.
The Markowitz Model
Most people agree that holding two stocks is less risky than holding one stock. For example,
holding stocks from textile, banking, and electronic companies is better than investing all the
money on the textile company’s stock. But building up the optimal portfolio is very difficult.
Markowitz provides an answer to it with the help of risk and return relationship.
Assumptions – The individual investor estimates risk on the basis of variability of returns i.e.
the variance of returns. Investor’s decision is solely based on the expected return and
variance of return only.
For a given level of risk, investor prefers higher return to lower risk than higher risk.
The Concept-In the world of uncertainty, most of the risk averse investors would like to join
Markowitz rather than keeping a single stock, because diversification reduces the risk.
UTILITY ANALYSIS
Utility is the satisfaction the investor enjoys from the portfolio return. An ordinary investor is
assumed to receive greater utility from higher return and vice-versa. The investor gets more
satisfaction or utility in X+1 rupees than from X rupee. If he is allowed to choose between
two certain investments, he would always like to take the one with larger outcome. Thus,
utility increases with increase in return.
The utility function makes certain assumptions about an investors’ taste of risk. The investors
are categorized into risk averse, risk neutral and risk seeking investor. All the three types can
be explained with the help of a fair gamble.
Risk averse rejects a fair gamble because the disutility of the loss is greater for him than the
utility of an equivalent gain. Risk neutral investor means that he is indifferent to whether a
fair gamble is undertaken or not. The risk seeking investor would select a fair gamble i.e. he
would choose to invest. The expected utility of investment is higher than the expected utility
of not investing.
The curves ABC are three different slopes of utility curves. The upward sloping curve A
shows increasing marginal utility. The straight line B shows constant utility, and curve C
shows diminishing marginal utility. The constant utility, a linear function means doubling of
returns would double the utility and it indicates risk neutral situation. The increasing marginal
utility suggests that the utility increases more than proportion to increase in return and shows
the risk lover. The curve C shows the risk averse investor. The utility he gains from
additional return declines gradually.

Investors generally like to get more returns for additional risks assumed and the lines would
be positively sloped. The risk lover’s utility curves are negatively sloped and converge
towards the origin. For the risk fearing, lower the risk of the portfolio, happier he would be.
The degree of the slope of indifference curve indicates the degree of risk aversion.
Leveraged Portfolios
In the above model, the investor is assumed to have a certain amount of money to make
investment for a fixed period of time. There is no borrowing and lending opportunities. When
the investor is not allowed to use the borrowed money, he is denied the opportunity of having
financial leverage.
Again, the investor is assumed to be investing only on the risky assets. Riskless assets are not
included in the portfolio. To have a leveraged portfolio, investor has to consider not only
risky assets but also risks free assets. Secondly, he should be able to borrow and lend money
at a given rate of interest.
What is Risk Free Asset?
The features of risk free assets are:
 Absence of default risk and interest risk.
 Full payment of principal and interest amount.
The return from the risk free asset is certain and the standard deviation of the return is nil.
The relationship between the rate of return of the risk free asset and risky asset is zero. These
types of assets are usually fixed income securities. But fixed income securities issued by
private institutions have the chance of default. If the fixed income securities are from the
government, they do not possess the default risk and the return from them are guaranteed.
Inclusion of Risk Free Asset
Now, the risk free asset is introduced and the investor can invest part of his money on risk
free asset and the remaining amount on the risky asset. It is also assumed that the investor
would be able to borrow money at risk free rate of interest. When risk free asset is included in
the portfolio, the feasible efficient set of the portfolios is altered. ORf is gained with zero risk
and the return is earned through holding risk free asset. Now, the investor would attempt to
maximize his expected return and risk relationship by purchasing various combinations of
riskless asset and risky assets. He would be moving on the line connecting attainable
portfolio A and risk free portfolio RF i.e. the line RFA, part of his money is invested in fixed
income securities i.e. he has lent some amount of money and invested the rest in the risky
asset within the point RFM. He is depending upon his own funds. But, if he moves beyond the
point M to B he would be borrowing money. Hence the portfolios located between the points
AM are lending portfolios and beyond the point M consists of borrowing portfolios. Holding
portfolio in AM segment with risk free securities would actually reduce risk more than the
reduction in return.

E(Rp) BorrowingBCML
Efficien
Lending M tFrontier

RF A

EFFICIENT FRONTIER
The efficient frontier is a concept in modern portfolio theory introduced by Harry
Markowitz and others. A combination of assets, i.e. a portfolio, is referred to as "efficient" if
it has the best possible expected level of return for its level of risk (usually proxied by the
standard deviation of the portfolio's return). Here, every possible combination of risky assets,
without including any holdings of the risk-free asset, can be plotted in risk-expected return
space, and the collection of all such possible portfolios defines a region in this space. The
upward-sloped (positively-sloped) part of the left boundary of this region, a hyperbola, is
then called the "efficient frontier". The efficient frontier is then the portion of the opportunity
set that offers the highest expected return for a given level of risk, and lies at the top of the
opportunity set or the feasible set. For further detail see modern portfolio theory.
CAPITAL ASSET PRICING MODEL (CAPM) THEORY
The required rate of return of an asset is having linear relationship with asset’s beta
(undiversifiable or systematic risk).
Assumptions of CAPM
1. An individual seller or buyer cannot affect the price of a stock.
2. Investors can borrow or lend any amount of money at the risk-free rate of return
3. All investors have homogeneous expectations; that is, they estimate identical
probability distributions for future rates of return.
4. All investments are infinitely divisible, which means that it is possible to buy or sell
fractional shares of any asset or portfolio.
5. There are no taxes or transaction costs involved in buying or selling assets.
6. There is no inflation or any change in interest rates, or inflation is fully anticipated.
7. Investors make their decisions only on the basis of the expected returns deviations and
covariances of all pairs of securities.
8. Unlimited quantum of short sales is allowed. Any amount of shares an individual can
sell short.

Lending and borrowing

Lending and borrowing Here, it is assumed that the investor could borrow or lend any
amount of money at riskless rate of interest. When this opportunity is given to the investors,
they can mix risk free assets with the risky assets in a portfolio to obtain a desired rate of
risk-return combination.
This formula can be used to calculate the expected returns for different situations, like mixing
riskless assets with risky assets, investing only in the risky asset and mixing the borrowing
with risky assets.
Now, let us assume that borrowing and lending rate to be 12.5% and the return from the risky
assets to be 20 %. There is a tradeoff between the expected return and risk. If an investor
invests in risk free assets and risky assets, his risk may be less than what he invests in the
risky asset alone. But if he borrows to invest in risky assets, his risk would increase more
than he invests his own money in the risky assets. When he borrows to invest, we call it
financial leverage. If he invests 50% in risk free assets and 50% in risky assets, his expected
return of the portfolio would be

E(Rp) Borrowing B CM
L Efficien
Lending M tFrontier

RF A

p
The line RfM represents all possible combination of riskless and risky asset. The 'M' portfolio
does not represent any riskless asset but the line RfM gives the combination of both. The
portfolio along the path RfM is called lending portfolio that is some money is invested in the
riskless asset or may be deposited in the bank for a fixed rate of interest. If it crosses the point
M, it becomes borrowing portfolio. Money is borrowed and invested in the risky asset. The
straight line is called capital market line (CML). It gives the desirable set of investment
opportunities between risk free and risky investments. The CML represents linear
relationship between the required rates of return for efficient portfolios and their standard
deviations.
For a portfolio on the capital market line, the expected rate of return in excess of the risk free
rate is in proportion to the standard deviation of the market portfolio. The price of the risk is
given by the slope of the line. The slope equals the risk premium for the market portfolio Rm
-Rf divided by the risk or standard deviation of the market portfolio. Thus, the expected
return of an efficient portfolio is
Expected return = Price of time + (Price of risk x Amount of risk)
Price of time is the risk free rate of return. Price of risk is the premium amount higher and
above the risk free return.
Security market line
The risk-return relationship of an efficient portfolio is measured by the capital market line.
But, it does not show the risk-return tradeoff for other portfolios and individual securities.
Inefficient portfolios lie below the capital market line and the risk-return relationship cannot
be established with the help of the capital market line. Standard deviation includes the
systematic and unsystematic risk. Unsystematic risk can be diversified and it is not related to
the market. If the unsystematic risk is eliminated, then the matter of concern is systematic
risk alone. This systematic risk could be measured by beta. The beta analysis is useful for
individual securities and portfolios whether efficient or inefficient.

Empirical tests of the CAPM In the CAPM, beta is used to estimate the systematic risk of the
~ty and reflects the future volatility of the stock in relation to the market. Future volatility of
the stock is estimated only through historical data. Historical data are used to plot the
regression line or the characteristic line and calculate beta. If historical betas are stable over a
period of time, they would be good proxy for their expected return or expected risk.
Robert A. Levy, Marshall E. Blume and others have studied the question of beta stability
indepth. Levy calculated betas for both individual securities and portfolios. His study results
have provided the following conclusions
(1) The betas of individual stocks are unstable; hence the past betas for the individual
securities are not good estimators of future risk.
(2) The betas of portfolios of ten or more randomly selected stocks are reasonably stable,
hence the past portfolio betas are good estimators of future portfolio volatility. This is
because of the errors in the estimates of individual securities' betas tend to offset one another
in a portfolio.
Various researchers have attempted to find out the validity of the model by
calculating beta and realised rate of return. They attempted to test (1) whether the intercept is
equal to Rf risk free rate of interest or the interest rate offered for treasury bills (2) whether
the line is linear and pass through the beta = I being the required rate of return of the market.
In general, the studies have showed the following results.
(1) The studies generally showed a significant positive relationship between the expected
return and the systematic risk. But the slope of the relationship is usually less than that of
predicted by the CAPM.
(2) The risk and return relationship appears to be linear. Empirical studies give no evidence
of significant curvature in the risk/return relationship.
(3) The attempt of the researchers to assess the relative importance of the market and
company risk has yielded definite results. The CAPM theory implies that unsystematic risk is
not relevant, but unsystematic and systematic risks are positively related to security returns.
Higher returns are needed to compensate both the risks. Most of the observed relationship
reflects statistical problems rather than the true nature of capital market.
(4) According to Richard Roll, the ambiguity of the market portfolio leaves the CAPM
untestable. The practice of using indices as proxies is loaded with problems. Different indices
yield different betas for the same security.
(5) If the CAPM were completely valid, it should apply to all financial assets including
bonds. But, when bonds are introduced into the analysis, they do not fall on the security
market line.
Present validity of CAPM: The CAPM is greatly appealing at an intellectual level, logical
and rational. The basic assumptions on which the model is built raise, some doubts in the
minds of the investors. Yet, investment analysts have been more creative in adapting CAPM
for their uses.
(1) The CAPM focuses on the market risk, makes the investors to think about the riskiness of
the assets in general. CAPM provides a basic concept which is truly of fundamental value.
(2) The CAPM has been useful in the selection of securities and portfolios. Securities with
higher returns are considered to be undervalued and attractive for buy. The below normal
expected return yielding securities are considered to be overvalued and suitable for sale.
(3) In the CAPM, it has been assumed that investors consider only the market risk. Given the
estimate of the risk free rate, the beta of the firm, stock and the required market rate of return,
one can find out the expected returns for a firm's security. This expected return can be used as
an estimate of the cost of retained earnings.
(4) Even though CAPM has been regarded as a useful tool to financial analysts, it has its own
critics too. They point out, that the inputs also should be based on the expectations of the
future. Empirical tests and analyses have used past data only.
(5) The historical data regarding the market return, risk free rate of return and betas vary
differently for different periods. The various, methods used to estimate these inputs also
affect the beta value. Since the inputs cannot be estimated precisely, the expected return
found out through the CAPM model is also subjected to criticisms.
DIFFERENCE BETWEEN CML AND SML
 The CML is a line that is used to show the rates of return, which depends on risk-free
rates of return and levels of risk for a specific portfolio. SML, which is also called a
Characteristic Line, is a graphical representation of the market’s risk and return at a
given time.
 While standard deviation is the measure of risk in CML, Beta coefficient determines
the risk factors of the SML.
 While the Capital Market Line graphs define efficient portfolios, the Security Market
Line graphs define both efficient and non-efficient portfolios.
 The Capital Market Line is considered to be superior when measuring the risk factors.
 Where the market portfolio and risk free assets are determined by the CML, all
security factors are determined by the SML.
ARBITRAGE PRICING THEORY

Arbitrage pricing theory is one of the tools used by the investors and portfolio managers. The
capital asset pricing theory explains the returns of the securities on the basis of their
respective betas. According to the previous models, the investor chooses the investment on
the basis of expected return and variance. The alternative model developed in asset pricing by
Stephen Ross is known as arbitrage Pricing Theory. The APT theory explains the nature of
equilibrium in the asset pricing in a less complicated manner with fewer assumptions
compared to CAPM.
Arbitrage: Arbitrage is a process of earning profit by taking advantage of differential
pricing for the same asset. The process generates riskless profit. In the security market, it is of
selling security at a high price and the simultaneous purchase of the same security at a
relatively lower price. Since the profit earned through arbitrage is riskless, the investors have
the incentive to undertake this whenever an opportunity arises. In general, some investors
indulge more in this type of activities than others. However, the buying and selling activities
of the arbitrageur reduce and eliminate the profit margin, bringing the market price to the
equilibrium level.
The assumptions
1. The investors have homogenous expectations.
2. The investors are risk averse and utility maximisers.
3. Perfect competition prevails in the market and there is no transaction cost.
The APT theory does not assume (I) single period investment horizon, (2) no taxes (3)
investors can borrow and lend at risk free rate of interest and (4) the selection of the portfolio
is based on the mean and variance analysis. These assumptions are present in the CAPM
theory.
Arbitrage portfolio According to the APT theory an investor tries to find out the
possibility to increase returns from his portfolio without increasing the funds in the portfolio.
He also likes to keep the risk at the same level. For example, the investor holds A, Band C
securities and he wants to change the proportion of the securities without any additional
financial commitment. Now the change in proportion of securities can be denoted by Xa , Xb,
and Xc . The increase in the investment in security A could be carried out only if he reduces
the proportion of investment either in B or C because it has already stated that the investor
tries to earn more income without increasing his financial commitment. Thus, the changes in
different securities will add up to zero. This is the basic requirement of an arbitrage portfolio.
If X indicates the change in proportion,
∆Xa +∆ Xb + ∆Xc = 0
APT and CAPM
The APT differs from the CAPM in that it is less restrictive in its assumptions. It allows for
an explanatory (as opposed to statistical) model of asset returns. It assumes that each investor
will hold a unique portfolio with its own particular array of betas, as opposed to the identical
"market portfolio". In some ways, the CAPM can be considered a "special case" of the APT
in that the securities market line represents a single-factor model of the asset price, where
beta is exposed to changes in value of the market.
Additionally, the APT can be seen as a "supply-side" model, since its beta coefficients reflect
the sensitivity of the underlying asset to economic factors. Thus, factor shocks would cause
structural changes in assets' expected returns, or in the case of stocks, in firms' profitability.
On the other side, the capital asset pricing model is considered a "demand side" model. Its
results, although similar to those of the APT, arise from a maximization problem of each
investor's utility function, and from the resulting market equilibrium (investors are considered
to be the "consumers" of the assets).
MODULE 5:PORTFOLIO EVALUATION AND REVISION
Portfolio management is a complex process that may be divided into eight broad categories:
1. Investment objectives and constraints
2. Quantification of capital market expectations
3. Asset allocation
4. Formulation of portfolio strategy
5. Selection of securities
6. Portfolio execution
7. Portfolio rebalancing
8. Portfolio evaluation
1 Investment objectives
The investment objectives may be expressed as follows:
Objectives
 Return requirements
 Risk tolerance
Constraints and preferences
 Liquidity
 Investment horizon
 Taxes
 Regulations
 Unique circumstances
The commonly stated investment goals are income to provide a steady stream of income
through regular interest/dividend payment. Second is Growth to increase the value of the
principal amount through capital appreciation. Third to have stability to protect the principal
amount invested from the risk of loss.
2 Quantification of capital market expectations
Investor need to address the following questions:
 What asset classes should be included or excluded from the portfolio?
 What weights should be assigned to the selected asset classes
 Which specific securities or investments should be held, within each asset class, and
in what amounts?
The first two questions relate to asset allocation and the third question relates to security
selection. To address the questions relating to asset allocation, investor need to estimate
returns, standard deviations and correlations for various asset classes.
3 Asset allocation
 Strategic asset allocation: It is concerned with establishing the long term asset mix of
a portfolio.
 Tactical asset allocation: Allocating funds based on market movements.
 Drifting asset allocation: Initial portfolio be left undisturbed. It is essentially a buy
and hold strategy. Irrespective of what happens to relative values, no rebalancing is
done.
 Balanced asset allocation: Periodical rebalancing of the portfolio to ensure that the
stock – bond mix is in line with the long – term “normal” mix say 50% in stocks and
50% in bonds.
 Dynamic(insured) asset allocation: Shifting the asset mix mechanistically in response
to changing market conditions.
4 Formulation of portfolio strategy
Passive management
Passive management is a process of holding a well-diversified portfolio for a long term with
the buy and hold approach. Passive management refers to the investor's attempt to construct a
portfolio that resembles the overall market returns. The simplest form of passive management
is holding the index fund that is designed to replicate a good and well defined index of the
common stock such as BSE-Sensex or NSE-Nifty. The fund manager buys every stock in the
index in exact proportion of the stock in that index. If Reliance Industry's stock constitutes
5%of the index, the fund also invests 5 %of its money in Reliance Industry stock.
The problem in the index fund is the transaction cost. If it is NSE-Nifty, the manager has to
buy all the 50 stocks in market proportion and cannot leave the stocks with smallest weights
to save the transaction costs. Further, the reinvestment of the dividends also poses a problem.
Here, the alternative is to keep the cash in hand or to invest the money in stocks incurring
transaction cost. Keeping away the stock of smallest weights and the money in hand fail to
replicate the index fund in the proper manner. The commonly used approaches in
constructing an index fund are as follows:
1.Keeping each stock in proportion to its representation in the index
2. Holding a specified number of stocks for example 20, which historically track the index in
the best manner.
3. Holding a smaller set of stocks to match the index in a pre-specified set of characteristics.
This may be in terms of sector, industry and the market capitalization.
Active management
Active Management is holding securities based on the forecast about the future. The portfolio
managers who pursue active strategy with respect to market components are called 'market
timers'. The portfolio managers vary their cash position or beta of the equity portion of the
portfolio based on the market forecast. The managers may indulge in group rotations. Here,
the group rotation means changing the investment in different industries; stocks depending on
the assessed expectations regarding their future performance.
Stocks that seem to be best bets or attractive are given more weights in the portfolio than
their weights in the index. For example, Information Technology or Fast Moving Consumer
Goods industry stocks may be given more weights than their respective weights in the NSE-
50. At the same time, stocks that are considered to be less attractive are given lower weights
compared to their weights in the index. Here, the portfolio manager may either remain
passive with respect to market and group components but active in the stock selection process
or he may be active in the market, group and stock selection process.
5 Selection of securities
Selection of bonds
Evaluate the following factors in selecting fixed income avenues
 Yield to maturity
 Risk of default
  Tax shield
 Liquidity
Selection of stocks
Three broad approaches are employed for the selection of equity shares: technical analysis,
fundamental analysis and random selection. Technical analysis looks at price behavior and
volume data to determine whether the share will move up or down or remain trendless.
Fundamental analysis focuses on fundamental factors like the earnings level, growth
prospectus and risk exposure to establish the intrinsic value of a share. The recommendation
to buy, hold or sell is based on a comparison of the intrinsic value and the prevailing market
price. The random selection approach is based on whether the market is efficient and
securities are properly priced.
6 Portfolio execution
This step consists of implementing the portfolio plan by buying /selling specified securities in
given amounts. This is the phase of portfolio execution is to effectively handling the portfolio
to understand the what the trading game is like, what is the nature of key players(transactors)
in this game who are the likely winners and losers in this game, and what guidelines should
be borne in mind while trading.
7 Portfolio rebalancing
Portfolio rebalancing involves reviewing and revising the portfolio composition. There are
three basic principles with respect to portfolio balancing: buy or hold strategy, constant mix
policy and portfolio insurance policy
Under the buy and hold strategy, the initial portfolio is left undisturbed. Irrespective of what
happens to relative values, no rebalancing is done. The constant mix policy calls for
maintaining the proportions of stocks and bonds is say 50:50. The portfolio insurance policy
calls for increasing the exposure to stocks when the portfolio appreciates in value and
decreasing the exposure to stocks when the portfolio depreciates in value. The basic idea is to
ensure that the portfolio value does not fall below a floor level.
8 PORTFOLIO PERFORMANCE EVALUATION
Treynor’s measure
Treynor’s measure basically gives us a measure of return per unit of market risk (or
systematic risk) that our investment earns. Strictly speaking, the larger the Treynor measure
the better. However, we would like to have some benchmark with which to compare our
individual Treynor measures
R  Rf
Ti  i
i
Sharpe performance measure: Thus, the Sharpe measure gives us a measure of return
per unit of total risk. Again, the higher the Sharpe measure, the better the performance.
We can also compare individual Sharpe measures to a benchmark:
Ri  R f
Si 
i
Comparing the Treynor and Sharpe measures
◦ For a completely diversified portfolio of assets, the Sharpe and Treynor
measures would be identical in what they are measuring
◦ Treynor measures performance relative to systematic risk
◦ Sharpe measures performance relative to total risk
Jensen’s Performance Index: it is a measure absolute performance because a definite
standard is set and against that the performance is measured. The standard is based on the
manager’s predictive ability. Successful prediction of security price would enable the
manager to earn higher returns than the ordinary investor expects to earn in a given level of
risk.
Rp-Rf = α +β (Rm-Rf)

Ri RFR
PORTFOLIO REVISION
The portfolio management process needs frequent changes in the composition of stocks and
bonds. In securities, the type of securities to be held should be revised according to the
portfolio policy. If the policy of investor shifts from earnings to capital appreciation, the
stocks should be revised accordingly.
The formula plans
The formula plans provide the basic rules and regulations for the purchase and sale of
securities. The amount to be spent on the different types of securities is fixed. The amount
may be fixed either in constant or variable ratio. This depends on the investor's attitude
towards risk and return. The commonly used formula plans are rupee cost averaging, constant
rupee value, the constant ratio and the variable ratio plans. The formula plans help to divide
the investible fund between the aggressive and conservative portfolios.
The aggressive portfolio consists more of common stocks which yield high return with high
risk. The aggressive portfolio's return is volatile because the share prices generally fluctuate.
The conservative portfolio consists of more bonds that have fixed rate of returns. It is called
conservative portfolio because the return is certain and the risk is less.
Assumptions of the formula plan
1. The first assumption is that certain percentage of the investor's fund is allocated to
fixed income securities and common stocks. The proportion of money invested in
each component depends on the prevailing market condition. If the stock market is in
the boom condition lesser funds are allotted to stocks.
2. The second assumption is that if the market moves higher, the proportion of stocks in
the portfolio may either decline or remain constant. The portfolio is more aggressive
in the low market and defensive when the market is on the rise.
3. The third assumption is that the stocks are bought and sold whenever there is a
significant change in the price. The changes in the level of market could be measured
with the help of indices like BSE-Sensitive Index and NSE-Nifty.
4. The fourth assumption requires that the investor should strictly follow the formula
plan once he chooses it.
5. The investors should select good stocks that move along with the market. They should
reflect the risk and return features of the market. The stock price movement should be
closely correlated with the market movement and the beta value should be around 1.
Rupee Cost Averaging
The simplest and most effective formula plan is rupee cost averaging. First, stocks with good
fundamentals and long term growth prospects should be selected. Such stocks' prices tend to
be volatile in the market and provide maximum benefit from rupee cost averaging. Secondly,
the investor should make a regular commitment of buying shares at regular intervals. Once he
makes a commitment, he should purchase the shares regardless of it stock's price, the
company's short term performance arid the economic factors affecting the stock market.
Constant Rupee Plan
Constant rupee, constant ratio and variable ratio plans are considered to be true formula
timing plans. These plans force the investor to sell when the prices rise and purchase as prices
fall. Forecasts are not required to guide buying and selling. The actions suggested by the
formula timing plan automatically help the investor to reap the benefits of the fluctuations in
the stock prices.
The essential feature of this plan is that the portfolio is divided into two parts, which consists
of aggressive and defensive or conservative portfolios. The portfolio mix facilitates the
automatic selling and buying of bonds and stocks.
The plan The constant rupee plan enables the shift of investment from bonds to stocks and
vice-versa by maintaining a constant amount invested in the stock portion of the portfolio.
The constant rupee plan starts with a fixed amount of money invested in selected stocks and
bonds. When the price of the stocks increases, the investor sells sufficient amount of stocks to
return to the original amount of the investment in stocks. By keeping the value of aggressive
portfolio constant, remainder is invested in the conservative portfolio.
The investor must choose action points or revaluation points. The action points are the times
at which the investor has to readjust the values of the stocks in the portfolio. Stocks' values
cannot be continuously the same and the investor has to be watchful of the market price
movements. Stocks' value in the portfolio can be allowed to fluctuate to a certain extent.
Percentage change in price like 5 %, 10%or 20%can be fixed by the investor. Allowing only
small percentage change would result in a lot of transaction cost and would not be beneficial
to the investor. If the action points are too large, the investor may not be able get full benefit
out of the price fluctuations.
Constant Ratio Plan
Constant ratio plan attempts to maintain a constant ratio between the aggressive and
conservative portfolios. The ratio is fixed by the investor. The investor's attitude towards risk
and return plays a major role in fixing the ratio. The conservative investor may like to have
more of bond and the aggressive investor, more of stocks. Once the ratio is fixed, it is
maintained as the market moves up and down. As usual, action points may be fixed by the
investor. It may vary from investor to investor. As in the previous example, when the stock
price moves up or down by 10 to 20 per cent action would be taken. Here, 10 per cent is
taken as action point.
Variable ratio plan
According to this plan, at varying levels of market price, the proportions of the stocks and
bonds change. Whenever the price of the stock increases, the stocks are sold and new ratio is
adopted by increasing the proportion of defensive or conservative portfolio. To adopt this
plan, the investor is required to estimate a long term trend in the price of the stocks.
Forecasting is very essential to this plan. When there is a wide fluctuation variable ratio plan
is useful.