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SAPM Prepared by Dr. Ch. Ravi Varma

Security Analysis and Portfolio ManagementUNIT 1

The investment environment

Source: Investment Analysis and Portfolio Management, M. Ranganatham & R. Madhumathi

Classification of Financial Markets:

Financial Assets Intangible Assets

ASSETS

Physical Assets

Fixed AssetsLand

BuildingsMachine etc.,

Movable AssetsMaterials

MerchandiseJewellery (Gold)

Currency Instruments

CashForegn Currency

GoodwillPatents

CopyrightsRoyalties

Claim InstrumentsDebentures

SharesDeposits

Unit CertificatesTax Saving Instruments


Source: Investment Analysis and Portfolio Management, M. Ranganatham & R. Madhumathi

Domestic Segment

Currency Market/Forex market

Financial Markets

Securities Market

International MarketNational Market

Foreign Segment

Capital Market Money Market

Equity Market Debt Market

Primary Market Secondary Market

Derivative MarketSpot Market


Investment Meaning & Definition: investment is an activity that is engaged in by people who have savings i.e. investments are made from savings.

Investment may be defined as a “commitment of funds made in the expectations of some positive rate of return.”

Characteristics of Investment:

Return Risk Safety Liquidity

Objectives of Investment:

Maximisation of Return Minimization of Risk Hedge against Inflation

Investment Vs Speculation: Traditionally investment is distinguished from speculation with respect to four factors. These are:

Risk Capital Gain Time Period Leverage

Financial instruments (Investment Avenues available in India): Corporate Securities Deposits in banks and non-banking companies


UTI and other mutual fund schemes Post office deposits and certificates Life insurance policies Provident fund schemes Government and semi government securities

Regulatory Environment: In India the ministry of finance, the reserve bank of india, the securities and exchange board of India etc. are the major regulatory bodies exercising regulatory control and supervision over the functioning of the financial system in the country.

Primary market or New Issue Market: when a new company is floated, its shares are issued to the public in the primary market as an IPO (shares or debentures). Similarly when a company decides to expand its activities using either equity finance or bond finance, the additional shares or bonds may be floated in the primary market.

Functions of New Issue Market: Origination Underwriting Distribution

Origination: Origination is the preliminary work in connection with the floatation of a new issue by a company. It deals with assessing the feasibility of the project, technical economic and financial as also making all arrangements for the actual floatation of the issue. As part of the origination work, decision may have to be taken on the following issues:

Time of floatation of the issue Type of issue


Price of the issue

Methods of floating new Issues:

Public issue Rights issue Private Placements

Principal steps in floating a public issue: there are three distinct stages in the successful completion of a public issue.

Pre issue tasks Opening and closing of the issue Post issue tasks

Pre issue tasks: Drafting and finalization of the prospectus Selecting the intermediaries and entering in to agreements with them

o Merchant bankero Registrar to an issue: collect applications from investors. Keeping

a record of applications and monies received from investors. Assisting the stock issuing company in determining the basis of allotment of securities in consultation with the stock exchanges. Finalizing the list of persons entitled to allotment of securities. Processing and dispatching allotment letters, refund orders certificates and other related documents.

o Share transfer agento Banker to an issue: acceptance of applications and application

monies. Acceptance of allotment or call monies. Refund of application monies. Payment of dividend or interest warrants.


o Other formalities

Opening and Closing Date of the Issue:

Earliest closing date: should not be less than three days from the opening date.

Latest Closing Date: shall not exceed ten days from the opening date.

Post Issue Tasks: All application forms have to be scrutinised processed and tabulated When the issue is under subscribed, underwriters are liable to

subscribe to the shortfall When it is oversubscribed, the bases of allotment has to be decided in

consultation with the stock exchange Allotment letters and certificates have to be dispatched to the

allottees. Refunds have to be dispatched to the rejected applications. Shares have to be listed in the stock exchanges for trading, for this

company has to enter in to a listing agreement with the stock exchange.

Regulation of Primary Market: up to 1992, primary market was controlled by the Controller of Capital Issues (CCI) appointed under the Capital Issues Control Act 1947. During that period, the pricing of capital issues was regulated by CCI. The SEBI was formed under the SEBI Act, 1992 with the prime objective of protecting the interests of investors in securities as well as for promoting and regulating the securities market. All public issues since jan, 1992 are governed by the rules, regulations and guidelines of issued by SEBI.

Book building:


SEBI guidelines defines book building as “A process undertaken by which a demand for the securities proposed to be issued by which a demand for the securities proposed to be issued by a body corporate is elicited and builtup and the price for such securities is assessed for the determination of the quantum of such securities to be issued by means of a notice, circular, advertisement document or information memoranda or offer document.”Incase the issuing company chooses to issue securities through book building process, then as per SEBI guidelines the issuer company can select any of the following methods.

1. 100% Book Building2. 75% Book Building and 25% Fixed Price3. 90% Book Building and 10% Fixed Price

Secondary Market

Stock Exchanges – Definitions:“A centralized market for buying and selling stocks where the price is determined through supply-demand mechanisms.”

“An organization that provides a facility for buyers and sellers of listed securities to come together to make trades in these securities.”

“Association of brokers and dealers in securities who transact business together.”

“An organized market place for securities featured by the centralization of supply and demand for the transaction of order’s by members, brokers for institutional and individual investors.”


According to the Securities Contracts Act 1956, which is the main law governing stock exchanges in India, “Stock exchange means any body of individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities.”

Functions of Stock exchanges:

It provides a market place for purchase and sale of securities such as shares, debentures, bonds etc.

Stock exchanges provide liquidity to the investments in securities i.e. it gives the investors a place to liquidate their holdings.

The stock exchanges help in the valuation of securities by providing the market quotations of the prices of securities.

Stock exchanges play the role of a barometer, namely an indicator of the state of health of the nation’s economy as a whole.

The stock exchanges provide the linkage between the savings in the household sector and the investments in the corporate sector. They indirectly help in mobilizing savings in channelizing them in to the corporate sector as securities.

No of Stock Exchanges in India and Important Exchanges: There are 25 stock exchanges in India. In which most of the transactions are carried out by two exchanges namely

Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Other important exchanges are Interconnected Stock Exchange of India (ISE) Over The Counter of Exchange of India (OTCEI)


Regulatory Body of Stock Exchanges:The securities contracts (Regulations) Act 1956 was regulating secondary market till SEBI Act 1992.Initially the SEBI was constituted as an interim administrative body in 1988 and given a statutory status on 30th Jan, 1992 by an ordinance to provide for the establishment of SEBI. Later in Apr, 1992 the SEBI Act was formed.

Securities trading:Trading system in stock exchanges are:

Floor Trading Screen Based Trading

The screen based trading systems are of two tpes:1. Quote Driven System2. Order Driven System

Quote Driven System: under the quote driven system the market maker, who is the dealer in a particular security, inputs, two way quotes into system i.e. his bid price (purchase) and offer price (Selling). Then the market participants place their orders based on the bid, order quotes. These are then atomatically matched by the system according to certain rules.Order Driven System: under the order driven system, clients place their buying and sell orders with the brokers. These are then fed in to the system. The buy and sell orders automatically matched by the system according to predetermined rules.

Types of orders: Market Order Limit Order Stop Order Stop Limit Orders Day Orders


Week Orders Month Orders Open Orders (GTC Good Till Cancelled Orders) Fill or Kill Orders.

Clearing and settlement procedures: Trading in stock exchanges is carried out in two phases. In the first phase, the execution of the orders submitted by clients takes place between brokers acting on behalf of the clients or investors.The process of securities, transfer of security and cash is done in the second phase which is known as the settlement of the trade.The earlier procedure of settlement was accounting period settlement. The stock exchanges now follow a settlement procedure known as “Compulsory Rolling settlement as mandated by SEBI. (T+2)T = Trade, T+1 = Custodian confirmation, T+2 = pay in / pay out of funds, T+3 = Auction of Shortage, T+4 = , T+5 = Pay in/ Pay off of auction shares.Depositories: NSDL ( Nov 6th 1996) & CDSL ( July 15th 1999)

Types of Speculators:Bulls Bears Lame Duck Stags

Calculation of Sensex and NIFTYSensex is calculated based on free float market capitalization methodMarket cap= total no.of shares*share priceFree float market cap= Market cap of all the openly traded sharesFree float market cap= Market cap * proportion of the shares freely tradedFree float Shares =openly traded shares ( Total no of shares - Promoters share)


Once the free float market cap of all the 30 stocks is calculated, it should be summed up and the value of sensed can be calculated based on the SENSEX base.

Thus the value of sensex is obtained

Base year for calculation of SENSEX is 1978-79Base year for calculation of NIFTY is 1995.

UNIT - 2CONCEPT OF RISK

Definition of Risk: The risk can be defined in terms of variability of returns. “Risk is the potential for variability in returns.” An investment whose returns are fairly stable is considered to be a low-risk investment. Whereas an investment whose returns fluctuate significantly is considered to be a high-risk investment.

Total Risk = Systematic Risk + Unsystematic Risk


1.Systematic Risks are out of external and uncontrollable factors, arising out of the market, nature of the industry and the state of the economy and a host of other factors.

2.Unsystematic Risks emerge out of the known and controllable factors, internal to the issuer of the securities or companies.

Examples of Systematic Risks:1. Market Risks – Changes in Market conditions2. Interest Rate Risks - Changes in interest rates3. Purchasing power or Inflation risks.

Examples of Unsystematic Risks:1. Business Risks relating to the industries2. Financial risks due to heavy interest burden or inefficient capital

management3. Management risk due to poor efficiency, faulty planning4. Labor and other input risks of the company.

measuring risk and returnsMeasurement of Return: The return depends on the cash inflows to be received from the investments.

Forecasted Dividend + Forecasted end of the Period Stock priceR = ---------------------------------------------------------------------------------------------

- 1Initial Investment

Exercise: Expected Dividend – Rs. 5/- Expected Stock Price at the end – 175/- Initial Investment – 120/-

Measurement of Expected Return when Probabilities are given:_ nX = ∑ Xi P(Xi)


i=1 _X = Expected Return Xi = Possible Returns

P (Xi) = related Probabilities.

Exercise: Possible Returns : 30, 40, 50, 60, 70Probabilities : 0.10, 0.30, 0.40, 0.10, 0.10

Risk: Expected returns are insufficient for decision making. The risk aspect should also be considered. The most popular measure of risk is the variance or standard deviation of the probability distribution of possible returns.

Measurement of Systematic Risk: The systematic risk of a security is measured by a statistical measure called Beta. The input data required for the calculation of beta are given historical data of returns of the individual security as well as the returns of a representative stock market index. Two statistical method may be used for the calculation of beta namely the correlation method and the regression method.

BOND ANALYSIS

Types of bonds:Premium Bonds, Investment Bonds, High Yield Bond, Government Bonds, Municipal bonds, Corporate Bonds, Convertible Bonds, Sinking Fund Bonds, Serial Bonds, Mortgage or Secured Bonds, Collateral Trust Bonds, Income Bonds, Adjustment Bonds, Assumed Bonds, Redeemable and Irredeemable Bonds.

Bond Pricing Theorems:Theorem 1: If a bond’s market price increases, then its yield must decrease, conversely, if a bond’s market price decreases, then its yield must increase.


Theorem 2: If a bond’s yield does not change during its life, then the size of its discount or premium will decrease as its ife gets shorter.Theorem 3: if a bond’s yield does not change during its life, then the size of its discount or premium will decrease at an increasing rate as its life gets shorter.Theorem 4: a decrease in a bond’s yield will raise the bond’s price by an amount that is greater in size than the corresponding fall in the bond’s price that would occur if there were an equal-sized increase in the bond’s yield.Theorem 5: the percentage change in a bond’s price associated with a change in its yield will be smaller if its coupon rate is higher.

Convexity:Price of a bond and its yield are inversely relative. The rise in bond price would cause a fall in yield and vice versa. This has been proved in theorem 1 of bond price theorem. 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 similar amount of increase in bond’s yield. Hence relationship is not linear. The relationship is often referred to convexity and it measures the sensitivity between them.The concept of convexity is applicable to all types of bonds. The degree of convexity differ from bond to bond depending upon the size of the bond, the years to maturity and the current market price.

Properties of Convexity:

Bond Price

YTM


Convexity of a curve is always defined as the rate of change of its slope, i.e., by its second derivative. The more quickly the slope of a curve changes in one direction, the more convex is the curve.

Property 1: A bond’s convexity is always positiveProperty 2: The dimension of a bond’s convexity is Years2

Bond immunization:Rise in interest rate reduces the bond’s price and hence investor increases a capital loss. Thus, a rise in interest rate has a positive effect and a negative effect also. The strategy of an investors to protect themselves from interest rate risk is referred to a bond immunization.Immunization is a technique that makes the bond holder to be relatively certain about the promised stream of cash flows. The opposite effect of coupon rate risk and the price risk can be made to offset each other.The coupon amount can be reinvested in the bonds offering higher interest rates and losses that occur due to fall in the price of bond can be offset and bond is said to be immunized. In a nut shell, immunization is the process of constructing bond portfolio so that the realized return will always be at least equal to the promised return.Immunization offers complete protection against interest rate risk only if the following conditions exist.

1. The investment is made in a default free bond or portfolio of bonds.2. The buy and hold strategy is adopted.3. There is only a time change in interest rate during the investment

horizon.4. The term structure is flat and5. The duration of a bond or portfolio of bond is matched with the

investment horizon.


Active bond management and passive bond management:Active Bond Management strategies: active bond management need to adopt more/enhanced investment strategies so as to attain effective bond portfolio. Based on the estimates of interest rates, investors would be able to render specific duration for their investment. If the interest rates are high then duration assigned would be less and if the interest rates are reasonable then duration will be more. After identifying the mispriced bonds, investors would be able to recognize the bonds which have been underpriced and overpriced and hence can be valued correctly. However, fulfilling these two objectives is a complicated activity and hence involves collection of accurate information and effective analysis which can be accomplished by adopting various investment strategies.1. Horizon Analysis: this is one of the efficient method to forecast interest rates. In horizon analysis, estimations are made with regard to reinvestment rates and future market yields based on which, the returns of various bonds are compared and evaluated for a specified time period to recognize.2. Bond Swaps: Bond swaps acts as an effective tool in assigning accurate value to the mispriced bonds. The bonds of underpriced are exchanged with the bonds of overpriced which ultimately enhances the investors rate of return.a) Substitution Swaps: in this swaps, even though bonds posses identical characteristics their value differs while dealing in trading activities and hence exchanged for different values.b) Pure yield pickup swap: the purpose of this swap is to earn more return by selecting long term bonds. If there exists any short term bonds, then even those bonds are transposed to long term bonds.c) Inter market spread swap: in this swap, higher returns are earned by exchanging the bonds of various markets, as return of one market would be different from other market.


d) Rate anticipation swap: in this swap, profits are earned by observing the movement of the market and thereby anticipating the rate of return.3. Contingent Immunization: contingent immunization is applied as far as the portfolio is able to gain profitable returns. Once, if it is noticed that the profits are not proper then immediately portfolio would be safeguarded. Contingent immunization is applied to both active and passive portfolio strategy.4. Riding the yield curve: these method is applicable to the portfolio managers whose aim is to obtain liquidity date and again reinvest. Another way is to ride the yield curve but it is subjected to certain condition.

Passive Bond Management strategies: in a passive bond portfolio, investors do not try to participate actively in trading activities so as to perform better than the market. Moreover, they expect a little low returns to be protected from uncertain risk.1. Buy and Hold strategies2. Indexing3. Techniques, Vehicles and Costs.4. Alternative Vehicles

EQUITY ANALYSIS

Introduction:Equity analysts employ two kinds of analysis, viz., fundamental analysis and technical analysis. Fundamental analysts assess the fair market value of equity shares by examining the assets, earnings prospects, cash flow projections, and dividend potential. Fundamental analysis differ from technical analysts who essentially rely on price and volume trends and other market indicators to identify trading opportunities.


The techniques of fundamental valuation which may broadly be divided into three categories:

Balance sheet valuation:a) Book value: The book value per share is simply the net worth of the company divided by the number of outstanding equity shares.Criticism: Balance sheet figures rarely reflect earning power and hence the book value per share cannot be regarded as a good proxy for the true investment value.

b) Liquidation value: The liquidation value per share =

value realized from liquidating Amount to be paid to all the creditors and all the assets of the firm - preference share holders

Number of outstanding equity shares

The liquidation value method appears more realistic than book value, there are two serious problems in applying it. 1. It is very difficult to estimate realized values of various assets. 2. Liquidation value does not reflect earning capacity.

Replacement Cost: This b/s measure considered by analysts in valuing a firm is the replacement cost of its assets less liabilities. The use of this

Discounted Cash Flow Techniques

Dividend Discount Model

Free Cash flow Model

Relative Valuation Technique Price-earning Ratio Price-book value ratio Price-sales Ratio

Balance Sheet Equation Techniques

Book Value Liquidation Value Replacement Cost

Techniques of Fundamental Equity Valuation


measure is based on the premise that the market value of a firm cannot deviate too much from its replacement cost. A major limitation in this method that organizational capital, a very valuable asset, is not shown on the balance sheet.

Although balance sheet analysis may provide useful information about book value, liquidation value, or replacement cost, the analyst must focus on expected future dividends, earnings and cash flows to estimate the value of a firm as a going entity.

Discounted Cash-flow techniquesa) Dividend Discount Model: According to dividend discount model, the

value of an equity share is equal to the present value of dividends expected from its ownership plus the present value of the sale price expected when the equity share is sold.

Assumptions: D1 S1

One year holding period: S0 = --------------- + -------------- (1+K)1 (1+K)1

D1 D2 Dn + Sn

Multiple Holding Period: S0 = ----------- + ---------- + ------- + -------------- (1+K)1 (1+K)2 (1+K)n

D1 d0(1+g)


Constant Growth Model: S0 = -------------- or ---------------- (K – g) (K – g)

Multiple Growth Model: S0 = V1 + V2

n Dt DN(1+g)S0 = ∑ --------- + ----------------------

t=1 (1+K)t (k - g)(1 + k)n

b) Free Cash flow model: The free cash flow model broadly involves determining the value of the firm as a whole (Enterprise value) by discounting the free cash flow to investors and then substracting the values of preference and debt to obtain the value of equity. It involves the following procedure:

1. Divide the future into two parts, the explicit forecast period and the balance period.

2. Forecast the free cash flow, year by year, during the explicit forecast period. FCF = NOPAT – Net investment

3. Calculate the weighted average cost of capitalWACC = Were + Wprp + Wdrd(1-t)

4. Establish the horizon value of the firm: the horizon value (VH) is the value placed on the firm at the end of the explicit forecast period (H years). Since the FCF is expected to grow at a constant rate of g beyong H, the horizon value is equal to:

FCFH+1VH = -----------------

WACC – g

5. Estimate the enterprise value


FCF1 FCF2 FCFH VHEV = ---------------- + --------------- + ---------- + ------------- + ----------------- (1+WACC) (1+WACC)2 (1+WACC)H (1+WACC)H

Part 1: Present value of the FCF during the explicit forecast periodPart 2: Present value of horizon value

6. Derive the equity value: Equity Value = Enterprise value – Preference value –Debt value.

7. Compute the value per share: Equity value / Number of outstanding equity shares.

Relative Valuation Model: Share Price

a) P/E ratio: ------------------------------- Earnings Per Share

(1 - b)P/E = ------------

r - gb) Price/ Book value: during the 1990s “Eugene Fama” and others suggested

that the PBV ratio explained to a significant extent the returns from stocks.

Price/book value ratio = Market price per share at time t / Book value per share at time t.

ROE(1 + g)(1 – b) PBV = -------------------------------

r - gc) Price/sales ratio: Market Value of Equity Capital / Annual sales of the firm.

PS to NPM ratio = PS / Net Profit Margin


d)Economic value added (EVA): A measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). (Also referred to as "economic profit".) The formula for calculating EVA is as follows:

EVA = Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)

Equity Portfolio Management:

UNIT – 3

Active Strategies Market Timing Sector Rotation Security Selection Use of a Specialized

Investment Concept

Passive Strategies Buy and Hold

Strategy Indexing Strategy

Equity Portfolio Strategies

Technical Analysis

Security Analysis

Fundamental Analysis


Fundamental Analysis - Introduction:Fundamental analysis is really a logical and systematic approach to estimating the future dividends and share price. It is based on the basic premise that share price is determined by a number of fundamental factors relating to the economic, industry and company. Hence, the economic fundamentals, industry fundamentals and company fundamentals have to be considered while analyzing a security for investment purpose.

Fig: EIC analysis Framework

Macroeconomic Analysis:Investors are concerned with those variables in the economy which effect the performance of the company in which they intend to invest. A study of these

Company AnalysisEconomy Analysis

Industry Analysis

Company Analysis

Economy

Analysis

Industry

Analysis


economic variables would give an idea about future corporate earnings and the payment of dividends and interest to investors.

Different economic variables in Financial analysis are: Growth rate of Gross Domestic Product and GNP Industrial Growth Rate Agriculture and monsoons Savings and investments Government budget and deficit Price level and inflation Interest rate Balance of payment, forex reserves, and exchange rate Foreign investments (FDIs and FIIs) Infrastructural facilities and arrangements sentiments

Industry analysis:“Industry is defined as a group of firms producing reasonably similar products which serve the same needs of a common set of buyers.” Industries are traditionally classified on the basis of products. The objective of industry analysis is to assess the prospects of various industrial groupings. Admittedly, it is almost impossible to forecast exactly which industrial sectors will appreciate the most. Yet careful analysis can suggest which industries have a brighter future than others and which industries are plagued with problems that are likely to persist for a while.

Concerned with the basics of industry analysis, divided into four parts:


Sensitivity to the business cycle Industry life cycle analysis Study of the structure and characteristics of an industry Profit potential of industries: Porter model.

Sensitivity to the business cycle:

Industry Life Cycle Analysis:

Pioneering Stage Rapid Growth Stage Maturity and Stabilisation stage Decline Stage

Study on Structure and Characteristics of an Industry:

I. Structure of the Industry and Nature of CompetitionII. Nature and Prospects of DemandIII. Cost, Efficiency and ProfitabilityIV. Technology and Research

Profit Potential of Industries: Porter Model

Financial Leverage

Sensitivity to the Business Cycle

Sensitivity of Sales Operating Leverage


Threat of New Entrants

Bargaining Power

Of Suppliers Bargaining Power of Buyers

Threat of New

Substitutes

Company analysis:Company analysis deals with the estimation of return and risk of individual shares. Many pieces of information influence investment decisions. Information regarding companies can be broadly classified into two broad groups: internal and external. Internal information consists of data and events made public by companies concerning their operations. The external sources of information are those generated independently outside the company. These are prepared by investment services and the financial press.

PotentialEntrants

The IndustryRivalry AmongExisting Firms

Suppliers Buyers

Substitutes

Financial Analysis

Company Analysis

Strategy Analysis Accounting Analysis


Strategy Analysis:

a) Competitive Strategy:Fig: Competitive Position of the firm

Superior

Relative Differentiation Position

InferiorSuperior Relative Inferior

Cost Position

b) Corporate Strategy Analysis:Suitability , adaptability, Government encouragement, Relations with suppliers and customers, credit standards etc.

Accounting Analysis: Disclosure of accounting information. Adherence to basic accounting standards.

Financial Analysis: Liquidity Ratios Profitability Ratios Leverage Ratios and Turnover Ratios

Cost-cum-differentiation advantage

Differentiation advantage

Low cost advantage

Stuck-in-the middle


Other Variables: Company market share Capacity utilization Modernization and expansion plans Order book position Availability of raw materials

Assessment of Risk: Degree of Operating Leverage Degree of Financial Leverage Degree of Combines Leverage

TECHNICAL ANALYSIS

The rationale behind technical analysis is that share price behavior repeats itself over time and analysts attempt to derive methods to predict this repetition. A technical analyst looks at the past share price data to see if he can establish any patterns. He then looks at current price data to see if any of the established patterns are applicable and, if so, extrapolations can be made to predict the future price movements. Although past share prices are the major data used by technical analysts, other statistics such as volume of trading and stock market indices are also utilized to some extent.

Methods of technical analysis:Dow theory (primary movements, secondary reactions and minor reactions)Price Charts (xy)Bar chartsLine chartsJapanese candlestick chartsChart Patterns:


Support and Resistance patternsReversal patterns (head and shoulder formation, inverse head and shoulder pattern)Continuation patterns (triangle, flags and pennants)

Elliot wave theory

Mathematical Indicators:Moving averagesOscillatorsMoving Average Convergence and Divergence (MACD)

Market Indicators:Breadth of the MarketShort InterestOdd-lot indexMutual fund cash ratio

MARKET EFFICIENCYEfficient Market Theory (EMF) definition: According to Fama, “An efficient market is a market where there are a large number of rational profit maximizers, actively competing with each trying to predict the future market and where the current information is almost freely and equally available to all participants”. Requirements:

1. The investors must be rational and able to recognize efficient assets.2. Information must be discussed freely and quickly across, so that all

investors can react to new information.3. Taxes are assumed to have no noticeable effect on investment policy.


4. Transaction costs such as sales commissions on securities are ignored.5. Every investor is allotted to borrow or lend at the same rate.

in 1990, a French mathematician named Louis Bachelier published a paper suggesting that security price fluctuations were random. In 1953, Maurice Kendall in his paper reported that stock prices are wandering one.They appeared to be random and each successive change is independent of the previous one. Therefore, the movement of stock prices in a random and unpredictable manner is known as random walk of share price. The randomness in prices are determined by competitive forces and perfect information flow and are independent of the past prices.

Forms of EMH: market efficiency refers to the ability of financial assets to quickly adjust and reflect all information that is relevant to value in its price. The subject of market efficiency involves a thorough study of the efficient market hypothesis. Depending up on the level of information considered, there are three forms of EMH. 1. Weak Form: also known as random walk model. It says that current prices fully reflected all historical information hence any attempt to predict prices based on historical price or information is totally futile as future price changes are independent of past price changes.Semi Strong Form: according to this form, current stock prices reflect all publicly available information such as earnings stock and cash dividends, splits, mergers and takeovers, interest rate changes, etc.Strong form: according to the strong form, prices of securities fully reflect all available information both public and private i.e., if this form is true, prices reflect the information that is available to only selected groups like the management, financiers and stock exchange officials.

Assumptions of Random Walk Theory:


1. market is perfect and free without trade restrictions.2. Market absorbs all the information quickly and efficiently.3. information is free and costless and is quickly available to all at the

same time.4. Information is unbiased and correct5. Market players can analyse the information quickly and the information

is absorbed in the market through buy and sell signals.Demand and supply pressures are absorbed in the market through price changes. Such absorption leads to promote quick (rapid) movements in prices but in a random fashion.

UNIT - 4

Portfolio risk Measurement and analysis: Meaning and Definition of Portfolio:A grouping of financial assets such as stocks, bonds and cash equivalents, as well as their

mutual, exchange-traded and closed-fund counterparts. Portfolios are held directly by investors

and/or managed by financial professionals.

Portfolio Return:the expected return on a portfolio is simply the weighted average return of the individual sets in the portfolio, the weights being the fraction of the total funds invested in each asset.

Rp = w1r1+w2r2+wnrn = ∑wjrj

Where:Rj = expected return on each individual asset.Wj = fraction for each respective asset investmentN = number of assets in the portfolio.

Portfolio Risk:


Unlike returns, the risk of a portfolio is not simply the weighted average of the standard deviations of the individual assets in the contribution, for a portfolio’s risk is also dependent on the correlation coefficients of its assets. The correlation coefficient is a measure of the degree to which two variables “move” together.

Markowitz ModelHarry Markowitz wrote an article titled Portfolio Selection that was published in 1952 and is the basis of Modern Portfolio Theory. In that paper, he laid out his mathematical arguments in favor of portfolio diversification. Markowitz shared the Nobel Prize in Economics in 1990 with two other scholars “for their pioneering work in the theory of financial economics.”Markowitz's theories emphasized the importance of portfolios, risk, the correlations between securities and diversification.According to MPT risk can be categorized as Systematic risk and Unsystematic risk. Diversification generally does not protect against systematic risk because a drop in the entire market and economy typically affects all investments. However, diversification is designed to decrease unsystematic risk.


Fig: The Efficient Frontier

Single Index ModelTo simplify analysis, the single-index model assumes that there is only 1 macroeconomic factor that causes the systematic risk affecting all stock returns and this factor can be represented by the rate of return on a market index. According to this model, the return of any stock can be decomposed into the expected excess return of the individual stock due to firm-specific factors, commonly denoted by its alpha coefficient (α), which is the return that exceeds the risk-free rate, the return due to macroeconomic events that affect the market, and the unexpected microeconomic events that affect only the firm. Specifically, the return of stock i is:ri = αi + βirm + ei

The term βirm represents the stock's return due to the movement of the market modified by the stock's beta (βi), while eirepresents the unsystematic risk of the security due to firm-specific factors.


Macroeconomic events, such as interest rates or the cost of labor, causes the systematic risk that affects the returns of all stocks, and the firm-specific events are the unexpected microeconomic events that affect the returns of specific firms, such as the death of key people or the lowering of the firm's credit rating, that would affect the firm, but would have a negligible effect on the economy. The unsystematic risk due to firm-specific factors of a portfolio can be reduced to zero by diversification.The index model is based on the following:

Most stocks have a positive covariance because they all respond similarly to macroeconomic factors.

However, some firms are more sensitive to these factors than others, and this firm-specific variance is typically denoted by its beta (β), which measures its variance compared to the market for one or more economic factors.

Covariances among securities result from differing responses to macroeconomic factors. Hence, the covariance (σ2) of each stock can be found by multiplying their betas by the market variance:

Cov(Ri, Rk) = βiβkσ2.

This last equation greatly reduces the computations, since it eliminates the need to calculate the covariance of the securities within a portfolio using historical returns and the covariance of each possible pair of securities in the portfolio. With this equation, only the betas of the individual securities and the market variance need to be estimated to calculate covariance. Hence, the index model greatly reduces the number of calculations that would otherwise have to be made for a large portfolio of thousands of securities.

Capital Asset Pricing Model


A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

Assumptions of CAPM:

1. All investors aim to maximize economic utilities (Asset quantities are given and fixed).

2. All investors are rational and risk-averse.3. Investors are broadly diversified across a range of investments.4. Investors are price takers, i.e., they cannot influence prices.5. All investors can lend and borrow unlimited amounts under the risk

free rate of interest.6. There are no transaction or taxation costs.7. Investors deal with securities that are all highly divisible into small

parcels (All assets are perfectly divisible and liquid).8. All Investors have homogeneous expectations.9. Information is available at the same time to all investors.

Capital Market Line:


A line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return.The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier. This is achieved visually through the security market line (SML).

Security Market Line:A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketable securities.

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.

The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed.

Arbitrage Pricing theory:


Introduction: an alternative model of asset pricing was developed by Stephen Ross and is known as Arbitrage Pricing Theory (APT). According to the theory, the returns of the securities are influenced by a number of macro economic factors such as growth rate of industrial production, rate of inflation, spread between low grade and high grade bonds.

Arbitrage Pricing for One Risk Factor & Two Risk Factor: the one factor model is equivalent to the CAPM, __ is equal to the risk free rate (R f). However, the assumptions of the two models differ. Both models assume investors:

1. prefer more wealth to less. 2. are risk-averse3. Have homogeneous expectations 4. That capital markets are perfect.

However, the APT, unlike the CAPM, does not assume:1. A one period horizon. 2. Returns are normally distributed3.A particular type of utility function 4. A market portfolio or5. That the investor can borrow or lend at the risk free return.

Assumptions of APT:1. The investors have homogenous expectations.2. The investors are risk averse and utility maximizers3. Perfect competition prevails in the market and there is no transaction

cost.

Advantages of APT:APT in Passive Management: multi index model can greatly improve the passive management of portfolios. Multi-index model can be used to track an index in a better way or to construct an appropriate passive portfolio for a client.


APT and Active Management: another application of APT is in identifying mispriced securities. This is similar to the CAPM model. Apt is used to estimate the required return on a stock based on the various return generating factors and sensitivity of the security to these factors. Along with the required rate of return, expected return on the stock is also estimated.

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Meaning: It is essentially the process of comparing the return earned on a portfolio with the return earned on one or more other portfolios or on a benchmark portfolio. It comprises two functions:

Measuring Portfolio Return:

(NAV1 – NAVt-1) + Dt + CtRP = ----------------------------------------

NAVt-1

Performance Evaluation Methods:

PerformanceEvaluation

Performance Evaluation

Performance Measurement

Methods of Performance Evaluation


Risk Adjusted Returns:

Sharpe Ratio or Reward to Variability Ratio:

Rp – RfSharpe Ratio (SR) = ---------------

σp

Treynor Ratio or Reward to Volatility Ratio:

Rp – RfTreynor Ratio (TR) = ---------------

βp

Differential Return Method or Jensen Ratio:

Expected Return of the E(Rp) = Rf + βp(Rm – Rf)

Differential Return Method

Decomposition of Performance

Risk Adjusted Returns

Treynor Ratio or Reward to Volatility

Risk Adjusted Returns

Sharpe Ratio or Reward to Variability


Differential Return αp = Rp – E(Rp)

Decomposition of Performance or Fama Method:

Total Return = Risk free return + Excess Return

Return on portfolio = Riskless rate + Return from market risk + Return from diversifiable risk + Return from pure selectivity. Rp = Rf + R1 + R2 + R3

R1 = βp(Rm – Rf)R2 = [(σp / σm) - βp] (Rm – Rf)R3 = Rp – (Rf + R1 + R2)

Fama’s net selectivity = Rp – [Rf + (σp / σm) (Rm – Rf)]

Portfolio RevisionNeed for Revision:The primary factor necessitating portfolio revision is changes in the financial markets since the creation of the portfolio. The need for portfolio revision may arise because of some investor related factor also. These factors may be listed as:

Availability of additional funds for investment. Change in risk tolerance Change in the investment goals. Need to liquidate a part of the portfolio to provide funds for some

alternative use.

Constraints in Portfolio Revision: Transaction Costs Taxes


Statutory Stipulations Intrinsic Difficulty

Portfolio Revision Strategies:Formula Plans: Constant Rupee Value Plan, Constant Ratio Plan, Dollar Cost Averaging plan.

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