Investment-Management-munotes

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INVESTME NTMANAGEME NT
Unit Structure
1.0Learning Objectives
1.1Introduction to Investment
1.2Objectives of Investment
1.3Need and Importance of Investment
1.4Investor & its types
1.5Philosophy of Investor
1.6Investor Opportunity
1.7Summary
1.0LEAR NING OBJECTIVES
After studying this lesson you are able to:
Understand the meaning of Investment.
Learn about Objectives and Types of Investment and Investors.
Know about different investor opportunity
1.1 INTRODUCTIO N
A person will be earning and spending money throughout his life.
Most of the times, there are imbalances between the earnings and spending
of a person. This imbalance will lead a person either to borrow or to save
to capitalize the long run benefits from the income.
When current inc ome is more than current consumption, people
tend to save the excess money. One option is to save the money in the
cupboard until some future time when consumption exceeds current
income or another option is that a person can give up the present
possession of this money for a further larger amount of money that will be
available for future consumption. Money does not have any value unless it
is invested. This trade -off of present consumption for future consumption
is the reason for savings. When the savings are made to make them
increase over time is called investment. Money has to be invested in some
financial asset to get a return. It is assumed that a person is risk averse and
simultaneously he expects a good return on the money that he invests.
Investm ent is the sacrifice of some present value for the uncertain
future reward. An investment decision is a trade -off between risk andmunotes.in

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2return. All investment choices are made in accordance with the personal
investment ends in contemplation of an uncertain futu re.
1.2 CONCEPT OF I NVESTME NT
The term investment has many facets and is used in many fields
like management, finance, economics etc. but we will be strictly sticking
ourselves to the meaning that is about keeping in mind the financial
market.
Warren B uffet, one of the most respected investors all around the
world and CEO & Chairman of one of the world famous Investment
Company Berkshira Hathway has opined that if a person invests money in
the market with even a hint of thought of selling it once the pr ice rises is
not at all an investment.
An investment is said to be genuine if it has been made keeping in
mind certain expected rate of return in mind. In the above case, if that
person had just taken the Tejas Network share without expecting the
dividends then it is not a genuine investment.
There are three things that compensate the investor collectively
from the Expected rate of Return such as : 1) Time 2) Inflation 3)
Uncertainty
The first one is the time for which the funds are committed. Let ’s
think that Mr. Akash has lot of excess money and he does not know what
to do with that so he just digs a hole on the floor of his home and buries all
the excess money for two years and after two years he takes money and it
should not be surprising for h im to find out that amount has not changed.
It is just to show that if he had invested the same thing like markets or
banks or post offices then he would have received some rate of interest
and this is called as pure rate of interest.
Second one is rate o f inflation. Just think that you have 100 rupees
now in your pocket and with that you can buy 2 kg of sugar but instead of
that you choose to invest it in market for one year. There is something
called as inflation which changes the purchasing value whenev er there is
fluctuation in its value so if the inflation rate is% per annum you would
definitely expect the investment that you have done in the market to give
you a return of 4 rupees so that you can buy the same 2kg of sugar after
one year. This is calle d as nominal rate of interest and it is the sum of pure
rate of interest and compensation for inflation.For example, A person purchases shares of Tejas Network
company worth 10000/ -intending to hold them for a long term
and expecting at least Rs. 50 dividends on them.
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3The third and the last one is uncertainty of the future payments.
The payments that we are expecting are uncertain .Hence,the risk element
is involve d and the investors are ready to take that risk and in return they
expect something called as risk premium. Risk premium is nothing but the
risk free returns plus extra returns for risk.
1.3 DEFI NITIO N
“An investment operation is one which, upon th orough analysis ,
promises safety of principal and an adequate return. Operation not meeting
these requirements are speculative.”
By Graham and Qadd’s Security Analysis ,
“Investment management is the process of managing money
including investments, budgeting, banking and taxes, also called as money
management.”
1.4 OBJECTIVES OF I NVESTME NT
When a person earns more than he spends, he has surplus money.
When the money is saved, it is kept in the form of cash and will be readily
available for use at any point o f time. But the money kept as cash remains
stagnant and does not grow it isbecause money has not been put into use.
When the money saved is put into some form of use, then it starts earning
and the owner get the return on it. A person who has surplus mone y is
prone to invest the same in some assets with the view to earn some return.
There is no guarantee on the money invested as it depends on the type of
the investment made and the risk level associated with it. There are
different types of assets availabl e for investment with different risk -return
characteristics and the investor will choose the assets which offers him
higher return for the level of risk he is prepared to take.
Primary Objectives
The options for investing our savings ar e continually increasing,
yet every single investment vehicle can be easily categorised according to
three fundamental characteristics –safety, income and growth which alsoObjectives of InvestmentPrimary Objectives1)Safety
2)Income
3)Growth of CapitalSecondary Objectives1)Marketability
2)Liquidity
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4correspond to type of investor objectives. While it is possible for an
investor to have more than one of these objectives, the success of one must
come at the expense of others.
1. Safety: -Perhaps, there is truth to the axiom that there is no such
thing as a completely safe and secure investment. Yet, we can get close to
ultimate safet y for our investment funds through the purchase of
government issued securities in stable economic systems, or through the
purchase of the highest quality corporate bonds issued by the economy’s
top companies. Such securities are arguably the best means of preserving
principle while receiving a rate or return.
The safety investment are usually found in the money market and
include such securities as Treasury bills (T -bills), Certificate of Deposits
(CD), Commercial Paper or in the fixed income bonds market in the form
of municipal and other government bonds, and in corporate bonds. The
securities listed above are ordered according to the typical spectrum of
increasing risk and, in turn, increasing potential yield. To compensate for
their higher risk, corpor ate bonds return a greater yield than T -bills.
2. Income: -The safety investment are also the ones that are likely to
have the lowest rate of income return or yield. Investors must inevitably
sacrifice a degree of safety if they want to increase their yield s. This is the
inverse relationship between safety and yield; as yield increases, safety
generally goes down, and vice versa.
In order to increase their rate of investment return and take on risk
above that of money market instruments or government bonds, investors
may choose to purchase corporate bonds or preferred shared with lower
investment ratings. Investment grade bonds rated at A or AA are slightly
riskier than AAA bonds, but presumably also offer a higher income return
than AAA bonds.
Most investo rs, even the most conservative minded ones, want
some level of income generation in their portfolios, even if it’s just to keep
up with the economy’s rate of inflation. But maximizing income return
can be an overarching principle for a portfolio, especiall y for individuals
who require a fixed sum from their portfolio every month.
3. Growth of Capital: -Growth of Capital is most closely associated
with the purchase of common stock, particularly growth securities, which
offer low yields but considerable opportunities for increase in value. For
this reason, common stock generally ranks among most speculative of
investments as their return depends on what will happen in anFor Example: A retired person who requires a certain amount
every month, is well served by holding reasonably safe assets
that provide funds over and above their income generating
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5unpredictable future. Blue -chip stocks, by contrast, can potentially offer
the best of all worlds by possessing reasonable safety, modest income and
potential for growth in capital generated by long term increase in
corporate revenues and earnings as the company matures. Yet, rarely is
any common stock able to provide the near absolute sa fety and income
generation of government bonds.
Secondary Objectives
1.Tax Minimisation: An investor may pursue certain investments in
order to adopt tax minimisation as part of his or her investment strategy. A
highly paid executive wants to seek investme nts with favourable tax
treatment in order to less er his or her overall income tax burden.
2.Liquidity: -Liquidity refers to an investment ready to convert into
cash position. In other words, it is available immediately in cash form.
Liquidity means that i nvestment is easily realisable, saleable or
marketable. When the liquidity is high, then the return may be low. For
example, UTI units. An investor generally prefers liquidity for his
investments, safety of funds through a minimum risk and maximisation of
return from an investment.
3.Marketability: -Marketability refers to buying and selling of Securities
in market. Marketability means transferability or saleability of an asset.
Securities are listed in a stock market which are more easily marketable
than which are not listed. Public Limited Companies shares are more
easily transferable than those of private limited companies.
4.Concealability: -Concealability means investment to be safe from
social disorders, government confiscations or unacceptable levels of
taxation, property must be concealable and leave no record of income
received from its use or sale. Gold and precious stones have long been
esteemed for these purposes, because they combine high value with small
bulk and are readily transferable.
1.5NEED A ND IMPORTA NCE OF I NVESTME NTS
An investment is an important and useful factor in the context of
present day conditions. Some important factors are :
• Longer life expectancy or planning for retirement
Investment decisions have become more signifi cant as most people
in India retire between the ages of 58 to 60 andso,they are planned to
save their money. Saving by themselves do not increase wealth, saving
must be invested in such a way that the principal and income will be
adequate for a greater n umber of retirement years. Longer life expectancy
is one reason for effective saving and further investment activity that help
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6• Increasing rates of taxation
When tax rate is increased, it will focus for generating saving by
tax payer. When the tax payer invest their income into provident fund,
pension fund, Unit Trust of India, Life Insurance, Unit Linked Insurance
Plan, National Saving Certificates, Development Bonds, Post Office
Cumulative Deposit Schemes etc. it affects the taxable income.
•H i g hi n t e r e s tr a t e s
Interest rate is one of the most important aspects of a sound
investment plan. The interest rate differs from one investment to another.
There may be changes between degree of risk and safe investments. They
may also differ due to different benefit schemes offered by the institutions.
A high rate of interest may not be the only factor favouring the outlet for
investment. Stability of interest is an important aspect of receiving a high
rate of interest.
•H i g hr a t eo f inflation
Inflation has become a continuous problem. It affects in terms of
rising prices. Several problems are associated and coupled with a falling
standard of living. Therefore, investor careful scrutiny of the inflation will
make further investment process delayed. Investor ensures to check up
safety of the principal amount andsecurity of the investment. Both are
crucial from the point of view of the interest gained from the investments.
• Larger incomes
Income is another important element of t he investment. When
government provides jobs to the unemployed persons in the country, the
ultimate result is ensuring of income than saving the extra income. More
incomes and more avenues of investment have led to the ability and
willingness of working pe ople to save and invest their funds.
Investment Channels
The growth and development of the country leading to greater
economic prosperity has led to the introduction of a vast areas of
investment outlets. Investment channels means an investor is willing to
invest in several instruments like corporate stock, provident fund, life
insurance, fixed deposits in the corporate sector and unit trust schemes.
1.6INVESTOR
“A person whose principal concern in the purchase of a security is
the minimizing of risk, compared to the speculator who is prepared to
accept calculated risk in the hope of making better -than-average profits, or
the ‘gambler’ who is prepared to take even greater risks. More generally it
refers to people who invest money in investment products .”
“An individual who makes investments. An investor can act on
behalf of others, for example, stock brokers or mutual fund managers
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7Types of Investors
Investors are mainly of two typ es:
Individual Investors
Individual Investor are individuals who invest their funds into
financial assets. They are in mass. Each individual will have
comparatively smaller amount of investible surplus. Majority of individual
investors lack the knowledge and skills required to carry out analysis of
the investment opportunities available in the market.
Institutional Investors
Institutional investor are institutions that mobilize money from
individuals and other sources and invest them in financial assets . Mutual
Funds, Insurance Companies, Investment Companies, Banks, NBFCs,
Financial Investment etc., are institutions who invest their surplus funds.
They engage professionals to manage their investment and to carry out
extensive analysis for making investm ents and continuously monitoring
the performance of the investments. Such professionals are also
responsible for corrective decisions and alteration of investment whenever
it is required. Institutional investors are better equipped to maximise their
return and minimise their risk.
Philosophy of Investor
•Safety Players
Safety Players who take the path of least resistance, looking
primarily for security and safety in their investments and doing what has
worked previously.
•Entrepreneurs
Entrepreneu rs are a particularly male -dominated profile driven by
a passion for excellence and commitment, and who are not motivated by
money in itself. Financial success is a scorecard and stock investment is a
method of implementing and demonstrating that success.
•Optimists
Optimists are non -risk oriented, often near retirement, seeking
peace of mind, these are investors who don’t like to become too involved
with their own financial management as it would cause them stress and
reduce their enjoyment of life.
•Hunters
Hunters are often educated, high -earning women with an impulsive
streak, a ‘live now attitude.’ They have a strong work ethic, much like
entrepreneurs, but lack the same confidence in themselves. They may
attribute their success to luck rather than ability.
•Achievers
Achievers are conservative, risk -averse, these investors like to feel
in control of their money, with security and protection of their assets amunotes.in

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8primary consideration. They are often, married, well educated, high -
earners who f eel that hard work and diligence is more likely to bring
financial reward than investing.
•Perfectionists
Perfectionists are afraid of making financial mistakes, they tend to
avoid investment decisions altogether. They lack confidence and self -
esteem, and have low pride in handling financial matters, finding every
conceivable excuse for not taking action. For them no investment is
without fault.
•Producers
Producers are highly committed to their work. They may earn less
due to a lack of self -confid ence in money management. And with a lack of
basic financial knowledge they may have less available funds to invest.
They do not appreciate how to evaluate risk appropriately.
•High Rollers
High Rollers are thrill seekers, power seekers, creative and
extroverted ;they work hard and play hard. They have to be involved in
high risk investing with a large amount of their assets. Financial security
bores them -even though their actions may have financially dangerous
consequences.
•Money Masters
Money Masters are tending to have a balanced financial outlook
that gives contentment and security; these investors like to be involved
with the management of their money and their choice of investments,
although they will take onboard good, sound adv ice. They are determined
individuals, not easily thrown of their chosen course, and who don’t leave
things to luck.
•Adventurers
Adventurers are confident ‘go for ’and ready to take chances.
•Celebrities
Celebrities are tho se who need to be in the center of things and
don’t like to be left out, often constantly checking whether they should be
in the latest fashionable investment but may not really have any clue as to
how to take control of their finances.
•Individualists
Individualists are confident individuals who make their own
decisions but who are methodical, careful, balanced and analytical.
•Guardians
Guardians are investors, often older ones, who are cautious and
intent on safeguarding their wealth, shunning volatility or excitement.munotes.in

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91.7INVESTME NT OPPORTU NITIES
Investment activity includes buying and selling of the financial
assets, physical assets and marketable assets in primary and secondary
markets. Investment activity involves the us e of funds or savings for
further creation of assets or acquisition of existing assets.
I.Financial Assets II. Physical Assets
III. Marketable Assets
A. Classification of Investme nt
On the Basis of Physical Investments
Physical investments are:
•H o u s e
•L a n d
• Building
• Gold and Silver
• Precious stones
On the Basis of Financial Investment
Financial investments further classified on the basis of:
i)Marketable and Tra nsferable investments
Marketable investments are: 3
Shares ( Equity Shares & Preference Shares)
Debentures of Public Limited Companies, particularly the listed
company in Stock Exchange
Bonds of Public Sector Units Government Securities, etc.Investor•C a s h
• Bank Deposits
•P F ,L I CS c h e m e s
•P e n s i o nS c h e m e s
• PO certificates and
Deposits•House, Land, Buildings, Flats• Gold, Silver and Metals•C o n s u m e rD u r a b l e sShares, Bonds, Govt.
Securities etc.
New Issue
(Primary Market)Stock Market
(Secondary Market)
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10ii)Non-Marketable Investments
Non-marketable investments are:
• Bank Deposits
• Provident and Pension Funds
• Insurance Certificates
• Post office Deposits
• National Saving Certificates
• Company Deposits
• Private Companies Shares etc.
B.Modes of Investm ent
Modes of investment consist of:
• Security Forms of Investment
•N o n -Security Forms of Investment/Non -Marketable Investment Security
Forms of Investment :
i)Security forms of investment includes the following:
• Corporate Bonds/Debenture
(a) C onvertible
(b) Non -Convertible
• Public Sector Bonds
(a) Taxable
(b) Tax Free
•P r e f e r e n c eS h a r e s
• Equity Shares
(a) New Issue
(b) Rights Issue
(c) Bonus Issue
ii)Non-Security Forms of Investment (non transferable)
Non-security forms of investmen t as outlined below:
• National Savings Scheme
• National Savings Certificates
•P r o v i d e n tF u n d s
(a) Statutory Provident Fund
(b) Recognised Provident Fund
(c) Unrecognised Provident Fund
(d) Public Provident Fund
• Corporate fixed deposits
(a) Pub lic Sector
(b) Private Sectormunotes.in

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11• Life insurance policies
(a) Whole Life Policies
(b) Limited -payment Life Policy
(c) Convertible Whole Life Assurance Policy
(d) Endowment Assurance Policy
(e) Jeevan Mitra
(f) The Special Endowment Plan with Profits
(g) Jeevan Saathi
(h) The New Money Back Plan
(i) Marriage Endowment/Educational Annuity Plan with Profits
(j) Bima Sandesh Premium Back Term Insurance Plan
(k) New Children’s Deferred Assurance Plan
(l) Jeevan Dhara
(m) New Jana Raksha Plan with Profits
(n) Jeevan Akshay Plan
(o) Jeevan Balya Plan
(p) Jeevan Kishor
(q) Jeevan Griha
(r) Jeevan Sarita and Others
• Unit schemes of Unit Trust of India (Some are marketable among these)
(a) Unit Scheme, 1964
(b) Reinvestment Plan, 1966
(c) Unit Linked Insurance Plan, 1971
(d) Capital Gains Unit Scheme, 1983
(e) Children’s Gift Growth Funds, 1986
(f) Parent’s Gift Growth Funds, 1987
(g) Monthly Income Unit Scheme with Extra Bonus Plus Growth
(h) Master Shares
(i) Master Gains
(j) Equity Linked Sav ings Scheme
(k) Growing Monthly Income Unit Scheme
(l) Master share Plus etc.
•Post Office Savings Bank Account
(a) Recurring Deposits
(b) Time Deposits
(c) Monthly Income Scheme
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12•Others
(a) Rahat Patras or Reli ef Bonds
(b) Kisan Vikas Patra
(c) Deposits in Co -operative Banks
(i) Recurring deposits
(ii) Time deposits, etc.
1.8SUMMARY
The purpose of this unit is to provide background that can be used
in subsequent chapters. To achieve that goal, we covered several topics:
We discussed why individuals save part of their income and why they
decide to invest their savings. We defined investment as the current
commitment of these savings for a period of time to derive a rate of
return that compensates for the time involved, the expected rate of
inflation, and the uncertainty.
We discussed the objectives of investment in which we studies the
primary objectives and secondary objectives of investment and also
explained the importance of investment.
We considered t he term ‘Investor’ ,explain edthe types of investor and
thephilosophy of investor s.
We discussed the different opportunities of Investment ,Classification
of Investment and Modes of Investment.
1.9REVIEW QUESTIO NS:
1.Define the term Investment. Explain the objectives of Investment
2.What is Investment? Explain the importance of Investment
3.Who is Investor? Discuss the Philosophy of Investor
4.Discuss the different opportunities for Investor.


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132
FUNDAME NTAL ANALYSIS
Unit Structure
2.0Learning Objectives
2.1Introduction
2.2Fundamental Analysis
2.3Economic Analysis
a)Introduction
b)Concept
c)Factors of Macro Economic Analysis
d)Economic Factors Influenced to Investment Management
2.4Summary
2.0LEARNING OBJECTIVES
After studying this lesson you are able to:
To understand the meaning of fundamental analysis
To know the impact of economic factors on stock value
To know the Economic factors influenced Investment Management
2.1INTRODUCTIO N
Investme nt decisions are a part of our economic life. Everybody
makes such decisions in different contexts at different times. Some are
able to reap more profits through them; while others simply lose their
money. Attempts should, therefore, be made to understand and know the
way sound investments decision can be made in order to improve the
change of making profit through them. Investment decision making being
continuous in nature should be attempted systematically. These are
fundamental analysis and technical ana lysis. In this approach, the investor
attempts to look at fundamental factors that affect risk return
characteristics of the security. While in the second approach, the investor
tries to identify the price trends that reflect these characteristics. Technic al
analysis concentrates on demand and supply of securities and prevalent
trend in share price mean by various market indices in the stock market.
2.2FUNDAME NTAL A NALYSIS
In the fundamental approach, an attempt is made to analyse various
fundamental or basic factors that affect the risk -return of the securities.munotes.in

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14The effort here is to identify those securities that one perceives as
mispriced in the stock market. The assumption in this case is that the
market price of the security and the price as justifie d by its fundamental
factors called intrinsic value are different and the market place provides an
opportunity for a discerning investor to detect such discrepancy. The
moment such a description is observed, a decision to invest or disinvest is
made. The d ecision rule under this approach is like this:
If the price of a security at the market price is higher than the one,
which is justified by the security fundamentals, sell that security. This is
because, it is expected that the market will sooner or later realise its
mistake and price the security properly. A deal to sell this security should
be based on its fundamentals, it should be both before the market correct
its mistake by increasing the price of security in question. The price
prevailing in market is called market price (MP) and the one justified by
its fundamentals is called intrinsic value (IV).
1. If IV > MP, buy the securities
2. If IV < MP, sell the securities
3. If IV =MP, no action
The fundamental factors mentioned above may relate to the
economy o r industry or company or some of this. Thus, economy
fundamentals, industry fundamentals and company fundamentals are
considered while prizing the securities for taking investment decision.
This framework can be properly utilized by making suitable adjustm ents
in a regular context. This kind of fundamental analysis is known as ‘top
down approach’ because the analysis starts from an analysis of the
economy, moves to industry, and narrows down to the company. This is
also called EIC (Economy, Industry and Com pany) analysis. Fundamental
analysis is a combination of economic, industry and company analysis to
obtain a stock’s current fair value and predict its future value.
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15The fundamental analysis of the investment management involves three
major steps. They are as outlined below :
• Economic Analysis
• Industry Analysis
• Company Analysis
2.3ECO NOMIC A NALYSIS
a) Introduction
Companies are a part of the industry, which itself is a part of the
overall economy. Thus, the performance of a company depends upon the
performance of the economy in the first place. In order to estimate stock
price changes, an analyst must spend more than a little time probing the
forces operating in the overall economy. A failure to examine the overall
economic influences is a naïve , that of assuming that individual companies
follow their own private paths in a vacuum.
It is important to predict the course of the national economy,
because economic activities affect corporate profits, investor attitudes and
expectations and then ulti mately influence the security prices. If the
economy is in recession or stagnation, ceteris paribus, the performance of
the company will be bad in general, with some exceptions. However, on
the other hand, if the economy is booming, income is rising and de mand is
good, then the industries and the companies in general may be prosperous,
with some expectations .However ,An outlook of subsiding economic
growth, can lead to lower corporate profits.
b) Concept
Economic analysis is a study of the general economic factors that
go into an evaluation of a security’s value. The stock market is an integral
part of an economy. When the level of economic activity is low, stock
prices are low, and when the level of economic activity is high, stock
prices are high, reflecti ng a booming outlook for the sales and profit of the
firms. An analysis of the macroeconomic environment is essential to
understand the behaviour of stock price.
c) Macro -Economic Analysis
The analysis of the following factors indicates the trends in macro -
economic changes that effect the risk and return on investment.
i. Gross Domestic Product
The economic well -being of any nation can be depicted through
several measures. However, the annual total output of goods and services
stands out as the best available measure. The most commonly used
measure of the aggregate output of any economy is the gross domestic
product (GDP).
Gross domestic product is the total market value of a nation’s
output. It is the market value of all final goods and services producedmunotes.in

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16within a given period of time by factors of production located within a
nation. It is a key concept in the national income and product accounts.
GDP, as a measure of the total production of an economy, acts as an
economic barometer of a nation.
ii. Savings and in vestment
It is obvious that growth requires investment, which is turn,
requires a considerable amount of domestic savings. Growth in savings
naturally leads to more investments. High capital investment means
possibility of more production, more demand and supply, better prices in
the future and consequently, higher business profits and a positive outlook
for the stock market. Savings are distributed over different assets like
equity shares, deposits, mutual fund units, real estate etc. The primary
market is a channel through which the savings of investors are made
available to corporate bodies.
iii. Inflation
A simple explanation of inflation is that it refers to a situation
where too much money is chasing too few goods. Inflation indicates a rise
in the price o f goods and services. Along with the growth of GDP, if the
inflation rate also increases, then the real rate of growth would be very
low. Inflation and stock market have a very close relationship. If there is
inflation, the stock market is adversely affect ed. The price of stock is
directly related to the performance of the company.
iv.Interest rates
Interest rate play a key role in the general business cycle and the
financial markets. When interest rates or interest rate expectations change,
the effects becom ef a r -reaching. When rates rises, consumer spend less,
slowing down the retail sales which lead to lower corporate profits, a
declining stock market, and higher employment. Vice versa holds good.
The effect of declining corporate profits on the stock marke t is
compounded by the fact that higher interest rates make interest bearing
investments more attractive, causing an exodus of money from the stock
market.
v.Budget and fiscal deficit
The budget draft provides a detailed account of government
revenues and expenditures. A deficit budget may lead to a high rate of
inflation and adversely affect the cost of production. A surplus budget may
result in deflation. A balanced budget is highly favourable to the stock
market.
Fiscal deficit is the difference between the government’s total
receipts (excluding borrowing) and total expenditure. It can be expressed
as follows:
Fiscal deficit = Total expenditure (revenue + capital) –( Revenue receipts
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17vi.Tax structure
Every year in march, the business community eagerly awaits the
statement from the government regarding the tax policy. Concession and
incentives given to a particular industry encourage investment in that
particular industry. The finance minister introduced tax exemptions for
stock market investments in union Budget (2012 -13) to attract retail
investors to the stock market. GST has been introduced in the year 2017.
vii.Balance of Payment
The balance of payment is the record of a country’s money receipts
from abroad and payments to fo reign countries. The difference between
receipts and payments may be surplus or a deficit. Balance of payment is a
measure of the strength of the rupee on the external account. If the deficit
increases, the rupee value may depreciate against other currenci es, thereby
affecting the cost of imports. Industries involved in the export and imports
are markedly affected by changes in the fore ign exchange rate. The
volatility of the foreign exchange rate affects the investment of the foreign
institutional investor s in the Indian stock market. A favourable balance of
payments has a positive effect on the stock market.
viii.Foreign Direct Investment
According to the International Monetary Fund (IMF), the
definition of the foreign direct investment (FDI) includes differen t
elements, namely, equity capital, reinvestment earnings of foreign
companies, inter -company debt transactions, short and long -term loans,
financial leasing, trade credits, investment made by foreign venture capital
investors and so on. FDIs help in the upgrading the technology, skills and
managerial capabilities and bring much needed capital into the economy.
They also help in providing employment opportunities.
ix. Investment by Foreign Institutional Investor (FIIs)
FIIs are considered to be the main driv ers of the stock market.
Outflows of FII investment affect the stock market negatively.
Considering the importance of FIIs investments, in Jan, 2012, the
government announced its decision to allow qualified foreign investor
(QFIs) to invest directly in the Indian equity market
x. International economic conditions
Worldwide economics are not independent but interdependent. The
boom or depression in one country affects other countries and the stock
market. For example, the sub -prime crisis in the US, bankruptci es and 29
% drop in the Dow Jones and NASDAQ had an impact on the Indian
economy.
xi.Monsoon and agriculture
In spite of technological advancements, Indian agriculture still
depends heavily on the monsoons. Good monsoon are a boon for
agriculture. Agricultur e is directly and indirectly linked to many
industries. For example ,the sugar, cotton, textile and food processingmunotes.in

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18industries depend upon agriculture for raw materials. Farm equipment,
fertilizer, and insecticide industries supply the inputs used in agric ulture.
A favourable monsoon leads to higher demands for these inputs, a bumper
crops and more disposable income in rural areas. This leads to buoyancy
in the stock market. When the monsoon fails, agriculture production and
hydropower generation decline. T hey cast a shadow on the share market.
xii.Infrastructure facilities
Good infrastructure facilities affect the stock market that is
favourable. Infrastructure facilities are essential for the growth of the
industrial and agricultural sectors. A wide communic ations network is a
must for the growth of the economy. Regular supply of energy without
any power cuts will enhance production. The banking and financial sector
should also be strong enough to provide adequate support to industry and
agriculture. In India , even though infrastructural facilities have been
developed, they are not enough. The government has liberalised its policy
for the communication, transport and power sector.
xiii.Demographic factors
Demographic data provide details about the population of ag e,
occupation, literacy and geographical location. This is needed to forecast
the demand for consumer goods. The population by age indicates the
availability of a skilled workforce. The cheap labour force in India has
encouraged many multinationals to laun ch their ventures. Indian labour is
cheaper compared to its western part. Population, by providing employees
and demand for products, affects industry and the stock market
d) Economic Analysis factors influenced Investment Management
•Demand of security fr om the investor. It has created a heavy demand
for security. If demand, the price value of the securities is increased in
the market.
•Demand and supply is also influenced byinvestment ;for example, if
supply of securities is greater, the result is the price of securities is
reduced.
•If demand for security, there is no supply, in this circumstance, the
price of such company’s shares is high.
•Economic factors have help to creation of savings.
•Economy tells something about theeffective way to ear n income and
then how to convert a successful saving avenue to the common people.
•Economical factors are infavour with investment decisions. If there is
inflation, the result is price increased for commodities. At the same
time, business earns more pr ofit that will beconvert as saving. If there
isdeflation ,the commodities price is reduced. At the same time,
common people save money and then will investment companies.munotes.in

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192.4SUMMARY
Fundamental analysis is the study of the economic factors, and the
industrial environment and other factors that have a bearing on the
company.
A commonly advocated procedure for fundamental analysis involves
three steps: Macro Economic Analysis, Industry analysis and
Company analysis.
The state of the economy determines th e growth of GDP and
investment opportunities.
An economy with favourable savings, investments, stable prices,
balance of payments, and infrastructural facilities provides the best
environment for common stock investment
The leading, coincidental and laggin g indicators help to forecast
economic growth. A rising stock market indicates a strong economy
ahead.
And, also explains the significance of Economical factors which are
favourable for investment decisions.
5. REVIEW QUESTIO NS:
1.What is fundamental Analy sis? Explain the concept of Economic
analysis.
2.What are the factors influencing economic analysis?
3.Explain the importance of economic analysis and the state the
economic factors considered for this analysis.
munotes.in

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203
INDUSTRY ANALYSIS (PART -A)
Unit Structure
3.0Learning Objectives
3.1Industry Analysis -Introduction
3.2Elements of Industry Analysis
3.3Need of Industrial Analysis
A. Classification of Industry
B. Industry Groups
3.4Summary
3.5Review Q uestions
3.0LEAR NING OBJECTIVES
After studying this lesson you are able to:
To understand the meaning of Industry analysis
To know the elements of industry analysis
To understand the need of industry analysis
To know the classification of industries and industrial groups
3.1INTRODUCTIO N
The term ‘Industry’ refers to a group of firms producing similar or
reasonably similar products. For example, textile industry includes
spinning mills, weaving mills, dyeing units, textile processing units,
garment man ufacturing units etc. In an economy, there will be many
industries. Textile, steel, automobile, chemical, food processing industry
etc. are some of the major industries.
The prospects of a company depend on the fortunes of the industry
to which the compan y belongs. Hence, an investor, before analysing the
company in which he is going to invest, has to analyse the industry to
which the company belongs. If a particular industry has good scope for
improved performance, a company belonging to that industry is also
expected to perform well unless the company has some inherent weakness
that may affect its performance. When a particular industry show signs of
growth, it offers a strong foundation for the different companies belonging
to that industry to perform we ll. For example., let us assume that textilemunotes.in

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21industry is found to have excellent growth prospects for the next ten years.
This conclusion could have been arrived at only after studying and
analysing various factors that have a bearing on the performance of the
textile industry. When the textile industry is expected to perform well for
the next ten years, it reveals that the different firms/companies that are
operating in the textile sector are also having good scope for showing
better performance for the ne xt ten years.
3.2ANALYSIS OF I NDUSTRY -ELEME NTS
Under a given economic condition, on the basis of structural and
operational features ,one industry may perform better that another. The
following are some of the key industry elements that need to be stu died:
i. Demand Supply Gap
The demand for a product depends on factors like consumer
preference, affordability, availability of substitute products etc. Since, the
factors that determine the demand for a product change gradually over a
period of time, the ch ange in demand for a product is also gradual. On the
other hand, the supply of a product depends on the existing production
capacity for the product and the rate at which additional production
capacities are added. In view of this, the production capacity for producing
a product does not vary smoothly, but will show irregular variations. Due
to this, there is bound to be gap between the demand and supply. There
can be shortage of production capacity in which case the demand will be
more than the supply. The re can also be a situation where the demand has
come down, making the available production capacity or may experience
under capacity.
ii. Growth rate of the industry
The faster the growth of an industry, the better it is. Analysing the
past performance of the industry in terms of growth and profitability will
throw light on the future prospects of the industry. The trend of growth in
the immediate past will act as a pointer to the likely future performance of
the industry. Centre for Monitoring Indian Economy (CMIE) published
periodically, statistical data on industry wise growth rate which will be of
great use for the analyst. CMIE has built a large and well -integrated
database on Indian economy.
iii. Competition
Competition is to be handled with care. While certa in amount of
competition existing in the industry among the domestic firms coupled
with that arising out of the foreign firms is desirable and adds to a healthy
growth of the industry, excess competition market structure. The
competition existing in an ind ustry is a direct function of the number of
firms operating in the industry, their market shares, their pricing policies,
degree of homogeneity in the products, entry and exist barriers and other
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22iv. Labour Conditions
As unions grow in power in our economy, the state of labour
conditions in the industry under analysis becomes even more important,
i.e. if we are dealing with a very labour intensive production process or a
very mechanized capital intensive process where labour performs crucial
operations, the possibility of a strike becomes an important factor to be
reckoned with. In a labour intensive industry, the variable costs would
undoubtedly dominate the fixed costs. However, even in this case the loss
of customer goodwill during a long s trike would probably bemore than
offset the possible advantages of low fixed costs.
v. Technology and Research
Industries have a certain degree of dependence on technology.
Some industries might be more affected by the changes in technology than
others. On having chosen an investment, which suits the risk profile of the
investor, important technological changes on the horizon and their
implications to the future performance of the industry must be carefully
scanned. A study also needs to be done on the resea rch and development
outlays as a percentage of the industry sales, as to how much of the
incremental sales and profitability can be attributed to the new products.
vi. Government’s Attitude Towards the Industry
There are industries that have historically had excessive
government controls, whether through direct or indirect means. Society,
environment, scarce natural resources and forex requirement are some of
the factors that make the government control the industry. As government
becomes more influential in attempting to regulate business and to
advocate consumer protection, the performance of the industry might well
be affected. Not necessarily that the government interference will drive it
out of the business but the profits of the industry can be adversely
affected. Sometimes an industry may loose its importance because of the
legal restrictions that are placed on it.
vii.Cost Structure and Profitability
Every industry has its own structure. Cost structure refers to the
proportion of fixed and variable costs. Certain industries (cement
industries, steel industries etc.) require a larger proportion of fixed cost.
When the proportion of fixed cost is higher, larger sales volumes are
required to reach the Break Even Point and profitability can be
strengthened by i mproving the capacity utilization of the plant to its
maximum possible limit. However, industries that have large fixed cost
have longer gestation period. Moreover, when the demand for their
product increases suddenly, the industry cannot immediately absor bt h e
increased demand since it will take a longer time and will also require
huge investments for creating additional production facilities to cater to
the increased demand. On the other hand, in industries where the fixed
cost forms only a smaller part o f the total cost, the Break even point will
be reached faster and additional production capacity, if warranted ,can be
created within a short period of time and with a comparatively smallermunotes.in

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23investment. Thus, industries with lower production of fixed cost e njoy
greater flexibility than industries that required a larger proportion of fixed
cost.
viii.Profit Margin
Average profit margin offered by industries differ. Over a period
of time, some industries may be offering a higher return as compared to
other industr ies. Higher profit margins over a period of time indicate
growth of the concerned industrial sector while lower profit margins
sustained for a longer period.
ix. Barriers to Entry
Entry barriers for new firms will protect existing firms in the
industry from c ompetition. The entry barrier may be either due to
Governement’s restrictions in allowing entry to new firms in the sector or
due to inherent conditions that are specific to the industry that make entry
of new firms difficult. For example, very huge capita l investment required,
non-availability of technical know -how etc are some of the factors that
may be inherent to a particular industry that will act as entry barriers to
new comers in the field. An industry that does not possess any entry
barriers is open to stiff competition and individual firms in the industry
should be always on vigil to ensure that they do not lose their competitive
position
3.3NEED OF I NDUSTRY A NALYSIS
Industry analysis is useful in a number of investment applications
that make use of fundamental analysis.
Understanding a company’s business and business environment:
Industry analysis is often a critical early step in stock selection and
valuation because it provides insights into the issuer’s growth
opportunities, competitive dyna mics, and the business risks. For a credit
analyst, industry analysis provides insights into the appropriateness of a
company’s use of debt financing and into its ability to meet its promised
payments during economic contractions.
Identifying active equit y investment opportunities:
Investors taking a top down investing approach use industry
analysis to identify industries with positive, neutral, or negative outlooks
for profitability and growth. Generally, investors will then overweight,
market weight, or underweight those industries relative to the investor’s
benchmark if the investor’s benchmark andif the investor judges that the
industry’s perceived prospects are not fully incorporated in market prices.
Apart from securities selection, some investors at tempt to outperform their
benchmarks by industry or sector rotation that is timing investment in
industries in relation to an analysis of industry fundamentals and business
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24Portfolio performance attribution:
Performance attribution, whic h addresses the sources of a
portfolio’s returns, usually in relation to the portfolio’s benchmark,
includes industry or sector selection. Industry classification schemes play
a role in such performance attribution.
A. CLASSIFICATIO NOF INDUSTRY
Industri es or Industrial activities can be further classified into four
categories. They are as mentioned below:
I. Extractive Industries
Extractive industries refer to those activities which are concerned
with the extraction or production of wealth from soil, air, water or from
beneath the surface of the earth. They include :
• Agriculture
• Mining
• Fishing
• Fruit gathering
II. Genetic Industries
Genetic industries refer to those activities which are undertaken for
reproducing or multiplying plants and animals wi th the object of earning
profit from their sale. Examples are:
• Nurseries raising seedlings and plants
• Cattle breeding
• Poultry farming etc.
III.Construction Industries
Construction industries refer to those activities which are
concerned with the crea tion of infrastructure necessary for economic
development. Examples are:
• Construction of buildings, roads, bridges, lines, dams, canals etc.
IV.Manufacturing Industries
Manufacturing industries refer to activities with the creation of
form utility. It me ans that, raw material converted into finished goods.
Examples are:
• Conversion of raw cotton into cotton textiles.
• Conversion of raw jute into jute manufactures.
• Production of sugar from sugarcane.
• Production of iron and steel from iron ore etc .munotes.in

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25Types of Manufacturing Industry
Manufacturing industries may be sub -divided into four types. They are:
a. Analytical Industries
Analytical industries refers to those manufacturing industries
which produce many types of products by analysing and separatin gt h e
same basic raw materials into different products. For example: Oil refining
is an analytical industry. In oil refining, the same crude oil is analysed and
separated into different products like petrol, diesel oil, kerosene,
lubricating oil etc.
b. Synthetic Industries
Synthetic industries refer to all those manufacturing industries
where various materials are combined together in the manufacturing
process to manufacture a new product.
For example: • Cement industry is a synthetic industry. i.e., ceme nt is
produced by a cement industry by combining many materials like as
concrete, gypsum, coal etc.
c. Processing Industries
Processing industries refer to those manufacturing industries where
the raw materials are processed through different stages/process into
finished goods.
For example: • Textile Industry • Paper Industry
d. Assembly Line Industries
Assembly line industries refer to those manufacturing industries
where different component parts that are already manufactured are
assembled into final produ cts.
For example: • Automobile Industry • Television Industry
B. INDUSTRY GROUPS
Industry groups can be classified:
oOn the basis of normal sizewise classification
It can be further classified into as follows:
• Small scale units
• Medium scale unit s
• Large sized industriesmunotes.in

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26oOn the basis of proprietary based classification
Industries have been classif ied on the basis of proprietary :
• Private Sector Industries
• Public Sector Industries
• Joint Sector (Jointly owned by private and public) Ind ustries.
oOn the basis of use based classification
Industries have also been classified on t he basis of use based :
• Basic Industries
• Capital Goods Industries
• Intermediate Goods
• Consumer Goods Industries
oOn the basis of input based classification
• Agro based products
• Forest based products
• Marine based products
• Metal based products
• Chemical based products
3.4SUMMARY
Industry analysis is the analysis of a specific branch of
manufacturing, service, or trade. Understanding the industry in which a
company operates provides an essential framework for the analysis of the
individual company. Equity analysis and credit analysis are often
conducted by analysts who concentrate on one or several industries, which
results in synergies and effici encies in gathering and interpreting
information.
Industry analysis is useful for :
Understanding a company’s business and business environment.
Identifying active equity investment opportunities.
Formulating an industry or sector rotation strategy.
Portf olio performance attribution.
Classification of Industry Analysis
Extractive Industries
Genetic Industries
Construction Industries
Manufacturing Industries
Industry Groupsmunotes.in

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27Industry groups can be classified:
o On the basis of normal sizewise classificati on
o On the basis of proprietary based classification
o On the basis of use based classification
o On the basis of input based classification
3.5REVIEW QUESTIO NS:
1.What is Industry Analysis? Explain the elements of industry analysis
2.Write a note on classifi cation of industry and groups of industry
3.Explain the Industry analysis and its need.

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284
INDUSTRY ANALYSIS (PART -B)
Unit Structure
4.0Learning Objectives
4.1Industry Analysis -Industry Life Cycle
4.2Economic Factor & Industrial Analysis
4.3SWOT analysis of Industries -Porter’s Five Force Model
4.4Summary
4.5Self Assessment Ques tion
4.0LEAR NING OBJECTIVES
After studying this lesson you are able to:
To know the stages of Industry Life Cycle and its limitations
To know the Economic Factor and Industry Analysis
To Understand Porter’s Five Force Model
4.1INDUSTRY A NALYSIS -INDUSTRY LIFE CYCLE
Every product is found to have a life cycle. Since, an industry is
made up of firms producing same or similar category of products every
industry also has a life cycle.
Industry have been found to go through the following four stages:
I.Pioneering Stage
II.Rapid Growth Stage
III.Maturity and Stabilization Stage
IV.Declining Stage
The above four stages make a complete life cycle for an industry
I.Pioneering Stage
In this stage, the prospective demand for the product is promising
and the technology of th e product is low. The demand for the product
encourages many producers to produce that particular product. There is
severe competition and only the fittest companies survive this stage. The
producers try to develop the brand name, differentiate the product ,a n d
create a product image. This leads to non -price competition too. The
severe competition often leads to the change of position of the firms inmunotes.in

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29terms of market share and profits. In this situation, it is difficult to select
companies for investment bec ause the survival rate is unknown.
Features of Fastest Growing/Pioneering Companies
In this stage, Active Investor will notice a great increase in the
activity of the company.
Production can raise and there will be great demand for the product.
In thi s stage, profit is high.
A heavy competition from competitors.
The competitive pressures keep on increasing with the entry of new
firms and the prices keep on declining and then ultimately the
companies Profits fall.
A few efficient companies run the bus iness and most of the other
companies are wiped out in the growing or pioneering stages of the
companies. Companies are wiped out in the growing or pioneering
stages of the companies.
II. Rapid Growth Stage
This stage starts with the appearance of surviving firms from the
pioneering stage. The companies that have withstood the competition
steadily improve their market share and financial performance. The
technology used in production improves resulting in low cost of
production and good quality products. The companies have stable growth
rate in this stage and they declare dividends to their shareholders. It is
advisable to invest in the shares of these companies. The pharmaceutical
industry has improved its technology and the top companies in this sector
are giving dividends to their shareholders. The power and
telecommunications industries can also be cited as examples of industries
in this expansion stage. In this stage the growth rate is more than the
industry’s average growth rate.
Features of Growing/Exp ansion Stage
In this stage, further investment is needed.
Product and services price is stabilised.
Companies earn huge profits.
Investor yield on good return from investment.
Companies internally generat efunds to keep financial requirement of
the org anisation.
This stage is also known as maturity stage for companies.
Companies start with expansion and diversification of products.
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30III. Maturity and Stabilization Stage
In the stabili zation stage, the growth rate tends to moderate and the
rate of growth more or less equals the industrial growth rate or the gross
domestic product growth rate. Symptoms of obsolescence may appear in
technology. To keep going, technological innovations in the production
process and products have to be introduced. Investors must closely
monitor the events that take place in the maturity stage of the industry
Features of Maturity and Stabilization
Increase in sales.
Profits of the company is tosome extent reduced.
During this stage, growth is also reduced.
Company spent huge amount for advertisement for promotion of
goods and service.
Investors plan and arecareful about their investment avenues in the
business.
Investors arecautious about future plan and ready to sell their
securities in the financial market.
IV. Declining Stage
In this stage, demand for the particular product and the earnings of
the companies in the industry decline. Nowadays, very few consumers
demand black and white television sets. I nnovation and changes in
consumer preferences lead to this stage. The specific feature of the
declining stage is that even in a boom ,the growth of the industry is low
and declines at a higher rate during a recession. It is better to avoid
investing in the shares of the low growth industry even during a boom.
Investment in the shares of these types of companies leads to erosion of
capital
Features of Declining Stage
Companies are continuously making loss in the business.
Investor has not received yield i n terms of dividend.
Customers are rejected to declining companies product.
Even investors los etheir principal amount.
Expenditure is increased and revenues is decreased.
Companies close their business units.
Investor looks for new investment opportu nities.munotes.in

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31Limitations of Industry Life Cycle
The four phases which industries go through as explained above
are based on the observation of the life cycle that different industries
undergo. There can always be expectations. However, continuous close
observation and judicious interpretation can reveal the industry life cycle
trend and characteristics. Industry life cycle has the following limitations: -
i.Since, the performance of companies, to a larger extend depends on
the performance of the industry concerned, a prudent investor will
have to study the industry life cycle first before deciding upon the
company which he chooses to invest.
ii.When an industry is in its pioneering stage, an investor should be
doubly cautious in choosing the companies for his investment. This
stage of the life cycle which is marked by high growth rate as well as
high mortality rate i smore suited for speculators than for prudent
investors.
iii.When an industry has moved into rapid growth stage, a prudent
investor must act quickly and increase his investment in the industry in
order to reap the benefits of rapid as well as stable growth. When an
industry shows signs of stagnation, a prudent investor should avoid
further financial commitments in the industry and should look for
other opportunities of investment that offers scope for better returns.
He can even switch his investments from industries that are in
stagnation stage to industries that are still in their growth stage.
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32iv.When an industry shows signs of decline, a prudent invest or must act
quickly and disinvest his holding in the industry in order to avoid
heavy losses that may follow soon if the investments in the declining
industrial sector are not withdrawn.
4.2ECO NOMIC FACTOR A NDINDUSTRY A NALYSIS
Investment decisions are a part of our economic life, made by
almost everybody in different contexts at different times. Long regarded as
an art, investment decision making has only recently been considered as
science with an attendant body of literature being developed helping us
understand its dynamics. Investment decision making is now accepted
both as an art as well as science. Decision makers attempt to update
themselves on the characteristics of return securities, which keep
changing. Their understanding needs sustained effor ts.Conceivable
investment opportunities were discussed earlier units.
As per research studies available so far, nearly 50 % of the stock
price changes can be attributed to market influences which are general and
are caused by the economic and industry fa ctors. It is therefore important
that any stock market investment is to be preceded by an economic
analysis and industry analysis. The economy and industry are so wide and
comprehensive that it is difficult to encompass all the likely factors
influencing t hem to be captured in any set of possible indicators.
As the stock market is supposed to be the window of the economy,
the totality of forces including socio -political factors operating on the
economy would influence the stock market.
In the economy, so me industries are expanding while others are
stagnant and some contracting, depending on the demand and market
conditions. The investor has to choose the growth industry and in that
industry, choose the scrips, undervalued as judged by his study and
analys is.
Investment Objectives
i.The basic objective of investment is the return on it or yields. The
yields are higher, the higher is the risk taken by investor. The riskless
return is the bank fixed deposit rate of 6 to 7% at present. Here, the
risk is least a s funds are safe and return are certain.
ii.Each investor has his own asset preference and choice of investments.
Thus, some risk averse operators put their funds in bank or post office
deposits or deposits/ certificates with co -operatives and PSUs. Some
invest in real estate, land and buildings while others invest mostly in
gold, silver and other precious stones, diamonds etc.
iii.Every investor aims at providing for minimum comforts of a house
furniture, vehicles, consumer durables and other household
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33future income, saving in insurance (LIC and GIC), pension and
provident funds etc.
iv.Lastly, after satisfying all the needs and requirements, the rest of the
savings would be invested in financial a ssets which will give him
future incomes and capital appreciation, so as to improve his future
standard of living. These may be stock/ capital market investment.
Cost Benefit Analysis
In making investment of the last point, namely, in financial assets
ofdeposits, bonds, debentures, shares etc. investment management
involves a cost benefit analysis.
The major costs are the risk involved and major benefits are the
returns involved. Risk is measured by the variability of the returns. But the
risk is of vari ous types :non-payment of dividend/ interest, delay or non -
payment of principal, variability of return or market value of investments.
These risks may be classified as: -
i.Company Risk
It is unique risk to the company ;about its own management practices
and operations.
ii.Business Risk
The risk of business is relative to trade/ business of the company,
product, inputs/ outputs etc.
iii.Market Risk and Financial Risk
Interest Rate, Labour problem, Inflation effect may lead to financial
and market risk
iv.Economy Risk of the Nation
Among economy risk, Government policies, Inflation, Monetary and
Fiscal Policies etc.
v.International Factors
International factors imports and exports and international prices of
inputs of domestic goods etc. can be cited.
The investor has to assess the costs and benefits of each investment,
in the process of Investment Management.
4.3SWOT A NALYSIS OF I NDUSTRIES
The strength of the industry and its competitiveness can be
analysed with the help of SWOT and porter’s Five Force Model. As
mentioned earlier ,elements of Industry analysis (in unit/chapter1.3) itself
would become strengths, weakness, opportunities and threats (SWOT) for
the industry. Hence ,the investor should carry out a SWOT analysis for the
chosen industry. Take for instance, increase in the demand for anmunotes.in

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34industry’s product becoming its strength, and the presence of numerous
players in the market, i.e., competition becoming a threat to a company in
the industry. The progress in the research and development in that
particular in dustry is an opportunity while the entry of multinationals in
the industry and cheap imports of the product are a threat to it. This is the
way the factors are arranged and analysed.
Porter’s Five Force Model
The competitive structure of an industry affec ts its profitability.
The competitive structure differs from industry to industry. Michael E.
Porter of Harvard Business School in 1979 came up with a model to
analyse the competitive structure of an industry. In his opinion, five
competitive forces decide the attractiveness and profitability of an
industry.
1. Threat of new entrants/competitors
2. Threat of Substitutes/ Pressure from Substitute Product
3. Bargaining power of Suppliers
4. Bargaining power of Buyer.
5. Rivalry among existing firms
1. Threat of new entrants/competitors
The entry of new companies in the market increases the
competition and reduces profitability. The barriers to entry decide the
number of new entrants. Entry barriers are higher in industries like aircraft
manufacture than in the car industry. The government rules and
regulations for establishing a company in such industries as the steel
industry may be more stringent than in others. The investment
requirements to establish a company, economies of scale, customer
switching cos ts, creation of distribution channels, and the resistance ofDegree ofCompetitionThreat of newentrants/competitBargaining
power of
Pressure
from
SubstituteProductRivalry among
existing firmsBargaining
power of
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35existing players are the main barriers for an entrepreneur to start a
company.
2. Threat of Substitutes/ Pressure from Substitute Product
Availability of substitute products reduces the scale of th e
industry’s products and in turn, the profitability. The threats posed by
substitutes depends on the following factors:
Willingness of the buyers to utilize substitute products
The price level of the substitute.
The degree of similarity and performance o f the substitute.
The cost incurred in switching over to substitutes
3. Bargaining power of Suppliers
Every industry requires raw materials for production. Suppliers
may be individuals or companies that provide the required raw materials
to the firm. The cos t of raw materials form a significant portion of the total
cost of production. If there are few suppliers, and they are also organised
as cartel, the suppliers bargaining power is high. When there are many
suppliers who are fragmented, their bargaining pow er is less. The
bargaining power of the supplier is high when:
Number of supplier is low.
There are many buyer.
Products are similar and of high worth.
There is the possibility of suppliers integrating forward into the
industry.
There is the profitability of buyers integrating backwards into supply is
lower
The product may be demanded by not just a single industry but by
others also.
4. Bargaining power of Buyer.
Here, customers of the industry’s product are referred to as buyers.
A strong customer can deman d a higher quality product or service for the
same price. If they cannot get that, they may move over to other similar
products. Usually, the more the number of customers for the industry’s
product, the less their commercial power over it. If the number of
producers is high, they can switch from one to the other. When the
products are similar and standardised, the possibility of a switch is high.
5. Rivalry among existing firms
In an industry, all the firms try to improve their market share. If it
is a fast moving consumer goods industry or the telecommunications
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36market share and keep their existing share intact. The intensity of
competition depends on the following factors:
The structure of competition: When there are more players, the
competition is high. It is less when there is a market leader, and if
there are cartels.
Cost Structure of the industry: In some industries, the fixed cost is
high. To make use of unutilised capacity, firms may cut the price of
the end product. This may create a market for their products and create
problems for the other players. At the same time, if the variable costs
are more than the fixed costs, the problem of using the unutilised
capacity may not arise.
Degree of Differentiation: Firms in industries with similar products
and specification typically face the following:
Stiff competition: Usually, coal and steel products are similar in
nature
Cost of switching: If the cost of switching from one product to
another is high, there will be less competition. In consumer goods, the
switching cost is less and hence the competition is high.
Strategies: The strategies followed by the competitors affect the level
of rivalry. If they follow an aggressive growth strate gy, the marketing
strategy will be aggressive. This will affect the level of competition.
Exit barriers: When firms face high exit barriers, the competition
may be severe.
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374.4SUMMARY
An industry’s position in its life cycle often has a large impact o n
its competitive dynamics, so it is important to keep this positioning in
mind when performing strategic analysis of an industry. Industries, like
individual companies, tend to evolve over time and usually experience
significant changes in the rate of gro wth and levels of profitability along
the way. Just as an investment in an individual company requires careful
monitoring industry analysis is a continuous process that must be repeated
over time to identify changes that may be occurring.
Au s e f u lf r a m e w o r k for analysing the evolution of an industry is an
industry life cycle, which identifies the sequential stages that an industry
typically goes through. The four stages of an industry life cycle are
Pioneering Stage
Rapid Growth Stage
Maturity and Stabiliz ation Stage
Declining Stage
The framework for strategic analysis known as “Porter’s five
forces” can provide a useful starting point. Porter maintains that
the profitability of companies in an industry is determined by five
forces:
i.The influence or threat of new entrants, which in turn is determined by
economics of scale, brand loyalty, absolute cost advantages, customer
switching costs, and government regulations.
ii.The influence or threat of substitute products,
iii.The bargaining power of customers, which is function of switching
costs among customers and the ability of customers to produce their
own product.
iv.The bargaining power of suppliers, which is function of the feasibility
of product substitution, the concentration of the buyer and supplier
groups, and switching costs and entry costs in each case and,
v.The intensity of rivalry among established companies, which in turn is
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384.5REVIEW QUESTIO NS:
1.Explain Industry Life Cycle Analysis? What are its limitations
2.Explain Porter Model of Industry analysis.
3.Why is industry analysis important? Why should it follow economic
analysis?
4.Industry life cycle shows the status of the industry and gives clues as
to entry and exit for investors. Elucidate
5.Discuss SWOT and Porter’s Five Force Model.

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395
COMPA NYANALYSIS
Chapter Outline
5.0Learning Objectives
5.1Introduction
5.2Need for Company Analysis
5.3Company Analysis
(Factors affecting the value of Stock prices of Company)
A] Business Model
B] Corporate Governance
C] Management
D] Operatin gE f f i c i e n c y
E] Capital Structure
F] Financial Performance
5.4Mode of Analysis
A] Economic Value added Method
B] Hybrid Valuation Model
C] Relative Valuation Model
5.5Analysis of Financial Statement
5.6Summery
5.7Self-Assessment Question s
5.0LEAR NING OBJECTIVES
After studying this lesson you are able to:
To know the factors influencing value of company
To understand different measurement of earnings
To understand mode of analysis
5.1INTRODUCTIO N
In the previous lesson ,we have dis cussed about Economic
Analysis and Industry Analysis and now in this lesson light is thrown on
company analysis. In the company analysis the investment analyst collectmunotes.in

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40all the information related to the company and evaluates the present and
future value of the stock. In this analysis, all the factors affecting the
earnings of a particular company are considered. The risk and return
associated with the purchase of a stock is analysed to take a better
investment decision. The valuation process depends upon th e investor
ability to draw information from the relationship and inter -relationship
among the company related variables. Up -todate information is required
on the status and trends in the economy, particular industries and firms.
Success in investing will b e largely dependent on:
Discovering new and credible information rapidly and in more
details then others do. This depends upon the analyst ability to develop a
system that couples original thoughts and unique ways of forming
expectations about the prospec ts for individual company. For this purpose
various public and private sources of information are analyzed.
Applying superior judgement so as to ascertain the relevance of
information to the decision at hand. Judgement depends upon one’s
knowledge and exp eriences. By applying various tools of analysis to the
data, the investor formulates expectations and judgement about the
alternatives available to him.
Internal information consists of data and events made public by firms
concerning their operations. The principle information sources
generated internally by a firm are its financial statements.
External sources of information are those generated independently
outside the company. They provide supplement to internal sources. A
good analyst must train himse lf to understand the kind of flexibility
permitted in accounting and the effect of this flexibility on his
interpretation of what he sees.
5.2NEED FOR COMPA NYANALYSIS
In order to provide proper perspective to company analysis, let us
begin with the wa y investor makes investment decisions given his goal
maximization. For earning better profits ,investors apply simple and
common sense decision rule of maximization. I.e. Buy the share at a low
price & sell the share at high price. This rule is very simple to understand,
but difficult to apply in actual practice. Huge efforts are made to
operationalize it by using a proper formal & analytical framework. In this
respect ,fundamental analysis provides the investor a real benchmark in
terms of intrinsic value. The value is dependent upon industry and
company fundamentals. Company analysis provides a direct link to
investor’s action and his investment goal in operational terms. This is
because an investor buys the equivalent of a company and not that of
industry or economy. This framework provides him with a proper
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41essential that a careful examination of company’s quantitati ve and
qualitative fundamentals is carried out.
5.3COMPA NYANALYS IS
Company analysis is a process carried out by investors to evaluate
securities, collecting info related to the company’s profile, products and
services as well as profitability. A company analysis incorporates basic
info about the company, like the miss ion statement and apparition and the
goals and values. During the process of company analysis, an investor also
considers the company’s history, focusing on events which have
contributed in shaping the company.
Also, a company analysis looks into the good s and services offered
by the company. If the company is involved in manufacturing activities,
the analysis studies the products produced by the company and also
analyses the demand and quality of these products. Conversely, if it is a
service business, th e investor studies the services put forward. In the
company analysis ,the investor assimilates the several bits of information
related to the company and evaluates the present and future values of the
stock. The risk and return associated with the purchase of the stock is
analysed to take better investment decisions. The valuation process
depends upon the investors’ ability to elicit information from the
relationship and inter -relationship among the company related variables.
Fundamental analysis is the met hod of analyzing companies based
on factors that affect their intrinsic value. There are two sides to this
method: the quantitative and the qualitative. The quantitative side
involves looking at factors that can be measured numerically, such as the
company ’s assets, liabilities, cash flow, revenue and price to -earnings
ratio. The limitation of quantitative analysis, however, is that it does not
capture the company’s aspects or risks unmeasurable by a number of
things like the value of an executive or the r isks a company faces with
legal issues. The other side of fundamental analysis isthequalitative side .
Although relatively more difficult to analyze, the qualitative factors are an
important part of a company. Since they are not measured by a number,
they mostlyrepresent an either negative or positive force affecting the
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42Factors affecting the value of Stock prices of Company
Thepresent and future values are affected by a number of factors and they
are given in figure.
A] BUSI NESSMODEL
This is referred to as a company's business model –it's how a
company makes money. You can get a good overview of a company's
business model by checking out its website. Sometimes business models
are easy to understand. Take Dominos, for instance, which sells Pizzas,
soft drinks, Chococakes and whatever other new special they are
promoting at the time. It's a simple model, easy enough for anybody to
understand.
Other times, you'd b e surprised how complicated it can get. Boston
Chicken Inc. is a prime example of this. Back in the early '90s its stock
was the darling of Wall Street. At one point the company's CEO bragged
that they were the "first new fast -food restaurant to reach Rs. 1 Crore in
sales since 1969". The problem is, they didn't make money by selling
chicken. Rather, they made their money from royalty fees and high -
interest loans to franchisees. Boston Chicken was really nothing more than
a big franchisor. On top of this, m anagement was aggressive with how it
recognized its revenue. As soon as it was revealed that all the franchisees
were losing money, the house of cards collapsed and the company went
bankrupt .
At the very least, you should understand the business model of any
company you invest in. The " Oracle of Omaha ", Warren Buffett, rarely
invests in tech stocks because most of the time he doesn't understand
them. This is not to say the technology sector is bad, but it's not Buffett's
area of expertise; he doesn't feel comfortable investing in this area.
Similarly, unless you understand a company's business model, you don't
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43know what the dr ivers are for future growth, and you leave yourself
vulnerable to being blindsided like shareholders of Boston Chicken were.
B] CORPORATE GOVER NANCE
Corporate governance describes the policies in place within an
organization denoting the relationships and responsibilities between
management, directors and stakeholders . These policies are defined and
determined in the compa ny charter and its bylaws, along with corporate
laws and regulations. The purpose of corporate governance policies is to
ensure that proper checks and balances are in place, making it more
difficult for anyone to conduct unethical and illegal activities. Good
corporate governance is a situation in which a company complies with all
of its governance policies and applicable government in order to look out
for the interests of the company's investors and other stakeholders.
Although, there are companies and o rganizations that attempt to
quantitatively assess companies on how well their corporate governance
policies serve stakeholders, most of these reports are quite expensive for
the av erage investor to purchase.
Fortunately, corporate governance policies typically cover a few
general areas: structure of the board of directors, stakeholder rights and
financial and information transparency. With a little research and the right
questions i n mind, investors can get a good idea about a company's
corporate governance.
Financial and Information Transparency
This aspect of governance relates to the quality and timeliness of a
company's financial disclosures and operational happenings. Sufficient
transparency implies that a company's financial releases are written in a
manner that stakeholders can follow what management is doing and
therefore have a clear understanding of the company's current financial
situation.
Stakeholder Rights
This aspect of corporate governance examines the extent that a
company's policies are benefiting stakeholder interests, notably
shareholder interests. Ultimately, as owners of the company, shareholders
should have some access to the board of directors if they have co ncerns or
want something addressed. Therefore companies with good governance
give shareholders a certain amount of ownership voting rights to call
meetings to discuss issues with the board.
Structure of the Board of Directors
The board of directors is c omposed of representatives from the
company and representatives from outside of the company. The
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44independent assessment of management's performance, making sure that
the interests of shareh olders are represented.
The key word when looking at the board of directors is
independence. The board of directors is responsible for protecting
shareholder interests and ensuring that the upper management of the
company is doing the same. The board poss esses the right to hire and fire
members of the board on behalf of the shareholders. A board filled with
insiders will often not serve as objective critics of management and will
defend their ac tions as good and beneficial, regardless of the
circumstances.
C]MANAGEME NT
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. Th e basic objective of management
is to attain the stated objectives of the company and once these objectives
are achieved, investors will have a profit. A management that ignores
profit does more harm to the investors than one that over emphasizes it.
The g ood management depends on the qualities of the manager. Koontz
and O’Donnell suggest the following as a special trait of an able manager:
➢Ability to get along with people
➢Leadership
➢Analytical competence
➢Industry
➢Judgement
➢Ability to get things done.
Since the traits are difficult to measure, managerial performance is
evaluated against setting and accomplishing a verifiable objective. If the
investor needs greater proof of excellence of management, he has to
analyse management ability. The anal ysis can be carried out on the
following ways:
a)The background of managerial personnel contributes much to the
success of the management. The manager’s age, educational background,
advancement within the company, levels of responsibility achieved and
the activities in the social sphere can be studied.
b)The record of management over the past years has to be reviewed. For
several companies what the top management have done during its tenure
in office are given in the financial weeklies and monthlies alo ng with
critical comments. This gives an insight into the ability of the top
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45c)The management’s skill to have market share ahead of others is a proof
of managerial success. The investor can rely on this type of management
and choose the stock .
d)The next criterion the investor should analyse is the company’s strength
to expand. A firm may expand from within and diversify products in the
known lines. Sometimes it may acquire other company to expand its
market. The horizontal or vertical expan sion of the production is a health y
sign of an efficient management.
e)The management’s ability to maintain efficient production by proper
utilization or Plant and machinery has to be analysed. Suitable inventory
planning and scheduling have to be drafte da n dw o r k e do u tb yt h e
management.
f)The management’s capacity to finance the company adequately has to
be studied. Accomplishing the financial requirement is a direct reflection
of managerial ability. The management should adopt a realistic dividend
policy in relation to earnings. A realistic dividend policy boosts the image
of the company’s stock in the market.
g)The functional ability of management to work with employees and
union is another area of concern. A union poses a threat to the smooth
functioning of the firm. In this context ,the management should be able to
maintain harmonious relationship with the employees and unions.
h)The management’s adaptability to scientific management and quality
control techniques should be analysed. The managem ent should be able to
give due weightage to maintain technical competence.
After analyzing the above mentioned factors, the investor should
select companies that possess excellent management and maintain the
competitive position of the company in the mark et. The investor should
also remember that the individual traits of a single manager alone cannot
make the company profitable and there should be a strong management
system to do so.
D]OPERATI NGL E V E R A G E
If the firm’s fixed cost is high in the total cost the firm is said to
have a high degree of operating leverage. Leverage means the use of a
lever to raise a heavy object with a small force. High degree of operating
leverage implies, other factors being held constant, relatively small change
in sales resu lt in a large change in return on equity. This can be explained
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46Let us take firm A and B. The firm A has relatively small amount
of fixed charges say, `40,000. Firm A would not have much automated
equipment, so its depreciation and maintenance costs are low. The variable
cost per cent is higher than it would be if the firm used more automated
equipment .In the other case ,firm B has high fixed costs, `1,20,000.
Here the firm uses automated equipment (with which one operator
can turn out many units at the same labour cost) to a much larger extent.
The break -even occurs at `40,000 units in firm A and `60,000 units in
firm B.
The selling price (P) is `4; the variablecost is `3 for firm A and `2 for firm
Bp e r cent.
The break -even occurs when ROE (return on equity) = 0, and hence, when
earnings before interest and taxes (EBIT) = 0.
EBIT = 0 =PQ –VQ–F
Here,
P is the average sales price per unit of output,
Q is units of output, V is the variable cost per unit, a nd F is the fixed
operating costs.
The break -even quantity is = F / (P -V)
For Firm A = = 40,000 units
For Firm B = =60,000 units
To a large extent, operating leverage is determined by technology.
For example, telephon e companies, iron and steel companies and electric
utilities have heavy investments in fixed assets leading to high fixed costs
and operating leverage. On the other hand ,cosmetics companies, and
consumer goods producing companies may need significantly lo wer fixed
costs, and hence lower operating leverage. The investor should understand
the operating leverage of the firm because the firm with high operating
leverage is affected much by the cyclical decline. The operating efficiency
of the firm determines t he profit expectation of the company.
E]CAPITAL STRUCTURE
The equity holders’ 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 c omputing
leverage ratios. The debt ratio indicates the position of the long term and
short term debts in the company finance. The debt may be in the form of
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47Preference Shares
In the early days the pr eference share capital was never a
significant source of capital. At present, many companies resort to
preference shares. The preference shares induct some degree of leverage
in finance. The leverage effect of the preference shares is comparatively
lesser than the debt because the preference share dividends are not tax
deductible. If the portion of preference share in the capital is larger, it
tends to create instability in the earnings of the equity shares when the
earnings of the company fluctuate. Someti mes the preference share may
be convertible preference share; in that case it dilutes the earnings per
share. So the investor should look into the preference share component of
the capital structure.
Debt
Long term debt is an important source of finance. It has the
specific benefit of low cost of capital because interest is tax deductible.
The leverage effect of debt is highly advantageous to the equity holders.
During the boom period the positive side of the leverage effect increases
the earnings of the s hare holders. At the same time, during recession the
leverage effect inducts instability in earnings per share and can lead to
bankruptcy. Hence, it is important to limit the debt component of the
capital to a reasonable level. The limit depends on the fir m’s earning
capacity and its fixed assets.
i) Earnings Limit of Debt
The earnings determine whether the debt is excessive or not. The
earnings indicate the probability of insolvency. The ratio used to find out
the limit of the debts is the interest covera ge ratio i.e., the ratio of net
income after taxes to interest paid on debt. The ratio shows the firm’s
ability to pay the interest charges, the number of times interest is covered
by earnings.
ii) Assets Limit to Debt
This asset limit is found out by fix ed assets to debt ratio. The
financing of fixed assets by the debt should be within a reasonable limit.
For industrial units the recommended ratio level is below 0.5.
F]FINANCIAL PERFORMA NCE(FINANCIAL STATEME NTS)
a) Balance Sheet: The level, trends, an d stability of earnings are powerful
forces in the determination of security prices. Balance sheet shows the
assets, liabilities and owner’s equity in accompany. It is the analyst’s
primary source of information on the financial strength of a company.
Acco unting principles dictate the basis for assigning values to assets.
Liability values are set by contracts. When assets are reduced by
liabilities, the book value of shareholder’s equity can be ascertained. The
book value differs from current value in the m arket place, since market
value is dependent upon the earnings power of assets and not their cost of
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48b) Profit and Loss account : It is also called as income statement. It
expresses the results of financial operations during an accou nting year i.e.
with the help of this statement we can find out how much profit or loss has
taken place from the operation of the business during a period of time. It
also helps to ascertain how the changes in the owner’s interest in a given
period has tak en place due to business operations. Last of all, for
analyzing the financial position of any company following factors need to
be considered for evaluating present situation and prospects of company.
Limitations of Financial Statements
1.The financial stat ements contain historical information. This
information is useful; but an investor should be concerned more about
the present and future.
2.Financial statements are prepared on the basis of certain accounting
concepts and conventions. An investor should know them.
3.The statements contain only information that can be measured in
monetary units. For example, the loss incurred by a firm due to flood
or fire is included because it can be expressed in monetary terms. The
loss incurred by the company due to the loss of reputation is not given
in the statement because it cannot be measured in monetary unit.
4.Sometimes management may resort to manipulation of data and
window dressing. This can be carried out by a. Method of charging
depreciation b. Valuation of inven tory c. Revaluation of fixed asset
d. Changing the accounting year
An investor should scrutinize the financial statements to find out
the manipulations, if any. The auditors’, report and notes to the balance
sheet give vital clue to the investor in this regard. Analysis of financial
statements should be undertaken only after nullifying the effects of any
such manipulation.
5.4MODE OF A NANLYSIS
Nowadays ,investors are aware that relying only on the earning per
share and Return on equity to measure the performance of a company do
not reflect the value of the company’s share. Earnings does not reflect the
changes in the risk and inflation. Further ,they do take account of
additional cost of capital in vested in the business in the growth process.
Therefor e, alternative methods are used to assess the performance of the
company. These are follows:
2.1.4 A] Economic Value Added Method
It is a financial performance method to calculate the true economic
profit of the company. EVA is an estimate of the amount b yw h i c h
earnings exceeds or fall short of the required minimum rate of return for
shareholders or lenders at comparable risk. EVA can be calculated at
divisional level. EVA is economic and based on the idea that a business
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49EVA can be calculated as :
EVA = Net Operating Profit after Tax -(Capital Invested
Weighted Avg. Cost of Capital)
EVA can be used for the following purpose:
Setting organisational goals
Performance measurement
Determining bonus
Motivating managers
Capital budgeting
Corporate valuation
2.1.4 B] Hybrid Valuation Method
The income and asset -based approaches to valuation have relative
strengths as well as obvious limitations. For example, the income
approach allow s for specific and direct estimation of future benefits to the
owners, which is consistent with the theory of value. On the other hand, if
the estimation of future benefits is directly based on historical income, the
precision of the estimate will depend h eavily on the persistence embodied
in the historical income measure and on the growth assumptions
incorporated into the model. If, for example, current or historical income
contains large transitory components, the relationship between historical
and futur e income may be distorted. In addition, to the extent an
inappropriate discount rate is utilized, value estimates will be adversely
affected. Asset -based valuation approaches can be effective in the accurate
identification of individual asset and liability values will yield a reliable
value estimate. In addition, unlike the income approach, an equity
discount rate, the estimation of which can have a significant impact on the
valuation conclusion, is not required for an asset -based approach. On the
other han d, it is often difficult to accurately restate book value to current
value for an array of assets, especially when a significant amount of
unrecorded intangible asset sexists. This method includes the
characteristics of both income and asset based valuatio nm e t h o d s .
For example, the income approach allows specific and direct
estimation of future benefits to the owners, which is consistent with the
theory of value. The estimation of future benefits is directly based on
historical income .The precision of the estimate will depend heavily on the
persistence embodied in the historical income measure and on the growth
assumptions incorporated into the model asset -based valuation ,
approaches can be effective in the accurate identification of individual
asset an d liability values will yield a reliable value estimate. In addition,
unlike the income approach, an equity discount rate, the estimation of
which can have a significant impacton the valuation conclusion, is not
required for an asset -based approach. Taken collectively, however, income
and asset -based valuations generally yield better valuation accuracy and
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502.1.4 C]Relative Valuation Model
A relative valuation model is a business valuation method that
compares a firm's value to that of its competitors to determine the firm's
financial worth. Relative valuation models are an alternative to absolute
value models, which try to determine a company's intrinsic worth based on
its estimated future free cash flows discounted to their present value .L i k e
absolute value models, investors may use relative valuation models when
determining whether a company's stock is a good buy. Relative valuation
uses multiples and benchmarks to determine the firm’svalue. A
benchmark is selected by finding an average and that average is used to
determine relative value. There are many different types of relative
valuation ratios, s uch as price to free cash flow, enterprise value (EV),
operating margin, price to cash flow forreal estate and price -to-sales ( P/S)
for retail. One of the most popular relative valuation multiples is the price -
to-earnings (P/E) ratio. It is calculated by dividing stock price by earnings
per share (EPS). A company with a high P/E ratio is trading at a higher
price per dollar of ear nings than its peers and is considered overvalued.
Likewise, a company with a low P/E ratio is trading at a lower price per
dollar of EPS and is considered undervalued. This framework can be
carried out with any multiple of price to gauge relative market v alue.
5.5ANALYSIS OF FI NANCIAL STATEME NT
The analysis of financial statements reveals the nature of
relationship between income and expenditure, and the sources and
application of funds. The investor determines the financial position and
the progress of the company through analysis. The investor is interested in
the yield and safety of his capital. He cares much about the profitability
and the management’s policy regarding the dividend. For this purpose ,one
can use the following simple analysis.
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512.1.5 A] Comparative Financial Statements
A set of comparative financial statements presents a company’s financial
performance for two or more consecutive periods in side -by-side columns.
The presentation is also referred to as the comparative format becaus e it
allows users to easily compare performance results from one period to the
next without having to look at multiple financial statements . Both periods’
statements are shown on a singl e report. The main purpose of a
comparative statement is, (you guessed it ), to compare two or more
different accounting periods together. Most of the time only two peri ods
are shown because reports listing too many columns tend to become
cluttered and difficult to read. Remember, the entire purpose of issuing
comparative statements is to give users something that is useful. A report
with ten years of accounting informati on can be difficult to read.
You can think of the comparative format like two financials that
are listed side -by-side on one report. Some comparative statements also
have two additional columns for ratios and analyzes. Typically one
column is added for t he total dollar amount of change between the two
periods and another is added for the percentage change. These columns
allow users to easily see the difference in performance from one period to
the next.
Example
The most common comparative financials are year-end statements.
These reports show the activity for both years. For example, a comparative
income statement might cover 2019 and 2020 year -end activity. Income
andexpenses from both years are listed side -by-side with an additional
column showing the variance between each year.
Investors and creditors can easily look at the variance column to
see why profits were up or down. For instance, net income might be lower
in year 2020, but total revenues are similar. By looking at the comparative
expenses, users can see that 2020 has much higher expenses resulting in a
lower net income .
2.1.5 B] Trend Analysis
In order to compare the financial statements of various years trend
percentages are significant. Trend analysis helps in future forecast of
various items on the basis of the data of previous years. Under this
method ,one year is taken as base year and on its basis the ratios in
percentage for other years are calculated. From the study of these ratios ,
the changes in that item are examined and trend is estimated. Sometimes
sales maybe increasing continuously and the inventories may also be
rising. This would indicate the loss of market share of a particular
company’s product. Likewise ,sales may have an increasing trend but
profit may remain the same. Here the investor has to look into the cost and
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52One year is taken as the base year. Generally, the first year is taken
as the base year. The figure of base year is taken as 100. The trend
percentages are calculated in relation to this base year. If a figure in other
year is less than the figure in base ye ar, the trend percentage will be less
than 100 and it will be more than 100 if figure is more than the base year
figure. Each year’s figure is divided by the base year figure.
Trend Percentage =
2.1.5 C] Common Size Statement
The c ommon -size statements, balance sheet and income statement
are shown in analytical percentages. The figures are shown as percentages
of total assets, total liabilities and total sales. The total assets are taken as
100 and different assets are expressed as ap e r c e n t a g eo ft h et o t a l .
Similarly, various liabilities are taken as a part of total liabilities.
These statements are also known as component percentage or 100
per cent statements because every individual item is stated as a percentage
of the total 100. The short -comings in comparative statements and trend
percentages ,where changes in items could not be compared with the
totals ,have been covered up. The analyst is able to assess the figures in
relation to total values.
The commo n-size statements may be prepared in the following way:
(1) The totals of assets or liabilities are taken as 100.
(2) The individual assets are expressed as a percentage of total assets, i.e.,
100 and different liabilities are calculated in relation to to tal
liabilities. For example, if total assets are Rs 5 lakhs and inventory
value is Rs 50,000, then it will be 10% of total assets
(50,000 ×100/5,00,000)
2.1.5 D] Fund Flow Analysis
The balance sheet gives a static picture of the company’s position
on a pa rticular date. It does not reveal the changes that have occurred in
the financial position of the unit over a period of time.
The investor should know,
a) How are the profit utilized?
b) Financial source of dividend
c) Source of finance for capital expendi tures
d) Source of finance for repayment of debt
e) The destiny of the sale proceeds of the fixed assets and
f) Use of the proceeds of the share for debenture issue or fixed deposits
raised from public.
These items of information are provided in the funds flow
statement. It is a statement of the sources and applications of funds. It
highlights the changes in the financial condition of a business enterprise
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53amount of funds generated or lost in operations. He could see how these
funds have been divided into three significant uses like taxes, dividends
and reserves. Moreover, the application of long term funds towards the
acquisition of current assets can be found out. This would reveal the re al
picture of the financial position of the company.
2.1.5 E] Cash Flow Analysis
The investor is interested in knowing the cash inflow and outflow of the
enterprise. The cash flow statement expresses the reasons of change in
cash balances of company betw een two dates. It provides a summary of
stocks of cash and uses of cash in the organization. It shows the cash
inflows and outflows. Inflows (sources) of cash result from cash profit
earned by the organization, issue of shares and debentures for cash,
borrowings, sale of assets or investments, etc. The outflows (uses)of cash
results from purchase of assets, investment redemption of debentures or
preferences shares, repayment of loans, payment of tax, dividend, interest
etc. With the help of cash flow statem ent the investor can review the cash
movement over an operating cycle. The factors responsible for the
reduction of cash balances in spite of increase in profits or vice versa can
be found out.
2.1.5 F] Ratio Analysis
Ratio is a relationship between two figures expressed
mathematically. It is quantitative relationship between two items for the
purpose of comparison. Ratio analysis is a technique of analyzing
financial statements. It helps in estimating financial soundness or
weakness. Ratios present the r elationships between items presented in
profit and loss account and balance sheet. It summaries the data for easy
understanding, comparison and interpretation.
Because Ratio Analysis is based upon accounting information, its
effectiveness is limited by the distortions which arise in financial
statements due to such things as Historical Cost Accounting and inflation.
Therefore, Ratio Analysis should only be used as a first step in financial
analysis, to obtain a quick indication of a firm's pe rformance and to
identify areas which need to be investigated further. The ratios are divided
in the following group:
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542.1.5 F] a) Liquidity Ratios
Liquidity ratio s means ability of the company to pay the short term
debts in time. These ratios a re calculated to analyze the short term
financial position and short term financial solvency of firm. Commercial
banks and short term creditors are interested in such analysis. These ratios
are:
Sr.No.RATIOS FORMULAS
1 Current Ratio Current Assets/Curr ent Liabilities
2 Quick Ratio Liquid Assets/Current Liabilities
3 Absolute Liquid Ratio Absolute Liquid Assets/Current Liabilities
2.1.5 F] b) Profitability Ratio
Earning of more and more profit with the optimum use of
available resources of business is called profitability. The investor is very
particular in knowing net profit to sales, net profit to total assets and net
profit to equity. The profitability ratio measures the overall efficiency and
control of firm.Sr.No.RATIOS FORMULAS
1 Gross Profit Ratio Gross Profit/Net Sales X 100
2 Operating Cost Ratio Operating Cost/Net Sales X 100
3 Operating Profit ratio Operating Profit/Net Sales X 100
4 Net Profit Ratio Operating Profit/Net Sales X 100
5Return on Investment
RatioNet Prof it After Interest And Taxes/
Shareholders Funds or Investments X1 0 0
6Return on Capital
Employed RatioNet Profit after Taxes/ Gross Capital
Employed X 100
7Earnings Per Share
RatioNet Profit After Tax & Preference
Dividend /No of Equity Shares
8 Dividend Pay Out RatioDividend Per Equity Share/Earning Per
Equity Share X 100
9Earning Per Equity
ShareNet Profit after Tax & Preference Dividend
/ No. of Equity Share
10 Dividend Yield RatioDividend Per Share/ Market Value Per
Share X 100
11 Price Earnings RatioMarket Price Per Share Equity Share/
Earning Per Share X 100
12Net Profit to Net Worth
RatioNet Profit after Taxes / Shareholders Net
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552.1.5 F] c) Turnover Ratios
These ratios show how well the assets are used and the extent of
excess inventory. The different type of turnover ratios are as follows:
Sr.
No.RATIOS FORMULAS
1 Inventory Ratio Net Sales / Inventory
2 Debtors Turnover Ratio Total Sales / Account Receivables
3 Debt Collection RatioReceivables x Months or day s in a
year / Net Credit Sales for the year
4 Creditors Turnover RatioNet Credit Purchases / Average
Accounts Payable
5 Average Payment PeriodAverage Trade Creditors / Net Credit
Purchases X 100
6Working Capital Turnover
RatioNet Sales / Working Cap ital
7 Fixed Assets Turnover RatioCost of goods Sold / Total Fixed
Assets
8 Capital Turnover Ratio Cost of Sales / Capital Employed
2.1.5 F] d) Capital Structure Ratios
Sr.
No.RATIOS FORMULAS
1Debt Equity RatioTotal Long Term Debts / ShareholdersFund
2Proprietary Ratio Shareholders Fund/ Total Assets
3Capital Gearing ratioEquity Share Capital / Fixed InterestBearing Funds
4Debt Service RatioNet profit Before Interest & Taxes /Fixed Interest Chargesmunotes.in

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56Following Exercise demonstrates t he analysis of financial statements
using Ratio Analysis
Balance Sheet
AssetsLiabilities andOwners'
Equity
Current
AssetsCurrent
Liabilities
Cash 400 Accounts
Payable200
Accounts
Receivable700 Notes Payable 500
Inventory 1000Total CurrentLiabili ties700
Total
Current
Assets2100 Long -Term
Liabilities
Long -Term
Debt800
Fixed Assets Total Long -
Term
Liabilities800
Property,Plant, andEquipment800 Owners' Equity
Less
Accumulated
Depreciation400Common Stock(`1P a r )400Net FixedAssests400 Capital Surplus 500
Retained
Earnings100Total Owners'Equity1000
Total Assets 2500Total Liab.and Owners'Equity2500Income Statement
Sales 3500
Cost of Goods Sold 500
Administrative
Expenses300
Depreciation 271Earnings BeforeInterest and Taxes2429
Interest Expense 110
Taxable Income2319
Taxes 536
Net Income 1783
Dividends 980Addition to RetainedEarnings803
Other InformationNumber of SharesOutstanding400
Price per Share 7.71
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57Ratio Formula Explanation Answer
Current RatioTotal Current Assets
=`2100
Total Current
Liabilities = `7003
Quick Ratio
Total Current Assets= `2100
Inventory = `1000Total CurrentLiabilities = `7001.57
Receivables
Turnover
Sales = `3500Accounts Receivables=`700 5t i m e s
Days' Receivables
Receivables Turnover=5t i m e s( f r o mabove). 73 days
Inventory Turnover
COGS = `500
Inventory = `10000.5
times
Days' Inventory
Inventory Turnover =0.5 times (fromabove).730
daysFixed AssetsTurnover
Sales = `3500Net Fixed Assets =`4008.75
timesTotal AssetsTurnover
Sales = `3500
Total Assets = `25001.4
timesTimes InterestEarned (TIE)
EBIT = `2429Interest Expense =`11022.08
times
Debt RatioTotal Assets = `2500Total Owners' Equity=`1000Note: Total Debt iscomputed bysubtracting TotalOwners' Equity fromTotal Assets60%
Debt to EquityRatioTotal Assets = `2500Total Owners' Equity=`1000Note: Total Debt iscomputed bysubtracting TotalOwners' Equity fromTotal Assets.150%
Equity Multiplier
Total Assets = `2500Total Owners' Equity=`10002.5
Profit Margin
Net Income = `1783
Sales = `3500 50.94%
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58Return on Assets(ROA)
Net Income = `1783
Total Assets = `250071.32%Return on Equity(ROE)
Net Income = `1783Total Owners' Equity=`1000 178.3%
Payout Ratio
Net Income = `1783
Dividends = `980
54.96%
Retention RatioNet Income = `1783Addition to RE =`803Note: The sum of thePayout Ratio and theRetention Ratio is100%.45.04%Earnings Per Share(EPS)
Net Income = `1783Number of SharesOutst anding = 400 `4.46Book Value PerShare
Total Owners' Equity= `1000Number of SharesOutstanding = 400`2.5
Price/Earnings
Ratio
Price Per Share =`7.71Earnings Per Share(EPS) = `4.46Note: See theEPS/Book Value PerShare calculation foradditional
information1.73
Market -to-Book
Ratio
Price Per Share =`7.71Book Value Per Share=`2.53.08
5.6SUMMARY
The competitive edge of the company could be measured with the
help of company market share, growth and stability of its annual sale s.
The financial statement of the company reveals the needed information to
the investor to make investment decision. Analysis of the financial
statistics must be supplemented with an appraisal, mostly of a qualitative
nature, of the company present situat ion and prospects. Based on how the
company has done in the past and how it is likely to do in future, the
investment analyst use different ratios like EPS, DPS etc.
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59Company analysis is the evaluation of the financial performance of
the company.
The busin ess model describes the company’s operations
The competitiveness of the company can be studied with the help of
market share, the growth of annual sales, and the stability of annual
sale.
Corporate governance refers to the set of systems and practices tha t
ensure accountability, transparency of the company.
Corporate culture refers to the collective beliefs, value systems, and
procedures in place in the company.
EPS is the earnings after tax divided by the number of common
shares outstanding.
Economic valu e added method measures a surplus that is created by
investment.
The hybrid model is a derivative of the income approach and the
asset based approach.
In relative valuation, the value of the company is determined in
relation to how similar companies are pr iced in the market
Financial statements are analysed through comparative statements,
trend analysis, common size statements, fund flow analysis, cash
flow analysis and ratio analysis.
5.7SELF -ASSESSME NT QUESTIO NS
1.Briefly explain the factors affecting t he value of stock of a company.
2.How does management of a company affect its stock prices?
3.Explain financial analysis of a company.
4.Describe the different techniques of financial analysis and explain
the limitations of financial analysis.
5.What are the metho ds adopted to analyse the financial statements of
ac o m p a n y ?
6.What are the different types of Ratios to analyse the company’s
earnings performance.
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606
TECH NICAL A NALYSIS -I
Unit Structure
6.0Learning Objectives
6.1Introduction to Technical Analysis
6.2Different Charting Techniques
-Line Chart
-Bar Chart
-Candlestick Chart
-Point & Figure Chart
6.3Different Chart PATTERN
-Support & Re sistance
-Trend lines
-Head & Shoulders
-Double Tops & Bottom
-Triangles
6.4Summ ary
6.5Self-Assessment Questions
6.0LEAR NING OBJECTIVES
After studying this lesson you are able to:
Understand different charting techniques
Understand different charting Patterns
6.1INTRODUCTIO NTO TECH NICAL A NALYSIS
The technical analysis is based on the doctrine given by Charles H.
Dow in 1884, in the Wall Street Journal. He wrote a series of articles in
the Wall Street Journal .A.J. Nelson, a close friend o f Charles Dow
formalized the Dow Theory for economic forecasting. The analysts used
charts of individual stocks and moving averages in the early1920’s. Later
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61The share price movement is analysed broadly with two
approaches, namely, fundamental approach and the technical approach.
Fundamental approach analyses the share prices on the basis of economic,
industry and company statistics. If the price of the share is lower t han its
intrinsic value, investor buys it. But, if he finds the price of the share
higher than the intrinsic value he sells and gets profit. The technical
analyst mainly studies the stock price movement ,of the security market. If
there is an uptrend in th e price movement investor may purchase the
Security. With the onset of fall in price he may sell it and move from the
Security. Basically, technical analysts and the fundamental analysts aim at
good return on investment.
It is a process of identifying tre nd reversals at an earlier stage to
formulate the buying and selling strategy. With the help of several
indicators they analysed the relationship between price -volume and
supply -demand for the overall market and the individual stock. Volume is
favourable 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.
Despite all the fancy and exotic tools it employs, technical an alysis
really just studies supply and demand in a market in an attempt to
determine what direction, or trend, will continue in the future. In other
words, technical analysis attempts to understan d the emotions in the
market by studying the market itself, as opposed to its components. If you
understand the benefits and limitations of technical analysis, it can give
you a new set of tools or skills that will enable you to be a better trader or
inves tor.
Assumptions
1)The market value of the Security is determined by the relation of
supply and demand.
2)Security prises behave in a manner that their movement is continuous
in a particular direction for some time
3)The market discounts everything. The price of the security quoted
represents the hopes, fears and inside information received by the
market players. Inside information regarding the issuing of bonus
shares and right issues may support the prices. The loss of earnings
and information regarding the forthcoming labour problem may result
in fall in price. These factors may cause changes in demand and
supply.
4)The market always moves in trend. Except for minor deviations, the
stock prices move in trends. The price may create definite patterns
too. The tr end may be either increasing or decreasing. The trend
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625)Any layman knows the fact that history repeats itself. It is true to the
stock market also. In the rising market investor’s psychology have tip
beats and th ey 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 and thus plunging the
share price further. The market technicians assume that past pri ces
predict the future.
6.2DIFFERE NT CHARTI NG TECH NIQUES
Line Chart
The most basic of the four charts is the line chart because it
represents only the closing prices over a set period of time. The line is
formed by connecting the closing prices over the time frame.
However, the closing price is often considered to be the most important
price in stock data compared to the high a nd low for the day and this is
why it is the only value used in line charts. The line chart is also called a
close -only chart as it plots the closing price of the underlying security,
with a line connecting the dots formed by the close price. In a line cha rt
the price data for the underlying security is plotted on a graph with the
time plotted from left to right along the horizontal axis, or the x -axis and
price levels plotted from the bottom up along the vertical axis, or the y -
axis. The uncluttered simpli city of the line chart is its greatest strength as
it provides a clean, easily recognizable, visual display of the price
movement. This makes it an ideal tool for use in identifying the dominant
support and resistance levels ,trend lines , and certain chart patterns .
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63Howev er, the line chart does not indicate the highs and lows and,
hence, they do not indicate the price range for the session. Despite this,
line charts were the charting technique favoured by Charles Dow who was
only interested in the level at which the price closed. This, Dow felt, is the
most important price data of the session or trading period as it determine s
that period's unrealized profit or loss.
Line charts or close -only charts are still favoured by numerous
traders who agree the closing price is the m ost important data and are not
concerned with the noise created price spikes and minor price movements,
or the speculation that characterizes the start of the trading session.
Bar charts Bar Charts are one of the most popular forms of stock charts
and were the most widely used charts before the introduction of
candlestick charts . Bar charts are drawn on a graph that plots time on the
horizontal axis and price levels on the vertical axis. These charts provide
much more information than line charts as they consists of a series of
vertical bars that indicate various price data for each time -frame on the
chart. This data can be either the open price, the high price, the low price
and the close price, making it an
OHLC bar chart, or the high price, the low price and the close price,
making it an HLC bar chart. The height of each OHLC and HLC bar
indicates the price range for that period with the high at the top of the bar
and the low at the bottom of the bar. Each OHLC and HLC bar has a small
horizontal tick to the right of th e bar to indicate the close price for that
period. An OHLC bar will also have a small horizontal tick to the left of
the bar to indicate the open price for that period. The extra information is
one of the reasons why the OHLC charts are more popular than H LC
charts. In addition, some charting applications use colours to indicate
bullish or bearishness of a bar in relation to the close of the previous bar.
This makes the OHLC bar chart quite similar to the candlestick chart ,
except that the OHLC chart does not indicate bullishness or bearishness of
the period of one bar as clearly as the candlesti ck chart (the colour of an
OHLC bar is always in relation to the close of the pervious bar rather than
the open and close of the current bar).Most bar charts contain a lower pane
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64that plots the total volume traded during a particular period. This part of
the chart has a separate scale on the vertical axis to illustrate volume
levels. It too consists of typical vertical bars.
The charts of the EUR/USD shown in figure 2.2.1 and figure
2.2.2 illustrate the line and bar charts in terms of the amount of
information each one parts. First is the line chart that only plots the close
price of the underlining security and the second is the OHLC bar chart.
Both charts have a 15 -minute time frame and cover the exact same period.
Japanese Candlestick Charts
Japanese candlestick charts form the basis of the oldest form of
technical analysis. They were developed in the 17th century by a Japanese
rice trader named H omma and was introduced to the rest of the world in
Steve Nison's book, Japanese Candles tick Charting Techniques .
Candlestick charts provide the same information as OHLC bar charts,
namely open price, high price, low price and close price .However,
candlestick charting also provide a visual indication of market psychology,
market sentiment, and potential weakness, making it a rather valuable
trading tool.
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65Candlesticks indicate a bullish up bar, when the closing price is
higher than the opening price, using a light colour such as white or green,
and a bearish down bar, when the closin g price is lower than the opening
price, using a darker colour such as black or red for the real body of the
candlestick. Thus, on a green candlestick, the close price will be at the top
of the candlestick real body and the open price at the bottom as the close
price is higher than the open price; conversely on a red bar the close price
will be at the bottom of the candlestick real body and the open price at the
top as the close price is lower than the open price. For both a bullish and a
bearish candlestic k, the high price and the low and the low price for the
session will be indicated by the top and bottom of the thin vertical line
above and below the real body. This vertical line is called the shadow or
the wick.
The shape and colour of a candlestick can change several times
during its formation. Therefore the trader must wait for the candlestick to
be formed completely at the end of the time -frame to analyse the
candlestick, forcing the trader to wait for the bar to close.
Candlesticks are also good in dicators of market psychology, i.e.,
the feelings of fear and greed experienced by the buyers and sellers, and
the strength of those feelings. Thus a bullish (green or white) candlestick
with no shadows (which is called a Marubozu) indicate strong bullishn ess,
and the longer the Marubozu candlestick the stronger the bullishness. A
bullish candlestick with a relatively long lower shadow, a relatively small
real body and a short or no upper shadow indicates that the buyers were
able to drive the price up from the low. This is also a strong bullish
candlestick. However, a bullish candlestick with a relatively long upper
shadow, a relatively small real body and a short lower shadow indicates
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66that sellers were able to drive the price down from the high but were n ot
able to defeat the buyers. Although this candlestick is bullish, it is weak;
and the longer the upper shadow and the smaller the real body, the weaker
the candlestick.
Candlestick charts also indicate potential trend reversal patterns in
only one to four candlesticks with subsequent candlestick patterns proving
confirmation. When us ing a candlestick for confirmation of a potential
trade signal, it is important to take into account the relative strength or
weakness of that candlestick and its location overall in the trend lines on
the chart. A weak candlestick should never be taken as a confirmation of a
potential trade.
Point and Figure (P&F) charts
Point and Figure (P&F) charts date back to at least 1880's and
differ from other charts as it does not plot price movement from left to
right within fixed time intervals. It also does not plot the volume traded.
Instead it plots unidirectional price movements in one vertical column and
moves to the next column when the price changes direction. It represent
increase in price by plotting X's in the column and decrease in price by
plotting O' s. Each X and O represents a box of a set size or price amount.
This box size determines how far the price must move before another X or
O is added to the chart, depending on the direction of the price movement.
Thus if the box sixe is set at 15, the price must move 15 points above the
previous box before the next X or O is plotted. Any movement below 15 is
ignored. For this reason, very little plotting occurs during stagnant market
conditions while a considerable amount of plotting may occur during
volatil e market conditions.
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67The chart also has a box reversal amount that determines how
many boxes must occur in the opposite direction before it is seen as a
reversal. Only once the price is seen as having reversed ,a new column is
started. A3b o xr e v e r s a lr equires the price to move three boxes (of 45
points if each box represents 15 points) against the current direction before
it is seen as a reversal.
Some traders argue that P&F charts are one of the best charting
techniques for accurately d etermining entry and exit signals as they
present a clear indication of support and resistance lines , as well as clear
trend lines .
6.3DIFFERE NT CHART PATTER NS
The two basic elements of technical analysis, and the study of chart
patterns in particular, are the concep ts of support and resistance andtrend
lines.T h e Dow Theory of trends , (Chapter 2.3) for example, is based on
support and resistance and states that a market is in an uptrend when it
makes higher highs and higher lows, and is in a downtrend when it makes
lower lows an d lower highs. The highs are formed at resistance levels
where selling is strong enough to reverse the rally in prices while the lows
are formed at support levels where buying is strong enough to reverse the
decline in prices. However, support and resistan ce lines, which are
horizontal lines, are often confused with trend lines, which are lines that
slope in the direction of the trend.
6.2.3(A)Support and Resistance (S/R) Lines
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68Support and Resistance lines are often confused with trend lines .
However, support and resistance lines are horizontal lines drawn under the
minor lows and above the highs ,respectively. They indicate where a
previous rally met resistance that drove the price back down and where a
previous decline met support that pushed the price back up. These are two
important levels in terms of trend identification since an uptrend will tend
to break through previous resistance levels to make higher highs while a
down trend will break through the previous support levels under the
market to make lower lows. When the support line below the recent minor
low in broken in an uptrend, it indicates that the uptrend is weakening and
may reverse soon. Similarly, when the r ecent resistance line in a down
trend is broken, it indicates that the trend is weakening and that a trend
reversal may occur. When a support or a resistance line is broken, it often
swaps around to become a resistance or support line for future price
move ments.
When the price moves back to a support or resistance line, it is said
to be testing the support or resistance. If the support or resistance line
holds, and is not violated or broken, the test is said to have failed. The
more failed tests a support o r resistance line has, the more significant that
line becomes. When a support or resistance line is significant, they
provide entry signals when a test of the line fails, as well as when a test
succeeds in violating or breaking the support or resistance.Su pport and
resistance lines that are less significant do not provide good entry and exit
signals but are more useful for identifying chart patterns and for use in
conjunction with technical indicators .
6.2.3 (B) Trend Lines
Trend lines are key elements of chart patterns as they indicate
significant price levels. Thus an understanding of trend lines, and what
they re present are important for successful technical analysis. In an
uptrend, which is characterized by higher highs and lower lows, with the
higher lows referred to as correction lows or reaction lows as the market
corrects an overbought condition, a trend line can be drawn below the
correction lows connecting two or more of the lows. A trend line that
connects only two correction lows is a tentative trend line and is only
confirmed when the price test the line successfully, i.e., the price touches
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69the line and bounces of it, for a third time. When a trend line has been
identified, it can used to identify potential areas of support for subsequent
correcti on lows. Should the price break the trend line, i.e., penetrate or
violate the trend line and close below it, then trend could be broken.
However, only a lower low will confirm a reversal of the uptrend. In
addition, an increase in volume at the break increases the validity of that
break while a decrease in volume increases the probability of a false
break. Furthe rmore, the actual drawing of trend lines is more of an art than
a science and take a bit of time to get right. As a guideline, drawing the
trend lines along areas of co ngestion rather than at the tip of the spikes is
the preferred method for most technical analysts.
The same is true for a downtrend, which are characterized by lower
lows and lower highs. The lower highs are referred to as reaction or
correction highs as the market attempts to correct oversold conditions. A
trend line can be drawn above the t rend to connect two or more correction
highs. When the trend line connects only two correction highs, it is a
tentative trend line and is only confirmed when the price tests the trend
line a third time without violating it. These trend lines are potential areas
of resistance for subsequent correction highs. When the price penetrates
the trend line and close above it, then trend line could be broken but a
reversal of the downtrend is only confirmed by a higher high.The strength
or significance of a trend lin e increases every time the price return sto test
the trend line without violating it. In addition, trend lines on charts with
longer timeframes have a greater significance than tre nd lines on charts
with shorter timeframes.
6.2.3 (C) Head and Shoulders
The Head and Shoulders pattern is one of the most reliable trend
reversal patterns and is usually seen in uptrends, where it is also referred
to as Head and Shoulders Top, though the y can appear in downtrends as
well, where they are also referred to as Head and Shoulders Bottom or
Inverse Head and Shoulders. As they are trend reversal patterns, the Head
and Shoulders patterns require the presence of an existing trend.
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70Head and Shoulde rs Top
Head and Shoulders Top is formed when a higher high in an
uptrend is followed by a lower high. The result is a series of three peaks
where the centre peak, the head, is higher than the two peaks, the
shoulders, on either side of it. The two shoulder s do not need to be the
same size or the same height, but they must be lower than the head.
Head and Shoulders Bottom
Head and Shoulders Bottom or Inverse Head and Shoulders is the
opposite of Head and Shoulders Top and is formed in a downtrend when a
lowe r low is followed by a higher low. The result is a series of three lows
or dips where the low of the middle dip, which is the head, is lower than
the dips, or the shoulders, on either side of it. As with the Head and
Shoulders Top, the two shoulders do not need to be the same size or the
same height, but their lows must be higher than the low of the head.
6.2.3 (D) Double Top and Double Bottom Patterns
The double tops and double bottoms patterns are two related chart
patterns that are some of the easiest trend reversal patterns to identify that
appear on line,bar,candlestick charts ,a n d Point -and-Figure charts .
Double Tops
The double tops is a bearish trend reversal pattern that often marks
the end of an uptrend and the start of a down trend. It consists of two
consecutive pea ks that reach a resistance level at more or less the same
high value, with a valley separating the two peaks. The low of the valley is
important for price projection p urposes, but the shape that the peaks take
is not important despite some traders talking about Adam and Eve tops.
Volume is also of importance, with the volume on the second peak
preferably lower than the volume on the first peak.
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71The double tops pattern has two entry signals to sell short. The first
is given when the price fails to break the previous resistance level at first
peak. However, this is a tentative entry as the price may rebound before
reaching the support level between the two peaks and signal the
continuation of the uptrend. The second entry signal is the more reliable
signal. It is given when the previous support level created on the
retracement from the first peak is violated. This should preferably occur
on higher volume as a drop in volume may indicate a false break.
Double Bottoms
The double bottom pattern is a bullish counterpart to the double
tops. It often marks the end of a down trend and the possible start of a
protracted up trend. It consists of two consecutive troughs or dips that
bounce of a support level at more or less the same low value, with a p eak
separating the two dips. Similar to the valley in the double tops, the high
that the interceding peak reaches in the double bottom is important for
price projection purposes, and the shape that the two dips is of much
importance. Volume is also of impo rtance here, with the ideal pattern
having a lower volume on the second dip than the volume on the first dip.
2.2.3(E) Triangles
Ascending Triangles
The ascending triangle pattern is similar to the symmetrical
triangle except that its upper trend line is a horizontal resistance line .
Ascending triangles are generally bullish in nature and are most reliable
when they appear as a continuation pattern in an uptrend. In these patterns,
buyers slightly outnumber sellers. The market becomes overbought and
prices start to drop. However, buyers then re -enters the market and prices
are driven back up to the recent high, where selling occurs once more.
Buyers re -enter the market, but at a higher level than before. The result is
a steady high at more or less the same level but series of higher lows.
Prices eventually break through the resistance level where the high peaks
were formed and are propelled even higher as new buying comes in and
volume increases.
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72Descending Triangles
The descending triangle pattern is similar to the symmetrical
triangle except that its lower trend line forms a horizontal support line .
Descending triangles are bearish in nature and are most reliable whe n they
appear as a continuation pattern in a downtrend. In these patterns, sellers
slightly outnumber buyers. The market becomes oversold and prices start
to climb. However, sel lers then re -enter the market and prices are driven
back down to the recent low, where buying occurs once more. Sellers re -
enter the market, but at a lower level than before. The result is lower highs
with a steady low. Prices eventually break through the support line where
the lows were formed and are propelled even lower as selling increases
along with an expansion in volume.
Flag Pattern
The flag pattern is one of the short -term continuation patterns . It is
quite similar to the pennant pattern with the "flag" representing a
relatively short consolidation period following a sharp price movement
and marks the mid -point of a longer price movement. It is not a reversal
pattern . The flag pattern occurs when the chart tracks a rapid, near vertical
price movement that is followed by a sho rt period of congestion or
consolidation that is characterized by lower volumes. The initial near
vertical movement forms the "flagpole" while the congestion area forms
the actual flag and is caused by the profit taking of traders that were
fortunate enoug h to be in the correct position before the flagpole formed,
and by traders who missed the initial movement who are now entering the
market.
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73The congestion area of the flag usually takes either the shape of a
parallelogram that tilts in the oppos ite direction of the flagpole or the
shape of a rectangle . Usually the consolidation period is accompanied by a
decline in volumes until the beak out occurs. A valid break out wou ld be
in the same direction of the initial price movement that formed flagpole,
and usually occurs after approximately 8 bars but definitely within a
maximum of 20 bars. If the consolidation phase lasts longer than 20 bars
then the probability that the mom entum that created the initial price
movement has dissipated increase and the consequent probability that the
flag pattern itself will fail increases. This is particularly true of bearish
flag patterns.
6.4SUMM ARY
This chapter analyses the behaviour of the security prices through
different charting techniques and different chart patterns. Acc ording to the
technical analyst s,their method is simple and gives an investor a bird’s
eye on the future of security price by measuring the past moves of prices.
They predicted the stock prices through Line Chart, Bar Chart, And
Candlestick Charts and other. Technical analysis includes the study of
various chart patterns such as Support and Resistance, Head and
Shoulders, Triangles and Flag Pattern which helps to pre dict the upward
and downward swing in the market. Following are few concepts used in
charting techniques:
•Resistance —a price level that may prompt a net increase of selling
activity
•Support —a price level that may prompt a net increase of buying
activity
•Trending —the phenomenon by which price movement tends to
persist in one direction for an extended period of time
•Average true range —averaged daily trading range, adjusted for price
gaps
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74•Chart pattern —distinctive pattern created by t he movement of
security prices on a chart
•Momentum —the rate of price change
•Point and figure analysis —a priced -based analytical approach
employing numerical filters which may incorporate time references,
though ignores time entirely in its constr uction.
•Cycles -time targets for potential change in price action (price only
moves up, down, or sideways)
6.5SELF -ASSESSME NT QUESTIO NS
1. Explain the technical analysis and its assumptions.
2. What are the charts? How are they interpreted in technical
analysis?
3. Chart patterns are helpful in predicting the stock price movement’.
Comment.
4. Explain the different types of charting techniques.
5. Explain the different chart patterns.
6. Briefly explain the Line Chart and Bar Chart.
7. Briefly explain the ascending and d escending triangles.
8. What is a point and figure chart, and how is it used?

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757
TECH NICAL A NALYSIS -II
Unit Structure
7.0Learning Objectives
7.1Introduction
7.2Dow Theory
-Assumptions
-Market Trend or Price Movements
-The Three Stages of Primary Bull Markets and Primary Bear
Markets
-Signal Confirmation
7.3Technic al Indicators
-Volume Indicators
-Market Sentiment Indicators
-Confidence Index
7.4Summary
7.5Self-Assessment Questions
7.0LEAR NING OBJECTIVES
After studying this lesson you are able to:
Understand The Dow Theory
Use volume indicators, market s entiment indicators
Understand confidence index
7.1INTRODUCTIO N
However fundamental analysts examine earnings, dividends, new
products, research and the like, technical analysts examine what investors
fear or think about those developments and whether or not investors have
the ability to back up their opinions; these two concepts are called
psychology and supply/demand. Technicians employ many techniques,
one of which is the use of charts which we have already studied in the
earlier chapter. Using charts ,technical analysts seek to identify price
patterns and market trends in financial markets and attempt to exploit
those patterns. Technicians using charts search for typical price chart
patterns, such as the well -known head and shoulders or double top/bot tom
reversal patterns, study technical indicators, moving averages, and look for
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76such as flags patterns. Technical analysts also widely use market
indicators of many sorts, some of whi ch are mathematical transformations
of price, often including up and down volume, advance/decline data and
other inputs. Adherents of different techniques (for example, candlestick
charting,) may ignore the other approaches, yet many traders combine
elemen ts from more than one technique. Some technical analysts use
subjective judgment to decide which pattern(s)a particular instrument
reflects at a given time, and what the interpretation of that pattern should
be. Others employ a strictly mechanical or syste matic approach to pattern
identification and interpretation. Technical analysis is frequently
contrasted with fundamental analysis, the study of economic factors that
influence the way investor’s price financial markets. Technical analysis
holds th eprices that already reflect all such trends before investors are
aware of them. Some traders use technical or fundamental analysis
exclusively, while others use both types to make trading decisions which
conceivably is the most rational approach. Users of techni cal analysis are
often called technicians or market technicians. Some prefer the term
technical market analyst or simply market analyst. An older term, chartist
issometimes used, but as the discipline has expanded andmodernized, the
use of the term chart ist has become less popular, as it is only one aspect of
technical analysis. In this chapter ,we are going to study the Dow Theory
and Different Technical Indicators.
7.2 DOW THEORY
The Dow Theory has been around for almost 100 years. Developed
by Charle s Dow and refined by William Hamilton, many of the ideas put
forward by these two men have become axioms of Wall Street. Dow
Theory is widely considered asone of the earliest forms of technical
analysis. It was originally publicised by Charles H. Dow who noticed that
stocks tended to move up or down in trends, and they have a habit of to
move together, although the extent of their movements could vary. He
used this knowledge to develop the Dow -Jones Averages that are still in
use today. Charles Dow did not use his observations to forecast potential
price movements but saw it as a barometer of the general business climate.
William P. Hamilton, who succeeded Charles Dow as the Editor of The
Wall Street Journal, refined Dow's principles and developed them into a
theory, which he explained in his book, The Stock Market Barometer: A
Study of Its Forecast Value of 1922. Both Dow's work and Hamilton's
work were analysed and studied by Robert Rhea who refined Dow Theory
further into the theory we know today, in his book, The Dow Theory of
1932.
Assumptions of the Dow Theory
The Market Value of a Security or stock is related to demand and
supply factors functioning in the market.
Stock prices behave in a manner that their movement is continuous in
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77Demand and supply of a security surrounded by the s amerational and
irrational factors.
Whenever there are shift in demand and supply, this can be detected
through chart patterns specially to show the market action.
The Movement of a stock price if going upward will continue to doso
for a while barring certain minor fluctuations in stock prices.
Trends in a stock prices have been seen to change when there is a shift
in Demand and Supply factors.
Market Trends or Price Movements :
The market as a whole has a trend and that this trend is
conveniently measured in terms of two sets of Dow Jones Averages,
Transports and Industrials. Dow Theory has for one of its fundamental
concepts the existence of not one, but three movements of the Ave rages.
They are known as:
A. Primary movements
B. Secondary movements
C. Daily fluctuations
A.Primary moves last from a few months to many years and represent the
broad underlying trend of the market.
B.Secondary or reaction movements last for a few weeks to many
months and move counter to the primary trend.
C.Daily fluctuations can move with or against the primary trend and last
from a few hours to a few days, but usually not more than a week.
Primary movements
As mentioned, represent the broad u nderlying trend. These actions
are typically referred to as BULL or BEAR trends. Bull means buying or
positive trends and Bear means negative or selling trends. Once the
primary trend has been identified, it will remain in effect until proven
otherwise. Ha milton believed that the length and the duration of the trend
were largely undeterminable. Many traders and investors get hung up on
price and time targets. The reality of the situation is that nobody knows
where and when the primary trend will end. The ob jective of Dow Theory
is to utilize what we do know, not to randomly guess about what we do
not.Through a set of guidelines ,Dow Theory enables investors to identify
the primary trend and invest accordingly. Trying to predict the length and
duration of th e trend is an exercise in futility. Success according to
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78Secondary movements
Secondary movements run counter to the primary trend and are
reactionary in nature. In a bull market ,as e c o n d a r ym o v ei s considered a
correction. In a bear market, secondary moves are sometimes called
reaction rallies. Hamilton characterized secondary moves as a necessary
phenomenon to combat excessive speculation. Corrections and counte r
moves kept speculators in check and added a healthy dose of guess work
tomarket movements. Because of their complexity and deceptive nature,
secondary movements require extra careful study and analysis. He
discovered investors often mistake a secondary move as the beginning of a
new primary trend.
Daily fluctuations
While important ,when viewed as a group can be dangerous and
unreliable individually. Getting too caught up in the movement of one or
two days can lead to hasty decisions that are based on emotion. To invest
successfully ,it is vitally important to keep the whole picture in mind when
analysing daily price movements. In general ,they agreed the study of
daily price action can add valuable insight, but only when taken in greater
context.
TheThree Stages of Primary Bull Markets and Primary Bear
Markets :Hamilton identified three stages to both primary bull and
primary bear markets. The stages relate as much to the psychological state
of the market as to the movement of prices.
Primary Bull M arket
Stage 1. Accumulation
Hamilton noted that the first stage of a bull market was largely
indistinguishable from the last reaction rally in a bear market. Pessimism,
which was excessive at the end of the bear market, still reigns at the
beginning of a bull market. In the first stage of a bull market, stocks begin
to find a bottom and quietly firm up. After the first leg peaks and starts to
head down, the bears come out proclaiming that the bear market is not
over. It is at this stage that careful analy sis is warranted to determine if the
decline is a secondary movement. If itis a secondary move, then the low
form edabove the previous low fora quiet period will ensue as the market
firm and then an advance will begin. When the previous peak is surpassed ,
the beginning of the second leg and a primary bull will be confirmed.
Stage 2. Movement with Strength
The second stage of a primary bull market is usually the longest,
and sees the largest advance in prices. It is a period marked by improving
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79the easiest stage to make profit as participation is broad and the trend
followers begin to participate.
Stage 3. Excess
Marked by excess speculation and the appearance of inflationary
pressures. During the third and final stage, the public is fully involved in
the market, valuations are excessive and confidence is extraordinarily
high.
Primary Bear Market
Stage 1. Distribution
Just as accumulation is the hallmark of the first stage of a primary
bull market, distribution marks the beginning of a bear market. As the
"smart money" begins to realise that business conditions are not quite as
good as one thought, and thus they begin to sell stock. There is little in the
headlines to indicate a bear market is at hand and general business
conditions remain good. However ,stocks begin to lose their lustre and the
decline begins to take hand. After a moderate decline, there is a reaction
rally that retraces a portion of the decline. Hamilton noted that reaction
rallies during a bear market were quite swift and sharp. This quick and
sudden movement would invigorate the bulls to proclaim the bull market
alive and well. However the high reaction of the secondary move would
form and be lower than the pr evious high. After making a lower high, a
break below the previous low, would confirm that this was the second
stage of a bear market.
Stage 2. Panic Phase
As with the primary bull market stage ,two of a primary bear
market provides the largest move. Thi s is when the trend has been
identified as down and business conditions begin to deteriorate. Earnings
estimates are reduced, shortfalls occur, profit margins shrink and revenues
fall.
Stage 3. Despair
At the final stage of a bear market all hope is lost and stocks are
frowned upon. Valuations are low, but the selling continues as participants
seek to sell no matter what. The news from corporate America is bad, the
economic outlook is bleak and no buyers are to be found. The market will
continue to declin e until all the bad news is fully priced into the stocks.
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80Signal Confirmation
The Dow Theory employs the two of the Dow Jones Averages i.e.
the industrial average and transp ortation average. The Dow Theory is built
upon the assertion that measures the stock prices that tend to move
together. If the industrial average is rising then the transportation average
should also be rising. Such simultaneously occurring price movements
suggest the strong bull market. If one of the averages start declining after a
period of rising stock prices, then the two are odds. For Example, the
industrial average may be rising while the transportation average is falling.
This suggests the industria list may soon start to fall. Hence ,the market
investors will use this signal to sell securities and convert it into cash. The
Converse occurs when after a period of falling a security prices one of the
averages start to rise while the other continue to fall. According to Dow
Theory, this divergence suggest that this phase is over and that the security
prices in general will soon start to rise.
These signals are illustrated in figure 2.3.1 which illustrate the buy
signal. In the given figure ,both industri al and transportation averages have
been declining when the industrial average start to rise. Although the
transportation average is still declining, the increase in the industrial
average suggest that the decline market is over. This change is then
confir med when the transportation average also start sto rise.
The Figure 2.3.2 shows the opposite case in which both the
averages have been rising the industrial average start sdeclining while the
transportation average continues to rise. This suggest that the market is
going through some uncertainty and until they start moving together again
there is uncertainty as to the future direction of stock prices.
7.3 TECH NICAL I NDICATORS
Indicators are the keystones of technical analysis and play an
important rol e in giving and confirming entry and exit signals in stock
trading systems. There are quite a number of different types of indicators
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81Leading Indicators
Lagging Indicators
Leading Indicators
Leading indicators are d esigned to lead price movements. Benefits
of leading indicators are early signalling for entry and exit, generating
more signals and allow more opportunities to trade. They represent a form
of price momentum over a fixed look -back period, which is the numb er of
periods used to calculate the indicator. In other words, they indicate the
probability of a trend reversal in advance. Some of the popular leading
indicators include the Commodity Channel Index (CCI), the Relative
Strength Index (RSI).
Lagging Indic ators
Lagging Indicators, which follow the price movement, are usually
trend -following indicators, such as the moving averages (MA). These
indicators turn only after the price action has already turned and therefore
lag price action. These indicators work well when prices move in
relatively long trends. They don’t warn you of upcoming changes in
prices, they simply tell you what prices are doing (i.e., rising or falling) so
that you can invest accordingly. These trend following indicators make
you buy and sell late and, in exchange for missing the early opportunities,
they greatly reduce your risk by keeping you on the right side of the
market.
Leading indicators are usually considered better than lagging
indicators as they probable direction before they occur; however, their
predictive nature does not necessarily increase their accuracy or validity.
Indicators also measure different aspects of the market action regardless of
whether they are lagging and leading indicators.
In addition, depending on how t hey are calculated, indicators can
oscillate above and below a zero line. These are called oscillating
indicators. Other types of indicators can be trend indicators, momentum
indicators, volatility indicators, market strength indicators and cycle
indicator s.
A) MARKET SE NTIME NTINDICATORS
The price move of any security is due in part to market sentiment.
When there is little or no news about a security, then market sentiment
may be the biggest factor in any price moves in the short run. Even when
importan t news about a particular company or security is published, the
resultant price moves are often enhanced or diminished by whether the
market is bullish or bearish at that time.
There are many attempts to accurately measure market sentiment
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82sentiment indicators, such as volume indicators, can be used for individual
securities, most market sentiment indicators are based on broad market
data.
Contrarian Indicators
Some older market ind icators are based on the idea, right or wrong,
that uninformed traders usually make the wrong decision, buying at
market tops and selling at market bottoms. For example, an old sentiment
indicator is based on odd -lot trading statistics, which measures the number
of shares of stock being bought or sold in odd lots, which are less than the
100 shares composing a round lot. Based on the odd -lot theory ,most of
these buyers are presumed to have little money to trade and are, therefore,
presumed to be the least sophisticated market players, and so they buy
when the optimism has peaked, and they sell when pessimism has peaked
and the market has bottomed out. Informed traders see odd-lot buying as a
sell signal and odd -lot selling as a buy signal, so they do exactl y opposite
of what the uninformed traders are doing.
Odd-Lot Short Sale Ratio
However, the odd -lot theory has not been a very good indicator,
probably because most odd -lot buyers are not traders, but are buying for
the long term and only when they have th emoney, and, thus, are not good
indicators of market sentiment. Somewhat more reliable, since short
sellers are traders, is the odd -lotshort sale ratio, which is the number of
odd-lot short sales divided by the number odd -lot sales. Presumably, a
higher odd-lotshort sale ratio indicates a market bottom.
Put/Call Volume Ratio
Another sentiment indicator considered more reliable is the put/call
volume ratio, which is the ratio of the total number of puts to the total
number of calls traded in 1 day. A p ut is an option that increases in value
if the underlying security decreases in value. So you would buy a put if
you expected that the price of the underlying security was going to decline
in the near future. A call is an option that increases in value as the
underlying security increases in value, so you would buy a call if you
expected the price of the underlying was expected to go up soon. The
put/call volume ratio is a contrarian indicator, because it is generally at a
maximum at market bottoms. Hence, it would seem that uninformed
players buy puts when the market has already declined.
Market Volatility
Another popular measure of market sentiment is market volatility,
which is the amount that prices of an index or security at a particular time
deviates from the mean price as measured over a specified time period.
The greater the volatility, it is reasoned, the greater the anxiousness of the
traders, and traders feel more anxious when the market is declining or at
the bottom than when it is rising. Low v olatility implies that the
uninformed traders are complacent and therefore is a sell signal while high
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83B) VOLUME I NDICATORS
Since market sentiment is the sentiment of the masses, it makes
sense that tracking volume could be useful in divining market sentiment or
the sentiment about a particular security. One sensible way of tracking
sentiment is by noting the volume on uptrends or downtrends. High
volume serves as a confirmation of the trend. Price moves based on low
volume have much less significance.
On-Balance Volume (OBV)
On Balance Volume (OBV) was developed to determine positive
and negative volume flow for a given security by comparing volume to
price movements. It is a simple indicator that adds a time-frame's volume
when the closing price is up and subtracts the time-frame's volume when
the closing price is down. The OBV line is a running cumulative total of
this volume. The time -frame can b emonthly, weekly, hour ly, 15 minutes,
etc.
As already stated, OBV is calculated by adding the timeframe's
volume to a running cumulative total when the security's closing price is
up, and subtracting the volume from the running cumulative total when
security's closing price is down.
If the closing price is higher than the previous closing price for the
time-frame, then the new OBV is calculated using the formula:
OBV= current OBV + Volume
If the closing price is lower than previous closing price, then the
new OBV is calculated using the formula:
OBV = current OBV -Volume
The direction of the OBV line is more important than the value of
the OBV as the OBV line indicates buying or selling strength. A rising
OBV indicates increased demand for a security ,which is a requirement of
a strong uptrend, and a rise in the security's price can be expected.
Conversely, divergence between the OBV and a rising security price
suggests that the uptrend is weak and will not persist. In a ranging market,
a rising OBV indicates a potential bullish breakout while a falling OBV
indicates a bearish breakout.
Accumulation/Distribution (A/D)
Accumulation/Distribution (A/D) was developed for trading stocks
but it can also be applied to futures and other securities.
Accumulati on/Distribution (A/D) is an enhancement over On Balance
Volume (OBV) as it considers price and volume. However, it takes the
relationship between the opening and the close, and the price range into
account rather than just the close. For A/D volume is cons idered bullish
when the price close is higher than the open and bearish when the price
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84the indicator is dependent on the distance between the open and the close,
and distance between the high and the low, or the price range.
Accumulation/Distribution (A/D) is calculated in two steps. First,
the difference between the close and the open is calculated and divided by
the difference between the high and the low of the price range. The res ult
is then multiplied by the volume. The formula is:
A/D = (Close –Open) / ( (High -Low ) x Volume )
As with the OBV, the direction of the A/D line indicates buying or
selling strength with a rising A/D indicating increased demand for the
underlying s ecurity, while a decline in A/D indicating a decline in the
demand for the underlying security. When A/D increases the price of the
underlying security is expected to rally and when the A/D decreases the
price is expected to drop. However, when this price continues to rally
while A/D declines or continues to fall when A/D increases divergence
between A/D and the price occurs. This is the key signal that A/D provides
andindicates that a price reversal is probable.
Money Flow Index (MFI)
The Money Flow Inde x (MFI) is an oscillating momentum and
market strength indicator. It is also a leading indicator, which means it
tends to lead price action. The ultimate aim of the MFI is to determine
whether money is flowing in or out of a security over a specified look -
back period, with the default being 14 days or periods. As a general rule,
when the MFI indicator rises, it implies that there is buying pressure as
money is flowing into the security and when the indicator drops, it implies
that there is selling pressure as money is flowing out of the security.
The calculation for the MFI is rather complex and consists of a
number of steps:
First, calculate the Typical Price (TP) for each period that makes
upthe look -back period using the formula:
Typical Price = ( Hig h + Low + Close ) / 3
Second, calculate the Raw Money Flow for each period by
multiplying the Typical Price of each period by the volume of that period:
Raw Money Flow = Typical Price x Volume
Third, calculate the Positive Money Flow for the look back pe riod
bycalculating the sum ofthe positive Raw Money Flow values:
Positive Money Flow = Sum of positive Raw Money Flow over look-
back period
Fourth, calculate the Negative Money Flow for the look back
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85Negative Money Flow = Sum of negative Raw Money Flow over
look-back period
Fifth, calculate the Money Flow Ratio for the look back period by
dividing the Positive Money Flow by the Negative Money Flow:
Money Flow Ratio = Positive Money Flow / Negative Money Flow
Finally, calculate the MFI using the formula:
MFI = 100 –100 / ( 1 + Money Flow Ratio )
The result is a range -bound line that oscillates between zero and
one hundred.
C) CO NFIDE NCE INDEX
The technical analysis is that it an alyse the market through a
calculation of the confidence index. This index shows the ratio of yields
between the types of bonds. These bonds are the high grade bounds and
the low grade bonds and the confidence index shows the willingness of the
investor to invest in the market. This technique shows that the purchase
and sale of investment from high grade to low grade bonds depends on the
kind of confidence that the investors gains about the stock market price
movements. When the investor is confident that t he company is stable an d
thestock market is reflecting peek period, then they would like to take a
risk in the market and try to gain high yields in the purchase of bonds. The
investors would make a gain by shifting their investment in such a manner
that they are high yielding. Usually, large institutional investors make
portfolio choice in the bond market but it is the influence of the small
investor and the change Inthe prices which is marketed by the technical
chartists to find out the confidence index . The confidence index is limited
to point to theupper limit being limited to one. When the confidence index
is rising ,it indicates optimism and the technical analyst predicts that the
money market is showing a chance for making speculative profit. At this
time, most of the investors do not mind taking heavy risks and buying
even low grade bonds. The assumptions is that the yields which are
received on a high quality bond will be low than the yield on low quality
bond at all times. The technical analyst a nalyses the indicator of the
confidence index to measure in time period from two months to a
maximum of eleven months.
The confidence index also indicates a fall in the stock prices and
shows that the low grade yields rises faster and fall slower than thehigh
grade yields. A depression in the moment causes the investors to become
risk averse and short time speculators do not take an advantage to shift in
prices from high grade to low grade bonds. This is so because they expect
a downward trend in the economy to follow. Research has shown that
confidence index is not always positively correlated with the stock market.
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86trend because it is called as leading indicator, yet the signals which
reformed by it show errors.
7.4 SUMMARY
The technical analysts studies the behaviour of the price of the stock to
determine the future price of the stock.
According to Charles Dow, stock price movements are divided into
three: the primary movement, the s econdary movement and the daily
fluctuations.
A primary trend may be a bull market moving in a steady upward
direction, or a bear market steadily dropping.
A secondary trend or secondary reaction is the movement of the
market contrary to the primary trend.
Support level is the barrier for further decline. It provides a base for an
up move. The resistance level is the level in which advances are
temporarily stopped and the sellers overcome the demand.
Volume of the trade confirms the trend. Fall of volume wi th the rise in
price indicates trend reversal and vice -versa.
Moving averages are used as a technical indicator. It smoothens out
the short -term fluctuations, helpful in comparing the stock price
movement with the index movement and discovering the trend.
7.5 SELF -ASSESSME NT QUESTIO NS
1.How does technical analysis differ from the fundamental analysis?
2.Explain in detail the Dow Theory and how is it used to determine the
direction of stock market?
3.Explain the stages of primary bull market and primary bear market.
4.Write a note on signal confirmation.
5.Explain various volume indicators.
6.Explain various market sentiment indicators.
7.What is mean by confidence index?
8.Write a note on different price movements.
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878
PORTFOLIO THEORY A ND
RISK & RETUR N
Unit Structure
8.0Learning Objectives
8.1Introduction of Portfolio
8.2Portfolio Selection
8.3Efficient Portfolio & Optimal Portfolio
8.4Risk and Return
8.5Summ ary
8.6Solved Problems
8.7Self-Assessment Question s
8.0LEAR NING OBJECTIVES
After studying this lesson you are able to:
Understand the concept of portfolio
Explain the concept of efficient & optimal portfolios
Understand the meaning of Risk, Return
Explain Types of Risk
Measure the two asset portfolio risk
8.1INTRODUCTIO NOF PORTFOLIO
Each and every security have risk return features. The expected
return on security is flexible. This flexibility (change) is a risk of that
particular security. No investor invest his/her entire wealth in a single
security, because of an aversion to risk. It is hoped that if money is
invested in several securities ,simultaneously, the loss in one will be
compensated by the gain in others. Thus, holding more than one security
at a time is an attempt to spread and minimiz e risk. Most investors thus
tend to invest in a group of securities rather than a single security.
Such a group of securities/ assets held together as an investment is
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88For Example,
Mr. A Invested his `20,00,000 in following manner
shares of Tata Power `4,50,000
Government Bonds `8,00,000
NSC & NSS `2,50,000
Real Estate `5,00,000
The process of creating such a portfolio is called diversification. It
is an attempt to spread and minimize the risk in investment. This is
required to be achieved by holding different types of securities across
different industry groups. From a given set of securities, any number of
portfolios can be constructed. A rational investor attempts to find the most
efficient of these portfolios. The eff iciency of each portfolio can be
evaluated only in terms of the expected return and risk of the portfolio as
such. Thus, determining the expected return and risk of different portfolios
is a primary step in portfolio management. This step is designated as
portfolio analysis.
Many time the investors go on acquiring these assets in an ad hoc
and unplanned manner and the result is high risk, low return profile which
they may face. Such different assets would constitute a portfolio and wise
investor not only p lans his/ her portfolio as per his/her risk return profile
but also manages his portfolio efficiently which results inhighest return at
low level of risk. In other words ,it is called as portfolio management.
8.2 PORTFOLIO SELECTIO N
Selection of Port folio
The selection of portfolio depends on the various objectives of the
investor. The selections of portfolio under different objectives are dealt
subsequently.
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’s preferences. Money is invested in short term debt and fixed
income securities. Here the growth of income be comes the secondary
objective and stability of principal amount may become the third. Even
within the debt portfolio, the funds inve sted in short term bonds depend on
the need for stability of principal amount in comparison with the stability
of income. If the appreciation of capital is given third priority, instead ofmunotes.in

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89short term debt the investor opts for long term debt. The maturity period
may not be a constraint.
Growth and Income and Asset Mix
Here the investor requires a certain percentage of growth i nt h e
dividend received from his investment. The investor’s portfolio may
consist of 60 to 100 % equities and 0 to 40 % debt instrument. The debt
portion of the portfolio may consist of concession regarding tax
exemption. Appreciation of principal amount i s given third priority. For
example ,computer software, hardware and non -conventional energy
producing company shares provide good possibility of growth in dividend.
Capital Appreciation and Asset Mix
Capital appreciation and asset mix Capital appreciatio n means that
the value of the original investment increases over the years. Investment in
real estates 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 h igher than their original issue prices. For example ,
Satyam Computers share value was `306 in April 1998 but in October
1999 the value was `1658.
Likewise, several examples can be cited. The market capitalisation
also has increased. Next to real assets, the stock markets provide best
opportunity for capital appreciation. If the investor’s objective is capital
appreciation, 90 to 100 per cent of his portfolio may consist of equities
and 0 -10% of debts. The growth of income becomes the secondary
objective.
Safety of Principal and Asset Mix
Usually, 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. Al l the investors
have this objective in their mind. No one likes to lose his money invested
in different assets. But, the degree may differ. The investor’s portfolio
may consist more of debt instruments and within the debt portfolio more
would be on short t erm debts.
Markowitz Theory
Many investors have agree dthat holding 2 securities is less risky
than holding 1. For example, holding stocks from pharma, banking, and
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90company’s stock . But building up the optimum portfolio is very difficult.
Markowitz provides an answer to it with the help of risk and return
relationship. The variability of each security and covariance for their
returns reflected through their inter -relationships which should be taken
into account. Thus, as per the Modem Portfolio Theory, expected returns,
the variance of these returns and covariance of the returns of the securities
within the portfolio are to be considered for the choice of a portfolio. A
portfolio is said to be efficient, if it is expected to yield the highest return
at the lowest risk. A set of efficient portfolios can be generated by using
the above process of combining various securities whose combined risk is
lowest for a given level of return for the same amount of investment.
Assumptions of Markowitz Theory
The theory of Markowitz as stated above is based on a number of
assumptions, these are:
1. Investors seek to maximize the expected return of total wealth.
2. All investors have the same expec ted single period investment horizon.
3. All investors are risk -adverse, that is they will only accept greater risk if
they are compensated with a higher expected return.
4. Investors base their investment decisions on the expected return and
risk.
5. All markets are perfectly efficient (e.g. no taxes and no transaction
costs).
The unsystematic and company related risk can be reduced by
diversification into various securities and assets whose variability is
different and offsetting or put in different word s which are negatively
correlated or not correlated at all.
8.3 EFFICIE NT PORTFOLIO &O P T I M A L
PORTFOLIO
Efficient Portfolio
An investor can combine securities or assets to form several
portfolios. However all portfolios may not be efficient in terms of risk &
return relationship. An efficient portfolio is one that has the highest
expected returns at a given level of risk, The efficient frontier is the
frontier form by the set of efficient portfolios. In Figure 3.1.1 ,the curve
starting fr om portfolio P, which is the minimum variance portfolio, &
extending tothe portfolio R is the efficient frontier. All portfolios on the
efficient frontier are efficient portfolios and the portfolios outside the
efficient frontier are inefficient portfolios. For example ,portfolio Q has
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91Optimal Portfolio
The optimal portfolio concept falls under the modern portfolio
theory .T h e theory assumes (among other things) that investors fanatically
try to minimize riskwhile striving for the highest return possible. The
theory states that investors will act rationally, always mak ing decisions
aimed at maximizing their return for their acceptable level of risk.
The optimal portfolio was used in 1952 by Harry Markowitz, and it
shows us that it is possible for different portfolios to have varying levels
of risk and return. Each inve stor must decide how much risk they can
handle and th en allocate (or diversify) their portfolio according to this
decision.
The chart below illustrates how the optimal portfolio works. The
optimal -risk portfolio is usually determined to be somewhere in th e middle
of the curve because as you go higher up the curve, you take on
proportionately more risk for a lower incremental return. On the other end,
low risk/low return portfolios are pointless because you can achieve a
similar return by investing in risk-free assets , like government securities.
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928.4 RISK & RETUR N
Risk
Risk can be defined as the chance that the expected or prospective
(not materialize )actual outcome of investment may b e less than the
expected outcome. The greater the variability or dispersion of the possible
outcomes, or the broader the outcomes, the greater the risk. Risk is
inherent in any investment. This risk may relate to loss of capital, delay in
repayment of capi tal, non -payment of interest, or variability of returns.
While some investments like government securities and bank deposits are
almost riskless, others are more risky. The risk of an investment depends
on the following factors.
1. The longer the maturity period, the larger is the risk.
2. The lower the credit worthiness of the borrower, the higher is the risk.
3. The risk varies with the nature of investment. Investments in ownership
securities like equity shares carry higher risk compared to investments in
debt instruments like debentures and bonds.
Risk and return of an investment are related. Normally, the higher the risk,
thehigher is the return.
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93Types of Risk :
Systematic Risks
Non diversifiable risk is called systematic risk. It arises on account
of economy wide uncertainties & the investor’s tendency andis also called
as Market Risk. Some examples are Government changes ,interest rate
policy, corporate tax rate increased etc.
i)Market Risk
Market risk arises out of changes in Demand and Supply of goods
and service in the markets. Market risk is unpredictable. It is not
controllable. It is uncontrollable factor of the risk. Investors have failure
due to lack of knowledge of market.
ii)Interest Rate Risk
Investment isalways expected to return in terms of interest rate.
Interest rate changes from time to time. The loan borrowed by companies
and stock brokers generally depend on interest rates. When interest rate is
changed, the market activity and investor perceptions change with the
changes in interest rates. The monetary and fiscal policy that is not
controllable by the investor affects the riskiness of investment due to their
effects in terms of returns, expectations and total principal amount.
iii)Purchasing Power Risk
Purchasing power risk is the uncontrollable risk. Inflation means it
rises the prices of the commodities and service. Cost push inflation is
caused due to wage rise or rise in input prices. Price of the commodities
increase due to inadequate supplies and rising demand.
Other Riskmunotes.in

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94Unsy stematic Risks
All diversifiable risks are called unsystematic risk. These arises
from the unique uncertainties of individual securities. These type of risk
can be totally reduced through diversification.
i)Business Risk
Business risk refers to the vari ability of the business, sales,
income, profits etc. It can depend on the market conditions for the product
mix, input supplies, strength of competitors etc. Business risk is internal
risk due to fall in production, labour problems, raw material problems o r
inadequate supply of electricity etc. It leads to fall in revenues and in
profit of the company.
ii)Financial Risk
Financial risk refers to the method of financing adopted by the
company, high leverage leading to larger debt servicing problems or short
term liquidity problems due to bad debts, delayed receivables and fall in
current assets or rise in current liabilities. Financial problems observed are
in terms of earnings, profits, dividends.
iii)Default or Insolvency Risk
The borrower/issuer of sec urities may become insolvent due to
default or delay inthe payment in terms of instalments or principal
repayments.
Other Risks
i)Political Risks
Political risks refer to changes in the government tax rate,
monetary policy, fiscal policy, impositions co ntrol and administrative
regulations etc.
ii)Management Risk
Management risk refers to error and inefficiencies of management,
causing losses to the company.
iii)Marketability Risks
It refers to theinvolve dloss of liquidity or loss of value in
conver sions from one asset to another.
Expected Return on a Portfolio
As a first step in portfolio analysis, an investor needs to specify the
list of securities eligible for selection or inclusion in the portfolio. Next he
has to generate the risk -return expect ations for these securities. These are
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95or standard deviation of the return. The expected return of a portfolio of
assets is simply the weighted average of the return of the individu al
securities held in the portfolio. The weight applied to each return is the
fraction of the portfolio invested in that security.
Let us consider a portfolio of two equity shares X and Y with
expected returns of 15 % and 20 % respectively. If 40 % of the total funds
are invested in share X and the remaining 60 %,
in share Y, then the expected portfolio return will be:
E(Rp) = WxE ( R x ) + ( 1 -W) x E(Ry)
= (0.40 x 15) + (0.60 x 20)
= 18 %
The formula for the calculation of expected portfolio return m ay be
expressed as shown below:
Risk of a Portfolio
The variance of return and standard deviation of return are
alternative statistical measures that are used for measuring risk in
investment. These statistics measure the extent to which returns are
expected to vary around an average over time. The calculation of variance
of a portfolio is a little more difficult than determining its expected return.
The variance or standard deviation of an individual security
measures the riskiness of a securi ty in absolute sense. For calculating the
risk of a portfolio of securities, the riskiness of each security within the
context of the overall portfolio has to be considered. This depends on their
interactive risk, i.e. how the returns of a security move wi th the returns of
other securities in the portfolio and contribute to the overall risk of the
portfolio.
Covariance is the statistical measure that indicates the interactive
risk of a security relative to others in a portfolio of securities. In other
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96word s, the way security returns vary with each other affects the overall
risk of the portfolio.
The covariance between two securities X and Y may be calculated using
the following formula:
The covariance is a measure of how returns of two sec urities move
together. If the returns of the two securities move in the same direction
consistently ,the covariance would be positive. If the returns of the two
securities move in opposite direction consistently the covariance would be
negative. If the mov ements of returns are independent of each other,
covariance would be close to zero. Covariance is an absolute measure of
interactive risk between two securities. To facilitate comparison,
covariance can be standardized. Dividing the covariance between two
securities by product of the standard deviation of each security gives such
a standardised measure. This measure is called the coefficient of
correlation. This may be expressed as:
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97It may be noted from the above formula that covariance may be
expressed as the product of correlation between the securities and the
standard deviation of each of the securities. Thus,
Cov xy=r xyσxσy
The correlation coefficients may range from -1 to 1. A value of -1
indicates perfect negative correlation betwe en security returns, while a
value of +1 indicates a perfect positive correlation. A value close to zero
would indicate that the returns are independent. The variance (or risk) of a
portfolio is not simply a weighted average of the variances of the
individ ual securities in the portfolio. The relationship between each
security in the portfolio with every other security as measured by the
covariance of return has also to be considered. The variance of a portfolio
with only two securities in it may be calcula ted with the following
formula.
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98Portfolio standard deviation can be obtained by taking the square root of
portfolio variance .
Example -calculation of portfolio variance and portfolio standard
deviation.
Two securities P and Q generate the following sets of expected
returns, standard deviations and correlation coefficient: A portfolio is
constructed with 40 per cent of funds invested in P and the remaining 60
per cent of funds in Q.
P Q
r= 15 percent 20 percent
σ= 50 percent 30 percent
rpq= -0.60
Solution
The return and risk of a portfolio depends on two sets of factors (a)
the returns and risks of individual securities and the covariance between
securities in the portfolio, (b) the prop ortion of investment in each
security. The first set of factors is parametric to the investor in the sense
that he has no control over the returns, risks and covariance of individual
securities. The second sets of factors are choice variables in the sense that
the investor can choose the proportions of each security in the portfolio.
Security Returns Perfectly Positively Correlated
When security returns are perfectly positively correlated the
correlation coefficient between the two securities will be +1. T he returns
of the two securities then move up or down together.
The standard deviation then becomes simply the weighted average
of the standard deviations of the individual securities.
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99σp=X 1σ1+X 1σ2
Taking the same example that we considered ea rlier for calculating
portfolio variance, we shall calculate the portfolio standard deviation when
correlation coefficient is +1.
Standard deviation of security P = 50
Standard deviation of security Q = 30
Proportion of investment in P = 0.4
Proportion of investment in Q = 0.6
Correlation coefficient = +1.0
Portfolio standard deviation may be calculated as:
σp=X 1σ1+X 1σ2
=( 0 . 4 )( 5 0 )+( 0 . 6 )( 3 0 )
=3 8
Being the weighted average of the standard deviations of
individual securities, the portfolio standard deviation will lie between the
standard deviations of the two individual sec urities. In our example, it will
vary between 50 and 30 as the proportion of investment in each security
changes.
For example, if the proportion of investment in P and Q are 0.75 and 0.25
respectively, portfolio standard deviation becomes:
=( 0 . 7 5 )( 50) + (0.25) (30)
=4 5
Security Returns Perfectly Negatively Correlated
When security returns are perfectly negatively correlated, the
correlation coefficient between them becomes -1. The two returns always
move in exactly opposite directions.
The portfo lio variance may be calculated as:
σp=X 1σ1-X1σ2
For the illustrative portfolio considered above, we can calculate the
portfolio standard deviation when the correlation coefficient is —1.
=( 0 . 4 )( 5 0 ) -(0.6) (30)
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100The portfolio risk i s very low. It may even be reduced to zero. For
example, if the proportion of investment in P and Q are 0.375 and 0.625
respectively, portfolio standard deviation becomes:
=( 0 . 3 7 5 ) ( 5 0 ) -(0.625)(30)
=0
Here, although the portfolio contains two risk y assets, the portfolio
has no risk at all. Thus, the portfolio may become entirely risk free when
security returns are perfectly negatively correlated. Hence, diversification
becomes a highly productive activity when securities are perfectly
negatively co rrelated, because portfolio risk can be considerably reduced
and sometimes even eliminated. But, in reality, it is rare to find securities
that are perfectly negatively correlated.
8.5SUMMARY
Markowitz developed algorithms to minimise portfolio risk.
Diversification reduces the unsystematic risk component of the
portfolio.
Many portfolios may be attainable. But some portfolios are attractive
because they give more return for the same level of risk or same return
with lesser level of risk. These portfol ios form the efficient frontier.
The total risk of an asset can be divided into two parts: systematic risk
that cannot be eliminated by diversification, and unsystematic risk that
can be eliminated by diversification. It follows that the only risk that
remains in a well -diversified portfolio is systematic risk.
If securities with less than perfect positive correlation between their
price movements are combined risk can be reduced considerably. The
risk would be nil or the standard deviation would be zero if two
securities have perfect negative correlation. Risk cannot be reduced if
the securities have perfect positive correlation.
Expected Return =111n
pRi X Rportfolio variance =22 2211 22 1 2 1 , 22x x x x CoVOR22 2 2 211 22 1 2 1 2 1 22 Px x x x r Where,xthe weight of the asset2= the variance of the asset
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1018.6SOLVED PROBLEMS
1.Calculate the expected return and variance of a portfolio comprising
two securities, assuming that the portfolio weights are 0.75 for security 1
and 0.25 for security 2. The expected return for security 1 is 18 per cent
and its stan dard deviation is 12 per cent, while the expected return and
standard deviation for security 2 are 22 per cent and 20 per cent
respectively. The correlation between the two securities is 0.6.
Solution
Calculation of expected return of portfolio:
=( 0 . 7 5 x1 8 )+( 0 . 2 5x2 2 )
=1 3 . 5+5 . 5
=19 %
Calculation of portfolio variance:
=( 0 . 7 5 )2(12)2+( 0 . 2 5 )2(20)2+2( 0 . 7 5 )( 0 . 2 5 )( 0 . 6x1 2x2 0 )
=8 1+2 5+5 4
=1 6 0%
2.Consider two securities, P and Q, with expected returns of 15 per cent
and 24 per cent respectively, and standard deviation of 35 per cent and 52
per cent respectively.
Calculate the standard deviation of a portfolio weighted equally
between the two securities if their correlation is -0.9.
Solution
Calculation of portfolio standard deviation:
=( 0 . 5 )2(35)2+( 0 . 5 )2(52)2+2( 0 . 5 )( 0 . 5 )( -0.9 x 35 x 52)
=3 0 6 . 2 5+6 7 6 -819
=1 6 3 . 2 5
σ=
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1023.A portfolio is constituted with four securities having the following
characteristics:
Secur ity Return (per cent) Proportion of investment
P 17.5 0.15
Q 24.8 0.25
R 15.7 0.45
S 21.3 0.15
Calculate the expected return of the portfolio.
Solution
Expected return of the portfolio is calculated with the following formula:
=( 0 . 1 5x1 7 . 5) + (0.25 x 24.8) + (0.45 x 15.7) + (0.15 x 21.3)
=2 . 6 2 5+6 . 2 0 0+7 . 0 6 5+3 . 1 9 5
=1 9 . 0 8 5%
3.1.5Self Assessment Questions
(a)Theory
1 Explain the concept and process of portfolio analysis?
2 Explain efficient portfolio.
3 Explain Optimal Portfolio.
4 Define the Mar kowitz diversifications.
5 Explain the assumptions of Markowitz theory.
6 What are the simple diversification (a) will it reduce total risk (b)
will it reduce
7 unsystematic risk?
8 Explain risk and return concept.
9 Explain the types of risks.
(b)Problems
1.An in vestor places 30 per cent of his funds in Security X and the
balance in Security Y. The expected returns on X an dYa r e1 2a n d1 8p e r
cent, respectively. The standard deviations of returns on X and Y are 20
and15 per cent, respectively.(a) Calculate the expected return on the
portfolio.(b) Calculate the variance of returns on the portfolio assuming
that the correlat ion between the returns on the two securities is:(i) +1.0
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1032.An investor holds a portfolio that comprises 20 per cent X, 30 per cent
Y and 50 per cent Z. The standard deviations of returns on X, Y and Z
are22, 15 and 10 per cent , respectively, and the correlation between
returns on each pair of securities is 0.6. Prepare a variance covariance
matrix for these three securities and use the matrix to calculate the
variance and standard deviation of returns for the portfolio.
3.Stocks X and Y display the following returns over the past three years.
Year Return of X Return of Y
1994 14 % 12%
1996 16% 18%
1996 20% 15%
a) What is the expected return on portfolio made up of 40% of X and 60%
of Y.
b) What is the sta ndard deviation (risk) of each stock X and Y.
c) What is the portfolio risk of a portfolio made up of 40% of X and 60%
of Y.
d) Determine the correlation coefficient of stock X and Y.
4.Calculate the co -variance and coefficient of correlation from the
following data. Stocks X and Yand their returns and expected returns are
given below
Return Expected Return
Stock X 14 18
Stock Y 26 18
Stock X 22 18
Stock Y 10 18
5.Stocks P and Q display the following returns over the past three years.
Year Return of P Return of Y
1994 28 % 24%
1996 32% 36%
1996 40% 30%
a) What is the expected return on portfolio made up of 40% of X and 60%
of Y.
b) What is the standard deviation (risk) of each stock X and Y.
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1049
CAPITAL ASSET PRICI NGM O D E L
(CAPM)
Unit Structure
9.0 Learning Objectives
9.1Introduction of CAPM
9.2Assumptions & Limitations of CAPM
9.3Capital Market Line
9.4Security Market Line
9.5Difference between Capital Market Line & Security Market Line
9.6Summ ary
9.7Solved Problems
9.8Self-Assessment Questions
9.0LEAR NING OBJECTIVES
After studying this lesson you are able to:
Understand the concept of CAPM
Explain Assumptions & Limitations of CAPM
Understand Capital Market Line & Security Market L ine
9.1 INTRODUCTIO N
The Capital Asset Pricing Model (CAPM) is the model that
provides a framework to determine the required rate of return on an asset
or investment and it indicates the relationship between risk & return on
asset. Investors are interes ted in knowing the systematic risk when they
search for efficient portfolios. They would like to have assets with
systematic risk. Investors would take a high risk only if they provide high
rate of returns. The essential rate of return specified by CAPM he lps in
valuing an asset / investment. With the help of CAPM investor can
compare estimated rate of return and required rate of return on investment.
Capital Market Line determine the actual relationship between risk &
return for securities in efficient por tfolios. CAPM also explains how assets
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1053.2.2 (A) ASSUMPTIO NSO FC A P M
Capital market theory involves a set of predictions concerning
equilibrium expected return on risky assets. John Lintner, Markowitz, Jan
Mossin a nd William Sharpe provided the basic structure for the CAPM
model. CAPM is an economic model which describes how the securities
are priced in the securities market.It is a model of linear general
equilibrium return. Capital market theory builds on Markowit z portfolio
theory to diversify his or; her portfolio, according to the Markowitz
model, choosing a location on the efficient frontier that matches his or her
return -risk references. CAPM is based on many important assumptions
these are:
1)An individual sel ler or buyer cannot affect the price of a stock.
2)Investors are assumed to have homogenous expectations about the
expected return and risks of securities during the decision -making
period.
3)The investor can lend or borrow any amount of funds at the risk less
rate of interest. All investors form portfolios from publically traded
securities like shares, treasury bills or Government securities.
4)Investors make their decisions only on the basis of the expected
returns, standard deviations and co -variances of all pairs of securities.
5)All investors have the same one -period time horizon.
6)Total asset quantity is fixed and all assets are marketable & divisible.
7)There is no transaction cost i.e. no cost involved in buying and selling
of stocks.
8)There is no personal inco me tax. Hence, the investor is indifferent to
the form of return ,either capital gain or dividend.
3.2.2 (b) LIMITATIO NSO FC A P M
1)It is based on unrealistic assumptions. For example, it is very
difficult to find risk -free security. CAPM may not accurately
explain the investment behaviour of investors.
2)It is difficult to test the validity of CAPM.
3)Betas do not remain stable over time.
The CAPM is an equilibrium model that encompasses two
important relationships. The first, the capital market line specifie st h e
equilibrium relationship between expected return and risk for efficientmunotes.in

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106portfolios. The second, the security market line specifies the equilibrium
relationship between expected return and systematic risk. It applies to
individual securities as well a s portfolios.
9.3 THE CAPITAL MARKET LI NE
The market portfolio is a portfolio comprised of all stocks in the
market. Each asset is held in proportion to its market value to the total
value of all risky assets. At this stage, the investor has the ability to
borrow or lend any amount of money at the riskiness rate of interest. The
efficient frontier of the investor is given in figure. 9.2.1
The figure shows the efficient frontier of the investor. The investor
prefers any point between B and C because, with the same level of risk
they face on line BA, they are able to get superior profits. The ABC line
shows the investor’s, portfolio of risky assets. The investors can combine
riskless asset either by lending or borrowing.
The line R fSr e p r e s e n ts all possible combination of riskless and
risky asset. The ‘S’ portfolio does not represent any riskless asset but the
line RS gives the combination of both. The portfolio along the path RS is
called lending portfolio that is some money is invested in th e riskless asset
or may be deposited in the bank for a fixed rate of interest. If it crosses the
point S ,it becomes borrowing portfolio. Money is borrowed and invested
in the risky asset. The straight line is called capital market line (CML).
Thus ,all ef ficient portfolios will lie on the capital market line.
Figure9.2.1munotes.in

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107The slope of the CML can be regarded as the reward per unit of
risk borne. This equals to the difference between the expected return on
the market portfolio (E m-T) & that of the risk less security divided by the
difference in their risk ( σm-0).
The Capital Market Line represents linear relationship between the
required rates of return for efficient portfolios and their standard
deviations.
The equation for capital market line is:
Where,
Rp=portfolio’s expected rate of return
Rm=expected return on market portfolio
σm=standard deviation of market portfolio
σp=standard deviation of the portfolio
Rf= risk free rate
Separation Theorem
Because we are assuming homog eneous expectations, in
equilibrium all investors will determine the same tangency portfolio.
Further, under the assumptions of capital market theory all investors agree
on the risk -free rate. An investor can mix lending and borrowing with an
efficient por tfolio of risky assets. Borrowing and lending possibilities,
combined with one portfolio of risky assets, offer an investor whatever
risk-expected return combination he or she seeks that is, investors can be
anywhere they choose on this line depending on t heir risk -return
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108preferences, but they will choose the same combination of risky securities
as denoted by the tangency point.
For example,
An investor could:
1.Invest 100 percent of investable funds in the risk -free asset, providing
an expected return of R Fand zero risk.
2.Invest 100 percent of investable funds in risky -asset portfolio -M,
offering E (R M),with its risk σm
3.Invest in any combination of return and risk between these two points ,
obtained by varying the proportion w rfinvested in the risk -free asset.
4.Invest more than 100 percent of investable funds in the risky -asset
portfolio M by borrowing mon ey at the rate R F, thereby increasing
both the expected return and the risk beyond that offered by portfolio
M.
9.4 SECURITY MARKET LI NE
The risk -return relationship of an efficient portfolio is measured by
the capital market line. But, it does not show the risk -return trade off 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. Th e beta analysis is useful for
individual securities arid portfolios whether efficient or inefficient.
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109When an additional security is added to the market portfolio, an additional
risk is also added to it. The variance of a portfolio is equal to the weighted
sum of the co -variances of the individual securities in the portfolio.
If the security ‘i’ isincluded, the covariance isbetween the security and
the market measures the risk. Covariance can be standardized by dividing
it by standard devi ation of market portfolio coyi m/σm. This is a standardise
measure of a systematic risk of the security.
Then, the expected return of the security ‘i’ is given by the equation:
Rs–Rf=C o yi m/σ2m(Rm–Rf)
This equation can be rewritten as follows:
E(R s)= R f+
j[E(R m)-Rf]
Where,
E(R s)= expected return on security s
Rf= risk free rate
E(R m)= expected return on market portfolio
s= undiversifiable risk of security s
Example:
If we assume the expected market risk premium to be 8% and the
risk free rate of return to be 17%, we can calculate expected return for A,
B and C securities having beta 0.60, 1.00 and 1.20 respectively by using
above mentioned formula.
Therefore,
Security A Security B Security C
Formula : E(Rj)= Rf +
j[E(Rm) -Rf]
E(R) = 0.08+(0.17 –0.08)
0.60
=0 . 1 3 4i . e .1 3 . 4 0 %E(R) = 0.08+(0.17 –0.08)
1.00
=0 . 1 7 0i . e .1 7 . 0 0 %E(R) = 0.08+(0.17 –0.08)
1.20
=0 . 1 8 8i . e .1 8 . 8 0 %
The beta coefficient of the equat ion of SML is same as the beta of
the market model. In equilibrium, all efficient and inefficient portfolios lie
along the security market line. The SML line helps to determine the
expected return for a given security beta. In other words, when betas are
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110The same can be found out easily from the figure too. All we have to do is,
to mark the beta on the horizontal axis and draw a vertical line from the
relevant point to tou ch the SML line. Then from the point of intersection,
draw another horizontal line to touch the Yaxis. The expected return could
be very easily read from the Y axis. The securities B and C are aggressive
securities, because their beta values are greater th an one. When beta
values are less than one, they are known as defensive securities. In our
example, security A has the beta value less than one.
Level of the security beta indicates:
Ifβ=1It indicate ssystematic risk, equal to the aggregate market ris k
and the required rate of return on the security will be equal to the
market rate of return.
Ifβ>1,It indicates its systematic risk is greater than the aggregate
market. In this situations ,there are more fluctuations in the securities
return than the market returns .
Ifβ<1,It indicates its systematic risk is lower than the aggregate
market risk. In this situations ,securities are less sensitive for returns
compare to the market returns.
9.5. DIFFERE NCE BETWEE NCAPITAL MARKET
LINE&S E C U R I T YM A R KET LI NE
• Both specify a relation between risk and Expected returns:
Expected Return = “Time Premium” + “Risk Premium”
Where “Risk Premium” = “quantity of risk” ,“price of risk”
• Measure of risk.
–In the CML, risk is measured by s tandard deviation.
–In the SML, risk is measured by beta.
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111• Applicability:
–CML is applicable only to an investor’s final (combined)
portfolio (which is efficiently diversified, with no Unique risk) In
the CAPM world, everybody holds portfolio which lie on the
CML.
–SML i s applicable to any security, asset or portfolio (which may
contain both components of risk). In a CAPM world ,every asset
lies on the SML.
9.6 SUMM ARY
➢The CAPM model is based on specific assumptions. The investor
could borrow or lend any amount of m oney at riskiness rate of
interest.
➢All investors hold only the market portfolio and the riskless securities.
➢The capital market line represents the relationship between the
expected return and standard deviation of the portfolio.
➢The risk of the sec urity is indicated by its covariance with the market
portfolio.
➢Security market line shows the linear relationship between the
expected returns and betas of the securities.
➢The objective of the asset pricing model is to identify the equilibrium
asset p rice for expected return and risk. If the asset prices are not
equal, there is a scope for arbitrage.
9.7 SOLVED PROBLEMS
1.Security Z has a beta of 0.75 while security S has a beta of 1.45.
Calculate the expected return for these securities, assuming t hat the risk
free rate is 5 per cent and the expected return of the market is 14 per cent.
Solution
The expected return can be calculated using CAPM
Ri = Rf + βi( R m=R f )
For Security Z
Ri =5+0 . 7 5( 1 4 –5)
=5+6 . 7 5
=1 1 . 7 5p e rc e n t
For Security S
Ri =5+1 . 4 5( 1 4 –5)
=5+1 3 . 0 5
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1122.A security pays a dividend of `3.85 and sells currently at `83. The
security is expected t o sell at `90 at the end of the year. The security has a
beta of 1.15. The risk free rate is 5 per cent and the expected return on
market index is 12 per cent. Assess whether the security is correctly
priced.
Solution
To assess whether a security is corre ctly priced, we need to calculate
(a) the expected return as per CAPM formula,
(b) the estimated return on the security based on the dividend and increase
in price over the holding period.
Expected return
Ri =R f+ βi( R m=R f )
=5+1 . 1 5( 1 2 –5)
=5+8 . 0 5
=1 3 . 0 5p e rc e n t
Estimated return
Ri =
=
=
=13.07%
As the estimated return on the security is more or less equal to the
expected return, the security c an be assessed as fairly priced.
3.The following data are available to you as portfolio manager:
Security Estimated return (per cent) Beta Standard deviation (per cent)
A 30 2.0 50
B 25 1.5 40
C 20 1.0 30
D 11.5 0.8 25
E 10.0 0.5 20
Market index 15 1.0 18
Govt. security 7 0 0
In terms of the security market line, which of the securities listed
above are Under -priced?
Solution
We can use CAPM to determine which of the securities listed are
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113For this we have to calculate the expected return on each security using
CAPM equation:
Ri=R f+βi(Rm=R f)
Given that Rf(Govt. security return rate) = 7a n d
Rm = 15
Now,
Security A =7+2 . 0( 1 5 -7) =2 3p e rc e n t
Securit yB =7+1 . 5( 1 5 -7) =1 9p e rc e n t
Security C =7+1 . 0( 1 5 -7) =1 5p e rc e n t
Security D =7+0 . 8( 1 5 -7) =1 3 . 4p e rc e n t
Security E =7 +0 . 5( 1 5 -7) =1 1p e r c e n t
The expected return as per CAPM formula and the estimated return of
each securit y can be tabulated.
Security Expected return (per cent) Estimated return (per cent)
A 23.0 30.0
B 19.0 25.0
C 15.0 20.0
D 13.4 11.5
E 11.0 10.0
A security whose estimated return is greater than the expected
return is assumed to be under priced because it offers a higher return than
that expected from securities with the same risk.
9.8 SELF -ASSESSME NT QUESTIO NS
(a)Theory Questions
1)What is Capital Asset Pricing Model.
2)What are the basic assumptions & limitation of CA PM?
3)Explain Capital Market Line.
4)Define Security Market Line.
5)Distinguish between the security market line and capital market
line?
(b)Problems:
1.Suppose the market premium is 9%, market volatility is 30% and the
risk-free rate is 3%.
a)Suppose a securi ty has a beta of 0.6. According to the CAPM, what is
its expected
return?
b)A security has a volatility of 60% and a correlation with the market
portfolio of 25%.
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114c)A security has a volatility of 80% and a correlation with the
market portfolio of -25%. According to the CAPM, what is its
expected return?
Ans: a) 8.40% b) 7.50% c) -3%
2.Stock A has a beta of 1.20 and Stock B has a beta of 0.8. Suppose R f=
2% and R m= 12%.
(a) According to the CAPM, what are the expected returns for each stock?
(b) What is the expected return of an equally weighted portfolio of these
two stocks?
(c) What is the beta of an equally weighted portfolio of these two stocks?
Ans: a) A= 14%, B= 10% b) 12% c)1
3.Suppose you estimate that stock A has a volatility of 32% and a beta of
1.42, whereas stock B has a volatility of 68% and a beta of 0.75.
(a) Which stock has more total risk?
(b) Which stock has more market risk?
Ans: a) 13.36% b)8%
Stock B has more total risk. Stock A has more market risk.
4.The following table gives an analysts expected return on 2 stocks for
particular market returns.
Market return Aggressive stock
Defensive stock
6% 2%
8%
20% 30%
16%
a) What are the β’s of the two stocks
b)What is the expected return on each stock if the market return equally
likely to be 6% or 20%
5.The following table gives an analysts expected return on two stocks for
particular market returns.
Market return Aggressive stocks
Defensive stock
5% -5%
8%
25% 40%
18%
a)What are the β’s of the two stocks
b)What is the expected return on each stock If the risk free rate is 8%
what is SML?
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11510
EFFICIE NTM A R K E TT H E O R Y( E M T )
Unit Structure
10.0 Learning Objectives
10.1 Introduction
10.2 Concept of Efficient Market Theory
10.3 Assumptions of Efficient Market Theory
10.4 Random Walk Theory
3.3.5 Efficient Market Hypothesis (EMH)
-Weak F orm
-Semi Strong Form
-Strong Form
10.6 Different Empirical Tests
10.7 Anomalies to EMH
10.8 Comparison of Random Walk
10.9 Summary
10.10 Self-Assessment Questions
10.0LEAR NING OBJECTIVES
After studying this lesson you are able to:
Familiar with th e Efficient Market Theory
Understand different forms of market.
Explain Random Walk Theory
Understand Different Empirical Tests
10.1 INTRODUCTIO N
Financial markets, particularly the stock markets attract investors
as well as academicians. Investors want to predict the market to earn more
returns on their investments. Academicians want to predict it in order to
test the effectiveness of their predictive models. In fact, financial markets
put a great challenge before the researchers who are interested in th e
development of predictive models. Not only financial economists, but
researchers from other streams including statistics, mathematics, physics,
psychology and social sciences, leveraged with the expertise of the
irrespective domains, have attempted to bu ild predictive models for stockmunotes.in

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116prices. But all of these efforts seem to yield little success. Why are the
prices of financial assets unpredictable? The Efficient Market Theory
provides the answer to this question. The financial market has direct
influence of the money along with information therein. The prices of
financial assets at a point of time reflect the expectations of investors
which are shaped mainly by the available information. Accuracy and the
quickness in which market translated the expectatio n into prices are
termed as market efficiency.
Fama (1970) stated, ‘A market in which prices always fully reflect
available information is called efficient.’ In an efficient market ,price
rapidly translate in to the available information.
Here ,the term market efficiency is used in context to the
‘informational efficiency’ rather than the ‘operational efficiency’ and the
‘allocative efficiency’. The market efficiency hypothesis deals with the
information processing on stock market and provides an idea of how the
information flow can affect the valuation of firms. Based on the
background of the globalisation and mobilisation of the world ,this
hypothesis becomes increasingly important as the information flow is
getting steadily faster with the new technolog ieswhich make it possible to
have access to information all over the world.
10.2 CO NCEPT OF MARKET EFFICIE NCY
An efficient market can be defined as one where the current market
price and the fair value resemble as all pertinent information which is
incorporated immediately. Concept of market efficiency have to be
specific not only about the market which is being considered but also
about the investor group which is covered. It is extremely unlikely that all
markets are efficient to all investors, but it is entirely possible that a
particular market (e.g. the Bombay Stock Exchange) is efficient with
respect to the average investor. It is possible that some markets are
efficient while others are not, and that a market is efficient with respect to
some inves tors and not to others. This is a direct consequence of different
tax rates and transaction costs which confer advantages on some investors
relative to others. Definitions of market efficiency are also linked up with
assumptions about what information is a vailable to investors and reflected
in the price. For instance, a strict definition of market efficiency that
assumes that all information, public as well as private, is reflected in
market prices would imply that even investors with precise inside
informa tion will be unable to beat the market.
10.3 ASSUMPTIO NSO FE F F I C I E NTM A R K E T
THEORY
For the capital market efficiency theory to operate following
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117Information is free & quick to flow.
All investors have same access to information.
Transaction cost, taxes are not there and not hampering the free force
of market.
Investors are rational.
Investors behave in a cost effective competitive manner for
optimisation of returns.
Every investors has a access to lending and borrowing at a same ra te.
Market prices are not sticky and absorbs the market information
quickly.
Market responds to new technology, trends, changes in tastes and
habits etc. of consumers efficiently and quickly.
10.4 RA NDOM WALK THEORY
Stock price behaviour is explained by the theory in the following
manner. A change occurs in the price of a stock only because of certain
changes in the economy, industry or company. Information about these
changes alters the stock prices immediately and the stock moves to a new
level, either upwards or downwards, depending on the type of information.
This rapid shift to a new equilibrium level whenever new information is
received is recognition of the fact that all information which is known is
fully reflected in the price of the stock. Furthe r change in the price of the
stock will occur only as a result of some other new piece of information
which was not available earlier. Thus, according to this theory, changes in
stock prices show independent behaviour and are dependent on the new
pieces of information that are received but within themselves are
independent of each other. Each price change is independent of other price
changes because each change is caused by a new piece of information.
The basic premise in random walk theory is that the information on
changes in the economy, industry and company performance is
immediately and fully spread so that all investors have full knowledge of
the information. There is an instant adjustment in stock prices either
upwards or downwards. Thus, the curre nt stock price fully reflects all
available information on the stock. Therefore, the price of a security two
days ago can in no way help in speculating the price two days later. The
price of each day is independent. It may be unchanged, higher or lower
from the previous price, but that depends on new pieces of information
being received each day. The random walk theory presupposes that the
stock markets are so efficient and competitive that there is immediate
price adjustment. This is the result of good communication system through
which information can be spread almost anywhere in the country
instantaneously. Thus, the random walk theory is based on the hypothesis
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118known as the efficie ntmarket hypothesis (EMH) or the efficient market
model.
10.5 EFFICIE NT MARKET HYPOTHESIS (EMH)
The efficient market hypothesis (EMH) deal with informational
efficiency and strongly based on the idea that the stock market prices or
returns are unpredict able and do not follow any regular pattern ;so it is
impossible to “beat the market”. According to the EMH theory ,security
prices immediately and fully reflect all available relevant information. The
EMH theory suggests that the asset prices are determine d by the demand
and supply in the competitive market with rational investors. Rational
investors gather information very rapidly and immediately incorporate this
information into stock prices. Only new information, i.e. news, cause
change in prices but the news, by definition, is unpredictable; therefore
stock market which is immediately influenced by the news is also
unpredictable. James Lorie has defined the efficient market as“Efficient
markets means the ability of the capital market to function efficie ntly, so
that prices of securities react rapidly to new information. Such efficiency
will produce prices that are appropriate in term of current knowledge and
investors will be less likely to make unwise investments.”
The efficient market hypothesis does not by any means deny the
profitability of investing. It merely states that the rewards obtainable from
investing in highly competitive markets will be fair, on the average, for the
risks involved. Importantly, however, the three forms of the efficient
market hypothesis hold that acting on publicly available information
cannot improve one’s performance beyond the market’s assessment of a
fair rate of return. The weak form of the efficient market hypothesis
describes a market in which historical price data a re efficiently digested
and, therefore, are
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119useless for predicting subsequent stock price changes. This is
distinguished from a semi strong form under which all publicly available
information is assumed to be fully discounted in current securities pri ces.
Finally, the strong form describes a market in which not even those with
privileged information can obtain superior investment results. In 1970,
Fama classified efficient market hypothesis in three categories according
to the level of information refl ected in market prices –weak form, semi -
strong form and strong form; a summarized description of these different
forms of market efficiency is presented below:
The Weak Form of the Market
The weak form efficiency is based on ‘random -walk’. In weak
form of market efficiency ,stock prices reflect all available trading
information which can be derived from the market data such as past price,
trading volume etc, so nobody can use information related to past price to
identify the undervalued security and mak ea big profit by them .It implies
that no one should be able to outperform the market using something that
"everybody else knows". If the markets are efficient in weak fo rm,
technical trading rules cannot be used to make profit on a consistent basis.
This form of market efficiency is called weak -efficiency because the
security prices are the most publicly and easily accessible pieces of
information. The weak form of the efficient market hypothesis is a valid
description of the market for anyone who is inte rested in developing
profitable investment strategies from historical price or volume
information. There is neither a theoretical foundation nor empirical
support for technical analysis based on historical price and volume data.
Although number of empirica l studies support weak form of efficient
market ,there are still number of financial researchers who are studying the
past stock price series and trading volume data in attempt to generate
profit. In short ,weak form of efficient market implies that:
Stock prices quickly incorporate all past price information which can
be derived by trading data (i.e. past prices, volume, short interest).
Everyone knows the past price movement of market, therefore nobody
can outperform the market on a consistent basis usi ngsome trading
strategy based on past price trends (as done by technical analysts).
Prices follow a “random walk” or more precisely an ‘exponential
random walk'.
Semi -Strong Form of the Market
In semi -strong form ,all publicly available information are
incorporated into current stock prices. Publicly available information
includes past price information plus company’s annual reports (such as
financial reports, balance sheet and profit and loss account), company's
announcement, macro economic factors such as (inflation, unemployment
etc) and others. Some information (to the extent anticipated in advance) is
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120took place. Such matters like earnings reports, bonus, and rights affect the
marketeven in anticipation before the formal announcements. Semi -strong
form implied that share prices adjust to publicly available new information
very rapidly and in an unbiased fashion, such that no one should be able to
outperform the market using somet hing that "everybody else knows". This
indicates that a company's financial statements are of no help in
forecasting future price movements and securing high investment returns.
Evidences of empirical studies (most of them are based on event -study
methodol ogy) broadly support this form of efficiency. In short ,semi –
strong form of efficient market implies that:
Market prices incorporate all publicly available information.
Publicly available information is easily reachable for everybody so no
investor can use it to device the strategy which could outperform the
market on a consistent basis.
Share prices adjust to publicly available new information very rapidly
and in an unbiased fashion, such that no excess returns can be earned
by trading on that informati on.
Neither technical analyst nor fundamental analyst will be able to help
the investors to outperform in the market.
Strong Form of the Market
In strong form efficiency ,stock prices quickly reflect all types of ,
information which include public informa tion plus companies inside or
private information. Thus, it is the combination of public and private
information that is incorporated into current prices. This form implies that
even companies management can not make profit from inside information ;
they ca nnot take advantage of inside affairs or important decision or
strategies to beat the market. According to strong -form market efficiency,
inside information is also already incorporated into stock prices ;the
common rational behind this is unbiased market anticipation that already
react in to market before companies strategic decision. Strong form of
efficiency is hard to believe in practice except where rules and regulations
of law are fully ignored. Studies (Reilly &Brown, 2008) that examined the
result o f the corporate insiders and stock exchange specialists do not
support the strong form of efficient market hypothesis. Empirical evidence
has been mixed, but has generally not supported strong forms of the
efficient -market hypothesis Implications of strong form of efficiency are :
Market prices incorporate all public and private information.
Nobody can gain abnormal return even those who have inside
information.
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12110.6 DIFFERE NT EMPIRICAL TESTS
Random Walk Test
There were many researches and test carried on to the weak form
of efficient market hypothesis. Majority studies pointed a questioned
‘whether security prices follows a random walk’. A random walk when it
is applied to security prices means that all theprice changes which have
occurred today are completely independent of the prices prior to this day.
The weak form of the efficient market considers only the average change
of today’s prices of security. It clarifies that the large price changes are
followed by larger price changes. This observation violates the random
walk behaviour but it does not violate the weak form of the efficient
market.
Simulation Test
In 1959 ,Robert & Osborne took the Dow Jones Industrial Average
and compare dits level with a variable generated by a random walk
mechanism. They concluded from test that the mechanism of a random
walk showed patterns which were v erysimilar to the movements of stock
prices. The another finding from test is that a series of cumulative random
numb erswere closely similar to actual stock price series. This Research is
also called as Simulation Test.
Fama Serial Co Relation Test
After of Dow Jones study (1962) in 1965 Fama also tested the
serial correlation of daily price changes. He studied 30 fir m’scorrelation
which shows an average correlation of -0.03. This test was very weak
because it was very close to zero and therefore it could not indicate any
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122Run Test
This test ignores the absolut e values of the numbers in the series
and took into the research only the positive and negative signs. The Run
Tests are made by counting the number of signs or Runs in the same
direction. The Actual Runs are observed and compared with the number
that are expected from the price changes thatare randomly generated.
Filter Test
Alexander made this Filter Rule Test in 1961 to find out ‘if any
abnormal return could be eared using past price data.’ This test works in
the following manner when security price w asadministrated by a certain
% over a previous point of its purchase. If the price falls from the previous
high point, then it should be sold when the decline is in excess of the
specified percentage. According to Alexander, the Filter Test gives the
large rates of return.
Market Reaction Test
Fama, Fischer, Jensen and Roll tested the semi -strong form of
efficient market in 1969.
Announcement of stock splits contains an economic information.
Their Research considered the abnormal returns of a security at the
announcement of stock split. The behaviour of the security prices in the
market after the announcement of stock split showed exactly the
predictions of the efficient market hypothesis. After the public
announcement ,an investor could gain abnormal r eturns on the basis of
information of the stock split. The average cumulative abnormal return
which was going higher and increasing just before the announcement
stopped increasing or decreasing in any significant manner in the next
period after the split a nnouncement was made.
Price Change Test
A study was conducted by the Scholes in 1972, to observe the
reactions of the security prices to the offer of secondary stock issues. A
Study shows that the prices of securities decreases when the issuer was a
company which indicated to market that offer contained some bad news.
But the secondary offering by an investor bank and insurance companies
were not viewed in a negative manner and the security prices did not
significantly fall. The price behaviour of a seco ndary issues lent support
with the market just to a new piece of information in an unbiased manner
and almost immediately.
Effect on Large Trade on Prices
Kraus and Stoll conducted a research study to examine the effect
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123there was a temporary effect on security prices which were associated with
the large trade block. The trades which were known to effect large
transactions were shown by a decrease in prices but the price rose almost
immediately and was totally reactionary by the end of the day.
Collin ’sT e s t
In 1975, Collin tested the strong form of efficient market in which
he shows that the consolidated earnings of a multi -product firm could be
accurately predicted by using segmen t and profit data rather than by using
consolidated historical data. He formulated a test by adopting a strategy of
two sets of estimates of annual earnings for a multi product firm
numbering 92 for 3 years -6,8,9,and 70. One set used historical
segmen ted data and the other historical consolidated number. In1 9 6 8a n d
1969 ,he founded that he could earn a statistically significant abnormal
return. But in 1970 ,results were repudiated. In this way he showed that
the market was not efficient to know the pu blic segment review and profit
data of multi -product firms.
Mutual Fund Performance
Efficient market hypothesis is separated by the performance of
mutual funds. The performance of the mutual funds are tasted in
1972,1966 and 1969. The research hypothesi s was that ‘the mutual funds
could earn extra ordinary return and constantly achieve a higher than
average performance because they have the excess inside information
which is not otherwise publically known’. The study shows that the
mutual funds were not better in performance than an individual who
purchases the same securities with the same risk. Mutual fund
performance is not an indication of inside information. Alternatively
suggested that no mutual funds has consistent access to non –public
informatio n.
10.7 ANOMALIES TO EMH
Consistent abnormal patterns in asset return in the market are
called anomalies. In other world, anomalies are empirically observed
consistent patterns in the asset prices and returns which are inconsistent
with EMH. Researchers believe that anomalies are the result of the
shortfalls in the models applied for testing market efficiency, rather than
of inefficiency of market. EMH theory says that nobody can make excess
profit or outperform in market whereas anomalies are all about ‘ How to
make profit in the market’. These indicate market inefficiency or in
another words inadequacies in the underlying asset -pricing model. After
itsdocumentation and analysis in the academic literature, anomalies often
seem to disappear, reverse, or so othe. It raises a question, whether profit
opportunities existed in the past, but have since been arbitraged away, or
whether the anomalies were simply statistical peculiarity that engrossed
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124anomalies documented by researchers and still continues to grow inw h i c h
some important or famous market anomalies are:
Size Effect (Small Firm Effect):
Researchers such as Banz, (1981), Reinganum (1981) etc. found
that the stock of small firms (small capitalized firm) provide higher return
than the stocks of the large firms. Banz (1981) examined 10 small and 10
large companies of New York stock exchange for the period of 1931 to
1975 and he found that returns are highly correlated with size of f irms.
Fama and Frence (1992, 1993)in their famous studies, confirmed that the
small capitalization firms provide higher returns than large capitalization
firms.
The Value Effect :
Stocks with a low valuation and low price -to-book ratio earn on
average hi gher returns than growth stocks with a high valuation and high
price -to book ratios. Fama and French (1992) analyzed data for the period
1963 -1990 from across -section of companies and found that the premium
for investing in value stocks instead of growth stocks was about three and
half to four percent.
The Momentum Effect (Past price movement Effect):
It consists of two kinds of effects:
Contrarian Effect:
De Bondt and Thaler (1985) and Guin (2005) observed in their
empirical results that past loser (s tock which has low return in past 3 -
5years) overtake winners (stock with high return of the past 3 -5years).
This suggests that in long run market tends to over -react to information
which is subsequently corrected producing the reversal effect.
Continua tion Effect:
Jegadeesh and Titman, (1993) found high returns are obtained by
recent past winner than past losers. This effect is found highly effective
for short term winners in several studies ;even Fama and French (1996)
could not explain the short term momentum effect. Guin, (2005)
comments -“Stocks that have outperformed the market usually continue to
doso for an intermediate period of time, three to five years on average”.
This effect suggests that the market under -react to information in short
run. The information gets reflected in price gradually (not instantaneously
as claimed by the supporters of EMH) producing returns which are
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125Neglected Firm Effect :
Stocks with a relatively small analyst follo wing have higher risk-
adjusted returns on average than stocks with many analysts.
Liquidity Effect :
According to Amihud and Mendelson (1986), higher returns
compensate for low liquidity of small firm stocks than high liquidity stock.
Speculative Econom ic Bubbles Effect:
Economic bubbles are typically followed by an overreaction of
hysterical selling, allowing shrewd (wise) investors to buy stocks at
bargain prices.
Buyback of Shares :
Studies have found that after announcement of stock repurchases,
stock outperform in the market in competition to the stocks of the
companies who have come with their new issues. This evidence seems to
confirm the theory that managers tend to have inside information
regarding the value of their company’s stock and their d ecisions whether
to issue or buyback their stock may signal over or undervaluation.
Announcement Effect :
Ball (1978) discovered in his empirical study that announcement
related to financial health, made by the company reflects on the movement
of the stoc k of the related company. Stocks with positive surprises tend to
go upward those with negative surprises tend to go downward. Some refer
to the likelihood (possibility) of positive earnings surprises to be followed
by several more earnings as the "cockroac h" theory which says when you
find one, there are likely to be more in hiding.
Low P/E Ratio :
Basu (1977) documented the use of price/earnings ratios (P/E) to
forecast stock returns. In a study of 1400 firms over the period 1956 -71,
he observed that low P/E securities outperforming their high P/E
counterparts by more than seven percent per year. Basu regards his results
as indicative of market inefficiency.
Day-of-the-Week Effect:
The most common calendar anomaly is day -of-the-week effect.
This anomaly states that expected returns are not same for all the week
days. It is well noticed that the average return on Monday is significantly
negative and is lower than average returns of other week days. On the
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126Mondays are found to be negative in many studies, which are commonly
referred to as the weekend effect. There are variations in some countries as
in Australia and Japan negative Tuesday effect, instead of Monday -effect,
is observed. The use of daily data makes it possible to examine the
relationship between the changes that occur in stock prices from one
trading day to the next and over weekends or, in other words, to study the
weekend effect. In particular, it is possible tots whether th e rapidity of the
process whereby stock prices are formed changes when the market is
closed, i.e. whether the process is defined in terms of market time or real
time.
Turn -of-the-Month Effect:
The turn -of-the-month effect could not gain as much popularit y in
the literature as other calendar anomalies such as the day-of-the-week
effect and the month -of-the-year effect. It has been observed that a
positive rate of return occurs only in the first half of the month beginning
from the last few days of the prev ious month. This implies that average
daily returns of stocks on turn of the month are different from the average
daily returns in rest of the month.
Month -of-the-Year Effect:
This effect states that return on common stock is not the same for
all the mon ths of the year. Empirical studies conducted in various
countries have found that the statistically significant positive returns to
common stocks occur in January. Month -of-the year effect is not same for
all countries e.g. for USA returns are obtained high in December while the
strongest month in the UK and Tokyo stock market is January. However ,
in most countries returns are found significantly higher in month of
January than rest of the months of the year that’s why this effect is also
called ‘January effect’. In India ,empirical research found high return in
month of March. So we will use the term “month -of the -year” instead of
January effect further for our empirical research to check whether this
effect is found in the month of March or in other month in India.
Holiday Effect:
Another important seasonal anomaly commonly found in the
markets is ‘holiday effect’. This effect is related to the behaviour of stock
prices around a public holiday. Higher returns are observed around
holidays, mainly in the p re-holiday period as compared to returns of the
normal trading days. Holiday effect is segmented in to pre-holiday and
post-holiday effects. Pre holiday refers days before holidays and post -
holiday refers days pertaining immediately after holidays. Returns are
found higher in pre -holiday in comparison to post holiday when market
goes comparatively down. Some researchers think that the day -of-the-
week effect is a special case of the holiday -effect. In this study ,we will
examine the existence of these calend ar anomalies in Indian stock market;
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12710.8 COMPARISO NOF RA NDOM WALK AND
RANDOM WALK MODEL WITH TECH NICAL
ANALYSIS
The Random Walk Hypothesis is contrary to the technical
analyst’s view of behaviour of stock prices. It does not believe that the
past historical prices have any indication to the future stock prices.
According to the technical analyst, history repeats itself and bystudying
the past behaviour of stock prices, future pri ces can be predicted. The
Random Walk hypothesis is in direct oppositions to the analysis of the
technical School of thought.
Random Walk Model with Fundamental Analysis
The random walk hypothesis is in conjunction and to some extent
believes in fundamen tal analysis. It believes that changes in information
help the superior analyst who has the capability of using inside
information to outperform other investors of the buy and hold strategy
during the short runs. This is entirely possible because of some s uper
analytical power. Therefore Random Walk Theory in its semi strong form
supports the fundamental school of thought. It also states that fundamental
analysis which is superior in nature will definitely lead to superior profits.
10.9 SUMM ARY
Efficient Market Theory
Efficient market theory states that the share price fluctuations are
random and do not follow any regular pattern.
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.
Weak Form of EMH
Current prices reflect all information found in the volumes.
Future prices cannot be predicted by analysing the prices from thepast.
Buying and selling activities of the information traders lead the market
price to align with the intrinsic value.
Semi -Strong Form
The security price adjusts rapidly to all publicly available information.
The prices not only reflect the past price data, but also the available
information regarding the earnings of the corporate, dividend, bonus
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128The market has to be semi -strongly efficient, timely and correct
dissemination of information .
Strong Fo rm
All information is fully reflected on security prices.
It represents an extreme hypothesis which most observers do not
expect it to be literally true.
Information whether it is public or inside cannot be used consistently
to earn superior investors’ ret urn in the strong form.
10.10 SELF -ASSESSME NT QUESTIO NS
1.What is an efficient market?
2.Write a note on market efficiency.
3.What is efficient market and what are the assumptions of EMT?
4.Explain efficient market hypothesis.
5.Explain different forms of efficien t market.
6.Explain the various Empirical Tests.
7.What are the different anomalies of efficient market?
8.Compare the random walk model with technical analysis and
fundamental analysis.

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12911
FUTURES :THE BASICS
Unit Structure
11.0 Learning Objectives
11.1 Introduction
11.2 Future Contract: Meaning and Definition
11.3 Features, Merits & Demerits of Future Contracts
11.4 Types of Futures Contracts
11.5 Summary
11.0LEAR NING OBJECTIVES
After studying this lesson you are able to:
Understand the basic concept of future.
Define future contracts
Know the various features, merits & demerits of a future contract.
Know about the various types of futures like stock index futures,
interest rate futures, foreign currency futures, bond index futures and
commodity futures.
11.1INTRODUCTIO N
In simple word s,future refers to financial contracts that obligate a
seller to sell an asset or a buyer to buy an asset at a predetermined price
and at a pred etermined time in the future. Today, most common assets
which are traded in the futures market are equities, commodities like
metals (gold, silver, platinum), agriculture products (wheat, soya bean,
cotton etc.), and stock index and so on.
The future cont ract is an agreement between two parties where
each party agrees to transact with respect to an underlying asset at a
predetermined price (future price) and at a specified future date. They are
traded on future exchange ,so, the exchange becomes counter pa rty. Future
contract includes the settlement date, description of asset on which futures
are sold, size of contract and settlement cycle. Future contracts are marked
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13011.2FUTURE CO NTRACT: MEA NINGAND
DEFI NITIO N
A futures contract is an agreement between two parties to buy or
sell a particular asset on a specified future date. These are traded on
recognised exchanges like NCDEX, MCX, NSE and BSE etc. The terms
and conditions of a futures contract li ke contract size (quantity/ amount of
the asset), price and price limits, delivery terms (delivery place and time)
and position of a trader (long or short) are standardised by the exchanges
where they trade. Thus, futures are an exchange traded derivatives .
Definition:
“Futures are exchange traded contracts to sell or buy financial
instruments or physical commodities for future delivery at an agreed
price”
Website of Bombay Stock Exchange
“Futures contracts are organised/ standardised contracts, which are
traded on the exchange
www.derivatives india.com
Examples
Currently onions are selling at `4 per kg. You are sure that due to
bad weather, the prices might go up after 3 months –and that’s when
you’ll need a lot of onions for your wedding. So you enter into a contract
with me to buy 20kg onions at `4 per kg after 3 months.
Now after 3 months, the price of onions is either `6o r `2p e rk g .
In any case you pay me `4 per kg (because we entered into a futures
contract ) and I deliver 20kg onions to you.
If the current price is `6, you have saved `2p e rk go r `40 overall.
If the current price is `2, you have lost `2p e rk go r `40 overall.
11.3 FEATURES OF FUTURE CO NTRACT
The Futures have the following salient feature s
1) Standardised Specification
Futures contracts are exchange traded contracts to sale or buy
financial assets of commodities. All the terms and conditions of these
contracts such as quantity of the asset, quality of the asset, price methods
& settlement te rms, the delivery date, the place of delivery, the process of
delivery are standardised by the Exchange andall the parties must have to
abide by these specification and performs the future contracts.munotes.in

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1312) Exchange Traded
Future contracts are organised/ standardised contract, which
are always traded on exchange.
3)Performance of the Contract through an associated Clearing
House of the Future Exchange
Each Futures Exchange has an associated Clearing House. T he
seller has to deliver the asset to the clearing house and the clearing house
deliver the same to the buyer. Similarly, the buyer has to make payment to
the clearing house and the clearing house has to pay to the seller. The
clearing house acts as a midd leman between the buyer and seller in all
futures contracts. In one way, the clearing house is the counterparty to the
buyer for delivery of asset and in another way ,it is the counterparty to the
seller for making payment against delivery. Thus, the clear ing houseA Futures Exchange (An association of certain
members)
Facilitate for trading in future contracts
Trading in Commodities
Futures onl yTrading in
Financial
Futures onlyTrading both Financial
& Commodity Futures
onlyStandardised
Specifications
by Ex change for
futures tradingUnderlying Assets
Settlement termsDelivery TermsQuantityQualityPrice Method &Mode of
SettlementDate, Place &Process
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132facilitates the smooth operation of future trading because it guarantees
fulfilment of the final term of a future contract.
4) Margin Money
A clearing house collects margin money from the participants of a
future contract. Both the Parties -i.e., the seller and the buyer of a future
contract pay a margin to the clearing house. This margin is called the
initial margin (IM).
Thus, a clearing house undertakes the following two types of default
risks:
i.Buyer’s Default: The clearing hou se has to buy the Asset/
Commodities from the seller and pay the money.
ii.Seller’s Default: The clearing house has to buy the commodities
from the open market, give delivery to the buyer and collect money
from him.
In both the cases, the clearing house bear s the performance risk as
well as credit risk. In order to minimise or eliminate such risks, the
clearing house prescribes a margin money system for trading in future
contracts. There are different margins payable by the participants in future
contracts su ch as Initial margin, Mark to marked, Daily margin, Delivery
margin etc.
5) Basis
It is normally calculated as CASH PRICE minus FUTURE PRICE of an
asset
Mathematically,
It can be either positive or negative. A positive number indicates a future
discount (B ackwardation) and a negative number indicates a future
premium (Contago). Basis may change its sign several times during the
life of the contract. It turns to zero at maturity of the futures i.e., both cash
and future prices converge at maturity
6) Mark to M arket SystemBasis = Cash Price–FuturePerson
APerson
BClearingHouseFundsBuyerSellerAssets/CommoditiesAssets/Commodities
The Middleman Role of Clearing House
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133Future contracts are based on the practice of mark to market accounting
system. The mark to market is a system by which the price of the
exchange traded asset/ commodities are valued each day and the losses
and gains are settled between the bu yer and seller daily through the
recognised exchange.
7) Delivery
A future contract is an exchange traded forward contract. As a principle, at
maturity the seller delivers the underlying and the buyer makes the
payment. Some of the Future Contracts are close do u tb e f o r em a t u r i t ya n d
some of the contracts are performed by delivery and payment at maturity.
8) Settlement in Cash for Difference
A party in short (seller) or long ( buyer) position has to settle in cash for
the difference between the agreed price at which the contract was entered
and the cash price at expiration date. This cash settlement is encouraged
due to inconvenience or impossibility in delivery of underlying assets.
Example: On 1stJanuary, Miss Shilpa enters into a Future contract to buy
500shares of ‘K Ltd’ at an agreed price of `130/-per share in March. If on
maturity date(as determined by the Stock Exchange during the month of
December), the price of the Equity share rise to `160/-per share, Miss
Shilpa will receive `30 per share and oth erwise if the price of share falls to
`110/-, Miss Shilpa will pay `20/-per share.
4.Advantages & Disadvantages of Future Contract
There are numerous benefits of trading in future contracts
Future contracts can be used to hedge the risk involved in price
fluctuations of commodities, currencies, interest rates & stock prices.
An investor can get into futures contract by using a small amount as
the initial margin. This enables a speculator to take positions in
assets and take the benefits of price fluctuatio ns in the market.
There is no counter party risk; there is no risk of default as futures
contracts are traded on exchanges. Investors can take full benefits
from both upward and downward movement in the prices of assets.
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134futures contract depending upon the investors’ perceptions about
market movement.
Futures contracts are traded on exchange, an investor doesn’t have to
wait till the maturity of the contract and so can sell the contract
befor e the date of maturity ,provided the investors want to get out
the position before the maturity of the contracts.
Futures contracts also have disadvantages
These contracts trade on leverage, i.e., only up to 15% of the total
investment amount is required to initiate future contract. At times, an
investor can lose more money than he has invested in a future
contracts.
Future contracts are standardised, i.e., not customised to satis fyt h e
needs of the investor, and so the investor has to work on finding the
best future contract to hedge his/her risk.
11.4 TYPES OF FUTURE CO NTRACT
A) Future Contract : A futures contract is an agreement that requires
a party to be involved in the agreement either to buy or sell something at a
designated future date at a predetermined price. The basic economic
function of futures markets is to provide an opportunity for market
participants to hedge against the risk of adverse price movements. Future
Contracts are categorized as either financial futures or commodity futures.
I) Financial Futures
Future contract based on a financial instrument or financial indexes are
known as financial futures. Financial Futures can be classified as: -Future Contracts
Financial Contract
Stock Index FuturesCommodity Futures
Interest Rate Futures (IRF)
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1351) Stock Index Futures
In India, popular indices are Sensex and N ifty. Special type of
stock indices are available in India like BSE PSU (Bombay Stock
Exchange Public Sector Undertakings) Index, S & P BSE Consumer
Durables, S & P BSE Capital Goods, NIFTY IT, NIFTY Bank etc.
Essentially, a stock index is used to measure the change of direction and
magnitude of the general stock market.
Examples: Stock Index Futures
Indian Indices Global Indices
1) S&P BSE sensex
2) Nifty 50
3) Nifty MID100 Free1. FTSE in UK
2. DAX in Germany
3. Straits Times
4. Taiwan Index
2) Interest Rate Futures (I RF)
An interest rate future is a futures contract with an underlying
instrument that pays interest. An interest rate future is a contract between
the buyer and seller agreeing to the future delivery of any interest -bearing
asset. The interest rate future a llows the buyer and seller to lock in the
price of the interest -bearing asset for a future date. Interest rate future
contracts can be classifies by the maturity of their underlying security.
Thus,
(a) Short term interest rate futures: It has an underlyin g security that
matures in less than 1 year. For ex. -91 days Treasury Bills, Commercial
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136(b) Long term interest rate futures: The maturity of the underlying security
of long term futures contracts exceeds 1 year. F or ex. -Corporate bonds
and debentures, Government loans and public sector undertaking (PSU)
bonds
3) Currency Futures
A currency future contract is a contract that allows market
participants to trade underlying exchange rate for a period of time in the
future.
Currency Futures were first traded in CME (The Chicago
Mercantile Exchange) in 1972. In India, trading in futures was launched
on 29thAug, 2008. To facilitate the operational framework, the RBI has
prescribed the policies while SEBI handle, the trad ing, settlement, and
execution aspect.
Foreign currency exchange is a relative price exchange rate. It may
be quoted as direct or indirect. A direct quote gives the home currency
price of a certain amount of foreign currency. In case of indirect quoting,
the value of one unit of home currency is presented in terms of foreign
currency.
Example:
Direct Rate Indirect Rate
`64.37 = 1$ `1= 0.01$
When a client deals with a future contract, he has to operate
through the commission agents. The commission a gent may be a bank or
financial institution. The client has to deposit the margin money with the
clearing house. Daily settlement starts and continu es till final settlement
on maturity. In the majority of futures contract ,delivery of currencies is
not mad e but is offset by a reversing deal. The client gets only the
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137
II. Commodity Futures
The Commodity Futures market in India dates back to more than a
century. The first organized futures market was established in 1875, under
the name of ’Bombay Cotton Trade Association’ to trade in cotton
derivative contracts. This was followed by institutions for futures trading
in oilseeds, foodgrains, etc. The futures market in India underwent rapid
growth between the period of First and Se cond World War. As a result,
before the outbreak of the Second World War, a large number of
commodity exchanges trading futures contracts in several commodities
like cotton, groundnut, groundnut oil, raw jute, jute goods, castorseed,
wheat, rice, sugar, pr ecious metals like gold and silver were flourishing
throughout the country.
Out of 17 recognized Exchanges, MCX, NCDEX, NMCE, ACE,
UCX and ICEX, contributed 99% of the total value of the commodities
traded during the year 2013 -14. Out of the 113 commodit ies, regulated by
the FMC(Forward Market Commission), in terms of value of trade, Gold,
Crude oil, Silver, Copper, Natural Gas, Lead, Soy Oil, Zinc, Soybean and
Castorseed are the prominently traded commodities. The total volume of
trade across all Exchang es in 2013 -14 was 8,832.76 lakh MT at a value of
Rs. 101 lakh Crores. The total of deliveries of all commodities on
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138
11.5 SUMMARY
Future Contracts are exchange traded contracts between two
parties to trade (buy/ sell) standardised financial instruments or physical
commodities. The terms of the contracts such as quality, quantity, delivery
time, delivery place and settlement procedure are standardised by an
Exchange.
This unit discussed the various characteristics of future contracts.
The Features are:
1) Standardised Specification
2) Exchange Traded
3) Performance of the Contract through an associated Clearing House of
the Future Exchange
4) Margin Money
5) Basis
6) Mark to Market S ystem
7) Delivery
8) Settlement in Cash for Difference
Further, it explains advantages & disadvantages and types of future
contracts
Review Questions:
1.Explain the concept Future Contract. Discuss the characteristics of
futures contracts
2.What areFuture Contracts? Explain its merits
3.Define “Future Contract”. Discuss its demerits
4.Discuss various types of futures contracts
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13912
OPTIO NS:THE BASICS
Unit Structure
12.0 Learning Objectives
12.1 Introduction
12.2 Option Contract: Meaning and Definition
12.3 Types of Option
12.4 Basic Terms used in Option Trading
12.5 F & O Trading System
12.6 Advantages of Option Trading
12.7Clearing and Settlement System for Option Trading
12.0LEAR NING OBJECTIVES
After studying this lesson you are able to:
Understand the basic concept and different types of option contract.
Know the terms used in option trading.
Understand the Option tr ading system and its advantages
12.1INTRODUCTIO N
An option is the right to buy or sell a particular asset for a limited
time at a specified rate. These contracts give the buyer a right, but do not
impose an obligation, to buy or sell the specified asset at a set price on or
before a specified date.
An option is a special type of contract which gives its holder the
right (but not obligation) to buy or sell an asset at a fixed price at some
future price at some future date. There are only two basics type so f
options, i.e., Call option and Put Options. A call option is the right to buy
an underlying asset at a specified price over a given time period, while a
put option is a right to sell an underlying asset at a specified price over a
given time period. According to the language of option contract, the owner
who obtains (buys) the right to trade (buy/sell) an asset is known as option
holder . The counterparty who grants (sells) the right as option writer.munotes.in

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140Conceptually, the option contract is shown belo w:
a) Right to Buy Option
Parties Buyer of the Asset Seller of the Asset
Status Option Holder Option Writer
Right Yes No
Obligation No Yes
b) Right to Sell Option
Parties Buyer of the Asset Seller of the Asset
Status Option Writer Option Holder
Right No Yes
Obligation Yes No
Thus, the option holder is the buyer of the option and the option
writer is the seller of the option
12.2DEFI NITIO NS:
1) Option is a financial derivative that represents a contract sold by
one party (option writer) to a nother party (option holder). The contract
offers the buyer the right, but not obligation to buy (call) or sell (put) a
security or other financial asset at an agreed upon price (the strike price)
during a certain period of time or on a specified date.
2) “An option is a derivative contract or instrument that gives the
option holder the right, but not obligation, to trade an underlying asset for
a specific price on or before a specified time price.
12.3TYPES OF OPTIO N
Options may be classified on the basi s of right to trade without
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1411.1.Types of Option on the Basis of Right
On the basis of “right to trade without obligation”, options may be
classifies as call options and put options:
A call option: An option which conveys the right to buy something
is called a Call. A call option gives the holder the right but not obligation
to buy an underlying asset at specified price on or before a certain date.
i.e., over a given time period.
A put option: An option which conveys the right to sell something
is called a Put. A put option gives the holder the right to sell an asset at a
specified price on or before a certain date, i.e., over a given time per iod
Conceptually, these two types of options are shown below:
Option
typeBuyer of the right Seller of the right
Call Right to buy at the
specified priceObligation to sell at the specified
price.
Put Right to sell at the
specified priceObligation to buy at the specified
price.
1.2.Types of Option Trading Practice
There are two types of option trading, i.e., Exchange traded options
and Over the Counter traded options.Classification of Option
On the basis
Right to trade
without obligationNature of trading Style of ExerciseRight tobuyRightto sellOver the
Counter
(OTC)Exchange
Traded
(ET)1)AmericanOption
2)European
Option
Call
OptionPut
Option
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142The option can be traded on an organised or on the over the
counter (OTC) market. An exchange traded option contract is very similar
with futures while an OTC option is like a Forward Contract. However,
these two types of options are different in following points.
Points Exchange Traded Options Over the Counter Traded
Option
Sort of Mar ket Exchanges OTC Market
Norms Specified and
StandardisedNegotiated between two
counterparties
Restricted
termsUniform underlying
assets, limited number of
strike prices, limited
maturity dates. Etc.No restriction in underlying
quantity, strike price and
maturity dates. Etc.
Default risk Very low Very high
Deposit of
margin MoneyObligatory on part of the
option writerNot required
Transaction
CostVery low Moderate and high
3.3 Types of Option on the Basis of Style of Exercise
In finance, the style of an option denotes the date on which the
option may be exercised. Depending on when an option can be exercised,
it is classified in to the following two categories :
1) American Style Option or American Option: In this style, the
option can be exercised by the option holder during any time during the
life of the contract i.e., on or before the expiration date. Thus, in an
American style, the option holder has right to exercise his right to buy/ sell
any time before the expiry date.
2) European style Option o r European option: In this style, the option
may be exercised only on the expiry date of an option, i.e, at a single pre -
defined point of time.
12.4BASIC TERMS USED I NOPTIO NTRADI NG
Options markets are quite complicated and risky. Options are used
to eliminate the risks. But if one party makes money then the other party
must loose money. But the holder of an option contract must understand
the following basics or fundamentals so that he can bet against the seller
or writer of the option.
1. The Option Con tract: An option is a contract. It gives the buyer
the right, but not obligation, to buy or sell, an underlying asset at a specific
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1432. Underlying Asset: The underlying asset of an option contract may
be stock, commodity, cur rency, index or debts. Thus, the specific asset
which is exchanged if the option is exercised iscalled underlyings.
3. The agreed Contract Price: The price at which the option may be
exercised and the underlying assets bought or sold is called Strike Price or
Exercise Price. The exchanges decide the strike price at which call and put
options are traded.
4. Style of Options: An option style refers to whether the option
contract can be exercised before the expiration date or not. On the basis of
the timing of th e possible exercise, an option contract may have any one of
the following style :
American Style: In this style, the option can be exercised by the
option holder any time duing the life of the contract, i.e., on or before the
expiration date.
European St yle:In this style, the option can be exercised only on
the expiration date of the option contract
5. Expiration Date: All options have a maturity or expiry date after
which the option to trade cannot be exercised. The date when the option
expires or matures is refered to as expiration date. In case an option is not
exercised, it expires automatically.
6. Exercise Date: The date on which the option holder exercises his
option is called Exercise date. In case of European style of option, both
expiration date and exercise date are same. But in case of American style,
the exercise date may be any date on or before the date of maturity.
7. Exchange traded Options and Over the Counter Option:
Options which are traded on exchanges are called Exchange traded
Options. The se options are standardised in terms of quantity, trading
cycle, expiration date, strike prices, type of option, style of option and
mode of payments etc.
Options which are not traded on exchanges are called over the
counter option.
8. Option Premium: In an option contract, the option holder buys
the right from the option writer. To buy such right, he has to pay certain
amount to the option writer as consideration. The price which is paid by
the option holder to the option writer for acquiring the right to t rade
(buy/sell) is known as option premiu m. Once, it is paid, it remains with the
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1449. Position of an Option Participants
There are four types of option participants depending on the
positions the take. They are
i.Buyers of calls, i.e., call option buyers
ii.Sellers of calls, i.e., call option sellers
iii.Buyers of puts, i.e., put option buyers
iv.Sellers of puts, i.e., put option sellers
12.5OPTIO NTRADI NG SYSTEM
5.1 National Exchange for Automated Trading ( NEAT –F&O):
Futures and option trading system of NSE called NEAT -F&O
trading system provides a fully automated screen based trading for index
futures and options, stock futures and options and futures on interest rate
on a nationwide basis as well as an onlin e monitoring and surveillance
mechanism. It supports an order driven market and provides complete
transparency of trading operations. It is similar to that of trading of
equities in the cash market segment.
The software for the F & O market has been devel oped to facilitate
efficient and transparent trading in futures and option instruments.
Keeping in view the familiarity of trading members with the current
market trading system, modifications have been introduced in the existing
capital market trading sys tem so as to make it suitable for trading futures
and options.
5.2 Trading Mechanism:
The NEAT -F&O system supports an order driven market, wherein
orders match automatically. Order matching is essentially on the basis of
security, its price, time and qu antity. All quantity fields are in units and
price in rupees. The lot size on the futures and option market is 75 for
Niftty50. The exchange notifies the regular lot size and tick size for each
security traded on this segment from time to time. Orders, as and when
they are received, are first time stamped and then immediately processed
for potential match. When any order enters the trading system, it is an
active order. If it finds a match, a trade is generated. If a match is not
found, then the orders are stored in different books. Orders are stored in
price -time priority in various books in the following sequence:
Best price
Within price, by time priority
5.3 Entities in the Trading System:
There are four entities in the trading system
i.Trading Member
Trading members are members of NSE. They are trade either on their
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145exchange assigns ID to each trading member. Each trading member can
have more than one user.
ii.Clearing Members
Clearing m embers are members of NSCCL. They carry out risk
management activities and confirmation/ inquiry of trades through the
trading system.
iii.Professional Clearing Members
Professional clearing members are clearing members who are not trading
members. Typically, banks and custodians become professional clearing
members and clear and settle for their trading members.
iv. Participants
A participant is a client of trading members like financial institutions.
These clients may trade through multiple trading members but settle
through a single clearing member.
5.4. Corporate Hierarchy
In the F & O trading software, a trading member has the facility of
defining a hierarchy amongst users of the system. This hierarchy
comprises corporate manager, branch manager and dealer.
Corporate Manager: The term corporate manager is assigned to a
user placed at the highest level in a trading firm. Such a user can perform
all the functions such as order and trade related activities, receiving reports
for all branches of the trading me mbers firm and also all dealers of the
firm. Additionally, a corporate manager can define exposure limits for the
branches of the firm. This facility is available only to the corporate
manager.
Branch Manager: The branch manager is a term assigned to a us er
who is placed under the corporate manager. Such a user can perform and
view order and trade related activities for all dealers under that branch.
Dealers: Dealers is a user at the lower level of the hierarchy. A
dealer can perform ;doesn’t have assess to information on other dealer
under either the same branch or other branches.
5.5. Order Types and Conditions
The system allows the trading members to enter orders with
various conditions attached to them as per their requirements. These
conditions are broadly divide d into the following categories:
A. Time Conditions
Day order: A day order, as the name suggests, is an order which is
valid for the day on which it is entered. If the order is not executed during
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146Immediate or Cancel (IOC): An IOC order allows the user to buy
or sell a contract as soon as the order is released into the system, failing
which the order is cancelled from the system. Partial match is possible for
the order, and the unmatched portion of the order is cancelled
immediately.
B. Price Conditions
Stop Loss: This facility allows the user to release an order into the
system, after the market price (Last Traded Price -LTP) of the security
reaches or crosses a threshold price, e.g. if for the stop loss buy order, the
trigger is 1027, the limit price is 1030 and the market (last traded) price is
1023 then this order is released into the system once the market price
reaches or exceeds 1027. This order is added to the regula r lot book with
time of triggering as the time stamp, as a limit order of 1030. For the stop
loss sell order, the trigger price has to be greater than the limit price.
C. Other Conditions
Market Price: Market orders are orders for which no price is
specified at the time the order is entered (i.e. price is market price). For
such order, the system determines the price.
Limit price: Price of the order after triggering from stop loss book.
Trigger Price: It is the price at which an order gets triggered from
stop loss book.
5.6 Market Watch
The purpose of market watch is toallow continuous monitoring of
contracts or securities that are of specific interest to the user. It displays
trading information for contracts selected by the user. The user also gets a
broadcast of all the cash market securities on the screen. This function is
also available if the user selects the relevant securities for display on the
market watch screen.
5.7 Placing Orders on the Trading System
While entering orders on the trading syst em for both future and
option market ,members are required to identify orders as being
proprietary or client orders. Proprietary orders should be identified as Pro
and those of clients should be identified as Cli. Apart from this, in the
case of Clitrades, the client account number should also be provided. The
future and options market is zero sum game, i.e. the total number of long
in contracts always equals to total number of short in contracts. The total
number of outstanding contracts ( long/short) a t any time is called open
interest. This open interest figure is a good indicator of the liquidity in the
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14712.6ADVA NTAGES OF OPTIO NTRADI NG
A. Risk Management: Put options allow investors holding shares to
hedge against fall in their value. Thi s can be considered similar to taking
out insurance against a fall in the share price.
B. Time to decide: By taking a call options the purchase price for the
shares is locked -in. This gives the call option holder ,until the expiry day ,
to decide whether or n ot to exercise the option and buy the shares.
Likewise, the taker of a put option has time to decide whether or not to sell
the shares.
C. Speculation: The ease of trading in and out of an option makes it
possible to trade options with no intention of ever e xercising them. If an
investor expects the market to rise, he may decide to buy cal loptions. If
expecting a fall, he may decide to buy put options. Either way the holder
can sell the option prior to expiry to take a profit or limit a loss.
D. Leverage: Leverage provides the potential to make a higher return
from a smaller initial outlay than investing directly. However, leverage
usually involves more risks than a direct investment in the underlying
shares. Trading in options can allow investors to benefit f rom a change in
the price of the shares without having to pay the full price of the shares.
E. Income Generation: Shareholders can earn extra income over and
above dividends by writing call options against their shares. By writing an
option they receive the option premium upfront. While they get to keep
the option premium, there is a possibility that they could be exercised
against and have to deliver their shares to the taker at the exercise price.
F. Strategies: By combining different options, investors can c reate a
wide range of potential profit scenarios.
12.7 CLEARI NGA ND SETTLEME NT SYSTEM FOR
OPTIO NTRADI NG
The clearing and settlement process comprises of the following three main
activities:
a. Clearing
b. Settlement
c. Risk Management
7.1National Securities C learing Corporation Limited ( NSCCL)
NSCCL undertakes clearing and settlement of all trades executed
on the futures and options segement of the NSE. It also acts as legal
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148financial settle ment. Clearing and settlement activities in the Option
segment are undertaken by NSCCL with the help of the following entities:
Clearing Members (CMs): Primarily, the CMs perform the
following functions:
i) Computing obligation of all their TMs i.e. determin ing positions to
settle.
ii) Performing actual settlement
iii) Setting position limits based on upfront deposits/ margins for each
TM and monitoring positions on a continuous basis. Currently, all
the options contracts are cash settled
Clearing Mechanism
The firs t step is clearing process is working out open position and
obligations of clearing. The open positions of a CM is arrived at by
aggregating the open positions of all the trading members (TMs) and all
custodial participants (CPs) clearing through him, in t he contracts which
they have traded. The open position of a TM is arrived at by summing up
his proprietary open position and open position of client, in the contracts
which when they have traded. While entering orders on the trading
system, TMs identify or ders as either proprietary or client through Pro/ Cli
indicators are provided in the order entry screen. Proprietary positions are
calculated on net basis (buy/sell) for each contract and that of client, i.e. a
buy trade is off set by a sell trade and a se ll trade is off set by a buy trade.
A TMs open position is the sum of proprietary open position, client open
short position.
7.2 Settlement Mechanism
Option contracts have three types of settlement:
a) Daily Premium Settlement
b) Interim exercise settlement in case of option contract
c) Final settlement
a) Daily Premium Settlement: Buyer of an option is obligated to
pay the premium towards the options purchased by him. Similarly, the
seller of an option is entitled to receive the premium for the option sold by
him. T he premium receivable amount are netted to compute the net
premium payble or receivable amount for each client for each option
contract.
Although most option buyer and sellers close out their options
positions by an offsetting closing transactions, an und erstanding of
exercise can help an option buyer determine whether exercise might be
more advantageous than an offsetting sale of an option. There is always a
possibility of the option seller being assigned an exercise. Once an
exercise of an option has bee n assigned to an option seller, the option
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149amount in the case of a cash settled option) even though he may not yet
have been notified of the assignment
b) Interim Exercise Settlemen t: Interim exercise settlement takes
place only for option contracts on securities. An investor can exercise his
in the money options at any time during trading hours, through his trading
member. Interim exercise settlement is effected for such options at the
close of the trading hours, on the day of exercise. Valid exercised option
contracts with the same series (i.e. having the same underlying, same
expiry date and same strike price) on a random basis, at the client level.
The CM who has exercised the opt ion receives the exercise settlement
value per unit of the option from the CM who has been assigned the option
contracts
c) Final Exercise Settlement: Final exercise settlement is effected for
all open long in the money strike price options existing at the c lose of
trading hours, on the expiration day of an option contract. All such long
positions are exercised and automatically assigned to short positions in
option contracts with the same series, on a random basis. The investor who
has long in the money opti ons on the expiry date will receive the exercise
settlement value per unit of the option from the investor who has been
assigned the option contract.
12.8SUMMARY
An option is a special type of contract between two parties where
one party grants the other party the right to buy or sell a specific asset or
commodity (or instrument) at a specified price within a specific time
period. There are only two basic type of option i.e., call option and put
option.
Call option means right to buy without obligation w hile put option
means right to sell without obligation. To get the right, the buyer has to
pay premium to the seller of the option. The buyer of the option is known
as option holder while the seller of the option is known as writer. There
are two distincti ve styles of option contract., i.e., European style and
American style.
This unit has highlighted the various terminologies which are
commonly used in option contract. There are the option contract,
Underlying asset, Strike (Exercise Price), Expiration dat e, Option
Premium, etc.
Further, it discussed about the Option trading system and
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15012.9SELF ASSESSME NT QUESTIO N
1)What is an Option? Briefly discuss the various types of options
2)Distinguish between Exchange Traded Options and Over the
Counter Tr aded Option
3)Explain the following terms in the language of option finance:
a)Option Premium
b)Underlying Asset
c)Exercise Date
d)Expiration Date
e)Option Contract
f)Agreed Contract Price
4)Explain Option Trading System in detail
5)Discuss the Clearing and Settlement Syste m for Option Trading

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15113
PRICI NGOFOPTIO N&FUTURES
Unit Structure
13.0 Learning Objectives
13.1 Option Pricing
(a) An Introduction to Option pricing
(b) Value of Option
(c) Deter minants of Option Pricing
(d ) Option Pricing Model
13.2 Binomial Option Pricing M odel(BOPM)
13.3 Summary
13.4 Self Assessment Question
13.0LEAR NING OBJECTIVES
After studying this lesson you are able to:
Know the basics of option pricing.
Know about the six determinants of option pricing
Express the upper limit and lower limit of cal l option as well as put
option price Know the fundamentals of put -call parity
Know the clearing and settlement system for option trading
13.1(A) A NINTRODUCTIO NTO OPTIO NPRICI NG
A call option gives the holder the right to buy an asset at a fixed (stri ke)
price while the put option gives the holder the right to sell at a fixed
(strike) price. Let us consider a stock option. A call option holder pays
option premium to the writer of the option. In return, the option writer is
obliged to sell the shares if the option is exercised by the option holder. If
the stock price (St) at the time of exercise is less than the exercise price
(X), the option holder will not exercise the option. In this case the liability
of the option writer is nil. On the other hand, i f the stock price (St) is
higher than the exercise price (X), the option holder will exercise the
option. The reverse situation is in case of put option. Thus, in option
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152It is very clear that the option holder pays certai n price which is
otherwise known as option premium to the option writer to obtain the right
to trade, i.e., to buy or sell.
Option prices have two components; prices are determined by six
factors and the way prices changes are measured by six indicators ( called
Greeks). There are various models used to determine the option price.
To understand the option pricing one has to conceptualise each
element of the following figure.
(b) Value of Option
The price of an option is determined by the option’s intrin sic value
and time value. It can be mathematically written as follows:
Option value = Intrensic value of an option + Time value of an option
Time value of an option = Option value –Intrinsic value of an optionoption Option HolderPrice (trading)
Right
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153Intrinsic Value of an Option
The intrinsic value of an option is the current value of the option. So,
the intrinsic value of an option can be defined by the following
equation:
Intrinsic Value = Current Stock price –Strike price
If the current trading stock price is less than or equal to the stri ke
price, the call option is said to be out of money. If the current trading
stock price is higher than the strike price, the call option is said to be in
the money. Let’s understand the concept by taking an example.
Suppose a long call option with a strik e price of `100 has stock trading
at`90. So, here the stock price is less than the strike price (90< 100),
and therefore, the option said to be out of the money, i.e, it has zero
intrinsic value. Another long call option with a strike price of `100 has
its stock trading at `110. So, here the stock price is higher than the
strike price. Therefore, we can conclude the long call option is in the
memory option.
Let’s take an example of a long put option. If the strike price of a long
put option is `100 and th e current stock price is `110, the long put
option is said to be out of the money option, i.e., the option has zero
intrinsic value. If the strike price of a long put option is `100 and the
current stock price `90, the long put option is said to be in mone y
option. Remember that an investor gets money in the long put option
when the strike price is greater than the stock price.
For long call and long put options, we can write the following
equations for intrinsic value calculations:
Intrinsic value for a long call option = Max (S –K, 0)
Intrinsic value for a long call option = Max (K -S, 0)
Where, K is the strike price & S is the stock price
Time Value of an Option
The time value of an option is the premium that an investor is willing
to pay over and a bove the intrinsic value of an option. The buyer of a
long call option speculates that in the future, the price of stock will go
above the strike price and so, will generate profit for the buyer. So, for
this reason, the buyer of the option is willing to p ay a premium above
the intrinsic value of an option. For example, if a long call option with
a strike price of `100 and an option value of `20 is currently stock
trading at `110, the intrinsic value of the option is `10 and the time
value of the option is `10 (20 -10). Taking another example, if a long
call option with a strike price of `100 and an option value of `20 is
currently stock trading at `90, the intrinsic value of the option is zero
and the time value of the option is `20 (option value -intrinsic value).
b) Determinants of Option Price
The price at which the stock under option may be put or called is
the contract prices. Sometimes, it is referred to as the striking price.
During the life of the contract, the contract price remains fixed, except th atmunotes.in

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154market practice is for the contract price to be reduced by the amount of
any dividend paid or by the value of any stock right which becomes
effective during the life of the contract. In purchasing an option the
amount the buyer pays for the option privi lege is called the premium, or
sometimes the option money. In most option transactions ,the contract
price is the stock market price prevailing at the time the option is written,
and the premium becomes the variable over which buyer and seller
bargain.
There are six factors influencing the value of an option. These are:
1.Current Price of the Underlying Security (St) at Maturity
We know that pay -off an option is calculated by comparing the
current price (St)of the underlying asset with its strike price (X) .
Thus:
Option Call option Put Option
Pay-off` (St–X) (X-St)
In case of increase in the value of underlying asset, the value of
call option will increase and the value of put option will decrease. In case
of decrease in the value of underlying asse t, the value of call option will
decrease and the value of put option will increase.
Thus, the higher the asset price, the higher is the chance that it will
rise above the exercise price and therefore, the higher the premium for call
option. On the other hand, the higher the asset price, the lower is the
chance that it will fall below the strike price and therefore, the premium
for the put option would be lower.
Example:
Call Option
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155
Call Option Price and C urrent Price of the Underlying
Put Option
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1562.Strike (Exercise) Price of an Option (X)
A call option will be exercised only when the price of the
underlying asset at maturity (St) exceeds the s trike price (X). A put
option will be exercised only when the strike price exceeds the
price of the underlying asset at maturity. The pay off in both option
may be summarised in the following table:
Types of Option Option Buyer (Holder) Option Seller (Wr iter)
Call Option Max [0,(St –X)] Min [0,(X -St)
Put Option Max [0,(X –St)] Min [0,(St –X)]
Example:
Call Option
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157Put Option
Strike Price and Put Option Value
In case of call option, the lower th e strike price, the higher would
be the pay -off. This means the value of the call will be higher and
ultimately the option premium will be higher. Logically, if the strike price
of an option contract is lower, then the asset price will easily exceed this
level. Accordingly, the option seller (writer) will demand for higher
premium because the profitability of exercising the option by the option
by the option holder is very less. The situation is the reverse for a put
option.
From, the above, it is clear t hat there is a negative correlation
between strike price and option value in case of call option and positive
correlation between call option and positive correlation between strike
price and option value in case of put option.
3.Time of Maturity (T)
Time to maturity is one of the important factor which influence the
option value. Generally, the option the time taken for maturity, the higher
is the option value. Because, the longer the life of an option, the greater
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158Option value is the aggregate of its intrinsic value and time value.
As an option’s expiration date approaches, its time value diminishes and
ultimately becomes zero.
4.Volatility of the Underlying SecurityVolatility of the underlying asset influences the value of an option.
The fluctuation in the price of an asset brings risk to the investors. Options
are used to manage such risk. For example, the call option protects the
option holder against upwa rd movement of the price and a put option
protects against downward movement of price. But the degree of
variability (i.e., volatility) in the prices of the underlying assumes risk
contents in the dealings. The volatility is measured by Standard Deviation.Both call options and put options become more valuable when
volatility of the underlying asset increase.
5.Risk free Interest Rate (R)
The risk interest rate affects the price of an option indirectly.
There are two fold effect o f risk free interest on option contract. These are:
Cause Effects
Increase in the interest rate in an
economy (country as a whole)i.The price of underlying will rise .
ii.The present value of future cash
flow receives by the holder of the
option decreases.
In case of a call option, the exercise price is fixed at the time of
contract. The holder pays this contract price at a future date when he
exercises his option.
Similarly, in case of a put option, the option holder receives the
exercise price at a future date when he exercise his option.
The present value of the exercise price depends on the interest rate
(r ) and the time until the expiration of the option (T)
Example:
Exercise Price Risk free
Interest RateTime to
ExpirationPresent Value of
Exercise Price
240 10% 1y e a r 240218.181.10
240 11% 1y e a r 240216.21.11
240 12% 1y e a r 240214.21.12
From the above example, it is clear that if the interest rate rises, the
present value declines. This situation will be favourable to the call holder
and unfavourable to the put holder. Thus, the call option price increases asmunotes.in

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159the risk free interest rate increases and vice versa. Similarly, the put option
price declines as the ri sk free interest rate increases
6.Dividends Expected During the Life of the Asset (D)
The most common popular type of call option is the option on
stocks.
Sometimes, stock can be sold just before the declaration of
dividend i.e., div idend has become due to the shareholder but has not been
received by him. In such circumstances, if the market price includes the
accrued dividend, then the price will be higher to the extent of such
dividend. In this case, the buyer will receive such divi dend as and when
the dividend will be paid by the company. Thus, when the stock price
includes dividend, the price is called cum -dividend price.
Contrary to this, if the market price of stock does not include
such dividend, then the buyer p ays only the normal market price and
ultimately the seller receives the accrued dividend as it is due to him.
Thus, when the stock price does not include the amount of dividend, then
such price is called ex -dividend price.
In option trading, d ividends that are expected during the life of the
option are another determinant of the option price. Particularly, in case of
Ex-dividend price, the call value will decrease and put value will increase.
To provide protection to the option holder, the opti on contract generally
specifies that the exercise price and the number of shares will be adjusted
for stock splits and stock dividends.
(C) Option Pricing Model
13.2 THE BI NOMIAL OPTIO NPRICI NG MODEL
(BOPM)
Introduction
In finance, the Binomial Option P ricing Model (BOPM) provides a
generalisable numerical method for the valuation of options. The original
version of this Binomial model was developed by John Cox, Stephen Ross
and Mark Rubinstein in 1979. This model is also known as C -R-R model.
This mode l is a “discrete -time” model, because it breaks down the
total time to expiration into potentially a very large number of time
intervals or steps. These steps form a tree like format. At each step, it is
assumed that the price of the underlying asset say stock will up or down
by an amount calculated using volatility and time to expiration. Thus, this
model is based on binomial approach. This approach assumes that the
price of the stock at every point of time may have only two possible states
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160Initially, a tree of stock prices is drawn showing the possible stock
prices at every point of time forward from (left to right). This tree is
commonly known as Binomial Tree.
The Su and Sd are calculated using the assumptions of how much
would be the upward movement and how much would be the downward
movement. The mathematical formula for calculating Su and Sd are as
follows:
Su = S ×u, Sd = S ×d
Where, S is the current price of the underlying asset
u is the upward movement in the price of the asset
d is the downward movement in the price of the asset.
Let’s say a stock is trading at `100, and the upward and downward
movements expected are 25% and 20% respectively. Then, the upward
movement u is 1.25 and Su equals `125, and the downward movement d is
0.80 and Sd equals `80.
u-up, d -down
Point to Note:
i.This Binomial tree produces a binomial distribution of underlying
stock prices.
ii.The Binomial tree represents all the possible path s that the stock
price could take during the life of the option.
From the above concept, we may define a BOPM tree as follows:
“
A BOPM tree is an option pricing model, obeys a binomial
generating process, in which the underlying stock can ass ume one of only
two possible discrete values in the next time period, for each value that it
can take in the proceeding time period.S0uS0dS0u2S0
udS 0
d2S0u3S0
u2dS0
ud2S0
d3S0 munotes.in

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161The tree must be systematically structured and ended at the
expiration of the option. The most important con cept of this model is that
all the terminal option prices for the final possible stock price are known
as they simply equal to their intrinsic value. Thus, the option values at the
final points of times are calculated first.
Next option pric es at each step of the tree are calculated working
back from expiration to present. The option prices at each step are used to
derive the option prices at next step of the tree. For calculating the option
prices, this BOPM uses “Risk Neutral Valuation’’ me thod.
Example 1: The current market price of a stock is 200. It is expected that
the price may either move up by 10% or move down by 5% by the end of
the month.
Here, S0 = 200 up factor (u) = 10%, down factor (d) = 5%
Now we represent th e above facts in the following binomial tree.
In the above example, we may calculate u factor and d factors:
u factor =
d factor =
Note: By definition
The risk neutral valuation is based on the fol lowing three factor
i.Probabilities of the stock prices moving up or down.S0Su
Sd
S0200Su220Sd190munotes.in

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162ii.The risk free rate of interest.
iii.The time interval of each step.
Assumption of the Binomial Option Pricing Model
There are five basic assumptions underlying these BOPM which are state d
as follows:
I.Stock price movements obeys the binomial process is short
periods -
This BOPM assumes that during a short interval of time, the stock
can take only two values –the up move or the down move. Thus, the
underlying stock price will either:
-Incre asing by a factor of u % (an up tick)
-decreasing by a factor of d % ( an down tick)
Let the original stock price is (S0) at the initial point of time say (t0).
Then the stock price moves to one of the two new values say Su(up
value) and Sd(down value) at the next point of time say (t1).
II.Use of priori or transition probability to quantity the uncertainty
about stock price movements
The uncertainty is that we do not know which of the two states ( up
or down) will happen. But we can able to determine the ch ance of
happening such upward or downward state in advance by using
priori or transition probability.
The up (u) and down (d) factor are calculated using the underlying
volatility (d) and the time duration of a step (t). Taking the condition
that the vari ance of the log of the price is d2t, we have
Priori or transition probabilities for price movement. The probability of an
up movement is assumed to be (P) and the probability of a down
movement is assumed to be (1 –P).
Formula: -P=
Example 1:
If u = 1.1, d = 0.9, r =0.12 and t = 3 months = 0.25. Find probability of up
movement and probability of down payment.
Solution: We denote probability of up movement is P and probability of
down payment is (1 -P). P is calculated by using the following formula:u=
d=
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163P=
P=
P=
P= 0.6523
The probability of down movement is 1 -P=1 -0.6523 = 0.3477
Example 2
Current stock price is `160 at time (t0). It will go up by 20 % or down by
10% in the next poin t of time (t1). Suppose the probability of the up move
is 0.6. Find out the expected stock price at time t1. Use binomial model.
Solution:
Here S0= `160Su = 160
=1 9 2
P=0 . 6
Sd = 160
=1 4 2
1–P=0 . 4
Now we draw the binomial tree:
III.Constant Interest Rate (r% Per Period): It is assumed that there is
no interest rate uncertainty. The one period interest rate ( r) is
constant over the life of the option.
Example:3
A stock is currently priced at `160. In one month, the stock price
may go up by 25 %, or go down by 12.50%. The strike price is `180. Find
pay-off of a call option. Use binomial tree.
Solution:
Computation of stock price at t1
Pay-off = 200 –180 = 20Su192Sd144160P = 0.61–P=0 . 4munotes.in

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164IV.Markets are Perfect:
No arbitrage opportunities
No commission
No bid ask spreads
No taxes
No margin requirement
No transaction cost.
No dividends
V.Participants use Red Ocean Strategy: Red Ocean Strategy implies
to involve in full competition. Thus, the market participants act as
price takers and not the price makers.
Characteristics of the Binomial Option Pricing Model
There are five important features of C -R-R option pricing model. These
are
a.It is Constant Dis crete time model: This model breaks down the
total time of expiration into potentially a very large number of time
intervals. The length of such time intervals remain constant
throughout the Binomial tree. The end of each time interval is known
as ‘ node’.
b.Volatility remains constant throughout model: Volatility is the
variability about the mean value of the stock price. It is measured by
standard deviation ( σ).The volatility represented by standard
deviation remains constant throughout the binomial tree.
c.The probability of an up movement and down movement remain
constant throughout the model.160160×(1 + 0.25) = 200160×(1-0.125) = 140up state
downstatemunotes.in

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165
d. The Binomial tree is recombinant: The Binomial model ensures
that the tree is recombinant, i.e., if the underlying asset moves
up and then down (u,d) the price will be same as if it had moved
down and then up (d, u). Here the two paths merge or
recombine.
e.Option Price is determined by Backward Pro cess Calculation: The
option price at each step of the tree are calculated working back from
expiration to the present. The option prices at each step are used to
derive the option prices at the next step of the tree using risk neutral
valuation method. Th e value computed at each stage is the value of the
option at that point in time.
13.3 SUMMARY
A call option gives the holder the right to buy an asset at a fixed
(strike) price while the put option gives the holder the right to sell at a
fixed (strike) p rice.
Intrinsic Value of an Option
The intrinsic value of an option is the current value of the option.
Intrinsic Value = Current Stock price –Strike priceS0SuSdS0munotes.in

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166Time Value of an Option
The time value of an option is the premium that an investor is willing
topay over and above the intrinsic value of an option. The buyer of a
long call option speculates that in the future, the price of stock will go
above the strike price and so, will generate profit for the buyer.
Determinants of Option Price
Current Price of the Underlying Security (St) at Maturity
Strike (Exercise) Price of an Option (X)
Time of Maturity (T)
Volatility of the Underlying Security ( σ)
Risk free Interest Rate (R)
Dividends Expected During the Life of the Asset (D).
The Binomial Option Pricing Model (BOPM)
This model is also known as C -R-R model. This model is a “discrete -
time” model, because it breaks down the total time to expiration into
potentially a very large number of time intervals or steps. These steps
form a tree like format. At each step, it is assumed that the price of the
underlying asset say stock will up or down by an amount calculated
using volatility and time to expiration.
13.4 SELF -ASSESSME NT QUESTIO N
1)What is option price? Explain the two components of option value?
2)What are the six variables thataffect option pricing?
3)What do you mean by BOPM? Discuss its important characteristics.
4)What are the assumptions of BOPM?
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16714
DIFFERE NCE BETWEE NFUTURE,
OPTIO NS, FORWARDS & BADLA
CONTRACTS
Unit Structure
14.0 Learning Objectives
14.1 Distinguish between Forward Contract and Future Contract
14.2 Distinguish between Option Contract and Future Contract
14.3 Distinguish betwee n Badla Contract and Future Contract
14.4 Self Assessment Question
14.0LEAR NING OBJECTIVES
After studying this lesson, you are able to:
Understand the difference between Forward, Future, Option and
Badla Contract
14.1 DISTI NCTIO N BETWEE N FORWARD
CONTRACTS A ND FUTURE CO NTRACTS
Sr.
No.Points of
DistinctionForward Contracts Future Contract
1 ConceptA forward contract is an
agreement between two
parties to buy or sell an
asset(which can be of any
kind) at a certain future date
for a certain price agreed
upon now.A futures contract is a
standardised contract,
traded on a future
exchange, to buy or sell a
certain underlying
instrument at a specified
price, at a certain future
date.
2 StructureThe contract is customised
to the needs of the parti es.
Usually, initial payment is
not required.This contract is
standardised to the needs
of the customers. Initial
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1683 Trading
PlacePrivate deal and traded on
OTC(over the counter)Traded through specified
or recognised stock
exchanges only.
4 Method of
TransactionDirect negotiations between
buyer and the sellerQuoted and traded on the
exchange.
5 Delivery
DateOne specified delivery date
in future.Range of delivery date.
6 Nature of
SettlementOnly on the date of
maturity. A forw ard
contract may be settled by
physical delivery of the
asset.Daily settlement through
mark to market process or
by differential cash
settlement.
7
Size of the
ContractDepends on how big the
transaction and what are the
requirements of the
transaction.The size of the contract is
standardised through
Future Exchange.
8
RiskThere is a chance of non -
performance risk as well as
credit default risk.No such chances occur in
a future contract as it is an
Exchange traded deal.
9 Quantum of
counterparty
riskHigh counterparty risk Low counterparty risk
14.2DISTI NCTIO NBETWEE NOPTIO NSC O NTRACTS
AND FUTURES CO NTRACTS
Sr.
No.Points of
DistinctionOptions Futures
1 Right and
ObligationAn option gives the buyer
the right but not the
obligation while the seller
has an obligation to comply
with the contact. It represents
a right to one partly and an
obligation on the other.In case of futures, there is an
obligation on the part of the
buyer and the seller. It
represents an obligation to
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1692 Premium
and
MarginsBuyer of the option
contracts pay premium to
the seller of the contracts
for obtaining the right. It
is non -refundable
whether the option is
exercised or not.Both buyer and seller have
to deposit upfront margin
with the exchange.
Different types of margins
like initial margin,
maintenance margin and
variation margins etc. are
to be deposited by the
traders.
3Pay-off
(Profit/
Loss)The buyers of option
contracts have the
possibility of unlimited
profit but t heir losses are
restricted to the premium
paid. Seller of the option
contracts have the
possibility of limited
profit only to the extent
of the premium received
but they are exposed to
the possibility of
unlimited lossesIn case of raise in futures
prices, the buyer gains and
vice versa. The position is
opposite in case of the
seller of the future contract.
Thus both buyer and seller
face the possibility of
unlimited gain or loss.
4Common
users in the
Derivative
MarketOptions are preferential
derivati ve contracts for
the hedgers in the
derivative market to
minimise risk. Normally,
they are the covered call
writers.Futures are the preferential
contracts for the
speculators in the
derivative market to
maximise profit. Normally,
they are the call holders
5 Pricing
MethodsBinomial option pricing
model and Black -Scholes
model are used.Cost of carry model,
Expectation model, Normal
Backwardation model and
CAPM are used. munotes.in

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17014.3DISTI NGUISH BETWEE NBADLA CO NTRACT
AND FUTURE CO NTRACT
Badla Futur es
Expiration date unclear Expiration date known
Spot market and different
expiration dates are mixed upSpot market and different expiration
dates all trade distinct from each
other.
Identity of counterparty often
knownClearing corpn. is counterpart
Counterparty risk present No counterparty risk
Badla financing is additional
source of riskNo additional risk
Badla financing contains default -
risk premiaFinancing cost at close to riskless
thanks to counterparty guarantee
Asymmetry between long and
shortLong and short are symmetric
Position can breakdown if
borrowing/lending proves
infeasibleYou can hold till expiration date for
sure, if you want to
14.4 SELF ASSESSME NT QUESTIO N
1. Distinguish between
a)Forward Contract and Future Contract
b)Option Contract and Future Contract
c)Badla Contract and Future Contract
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171Bibliography
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