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1 1
INTRODUCTION TO SECURITIES
Unit Structure
1.0 Objectives
1.1 Introduction
1.2 Meaning of securities
1.3 Characteristics and Structure of Securities Market
1.4 Capital Market
1.5 New Issue Market
1.6 Dematerialization
1.7 Summary
1.8 Unit End Questions
1.9 Suggested Readings
1.0 OBJECTIVES
Themainpurposeofthischapteris –
To explain the meaning of securities
To understand the characteristics and structure of Securities
To discuss the various types of Securities
To explain Capital Market
To describe New Issue Market
To understand Dematerialization
1.1 INTRODUCTION
In every economic system, some organisations or individuals can produce
surpluses while others can produce deficits. Units that produce surpluses
are known as savers, whereas those that produce deficits are known as
spenders. At the spect ral level, homes in our nation are surplus -producing
when businesses and the government are running deficits. However, this is
only accurate on an overall scale. You will undoubtedly come across both
business entities that generate surpluses and individual families that
generate deficits.
What the surplus -generating units do with their surpluses or saves is the
question that emerges in this situation. As you can see, they only have two
options available to them. They have the option of investing their savin gs munotes.in
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2 or keeping them as cash on hand.For transactional, preventative, or
speculative requirements, liquid cash must be held. The units that produce
excess could make investments in a variety of ways. They might invest in
tangible assets like land, buildings, machinery, and precious metals like
gold and silver. They may also invest in financial assets like shares and
debentures, Unit Trade India units, treasury bills, commercial paper, and
other types of paper.
A capital market is a place where governments and commercial businesses
(companies) can raise long -term capital and trade securities (both debt and
equity). It is described as a market where money is lent for periods longer
than a year because other markets are used to raise short -term capital (e.g.,
the money market).
1.2 MEANING OF SECURITIES
Any financial asset that can be traded is considered to be a security. The
characteristics of what can and cannot be classified as securities typically
depend on the legal system of the country where the assets are exchanged.
The exchange markets are where securities are traded. The legal
definitions of the term, which primarily classify equities and fixed income
as securities, differ from the common understanding that it applies to all
sorts of financial instrument s.
However, securities can also be notes, swaps, warrants, mutual funds,
interest -bearing Treasury bills, and debentures. Additionally, participation
in oil drilling initiatives is regarded as a security. The issuer of the security
is the legal entity that issues the security.
The degree of inherent risk in various securities varies. For instance, while
some stocks are riskier than others, overall stocks are thought to be riskier
than bonds. An investor chooses the appropriate securities in accordance
with the level of risk he wishes to accept. Furthermore, the degree of
liquidity varies among securities. Because investors can enhance the price
of these assets by purchasing additional securities and obtaining a better
return on investment, highly liquid secu rities including bonds, stocks, and
money market instruments are traded more often.
Definition: Securities are negotiable financial instruments issued by a
company or government that give ownership rights, debt rights, or rights
to buy, sell, or trade an o ption.
1.3 CHARACTERISTICS AND STRUCTURE OF
SECURITIES MARKET
The terms of the exchange of money between two parties —in this
case, the buyer and the seller —are expressed by securities.
Borrowers and equity funders can issue securities to raise funds at a
fair price and grant investors ownership of the securities. munotes.in
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Introduction to securities
3 Businesses use a regulated contract and a controlled and supervised
method to issue securities to investors with excess capital to raise
money.
Investors have a right to the rights represented by t he securities, even
though the terms of the capital raise are determined by the security's
issuer.
Securities can be broadly divided into two categories: debt and equity
(risk participation) (claim on cash flows).
Equity securities are issued forever, wher eas debt securities are issued
for a specified time period. While equity pays dividends, it is not
guaranteed, debt securities pay interest.
Structure of Securities Market
The term "primary market" describes the area of the market where
corporations issue securities as either a new issue or an offer for sale.
Both equities and debt securities have an initial public offering (IPO)
market.
The secondary markets are where these securities are really traded.
Eventually, primary debt and equity issues are traded in the secondary
market to determine prices. The primary trading market is the
secondary market.
Futures and options are traded in the derivatives market. Derivatives,
which are only contracts and are used to control the risk inherent in
the security, con trast equities, which denote ownership. Derivative
contracts are a trading option for traders.
1.4 CAPITAL MARKET
The capital market refers to the marketplace where investment funds like
bonds, shares, and mortgages are traded. The capital market's primary
function is to direct investments from investors with surplus funds to those
who are experiencing a shortfall. The capital market provides both
overnight and long -term funds. The market for securities known as the
capital market is where businesses and go vernments can raise long -term
financing. It is a market where loans for terms greater than a year are
made.
Equity instruments, credit market instruments, insurance instruments,
foreign currency instruments, hybrid instruments, and derivative
instruments a re only a few of the capital market instruments utilised for
market trade. In order to profit from their respective markets, investors use
these.
All of these are referred to be capital market instruments because they
generate money for businesses, corpora tions, and occasionally national
governments. munotes.in
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4 Because long -term funds are raised through trading on debt and equity
securities, this market is often referred to as the securities market. Both
businesses and governments may carry out these actions.
The pri mary market and secondary market make up the capital market.
Newly issued bonds and stocks are traded in the primary market, and
existing bonds and stocks are bought and sold in the secondary market.
Bond market and stock market are two common categories o f the capital
market.
Bond Market offers finance through the issue and trading of bonds.
By issuing shares or stock and through share trading, the stock market
offers financing.
Capital Market as a whole makes it easier to raise money by
exchanging long -term financial assets.
1.5 NEW ISSUE MARKET
The primary capital market is another name for the New Issue Market, or
NIM. In this market, newly -introduced securities are offered for sale to the
general public for the first time. As the money obtained from thi s market
offers long -term funding, it is often referred to as the "long -term debt
market."
Business entities may raise money in the primary market through a private
placement, rights issue, or initial public offering. Selling securities to the
general publ ic on the primary market is known as an initial public offering
(IPO). This initial public offering may be conducted using either the book -
building method, the fixed price method, or both methods combined.
According to SEBI standards, an issuer company may opt to issue
securities in the following ways if the issuer chooses to go the book -
building path to do so:
1. The entire net offer made to the general public via the book -building
method
2. Through the book -building process and 25% of the fixed price port ion,
the public will receive 75% of the net offer.
The new issue market and stock exchange make up India's industrial
securities markets. The new issue market deals with new securities that
have never before been offered to the investing public, or securit ies that
are issued for the first time. As a result, the market makes a fresh block of
securities available for public subscription. In other words, the new issue
market is concerned with how corporations raise new capital for cash or
for something other t han cash.
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5 The market for new issues includes every institution engaged in handling
new claims. These claims are made in the forms of equity shares,
preference shares, debentures, rights issues, deposits, etc. The new issue
markets include all financial in stitutions that contribute, underwrite, and
directly subscribe to the securities.
1.6 DEMATERIALIZATION
The technique of dematerialization allows a client to turn their physical
certificates into electronic balances. An investor must have an account
with a DP if they plan to dematerialize their securities. The client is
required to deface and turn over to the DP any certificates registered in its
name. After electronically notifying NSDL, the DP transmits the securities
to the relevant Issuer/R&T agent.
The market microstructure of Indian stock exchanges has evolved
significantly as a result of dematerialized securities trading, settlement,
and custody. An investor would typically choose a stock with greater
liquidity to one with less. Lower transaction cost s and simpler entrance
and exit options are associated with more liquidity. Higher liquidity is
therefore preferable. Ownership transfers for demat shares happen
relatively rapidly. The ability of investors to frequently churn their
portfolios would improv e turnover and liquidity.
Physical (paper) shares are unquestionably inferior to dematerialized
shares. Problems with counterfeit, forgeries, theft, and duplication plague
physical shares. According to logic, there should be more demand for
demat shares, w hich is anticipated to drive up (and, to a lesser extent,
drive down) share prices and produce larger profits (and, conversely, less
loss) for investors compared to the predemat time. This increased demand
will remain for a while (the adjustment period may last for a few months)
only.
1.7 SUMMARY
A capital market is a place where governments and commercial
businesses (companies) can raise long -term capital and trade
securities (both debt and equity).
Debt securities, such as bonds and certificates of depos it, typically
require the holder to pay periodical interest payments, the principal
amount owed, as well as any other contractual obligations that may be
specified.
Equity instruments, credit market instruments, insurance instruments,
foreign currency ins truments, hybrid instruments, and derivative
instruments are only a few of the capital market instruments utilised
for market trade.
The institutions that trade in new claims are all included in the new
issue market. munotes.in
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6 Equity shares, preference shares, debe ntures, rights issues, deposits,
etc. are the forms in which these claims are generated.
The new issue markets include all financial institutions that
contribute, underwrite, and directly subscribe to the securities.
Physical (paper) shares are unquestio nably inferior to dematerialized
shares. Problems with counterfeit, forgeries, theft, and duplication
plague physical shares.
1.8 UNIT END QUESTIONS
A. Descriptive Questions:
1. What do you mean by securities?
2. Explain the characteristics of Securities market.
3. Write note on structure of securities market.
4. What is dematerialisation?
5. What are the types of derivatives securities?
B. Fill in the blanks:
1. The ……………….. refers to the marketplace where investment funds
like bonds, shares, and mortgages are traded.
2. The primary capital market is another name for the……………...
3. The new issue market and stock exchange make up ……………
industrial securities markets.
4. ………………. allows a client to turn their physical certificates into
electronic balances.
Answer:
1. capital mar ket
2. New Issue Market
3. India's
4. Dematerialization
1.9 SUGGESTED READINGS
Graham, Benjamin, David, L., Dodd, Sidney Cottle, et al., Security
Analysis: Principles and Techniques, 4th ed., New York McGraw –
Hill Book Co. Inc., 1962.
Granger, Clive W and Morgenstem Oskar, Predictability of Stock
Market Prices, Lexington, Health Lexington, 1970. munotes.in
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Granville, Joseph E., A Strategy of Daily Timings for Maximum
Profit, Englewood Cliffs, N.J., Prentice -Hall, 1960.
Gup, Benton E., Basics of Investing, N.Y. Wiley, 1979.
Gupta L.C., Rates of Return on Equities: The Indian Experience,
Bombay, Oxford University Press, 1981.
Sudhindra Bhat, Security Analysis and Portfolio Management, Excel
Book
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8 2
SECURITIES - RISK AND RETURN
ANALYSIS
Unit Structure
2.0 Objectives
2.1 Introduction
2.2 Types of Securities
2.3 Probability V/s Absolute loss in risk management
2.4 Volatility in price
2.5 Statistical tools for risk calculation
2.6 Types of Risk
2.7 Risk and Expected Return
2.8 Risk-Return Relationship
2.9 Summary
2.10 Unit End Questions
2.11 Suggested Readings
2.0 OBJECTIVES
Themainpurposeofthischapteris –
To understand the types of securities
To explain Probability V/s Absolute loss in risk management
To explain volatility in price
To understand Statistical tools for risk calculation
To discuss types of risk
To understand the concept of risk & expected Return
To analyse risk return relationship
2.1 INTRODUCTION
Investing is a hybrid of an art and a science, unlike natural science and
like medi cine, law, and economics. There are some aspects of investing
that are best approached scientifically. The development of computer
skills has sped up the application of scientific approaches. However, as
businesses are run by individuals, they are suscepti ble to issues brought
on by their poor judgement. The corporations also operate in a highly
competitive and dynamic environment, and many of them do so on a
national and international scale. The judgement aspect still predominates
in investment decisions a s a result. Although it is doubtful that investing munotes.in
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9 will ever be considered a science, study, education, and experience have
turned investment into a discipline. A disciplined, reliable, and organised
procedure without rigidity in either thought or approach is what is meant
by discipline.
Financial Analysis
The informational and predicative component of investing is financial
analysis. It offers data on the past, present, and future while also
quantifying expectations. Financial analysis is used to make dec isions on
corporate financial policies, capital budgeting, and the wise choice of
assets to invest in. Economic, capital market, sector, and specialised
security evaluations are some of the analytical tools that have been
utilised for these objectives.
Economic Analysis
In terms of the country's output of goods and services, inflation,
profitability, monetary and fiscal policy, and productivity, economic
analysis provides both short - and long -term estimates for the entire
economy. As a result, it serves as the basis for financial market, industry,
sector, and firm projections of the future.
Capital Market Analysis
In order to determine the value and return expectations for securities and
to distinguish between overpriced and underpriced securities, capital
market analysis looks at the industries and securities of specific
companies.
Sector analysis sits between capital market analysis and security
analysis, combining elements of both. Sector analysis, which is more
comprehensive than business and industry a nalysis, can be seen as a link
between the capital market setting and key stock groupings that either
cross or combine numerous industries (e.g., according to economic
sector, growth rate, or earnings cycles).
Comparative Selection of Securities
It is nec essary to appraise securities before choosing among different
investment options so that their relative attractiveness in terms of return
and risk may be assessed at any moment. Only consistent analytical
techniques may be used to achieve this goal, and in dustry and business
forecasts must be based on internally consistent sets of economic and
capital market estimates.
Since consistency and comparability are crucial, they ought to serve as
the process' dual objectives for investment analysis. While comparab ility
looks for accurate data on firms for each time period, consistency applies
to data for a single company over time. The investor cannot use solid
judgement to spot instances of overvaluation and undervaluation without
consistency and comparability. munotes.in
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10 Making Investment Decisions The best way to understand how
investment decisions are made is as an integrated process to which
security analysis uniquely contributes. The definition of objectives and
the evaluation of success in portfolio management call for the consistent
use of economic, capital market, and sector analyses. By highlighting the
securities that are either fairly priced or underpriced and most likely to
deliver the desired results, security analysis aids investment decision -
makers.
The followin g goals serve as the foundation for developing investment
policies and asset allocation strategies:
1. To continuously preserve the purchasing power of its assets, adjusted
for inflation, and to generate a satisfactory "real" rate of return.
2. To minimise portfolio risk and volatility while maintaining sufficient
spending stability from year to year.
2.2 TYPES OF SECURITIES
Debt securities, equity securities, derivative securities, and hybrid
securities —a mix of debt and equity —are the four primary types o f
security.
Debt Securities
Debt securities, also known as fixed -income securities, are a
representation of borrowed money that needs to be repaid, with terms
defining the sum borrowed, the interest rate, and the maturity date. In
other words, debt secur ities are financial instruments that can be traded
between parties, such as bonds (such as government or municipal bonds)
or certificates of deposit (CDs).
Debt securities, such as bonds and certificates of deposit, typically require
the holder to pay peri odical interest payments, the principal amount owed,
as well as any other contractual obligations that may be specified. These
securities are typically sold for a set period of time before being redeemed
by the issuer.
Based on a borrower's credit history, track record, and solvency —the
capacity to repay the loan in the future —the interest rate on a debt security
is decided. In order to make up for the amount of risk taken, a lender munotes.in
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11 would need to charge a higher interest rate the larger the possibility that
the borrower would default on the loan.
It is vital to note that the daily dollar volume of trading in debt securities is
substantially higher than that in stocks. The rationale is that institutional
investors, together with governments and not -for-profit organisations, own
the majority of debt securities.
Equity Securities
Shareholders' ownership interest in a company is represented by equity
securities. To put it another way, becoming a shareholder of an
organisation requires making an investment in its equity capital.
Holders of equity securities are not entitled to a regular payment, but they
can make capital gains by selling their stocks, which is how they vary
from holders of debt securities. Another distinction is that equity securities
give the hold er ownership rights, making him a shareholder with a stake
corresponding to the number of bought shares.
If a company files for bankruptcy, the equity holders can only split the
interest that is left over after all obligations have been met by the holders
of debt security. Companies regularly pay dividends to shareholders who
share in the earned profits from their main company operations, but debt
holders do not get dividend payments.
Derivative Securities
Financial instruments known as derivative securitie s have a value based on
fundamental factors. Assets like stocks, bonds, currencies, interest rates,
market indexes, and goods are examples of variables. Utilizing derivatives
is primarily done to weigh risks and reduce them. It is accomplished
through gain ing access to difficult -to-reach assets or markets, providing
favourable conditions for speculation, and providing insurance against
price fluctuations.
In the past, derivatives were employed to guarantee stable currency rates
for items that were transacte d abroad. International traders required an
accounting system to fix the exchange rates of their various national
currencies.
Four primary categories of derivative securities exist:
1. Futures
Futures, often known as futures contracts, are agreements betwe en two
parties to buy and deliver an item at a predetermined price at a later
period. Futures are exchanged on an exchange with standardised contracts.
The parties engaged in a futures transaction must acquire or sell the
underlying asset.
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12 2. Forward
Although forwards, or forward contracts, are comparable to futures, they
are exclusively traded in retail settings. The terms, amount, and method of
settlement for the derivative must be agreed upon by the buyer and seller
before the formation of a forward co ntract.
The risk incurred by both sellers and buyers is another distinction from
futures. When one party declares bankruptcy, there is a chance that the
other party won't be able to defend its rights, which could reduce the value
of its position.
3. Option s
Options, or options contracts, are comparable to futures contracts in that
they involve the purchase or selling of an asset between two parties at a
defined price at a future date. The main distinction between the two types
of contracts is that, in the c ase of an option, the buyer is not obligated to
carry out the action of purchasing or selling.
4. Swaps
In a swap, one type of cash flow is exchanged for another. For instance, a
trader can change from a fixed interest rate loan to a variable interest rate
loan or vice versa via an interest rate swap.
Hybrid Securities
As the name implies, a hybrid security is a kind of security that combines
features of both debt and equity securities. Hybrid securities are frequently
used by banks and other organisation s to raise capital from investors.
Similar to bonds, they often make a greater interest payment promise at a
set or variable rate until a specific future date. The frequency and timing
of interest payments are not guaranteed, unlike with bonds. Even better , an
investment may be withdrawn at any time or converted into shares. munotes.in
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13 Preferred stocks, which enable the holder to receive dividends before the
holders of common stock, convertible bonds, which, depending on the
conditions of the contract, can be converte d into a known quantity of
equity stocks during the life of the bond or at maturity, are examples of
hybrid securities.
Hybrid securities are intricate goods. Even seasoned investors may find it
challenging to comprehend and assess the risks associated wit h trading
them. When purchasing hybrid securities, institutional investors can have
trouble comprehending the terms of the agreement they enter into.
2.3 PROBABILITY V/S ABSOLUTE LOSS IN RISK
MANAGEMENT
Probability and absolute loss are two distinct concep ts that are used in risk
management to evaluate and manage risks. Absolute loss is the amount of
loss that would occur if an event were to occur, whereas probability is the
possibility that an event will occur.
Probability, which is frequently used to meas ure the degree of risk
associated with a specific event or scenario, is a significant aspect in
estimating the chance of a risk occurring. Probabilities are frequently
expressed in risk management as percentages or decimal values between 0
and 1, where a h igher probability denotes a higher likelihood of the event
occurring.
On the other hand, absolute loss is a measurement of the real financial or
other loss that would come from the occurrence of the event. This is
crucial for risk management because it mak es it easier to estimate a risk's
possible effects and choose the right amount of risk transfer or mitigation.
Probability and absolute loss are both significant elements of risk
management, and it is frequently necessary to take both into account when
choosing risk management tactics. For instance, a risk management
strategy may need to be different for a high -probability event with a low
absolute loss than for a low -probability event with a large absolute loss.
2.4 VOLATILITY IN PRICE
Price volatility is the degree of change in a financial asset's price over
time. It is a gauge of how much an asset's price swings, and it is often
computed using statistical concepts like variance or standard deviation.
A variety of causes, such as movements in supply and de mand, economic
or political events, adjustments to interest rates or inflation, and changes in
investor or market mood, can all contribute to volatility. When these
elements alter, the price of an asset may quickly fluctuate, increasing
volatility.
Volatil ity for investors can present both a risk and a possibility. On the
one hand, if an investor is holding an asset that undergoes a sharp price
decrease, extreme volatility can result in huge losses. On the other side, munotes.in
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14 extreme volatility can also present opp ortunities for profit if a trader can
purchase a security at a discount and then sell it at a premium after the
market stabilises.
2.5 STATISTICAL TOOLS FOR RISK CALCULATION
Statistical tools are widely used in risk management to calculate and
analyze risk . Here are some common statistical tools for risk calculation:
Probability distribution: Probability distribution is a mathematical
function that describes the likelihood of different outcomes in a random
event. It is often used in risk management to model the probability of
different scenarios, such as the probability of a financial loss occurring.
Correlation analysis: Correlation analysis is used to measure the
strength of the relationship between two variables. In risk management,
correlation analysis c an be used to assess the relationship between
different assets or between an asset and a market index.
Monte Carlo simulation: Monte Carlo simulation is a statistical
method that uses random sampling to generate possible outcomes for a
given set of variabl es. It is often used in risk management to model the
potential outcomes of different scenarios and assess the likelihood of
different risks.
Sensitivity analysis: Sensitivity analysis is used to measure how
changes in one variable can impact the outcome of a model or simulation.
In risk management, sensitivity analysis can be used to assess the impact
of different scenarios on a portfolio or investment strategy.
Value at Risk (VaR): Value at Risk is a statistical measure used to
estimate the potential loss that could be incurred from an investment or
portfolio over a certain time period with a given level of confidence. It is
often used in risk management to assess the potential downside risk of a
portfolio or investment strategy. 2.6Types of Risk
Risk is the likelihood that the anticipated return from the security will not
occur. Every investment entail risks that increase the riskiness of future
investment returns. Political, economic, and industry considerations could
all be contributing contributors to unc ertainty.
Future risk may be systematic, depending on its source. Unsystematic risk
pertains to a particular industry or company, whereas systematic risk
affects the market as a whole. The first three risk variables listed below are
organised in a systemat ic fashion, whereas the remainder are not.
Depending on whether it affects the market as a whole or simply one
industry, political risk can be categorised. munotes.in
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Risk in finance is the likelihood that the results will be different from what
is anticipated. The volatility of returns is the definition of risk in the
Capital Asset Pricing Model (CAPM). According to the "risk and return"
theory, investments in riskier assets should generate higher projected
returns to make up for the higher volatility and greater r isk.
Systematic versus Non -systematic Risk
Traditional sources of risk that affect returns are divided into two
categories by modern investment analysis: those that are ubiquitous in
nature, like market risk or interest rate risk, and those that are specif ic to a
given security concern, such business or financial risk. As a result, we
must take these two types of total risk into account. These words are
defined in the discussion that follows. We have systematic risk and non -
systematic risk when we divide to tal risk into its two components, a
general (market) component and a specific (issuer) component, which are
additive:
Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Non -systematic risk
Systematic Risk:
The dive rsifiable or non -market portion of the overall risk can be
eliminated by an investor by creating a diversified portfolio. The market
risk, or non -diversifiable element, is what is left. Systematic (market) risk
is the term for variation in a security's tot al returns that is directly related
to broad trends in the market or economy.
Because systematic risk directly includes interest rate, market, and
inflation concerns, practically all financial instruments, including bonds
and equities, carry some degree of systematic risk. No matter how well the
investor diversifies, the risk of the whole market cannot be avoided, hence
the investor cannot escape this portion of the risk. Most stocks will suffer
if the stock market falls quickly, and most stocks will gain v alue if it rises
sharply, as it did in the latter several months of 1982. Regardless of what
any one investor does, these moves continue to happen. It is obvious that
market risk is important to all investors. munotes.in
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16 Non-systematic Risk:
The variance in a securi ty's total returns that is independent to market
performance The non -systematic (non -market) risk is referred to as notes
variability. This risk is specific to a given security and is linked to other
risks, including business and financial risk and liquidi ty risk. Even though
all securities have a certain amount of non -systematic risk, it is typically
associated with common stocks.
Difference between systematic and non -systematic rick
All assets are affected by broad macro variables, which are the cause of
systematic (market) risk. The causes of non -systematic (non -market) risk
are specific to a security.
Types of Systematic Risk
1. Market Risk:
Market risk is the variation in a security's returns brought on by changes in
the overall market. All securities are subject to market risk, which includes
events like recessions, wars, shifts in economic structure, modifications to
tax laws, and even shifts in consumer preferences. Systematic risk and
market risk are sometimes used interchangeably.
2. Interest Rate Risk:
Interest rate risk is the variation in a security's return brought on by
variations in the level of interest rates. Security prices typically move
opposite of interest rates when such changes occur, all other circumstances
being equal. The valuation of securities is related to the cause of this
movement. Bonds are more directly impacted by interest rate risk than are
common stocks, and it is a significant risk for all bondholders. Bond prices
move the other way from changes in interest rates.
3. Purc hasing Power Risk:
Purchasing power risk, commonly referred to as inflation risk, is a factor
that impacts all securities. This is the chance that money invested may lose
some of its purchasing power. Even if the nominal return is safe, there is
risk asso ciated with the real (inflation -adjusted) return when inflation is
unclear (e.g., a Treasury bond). This risk is linked to interest rate risk
since lenders need to charge higher inflation premiums to cover the loss of
buying power, which causes interest ra tes to typically climb when
inflation does.
Types of Unsystematic Risk
1. Regulation Risk:
Because of specific rules or tax laws that provide them a benefit of some
sort, some investments may be more alluring than others. For instance,
municipal bonds pa y interest that is not subject to federal, state, or local
taxation. Municipals can price bonds to offer a lower interest rate as a munotes.in
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17 result of that particular tax exemption because the net after -tax yield may
still be appealing to investors. The danger of a regulation change that can
have a negative impact on an investment's reputation is significant. Many
existing limited partnerships that relied on special tax considerations as
part of their overall return were significantly less attractive in 1987 as a
result of changes to the tax code. Prices for many limited partnerships fell
when investors were left with securities that were, in fact, different from
what they had initially expected.
2. Business Risk:
Firm risk refers to the risk associated with operat ing a business in a
specific sector or setting. For instance, U.S. Steel, one of the biggest
producers of steel, has particular issues. Similar issues arise for General
Motors as a result of recent events like the global energy market and
Japanese imports.
3. Reinvestment Risk:
The YTM calculation makes the assumption that the investor will reinvest
all bond coupons at a rate that is equal to the bond's computed YTM,
generating interest on interest for the duration of the bond at the computed
YTM rate. In essence, this computation takes for granted that the yield to
maturity is equal to the reinvestment rate.
4. Bull -Bear Market Risk:
This risk results from the fluctuation in market returns brought on by the
alternating forces of bull and bear markets. A b ull market is a period of
time during which a securities index rises steadily after a period of time
during which it fell, known as a trough. When the market index reaches its
high and begins to trend lower, the bull market is over. A bear market is
the pe riod of time when the market falls to its subsequent low point.
5. Management Risk:
All things considered, management is composed of mortal, imperfect, and
prone to error, decision -making individuals. Management mistakes can
hurt people who invested in th eir companies. Forecasting errors is a
challenging task that may not be worthwhile, which leads to an
unnecessarily pessimistic view.
When shareholder owners assign daily decision -making power to
managers who are hired employees rather than substantial own ers, a
connection between agent and principal is created. According to this
hypothesis, owners will exert more effort than employees to increase the
company's value. According to numerous studies in the area, buying stock
in companies where CEOs have subst antial equity stakes can help
investors cut their losses from hard -to-analyse management errors.
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18 6. Default Risk:
It is that portion of an investment's overall risk that arises from
modifications to the investment's financial stability. For instance, ch anges
in the firm's financial integrity will be reflected in the market price of its
securities when a corporation that issues securities moves either further
away from bankruptcy or closer to it. Default risk is the variation in return
that investors enco unter as a result of changes in the credit worthiness of a
company in which they have invested.
Nearly 80% of the losses experienced by investors due to default risk are
not brought on by actual defaults and/or bankruptcies. Investor losses from
default ri sk typically occur from declining security prices due to a
corporation's weakening financial standing; by this point, the market price
of the ailing firm's securities will have already dropped to close to zero.
This isn't always the case, though; "creative " accounting techniques used
by companies like Enron, WorldCom, Arthur Anderson, and Computer
Associates may keep stock values quoted even when the company's net
worth is utterly depleted. Therefore, the total losses brought on by the
course of financial d egradation would not exceed the bankruptcy losses by
much.
7. International Risk:
Country risk and currency rate risk are both examples of international risk.
Exchange Rate Risk: In today's more globally interconnected investing
environment, all investors who make overseas investments run the risk of
receiving uncertain returns when they convert their foreign winnings back
to their home currencies. Investors today must be aware of and
comprehend exchange rate risk, which may be defined as the variability i n
returns on securities induced by currency movements. This is in contrast to
the past, when the majority of US investors ignored overseas investing
choices. Currency risk is another name for exchange rate risk.
8. Country Risk:
Political risk, often know n as country risk, is a significant risk for
investors today. The political and, consequently, economic stability and
sustainability of a country's economy must be taken into consideration as
more investors, both directly and indirectly, make direct and in direct
investments abroad.
9. Liquidity Risk:
The risk connected with a specific secondary market where a securities
trades is called liquidity risk. Liquid investments are those that can be
swiftly purchased or sold without experiencing a significant pri ce
reduction. The risk associated with liquidity increases with the degree of
uncertainty surrounding the timing and cost concession. While a small
OTC stock may have significant liquidity risk, a Treasury bill has little to
no liquidity risk. munotes.in
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Securities - Risk and return
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19 10. Politica l Risk:
It results from a politically powerful group taking advantage of a
politically weaker group, and as a result of multiple factions' attempts to
strengthen their respective positions, the variability of return on the
impacted assets increases. Polit ical risk refers to the variability of return
that results from changes made by the legislative, judicial, or
administrative branches of the government, regardless of whether they are
motivated by business or political reasons.
11. Industry Risk :
An indus try can be viewed as a group of businesses that compete with one
another to market a common good. Industry risk is the part of an
investment's overall return variability that is brought on by occurrences
that have an impact on the businesses and products t hat make up the
industry.
2.7 RISK AND EXPECTED RETURN
The two primary factors affecting an investment decision are risk and
projected return. Simple terms: How much do individual results depart
from the expected value? Risk is correlated with the variabil ity of the rates
of return from an investment. Risk can be quantified statistically using any
of the dispersion metrics, including variance, standard deviation, and co -
efficient of range.
The risk involved in investment depends on various factors such as:
1. The length of the maturity period; investments are riskier when the
maturity period is longer.
2. The creditworthiness of the security issuer – The borrower's capacity to
make regular interest payments and repay the principal will confer safety
to the investment and lower risk.
3. The instrument's or security's nature affects the risk as well. In general,
risk-free or least risky investments include government securities and
fixed deposits with banks; riskier investments include corporate debt
instrume nts like debentures and ownership instruments like equity shares.
Once more, the relative risk ranking of instruments and investment safety
are related.
4. Due to the volatility of return rates and the fact that equity investors are
still subject to the re sidual risk of bankruptcy, equity shares are regarded
as the riskiest investment.
5. The liquidity of an investment also determines the risk involved in that
investment. Liquidity of an asset refers to its quick saleability without a
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20 5. The risk associated with an investment is also influenced by its
liquidity. An asset's liquidity is defined as its capacity to be quickly sold
without a loss or with a little loss.
6. In addition to the aforementioned elements, there are oth er more factors
that influence risk and investment, such as economic, industry, and firm -
specific factors.
The rate of return that the investor anticipates is a significant additional
aspect in making an investment decision. The yield and capital growth
make up the investor's anticipated rate of return.
Determinants of the Rate of Return
The investor's estimated rate of return is thus largely determined by three
factors:
1. The risk -free real rate for time preferences.
2. The anticipated inflation rate.
3. The risk specific to the investment, which is related with it.
Hence, Required return = Risk -free real rate + Inflation premium + Risk
premium
ROR = Current yield + Capital gain yield
2.8 RISK -RETURN RELATIONSHIP
In general, taking on more investment ris k is the only way to achieve
larger investment returns. This isn't necessarily true in every situation,
though. For instance, diversification an investment portfolio can
frequently yield a comparable return with lower risk than an undiversified
investment portfolio. However, as a portfolio gets bigger, there is a limit
to how effective diversification may be.
The risk -return trade -off is a key tenet of successful investing. There are
numerous different asset classes and investment kinds, including, but not
limited to, money market securities, bonds, public equities, private equity,
private debt, and real estate. The investment risk associated with each of
these asset classes varies. Investments with varying risk -return profiles
might help satisfy the various risk appetites of different investor groups. munotes.in
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Securities - Risk and return
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21
Take a look at the graph above. Governments issue the first asset class,
risk-free bonds, which are typically regarded as "risk -free" investments
since a government can print money to settle its debts. As a r esult, risk -
free bonds are the safest asset and offer the lowest rate of return on
investments.
We can observe that as the risk -return range increases, each asset class
becomes riskier. Each asset class's prospective investment return does,
however, also r ise.
Private equity is the fifth asset class, and it entails financial investments in
privately held businesses that are not exchange -listed. These investments
often carry more risk than common stocks, including added hazards like
liquidity risk. Private e quity does, however, provide investors the best
possible investment returns despite these increased risks.
2.9 SUMMARY
The likelihood that the expected return from the security will not
occur might be referred to as risk.
Uncertainties are a part of every investment, which increases the risk
of future investment returns.
Political, economic, and industry considerations could all be
contributing contributors to uncertainty.
Depending on the cause of the risk, it may become systematic in the
future.
Systemati c risk pertains to the market as a whole, whereas
unsystematic risk is unique to a particular industry or company.
Of the risk factors discussed below, only the first three are systematic
in character. munotes.in
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22 Depending on whether it affects the market as a whole or simply one
industry, political risk can be categorised.
The systematic risk of a security that cannot be mitigated by
diversification is measured by beta.
Beta is a measure of risk that compares the risk of a single stock to the
risk of the entire marke t portfolio of equities.
2.10 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. Define Risk.
3. Write note on Purchasing Power Risk .
4. Explain Business Risk .
5. Differentiate between Systematic versus Non -systematic Risk .
6. Discuss Risk and Expected Return .
7. Describe the various types of securities.
8. Enumerate the difference between Equity and Hybrid securities.
9. Write note on Probability V/s Absolute loss in risk management.
B. Fill in the blanks:
1. .................. is the risk asso ciated with the particular secondary market in
which a security trades.
2. The rate of return expected by the investor consists of the ..................
and ..................
3. Beta is useful for comparing the relative .................. of different stocks.
4. .................. are considered to be the most risky investment.
5. The .................. for some future period is known as the expected return.
Answer:
1. Liquidity risk
2. yield, capital appreciation
3. systematic risk
4. Equity shares
5. anticipated return munotes.in
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23 2.11 SUGGESTED READINGS
Bonus Shares, A Study of the Dividend and Price Effects of Bonus
Shares Issues, Bombay, MacMillan, 1973.
Graham, Benjamin, David, L., Dodd, Sidney Cottle, et al., Security
Analysis: Principles and Techniques , 4th ed., New York McGraw –
Hill Book Co. Inc., 1962.
Granger, Clive W and Morgenstem Oskar, Predictability of Stock
Market Prices, Lexington, Health Lexington, 1970.
Granville, Joseph E., A Strategy of Daily Timings for Maximum
Profit, Englewood Clif fs, N.J., Prentice -Hall, 1960.
Gup, Benton E., Basics of Investing, N.Y. Wiley, 1979.
Gupta L.C., Rates of Return on Equities: The Indian Experience,
Bombay, Oxford University Press, 1981.
Sudhindra Bhat, Security Analysis and Portfolio Management, E xcel
Book
munotes.in
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24 3
EFFICIENT MARKET HYPOTHESIS
Unit Structure
3.0 Objectives
3.1 Introduction
3.2 Random Walk theory
3.3 Significance of Efficient Market Hypothesis
3.4 Uses of Efficient Market Hypothesis
3.5 Summary
3.6 Unit End Questions
3.7 Suggested Readings
3.0 OBJECTIVES
Themainpurposeofthischapter is–
To explain Random walk theory
To discuss the significance of Efficient Market Hypothesis
To describe uses of Efficient Market Hypothesis
3.1 INTRODUCTION
The present prices of securities reflect all available information about the
security in an effici ent capital market because security prices respond
quickly to the emergence of fresh information. During the past 20 years,
some of the most fascinating and significant academic studies have
examined the efficiency of our capital markets. This in -depth stu dy is
crucial because the consequences for investors and portfolio managers in
the actual world are wide -ranging. Additionally, one of the most divisive
topics in investing research is the issue of how efficient capital markets
are. Recent research in beha vioural finance, which is increasing quickly
and has significant consequences for the idea of efficient capital markets,
has given the argument a new dimension. Due to its significance and the
controversy surrounding it, the terms efficient capital markets and efficient
market hypothesis (EMH) must be understood. You should be aware of
the research findings that either support or refute the EMH as well as the
analyses used to test it. The ramifications of these findings should also be
considered as you rese arch alternative investments and build your
portfolio.
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Efficient Market Hypothesis
25 3.2 RANDOM WALK THEORY
In essence, tests of market efficiency determine whether the three broad
forms of information —past prices, other public information, and inside
information —can be used to genera te returns on investments that are
higher than average. Regardless of the knowledge at hand, it is difficult to
generate above -average returns in an efficient market unless exceptional
risk is taken.
Furthermore, in such a market, no person or group of inv estors can
regularly outperform other investors. They are also known as weak -form
(price information), semi -strong -form (other public information), and
strong -form (inside knowledge) tests of market efficiency.
Weak -form and the Random Walk
This is the old est statement of the hypothesis. It holds that present stock
market prices reflect all known information with respect to past stock
prices, trends, and volumes. Thus it is asserted, such past data cannot be
used to predict future stock prices. Thus, if a s equence of closing prices
for successive days for XYZ stock has been 43, 44, 45, 46, 47, it may seen
that tomorrow’s closing price is more likely to be 48 than 46, but this is
not so. The price of 47 fully reflects whatever information is implied by or
contained in the price sequence preceding it. In other words, the stock
prices approximate a random walk. (That is why sometimes the terms
Random Walk
Hypothesis and Efficient Market Hypothesis are used interchangeably). As
time passes, prices wander or walk more or less randomly across the
charts. Since the walk is random, a knowledge of past price changes does
nothing to inform the analyst about whether the price tomorrow, next
week, or next year will be higher or lower than today’s price.
The weak form of t he EMH is summed up in the words of the
pseudonymous ‘Adam Smith’, author of The Money Game: “prices have
no memory, and yesterday has nothing to do with tomorrow.” It is an
important property of such a market, so that one might do as well flipping
a coin as spending time analyzing past price movements or patterns of past
price levels.
Thus, if the random walk hypothesis is empirically confirmed, we may
assert that the stock market is weak -form efficient. In this case any work
done by chartists based on pas t price patterns is worthless.
Random walk theorists usually take as their starting point the model of a
perfect securities market in which a relatively large number of investors,
traders, and speculators compete in an attempt to predict the course of
future prices. Moreover, it is further assumed that current information
relevant to the decision -making process is readily available to all at little
or no cost. If we ‘idealize’ these conditions and assume that the market is
perfectly competitive, then equity prices at any given point of time would
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26 becomes known. And unless the new information is distributed over time
in a non -random fashion – and we have no reason to presume this – price
movements in a perfect market will be statistically independent of one
another. If stock price changes behave like a series of results obtained by
flipping a coin, does this mean that on average stock price changes have
zero mean? Not necessarily. Sinc e stocks are risky, we actually expect to
find a positive mean change in stock prices.
Example: Suppose an investor invests 1,000 in a share. Flip a coin; if
heads comes up he loses 1%, and if tails shows up he makes 5%. The
value of investment will be as shown in figure.
Random Walk with Positive Drift (Two -Period -Case)
Suppose that an investor flips the coin (looks up the prices) once a week
and it is his decision when to stop gambling (when to sell). If he gambles
only once, his average return is 1/2 × `990 +1/2 × `1050 = `1020 since the
probabilities of ‘heads’ or ‘tail’ are each equal to 1/2. The investor may
decide to gamble for another week. Then the expected terminal value of
his investment will be:
½ x980.1+1/4 x 1039.5+1/5x1039.5+1/4x1102.5 + `10 40.4
Now assume that these means are equal to the value of the given shares at
the end of the first week and at the end of the second week. The fact that
the shares went up in the first period, say to 1050, does not affect the
probability of the price goin g up 5% or that ongoing changes in each
period are independent of the share price changes in the previous period.
In each period, we would obtain the results that one could obtain by
flipping a coin, and it is well known that the next outcome of flipping a
coin is independent of the past series of ‘heads’ and ‘tails.’ Note, however,
that on an average we earn 2% if we invest for one week and 4.04% if we
invest for two weeks. Thus, the random walk hypothesis does not
contradict the theory that asserts that r isky assets must yield a positive
mean return. We say in such a case, a random walk process with a munotes.in
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Efficient Market Hypothesis
27 “positive drift” can characterize share price changes. In our specific
example, the drift is equal to:
1/2x5% +1/2 x ( –1%) = 2%, which implies that on averag e the investment
terminal value increases every period by 2%.
Thus, reflecting the historical development, the weak form implies that the
knowledge of the past patterns of stock prices does not aid investors to
attain improved performance. Random walk ther apists view stock prices
as moving randomly about a trend line, which is based on anticipated
earning power. Hence they contend that (1) analysing past data does not
permit the technician to forecast the movement of prices about the trend
line and (2) new information affecting stock prices enters the market in
random fashion, i.e. tomorrow’s news cannot be predicted nor can future
stock price movements be attributable to that news.
Testing Market Efficiency
The EMH can be tested in a variety of methods. Dir ect and indirect tests
of market efficiency have been developed by analysts. Certain investing
methods or trading rules are evaluated using direct tests. A test of a
particular technical indicator's predictive power is an illustration of a
direct test. Sta tistics -based testing of pricing or returns are known as
indirect tests. For instance, the serial correlation of returns should be near
to zero if prices move in a random manner.
Establishing a Benchmark: Test of the EMH must usually establish
some sort of benchmark. The most common benchmark is the so -called
buy-and-hold portfolio.
The Time Factor: The time period(s) selected can, of course, always be
criticized. A trading rule partisan may respond to a conclusion that the rule
did not work by saying, “of course my trading rule didn’t work over that
period.”
Kiss and Tell: Suppose that someone discovered an investment strategy
that really worked and made a lot of money. Why would this person want
to tell anyone? He or she could try to make money writing a b ook or an
investment newsletter describing the strategy, but it would probably
generate more money if keep secret. Suppose an analyst discovers that
stocks beginning with the letter K rise on Wednesdays and fall on Fridays.
Market Efficiency: Implications
Economist Dick Thaler In an August, FT opinion said quite nice things
about "The Myth of the Rational Market." In it, he makes the case that the
efficient market hypothesis consists of two main ideas, "No Free Lunch"
and "The Price is Right," that have met very different fates over the past
decade or so. After running through the history, he concludes:
What lessons should we draw from this? On the free lunch component
there are two. The first is that many investments have risks that are more
correlated than they appear. The second is that high returns based on high munotes.in
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28 leverage may be a mirage. ... On the price is right, if we include the earlier
bubble in Japanese real estate, we have now had three enormous price
distortions in recent memory. They led to misall ocations of resources
measured in the trillions and, in the latest bubble, a global credit
meltdown. If asset prices could be relied upon to always be "right", then
these bubbles would not occur. But they have, so what are we to do?
While imperfect, financ ial markets are still the best way to allocate capital.
Even so, knowing that prices can be wrong suggests that governments
could usefully adopt automatic stabilising activity, such as linking the
down -payment for mortgages to a measure of real estate frot hiness or
ensuring that bank reserve requirements are set dynamically according to
market conditions. After all, the market price is not always right.
3.3 SIGNIFICANCE OF EFFICIENT MARKET
HYPOTHESIS
According to the Efficient Market Hypothesis (EMH), finan cial markets
are "informationally efficient," which means that the present market price
of a security reflects all of the information that is currently available about
the security. The EMH is significant because it affects investors, financial
analysts, a nd politicians in a significant way.
One of the main conclusions drawn from the EMH is that it is extremely
challenging for investors to continuously outperform the market over the
long run. This is because, in accordance with the EMH, the market price
already incorporates all available information, making it challenging to
determine whether a security is cheap or overvalued. As a result, investors
may be better off investing in a diversified portfolio of stocks or other
securities, rather than attempting t o pick individual winners.
The EMH also has the critical implication that financial analysts may not
be very good at forecasting future stock values. Any new information that
an analyst discovers is likely to already be reflected in the stock price if
the market is truly informationally efficient, making it impossible to profit
from this information. This has significant ramifications for financial
regulation since it implies that implementing more stringent disclosure
standards or other types of market ope nness may only have marginal
benefits.
3.4 USES OF EFFICIENT MARKET HYPOTHESIS
The Efficient Market Hypothesis (EMH) has several uses and implications
for investors, financial analysts, and policymakers. Here are some of the
most important uses of the EMH:
Investing strategy: According to the EMH, it is exceedingly
challenging for investors to continuously outperform the market over the
long run because a security's current market price already takes into
account all of the information that is currently kno wn about it. As a result, munotes.in
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Efficient Market Hypothesis
29 rather than trying to choose specific winners, investors may be better
suited investing in a diverse portfolio of stocks or other securities.
Risk management: A portfolio's risk can be managed with the aid of
the EMH. It is challe nging for any one event or piece of news to have a
major impact on the market price of a security because the market price
already fully represents all available information. Hence, diversification
among several securities can aid in lowering the risk that the portfolio will
be impacted by a single asset or event.Financial regulation: The EMH has
important implications for financial regulation. If financial markets are
truly informationally efficient, then there may be limited benefits to
mandating increase d disclosure requirements or other forms of market
transparency. Policymakers may need to consider other approaches to
improve market outcomes, such as reducing information asymmetry or
promoting competition.
Academic research: The EMH is a widely studied and debated topic
in finance, and has led to a large body of academic research. Researchers
have used the EMH to test various theories about financial markets, and to
explore the relationship between information, prices, and market
efficiency.
3.5 SUMMARY
Hypothesis and Efficient Market Hypothesis are used
interchangeably). As time passes, prices wander or walk more or less
randomly across the charts.
Since the walk is random, a knowledge of past price changes does
nothing to inform the analyst about whet her the price tomorrow, next
week, or next year will be higher or lower than today’s price.
One of the main conclusions drawn from the EMH is that it is
extremely challenging for investors to continuously outperform the
market over the long run.
A market portfolio is a portfolio that includes a weighted total of each
asset on the market, with weights based on their relative market
presence (with the necessary assumption that these assets are
infinitely divisible).
According to Weak -Form and the Random Wa lk, current stock
market prices accurately reflect all available knowledge regarding
historical stock prices, trends, and volumes. Thus, it is said that such
historical data cannot be used to forecast stock prices in the future.
3.6 UNIT END QUESTIONS
A. Descriptive Questions:
1. Explain Random Walk theory
2. Discuss the s ignificance of Efficient Market Hypothesis munotes.in
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30 3. What are the uses ofEfficient Market Hypothesis?
B. Fill in the blanks:
1. Direct and indirect tests of market efficiency have been developed
by……….
2. One of the main conclusions drawn from the EMH is that it is extremely
challenging for ……………….. to continuously outperform the market
over the long run.
3. A ……………… risk can be managed with the aid of the EMH.
4. ……………….. may need to consider oth er approaches to improve
market outcomes, such as reducing information asymmetry or promoting
competition.
5. The …………….. has important implications for financial regulation.
Answer:
1. analysts
2. investors
3. portfolio's
4. Policymakers
5. EMH
3.7 SUGGES TED READINGS
Graham, Benjamin, David, L., Dodd, Sidney Cottle, et al., Security
Analysis: Principles and Techniques, 4th ed., New York McGraw –
Hill Book Co. Inc., 1962.
Granger, Clive W and Morgenstem Oskar, Predictability of Stock
Market Prices, Lexing ton, Health Lexington, 1970.
Granville, Joseph E., A Strategy of Daily Timings for Maximum
Profit, Englewood Cliffs, N.J., Prentice -Hall, 1960.
Gup, Benton E., Basics of Investing, N.Y. Wiley, 1979.
Gupta L.C., Rates of Return on Equities: The Indian Experience,
Bombay, Oxford University Press, 1981.
Sudhindra Bhat, Security Analysis and Portfolio Management, Excel
Books
munotes.in
Page 31
31 4
EQUITY RESEARCH AND VALUATION
Unit Structure
4.0 Objectives
4.1 Introduction
4.2 Sources of financial information
4.3 Industry analysis
4.4 Company analysis
4.5 Valuation of Equity shares
4.6 Summary
4.7 Unit End Questions
4.8 Suggested Readings
4.0 OBJECTIVES
The main purpose of this chap teris–
To discuss the Sources of financial information
To understand Industry analysis
To describe company anlaysis
To explain Valuation of Equity shares
4.1 INTRODUCTION
Equity research is the process of analyzing and valuing stocks, and it
involves exami ning a company's financial statements, industry trends, and
macroeconomic factors to determine the intrinsic value of its shares. The
purpose of equity research is to provide investors with information to help
them make informed investment decisions.
Valua tion is an important part of equity research, and it involves
determining the intrinsic value of a company's shares based on its financial
statements, market conditions, and other relevant factors.
4.2 SOURCES OF FINANCIAL INFORMATION
In security analysis , sources of financial information can be divided into
two categories: primary sources and secondary sources.
Primary sources of financial information for security analysis include:
Company financial statements: Financial statements such as the
income stat ement, balance sheet, and cash flow statement can provide munotes.in
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32 detailed information about a company's financial performance,
liquidity, and solvency.
Annual reports: Publicly traded companies are required to publish
annual reports that provide detailed informat ion about their business
operations, financial performance, and strategic plans.
SEC filings: Companies are required to file various reports with the
Securities and Exchange Commission (SEC), such as 10 -K and 10 -Q
filings, which provide detailed financial and non -financial disclosures.
Company presentations: Some companies may provide presentations
to investors that offer additional insights into their financial
performance and strategic plans.
Secondary sources of financial information for security analysi s include:
Financial news websites: Websites like Bloomberg, Reuters, and
CNBC can provide up -to-date financial news and analysis.
Investment research reports: Research reports from investment banks,
brokerage firms, and independent research providers can provide
analysis and recommendations on specific companies or industries.
Market data providers: Companies like S&P Global Market
Intelligence and FactSet provide financial data, news, and analysis.
Financial databases: Databases such as Bloomberg Terminal and
Refinitiv Eikon provide real -time financial data and analytics.
Trade publications: Industry -specific trade publications can provide
information on market trends, new product developments, and
industry -specific financial metrics.
Social media: Platfor ms like Twitter, Reddit, and LinkedIn can
provide valuable insights and perspectives on financial news and
trends.
It's important to use a combination of primary and secondary sources of
financial information and verify the accuracy of the information befo re
making any investment decisions.
4.3 INDUSTRY ANALYSIS
The performance of the industry depends on many factors one of them is
industry life cycles which involve various stages of where an industry
performs. For example, the biotechnology industry which is s till new, so
the investors may find many firms giving higher rate of returns and seeing
that the investment rate also increases in those firms. Whereas the older
industry like the public utility gives the lower rate of return and hence gets
lower rate of i nvestment in their firms. munotes.in
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Equity Research and
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33 As the biotechnology industry is new so they are able to use their best
technology available that create greater opportunities for investments in
resources that are highly profitable. Also, their new products are protected
by pat ents and so their profit margins are high. Since they have investment
opportunities are highly lucrative so they plough back their profits into the
firm so as to increase greater profits. But with time, profit will reduce as
seeing more profit in this indu stry more firms will be attracted and so the
more competition will reduce the profit margin. This will further lead to
slow growth and then finally leads to negative growth in the industry.
So, this analysis shows the industry life cycle is divided into fo ur stages:
1. Start -up stage:
In this stage, the industry is characterized by growth that increases rapidly
because of new technology and product such as personal computer in
1980s and personal phones in 1990s. It is unpredictable to analyse which
firm wi ll perform better in the long run and which will be successful and
which firms in that industry will become the industry leader.
2. Consolidation stage:
When the product becomes established, emergence of the industry leader
begins to arise. The firms tha t survive in the start -up stage are more stable,
and also its prediction of market share also becomes easier in this stage.
Also, the performance of firms that could survive starts matching to the
overall performance of the industry. At this stage, the ind ustry still seems
to be faster growing because the products become commonly used and
also products penetrate the marketplace.
3. Maturity stage:
At this stage, the products reach its full potential for use by its consumers.
Also, here the profits margin becomes small, with slow sales, price
competition increases considerably, market penetration become high and
also little opportunity to expand further.
4. Relative Decline:
In this stage, the industry might start to shrink or grow at lower rate than
the ov erall economy. This is due to obsolesce in products, competition in
new markets and low -cost suppliers.
4.4 COMPANY ANALYSIS
After analyzing the economic and industry conditions, the financial health
of the company is analysed by the investors. For this invest or analyse the
financial statements of the company, where they can easily calculate the
ratios of the company that can be categorized into price, profitability,
leverage, efficiency, and liquidity. The ratio analysis is performed on the
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34 The some of the ratios from each category those are essential at the time of
analysis are stated below:
1. P/E Ratio:
The price/earnings ratio is a price ratio which is calculated by dividing
stock price of the current period with the earning per share of previous
four quarters.
For example:
Current Stock price = Rs 20
Earnings per share of last four quarters = Rs.2
P/E Ratio = Rs. 20/ Rs. 2
= Rs. 10
The investor’s expectation of future performan ce affects the determination
of the current price to earnings ratio of the company. The investors use the
approach to compare the P/E ratio of companies within the same industry.
Companies with lower P/E ratio are better when everything else remain
same.
2. Net Profit Margin:
It is the profitability ratio that is calculated by dividing net income by total
sales of a company. It indicates how much profit a company is able to earn
out of the sales of the company.
Net Profit Margin = Net Profit / Total Sales
3. Book Value per Share
It is the price ratio that is calculated by dividing total net assets (assets
minus liabilities) by total outstanding shares of the company. It is the good
method to check if the stock is under priced or overpriced. If the stock i s
selling at a price that is below the book value, then the security is under -
priced.
4. Current Ratio:
It is the liquidity ratio which is calculated by dividing current assets by
current liabilities of a company. It tells the investor that whether the
company is able to meet its current debt obligations or not. If the ratio is
more than 2:1 then it is said that the company is liquid. If the company has
the current ratio 3:1 then this means the current assets of that company is
sufficient to pay three tim es the current liabilities of a company.
Current Ratio = Current Assets / Current liabilities
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35 5. Debt Ratio:
It is a leverage ratio which is calculated by the dividing total liabilities by
total assets. It tells how much total assets are financed with the debt. If the
ratio is 30% then it is said that 30% of assets are financed by the borrowed
funds and rest though another source of finance. When the economy is in
stress or there is the hike in interest rates, then the companies with high
debt ratio hav e to bear financial problems. But in good times, the higher
debt ratio helps in increase the profitability of companies by financing
growth at low cost.
Debt Ratio = Total Debt / Total Assets
5. Inventory Ratio:
It is an efficiency ratio that is calculat ed by dividing total cost of goods
sold by the average inventory. It tells the investor how the inventories are
managed by telling how many times the inventories are replaced or turn
over. This ratio depends on the nature of industry the company falls in a nd
also it is important to compare the ratio between the companies in the
same industry.
Inventory Ratio = Total Cost of Goods Sold / Average inventory
4.5 VALUATION OF EQUITY SHARES
The valuation of equity shares involves estimating the intrinsic value of a
company's stock based on various financial and non -financial factors.
Here are some commonly used methods for valuing equity shares:
Discounted Cash Flow (DCF) analysis: This method estimates the
present value of a company's future cash flows by discount ing them back
to their present value using a discount rate. The DCF analysis is based on
a company's expected future cash flows, growth rates, and risk factors.
Price -to-Earnings (P/E) ratio: The P/E ratio is calculated by dividing
the company's current st ock price by its earnings per share (EPS). This
method compares the company's current stock price to its earnings and can
be used to compare the valuation of the company to its peers.
Price -to-Book (P/B) ratio: The P/B ratio is calculated by dividing the
company's current stock price by its book value per share. The book value
per share is the total assets minus liabilities divided by the number of
outstanding shares. This method compares the company's current stock
price to its book value and can be used t o compare the valuation of the
company to its peers.
Dividend Discount Model (DDM): The DDM estimates the intrinsic
value of a company's stock based on the present value of its future
dividends. The model assumes that the company will continue to pay
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36 Free Cash Flow (FCF) to Equity: This method estimates the intrinsic
value of a company's equity shares based on its free cash flow to equity,
which is the amount of cash that is availa ble to the company's equity
shareholders after all expenses and investments are made. This method
focuses on the company's ability to generate cash and can be used to
compare the valuation of the company to its peers.
It is important to note that no single valuation method is perfect, and
different methods may produce different results. It is important to consider
multiple factors and use a combination of valuation methods to arrive at a
more accurate estimate of a company's intrinsic value.
4.6 SUMMARY
Indust ry and company analysis are two important components of equity
research that help investors make informed investment decisions.
Industry analysis involves examining the trends, competitive landscape,
and macroeconomic factors affecting a particular industr y. This
analysis helps investors understand the broader context in which a
company operates and identify trends that may impact its future growth
prospects.
Company analysis involves analyzing a specific company's financial
statements, management team, bu siness model, competitive
advantages, and other relevant factors to determine its intrinsic value
and growth potential. This analysis helps investors evaluate whether a
company is undervalued or overvalued and make informed investment
decisions.
Both indu stry and company analysis are important components of
equity research and are used by investors to make informed investment
decisions.
By examining industry trends and analyzing individual companies,
investors can identify undervalued stocks and build a d iversified
portfolio that is well -positioned for long -term growth.
4.7 UNIT END QUESTIONS
A. Descriptive Questions:
1. Discuss the Primary sources of financial information.
2. What are the Secondary sources of financial information?
3. Write note on Industry analys is.
4. Write note on Company analysis.
5. Discuss the industry life cycle stages.
6. What is P/E ratio?
7. Explain the methods used for valuing equity shares.
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37 B. Fill in the blanks:
1. …………. method estimates the present value of a company's future
cash flows by disco unting them back to their present value using a
discount rate.
2. The ……….. estimates the intrinsic value of a company's stock based
on the present value of its future dividends.
3. ………………… indicates how much profit a company is able to earn
out of the sal es of the company.
4. In ……………… stage, the industry might start to shrink or grow at
lower rate than the overall economy.
5. Industry life cycle is divided into ……….. stages.
Answer:
1. Discounted Cash Flow (DCF) analysis
2. Dividend Discount Model (DDM)
3. Net Profit Margin
4. Relative Decline
5. four
4.8 SUGGESTED READINGS
Bonus Shares, A Study of the Dividend and Price Effects of Bonus
Shares Issues, Bombay, MacMillan, 1973.
Graham, Benjamin, David, L., Dodd, Sidney Cottle, et al., Security
Analysis: Principles and Techniques, 4th ed., New York McGraw –
Hill Book Co. Inc., 1962.
Granger, Clive W and Morgenstem Oskar, Predictability of Stock
Market Prices, Lexington, Health Lexington, 1970.
Granville, Joseph E., A Strategy of Daily Timings for Maxim um
Profit, Englewood Cliffs, N.J., Prentice -Hall, 1960.
Gup, Benton E., Basics of Investing, N.Y. Wiley, 1979.
Gupta L.C., Rates of Return on Equities: The Indian Experience,
Bombay, Oxford University Press, 1981.
Sudhindra Bhat, Security Analysis an d Portfolio Management, Excel
Books
munotes.in
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38 5
FIXED INCOME SECURITY ANALYSIS
Unit Structure
1.0 Learning Objectives
1.1 Introduction
1.2 Systematic and unsystematic risk
1.3 Warrants and convertibles
1.4 Bond valuation
1.5 Summary
1.6 Unit End Questions
1.7 References
5.0 LEARNING OBJECTI VES
After studying this unit, you will be able:
To understand systematic and unsystematic risk
To discuss warrants and convertibles
To explain bond valuation
To describe Volatility term structure
5.1 INTRODUCTION
An investment that offers a return in the form of regular, set interest
payments as w ell as the ultimate repayment of principal at maturity is
referred to as a fixed -income security. A fixed -income security's payments
are predetermined, as opposed to variable -income securities, whose
payments fluctuate depending on some underlying factor, such as short -
term interest rates.
Fixed -Income Securities are debt products that offer investors fixed
interest payments in the form of coupon payments. The invested money is
returned to the investor at maturity, while interest payments are normally
made every two years. The most popular type of fixed -income securities
are bonds. Businesses raise funds by selling investors fixed -income
products.
A bond is an investment product that businesses and governments issue to
raise money for operations and project financing. Government and
corporate bonds make up the majority of bonds, which can also have a
range of maturities and face values. The amount that the investor will get
when the bond matures is known as the face value. On major exchanges,
corporate and go vernment bonds are often listed with $1,000 face prices,
commonly referred to as the par value. munotes.in
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39 5.2 SYSTEMATIC AND U NSYSTEMATIC RISK
Every investment, including shares and debentures, has some risk.
Systematic risk and unsystematic risk are the two main ty pes of risk, and
they together make up total risk. The systemic risk is a result of outside,
uncontrollable factors that don't pertain to any one sector of the economy
or type of asset and affect the entire market, causing price fluctuations
across the boa rd for all securities.
Unsystematic risk, on the other hand, is defined as the risk that results
from known and regulated variables that are industry - or security -
specific.
Definition of Systematic Risk
By "systematic risk," we consider variations in secur ity returns brought
on by macroeconomic business elements like social, political, or
economic concerns. These variations are connected to shifts in the
market's overall return. Changes in governmental policy, natural
disasters, changes in the domestic econ omy, factors affecting the global
economy, etc. are all sources of systematic risk. Over time, the risk could
cause investments' values to decline. It is separated into three groups,
which are described as follows:
o Interest risk : Risk caused by the fluctua tion in the rate or interest
from time to time and affects interest -bearing securities like bonds and
debentures.
o Inflation risk : Alternatively known as purchasing power risk as it
adversely affects the purchasing power of an individual. Such risk arises
due to a rise in the cost of production, the rise in wages, etc.
o Market risk : The risk influences the prices of a share, i.e. the prices
will rise or fall consistently over a period along with other shares of the
market.
Definition of Unsystematic Risk
Unsy stematic risk is the risk brought on by changes in a company's
security returns as a result of internal, or micro -economic, or
organisational factors. The elements that lead to such risk are related to a
specific security of a business or industry, thus th ey only have an impact
on that particular organisation. If the essential steps are done in this
regard, the company can avoid the risk. It has been separated into two
categories: business risk and financial risk.
o Business risk: The company's performance is a risk that comes with
securities. A business risk is when a corporation performs worse than
average. Business risks can result from a variety of circumstances,
including shifting government regulations, increased competition, shifting
consumer tastes and preferences, creation of substitute products,
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40 o Financial risk: Alternatively known as leveraged risk. When there is a
change in the capital structure of the company, it amounts to a financial
risk. The debt – equity ratio i s the expression of such risk.
Another difficult goal is to avoid both systematic and irrational risk.
Systematic risk is brought on by external influences, which are both
inescapable and uncontrollable. Additionally, it impacts the entire market,
but it c an be minimised through hedging and asset allocation. Since
internal factors are what produce unsystematic risk, it may be easily
managed and avoided, at least in part, by portfolio diversification.
5.3 WARRANTS AND CON VERTIBLES
Securities used in derivati ve investment transactions include warrants and
convertibles. Both of these kinds of options grant holders the right to make
additional investments in certain firm stocks. A warrant specifically grants
investors the right to purchase the underlying securit y at a specific price in
the future. Convertibles, on the other hand, give investors the option to
convert their security into common shares at a later time. In order to help
investors, maximise their returns, both of these securities are available as
investment choices. However, these two are not equivalent. Therefore, it is
crucial to understand the intent behind the usage of these two instruments.
Investors should therefore be aware of and understand the distinction
between warrants and convertibles.
War rants:
It grants investors the right to purchase the underlying share, bond, or
other security at a specific price and date in the future. Investors are not
required to purchase the underlying security at that moment or that price,
though. The investor mus t also pay the predetermined amount to purchase
the stock, investment, or instrument if they choose to exercise the warrant.
Many warrant features are also found in options.
Each warrant contains information on how many underlying securities, at
what price , and on what date, an investor may purchase them. A warrant
may be valid for a variety of periods of time, including several years.
Warrants are also tradable by investors, and their value is based on both
time and intrinsic value. A warrant will be worth more if it has more time
until expiration. If the market value of the underlying security is higher
than the exercise price of the warrant, the situation will be similar.
Convertibles
Convertibles, on the other hand, provide investors the choice to conver t
bonds or preferred stocks into common stock at a future date and price.
This kind of security is typically used by businesses seeking immediate
money or without access to conventional lending solutions. The number of
common shares an investor would recei ve in place of the bond or
preference shares is determined by a firm using a conversion ratio.
Additionally, the instrument is fully convertible, converting the entire
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41 convertible , in which case a portion will be changed to common stock and
the balance will be retained as a bond.
Difference Between Warrants and Convertibles
o Time Frame
Given that warrants have an expiration date, many people consider them to
be short -term investment s. Convertibles, on the other hand, last longer and
are therefore long -term options.
o Cash Outflow
When a warrant is exercised, the investor must provide more funds in
order to purchase the shares. As a result, in this case, the corporation
receives additi onal funds from the instrument holder. However, from the
standpoint of investors, there is no additional capital outflow in the case of
convertibles. The conversion ratio is used to convert the same security to
common stock.
o Fixed Price
The warrants contai n information at the time of issuance regarding the
price at which an investor will be able to purchase the underlying security
in the future. And this price won't change till the contract ends.
Convertibles, on the other hand, do not have a fixed price. T he number of
common shares that an investor would receive upon converting the bond
or preference shares is instead determined by the issuer using a conversion
ratio.
o Detachable
There is something special about warrants. They can be traded separately
from t he underlying security because they are detachable. Investors cannot
exchange convertibles individually since they are not separable.
5.4 BOND VALUATION
The present value of anticipated future returns, earnings, or cash flows
from a bond investment is dete rmined using the bond valuation method.
The valuation method is used by an investor to analyse if the cost of a
debt instrument, such as a bond, is reasonable given the potential returns.
An investor might use bond valuations to help them decide whether th e
future yields from a bond investment are right for their portfolio. A
bond's trading prices, interest rate, and par value are thus used by an
investor to determine the bond's value. While the bond’s interest rates
and par value remain the same, changes o ccur in the bond prices and
investors’ returns over time.
A bond is a debt instrument, which means the issuer borrows money
from a lender or investor. The bond issuer agrees to a set interest rate in
return for the investor's ownership of the bond. As a re sult, the interest munotes.in
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42 gives the bondholder a consistent income until the bond's maturity date.
As a result, at maturity, the borrower pays the bondholder the face value
of the bond, less or more, as appropriate.
A zero -coupon bond, on the other hand, won't gi ve the investor or
bondholder any coupon payments or timely interest. Instead, the bond
price is reduced or the bond issuer issues the bond at a discounted rate to
its face value in the case of a zero -coupon bond. As a result, at bond
maturity, the investo r is assured to receive the bond's full -face value. As
a result, the investor earns interest on the difference between the bond's
purchase price and par value at maturity.
Due to the lower price of the bond at purchase, zero coupon bond
valuation typically results in higher yields to maturity or returns for an
investor when the bond matures.
A bond's coupon rate is expressed as a proportion of the bond's principal
or par value. Therefore, the investor will get this percentage amount as
part of the periodic coupon payments at predetermined intervals, such as
quarterly, semi -annually, or annually. So, useful determinants for bond
valuation are the bond price, principal value or par value, coupon rate of
a bond, and time till maturity.
Formula of Bond Valuation
1) Calculating the value of a single cash flow from future coupon payment
by estimating its present value for an investor,
PV = C/(1+r)^1 + C/(1+r)^2 + ... + C/(1+r)^n + F/(1+r)^n
where:
PV = Pr esent value of the bond C = Coupon payment r = Discount rate or
yield to maturity n = Number of periods until maturity F = Face value or
principal amount
In this formula, the coupon payment is the fixed annual interest rate paid
by the bond issuer, which i s usually a percentage of the bond's face value.
The discount rate or yield to maturity is the required rate of return that an
investor expects to earn on the bond.
The sum of the present value of all the expected cash flows from the bond
is equal to the b ond's current value. If the bond is trading at a discount to
its face value, the present value of the cash flows will be less than the face
value. If the bond is trading at a premium to its face value, the present
value of the cash flows will be greater th an the face value.
A bond’s yield to maturity or discount rate gives the investor an estimate
of how their future returns might change due to inflations or currency
changes.
The value of a bond to an investor is explained by its bond valuation.
Based on th e current value of expected future returns, it aids an investor in munotes.in
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43 making an informed decision when making an investment or expenditure.
As a result, in order to maximise their utility, investors choose to invest in
bonds with higher bond yields that will maximise their returns.
Consequently, to calculate bond valuation or future bond price, an investor
should have certain crucial information for its calculation. Such as,
1. Coupon rate
2. Estimated coupon payments
3. Payment cycles
4. Yield to maturity, also known as the discount rate, basically adjusts
the future returns based on the market interest rate, inflation, and
currency fluctuations.
5. Date of maturity of the bond or number of years
5.5 SUMMARY
● The bond market, also known as the debt market or credit market, i s
a financial exchange where investors can trade in debt instruments
issued by both governments and corporations .
● The primary market and secondary market are the two main
divisions that make up the bond market.
● The variable rate saving bonds 2020 (FRSB) t hat the RBI issues are
also known as RBI bonds. 7 -year taxable bonds with an interest rate
that fluctuates throughout the course of the bond's term.
● A coupon bond is a specific kind of bond that has attached coupons
and makes periodic interest payments (us ually annually or semi -
annually) throughout its life as well as its par value upon maturity.
● A zero -coupon bond is a specific variety of fixed -rate bond. In this
instance, there is no interest paid from the time the bond is issued
until it matures. they "p ay" a set coupon of 0% as a result.
● A floater is more beneficial to the holder as interest rates are rising
because it allows a bondholder to participate in the upward
movement in rates since the coupon rate of the bond will be
adjusted upwards.
● A forward rate is a set price that is agreed upon by all parties for the
delivery of a good at a particular future date.
5.6 UNIT END QUESTIO NS
A. Descriptive Questions:
Short Answers:
1. Differentiate between systematic and unsystematic risk. munotes.in
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44 2. Write note on Bond valuation.
3. Write note on warrants.
5. What do you understand by Bond Valuation?
6. Explain the difference Between Warrants and Convertibles.
B. Fill in the blanks:
1. …………… is the amount of money the bond will be worth when it
matures.
2. A …………… issued by the central or state governments of India is a
government securities bond.
3. ……………. is also known as a "pure discount bond".
4. A floating rate note (FRN), also known as a…………...
5. The price stated in real -time for the immediate settlement of a contr act
is known as a ……….
Answers :
1- Face value, 2 - debt instrument, 3 - Zero coupon bond , 4-floater , 5- spot
rate or spot price.
5.7 REFERENCES
Bonus Shares, A Study of the Dividend and Price Effects of Bonus
Shares Issues, Bombay, MacMillan, 1973.
Graham, Benjamin, David, L., Dodd, Sidney Cottle, et al., Security
Analysis: Principles and Techniques, 4th ed., New York McGraw –
Hill Book Co. Inc., 1962.
Granger, Clive W and Morgenstem Oskar, Predictability of Stock
Market Prices, Lexington, Health Lexingto n, 1970.
Granville, Joseph E., A Strategy of Daily Timings for Maximum
Profit, Englewood Cliffs, N.J., Prentice -Hall, 1960.
Gup, Benton E., Basics of Investing, N.Y. Wiley, 1979.
Gupta L.C., Rates of Return on Equities: The Indian Experience,
Bombay, Oxford University Press, 1981.
Sudhindra Bhat, Security Analysis and Portfolio Management, Excel
Books
munotes.in
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45 6
INDEXING AND BENCHMARKING
Unit Structure
6.0 Learning Objectives
6.1 Introduction
6.2 Indexing and Benchmarking
6.2.1 Creation of an index
6.2.2 Adjusting for corporate adjustments in the index
6.2.3 Tracking an index.
6.3 Summary
6.4 Unit End Questions
6.5 References
6.0 LEARNING OBJECTI VES
After studying this unit, you will be able:
To understand Indexing and Benchmarking
To discuss Creation of an index
To explain Tracking an index
6.1 INTRODUCTION
Indexing and benchmarking are two important concepts in finance that are
commonly used to measure and evaluate the performance of investment
portfolios.
Indexing refers to the practice of investing in a portfolio of securities that
is designed to replicate the performance of a specific market index, such
as the S&P 500 or the Nasdaq Composite. Indexin g is based on the
premise that it is difficult for active managers to consistently outperform
the market over the long term, and that a low -cost index fund can provide
investors with broad market exposure and competitive returns.
Benchmarking, on the other hand, is the process of comparing the
performance of an investment portfolio to a specific benchmark, such as a
market index or a peer group of similar funds. Benchmarking is used to
evaluate the relative performance of an investment portfolio, and can he lp
investors to identify areas where they may be underperforming or
outperforming their peers.
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46 6.2 INDEXING AND BENCHMA RKING
Indexing:
An index is a tool for tracking the performance of a collection of assets
in a consistent manner. The performance of a group of securities meant
to mirror a particular market segment is often measured through indexes.
Other financial or economic indicators, such as interest rates, inflation, or
manufacturing production, are also measured by indices. Indexes are
frequently used as benchmarks to measure how well a portfolio's returns
performed. One well -liked method of investing is indexing, which
involves passively trying to mimic an index rather than trying to
outperform it.
A measure or indicator of anything is called an index. It usually refers to
a statistical measurement of change in a securities market in finance.
Stock and bond market indices for financial markets are made up of a
fictitious portfolio of securities that represent a specific market or a
subset of it. (Invest ing directly in an index is not possible.) Common
benchmarks for the American stock and bond markets are the S&P 500
Index and the Bloomberg US Aggregate Bond Index, respectively.
Each stock market and bond market index is calculated using a different
form ula. The majority of the time, an index's relative movement is more
significant than the actual numeric value it represents. For instance, if the
FTSE 100 Index is trading at 6,670.40, investors can infer that the index
has increased by almost seven times from its initial base level of 1,000.
Index Investing
Indexes are frequently used as benchmarks to compare the performance
of exchange -traded funds and mutual funds (ETFs). To give investors an
idea of how much more or less the managers are making on their money
than they would in an index fund, many mutual funds, for instance,
benchmark their returns to the return in the S&P 500 Index.
A type of passive fund management is "indexing." Instead of actively
stock selecting and market timing —that is, deciding w hich securities to
invest in and planning when to buy and sell them —a fund portfolio
manager instead creates a holdings list that closely resembles the stocks
of a specific index. The theory is that by closely matching the index's
profile —the stock market overall or a significant portion of it —the fund
will match its performance.
Since indexes cannot be purchased directly, index funds are developed to
monitor their performance. These funds contain securities that closely
resemble those contained in an index , enabling an investor to place a fee -
based wager on the index's performance. The widely used Vanguard
S&P 500 ETF (VOO), which closely resembles the S&P 500 Index, is an
illustration of an index fund. munotes.in
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47 6.2.1 Creation of Index
Indexes can be constructed in a variety of methods, frequently taking
into account how to weight the index's various components. These are
the three key methods:
• A market -cap, or capitalization -weighted index, such as the S&P 500,
gives more weight to the index's constituents with th e highest market
capitalization (market value).
• A price -weighted index gives the components with the highest prices
more weight (such as the Dow Jones Industrial Average)
• An equal -weighted index assigns the same weights to each component
(this is somet imes called an unweighted index)
How Beneficial Are Indexes?
Indexes are helpful in that they offer reliable benchmarks that may be
used to gauge the success of a strategy or portfolio's investments. One
can determine a strategy's true performance by analy sing how it performs
in comparison to a benchmark.
Indexes can give investors a streamlined view of a sizable market
segment without requiring them to look at each and every asset included
in the index. For instance, it would be impractical for a regular i nvestor
to analyse hundreds of different stock prices in order to comprehend how
various technology businesses' financial situations change over time. A
sector -specific index might display the sector's typical tendency.
6.2.2 Adjusting for corporate adjust ments in the index
Corporate actions such as stock splits, mergers, and spin -offs can impact
the components of an index and its performance. As a result, index
providers may adjust the index to account for these corporate actions.
When a stock split occurs , for example, the total number of shares
outstanding for a company increases, and the price per share decreases
proportionally. To maintain the proper weighting of the stock in the index,
the index provider may adjust the number of shares for the affected
company in the index calculation.
Similarly, in the case of a merger or acquisition, the index provider may
adjust the weightings of the companies involved in the merger or
acquisition to reflect the new corporate structure. If one company acquires
anothe r, the index provider may remove the acquired company from the
index and replace it with the acquiring company.
Spin-offs are another type of corporate action that may require
adjustments to the index. In a spin -off, a company creates a new
subsidiary and distributes shares of the subsidiary to its existing
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48 may add the new subsidiary to the index and adjust the weightings of the
parent company and the new subsidiary accordingly.
6.2.3 Tracking an index
Tracking an index refers to the process of replicating the performance of a
particular stock market index by investing in a portfolio of securities that
mirrors the components and weightings of the index. This is typically done
through th e use of index funds or exchange -traded funds (ETFs).
An index fund is a type of mutual fund that aims to replicate the
performance of a specific index by holding all the securities in the index in
the same proportion as their weight in the index. Index fu nds are managed
passively and seek to minimize transaction costs and fees by holding a
diversified portfolio of securities that closely matches the index they track.
ETFs are similar to index funds, but they trade like individual stocks on an
exchange, all owing investors to buy and sell shares throughout the day at
market prices. Like index funds, ETFs aim to replicate the performance of
a particular index, but they may use different strategies to achieve this
goal, such as using derivatives or sampling the index.
By tracking an index, investors can gain exposure to a broad range of
stocks with low transaction costs and fees. Additionally, index tracking is
a passive investment strategy that requires minimal research and
management, making it a popular choic e for many investors. However, it
is important to note that tracking an index does not guarantee returns, and
the performance of the index may be affected by a variety of factors such
as market conditions, economic events, and geopolitical risks.
Benchmark ing:
Benchmark is an index that is used to gauge the general effectiveness of
a mutual fund. It offers a rough estimate of how much an investment
should have made, which may be compared to the actual amount it has
made. A mutual fund's goal should ideally be to mirror the value of its
benchmark.
The fund houses typically choose the benchmark index for a certain
investment. It is regarded as the minimum need for that scheme's return.
For smallcap, midcap, and large -cap equity funds in India, a number of
different fund institutions provide benchmarking information using
indices like CNX Midcap and Smallcap, BSE 200, NIFTY, Sensex, etc.
Importance of Benchmarking
The fluctuation of the financial market affects how well mutual funds
function. An established fram ework for return comparisons is provided by
benchmarking in mutual funds; for instance, if an equities fund is
benchmarked against the Sensex, its return can be compared to the
performance of the Sensex. munotes.in
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Indexing and Benchmarking
49 While underperforming funds deliver lower returns th an their benchmark
value, outperforming funds offer better returns than the benchmarking
value.
Benchmark indices are chosen by fund houses based on a variety of
variables, including the sectoral or theme strategies of the specific
investment or even its m arket capitalization. Small and mid -cap funds are
preferable for seasoned investors and people with higher risk appetites,
whereas large -cap funds often suit investors with a smaller appetite for
risk. The many benchmarking indices that are available for t hese various
funds provide a clear perspective on the performance and portfolio of
these funds, enabling an investor to choose the best option given their
return expectations.
An investment's tenor should ideally be at least one year in order to be
benchma rked for performance. It provides plenty of time to assess the risk
connected to the type of stock owning. Additionally, it enables
benchmarking tools to evaluate a portfolio's fund allocation, risk profile,
and return.
6.3 SUMMARY
● The fund houses typicall y choose the benchmark index for a certain
investment .
● ETFs are similar to index funds, but they trade like individual stocks
on an exchange, allowing investors to buy and sell shares throughout the
day at market prices.
● An index fund is a type of mutual f und that aims to replicate the
performance of a specific index by holding all the securities in the index
in the same proportion as their weight in the index.
● Index funds are managed passively and seek to minimize transaction
costs and fees by holding a d iversified portfolio of securities that closely
matches the index they track.
● Spin-offs are another type of corporate action that may require
adjustments to the index.
● Indexes can give investors a streamlined view of a sizable market
segment without requir ing them to look at each and every asset included
in the index.
6.4 UNIT END QUESTIO NS
A. Descriptive Questions:
Short Answers:
1. How to create an index?
2. What is Indexing?
3. Explain the concept of benchmarking. munotes.in
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50 4. Differentiate between Indexing and Benchmarking.
5. How Beneficial Are Indexes?
B. Fill in the blanks:
1. An …………..is a tool for tracking the performance of a collection of
assets in a consistent manner.
2. A measure or indicator of anything is called an………..
3. A type of ……………. fund management is "indexing ."
4. …………. are similar to index funds
5. ………….is an index that is used to gauge the general effectiveness of a
mutual fund.
Answers :
1- index, 2 - index, 3 - passive , 4- ETFs, 5 - Benchmark .
6.5 REFERENCES
Bonus Shares, A Study of the Dividend and Price Effe cts of Bonus
Shares Issues, Bombay, MacMillan, 1973.
Graham, Benjamin, David, L., Dodd, Sidney Cottle, et al., Security
Analysis: Principles and Techniques, 4th ed., New York McGraw –
Hill Book Co. Inc., 1962.
Granger, Clive W and Morgenstem Oskar, Pre dictability of Stock
Market Prices, Lexington, Health Lexington, 1970.
Granville, Joseph E., A Strategy of Daily Timings for Maximum
Profit, Englewood Cliffs, N.J., Prentice -Hall, 1960.
Gup, Benton E., Basics of Investing, N.Y. Wiley, 1979.
Gupta L.C ., Rates of Return on Equities: The Indian Experience,
Bombay, Oxford University Press, 1981.
Sudhindra Bhat, Security Analysis and Portfolio Management, Excel
Books
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51 7
TECHNICAL ANALYSIS
Unit Structure
7.0 Objectives
7.1 Introduction
7.2 Concept of Technical analysis
7.2.1 AssumptionsofTechnicalAnalysis
7.3 Technical vs Fundamental Analysis
7.4 Tools and Techniques of Technical Analysis
7.4.1 Dow Theory
7.4.2 Types of charts
7.5 Technical Indicators
7.6 Summary
7.7 Unit End Questions
7.8 Suggested Readings
7.0 OBJECTIVES
The main purpose of this chapter is–
To discuss the concept and assumptions of technical analysis
To understand the difference between Technical an d Fundamental
analysis
To explain Tools and Techniques of Technical Analysis
To understand Dow theory
7.1 INTRODUCTION
There are two primary methods for security analysis: fundamental
analysis and technical analysis. Fundamental analysis is typically utili sed
in combination with technical analysis rather than as a replacement for it.
On the basis of examination of the economy, industries, and companies,
fundamental analysis makes stock price predictions. With the use of a
risk-return framework based on earn ing potential and the general
economic climate, the stock value is assessed. Technical analysis,
however, contends that market forces such as supply and demand
determine stock prices. It barely bears any relationship to intrinsic worth.
A given stock's mar ket price already takes into account all of its financial
and market information. Technical analysts have created tools and
methods specifically for studying markets. Technical analysts research
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52 points and their unbiased evaluation. In order to create certain traits that
would aid in identifying significant market tops and bottoms, the
historical turning moments are researched. The majority of human
behaviours are similar, though not ide ntical, and the technician uses a
variety of techniques to try and accurately spot trends and capitalise on
them.
7.2 CONCEPT OF TECHNICAL ANALYSIS
"Technical analysis is directed towards predicting the price of a security.
The price at which abuyer and se ller settle a. deal is considered to be the
one precise figure which synthesizes, weighs andfinally expressesall
factors, rationaland irrational quantifiable and non -quantifiable and is the
onlyfigure thatcounts". As a result, technical analysis offers a c lear and
comprehensive picture of what is occurring to a security's price. It
provides a general outline of the entire scenario, much like a shadow or
reflection, and it truly functions in real life.
7.2.1 Assumptions of TechnicalAnalysis
There are some ba sic assumptions underlying the technical analysis.
These assumptions arediscussed asfollows:
1. The combination of factors affecting supply and demand in the market
determines a security's market value alone.
2. There are several elements surrounding a security 's supply and
demand that can be both rational and irrational.
3. Depending on the attitudes, psychology, and emotions of operators or
traders, the price of a security moves in trends or waves that can be
either upward or downward.
4. Historical trends have an impact on current trends, and research of
past pricing trends can help predict future trends.
5. Be prepared for slight fluctuations; stock values typically follow
trends that last for a significant amount of time.
6. Anytime there is a change in the demand a nd supply elements, stock
price patterns can change.
7. Charts created specifically to display market activity can be used to
spot changes in demand and supply, regardless of when or why they
happen.
8. Some chart trends have a propensity to repeat. Price move ments are
tracked by patterns that are projected by charts, and technical analysis
uses existing patterns to predict future patterns.
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53 7.3 TECHNICAL VS FUNDAMENTAL ANALYSIS
The major differences between the technical and fundamental analysis
areas follows :
I. While fundamental research aims to identify long -term values,
technical analysis attempts to forecast short -term price changes.
II. While fundamental research focuses on aspects linked to the
economy, industry, and company, technical analysis focuses
mostly on internal market data, especially price and volume data.
III. While long -term investors employ the findings of fundamental
analysis, traders who seek to earn rapid money frequently rely on
the findings of technical analysis.
IV. Fundamental analysis is complex , time -consuming, and laborious
in nature since it requires gathering and analysing enormous
amounts of data. On the other hand, technical analysis is a quick
and easy way to predict how stock prices will react.
V. The technical analyst claims that their app roach is preferable than
fundamental analysis because the latter is dependent on financial
statements, which are vulnerable to a number of flaws such as
incomplete disclosure and subjectivity.
VI. A longer -term strategy is fundamental examination. Even if an
analyst finds a security that is out of period, it could take some
time for the market to bid its price higher. Fundamental analysis is
perceived by technical analysts as being slower and inferior to their
own methods and charts.
Therefore, technical and fundamental analysis offer completely different
methods for appraisal. However, in practise, it is usually employed to
achieve better outcomes to judiciously combine both of these ways.
These two methods are utilised in conjunction with one another rather than
as a substitute.
7.4 TOOLS OF TECHNICAL ANALYSIS
There are several methods and tools available for performing technical
analysis. Basically, the following four crucial points of view are used to
conduct this analysis:
1. Price: Any time a security's pric e changes, investor sentiment, the
demand for and supply of securities also fluctuate.
2. Time: The amount of price fluctuation is a function of time. The
magnitude of the price adjustment that follows will increase the
longer it takes for a trend to reverse .
3. Volume: A minor change in the volume of transactions indicates that
the change is not significant enough. The intensity of price munotes.in
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54 adjustments is represented in the volume of transactions that are
associated with it.
4. Width: The extent to which a change in trend extends throughout the
majority of sectors and industries —or is concentrated in a small number
of securities —is a key indicator of the quality of a price change.
Analyzing market size reveals the degree to which pricing adjustments
have occurred in the market in accordance with specific broad patterns.
The following technical analysis tools and procedures are explored in
relation to the aforementioned dimensions:
7.4.1 DOWTHEORY
One of the earliest technical theories that is still commonly used is th e
Dow Theory, which Charles Dow first proposed in 1900. This theory is
where the fundamental ideas of technical analysis come from.
According to Charles Dow "The market is always considered as having
three movements, allgoing at the same time. The first is the narrow
movement from day to day. The second is the shortswing, running from
two weeks to a month or more and third is the main movement, covering
at leastfouryearsin itsduration”.
According to the hypothesis, 90% of stock activity is psychological and
10% is logical. Prices vary according to the mood of the market, and the
mood can be detected by examining transaction prices and volumes.
The Dow Theory does not attempt to foretell future movements or
estimate the extent or duration of such market trend s; it just explains the
direction of market trends. The hypothesis typically relies on stock
behaviour to reflect underlying market trends. As a result, the theory's
tenets were tested using market indexes that were created especially to
track market devel opments.
Basic tenets of Dow Theory:The following are the few and simple
basic principles of the Dow Theory:
1. Since the index numbers represent the aggregate market activity of
thousands of investors and brokers, they discount everything save divine
acts. As a result, share prices represent the collective opinion of all stock
market participants regarding both the existing and anticipated changes
in the demand -supply dynamics of stocks.
2. The term "market" refers to overall price changes for shares as we ll as
primary, secondary, and minor trend swings. The main market trends are
represented by primary movements, which can span anywhere from a
year to many years. It may be either a bullish (rising) or bearish (falling)
trend. Secondary swings in the opposi te direction pause periodic
movements in the leading trend's direction. The length of the secondary
trends typically ranges from a few weeks to a few months. To prevent
deviations from the main trend's general bounds, this trend acts as a
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55 their brief duration and amplitude changes, these have minimal analytical
value.
3. The primary trend is upward as long as each subsequent price advance
reaches a level higher than the one before i t and each secondary reaction,
or price decrease, comes to a finish at a level higher than the one before
it. This is called a "bull market”.
4. The primary trend is downward, and this is referred to as a "bear
market" when each intermediate downturn carri es prices to gradually
lower levels and each intervening recovery fails to get them back up to
the peak level of the prior increase.
5. The intermediate corrections or dips that take place in bull markets, as
well as the intermediate advances or recoveries that take place in bear
markets, are considered secondary trends. These often last three weeks to
many months and retrace between one -third and twothirds of the price
gain or loss seen during the prior swing, in the main direction.
6. The sporadic change s with a typical duration of six days but
infrequently three weeks are known as minor trends. These have no use
other than to contribute to secondary trends. The only trend that is
theoretically manipulable is this one.
7. Occasionally, a line can take the place of the secondary trend.
According to the Dow Theory, a line is a sideways movement that lasts
for two to three weeks, or even months, and during which prices change
by no more than 5% of their mean values.
8. Until a trend's reversal has been clear ly signalled, it should be
expected that it will continue. When a secondary reaction of drop carries
prices lower than the level registered during the earlier reaction and the
succeeding advance fails to carry prices beyond the apex of the prior
recovery, this signals the end of a bull market. The end of a bearmarket is
signaled when an intermediate recovery carries prices to a level higher
than the oneregistered in the previous advance and the subsequent
decline halts above the level recorded intheearlierr eaction.
Thefollowingfiguregives an exampleofa bull markettrend .
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56
This figure shows a bull market interrupted by reactions. The following
figure shows a bear markettrend.
This figures shows abear market in terrupted by recover ies.
Dow Theory's Short comings: The Dow Theory has been around for a
while and is frequently used in technical analysis. The following reasons,
however, have led to criticism of the theory:
The Dow Theory predicts one trend change, frequently too late. On ly
when the nearest intermediate button is breached by more than 3% of the
level and the succeeding rise fails to raise index prices above the
previous high does a bull market come to an end. According to estimates,
the theory frequently detects a trend re versal 20 to 25% after a peak or
trough has occurred. But then there is no other way of forecasting that
the change of trend has takenplaceatthetopand itisbetterto belatethantobe
wrong.
Because the Dow Theory depends on interpretation, it is vulnerable to all
the risks associated with human interpretation. Experience has
demonstrated that the interpretation of the theory is usually where it goes
wrong, rather than the theory itself.
7.4.2 Types of charts
One school of though led by William L. Jiler develope d a comprehensive
technique called "Chart Reading". Charts provide visual assistance
detecting the emerging and changing patterns and changing patterns of
price behaviour.
The core element of chartism is that share prices exhibit patterns over
time. These are a mirror of investor behaviour, and it may be assumed that
the stock market has a tendency for history to repeat itself. When a given
pattern of behaviour reappears in the future, it will probably yield the
same results as it did in the past. The diffe rent kinds of regularly used
charts are:
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PRIa) Line chart
b) Bar chart
c) Point andfigurechart
a) Line charts: A line chart is the most basic type of chart. Line charts
are straightforward graphs created by connecting the points created by
plotting the closing price of the stock on a given day across time. The
highs and lows of stock prices for each time are ignored by line charts. A
typical line chart is shown in the following figure.
b) Bar charts: It is a straightforward charting method. Prices are
indicated on the vertical axis of this chart, and time is indicated on the
horizontal axis. On a single line, the market or price change for a specific
session is shown (often a day). The high and low prices at which the
stock traded or the market fluctuated are displa yed in the vertical portion
of the line. The price or level at which the stock or market closed is
shown by a brief horizontal tick on the vertical line. The bar chart in the
following image:
Candlestick Charts: The Candlestick chart is similar to a bar chart, but it
differs in the way that it is visually constructed. Similar to the bar chart,
the candlestick also has a thin vertical line showing the period's trading
range. The difference comes in the formation of a wide bar on the vertical
line, which il lustrates the difference between the open and close
And, like bar charts, candlesticks also rely heavily on the use of colours to
explain what has happened during the trading period. A major problem
with the candlestick colour configuration, however, is that different sites
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58 use different standards; therefore, it is important to understand the
candlestick configuration used at the chart site you are working with.
There are two colour constructs for days up and one for days that the price
falls.
When the p rice of the stock is up and closes above the opening trade, the
candlestick will usually be white or clear. If the stock has traded down for
the period, then the candlestick will usually be red or black, depending on
the site. If the stock's price has clos ed above the previous day's close but
below the day's open, the candlestick will be black or filled with the
colour that is used to indicate an up day.
A Candlestick Chart
Point - and - Figure Chart: Bar chartists count on discovering certain
buying and selling forces in the market, on the basis of which they predict
future price trends. These forces consist of three factors – time, volume
and price. Members of another school, known as the point -and-figure
chartists, question the usefulness of the first t wo factors. They argue that
the way to predict future price fluctuations is to analyze price changes
only. Consequently, they assert, no volume action need be recorded, and
the time dimension (day, week, ormonth) should also be ignored. If only
significant price changes are important, then one need only capture the
significant (say, one point or more, ignoring all fractions) price changes in
a stock, no matter how long it takes for the stock to register this change.
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59 A Point and Figure Chart
Charts ar e one of the most fundamental aspects of technical analysis. It is
important that you clearly understand what is being shown on a chart and
the information that it provides. Now that we have an idea of how charts
are constructed.
7.5 TECHNICAL INDICATORS
Indic ators and Oscillators
Indicators are calculations based on the price and the volume of a security
that measure such things as money flow, trends, volatility and momentum.
Indicators are used as a secondary measure to the actual price movements
and add addi tional information to the analysis of securities.
Indicators are used in two main ways: to confirm price movement and the
quality of chart patterns, and to form buy and sell signals.
There are two main types of indicators: leading and lagging. A leading
indicator precedes price movements, giving them a predictive quality,
while a lagging indicator is a confirmation tool because it follows price
movement. A leading indicator is thought to be the strongest during
periods of sideways or non -trending trading ra nges, while the lagging
indicators are still useful during trending periods.
Aroon Oscillator
An expansion of the Aroon is the Aroon oscillator, which simply plots the
difference between the Aroon up and down lines by subtracting the two
lines. This line i s then plotted between a range of -100 and 100. The
centreline at zero in the oscillator is considered to be a major signal line
determining the trend. The higher the value of the oscillator from the
centreline point, the more upward strength there is in t he security; the munotes.in
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60 lower the oscillator's value is from the centreline, the more downward the
pressure.
Relative Strength Index
The relative strength index (RSI) is another one of the most used and well -
known momentum indicators in technical analysis. RSI he lps to signal
overbought and oversold conditions in a security. The indicator is plotted
in a range between zero and 100. A reading above 70 is used to suggest
that a security is overbought, while a reading below 30 is used to suggest
that it is oversold. This indicator helps traders to identify whether a
security's price has been unreasonably pushed to current levels and
whether a reversal may be on the way.
Technical Indicators
Most of the technical indicators make sense when examined individually
but w hen one examines many technical indicators simultaneously, the
interpretation of their collective meaning is often contradictory and
confusing. Once technical analyst issued the following report:
The breadth of the market remains pretty bearish, but the od d-lot index is
still in balance and is more bullish than bearish. While the short interest is
not bearish, brokers loans are at a dangerously high level. Business indices
are beginning to turn sharply upward and most psychological indicators
are generally uptrend. The index of 20 low -priced stocks remains in a
general upward trend, but the confidence index still is in a long -term
downtrend. The Canadian gold price index is still in a downtrend, which
normally implies a higher stock market ahead.
Professiona l and public opinion remains cautiously optimistic, which is
also an indication of a higher stock market, but on a decline below 800,
the Dow Jones Industrial averages would emit a definite sell signal.
The author of this technical report presented numerou s technical indicators
that collectively add up to organized confusion. Some of the major
technical indicators are described in the following sections. Each indicator
makes sense by itself, but interpreting all of them at the same time
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61 1. The Short Interest Ratio Theory: The short interest ratio is derived by
dividing the reported short interest or the number of shares sold short, by
the average volume for about 30 days.
When short sale s increase relative to total volume, the indicator rises. A
ratio above 150% is considered bullish, and a ratio below 100% is
considered bearish.
The logic behind this ratio is that speculators and other investor sell stocks
at high price in anticipation o f buying them back at lower prices. Thus,
increasing short selling is viewed as a sign of general market weakness,
and short covering (as evidenced by decreasing short positions) as a sign
of strength. An existing large short interest is considered a sign of
strength, since the cover (buying) is yet to come; whereas an established
slight short interest is considered a sign of weakness (more short sales are
to come).
2. Confidence Index: It is the ratio of a group of lower -grade bonds to a
group of higher gr ade bonds. According to the theory underlying this
index, when the ratio is high, investors' confidence is likewise high, as
reflected by their purchase of relatively more of the lower -grade securities.
When they buy relatively more of the higher -grade sec urities, this is taken
as an indication that confidence is low, and is reflected in a low ratio.
3. Spreads: Large spreads between yields indicate low confidence and are
bearish; the market appears to require a large compensation for business,
financial an d inflation risks. Small spreads indicate high confidence and
are bullish. In short, the larger the spreads, the lower the ratio and the less
the confidence. The smaller the spreads, the greater the ratio, indicating
greater confidence.
4. Advance - Declin e ratio: The index -relating advance to decline is
called the advance decline ratio. When advances persistently outnumber
declines, the ratio increases. A bullish condition is said to exist, and vice
versa. Thus, an advance decline ratio tries to capture th e market's
underlying strength by taking into account the number of advancing and
declining issues.
5. Market Breadth Index: The market breadth index is a variant of the
advance decline ratio.
To compute it, we take the net difference between the number of stocks
rising and the number of stocks falling, added (or subtracted) to the
previous.
Example: If in a given week 600 shares advanced, 200 shares declined,
and 200 were unchanged, the breadth would be 2[9600 -200)/200]. The
figure of each week is added to previous week's figure. These data are
then plotted to establish the pattern of movement of advance and declines.
The purpose of the market breadth index is to indicate whether a
confirmation of some index has occurred. If both the stock index and the munotes.in
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62 market breadth index increase, the market is bullish; when the stock index
increase but the breadth index does not, the market is bearish.
6. The Odd -Lot Ratio: Odd-lot transactions are measured by odd -lot
changes in index. Oddlots are stock transactions of l ess than, say, 100
shares. The odd -lot ratio is sometimes referred to as a yardstick of
uniformed sentiment or an index of contrary opinion because the odd -lot
theory assumes that small buyers or sellers are not very bright especially at
tops and bottoms w hen they need to be the brightest. The odd -lot short
ratio theory assumes that the odd -lot short sellers are even more likely to
be wrong than odd -lotters in general. This indicator relates odd -lot sales to
purchases.
7. Insider Transactions: The hypothesi s that insider activity may be
indicative of future stock prices has received some support in academic
literature. Since insiders may have the best picture of how the firm is
faring, some believers of technical analysis feel that these inside
transactions offer a clue, to future earnings, dividend and stock price
performance.
If the insiders are selling heavily, it is considered a bearish indicator and
vice versa.
Stockholders do not like to hear that the president of a company is selling
large blocks of st ock of the company. Although the president's reason for
selling the stock may not be related to the future growth of the company, it
is still considered bearish as investors figure the president, as an insider,
must know something bad about the company tha t they, as outsiders, do
not know.
7.6 SUMMARY
The term technical analysis is used to mean a fairly wide range of
techniques; all based on the concept that past information on prices and
trading volume of stocks gives the enlightened investor a picture of
what lies ahead.
It attempts to explain and forecast changes in security prices by
studying only the market data rather than information about a company
or its prospects, as is done by fundamental analyst.
Fundamentalists make their decisions on quality, val ue and depending
on their specific investment goals, the yield or growth potential of the
security.
They are concerned with the basis, the corporation's financial strength,
record of growth in sales and earnings, profitability, the investment
acceptance a nd so on.
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63 7.7 UNIT END QUESTIONS
A. Descriptive Questions:
1. What is Technical Analysis?
2. Explain the Dow Theory
4. Write note on Type of Charts - Construction of Charts.
5. Whatare the technical indicators?
6. Explain The Short Interest Ratio Theory.
B. Fill in the blanks:
1. Technical analysis is a method of .................. securities by analyzing the
statistics generated by market activity, such as past prices and volume .
2. According to Dow, "The market is always considered as having
........... ....... movements, all going at the same time.”
3. .................. indicators are used to determine what the main body of
stocks is doing.
4. A ………is the most basic type of chart.
5. The …………… chart is similar to a bar chart, but it differs in the way
that it is visually constructed.
Answer:
1. evaluating
2. three
3. Breadth -of-market
4. line chart
5. Candlestick
7.7 SUGGESTED READINGS
• Samuels J.M,F.M. Wilkesard R.E. Brayshaw, Management of
Company Finance, Chapman and Hall, London
• Smith, Edger Lawrence , Common Stocks as Long -term Investment,
New York, Mac Millan.
• Sprinkel, Beryl, W., Money and Stock Prices, Home wood III, Richard
S. Irwin, Inc.
• Sudhindhra Bhatt, Security Analysis and Portfolio Management, Excel
Books.
• Fischer, D.E., Security Analysis and Portfolio Management, Prentice
Hall, 1983.
• Reilly, F.K., Investment Analysis & Portfolio Management, Drygen
Press,1985.
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64 8
CAPITAL MARKET THEORIES
Unit Structure
8.0 Objectives
8.1 Introduction
8.2 Introduction to CAPM
8.3 Capital Market Line (CML)
8.4 Security Market Line (SML)
8.5 Risk free lending and borrowings
8.6 Benefits and Limitations of CAPM
8.7 Portfolio risk and return
8.8 Summary
8.9 Unit End Question s
8.10 Suggested Readings
8.0 OBJECTIVES
Themainpurposeofthischapteris –
To understand Capital Market Line (CML)
To explain Security Market Line (SML)
To anlayse Risk free lending and borrowings
To discuss benefits and limitations of CAPM
To understand Portfolio risk and return
8.1 INTRODUCTION
In the previous sections, we saw how measurements of central tendency
and measures of variation, such as mean and standard deviation, may be
used to describe the risk and return of investments. In truth, statistics are
the cornerstone of modern finance, and statistical models have served as
the foundation for almost all financial breakthroughs over the last thirty
years, collectively referred to as "Modern Portfolio Theory." This makes it
important to go through the definit ion of a statistic and how it pertains to
the investing problem. A statistic, in general, is a function that condenses a
lot of data into a little quantity of data. For instance, the average represents
the typical "location" of a group of numbers as a sing le number. Statistics
ignore a lot because they reduce a lot of information to a few usable
values. Prior to the development of current portfolio theory, a fundamental munotes.in
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65 study of the company, its financial statements, and its dividend policy
served as the pr imary foundation for the decision of whether to include a
share in a portfolio. By suggesting that a security's value to an investor
might be best assessed by its mean, standard deviation, and correlation to
other securities in the portfolio, finance profe ssor Harry Markowitz set off
a revolution. This bold proposal amounted to discarding a lot of essential
data about the company, including its earnings, dividend policy, capital
structure, market, and competitors, in favour of calculating a few basic
number s. In this lesson, we'll follow Markowitz's example and examine
where modern portfolio theory technologies can take us.
8.2 INTRODUCTION TO CAPM
The Capital Asset Pricing Model was created by William F. Sharpe and
John Linter (CAPM). The portfolio theory c reated by Harry Markowitz is
the foundation of the concept. The model emphasises that systematic risk
and unsystematic risk combine to form the risk element in portfolio
theory. According to the model, a security's return is inversely
proportional to its s ystematic risk, which cannot be mitigated by
diversification. The overall risk is determined by combining the two
categories of risks mentioned above. The sum of the market -related
variation and the company -specific variance represents the total variance
of returns. The CAPM provides a tool for investors to evaluate the effects
of a proposed security investment on the total risk and return of the
portfolio while also explaining the behaviour of security prices. According
to CAPM, the beta coefficient, which measures systematic risk, is used to
determine how to price securities so that the risk premium or excess
returns are proportional to it. The model is used to analyse the
implications of holding securities in terms of risk and return. The term
"CAPM" desc ribes the process through which securities are valued in
accordance with the expected risks and returns. An investor who is
apprehensive about taking risks favours risk -free securities. The danger is
higher for a small investor with few securities in his p ortfolio. He needs to
stock his portfolio with well -diversified securities in order to lower the
unsystematic risk.
The amount paid for the asset today determines the asset return. When the
asset is introduced to the market portfolio, the price paid must g uarantee
that the asset's risk/return characteristics increase. The CAPM is a model
that determines, given the risk -free rate accessible to investors and the risk
of the market as a whole, the theoretically needed return (i.e., discount
rate) for an asset in a market.
The CAPM is usually expressed:
E(Ri) = Rf + i(E(Rm ) – Rf)
E(Rm ) – (Rf) is the market premium, the historically observed excess
return of the market over the risk -free rate.
The asset's future cash flows can be discounted to their present va lue using
this rate once the CAPM's expected return, E(ri), has been computed in munotes.in
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66 order to determine the asset's proper price. (Once more, the theory
assumes that a parameter based on historical data can be paired with an
anticipation for the future.)
Less sensitive equities have lower betas and are discounted at lower rates,
while riskier stocks have larger betas and are discounted at greater rates.
Theoretically, an asset is accurately valued when its observed price is
equal to its value as determined by the discount rate computed from the
CAPM. The asset is overpriced if the observed price exceeds the
valuation; it is undervalued if the price is too low.
Assumptions:
Because the CAPM is a theory, we must assume for argument that:
The world's assets are all exchanged.
All assets can be divided indefinitely.
The whole global investment community holds all assets.
There is a lender for each borrower.
The globe has risk -free security.
All lenders and borrowers use the riskless rate.
Everyone concurs on the Mean -STD picture's inputs.
Simple utility functions do a good job of describing preferences.
Security distributions are normal, or at the very least, two parameters
adequately describe them.
In our world, there are only two distinct time periods.
These con ditions make up a lengthy list that collectively sum up the ideal
society for capitalists. Even human capital can be purchased and sold in
perfectly liquid fractional amounts! For investors who are afraid of taking
risks, the riskless asset is the ideal, s ecure sanctuary. This implies that
everyone poses an equivalent risk to creditors. In the domain of CAPM,
nobody has an informational advantage. There are no disagreements over
predicted returns because everyone has kindly provided all of their
knowledge r egarding the potential risk and return of the securities. Every
customer preference is public knowledge. Using a straightforward utility
function, risk attitudes are well defined. The distribution of future return
amounts is clearly defined. Last but not l east, the flexibility to modify
your opinion later on does not complicate decisions. You make an
irrevocable investment at one moment, profit from it in the following
period, and then the investment issue vanishes. At that time, terminal
wealth is calculat ed; the winner is the person who dies with the most toys!
"A frictionless one -period, multi -asset economy with no asymmetric
information" is the formal name for this situation.
Investment Implications: According to the CAPM, every investor will
desire to h old "capitalweighted" portfolios of the world's wealth. When the
CAPM was created in the 1960s, this approach resembled a portfolio that
was already well -known to many people: the S&P 500. The majority of
the largest stocks in the US are included in the ca pital-weighted S&P 500.
The US was the largest market in the world at the time, so it appeared to munotes.in
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67 be a reasonable approximation of the "cake." Surprisingly, the solution
was right in front of us; the tangency portfolio must resemble the S&P
500. It's no co incidence that index funds started to be used extensively
around this period. Mutual funds and/or money managers who manage
index funds merely replicate the S&P's performance. The benefits of
indexing were realised by numerous organisations and individuals .
Capital -weighted portfolios automatically adjust to changes in value when
stocks grow, so investors need not constantly change their weights — it is
a "buy -and-hold" portfolio. As a result, trading costs were minimal under
this method. Additionally, ther e wasn't much proof that active portfolio
management outperformed the S&P index at the time, so why not?
8.3 CAPITAL MARKET LINE
The optimal risk -return trade -off is provided by the graph of the needed
return and risk (as determined by standard deviation) of a portfolio that
consists of a risk -free asset and a collection of risky assets.
It is assumed that all investors have the same (homogeneous) expectations.
As a result, they will all encounter the same efficient frontier. According
to his preferred level of risk, each investor will attempt to mix the same
risky portfolio with various levels of loan or borrowing. Since every
investor owns the same dangerous portfolio, it will contain every risky
security available on the market. The market portfolio M is th e name
given to this collection of all hazardous securities. Each securitywillbe
heldintheproportionwhichthe marketvalue ofthe security bears to the total
market value of all risky securities in the market. Allinvestors will hold
combinations of only two a ssets, the market portfolio and a
risklesssecurity. All these combinations will lie along the straight line
representing the efficientfrontier.
The capital market line is the result of all investors combining their market
portfolios with risk -free assets ( CML). This capital market line will be
followed by all investors' efficient portfolios as a whole.
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68 For effective portfolios, the CML offers a risk return relationship and a
risk measure. The portfolio's standard deviation of return serves as the
proper ri sk indicator for an effective portfolio. For these effective
portfolios, there is a linear relationship between the expected return and
the standard deviation -based measure of risk.
For all effective portfolios, CML displays the link between risk and retur n.
The capital market line would be where they all lay. Except for efficient
portfolios, all other portfolios will be below the capital market line. The
risk-return connection of inefficient portfolios or individual stocks is not
covered by the CML.
8.4 SECURI TY MARKET LINE
It is a line drawn on a chart that acts as a graphical depiction of the Capital
Asset Pricing Model (CAPM), which contrasts distinct marketable assets'
levels of systematic risk (also known as market risk) with the projected
return of the e ntire market at a certain period.
For all securities and portfolios, whether efficient or inefficient, the
Capital Asset Pricing Model describes the connection between expected
return and risk. Systematic risk and unsystematic risk, or diversifiable risk,
make up the entire risk of an investment as determined by standard
deviation. The unsystematic risk is decreased as an investment's
diversification increases and a portfolio's number of securities increases.
Unsystematic risk typically decreases to zero f or highly well diversified
portfolios, leaving only systematic risk, as measured by beta, as the
important risk. Therefore, it is maintained that beta is the proper indicator
of a security's risk. The predicted return of a securities or a portfolio
should, therefore, be correlated with the risk of that security or portfolio as
defined by beta, which is a measure of the security's sensitivity to
fluctuations in market return.
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69 A beta value more than one suggests increased market sensitivity, whilst a
beta val ue less than one indicates decreased market sensitivity. A value of
one means that the security moves in perfect sync with the market, both in
terms of speed and direction.
It's important to compare SML and CML. Both assume that risk and return
have a line ar (straight line) relationship.
1. In SML, the risk is defined as systematic risk and measured by beta, but
in CML, the risk is defined as total risk and quantified by standard
deviation.
2. The security market line is applicable for all portfolios and in dividual
securities, whereas the capital market line is only valid for efficient
portfolios.
3. SML is the foundation of Capital Asset Theory, whereas CML is the
foundation of Capital Market Theory.
8.5 RISK FREE LENDING AND BORROWINGS
Systematic risk (B), pro jected market return, and risk -free rate are the
three variables covered by CAPM. Of the three parameters, the risk free
rate receives the least attention. In CAPM, it is only used twice. The risk
premium is initially determined using it as a minimum rate of return ®.
(rm -R). Any inaccuracy in calculating the risk -free rate of return would
consequently result in an incorrect calculation of the expected rate of
return for an asset or portfolio. By selecting the incorrect risk -free rate, the
analyst would ha ve inadequate information with which to generate
forecasts or a faulty understanding of the sources of the asset's returns and
performance.
The risk -free asset is one of the investor's two options according to CAPM
theory. By adding more risk -free assets t o the portfolio, the investor can
lower portfolio risk. Conversely, he can raise portfolio risk by reducing
the position of risk -free assets or by borrowing money at a risk -free rate to
make new investments. The rate that will actually persuade investors t o
select between current or future consumption, savings or investment is the
risk-free rate. The cost of time or the risk -free rate of return is what must
be paid to persuade an investor to forego present consumption in exchange
for a specific future sum, or to forego liquidity.
James Tobin's proposed separation theorem The CAPM, which claims that
investors choose their portfolios exclusively based on risk and return,
separating that choice from all other criteria, is insufficient since it ignores
other sig nificant aspects. In order to reach a personally preferred overall
combination of risk and return, it is expected that each investor will
distribute his assets among risky securities in the same relative proportion
and add risk -free borrowing or lending. I ndependent of the investor's
preference for risk vs return, every portfolio contains a risky component.
This is justified by the fact that each investor's portfolio's riskier assets are
simply outside of either axis. Even if the investor invests nothing in these munotes.in
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70 assets, their prices will progressively fall, increasing their projected
returns, until a non -zero share of the resulting tangency portfolio is
connected with them. Everything will balance out in the end. The market
will be brought into balance once all price manipulating has ceased.
8.6 BENEFITS AND LIMITATIONS OF CAPM
Benefits
Eliminates Unsystematic Risk
A diversified portfolio, similar to a market portfolio, is what the CAPM
model assumes the investor has. Unsystematic (specific) risk is elimina ted
by diversifying your holdings.
Systematic Risk
Other return models, such as the dividend discount model, do not take
systematic risk into account. Market risk, often referred to as systematic
risk, is a significant factor because it is unpredictable an d frequently
cannot be avoided because it is not completely anticipated.
Investment Appraisal
Comparing the CAPM to other rates, an investor might use it to evaluate
an investment because it provides a higher discount rate. This model
makes a strong connec tion between systematic risk & needed return.
Ease of Use
Simple calculations like the CAPM can be quickly stressed -tested to
generate a range of potential outcomes. These results give assurance
regarding the necessary rate of returns.
Limitations of CAPM
Too Many Assumptions
Many criticise the CAPM model for being unrealistic since it relies on
too many assumptions. As a result, it might not produce accurate
findings.
Assigning Values to CAPM Variables
The yield on short -term government securities is the u sually accepted rate
that is used as the risk -free rate (Rf). The yield fluctuates daily, which
causes volatility, which is a concern when using this input.
ROI (Return on the Market): The average capital gain plus the typical
dividend yield add up to the return on a stock market. In a short -term
market, the return on the market may be negative. The long -term market
return is therefore used. The fact that these returns are retrograde and not
forward -looking is the other significant negative. munotes.in
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71 Beta (B): For a ll listed companies, beta values are routinely disclosed on
all stock exchanges. Because the value of beta is not constant but varies
over time, there is uncertainty in the projected return value in this
situation.
Ability to Borrow at Risk -free Rate
The C APM makes four main assumptions. One of the underlying
presumptions is that investors would be able to borrow and lend money at
risk-free rates. This presumption does not reflect reality. It is impossible
for private investors to borrow or lend money at th e same rate as the US
government.
As a result, the predicted return determined by the CAPM model may not
be accurate in this case.
Determination of Project Proxy Beta
The issue could appear while determining a project -specific discount rate
utilising the C APM. Equity beta and portfolio/investment beta are
typically not the same. The company must therefore locate a proxy beta
for the project.
Finding a reliable proxy beta, however, may be challenging and have an
impact on the outcome's dependability.
8.7 POR TFOLIO RISK AND RETURN
Capital market theory, a branch of financial economics that aims to
explain the behaviour of financial markets and the pricing of financial
assets, is based on two fundamental ideas: portfolio risk and return. The
expected return on their investments and the amount of risk they are
exposed to are investors' two main concerns, according to capital market
theory.
A key idea in capital market theory is the risk -return tradeoff, which
contends that investors seek larger profits in exchang e for taking on
greater amounts of risk. In other words, investors will only accept
increased risk if it results in a bigger expected return.
The capital market theory also acknowledges that by spreading out their
investments among a variety of different a ssets, investors can lower their
overall risk. Although still generating a comparable level of return to a
more concentrated portfolio, investors can lessen the impact of
idiosyncratic or company -specific risks by keeping a diversified portfolio.
Another k ey idea in capital market theory is the efficient market
hypothesis, which contends that financial markets are effective and that
prices swiftly adapt to take into account all available information. If
financial markets are genuinely efficient, it might be challenging for
investors to continuously use stock picking or market timing tactics to
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72 8.8 SUMMARY
John Linter and William F. Sharpe developed the Capital Asset
Pricing Model (CAPM). The portfolio theory creat ed by Harry
Markowitz is the foundation of the concept. The model emphasises
that systematic risk and unsystematic risk combine to form the risk
element in portfolio theory.
According to the model, a security's return is inversely proportional to
its syste matic risk, which cannot be mitigated by diversification.
The overall risk is determined by combining the two categories of
risks mentioned above.
Market -related variation plus company -specific variance equals the
total variance of returns.
The CAPM provid es a tool for investors to evaluate the effects of a
proposed security investment on the total risk and return of the
portfolio while also explaining the behaviour of security prices.
The CAPM model is used to analyse the risk -return implications of
holdin g assets, and it proposes that the prices of securities are set in a
way that the risk premium or excess returns are proportional to
systematic risk, which is reflected by the beta coefficient.
The term "CAPM" describes the process through which securities are
valued in accordance with the expected risks and returns.
According to CAPM, the beta coefficient, which measures systematic
risk, is used to determine how to price securities so that the risk
premium or excess returns are proportional to it.
The mode l is used to analyse the implications of holding securities in
terms of risk and return. 8.9 Unit End Questions
A. Descriptive Questions:
1. What is Risk free lending and borrowings ?
2. Write note on Capital Market Line.
3. Explain Security Market Line
4. What do you analyse as the benefits and limitations of CAPM ?
5. Do you believe that the CAPM's included and are reasonable? why or
why not?
6. Discuss the difference between CML and SML.
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73 B. Fill in the blanks:
1. The ………….is one of the investor's two opt ions according to CAPM
theory.
2. The CAPM makes …………….main assumptions.
3. ……….. and William F. Sharpe developed the Capital Asset Pricing
Model (CAPM) .
4. The .................... expresses the basic theme of the CAPM .
5. The CAPM is a theoretical solutio n to the identity of the ....................
portfolio .
Answer:
1. risk-free asset
2. four
3. John Linter
4. Security Market Line (SML)
5. tangency
8.10 SUGGESTED READINGS
• Samuels J.M, F.M. Wilkesard R.E. Brayshaw, Management of
Company Finance, Chapmanan d Flail, London
• Smith, Edger Lawrence, Common Stocks as Long -term Investment,
New York, Mac Millan.
• Sprinkel, Beryl, W., Money and Stock Prices, Homewood III, Richard
S. Irwin, Inc.
• Sudhindhra Bhatt, Security Analysis and Portfolio Management,
Excel Books.
• Fischer, D.E., Security Analysis and Portfolio Management, Prentice
Hall, 1983.
• Reilly, F.K., Investment Analysis & Portfolio Management, Drygen
Press, 1985.
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74 9
FACTOR MODELS AND ARBITRAGE
PRICING THEORY
Unit Structure
9.0 Objectives
9.1 Introduction
9.2 Arbitrage pricing theory
9.2.1 Assumptionsof APT
9.2.2 ArbitrageinEconomicsandFinance
9.2.3 ConditionsforArbitrage
9.3 Factor Models
9.4 Summary
9.5 Unit End Questions
9.6 Suggested Readings
9.0 OBJECTIVES
Themainpurposeofthischapteris –
To discuss Arbitrage pricing theory
To discuss the assumptions of APT
To explain the conditions for arbitrage
To understand Factor Models
9.1 INTRODUCTION
The general theory of asset pricing known as the arbitrage pricing the ory
(APT) in finance has a significant impact on share prices. According to the
APT, the expected return of a financial asset can be predicted as a linear
function of multiple macroeconomic variables or hypothetical market
indexes, with the sensitivity to changes in each variable being represented
by a factor -specific beta coefficient. The asset will then be priced
accurately using the model -derived rate of return; the asset price should be
equal to the anticipated end -of-period price discounted at the mode l-
implied rate. Arbitrage should bring the price back into line if it starts to
diverge. The economist Stephen Ross developed the hypothesis in 1976.
The CAPM and the Arbitrage Pricing Model (APM) have very similar
appearances, however the APM's history is fundamentally different. The
CAPM is a single -factor model, but the APM is a multifactor model with a
collection of beta values —one for each factor —rather than simply a single
beta value. The expected return on an investment is based on both how munotes.in
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75 that inve stment responds to a set of specific macroeconomic factors (the
level of response being measured by the betas) and the risk premium
associated with each of those macroeconomic factors, according to
arbitrage pricing theory, from which the APM originates. A ccording to
Ross's APM, which he created in 1976, there are four components that
explain the relationship between a security's risk and risk premium.
9.2 ARBITRAGE PRICING THEORY
Arbitrage Pricing Theory (APT) is an alternate version of Capital Asset
Pricing Model (CAPM) . This theory, like CAPM provides investors with
estimated required rate of return on risky securities. APT considers risk
prem ium basis specified set of factors in addition to the correlation of the
price of the asset with expected excess return on the market portfolio. As
per assumptions under Arbitrage Pricing Theory, return on an asset is
dependent on various macro -economic fa ctors like inflation, exchange
rates, market indices, production measures, market sentiments, changes in
interest rates, movement of yield curves etc.
The Arbitrage pricing theory based model aims to do away with the
limitations of one -factor model (CAPM) that different stocks will have
different sensitivities to different market factors which may be totally
different from any other stock under observation. In layman terms, one
can say that not all stocks can be assumed to react to single and same
parameter always and hence the need to take multifactor and their
sensitivities.
Calculating Expected Rate of Return of an Asset Using Arbitrage
Pricing Theory (APT)
Arbitrage Pricing Theory Formula – E(x) = rf + b1 * (factor 1) +b2
*(factor 2) + ….+bn *(factor n)
Where,
E(X) = Expected rate of return on the risky asset
Rf = Risk-free interest rate or the interest rate that is expected from a risk -
free asset
(Most commonly used in U.S. Treasury bills for U.S.)
B = Sensitivity of the stock with respect to the factor ; also referred to as
beta factor 1, 2 …
N = Risk premium associated with respective factor
As the formula shows, the expected return on the asset/stock is a form of
linear regression taking into consideration many factors that can affect the
price of the asset and the degree to which it can affect it i.e. the asset’s
sensitivity to those factors. munotes.in
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76 If one is able to identify a single factor which singly affects the price, the
CAPM model shall be sufficient. If there are more than one factor
affecting the pri ce of the asset/stock, one will have to work with a two -
factor model or a multi -factor model depending on the number of factors
that affect the stock price movement for the company.
The APT is a substitute for the Capital Asset Pricing Model (CAPM) in
that both assert a linear relation between assets’ expected returns and their
covariance with other random variables. (In the CAPM, the covariance is
with the market portfolio’s return.) The covariance is interpreted as a
measure of risk that investors cannot avoid by diversification. The slope
coefficient in the linear relation between the expected returns and the
covariance is interpreted as a risk premium. Such a relation is closely tied
to mean -variance efficiency
ARBITRAGE PRICING THEORY ASSUMPTIONS
The th eory is based on the principle of capital market efficiency and
hence assumes all market participants trade with the intention of profit
maximisation
It assumes no arbitrage exists and if it occurs participants will engage
to benefit out of it and bring b ack the market to equilibrium levels.
It assumes markets are frictionless, i.e. there are no transaction costs,
no taxes, short selling is possible and an infinite number of securities is
available.
ARBITRAGE PRICING THEORY BENEFITS
APT model is a multi -factor model. So, the expected return is
calculated taking into account various factors and their sensitivities that
might affect the stock price movement. Thus, it allows selection of
factors that affect the stock price largely and specifically.
APT mode l is based on arbitrage free pricing or market equilibrium
assumptions which to a certain extent result in a fair expectation of the
rate of return on the risky asset.
APT based multi -factor model places emphasis on the covariance
between asset returns an d exogenous factors, unlike CAPM. CAPM
places emphasis on the covariance between asset returns and
endogenous factors.
APT model works better in multi -period cases as against CAPM which
is suitable for single period cases only.
APT can be applied to the cost of capital and capital
budgeting decisions.
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77 The APT model does not require any assumption about the empirical
distribution of the asset returns, unlike CAPM which assumes that
stock returns follow a normal distribution and thus APT a less
restrictive model.
9.3 FACTOR MODELS
Single Factor Model
The Capital Asset Pricing Model is the model's most popular application
(CAPM).
The relationship between systematic risk and the anticipated return on
equities is clearly communicated by the CAPM model. Based on th e risk
assessment, it determines the required return. This is accomplished by
using a risk multiplier known as the Beta coefficient (β).
Formula/structure
E(R) i = R f+ β(E(R m)- Rf)
Where E(R) I is the Expected return of investment
• The Risk -Free Rate of Ret urn, or Rf, is a hypothetical rate of return with
no hazards.
• The investment's beta, which compares the volatility of the investment to
the market as a whole,β
• E(Rm) represents the market's anticipated return.
The Market Risk Premium is denoted by E(Rm )-Rf.
The most popular model in finance is the CAPM, which is a
straightforward design. The Weighted Average Cost of Capital/Cost of
Equity is determined using this.
However, this model is predicated on a few slightly implausible premises,
including the no tion that "the riskier the investment, the higher the return,"
which may not hold true in all scenarios, and the notion that historical data
accurately predicts the future performance of the asset or stocks, among
other things.
What if the rate of return i s determined by a number of variables rather
than simply one? As a result, we continue on to the financial models and
explore them in detail.
Multiple Factor Model
The additions to one financial model are multiple factor models. One of its
most common uses is in the area of arbitrage pricing theory.
Rs,t = R f +α+ β 1×F1,t + β 2×F2,t + β 3×F3,t+ …….β n×Fn,t+ Ě
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78 Rf is the Risk -Free Rate of Return
α is the security's Alpha; Alpha is the factor model's constant term. It
stands for the investment's excess return when comp ared to the
benchmark index's return. The margin by which the investment
outperforms the index is the measure of this. For investors, the higher
the alpha, the better.
F1,t, F2,t, F3,t are the factors – macroeconomic parameters including the
GDP, foreign i nstitutional investors, inflation rate, and exchange rate.
P/E ratio, market capitalisation, and other fundamental variables.
β1, β2, β3 are the factor loadings. – The coefficients of the factors, as
previously mentioned, are what are referred to as factor loadings or
component loadings. For instance, the beta calculation helps investors
assess the degree to which a stock fluctua tes in proportion to market
change.
Ě indicates the error term - The error term in the equation is utilised to
increase the calculation's accuracy. It can occasionally be used to
describe the investor -accessible security -specific news..
The following pres umptions form the foundation of the arbitrage
pricing theory, one of the popular categories of financial models:
Asset returns can be described by a linear component model.
Diversification may help to eliminate asset - or company -specific risk.
There are no more opportunities for arbitrage.
9.4 SUMMARY
The fundamental idea of the CAPM is embodied in the Security
Market Line (SML), which states that the expected return of a security
rises linearly with risk evaluated with "beta." The SML is a straight
line with a n increasing slope that passes through the market portfolio
and an intercept at the risk -free return securities.
The efficiency barrier, known as the "Capital Market Line," which
results from the assumption that the risk -free lending and borrowing
rates a re the same, leads to some crucial implications (CML).
A sane investor would refrain from buying an asset if it did not
enhance the risk -return characteristics of his current holdings.
The questioned item will be included in the market portfolio since a
sensible investor would own it. In this situation, MPT determines the
necessary return for a correctly priced asset.
The vertical intercept point of the regression line is given by the alpha
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79 Modern portfolio theory is said to have its foundat ions in Harry
Markowitz.
He claims that risk and return, the two characteristics of an asset that
matter most to investors, may be traded off through portfolio
diversification.
The core of his idea is that an investor doesn't really care about the
risk o f a certain asset.
9.5 UNIT END QUESTIONS
A. Descriptive Questions:
1. What are your uses for the APT as an investor?
2. What is Single Factor model?
3. Discuss the Assumptionsof APT
4. Analyze the Arbitrage Pricing Model critically.
5. Explain Arbitragei nEconomicsandFinance.
6. Discuss the various types of factor model.
B. Fill in the blanks:
1. The APT differs from the CAPM in that it is .................... in its
assumptions .
2. .................................... models are used to construct portfolios with
certain characteristics, such as risk, or to track indexes.
3. Portfolio management is concerned with efficient management of
.................... in the securities.
4. ………… based its assumptions on a "factor model" of asset returns.
5. The additions to one financial model are ……………….. factor
models. .
Answer:
1. less restrictive
2. multi factor
3. investment
4. APT
5. multiple
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80 9.6 SUGGESTED READINGS
Bonus Shares, A Study of the Dividend and Price Effects of Bonus
Shares Issues, Bombay, MacMillan, 1973.
Graham, Benjamin, David, L., Dodd, Sidney Cottle, et al., Security
Analysis: Principles and Techniques, 4th ed., New York McGraw –
Hill Book Co. Inc., 1962.
Granger, Clive W and Morgenstem Oskar, Predictability of Stock
Market Prices, Lexington, Health Lexington, 1970.
Granville, Joseph E., A Strategy of Daily Timings for Maximum
Profit, Englewood Cliffs, N.J., Prentice -Hall, 1960.
Gup, Benton E., Basics of Investing, N. Y. Wiley, 1979.
Gupta L.C., Rates of Return on Equities: The Indian Experience,
Bombay, Oxford University Press, 1981.
Sudhindra Bhat, Security Analysis and Portfolio Management, Excel
Books
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81 10
INVESTMENT DECISION THEORY
Unit Structure
10.0 Learning Objectives
10.1 Introduction
10.2 Investment decision theory
10.3 Summary
10.4 Unit End Questions
10.5 References
10.0 LEARNING OBJECT IVES
After studying this unit, you will be able to:
To illust rate Investment decision theory
To understand Modern Portfolio Theory
To discuss Behavioral finance
To describe Capital Asset Pricing Model
10.1 INTRODUCTION
Investment decision theory is a framework that helps investors make
informed decisions about how t o allocate their resources to different
investment opportunities. The theory is based on the principle that
investors should make decisions based on the expected returns and risks
associated with different investments.
The basic premise of investment decis ion theory is that investors should
aim to maximize their expected returns while minimizing their risks. To
do this, they need to consider a range of factors, including the expected
returns and risks of different investments, the correlation between differ ent
assets, and their own risk tolerance.
10.2 INVESTMENT DECI SION THEORY
One of the key concepts in investment decision theory is the idea of
portfolio diversification. This involves spreading investments across a
range of different asset classes and inve stment opportunities in order to
reduce the overall risk of the portfolio. By diversifying their portfolio,
investors can reduce the impact of any one investment performing poorly,
while also increasing the potential for positive returns. munotes.in
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82 Another important concept in investment decision theory is the idea of the
efficient frontier. This is the set of portfolios that offer the highest
expected returns for a given level of risk. By constructing a portfolio that
lies on the efficient frontier, investors can ma ximize their expected returns
while minimizing their overall risk.
The best way to understand how investment decisions are made is as an
integrated process to which security analysis uniquely contributes. The
definition of objectives and the evaluation of success in portfolio
management call for the consistent use of economic, capital market, and
sector analyses. Security analysis assists the investor by pointing out the
undervalued or properly valued assets that are most likely to deliver the
desired outco mes.
The following goals serve as the foundation for developing investment
policies and asset allocation strategies:
1. To continuously preserve the purchasing power of its assets, adjusted
for inflation, and to generate a satisfactory "real" rate of retur n.
2. To minimise portfolio risk and volatility while maintaining sufficient
spending stability from year to year.
There are several key theories that are important in security analysis and
portfolio management, including:
Modern Portfolio Theory: Develope d by Harry Markowitz, this theory
emphasizes the importance of diversification in reducing portfolio risk.
According to this theory, investors should focus on creating portfolios
that are diversified across multiple asset classes to minimize risk.
Behavior al Finance: This theory combines principles of psychology
with finance to explain why people make certain investment decisions.
It suggests that investors are often influenced by emotions and biases,
and that these factors can lead to irrational investment decisions.
Capital Asset Pricing Model: This theory attempts to quantify the
relationship between risk and expected returns. It suggests that
investors should expect higher returns from riskier investments, and
that the riskier the investment, the greater the potential reward.
Modern Portfolio Theory (MPT)
Modern Portfolio Theory (MPT) is a framework for managing investment
portfolios that was developed by Harry Markowitz in the 1950s. MPT is
based on the principle that investors can minimize risk and maxi mize
returns by creating a diversified portfolio of assets.
The MPT makes the assumption that investors are logical and risk -averse,
i.e., they want to maximise profits while limiting risk. Systematic risk and
unsystematic risk are the two different catego ries of risk, according to
MPT. Unsystematic risk is the risk that is unique to a certain asset or munotes.in
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83 company, whereas systematic risk is the risk that is inherent in the market
as a whole.
MPT argues that portfolio diversification across various assets can h elp
investors lower their unsystematic risk. Investors can lessen the effect of
any one asset's performance on the portfolio as a whole by holding a mix
of assets. Also, MPT advises that rather than concentrating on the
characteristics of individual assets , investors should concentrate on the
overall risk and return characteristics of the portfolio.
The efficient frontier, which is the collection of ideal portfolios that
provide the best projected return for a specific degree of risk, was another
idea devel oped by MPT. The efficient frontier is based on the notion that
diversifying an investor's portfolio can boost returns without increasing
risk.
Critics of MPT contend that certain assumptions, including as the notion
that investors are rational and that hi storical data may forecast future
performances, may not hold true in the actual world.
Behavioral finance
To better understand how human behaviour affects financial decisions and
market results, the field of research known as "behavioural finance" blends
financial theory with psychological concepts. It investigates how biases,
emotions, and cognitive mistakes affect how people make financial
decisions.
According to behavioural finance, people don't always act logically while
making financial decisions. Psyc hological biases including over
confidence, loss aversion, and herding tendencies may have an impact on
them. These biases can cause individuals to make illogical decisions and
have an impact on market results, leading to inefficiencies that smart
investor s can take advantage of.
Prospect theory, a fundamental idea in behavioural finance, contends that
people are more sensitive to losses than gains. As a result, even if the
prospective returns are modest, individuals could be willing to take on
additional r isk to prevent losses. This may result in overly conservative or
aggressive portfolio management techniques.
The disposition effect, which reflects investors' propensity to sell winning
investments too soon and hold onto losing investments for an excessive ly
lengthy period of time, is another crucial idea in behavioural finance.
Reduced returns and subpar portfolio performance may result from this.
Behavioral finance has implications for investors and financial
professionals. By understanding the impact of psychological biases on
financial decision -making, investors can make more informed decisions
and avoid common pitfalls. Financial professionals can also use this
knowledge to design investment products and strategies that take into
account the psychologic al biases of investors. munotes.in
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84 The Capital Asset Pricing Model (CAPM)
A popular financial model for calculating projected returns on investments
based on risk is the capital asset pricing model (CAPM). The required rate
of return that an investor should anticipat e receiving on a specific
investment is calculated using the CAPM.
The foundation of CAPM is the concept that there are two different types
of investment risk: systematic risk and unsystematic risk. Unsystematic
risk is a risk that is unique to a certain b usiness or industry, whereas
systematic risk is a risk that is inherent in the entire market.
According to CAPM, three variables —the risk -free rate, the market risk
premium, and the investment's beta —determine the expected return on an
investment. The retu rn on a risk -free investment, like a Treasury bond
issued by the United States, is known as the risk -free rate. The increased
return that investors anticipate receiving in exchange for accepting market
risk is known as the market risk premium. Last but not least, the
investment's beta measures how sensitive it is to market risk; a beta
greater than 1 denotes a higher level of market risk, while a beta less than
1 denotes a lower level of market risk.
CAPM suggests that the expected return on an investment c an be
calculated using the following formula:
Expected Return = Risk -Free Rate + Beta x (Market Risk Premium)
Investors and financial experts frequently use CAPM to calculate the
required rate of return for an investment and assess the performance of
inves tment portfolios. However, detractors of CAPM contend that it is
based on a number of oversimplifying presumptions that could not hold
true in actuality, including the concepts that investors are logical and
markets are efficient.
10.3 SUMMARY
Investment d ecision theory is a framework that helps investors make
informed decisions about how to allocate their resources to different
investment opportunities.
MPT is based on the principle that investors can minimize risk and
maximize returns by creating a diver sified portfolio of assets.
MPT provides a framework for investors to create diversified
portfolios that minimize risk and maximize returns.
Behavioral finance suggests that individuals do not always behave
rationally when making financial decisions.
CAPM is based on the principle that there are two types of risk
associated with an investment: systematic risk and unsystematic risk. munotes.in
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85 10.4 UNIT END QUESTI ONS
A. Descriptive Questions
1. Write note on Investment theory .
2. Explain The Capital Asset Pricing Model .
3. Discuss Behavioral finance approach.
4. Analyse Modern Portfolio Theory (MPT).
B. Fill in the Blanks
1. Modern Portfolio Theory was developed by ………….
2. According to …………….finance, people don't always act logically
while making financial decisions.
3. CAPM s tands for …………
4. Beta measures how sensitive ………….. is to market risk.
5. Investors and financial experts frequently use ………….. to calculate
the required rate of return for an investment and assess the performance of
investment portfolios.
Answers
1-Harry Markowitz
2-behavioural,
3-Capital Asset Pricing Model,
4-investment ,
5- CAPM
10.5 REFERENCES
References book
Derivatives Market NCFM Module. National Stock Exchange
India Limited Publications: Bombay: 2007.
GuptaS. L(2007). Financial Derivatives Prent ice Hall. New Delhi.
Indian Stock Market Review. National Stock Exchange Publications.
Jaynath Rama Varma (2008). Derivatives and Risk Management .
Tata McGraw Hill Publications: New Delhi.
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86 11
PORTFOLIO THEORY
Unit Structure
11.0 Learning Objectives
11.1 Introduction
11.2 Portfolio theory Construction and analysis
11.3 Portfolio optimization
11.4 Portfolio management strategies
11.5 Portfolio performance measurement.
11.6 Summary
11.7 Unit E nd Questions
11.8 References
11.0 LEARNING OBJECT IVES
After studying this unit, you will be able to:
To discuss Portfolio theory Construction and analysis
To explain Portfolio optimization
To understand Portfolio management strategies
To describe Portfol io performance measurement
11.1 INTRODUCTION
A portfolio is a collection of financial speculations, including closed -end
assets and trade -exchanged assets, securities, goods, money, and money
equivalents (ETFs). Most people agree that stocks, bonds, and c ash
constitute the core of a portfolio. Despite the fact that this is frequently the
case, it shouldn't be the norm. A portfolio could include a variety of assets,
including as real estate, handiwork, and unorganized businesses.
The understanding of enhan cement, which essentially means not to tie up
your assets in one spot, is one of the key concepts for portfolio executives.
Expansion spreads bets throughout many business initiatives, financial
instruments, and classes in an effort to reduce risk. It refe rs to increasing
returns by investing in a variety of areas that would all react differently to
the same situation. There are many methods for growing. It's up to you
how you decide to go about doing it. Your future goals, your appetite for munotes.in
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87 risk, and your character are all important considerations when deciding
how to build your portfolio.
A speculative portfolio might be compared to a pie that has been cut into
pieces, each of which has a different wedge -shaped size and addresses a
different resource class or prospective type of endeavour. Financial
supporters anticipate creating a globally diversified portfolio to achieve a
risk return portfolio designation that is appropriate for their level of risk
resistance.
Despite the fact that money, stocks, and bon ds are the main building
blocks of a portfolio, you can diversify your holdings by adding a variety
of assets, such as real estate, gold stocks, various types of securities,
pieces of art, and other artisanal treasures.
The definition of a portfolio states that it is a collection of various
resources that have financial backers. The aforementioned range of
financial resources may also consist of assets such as gold, equities,
reserves, subordinated debt, real estate, cash analogues, bonds, and so
forth. Peo ple invest their money in such resources in order to generate
income while ensuring that the resource's initial worth remains intact.
11.2 PORTFOLIO THEOR Y CONSTRUCTION AND
ANALYSIS
The Dow Theory and Elliot Wave Theory
One of the earliest and most well -known technical instruments is the Dow
Theory. Charles Dow, who established the Dow Jones organisation and
served as The Wall Street Journal's editor, is credited with creating it. In
1902, Charles Dow went away.
W.P. Hamilton and Robert Rhea derived the Dow Theory from an
editorial that Dow wrote between 1900 and 1902. The original Dow
Theory has been modified, expanded upon, and in some cases abbreviated
by numerous authors. It serves as the foundation for a variety of additional
technical analyst technique s.
The Great Crash of 1929 is seen as having been predicted by the Dow
Theory. The Wall Street Journal's still -famous editorial "A Twin in the
Tide," which was published on October 23, 1929, accurately predicted that
the bull market had ended and that a be ar market had begun. The Dow
Theory received a lot of positive attention after the terrible market
meltdown that followed the projection. The Dow Theory, according to
Greiner and Whitecombe, "provides a time -tested approach of reading the
stock market baro meter."
There are many variations of this theory, but in general it describes three
different types of market movements: the major trend, which frequently
lasts for a year or longer; the secondary intermediate trend; which can
move counter to the primary t rend for one to several months; and the munotes.in
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88 minor movements, which only last for a few hours to a few days. The most
crucial choice for a Dow believer is identifying the main market trend.
The Theory: According to Dow, "The market is always considered as
havin g three movements, all going at the same time. The first is the
narrow movement from day -to-day. The second is the short swing running
from two weeks to a month or more, the third is the main movement
covering at least four years in duration".
These moveme nts are called:
1. Daily fluctuations (minor trends)
2. Secondary movements (trends), and
3. Primary trends
The long -term cycle that drives the entire market up or down is the main
trend (bull or bear markets). The secondary trend restrains the primary
trend in some way. It comes to an end to remedy departures from its
overall parameters. Due to their brief existence and amplitude changes, the
small trends are of little analytical use. The Dow Theory is represented in
Figure 4.1.
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The Dow Jones Averages
The Dow Theory is built upon the assertion that measures of stock prices
tend to move together.
It employs two of the Dow Jones' averages.
1. Dow -Jones Transportation Average (DJTA)
2. Dow -Jones Transportation Average (DJTA)
Bear market – If both the avera ges are rising
Bear market – If both the averages are falling
Uncertain – If one is rising and other is falling
Charles Dow was an advocate of basic analysis, but today the Dow Theory
is mostly a technical approach to the stock market. It claims that stock
prices exhibit patterns over a period of four to five years, and that stock
price indices reflect these patterns. The industrial average and the
transportation average are two of the Dow Jones averages used in the Dow
Theory. In most cases, the utility av erage is disregarded.
The Dow Theory is based on the idea that stock price measures frequently
move in tandem.
The transportation average should increase if the Dow Jones industrial
average is. Such synchronous price changes are indicative of a robust bull
market. The market is unsure of the direction of future stock prices when
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90 The two are at odds if one of the averages begins to fall after a period of
rising stock prices. For instance, the transportation average may be
declining while the industrial average is rising. This means that instead of
continuing to grow, the industries may soon start to decline.
To sell assets and convert to cash, the market investor will therefo re act on
this indication.
The opposite happens when, following a stretch of declining security
prices, one of the averages begins to rise while the other keeps decreasing.
This divergence signals that this phase is gone and that securities prices
generall y will soon begin to climb, in accordance with the Dow Theory.
Next, the wise investor will buy securities in anticipation of a rise in price.
The Elliott Wave theory
Ralph Nelson Elliott created the Elliott Wave theory in the 1930s. Elliott
needed someth ing to do with his time after being forced into retirement
owing to a medical condition, so he started analysing 75 years' worth of
annual, monthly, weekly, daily, and self -made hourly and 30 -minute
charts across numerous indices.
In 1935, Elliott produced an extraordinary prediction of the stock market
bottom, which helped the theory become well -known. Since then, it has
evolved into a standard for tens of thousands of traders, private investors,
and portfolio managers.
Elliott provided detailed guidelines for how to recognise, foresee, and
profit from these wave patterns. R.N. Elliott's Masterworks, which was
released in 1994, covers these books, articles, and letters. The largest
independent financial analysis and market forecasting company in the
world, Elliott Wave International, bases its market analysis and
projections on Elliott's model.
He took care to point out that these patterns help to organise the
probability for future market activity rather than offering any type of
assurance regarding future price movement.
1 To pinpoint specific opportunities, they can be utilised in conjunction
with other types of technical analysis, such as technical indicators.
Different traders may perceive the Elliott Wave structure of a market
differently at any particu lar time.
How Elliott Waves Work
Using the Elliott Wave Theory, some technical analysts attempt to make
money from stock market wave patterns. According to this theory,
changes in stock prices may be forecast because they follow recurring up -
and-down patte rns known as waves, which are influenced by investor
psychology or mood.
According to the theory, waves can be divided into two categories: motive
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91 is subjective, not all traders will u nderstand the theory in the same manner
or concur that using it as a trading technique is a good idea.
Capital asset pricing model (CAPM)
The CAPM makes the assumption that investors have completely
diversified holdings. By assuming that investors demand a return on an
investment based solely on its systematic risk rather than its overall risk,
the CAPM assumes that investors do. Therefore, the "beta" risk metric
utilised in the CAPM is a measure of systematic risk.
Capital Asset Pricing Model
The capital asset pricing model offers a method that determines a
security's expected return depending on risk. The difference between the
return on the market and the risk -free rate multiplied by the risk -free rate
plus beta is the formula for the capital asset pric ing model.
Risk and the Capital Asset Pricing Model Formula
Understanding investment risk is necessary to comprehend the capital
asset pricing model. Individual securities are subject to the risk of
depreciation, which would result in an investor losing th eir investment.
Some assets carry more risk than others, therefore an investor may
anticipate a larger return on investment when taking on more risk.
Consider the scenario where a person has $100 and two acquaintances
want to borrow it. Both of them are gi ving a 5% return ($105) after a year.
The obvious decision would be to lend to the person who is more likely to
pay back the loan, or who has a lower default risk. The risk associated
with securities can be thought of in the same way.
The capital asset pri cing model with beta takes into consideration the risk
inherent in assessing a certain stock. In the context of the capital asset
pricing model formula, beta is a measure of the risk associated with
buying a particular stock in comparison to market risk. T he market's beta
would be 1.
Inversely, a security with a beta of.5 would have less risk than the market
and one with a beta of 1.5 would be proportionally riskier than the market. munotes.in
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92 Risk Free Rate in the Capital Asset Pricing Model Formula
The projected rat e on an investment that is presumptively risk -free is
known as the risk -free rate. Since the US Treasury bill rate is short -term
and relies on a fiat currency, it is frequently used for the country. If the US
Treasury bill rate were to collapse, it would c onceivably cause a
significant enough disruption to make it difficult to estimate value or,
worse, the entire monetary system.
Risk Premium in the Capital Asset Pricing Model Formula
The capital asset pricing model formula can be broken up into two
compone nts: the risk -free rate and the risk premium of the particular
security.
The difference between the market return and a risk -free return multiplied
by beta is the risk premium. The risk of the entire market can then be
calculated using the capital asset pricing model formula by deducting the
market return from a risk -free return. The risk of a certain stock can
therefore be calculated by multiplying beta by the market risk. The risk
associated with a specific security in relation to the market is known as
beta. A beta of two would make the market twice as hazardous. In real
life, risk and volatility are the same thing. A stock with a beta greater than
the market beta of 1 will often grow more than the market when the
market is up and decrease more than the market when the market is down.
Capital Asset Pricing Model
Alternative Capital Asset Pricing Model Formula
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93 The formula will appear as above when regression analysis is used to the
capital asset pricing model based on prior returns. Epsilon is regarde d as
the regression error, whereas alpha is regarded as the risk -free rate.
When the actual return equals the expected return, there is absolutely no
danger that the investment's return will deviate from the expected return,
which is the minimal amount of return demanded by investors. The term
"risk -free rate of return" refers to this minimal rate of return .
The formula for the CAPM, which is included in the Paper F9 formulae
sheet, is as follows:
E(ri ) = Rf + βi(E(rm) – Rf)
E(ri) = return required on fina ncial asset i
Rf = risk -free rate of return
βi = beta value for financial asset i
E(rm) = average return on the capital market
This formula expresses the required return on a financial asset as the sum
of the risk -free rate of return and a risk premium – βi (E(rm) - Rf) – which
compensates the investor for the systematic risk of the financial asset. If
shares are being considered, E(rm) is the required return of equity
investors, usually referred to as the ‘cost of equity’.
The formula is that of a straight line, y = a + bx, with βi as the independent
variable, Rf as the intercept with the y axis, (E(r m ) - Rf) as the slope of
the line, and E(ri) as the values being plotted on the straight line. The line
itself is called the security market line (SML), as s hown in Figure 1.
The Security Market Lin
Over -pricing and under -pricing securities
Proper pricing is one of the largest obstacles your business will encounter,
regardless of what you sell. You need a pricing strategy that works for
your target demograph ic, but you don't want it to be excessively high or munotes.in
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94 low. Some profitable businesses, like Amazon, have a competitive edge
thanks to a smart pricing strategy that takes into account customer and
competition behaviour. Although it can seem preferable to unde rprice your
good or service, you will do better if you overcharge.
A security is deemed to be fairly valued when its current market price is
roughly comparable to its value estimate. The security is overvalued when
the market price exceeds the value estima te, while the security is
undervalued when the market price is less than the anticipated value.
Uncertainties arise when determining an estimated valuation for a
company, of course. Since a discovered mispricing may indicate a mistake
in the analyst's valu ation rather than the market's valuation, market prices
should be handled with caution but also with respect.
Market Price vs. Intrinsic Value
Arbitrage pricing theory (APT)
An alternative to the Capital Asset Pricing Model is called Arbitrage
Pricing Th eory (APT) (CAPM). The projected needed rate of return on
hazardous securities is provided to investors by this theory, similar to the
CAPM. APT takes into account the risk premium based on a
predetermined set of variables in addition to the relationship b etween asset
price and expected excess return on the market portfolio. According to the
underlying assumptions of the arbitrage pricing theory, an asset's return is
influenced by a variety of macroeconomic variables, including inflation,
currency rates, st ock market indices, production metrics, market mood,
changes in interest rates, movement of yield curves, etc.
The one -factor model (CAPM) has the limitation that different stocks will
have varied sensitivities to different market conditions, which may be
completely different from any other stock under observation. The arbitrage
pricing theory -based approach seeks to overcome this issue. In layman's
words, it can be said that not all stocks can be expected to consistently
respond to a single, consistent cri terion, necessitating the consideration of
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Calculating Expected Rate of Return of an Asset Using Arbitrage
Pricing Theory (APT)
Arbitrage Pricing Theory Formula – E(x) = rf + b1 * (factor 1) +b2
*(factor 2) + …. +bn *(factor n)
Where,
E(X) = Expected rate of return on the risky asset
Rf = Risk-free interest rate or the interest rate that is expected from a risk -
free asset
(Most commonly used in U.S. Treasury bills for U.S.)
B = Sensitivity of the stock with respec t to the factor; also referred to as
beta factor 1, 2 …
N = Risk premium associated with respective factor
As the formula shows, the expected return on the asset/stock is a form of
linear regression taking into consideration many factors that can affect th e
price of the asset and the degree to which it can affect it i.e. the asset’s
sensitivity to those factors.
The CAPM model should be enough if one can pinpoint a single
component that alone influences price. Depending on how many variables
are influencing the price of the asset or stock, one must use a two -factor
model or a multi -factor model to predict how the stock price will move for
the company.
The Capital Asset Pricing Model (CAPM) and the Asset Pricing Theory
(APT) both state a linear relationship b etween the expected returns on an
asset and its covariance with other random variables. (In the CAPM, the
covariance relates to the return of the market portfolio.) The covariance is
seen as a gauge of risk that diversification cannot shield investors agai nst.
The slope coefficient in the linear relation between the expected returns
and the covariance is interpreted as a risk premium. Such a relation is
closely tied to mean -variance efficiency.
Arbitrage pricing theory assumptions
The theory is based on the principle of capital market efficiency and
hence assumes all market participants trade with the intention of profit
maximization
It assumes no arbitrage exists and if it occurs participants will engage
to benefit out of it and bring back the market to equ ilibrium levels. munotes.in
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96 It assumes markets are frictionless, i.e. there are no transaction costs,
no taxes, short selling is possible and an infinite number of securities is
available.
Arbitrage pricing theory benefits
APT model is a multi -factor model. So, the e xpected return is
calculated considering various factors and their sensitivities that might
affect the stock price movement. Thus, it allows selection of factors
that affect the stock price largely and specifically.
APT model is based on arbitrage free pri cing or market equilibrium
assumptions which to a certain extent result in a fair expectation of the
rate of return on the risky asset.
APT based multi -factor model places emphasis on the covariance
between asset returns and exogenous factors, unlike CAPM. CAPM
places emphasis on the covariance between asset returns and
endogenous factors.
APT model works better in multi -period cases as against CAPM which
is suitable for single period cases only.
APT can be applied to the cost of capital and capital
budgeting decisions.
The APT model does not require any assumption about the empirical
distribution of the asset returns, unlike CAPM which assumes that
stock returns follow a nor mal distribution and thus APT a less
restrictive model.
Arbitrage pricing theory limitations
The model necessitates a concise summary of the variables affecting
the stock under examination. Finding and naming every aspect might
be challenging, and there is a chance that some will be missed.
Additionally, there is a chance that unintentional correlations will
occur, which could turn a component into a significant influence
provider or the opposite.
It will be necessary to calculate the expected returns for e ach of these
components, which, depending on the factor's nature, may or may not
always be readily available. The model calls for calculating each
factor's sensitivities, which can be laborious and may not be
realistically viable .
The factors that affect t he stock price for a particular stock may change
over a period of time. Moreover, the sensitivities associated may also
undergo shifts which need to be continuously monitored making it very
difficult to calculate and maintain.
The Arbitrage Pricing theory, often known as APT, was created to address
some of the shortcomings of CAPM that we covered at the conclusion of munotes.in
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97 the previous session. In particular, the CAPM only functions when we
make illogical assumptions about consumer preferences: Markowitz and
Sharpe defined that customers only care about the mean and standard
deviations of their wealth if their preferences are quadratic. Returns must
also be regularly distributed, or Gaussian. People hold a variety of views,
and most crucially, these beliefs influe nce how they invest their money.
As a result, it is unclear what the market portfolio exactly is. In reality, we
would use something like the S&P 500, but that is not the best option. The
CAPM depicts a world where b is king, but as investors hold various
portfolios, the value of b shifts. You get a different answer for b if you
measure the market portfolio in a different way (for example, by using a
different broad index of stocks and shares). APT was created to address
these shortcomings. When developing APT, Ross (1976) did away with
the assumptions of preferences and rigorous maximisation. He persisted in
his belief that businesses and stocks seek for opportunities to maximise
profits and that the market was challenging to outperform. Ross simply
assumed that the pursuit of arbitrage would keep investors at or near the
CAPM -derived equilibrium rather than developing an equilibrium
condition for the market from consumer preferences as Sharpe did. The
main concept behind APT is to consider the asset pairing s that one would
hold to rule out any potential for arbitrage. When two assets with the same
risk have varying returns, arbitrage is feasible.
You can short the low return asset, go long on the other using the proceeds
of the sale of the first, and in the ory, reap infinite rewards with no risk to
yourself.
How to use APT
To use APT, you'll need to follow these steps:
1. Identify the factors
2. Estimate the factor weights on each asset
3. Estimate the factor premia.
We'll take these in turn.
First, we have to find the factors. Candidates are things like
1. Changes in gdp growth,
2. Changes in the T -bill yield as a proxy for inflation
3. Changes in the yield spread between bills and bonds of interest,
4. Changes in the default premium of some corporate bonds,
5. Changes in oil prices, again as a proxy for inflation and so on
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98 Use factor analysis :
1. Calculate the asset returns' covariance, and then use that information to
extract the "factors" from the covariance matrix. Utilize data mining to
investi gate various portfolio combinations using a computer in order to
identify those whose returns can be considered as factors.
2. Factor Weights Regress historical asset prices on the factors to calculate
factor weights.
3. Premia Factor. You are aware of the important considerations and are
aware of how much importance each asset deserves. The creation of a
factor portfolio is now easy. Just use the formula above to plug one into
the other.
Strength and Weaknesses of APT
1. The model gives a reasonable descr iption of return and risk.
2. Factors seem plausible.
3. No need to measure market portfolio correctly.
4. Model itself does not say what the right factors are.
5. Factors can change over time.
6. Estimating multi -factor models requires more data.
The Law of one price, two factor arbitrage pricing
According to the economic principle known as the law of one price, when
certain conditions are taken into account, the price of an identical good or
service will be the same everywhere, irrespective of locatio n.
The law of one price takes into account a market that is free from friction,
meaning there are no transaction expenses, transportation costs, or legal
constraints, that currency exchange rates are constant, and that neither
buyers nor sellers are manipu lating prices. Because of the arbitrage
possibility, discrepancies in asset pricing across different regions would
eventually be eliminated, thus the law of one price.
By buying the asset in the market where it is accessible at a cheaper price
and selling it in the market where it is available at a higher price, the
arbitrage opportunity would be realised. Prices for the asset would
eventually align due to forces of market equilibrium.
The cornerstone of buying power parity is the law of one price. Accordin g
to the concept of purchasing power parity, two currencies are equivalent in
value when a basket of identical items is priced the same in both nations.
It makes certain that customers have the same purchasing power in all
international markets. munotes.in
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99 Due to var ying trading expenses and certain people's incapacity to access
markets, purchasing power parity is very challenging to attain.
It is possible to use the buying power parity calculation to compare prices
on markets where multiple currencies are traded. The method can be
updated periodically to uncover mispricings across multiple foreign
markets because currency rates might fluctuate frequently.
Example of the Law of One Price
After taking into account the effects of currency exchange rates, if the
price of any economic good or security is inconsistent across two separate
free markets, an arbitrageur will buy the asset in the cheaper market and
sell it in the more expensive market to make a profit.
When the law of one price is in effect, arbitrage gains like these will
continue until prices in all markets converge.
For example, if a particular security is available for $10 in Market A but is
selling for the equivalent of $20 in Market B, investors could purchase the
security in Market A and immediately sell it for $20 in Market B, netting a
profit of $10 without any true risk or shifting of the markets.
All other things being equal, prices on both markets should alter in
accordance with variations in supply and demand as securities from
Market A are sold on Mar ket B.
Market A, which is generally less expensive, should see an increase in the
price of these assets due to increased demand.
In contrast, greater supply in Market B, where the security is being sold by
the arbitrageur for a profit, ought to cause a dro p in its price. This would
eventually result in a price equilibrium between the security's two markets,
bringing it back to the situation suggested by the law of one price.
An alternative to the Capital Asset Pricing Model is called Arbitrage
Pricing Theor y (APT) (CAPM). Similar to CAPM, this theory gives
investors a projected necessary rate of return on risky securities. APT
takes into account the risk premium based on a predetermined set of
variables in addition to the relationship between asset price and expected
excess return on the market portfolio.
According to the underlying assumptions of the arbitrage pricing theory,
an asset's return is influenced by a number of macroeconomic variables,
including inflation, currency rates, stock market indices, pro duction
metrics, market mood, changes in interest rates, movement of yield curves,
etc.
The one -factor model (CAPM) has the limitation that different stocks will
have varied sensitivities to different market conditions, which may be
completely different fr om any other stock under observation. The arbitrage
pricing theory -based approach seeks to overcome this issue. In layman's
words, it can be said that not all stocks can be expected to consistently munotes.in
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100 respond to a single, consistent criterion, necessitating t he consideration of
multiple factors and their sensitivities.
Equilibrium risk -return relations
When economic forces are in balance, there is said to be an economic
equilibrium. In the absence coming from external influences, economic
variables essentially hold true to their equilibrium levels. Market
equilibrium and economic equilibrium are two different concepts.
Economic equilibrium is the set of economic variables (often price and
quantity) that the economy is driven towards by standard economic
process es like supply and demand.
The term economic equilibrium can also be applied to any number of
variables such as interest rates or aggregate consumption spending. The
point of equilibrium represents a theoretical state of rest where all
economic transactio ns that “should” occur, given the initial state of all
relevant economic variables, have taken place.
Economic equilibrium is a condition where market forces are balanced,
a concept borrowed from physical sciences, where observable physical
forces can bala nce each other.
The incentives faced by buyers and sellers in a market, communicated
through current prices and quantities drive them to offer higher or
lower prices and quantities that move the economy toward equilibrium.
Economic equilibrium is a theoret ical construct only. The market never
actually reach equilibrium, though it is constantly moving toward
equilibrium.
Economic Equilibrium in the Real World
Due to the frequently changing and ambiguous conditions that
underlie supply and demand, equilibrium is basically a theoretical concept
that may never be realised in an economy. Every key economic variable
undergoes continuous modification. By shooting a dart at a dartboard that
is randomly and unpredictable altering in size and shape while the board
and the thrower are both careening around independently on a roller rink,
one can actually achieve economic equilibrium. Without ever fully
achieving it, the economy strives towards equilibrium.
Entrepreneurs engage in competitive activity across the economy,
utilising their judgement to make educated assumptions about the optimal
mixtures of items, prices, and volumes to acquire and sell. Through the
process of earnings, entrepreneurs are in fact rewarded for bringing the
economy closer to equilibrium since a market economy rewards those who
make better predictions. Over time, entrepreneurs have more access to
knowledge about the pertinent economic conditions of supply and demand
thanks to the growth of the business and financial media, pricing circulars munotes.in
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101 and a dvertising, consumer and market research, and the development of
information technology.
This combination of market incentives that select for better guesses about
economic conditions and the increasing availability of better economic
information to educa te those guesses accelerates the economy toward the
“correct” equilibrium values of prices and quantities for all the various
goods and services that are produced, bought, and sold.
11.3 PORTFOLIO OPTIM IZATION
The Sharpe ratio, which gauges the excess ret urn gained for each unit of
risk taken, is stated to be highest for an ideal portfolio.
Modern Portfolio Theory provides the foundation for portfolio
optimization (MPT). The MPT is founded on the idea that investors want
the best possible return at the low est possible risk. Assets in a portfolio
should be chosen with this goal in mind; specifically, they should have a
low correlation with each other. Any MPT -based optimal portfolio is well -
diversified to prevent a crash when a certain asset or asset class p erforms
poorly.
Process of Optimal Portfolio
Asset Allocation for an optimal portfolio is essentially a two -part process:
1. Selecting Asset Classes – Portfolio managers pick the weight of each
asset class included after first selecting the asset classes to w hich they
intend to allocate funds. The most popular asset classes are stocks,
bonds, gold, and real estate.
2. Selecting Assets within Class – The manager chooses which asset
classes to invest in before determining how much of a specific stock or
bond to put in the portfolio. The risk -return relationship of an efficient
portfolio is depicted on a graph by the Efficient Frontier. An effective
portfolio is represented by each point on this curve.
11.4 PORTFOLIO MANAG EMENT STRATEGIES
There are Two Types of Portf olio Strategy
1. Active Management
2. Passive Management
Dynamic portfolio the board interaction alludes to a system where the goal
of contributing is to surpass the market return contrasted with a specific
benchmark by either purchasing undervalued protections or by short
selling overvalued protections. Both risk and reward are substantial in this
treatment. The asset administrator or financial backer must give careful
thought to this proactive method. munotes.in
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102 The CEOs cycle in the aloft portfolio speaks to a methodolog y whose goal
is to achieve recoveries that are comparable to those of the market. It is a
responsive method since the asset manager or financial backer responds
after the reaction of the market.
Understanding the Investment Process
Think about the pro cess involved in constructing a custom home. You
wouldn't begin by installing partitions or selecting paint colours. Starting
with an outline that reflects your desired outcome. Fostering the diagram
forces you to make specific decisions to ensure the hous e you build is in
line with your needs and goals. These decisions include the type of
establishment (section, unfinished basement, or storm cellar), the number
of floors, rooms, and bathrooms you desire, where the front door, kitchen,
and windows will be, etc. Once the diagram is complete, you have a solid
plan and impression to build upon when carrying out your arrangement.
During the development cycle you might make a few changes, yet you
have a general structure to continue in obliging any changes and wo rking
out your vision.
When your house is fabricated, it will require normal consideration,
support and refreshing. Afterward, you might need to roll out certain
improvements, adding a screen patio or open air kitchen, or rebuilding
certain rooms to mirro r your changing necessities or current plan patterns.
A solid establishment and strong development will give more prominent
adaptability in obliging these progressions not too far off.
The cycle of speculation is comparable. Think about your venture
portf olio, which is where your wealth will likely reside and maybe grow.
It must reflect the goals and needs of the present while still being flexible
enough to accommodate future developments. Regardless of whether you
design and implement your own cycle of sp eculation or work with a Investment
Process
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103 financial expert or firm, a few strategies are essential to pursuing the
results you seek. Unquestionably, the speculating interaction consists of
four key developments:
Goal Setting – The first step in the speculation cycle is und erstanding
and developing specific financial goals. Here is where you construct
your speculation diagram. If you're working with a Wealth Advisor,
they can help you identify and concentrate on your goals. The more
information you provide about your current financial situation, goals,
lifestyle objectives, time frame, and risk tolerance, the better your
wealth advisor will be able to develop a development strategy and
interaction that are specifically tailored to meet your needs.
Portfolio Construction – The development of the portfolio, which is
broken down into two crucial components: resource designation and
speculation decision, comes next in the cycle. Together, you and your
wealth advisor will develop a system for managing your resources.
Before your m oney growth strategy is put into action, you will have the
opportunity to audit and endorse any speculation proposals.
Asset assignment determines how your speculative funds are allocated
among the several venture classes, which are commonly referred to a s
values, fixed pay protections, money or currency market instruments,
and genuine resources (like land, products and different resources).
Options for resource allocation are also described in terms of interests
in domestic safeguards vs international or global resources.
Investment determination is the progression where the stocks that make
up the value part, the bonds that make up the proper pay part and the
genuine resources that make up the genuine resource part are chosen
for your portfolio.
Implemen tation – Once resource distribution and venture determination
choices are made, they should be executed through the buy and offer of
resources or protections, bringing about your speculation portfolio.
Portfolio Monitoring and Performance Evaluation – Checking the
status of the venture cycle's execution and evaluating the portfolio
come last. Over the long term, it's critical to monitor both your own
financial situation and the management of your portfolio. Any
advancements in your objectives, risk toleran ce, income, total assets, or
liquidity requirements —or changes that take place in your life, such as
a marriage or separation, the birth of a child, or the loss of a spouse —
will necessitate a similar refreshment of your money growth strategy.
When assessi ng portfolio execution, it's basic to quantify execution
inside the setting of your venture methodology. For instance, it's not
useful to anticipate returns comparable to the market if a part of your
portfolio is secured through a capital protection proced ure that tries to
give hazard changed returns.
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104 The Critical Role of Communication in the Investment Process
Communication is just as important as measurement for the ongoing
execution and execution of a speculation approach tailored to your wants
and ai ms. The questions "Am I Still on Target?" and "What Will Current
Market Patterns Mean for My General Technique?" cannot be answered
by speculative results, plans, annual reports, and unremarkable call
environments. These questions can, however, be answered by your
devoted Wealth Advisor, and that is just the beginning.
You may anticipate that your wealth advisor will meet with you on a
regular basis, depending on your needs and preferences, and will
collaborate with the investment committee to manage and co ntinuously
evaluate your portfolio to help ensure you stay on track towards your
goals. You can rely on your wealth advisor to actively recommend
adjustments to your financial strategy if economic conditions or conditions
in your day -to-day living change b ecause they invest some time in getting
to know you and acting as your own supporter and guide. Exchange
warnings will be sent to you if there is movement in your portfolio.
During the time spent speculation, there are principle 5 venture measure
steps th at assist financial backers with bettering clarify speculation
measure. Steps of venture measure assist financial backers with acquiring
understanding into their monetary circumstances. That gives a superior
comprehension of the monetary objectives to the financial backers.
The various steps in the speculation measurement process aid the customer
in learning more about the venture cycle as well as the actual operation of
the speculation interaction. Financial backers should give the requirement
of the mean s in speculation measure their utmost consideration before
really contributing, as the venture cycle steps lead in an issue -free manner
to a better arrangement, and in actually contributing with the aid of
speculation measure steps.
Here are the following steps involved in investment process that help
explain the process of investment:
1. Assess Your Current Financial Situation
2. Define Your Investment Objectives
3. Allocate Your Assets
4. Select an Investment Process Strategy
5. Monitor and Manage Investment Process
Step 1. Assess your Current Financial Situation
The first stage is to design in order to clarify the hypothetical interaction.
The first step in planning is determining your current financial situation.
You must keep your project goals at the forefront of you r mind while
keeping an eye on the supporting factors, including your assets, liabilities, munotes.in
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105 and, most importantly, your appetite for risk. You (and your
representative) will be better able to choose the appropriate techniques
and investment strategies if y ou make the effort to thoroughly review all
of the venture decision interaction processes.
Understanding is a crucial component of contributing, making this one of
the key phases of venture measurement. If financial backers are fully
aware of their financ ial situation and are able to afford high -risk areas,
different stages of the speculation cycle may be beneficial to them.
Here is a helpful speculative measure guide for each stage of your life to
help you plan the amount you should set aside for the year s to come.
Stage 2. Characterize your Investment Objectives
After studying the three elements mentioned above, you now need to
create a detailed risk bring profile back. You must choose the level of risk
you're ready to accept and the variations in gain you can tolerate because
the market is unstable. Remember the reliable rule: the greater the return,
the greater the risk.
This does not, however, mean that you should stake everything and put all
of your eggs in one basket. Making a system that can provid e you with a
good amount of profits at an acceptable level of risk is the path to a
successful venture.
One of the key steps in venture measurement is defining your investment
targets. The venture measurement tools help the financial backers go in the
right direction. Examining your financial situation was perhaps one of the
most important steps in the speculative procedure. Knowing where you
stand financially helps you become aware of what your financial goals
should be.
With the help of the processes in t he venture choosing cycle, you should
then set the benchmarks to monitor how your speculation is performing.
Along with showing you a picture of the exhibition, it will also enable you
to easily make changes as needed.
Stage 3. Distribute your Assets
As a first -time buyer or a long -term investor, you should keep in mind that
real estate is a time -consuming investment that can be difficult to
liquidate. This means that switching to trading in the present is really
tough, and if you try to sell quickly, it usually means taking a hit on the
price. However, the property offers a steady return because you will
receive the month -to-month lease each month. Before investing in real
estate, speak with a home financing specialist.
As a young specialist, you may be b etter equipped to handle difficulties
and distribute more resources. But given that people are getting closer to
retirement, it's normal. that they'll cash out a specific sum since their
danger resilience is lower. munotes.in
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106 Stage 4. Select an Investment Process St rategy
Whenever you've assigned your resources, you'll need to settle on how
you'll develop your cash. Basically, you have two kinds of portfolio
techniques to browse.
Passive -Passive portfolio the executives is a technique wherein the
financial backer's motivation is to reflect a market's file. It's a receptive
technique that permits the financial backer to procure restores
equivalent to the portion of the market.
Active -Active portfolio the board involves more danger since the
financial backer's motiva tion is to beat the market. Since this procedure
requires consistent tweaking, one's finished concentration and
consideration are required.
In case you're considering which type is better, the appropriate response
relies upon the resource classes you've c hosen and the impact of the
monetary areas included. To more deeply study their key contrasts,
investigate this aide.
Stage 5. Screen and Manage Investment Process
This is the remaining method used to interact with venture choice. Since
your processes ha ve been carried out, this is an excellent time to examine
and address your suppositions. You must observe your portfolio's
presentation at regular intervals to see how well it is doing. The
benchmarks you've set, whether they're quarterly or annual, will l et you
know if you're still on track to meet your goals.
Since changes in your day to day existence and the economy will happen
after some time, it's important to change your methodologies, too. On the
off chance that your venture interaction isn't in acco rdance with your
danger reward profile, you can re -balance it by selling speculations that
have arrived at their objectives and purchasing speculations that have an
exceptional yield potential.
Venture measure steps are the venturing stones of insightful speculation.
Speculation measure steps help financial backers so as to not wind up
being misinformed by others and are effective in making hazardous
ventures carefully.
Investment Alternatives
India currently has access to a variety of venture highways. Fo llowing
consideration of the advantages and drawbacks of several roads, a
financial backer would be in a position to select the optimal route on his
own. Indeed, financial backers can get guidance in choosing the right
investment roads from financial annou ncements, paper supplements on
financial topics, and speculation diaries.
Investment roads are the power source of assets. A confusing scope of
venture choices are accessible, they fall into two general classes, viz, munotes.in
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107 monetary resources and genuine resourc es. Monetary resources are paper
(or electronic) guarantee on certain issues like the public authority or a
corporate body. The significant monetary resources are value shares,
corporate debentures, government protections, and store with banks, mail
centre plans, common asset shares, protection strategies, and subordinate
instruments. Genuine resources are addressed by substantial resources like
private house, business property, horticultural ranch, gold, valuable stones,
and workmanship object. As the econ omy propels, the general
significance of monetary resources will in general increment. Obviously,
overall the two types of ventures are corresponding and not cutthroat.
Financial backers are free to select any one of at least one elective roads
according to their needs. Security, liquidity, and a reasonable return on
their contributed assets are priorities for all types of financial backers.
Along with new developments in the financial industry, India's choices for
speculation are constantly growing.
Curre ntly, speculation is possible on corporate safeguards, public
advantageous assets, common assets, and so on. As a result, investors
currently have access to a wide range of venture roadways. However, the
financial backers should exercise extreme caution wh ile spending their
well-deserved funds. A financial backer can choose the best road
subsequent to considering the benefits and negative marks of the
accompanying venture choices:
Shares
Debentures and Bonds
Public Deposits
Bank Deposits
Post Office Savings
Public Provident Fund (PPF)
Money Market Instruments
Mutual Fund Schemes
Life Insurance Schemes
Real Estates
Gold -Silver
Derivative Instruments
Commodity Market (commodities)
Financial supporters need to be familiar with the features and benefits of
vario us speculative options in order to make wise investments. These are
the several endeavour paths where lone financial backers can stash their
hard-earned money.
An essential component of abundant amplification is investment. As we
have previously seen and e xplored, the fundamental rule of investment is munotes.in
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108 that speculation can take place anywhere there is a requirement for
reserves or another type of interest. Before pursuing enterprise choices,
one should consider the risk/reward balance. Nowadays, business has
become much more challenging.
Customarily, individuals accepted that putting resources into higher -
hazard venture like stocks and bonds would prompt higher prizes over the
long run. Be that as it may, today one needs to confirm every one of the
terms and condition applied in market. Financial backer likewise needs to
check if the choices are fitting. Elective speculation assists with acquiring
benefit regardless of whether market is unpredictable. Speculation elective
has led to the new idea called the br oadening of asset. The following
inquiry which comes in the brain of financial backer is the place where
and how to broaden the assets. Indeed, even monetary ads, paper
supplement, magazines on monetary issue and venture diary offer
direction to the financ ial backer to choose appropriate speculation options.
Venture roads are the power source of assets. Decisions of appropriate
speculation options should be possible by getting return and hazard
profile. Wide scope of speculation choices are accessible now -a-days.
They are available in two general classes, viz. monetary resources and
genuine resources.
Verifiably, options were only available to institutional and high total asset
financial supporters due to restrictions on admission, insufficient liquidity,
and a lack of transparency, among other segmentation barriers. Though
options have been more widely recognised, they have also become more
widely available, more fluid, and more simple. Financial backers can
gradually obtain access to options through shared assets and trade in
traded assets based on their wants and requirements for the speculative
options that are selected. All types of financial backers are equally
interested in the health, safety, and productivity of the assets they have
given. With ongoin g advancements in the financial industry and growing
innovation, speculating alternatives are currently steadily growing.
Anyway the financial backers ought to be cautious about their well -
deserved cash. Financial backers should check the speculation choic es by
utilizing following inquiries:
Are you as expanded as you ought to be?
Do you have sufficient venture that is probably going to go up when
financial backers' speculation is down?
Do you truly need to enhance the asset? Why?
Other than this, is th ere any most ideal approach to differentiate the
assets?
This will serve to at last expand financial backer's certainty to contribute
and chance will lessen. Benefits and bad marks of all venture choices will
be dissected with the assistance of above ques tion and best choices will be
chosen thinking about all the danger factors. The significant outside munotes.in
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109 wellspring of capital is public investment funds, which can be acquired as
offer capital, debenture, credit capital and public store.
11.5 PORTFOLIO PERFO RMANCE MEASUREMENT
Single Index Model
For the sake of simplicity, Sharpe believed that a security's return could be
viewed as being linearly connected to a single index, such as the market
index. The market index should, in theory, include all of the securit ies that
are traded on the market. A popular average, however, can be used as a
stand -in for the market index.
The idea of a market between individual securities has gained acceptance
since any changes in securities might be linked to changes in the one
underlying element that the market index measures. The Market Model or
Single Index Model is the name given to the Markowitz Model's
simplification (SIM).
In an attempt to capture the relative contribution of each stock towards
portfolio risk, William Sharpe has developed a simple but elegant model
called as ‘Market Model’. His argument is like this.
We recognise that, to a certain extent, the portfolio risk decreases as the
number of stocks rises. Systematic risk is that portion of risk that cannot
be furth er lowered even when we add a few more equities to a portfolio.
This irreducible risk is related to the influence of systematically operating
elements, mostly at a certain market. All traded securities in a market are
included in a portfolio, which lowers risk to the extent of market impacts.
In such a scenario, comparing a stock's returns to those of the market
index makes it simple to quantify each stock's contribution to portfolio
risk. We can predict that a connection like this one will reveal the
provi ded scrip's market sensitivity. With a straightforward regression
equation, William Sharpe calculated the exact relationship between returns
on individual stocks and returns on Market Indices, such as the SENSEX,
ET Index, NSE Index, or RBI Index.
Where
Beta Predicting: Beta, as commonly defined, represents how sensitive the
return of an equity portfolio (or security) is to the return of the overall
market. It can be measured by regressing the historical returns of a munotes.in
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110 portfolio (or security) against the h istorical returns of an index; the
resulting slope of this regression line would be the historical beta. This can
be useful for attributing relative performance to various sources or for
explaining active risk over a certain period of time.
Portfolio manag ers are also very interested in what the beta of a portfolio
(or security) will be in the future, or what the realized beta will be. As one
might expect, predicting the value of beta can be a complicated process.
Historical betas were not particularly goo d predictors of realised betas in
the past when returns were normally available no more frequently than
monthly; reaching statistical significance typically required using returns
from previous periods that were no longer relevant. Barra was a pioneer in
the 1970s when it came to calculating anticipated betas based on
statistically significant historical links between equities returns and other
risk indicators, among other things, using multi -factor equity models. With
the idea that anticipated betas calcul ated in this way would be better
predictors of realised betas than previous betas were, other suppliers
followed this example and created their own multi -factor models.
11.6 SUMMARY
Portfolio management is a basic part of contributing. Every portfolio
the board system has an extraordinary arrangement of benefits and
disservices that should be weighed prior to choosing which way to deal
with seek after.
There can be as various kinds of portfolios and portfolio systems as
there are financial backers and cash supervisors. You additionally may
decide to have numerous portfolios, whose substance could mirror an
alternate system or venture situation, organized for an alternate need.
The objective of Portfolio management is to amplify the profits of
the whole por tfolio; not simply the profits from a couple of stocks in the
portfolio. By observing and dealing with your venture portfolio, you can
construct an enormous corpus to meet different monetary objectives
including making a retirement reserve. Yet, for that, it is important to
begin contributing as right on time as could be expected. This would give
you quite a while period to amplify your profits.
The risk management interaction is a component of the structure,
and is gotten from the danger the executive’s s trategy, which it
operationalises. The danger the board cycle is an orderly use of the
executive’s arrangements, systems and practices to the undertakings of
imparting, setting up the setting of, evaluating, checking and auditing
hazards.
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111 11.7 UNIT END QUESTIONS
A. Descriptive Questions
1. Discuss The Dow Theory .
2. Explain the process of Process of Optimal Portfolio .
3. What are the two Types of Portfolio Strategy?
4. Discuss Single Index Model
5. What are the steps involved in investment process that help explain the
process of investment?
B. Fill in the Blanks
1. ………………. can best be viewed as an integrated process to which
security analysis makes its unique contribution.
2. The ……………. is one of th e oldest and most famous technical tools.
3. The Dow Theory was developed by ………..
4. The Elliott Wave theory was developed by ………………in the 1930s.
Answers
1-Investment decision -making 2 -Dow Theory, 3 -W.P. Hamilton, 4 -Ralph
Nelson Elliott
11.8 REFERENCES
References book
Derivatives Market NCFM Module. National Stock Exchange India
Limited Publications:Bombay:2007.
Gupta S.L (2007). Financial Derivatives Prentice Hall. New Delhi.
Indian Stock Market Review. National Stock Exchange Publications.
Jaynath Rama Varma (2008). Derivatives and Risk Management .
Tata McGraw Hill Publications:New Delhi.
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