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ANNAMALAI UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION

Master of Business Administration (M.B.A.)

M.B.A. Financial Management
Second Year

Investment, Security and Portfolio Management

LESSONS: 1 – 24

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(For Private Circulation Only)
 MASTER OF BUSINESS ADMINISTRATION (M.B.A.)
M.B.A. FINANCIAL MANAGEMENT
Second Year
Investment, Security and Portfolio Management
Editorial Board

MEMBERS
Prof. Dr. E. Selvarajan
Dean
Faculty of Arts
Annamalai University
Annamalainagar
Dr. C. Samudhararajakumar Dr. C. Madhavi
Professor & Head Professor & Co-ordinator,
Dept. of Business Administration Management Wing
Annamalai University D.D.E., Annamalai University
Annamalainagar Annamalainagar
Internals
Dr. S. Arulkumar Dr. V. Sachithanantham
Assistant Professor & Dy. Co-ordinator Associate Professor
Management Wing Dept. of Business Administration
D.D.E., Annamalai University D.D.E., Annamalai University
Annamalainagar Annamalainagar
Externals
Dr. R. Thenmozhi Dr. P. Vikraman
Professor & Head Associate Professor
Dept. of Management Studies Dept. of Business Administration
University of Madras Anna University
Chennai Coimbatore

Lesson Writer
Dr. D. Senthil
Asst. Professor
Department of Business Administration
Annamalai University
Annamalainagar
 i

MASTER OF BUSINESS ADMINISTRATION (M.B.A.)

M.B.A. FINANCIAL MANAGEMENT
Second Year

INVESTMENT, SECURITY AND PORTFOLIO MANAGEMENT

SYLLABUS
Objective
The major objective of this course is to help students to learn the various
aspects of investment, security analysis, Portfolio evolution and portfolio
management.
Unit–I
Investment – Objectives Characteristics – Concepts – Increasing Popularity of
Investment – Features – Risk Of Investment – Success In Investment – Return On
Investment. Investment Vs Speculation – Gambling - Selection Of Securities –
Formulation Of Investment Strategy – Risk And Return – Meaning – Elements –
Systematic Risk and Unsystematic Risk – Measurement of Risk – Security
Investment Vs Non-Security Investment – Forms of Investment – Investment
Environment In India - Investment Process – Sources of Investment Information.
Unit–II
Stock Markets In India – Introduction Nature- Functions of Stock Exchange –
Organizational Structure of The Secondary Market - Book Building Process – Online
Trading, Dematerialization- Depositary Services – Market Membership – Regulatory
Frame Work – Stock Market And Financial Development In India - OTCEI- NSE -
Market Index – SENSEX, NIFTY. -New Issue Market – Listing of Securities – Types
of Transactions In A Stock Exchange – Mechanics of Share Trading – Execution of
Orders-Stock market Indexes-Security Credit-Rating.
Unit–III
Security Analysis – Fundamental Analysis – Industry And Company Analysis,
Technical Analysis – Concepts, Tools and Techniques of Analysis – Technical Analysis
Vs Trends Indicators, Indices and Moving Averages Applied in Technical Analysis.
Fundamental Analysis – Efficient Market Hypothesis – Concept And Forms of Market
Efficiency – Random Walk Theory – Assumption Of Random Walk Theory.
Unit–IV
Portfolio Analysis And Management – Elements of Portfolio Management –
Portfolio Models – Efficient Frontier and Selection of Optimal Portfolio – Markowitz
Model-Sharpe Single Index Model and Capital Asset Pricing Model - Arbitrage
Pricing Theory.
Unit–V
Performance Evaluation of Portfolios – Sharpe Model – Teryner’s Model for
Portfolio Evaluation – Evaluation of Mutual Funds – Portfolio Investment Process –
Bond Portfolio Management Strategies – Investment Timing and Portfolio
Performance Evaluation- Portfolio Management Strategies.
 ii

Unit–VI
Bond Valuation And Analysis Types of Bonds – Interest Rate Term - Structure
of Interest Rates – Measuring Bond Yields – Yield of Maturity –– Holding Period
Section – Bond Pricing Term – Bond Duration – Active And Positive Bond
Management Strategies - Bond Immunization Bond Volalitity - Bond Covering.
Preference Share Valuation And Analysis – Equity Shares – Equity Valuation And
Analysis - Financial Sector Reforms Related To Stock Market - Recent Development
In Capital Market.
Reference Books
1) Kevina S, Security Analysis and Portfolio Management, Prentice Hall India, 2008.
2) Donald E. Fisher and Donald J. Jordan, Security Analysis and Portfolio
Management, 6th Edition, Pearson Education, 1995.
3) Prasanachandra; Investment Analysis and portfolio management; Tata McGraw
Hill, 2009.
4) Preeti Singh, Security Analysis and Portfolio Management, Himalaya Publishing
Housing, 2000.
5) Punithavathy Pandian, Security Analysis and Portfolio Management, Vikas
Publishing House, 2009.
6) Yogesh Maheshwari, Investment Management, Prentice Hall India, New Delhi, 2008.
7) Alexander, Gorden J. and Sharp William F., Fundamentals of Investment
Management, Prentice Hall India, New Delhi, 2002.
8) Kevin S, Security Analysis And Portfolio Management, PHI, 2008.
9) Dhanesh Kumar Khatri, Security Analysis and Portfolio Management Macmillan,
2010.
Journals and Magazines
1) Journal for Portfolio Management
2) Financial Analysts Journal
3) International Journal of Portfolio Analysis and Management
4) Journal of Investment Management
5) Dalal Street Investment Journal
Web Resources
1) http://www.portfoliomanagement.in/benefits-of-portfolio-management.html
2) http://www.portfoliomanagement.in/
3) http://www.investorwords.com/2122/fundamental_analysis.html
4) http://www.investorwords.com/18930/Securities_and_Exchange_Board_of_Ind
ia_SEBI.html
5) www.equitymaster.com
6) www.moneycontrol.com
7) www.amfinding.com
8) www.pmi.org
 iii

MASTER OF BUSINESS ADMINISTRATION (M.B.A.)

M.B.A. FINANCIAL MANAGEMENT
Second Year
Investment, Security and Portfolio Management
CONTENT
Lesson Page
No.
Title
No.
1. Investment 1
2. Risk and Return 10
3. Investment Strategy 17
4. Investment Alternatives 24
5. Stock Market in India 37
6. New Issue Market 49
7. Listing of security 53
8. Stock Market Index and Credit Rate Agencies 64
9. Fundamental Analysis-I 70
10. Fundamental Analysis-II 77
11. Technical Analysis 85
12. Efficient Market Theory 100
13. Portfolio Management 111
14. Modern portfolio theory 116
15. Markowitz Portfolio Selection Model 123
16. Capital asset pricing model 129
17. Performance Evaluation of Portfolio 138
18. Mutual Funds 142
19. Investment Timing and Portfolio Performance Evaluation 147
20. Portfolio Management Strategies 152
21 Bonds and its Valuation 155
22 Preference Shares and its Valuation 170
23 Equity Shares and its Valuation 174
24 Recent Developments and Reforms in Capital Market 181
 LESSON 1

INVESTMENT
INTRODUCTION
In the financial industry, there are two concepts that form the basis of most
transactional activities. One is savings and the other is investments. There is a
huge overlap between the two concepts though, it terms of execution. Investment in
terms of financial context, means any money that is spent today in the hope of
financial benefits that may be reaped in a future time frame. Any investment is the
act of buying or creating assets with an expectation that the same would yield
interest earnings or dividend or capital appreciation or any other return that is
profitable as compared to the money put in initially. Almost all investments are
differentiated from other kinds of transactions based on the aim of the money
spent. Money spent on making investments is primarily with the aim of obtaining
some sort of return in a specific period of time.
A lot of times people confuse savings with investments. Savings and
investment are different from each other in their approach of utilizing the money
involved. While saving may be understood as a passive way of accumulating wealth,
investment can be seen as a more aggressive way of securing returns. Mostly,
under savings, customers avail a savings account and stash away cash in that
account. This cash can be used as and when required by the account holder.
OBJECTIVES
After reading this lesson the student should be able to understand Concepts
of Investment, Basic Investment Objectives, Characteristics of Investment, Success
in investment, Gambling, Difference between Speculation and Investment,
CONTENT
1.1 Meaning of investment
1.2 Concepts of Investment
1.3 Basic Investment Objectives
1.4 Characteristics of Investment
1.5 Increasing popularity of investments can be attributed to the following factors
1.6 Success in investment
1.7 Gambling
1.8 Difference between Speculation and Investment
1.9 Definition of 'Non-Security' and Security
1.1 MEANING OF INVESTMENT
Investment is an activity that is engaged in by people who have savings, i.e.
investments are made from savings, or in other words, people invest their savings.
But all savers are not investor’s .investment is an activity which is different from
saving. Let us see what is meant by investment.
 2

It may mean many things to many persons. If one person has advanced some
money to another, he may consider his loan as an investment. He expect to get
back the money along with interest at a future date .another person may have
purchased on kilogram of gold for the purpose of price appreciation and may
consider it as an investment.
In all these cases it can be seen that investment involves employment of funds
with the main aim of achieving additional income or growth in the values. The
essential quality of an investment is that it involves something for reward.
Investment involves the commitment of resources which have been saved in the
hope that some benefits will accrue in future.
Thus investment may be defined as “a commitment of funds made in the
expectation of some positive rate of return “since the return is expected to realize in
future, there is a possibility that the return actually realized is lower than the
return expected to be realized. This possibility of variation in the actual return is
known as investment risk. Thus every investment involves return and risk.
F. Amling defines investment as “purchase of financial assets that produces a
yield that is proportionate to the risk assumed over some future investment period.”
According to sharpe, ”investment is sacrifice of certain present value for some
uncertain future values”.
The financial and economic meanings are related to each other because the
savings of the individual flow into the capital market as financial investments, to be
used in economic investment. Even though they are related to each other, we are
concerned only about the financial investment made on securities.
Thus, investment may be defined as “a commitment of funds made in the
expectation of some positive rate of return”. Expectation of return is an essential
element of investment.
Since the return is expected to be realized in future, there is a possibility that
the return actually realized is lower than the return expected to be realized. This
possibility of variation in the actual return is known as investment risk. Thus, every
investment involves return and risk.
Financial investment involves of funds in various assets, such as stock, Bond,
Real Estate, Mortgages etc. Investment is the employment of funds with the aim of
achieving additional income or growth in value. It involves the commitment of
resources which have been saved or put away from current consumption in the
hope some benefits will accrue in future. Investment involves long term
commitment of funds and waiting for a reward in the future.
From the point of view people who invest their finds, they are the supplier of
Capital and in their view investment is a commitment of a person s funds to derive
future income in the form of interest, dividend, rent, premiums, pension benefits or
the appreciation of the value of their principle capital.
To the financial investor it is not important whether money is invested for a
productive use or for the purchase of second hand instruments such as existing
 3

shares and stocks listed on the stock exchange. Most investments are considered to
be transfers of financial assets from one person to another.
1.2 CONCEPTS OF INVESTMENT
Basic Investment Concepts
The word investment can be defined in many ways according to different
theories and principles. It is a term that can be used in a number of contexts.
However, the different meanings of “investment” are more alike than dissimilar.
Generally, investment is the application of money or other assets in the hope
that in the future it would appreciate or generate more income.
According to economics, investment is the utilization of resources in order to
increase income or production output in the future. An amount deposited into a
bank or machinery that is purchased in anticipation of earning income in the long
run are both examples of investments.
1.3 BASIC INVESTMENT OBJECTIVES
Any investment decision will be influenced by three objectives security,
liquidity and yield. A best investment decision will be one, which has the best
possible compromise between these three objectives.
Security
Central to any investment objective, we have to basically ensure the safety of the
principal. One can afford to lose the returns at any given point of time but s/he can
ill afford to lose the very principal itself. By identifying the importance of security, we
will be able to identify and select the instrument that meets this criterion. For
example, when compared with corporate bonds, we can vouch safe the safety of
return of investment in treasury bonds as we have more faith in governments than in
corporations. Hence, treasury bonds are highly secured instruments. The safest
investments are usually found in the money market and include such securities as
Treasury bills (T-bills), certificates of deposit (CD), commercial paper or bankers'
acceptance slips; or in the fixed income (bond) market in the form of municipal and
other government bonds, and in corporate bonds
Liquidity
Because we may have to convert our investment back to cash or funds to meet
our unexpected demands and needs, our investment should be highly liquid. They
should be en cashable at short notice, without loss and without any difficulty. If
they cannot come to our rescue, we may have to borrow or raise funds externally at
high cost and at unfavorable terms and conditions. Such liquidity can be possible
only in the case of investment, which has always-ready market and willing buyers
and sellers. Such instruments of investment are called highly liquid investment.
Return
Return refers to expected rate of return from an investment Return is an
important characteristics of investment. Return is the major factor which
influences the pattern of investment that is made by the investor. Investor always
prefers to high rate of return for his investment.
 4

1.4 CHARACTERISTICS OF INVESTMENT

The characteristics of investment can be understood in terms of as
- return,
- risk,
- safety,
- liquidity etc.
Return: All investments are characterized by the expectation of a return. In
fact, investments are made with the primary objective of deriving return. The
expectation of a return may be from income (yield) as well as through capital
appreciation. Capital appreciation is the difference between the sale price and the
purchase price. The expectation of return from an investment depends upon the
nature of investment, maturity period, market demand and so on.
Risk: Risk is inherent in any investment. Risk may relate to loss of capital,
delay in repayment of capital, nonpayment of return or variability of returns. The
risk of an investment is determined by the investments, maturity period, repayment
capacity, nature of return commitment and so on. Risk and expected return of an
investment are related. Theoretically, the higher the risk, higher is the expected
returned. The higher return is a compensation expected by investors for their
willingness to bear the higher risk.
Safety: Safety refers to the protection of investor principal amount and expected
rate of return. Safety is also one of the essential and crucial elements of investment.
Investor prefers safety about his capital. Capital is the certainty of return without
loss of money or it will take time to retain it. If investor prefers less risk securities, he
chooses Government bonds. In the case, investor prefers high rate of return investor
will choose private Securities and Safety of these securities is low.
Liquidity: Liquidity refers to an investment ready to convert into cash
position. In other words, it is available immediately in cash form. Liquidity means
that investment is easily realisable, saleable or marketable. When the liquidity is
high, then the return may be low. For example, UTI units.
An investor generally prefers liquidity for his investments, safety of funds
through a minimum risk and maximisation of return from an investment.
1.5 INCREASING POPULARITY OF INVESTMENTS CAN BE ATTRIBUTED TO THE
FOLLOWING FACTORS
1. Increase in working population, larger family incomes and/consequent
higher savings;
2. Provision of tax incentives in respect of investments in specified channels;
3. Increase in tendency of people to hedge against inflation;
4. Availability of large and attractive investment alternatives;
5. Increase in investment related publicity;
6. Ability of investments to provide income and capital gains, etc.
 5

1.6 SUCCESS IN INVESTMENT

1 Invest for Maximum Total Real Return
This means the return on invested rupee after taxes and after inflation. This is
the only rational objective for most long-term investors. Any investment strategy
that fails to recognize the insidious effect of taxes and inflation fails to recognize the
true nature of the investment environment and thus is severely handicapped.
2 Invest—Don’t Trade or Speculate
The stock market is not a casino, but if investors move in and out of stocks
every time they move a point or two, or if investors continually sell short… or deal
only in options…or trade in futures… And, like most gamblers, investors may lose
eventually—or frequently.
3 Remain Flexible and Open-Minded about types of Investment
There are times to buy blue chip stocks, cyclical stocks, corporate bonds,
Treasury instruments, and so on. And there are times to sit on cash, because
sometimes cash enables you to take advantage of investment opportunities. The
fact is there is no one kind of investment that is always best. If a particular
industry or type of security becomes popular with investors, that popularity will
always prove temporary and—when lost—may not return for many years.
4 Buy Low
Of course, you say, that’s obvious. Well, it may be, but that isn’t the way the
market works. When prices are high, a lot of investors are buying a lot of stocks.
Prices are low when demand is low. Investors have pulled back, people are
discouraged and pessimistic.
5 When Buying Stocks, Search for Bargains among Quality Stocks
Quality is a company strongly entrenched as the sales leader in a growing market.
Quality is a company that’s the technological leader in a field that depends on
technical innovation. Quality is a strong management team with a proven track record.
Quality is a well-capitalized company that is among the first into a new market. Quality
is a wellknown trusted brand for a high-profit-margin consumer product.
6 Diversify. in Stocks and Bonds, as in much else, there is Safety in numbers
No matter how careful you are, you can neither predict nor control the future.
A hurricane or earthquake, a strike at a supplier, an unexpected technological
advance by a competitor, or a government-ordered product recall—any one of these
can cost a company millions of dollars. Then, too, what looked like such a well-
managed company may turn out to have serious internal problems that weren’t
apparent when you bought the stock.
7 Aggressively Monitor your Investments
Expect and react to change. No bull market is permanent. No bear market is
permanent. And there are no stocks that you can buy and forget. The pace of change
is too great. Being relaxed, as Hooper advised, doesn’t mean being complacent.
 6

8 Learn from mistakes

The only way to avoid mistakes is not to invest—which is the biggest mistake
of all. So forgive yourself for your errors. Don’t become discouraged, and certainly
don’t try to recoup your losses by taking bigger risks. Instead, turn each mistake
into a learning experience. Determine exactly what went wrong and how you can
avoid the same mistake in the future.
9 Outperforming the Market is a difficult task
The challenge is not simply making better investment decisions than the
average investor. The real challenge is making investment decisions that are better
than those of the professionals who manage the big institutions. So any investment
company that consistently outperforms the market is actually doing a much better
job than you might think. And if it not only consistently outperforms the market,
but does so by a significant degree, it is doing a superb job.
1.7 GAMBLING
According to the Oxford dictionary, gambling means:“Taken risk in the hope of a
favourable outcome.” Gambling most often refers specifically to the wagering of
money on games of chance or more broadly to engaging in high risk behaviour.
Gambling refers to an act of involving an element of risk. A gambling involves taking
on risk without demanding compensation in the form of increased expected return.
Typical examples of gambling are horse races, card games, lotteries, etc.
Gambling consists in taking high risks not only for high returns, but also for thrill
and excitement. Gambling is unplanned and non scientific, without knowledge of
the nature of the risk involved. It is surrounded by uncertainty and is based on tips
and rumors. In gambling artificial and unnecessary risks are created for increasing
the returns.
1. The activity or practice of playing at a game of chance for money or other stakes.
2. The act or practice of risking the loss of something important by taking a chance
or acting recklessly:
1. It is based on chance of events happening.
2. It is an illegal activity.
3. It has no benefits to offer to the economy.
4. Gamblers bear the risk of loss on the basis of blind and reckless expectation.
1.8 DIFFERENCE BETWEEN SPECULATION AND INVESTMENT
Basis Speculation Investment
Meaning A message expressing The investing of money
anopinion based on
incomplete evidence
Types of contract Speculator is a owner of Investor is a creditor of the
the speculation Investment
 7

Length commitment In the case speculation In the case of investment the

the length of length of commitment is a long
commitment is a short term
term only
Source of Income The source of income is The source of income is
fluctuated and changes earning from the enterprise
in market price
Quantity of Risk Quantity of risk is the Quantity of risk is the low
high
Stability of Income Income is uncertain and Income is very stable
erratic
Psychological attitude of Speculator psychological Investor psychological attitude
Participants attitude is a daring and is a cautious and conservative
careless
Reasons for Purchase It is unscientific analysis It is scientific analysis of
of intrinsic worth intrinsic worth
1.9 DEFINITION OF 'NON-SECURITY' AND ‘SECURITY’
A type of investment that is not as freely marketable or transferable as a
security. Unlike a security, a non-security does not require the backing of an
underwriter or bank, and involves much less documentation and paperwork. This
lack of underwriting reduces the vehicle's liquidity and makes exchanging it
between parties more difficult. Non-security investments could still hold value, but
will not be quoted on any stock exchange or organized financial market.
A security is an instrument representing a freely transferable and salable
investment, which includes the risk of loss in value. Securities include assets such
as stocks, mutual funds, government bonds and debentures. Non-securities include
assets such as art, rare coins, baseball cards, life insurance, physical gold,
diamonds and bank guarantees. Individual Retirement Accounts (IRAs) restrict
some investments with this classification
A good or instrument that is not traded in a qualifying market (e.g. Boston
Stock Exchange) and is not easily marketable; i.e. it is not freely bought or sold as a
security. It has a value, but it may be not quickly converted into cash in a short
period of time and does not necessarily carry the backing of an underwriter or
bank.
Examples of securities are stocks, bonds and Treasury notes. Non-securities
include paintings, precious metals and stones like gold or diamonds, and bank
guarantees.
Non-Security form of Investment or non-marketable securities whose
ownership is not transferable. The examples can be:
1. National Savings Schemes
2. National Savings Certificate
 8

3. Provident funds
4. Corporate Fixed deposits
5. Life Insurance Policies
6. Unit Schemes of Unit Trust of India (Some are marketable)
7. Post office savings bank account
8. RBI Relief Bonds
9. Kisan Vikas Patra
10. Chit Funds, Nidhis etc.
REVISION POINTS
Investment: Investment is the employment of funds with the aim of achieving
additional income or growth in value.
Speculation: Speculation involves trading a financial instrument involving
high risk, in expectation of significant returns. The motive is to take maximum
advantage from fluctuations in the market.
Gambling: Gambling is unplanned and non scientific, without knowledge of
the nature of the risk involved.
INTEXT QUESTIONS
1. What is investment? Is investment different from speculation? Explain.
2. State the economic and financial meaning of investment. In the stock market, can
you differentiate the investor from the speculator?
3. Discuss the factors that differentiate the investor from speculator and gambler.
4. What are the investors objectives in investing his funds in the stock market?
SUMMARY
An investment is an asset or item that is purchased with the hope that it will
generate income or will appreciate in the future. In an economic sense, an
investment is the purchase of goods that are not consumed today but are used in
the future to create wealth. In finance, an investment is a monetary asset
purchased with the idea that the asset will provide income in the future or will be
sold at a higher price for a profit.
TERMINAL EXERCISE
1. Capital ____________ is the difference between the sale price and the purchase price.
Ans: Appreciation
 9

SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
1. Explain the primary and subsidiary objectives of investment.
2. “The investment process involves a series of activities starting from the policy
formulation” Discuss.
3. Investment and speculation are somewhat different and yet similar in certain
respect. Explain.
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
1. Collect data about the interest rates of various deposit schemes and suggest a
suitable deposit scheme.
KEY WORDS
Speculation, Gambling, Security, Investment.
 10

LESSON 2

RISK AND RETURN

INTRODUCTION
Investors purchase financial assets such as shares of stock because they
desire to increase their wealth, i.e., earn a positive rate of return on their
investments. The future, however, is uncertain; investors do not know what rate of
return their investments will realize. In finance, we assume that individuals base
their decisions on what they expect to happen and their assessment of how likely it
is that what actually occurs will be close to what they expected to happen. When
evaluating potential investments in financial assets, these two dimensions of the
decision making process are called expected return and risk.
OBJECTIVES
After reading this lesson the student should be able to understand Return,
Return on Investment (ROI), Risk on Investment, Types of Risk, Measurement of
Risk, Definition of Systematic Risk, Definition of Unsystematic Risk.
CONTENT
2.1 Return
2.2 Return on Investment (ROI)
2.3 Risk on Investment
2.4 Types of Risk
2.5 Measurement of Risk
2.6 Definition of Systematic Risk
2.7 Definition of Unsystematic Risk
2.8 Key Differences between Systematic and Unsystematic Risk
2.1 RETURN
Return expresses the amount which an investor actually earned on an
investment during a certain period. Return includes the interest, dividend and
capital gains; while risk represents the uncertainty associated with a particular
task. In financial terms, risk is the chance or probability that a certain investment
may or may not deliver the actual/expected returns. The risk and return trade off
says that the potential return rises with an increase in risk. It is important for an
investor to decide on a balance between the desire for the lowest possible risk and
highest possible return.
2.2 RETURN ON INVESTMENT (ROI)
Return on investment (ROI) measures the gain or loss generated on an
investment relative to the amount of money invested. ROI is usually expressed as a
percentage and is typically Return on investment (ROI)used for personal financial
decisions, to compare a company's profitability or to compare the efficiency of
different investments.
 11

The earning power of assets measured as the ratio of the net income (profit
less depreciation) to the average capital employed (or equity capital) in a company
or project.
Expressed usually as a percentage, return on investment is a measure of
profitability that indicates whether or not a company is using its resources in an
efficient manner. For example, if the long-term return on investment of a company
is lower than its cost-of-capital, then the company will be better off by liquidating
its assets and depositing the proceeds in a bank. Also called rate of return, or yield.
The return on investment formula is:
ROI = (Net Profit / Cost of Investment) x 100
2.3 RISK ON INVESTMENT
Risk in investment exists because of the inability to make perfect or accurate
forecasts. Risk in investment is defined as the variability that is likely to occur in
future cash flows from an investment. The greater variability of these cash flows
indicates greater risk. Variance or standard deviation measures the deviation about
expected cash flows of each of the possible cash flows and is known as the absolute
measure of risk; while co-efficient of variation is a relative measure of risk.
2.4 TYPES OF RISK
Personal Risk This category of risk deals with the personal level of investing.
The investor is likely to have more control over this type of risk compared to others.
Timing risk is the risk of buying the right security at the wrong time. It also
refers to selling the right security at the wrong time. For example, there is the
chance that a few days after you sell a stock it will go up several dollars in value.
There is no surefire way to time the market.
Tenure risk is the risk of losing money while holding onto a security. During
the period of holding, markets may go down, inflation may worsen, or a company
may go bankrupt. There is always the possibility of loss on the company-wide level,
too.
Company Risks are two common risks on the company-wide level. The first,
financial risk is the danger that a corporation will not be able to repay its debts.
This has a great affect on its bonds, which finance the company's assets. The more
assets financed by debts (i.e., bonds and money market instruments), the greater
the risk. Financial risk involves looking at a company's management, its leadership
style, and its credit history.
Management risk is the risk that a company's management may run the
company so poorly that it is unable to grow in value or pay dividends to its
shareholders. This greatly affects the value of its stock and the attractiveness of all
the securities it issues to investors.
Market risk is the risk that the value of a portfolio, either an investment
portfolio or a trading portfolio, will decrease due to the change in value of the
market risk factors. The four standard market risk factors are stock prices, interest
 12

rates, foreign exchange rates, and commodity prices.The price of a stock may
fluctuate widely within a short span of time even though earnings remain
unchanged. The causes of this phenomenon are varied, but it is mainly due to a
change in investors’ attitudes towards equities in general, or toward certain types or
groups of securities in particular. Variability in return on most common stocks that
is due to basic sweeping changes in investor expectations is referred to as market
risk. The reaction of investors to tangible as well as intangible events causes
market risk. Expectations of lower corporate profits in general may cause the larger
body of common stocks to fall in price. Investors are expressing their judgement
that too much is being paid for earnings in the light of anticipated events. The basis
for the reaction is a set of real, tangible events– political, social, or economic..
Purchasing-power risk refers that unexpected changes in consumer prices will
penalize an investor's real return from holding an investment. Because investments
from gold to bonds and stock are priced to include expected inflation rates, it is the
unexpected changes that produce this risk. Fixed income securities, such as bonds
and preferred stock, subject investors to the greatest amount of purchasing power
risk since their payments are set at the time of issue and remain unchanged
regardless of the inflation rate. When an investor buys a bond, he or she essentially
commits to receiving a rate of return, either fixed or variable, for the duration of the
bond or at least as long as it is held. But what happens if the cost of living and
inflation increase dramatically, and at a faster rate than income investment? When
that happens, investors will see their purchasing power erode and may actually
achieve a negative rate of return (again factoring in inflation). Put another way,
suppose that an investor earns a rate of return of 3% on a bond. If inflation grows
to 4% after the purchase of the bond, the investor's true rate of return (because of
the decrease in purchasing power) is -1%.
Liquidity risk is the risk that an investment, when converted to cash, will
experience loss in its value. When you want to sell the stock you are currently
holding, there is nobody there to buy your stock, meaning that there is no volume
in that stock.
Interest rate risk is another source of investment risk. Changes of the interest
rates on the securities is created risk for investors. If the interest rate goes up, the
marketing price of existing fixed income securities falls, and vice versa. This
happens because the buyer of a fixed income security would not buy if its par value
or face value if its fixed interest rate is lower than the prevailing interest rate on a
similar security.
Inflation risk is the danger that the dollars one invests will buy less in the
future because prices of consumer goods rise. When the rate of inflation rises,
investments have less purchasing power. This is especially true with investments
that earn fixed rates of return. As long as they are held at constant rates, they are
threatened by inflation. Inflation risk is tied to interest rate risk, because interest
 13

rates often rise to compensate for inflation. Return of investment (ROI) is less than
the market inflation rate.
Reinvestment risk is the danger that reinvested money will fetch returns lower
than those earned before reinvestment. Individuals with dividend-reinvestment
plans are a group subject to this risk. Bondholders are another.
National and International Risks refers to national and world events that can
profoundly affect investment markets. Economic risk is the danger that the
economy as a whole will perform poorly. When the whole economy experiences a
downturn, it affects stock prices, the job market, and the prices of consumer
products.
Industry risk is the chance that a specific industry will perform poorly. When
problems plague one industry, they affect the individual businesses involved as well
as the securities issued by those businesses. They may also cross over into other
industries. For example, after a national downturn in auto sales, the steel industry
may suffer financially.
Tax risk is the danger that rising taxes will make investing less attractive. In
general, nations with relatively low tax rates, such as the United States, are popular
places for entrepreneurial activities. Businesses that are taxed heavily have less
money available for research, expansion, and even dividend payments. Taxes are
also levied on capital gains, dividends and interest.
Political risk is the danger that government legislation will have an adverse
affect on investment. This can be in the form of high taxes, prohibitive licensing, or
the appointment of individuals whose policies interfere with investment growth.
Political risks include wars,changes in government leadership, and politically
motivated embargoes.
2.5 MEASUREMENT OF RISK
Understanding the nature and types of risk is not adequate unless the investor
or analyst is capable of measuring it in some quantitative terms. The quantitative
expression of the risk of a stock would make it comparable with other stocks.
However, the risk measurements cannot be considered fully accurate as it is caused
by multiplicity of factors such as social, political, economic and managerial aspects.
Risk is measured by the variability of returns. The statistical tool often used to
measure risk is the standard deviation. We know, standard deviation is a measure
of the values of the variables around its mean or it is the square root of the sum of
the squared deviations from the mean divided by the number of observations.
2.6 DEFINITION OF SYSTEMATIC RISK
By the term ‘systematic risk’, we mean the variation in the returns on
securities, arising due to macroeconomic factors of business such as social,
political or economic factors. Such fluctuations are related to the changes in the
return of the entire market. Systematic risk is caused by the changes in
government policy, the act of nature such as natural disaster, changes in the
 14

nation’s economy, international economic components, etc. The risk may result in
the fall of the value of investments over a period. It is divided into three categories,
that are explained as under:
 Interest risk: Risk caused by the fluctuation in the rate or interest from time to
time and affects interest-bearing securities like bonds and debentures.
 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.
 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.
2.7 DEFINITION OF UNSYSTEMATIC RISK
The risk arising due to the fluctuations in returns of a company’s security due
to the micro-economic factors, i.e. factors existing in the organization, is known as
unsystematic risk. The factors that cause such risk relates to a particular security
of a company or industry so influences a particular organization only. The risk can
be avoided by the organization if necessary actions are taken in this regard. It has
been divided into two category business risk and financial risk, explained as under:
 Business risk: Risk inherent to the securities, is the company may or may not
perform well. The risk when a company performs below average is known as a
business risk. There are some factors that cause business risks like changes in
government policies, the rise in competition, change in consumer taste and
preferences, development of substitute products, technological changes, etc.
 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 is the expression of such risk.
2.8 KEY DIFFERENCES BETWEEN SYSTEMATIC AND UNSYSTEMATIC RISK
The basic differences between systematic and unsystematic risk is provided in
the following points:
1. Systematic risk means the possibility of loss associated with the whole market
or market segment. Unsystematic risk means risk associated with a particular
industry or security.
2. Systematic risk is uncontrollable whereas the unsystematic risk is controllable.
3. Systematic risk arises due to macroeconomic factors. On the other hand, the
unsystematic risk arises due to the micro-economic factors.
4. Systematic risk affects a large number of securities in the market. Conversely,
unsystematic risk affects securities of a particular company.
5. Systematic risk can be eliminated through several ways like hedging, asset
allocation, As opposed to unsystematic risk that can be eliminated through
portfolio diversification.
 15

6. Systematic risk is divided into three categories, i.e. Interest risk, market risk
and purchasing power risk. Unlike unsystematic risk, which is divided into two
broad category business risk and financial risk.
REVISION POINTS
Return: Return expresses the amount which an investor actually earned on
an investment during a certain period.
Risk: Risk in investment is defined as the variability that is likely to occur in
future cash flows from an investment.
INTEXT QUESTIONS
1. Define risk and distinguish between systematic and unsystematic risk.
2. Discuss the principal sources of systematic and unsystematic risk.
SUMMARY
Investment risk is the possibility you may lose money on your investments or
that your investments may not keep pace with inflation. All investments carry
risk. However, the level of risk varies depending on the type of investment.
Generally, investments considered to carry higher levels of risk are those that have
the potential to deliver you higher investment returns, like growth assets.
Similarly, investments with the potential to deliver you lower investment returns,
like defensive assets, generally carry lower risk levels. Risk can come from a
range of sources depending on the type of investments you hold. For example,
changes in investment markets, economies, and social and political environments,
can affect different investments in different ways and cause them to go up or down
in value. The most common types of risk associated with investing include financial
losses, liquidity and changes to inflation, interest rates or currency prices, as well
as other investment-specific risks.
Investment returns are the amount you may earn or lose on your investment.
The amount is usually expressed as a percentage per year. As risk and return are
fundamentally linked, the greater an investment’s potential to achieve higher
returns, the greater the risk associated with it.
TERMINAL EXERCISES
1. ____________ risk deals with the personal level of investing.
Ans: Personal
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
 16

ASSIGNMENTS
1. Cite recent examples of political, social, or economic events (market risk)
that have excited 1.The stock market, and 2.Stocks in a specific industry,
to surge ahead or plummet sharply.
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Collect information about risk associated investments like equity shares,
commodity trading etc. from the nearest stock brokerage office and list out the
various risks on investment
KEY WORDS
Risk, systematic Risk, unsystematic Risk
 17

LESSON 3

INVESTMENT STRATEGY
INTRODUCTION
Systematic plan to allo cate investable assets among investment choices such
as bonds, certificates of deposit, commodities, real estate, stocks (shares). These
plans take into account factors such as economic trends, inflation, and interest
rates. Other factors include the investor's age, risk tolerance level, and short- or
long-term growth objectives. Corporate investment strategies specify funds required
to achieve a competitive advantage, and the monetary results (profits) expected
from such decisions. The three common corporate investment strategies are (1)
Building, (2) Defending, or (3) Harvesting the firm's market position.
OBJECTIVES
After reading this lesson the student should be able to understand Investment
Strategy, Elements of an Investment Strategy, Formulation of Investment Strategy,
Investment Process.
CONTENT
3.1 Investment Strategy
3.2 Elements of an Investment Strategy
3.3 Formulation of Investment Strategy
3.4 Investment Process
3.1 INVESTMENT STRATEGY
An investment strategy is a crafted plan to invest, maintain and realise fund
assets having regard to the investment objectives adopted by the fund. All strategies
by definition, including investment strategies, have pre-defined goals and
objectives. Clearly, the earlier sample investment strategy falls short as there is no
outlined investment objective for the trustee to target when making investment
decisions. To help achieve a fund’s investment objectives, a trustee may develop
and implement a single, all-encompassing strategy. Alternatively, a trustee may
develop a fund-wide strategy that also contains numerous sub-strategies from
which members can choose from. While these sub-strategies target particular
outcomes, they must be in keeping with the fund-wide strategy.
3.2 ELEMENTS OF AN INVESTMENT STRATEGY
Here are some integral components to take note of when constructing an
investment strategy. Trustees should document these and all other relevant factors
considered by them, including reports obtained from professional advisers.
Circumstances of the fund
An investment strategy must have regard to all the circumstances of a fund.
This includes, but isn’t limited to, the following:
 The fund’s purpose, for example paying lump sums, pensions or both,
 The fund’s current and contingent liabilities,
 18

 The fund’s tax position, for example, carried forward income/capital losses or
realised/unrealised tax liabilities,
 The fund’s overall financial state,
 A member’s existing retirement savings,
 Years to a member’s retirement,
 A member’s retirement income needs,
 The likely future contributions made for the benefit of a member, and
 The availability of investment choice for members.
Funds may establish a reserving policy to help smooth a member’s
investments returns. If so, a dedicated strategy, which forms part of the fund’s
broader investment strategy, must be adopted to manage these reserves.
3.3 FORMULATION OF INVESTMENT STRATEGY
Diversification, risk and return
Trustees have to consider the asset allocation most likely to deliver on the
fund’s investment objectives while ensuring the fund isn’t exposed to the dangers of
inadequate diversification. They’ll also need to determine acceptable levels of
investment risk and volatility of returns having regard to the fund’s objectives,
expected cash flows and liabilities.
Hedging
Trustees may employ numerous types of hedging strategies to minimise
certain risks. These risks vary and may include currency risk or investment risk.
Investment strategies should clearly document the extent to which trustees are able
to hedge against these risks.
Derivatives are one way of managing risk as they can protect assets in changing
markets. Superannuation funds can’t use derivatives for speculative purposes and
are limited to derivatives issued by an approved Australian or international exchange.
Using derivatives, such as covered call options, must be captured in a fund’s
investment strategy. A derivatives risk statement, formerly known as a risk-
management statement, will also need to be formulated, outlining the terms and
conditions of derivative use by the fund.
Insurance policies
Many superannuation funds own insurance policies on behalf of their
members. These policies are often established to help provide much-needed support
to a member and their family in the event of the member’s death, disablement or
sickness.
Leveraging or gearing
Superannuation funds are, for the most part, prohibited from leveraging. One
permissible form of leveraging is through internally-geared managed funds.
Superannuation funds are also able to gear through certain bare trust
arrangements, generally referred to as instalment warrant trusts. In any case, a
fund’s investment strategy should clearly outline its policy on leveraging. For
 19

instance, an investment strategy may restrict gearing via an instalment warrant

trust arrangement to certain types of assets, or limit the gearing ratio on the
investment, or impose a requirement to have the fund own death or total and
permanent disability cover on a member’s life so proceeds can be used to repay any
outstanding loan.
Liquidity and cash flow
A fund’s ability to meet liabilities, such as operating expenses, tax liabilities,
member benefits and death benefits when they become due, is paramount when
formulating investment strategies and making investment decisions.
Sole purpose test
Superannuation law prohibits a fund from being maintained for any purpose
other than a legally-prescribed core purpose or ancillary purpose. As a minimum, a
member’s benefits in a fund must be held for at least one core purpose, with
ancillary purposes being optional.
In general, maintaining the fund for a core purpose involves providing benefits
on or after any of the following events:
 a member’s retirement,
 a member’s 65th birthday, or
 a member’s passing, where this occurs before the member’s retirement or 65th
birthday,
By contrast, maintaining the fund for an ancillary purpose involves the
provision of benefits in circumstances such as:
 a member’s temporary disablement, where the benefit takes the form of
salary continuance payments, and
 a member’s passing, where this occurs after the member’s retirement or
65th birthday.
Restrictions on creating a charge against fund assets
Super funds are generally prohibited from creating a charge over a fund asset.
There are only limited exceptions to this rule, such as covered call options issued
by an approved exchange, or an instalment warrant trust arrangement that
complies with certain legislative restrictions.
Related-party transactions
Superannuation law places numerous restrictions on transacting with related
parties. A related party in relation to a fund includes members and standard
employer-sponsors. A related party also includes relatives and entities (trusts,
companies and partnerships) associated with members or standard employer-
sponsors of a fund.
Here are some important considerations regarding related party transactions.
These considerations are all interrelated and must not be viewed in isolation.
 20

Restrictions on acquiring assets from related parties

Assets that may be acquired from related parties are generally restricted to the
following:
 Listed securities,
 Business real property as defined under law,
 Life insurance policies, provided it’s not acquired from a fund member or
their relative,
 Units in a widely-held trust, a trust where more than 20 non-associated
parties beneficially own at least 75 per cent of units,
 Shares or units in certain non-geared holding companies and unit trusts as
defined under law, and
 In-house assets, subject to a 5 per cent limit.
Fund assets that aren’t in-house assets include life insurance policies,
business real property, shares or units in certain non-geared holding companies
and unit trusts, units in widely-held unit trusts and business real property,
irrespective of whether the business real property is subject to a lease or lease
arrangement with a related party. Also, some pre-11 August 1999 investment and
lease arrangements are exempt from in-house assets assessment. A fund asset
owned as tenants-in-common with a related party is not an in-house asset of the
fund, provided it is not subject to a lease or lease arrangement with a related party,
or if it is, the asset is business real property.
CONFLICTS OF INTEREST
Conflicts of interest may potentially arise where a trustee or related party
could benefit from a transaction taking place. The benefit may be a monetary
benefit, a kick-back of some form, a soft dollar benefit or other type.
Establishing solid ground rules as part of a fund’s investment strategy will
guide trustees and help to avoid conflicts of interest, particularly when it comes to
related party transactions.
Investors must have processes to monitor both investments and investment
strategies. The monitoring phase should take in changes to laws, interest rates and
shifts in market, economic and business conditions.
Formulating and executing an investment strategy is more than just a set of
asset allocation ranges. Investment strategies must identify specific goals for
trustees to pursue, along with listing the parameters on which trustees will base
their investment decisions. Trustees are legally accountable for investment
decisions they make. This is why it is important they review their existing
investment-related arrangements and take measures to address any weaknesses.
3.4 INVESTMENT PROCESS
Investment Process: Investment process gives answer of: how, when, where
and how much should be invest? The investment process guides a path towards the
success of market winning by dealing and describing: How an investor makes
 21

decisions about investment? Which investment alternative should be chosen? How

large the investment should be? When to invest?
The investment process consists following five-step procedure:
A) Investment policy should be set:
The investment process start by identifying goals and creating a new plan and
policy. Investment policy involves determining the investment objectives and
amount of one's investable wealth. The plan may consist of many future funding
needs such as retirement, college education, and land purchase. The investment
policy qualifies the investment goal. Making money alone cannot be an appropriate
objective. It is appropriate to state that the objective is to make a lot of money by
recognizing the possible losses. A clear investment policy help to plan, implement
and manage portfolio that achieve high return while controlling risk. Policies assist
in strategic assets allocation. setting a clear investment policy also involves the
identification of potential categories of financial assets for consideration in ultimate
portfolio. The identification of assets depends upon many things such as
investment objectives, investable wealth, tax consideration, retirement, education
expenses, mortgage, stocks, bonds, mutual funds, pensions, social security etc.
B) Performing security analysis:
There are thousands of securities to purchase on the financial markets. So
these securities must be analyzed. Analyzing securities is to find out the mis-priced
securities. Performance analysis of security is carried out through.
1) Stock screening by considering • Earning growth • Recent earnings
surprises • Price /earning ratio • Dividends • Market cap or size • Industry •
Relative Strength
2) Stock Research: Stock research is carried out after narrow down the list of
stock by stock screening. There is availability of great resources for researching
stocks. Company's annual report and its financial statement are used for financial
resources as: ¾ From the income statement • Earnings growth • Revenue growth •
Stable or increasing margins • Tax subsidies • Number of common share
outstanding. ¾ From the cash flow statement: • Cash flow: Ideally, cash flow should
be positive large and increasing. ¾ From Balance Sheet. • Debt to equity ratio, lower
is better and zero is ideal • Cash relative to annual sales • Return on equity; Higher is
better. • Receivables and inventory. • Current ratio, the higher the better.
3) Analysis: Many approaches can be used to analyze the securities. These
approaches, in broad sense can be classified into two types. i) Technical Analysis:
Technical Analysis of security prices involves the study of previous market price in
an attempt to predict the future price movement. Technical analysis ignores the
company underlying the stock and instead tries to predict price changes by
studying the market itself. In technical Analysis past trends in the price is
examined and is compared with the recent emerging trends. The matching of
emerging trends or patterns with the past one patterns repeat themselves. Moving
 22

averages, support and resistance, advance/decline lines, relative, strength,

momentum and volume of trading are examined in the technical Analysis. ii)
Fundamental Analysis: Fundamental analysis tries to identify the real or true value
of financial assets. The real value of any kind of financial assets is the present value
of the future cash flow given by the assets or expected by the holder. Fundamental
analysis evaluates a stock by examining the company, especially its operations and
its financial conditions. In fundamental analysis several valuation methods,
factoring in P/E ratio, dividend yields, book value, price/sales ratio, return on
equity etc. are looked. The fundamental analyst attempts to forecast the timing and
size of the cash flows and then converts them into their equivalent present value by
using appropriate discount rate.
C) Asset Allocation and portfolio Construction:
Assets allocation is based on investment goals, Investor experience and risk
tolerance. Assets allocation is putting savings into investments, as opposed to
letting it sit in bank. Dividing your money across different assets classes (stocks,
bonds, money, market etc) is the first step when making investments and is
arguably the most important decision. While constructing a portfolio, the
selectivity, timing and diversification need to be addressed by the investor. A well
construct portfolio help investors archive at desired investment goals. The portfolio
construction should ensure the optimum use of people, money and other resources.
Assets allocation and portfolio construction is of two types- active and passive.
Active assets allocation and portfolio construction is based on market views.
D) Portfolio Revision:
Portfolio revision is the repetition of previous three steps of investment
process. Over the period of time, the objectives of investor at may change and the
current portfolio may no longer be optimal. Portfolio revision is the evaluation of
outcome with the help of performance measures. Thus it can be said that portfolio
revision is the art of optimizing assets and raising the worth of a portfolio. A timely
revision of portfolio helps in obtaining maximum profit because: - The investor can
sell some unattractive securities and introduce attractive ones to form a new
optimal portfolio. - Some securities that are initially unattractive may turn out to be
attractive later and Vice Versa.
E) Portfolio performance evaluation:
This the last step in investment management process involves determining
periodically how the portfolio performed, in terms of not only the return earned, but
also the risk of the portfolio. For evaluation of portfolio performance appropriate
measures of return and risk and benchmarks are needed. A benchmark is the
performance of predetermined set of assets, obtained for comparison purposes. The
benchmark may be a popular index of appropriate assets–stock index, bond index.
The benchmarks are widely used by institutional investors evaluating the
performance of their portfolios. It is important to point out that investment
management process is continuing process influenced by changes in investment
environment and changes in investor’s attitudes as well. Market globalization offers
 23

investors new possibilities, but at the same time investment management become
more and more complicated with growing uncertainty.
REVISION POINT
Investment strategy: An investment strategy is a crafted plan to invest,
maintain and realise fund assets having regard to the investment objectives
adopted by the fund.
INTEXT QUESTIONS
1. What are the elements of investment strategies ?
2. what is portfolio revision ?
SUMMARY
The investment strategy aims to take advantage of the fund's long-term
horizon and considerable size to generate high returns and safeguard wealth for
future generations. The fund is to be invested responsibly within its overall
financial objective. The aim is to have diversified investments that bring a good
spread of risk and the highest possible return subject to the constraints set out in
the mandate from the Ministry of Finance. The strategy has evolved over time on
the basis of expert reviews, practical experience and in-depth analysis. Major
changes require parliamentary approval. There is broad political agreement that the
fund should not be a political instrument of foreign or climate policy.
TERMINAL EXERCISE
1. ______________ assist in strategic assets allocation.
Ans: policies
SUPPLEMENTARY MATERIALS
 money.rediff.com
 money control.com
 amfiindia.com
 nseindia
 bseindia.com
 rbi.org.in
ASSIGNMENT
1. Discuss the various steps involved in process of investment.
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Formulate suitable investment strategies in the current market scenario.
KEY WORDS
Investment strategies, Investment process, Portfolio Revision.
 24

LESSON 4

INVESTMENT ALTERNATIVES
INTRODUCTION
As volatile as the stock market can be, many investors have been looking into
safer ways to invest their money. So, "alternative investments" have become
increasingly popular. An alternative investment is any investment other than the
three traditional asset classes: stocks, bonds and cash. But alternative
investments don't take the place of those more traditional assets. Investors
shouldn't sell their stocks, cash out their savings accounts and put all their
money in these less traditional options. Most financial experts agree that alternative
investments are best when used to diversify financial portfolios. In other words,
instead of putting all of your money in stocks, put some in stocks, some in bonds,
and some in alternative investments like hedge funds, private equity, or even fine
art and wine.
OBJECTIVES
After reading this lesson the student should be able to Understand Various
Types of Investment.
CONTENT
4.1 Types Of Investment
4.2 Non-Negotiable Securities
4.3 Mutual Funds
4.4 Gold and Silver
4.5 Real Estate
4.6 Sources of Information
4.7 Selection of Securities
4.1 TYPES OF INVESTMENT
Equity Shares
The equity shares attract the interest of many. In the early nineties, the stock
market was the best and safety place for the common individual to invest. Since
1996 the share market prices have been low. This made the retail investors to turn
away from the stock market. The stock market classifies shares into Growth shares,
Income shares, Defensive shares, Cyclical shares and Speculative shares.
Fixed Income Securities
i) Preference Shares
Preference shares are shares which are preferred over common or equity
shares in payment of surplus or dividend i.e preference shareholders are the first to
get dividends in case the company decides to pay out dividends. Owners of
preference shares gets fixed dividend. However, in the event of liquidation of the
company they are paid after bond holders and creditors, but before equity holders.
 25

ii) Debentures
A debenture is one of the capital market instruments which is used to raise
medium or long term funds from public. A debenture is essentially a debt
instrument that acknowledges a loan to the company and is executed under the
common seal of the company. The debenture document, called Debenture deed
contains provisions as to payment, of interest and the repayment of principal
amount and giving a charge on the assets of a such a company, which may give
security for the payment over the some or all the assets of the company. Issue of
Debentures is one of the most common methods of raising the funds available to
the company. It is an important source of finance.
III) Bonds
Bonds are similar to the debentures but they are issued by the public sector
undertakings. The value of the bond in the market depends upon the interest rate
and the maturity. The coupon rate is the nominal interest rate offered on the
bonds. The coupon rate is contractual involving the terms and conditions of the
issuance of the debt security. Being contractual it cannot be changed during the
tenure of the instrument. The investors are not affected by lowering of the bank
rates. When the bank rates are lowered, actually, the value of the bonds, which are
carrying interest rates above the bank rate would appreciate. IDBI and ICICI have
issued various bonds to suit the needs of the investors. Some of them are deep
discount bond, education benefit bond, retirement benefit bond and index bond.
IV ) Kisan Vikas Patra (KVP)
 Amount Invested matures in 115 months.
 Rate of Interest 7.5%.
 Certificate can be purchased by an adult for himself or on behalf of a minor or
by two adults.
 KVP can be purchased from any Departmental Post office.
 Facility of nomination is available.
 Certificate can be transferred from one person to another and from one post
office to another.
 Certificate can be encashed after 2 & 1/2 years from the date of issue.
V) Government Securities
The securities issued by the Central, State Government and Quasi
Government agencies are known as Government securities or gilt edged securities.
As Government guaranteed security is a claim on the Government, it is a secured
financial instrument, which guarantees the income and the capital. The rate of
interest on these securities is relatively lower because of their high liquidity and
safety.
VI) Money Market Securities
Money market securities have very short term maturity say less than a year.
Common money market instruments are:
 26

 Treasury bills
 Commercial paper
 Certificate of deposit
Treasury Bills
These are government bonds or debt securities with maturity of less than a
year. T- bills are issued to meet short-term mismatches in receipts and
expenditure. Bonds of longer maturity are called dated securities.
Commercial Papers
Commercial Paper or CP is defined as a short-term, unsecured money market
instrument, issued as a promissory note by big corporations having excellent credit
ratings. As the instrument is not backed by collateral, only large firms with
considerable financial strength are authorised to issue the instrument.
Features of Commercial Paper
 The maturity period of commercial paper lies between 30 to 270 days.
 It is sold at a discount but redeemed at its par value.
 There is no well-developed secondary market for commercial paper; rather they
are placed with existing investors who intend to hold it till it gets matured.
 The primary purpose of issuing commercial paper is to raise short-term funds
so as to meet working capital requirements of the firm. However, firms also raise
money through CP’s to fill the gap between fund required currently and long
term funds raised from the market.
Certificate of Deposit
The certificate of deposit is a marketable receipt of funds deposited in a bank
for a fixed period at a specified rate of interest. They are bearer documents and
readily negotiable. The denominations of the CD and the interest rate on them are
high. It is mainly preferred by institutional investors and companies rather than the
individuals. The minimum size of the certificate is ` 10 lakh. The additional amount
is issued in multiples of ` 5 lakh.
4.2 NON-NEGOTIABLE SECURITIES
Deposits
Deposits earn fixed rate of return. Even though bank deposits resemble fixed
income securities they are not negotiable instruments. Some of the deposits are
dealt subsequently.
a) Bank Deposits
It is the simple investment avenue open for the investors. He has to open an
account and deposit the money. Traditionally the banks offered current account,
savings account and fixed deposit account. Current account does not offer any
interest rate. The drawback of having large amounts in savings accounts is that the
return is just 6.25 to 7.5 per cent(2017). The savings account interest rate is
regulated by the Reserve Bank of India and kept low because of the high cost of
servicing them. The savings account is more liquid and convenient to handle. The
fixed account carries low interest rate and the money is locked up for a fixed period
 27

The deposits in the banks are considered to be safe because of the RBI
regulation. The risk averse investors prefer the bank deposits.
b) Post Office Deposits
Like the banks, post office also offers fixed deposit facility and monthly income
scheme. Post office Monthly Income Scheme is a popular scheme for the retired.
 Interest payable annually but calculated quarterly.
 From 1.07.2017, interest rates are as follows:-
 Interest rates From 1.07.2017
 Period Rate
 1yr.A/c 6.8%
 2yr.A/c 6.9%
 3yr.A/c 7.1%
 5yr.A/c 7.6%
c) NBFC Deposits
A Non-Banking Financial Company (NBFC) is a company registered under the
Companies Act, 1956 engaged in the business of loans and advances, acquisition of
shares/stocks/bonds/debentures/securities issued by Government or local authority
or other marketable securities of a like nature, leasing, hire-purchase, insurance
business, chit business but does not include any institution whose principal business
is that of agriculture activity, industrial activity, purchase or sale of any goods (other
than securities) or providing any services and sale/purchase/construction of
immovable property. A non-banking institution which is a company and has principal
business of receiving deposits under any scheme or arrangement in one lump sum or
in instalments by way of contributions or in any other manner, is also a non-banking
financial company (Residuary non-banking company
Public Provident Fund Scheme (PPF)
Public Provident Fund (PPF) scheme is a popular long term investment option
backed by Government of India which offers safety with attractive interest rate and
returns that are fully exempted from Tax .Investors can invest minimum Rs. 500 to
maximum Rs. 1,50,000 in one financial year and can get the facilities such as loan,
withdrawal and extension of account.
National Savings Scheme (NSS)
Tax Exemption: National savings scheme is mostly considered to be a tax
savior product. This product offers a combination of increased earnings in the form
of capital appreciation and decrease in the tax payment amount, thereby, providing
the customer sufficient returns. Not a source of regular Income, It majorly intends
to help its customers reduce tax liability. Inflation rate fluctuations: Owing to its
feature of fixed rate of return, this product does not promise its buyers sufficient
safety measures against the fall or rise of inflation rates. Security: It being a savings
plan which offers tax benefits to its customers cannot be treated as collateral
against any kinds of loan from any financial or non-financial institution. Your
income is assured at the specified rate of interest. Since the NSS has the backing of
the GOI, this is a risk-free avenue of investment.
 28

Maturity Period: This scheme remains valid for a period of 4 years which can
be further extended if so deemed necessary by the customer.
Liquidity: This scheme does not offer liquidity. No premature withdrawal of the
fund is allowed except in few cases such as the death of the scheme buyer.
Withdrawal of Interest: The interest earned can be withdrawn by the customer
anytime. However, the initial investment can be fully withdrawn only after the expiry of
the investment period. Post that, the customer may choose to either close or extend the
scheme period solely on his/her discretion.
Scheme dispersion: With an investment amount ranging from a minimum Of
Rs.100 to no prescribed high limit for investment, the scheme units are dispersed
in various denominations.
Physical Units: NSS Units are issued by the Post office under the guidance of
GOI to the in the form of certificates and are to be held physically by the investor.
National Savings Certificate (NSC)
 NSC VIII Issue
 Scheme specially designed for Government employees, Businessmen and other
salaried classes who are Income Tax assesses.
 No maximum limit for investment.
 No Tax deduction at source.
 Certificates can be kept as collateral security to get loan from banks.
 Trust and HUF cannot invest.
Life Insurance
Life insurance is a contract for payment of a sum of money to the person
assured (or to the person entitled to receive the same) on the happening of event
insured against. Usually the contract provides for the payment of an amount on the
date of maturity or at specified dates at periodic intervals or if unfortunate death
occurs. Among other things, the contracts also provide for the payment of premium
periodically to the corporation by the policy holders. Life insurance eliminates risk.
The major advantages of life insurance are given below:
i. Protection Saving through life insurance guarantees full protection against risk
of death of the saver. The full assured sum is paid, whereas in other schemes
only the amount saved is paid.
ii. Easy Payments For the salaried people the salary savings’ schemes are
introduced. Further, there is an easy instalment facility method of payment
through monthly, quarterly, half yearly or yearly mode.
iii. Liquidity Loans can be raised on the security of the policy.
iv. Tax Relief Tax relief in Income Tax and Wealth Tax is available for amounts
paid by way of premium for life insurance subject to the tax rates in force.
 29

4.4 MUTUAL FUNDS

Investment companies or investment trusts obtain funds from large number of
investors through sale of units. The funds collected from the investors are placed
under professional management for the benefit of the investors. The mutual funds
are broadly classified into open-ended scheme and close-ended scheme.
Open-Ended Schemes
The open-ended scheme offers its units on a continuous basis and accepts
funds from investors continuously. Repurchase is carried out on a continuing basis
thus, helping the investors to withdraw their money at any time.
Closed – Ended Funds
The close-ended funds have a fixed maturity period. The first time investments
are made when the close end scheme is kept open for a limited period. Once closed,
the units are listed on a stock exchange. Investors can buy and sell their units only
through stock exchanges. The demand and supply factors influence the prices of
the units. The investor’s expectation also affects the unit prices. The market price
may not be the same as the net asset value.
Other Classification
The open-ended and close-ended schemes are classified on the basis of their
objectives. Some of them are given below
i. Growth Scheme Aims to provide capital appreciation over medium to long term.
Generally these funds invest their money in equities.
ii. Income Scheme This scheme aims to provide a regular return to its unit
holders. Mostly these funds deploy their funds in fixed income securities.
iii. Balanced Scheme A combination of steady return as well as reasonable growth.
The funds of these schemes are invested in equities and debt instruments.
iv. Money Market Scheme This type of fund invests its money on money market
instruments like treasury bills, commercial paper, etc.
v. Tax Saving Schemes This type of scheme offers tax rebates to investors. Equity
linked savings schemes and pension schemes provide exemption from capital
gains on specific investment.
vi. Index Scheme Here investment is made on the equities of the index.
Benchmark index is BSE sensex or NSE-50. The return are approximately equal
to the return on the index.
Exchange traded funds (ETFs )
Exchange Traded Funds are essentially Index Funds that are listed and traded
on exchanges like stocks. Until the development of ETFs, this was not possible
before. Globally, ETFs have opened a whole new panorama of investment
opportunities to Retail as well as Institutional Money Managers. They enable
investors to gain broad exposure to entire stock markets in different Countries and
specific sectors with relative ease, on a real-time basis and at a lower cost than
many other forms of investing.
 30

An ETF is a basket of stocks that reflects the composition of an Index, like S&P
CNX Nifty or BSE Sensex. The ETFs trading value is based on the net asset value of
the underlying stocks that it represents. Think of it as a Mutual Fund that you can
buy and sell in real-time at a price that change throughout the day.
4.4 GOLD AND SILVER
For ages, gold and silver have been considered as a form of investment. They
are considered as best hedge against inflation. This is a favourite form of
investment amongst the rural and semi-urban population. Besides, investors tend
to invest in jewellery instead of pure gold. As a result, when they buy jewellery, the
price realization is usually less than total purchase price (this is due to higher
making charge of jewellery). The price of gold has declined in the later part of the
nineties. Gold prices are suppressed because of large supplies overtaking the
demand. The government has allowed imports of gold to certain banks and agencies
and they have huge stocks of gold. The gold prices remained depressed in the
international markets too in the late nineties.
4.5 REAL ESTATE
The real estate market offers a high return to the investors. The word real
estate means land and buildings. There is a normal notion that the price of the real
estate has increased by more than 12 percent over the past ten years. The
population growth and the exodus of people towards the urban cities have made the
prices to increase manifold. Reasons for investing in real estate are given below:
1. High capital appreciation compared to gold or silver particularly in the urban
area.
2. Availability of loans for the construction of houses. The Central Government
budget provides huge incentives to the middle class to avail of housing loans.
Scheduled banks now have to disburse 3 percent of their incremental deposits
in housing finance.
3. Tax rebate is given to the interest paid on the housing loan. Further ` 75,000
tax rebate on a loan upto ` 5 lakhs which is availed of after April 1999. If an
investor invests in a house for about ` 6-7 lakh, he provides a seed capital of
about ` 1-2 lakh. The ` 5 lakh loan, which draws an interest rate of 15 percent,
will work out to be less than 9.6 percent because of the ` 75,000 exempted from
tax annually. In assessing the wealth tax, the value of the residential home is
estimated at its historical cost and not on its present market value.
4. The possession of a house gives an investor a psychologically secure feeling and
a standing among his friends and relatives.
Apart from making investment in the residential houses, the people in the
higher income bracket invest their money in time share plans of the holiday resorts
and land situated near the city limit with the anticipation of a capital appreciation.
Farm houses and plantations also fall in the line. In spite of the fast capital
appreciation investors generally do not invest in the real estate apart from owning
one or two houses. The reasons are:
 31

Requirement of Huge Capital: To purchase a land or house in the urban

area, the investor needs money in lakhs whereas he can buy equity, gold or form of
investment by investing thousands of rupees.
Malpractices: Often-gullible investors become cheated in the purchase of
land. The properties already sold are resold to the investors. The investor has lose
the hard-earned money.
Restriction of the Purchase: The land ceiling Act restricts the purchase of
agricultural land beyond a limit.
Lack of Liquidity: If the investor wants to sell the property, he cannot
immediately realize the money. The waiting period may be months or years.
The points to be taken care of while purchasing the real estate are:
1. The plots should be approved by the local authority because on the unapproved
layout construction of a house is not permitted.
2. Possibility of capital appreciation- It depends upon the locality and other facilities
of the site.
3. Originality of title deeds- The site should be free from encumbrance.
Encumbrance certificate for a minimum period of latest 15 years should be got
from the Registrars Office.
4. Plinth area should be verified.
5. Credibility of the broker
The role of broker cannot be undermined because it is he who introduces to
the parties and location of site. He should be faithful and loyal otherswise the
investor finds himself in trouble.
Art
Paintings are most sought after form of art. The price in the art market are
rising and this rise is expected to continue. The trend in the market today is to
invest in young upcoming painters whose prices will soar over the years. People
who have bought paintings from young painters in the last few years are happy
with the kind of financial as well aesthetic appreciation they have received over the
years.
Paintings of the young painters- The works of established painters are costly
and scope for appreciation in their values are limited. But prices of the good quality
paintings of the young painters may increase quickly.
1. Should possess the basic idea of the painting- This is needed to decide the
quality of the paintings. He should be able to judge the primary attributes of the
paintings such as spontaneity, nature of strokes, colour combination and
originality.
2. The investor should have aesthetic sense-because he may or may not be able
to resell the paintings. Therefore when he possesses the art piece the investor
should have a sense of fulfilment.
 32

Antiques
In western countries’ investment in antiques is more common than in India.
The antique is an object of historical interest. It may be a coin, sculpture,
manuscript or any other object of olden days. The owner of the antique has to
register himself with Archeological Society of India. The society after examining the
authenticity of the antique issues a “Certificate of registration”. Any dealings I.e.
purchase and sale of antique should be informed to the society. The government
has the right to buy the antique from the owner, if it wants to keep it in the
museum. In the case of investment, the investor has to be careful about the fake
antique and the risk in the price of the antique is uncertain.
4.6 SOURCES OF INFORMATION
Economic indicators
Indicators of economic developments are usually reported by The Financial
Post and The Globe & Mail. All major brokerage houses publish economic forecasts
at least annually, and business publications produce economic reports. Mutual
fund companies publish newsletters, quarterly and annual reports, and sometimes
monthly reports from fund managers.
Gross National Product (GNP)
Gross National Product (GNP) deserves watching. It is the total market value of
all goods and services purchased for direct use, and which won't require any
further production, distribution or processing. An increasing GNP indicates an
increase in economic activity, usually more jobs, more energy required, and more
factories in need of upgrading. If GNP has been low or negative for a time, an
increase may precede a rise in consumer spending on small appliances or clothing.
If the GNP continue to rise, more expensive items such as cars, large appliances, or
houses may be in demand, as well as raw materials like steel and lumber to make
them. But remember, GNP only signals a rise in activity, not that things are
actually getting better. When someone is diagnosed with cancer and requires
treatment, GNP goes up. When a major source of pollution has to be cleaned up,
GNP rises.
Consumer Price Index
The Consumer Price Index (CPI) gives an indication of the rate of inflation. It is
based on a basket of goods and services that the average consumer might
purchase. If the CPI rises quickly, investors may move to hedges against inflation
such as natural resource stocks and precious metals. If the CPI is stagnant or
decreasing, it may signal a reduction in interest rates which is good for fixed-
income investments such as bonds.
Unemployment Rates
Unemployment Rates measure the number of people registered as unemployed,
but they don't cover those who have given up looking for work. We all have a sense of
the level of unemployment from the news, so the trend is usually more important than
the actual level. If unemployment is increasing, there is more worry about job security,
and consumers tend to spend less. Government deficits may increase as money is used
 33

for job creation or unemployment insurance payments. If unemployment is decreasing,

worries about inflation may surface and it's sensible to watch the CPI.
Newspapers, Magazines, Newsletters.
Financial publications generally are a reliable financial resource that will keep
investors up-to-date regarding the economy and investment vehicles. Financial
publications are also a great way to stay informed about current financial trends or
changes. Below is a short list (in no particular order) of publications investors
might find helpful.
Websites
The Internet is a helpful resource for investment information. There are many
financial service company websites that can provide general information as well as
details about their own products.
 moneyyahoo.com
 Morningstar.com
 Moneycentral.msn.com
 CNNMoney.com
 moneyrediff.com
4.8 SELECTION OF SECURITIES
The process by which one chooses the securities, derivatives, and other assets
to include in a portfolio. In making securities selections, one considers the risk, the
return, the ethical implications, and other factors affecting both of the individual
securities and the portfolio as a whole.After the asset allocation strategy has been
developed, securities must be selected to construct the portfolio and populate the
allocation targets according to the strategy. Most investors typically choose from the
universe of mutual funds, index funds and exchange-traded funds by matching the
funds' investment objectives to the various components of their asset allocation
strategy. For example, a conservative investor may look toward funds that seek
capital preservation in addition to capital appreciation, while a more aggressive
investor may consider funds that strictly seek capital appreciation.
REVISION POINTS
Types of Investments in India: Government Securities (Bonds), Equity,
Mutual Funds, Debentures/ Exchange Traded Fund, Bonds, Real Estate, Gold,
Bank fixed deposits, Corporate Fixed Deposits, Post office savings schemes,
National Pension Scheme, Commodity, Investing in Art.
INTEXT QUESTIONS
1. Explain the process of investment undertaken by the investor.
2. Define securities. Give a brief account of different types of securities.
3. How do common stocks differ from preference stocks?
 34

SUMMARY
Investment carries some amount of risk. No risk leads to no or low returns!
Few instruments carry less risk while a few of them carry higher risk. It is said
“higher the risk – higher is the return!”
Government Securities (Bonds): Bonds issued by Central or State government.
These bonds are termed as the safest investment instruments in India. Example of
these bonds are “Dated government security” which are issued for a period of 10
years with a fixed coupon payment. These securities carry least amount of credit
risk as they are backed by the Government of India.
Equity: Investing in direct equity. One can start investing in Indian equities by
participating in primary markets (applying for IPO’s) and also by purchasing
securities from secondary markets (stock exchanges).
Investing in direct equity is termed risky and one needs to diversify the risk by
investing in multiple securities from various sectors. Example: investing in real
estate stocks, pharma stocks, PSU stocks and Oil stocks all at once. Equities carry
the maximum risk and (may) also provide you with maximum returns. Investors
can also participate in equities by investing in mutual funds.
Mutual Funds: Mutual fund is a financial instrument created with pool of
investments from many investors. Mutual funds are one of the best way to diversify
your portfolio. SIP’s are a form of Mutual fund where one tends to invest
systematically i.e. once a month or once in three months, etc.
Debentures/ Bonds: Corporate’s need money and they don’t go to banks every
time to fulfill their needs, they have two options to raise money – come up with an
IPO or issue bond with fixed term to maturity and fixed coupon payments. They
function just like the government bonds and the only difference is that they are a
bit riskier compared to government bonds.
Real Estate: In India investing in real estate is considered as the best form of
investment but only after gold. Historically real estate has performed well in India.
Investing in metros has become very expensive so it is advisable to invest in
outskirts
Gold: The only form of investment which most of our mothers and fathers
would believe in. Gold is considered as the best investment in India, that is the only
reason why India is the highest consumer of gold in the world. Most of the
people in India buy physical gold. ETF’s, Mutual funds, etc. are yet to pick up as an
investment avenues in India.
Bank fixed deposits: This considered as one of the traditional ways of
Investing. Most of the people in India with a bank account will have at least one
fixed deposit. FD’s offer a fixed return at the end of specified period. Currently bank
FD’s offer somewhere around 8% to 9% returns annually.
Corporate Fixed Deposits: They are just like bank FD’s they only difference is
that they are issued by corporations. They are a bit riskier compared to bank FD’s
 35

as most of these corporate deposits are unsecured an hence offer higher interest
rate. They offer interest rates as high as 10 to 12% p.a. as per 2017. An example of
this would be – FD by Mahindra Finance, Shriram Transport Finance, etc.
Post office savings schemes: These saving schemes by post offices are trusted
by many Indians. The scheme attracts decent returns. One can start investing with
as low as Rs 100 per month..
National Pension Scheme: The National Pension System (NPS) is a defined
contribution based pension system launched by Government of India. This
instrument is used for retirement planning by many.
Commodity: This is one of the latest passion for investors, trading in MCX to
offset the risk of their equity portfolio. Many headers and arbitrageurs use this
financial instrument. Retail investors can invest in commodity with the help of
commodity mutual funds in India.
Investing in Art: Art as a form of investment is quite common in developed
nations and the trend is picking up in India. Many affluent Indians buy art preserve
it and diversify their portfolios.
Venture Capital/ Angle Investing: Investing in someones business idea at an
early stage of the venture. You get equity for the amount invested and one can exit
the investment when the business is acquired by some other company or when the
company gets listed. These investments are highly il-liquid and carry huge risk.It is
not advisable for a retail investor to invest in these kind of instruments.
TERMINAL EXERCISE
1. A _________ is one of the capital market instruments which is used to raise
medium or long term funds from public.
Ans: Debenture
SUPPLEMENTARY MATERIALS
 money.rediff.com
 money control.com
 amfiindia.com
 nseindia
 bseindia.com
 rbi.org.in
ASSIGNMENTS
1. What are the various forms of investment alternatives? Give a detailed account of
any five.
2. Define negotiable security. What are the negotiable securities available to the
investor in the Indian capital market?
3. What are the advantages of placing money in the bank deposits? Discuss some of
the new innovative deposits of the banks.
 36

SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Collect information about various investment options and select best
investment option on the basis of your investment capacity.
KEY WORDS
Bonds, Equity share, Debentures, Mutual funds.
 37

LESSON 5

STOCK MARKET IN INDIA

INTRODUCTION
The BSE, Asia's first stock exchange, was established in 1875. BSE is one of
the world's fastest stock exchanges, with a median trade speed of 6 microseconds.
is the world's 11th largest stock exchange with an overall market capitalization of
$1.83 Trillion as of March, 2017. More than 5500 companies are publicly listed on
the BSE. The NSE, on the other hand, was founded in 1992 and started trading in
1994, as the first demutualized electronic exchange in the country. It was the first
exchange in the country to provide a modern, fully automated screen-based
electronic trading system which offered easy trading facility to the investors spread
across the length and breadth of the country. The NSE has a total market
capitalization of more than US$1.41 trillion, making it the world's 12th-largest
stock exchange as of March 2016. Both exchanges - BSE and NSE - follow the same
trading mechanism, trading hours, settlement process, etc.
OBJECTIVES
After reading this lesson the student should be able to understand
Establishment of BSE, Establishment of SEBI Establishment of NSE, Most
Important Functions of Stock Exchange, Meaning of Book Building.
CONTENT
5.1 Establishment of BSE (Bombay Stock Exchange)
5.2 Establishment of SEBI (Securities And Exchange Board of India)
5.3 Establishment of NSE (National Stock Exchange)
5.4 Most Important Functions of Stock Exchange
5.5 Meaning of Book Building
5.6 Book Building Process
5.7 The Price Fixation of Security
5.8 Dematerialization
5.9 Process of Dematerialization
5.10 Need For Dematerialization
5.11 Benefits of Dematerialization
5.12 Depository System
5.13 Benefits of Depository System
5.14 Market Membership
5.15 Regularity Frame Work
5.16 The Regulators
5.17 OTCEI
Indian Stock Market is one of the oldest Stock Market in Asia.
East India Company used to transact Loan Securities by the end of
18th Century. In the 1830s, trading on corporate stocks and shares in Bank and
Cotton presses took place in Bombay.
 38

5.1 ESTABLISHMENT OF BSE (Bombay Stock Exchange)

Few informal groups of Stock Brokers organized themselves in 1875 and were
formally organized as Bombay Stock Exchange (BSE). In 1956, the Government of
India recognized the Bombay Stock Exchange as the first Stock Exchange in the
country under the Securities Contracts (Regulation) Act.
But still there was no means to measure the overall performance of the
exchange. So, in 1986, Bombay Stock Exchange developed BSE Sensex (Sensex =
Sensitive Index), an index of top 30 companies, which gave a means to measure the
overall performance of the Exchange
5.2 ESTABLISHMENT OF SEBI (Securities and Exchange Board of India)
Until late 1980s, BSE ran with low transparency and an unreliable clearing
and settlement systems. Towards the end of the 1980s, new economic forces, the
economic growth and currency crisis emphasized the need for modernization of the
financial system. Government created the Securities and Exchange Board of India
(SEBI) in 1988.
5.3 ESTABLISHMENT OF NSE (National Stock Exchange)
In April 1992, Bombay Stock Exchange crashed due to Harshad Mehta Scam.
Finance minister Mr. Manmohan Singh urged the need of other Stock Exchange in
competition to BSE. He tapped the Industrial Development Bank (IDB) to take the
lead of the project of creating competition for BSE.
In November 1992, NSE (National Stock Exchange) was established as the first
electronically traded Stock Exchange in India. After a few years of operations, the
NSE has become the largest stock exchange in India.BSE also automated the
systems in 1995 but it never caught up with NSE Spot Market turnover.Three
segments of the NSE trading platform were established one after another. The
Wholesale Debt Market (WDM) commenced operations in June 1994 and the
Capital Market (CM) segment was opened at the end of 1994. Finally, the Futures
and Options segment began operating in 2000. Today the NSE takes the 14th
position in the top 40 futures exchanges in the world.
In 1996, the National Stock Exchange of India launched S&P CNX Nifty. CNX
Nifty (Nifty = National Fifty) is a diversified index of 50 stocks from 25 different
economy sectors.
In 1998, the National Stock Exchange of India launched its web-site and was
the first exchange in India that started trading stock on the Internet in 2000.
Today, NSE has roughly 66% of equity spot turnover and roughly 100% of equity
derivatives turnover.
5.4 Most Important Functions of Stock Exchange
Some of the Important Functions of Stock Exchange are listed below:
1. Providing a ready market
The organization of stock exchange provides a ready market to speculators and
investors in industrial enterprises. It thus, enables the public to buy and sell
securities already in issue.
 39

2. Providing a quoting market prices

It makes possible the determination of supply and demand on price. The very
sensitive pricing mechanism and the constant quoting of market price allows
investors to always be aware of values. This enables the production of various
indexes which indicate trends etc.
3. Providing facilities for working
It provides opportunities to Jobbers and other members to perform their
activities with all their resources in the stock exchange.
4. Safeguarding activities for investors
The stock exchange renders safeguarding activities for investors which enables
them to make a fair judgment of a securities. Therefore directors have to disclose all
material facts to their respective shareholders. Thus innocent investors may be
safeguard from the clever brokers.
5. Providing Scope for Speculation
To ensure liquidity and demand of supply of securities the stock exchange
permits healthy speculation of securities.
6. Liquidity
The main function of stock market is to provide ready market for sale and
purchase of securities. The presence of stock exchange market gives assurance to
investors that their investment can be converted into cash whenever they want. The
investors can invest in long term investment projects without any hesitation, as
because of stock exchange they can convert long term investment into short term
and medium term.
7. Better Allocation of Capital
The shares of profit making companies are quoted at higher prices and are
actively traded so such companies can easily raise fresh capital from stock market.
The general public hesitates to invest in securities of loss making companies. So
stock exchange facilitates allocation of investor’s fund to profitable channels.
8. Creating the discipline
Its members controlled under rigid set of rules designed to protect the general
public and its members. Thus this tendency creates the discipline among its
members in social life also.
9. Checking functions
New securities checked before being approved and admitted to listing. Thus
stock exchange exercises rigid control over the activities of its members.
10. Adjustment of equilibrium
The investors in the stock exchange promote the adjustment of equilibrium of
demand and supply of a particular stock and thus prevent the tendency of
fluctuation in the prices of shares.
 40

11. Maintenance of liquidity

The bank and insurance companies purchase large number of securities from
the stock exchange. These securities are marketable and can be turned into cash at
any time. Therefore banks prefer to keep securities instead of cash in their reserve
Thus it facilities the banking system to maintain liquidity by procuring the
marketable securities.
12. Promotion of the habit of saving
Stock exchange provide a place for saving to general public. Thus it creates the
habit of thrift and investment among the public. This habit leads to investment of
funds incorporate or government securities. The funds placed at the disposal of
companies are used by them for productive purposes.
13. Refining and advancing the industry
Stock exchange advances the trade , commerce and industry in the country. it
provides opportunity to capital to flow into the most productive channels. Thus the
flow of capital from unproductive field to productive field helps to refine the large
scale enterprises.
14. Promotion of capital formation
It plays an important part in capital formation in the country. its publicity
regarding various industrial securities makes even disinterested people feel
interested in investment.
15. Increasing Govt. Funds
The govt. can undertake projects of national importance and social value by
raising funds through sale of its securities on stock exchange.
16. Promotes the Habits of Savings and Investment
The stock market offers attractive opportunities of investment in various
securities. These attractive opportunities encourage people to save more and invest
in securities of corporate sector rather than investing in unproductive assets such
as gold, silver, etc.
5.5 MEANING OF BOOK BUILDING
Every business organisation needs funds for its business activities. It can raise
funds either externally or through internal sources. When the companies want to go
for the external sources, they use various means for the same. Two of the most
popular means to raise money are Initial Public Offer (IPO) and Follow on Public
Offer (FPO).
During the IPO or FPO, the company offers its shares to the public either at
fixed price or offers a price range, so that the investors can decide on the right
price. The method of offering shares by providing a price range is called book
building method. This method provides an opportunity to the market to discover
price for the securities which are on offer.
Book Building may be defined as a process used by companies raising capital
through Public Offerings-both Initial Public Offers (IPOs) and Follow-on Public
 41

Offers (FPOs) to aid price and demand discovery. It is a mechanism where, during
the period for which the book for the offer is open, the bids are collected from
investors at various prices, which are within the price band specified by the issuer.
The process is directed towards both the institutional investors as well as the retail
investors. The issue price is determined after the bid closure based on the demand
generated in the process.
5.6 BOOK BUILDING PROCESS
The following are the important points in book building process:
1. The Issuer who is planning an offer nominates lead merchant banker(s)
as ‘book runners’.
2. The Issuer specifies the number of securities to be issued and the price
band for the bids.
3. The Issuer also appoints syndicate members with whom orders are to be
placed by the investors.
4. The syndicate members put the orders into an ‘electronic book’. This
process is called ‘bidding’ and is similar to open auction.
5. The book normally remains open for a period of 5 days.
6. Bids have to be entered within the specified price band.
7. Bids can be revised by the bidders before the book closes.
8. On the close of the book building period, the book runners evaluate the
bids on the basis of the demand at various price levels.
9. The book runners and the Issuer decide the final price at which the
securities shall be issued.
10. Generally, the number of shares is fixed; the issue size gets frozen based
on the final price per share.
11. Allocation of securities is made to the successful bidders. The rest bidders
get refund orders.
5.7 THE PRICE FIXATION OF SECURITY
All the applications received till the last dates are analyzed and a final offer
price, known as the cutoff price is arrived at. The final price is the equilibrium price
or the highest price at which all the shares on offer can be sold smoothly. If the
price quoted by an investor is less than the final price, he will not get allotment.
If price quoted by an investor is higher than the final price, the amount in
excess of the final price is refunded if he gets allotment. If the allotment is not
made, full money is refunded within 15 days after the final allotment is made. If the
investor does not get money or allotment in a month’s time, he can demand interest
at 15 per cent per annum on the money due.
5.8 DEMATERIALIZATION
Dematerialization offers flexibility along with security and convenience.
Holding share certificates in physical format carried risks like certificate forgeries,
 42

loss of important share certificates, and consequent delays in certificate transfers.

Dematerialization eliminates these hassles by allowing customers to convert their
physical certificates into electronic format. Shares in the electronic format are held
in a Demat account.
5.9 PROCESS OF DEMATERIALIZATION
Dematerialization starts with opening a Demat account. For demat account
opening, you need to shortlist aDepository Participant (DP) that offers Demat
services.
To convert the physical shares into electronic/demat form, A Dematerialization
Request Form (DRF), which is available with the Depository Participant (DP), has to be
filled in and deposited along with share certificates. On each share
certificate, 'Surrendered for Dematerialization' needs to be mentioned.
The DP needs to process this request along with the share certificates to the
company and simultaneously to registrars and transfer agents through the
depository
Once the request is approved, the share certificates in the physical form will be
destroyed and a confirmation of dematerialization will be sent to the depository
The depository will then confirm the dematerialization of shares to the DP.
Once this is done, a credit in the holding of shares will reflect in the investor's
account electronically.
This cycle takes about 15 to 30 days after the submission of dematerialization
request
Dematerialization is possible only with a Demat account, Learn about how to
open a demat account to understand dematerialization.
5.10 NEED FOR DEMATERIALIZATION
Handling of paperwork related to shares in physical format often led to errors
and unforeseen mishaps in the past.
Tracking records and share documents with respect to transfer and upkeep
transactions was difficult
The authorities in charge of updating these documents could not keep up with
the increasing volume of share papers, which, if left unchecked, could cripple the
financial base of the Indian share market and associated businesses.
5.11 BENEFITS OF DEMATERIALIZATION
It allows you to conveniently manage your shares and transactions from
anywhere
Stamp duty is not levied on your electronic securities
When investors open a demat account, it provides paperless transactions
of securities.
Nominal holding charges are levied.
 43

5.12 DEPOSITORY SYSTEM

The trading in physical segment is full of inefficiencies due to handling of large
volumes of certificates and also involves various other problems like delays in
transfer, delay in settlement, loss in transit, forgerly certificates, stolen certificates,
mutilation of certificates, postal losses, court cases, litigation etc. To overcome
these deficiencies, a new system of trading, viz. Depository system was introduced,
which facilitates investor to hold securities in electronic form and to trade in these
securities. The first depository set up in India is National Securities Depository
Limited (NSDL) and is promoted by IDBI, UTI andNSE.
Depository is an organisation which holds your securities in electronic (also
known as ‘book entry’) form, in the same manner as a bank holds your money.
Further, a depository also transfers your securities without actually handling
securities, in the same day as a bank transfers funds without actually handling
cash.
5.14 BENEFITS OF DEPOSITORY SYSTEM
1. No danger of loss of share certificates since the shares are credited to
youraccount.
2. No possibility of bad deliveries.
3. Elimination of all rise associated with physical certificates such as loss,
theft,forgery, mutilation etc.
4. No need to affix share transfer stamp as it is a paperless trading.
5. No postal / courier charges.
6. Less brokerage charges.
7. After the settlement, pay in and pay out are on the same day for paperless
trading which means you get your securities and cash immediately.
8. Scriptless trading helps allocate corporate benefits faster.
9. Facilitates pledging and hypothecation of your securities.
10. Eliminates the problem of odd lot shares.
11. Facility to lock your account if you are abroad.
Services offered by NSDL :
The following services are offered by NSDL to the investors, through its agents
viz. Depository Participants.
1. Holding the investors securities in electronic form.
2. Dematerialisation and rematerialisation of securities.
3. Settlement of trades in electronic form.
4. Electronic credit of public offerings and non-cash corporate actions such as
rights, bonus etc.
 44

5.14 MARKET MEMBERSHIP

Categories of Membership
Membership of the Exchange/ NSCCL is open to corporate entities, limited
liability partnerships, partnership firms and individuals who fulfill the eligibility
criteria laid down by SEBI and NSE.
Two types of memberships are offered :
Normal - Unrestricted business expansion
Alpha - For focused proprietary trading with limited clientele
Trading Member
This category of membership entitles a member to execute trades on his own
account as well as on account of his clients but, clearing and settlement of trades
executed through the Trading Member would have to be done through a Trading-
cum Clearing Member or Professional Clearing Member of the Exchange
Trading cum Self Clearing Member
This category of membership entitles a member to execute trades and to clear
and settle the trades executed on his own account as well as on account of his
clients.
Trading cum Clearing Member
This category of membership entitles a member to execute trades on his own
account as well as on account of his clients and to clear and settle trades executed
by themselves as well as by other trading members who choose to use clearing
services of the member.
Professional Clearing Member
This category of membership entitles a member to clear and settle trades of
such members of the Exchange who choose to clear and settle their trades through
this member.
5.15 REGULARITY FRAME WORK
Indian Capital Markets are regulated and monitored by the Ministry of
Finance, The Securities and Exchange Board of India and The Reserve Bank of
India. The Ministry of Finance regulates through the Department of Economic
Affairs - Capital Markets Division. The division is responsible for formulating the
policies related to the orderly growth and development of the securities markets (i.e.
share, debt and derivatives) as well as protecting the interest of the investors. In
particular, it is responsible for institutional reforms in the securities markets,
building regulatory and market institutions, strengthening investor protection
mechanism, and providing efficient legislative framework for securities
markets. The Division administers legislations and rules made under the
Depositories Act, 1996,Securities Contracts (Regulation) Act, 1956 and Securities
and Exchange Board of India Act, 1992.
 45

5.16 THE REGULATORS

Securities & Exchange Board of India (SEBI)
The Securities and Exchange Board of India (SEBI) is the regulatory authority
established under the SEBI Act 1992 and is the principal regulator for Stock
Exchanges in India. SEBI’s primary functions include protecting investor interests,
promoting and regulating the Indian securities markets. All financial intermediaries
permitted by their respective regulators to participate in the Indian securities
markets are governed by SEBI regulations, whether domestic or foreign. Foreign
Portfolio Investors are required to register with DDPs in order to participate in the
Indian securities markets.
Reserve Bank of India (RBI)
The Reserve Bank of India (RBI) is governed by the Reserve Bank of India Act,
1934. It is responsible for implementing monetary and credit policies, issuing
currency notes, being banker to the government, regulator of the banking system,
manager of foreign exchange and regulator of payment & settlement systems while
working towards the development of Indian financial markets. The RBI regulates
financial markets and systems through different legislations. It regulates foreign
exchange markets through the Foreign Exchange Management Act, 1999
Income Tax Department, Govt. of India
The Central Board of Direct Taxes (CBDT) is the apex tax administration body
that functions under the Department of Revenue, Ministry of Finance and
administers direct taxation in India. This department is also responsible for
enforcing the Double Taxation Avoidance Agreements.
FPI Norms
Under the SEBI FPI Regulations, 2014, Foreign Institutional Investors (FIIs),
sub accounts and Qualified Foreign Investors (QFIs) were merged into a single
category, referred to as FPIs. Regulation 21 of the FPI Regulations provides a list of
securities in which FPIs are permitted to access and invest. This path breaking
Regulation ushers significant and positive changes in accessing the Indian Capital
Markets by foreign investors.
Some of the highlights being
 Risk based categorization of Investors introduced
 Documentation requirements have been eased across all categories with
minimalistic requirements for categories I and II
 Reduced Registration fees
 Simplified KYC norms by SEBI and RBI
 Speedier registration through Designated Depositary Participants (DDPs)
 Investment limits enhanced for specific Investor Categories
National Stock Exchange (NSE) – Rules and Regulations
In the role of a securities market participant, NSE is required to set out and
implement rules and regulations to govern the securities market. These rules and
regulations extend to member registration, securities listing, transaction
 46

monitoring, compliance by members to SEBI / RBI regulations, investor protection

etc. NSE has a set of Rules and Regulations specifically applicable to each of its
trading segments. NSE as an entity regulated by SEBI undergoes regular
inspections by them to ensure compliance.
5.17 OTCEI (Over-The-Counter Exchange of India)
OTCEI was incorporated in 1990 as a Section 25 company under the
Companies Act 1956 and is recognized as a stock exchange under Section 4 of the
Securities Contracts Regulation Act, 1956. The Exchange was set up to aid
enterprising promoters in raising finance for new projects in a cost effective manner
and to provide investors with a transparent & efficient mode of trading. Modelled
along the lines of the NASDAQ market of USA, OTCEI introduced many novel
concepts to the Indian capital markets such as screen-based nationwide trading,
sponsorship of companies, market making and scripless trading. As a measure of
success of these efforts, the Exchange today has 115 listings and has assisted in
providing capital for enterprises that have gone on to build successful brands for
themselves like VIP Advanta, Sonora Tiles & Brilliant mineral water, etc.
A successful market for technology & growth companies has to :
 demonstrate an understanding for new technology and concepts
 provide capital formation opportunities for young companies without a track
record
 be national in order to reach and service entrepreneurs and investors
 enable access to a wide spectrum of financial intermediaries
 be cost effective for issuers
 provide an exit route to venture capital & private equity funds for their investments
 adopt state of art trading systems and practices in tune with international
norms
 be well regulated to promote transparent and fair market practices
OTCEI, by virtue of its unique position, is well suited to service the
requirements of these companies, making it the natural choice for the emerging
technology and growth stocks. In fact, consumer favourites like VIP Advanta,
Sonora tiles and Brilliant Mineral Water are made by high growth companies that
have benefited by listing on OTCEI.
Securities are traded on OTCEI through the 'OTCEI Automated Securities
Integrated System' (OASIS), a state-of-art screen based trading system. OASIS
combines the principles of order driven and quote driven markets and enables
trading members to access a transparent & efficient market directly through a
nationwide telecommunication network. The first Indian stock exchange to
introduce nationwide computerised screen-based trading.
State-of-the-art, STRATUS fault tolerant computer server
Trading software modeled on TCAM software
 47

Connectivity through combination of satellite (VSAT) & terrestrial (lease

line/dialup) modes.
Excellent infrastructure/software support from CMC/TCS/HCL Comnet
Network of Members / Dealers spread over more than 50 cities.
OTC Exchange of India has been co-promoted by the leading financial institutions of
the country:
 ICICI Bank Limited
 Administrator of Specified Undertaking of Unit Trust of India
 IDBI Bank Limited.
 SBI Capital Markets Limited
 IFCI Limited
 Life Insurance Corporation of India
 Canbank Financial Services Limited
 General Insurance Corporation of India
 The New India Assurance Company Limited
 The Oriental Insurance Company Limited
 United India Insurance Company Limited
 National Insurance Company Limited
REVISION POINTS
 SEBI: Securities and Exchange Board of India.
 NSE: National Stock Exchange
 BSE: Bombay Stock Exchange
 OTCEI: Over-The-Counter Exchange Of India.
INTEXT QUESTIONS
1. What is the meanings of book buiding?
2. Explain The Process Of Book Buiding.
SUMMARY
 India's oldest and first stock exchange: Mumbai (Bombay) Stock Exchange.
Established in 1875. More than 6,000 stocks listed.
 Total number of stock exchanges in India: 22
 They are in: Ahmedabad, Bangalore, Calcutta, Chennai, Delhi etc.
 There is also a National Stock Exchange (NSE) which is located in Mumbai.
 There is also an Over The Counter Exchange of India (OTCEI) which allows listing
of small and medium sized companies.
 The regulatory agency which oversees the functioning of stock markets is the
Securities and Exchange Board of India (SEBI), which is also located in Bombay.
 48

TERMINAL EXERCISE
1. The organization of stock exchange provides a ___________to speculators and
investors in industrial enterprises.
Ans: Ready Market
SUPPLEMENTARY MATERIALS
 money.rediff.com
 money control.com
 amfiindia.com
 nseindia
 bseindia.com
 rbi.org.in
ASSIGNMENTS
1. Discuss the role of OTCEI (Over-The-Counter Exchange Of India)
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Visit nearest stock market and observe the various functions involved in the
stock market.
KEY WORDS
Bombay stock exchange, National stock exchange, Book building.
 49

LESSON 6

NEW ISSUE MARKET

INTRODUCTION
Companies raise funds to finance their projects through various methods. The
promoters can bring their own money of borrow from the financial institutions or
mobilise capital by issuing securities. The funds may be raised through issue of
fresh shares at par or premium, preferences shares, debentures or global
depository receipts.
OBJECTIVES
After reading this lesson the student should be able to understand distribution
functions of new issue market, prospectus, offer for sale private placement, right
issue, bonus share book building.
CONTENT
6.1 Objectives of a capital issue
6.2 Distribution functions of new issue market
6.1 THE MAIN OBJECTIVES OF A CAPITAL ISSUE ARE GIVEN BELOW
1. To promote a new company
2. To expand an existing company
3. To diversify the production
4. To meet the regular working capital requirements
5. To capitalise the reserves
In the primary market, the new issues of securities are presented in the form
of Public issues, Right issues and Private Placements. Its efficient operation is made
possible by the financial inter media ries and financial institutions, who arrange
long- term financial transactions for the clients.
Issues of the securities in the primary market may be made through
i. Prospectus,
ii. Offer for sale
iii. Private placement.
The securities offered to the public through prospectus are directly subscribed
by the investor. The issuing companies widely publicise the offer through various
media. The Securities Exchange Board of India (SEBI) has classified various issues
in Three groups i.e., New issues, Right issues and Preferential issues.
The SEBI has issued various guidelines regarding proper disclosure For
investor‘s protection. These guidelines are required to be duly observed by the
companies making issue of capital. The guidelines issued by the SEBI broadly cover
the requirements regarding issue of capital by the companies. The guidelines are
applicable to all the companies after the repeal of Controller of Capital Issues (CCI)
Act 1947.
The boom in the primary capital market, that started in the mid-eighties and
accelerated thereafter, started slowing down by 1995. There are several reasons for
this slowing down of resource mobilization in the primary market. In particular, the
 50

low retur n on new issues, some resulting in stock market fiasco, seems to have
shattered the confidence of the investors.
6.2 DISTRIBUTION FUNCTIONS OF NEW ISSUE MARKET
The distribution functions of new issue market are detailed under the following
headings.
1. Prospectus.
2. Offer for sale.
3. Private placement.
4. Right issue
5. Bonus Share.
6. Book Building.
1. Prospectus
This is a method by which a company directly sells its share to the public.
Through the media, the company advertises and interested persons are given the
prospectus which carry full details about the company. Based on this, the public
apply to the company and shares of the new company are allotted at the face value.
The old companies may issue shares at the market value with the due
permission of authorities concerned, (SEBI). The issue of shares is guaranteed by
an underwriter who ensures certain minimum quantity of sale of shares.
A copy of the prospectus should be submitted to SEBI for approval before
coming out to the public. This prospectus is known as Red herring prospectus
(RHP).
2. Offer for sale
Here the company resorts to the sale of shares through intermediaries who
are stock brokers or issue houses. By this method, the company is able to promote
the sale of shares and the sale is also guaranteed with the help of underwriters.
Intermediaries will take more interest in the sale of shares as they are offered to
them at a lesser price and they in turn will sell them at a higher price to the public.
The difference in the price will be the profit earned by the intermediaries. The
drawback of this system is that the company will not be benefited when the shares
are sold at a higher price by the intermediaries.
3. Private Placement
The shares of the companies are given to the investing public with the help of
issue houses. This method is adopted by certain companies as it prevents the
presence of underwriters. The issue houses are responsible for the sale of the
shares and no prospectus is required under this system. It also involves minimum
expenditure.
4. Rights issue
When a company wishes to expand its capital base, it prefers to issue shares
to the existing shareholders which are called rights shares. But before the issuing
 51

of the rights shares, the company should get permission of the Government (SEBI)
and a resolution has to be passed by the board of directors.
The rights issue will be based on a proportion of existing shares held by the
shareholders. A company can issue rights shares only after 2 years of its formation
or after 1 year of its first issue of shares, whichever is earlier. There is no need for
issue of prospectus or advertisements and this can be adopted only by an existing
company and not a new company. The price of rights shares may be fixed at a
premium also, subject to the permission of the Government (SEBI).
5. Bonus shares
When a company decides to capitalize its profit, it will issue bonus shares
which will be available only to the existing shareholders. Bonus shares can be
issued only by companies which earned profit, which is a commercial profit arising
out of their business operations. If a company earns profit by the sale of assets, it
will not be construed as profit.
For the issue of bonus shares, the company must fulfill statutory obligations of
providing various reserves and declaring dividend to the existing shareholders. After
meeting the statutory regulations, if the remaining profit is more than 40%, then
the company with the prior permission of Government (SEBI), can go in for the
issue of bonus shares. It will be issued on a proportion to existing shares held by
the shareholders.
6. Book Building
When a company, instead of offering shares directly to the public, invites bids
from the merchant bankers for the sale of shares, it is called book building. The
merchant bankers will take the full responsibility for the issue of the shares. The
entire procedure of allotment of listing of shares will be undertaken by the
merchant bankers.
The share price depends on the demand for the shares in the market. The
book runner or the merchant banker will select any stock exchange and register the
shares for the issue. If the stock exchange is having an on-line computer facility,
then the merchant banker will make available the shares through the on-line
system. The closing date for the sale of shares will be fixed by the merchant banker
after consulting with the stock exchange concerned.
Depending upon the offers received after the date of closure, the price will be
fixed. On finalization of the share price, the shares will be allotted. While allotting
shares, preference may be given to promoters, employees, and finally to QIB
(qualified institutional bidders) who are otherwise known as qualified
intermediaries.(The Details Of Book Building Is Discuss In The Previous Lesson)
REVISION POINTS
The primary market refers to the set up by which the industry raises funds by
issuing different types of securities. These securities are issued directly to the
investors, both individual and institutions. The primary market discharges the
 52

important function of transfer of savings, especially of the individual, Government

and public sector undertakings.
INTEXT QUESTIONS
1. Explain the nature of New Issues Market (NIM). How does NIM differ from
secondary market?
2. What are the parties involved in the issue of shares in the stock market?
SUMMARY
An Initial Public Offering (IPO) is a company’s first offering of equity to the
public. IPO is a major source of capital for firms. Thus IPOs market being an
important part of the primary market is an important segment of capital market of
the financial system, which plays a significant role in the economic growth and
development of a country by transferring resources from surplus units to deficit
units in an efficient and productive manner.
TERMINAL EXERCISE
1. When a company wishes to expand its capital base, it prefers to issue shares to
the existing shareholders which are called __________
Ans: Rights Shares
SUPPLEMENTARY MATERIALS
 money.rediff.com
 money control.com
 amfiindia.com
 nseindia
 bseindia.com
 rbi.org.in
ASSIGNMENTS
1. Explain the functions of the primary market.
2. What are the guidelines issued by the sebi in pricing and allotment of the new issue?
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Visit nearest stock exchange and observe the activities regarding IPO.
KEY WORDS
Security exchange board of India, Initial public offer, Primary Market.
 53

LESSON 7

LISTING OF SECURITY
INTRODUCTION
Listing means admission of securities to dealings on a recognized stock
exchange.The securities may be of any public limited company, Central or State
Government, quasi governmental and other financial institutions/corporations,
municipalities, etc.
OBJECTIVES
After reading this lesson the student should be able to Understand Listing of
security.
CONTENT
7.1 The Main Objectives of Listing of Security
7.2 Conditions for Listing
7.3 Types of Listing of Securities
7.4 Procedure for Listing Requirements
7.5 Procedure at the Stock Exchange
7.6 Advantages of Listing on Stock Exchange:
7.7 Criteria for Listing of Securities:
7.8 Types of Stock Market Transactions
7.9 Mechanics of Security Trading in Stock Exchanges
7.10 Execution of Order
7.1 THE MAIN OBJECTIVES OF LISTING OF SECURITY
1. provide liquidity to securities;
2. mobilize savings for economic development;
3. protect interest of investors by ensuring full disclosures.
7.2 CONDITIONS FOR LISTING
Before listing securities, a company has to fulfill the following conditions:
1. Shares of the company must be offered to the public through a prospectus and
25% of each class of securities must be offered.
2. The prospectus should clearly mention opening of subscription, receipt of
application, etc.
3. The capital structure of the company should be broad-based and there should-
be public interest in securities.
4. The minimum issued capital must be Rs. 3 crores of which Rs. 1.80 crores
must be offered to the public.
5. There must be at least five public shareholders for every Rs. 1 lakh of fresh
issue of capital and 10 shareholders for every Rs. 1 lakh of offer for sale of
existing capital. On the excess application money, the company will have to pay
 54

interest from 4% to 15%, if there is delay in refund and delay should not be
more than 10 weeks from the date of closure of subscription list.
6. A company with paid up capital of more than Rs. 5 crores should get itself
listed in more than one stock exchange, it includes the compulsory listing on
regional stock exchange.
7. The auditor or secretary of the company applying for listing should declare that
the share certificates have been stamped so that shares belonging to the
promoter’s quota cannot be sold or hypothecated or transferred for a period of
5 years.
8. Articles of Association of the company must have the following provisions:
a. A common form of transfer shall be used
b. Fully paid shares shall be used
c. No lien on fully paid shares
d. Calls paid in advance will not carry a right to dividend and will not be
forfeited before the claim becomes time-barred.
e. Option to call off shares shall be given only after sanction by the general
meeting.
9. Letter of allotment, Letter of regret and letter of rights shall be issued
simu1taneously.
10. Receipts for all the securities deposited, whether for registration or split and no
charges will be made for the services.
11. The company will issue consolidation and renewal certificates for split
certificate, letter of allotment, letter of rights and transfer, etc. when required.
12. The stock exchange should be notified by the company regarding the date of
board meeting, change in the composition of board of directors, and any new
issue of securities, in place of reissue of forfeited shares.
13. Closing the transfer books for the purpose of declaration of dividend, rights
issue or bonus issue. And for this purpose, due notice should be given to stock
exchange.
14. Annual return of the company to be filed soon after the annual general body
meeting.
15. The company will have to comply with conditions imposed by the stock
exchange now and then for 1istmg of security.
7.3 TYPES OF LISTING OF SECURITIES
1. Initial listing: Here, the shares of the company are listed for the first time on a
stock exchange.
2. Listing for public Issue: When a company which has listed its shares on a
stock exchange comes out with a public issue.
 55

3. Listing for Rights Issue: When the company which has already listed its
shares.in the stock exchange issues securities to the existing shareholders on
rights basis.
4. Listing of Bonus shares: When a listed company in a stock exchange is
capitalizing its profit by issuing bonus shares to the existing shareholders.
5. Listing for merger or amalgamation: When the amalgamated company issues
new shares to the shareholders of amalgamated company, such shares are
listed.
7.4 PROCEDURE FOR LISTING REQUIREMENTS
For listing the shares in the stock exchange, the public limited company will
have to submit supporting documents. They are:
 Certified copies of, Articles of Association, prospectus and agreements with
Underwriters.
 All particulars regarding capital structure.
 Copies of advertisements offering securities for sale during the last 5 years.
 Copies of Balance sheet, audited accounts and auditors’ report for the last 5
years.
 Specimen copies of shares and debentures, certificate letter of allotment, and
letter of regret.
 A brief history of the company since incorporation with any changes in capital
structure, borrowings, etc.
 Details of shares and debentures issued for consideration other than cash.
 Statement showing distribution of shares and particulars of commission,
brokerage, discounts or special terms towards the issue of shares.
 Any agreement with financial institutions.
 Particulars of shares forfeited.
 Details of shares or debentures for which permission to deal with is applied for.
 Certified copy of consent from SEBI.
7.5 PROCEDURE AT THE STOCK EXCHANGE
After the application is made the Listing Committee of the stock exchange will
scrutinize the application form of the company. Here, the stock exchange will
ensure the following.
1. The financial position of the company is sound
2. Solvency and liquidity positions are good
3. The issue is large and broad based to generate public interest. If the application
for listing is accepted, the listed company will be called to execute listing
agreement with the stock exchange. The company must follow certain
obligations which are:
 56

the company will treat all the applications with equal fairness.in case of over
subscription, the allotment will be decided in consultation with stock exchanges;
and the company will notify to the stock exchange any change in its management,
business, capital structure or bonus or rights issue of shares.
7.6 ADVANTAGES OF LISTING ON STOCK EXCHANGE:
a) Information about the company is available in detail.
b) Information provides awareness about the work of the organization. This
increases trading activity of purchase and sale of shares of the company.
c) Continuous dealing of the security raises its value in the securities market.
d) It provides convenience of sale of security. This lends liquidity to the shares.
e) There is safety in dealing as it is registered with SEBI.
f) It ensures creditworthiness.
g) The act of listing of shares creates a favourable impression on the investor.
h) Listing gives collateral value in making loans and advances from banks who
prefers quoted securities.
i) It widens the market of the security.
Thus, listing benefits both the investor as well as the company. Listing on
stock exchange is done only when the company follows the statutory rules laid
down under the Securities Exchange Board of India (SEBI).
The following statutory rules have been laid down for the listing of securities
under the SEBI.
A company requiring a quotation for its shares (i.e., desiring its securities to be
listed) must apply in the prescribed form supported by the documentary evidence
given below:
Documents to be attached:
i. Copies of Memorandum and Articles of Association, Prospectus or
Statement in lieu of Prospectus, Directors’ Reports, Balance Sheets, and
Agreement with Underwriters etc.
ii. Specimen copies of Share and Debenture Certificates, Letter of Allotment,
Acceptance, Renunciation etc.
iii. Particulars regarding its capital structure.
iv. A statement showing the distribution of shares.
v. Particulars of dividends and cash bonuses during the last ten years.
vi. Particulars of shares or debentures for which permission to deal is applied for.
vii. A brief history of the company’s activities since its incorporation.
7.7 CRITERIA FOR LISTING OF SECURITIES
The Stock Exchange has to direct special attention to the following particulars
while scrutinizing the application:
 57

i. Articles
a) Whether the Articles contain the following provisions:
i. A common form of transfer shall be used.
ii. Fully paid shares will be free from lien.
iii. Calls paid in advance may carry interest, but shall not confer a right to
dividend.
b) Unclaimed dividends shall not be forfeited before the claim becomes time
barred.
c) Option to call on shares shall be given only after sanction by the general
meeting.
d) Whether at least 49% of each class of securities issued was offered to the public
for subscription through newspapers for not less than three days.
e) Whether the company is of a fair size, has a broad based capital structure and
there is sufficient public interest in its securities.
ii. Listing of Agreement
After scrutiny of the application, the stock exchange authorities may, if they
are satisfied, call upon the company to execute a listing agreement which contains
the obligations and restrictions which listing will entail. This agreement contains 39
clauses with a number of sub-clauses.These cover various aspects of the issue of
letters of allotment, share certificates, transfer of shares, information to be given to
the stock exchanges regarding closure of register of members for the purpose of
payment of dividend, issue of bonus and right shares and convertible debentures,
holding of meetings of the board of directors for recommendation or declaration of
dividend or issue of right or bonus shares or convertible debentures, submission of
copies of directors’ report, annual accounts and other notices, resolutions and so
on to the shareholders.
The basic purpose behind making these provisions in the listing agreement is
to keep the shareholders and investors informed about the various activities which
are likely to affect the share prices of such companies so that equal opportunity is
provided to all concerned for buying or selling of the securities. On the basis of
these details, investors are able to make investment decisions based on correct
information.
The stock exchange enlisting the securities of a company for the purpose of
trading insists that all applicants for shares will be treated with equal fairness in
the matter of allotment. In fact, in the event of over-subscription, the stock
exchange will advise the company regarding the basis for allotment of shares. It will
try to ensure that applicants for large blocks of shares are not given under the
preference over the other.
i. To notify the stock exchange promptly of the date of the Board Meeting at which
dividend will be declared;
 58

ii. To forward immediately to the stock exchange copies of its annual audited
accounts after they are issued;
iii. To notify the stock exchange of any material change in the general nature or
character of the company’s business;
iv. To notify the stock exchange of any change in the company’s capital; and
v. To notify the stock exchange (even before shareholders) of the issue of any new
shares (right shares or otherwise) as the issue of any privileges or bonus to
members.
The company must also undertake:
a) Not to commit a breach of any condition on the basis of which listing has been
obtained;
b) To notify the exchange of any occasion which will result in the redemption,
cancellation or retirement of any listed securities;
c) Avoid as far as possible the establishment of a false market for the company’s
shares;
d) To intimate the stock exchange of any other information necessary to enable
the shareholders to appraise the company’s position.
According to Section 73 of the Companies Act, 1976, if a company indicate in
its prospectus that an application has been made or will be made to a recognized
stock exchange for admitting the company’s shares or debentures to dealings
therein, such permission must be applied for within a stipulated period to time.
The Securities Contracts (Regulation) Act, 1956, gives the Central Government
power to compel an incorporated company to get its securities with a recognized
stock exchange in accordance with the rules and regulations prescribed for the
purpose.
If a recognized exchange refuses to list the securities of a company, the
company can file an appeal against such a decision with the government. The Act
empowers the government to set aside or change the decision after giving proper
opportunity to both the parties to explain their position in this regard.
iii. Guidelines for Listing Securities
To ensure the effective working of the recognized stock exchange in the public
interest, Government framed Securities Contracts (Regulation) Rules, 1957. From
time-to-time, these Rules have been revised whenever it has been necessary to do
so depending on the environmental requirements through guidelines issued by the
government in this regard.
In November 1982, certain administrative guidelines governing the listing of
securities on recognized stock exchanges, in relaxation of Rule-19 (2) (b) if these
Rules were issued. These guidelines broadly cover the following:
 59

iv. Other Established or New Non-FERA Companies

In respect of:
a) Other established Non-FERA companies, that is, companies incorporated in
India within ten years of the date of the listing application and in which foreign
equity does not exceed 40 per cent, and
b) New companies without any foreign equity participation, the provisions of Rule
19 (2) (b) of the Securities Contracts (Regulation) Rules will apply. In other
words, the public offer should be at least 60 per cent of the issued capital of the
company in such cases.
Subscriptions by the Central Government, State Government and their
agencies and public financial institutions will be counted as a part of the public
offer up to a maximum extent of 11 per cent of the issued capital of the company.
v. Existing FERA Companies
In respect of existing companies having more than 40 per cent foreign equity
and undergoing the process of Indenisation under the Foreign Exchange
(Regulation) Act, 1973, the public offer should be balance of the issued capital after
deduction of the permissible level of foreign equity and the holding of existing
Indian shareholders.
However, in no case should the public offer be less than 20 per cent of the
issued capital of the company.
New Companies with Foreign Equity Participation
In respect of new companies with approved foreign equity participation, the
public offer should be the balance of the issued capital after deduction of the
capital subscribed by the foreign participants and the Indian promoters.
The following conditions should, however, be fulfilled
i. The public offer should in no case be less than 33 per cent of the issued capital
of the company.
ii. The share of the Indian promoters should not be more than 40 per cent of the
issued capital of the company.
vi. New Companies with Non-Resident Indian Equity Participation
Where non-residents of Indian nationally or origin of overseas companies,
partnership firms, trusts, societies and other corporate bodies, owned predominant
ownership is that at least 60 per cent of the ownership of these entitles should be
with non-residents of Indian nationality or origin (the criterion for determining such
predominant ownership is that at least 60 per cent of the ownership of these
entities should be with non-residents of Indian nationality or origin) are themselves
the promoters of the company after deduction of the capital subscribed by them.
However, public offer in such a case should not be less than 26% of the issued
capital of the company.
If the non-resident Indian equity is 74 per cent, the public offer should be 26
percent of the issued capital of the company.
 60

If the non-resident Indian equity is 40 per cent, the public offer should be 60
per cent of the issued capital of the company. [There is no relaxation of Rule 19(2)
(b) in this case].
If the non-resident Indian equity is 30 per cent, the public offer need not
exceed 60 per cent and the balance of 10 per cent can be allotted to friends,
relatives and associates of the promoters. [Here again, there is no relaxation of Rule
19(2) (b)].
vii. Joint Sector Companies
In a Joint sector company, the principal promoter will be a State Government
and/or its agencies and the co- promoter will be a private party. The shareholding
of the State Government and/or its agencies will not ordinarily be less than that of
the co-promoter.
In such cases, the public offer should be the balance of the issued capital of
the company after deduction of the capital subscribed by the promoters and the co-
promoters subject to the condition that the public offer should not normally be less
than 33-1/3 per cent of the issued capital of the company.
To illustrate, if the State Government and/or its agencies take up 26 per cent
and the co-promoter takes up 25 per cent of the issued capital of the company, the
balance of 49 per cent should be offered to the public.
xiii. Offer for the Sale of Existing Issued Capital
Companies can have their shares listed on recognized Stock Exchange by
arranging for an offer for sale of their existing issued capital. Such an offer for sale
can be combined with a fresh issue of capital also. The extent of public offer in
these cases should be in conformity with the provisions detailed above.
In addition, the following conditions should also be fulfilled
i. The net worth (i.e., existing paid up equity capital plus free reserves, excluding
reserves created out of revaluation of fixed assets) of the company should not
be less than its existing paid up capital and the company should not have
incurred a loss in each of the three years preceding the listing application.
ii. The offer should result in a wide distribution of shares among the general
public without undue concentration of large holdings, and the number of
public shareholders should be at least 20 for every Rs. 1 lakh of the public
offer.
iii. If the share is offered at a price above its par value, the price should have been
approved by the Central Government.
iv. The offer should set out all material particulars relating to the company and
the shares offered to the public. It must be in a form approved by the Stock
Exchange concerned and must comply with all conditions pertaining to public
advertisement, opening and closing of subscription lists, payment of
application money, disposal of applications, basis of allotment, etc., as are
applicable to a company offering fresh shares for public subscription in
 61

accordance with the listing regulations and instructions issued by the

government from time-to-time.
7.8 TYPES OF STOCK MARKET TRANSACTIONS
 An initial public offering (IPO), or stock market launch, is a type of public
offering where shares of stock in a company are sold to the general public, on
a securities exchange, for the first time.
 A secondary market offering is a registered offering of a large block of a security
that has been previously issued to the public.
 In the secondary market, securities are sold by and transferred from
one investor or speculator to another. It is therefore important that the
secondary market remain highly liquid.
 Private placement (or non-public offering) is a funding round of securities which
are sold not through a public offering, but rather through a private offering,
mostly to a small number of chosen investors.
 Stock repurchase (or share buyback) is the reacquisition by a company of its
own stock.
7.9 MECHANICS OF SECURITY TRADING IN STOCK EXCHANGES
An investor must have some knowledge of how the securities markets operate.
The marketing of old or new securities of the stock markets can be done only
through members of the Stock Exchange. These members are either individuals or
partnership firms.
An individual must use the facilities of these members for trading in securities.
The member is a registered dealer of an organized stock exchange. Trading among
the members of a recognized stock exchange is to be done under the statutory
regulations of the stock exchange. The members carrying on business are known as
‘brokers’ and can trade only on listed securities.
These members execute customer’s orders to buy and sell on the exchange
and their firms receive negotiated commissions on those transactions. About one-
fourth of all members of the exchange are ‘specialists’, so called because they
specialize in ‘making a market’ for one or more particular kind of stock.
In the process of trading in stock exchanges, there is the basic need for a
‘transaction’ between an individual and broker. A transaction to buy and sell
securities is also called ‘trades’. This is to be done through selection of a broker.
7.10 EXECUTION OF ORDER
Many investors who trade through online brokerage accounts assume they
have a direct connection to the securities markets, but they don't. When you push
that enter key, your order is sent over the Internet to your broker -- who in turn
decides which market to send it to for execution. A similar process occurs when you
call your broker to place a trade.
 62

While trade execution is usually seamless and quick, it does take time. And
prices can change quickly, especially in fast-moving markets. Because price quotes
are only for a specific number of shares, investors may not always receive the price
they saw on their screen or the price their broker quoted over the phone. By the
time your order reaches the market, the price of the stock could be slightly -- or
very -- different.
SEC regulations do not require a trade to be executed within a set period of
time. But if firms advertise their speed of execution, they must not exaggerate or
fail to tell investors about the possibility of significant delays.
An execution is the completion of a buy or sell order for a security. The
execution of an order happens when it is completely filled, not when it is placed by
the investor. When the investor places the trade, it goes to a broker, who then
determines the best way for it to be executed.
Breaking Down Execution
Brokers are required by law to give investors the best execution possible, and
can attempt to execute the transaction in the following ways:
1. Order to the Floor: This can take some time as it goes through human hands.
The floor broker will need to get the order and fill it.
2. Order to Market Maker: On exchanges such as the Nasdaq, market makers are
in charge of different stocks. The investor's broker may direct the trade to one of
these market makers for execution.
3. Electronic Communications Network (ECN): An extremely quick method,
whereby computer systems electronically match up buy and sell orders.
4. Internalization: If the broker's firm holds an inventory of the stock in question,
it may decide to execute the order from its own inventory.
REVISION POINTS
For trading in the stock market, a company has to list its securities in the
stock exchange. It means that the name of the company is registered in the stock
exchange. The company has to fulfill certain conditions according to Companies
Act. The company has to offer its shares or debentures to the public for
subscription. Only then, the company will be allowed to list its security in
the stock exchange.
INTEXT QUESTIONS
1. What is listing? Why do companies get their shares listed on the stock
exchange?
2. What are the advantages of the listing?
3. What are the pre-requisites for the listing?
4. Explain the procedures adopted for listing?
 63

SUMMARY
Advantages of Listing on Stock Exchange:
a) Information about the company is available in detail.
b) Information provides awareness about the work of the organization. This
increases trading activity of purchase and sale of shares of the company.
c) Continuous dealing of the security raises its value in the securities market.
d) It provides convenience of sale of security. This lends liquidity to the shares.
e) There is safety in dealing as it is registered with SEBI.
f) It ensures creditworthiness.
TERMINAL EXERCISE
1. ___________ means the shares of the company are listed for the first time on a
stock exchange.
Ans: Initial listing
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
1. How are right shares listed on stock exchanges?
2. Discuss the guidelines for listing securities.
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
1. Visit nearest stock exchange and enquire the necessary basic information for
filling the application of listing of securities of companies
KEY WORDS
Listing Securities, Delisting Security, Execution of order
 64

LESSON 8

STOCK MARKET INDEX AND CREDIT RATE AGENCIES

INTRODUCTION
A stock market index is a measure of the relative value of a group of stocks in
numerical terms. As the stocks within an index change value, the index value
changes. An index is important to measure the performance of investments against
a relevant market indexation.
OBJECTIVES
After reading this lesson the student should be able to Understand Stock
Market Index , Credit Rate Agencies.
CONTENT
8.1 Indices
8.2 Broad Market Indices
8.3 Credit Rating Agencies in India
8.1 INDICES
From among the stocks listed on the exchange, some similar stocks are
selected and grouped together to form an index. This classification may be on the
basis of the industry the companies belong to, the size of the company, market
capitalization or some other basis. For example, the BSE Sensex is an index
consisting of 30 stocks. Similarly, the BSE 500 is an index consisting of 500 stocks.
The values of the grouped stocks are used to calculate the value of the index.
Any change in the price of the stocks leads to a change in the index value. An index
is thus indicative of the changes in the market.
An Index is used to give information about the price movements of products in
the financial, commodities or any other markets. Financial indexes are constructed
to measure price movements of stocks, bonds, T-bills and other forms of
investments. Stock market indexes are meant to capture the overall behaviour of
equity markets. A stock market index is created by selecting a group of stocks that
are representative of the whole market or a specified sector or segment of the
market. An Index is calculated with reference to a base period and a base index
value.
Stock market indexes are useful for a variety of reasons. Some of them are:
They provide a historical comparison of returns on money invested in the stock
market against other forms of investments such as gold or debt.
 They can be used as a standard against which to compare the performance of
an equity fund.
 In It is a lead indicator of the performance of the overall economy or a sector of
the economy
 Stock indexes reflect highly up to date information
 65

 Modern financial applications such as Index Funds, Index Futures, Index

Options play an important role in financial investments and risk management
Some of the important indices in India are:
 Benchmark indices – BSE Sensex and NSE Nifty
 Sectoral indices like BSE Bankex and CNX IT
 Market capitalization-based indices like the BSE Smallcap and BSE Midcap
 Broad-market indices like BSE 100 and BSE 500
Stock market index is created by selecting a group of stocks that are
representative of the whole market or a specified sector or segment of the market.
An Index is calculated with reference to a base period and a base index value. An
Index is used to give information about the price movements of products in the
financial, commodities or any other markets. Financial indexes are constructed to
measure price movements of stocks, bonds, T-bills and other forms of investments.
Stock market indexes are meant to capture the overall behaviour of equity markets.
8.2 BROAD MARKET INDICES
These indices are broad-market indices, consisting of the large, liquid stocks
listed on the Exchange. They serve as a benchmark for measuring the performance
of the stocks or portfolios such as mutual fund investments.
NIFTY 50 Index
NIFTY Full Midcap 100 Index
NIFTY Next 50 Index
NIFTY Free Float Midcap 100 Index
NIFTY 100 Index
NIFTY Smallcap 250 Index
NIFTY 200 Index
NIFTY Smallcap 50 Index
NIFTY 500 Index
NIFTY Full Smallcap 100 Index
NIFTY Midcap150 Index
NIFTY Free Float Smallcap 100 Index
NIFTY Midcap 50 Index
NIFTY MidSmallcap 400 Index
India Vix Index
Sectoral Indices
Sector-based index are designed to provide a single value for the aggregate
performance of a number of companies representing a group of related industries or
within a sector of the economy.
Thematic Indices
Thematic indices are designed to provide a single value for the aggregate
performance of a number of companies representing a theme.
 66

Strategy Indices
Strategy indices are designed on the basis of quantitative models / investment
strategies to provide a single value for the aggregate performance of a number of
companies.
Fixed Income Indices
Fixed income index is used to measure performance of the bond market. The
fixed income indices are useful tool for investors to measure and compare
performance of bond portfolio. Fixed income indices also used for introduction of
Exchange Traded Funds.
Index Concepts
Indices and index-linked investment products provide considerable benefits.
Important concepts and terminologies are associated with Index construction.
These concepts are important for investors to learn from the information that
indices contain about investment opportunities.
More about Index Concepts
 Impact Cost
 Beta
 Total Returns Index
 Investible Weight Factors (IWFs)
 Tracking Error
Index Funds
An Index Fund is a type of mutual fund with a portfolio constructed to match
the constituents of the market index, such as NIFTY 50. An index fund provides
broad market exposure and lower operating expenses for investors.
8.3 CREDIT RATING AGENCIES IN INDIA
A credit rating agency is a company which rates the debtors on the basis of
their ability to pay back the debt in timely manner. They rate large scale borrowers,
whether companies or governments. There are three big credit rating agencies in
the world which are Standard and Poor’s (S&P), Moody’s and Fitch Ratings.
1. Stock indices reflect the stock market behaviour.
2. The unweighted price index is a simple arithmetical average of share prices on a
base date
3. In the wealth index, prices are weighted by market capitalisation.
4. The indices differ from each other on the basis of the number, the composition
of the stock, the weights and the base year.
5. BSE sensitive index comprises of 30 scrips on the basis of industry
representation, market capitalisation, liquidity, the market depth, and the
floating stock depth.
6. S & P. CNX Nifty, CNX Nifty Junior and S & P. CNX 500 are some of the indices
based on stocks traded on NSE.
There are mainly 4 credit rating agencies in India which are
 67

(I) Credit Rating and Information Services of India Limited (CRISIL)

CRISIL is an agile and innovative, global analytics company driven by its
mission of making markets function better.
CRISIL are India's foremost provider of ratings, data, research, analytics and
solutions. A strong track record of growth, culture of innovation and global
footprint sets us apart. We have delivered independent opinions, actionable
insights, and efficient solutions to over 100,000 customers. CRISIL's businesses
operate from India, the US, the UK, Argentina, Poland, China, Hong Kong and
Singapore.
CRISIL is majority owned by S&P Global Inc., a leading provider of transparent
and independent ratings, benchmarks, analytics and data to the capital and
commodity markets worldwide.
CRISIL's clients range from micro, small and medium companies to large
corporates, investors, to top global financial institutions. We work with commercial
and investment banks, insurance companies, private equity players and asset
management companies globally.
CRISIL also work with governments and policy makers in the infrastructure
space in India and in other emerging markets.
CRISIL analyses, insights and solutions help lenders, borrowers, issuers,
investors, regulators and intermediaries make sound decisions. We help clients
manage and mitigate risks, take pricing and valuation decisions, reduce time to
market, generate more revenue and enhance returns.
By helping shape public policy on infrastructure in emerging markets, CRISIL
helps catalyse economic growth and development in these geographies.
(II) Investment Information and Credit rating agency (ICRA)
 The second credit rating agency incorporated in India was ICRA in 1991.
 It was set up by leading financial/investment institutions, commercial banks
and financial services companies as an independent and professional
investment Information and Credit Rating Agency.
 It is a public limited company.
 It has its head office in New Delhi.
 ICRA’s majority shareholder is Moody’s.
(III) Credit Analysis & Research Ltd. (CARE)
 The next credit rating agency to be set up was CARE in 1993.
 It is the second-largest credit rating agency in India.
 It has its head office in Mumbai.
 CARE Ratings is one of the 5 partners of an international rating agency called
ARC Ratings.
 68

(IV) ONICRA
 It is a private sector agency set up by Onida Finance.
 It has its head office in Gurgaon.
 It provides ratings, risk assessment and analytical solutions to Individuals,
MSMEs and Corporates.
 It is one of only 7 agencies licensed by NSIC (National Small Industries
Corporation) to rate SMEs.
 They have Pan India Presence with offices over 125 locations.
Apart from these credit rating agencies, there are three more credit rating
agencies which are also registered with SEBI. These are Fitch Ratings India Private
Ltd., Brickwork Ratings India Private Limited, SME Rating Agency of India Ltd.
(SMERA).
SUMMARY
A stock market index is created by selecting a group of stocks that are
representative of the whole market or a specified sector or segment of the market.
An Index is calculated with reference to a base period and a base index value. An
Index is used to give information about the price movements of products in the
financial, commodities or any other markets. Financial indexes are constructed to
measure price movements of stocks, bonds, T-bills and other forms of investments.
Stock market indexes are meant to capture the overall behaviour of equity markets.
REVISION POINTS
From among the stocks listed on the exchange, some similar stocks are
selected and grouped together to form an index. This classification may be on the
basis of the industry the companies belong to, the size of the company, market
capitalization or some other basis. For example, the BSE Sensex is an index
consisting of 30 stocks. Similarly, the BSE 500 is an index consisting of 500 stocks.
INTEXT QUESTIONS
1. Why does an investor need stock market indices? how are they construct?
2. What are the factors that differentiate one index from another.
SUMMARY
A stock market index is created by selecting a group of stocks that are
representative of the whole market or a specified sector or segment of the market.
An Index is calculated with reference to a base period and a base index value. An
Index is used to give information about the price movements of products in the
financial, commodities or any other markets. Financial indexes are constructed to
measure price movements of stocks, bonds, T-bills and other forms of investments.
Stock market indexes are meant to capture
TERMINAL EXERCISE
1. BSE Sensex and NSE Nifty are ___________
Ans: Benchmark indices
 69

SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
What are the basic requirements for a stock to be include in the Nifty?
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Select two indices and compare their rating on equity shares of the company
KEY WORDS
S & P. CNX Nifty, CNX Nifty Junior , S & P. CNX 500.
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LESSON 9

FUNDAMENTAL ANALYSIS - I
INTRODUCTION
The intrinsic value of an equity share depends on a multitude of factors. The
earnings of the company, the growth rate and the risk exposure of the company
have a direct bearing on the price of the share. These factors in turn rely on the
host of other factors like economic environment in which they function, the
industry they belong to, and finally companies’ own performance.
OBJECTIVES
After reading this lesson the student should be able to understand Economy
Analysis, Industry Analysis.
CONTENT
9.1 Components of Fundamental Analysis
9.2 Economy Analysis
9.3 Industry Analysis
9.4 Industry Life Cycle
9.1 COMPONENTS OF FUNDAMENTAL ANALYSIS
Fundamental analysis comprises
 Economic Analysis
 Industry Analysis
 Company Analysis
9.2 ECONOMY ANALYSIS
Economy-wide factors such as growth rate of the economy, inflation rate,
foreign exchange rates, etc. which affect all companies. The performance of a
company depends on the performance of the economy. If the economy is booming,
incomes rise, demand for goods increases, and hence the industries and companies
in general tend to the prosperous. On the other hand, if the economy is in
recession, the performance of companies will be generally bad. Investors are
concerned with those variables in the economy which affect the performance of the
company in which they intend to invest. A study of these economic variables would
give an idea about future corporate earnings and the payment of dividends and
interest part of his fundamental analysis.
i) Growth Rates of Gross Domestic Product
An economy's overall economic activity is summarized by a measure of
aggregate output. As the production or output of goods and services generates
income, any aggregate output measure is closely associated with an aggregate
income measure. The GDP is a measure of all currently produced goods and
services valued at market prices.
The rate of growth of the national economy is an important variable to be
considered by an investor. GNP (gross national product), NNP (net national product)
and GDP (gross domestic product) are the different measures of the total income or
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total economic output of the country as a whole. The growth rates of these
measures indicate the growth rate of the economy. The estimates of GNP, NNP and
GDP and their rates are made available by the government from time to time.
ii) Inflation
The inflation rate is defined as the rate of change in the price level. Most
economies face positive rates of inflation year after year. The price level, in turn, is
measured by a price index, which measures the level of prices of goods and services
at given time. The numbers of items included in a price index vary depending on
the objective of the index. Usually three kinds of price indexes, having particular
advantages and uses are periodically reported by government sources. The first
index is called the consumer price index (CPI), which measures the average retail
prices paid by consumers for goods and services bought by them. A couple of
thousand items, typically bought by an average household, are included in this
index.
A second price index used to measure the inflation rate is called the producer
price index (PPI). It is a much broader measure than the consumer price index. The
producer price index measures the wholesale prices of approximately 3,000 items.
The items included in this index are those that are typically used by producers
(manufacturers and businesses) and thus it contains many raw materials and
semi-finished goods. The third and broadest measure of inflation is the called the
implicit GDP price deflator. This index measures the prices of all goods and services
included in the calculation of the current output of goods and services in the
economy, the GDP.
The three measures of the inflation rate are most likely to move in the same
direction, even though not to the same extent.
iii) Interest Rates
The concept of interest rates used by economists is the same as the one widely
used by ordinary people. The interest rate is invariably quoted in nominal terms—
that is, it is not adjusted for inflation. Thus, the commonly followed interest rate is
actually the nominal interest rate. Nevertheless, there are literally hundreds of
nominal interest rates. Examples include: savings account rate, six-month
certificate of deposit rate, 15-year mortgage rate, variable mortgage rate, 30-year
Treasury bond rate, 10-year General Motors bond rate, and commercial bank prime
lending rate. One can see from these examples that the nominal interest rate has
two key attributes—the duration of lending/borrowing involved and the identity of
the borrower.
iv) Government Budget and Deficit
Government plays an important role in the growth of any economy. The
government prepares a central budget which provides complete information on
revenue, expenditure and deficit of the government for a given period. Government
revenue come from various direct and indirect taxes and government made
expenditure on various developmental activities. The excess of expenditure over
 72

revenue leads to budget deficit. For financing the deficit the government goes for
external and internal borrowings. Thus, the deficit budget may lead to high rate of
inflation and adversely affects the cost of production and surplus budget may
results in deflation. Hence, balanced budget is highly favourable to the stock
market.
v) Exchange Rates
The performance and profitability of industries and companies that are major
importers or exporters are considerably affected by the exchange rates of the rupee
against major currencies of the world. A depreciation of the rupee improves the
competitive position of Indian products in foreign markets, thereby stimulating
exports. But it would also make imports more expensive. A company depending
heavily on imports may find devaluation of the rupee affecting its profitability
adversely.
vi) Infrastructure
The development of an economy depends very much on the infrastructure
available. Industry needs electricity for its manufacturing activities, roads and
railways to transport raw materials and finished goods, communication channels to
keep in touch with suppliers and customers.
The availability of infrastructural facilities such as power, transportation and
communication systems affects the performance of companies. Bad infrastructure
leads to inefficiencies, lower productivity, wastage and delays. An investor should
assess the status of the infrastructural facilities available in the economy before
finalizing has investment plans.
vii) Agriculture and monsoons
Agriculture is directly and indirectly linked with the industries. Hence increase
or decrease in agricultural production has a significant impact on the industrial
production and corporate performance. Companies using agricultural raw materials
as inputs or supplying inputs to agriculture are directly affected by change in
agriculture production. For example- Sugar, Cotton, Textile and Food processing
industries depend upon agriculture for raw material. Fertilizer and insecticides
industries are supplying inputs to agriculture. A good monsoon leads to higher
demand for inputs and results in bumper crops. This would lead to buoyancy in
stock market. If the monsoon is bad, agriculture production suffers and cast a
shadow on the share market.
viii) Economic and Political Stability
A stable political environment is necessary for steady and balanced growth. No
industry or company can grow and prosper in the midst of political turmoil. Stable
long-term economic policies are what are needed for industrial growth. Such stable
policies can emanate only from stable political systems as economic and political
factors are inter-linked. A stable government with clear cut long – term economic
policies will be conducive to good performance of the economy.
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ix) Sentiments
The sentiments of consumers and business can have an important bearing on
economic performance. Higher consumer confidence leads to higher expenditure
and higher business confidence leads to greater business investments. All this
ultimately leads to economic growth. Thus, sentiments influence consumption and
investment decisions and have a bearing on the aggregate demand for goods and
services.
The greatest shortcoming of the anticipatory surveys is that there is no
guarantee that the intentions surveyed will certainly materialise. The forecast based
on anticipatory surveys or surveys of intentions will be valid only to the extent that
the intentions are translated into action. Hence, the analyst cannot rely solely on
these surveys.
9.4 INDUSTRY ANALYSIS
Industry analysis is a type of investment research that begins by focusing on
the status of an industry or an industrial sector. A form of fundamental analysis
involving the process of making investment decisions based on the different stages
an industry is at during a given point in time. The type of position taken will
depend on firm specific characteristics, as well as where the industry is at in its life
cycle. Industry-wide factors such as demand-supply gap in the industry, the
emergence of substitute products, changes in government policy relating to the
industry, etc. these factors such as the age of its plant, the quality of management.
9.5 INDUSTRY LIFE CYCLE
The industry life cycle theory is generally attributed to Julius Grodensky. The
life cycle of the industry is separated into four well defined stages such as
 Pioneering stage
 Rapid growth stage
 Maturity and stabilization stage
 Declining stage
i) Pioneering Stage
The prospective demand for the product is promising in this stage and the
technology of the product is low. The demand for the product attracts many
producers to produce the particular product. There would be severe competition
and only fittest companies survive this stage. The producers try to develop brand
name, differentiate the product and create a product image. This would lead to non-
price competition too. The severe competition often leads to the change of position
of the firms in terms of market shares and profit. In this situation, it is difficult to
select companies for investment because the survival rate is unknown.
ii) Rapid Growth Stage
This stage starts with the appearance of surviving firms from the pioneering
stage. The companies that have withstood the competition grow strongly in market
share and financial performance. The technology of the production would have
improved resulting in low cost of production and good quality products. The
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companies have stable growth rate in this stage and they declare dividend to the
shareholders. It is advisable to invest in the shares of these companies. The
pharmaceutical industry has improved its technology and the top companies in this
sector are giving dividend to the shareholders. Likewise power industry and
telecommunication industry can be cited as examples of expansion stage. In this
stage the growth rate is more than the industry’s average growth rate.
iii) Maturity And Stabilization Stage
In the stabilization stage, the growth rate tends to moderate and the rate of
growth would be more or less equal to the industrial growth rate or the gross
domestic product growth rate. Symptoms of obsolescence may appear in the
technology. The keep going, technological innovations in the production process
and products should be introduced. The investors have to closely monitor the
events that take place in the maturity stage of the industry.
iv) Declining Stage
In this stage, demand for the particular product and the earnings of the
companies in the industry decline.innovation of new products and change in
consumer preferences lead to this stage. The specific feature of the declining stage
is that even in the boom period; the growth of the industry would be low and
decline at a higher rate during the recession. It is better to avoid investing in the
shares of the low growth industry even in the boom period. Investment in the
shares of these types of companies leads to erosion of capital
Factors to be Considered
Apart from industry life cycle analysis, the investor has to analyse some other
factors too. They are as listed below
 Growth of the industry
 Nature of the product
 Nature of the competition
 Labour
 Research and development
Classification of Industry
Industry means a group of productive or profit making enterprises organizations
that have a similar technically substitute goods, services or source of income.
Besides Standard Industry Classification (SIC), industries can be classified on the
basis of products and business cycle i.e. classified according to their reactions to the
different phases of the business cycle. These are classified as follows:
i) Growth Industry
The growth industries have special features of high rate of earnings and
growth in expansion, independent of the business cycle. The expansion of the
industry mainly depends on the technological change. For instance, inspite of the
recession in the Indian economy in 1997-98, there was a spurt in the growth of
information technology. It defied the business cycle and continued to grow. Like
 75

wise in every phase of the history certain industries like colour televisions,
pharmaceutical and telecommunication industries have shown remarkable growth.
ii) Cyclical Industry
The growth and the profitability of the industry move along with the business
cycle. During the boom period they enjoy growth and during depression they suffer
a set back. For example, the white goods like fridge, washing machine and kitchen
range products command a good market in the boom period and the demand for
them slackens during the recession
iii) Defensive Industry
Defensive industry defies the movement of the business cycle. For example,
food and shelter are the basic requirements of humanity. The food industry
withstands recession and depression. The stocks of the defensive industries can be
held by the investor for income earning purpose. They expand and earn income in
the depression period too, under the government’s umbrella of protection and are
counter cyclical in nature.
iv) Cyclical Growth Industry
This is new type of industry that is cyclical and at the same time growing. For
example, the automobile industry experiences periods of stagnation, decline but
they grow tremendously. The change in technology and introduction of new models
help the automobile industry to resume their growth path.
REVISION POINTS
Economy Analysis: Economy-wide factors such as growth rate of the
economy, inflation rate, foreign exchange rates, etc. which affect all companies.
Industry Analysis:Industry analysis is a type of investment research that
begins by focusing on the status of an industry or an industrial sector.
INTEXT QUESTIONS
1. What is meant by fundamental analysis? How does fundamental analysis differ
from technical analysis?
2. Explain the utility of the economic analysis and state the economic factors
considered for this analysis.
SUMMARY
Fundamental analysis is a method of evaluating a security in an attempt to
measure its intrinsic value, by examining related economic, financial and other
qualitative and quantitative factors.
TERMINAL EXERCISE
1. The performance of a company depends on the performance of the __________
Ans: economy
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
 76

nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
1. Do you think that knowing the current status of economy is useful in analysing
stock market movements? If so, explain.
SUGGESTED READINGS
1.M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2.Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3.Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Select five companies listed in the Nifty and rank them according to economic
and industrial analysis
KEY WORDS
Economy Analysis, Industry Analysis, Fundamental Analysis.
 77

LESSON 10

FUNDAMENTAL ANALYSIS - II
INTRODUCTION
Company specific factors such as the age of its plant, the quality of
management brand image of its products, its labour-management relations, etc.
these factors are likely to make a company’s performance quite different from that
of its competitors in the same industry.
OBJECTIVES
After reading this lesson the student should be able to understand Company
Analysis.
CONTENT
10.1 Company Analysis
10.2 Capital Structure
10.3 Analysis of Financial Statement
10.1 COMPANY ANALYSIS
In the company analysis the investor assimilates the several bits of
information related to the company and evaluates the present and future values of
the stock. The risk and return associated with the purchase of the stock is analysed
to take better investment decisions. The valuation process depends upon the
investors’ ability to elicit information from the relationship and inter-relationship
among the company related variables. The present and future values are affected by
a number of factors
i) Competitive Edge
Important business consideration for investors is competitive advantage. A
company's long-term success is driven largely by its ability to maintain a
competitive advantage and keep it. Powerful competitive advantages, such as Coca
Cola's brand name and Microsoft's domination of the personal computer operating
system, create a moat around a business allowing it to keep competitors at bay and
enjoy growth and profits. When a company can achieve competitive advantage, its
shareholders can be well rewarded for decades.Market share: The market share of
the company helps to determine a company’s relative position within the industry.
If the market share is high, the company would be able to meet the competition
successfully. The size of the company should also be considered while analyzing the
market share, because the smaller companies may find it difficult to survive in the
future.Growth of annual sales: Investor generally prefers to study the growth in
sales because the larger size companies may be able to withstand the business
cycle rather than the company of smaller size. The rapid growth keeps the investor
in better position as growth in sales is followed by growth in profit. The growth in
sales of the company is analyzed both in rupee terms and in physical terms.
Stability of annual sales: If a firm has stable sales revenue, other things being
remaining constant, will have more stable earnings. Wide variation in sales leads to
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variation in capacity utilization, financial planning and dividends. This affects the
Company’s position and investor’s decision to invest.
ii) Earnings
The earning of the company should also be analyzed along with the sales level.
The income of the company is generated through the operating (in service industry
like banks- interest on loans and investment) and non-operating income (ant
company, rentals from lease, dividends from securities). The investor should
analyze the sources of income properly. The investor should be well aware with the
fact that the earnings of the company may vary due to following reasons: Change in
sales. Change in costs. Depreciation method adopted. Inventory accounting
method. Wages, salaries and fringe benefits. Income tax and other taxes.
10.2 CAPITAL STRUCTURE
Capital structure is combination of owned capital and debt capital which
enables to maximize the value of the firm. Under this, we determine the proportion
in which the capital should be raised from the different securities. The capital
structure decisions are related with the mutual proportion of the long term sources
of capital. The owned capital includes share capital Preference shares: Preference
shares are those shares which have preferential rights regarding the payment of
dividend and repayment of capital over the equity shareholders. At present many
companies resort preference shares. Debt: It is an important source of finance as it
has the specific benefit of low cost of capital because interest is tax deductible. The
leverage effect of debt is highly advantageous to the equity shareholders. The limits
of debt depend upon the firm’s earning capacity and its fixed assets.
10.2.1 Management
Just as an army needs a general to lead it to victory, a company relies upon
management to steer it towards financial success. Some believe that management
is the most important aspect for investing in a company. It makes sense - even the
best business model is doomed if the leaders of the company fail to properly
execute the plan.
So how does an average investor go about evaluating the management of a
company? This is one of the areas in which individuals are truly at a disadvantage
compared to professional investors. You can't set up a meeting with management if
you want to invest a few thousand dollars. On the other hand, if you are a fund
manager interested in investing millions of dollars, there is a good chance you can
schedule a face-to-face meeting with the upper brass of the firm.
Every public company has a corporate information section on its website.
Usually there will be a quick biography on each executive with their employment
history, educational background and any applicable achievements. Don't expect to
find anything useful here. Let's be honest: We're looking for dirt, and no company is
going to put negative information on its corporate website.
Instead, here are a few ways for you to get a feel for management:
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a) Conference Calls
The chief executive officer (CEO) and chief financial officer (CFO) host quarterly
conference calls. (Sometimes you'll get other executives as well.) The first portion of
the call is management basically reading off the financial results. What is really
interesting is the question-and-answer portion of the call. This is when the line is
open for analysts to call in and ask management direct questions. Answers here
can be revealing about the company, but more importantly, listen for candor. Do
they avoid questions, like politicians, or do they provide forthright answers?
b) Management Discussion and Analysis (MD&A)
The management discussion and analysis is found at the beginning of the
annual report (discussed in more detail later in this tutorial). In theory, the MD&A
is supposed to be frank commentary on the management's outlook. Sometimes the
content is worthwhile, other times its boilerplate. One tip is to compare what
management said in past years with what they are saying now. Is it the same
material rehashed? Have strategies actually been implemented? If possible, sit
down and read the last five years of MD&A’s; it can be illuminating.
c) Ownership and Insider Sales
Just about any large company will compensate executives with a combination
of cash, restricted stock and options. While there are problems with stock options,
it is a positive sign that members of management are also shareholders. The ideal
situation is when the founder of the company is still in charge. Examples include
Bill Gates (in the '80s and '90s), Michael Dell and Warren Buffett. When you know
that a majority of management's wealth is in the stock, you can have confidence
that they will do the right thing. As well, it's worth checking out if management has
been selling its stock. This has to be filed with the Securities and Exchange
Commission (SEC), so it's publicly available information. Talk is cheap - think twice
if you see management unloading all of its shares while saying something else in
the media.
d) Past Performance
Another good way to get a feel for management capability is to check and see
how executives have done at other companies in the past. You can normally find
biographies of top executives on company web sites. Identify the companies they
worked at in the past and do a search on those companies and their performance.
e) Operating Efficiency
Corporate governance describes the policies in place within an organization
denoting the relationships and responsibilities between management, directors and
stakeholders. These policies are defined and determined in the company charter
and its bylaws, along with corporate laws and regulations. The purpose of corporate
governance policies is to ensure that proper checks and balances are in place,
making it more difficult for anyone to conduct unethical and illegal activities.
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Good corporate governance is a situation in which a company complies with all

of its governance policies and applicable government regulations in order to look
out for the interests of the company's investors and other stakeholders.
Although, there are companies and organizations that attempt to
quantitatively assess companies on how well their corporate governance policies
serve stakeholders, most of these reports are quite expensive for the average
investor to purchase.
Fortunately, corporate governance policies typically cover a few general areas:
structure of the board of directors, stakeholder rights and financial and information
transparency. With a little research and the right questions in mind, investors can
get a good idea about a company's corporate governance.
f) Financial and Information Transparency
This aspect of governance relates to the quality and timeliness of a company's
financial disclosures and operational happenings. Sufficient transparency implies
that a company's financial releases are written in a manner that stakeholders can
follow what management is doing and therefore have a clear understanding of the
company's current financial situation.
g) Stakeholder Rights
This aspect of corporate governance examines the extent that a company's
policies are benefiting stakeholder interests, notably shareholder interests.
Ultimately, as owners of the company, shareholders should have some access to the
board of directors if they have concerns or want something addressed. Therefore
companies with good governance give shareholders a certain amount of ownership
voting rights to call meetings to discuss pressing issues with the board.
10.2.2 Structure of the Board of Directors
The board of directors is composed of representatives from the company and
representatives from outside of the company. The combination of inside and outside
directors attempts to provide an independent assessment of management's
performance, making sure that the interests of shareholders are represented.
The key word when looking at the board of directors is independence. The
board of directors is responsible for protecting shareholder interests and ensuring
that the upper management of the company is doing the same. The board
possesses the right to hire and fire members of the board on behalf of the
shareholders. A board filled with insiders will often not serve as objective critics of
management and will defend their actions as good and beneficial, regardless of the
circumstances.
Information on the board of directors of a publicly traded company (such as
biographies of individual board members and compensation-related info) can be
found in the DEF 14A proxy statement.
We've now gone over the business model, management and corporate
governance. These three areas are all important to consider when analyzing any
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company. We will now move on to looking at qualitative factors in the environment

in which the company operates.
10.2.3 Financial Performance
The best source of financial information about a company is its own financial
statements. This is a primary source of information for evaluating the investment
prospects in the particular company’s stock. Financial statement analysis is the
study of a company’s financial statement from various viewpoints. The statement
gives the historical and current information about the company’s operations.
Historical financial statement helps to predict the future. The current information
aids to analyse the present status of the company.
The two main statements used in the analysis are:
 Balance sheet
 Profit and loss account
10.3.4 The Balance Sheet
The balance sheet shows all the company’s sources of funds (liabilities and
stockholders’ equity) and uses of funds at a given point of time. The balance sheet
can either be in the horizontal form or vertical form. The balance sheet provides an
account of the capital structure of the Sky Company. The network and the
outstanding long term debt are known from the balance sheet. The debt has certain
advantages in terms of cost and market acceptability. The use of debt creates
financial leverage beneficial or detrimental to the shareholders depending on the
size and stability of earnings.
If revenues are stable and certain, a large amount of debt can be carried and it
is beneficial to the shareholder. If the earnings fluctuate, the debt should below in
the capital structure, so that the payment of interest may not be detrimental to the
shareholders. It is better for the investor to avoid a company with excessive debt
component in its capital structure. From the balance sheet, liquidity position of the
company can also be assessed with the information on current assets and current
liabilities. The overall ability to pay its short term obligations can be found out.
10.3.4 The Profit and Loss Account
Analysis of the financial condition of the company requires a report on the flow
of funds too. The income statement reports the flow of funds from business
operations that takes place in between two points of time. It lists down the items of
income and expenditure. The difference between the income and expenditure
represents profit or loss for the period. It is also called income and expenditure
statement. Profit and loss account of the Sky Ltd., is given in table. The investor
should be aware of the limitations of the financial statements.
An investor should scrutinize the financial statements to find out the
manipulations, if any. The auditors’, report and notes to the balance sheet give vital
clue to the investor in this regard. Analysis of financial statements should be
undertaken only after nullifying the effects of any such manipulation.
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10.3 ANALYSIS OF FINANCIAL STATEMENT

The analysis of financial statements reveals the nature of relationship between
income and expenditure, and the sources and application of funds. The investor
determines the financial position and the progress of the company through
analysis. The investor is interested in the yield and safety of his capital. He cares
much about the profitability and the management’s policy regarding the dividend.
Towards this end, he can use the following simple analysis.
 Comparative financial statements
 Trend analysis
 Common size statements
 Fund flow analysis
 Cash flow analysis
 Ratio analysis
i) Comparative Financial Statement
In the comparative statement balance sheet figures are provided for more than
one year. The comparative financial statement provides time perspective to the
balance sheet figures. The annual data are compared with similar data of previous
years, either in absolute terms or in percentages.
ii) Trend Analysis
Here percentages are calculated with a base year. This would provide insight
into the growth or decline of the sale or profit over the years. Sometimes sales may
be increasing continuously, and the inventories may also be rising. This would
indicate the loss of market share of the particular company’s product. Likewise
sales may have an increasing trend but profits may remain the same. Here the
investor has to look into the cost and management efficiency of the company.
iii) Common Size Statement
Common size balance sheet shows the percentage of each asset item to the
total assets and each liability item to the total liabilities. Similarly, a common size
income statement shows each item of expense as a percentage of net sales. With
common size statement comparison can be made between two different size firms
belonging to the same industry. For a same company over the years common size
statement can be prepared.
iv) Fund Flow Analysis
The balance sheet gives a static picture of the company’s position on a
particular date. It does not revel the changes that have occurred in the financial
position of the unit over a period of time.
The investor should know,
a) How are the profit utilized?
b) Financial source of dividend
c) Source of finance for capital expenditures
d) Source of finance for repayment of debt
e) The destiny of the sale proceeds of the fixed assets and
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f) Use of the proceeds of the share for debenture issue or fixed deposits
raised from public.
These items of information are provided in the funds flow statement. It is a
statement of the sources and applications of funds. It highlights the changes in the
financial condition of a business enterprise between two balance sheet dates. The
investor could see clearly the amount of funds generated or lost in operations. He
could see how these funds have been divided into three significant uses like taxes,
dividends and reserves. Moreover, the application of long term funds towards the
acquisition of current assets can be found out. This would reveal the real picture of
the financial position of the company.
v) Cash Flow Statement
The investor is interested in knowing the cash inflow and outflow of the
enterprise. The cash flow statement is prepared with the help of balance sheet,
income statement and some additional information. It can be either prepared in the
vertical form or in the horizontal form. Cash flows related to operations and other
transactions are calculated. The statement shows the causes of changes in cash
balance between two balance sheet dates. With the help of this statement the
investor can review the cash movements over an operating cycle. The factors
responsible for the reduction of cash balances in spite of increase in profits or vice
versa can be found out.
vi) Ratio Analysis
Ratio is a relationship between two figures expressed mathematically.
Financial ratio provides numerical relationship between two relevant financial data.
Financial ratios are calculated from the balance sheet and loss account. The
relationship can be either expressed as a percent or as a quotient. Ratios
summarise the data for easy understanding, comparison and interpretation.
Financial ratios may be divided into six groups.
They are listed below:
 Liquidity Ratios  Turnover Ratios
 Leverage Ratios  Profit Margin Ratios
 Return on Investment Ratios  Valuation Ratios
REVISION POINT
Company analysis is a process carried out by investors to evaluate securities,
collecting info related to the company's profile, products and services as well as
profitability. It is also referred as 'fundamental analysis.
INTEXT QUESTIONS
1. What are the methods adopted to analyse the financial statements of a company?
2. Why is it important to understand competitive position of the product of the
company in purchasing the shares of the company?
3. How is the competitive position of a company within an industry determined?
4. What are the factors that affect the earnings per share of the company?
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SUMMARY
The competitive edge of the company could be measured with the company’s
market share, growth and stability of its annual sales.
TERMINAL EXERCISE
1.____________ is combination of owned capital and debt capital which enables to
maximize the value of the firm.
Ans: capital structure
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENT
1.What is meant by P/E ratio? What is the logic of using this concept in investment
decisions?
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Select thirty companies from mid cap shares and rank them according to
fundamental analysis.
KEY WORDS
Company analysis, Leverage Ratios, Liquidity.
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LESSON 11

TECHNICAL ANALYSIS
INTRODUCTION
The share price movement is analyzed broadly with two approaches, namely,
fundamental approach and the technical approach. Fundamental approach
analyses the share prices on the basis of economic, industry and company
statistics. If the price of the share is lower than its intrinsic value, investor buys it.
But, if he finds the price of the share higher than the intrinsic value he sells and
gets profit. The technical analyst mainly studies the stock price movement of the
security market. If there is an uptrend in the price movement investor may
purchase the scrip. With the onset of fall in price he may sell it and move from the
scrip. Basically, technical analysts and the fundamental analysts aim at good
return on investment.
OBJECTIVES
After reading this lesson the student should be able to understand Technical
Analysis.
CONTENT
11.1 Technical Analysis
11.2 Assumptions
11.3 Technical Tools
11.4 Dow Theory
11.5 Primary Trend
11.6 The Secondary Trend
11.7 Minor Trends
11.8 Support and Resistance Level
11.9 Indicators
11.10 Volume of Trade
11.11 The Breadth of the Market
11.12 Short Sales
11.13 Moving Average
11.14 Index and Stock Price Moving Average
11.15 Stock Price and Stock Prices’ Moving Average
11.16 Comparison of the Two Moving Averages
11.17 Oscillators
11.18 Charts
11.19 Technical Analysis and Fundamental Analysis
11.1 TECHNICAL ANALYSIS
It is a process of identifying trend reversals at an earlier stage to formulate the
buying and selling strategy. With the help of several indicators they analyzed the
relationship between price - volume and supply-demand for the overall market and
the individual stock. Volume is favorable on the upswing i.e. the number of shares
traded is greater than before and on the downside the number of shares traded
dwindles If it is the other way round, trend reversals can be expected.
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11.2 ASSUMPTIONS
1. The market value of the scrip is determined by the interaction of supply and
demand.
2. The market discounts everything. The price of the security quoted represents the
hopes, fears and inside information received by the market players. Inside
information regarding the issuing of bonus shares and right issues may support
the prices. The loss of earnings and information regarding the forthcoming
labour problem may result in fall in price. These factors may cause a shift in
demand and supply, changing the direction of trends.
3. The market always moves in trend. Except for minor deviations, the stock prices
move in trends. The price may create definite patterns too. The trend may lie
either increasing or decreasing. The trend continues for some time and then it
reverses.
4. Any layman knows the fact that history repeats itself. It is true to the stock
market also. In the rising market investors’ psychology have tip beats and they
purchase the shares in greater volumes, driving the prices higher. At the same
time, in the down trend they may be very eager to get out of the market by
selling them and thus plunging the share price further. The market technicians
assume that past prices predict the future.
11.3 TECHNICAL TOOLS
Generally used technical tools are Dow Theory, volume of trading, short
selling, odd lot trading, bars and line charts, moving averages and oscillators. In
this section some of the above mentioned tools are analyzed.
11.4 DOW THEORY
Dow developed his theory to explain the movement of the indices of Dow Jones
Averages. He developed the theory on the basis of certain hypotheses. The first
hypothesis is that, no single individual or buyer can influence the major trend of
the market.
However, an individual investor can affect the daily price movement by buying
or selling huge quantum of particular scrip. The intermediate price movement also
can be affected to a lesser degree by an investor.
His second hypothesis is that the market discounts everything. Even natural
calamities such as earthquake, plague and fire also get quickly discounted in the
market. The Pokhran blast affected the share market for a short while and then the
market returned back to normalcy.
His third hypothesis is that the theory is not infallible. It is not a tool to beat
the market but provides a way to understand it better.
An important part of Dow Theory is distinguishing the overall direction of the
market. To do this, the Theory uses trend analysis.
Before we can get into the specifics of Dow Theory trend analysis, we need to
understand trends. First, it's important to note that while the market tends to move
 87

in a general direction, or trend, it doesn't do so in a straight line. The market will

rally up to a high ( peak ) and then sell off to a low ( trough ), but will generally
move in one direction.
n upward trend is broken up into several rallies , where each rally has a high
and a low. For a market to be considered in an uptrend, each peak in the rally
must reach a higher level than the previous rally's peak, and each low in the rally
must be higher than the previous rally's low.
A downward trend is broken up into several sell-offs , in which each sell-off
also has a high and a low. To be considered a downtrend in Dow terms, each new
low in the sell-off must be lower than the previous sell-offs low and the peak in the
sell-off must be lower than the peak in the previous sell-off.
Now that we understand how Dow
Theory defines a trend, we can look at
the finer points of trend analysis.
Dow Theory identifies three trends
within the market: primary, secondary
and minor. A primary trend is the
largest trend lasting for more than a
year, while a secondary trend is an
intermediate trend that lasts three
weeks to three months and is often
associated with a movement against
the primary trend. Finally, the minor Fig 11.1
trend often lasts less than three weeks
and is associated with the movements in the intermediate trend.
Let us now take a look at each trend.
11.5 PRIMARY TREND
In Dow Theory, the primary
trend is the major trend of the
market, which makes it the
most important one to
determine. This is because the
overriding trend is the one that
affects the movements in stock
prices. The primary trend will
also impact the secondary and
minor trends within the market.
Dow determined that a primary
trend will generally last between
one and three years but could
vary in some instances. Fig 11.2
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For example, if in an uptrend the price closes below the low of a previously
established trough, it could be a sign that the market is headed lower, and not
higher.
When reviewing trends, one of the most difficult things to determine is how
long the price movement within a primary trend will last before it reverses. The
most important aspect is to identify the direction of this trend and to trade with it,
and not against it, until the weight of evidence suggests that the primary trend has
reversed.
11.6 SECONDARY OR INTERMEDIATE, TREND
In Dow Theory, a primary trend is the main direction in which the market is
moving. Conversely, a secondary trend moves in the opposite direction of the
primary trend, or as a correction to the primary trend.
For example, an upward
primary trend will be composed
of secondary downward trends.
This is the movement from a
consecutively higher high to a
consecutively lower high. In a
primary downward trend the
secondary trend will be an
upward move, or a rally. This
is the movement from a
consecutively lower low to a
consecutively higher low.
An illustration of a
secondary trend within a
primary uptrend. Notice how Fig 11.3
the short-term highs (shown by the horizontal lines) fail to create successively
higher peaks, suggesting that a short-term downtrend is present. Since the
retracement does not fall below the October low, traders would use this to confirm
the validity of the correction within a primary uptrend.
In general, a secondary, or intermediate, trend typically lasts between three
weeks and three months, while the retracement of the secondary trend generally
ranges between one-third to two-thirds of the primary trend's movement. For
example, if the primary upward trend moved the DJIA from 10,000 to 12,500
(2,500 points), the secondary trend would be expected to send the DJIA down at
least 833 points (one-third of 2,500).
Another important characteristic of a secondary trend is that its moves are
often more volatile than those of the primary move.
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11.7 MINOR TREND

The last of the three trend types in
Dow Theory is the minor trend, which
is defined as a market movement
lasting less than three weeks. The
minor trend is generally the corrective
moves within a secondary move, or
those moves that go against the
direction of the secondary trend. Due to
its short-term nature and the longer-
term focus of Dow Theory, the minor
trend is not of major concern to Dow
Theory followers. But this doesn't mean Fig 11.4
it is completely irrelevant; the minor trend is watched with the large picture in
mind, as these short-term price movements are a part of both the primary and
secondary trends.
Most proponents of Dow Theory focus their attention on the primary and
secondary trends, as minor trends tend to include a considerable amount of noise.
If too much focus is placed on minor trends, it can to lead to irrational trading, as
traders get distracted by short-term volatility and lose sight of the bigger picture.
11.8 SUPPORT AND RESISTANCE LEVEL
The concepts of support and resistance are undoubtedly two of the most highly
discussed attributes of technical analysis and they are often regarded as a subject
that is complex by those who are just learning to trade. This article will attempt to
clarify the complexity surrounding these concepts by focusing on the basics of what
traders need to know. You'll learn that these terms are used by traders to refer to
price levels on charts that tend to act as barriers from preventing the price of an
asset from getting pushed in a certain direction.
At first the explanation and idea behind identifying these levels seems easy,
but as you'll find out, support and resistance can come in various forms and it is
much more difficult to master than it first appears.
11.9 INDICATORS
Technical indicators are used to find out the direction of the overall market.
The overall market movements affect the individual share price. Aggregate
forecasting is considered to be more reliable than the individual forecasting. The
indicators are price and volume of trade. The volume of trade is influenced by the
behavior of price.
11.10 VOLUME OF TRADE
Dow gave special emphasis on volume. Volume expands along with the bull
market and narrows down in the bear market. If the volume falls with rise in price
or vice—versa, it4s-a matter of concern for the investor and the trend may not
persist for a longer time. Technical analyst used volume as an excellent method of
 90

confirming the trend. The market is said to be bullish when small volume of trade
and large volume of trade follow the fall in price and the rise in price. Large rise in
price or large fall in price leads to large increase in volume. Large volume with rise
in price indicates bull market and the large volume with fall in price indicates bear
market. If the volumes decline for five consecutive days, then it will continue for
another four days and the same is true in increasing volume.
11.11 THE BREADTH OF THE MARKET
The breadth of market is the term often used to study the advances and
declines that have occurred in the stock market. Advances mean the number of
shares whose prices have increased from the previous day’s trading. Declines
indicate the number of shares whose prices have fallen from the previous day’s
trading. This is easy to plot and watch indicator because data are available in all
business dailies.
The net difference between the number of stock advanced and declined during
the same period is the breadth of the market. A cumulative index of net differences
measures the market breadth. The following table gives the breadth of the market.
The advance/decline can be drawn as a graph. The.ID line does not exactly
show when a reaction will occur but it indicates that it will occur soon. The A/D
line is compared with the market index. Generally in a bull market, a bearish signal
is given when the AID line slopes down while the BSE Sensex is rising. In a bear
market, a bullish signal is given when the AID line begins rising as the Sensex is
declining to a new low.
11.12 SHORT SALES
Short selling is a technical indicator known as short interest. Short sales refer to
the selling of shares that are not owned. The bears are the short sellers who sell now
in the hope of purchasing at a lower price in the future to make profits. The short
sellers have to cover up their positions. Short positions of scrips are published in the
business newspapers. When the demand for a particular share increases, the
outstanding short positions also increase and it indicates future rise of prices. These
indications cannot be exactly correct, but they show the general situations.
Short sales of a particular month is selected and compared with the average
daily volume of the preceding month. This ratio shows, how many days of trading it
would take to use up total short sales. If the ratio is less than 1, market is said to
be weak or overbought and a decline can be expected. The value between 1 and 0.5
shows neutral condition of the market. Values above I indicate bullish trend and if
it is above 2 the market is said to be oversold. At market tops, short selling is high
and at market bottoms short selling is low.
11.13 MOVING AVERAGE
The market indices do not rise or fall in straight line. The upward and
downward movements are interrupted by counter moves. The underlying trend can
be studied by smoothening of the data. To smooth the data moving average
technique is used.
 91

The word moving means that the body of data moves ahead to include the recent
observation. If it is five day moving average, on the sixth day the body of data moves to
include the sixth day observation eliminating the first day’s observation. Likewise it
continues. In the moving average calculation, closing price of the stock is used.
The moving averages are used to study the movement of the market as well as
the individual scrip price. The moving average indicates the underlying trend in the
scrip. The period of average determines the period of the trend that is being
identified. For identifying short-term trend, 10 day to 30 day moving averages are
used. In the case of medium term trend 50 day to 125 day are adopted. 200 day
moving average is used to identify long term trend.
11.14 INDEX AND STOCK PRICE MOVING AVERAGE
Individual stock price is compared with the
stock market indices. The moving average of the
stock and the index are plotted in the same
sheet and trends are compared. If NSE or BSE
index is above stock’s roving average line the
particular stock has bullish trend. The price
may increase above the market average. If the
Sensex or Nifty is below the stock’s moving
average, the bearish market can be expected for
the particular stock.
If the moving average of the stock
penetrates the stock market index from above, it
generates sell signal. Unfavorable market
Fig 11.5
condition prevails for the particular scrip. If the
stock line pushes up through the market average, it is a buy signal.
11.15 STOCK PRICE AND STOCK PRICES’ MOVING AVERAGE
Buy and sell signals are provided by the
moving averages. Moving averages are used
along with the price of the scrip. The stock
price ma intersects the moving average at a
particular point. Downward penetration of the
rising average indicates the possibility of a
further fall. Hence sell signal is generated in
the figure Upward penetration of a falling
average would indicate the possibility of the
further rise and gives the buy signal. As the
average indicates the underlying trend, its
violation may signal trend reversal that is
shown in Figure

Fig 11.6
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11.6 COMPARISON OF THE TWO MOVING AVERAGES

When long term and short
term moving averages are drawn,
the intersection of two moving
averages generates buy or sell
signal. When the scrip price is
falling and if the short term average
intersects the long term moving
average from above and falls below
it, the sell signal is generated.
If the scrip price is rising, the
short term average would be above
the long term average. The short
term average intersects the long
term average from below indicating
a further rise in price, gives a buy Fig 11.7
signal. The sell and buy signals are
given in figures.
But, if the short term average
move above the long term average
and the long term average is falling,
investor should treat intersection
with suspicion. The short term
movement may not hold long.
Hence, the investor should
wait for the long term average to
turn up before buying the scrip.
Similarly, if the short term average
moves below the long term average
Fig 11.8
before the long term average has
flattened out or before it reverses its direction, the investor should wait for the fall
in the long term average for reversal of direction before moving out of the scrip.
11.7 OSCILLATORS
An oscillator is an indicator that fluctuates above and below a centerline or
between set levels as its value changes over time. Oscillators can remain at extreme
levels (overbought or oversold) for extended periods, but they cannot trend for a
sustained period. In contrast, a security or a cumulative indicator like On-Balance-
Volume (OBV) can trend as it continually increases or decreases in value over a
sustained period of time
Oscillators indicate the market momentum or scrip momentum. Oscillator
shows the share price movement across a reference point from one extreme to
another. The momentum indicates:
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 Overbought and oversold conditions of the scrip or the market.

 Signaling the possible trend reversal.
 Rise or decline in the momentum.
Generally, oscillators are analyzed along with the price chart. Oscillators
indicate trend reversals that have to be confirmed with the price movement of the
scrip. Changes in the price should be correlated to changes in the momentum, and
then only buy and sell signals can be generated. Actions have to be taken only
when the price and momentum agree with each other. With the daily, weekly or
monthly closing prices oscillators are built. For short term trading, daily price
oscillators are useful.
RATE OF CHANGE
Rate of change indicator or the ROC measures the rate of change between the
current price and the price ‘n’ number of days in the past. ROC helps to find out
the overbought and oversold positions in a scrip. It is also useful in identifying the
trend reversal. Closing prices are used to calculate the ROC. Daily closing prices
are used for the daily ROC and weekly closing prices for weekly ROC. Calculation of
ROC for 12 week or 12 month is most popular.
ROC GRAPH
ROC graph ROC can be plotted in a graph, x-axis representing days or months
and y-axis the values of ROC. If the first method is adopted, ROC oscillates across the
hundred lines. If the second method is used, the ROC oscillates around the zero line.
11.8 CHARTS
Charts are the valuable and easiest tools in the technical analysis. The graphic
presentation of the data helps the investor to find out the trend of the price without
any difficulty. The charts also have the following uses
 Spots the current trend for buying and selling.
 Indicates the probable future action of the market by projection
 Shows the past historic movement
 Indicates the important areas of support and resistance.
The charts do not lie but interpretation differs from analyst to analyst
according to their skills and experience. A leading technician, James Dines said,
“Charts are like fire or electricity they are brilliant tools if intelligently controlled
and handled but dangerous to a novice”.
POINT AND FIGURE CHARTS
Technical analyst to predict the extent and direction of the price movement of
a particular stock or the stock market indices uses point and figure charts. This PF
charts are of one-dimensional and there is no indication of time or volume. The
price changes in relation to previous prices are shown. The change of price
direction can be interpreted. The charts are drawn in the ruled paper. The following
figure shows the P and F chart.
 94

The prices are given in the left of the figure as shown. The numbers represent
the price of the stock at 2 point interval. The interval of price changes can be
1,2,3,5 or 10 points.
It depends on the analyst’s
preference further; it depends upon the
stock price movement. Higher points are
chosen for high priced stocks and vice
versa. Only whole number prices are
entered. In figure, the initial price 53
was entered in column 1 a X. The next
mark X will be made only if the stock
moves up to 55. As long as the price
moves up, the Xs a drawn in the vertical
column. Here the stock price has moved
to 57. When the stock price declines by
two points or more the chartist records Fig 11.9
the change by placing the ‘o’ in the next column. Then the movements are
interpreted. The trend reversals can be spotted easily. The figure shows the trend
reversals in the point and figure chart.

Fig 11.10
As long as the price moves between points A and B, there is little indication of
price rise. As the price raj.is1an4evel, it generates a buy signal. The market may turn
out to be bullish. Likewise, when the price pierces the down the support level C
indicates that the stock should be sold and the market may turn out to be bearish.
In spite of the simplicity in thawing the PF charts, they have some inherent
disadvantages also.
1. They do not show the intra- day price movement.
2. Whole numbers are only taken into consideration. This may result in the loss of
information regarding U minor fluctuations.
 95

3. Vo1um is not mentioned in the chart. Volume and trend of transactions are an
important guide to make investment decision. In a bull market, price rise is
accompanied by high volume of trading. The bear market is related to low
volume of trading.
Bar Charts
The bar chart is the simplest and most commonly used tool of a technical
analyst. To build a bar a dot is entered to represent the highest price at which the
stock is traded on that day, week or month. Then another dot is entered to indicate
the lowest price on that particular date.
A line is drawn to connect both the points a horizontal nub is drawn to mark
the closing price. Line charts are used to indicate the price movements. The line
chart is a simplification of the bar chart. Here a line is drawn to connect the
successive closing prices.
Chart Patterns
Charts reveal certain patterns that
are of predictive value. Chart patterns
are used as a supplement to other
information and confirmation of signals
provided by trend lines. Some of the
most widely used and easily
recognizable chart patterns are
discussed here.
V Formation: The name itself
indicates that in the ‘V’ formation there
is a long sharp decline and a fast
reversal. The ‘V’ pattern occurs mostly
Fig 11.11
in popular stocks where the market
interest changes quickly from hope to fear and vice-versa. In the case of inverted ‘A’
the rise occurs first and declines. There are extended ‘V’s.
In it, the bottom or top moves more slowly over a broader area.

Fig 11.12
Tops and Bottoms
Top and bottom formation is interesting to watch but what is more important,
is the middle portion of it. The investor has to buy after up trend has started and
 96

exit before the top is reached. Generally tops and bottoms are formed at the
beginning or end of the new trends. The reversal from the tops and bottoms
indicate sell and buy signals.
Double Top and Bottom
This type of formation signals the end of one trend and the beginning of
another. If the double top is formed when a stock price rises to a certain level, falls
rapidly, again rises to the same height or more, and turns down. Its pattern
resembles the letter ‘M’. The double top may indicate the onset of the bear market.
But the results should be confirmed with volume and trend.
In a double bottom, the price of the stock falls to a certain level and increase
with diminishing activity. Then it falls again to the same or to a lower price and
turns up to a higher level. The double bottom resembles the letter ‘W’. Technical
analysts view double bottom as a sign for bull market. The double top and bottom
figures are given below with illustrations.

Fig 11.13 Fig 11.14

Fig 11.15 Fig 11.16

Head and Shoulders

This pattern is easy to identify and the signal generated by this pattern is
considered to be reliable. In the head and shoulder pattern there are three rallies
resembling the left shoulder, a head and a right shoulder A neckline is drawn
 97

connecting the lows of the tops. When the stock price cuts the neckline from above,
it signals the bear market.
The upward movement of the price for some duration creates the left shoulder
At the top of the left shoulder people who bought during the uptrend begin to sell
resulting in a dip.
Near the bottom there would be reaction and people who have not bought in
the first up trend start buying at relatively low prices thus pushing the price
upward. The alternating forces of demand and supply create new ups and lows. The
following figures explain the head and shoulders pattern.
Inverted Head and Shoulders
Here the reverse of the previous pattern holds true. The price of stock’s falls
and rises that makes a inverted right shoulder. As the process of fall and rise in
price continues the head and left shoulders are created. Connecting the tops of the
inverted head and shoulders gives the neckline. When the price pierces the neckline
from beloç it indicates the end of bear market and the beginning of the bull market.
These patterns have to be confirmed with the volume and trend of the market.

Fig 11.17 Fig 11.18

Fig 11.19 Fig 11.20

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11.19 TECHNICAL ANALYSIS AND FUNDAMENTAL ANALYSIS

1. Fundamental analysts’ analyses the stock based on the specific goals of the
investors. They study the financial strength of corporate, growth of sales,
earnings and profitability. They also take into account the general industry and
economic conditions.
2. The technical analysts mainly focus the attention on the past history of prices.
Generally technical analysts choose to study two basic market data-price and
volume.
3. The fundamental analysts estimate the intrinsic value of the shares and
purchase them when they are undervalued. They dispose the shares when they
are overpriced and earn profits. They try to find out the long term value of
shares.
REVISION POINT
Technical analysts don't care whether a stock is undervalued or over valued,
the only thing that matters is a security's past trading data and what information
this data can provide about where the security might move in the future.
Technical analysis believes that the past behavior of stock prices gives an
indication of the future behavior. It tries to study the patterns in stock price
behavior through charts and predict the future movement in prices.
INTEXT QUESTIONS
1. How does technical analysis differ from the fundamental analysis?
2. Can stock prices have a support level and resistance level? If so, explain.
3. Moving averages not only smoothen the data, but also predict the market’.
Comment.
SUMMARY
Technical analysis is a method of evaluating securities by analyzing the
statistics generated by market activity, such as past prices and volume. Technical
analysts do not attempt to measure a security's intrinsic value, but instead use
charts and other tools to identify patterns that can suggest future activity.Just as
there are many investment styles on the fundamental side, there are also many
different types of technical traders. Some rely on chart patterns; others use
technical indicators and oscillators, and most use some combination of the two. In
any case, technical analysts' exclusive use of historical price and volume data is
what separates them from their fundamental counterparts.
TERMINAL EXERCISE
1. The ____________ are straight lines drawn connecting either the tops or bottoms
of the share price movement.
Ans: trent lines
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SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENT
1. ‘Chart patterns are helpful in predicting the stock price movement’. Comment.
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Select equity shares from small cap companies and rank them according to
Technical Analysis.
KEY WORDS
Chart, Oscillators, Moving averages.
 100

LESSON 12

EFFICIENT MARKET THEORY

INTRODUCTION
The theory that stock price changes have the same distribution and are
independent of each other, so the past movement or trend of a stock price or
market cannot be used to predict its future movement. In short, this is the idea
that stocks take a random and unpredictable path. A follower of the random walk
theory believes it's impossible to outperform the market without assuming
additional risk. Critics of the theory, however, contend that stocks do maintain
price trends over time - in other words, that it is possible to outperform the market
by carefully selecting entry and exit points for equity investments.
Stock prices are determined by a number of factors such as fundamental
factors, technical factors and psychological factors. The behavior of stock prices is
studied with the help of different methods such as fundamental analysis and
technical analysis. Fundamental analysis seeks to evaluate the intrinsic value of
securities by studying the fundamental factors affecting the performance of the
economy, industry and companies. There is a third theory on stock price behavior
which questions the assumptions of technical analysis.
The basic assumption in technical analysis is that stock price movement is
quite orderly and not random. The new theory questions this assumption. From the
results of several empirical studies on stock price movements, the advocates of the
new theory assert that share price movements are random. The new theory came to
be known as Random Walk Theory because of its principal contention that share
price movements represent a random walk rather than an orderly movement.
OBJECTIVES
After reading this lesson the student should be able to understand Random
Walk Theory, Efficient Market Theory.
CONTENT
12.1 Random Walk Theory
12.2 The Efficient Market Hypothesis
12.3 Forms of Market Efficiency
12.4 Empirical Tests of Weak Form Efficiency
12.5 Empirical Tests of Semi-Strong Form Efficiency
12.6 Tests of Strong Form Efficiency
12.7 Competitive Market Hypothesis
12.8 Market Inefficiencies
12.1 RANDOM WALK THEORY
Stock price behavior is explained by the theory in the following manner. A
change occurs in the price of a stock only because of certain changes in the
economy, industry or company. Information about these changes alters the stock
 101

prices immediately and the stock moves to a new level, either upwards or
downwards, depending on the type of information. This rapid shift to a new
equilibrium level whenever new information is received is recognition of the fact
that all information which is known is fully reflected in the price of the stock.
Further change in the price of the stock will occur only as a result of some other
new piece of information which was not available earlier. Thus, according to this
theory, changes in stock prices show independent behavior and are dependent on
the new pieces of information that are received but within themselves are
independent of each other. Each price change is independent of other price changes
because each change is caused by a new piece of information.
The basic premise in random walk theory is that the information on changes
in the economy, industry and company performance is immediately and fully
spread so that all investors have full knowledge of the information. There is an
instant adjustment in stock prices either upwards or downwards. Thus, the current
stock price fully reflects all available information on the stock. Therefore, the price
of a security two days ago can in no way help in speculating the price two days
later. The price of each day is independent. It may be unchanged, higher or lower
from the previous price, but that depends on new pieces of information being
received each day. The random walk theory presupposes that the stock markets are
so efficient and competitive that there is immediate price adjustment. This is the
result of good communication system through which information can be spread
almost anywhere in the country instantaneously. Thus, the random walk theory is
based on the hypothesis that the stock markets are efficient. Hence, this theory
later came to be known as the efficient market hypothesis (EMH) or the efficient
market model.
12.2 THE EFFICIENT MARKET HYPOTHESIS
This hypothesis states that the capital market is efficient in processing
information. An efficient capital market is one in which security prices equal their
intrinsic values at all times, and where most securities are correctly priced. The
concept of an efficient capital market has been one of the dominant themes in
academic literature since the 1960s. According to Elton and Gruber, “when
someone refers to efficient capital markets, they mean that security prices fully
reflect all available information”.’ According to Eugene Fama,2 in an efficient
market, prices fully reflect all available information. The prices of securities
observed at any time are based on correct evaluation of all information available at
that time. The efficient market model is actually concerned with the speed with
which information is incorporated into security prices. The technicians believe that
past price sequence contains information about the future price movements
because they believe that information is slowly incorporated in security prices. This
gives technicians an opportunity to earn excess returns by studying the patterns in
price movements and trading accordingly.
Fundamentalists believe that it may take several days or weeks before
investors can fully assess the impact of new information. As a consequence, the
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price may be volatile for a number of days before it adjusts to a new level. This
provides an opportunity to the analyst who has superior analytical skills to earn
excess returns.
The efficient market theory holds the view that in an efficient market, new
information is processed and evaluated as it arrives and prices instantaneously
adjust to new and correct levels. Consequently, an investor cannot consistently
earn excess returns by undertaking fundamental analysis or technical analysis.
12.3 FORMS OF MARKET EFFICIENCY
The capital market is considered to be efficient in three different forms: the
weak form, semi-strong form and the strong form. Thus, the efficient market
hypothesis has been subdivided into three forms, each dealing with a different type
of information. The weak form deals with the information regarding the past
sequence of security price movements, the semi-strong form deals with the publicly
available information, while the strong form deals with all information, both public
and private (or inside).
The different forms of efficient market hypothesis have been tested through
several empirical studies. The tests of the weak form hypothesis are essentially
tests of whether all information contained in historical prices of securities is fully
reflected in current prices. Semi-strong form tests of the efficient market hypothesis
are tests of whether publicly available information is fully reflected in current stock
prices. Finally, strong form tests of the efficient market hypothesis are tests of
whether all information, both public and private (or inside), is fully reflected in
security prices and whether any type of investor is able to earn excess returns.
12.4 EMPIRICAL TESTS OF WEAK FORM EFFICIENCY
The weak form of the efficient market hypothesis (EMH) says that the current
prices of stocks already fully reflect all the information that is contained in the
historical sequence of prices. The new price movements are completely random.
They are produced by new pieces of information and are not related or dependent
on past price movements. Therefore, there is no benefit in studying the historical
sequence of prices to gain abnormal returns from trading in securities. This implies
that technical analysis, which relies on charts of price movements in the past, is
not a meaningful analysis for making abnormal trading profits.
The weak form of the efficient market hypothesis is thus a direct repudiation of
technical analysis.
Two approaches have been used to test the weak form of the efficient market
hypothesis. One approach looks for statistically significant patterns in security price
changes. The alternative approach searches for profitable short-term trading rules.
Serial Correlation Test
Since the weak form EMH postulates independence between successive price
changes, such independence or randomness in stock price movements can be
tested by calculating the correlation between price changes in one period and
changes for the same stock in another period. The correlation coefficient can take
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on a value ranging from —1 to 1; a positive number indicates a direct relation, a

negative value implies an inverse relationship and a value close to zero implies no
relationship. Thus, if correlation coefficient is close to zero, the price changes can
be considered to be serially independent.
Run Test
The run test is another test used to test the randomness in stock price
movements. In this test, the absolute values of price changes are ignored; oly the
direction of change is considered. An increase in price is represented by + signs.
The decrease is represented by – sign. When there is no change in prices, it is
represented by ‘O’. A consecutive sequence.of the same sign is considered as a run.
Filter Tests
If stock price changes are random in nature, it would be extremely difficult to
develop successful mechanical trading systems. Filter tests have been developed as
direct tests of specific mechanical trading strategies to examine their validity and
usefulness.
It is often believed that, as long as no new information enters the market, the
price fluctuates randomly within two barriers—one lower, and the other higher—
around the fair price. When new information comes into the market, a new
equilibrium price will be determined. If the news is favorable, then the price should
move up to a new equilibrium above the old price. Investors will know that this is
occurring when the price breaks through the old barrier. If investors purchase at
this point, they will benefit from the price increase to the new equilibrium level.
Likewise, if the news received is unfavorable, the price of the stock will decline
to a lower equilibrium level. If investors sell the stock as it breaks the lower barrier,
they will avoid much of the decline. Technicians set up trading strategies based on
such patterns to earn excess returns.
The strategy is called a filter rule. The filter rule is usually stated in the
following way: Purchase the stock when it rises by x per cent from the previous low
and sell it when it declines by x per cent from the subsequent high. The filters may
range from 1 per cent to 50 per cent or more. The alternative to this active trading
strategy is the passive buy and hold strategy.
The returns generated by trading according to the filter rule are compared with
the returns earned by an investor following the buy and hold strategy. If trading
with filters results in superior returns that would suggest the existence of patterns
in price movements and negate the weak form EMH.
Distribution Pattern
It is a rule of statistics that the distribution of random occurrences will conform
to a normal distribution. Then, if price changes are random, their distribution should
also be approximately normal. Therefore, the distribution of price changes can be
studied to test the randomness or otherwise of stock price movements.
In the 1960s the efficient market theory was known as the random walk
theory. The empirical studies regarding share price movements were testing
whether prices followed a random walk.
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Two articles by Roberts and Osborne, both published in 1959, stimulated a

great deal of discussion of the new theory then called random walk theory.
Roberts’ study compared the movements in the Dow Jones Industrial Average
(an American stock market index) with the movement of a variable generated from a
random walk process. He found that the random walk process produced patterns
which were very similar to those of the Dow Jones index.
Osborne’s study found a close resemblance between share price changes and
the random movement of small particles suspended in a solution, which is known
in Physics as the Brownian motion. Both the studies suggested that share price
changes are random in nature and that past prices had no predictive value.
During the 1960s there was an enormous growth in serial correlation testing.
None of these found any substantial linear dependence in price changes. Studies by
Moore, Fama and Hagerman and Richmond are some of the early studies in this
area. Moore found an average serial correlation coefficient of — 0.06 for price
changes measured over weekly intervals. Fama’s study tested the serial correlation
for the thirty stocks comprising the Dow Jones industrial average for the five years
prior to 1962. The average serial correlation coefficient was found to be 0.03. Both
the coefficients were not statistically different from zero; thus both the studies
supported the random walk theory.
Fama also used run tests to measure dependency. The results again supported
the random walk theory. Many studies followed Moore’s and Fama’s work each of
which used different databases. The results of these studies were much the same
as those of Moore and Fama.
Hagerman and Richmond conducted similar studies on securities traded in the
‘over- the-counter’ market and found little serial correlation. Serial correlation tests
of dependence have also been carried out in various other stock markets around
the world. These have similarly revealed little or no serial correlation.
Much research has also been directed towards testing whether mechanical
trading strategies are able to earn above average returns. Many studies have tested
the filter rules for its ability to earn superior returns. Early American studies were
those by Alexander, who originally advocated the filter strategy, and by Fama and
Blume. There were similar studies in the United Kingdom by Dryden and in
Australia by Praetz. All these studies have found that filter strategies did not
achieve above average returns. Thus, the results of empirical studies have been
virtually unanimous in finding little or no statistical dependence and price patterns
and this has corroborated the weak form efficient market hypothesis
12.5 EMPIRICAL TESTS OF SEMI-STRONG FORM EFFICIENCY
The semi-strong form of the efficient market hypothesis says that current
prices of stocks not only reflect all informational content of historical prices, but
also reflect all publicly available information about the company being studied.
Examples of publicly available information are—corporate annual reports, company
announcements, press releases, announcements of forthcoming dividends, stock
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splits, etc. The semi-strong hypothesis maintains that as soon as the information
becomes public the stock prices change and absorb the full information. In other
words, stock prices instantaneously adjust to the information that is received.
The implication of semi-strong hypothesis is that fundamental analysts cannot
make superior gains by undertaking fundamental analysis because stock prices
adjust to new pieces of information as soon as they are received. There is no time
gap in which a fundamental analyst can trade for superior gains. Thus, the semi-
strong hypothesis repudiates fundamental analysis.
Semi-strong form tests deal with whether or not security prices fully reflect all
publicly available information. These tests attempt to establish whether share
prices react precisely and quickly to new items of information. If prices do not react
quickly and adequately, then an opportunity exists for investors or analysts to earn
excess returns by using this information. Therefore, these tests also attempt to find
if analysts are able to earn superior returns by using publicly available information.
There is an enormous amount and variety of public information. Semi-strong
form tests have been performed with respect to many different types of information.
Much of the methodology used in semi-strong form tests has been introduced by
Fama, Fisher, Jensen and Roll. Theirs was the first of the studies that were directly
concerned with the testing of the semi-strong form of EMH. Subsequent to their
study, a number of refinements have been developed in the test procedure.
The general methodology followed in these studies has been to take an
economic event and measure its impact on the share price. The impact is measured
by taking the difference between the actual return and expected return on a
security. The expected return on a security is generally estimated by using the
market model (or single index model) suggested by William Sharpe. The model used
for estimating expected returns is the following:
Ri = ai + biRm + ei
Where
Ri = Return on security i.
Rm = Return on a market index.
ai& bi = Constants.
ei = Random error.
This analysis is known as Residual analysis. The positive difference between
the actual return and the expected return represents the excess return earned on a
security. If the excess return is close to zero, it implies that the price reaction
following the public announcement of information is immediate and the price
adjusts to a new level almost immediately. Thus, the lack of excess returns would
validate the semi-strong form EMH.
Major studies on the impact of capitalization issues such as stock splits and
stock dividends have been conducted in the United States by Fama, Fisher, Jensen
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and Roll and Johnson, in Canada by Finn, and in the United Kingdom by Firth. All
these studies found that the market adjusted share prices instantaneously and
accurately for the new information. Both Pettit and Watts have investigated the
market’s reaction to dividend announcements. They both found that all the price
adjustment was over immediately after the announcement and thus, the market
had acted quickly in evaluating the information.
Other items of information whose impact on share prices have been tested
include announcements of purchase and sale of large blocks of shares of a
company, takeovers, annual earnings of companies, quarterly earnings, accounting
procedure changes, and earnings estimates made by company officials. All these
studies which made use of the Residual analysis approach, showed the market to
be relatively efficient.
Ball and Brown tested the stock market’s ability to absorb the informational
content of reported annual earnings per share information. They found that
companies with good earnings report experienced price increase in stock, while
companies with bad earnings report experienced decline in stock prices. But
surprisingly, about 85 per cent of the informational content of the earnings
announcements was reflected in stock price movements prior to the release of the
actual earnings figure. The market seems to adjust to new information rapidly with
much of the impact taking place in anticipation of the announcement.
Joy, Litzenberger and McEnally tested the impact of quarterly earnings
announcements on the stock price adjustment mechanism. Some of their results,
however, contradicted the semi-strong form of the efficient market hypothesis. They
found that the favorable information contained in published quarterly earnings
reports was not always instantaneously adjusted in stock prices. This may suggest
that the market does not adjust share prices equally well for all types of
information.
By way of summary it may be stated that a great majority of the semi- strong
efficiency tests provide strong empirical support for the hypothesis; however, there
have been some contradictory results too. Most of the reported results show that
stock prices do adjust rapidly to announcements of new information and that
investors are typically unable to utilize this information to earn consistently above
average returns.
12.6 TESTS OF STRONG FORM EFFICIENCY
The strong form hypothesis represents the extreme case of market efficiency.
The strong form of the efficient market hypothesis maintains that the current
security prices reflect all information both publicly available information as well as
private or inside information. This implies that no information, whether public or
inside, can be used to earn superior returns consistently.
The directors of companies and other persons occupying senior management
positions within companies have access to much information that is not available to
the general public. This is known as inside information. Mutual funds and other
 107

professional analysts who have large research facilities may gather much private
information regarding different stocks on their own. These are private information
not available to the investing public at large.
The strong form efficiency tests involve two types of tests. The first type of tests
attempt to find whether those who have access to inside information have been able
to utilize profitably such inside information to earn excess returns. The second type
of tests examine the performance of mutual funds and the recommendations of
investment analysts to see if these have succeeded in achieving superior returns
with the use of private information generated by them.
Jaffe, Lorie and Niederhoffer studied the profitability of insider trading (i.e. the
investment activities of people who had inside information on companies). They
found that insiders earned returns in excess of expected returns. Although there
have been only a few empirical studies on the profitability of using inside
information, the results show, as expected, that excess returns can be made. These
results indicate that markets are probably not efficient in the strong form.
Many studies have been carried out regarding the performance of American
mutual funds using fairly sophisticated evaluation models. All the major studies
have found that mutual funds did no better than randomly constructed portfolios of
similar risk. Firth studied the performance of Unit Trusts in the United Kingdom
during the period 1965— 75. He also found that unit trusts did not outperform the
market index for their given levels of risk. A small research has been conducted into
the profitability of investment recommendations by investment analysts. Such
studies suggest that few analysts or firms of advisers can claim above average
success with their forecasts.
The results of research on strong form EMH may be summarized as follows:
1. Inside information can be used to earn above average returns.
2. Mutual funds and investment analysts have not been able to earn superior
returns by using their private information.
In conclusion, it may be stated that the strong form hypothesis is invalid as
regards inside information, but valid as regards private information other than
inside information.
12.7 COMPETITIVE MARKET HYPOTHESIS
An efficient market has been defined as one where share prices always fully
reflect available information on companies. In practice, no existing stock market is
perfectly efficient. There are evident shortcomings in the pricing mechanism. Often,
the complete body of knowledge about a company’s prospects is not publicly
available to market participants. Further, the available information would not be
always interpreted in a completely accurate fashion. The research studies on EMH
have shown that price changes are random or independent and hence
unpredictable. The prices are also seen to adjust quickly to new information.
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Whether the price adjustments are correct and accurate, reflecting correctly and
accurately the meaning of publicly available information is difficult to determine.
All that can be validly concluded is that prices are set in a very competitive
market, but not necessarily in an efficient market. This competitive market
hypothesis provides scope for earning superior returns by undertaking security
analysis and following portfolio management strategies.
12.8 MARKET INEFFICIENCIES
Many studies have proved the prevalence of the market efficiency. At the same
time, several studies contradict the concept of market efficiency. For example, the
studies conducted Joy, Lichtenberger and Mc. Enally over the period of 1963-1968
gave different results. The authors have examined the quarterly earnings of the
stock prices. The earning of one quarter was compared with the same quarter of the
previous year. If the current year’s earnings were 40% or more than the earnings
for the same quarter in the previous year, the earnings were classified as good
earnings than anticipated. If the current quarter’s earnings were below 40% of the
previous year’s earnings, they are classified as bad than expected.
Then the abnormal returns were calculated from 13 weeks prior to the
announcement of the earnings to 26 weeks after the announcement of the earnings.
The stocks whose earn-ings are substantially greater than anticipated gave positive
abnormal returns. The stocks whose earnings are below the anticipated earnings
generated negative abnormal returns.
The author’s main claim is that after the announcement of the earnings,
stocks that reported earnings substantially above those of the previous year
continued to earn positive abnormal returns. According to the study, the investors
could have earned positive abnormal returns of around 6.5 per cent over the next
26 weeks simply by buying stocks that have reported earnings 40% above the
previous quarterly earnings. Meanwhile for those stocks with earnings substantially
below the previous year, the cumulative average abnormal return remained
relatively stable. This shows evidence against the semi-strong market hypothesis
because it states that when the information is made public the analyst could not
earn abnormal profits. A study made by C.P. Jones, R. S. Randleman for the period
1971-1980 had also given similar results to those of JLM.
Low PE effect many studies have provided evidences that stocks with low price
earnings ratios yield higher returns than stocks with higher PEs. This is known as
low PE effect. A study made by Basu in 1977 was risk adjusted return and even
after the adjustment there was excess return in the low price-earnings stocks. If
historical information of P/E ratios is useful to the investor in obtaining superior
stock returns, the validity of the semi-strong form of market hypothesis is
questioned. His results stated that low P/E portfolio experienced superior returns
relative to the market and high P/E portfolio performed in an inferior manner
relative to the overall market. Since his result directly contradicts semi-strong form
of efficient market hypothesis, it is considered to be important.
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Small firm effect the theory of the small firm effect maintains that investing in
small firms (those with low capitalization) provides superior risk adjusted returns.
Bans found that the size of the firm has been highly correlated with returns. Bans
examined historical monthly returns of NYSE common stocks for the period 1931-
1975. He formed portfolios consisting of 10 smallest firms and the 10 largest firms
and computed the average return for these portfolios. The small firm portfolio has
outperformed the large firm portfolio.
Several other studies have confirmed the existence of a small firm effect. The
size effect has given rise to the doubts regarding the risk associated with small
firms. The risk associated with them is underestimated and they do not trade as
frequently as the those of the large firms. Correct measurement of risk and return
of small portfolios tends to eliminate at least 50% of the small firm effect.
The weekend effect French in his study had examined the returns generated
by the Standard and poor Index for each day of the week. Stock prices tend to rise
all week long to a peak on Fridays. The stocks are traded on Monday at reduced
prices, before they begin the next week’s price rise. Buying on Monday and selling
on Friday from 1953 to 1977 would have generated average annual return 3.4%
while simple buy and hold would have yielded 5.5% annual return. If the
transaction costs are taken into account, the naive buy and hold strategy would
have provided higher return. Yet the knowledge of the weekend effect is still of v
Purchases planned on Thursday or Friday can be delayed until Monday, while sale
planned for Monday can b delayed until the end of the week. The weekend effect is
a small but significant deviation from perfectly random price movements and
violates the weekly efficient market hypothesis.
Similar to this BL Research Bureau has stated that the Bombay Stock
Exchange reveal a discernible pattern. Usually, Monday, is characterized by trading
blues, and Friday by frenzied activity The Friday rush is more to do with
speculators covering their open position. If the short sellers to cover their position
within this period, their open positions are called to auction where prices are dear.
REVISION POINT
Random walk model says that successive price changes are independent i.e.
previous price changes or changes in return are useless in predicting future price
or return changes
INTEXT QUESTIONS
1. How do technicians and random-walk advocates differ in their view of the stock
market?
2. Describe briefly the tests of weak form, semi-strong and strong form of efficient
market hypothesis.
3. What is the connection between the efficient-market hypothesis and the studies
of mutual-fund performance?
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SUMMARY
The efficient market theory states that the stock market reacts very quickly to
new information, so at any given time the market contains the sum of all investors’
views of the market.
2. What sequence of events might bring about an ‘efficient market’?
TERMINAL EXERCISE
__________ have been developed as direct tests of specific mechanical trading
strategies to examine their validity and usefulness.
Ans: Filter Tests
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
1. Explain the implications of the serial-correlation tests for
a) the random-walk theory,
b) technical analysis, and
c) fundamental analysis.
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Does the random-walk theory suggest that security price levels are random?
Explain.
KEY WORDS
Market hypothesis, Efficient market, Distribution Pattern.
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LESSON 13

PORTFOLIO MANAGEMENT
INTRODUCTION
Portfolio management means selection of securities and constant shifting of
the portfolio in the light of varying attractiveness of the constituents of the portfolio.
It is a choice of selecting and revising spectrum of securities to it in with the
characteristics of an investor. Portfolio management includes portfolio planning,
selection and construction, review and evaluation of securities. The skill in portfolio
management lies in achieving a sound balance between the objectives of safety,
liquidity and profitability. Timing is an important aspect of portfolio revision.
Ideally, investors should sell at market tops and buy at market bottoms. Investors
may switch from bonds to share in a bullish market and vice-versa in a bearish
market. Portfolio management is all about strengths, weaknesses, opportunities
and threats in the choice of debt vs. equity, domestic vs. international, growth vs.
safety, and many other trade offs encountered in the attempt to maximize return at
a given appetite for risk. Portfolio management is an art and science of making
decisions about investment mix and policy, matching investments to objectives,
asset allocation for individuals and institutions, and balancing risk against
performance. Portfolio management in common parlance refers to the selection of
securities and their continuous shifting in the portfolio to optimize the returns to
suit the objectives of the investor. This however requires financial expertise in
selecting the right mix of securities in changing market conditions to get the best
out of the stock market. In India, as well as in many western countries, portfolio
management service has assumed the role of specialized service now a days and a
number of professional merchant bankers compete aggressively to provide the best
to high net-worth clients, who have little time to manage their investments. The
idea is catching up with the boom in the capital market and an increasing number
of people are inclined to make the profits out of their hard earned savings.
OBJECTIVES
After reading this lesson the student should be able to understand portfolio
analysis and management.
CONTENTS
13.1 Portfolio Analysis And Management
13.2 Element Of Portfolio Management
13.1 PORTFOLIO ANALYSIS AND MANAGEMENT
A Portfolio Management refers to the science of analyzing the strengths,
weaknesses, opportunities and threats for performing wide range of activities
related to the one’s portfolio for maximizing the return at a given risk. It helps in
making selection of Debt Vs Equity, Growth Vs Safety, and various other trade offs.
 Major tasks involved with Portfolio Management are as follows.
 Taking decisions about investment mix and policy
 Matching investments to objectives
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 Asset allocation for individuals and institution

 Balancing risk against performance
There are basically two types of portfolio management in case of mutual and
exchange-traded funds including passive and active.
Passive management involves tracking of the market index or index investing.
Active management involves active management of a fund’s portfolio by manager or
team of managers who take research based investment decisions and decisions on
individual holdings.
Portfolio Construction is all about investing in a range of funds that work
together create an investment solution for investors. Building a portfolio involves
understanding the way various types of investments work, and combining them to
address your personal investment objectives and factors such as attitude to risk the
investment and the expected life of the investment. When building an investment
portfolio there are two very important considerations.
The first is asset allocation, which is concerned with how an investment is
spread across different asset types and regions. The second is fund selection, which
is concerned with the choice of fund managers and funds to represent each of the
chosen asset classes and sectors.
Both of these considerations are important, although academic studies have
consistently shown that in the medium to long term, asset allocation usually has a
much larger impact on the variability of a portfolio's return.
To help in choosing a suitable asset allocation we have created a Risk Profiler
that helps identify your attitude to risk and therefore better identify a combination
of investments to build a portfolio.
With such a vast number of investment funds to choose from, spanning the
full range of asset classes and world markets it is easy to become confused when
choosing which investments to make. It is even more difficult to choose the right
combination of investment to potentially meet your investment goals.
Investors know that expected return from individual securities carrying some
degree of risk. Risk was defined as the standard deviation around the expected
return. In effect we equated a security’s risk with the variability of its return. More
dispersion or variability about a security’s expected return meant the security was
riskier than one with less dispersion.
The simple fact that securities carrying differing degrees of expected risk lead
most investors to the notion of holding more than one security at a time, is an
attempt to spread risks by not putting all their eggs into one basket. Diversification
of one’s holdings is intended to reduce risk in an economy in which every asset’s
returns are subject to some degree of uncertainty. Even the value of cash suffers
from the in roads of inflation. Most investors hope that if they hold several assets,
even if one goes bad, the others will provide some protection from an extreme loss.
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13.2 ELEMENT OF PORTFOLIO MANAGEMENT

1. Review of Investment Avenues: The first step in the investment management
process is to understand the broad characteristics of various investment
avenues available.
2. Specification of investment Objective and Constraints: The second step in
the portfolio management process is to list down investment objectives and
constraints.
3. Choice of Assets Mix: In additional, one must maintain a comfortable liquid
balance in a convenient form to meet excepted and unexpected expenses in the
short run. While choosing the Debt equity mix an investor has to understand the
two key factors that have a bearing on the asset mix decision.
a. Risk tolerance i.e. Risk averse / Risk neutral / Risk seeker.
b. Investment horizon i.e. Short term / Long term.
4. Formulation of Portfolio Strategy: After choosing a certain asset mix next step
is to formulate an appropriate portfolio strategy. Two broad choices are available
in this respect, and active portfolio strategy or passive portfolio strategy.
5. Selection of Securities:
i. Selection of fixed incomes avenues(bonds)
An investor should carefully evaluate the following factors in selecting fixed
income avenues:
a. Yield to maturity.
b. Risk of default.
c. Tax shield.
d. Liquidity.
ii. Selection of Stocks: Three broad approaches are employed for the selection of
equity shares.
a. Technical analysis: This analysis looks at price behavior and volume data
to determine whether the share will move up or down or remain trend less.
b. Fundamental analysis: Fundamental analysis focuses on fundamental
factors like earning level, growth prospect and risk exposure to establish
the intrinsic value of a share.
c. The random selection approach: It is based on the premises that the
market is efficient and securities are properly prices.
iii. Selection of Real Estate / Commodities.
6. Portfolio Execution: This step is to implement the portfolio plan by buying and
/ or selling specified securities in given amounts as planned.
7. Portfolio Revision: Portfolio revision means changing the assets allocation of a
portfolio. Due to dynamic developments in the capital markets and the changes
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in the circumstance, even a well constructed portfolio tends to become inefficient

and hence need to be monitored and revised periodically. This usually entails
two things i.e. Portfolio rebalancing and portfolio upgrading.
Portfolio rebalancing: This involves reviewing and revising the portfolio
composition / mix i.e. shifting from stocks to bonds or vice-versa. There are
three basic policies in portfolio rebalancing.
a. Buy and hold policy: where no change is effected and portfolio mix of debt
equity is allowed to drift.
b. Constant mix policy: where the desired target proportion of debt and equity is
maintained when relative values of debt and equity in the portfolio changes.
E.g. if the target debt equity mix was 50:50 portfolio rebalancing is done to
maintain this target of 50:50 when any changes takes place in their market
values.
c. Portfolio insurance policy: increasing the exposure to stocks when portfolio
appreciates in value and vice- versa.
Portfolio updating: This involves re-assessing the risk-return
characteristics of various securities, selling the over – priced securities and
buying the under – priced securities. It also entails other change the investor
may consider necessary to enhance the performance of the portfolio.
8. Performance Evaluation: The key dimension of portfolio performance
evaluation is the rate of return and risk. Also the performance index models are
commonly used to evaluated the portfolios.
a. Assessment of return: The return of the portfolio can be calculated by
applying the Holding period return, Annualized return formulas. In case of
intermediate additions the technique of internal rate of return can be applied
to find out the return on the portfolio.
b. Risks: The risk of a portfolio can be measured in various ways. The two most
commonly used measures of risk are variance and beta.
REVISION POINT
Portfolio Construction: Portfolio is a combination of securities such as stocks,
bonds and money market instruments. The process of blending together the broad
asset classes so as to obtain optimum return with minimum risk is called portfolio
construction.
INTEXT QUESTIONS
1. What are the steps in the traditional approach?
2. Explain the constraints in the formation of objectives.
SUMMARY
The portfolio is a collection of investment instruments like shares, mutual
funds, bonds, fixed deposits and other cash equivalents etc. Portfolio management
is the art of selecting the right investment tools in the right proportion to generate
 115

optimum returns from the investment made.Best portfolio management practice

runs on the principle of minimum risk and maximum return within a given time
frame. A portfolio is built based on investor’s income, investment budget and risk
appetite keeping the expected rate of return in mind.
TERMINAL EXERCISE
1. The __________ selection approach: It is based on the premises that the market is
efficient and securities are properly prices.
Ans: Random
SUPPLEMENTARY MATERIALS
 money.rediff.com
 money control.com
 amfiindia.com
 nseindia
 bseindia.com
 rbi.org.in
ASSIGNMENTS
1. How would you formulate the asset mix according to the given objectives?
2. What are the differences between the traditional approach and modern approach?
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Can an investor ignore safety of principal? Why is knowledge of tax-status
importance for the investor?
KEY WORDS
Portfolio, traditional approach , modern approach
 116

LESSON 14

MODERN PORTFOLIO THEORY

INTRODUCTION
Modern Portfolio Theory Definition: Modern portfolio theory (MPT), popularly
known as mean-variance analysis, is a mathematical framework for accumulating a
portfolio of assets such that the expected return is optimized for a given level of risk
involved, generally defined as variance. Asset’s risk and return should not be
assessed by itself, but by how it contributes to a portfolio’s overall risk and return,
this is one of the key insights of modern portfolio theory.
OBJECTIVES
After reading this lesson the student should be able to Understand Modern
Portfolio Theory.
CONTENT
14.1 Modern Portfolio Theory Assumptions
14.2 Modern Portfolio Theory
14.1 MODERN PORTFOLIO THEORY ASSUMPTIONS
Modern portfolio theory assumptions has shown the effects on how financial
specialists view return, risk and portfolio administration. Theory exhibits how
diversified portfolio can minimize capital risk. For new investors, it is mandatory to
reconsider the risk before investing. There are times where investors go for risky
investments. (For example: future trading). In similar manner, you can invest in risk-
free assets as well to maximize your returns on portfolio. (For example: government
bonds, treasury bonds, etc.). Another important question about this theory is subject
to quantity of stocks for diversified portfolio. It is never recommended to hold 100
stocks as a part of diversification. By such complexity, Martin J. Gruber and Edwin
J. Elton, has very well explained in
their book “Modern Portfolio Theory
and Investment Analysis” (1981),
presume that investors would learn
how to achieve diversified portfolio
with merely 20 stocks
14.2 MODERN PORTFOLIO THEORY
A portfolio consists of a
number of different securities or
other assets selected for investment
gains. However, a portfolio also has
investment risks. The primary
objective of portfolio theory or
management is to maximize gains
while reducing diversifiable risk.
Diversifiable risk is so named because the risk can be reduced by diversifying
assets. Systemic risk, on the other hand, cannot be reduced through diversification,
 117

since it is a risk that affects the entire economy and most investments. So even the
most optimized portfolio will still be subject to systemic risk.
On the efficient frontier, there is a portfolio with the minimum risk, as
measured by the variance of its returns — hence, it is called the minimum variance
portfolio — that also has a minimum return, and a maximum return portfolio with
a concomitant maximum risk. Portfolios below the efficient frontier offer lower
returns for the same risk, so a wise investor would not choose such portfolios.
Below is a diagram constructed by combining an Asset A that has an expected
return of 14% and a standard deviation of 6%, with an Asset B that has an
expected return of 8% and a standard deviation of 3%, into various portfolios by
changing the weighting for each asset in each portfolio. All of the portfolios
consisting of these 2 assets lie on the graph below, which is the investment
opportunity set. The efficient frontier extends from the minimum variance portfolio
to the maximum return portfolio. Two of the portfolios lie below the efficient
frontier. These 2 portfolios will yield a smaller return for the same risk as those on
the efficient frontier. For instance, if an investor did not want to assume any greater
risk than that offered by Portfolio A and Portfolio B, then the investor would choose
Portfolio A over B, because both have the same risk, but Portfolio A returns 10.4%
while Portfolio B returns only 8%. Portfolio B consists only of Asset B; the
maximum return portfolio consists only of Asset A. Note that the minimum variance
portfolio not only has a greater expected return, but also a lower risk than a
portfolio consisting only of Asset B.

Most investors will assume a greater risk for a greater return. However,
investors differ in the amount of risk they are willing to take for a given return.
Investors who are risk averse require a greater return for a given amount of risk
than a risk lover. A risk-neutral investor is only concerned with the magnitude of
the return. However, most investors are risk averse to varying degrees.
 118

Although investors differ in their risk tolerance, they should be consistent in

their selection of any portfolio in terms of the risk-return trade-off. Because risk
can be quantified as the sum of the variance of the returns over time, it is possible
to assign a utility score (aka utility value, utility function) to any portfolio by
subtracting its variance from its expected return to yield a number that would be
commensurate with an investor's tolerance for risk, or a measure of their
satisfaction with the investment. Because risk aversion is not an objectively
measurably quantity, there is no unique equation that would yield such a quantity,
but an equation can be selected, not for its absolute measure, but for its
comparative measure of risk tolerance. One such equation is the following utility
formula:
Utility Score = Expected Return – 0.005σ2 × Risk Aversion Coefficient
The risk aversion coefficient is a number proportionate to the amount of risk
aversion of the investor and is usually set to integer values less than 6, and 0.005
is a normalizing factor to reduce the size of the variance, σ2, which is the square of
the standard deviation (σ), a measure of the volatility of the investment and
therefore its risk. This equation is normalized so that the result is a yield
percentage that can be compared to investment returns, which allows the utility
score to be directly compared to other investment returns, such as the return of
risk-free T-bills. For example, if a risk-free T-bill pays 4%, and XYZ stock has a
return of 12% and a standard deviation of 25%, the utility score of XYZ stock is
equal to:
Utility Score = 12 – 0.005 × 252 × 2= 12 – 6.25 = 5.75%
In the above example, we let the risk aversion coefficient be equal to 2. If
someone were more risk averse, we might use 3 instead of 2 to indicate the
investor's greater aversion to risk. In this case, the above equation yields:
Utility Score = 12 – 0.005 × 252 × 3 = 12 – 9.375 = 2.625%
Since 2.625% is less than the 4% yield of risk-free T-bills, this risk-averse
investor will reject XYZ stock in favor of T-bills while the other investor will invest in
XYZ stock since he assigns a utility score of 5.75% to the investment, which is
higher than the T-bill yield.
Another way to measure the risk averseness of an investor is by comparing the
desirability of a risky investment to a risk-free investment. The certainty equivalent
rate is the rate of return of a risk-free investment that would be equally attractive
as a risky investment. Since the utility score of a risk-free investment is simply its
rate of return (in other words, the variance of a risk-free investment is considered
zero, hence the 2nd term of the utility score formula is zero), the certainty
equivalent rate would equal the utility score of the risky investment. So for the 1st
investor above, a risk-free yield of 5.75% would be equally attractive as XYZ stock
yielding a risky 12%, while the 2nd investor would only consider XYZ stock if the
 119

risk-free rate were only 2.625%. In other words, each investor would be indifferent
to either investment if the risk-free rate were equal to their certainty equivalent
rate.
The set of all portfolios with the same utility score plots as a risk-indifference
curve. An investor will accept any portfolio with a utility score on her risk-
indifference curve as being equally acceptable.
These risk-indifference curves, calculated with the formula above setting the
risk aversion coefficient commensurate to the risk aversion level of 4 hypothetical
investors and the risk-free rate equal to 4%, shows that higher returns are required
for investors who are more risk averse.

However, there are many possible portfolios on many risk-indifference curves

that do not yield the highest return for a given risk. All of these portfolios lie below
the efficient frontier. The optimal portfolio is a portfolio on the efficient frontier that
would yield the best combination of return and risk for a given investor, which
would give that investor the most satisfaction.
These risk-indifference curves, calculated with the utility formula with the risk
aversion coefficient equal to 2, but with higher utility values resulting from setting
the risk-free rate to successively higher values. Of course, any investor, regardless
of risk aversion, would like to receive a higher return for the same risk. The utility
of these risk-indifference curves is that they allow the selection of the optimum
portfolio out of all of those that are attainable by combining these curves with the
efficient frontier. Where 1 of the curves intersects the efficient frontier at a single
point is the portfolio that will yield the best risk-return trade-off for the risk that
the investor is willing to accept.
 120

In the above graph, risk-indifference curves are plotted along with the
investment opportunity set of attainable portfolios. Data points outside of the
investment opportunity set designate portfolios that are not attainable, while those
portfolios that lie along the northwest boundary of the investment opportunity set is
the efficient frontier. All portfolios that lie below the efficient frontier have a risk-
return trade-off that is inferior to those that lie on the efficient frontier. If a utility
curve intersects the efficient frontier at 2 points, there are a number of portfolios on
the same curve that lie below the efficient frontier; hence they are not optimal.
Remember that all points on a risk-indifference curve are equally attractive to the
investor; therefore, if any points on the indifference curve lie below the efficient
frontier, then no point on that curve can be an optimum portfolio for the investor. If
a utility curve lies wholly above the efficient frontier, then there is no attainable
portfolio on that utility curve.
However, there is a utility curve such that it intersects the efficient frontier at
a single point—this is the optimum portfolio. The only attainable portfolio is on the
efficient frontier, and thus, provides the greatest satisfaction to the investor. The
optimum portfolio will yield the highest return for the amount of risk that the
investor is willing to take.
These risk-indifference curves were calculated with the utility formula, setting
the risk aversion coefficient to 2. Note that there is a point where 1 utility curve
intersects the efficient frontier at a single point—this is the optimum portfolio for
someone with a moderate amount of risk aversion. Portfolios on higher utility
curves are not attainable and those on lower utility curves have risk-return trade-
offs that are worse than the optimum portfolio. For instance, on the red curve
representing a utility of 6, there is a point on that curve that offers a slightly higher
return than the optimum portfolio, but at a much greater risk, so it is not as
satisfying as the optimum portfolio. A risk-lover might accept that small return for
 121

the much greater risk, which is why the risk-indifference curves of risk-lovers are
relatively flat while risk-averse investors have curves that are much steeper.

Portfolio Betas: A Measure of the Systematic Risk of Portfolios

By selecting the right assets in the right proportions, it may be possible to
reduce diversifiable risk to near zero, but the portfolio would still have systematic
risk, which also affects the general market. Portfolios, like stocks, have betas which
measure the systematic risk of the portfolio compared to that of the market.
The portfolio beta is equal to the sum of the beta of the weighted average of each
security's value over the value of the portfolio.
n
Dollar Amount of Asset k
Portfolio Beta    Beta for Asset k
k 1 Dollar Amount of Portfolio

REVISION POINTS
The main concepts in Modern Portfolio Theory, which are any investor's goal is
to maximize Return for any level of Risk. Risk can be reduced by creating a
diversified portfolio of unrelated assets then names for this approach are passive
investment approach because investors build the right risk to return portfolio for
broad asset with a substantial value and then investors behave passive and wait as
it growth.
INTEXT QUESTIONS
1.What are the assumption of modern portfolio theory?
2.what are the two Main Concept Of Modern Portfolio Theory ?
 122

SUMMARY
Modern portfolio theory (MPT) reduces portfolio risk by selecting and balancing
assets based on statistical techniques that quantify the amount of diversification by
calculating expected returns, standard deviations of individual securities to assess
their risk, and by calculating the actual coefficients of correlation between assets,
or by using a good proxy, such as the single-index model, allowing a better choice
of assets that have negative or no correlation with other assets in the portfolio.
TERMINAL EXERCISES
1. The main concepts in _______________ , which are any investor's goal is to
maximize Return for any level of Risk.
Ans: Modern Portfolio Theory
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
Discuss at what way modern portfolio theory help to investors while investing.
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEANING ACTIVITIES
“In a perfect market, all stock have the same risk premium”. Do you agree with
this statement?
KEY WORDS
Diversification, passive, return, risk
 123

LESSON 15

MARKOWITZ PORTFOLIO SELECTION MODEL

INTRODUCTION
Harry M. Markowitz, introduced new concept of risk management and their
application in selection of portfolios. His model is theoretical framework for analysis
of risk and return and their inter relationship. he generated number of portfolios
within a given amount of money and given preferences of investors for risk and
return. Markowitz emphasised that quality of a portfolio will be different from the
quality of individual assets within it.
Noted economist, Harry Markowitz (“Markowitz) received a Nobel Prize for his
pioneering theoretical contributions to financial economics and corporate finance.
His innovative work established the underpinnings for Modern Portfolio Theory—an
investment framework for the selection and construction of investment portfolios
based on the maximization of expected portfolio returns and simultaneous
minimization of investment risk.
OBJECTIVES
After reading this lesson the student should be able to Understand Markowitz
Portfolio Selection, Assumptions Of Markowitz Theory, Markowitz Portfolio
Selection, Sharpe’s Single Index Model.
CONTENT
15.2 Markowitz Portfolio Selection
15.2 Assumptions of Markowitz Theory
15.3 Markowitz Portfolio Selection
15.4 Sharpe’s Single Index Model
15.1 MARKOWITZ PORTFOLIO SELECTION
A continuous-time version of the Markowitz mean-variance portfolio selection
model is proposed and analyzed for a market consisting of one bank account and
multiple stocks. The market parameters, including the bank interest rate and the
appreciation and volatility rates of the stocks, depend on the market mode that
switches among a finite number of states. The random regime switching is assumed
to be independent of the underlying Brownian motion. This essentially renders the
underlying market incomplete. A Markov chain modulated diffusion formulation is
employed to model the problem. Using techniques of stochastic linear-quadratic
control, mean-variance efficient portfolios and efficient frontiers are derived
explicitly in closed forms, based on solutions of two systems of linear ordinary
differential equations. Related issues such as a minimum-variance portfolio and a
mutual fund theorem are also addressed. All the results are markedly different from
those for the case when there is no regime switching. An interesting observation is,
however, that if the interest rate is deterministic, then the results exhibit (rather
unexpected) similarity to their no-regime-switching counterparts, even if the stock
appreciation and volatility rates are Markov-modulated.
 124

15.2 ASSUMPTIONS OF MARKOWITZ THEORY

The Modern Portfolio Theory of Markowitz is based on the following
assumptions:
1.Investors are rational and behave in a manner as to maximise their. utility with a
given level of income or money.
2.Investors have free access to fair and correct information on the returns and risk.
3.The markets are efficient and absorb the information quickly and perfectly.
4.Investors are risk averse and try to minimise the risk and maximise return.
5.Investors base decisions on expected returns and variance or standard deviation
of these returns from the mean.
6.Investors prefer higher returns to lower returns for a given level of risk.
15.3 MARKOWITZ PORTFOLIO SELECTION

Once an investor is able to map the precise utility pattern of a risk return
combination, the investor can then superimpose the efficient frontier into this
utility map. The indifference line point that is tangential to the efficient frontier will
be the optimal portfolio selection for an investor. The portfolio selection point for a
moderate risk taker is shown in Figure.
 125

Markowitz H.M. (1952) introduced the term ‘risk penalty’ to state the portfolio
selection rule. A security will be selected into a portfolio if the risk adjusted rate of
return is high compared to other available securities. This risk adjusted rate of
return is computed as:
Risk adjusted return utility) = Expected return – Risk penalty
Risk penalty is computed as:
Risk Penalty = Risk squared/ Risk tolerance
Risk squared is the variance of the security return and risk tolerance is a
number between 0 and 100. Risk tolerance of an investor is stated as a percentage
point between these numbers and a very high risk tolerance could be stated as 90
or above and a very low risk tolerance level could be stated as between 0 and 20.
Assuming the expected return from a portfolio is 24 per cent, standard
deviation (risk) is 20 per cent, and risk tolerance level is rated as 40, the utility of
the portfolio for the investor with a risk tolerance level of 40 will be:
Portfolio utility = 24 – (400/40) = 24 – 10 = 14%.
Illustration 16.4: The following risk-return combinations of portfolios are
available to an investor. Assume the risk tolerance level for the investor is 30 per
cent, rank the portfolios and select the best portfolio that fits investor requirement.

Solution: The ranking of the portfolios will be as follows:

The portfolio that best fits the investor is G, with the portfolio utility of 9.37
percent.
15.4 SHARPE’S SINGLE INDEX MODEL
Sharpe W.E. (1964) justified that portfolio risk is to be identified with respect to
their return co-movement with the market and not necessarily with respect to within
the security co-movement in a portfolio. He therefore concluded that the desirability of
a security for its inclusion is directly related to its excess return to beta ratio,
R (i) – R (f)/ β (i)
Where
R (i) = expected return on security i R (f) = return on a riskless securityΒ (i) =
beta of security
This ranking order gives the best securities that are to be selected for the
portfolio.
 126

Cut-off Rate:
The number of securities that are to be selected depends on the cut-off rate.
The cut-off rate is determined such that all securities with higher ratios are
included into the portfolio. The cut-off rate for the selection of a security into a
portfolio is determined as:

where σm2 = market variance Ri = security return Rf = risk free return βI = security
betaσei2 = security error variance
The final cutoff rate C* is one where the cut-off value is highest and the next
inclusion of a security reduces the cut-off value noticeably. Percentage of
investment in each security The percentage of investment in each of the securities
in a portfolio with optimal C* cut-off rate is decided as follows:
ω (i) = Z I Σn(i =1) Zi Where Zi =βσ/ iei
The following securities are available for investment for an investor. Select the
optimal portfolio using the Sharpe’s Single Index Portfolio Selection method.
Assume the risk free rate of return as 5 per cent and the standard deviation of the
market return as 25 per cent.

The selection of the portfolio from these securities will be by building the
following table. The table ranks the securities on the basis of the Sharpe measure of
excess returns relative to beta risk:
 127

Columns: (1) (Ri – Rf) (2) (Βi/σei2) (3) (1)*(2) (4) Cumulative of column 3 values
(5) σm2 * (4) (6) (Βi2/σei2) (7) Cumulative of column 6 values (8) 1 + [σm2 * (7)] (9)
Ci = (5)/ (8)
The ranking of securities on the basis of their risk related returns is then
followed by the computation of Ci for a portfolio of the combined securities. The
maximum Ci or C* is that amount after which the inclusion of other securities do
not contribute to increased returns with respect to the risk inherent in that
security. In the example, inclusion of the first four securities is optimal for the
investor, since after that, the Ci values ((column (9)) are less. The quantum of
investment in these securities J, D, F and G are determined using the following
Table:

The proportion of investments in each security is determined as follows:

ωf = (0.0263/0.0295) = 89.21%ωj = (0.0015/0.0295) = 5.17%ωd =
(0.0008/0.0295) = 2.87%ωd = (0.0008/0.0295) = 2.87%ωg = (0.0008/0.0295) =
2.76%
REVISION POINTS
Markowitz Portfolio Theory deals with the risk and return of portfolio of
investments. Before Markowitz portfolio theory, risk & return concepts are handled
by the investors loosely. The investors knew that diversification is best for making
investments but Markowitz formally built the quantified concept of diversification.
He pointed out the way in which the risk of portfolio to an investor is reduced
through diversification. The particular measure of portfolio risk was first developed
by the Markowitz and the expected risk & return for portfolio are derived on the
basis of the covariance relationship.
INTEXT QUESTIONS
1. What are Assumptions Of Markowitz Theory ?
2. What Is Cut Off Rate.
SUMMARY
Modern Portfolio Theory (MPT) is an investment theory whose purpose is to
maximize a portfolio’s expected return by altering and selecting the proportions of
the various assets in the portfolio. It explains how to find the best possible
diversification. If investors are presented with two portfolios of equal value that offer
the same expected return, MPT explains how the investor will prefer and should
 128

select the less risky one. Investors assume additional risk only when faced with the
prospect of additional return.
TERMINAL EXERCISE
1. Investors are risk averse and try to minimise the risk and maximise return is
one of the assumption of __________________
Ans: Markowitz Theory
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
1. 1.Define Markowitz diversification.explain the statistical methods used by
Markowitz to obtain the risk reducing benefit?
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
How does the efficient frontier change when the short falling is not allowed?
KEY WORDS
Expected Returns, Standard Deviation, Mean.
 129

LESSON 16

CAPITAL ASSET PRICING MODEL

INTRODUCTION
A fundamental question in finance is how the risk of an investment should
affect its expected return. The Capital Asset Pricing Model (CAPM) provided the first
coherent framework for answering this question. The CAPM was developed in the
early 1960s by William Sharpe (1964), Jack Treynor (1962), John Lintner (1965a, b)
and Jan Mossin (1966). The CAPM is based on the idea that not all risks should
affect asset prices. In particular, a risk that can be diversified away when held
along with other investments in a portfolio is, in a very real way, not a risk at all.
The CAPM gives us insights about what kind of risk is related to return. This paper
lays out the key ideas of the Capital Asset Pricing Model, places its development in
a historical context, and discusses its applications and enduring importance to the
field of finance.
OBJECTIVES
After reading this lesson the student should be able to understand Capital
Asset Pricing Model.
CONTENT
16.1 Capital Asset Pricing Model
16.2 Assumptions Of Capm
16.3 Lending And Borrowing
16.4 Risk - Return Trade Off
16.5 Security Market Line
16.6 Evaluation Of Securities
16.7 Empirical Tests Of The Capm
16.8 Present Validity Of Capm
16.9 Arbitrage Pricing Theory
16.1 CAPITAL ASSET PRICING MODEL
The model takes into account the asset’s sensitivity to non-diversifiable risk
(also known as systematic risk or market risk), often represented by the quantity
beta (β) in the financial industry, as well as the expected return of the market and
the expected return of a theoretical risk-free asset. CAPM assumes a particular
form of utility functions (in which only first and second moments matter, that is
risk is measured by variance, for example a quadratic utility) or alternatively asset
returns whose probability distributions are completely described by the first two
moments (for example, the normal distribution) and zero transaction costs
(necessary for diversification to get rid of all idiosyncratic risk). Under these
conditions, CAPM shows that the cost of equity capital is determined only by
beta.[1][2] Despite it failing numerous empirical tests, [3] and the existence of more
modern approaches to asset pricing and portfolio selection (such as arbitrage
 130

pricing theory and Merton’s portfolio problem), the CAPM still remains popular due
to its simplicity and utility in a variety of situations.
The CAPM was introduced by Jack Treynor (1961, 1962),[4] William F. Sharpe
(1964), John Lintner (1965a,b) and Jan Mossin (1966) independently, building on
the earlier work of Harry Markowitz on diversification and modern portfolio theory.
Sharpe, Markowitz and Merton Miller jointly received the 1990 Nobel Memorial
Prize in Economics for this contribution to the field of financial economics. Fischer
Black (1972) developed another version of CAPM, called Black CAPM or zerobeta
CAPM, that does not assume the existence of a riskless asset. This version was
more robust against empirical testing and was influential in the widespread
adoption of the CAPM.
16.2 ASSUMPTIONS OF CAPM
All investors
1. Aim to maximize economic utilities (Asset quantities are given and fixed).
2. Are rational and risk-averse.
3. Are broadly diversified across a range of investments.
4. Are price takers, i.e., they cannot influence prices.
5. Can lend and borrow unlimited amounts under the risk free rate of interest.
6. Trade without transaction or taxation costs.
7. Deal with securities that are all highly divisible into small parcels (All assets are
perfectly divisible and
8. liquid).
9. Have homogeneous expectations.
10. Assume all information is available at the same time to all investors.
16.3 LENDING AND BORROWING
Here, it is assumed that the investor could borrow or lend any amount money
at riskless rate of interest. When this opportunity is given to the investors, they can
mix risk free assets with the risky assets in a portfolio to obtain a desired rate of
risk-return combination.
Rp = Portfolio return
Xf = the proportion of funds invested in risk free assets
1- Xf = the proportion of funds invested in risky assets
Rf = Risk free rate of return
Rm = Return on risky assets
The expected return on the combination of risky and risk free combination is
Rp = RfXf + Rm(1 – Xf)
This formula can be used to calculate the expected returns for different
situations, like mixing ri assets with risky assets, investing only in the risky asset
and mixing the borrowing with risky assets.
 131

Now, let us assume that borrowing and lending rate to be 12.5% and the
return from the risky assets to be 20%. There is a trade off between the expected
return and risk. If an investor invests in risk free assets and risky assets, his risk
may be less than what he invests in the risky asset alone. But if he borrows to
invest in risky assets, his risk would increase more than he invests his own money
in the risky assets. When he borrows to invest, we call it financial leverage. If he
invests 50% in risk free assets and 50% in risky assets, his expected return of the
portfolio would be
Rp = RfXf + Rm(1 – Xf)
= 12.5 x .5 + 20(1 - .5)
= 6.25 +10
= 16.25%
If there is a zero investment in risk free asset and 100% in risky asset, the
return is
Rp = RfXf + Rm(1 – Xf)
= 0 + 20%
= 20%
If - .5 in risk free asset and 1.5 in risky asset, the return is
Rp = RfXf + Rm(1 – Xf)
= (l2.5 x -.5) + 20x 1.5
= -6.25 + 30
= 23.75
The variance of the above mentioned portfolio can be calculated by using the equation.
σ2p = σ2fX2f + σ 2m(1 – Xf)2 + 2CovfmXf(1 – Xf)
The previous example can be taken for the calculation of the variance. The
variance of the risk free asset is in. The variance of the risky asset is assumed to be
15. Since the variance of the risky asset is zero, the 1,rtfolio risk solely depends on
the portion of investment on risky asset.
Proportion in risky asset (1-Xf) Portfolio risk
0.5 1.0
1.5 7.5
1.5 22.5
The risk is more in the borrowing portfolio being 22.5% and the return is also
high among the three alternatives. In the lending portfolio, the risk is 7.5% and the
return is also the lowest. The risk premium is proportional to risk, where the risk
premium of a portfolio is defined as the difference between Rp - Rf i.e. the amount
by which a risky rate of return exceeds the riskless rate of return.
16.5 RISK - RETURN TRADE OFF
Portfolio Risk-free Risk Portfolio Factor of
Return Return Premium Risk Proportionality
Rp Rf R p - Rf σ (Rp – Rf)/σp
16.25 12.5 3.75 7.5 0.5
20.0 12.5 7.5 15.0 0.5
23.75 12.5 11.25 22.5 0.5
The risk-return proportionality ratio is a constant .5, indicating that one unit
of risk premium is accompanied by 0.5 unit of risk.
 132

16.6 SECURITY MARKET LINE

The risk-return relationship of an efficient portfolio is measured by the capital
market line. But, it does not show the risk-return trade off for other portfolios and
individual securities. Inefficient portfolios lie below the capital market line and the
risk-return relationship cannot be established with the help of the capital market
line. Standard deviation includes the systematic and unsystematic risk.
Unsystematic risk can be diversified and it is not related to the market. If the
unsystematic risk is eliminated, then the matter of concern is systematic risk alone.
This systematic risk could be measured by beta. The beta analysis is useful for
individual securities arid portfolios whether efficient or inefficient.
When an additional security is added to the market portfolio, an additional
risk is also added to it. The variance of a portfolio is equal to the weighted sum of
the co-variances of the individual securities in the portfolio.If we add an additional
security to the market portfolio, its marginal contribution to the variance of the
market is the covariance between the security’s return and market portfolio’s
return. If the security i am included, the covariance between the security and the
market measures the risk. Covariance can be standardized by dividing it by
standard deviation of market portfolio coy im/σm. This shows the systematic risk of
the security. Then, the expected return of the security i is given by the equation:
Ri – Rf = (Rm – Rf/σm) Coy im/σm
This equation can be rewritten as follows
Ri – Rf = Coy im/σ2m (Rm – Rf)
The first term of the equation is
nothing but the beta coefficient of the
stock. The beta coefficient of the
equation of SML is same as the beta of
the market (single index) model. In
equilibrium, all efficient and inefficient
portfolios lie along the security market
line. The SML line helps to determine the
expected return for a given security beta.
In other words, when betas are given, we
can generate expected returns for the
given securities. This is explained in fig.
If we assume the expected market risk premium to be 8% and the risk free
rate of return tube 7%, we can calculate expected return for A, B, C and D
securities using the formula
E(Ri)= Rf + ßi[E(Rm)-Rf]
If beta for ß = 1
If beta for = 1
= 7 + 1 (8) = 15%
 133

Security A
Beta = 1.10
E(R) =7+1.10(8)
= 15.8
Security B
Beta = 1.20
E(R) = 7 + 1.20(8)
= 16.8 = 16.6
Security C
Beta = .7
E(R) = 7 + .7(8)
=12.6
The same can be found out easily from the figure too. All we have to do is, to
mark the beta on the horizontal axis and draw a vertical line from the relevant
point to touch the SML line. Then from the point of intersection, draw another
horizontal line to touch the Y axis. The expected return could be very easily read
from the Y axis. The securities A and B are aggressive securities, because their beta
values are greater than one. When beta values are less than one, they are known as
defensive securities. In our example, security C has the beta value less than one.
16.6 EVALUATION OF SECURITIES
Relative attractiveness of the security can be found out with the help of
security market line. Stocks with high risk factor are expected to yield more return
and vice-versa. But the investor would be interested in knowing whether the
security is offering return more or less proportional to its risk.
Evaluation of Securities with SML
The figure provides an explanation
for the evaluation. There are nine points
in the diagram. A, B and C lie on the
security market line, R, S and T above
the SML and U, V and W below the SML.
ARU have the same beta level of, 9.
Likewise beta values of SBV = 1.00 and
TCW = 1.10. The stocks above the SML
yield higher returns for the same level of
risk. They are underpriced compared to
their beta value. With the simple rate of
return formula, we can prove that they
are undervalued.
Pi is the present price P0 - the purchase price and Div - Dividend. When the
purchase price is low i.e. when the denominator value is low, the expected return
could be high. Applying the same principle the stocks U, V and W can be classified
as overvalued securities and are expected to yield lower returns than stocks of
comparable risk. The denominator value may be high i.e. the purchase price may
be high. The prices of these scripts may fall and lower the denominator. There by,
they may increase the returns on securities.
 134

The securities A, B and C are on the line. Therefore considered to be

appropriately valued. They offer returns in proportion to their risk. They have
average 4oclc performance, since they are neither undervalued nor overvalued.
Market Imperfection and SML
Information regarding the share price SML in Imperfect Market
an4 market condition may not be
immediately available to all investors.
Imperfect information may affect the
valuation of securities. In a market with
perfect information, all securities should lie
on SML. Market imperfections would lead to
a band of SML rather than a single line.
Market imperfections affect the width of the
SML to a band. If imperfections are more,
the width also would be larger. SML in
imperfect market is given in figure.
16.7 EMPIRICAL TESTS OF THE CAPM
In the CAPM, beta is used to estimate le systematic of the security and reflects the
future volatility of the stock in relation to the market. Future volatility of the stock is
estimated only through historical data. Historical data are used to plot the regression
line or the characteristic line and calculate beta. If historical betas are stable over a
period of time, they would be good proxy for their ex-ante or expected risk.
Robert A. Levy, Marshall B. Blume and others have studied the question of
beta stability in depth. I calculated betas for both Individual securities and
portfolios. His study results have provided the following conclusions
1. The betas of individual stocks are unstable; hence the past betas for the
individual securities are not good estimators of future risk.
2. The betas of portfolios of ten or more randomly selected stocks are reasonably
stable, hence the portfolio betas are good estimators of future portfolio volatility.
This is because of the errors in the estimates of individual securities’ betas tend
to offset one another in a portfolio.
Various researchers have attempted to find out the validity of the model by
calculating beta and realized rate of return. They attempted to test (1) whether the
intercept is equal to i.e. risk free rate of interest or the interest rate offered for treasury
bills (2) whether the line is linear and pass through the beta = 1 being the required rate
of return of the market. In general, the studies have showed the following results.
1. The studies generally showed a significant positive relationship between the
expected return and t systematic risk. But the slope of the relationship is usually
less than that of predicted by the CAPM.
2. The risk and return relationship appears to be linear. Empirical studies give no
evidence of significant curvature in the risk/return relationship,.
3. The attempts of the researchers to assess the relative importance of the market
and company risk have yielded definite results. The CAPM theory implies that
 135

unsystematic risk is not relevant, but unsystematic and systematic risks are
positively related to security returns. Higher returns are needed to compensate
both the risks. Most of the observed relationship reflects statistical problems
rather than the true nature of capital market.
4. According to Richard Roll, the ambiguity of the market portfolio leaves the CAPM
untestable. The practice of using indices as proxies is loaded with problems.
Different indices yield different betas for the same security.
5. If the CAPM were completely valid, i4 should apply to all financial assets
including bonds. But, when bonds are introduced into the analysis, they do not
fall on the security market line.
16.8 PRESENT VALIDITY OF CAPM
The CAPM is greatly appealing at an intellectual level, logical and rational. The
basic assumptions on which the model is built raise, some doubts in the minds of
the investors. Yet, investment analysts have been more creative in adapting CAPM
for their uses.
1. The CAPM focuses on the market risk, makes the investors to think about the
riskiness of the assets in general. CAPM provides basic concepts which are truly
of fundamental value.
2. The CAPM has been useful in the selection of securities and portfolios. Securities
with higher returns are considered to be undervalued and attractive for buy. The
below normal expected return yielding securities are considered to be overvalued
and Suitable for sale.
3. In the CAPM, it has been assumed that investors consider only the market risk.
Given the estimate of the risk free rate, the beta of the firm, stock and the required
market rate of return, one can find out the expected returns for a firm’s security.
This expected return can be used as an estimate of the cost of retained earnings.
4. Even though CAPM has been regarded as a useful tool to financial analysts, it
has its own critics too. They point out, when the model is ex-ante, the inputs
also should be ex-ante, i.e. based on the expectations of the future. Empirical
tests and analyses have used ex-post i.e. past data only.
5. The historical data regarding the market return, risk free rate of return and betas
vary differently for different periods. The various methods used to estimate these
inputs also affect the beta value. Since the inputs cannot be estimated precisely,
the expected return found out through the CAPM model is also subjected to
criticism 4
16.9 ARBITRAGE PRICING THEORY
In finance, arbitrage pricing theory (APT) is a general theory of asset pricing
that holds that the expected return of a financial asset can be modeled as a linear
function of various macro-economic factors or theoretical market indices, where
sensitivity to changes in each factor is represented by a factor-specific beta
coefficient. The model-derived rate of return will then be used to price the asset
correctly—the asset price should equal the expected end of period price discounted
 136

at the rate implied by the model. If the price diverges, arbitrage should bring it back
into line.
The theory was proposed by the economist Stephen Ross in 1976.
The APT formula is:
E(rj) = rf + bj1RP1 + bj2RP2 + bj3RP3 + bj4RP4 + ... + bjnRPn
where:
E(rj) = the asset's expected rate of return
rf = the risk-free rate
bj = the sensitivity of the asset's return to the particular factor
RP = the risk premium associated with the particular factor
The general idea behind APT is that two things can explain the expected return
on a financial asset: 1) macroeconomic/security-specific influences and 2) the
asset's sensitivity to those influences. This relationship takes the form of the
linear regression formula above.
There are an infinite number of security-specific influences for any given
security including inflation, production measures, investor confidence, exchange
rates, market indices or changes in interest rates. It is up to the analyst to decide
which influences are relevant to the asset being analyzed.
Once the analyst derives the asset's expected rate of return from the APT
model, he or she can determine what the "correct" price of the asset should be by
plugging the rate into a discounted cash flow model.
Note that APT can be applied to portfolios as well as individual securities. After
all, a portfolio can have exposures and sensitivities to certain kinds of risk factors
as well.
The APT was a revolutionary model because it allows the user to adapt the
model to the security being analyzed. And as with other pricing models, it helps the
user decide whether a security is undervalued or overvalued and so he or she
can profit from this information. APT is also very useful for building portfolios
because it allows managers to test whether their portfolios are exposed to certain
factors.
APT may be more customizable than CAPM, but it is also more difficult to
apply because determining which factors influence a stock or portfolio takes a
considerable amount of research. It can be virtually impossible to detect every
influential factor much less determine how sensitive the security is to a particular
factor. But getting "close enough" is often good enough; in fact studies find that
four or five factors will usually explain most of a security's return: surprises in
inflation, GNP, investor confidence and shifts in the yield curve.
REVISION POINTS
In finance, the capital asset pricing model (CAPM) is a model used to
determine a theoretically appropriate required rate of return of an asset, to make
decisions about adding assets to a well-diversified portfolio.
 137

INTEXT QUESTIONS
1. What are the basic assumptions of CAPM? What are the advantage of adopting
CAPM model in the portfolio management?
2. Explain the CAPM theory and its validity in the stock market?
SUMMARY
The capital asset pricing model (CAPM) is used to calculate the required rate of
return for any risky asset. The general idea behind CAPM is that investors need to
be compensated in two ways i.e.,time value of money and risk.
TERMINAL EXERCISE
1. ______________ is used to calculate the required rate of return for any risky asset.
Ans: The capital asset pricing model
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
1. State the reason for the treynor and sharpe giving conflicting performance ranking?
2. Disting between the securitity market line and capital market line?
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
“When the borrowing and lending are different, the notion of market price of
the risk is meaningless”. Appraise the statement.
KEY WORDS
Risky assets, rate of return, capital asset price
 138

LESSON 17

PERFORMANCE EVALUATION OF PORTFOLIO

INTRODUCTION
The portfolio performance evaluation primarily refers to the determination of
how a particular investment portfolio has performed relative to some comparison
benchmark. The evaluation can indicate the extent to which the portfolio has
outperformed or under-performed, or whether it has performed at par with the
benchmark.
First, the investor, whose funds have been invested in the portfolio, needs to
know the relative performance of the portfolio. The performance review must
generate and provide information that will help the investor to assess any need for
rebalancing of his investments. Second, the management of the portfolio needs this
information to evaluate the performance of the manager of the portfolio and to
determine the manager’s compensation, if that is tied to the portfolio performance.
The performance evaluation methods generally fall into two categories, namely
conventional and risk-adjusted methods.
OBJECTIVES
After reading this lesson the student should be able to understand Portfolio
Performance Measures, Capital Asset Pricing Model, Portfolio Beta
CONTENT
17.1 Portfolio Performance Measures
17.2 Capital Asset Pricing Model (CAPM)
17.3 Portfolio Beta
17.1 PORTFOLIO PERFORMANCE MEASURES
Portfolio performance evaluation involves determining periodically how the
portfolio performed in terms of not only the return earned, but also the risk
experienced by the investor. For portfolio evaluation appropriate measures of return
and risk as well as relevant standards (or “benchmarks”) are needed. In general, the
market value of a portfolio at a point of time is determined by adding the markets
value of all the securities held at that particular time.
The essential idea behind performance evaluation is to compare the returns
which were obtained on portfolio with the results that could be obtained if more
appropriate alternative portfolios had been chosen for the investment.
Such comparison portfolios are often referred to as benchmark portfolios. In
selecting them investor should be certain that they are relevant, feasible and known
in advance. The benchmark should reflect the objectives of the investor.
Beta
Beta (β) measures the systematic risk of a portfolio. It is the sensitivity of a
portfolio to an index, typically an equity index. If beta is one, then the portfolio
carries the same systematic risk as the index. If beta is less than one, then the
systematic risk is less than that of the index. If beta is more than one, then the
 139

systematic risk is more than the index. It should be noted that apart from
systematic risk, portfolios also carry specific risk, which is the risk of individual
securities making losses even when the index is going up. Thus beta is not a full
measure of risk.
Beta can be calculated as:

17.2 CAPITAL ASSET PRICING MODEL (CAPM)

CAPM was developed by W. F. Sharpe. CAPM simplified Markowitz‘s Modern
Portfolio theory, made it more practical. Markowitz showed that for a given level of
expected return and for a given feasible set of securities, finding the optimal
portfolio with the lowest total risk, measured as variance or standard deviation of
portfolio returns, requires knowledge of the covariance or correlation between all
possible security combinations. When forming the diversified portfolios consisting
large number of securities investors found the calculation of the portfolio risk using
standard deviation technically complicated.
Measuring Risk in CAPM is based on the identification of two key
components of total risk (as measured by variance or standard deviation of return):
 Systematic risk
 Unsystematic risk
Systematic risk is that associated with the market (purchasing power risk,
interest rate risk, liquidity risk, etc.)
Unsystematic risk is unique to an individual asset (business risk, financial
risk, other risks, related to investment into the particular asset) while unsystematic
risk can be mitigated through diversification by holding many different assets in the
portfolio, systematic risk cannot be avoided through diversification.
In CAPM, investors are compensated for taking only systematic risk. Though,
CAPM only links investments via the market as a whole. The CAPM predicts what
an expected rate of return for the investor should be, given other statistics about
the expected rate of return in the market and market risk (systematic risk):
E(r j) = Rf + β(j) * ( E(rM) - Rf)
E(r j) - expected return on stock j;
Rf - risk free rate of return;
E(rM) - expected rate of return on the market
β(j) - coefficient Beta, measuring undiversified risk of security j.
17.3 PORTFOLIO BETA
It can be used as an indication of the amount of market risk that the portfolio
had during the time interval. It can be compared directly with the betas of other
portfolios. One cannot compare the ex post or the expected and the expected return
of two portfolios without adjusting for risk. To adjust the return for risk before
comparison of performance risk adjusted measures of performance can be used:
 140

 Sharpe’s ratio;
 Treynor’s ratio;
 Jensen’s Alpha.
William F Sharpe developed a method of measuring return per unit of risk in
1966. The reward to variability ratio attempted by Sharpe is referred to as the
Sharpe ratio. In fact, this ratio is simply the ratio of the reward, defined as the
realized portfolio return Rp in excess of the risk free rates Rf, to the variability of
return as measured by the standard deviation of returns (p).
Sharpe’s ratio shows an excess a return over risk free rate, or risk premium,
by unit of total risk, measured by standard deviation:
rp  rf
Sharpe' s ratio 
p
Here:
rp - the average return for portfolio p during some period of time;
rf - the average risk-free rate of return during the period;
σp - standard deviation of returns for portfolio p during the period.
Treynor’s ratio shows an excess actual return over risk free rate, or risk
premium, by unit of systematic risk, measured by Beta:
rp  rf
Treynor' s ratio 
p
Here: βp – Beta, measure of systematic risk for the portfolio p.
Jensen‘s Alpha shows excess actual return over required return and excess of
actual risk premium over required risk premium. This measure of the portfolio
manager’s performance is based on the CAPM.
Jensen’s Alpha = rp – {rf + βp (rm – rf)}
Here: rm - the average return on the market in period t;
(rm – rf) - The market risk premium during period t.
It is important to note, that if a portfolio is completely diversified, all of these
measures (Sharpe, Treynor’s ratios and Jensen’s Alfa) will agree on the ranking of
the portfolios. The reason for this is that with the complete diversification, total
variance is equal to systematic variance. When portfolios are not completely
diversified, the Treynor’s and Jensen’s measures can rank relatively undiversified
portfolios much higher than the Sharpe measure does. Since the Sharpe ratio uses
total risk, both systematic and unsystematic components are included.
REVISION POINTS
The portfolio performance evaluation involves the determination of how a
managed portfolio has performed relative to some comparison benchmark.
Performance evaluation methods generally fall into two categories, namely
conventional and risk-adjusted methods. The most widely used conventional
 141

methods include benchmark comparison and style comparison. The risk-adjusted

methods adjust returns in order to take account of differences in risk levels
between the managed portfolio and the benchmark portfolio. The major methods
are the Sharpe ratio, Treynor ratio, Jensen’s alpha, Modigliani and Modigliani, and
Treynor Squared. The risk-adjusted methods are preferred to the conventional
methods.
INTEXT QUESTIONS
1. State the reason for the treynor and sharpe giving conflicting performance ranking?
2. what is beta? Is it abetter measure of risk than the standard deviation?
SUMMARY
The portfolio performance evaluation primarily refers to the determination of
how a particular investment portfolio has performed relative to some comparison
benchmark. The evaluation can indicate the extent to which the portfolio has
outperformed or under-performed, or whether it has performed at par with the
benchmark.
TERMINAL EXERCISE
1. Beta (β) measures the _______________of a portfolio.
Ans: Systematic Risk
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
1. How would you calculate the systematic,unsystematic risk of asecurity and
portfolio risk?
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Select private sector mutual fund schemes and rank them according to
Sharpe’s ratio.
KEY WORDS
Sharpe Ratio, Treynor Ratio, Jenson Ratio.
 142

LESSON 18

MUTUAL FUNDS
INTRODUCTION
A mutual fund is a professionally-managed investment scheme, usually run by
an asset management company that brings together a group of people and invests
their money in stocks, bonds and other securities. High inflation often impacts the
savings of individuals. In view of the same, generating "market-linked" returns over
a longer period of time is critical for meeting our goals. Mutual Fund schemes in
this category are positioned with an objective to produce "market-linked" returns
over a period of time.
OBJECTIVES
After reading this lesson the student should be able to understand mutual
fund, type of mutual fund schemes
CONTENT
18.1 Mutual Fund
18.2 Type of Mutual Fund Schemes
18.3 Evaluation of Mutual Funds
18.1 MUTUAL FUND
A mutual fund is a pool of money managed by a professional Fund Manager.It
is a trust that collects money from a number of investors who share a common
investment objective and invests the same in equities, bonds, money market
instruments and/or other securities. And the income and/or gains generated from
this collective investment is distributed proportionately amongst the investors after
deducting applicable expenses and levies, by calculating a scheme’s “Net Asset
Value” or NAV. Simply put, the money pooled in by a large number of investors is
what makes up a Mutual Fund.
Here’s a simple way to understand the concept of a Mutual Fund Unit. Let’s
say that there is a box of 12 chocolates costing ₹40. Four friends decide to buy the
same, but they have only ₹10 each and the shopkeeper only sells by the box. So the
friends then decide to pool in ₹10 each and buy the box of 12 chocolates. Now
based on their contribution, they each receive 3 chocolates or 3 units, if equated
with Mutual Funds. And how do you calculate the cost of one unit? Simply divide
the total amount with the total number of chocolates:
40/12 = 3.33.So if you were to multiply the number of units (3) with the cost per
unit (3.33), you get the initial investment of ₹10.
This results in each friend being a unit holder in the box of chocolates that is
collectively owned by all of them, with each person being a part owner of the box.
Next, let us understand what is “Net Asset Value” or NAV. Just like an equity
share has a traded price, a mutual fund unit has Net Asset Value per Unit. The
NAV is the combined market value of the shares, bonds and securities held by a
fund on any particular day (as reduced by permitted expenses and charges). NAV
 143

per Unit represents the market value of all the Units in a mutual fund scheme on a
given day, net of all expenses and liabilities plus income accrued, divided by the
outstanding number of Units in the scheme.
Mutual funds are ideal for investors who either lack large sums for investment,
or for those who neither have the inclination nor the time to research the market,
yet want to grow their wealth. The money collected in mutual funds is invested by
professional fund managers in line with the scheme’s stated objective. In return,
the fund house charges a small fee which is deducted from the investment. The fees
charged by mutual funds are regulated and are subject to certain limits specified by
the Securities and Exchange Board of India (SEBI).
India has one of the highest savings rate globally. This penchant for wealth
creation makes it necessary for Indian investors to look beyond the traditionally
favoured bank FDs and gold towards mutual funds. However, lack of awareness
has made mutual funds a less preferred investment avenue.
Mutual funds offer multiple product choices for investment across the
financial spectrum. As investment goals vary – post-retirement expenses, money for
children’s education or marriage, house purchase, etc. – the products required to
achieve these goals vary too. The Indian mutual fund industry offers a plethora of
schemes and caters to all types of investor needs.
Mutual funds offer an excellent avenue for retail investors to participate and
benefit from the uptrends in capital markets. While investing in mutual funds can
be beneficial, selecting the right fund can be challenging. Hence, investors should
do proper due diligence of the fund and take into consideration the risk-return
trade-off and time horizon or consult a professional investment adviser. Further, in
order to reap maximum benefit from mutual fund investments, it is important for
investors to diversify across different categories of funds such as equity, debt and
gold.
While investors of all categories can invest in securities market on their own, a
mutual fund is a better choice for the only reason that all benefits come in a
package.
18.2 TYPE OF MUTUAL FUND SCHEMES
Mutual Fund schemes could be ‘open ended’ or close-ended’ and actively
managed or passively managed.
Open-Ended and Closed-End Funds
An open-end fund is a mutual fund scheme that is available for subscription
and redemption on every business throughout the year, (akin to a savings bank
account, wherein one may deposit and withdraw money every day). An open ended
scheme is perpetual and does not have any maturity date.
A closed-end fund is open for subscription only during the initial offer period
and has a specified tenor and fixed maturity date (akin to a fixed term deposit).
Units of Closed-end funds can be redeemed only on maturity (i.e., pre-mature
 144

redemption is not permitted). Hence, the Units of a closed-end fund are

compulsorily listed on a stock exchange after the new fund offer, and are traded on
the stock exchange just like other stocks, so that investors seeking to exit the
scheme before maturity may sell their Units on the exchange.
Actively Managed and Passively Managed Funds
An actively managed fund is a mutual fund scheme in which the fund manager
“actively” manages the portfolio and continuously monitors the fund's portfolio,
deciding on which stocks to buy/sell/hold and when, using his professional
judgement, backed by analytical research. In an active fund, the fund manager’s aim is
to generate maximum returns and out-perform the scheme’s bench mark.
A passively managed fund, by contrast, simply follows a market index, i.e., in a
passive fund , the fund manager remains inactive or passive inasmuch as, she does
not use her judgement or discretion to decide as to which stocks to buy/sell/hold ,
but simply replicates / tracks the scheme’s benchmark index in exactly the same
proportion. Examples of Index funds are an Index Fund and all Exchange Traded
Funds. In a passive fund, the fund manager’s task is to simply replicate the
scheme’s benchmark index i.e., generate the same returns as the index, and not to
out-perform the scheme’s bench mark.
18.3 EVALUATION OF MUTUAL FUNDS
Investing in mutual funds has an inherent risk assumed upon the ownership.
However, performance of the mutual funds can be quantified with the mathematical
calculation of the historical returns. The correlation of the potential risk and the
potential returns constantly put forth the opportunities to invest in mutual funds
and drive maximum potential returns with minimum underlying risk.
Risk adjusted returns
Risk adjusted returns are the calculative returns investors funds make
compared to the risk indicated over the period of time. If compared, a couple of
mutual funds which drive the same percentage of returns over the same period of
time, the lesser risk funds have a higher Risk Adjusted Returns.
Benchmark
Benchmarking is the measurement of quality of the funds against the
standard measurements. It is a point of reference compared to the funds peer
markets. Irrespective of the objectives of investment in mutual funds, benchmark
helps you gauge the performance of your investment against the market
competition. Considering historical returns against the market conditions will help
you determine the relevance of the performance benchmark for your investments.
However, historical return is not a reliable indicator of future results.
Relative Performance with peers
Relative performance with peers is a yardstick of the effectiveness of your
mutual fund of the same category. Mutual Funds actively try to top the ranking of
the fund universe. Intended towards a higher return for the determined period of
value learning, the relative peer performance is recommended.
 145

Quality of stocks in the portfolio

Quality of stocks in the portfolio is reflected in its ability to drive superior
returns on capital invested for a specific period of time. It is wise to check the
industry leadership position of the mutual fund. Quality of the stocks in the
portfolio would reflect in returns hence in the performance. Qualitative statistics
and historical performance of mutual funds would help evaluating the performance.
Fund manager is an important person who makes investment decisions and stock
selection in the portfolio. Understand fund manager’s competence according to fund
management knowledge and ability. Fund manager’s past performance would be a
good parameter to track record and could turn to be of a great value for investments.
REVISION POINTS
A Mutual Fund operated by an investment company which raises money from
shareholders and invests in a group of assets, in accordance with a stated set of
objectives.
INTEXT QUESTIONS
1. Discuss the growth of the mutual funds in india.
2. What is a open ended fund and closed ended fund?
3. What is entry and exit load in mutual fund?
4. What is gilt edged fund?
SUMMARY
A mutual fund is a professionally-managed investment scheme, usually run by
an asset management company that brings together a group of people and invests
their money in stocks, bonds and other securities All the mutual funds are
registered with SEBI. They function within the provisions of strict regulation
created to protect the interests of the investor.
TERMINAL EXERCISE
1. A ____________is a pool of money managed by a professional Fund Manager
Ans: mutual fund
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
1. What is meant by mutual funds? What are the advantage of professionally of
managed portfolio?
2. Dintinguish between the open –end and closed-end mutual funds.
3. Givan an account of the various types of mutual funds available in the capital
market?
 146

SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Select fifty private sector mutual funds and rank them according to Treynor’s
ratio.
KEY WORDS
Fund Manager, Open Ended, Closed End
 147

LESSON 19

INVESTMENT TIMING AND PORTFOLIO PERFORMANCE EVALUATION

INTRODUCTION
Portfolio evaluating refers to the evaluation of the performance of the
investment portfolio. It is essentially the process of comparing the return earned on
a portfolio with the return earned on one or more other portfolio or on a benchmark
portfolio. Portfolio performance evaluation essentially comprises of two functions,
performance measurement and performance evaluation. Performance measurement
is an accounting function which measures the return earned on a portfolio during
the holding period or investment period. Performance evaluation, on the other
hand, address such issues as whether the performance was superior or inferior,
whether the performance was due to skill or luck etc.
The ability of the investor depends upon the absorption of latest developments
which occurred in the market. The ability of expectations if any, we must able to
cope up with the wind immediately. Investment analysts continuously monitor and
evaluate the result of the portfolio performance. The expert portfolio constructor
shall show superior performance over the market and other factors. The
performance also depends upon the timing of investments and superior investment
analysts capabilities for selection. The evolution of portfolio always followed by
revision and reconstruction. The investor will have to assess the extent to which the
objectives are achieved. For evaluation of portfolio, the investor shall keep in mind
the secured average returns, average or below average as compared to the market
situation. Selection of proper securities is the first requirement.
OBJECTIVES
After reading this lesson the student should be able to understand Investment
Timing, Portfolio Performance Evaluation
CONTENT
19.1 Investment Timing
19.2 Portfolio Performance Evaluation
19.3 Benchmark Comparison
19.1 INVESTMENT TIMING
Market timing is the act of moving in and out of the market or switching
between asset classes based on using predictive methods such as technical
indicators or economic data. Because it is extremely difficult to predict the future
direction of the stock market, investors who try to time the market, especially
mutual fund investors, tend to underperform investors who remain invested.
Some investors, especially academics, believe it is impossible to time the
market. Other investors, notably active traders, believe strongly in market timing.
Thus, whether market timing is possible is really a matter of opinion. What can be
said with certainty is it is very difficult to successfully time the market consistently
over the long run. For the average investor who does not have the time, or desire, to
 148

watch the market on a daily basis, there are good reasons to avoid market timing
and focus on investing for the long run.
For investors, the real costs of lost time and opportunity are almost always
greater than the potential benefit of shifting in and out of the market.
Opportunity Costs: Research shows that, if an investor remained fully invested
in the Standard & Poor’s 500 Index from 1995 through 2014, he would have earned
a 9.85% annualized return. However, if he missed only 10 of the best days in the
market, his return would have been 6.1%. Some of the biggest upswings in the
market occur during a volatile period when many investors flee the market.
Transaction Costs: Countless studies have shown that mutual fund investors
who move in and out of funds and fund groups trying to time the market or chase
surging funds underperform the indices by as much as 3% due to transaction
costs, especially when investing in funds with expense ratios greater than 1%.
Taxation Costs: Buying low and selling high, if done successfully, generates
tax consequences. Add to this the hidden tax consequence of investing in high
turnover funds that generate substantial tax consequences affecting investor
returns.
In case of firm evaluates a number of investment projects every year. In the
absence of a capital constraint, it will undertake all those projects, which have
positive net present values (NPVs) and reject those, which have negative net present
values (NPVs). Further analysis may, however, indicate that some of the profitable
projects may be more valuable (that is, they may have higher NPVs) if undertake in
the future. If may also be related that some of the unprofitable projects may yield
positive NPVs if they are accepted later on. These categories of investment projects
may have different degrees of postponability; some of them may be postponed at the
most to one or two periods, while a few may be undertaken any time in future.
Those projects, while are postponable, involve two mutually exclusive alternatives:
undertake investment now, or later. The firm should determine the optimum timing
of investment.
The timing of investment may be a critical factor in case of those investment
projects, while occur once in a while and those, while are of strategic importance to
the firm. Such projects cannot be deferred for long. Postponability also creates
uncertainty. For example, the net present value (NPV) analysis may show that a
firm should introduce a new product next year. The firm may still decide to
introduce the product this year for two reasons: The firm may have a corporate
strategy of remaining market leader in introducing new products. If it anticipates
that its competitors will introduce the product this year if it does not, it may come
up with the product this year to remain the market leader. Also for the reason of
unanticipated competition from unknown quarters the firm may decide to introduce
the product now.
 149

19.2 PORTFOLIO PERFORMANCE EVALUATION

The evaluation of portfolio performance is important for several reasons. First,
the investor, whose funds have been invested in the portfolio, needs to know the
relative performance of the portfolio. The performance review must generate and
provide information that will help the investor to assess any need for rebalancing of
his investments. Second, the management of the portfolio needs this information to
evaluate the performance of the manager of the portfolio and to determine the
manager’s compensation, if that is tied to the portfolio performance. The
performance evaluation methods generally fall into two categories, namely
conventional and risk-adjusted methods.
The portfolio performance evaluation involves the determination of how a
managed portfolio has performed relative to some comparison benchmark.
Performance evaluation methods generally fall into two categories, namely
conventional and risk-adjusted methods. The most widely used conventional
methods include benchmark comparison and style comparison. The risk-adjusted
methods adjust returns in order to take account of differences in risk levels
between the managed portfolio and the benchmark portfolio. The major such
methods are the Sharpe ratio, Treynor ratio, Jensen’s alpha, Modigliani and
Modigliani, and Treynor Squared. The risk-adjusted methods are preferred to the
conventional methods
(i) Sharpe measure
William F Sharpe developed a method of measuring return per unit of risk in
1966. The reward to variability ratio attempted by Sharpe is referred to as the
Sharpe ratio. In fact, this ratio is simply the ratio of the reward, defined as the
realized portfolio return Rp in excess of the risk free rates Rf, to the variability of
return as measured by the standard deviation of returns (p).
Sharpe measure = ( Avg.Rp - Avg.Rf ) / p
where Avg. Rp is the average monthly return of fund
Avg.Rf is the average risk free return
p is the standard deviation of the return
(ii) Treynor measure
According to Treynor measure, the additional returns of the portfolio (fund)
over the risk free return is expressed in relation to portfolio’s systematic risk
measured by Beta(). This is known as reward to volatility and expressed as
Treynor measure = (Avg. Rp - Avg.Rf ) / p
Where
Avg. Rp is the average monthly return of fund
Avg. Rf is the average risk free return,
p is the Beta of the fund
(iii) Jensen measure
Jensen attempts to construct a measure of absolute performance on a risk-
adjusted basis that is definite standard against which performance of various funds
can be measured. According to Jensen, equilibrium average return on a portfolio
 150

would be a benchmark. Equilibrium average return is the return of the portfolio by

the market with respect to systematic risk of the portfolio. This is a return the
portfolio should earn with the given systematic risk
EARp = Rf + p* (Rm - Rf )
Where
EARp is the equilibrium average return of the portfolio.
Difference between equilibrium average return and average return of the portfolio
indicates superior/inferior performance of the fund. This is called as Alpha ()
p = Avg.Rp - EARp
If alpha is positive, the portfolio has performed better and if it is negative, it
has not shown performance up to the benchmark, i.e. the market index.
19.4 BENCHMARK COMPARISON
i) Sharpe measure - Benchmark comparison
The Sharpe ratio of the schemes and its difference from the Sharpe ratio of the
benchmark S&P CNX 500 index is listed. S&P CNX 500 is used as the market
proxy and its Sharpe index is calculated (BMS). The difference between SI of the
portfolio and BMS is tabulated along with the SI of the portfolio.
ii) Treynor measure - Benchmark comparison
The Treynor index of the portfolio and its difference from the Treynor index of
the benchmark, are tabulated. The S&P CNX 500 is used as the benchmark. The
difference and its ranking within AMC and the frequency distribution based on
positive and negative values of difference between Treynor ratio of scheme and
Benchmark are also listed.
Fama's component of investment performance
The risk adjusted performance measures judge the overall performance of a
fund. However, it is useful to breakdown the performance into different components
of performance. Thus in addition to using the explicit risk return trade off measures
for performance evaluation of mutual funds, an attempt is also made to evaluate the
performance of schemes on the basis of decomposition of portfolio performance by
using Fama's components of investment performance measure. Fama argues that the
difference between return on an active bet and return on a passive bet which is
obtained from the security market line (SML) may arise due to the selectivity skills of
fund managers. It may be noted that this difference is analogous to alpha of Jensen
measure. However, Fama suggested that selectivity could be decomposed into return
due to diversification and return due to net selectivity. The former is nothing but
compensation for diversifiable risk to which the active bet is exposed while the latter
reflects the true stock selection ability of the fund managers.
The fama's decomposition technique to decompose excess returns arising from
selectivity, into diversification and net selectivity for each of the schemes. It may be
noted that a positive net selectivity would indicate superior performance for a fund
if the fund portfolio were not well diversified. However, regarding well diversified
 151

portfolio both the net selectivity and selectivity are not likely to be significantly
different from each other.
a) Net selectivity [Rp – Rf] -[σ p /σ m ] *[R m – R f]
b) Selectivity which is the sum of diversification and net selectivity
R p is the portfolio return
R m is the market return
R f is the risk free return
σ p ,σ m is the standard deviation of portfolio and market respectively.
REVISION POINTS
Portfolio evaluation is the last step in the portfolio management process, it is
by no means the least important. On the contrary, proper performance
measurement, attribution, and appraisal can enhance the probability of success for
the entire investment process.
INTEXT QUESTIONS
1. What is investment timing?
2. What is sharpe model?
SUMMARY
The portfolio performance evaluation primarily refers to the determination of
how a particular investment portfolio has performed relative to some comparison
benchmark. The evaluation can indicate the extent to which the portfolio has
outperformed or under-performed, or whether it has performed at par with the
benchmark.
TERMINAL EXERCISE
1. Performance measurement is an ____________________which measures the return
earned on a portfolio during the holding period or investment period.
Ans: Accounting Function
ASSIGNMENT
1. Discuss fama’s model.
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
“Formula plans aid the investor in overcoming his emotional involvement with
the timing of purchase and sales of stock”. Comment
KEY WORDS
Fama Model, Investment Portfolio, Investment Period, Holding Period
 152

LESSON 20

PORTFOLIO MANAGEMENT STRATEGIES

INTRODUCTION
Effective portfolio management provides a mechanism to make sure that the
organization is doing the right “things” and achieving appropriate benefits. In many
organizations, there could be hundreds of such programs and projects running
across different functions with a geographically dispersed setting. This complexity
causes organizations to struggle with doing the right “things” and realizing
appropriate benefits. The outcome is that organizations receive a poor return from
their investment by failing to unlock the full value of their capital investments. The
following are the key elements for portfolio management to be effective through a
combination of great strategy and powerful execution.
OBJECTIVES
After reading this lesson the student should be able to Understand Active
Portfolio Management Strategy, Passive Portfolio Management Strategy
CONTENT
20.1 Active Portfolio Management Strategy
20.2 Passive Portfolio Management Strategy
20.1 ACTIVE PORTFOLIO MANAGEMENT STRATEGY
The Active portfolio management relies on the fact that particular style of
analysis or management can generate returns that can beat the market. It involves
higher than average costs and it stresses on taking advantage of market
inefficiencies. It is implemented by the advices of analysts and managers who
analyze and evaluate market for the presence of inefficiencies.
The active management approach of the portfolio management involves the
following styles of the stock selection.
Top-down Approach: In this approach, managers observe the market as a
whole and decide about the industries and sectors that are expected to perform well
in the ongoing economic cycle. After the decision is made on the sectors, the
specific stocks are selected on the basis of companies that are expected to perform
well in that particular sector.
Bottom-up: In this approach, the market conditions and expected trends are
ignored and the evaluations of the companies are based on the strength of their
product pipeline, financial statements, or any other criteria. It stresses the fact that
strong companies perform well irrespective of the prevailing market or economic
conditions.
20.2 PASSIVE PORTFOLIO MANAGEMENT STRATEGY
Passive asset management relies on the fact that markets are efficient and it is
not possible to beat the market returns regularly over time and best returns are
obtained from the low cost investments kept for the long term.
 153

The passive management approach of the portfolio management involves the

following styles of the stock selection.
Efficient market theory: This theory relies on the fact that the information
that affects the markets is immediately available and processed by all investors.
Thus, such information is always considered in evaluation of the market prices. The
portfolio managers who follows this theory, firmly believes that market averages
cannot be beaten consistently.
Indexing: According to this theory, the index funds are used for taking the
advantages of efficient market theory and for creating a portfolio that impersonate a
specific index. The index funds can offer benefits over the actively managed funds
because they have lower than average expense ratios and transaction costs.
Apart from Active and Passive Portfolio Management Strategies, there are three
more kinds of portfolios including Patient Portfolio, Aggressive Portfolio and
Conservative Portfolio.
Patient Portfolio: This type of portfolio involves making investments in well-
known stocks. The investors buy and hold stocks for longer periods. In this
portfolio, the majority of the stocks represent companies that have classic growth
and those expected to generate higher earnings on a regular basis irrespective of
financial conditions.
Aggressive Portfolio: This type of portfolio involves making investments in
“expensive stocks” that provide good returns and big rewards along with carrying
big risks. This portfolio is a collection of stocks of companies of different sizes that
are rapidly growing and expected to generate rapid annual earnings growth over the
next few years.
Conservative Portfolio: This type of portfolio involves the collection of stocks
after carefully observing the market returns, earnings growth and consistent
dividend history.
REVISION POINTS
Simply put, portfolio strategy is a roadmap by which investors can use their
assets to achieve their financial goals. Portfolio theory refers to the design of
optimal portfolios and its implication for asset pricing.
INTEXT QUESTIONS
1.What is Active Portfolio Management Strategy?
2.what is Conservative Portfolio?
SUMMARY
Portfolio Management Strategies refer to the approaches that are applied for
the efficient portfolio management in order to generate the highest possible returns
at lowest possible risks. There are two basic approaches for portfolio management
including Active Portfolio Management Strategy and Passive Portfolio Management
Strategy.
 154

TERMINAL EXERCISE
1. One of the basic approaches for portfolio management is
_________________________________ .
Ans: Active Portfolio Management Strategy
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
1, Discuss active and Passive Portfolio Management Strategy.
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
What kind of security do you think would select fit your aggressive portfolio?
KEY WORDS
Patient Portfolio, Aggressive Portfolio, Conservative Portfolio
 155

LESSON 21

BONDS AND ITS VALUATION

INTRODUCTION
Bonds are long-term debt securities that are issued by corporations and
government entities. Purchasers of bonds receive periodic interest payments, called
coupon payments, until maturity at which time they receive the face value of the
bond and the last coupon payment. Most bonds pay interest semiannually.
The Bond Indenture or Loan Contract specifies the features of the bond issue. The
following terms are used to describe bonds
OBJECTIVES
After reading this lesson the student should be able to UnderstandMeaning of
bond, Bond Terms, Bond Price and Yield, Types of Bond Risk, The term structure of
interest rate.
CONTENT
21.1 Meaning of bond
21.2 Bond Terms
21.3 Bond Price and Yield
21.4 Types of Bond Risk
21.5 The term structure of interest rate (yield curve)
21.6 Bond portfolio management strategies
21.7 Bond Duration
21.8 Compound Yield to Maturity (RCYTM).
21.9 Period Of Holding For Capital Gains As Per The Income-Tax Act, 1961
21.1 MEANING OF BOND
A bond is a security representing a loan. It is a liability for the issuer (usually
a government or company), and an asset for the bondholder (usually an entity or
individual investor). A bond holder is an individual or entity that has loaned money
to a bond issuer.
21.2 BOND TERMS
Par Value
Par value is the amount of money (usually $1000 per bond) that will be
returned to the bondholder at the maturity date.
Coupon
The interest the bond pays annually.
Coupon Rate
The coupon rate is the coupon (interest) divided by par value. If a bond pays
$30 annually it has of coupon rate of 3.0% ($30 divided by $1,000).
Maturity
Maturity is the length of time before the bond issuer pays the par value to the
bond holder. Obviously, the maturity decreases as time passes.
 156

Duration
Duration is a complicated calculation but an important risk measurement.
Duration is the weighted average time period of the present value of cash flows
(interest and principle payments).
Zero coupon bonds will have a duration equal to the maturity because all cash
flows are received at maturity. Bonds that pay interest will have a duration less
than maturity because of interest payments paid before maturity. The higher the
coupon the shorter the duration because more cash flows are received early.
The interest rate term
The term structure of interest rates is the relationship between interest rates
or bond yields and different terms or maturities. The term structure of interest
rates is also known as a yield curve, and it plays a central role in an economy
21.3 BOND PRICE AND YIELD
Explain Bonds
If the bondholder purchased a bond at par when issued, the price would be
Rs1,000 and the yield would be the coupon rate. But most investors purchase
bonds at a price over or below par value. Many of these purchases are made on the
secondary market where bonds are traded regularly (similar to a stock exchange),
making buying and selling bonds easy.
The market price of a bond will most likely be more or less than the par value
(the amount paid the bondholder at maturity). The bondholder will still receive the
coupon or interest (usually semi-annually) and the par value at maturity.
Current Yield
Current yield is the coupon (interest) divided by the current market price of
the bond, which maybe more or less than the par value.
Yield to Maturity
Yield to Maturity is the amount of return (expressed as a percentage) a
bondholder will make on the bond if purchased at market value and held to maturity.
This is a complicated calculation usually supplied by the bond broker or exchange.
The yield to maturity takes into account the coupon paid until maturity and
the difference between the market price of the bond and par value. If the market
price is lower than par value, ,the yield to maturity will be higher than the coupon
rate because the bondholder will receive more money (par value) at maturity than
the price paid for the bond. If the market price is higher than par value, the yield to
maturity will be lower than the coupon rate because the bondholder will receive less
money (par value) than the price paid for the bond.
TYPES OF BOND RISK
Bonds have two main types of bond risk that every investor should understand
before purchasing a bond (making a loan).
Credit Risk
Credit risk is the risk that the issuer will be unable to pay the coupon
(interest) and/or par value at maturity. The financial position of an issuing entity
can change over time, affecting the price of the bond before maturity.
 157

Interest Rate Risk

The price of a bond moves in the opposite direction of bond yields. Since the
coupon (interest) on the bond is fixed, the price of the bond will rise or fall to
provide a yield to maturity on the bond equal to the current market rate required by
investors.
The price change of a bond will approximate the change in interest rate times
the duration of the bond. For example, if interest rates rise 2% and an investor
owns a bond with an 8 year duration, the price of the bond will decline by
approximately 16%. A bond with a long duration will be much more volatile than a
bond with a short duration when interest rates change.
A technique for determining the fair value of a particular bond. Bond valuation
includes calculating the present value of the bond's future interest payments, also
known as its cash flow, and the bond's value upon maturity, also known as its face
value or par value. Because a bond's par value and interest payments are fixed, an
investor uses bond valuation to determine what rate of return is required for an
investment in a particular bond to be worthwhile.
Bond valuation is only one of the factors investors consider in determining
whether to invest in a particular bond. Other important considerations are: the
issuing company's credit worthiness, which determines whether a bond is
investment-grade or junk; the bond's price appreciation potential, as determined by
the issuing company's growth prospects; and prevailing market interest rates and
whether they are projected to go up or down in the future
The variety of debt instruments in the Indian market.
Debt instruments Type Typical features
 158

In order to understand the valuation of bonds, we need to be familiar with

certain bond-related terms.
Par Value- It is the value stated on the face of the bond. It represents the
amount the firm borrows and promises to repay at the time of maturity. Usually the
par or face value of bonds issued by business firms is Rs. 100. Sometimes it can be
Rs. 1000.
Coupon Rate and Interest-A bond carries a specific interest rate which is
called the coupon rate. The interest payable to the bond holder is simply par value
of the bond × coupon rate. Most bonds pay interest semi-annually. For example, a
GOI security which has a par value of Rs. 1000 and a coupon rate of 11 per cent
pays an interest of Rs. 55 every six months.
Maturity Period-Typically, bonds have a maturity period of 1-10 years;
sometimes they have a longer maturity. At the time of maturity the par (face) value
plus perhaps a nominal premium is payable to the bondholder.
The time value concept
Time Value of Money (TVM) is an important concept in financial management.
It can be used to compare investment alternatives and to solve problems involving
loans, mortgages, leases, savings, and annuities.
TVM is based on the concept that a dollar that you have today is worth more
than the promise or expectation that you will receive a dollar in the future. Money
that you hold today is worth more because you can invest it and earn interest. After
all, you should receive some compensation for foregoing spending. For instance,
you can invest your dollar for one year at a 6% annual interest rate and accumulate
$1.06 at the end of the year. You can say that the future value of the dollar is $1.06
given a 6% interest rate and a one-year period. It follows that the present value of
the $1.06 you expect to receive in one year is only $1.
A key concept of TVM is that a single sum of money or a series of equal,
evenly-spaced payments or receipts promised in the future can be converted to an
equivalent value today. Conversely, you can determine the value to which a single
sum or a series of future payments will grow to at some future date.
Future Value is the amount of money that an investment with a fixed,
compounded interest rate will grow to by some future date. The investment can be
a single sum deposited at the beginning of the first period, a series of equally-
spaced payments (an annuity), or both. Since money has time value, we naturally
expect the future value to be greater than the present value. The difference between
the two depends on the number of compounding periods involved and the going
interest rate Future Value = present value (1 + interest rate).
If the deposited money is allowed to cumulate for more than one time, the
period exponent is added to the previous equation.
Future value = (Present Value) (1 + interest rate) t
t- The number of time periods the deposited money accumulates as interest.
 159

The present value

The present value of money can be found simply by reversing the earlier
equation.
Present value × (1 + interest rate) = Future value
Present value = Future value/ 1 + interest rate
The multiple period of present value equation takes into account of the
multiple periods.
Present value = Future value/ (1 + interest rate)t
21.5 THE TERM STRUCTURE OF INTEREST RATE (YIELD CURVE)
A yield curve displaying the relationship between spot rates of zero-coupon
securities and their term to maturity. The resulting curve allows an interest rate
pattern to be determined, which can then be used to discount cash flows
appropriately. Unfortunately, most bonds carry coupons, so the term structure
must be determined using the prices of these securities. Term structures are
continuously changing, and though the resulting yield curve is usually normal, it
can also be flat or inverted.
The general reception is that the curve will be upward moving up to a point
then it becomes flat. This is indicated in the following Figure.
Rising yield curve

There are at least three competing theories that attempt to explain the term
structure of the interest rates viz., the expectation theory, liquidity preference
theory and preferred habitat or segment theory.
Expectation theory-

This hypothesis assumes that the various maturities are ;perfect substitutes
and suggests that the shape of the yield curve depends on market participants'
expectations of future interest rates. These expected rates, along with an
assumption that arbitrage opportunities will be minimal, is enough information to
construct a complete yield curve. For example, if investors have an expectation of
what 1-year interest rates will be next year,
the 2-year interest rate can be calculated as
the compounding of this year's interest rate
by next year's interest rate. More generally,
rates on a long-term instrument are equal to
the geometric mean of the yield on a series of
short-term instruments. This theory perfectly
explains the observation that yields usually
move together. However, it fails to explain the
persistence in the shape of the yield curve.
 160

Shortcomings of expectations theory: Neglects the risks inherent in investing

in bonds (because forward rates are not perfect predictors of future rates).
Interest rate risk Reinvestment rate risk The long term rates will exceed the
current short term rates if there is an expectation that the market rates would be
higher in the future. Thus the yield curve depends upon the expectations of the
investors.

A rising yield curve (a) indicates that the investors’ expectation of a continuous
rise in interest rate. The flat yield curve (b) means that the investors expect the
interest rate to remain constant. The declining yield curve (c) shows that the
investor expects the interest rate to decline.
Liquidity preference theory
The Liquidity Premium Theory is an offshoot of the Pure Expectations Theory.
The Liquidity Premium Theory asserts that long-term interest rates not only reflect
investors’ assumptions about future interest rates but also include a premium for
holding long-term bonds (investors prefer short term bonds to long term bonds),
called the term premium or the liquidity premium. This premium compensates
investors for the added risk of having their money tied up for a longer period,
including the greater price uncertainty. Because of the term premium, long-term
bond yields tend to be higher than short-term yields, and the yield curve slopes
upward. Long term yields are also higher not just because of the liquidity premium,
but also because of the risk premium added by the risk of default from holding a
security over the long term. The market expectations hypothesis is combined with
the liquidity premium theory:

Where rpn is the risk premium associated with an n year bond

Segmentation theory
This theory is also called the segmented market hypothesis. In this theory,
financial instruments of different terms are not substitutable. As a result, the
Supply and demand in the markets for short-term and long-term instruments is
determined largely independently. Prospective investors decide in advance whether
they need short-term or long-term instruments. If investors prefer their portfolio to
be liquid, they will prefer short-term instruments to long-term instruments.
 161

Therefore, the market for short-term instruments will receive a higher demand.
Higher demand for the instrument implies higher prices and lower yield. This
explains the Stylized fact stylized fact that short-term yields are usually lower than
long-term yields. This theory explains the predominance of the normal yield curve
shape. However, because the supply and demand of the two markets are
independent, this theory fails to explain the observed fact that yields tend to move
together (i.e., upward and downward shifts in the curve).
21.6 BOND PORTFOLIO MANAGEMENT STRATEGIES
Bond portfolio management strategies can help investors get the most of their
portfolio, by actively managing fixed income investments to ensure maximum
returns. These strategies include interest rate anticipation, sector rotation and
security selection.
Bond portfolio management strategies are based on managing fixed income
investments in pursuit of a particular objective – usually maximizing return on
investment by minimizing risk and managing interest rates. The management of the
portfolio can be done by professional investment managers or by investors
themselves.
Here’s a look at the key strategies:
Interest Rate Anticipation
Bond portfolio management strategies that involve forecasting interest rates
and altering a bond portfolio to take advantage of those forecasts are called
“interest rate anticipation” strategies. Interest rates are the most important factor in
the pricing of bonds.
The price of a bond is based on its interest rate, or yield, at any particular
time. The most important influence on a bond’s yield is the term structure of
interest rates. Generally, the market interest rate for any particular term of bond is
represented by the yields on government bonds, as these are viewed as highly liquid
and of very low default risk.
Basic interest rate anticipation strategy involves moving between long-term
government bonds and very short-term treasury bills, based on a forecast of
interest rates over a certain time horizon.
Since long-term bonds change the most in value for a given change in interest
rates, a manager would want to hold long-term bonds when rates are falling. This
would provide the maximum increase in price for a portfolio. The reverse is true in
a rising interest rate environment. Long-term bonds fall the most in price for a
given rise in interest rates and a manager would want to hold treasury bills.
Treasury bills have a very short duration and do not change very much in value.
Yield curve strategies are more sophisticated interest rate anticipation
strategies that take into account the differences in interest rates for different terms
of bonds, called the “term structure” of interest rates. A chart of the interest rates
for bonds of different terms is called the “yield curve.” A yield curve strategy would
 162

position a bond portfolio to profit the most from an expected change in the yield
curve, based on an economic or market forecast.
Sector Rotation in Bonds
Bond portfolio management strategies based on sector rotation involve varying
the weight of different types of bonds held within a portfolio. An investment
manager will form an opinion on the valuation of a specific sector of the bond
market, based on fundamental credit factors, technical factors (such as supply and
demand), and relative valuations compared to historical norms within that sector. A
manager will usually compare her portfolio to the weightings of the benchmark
index that she is being compared to on a performance basis.
Security Selection for Bonds
Security selection for bond management involves fundamental and credit
analysis and quantitative valuation techniques at the individual security level.
Fundamental analysis of a bond considers the nature of the security and the
potential cash flows attached to it. Credit analysis evaluates the likelihood that the
payments will continue to be made over the bond’s term. Modern quantitative
techniques use statistical analysis and advanced mathematical techniques to
attach values to the cash flows and assess the probabilities inherent in their
nature.
21.7 BOND DURATION
A measure of the sensitivity of the price (the value of principal) of a fixed-
income investment to a change in interest rates. Duration is expressed as a number
of years. Rising interest rates mean falling bond prices, while declining interest
rates mean rising bond prices. The duration number is a complicated calculation
involving present value, yield, coupon, final maturity and call features. Fortunately
for investors, this indicator is a standard data point provided in the presentation of
comprehensive bond and bond mutual fund information. The bigger the duration
number, the greater the interest-rate risk or reward for bond prices.
It is a common misconception among non-professional investors that bonds
and bond funds are risk free. They are not. Investors need to be aware of two main
risks that can affect a bond's investment value: credit risk (default) and interest
rate risk (rate fluctuations). The dual use of the word "duration", as both the
weighted average time until repayment and as the percentage change in price, often
causes confusion. Strictly speaking Macaulay duration is the name given to the
weighted average time until cash flows are received, and is measured in years.
Modified duration is the name given to the price sensitivity and is the percentage
change in price for a unit change in yield. When yields are continuously-
compounded Macaulay duration and modified duration will be numerically equal.
When yields are periodically-compounded Macaulay and modified duration will
differ slightly, and in this case there is a simple relation between the two. Modified
duration is used more than Macaulay duration.
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FV = par value C = coupon payment per period (half-year)i = discount rate per
period (half-year)a = fraction of a period remaining until next coupon paymentm =
number of full coupon periods until maturity P = bond price (present value of cash
flows discounted with rate i)
Immunization
A bond portfolio is immunized if its investment performance is not sensitive to
changes in interest rates. A bond portfolio manager can use the concept of duration
and to immunize the portfolio. The immunization techniques fall into two
categories: (1) the bank immunization case and the planning period case. The
primary focus of this paper is on the planning period case The Planning Period Case
With this technique the bond portfolio manager is concerned with managing a
portfolio toward an horizon period. Many bond portfolios have a definite planning
period, with the goal being to achieve a target value for the portfolio at the end of
the planning period.
A typical problem occurs in pension fund management, with the bond
manager managing the bonds in the pension fund toward a horizon date set when
pensions become payable.
The problem confronting the bond manager in this case concerns the effect of
changing interest rates on the immediate value of the bond portfolio and on
the reinvestment rate, the rate at which cash thrown off by the bond portfolio can
be reinvested. Overall, a manager investing toward a future horizon period tries to
maximize the value of the portfolio on that future date, subject to risk constraints.
Equivalent to maximizing the future value of a portfolio, a manger might attempt to
maximize the Realized.
21.8 COMPOUND YIELD TO MATURITY (RCYTM)
Illustration Mr “ x ” has Rs. 50,000 to make one time investment. His son
has entered the Higher Secondary school and he needs his money back after two
years for his son’s educational expenses. As x’s outflow is one time outflow,
duration is simply two years. Now he has a choice of two types of bonds.
Bond ‘A’ has a coupon rate of 7 per cent and maturity period of four years with
a current yield of 10 per cent. Current price is Rs. 904.90.Bond ‘B’ has the coupon
rate of 6 per cent, a maturity period of one year and a current yield of 10 per cent.
The current price is Rs. 963.64.
Risk- The two bonds pose two types of risk to him. He can invest all his money
in bond ‘B’ with the aim of reinvesting the proceeds from the maturing bonds into
another issue of one year period. If the interest rate declines in the market during
the next year, he has to reinvest his money in low yielding bonds and may incur a
loss. Now, he has to face the reinvestment risk. On the other hand, if he invests his
money in ‘A’ bond, that also involves certain amount of risk. He cannot hold it till it
 164

matures, because he needs the money after two years and has to sell it in the
middle. If there is a rise in the market interest rate then the price of the bond will
fall down and vice versa. If a rise in interest rate is assumed, the investor has to
incur loss.
Solution: Mr “ x ” can solve the problem by investing part of the money in
one year bonds and a part in four year bonds. But, he should know how much to
be invested in each of these bonds. This can be got by solving the following
equation.
(X1 × D1) + (X2 × D2) = 2
That is X1 = the proportion of investment in bond ‘A’
X2 = the proportion of investment in bond ‘B’
D1 = Duration of bond ‘A’
D2 = Duration of bond ‘B’
The duration of the one year bond is only one year because it makes onetime
payment. Duration of bond 2,

D=

Applying the formula

(X × 1) + (X2 × 3.6030) = 2
X1 can be written as (1 – X2), then
[(1 – X2)1] + [X2. 3.603] = 2
1 – X2 + 3.6030 X2 = 2
X2 = 0.3842
X1 = 0.6158.
Mr “ x ” should put 61.58% of his investible funds in one year bond and 38.42 per
cent in the four year bond. For investing in both the bonds he needs Rs. 41322.31
= Rs. 50,000% (1.10)2] to have fully immunized bond portfolio.
The money to beinvested is,
One year bond = Rs. 41322.31 × X1 = Rs. 41322.31 × 0.6158
= Rs. 25446.28.
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Four year bond = 41322.31 × 0.3842 = 15876.03.

From here we can find out how many bonds he can buy,
One year bond price Rs. 963.64 = Rs.25446.28/ 963.64
= 26.4
Approximately 26 bonds,
Four year bond price = 904.89= Rs.15876.03/ 904.89
= 17.54
Approximately = 18 bonds.
According to the theory the rise in the market interest is offset by the
reinvestment of matured bonds at a higher rate of interest. Theoretically it seemed to
be very simple, but in practice it is not so simple because of the following reasons:
Immunization and duration are based on the assumption that the change in
the interest rate would occur before payments are received from both the bonds.
This may not be true always. The shift may occur after receiving the cash flow.
Another assumption is that the bonds have same yield. This also may not be
applicable. The yield may vary according to the period of maturity.It is assumed
that the shift in the interest rate affects all the bonds equally. Many a time, the
shift in interest rates affects different bonds differently.The whole analysis is based
on the belief that there will not be any call risk or default risk. But evidence has
proved that bond investment is not free from call risk or default risk.
 166

From the above example 10.9, it is clear that the bond with larger coupon
payments has a shorter duration compared to the bond with low coupon rate.
General rule

Larger the coupon rate, lower the duration and less volatile the bond
price.Longer the term to maturity, the longer the duration and more volatile the
bone.Higher the yields to maturity, lower the bond duration and bond volatility, and
vice versa.In a zero coupon bond, the bond’s term to maturity and duration are the
same. The zero coupon bond makes only one balloon payment to repay the
principal and interest on the maturity date.
Importance of duration-The concept of duration is important because it
provides more meaningful measure of the length of a bond, helpful in evolving
immunization strategies for portfolio management and measures the sensitivity of
the bond price to changes in the interest rate.
Duration and price changes- The price of the bond changes according to the
interest rate. Bond’s price changes are commonly called bond volatility. Duration
analysis helps to find out the bond price changes as the yield to maturity changes.
The relationship between the duration of a bond and its price volatility for a change
in the market interest rate is given by the following formula.
Percentage change in price = –MD [BP] /100
MD = Modified duration
BP = Basis point is 0.01 of 1% (1% = 100).
Modified duration MD = D/1 + RP
Where D = Duration
R = Market Yield
P = Interest payment per year (usually two)
21.9 PERIOD OF HOLDING FOR CAPITAL GAINS AS PER THE INCOME-TAX ACT, 1961
A capital asset may either be a short-term or long-term capital asset,
depending on the period of holding. Gains from alienation thereof would be short-
term capital gains or long-term capital gains.
Under section 2(42A) of the Income-tax Act, 1961 (Act), a short-term capital
asset means a capital asset held for not more than 36 months immediately
preceding the date of its transfer. However, in the following cases, an asset held for
a period of 12 months or less was regarded as a short-term asset:-
Equity or preference share in an Indian company (whether listed or not)
 Units of a mutual fund (whether listed or not).
 Any other listed security (debentures, government securities, etc).
 Unit of the Unit Trust of India.
 Zero coupon bonds.
 167

Change in period of holding of share and securities section 2(42A)

Per the existing provisions, short-term capital asset means a capital asset held
by tax payer for not more than 36 months immediately preceding the date of its
transfer. However, in the case of a share held in a company or any other security
listed in a recognised stock exchange in India or a unit of the Unit Trust of India or
a unit of a Mutual Fund or a zero coupon bond, the period of holding for qualifying
it as short-term capital asset is not more than 12 months. Budget proposes that
securities (other than a listed security) and units of mutual funds (other than
equity oriented funds) [hereinafter referred to as ‘Securities’] shall be regarded as
short term capital asset where the same are held for a period of less than 36
months.
Consequently, capital gains earned by resident & non-resident tax payers on
transfer of Securities held for a period of more than 12 months but less than 36
months would be chargeable to tax @30% & 40% respectively (instead of 20% if the
shares are not freely marketable or 10%1 if the shares are freely marketable, as
applicable under the existing income tax provisions).
The Memorandum to the Finance (No. 2) Bill, 2014 explained that shorter
period of holding of not more than 12 months for consideration as short-term
capital asset was introduced for encouraging investment on stock market where
prices of the securities are market determined. Question therefore arises whether
withdrawal of the benefit suggest that investment in stock markets is the only
avenue of foreign investment being considered favorably.
The Finance Minister in his speech mentioned that Government will endeavor
not to introduce retrospective taxes. As the Budget got presented in July 2014 and
the amendment to section 2(42A) was proposed to take effect from assessment year
2015-16 (i.e. April 1, 2014 onwards), the amendment could have a colour of
retrospectively. However, to provide relief for taxpayers, the Lok Sabha (while
passing the Finance (No. 2) Bill, 2014) introduced a deeming provision that such
Securities shall continue to be long-term capital assets if they have been
transferred during the period from 1 April, 2014 to 10 July, 2014 after holding
them for a period of more than 12 months (instead of more than 36 months).
Taxability of long term capital gain: Long term capital gain shall be taxable
at 20% under section 112 of income tax act. Benefit of indexation shall be available
to the assessee under section 48 of income tax act 1961.There is no change in
finance act 2014 and 2015 regard to indexation.
Taxability of Short term capital gain: Short term capital gain shall be
taxable at normal rate i.e. 30% for resident and 40% for non resident.
Covered Bond
A covered bond is a security created from public sector loans or mortgage
loans where the security is backed by a separate group of loans; it typically carries a
maturity rate of two to 10 years and enjoys relatively high credit ratings. Covered
bonds provide an efficient, lower-cost way for lenders to expand their business rather
 168

than issuing unsecured debt instruments. The European Union created

guidelines for covered bond transactions in 1988 that let investors in the bond
market put more of their assets in covered bonds than previously allowed.
Breaking Down 'Covered Bond'
Covered bonds are derivative investments, similar to mortgage-backed and
asset-backed securities, that are common in Europe and slowly gaining interest in
the United States. A financial institution purchases investments that produce cash,
typically mortgages or public sector loans, puts the investments together and issues
bonds covered by the cash flowing from the investments. Issuing covered bonds lets
financial institutions buy and sell assets to improve credit quality, lower borrowing
costs and finance public debt. The institutions may replace defaulted or prepaid
loans with performing loans to minimize risk of the underlying assets not
performing as well as expected. Investors may put money into safer assets and
receive a relatively high return.
Safety of Covered Bonds
The underlying loans of a covered bond stay on the balance sheet of the
financial institution issuing the bond. Therefore, if the institution becomes
insolvent, investors holding the bonds may still receive their scheduled interest
payments from the underlying assets of the bonds, as well as the principal at the
bond’s maturity. Because of the extra layer of protection, covered bonds typically
have AAA ratings.
Passive bonds
Passive bonds – also called index funds – invest in a portfolio of bonds
designed to match the performance of a particular index, Aggregate Bond Index.
Index funds simply hold the securities that are in the index, or, in many cases, a
representative sample of the index holdings. When the composition of the index
changes, so do the fund’s holdings. In this case, the managers of the funds aren’t
seeking to produce returns greater than the benchmark – the goal is simply
matching its performance.
Active bonds
Active bonds are those with portfolio managers who try to choose bonds that
will outperform the index over time and avoid those they see as likely to
underperform. In general, their goal is to find bonds that are undervalued or to
position the portfolio for anticipated changes in interest rates. Active managers can
adjust their funds’ average maturity, duration, average credit quality, or positioning
among the various segments of the market.
REVISION POINT
Bonds: Bonds are long-term debt securities that are issued by corporations
and government entities.
INTEXT QUESTIONS
1. What is bond?
2.what are the different types of bonds?
 169

SUMMARY
Bonds are issued by organizations generally for a period of more than one year
to raise money by borrowing. Organizations in order to raise capital issue bond to
investors which is nothing but a financial contract, where the organization
promises to pay the principal amount and interest (in the form of coupons) to the
holder of the bond after a certain date. (Also called maturity date).Some Bonds do
not pay interest to the investors, however it is mandatory for the issuers to pay the
principal amount to the investors.
TERMINAL EXERCISE
1. _______________ are long-term debt securities that are issued by corporations and
government entities.
Ans: bonds
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
1. Discuss the various methods of bond valuation.
2. Distinquish from active bonds and Passive bonds
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
What is essential ingredient in all active portfolio strategies?
KEY WORDS
Covered Bond, Debenture, Debt Security
 170

LESSON 22

PREFERENCE SHARES AND ITS VALUATION

INTRODUCTION
Preference shares are those shares which carry certain special or priority
rights. Firstly, dividend at a fixed rate is payable on these shares before any
dividend is paid on equity shares. Secondly, at the time of winding up of the
company, capital is repaid to preference shareholders prior to the return of equity
capital. Preference shares do not carry voting rights. However, holders of preference
shares may claim voting rights if the dividends are not paid for two years or more
on cumulative preference shares and three years or more on non-cumulative
preference shares
OBJECTIVES
After reading this lesson the student should be able to Understand
CONTENT
22.1 Preference shares
22.2 Valuation of Preference Shares
22.1 PREFERENCE SHARES
Definition: Preference shares allow an investor to own a stake at the issuing
company with a condition that whenever the company decides to pay dividends, the
holders of the preference shares will be the first to be paid.
Description: Dividend payment of the preference shareholders is fixed and if
somehow company liquefies, the owners of the preference shares will be the first
one to get their money back after the company has paid back its debt. There are
different kind of preference shares available, such as cumulative and non
cumulative preference shares, redeemable and non-redeemable preference shares,
convertible and non-convertible preference shares, participating and non
participating preference shares.
Different types of Preference Shares are as follows:
1. Cumulative Preference Share In case where a company does not declare
dividends for a particular year, they are carried to next year. They are treated as
arrears.And a preference share is said to be cumulative in a case when the
arrears pertaining to dividend are cumulative in nature and such arrears are
cleared before any dividend payment to equity shareholders.
2. Non- Cumulative Preference shares: As the name suggests, it does not
accumulate dividends. Dividend skipped by the company are not paid, which
means they have the right to avail dividend from the profits earned from that
particular year.Notably, dividends are only payable from net profits of each year.
So, in case where there are no profits for a particular year, the arrears of
dividend cannot be claimed in subsequent years. Preference shares are
cumulative in nature unless explicitly described as otherwise.
 171

3. Redeemable Preference shares: These are shares which can be redeemed or

repaid after the fixed period as issued by the company or even before at the
option of the company.
4. Non-redeemable Preference shares: These shares cannot be redeemed during the
life of the company.
5. Convertible Preference Shares: These Shares can be converted into equity at the
option of the holder after the stated tenure.
6. Non-convertible Preference shares These Shares which cannot be converted to
equity are called non convertible shares.
7. Participating Preference shares: Such shares have the right to participate in
surplus profits of the company at the time of liquidation after the company had
paid to other holders.
8. Non-participating Preference Shares: Preference shares, which have no right to
participate in the surplus profits or in any surplus on liquidation of the
company, are called non-participating preference shares.
22.2 VALUATION OF PREFERENCE SHARES
Meaning: Preference shares are issued by a joint stock company for raising
share capital from the public. It may be redeemable preference shares or
irredeemable preference shares.
The value of preference shares also is, generally, determined through the
capitalization technique.
The process of determination of the present value of preference share is the
same as that of bonds or debentures. The processor determination of the present
value of a preference share can be considered under two heads viz.
1. When preference shares is redeemable.
2. When preference shares is irredeemable.
When Preference Share is Redeemable
Present value of a redeemable preference share can be determined by
estimating its future cash flows, and then discounting the estimated future cash
flows at an appropriate capitalization rate or discount rate.
The estimated future cash flows from the preference share consists of the
stream of future dividend payment plus the par value of the preference share.
The following formula may be used to determine the present value of the
preference share (assuming that the preference share has a maturity period of 3 years):
V = D/(1 + K) + D/(1 + K) (1 + K) + {(D+M)/(1 + K) (1 + K) (1 + K)}
Where,
V = Present value of the preference shares.
D = Annual dividend payment.
Kp = Capitalization rate or discount rate.
M = Maturity value i.e., the value of the preference share.
 172

Alternatively, the present value of the preference share can be determined

through the table called the present value Tables.
Present Value of Perpetual or an Irredeemable Preference Share
The present value of irredeemable preference share can be determined by
simply discounting the streams of dividend payment for the infinite period by an
appropriate capitalization rate of the discount rate.
Formula:
V = D/Kp
Where,
V = Present value of the preference share.
D = Annual dividend payment on the preference share.
Kp = Capitalization rate.
REVISION POINTS
Preference shares are those shares which carry certain special or priority
rights. Firstly, dividend at a fixed rate is payable on these shares before any
dividend is paid on equity shares. Secondly, at the time of winding up of the
company, capital is repaid to preference shareholders prior to the return of equity
capital.
INTEXT QUESTIONS
1. Distinguish preference share from equity.
2. what is the feature of preference share?
SUMMARY
Preference shares have the characteristics of both equity shares and
debentures. Like equity shares, dividend on preference shares is payable only when
there are profits and at the discretion of the Board of Directors.
Preference shares are similar to debentures in the sense that the rate of
dividend is fixed and preference shareholders do not generally enjoy voting rights.
Therefore, preference shares are a hybrid form of financing.
TERMINAL EXERCISE
1. __________________can be converted into equity at the option of the holder after
the stated tenure.
Ans: Convertible Preference Shares
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
 173

ASSIGNMENTS
1. Discuss the difference type of preference shares.
2. Brefly discuss the difference types of preference share valuation.
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Discuss the process of valuation of preference shares.
KEY WORDS
Cumulative, Participative, Convertible
 174

LESSON 23

EQUITY SHARES AND ITS VALUATION

INTRODUCTION
Equity share is a main source of finance for any company giving investors
rights to vote, share profits and claim on assets. Various types of equity capital are
authorized, issued, subscribed, paid up, rights, bonus, sweat equity etc. The value
of equity shares are expressed in terms of face value or par value, issue price, book
value, market value etc.
Equity Shares: Features, Advantages and Disadvantages of Equity Shares
Equity shares were earlier known as ordinary shares. The holders of these
shares are the real owners of the company. They have a voting right in the meetings
of holders of the company. They have a control over the working of the company.
Equity shareholders are paid dividend after paying it to the preference
shareholders.
The rate of dividend on these shares depends upon the profits of the company.
They may be paid a higher rate of dividend or they may not get anything. These
shareholders take more risk as compared to preference shareholders.
Equity capital is paid after meeting all other claims including that of
preference shareholders. They take risk both regarding dividend and return of
capital. Equity share capital cannot be redeemed during the life time of the
company.
OBJECTIVES
After reading this lesson the student should be able to understand Features of
Equity Shares, Advantages of Equity Shares, Disadvantages of Equity Shares.
CONTENT
23.1 Features of Equity Shares
23.2 Advantages of Equity Shares
23.3 Disadvantages of Equity Shares
23.4 Deferred Shares
23.5 Stock Valuation
23.1 FEATURES OF EQUITY SHARES
Equity shares have the following features:
i. Equity share capital remains permanently with the company. It is returned only
when the company is wound up.
ii. Equity shareholders have voting rights and elect the management of the
company.
iii. The rate of dividend on equity capital depends upon the availability of surplus
funds. There is no fixed rate of dividend on equity capital.
 175

23.2 ADVANTAGES OF EQUITY SHARES

1. Equity shares do not create any obligation to pay a fixed rate of dividend.
2. Equity shares can be issued without creating any charge over the assets of the
company.
3. It is a permanent source of capital and the company has to repay it except under
liquidation.
4. Equity shareholders are the real owners of the company who have the voting
rights.
5. In case of profits, equity shareholders are the real gainers by way of increased
dividends and appreciation in the value of shares.
23.3 DISADVANTAGES OF EQUITY SHARES
1. If only equity shares are issued, the company cannot take the advantage of
trading on equity.
2. As equity capital cannot be redeemed, there is a danger of over capitalisation.
3. Equity shareholders can put obstacles for management by manipulation and
organising themselves.
4. During prosperous periods higher dividends have to be paid leading to increase
in the value of shares in the market and it leads to speculation.
5. Investors who desire to invest in safe securities with a fixed income have no
attraction for such shares.
23.4 DEFERRED SHARES
These shares were earlier issued to Promoters or Founders for services
rendered to the company. These shares were known as Founders Shares because
they were normally issued to founders. These shares rank last so far as payment of
dividend and return of capital is concerned. Preference shares and equity shares
have priority as to payment of dividend.
These shares were generally of a small denomination and the management of
the company remained in their hands by virtue of their voting rights. These
shareholders tried to manage the company with efficiency and economy because
they got dividend only at last. Now, of course, they cannot be issued and they are
only of historical importance. According to Companies Act 1956, no public limited
company or which is a subsidiary of a public company can issue deferred shares.
23.5 STOCK VALUATION
Stock Valuation is more difficult than Bond Valuation because stocks do not
have a finite maturity and the future cash flows, i.e., dividends, are not specified.
Therefore, we use different techniques for stock valuation as mentioned as;
1. Balance- Sheet Valuation
2. Dividend discount models
3. Price earning method
4. CAPM
 176

Balance-Sheet Valuation
Analysts often look at the balance sheet of the firm to get a handle on some
valuation measures. Three measures derived from the balance sheet are: book
value, liquidation value, and replacement cost.
1. Book Value
The most common valuation measure is book value. The book value per share
is simply the net worth of the company (which is equal to paid up equity capital
plus reserves and surplus) divided by the number of outstanding equity shares.
For example, if the net worth of X Limited is Rs 37 crore and the number of equity
shares of Zenith is 2 million; the book value per share works out to Rs 18.50 (Rs 37
crore divided by 2 crore).
A closer examination, however, quickly reveals that what is regarded as
‘objective’ is based on accounting conventions and policies which are characterised
by a great deal of subjectivity and arbitrariness. An allied and a more powerful
criticism against the book value: measure, is that the historical balance sheet
figures on which it is based are often very divergent from current economic value.
Balance sheet figures rarely reflect earning power and hence the book value per
share cannot be regarded as a good proxy for true investment value.
2. Liquidation Value
Value realised from liquidating Amount to be paid to all the creditors all the
assets of the firm and preference shareholders Number outstanding equity shares
To illustrate, assume that Pioneer Industries would realise Rs 45 million from the
liquidation of its assets and pay Rs 18 million to its creditors and preference
shareholders in full settlement of their claims. If the number of outstanding equity
shares of Pioneer is 1.5 million, the liquidation value per share works out to: Rs
45mn- Rs 18mn = Rs 18 1.5 mn While the liquidation value appears more realistic
than the book value, there are two serious problems in applying it.
a. It is very difficult to estimate what amounts would be realised from the
liquidation of various assets
b. The liquidation value does not reflect earning capacity. Given these problems,
the measure of liquidation value seems to make sense only for firms, which are
‘better dead and alive’ - such firms are not viable and economic values cannot
be established for them.
Dividend Discount Model
Dividend discount models are designed to compute the intrinsic value of a
share of common stock under specific assumption as to the expected growth
pattern of future dividends and the appropriate discount rate to employ. According
to the dividend discount model, the value of an equity share is equal to the present
value of dividends expected from its ownership plus the present value of the sale
price expected when the equity share is sold. For applying the dividend discount
model, we will make the following assumptions:
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i. Dividends are paid annually-this seems to be a common practice for business

firms in India; and
ii. The first dividend is received one year after the equity share is bought.
I. Single Period Valuation Model
Let us begin with the case where the investor expects to hold the equity share
for one year. The price of the equity share will be:
Po = D1/(1+r) + P1 (1+r)
Where:
Po is the current price of the equity share
D1 is the expected dividend expected next year
P1 is the price expected next year
r is the rate of return required on the equity share.
Lets take an example. Assume that the equity share of a company is expected
to provide a dividend of Rs 2 and fetch a price of Rs 18 a year hence. What price
would it sell for now if investors’ required rate of return is 12%.
Po = 2.0/(1.12)+18(1.12) = Rs 17.86
If the current price, Po becomes Po (1+g) s, a year hence, we get:
Po = D1/(1+r) + Po (1+g)/(1+r)
or
Po = D1/(r-g)
II Multi-Period Valuation Model
Now that we have already covered the basics of equity share valuation in a
single period framework, we will now discuss the more realistic, and also a bit
complex, case of multi-period valuation.
Since equity shares have no maturity period, they may be expected to bring a
dividend stream of infinite duration. Hence the value of an equity share may be put as:
Po = D1/(1+r) + D2/(1+ r)2 + D3/(1+ r)3 +—————+
Dn /(1+ r)n = S D/(1+ r)t t=1
where:
Po is the price of the equity share today
D1 is the dividend expected a year hence
D2 is the dividend expected two years hence
DÜ is the dividend expected at the end of infinity
r is the expected rate of return on the equity share.
We know that the equation above presents the valuation model for an finite
horizon. Lets now see whether it is applicable to a finite horizon also. Lets consider
how an equity share would be valued by an investor who plans to hold it for n years
and sell it thereafter for a price of Pn. The value of the equity share to him would be:
Po = D1/(1+r) + D2/(1+ r) 2 + D3/(1+ r)3 Pn /(1+ r)n/
= S Dt/(1+r) t + Pn/(1+r) n
t=1
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If you notice, we have got the same equation as a generalize multi period
valuation formula. This equation is general enough to permit any dividend pattern-
constant, rising, declining, or randomly fluctuating.
Price earning method
The ratio of price per share to earnings per share, commonly called as the P/ E
ratio. The reciprocal of P/E ratio is called as (earnings -price) E/P ratio or earnings
yield. Investors seem to attach a lot of importance to P/E ratios. Under this
approach we estimate the P/E ratio as follows:
P0 = E1* (P0/E1)
P0 is the estimated price
E1 is the estimated earnings per share
P0/E1 is the justified price –earnings ratio
Investors must have noticed that the financial dailies give information on P/E
ratios of a large number of companies, and financial analysts evaluate the
performances and prospects of shares in terms of P/E
Lets start with some of the determinants of P/E ratio .The determinants of the
P/E ratio can be derived from the dividend discount model, which is the foundation
for valuing equity stocks. Lets begin with constant growth model. We know that:
Po = D1/(r-g)
In this model:
D1 = E1 (1-b)
r- (ROE*b)
If we divide, both the sides by E1, we get:
P0/E1 = (1-b)
r- (ROE*b)
the above equation indicate that
1. The dividend payout ratio, (1-b)
2. The required rate of return, r
3. The expected growth rate, ROE*b
When interest rates increase, required rates of return on all securities,
including equity stocks increase, pushing security prices downward.
When interest rates fall, security prices rise.
P/E Ratio and Risk
Other things being equal, riskier stocks have lower P/E multiples. We can note
this easily by examining the formula for the P/E ratio of the constant growth model:
P/E = (1-b)
(r-g)
We can conclude that Riskier stocks have higher required rate of return (r) and
hence lower P/ E multiples. This is true in all cases, not just the constant growth
model. For any expected earnings and dividend stream, the present value will be lower
when the stream is considered to be riskier. Hence the P/E multiple will be lower.
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Capital Asset Pricing Model

“Cap-M” looks at risk and rates of return and compares them to the overall
stock market. In other words, we can say that it is a model describing the
relationship between risk and expected return that is used in the pricing of risky
securities. CAPM says that the expected return of a security or a portfolio equals
the rate on a risk-free security plus a risk premium. If this expected return does not
meet or beat the required return then the investment should not be undertaken. If
you use CAPM you have to assume that most investors want to avoid risk, (risk
averse), and those who do take risks, expect to be rewarded. Valuation with the
Capital Asset Pricing Model uses a variation of discounted cash flows; only instead
of giving yourself a “margin of safety” by being conservative in your earnings
estimates, you use a varying discount rate that gets bigger to compensate for your
investment’s riskiness. There are different ways to measure risk; the original CAPM
defined risk in terms of volatility, as measured by the investment’s beta coefficient.
Calculate the required rate of return by using CAPM in the following way:
Ks = Krf + B ( Km - Krf)
Where:
Ks is the Required Rate of Return, (or just the rate of return).
Krf is the Risk Free Rate (the rate of return on a “risk free investment”,
Government Treasury Bills) B = Beta. A measure of volatility, or systematic risk, of
a security or portfolio in comparison to the market as a whole. Also known as beta
coefficient. A beta of 1 indicates that the security’s price will move with the market.
A beta greater than 1 indicates that the security’s price will be more volatile than
the market. A beta less than 1 means that it will be less volatile than the market.
Km = The expected return on the overall stock market.
REVISION POINTS
A point comes where the company reaches a very big level and requires huge
capital investment for business growth. It then offers its equity share to the general
public. This is called Initial Public Offer (IPO). More such issues in future are called
Follow-on Public Offer (FPO).
Authorized Share Capital: It is the maximum amount of capital which can be
issued by a company. It can be increased from time to time. Some fee is required to
be paid to legal bodies accompanied with some formalities.
Issued Share Capital: It is that part of authorized capital which is offered to
investors.
Subscribed Share Capital: It is that part of Issued capital which is accepted
and agreed by the investor.
Paid Up Capital: It is the part of subscribed capital, the amount of which is
paid by the investor. Normally, all companies accept complete money in one shot
and therefore issued, subscribed and paid capital becomes one and the same.
Conceptually, paid up capital is the amount of money which is actually invested in
the business.
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Rights Share: These are the shares issued to the existing shareholders of a
company. Such kind of shares is issued to protect the ownership rights of the
investors.
Bonus Share: These are the type of shares given by the company to its
shareholders as a dividend. There are various advantages and disadvantages of
bonus shares like dividend, capital gain, limited liability, high risk, fluctuation in
the market, etc.
INTEXT QUESTIONS
1. What is equity share?
2. What is bonus share?
SUMMARY
Normally, a company is started with equity finance as its first source of
capital from the owners or promoters of that company. After a certain level of
growth, more capital is required for further growth. The company then finds an
investor in the form of friends, relatives, venture capitalists, mutual funds, or any
such small group of investors and issue fresh equity shares to these investors.
TERMINAL EXERCISE
1. Equity shares were earlier known as _____________ shares
Ans: ordinary
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
ASSIGNMENTS
1. Discuss the valuation methods of equity.
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
What is the relationship between the P/e ratios and RISK.
KEY WORDS
Rights shares, bonus shares, ordinary shares
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LESSON 24

RECENT DEVELOPMENTS AND REFORMS IN CAPITAL MARKET

INTRODUCTION
The Indian capital market has witnessed major reforms in the decade of
1990s and thereafter. It is on the verge of the growth. Thus, the Government of
India and SEBI has taken a number of measures in order to improve the working
of the Indian stock exchanges and to make it more progressive and vibrant.
OBJECTIVES
After reading this lesson the student should be able to understand Recent
Developments, Reforms in Capital Market of India
CONTENT
24.1 Recent Developments
24.2 Reforms in Capital Market of India
24.3 Recent Reform in capital market
24.1 RECENT DEVELOPMENTS
 Signing MOU with European Regulators - 27 Members State on 28th July 2014
 Multilateral Competent Authority Agreement (MCAA) on Automatic exchange of
information on 3rd June 2015
 Foreign Accounts Tax Compliance Act (FATCA) with US on July 09, 2015 for
international tax compliance
 SEBI - International Financial Services centers (IFSC) Guidelines 2015
 SEBI’s Complaint Redressal System (SCORES) - platform to approach concerned
companies or SEBI
 SEBI guidelines on Foreign Portfolio Investment (FPI) and Foreign Institutional
Investors (FII) - simplification
 SEBI issue and listing of Debt securities by municipalities
 SARAL account opening form
24.2 REFORMS IN CAPITAL MARKET OF INDIA
The major reforms undertaken in capital market of India includes:-
1. Establishment of SEBI : The Securities and Exchange Board of India (SEBI)
was established in 1988. It got a legal status in 1992. SEBI was primarily set
up to regulate the activities of the merchant banks, to control the operations of
mutual funds, to work as a promoter of the stock exchange activities and to act
as a regulatory authority of new issue activities of companies. The SEBI was set
up with the fundamental objective, "to protect the interest of investors in
securities market and for matters connected therewith or incidental thereto."
The main functions of SEBI are:-
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a. To regulate the business of the stock market and other securities

market.
b. To promote and regulate the self regulatory organizations.
c. To prohibit fraudulent and unfair trade practices in securities
market.
d. To promote awareness among investors and training of
intermediaries about safety of market.
e. To prohibit insider trading in securities market.
f. To regulate huge acquisition of shares and takeover of
companies.
2. Establishment of Creditors Rating Agencies: Three creditors rating agencies
viz. The Credit Rating Information Services of India Limited (CRISIL - 1988), the
Investment Information and Credit Rating Agency of India Limited (ICRA -
1991) and Credit Analysis and Research Limited (CARE) were set up in order to
assess the financial health of different financial institutions and agencies
related to the stock market activities. It is a guide for the investors also in
evaluating the risk of their investments.
3. Increasing of Merchant Banking Activities: Many Indian and
foreign commercial banks have set up their merchant banking divisions in
the last few years. These divisions provide financial services such as
underwriting facilities, issue organising, consultancy services, etc. It has
proved as a helping hand to factors related to the capital market.
4. Candid Performance of Indian Economy: In the last few years, Indian
economy is growing at a good speed. It has attracted a huge inflow of Foreign
Institutional Investments (FII). The massive entry of FIIs in the Indian capital
market has given good appreciation for the Indian investors in recent times.
Similarly many new companies are emerging on the horizon of the Indian
capital market to raise capital for their expansions.
5. Rising Electronic Transactions: Due to technological development in the last
few years. The physical transaction with more paper work is reduced. Now
paperless transactions are increasing at a rapid rate. It saves money, time and
energy of investors. Thus it has made investing safer and hassle free
encouraging more people to join the capital market.
6. Growing Mutual Fund Industry: The growing of mutual funds in India has
certainly helped the capital market to grow. Public sector banks, foreign banks,
financial institutions and joint mutual funds between the Indian and foreign
firms have launched many new funds. A big diversification in terms of
schemes, maturity, etc. has taken place in mutual funds in India. It has given a
wide choice for the common investors to enter the capital market.
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7. Growing Stock Exchanges : The numbers of various Stock Exchanges in

India are increasing. Initially the BSE was the main exchange, but now after
the setting up of the NSE and the OTCEI, stock exchanges have spread across
the country. Recently a new Inter-connected Stock Exchange of India has
joined the existing stock exchanges.
8. Investor's Protection : Under the purview of the SEBI the Central Government
of India has set up the Investors Education and Protection Fund (IEPF) in
2001. It works in educating and guiding investors. It tries to protect the
interest of the small investors from frauds and malpractices in the capital
market.
9. Growth of Derivative Transactions : Since June 2000, the NSE has
introduced the derivatives trading in the equities. In November 2001 it also
introduced the future and options transactions. These innovative products
have given variety for the investment leading to the expansion of the capital
market.
10. Insurance Sector Reforms : Indian insurance sector has also witnessed
massive reforms in last few years. The Insurance Regulatory and Development
Authority (IRDA) was set up in 2000. It paved the entry of the private insurance
firms in India. As many insurance companies invest their money in the capital
market, it has expanded.
11. Commodity Trading : Along with the trading of ordinary securities, the trading
in commodities is also recently encouraged. The Multi Commodity Exchange
(MCX) is set up. The volume of such transactions is growing at a splendid rate.
24.3 RECENT REFORM IN CAPITAL MARKET
Financial Data Management Center
A government appointed panel has suggested setting up a financial data
management centre (FDMC) for managing the repository of financial regulatory data
to ensure stability in the economy. The Committee, headed by Ajay Tyagi (additional
secretary in finance ministry), has submitted its report and a draft bill titled ‘The
financial data management centre bill 2016’. Finance minister Arun Jaitley in
budget speech 2016-17 had announced setting up of financial data management
centre under the aegis of the financial stability and development council (FSDC) to
facilitate integrated data aggregation and analysis in the financial sector. The
Committee has “worked out for an Act to provide for the establishment of a data
centre for managing the repository of financial regulatory data, to enable
standardisation of data across the financial sector and providing analytical
support” to the FSDC on issues related to financial stability of the economy and
matters connected therewith.
Financial Sector Appellate Tribunal
The Securities Appellate Tribunal (SAT) deals only with securities cases, but
there could be an FSAT for all financial services, Malhotra said at a law ministry
press conference. This suggestion first came from the Financial Sector Legislative
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Reforms Commission in March 2013. The B.N. Srikrishna-led commission

recommended FSAT as an appellate tribunal for all financial regulators—Insurance
Regulatory and Development Authority (Irda), capital markets regulator Securities
and Exchange Board of India (Sebi) and Pension Fund Regulatory and Development
Authority (PFRDA). In 2014, the government promulgated an ordinance that
allowed Irda appeals to be brought before SAT. Later, it was accepted as law by the
Parliament by way of the Insurance Laws (Amendment) Act 2015, passed last
March. The PFRDA rules were changed to bring appeals against the authority’s
orders before SAT.J.N. Gupta, a former executive director of Sebi and founder of
SES Governance, said that any centralized tribunal for redressal was a good idea.
The finance ministry is learnt to be considering using the Resolution Corporation,
proposed in the Financial Sector Legislative Reforms Commission (FSLRC) report,
as a code for insolvency and bankruptcy in financial companies. The
government has already formed a task force for setting up the body with a mandate
to complete the work by October 2015; this is, however, likely to be extended to the
end of the year. The insolvency code for financial institutes will contain a safe
harbour provision, specifically for institutes contributing to the infrastructure of the
financial markets in India. Under this provision, the normal rules for bankruptcy,
including the temporary suspension of rehabilitation or winding up, will not apply.
The Financial Stability and Development Committee is overseeing non-legislative
implementation of the proposals in the FSRLC report. The government is of the
opinion that the legislative part of the recommendations will require certain
administrative and legal changes in the present format.
Public Debt Management Agency
The Finance Ministry has set up a Public Debt Management Cell (PDMC) with
a view to streamline government borrowings and better cash management with the
overall objective of deepening bond markets. The interim arrangement, the circular
said, will allow separation of debt management functions from RBI to PDMA in a
gradual and seamless manner, without causing market disruptions .
Financial Redressal Agency
A task force constituted by the finance ministry to create a framework for a
sector-neutral Financial Redressal Agency (FRA) to address grievances of retail
consumers against all financial service providers (FSPs) has recommended that the
agency should have the authority to direct FSPs to pay compensation to aggrieved
consumers.
The idea of an FRA, first articulated by the Financial Sector Legislative
Reforms Commission (FSLRC), found resonance in the 2015-16 budget speech of
finance minister Arun Jaitley. The government later constituted a 10-member task
force under former pension regulator Dhirendra Swarup. The government, which
received the task force report in June, has now invited comments from stakeholders
on the report by 31 January 2017.
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The task force highlighted the need for basic protections to be provided in law
through a new financial consumer protection and redress legislation. However, it
has urged the government to operationalize a shell FRA initially through an
executive order with a budget of Rs100 crore. In the first phase, the FRA will be
empowered to redress complaints being handled by Insurance Regulatory and
Development Authority of India (Irdai), Insurance Ombudsman, and Pension Fund
Regulatory and Development Authority (PFRDA). In the second phase, FRA will
redress complaints by retail consumers against FSPs regulated by Securities and
Exchange Board of India (Sebi) as well as retail complaints that are handled by the
Reserve Bank of India (RBI) and Banking Ombudsman.
FRA would be managed by a board to be appointed by the financial regulators
in consultation with the government. It would also have an independent
assessment officer to consider complaints against the FRA’s redress function
arising out of issues related to its standard of service.
The design of FRA offers a simplified resolution process, allowing retail
consumers in distant locations to pursue effective remedies against FSPs without
imposing significant costs on them. FRA will try to resolve all complaints through
mediation. “Cases where the parties are unable to reach a settlement would be
resolved through a light-touch adjudication process. It will discourage court-like
processes. The FRA will establish a front-end presence in diverse locations for
consumers to submit complaints,” according to a statement by the finance
ministry.
The accountability of FRA will be ensured through robust requirements on
disclosure and performance review. FRA will provide an independent feedback loop
to regulators on complaints, including information on complaints received against
unregulated FSPs, with a view to assisting them in strengthening consumer
protection regulation and supervision.
Consumers will be able to appeal against the orders of FRA at Securities
Appellate Tribunal (SAT). This would standardize the availability of such an
independent mechanism across the financial sector.
REVISION POINTS
Amendments to the Securities laws
a) to strengthen SEBI & to give it greater investigation powers.
b) to provide for legal framework for trading of securitized instruments
• PAN as the sole identification number
• Short selling and securities lending and borrowing scheme
• Unified exchange traded market for corporate bonds
• Simpler and quicker procedures for registration and operation by Foreign
Institutional Investors
• Simplification of issue process.
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INTEXT QUESTIONS
1. What is the aim of Financial Redressal Agency?
2. Discuss the role of the Public Debt Management Agency.
SUMMARY
The central government establish various agencies like Financial Data
Management Center, Financial Redressal Agency for protect the investor safty. If
the present situation continues, Indian can expect in future the uplinking of our
stock market with that of the developed countries.
ASSIGNMENTS
1. Discuss the recent reforms in capital market .
TERMINAL EXERCISE
1. ____________ as the sole identification number.
Ans: PAN number
SUPPLEMENTARY MATERIALS
money.rediff.com
money control.com
amfiindia.com
nseindia
bseindia.com
rbi.org.in
SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
LEARNING ACTIVITIES
Discuss the various issues posed by foreign portfolio investment to the policy-
maker. Is it a measure of success and an end itself?
KEY WORDS
Redressal, Financial Data Management Center, Financial Redressal Agency

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