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[Link]: Investment is action (or) process of investing money for profit.

Example: equity shares, preference share and debentures etc.

DEFINITION OF INVESTMENT

“An investment is the purchase of goods that are not consumed today but are used in the future to
create wealth”.

“An investment is a commitment of funds make in the expectation of some positive rate of
return”.

According to oxford dictionary “investment is defined as the action or process of investment

money for profit”.

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STATISTICAL MEASURE OF RISK

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TYPES OF RETURN

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. RISK FACTORS
A. Business Risk: - The risk of doing business in a particular industry or environment is called
business risk.

# Fluctuations in operating income

# Arise due to external & internal business factors

B. Financial Risk: -
# associated with the capital structure of the firm

# Variability of the income to the equity

A. BUSINESS RISK
Business risk is that portion of the unsystematic risk caused by the operating environment of the
business. Business risk arises from the inability of a firm to maintain its competitive edge and the
growth or stability of the earnings. Variation that occurs in the operating environment is reflected
on the operating income and expected dividends. The variation in the expected operating income
indicates the business risk.

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For example take Anu and Vinu companies. In Anu company, operating income could grow as
much as 15 per cent and as low as 7 per cent. In Vinu Company, the operating income can be
either 12 per cent or 9 per cent. When both the companies are compared, Anu company's
business risk is higher because of its high variability in operating income compared to Vinu
company. Thus, business risk is concerned with the difference between revenue and earnings
before interest and tax. Business risk can be divided into external business is and internal
business risk.

a)Internal Business Risk

Internal business risk is associated with the operational efficiency of the firm. The operational
efficiency differs from company to company. The efficiency of operation is reflected on the
company's achievement of its pre-set goals: and the fulfillment of the promises to its inventors.

(1) Fluctuations in the sales the sales level has to be maintained. It is common in business to
lose customers abruptly because of -competition. Loss of customers will lead to a loss in
operational income. Hence, the company has to build a wide customer base through various
distribution channels. Diversified sales force may help to tide over this problem.

(2)Research and development (R&D) Sometimes the product may go out of style or become
obsolescent. It is the management, who has to overcome the problem of obsolescence by
concentrating on the in-house research and development program.

For example, if Maruti Udyog has to survive the competition, it has to keep its Research and
Development section active and introduce consumer oriented technological changes in the
automobile sector. This is often carried out by introducing sleekness, seating comfort and break
efficiency in their automobiles. New products have to be produced to replace the old one. Short
sighted cutting of R and D budget would reduce the operational efficiency of any firm.

(3) Personnel management The personnel management of the company also contributes to
the operational efficiency of the firm. Frequent strikes and lock outs result in loss of production
and high fixed capital cost. The labour productivity also would suffer. The risk of labour
management is present in all the firms.

(4) Fixed cost The cost components also generate internal risk if the fixed cost is higher in
the cost component. During the period of recession or low demand for product, the company
cannot reduce the fixed cost. At the same time in the boom period also the fixed factor cannot
vary immediately. Thus, the high fixed cost component in a firm would become a burden to the
firm.

(5) Single product The internal business risk is higher in the case of firm producing a single
product. The fall in the demand for a single product would be fatal for the firm. Further, some
products are more vulnerable to the business cycle while sonic products resist and grow against
the tide. Hence, the company has to diversify the products if it has to face the competition and
the business cycle successfully. Take for instance, Hindustan Lever Ltd., which is producing a
wide range of consumer cosmetics is thriving successfully in the business. Even in
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diversification, diversifying the product in the unknown path of the company may lead to an
internal risk. Unwieldy diversification is as dangerous as producing a single good.

B) EXTERNAL RISK

External risk is the result of operating conditions imposed on the firm by circumstances beyond
its control. The external environments in which it operates exert some pressure on the firm. The
external factors are social and regulatory factors, monetary and fiscal policies of the government,
business cycle and the general economic environment within which a firm or an industry
operates. A government policy that favors a particular industry could result in the rise in the
stock price of the particular industry. For instance, the Indian sugar and fertilizer industry depend
much on external factors.

1. Social and regulatory factors Harsh regulatory climate and legislation against the
environmental degradation may impair the profitability of the industry. Price control,
volume control, import/export control and environment control reduce the profitability of
the firm. This risk is more in industries related to public utility sectors such as telecom,
banking and transportation.

2. Political risk Political risk arises out of the change in the government policy. With a
change in the ruling party, the policy also changes. When Sri. Manmohan Singh was the
finance minister, liberalization policy was introduced. During the Bharathiya Janata
government, even though efforts are taken to augment the foreign investment, more stress
is given to Swdeshi. Political risk arises mainly in the case of foreign investment.

3. Business cycle: The fluctuations of the business cycle lead to fluctuations in the earnings
of the company. Recession in the economy leads to a drop in the output of many
industries. Steel and white consumer goods industries tend to move in tandem with the
business cycle. During the boom period, there would be hectic demand for steel products
and white consumer goods. But at the same time, they would be hit much during the
recession period. At present, the information technology industry has resisted the
business cycle and moved counter cyclically during the recession period. The effects of
the business cycle vary from one company to another. Sometimes, companies with
inadequate capital and consumer base may be forced to close down. In some other case,
there may be a fail in the profit and the growth rate may decline. This risk factor is
external to the corporate bodies and they may not be able to control it.

[Link] RISK

It refers to the variability of the income to the equity capital due to the debt capital. Financial
risk in a company is associated with the capital structure of the company. Capital structure of the
company consists of equity funds and borrowed funds. The presence of debt and preference
capital results in a commitment of paying interest or pre fixed rate of dividend. The residual
income alone would be available to the equity holders. The interest payment affects the
payments that are due to the equity investors. The debt financing increases the variability of the
returns to the common stock holders and affects their expectations regarding the return. The use
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of debt with the owned funds to increase the return to the shareholders is known as financial
leverage.

Debt financing enables the corporate to have funds at a low cost and financial leverage to the
shareholders. As long as the earnings of a company are higher than the cost of borrowed funds,
shareholders' earnings are increased. At the same time when the earnings are low, it may lead to
bankruptcy to equity holders.

RISK CLASSIFICATION (OR) TYPES OF RISK

The investment risk is categorized into two. They are

Total Risk= Systematic+ Unsystematic

Total Risk= Market Risk+ specific Risk

Total Risk= Uncontrollable + Controllable

Total Risk= External Risk + Internal Risk

SYSTEMATIC RISK: Systematic risk arises on account of the economy-wide uncertainties and
the tendency of individual securities to move together with changes in the market. This part of
risk cannot be reduced through diversification. It is also known as market risk.

Types of Systematic Risk

1) Market Risk: The variability in a security’s returns resulting from fluctuations in the
aggregate market is known as market risk. All securities are exposed to market risk including
recessions, wars, structural changes in the economy, tax law changes and even changes in
consumer preferences. Market risk is sometimes synonymously with systematic risk.

2) Interest Rate Risk: The variability in a security’s returns resulting from changes in the
level of interest rates is referred to as interest rate risk. Such changes generally affect securities
inversely; i.e., other things being equal, security prices move inversely to interest rates. The
reason for this movement is tied up with the valuation of securities. Interest rate risk affects
bonds more directly than common stocks and is a major risk that all bondholders face. As
interest rates change, bond prices change in the opposite direction.

3) Purchasing Power Risk: A factor affecting all securities is purchasing power risk, also
known as inflation risk. This is the possibility that the purchasing power of invested dollars will
decline. With uncertain inflation, the real (inflation - adjusted) return involves risk even if the
nominal return is safe (e.g., a treasury bond). This risk is related to interest rate risk, since
interest rates generally rise as inflation increases, because lenders demand additional inflation
premiums to compensate for the loss of purchasing power.

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4) Regulation Risk: Some investments can be relatively attractive to other investments

because of certain regulations o tax laws that give them an advantage of some of kind. Municipal
bonds, for example, pay interest that is exempt from local, state and federal taxation. As a result
of that special tax exemption, municipals can price bonds to yield a lower interest rate since the
net after – tax yield may still make them attractive to investors.

[Link] risk of regulatory change that adversely affect the structure of an investment is a real
danger.

5) Bull - Bear Market Risk: This risk arises from the variability in the market returns
resulting from alternating bull and bear market forces. When security index rises fairly
consistently from a low point, called a trough, over a period of time, this upward trend is called a
bull market. The bull market ends when the market index reaches a peak and starts a down ward
trend. The period during which the market declines to the next trough is called a bear market.

6) International Risk: It includes the following risks.

• Exchange Rate Risk: all investors who invest internationally in today’s increasingly
global investment arena face the prospect of uncertainty in the returns after they convert the
foreign gains back to their own currency,un like the past, when most US investors ignored
international investing

alternatives, invertors today must recognize and understand exchange rate risk, which can be
defined as the variability in returns on securities caused by currency fluctuations exchange rate
risk is sometimes called currency risk.

• Country Risk: Country risk, also referred to as political risk. It arises from the
exploitation of a politically weak group for the benefit of politically strong group. Now a day’s
the FDI’s are becomes very famous because of globalization.

• Liquidity Risk: it is associated with the particular secondary market in which a security
trade. An investment can be bought or sold quickly and without and without significant price
concession is considered liquid. The more uncertainty about the time element and the price
concession, the greater the liquidity risks. A Treasury bill has little or no liquidity risk, where as
a small OTC stock may have substantial liquidity risk

FACTORS WHICH INFLUENCE SYSTEMATIC RISK:

• Government Policies
• Inflation
• Interest Rates
• Foreign Exchange Fluctuations
• Political changes
• Economic Conditions

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UN – SYSTEMATIC RISK: Unsystematic risk arises from the unique uncertainties of

individual securities. It is also called unique risk. Unsystematic risk can be totally reduced
through diversification.

unsystematic risk is unique and peculiar to a firm or an industry. Unsystematic risk stems from
managerial inefficiency, technological change in the production process, availability of raw
material, changes in the consumer preference, end labour problems. The nature and magnitude of
the above mentioned factors differ from industry to industry, and company to company. They
have to be analyzed separately for each industry and firm. The changes in the consumer
preference affect the consumer products like television sets, washing. Machines, refrigerators,
etc. more than they affect the iron and steel industry. Technological changes affect the
information technology industry more than that of consumer product industry. Thus, it differs
from industry to industry. Financial leverage of the companies that is debt-equity portion of the
companies differs from each other. The nature and mode of raising finance and paying back the
loans, involve a risk element. All these factors form the unsystematic risk and contribute a
portion in the total variability of the return. Broadly, unsystematic risk can be classified into:

Risk preference

A risk-averse investor will choose among investments with the equal rates of return, the
investment with lowest standard deviation. Similarly, if investments have equal risk (standard
deviations), the investor would prefer the one with higher return.

A risk-neutral investor does not consider risk, and would always prefer investments with higher
returns.

A risk-seeking investor likes investments with higher risk irrespective of the rates of return. In
reality, most (if not all) investors are risk-averse.

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FACTORS WHICH INFLUENCE UN SYSTEMATIC RISK

• Managerial inefficiency
• Technical Change
• Inefficiency of R&D
• Availability of R/M
• Changes in consumer preferences

Examples of un systematic risk

1. The company workers declare strike.

2. The R&D expert leaves the company.
3. A formidable competitor enters into market.
4. The company losses a big contract.
5. The company makes a breakthrough in process innovation.
6. The government increases custom duty on the material used by the company.

BOND VALUATION
VALUATION OF SECURITIES:

Valuation of Financial Securities, Instruments & Derivatives. Securities Valuation means

determining the market value of equity instruments (viz. common stock and preferred stock),
debt instruments (viz. ... options and futures) issued by government agencies, financial
institutions and corporate organizations. The main factors driving the securities market value
include liquidity, demand and supply of similar instruments, stock market rates of similar
securities, present value of future cash flows etc

TYPES OF SECURITIES

a) Equity shares (or) Common shares: Represent ownership in a company and a claim
(dividends) on a portion of profits. Investors get one vote per share to elect the board
members, who oversee the major decisions made by management. Over the long term,
common stock, by means of capital growth, yields higher returns than almost every other
investment. This higher return comes at a cost since common stocks entail the most risk.
If a company goes bankrupt and liquidates, the common shareholders will not receive
money until the creditors, and preferred shareholders are paid.

b) Preferred share represents some degree of ownership in a company but usually doesn't
come with the same voting rights. (This may vary depending on the company.) With
preferred shares investors are usually guaranteed a fixed dividend forever. This is
different than common stock, which has variable dividends that are never guaranteed.
Another advantage is that in the event of liquidation preferred shareholders are paid off
before the common shareholder (but still after debt holders). Preferred stock may also be
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callable, meaning that the company has the option to purchase the shares from
shareholders at any time for any reason (usually for a premium). Some people consider
preferred stock to be more like debt than equity.

c) Bond- an issued security establishing its holder's right to receive from the issuer of the
bond, within the time period specified therein, its value and the interest fixed therein on
this value or other property equivalent. The bond may provide for other property rights of
its holder, where this is not contrary to legislation.
d) Debentures: A debenture is a type of debt instrument that is not secured by physical
assets or collateral. Debentures are backed only by the general creditworthiness and
reputation of the issuer. Both corporations and governments frequently issue this type of
bond to secure capital.
e) Like other types of bonds, debentures are documented in an indenture.
e) Units of mutual funds: An investment programme funded by shareholders that trade in
diversified holdings and is professionally managed. A mutual fund is a professionally managed
investment fund that pools money from many investors to purchase securities. These investors
may be retail or institutional in nature. Mutual funds have advantages and disadvantages
compared to direct investing in individual securities.

APPROACHES OF VALUATION

BOND VALUATION
Bond valuation: In finance, a bond is an instrument of indebtedness of the bond issuer to the
holders. The most common types of bonds include municipal bonds and corporate bonds. The
bond is a debt security, under which the issuer owes the holders a debt and (depending on the
terms of the bond) is obliged to pay them interest (the coupon) or to repay the principal at a later
date, termed the maturity date. Interest is usually payable at fixed intervals (semiannual, annual,
and sometimes monthly). Very often the bond is negotiable, that is, the ownership of the
instrument can be transferred in the secondary market. This means that once the transfer agents
at the bank medallion stamp the bond, it is highly liquid on the secondary market.

FEATURES OF BOND

1) Principal: Nominal, principal, par, or face amount is the amount on which the issuer pays
interest, and which, most commonly, has to be repaid at the end of the term. Some
structured bonds can have a redemption amount which is different from the face amount
and can be linked to the performance of particular assets.

2) Maturity: The issuer has to repay the nominal amount on the maturity date. As long as all
due payments have been made, the issuer has no further obligations to the bond holders
after the maturity date. The length of time until the maturity date is often referred to as
the term or tenure or maturity of a bond. The maturity can be any length of time, although
debt securities with a term of less than one year are generally designated money market
instruments rather than bonds. Most bonds have a term of up to 30 years. Some bonds
have been issued with terms of 50 years or more, and historically there have been some
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issues with no maturity date (irredeemable). In the market for United States Treasury
securities, there are three categories of bond maturities:

O Short term (bills): maturities between one and five years;

O Medium term (notes): maturities between six and twelve years; o Long term (bonds):
maturities longer than twelve years.

3) Coupon: The coupon is the interest rate that the issuer pays to the holder. Usually this
rate is fixed throughout the life of the bond. It can also vary with a money market index,
such as LIBOR, or it can be even more exotic. The name "coupon" arose because in the
past, paper bond certificates were issued which had coupons attached to them, one for
each interest payment. On the due dates the bondholder would hand in the coupon to a
bank in exchange for the interest payment. Interest can be paid at different frequencies:
generally semi-annual, i.e. every 6 months, or annual. Bond issued by the Dutch East
India Company in 1623

4 )Yield: The yield is the rate of return received from investing in the bond. It usually refers
either to The current yield, or running yield, which is simply the annual interest payment divided
by the current market price of the bond (often the clean price).The yield to maturity, or
redemption yield, which is a more useful measure of the return of the bond. This takes into
account the current market price, and the amount and timing of all remaining coupon payments
and of the repayment due on maturity. It is equivalent to the internal rate of return of a bond.

4) Credit quality: The quality of the issue refers to the probability that the bondholders will
receive the amounts promised at the due dates. This will depend on a wide range of
factors. High-yield bonds are bonds that are rated below investment grade by the credit
rating agencies. As these bonds are riskier than investment grade bonds, investors expect
to earn a higher yield. These bonds are also called junk bonds.

5) Market price: The market price of a tradable bond will be influenced, amongst other
factors, by the amounts, currency and timing of the interest payments and capital
repayment due, the quality of the bond, and the available redemption yield of other
comparable bonds which can be traded in the markets. The price can be quoted as clean
or dirty. "Dirty" includes the present value of all future cash flows, including accrued
interest, and is most often used in Europe. "Clean" does not include accrued interest, and
is most often used.

TYPES OF BONDS
1) Government Bonds: Government can be issued by national governments as well as lower
levels of government. At the national or federal level, these government bonds are known

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as “sovereign” debt, and are backed by the ability of a nation to tax its citizens and to
print currency.

2) bonds: Municipal, also known as "munis" are bonds issued by state or local governments
or by government agencies. These bonds are typically riskier than national government
bonds; cities don't go bankrupt that often, but it can happen (for example in Detroit and
Stockton, CA). The major advantage to munis for investors is that the returns are free
from federal tax, and furthermore, state and local governments will often consider their
debt non-taxable for residents, thus making some municipal bonds completely tax free,
sometimes called triple-tax free. Because of these tax savings, the yield on a muni is
usually lower than that of an equivalent taxable bond. Depending on your personal
situation, a muni can be a great investment on an after-tax basis.

3) Corporate Bonds: The other major issuers of bonds are corporations, and corporate bonds
make up a large portion of the overall bond market. Large corporations have a great deal
of flexibility as to how much debt they can issue: the limit is generally whatever the
market will bear. A corporate bond is considered short-term corporate when the maturity
is less than five years; intermediate is five to 12 years, and long-term is over 12 years.

4) Convertible bonds: Convertible bonds are debt issued by corporations that give the
bondholder the option to convert the bonds into shares of common stock at a later date.
The rate at which investors can convert bonds into stocks, that is, the number of shares an
investor gets for each bond, is determined by a metric called the conversion rate. The
conversion rate may be fixed or change over time depending on the terms of the offering.

5) Callable bonds: Callable bonds are bonds that can be redeemed by the issuer at some
point prior to its maturity. If interest rates have declined since the company first issued
the bond, the company is likely to want to refinance this debt at a lower rate of interest. In
this case, the company calls its current bonds and reissues them at a lower rate of interest.
Callable bonds typically have a higher interest rate to account for this added risk to
investors. When homeowners refinance a mortgage, they are calling in their older debt
for a new loan at better rates.

6) Corporate Bonds: A company can issue bonds just as it can issue stock. Large
corporations have a lot of flexibility as to how much debt they can issue: the limit is
whatever the market will bear. Generally, a short-term corporate bond has a maturity of
less than five years, intermediate is five to 12 years and long term is more than 12 years.

7) Term Bonds: Term are bonds from the same issue that share the same maturity dates.
Term bonds that have a call feature can be redeemed at an earlier date than the other
issued bonds. A call feature, or call provision, is an agreement that bond issuers make
with buyers. This agreement is called an "indenture," which is the schedule and the price
of redemptions, plus the maturity dates.

8) Fixed rate bonds have a coupon that remains constant throughout the life of the bond.
A variation is stepped-coupon bonds, whose coupon increases during the life of the bond.
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9) Zero-coupon bonds: Zero-coupon bonds (zeros) pay no regular interest. They are
issued at a substantial discount to par value, so that the interest is effectively rolled up to
maturity (and usually taxed as such). The bondholder receives the full principal amount
on the redemption date. An example of zero coupon bonds is Series E savings bonds
issued by the U.S. government.

10) High-yield bonds: High-yield bonds (junk bonds) are bonds that are rated below
investment grade by the credit rating agencies. As these bonds are riskier than investment
grade bonds, investors expect to earn a higher yield.

11) Convertible bonds: Convertible bonds let a bondholder exchange a bond to a number
of shares of the issuer's common stock. These are known as hybrid securities, because
they combine equity and debt features.

12) Exchangeable bonds: Exchangeable bonds allows for exchange to shares of a

corporation other than the issuer.

13) Bonds: Bearer is an official certificate issued without a named holder. In other words,
the person who has the paper certificate can claim the value of the bond. Often they are
registered by a number to prevent counterfeiting, but may be traded like cash. Bearer
bonds are very risky because they can be lost or stolen.

14) Registered bonds: Registered bond is a bond whose ownership (and any subsequent
purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond.
Interest payments and the principal upon maturity are sent to the registered owner.

15) Social impact bonds: Social impact bonds are an agreement for public sector entities to pay
back private investors after meeting verified improved social outcome goals that result in public
sector savings from innovative social program pilot projects.

METHODS OF BOND VALUATION:

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Understanding Alpha Risk

Alpha Risk measures the risk of comparing two different sets of data and determining that the differences are
significant, when in fact they are not significant. For example, this can occur when a team looks at data from a
current operational process and the possible outcome if they changed an aspect of the process. An analysis of
the two might show a difference in outcomes, such as less product defects. The team recommends that this
single change will provide significantly different outcomes. Executives agree to put the change into action.
Then, outcomes do not improve – or may even worsen.

That’s a common mistake. It’s known as a Type I error.

Alpha Risk measures the chance of a Type I error. The primary variable that increases the chance of Alpha
Risk is the sample size used in the statistical test or comparison. The smaller the sample size, the higher the
Alpha Risk becomes. Conversely, larger sample sizes lower Alpha Risk.

Examples of Alpha Risk

Small sample sizes plague statistical analysis in everything from sports teams to financial investments. For
example, baseball teams may overvalue a hitter who goes on a hot streak, deeming the statistical difference
between his stats and those of his fellow players as significant. He’s made a starter, but a month later, he’s
back on the bench, his hitting numbers falling.

The same thing can happen to market investors who place too much emphasis on short-term stock movement,
then get burned when the stock price falls. In both cases, regression to the mean has occurred. This refers to the
statistical phenomenon in which a period of natural variation in repeated data (in these examples, more hits or
higher stock prices) are typically followed by measurements closer to the long-term mean.

Alpha Risk also presents itself in medical research. If a new medicine is tested and the condition it treats
improves, researchers might conclude that the medicine made the difference. But in just one lab test, other
variables could have caused the patient’s improvement. That’s why multiple tests are needed to avoid making a
Type I mistake in research.

The best way to avoid Alpha Risk is to increase the size of the statistical sample. Teams then have a better
chance of capturing a more representative sample of process outcomes.

YIELD TO PUT

Yield to put (YTP) is the interest rate that investors would receive if they held the bond until its
put date. To calculate yield to put, the same modified equation for yield to call is used except the
bond put price replaces the bond call value and the time until put date replaces the time until call.
Date.

Yield Curve
The shape of the curve helps investors get a sense of the likely future course of interest rates. A
normal upward-sloping curve means that long-term securities have a higher yield, whereas an
inverted curve shows short-term securities have a higher yield.

The Yield Curve is a graphical representation of the interest rates on debt for a range of
maturities. It shows the yield an investor is expecting to earn if he lends his money for a given
period of time. The graph displays a bond’s yield on the vertical axis and the time to maturity
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across the horizontal axis. The curve may take different shapes at different points
in the economic cycle, but it is typically upward sloping.

A fixed income Analyst may use the yield curve as a leading economic indicator, especially
when it shifts to an inverted shape, which signals an economic downturn, as long-term returns
are lower than short-term returns.

Types of Yield Curves

1. Normal

This is the most common shape for the curve and, therefore, is referred to as the normal curve.
The normal yield curve reflects higher interest rates for 30-year bonds as opposed to 10-year
bonds. If you think about it intuitively, if you are lending your money for a longer period of time,
you expect to earn a higher compensation for that.

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The positively sloped yield curve is called normal because a rational market will generally want
more compensation for greater risk. Thus, as long-term securities are exposed to greater risk, the
yield on such securities will be greater than that offered for lower-risk short-term securities.

A longer period of time increases the probability of unexpected negative events taking place.
Therefore, a long-term maturity will typically offer higher interest rates and have
higher volatility.

2. Inverted

An inverted curve appears when long-term yields fall below short-term yields. An inverted yield
curve occurs due to the perception of long-term investors that interest rates will decline in the
future. This can happen for a number of reasons, but one of the main reasons is the expectation
of a decline in inflation.

When the yield curve starts to shift toward an inverted shape, it is perceived as a leading
indicator of an economic downturn. Such interest rate changes have historically reflected the
market sentiment and expectations of the economy.

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3. Steep

A steep curve indicates that long-term yields are rising at a faster rate than short-term yields.
Steep yield curves have historically indicated the start of an expansionary economic period. Both
the normal and steep curves are based on the same general market conditions. The only
difference is that a steeper curve reflects a larger difference between short-term and long-term
return expectations.

4. Flat

A flat curve happens when all maturities have similar yields. This means that the yield of a 10-
year bond is essentially the same as that of a 30-year bond. A flattening of the yield curve
usually occurs when there is a transition between the normal yield curve and the inverted yield
curve.

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5. Humped

A humped yield curve occurs when medium-term yields are greater than both short-term yields
and long-term yields. A humped curve is rare and typically indicates a slowing of economic
growth.

Influencing Factors

1. Inflation

Central banks tend to respond to a rise in expected inflation with an increase in interest rates. A
rise in inflation leads to a decrease in purchasing power and, therefore, investors expect an
increase in the short-term interest rate.

2. Economic Growth

Strong economic growth may lead to an increase in inflation due to a rise in aggregate demand.
Strong economic growth also means that there is a competition for capital, with more options to

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invest available for investors. Thus, strong economic growth leads to an increase in yields and a
steeper curve.

3. Interest Rates

If the central bank raises the interest rate on Treasuries, this increase will result in higher demand
for treasuries and, thus, eventually lead to a decrease in interest rates.

Importance of the Yield Curve

1. Forecasting Interest Rates

The shape of the curve helps investors get a sense of the likely future course of interest rates. A
normal upward-sloping curve means that long-term securities have a higher yield, whereas an
inverted curve shows short-term securities have a higher yield.

2. Financial Intermediary

Banks and other financial intermediaries borrow most of their funds by selling short-term
deposits and lend by using long-term loans. The steeper the upward sloping curve is, the wider
the difference between lending and borrowing rates, and the higher is their profit. A flat or
downward sloping curve, on the other hand, typically translates to a decrease in the profits of
financial intermediaries.

3. The Tradeoff Between Maturity and Yield

The yield curve helps indicate the tradeoff between maturity and yield. If the yield curve is
upward sloping, then to increase his yield, the investor must invest in longer-term securities,
which will mean more risk.

4. Overpriced or Underpriced Securities

The curve can indicate for investors whether a security is temporarily overpriced or underpriced.
If a security’s rate of return lies above the yield curve, this indicates that the security is
underpriced; if the rate of return lies below the yield curve, then it means that the security is
overpriced.

Yield Curve Theories

1. Pure Expectation Theory

This theory assumes that the various maturities are substitutes and the shape of the yield curve
depends on the market’s expectation of future interest rates. According to this theory, yields tend

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to change over time, but the theory fails to define the details of yield curve shapes. This theory
ignores interest rate risk and reinvestment risk.

2. Liquidity Preference Theory

This theory is an extension of the Pure Expectation Theory. It adds a premium called liquidity
premium or term premium. This theory considers the greater risk involved in holding long-term
debts over short-term debts.

3. Segmented Markets Theory

The segmented markets theory is based on the separate demand and supply relationship between
short-term securities and long-term securities. It is based on the fact that different maturities of
securities cannot be substituted for one another.

Since investors will generally prefer short-term maturity securities over long-term
maturity securities because the former offers lower risk, then the price of short-term securities
will be higher, and thus, the yield will be correspondingly lower.

4. Preference Habitat Theory

This is an extension of the Market Segmentation Theory. According to this theory, investors
prefer a certain investment horizon. To invest outside this horizon, they will require some
premium. This theory explains the reason behind long-term yields being greater than short-term
yields.

BOND IMMUNIZATION: Immunization is a technique that makes the bond portfolio holder to
be relatively certain about the promised stream of cash flows. The bond interest rate risk arises
from the changes in the market interest rate. The market rate affects the coupon rate and the price
of the bond. In the immunization process, the coupon rate risk and the price risk can be made to
offset each other. Whenever there is an increase in the market interest rate, the prices of the
bonds fall. At the same time the newly issued bonds offer higher interest rate. The coupon can be
reinvested in the bonds offering higher interest rate and losses that occur due to the fall in the
price of bond can be offset and the portfolio is said to be immunized.

STRATEGIES FOR INVESTING IN BONDS. IMMUNIZATION

Two types of strategies investing in bonds:

Passive management strategies;
Active management strategies.
Passive bond management strategies are based on the proposition that bond prices are
determined rationally, leaving risk as the portfolio variable to control.

FEATURES OF THE PASSIVE MANAGEMENT STRATEGIES:

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1. They are the expression of the little volatile in the investor’s forecasts regarding interest rate
and/ or bond price;
2. Have a lower expected return and risk than do active strategies;
3. The small transaction costs.
The passive bond management strategies include following two broad classes of strategies:
Buy and hold strategies; Indexing strategies.
Buy and hold strategy is the most passive from all passive strategies. This is strategy for any
investor interested in non active investing and trading in the market. An important part of this
strategy is to choose the most promising bonds that meet the investor’s requirements. Simply
because an investor is following a buy-and-hold strategy does not mean that the initial selection
is unimportant. An investor forms the diversified portfolio of bonds and does not attempt to trade
them in search for the higher return. Following this strategy, the investor has to make the
investment decisions only in these cases:

The bonds held by investor lost their rating, it decreases remarkably;

The term to maturity ended;
The bonds were recalled by issuer before term to maturity

Using Indexing strategy the investor forms such a bond portfolio which is identical to the well
diversified bond market index. While indexing is a passive strategy, assuming that bonds are
priced fairly, it is by no means a simply strategy. Each of the broad bond indexes contains
thousands of individual bonds. The market indices are continually rebalanced as newly issued
bonds are added to the index and existing bonds are dropped from the index as their maturity
falls below the year. Information and transaction costs make it practically impossible to purchase
each bond in proportion to the index. Rather than replicating the bond index exactly, indexing
typically uses a stratified sampling approach. The bond market is stratified into several
subcategories based on maturity, industry or credit quality. For every subcategory the percentage
of bonds included in the market index that fall in that subcategory is computed. The investor then
constructs a bond portfolio with the similar distribution across the subcategories.

There are various indexing methodologies developed to realize this passive strategy. But for all
indexing strategies the specific feature is that the return on bond portfolio formed following this
strategy is close to the average bond market return.
Active bond management strategies are based on the assumption that the bonds market is not
efficient and, hence, the excess returns can be achieved by forecasting future interest rates and
identifying over valuate bonds and under valuated bonds.
There are many different active bond management (speculative) strategies.
the active reaction to the forecasted changes of interest rate; Bonds swaps; Immunization.
The essentiality of the active reaction to the anticipated changes of interest rate strategy: if the
investor anticipates the decreasing in interest rates, he / she is attempting to prolong the maturity
of the bond portfolio or duration, because long-term bonds’ prices influenced by decrease in
interest rates will increase more than short-term bonds’ prices; if the increase in interest rates is
anticipated, investor attempts to shorten the maturity of the bond portfolio or duration, by
including more bondswith the shorter maturity of the portfolio.

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The essentiality of bond swaps strategies is the replacement of the bond which is in the portfolio
by the other bond which was not in the portfolio for the meantime. The aim of such replacement
– to increase the return on the bond portfolio based on the assumptions about the tendencies of
changes in interest rates. There are various types of swaps, but all are designed to improve the
investor’s portfolio position. The bond swaps can be:
1 Substitution swap;
2 Interest rate anticipation swap;
3 Swaps when various bond market segments are used.
The essentiality of substitution swap: one bond in the portfolio is replaced by the other bond
which fully suits the changing bond by coupon rate, term to maturity, credit rating, but suggests
the higher return for the investor. The risk of substitution swap can be determined by the
incorrect rating of the bonds and the exchange of the unequal bonds causing the loss of the
investor.
Interest rate anticipation swap is based on one of the key features of the bond
– the inverse relationship between the market price and the interest rate (this means that
when the interest rates are growing, the bonds prices are decreasing and vice versa. The investor
using this strategy bases on his steady belief about the anticipated changes of interest rates and
attempts to change frequently the structure of his/ her bond portfolio seeking to receive the
abnormal return from the changes in bonds’ prices. This type of swaps is very risky because of
the inexact and unsubstantiated forecasts about the changes in the interest rates.
Swaps when various bond market segments are used are based on the assessment of differences
of yield for the bonds in the segregated bond market segments.

Swaps when various bond market segments are used are based on the assessment of differences
of yield for the bonds in the segregated bond market segments.
The differences of the yields in the bond market are called yield spreads and their existence can
be
explained by differences between
• Quality of bonds credit (ratings);
• Types of issuers of the bonds(government, company, etc.);
• The terms to maturity of the bonds (2 years, 5 years, etc.).
This strategy is less risky than the other swaps’ strategies; however the return for such a portfolio
is lower also. Duration is the present value weighted average of the number of years over which
investors receive cash flow from the bond. It measures the economic life or the effective maturity
of a bond (or bond portfolio) rather than simply its time to maturity. Such concept, called
duration (or Macaulay's duration) was developed by Frederick Macaulay. Duration measures the
time structure of a bond and the bond’s interest rate risk. The time structure ways. The common
way to state is how many years until the bond matures and the principal money is paid back. This
is known as asset time to maturity or its years to maturity. The other way is to measure the
average time until all interest coupons and the principal is recovered. This is called Macaulay’s
duration. Duration is defined as the weighted average of time periods to maturity, weights being
present values of the cash flow in each time period. DURATION AND PRICE CHANGESThe
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

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maturity changes. The relationship between the duration of a bond and its price volatility for a
change in the market the Macaulay Duration
In order to arrive at the modified duration of a bond, it is important to understand the numerator
component – the Macaulay duration – in the modified duration formula.

The Macaulay duration is the weighted average of time until the cash flows of a bond are
received. In layman’s term, the Macaulay duration measures, in years, the amount of time
required for an investor to be repaid his initial investment in a bond. A bond with a higher
Macaulay duration will be more sensitive to changes in interest rates.

The formula for Macaulay duration is as follows:

Where:

ti is the time period

PVi is the present value of the time-weighted cash flow
V is the present value of all cash flow.
Below is an example of calculating Macaulay duration on a bond.

Example of Macaulay Duration

Tim holds a 5-year bond with a face value of $1,000 and an annual coupon rate of 5%. The
current rate of interest is 7%, and Tim would like to determine the Macaulay duration of the
bond. The calculation is given below:

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The Macaulay duration for the 5-year bond is calculated as $4152.27 / $918.00 = 4.52 years.
Putting it Together
Now that we understand and know how to calculate the Macaulay duration, we can determine the
modified duration.
Using the example above, we simply insert the figures into the formula to determine the
modified duration:

The modified duration is 4.22.

Interpreting the Modified Duration

How do we interpret the result above? Recall that modified duration illustrates the effect of a
100-basis point (1%) change in interest rates on the price of a bond.

Therefore,

 If interest rates increase by 1%, the price of the 5-year bond will decrease by 4.22%.
 If interest rates decrease by 1%, the price of the 5-year bond will increase by 4.22%.

The modified duration provides a good measurement of a bond’s sensitivity to changes in

interest rates. The higher the Macaulay duration of a bond, the higher the resulting modified
duration and volatility to interest rate changes.

Modified duration, a formula commonly used in bond valuations, expresses the change in the
value of a security due to a change in interest rates.
Formula for Modified Duration
The formula for modified duration is as follows:

Modified Duration - Formula

Where:

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Macaulay Duration is the weighted average number of years an investor must maintain his or her
position in the bond where the present value (PV) of the bond’s cash flow equals the amount
paid for the bond. In other words, it is the time it would take for an investor to retrieve the money
initially invested in the bond
YTM stands for Yield to Maturity and is the total return on a bond if held until maturity
n is the number of coupon periods per year.

FUNDAMENTAL ANALYSIS

FRAMEWORK OF FUNDAMENTAL ANALYSIS: The intrinsic value of an equity share

depends on a multitude of factors. The earning of the company the growth rate and the risk
exposure of the company has a direct bearing on the price of the share.

Fundamental analysis consists of

A. Economic analysis

B. Industry analysis

C. Company analysis

A . ECONOMIC ANALYSIS: The level of economic activity has an impact on investment in

many ways. If the economy grows rapidly, the industry can also be expected to show Rapid
growth and vice versa. The economics analysis is essential to understand the behavior of the
stock prices the economic analysis factors for as follows

a) Gross Domestic Product (GDP): GDP indicate the rate of growth of the economy. GDP
represents the aggregate value of the goods and services produced in the economy. The higher
growth rate are more favorable to the stock market.

b) Savings and investments: It is obvious that growth requires investment which in turn
requires substantial amount of domestic savings. The saving the Savings and investment patterns
of public affect the stocks to a great extent.

c) Inflation: High rate of inflation is harmful to the stock market. Inflation means increasing
of share prices.
d) Interest rates: the interest rate affects the cost of Financing to the firms. A decrease in
interest rate implies lower cost of finance for firms and profitability.
e) Budget: The budget draft provides an elaborate account of the government
revenues and expenditure. A deficit budget may affect the cost of production. Supplies budget
may results in deflation. Hence balanced budget is highly favorable to the stock markets.

f) Tax structure: The tax structure also influence the stock market low tax structure will
give a scope to increase to investment in stock market.

g) The balance of payment: The balance of payment is a measure of the strength of rupee on
external account receipts-payments is the balance of payment receipts are more payments are
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less than the balance of payment is in surplus. Surplus balance of payment is a positive effect on
the stock market.

h) Monsoon and Agriculture: Agriculture is also directly and indirectly affects the stock
market because some Industries like sugar, cotton, Textiles and food depends on monsoon and
Agriculture.

i) Infrastructure facilities: Infrastructure facilities are essential for the growth of industries
and Agricultural sector. This will impact on stock market.

B INDUSTRY ANALYSIS
: After conducting Economic analysis look into various industries. Industry is a group of firms
that have similar the technological of productions and produce similar products. Analyzing
different industries is call industry analysis.

KEY CHARACTERISTICS/ FACTORS OF INDUSTRY ANALYSIS:

1. Past sales and earnings: to analyze industry past sales and earnings will help us to forecast the
future of the industry.
2. Permanence: if the analyst feels the technology used in the particular industry is having
the long future the investment will give more returns.
3. Government attitude towards industry: This analysis helps the investor to know the
government is positive or negative towards the particular Industry. If the government is favorable
about industry than the goods return in the future.
4. Labour conditions: labour conditions are also important to the investors to know the industry
future.
5. Competitive conditions: the industry competitive conditions is healthy than it is good sign for
profits visa versa.
6. Product differentiation advantages: That selected industry producing unique product that
particular industry have more demand.
7. SWOT analysis: every investor has to analysis that the internal strength and weakness.
External opportunities and threats of the industry
8. Industries share price relative Industry: Industry share price and earning also influence the
investors to purchase or sale of shares

CLASSIFICATION BY BUSINESS CYCLE/INDUSTRY CLASSIFICATION:

.Growth industries: These industries grow consistently and its growth and its growth may exceed
the average growth of the economy.
High rate of earnings
Wider expansion of business
By considering technological changes
By considering 20th industry: - 1) Automobile industry 2) Aero plane industry
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2. Cyclical Industries: These industries mostly likely the benefit from a period of economic
prosperity and most likely suffers from economic recession.
Ex: Fridges, Washing machines and Seasonal products.
3. Defensive Industries: These industries specify the movement of the business cycle.
Defensive industries often contain firms whose securities on investor might hold for income.
Food and shelter are the basic requirements of humanity. These types of industries we can
consider as defensive industries.
4. Cyclical Growth Industries: These industries pass both characteristics of cyclical growth
industries. Ex: Automobile industries; because these industry experiences period of stagnation,
decline but they grow tremendously.

INDUSTRY LIFE CYCLE:

The industry life cycle theory is generally attitude to Julius grodensky. The life cycle of the
industry is separated into 4 well designer stages such as:

[Link]/Pioneering stage

[Link] growth stage

[Link] stage

[Link] stage

1. Introduction/Pioneering stage: In this stage the demand of the product is low. Company
tries to develop branded name and image in this stage it is difficult to select company is
because the survival rate is unknown.
Example: Genetic engineering
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2. Growth stage: this stage starts with the appearance of surviving firms from the pioneering
stage in this stage companies is growth strongly in market share and financial
performance. This will create domain for company sharing.
Example: Software Industry

3. Maturity stage: In this stage is the growth rate tense to Moderate and the rate of the
growth would be more or less equal to the industrial growth rate or the Gross Domestic
Product growth rates. Sales may be increasing at a slower rate. Indicates labour cost
enhancing in technology and stationery demands.
4. Declining stage: In the stage demand for the particular product and the earning of the
companies in the industry decline. Nowadays very few customers using black and white TV.
Innovation of new product and change in customer preference lead to this stage it is better to
avoid investing in the share of the low growth Industries even in the Boom period.

COMPANY ANALYSIS: After analyzing economic and industry analysis investor look into
company analysis. Analyzing company condition is called company analysis. For earning profits
investors apply a simple and common sense decision rule of maximization. That is:
•Buy the share at a low price
•Sell the share at a high price
The above decision rule is very simple to understand, but difficult to apply in actual price. For
this investor need to knowhow to find out whether the price of a company’s share is low or
high?What is the benchmark used to compare the price of the share?

These values are depending on Economy, Industry and Company fundamentals.

Company level analysis provides a direct link to investor’s action and his investment goals in
operational terms. The following fundamentals we have to analyze for knowing intrinsic value of
the security.

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FACTORS
:-The first variable that influences future earnings is competitive edge. For
competitive of any company we have to see marketing results of the firm in comparison to
industry. This is determined by the share of the company in the industry, growth of its sales and
stability of sales.
: Before we start analysis of company we should see its accounting
policies. There is a risk of faulty interpretation of corporate earnings and consequent bad
judgment in purchasing or selling stock. The accounting variations in reporting cost, expenses
and extraordinary items could change earnings to a great extent.
The return on equity holder’s investment can be magnified by using financial
leverage, i.e. using debt financing instead of equity financing. This use of financial leverage may
be measured by capitalization ratios which indicate the extent to which the firm finances its
assets by use of debt or preference shares. These ratios are also referred as debt ratios.
Management: Some experts believe that the quality of a company’s management may be
single most important influence on its future profitability and overall success. The analysts can
evaluate management by getting information on some specific questions such as listed below.
i. What is the age and experience characteristic of management?
ii. How effective is the company’s strategic planning?
iii. Has company developed and followed a sound marketing strategy?
Operating efficiency: The operating efficiency and the earnings of the company are directly
influenced by the company’s operating characteristics. A company that is constantly expanding
its physical facilities and continues to operate at full capacity is more likely to produce profits
and earnings in future.
Financial performance: The analyst has to analyze financial statements for knowing financial
strengths and weaknesses of the company; which helpful for identifying intrinsic value of the
security. The following tools are to be used for analyzing financial strengths and weaknesses of
the company. i.e Ratio analysis, Comparative analysis, Common size analysis, Trend analysis,
Funds flow analysis, Cash flow analysis, Break even analysis.
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SWOT Analysis

SWOT analysis is a strategic planning tool used to evaluate the strengths, weaknesses,
opportunities, and threats involved in a business venture, project, or in some cases, an individual.
A SWOT analysis serves as a foundation for strategic planning, providing a holistic view of
factors influencing a particular situation, enabling better decision-making and strategy
formulation.
• Strength: Strength of a company can be identified from internal attributes and resources that
give an entity an advantage over others. These could include factors like a strong brand, skilled
workforce, unique technology, or efficient processes. Investing in companies with strong
fundamentals or unique competitive advantages can be a part of a strategy focusing on long-term
growth.

• Weakness: Weaknesses could involve issues such as poor management, limited resources,
outdated technology, or high production costs, placing the entity at a disadvantage compared to
others. Recognizing weaknesses is crucial for risk management and strategy formulation.
Investments with glaring weaknesses might be approached cautiously or may require specific
strategies to mitigate risks.

• Opportunities: Opportunities indicates the external factors that could be beneficial if leveraged
properly. Opportunities might arise from market trends, new technologies, changing consumer
behavior, or even regulatory changes. Investing in sectors poised for growth or companies with
potential for expansion due to market shifts can be a part of a growth-oriented strategy.
Opportunities in emerging markets, technological advancements, or shifting consumer trends can
guide investors to allocate resources strategically.

• Threats: External elements that could pose a risk or challenge to the entity can be identified as
threats to the company’s growth. Threats could come from competitors, economic downturns,
changing regulations, or technological disruptions. Understanding threats is vital for risk
assessment and mitigation. Potential threats like industry disruptions, regulatory changes, or
intense competition can influence investment decisions. Strategies might involve diversification
across industries or regions to mitigate sector-specific risks or investing in companies capable of
adapting to market changes.

Porter’s Five Forces Analysis

The concept of Porter’s Five Forces was coined by Michael Porter, a Professor of Strategy at
Harvard Business school. It states that a company’s profitability in an industry is determined by
five-industry factor – Bargaining Power of Buyers, Bargaining Power of Suppliers, Rivalry
among Existing Competitors, Threats of Substitutes products, and Threat of New Entrants.
Porter’s Five Forces Analysis helps investors evaluate the attractiveness of an industry and make
informed investment decisions by understanding the competitive forces at play.

• Bargaining Power of Buyers: Bargaining power of buyers refer to the ability to put pressure
on the company and show the consumer power to the price of the product. An industry with high

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bargaining power of buyers is one where buyers can choose from a variety of products offered by
multiple companies. Now a days, power of customers is high in many industries to attract buyers
for the company as price lure customers. Companies gives out offers and discounts for attracting
customers. If buyers have limited power, companies can maintain higher prices and better profit
margins. Strong brand loyalty, unique products, or a lack of substitutes
can limit the ability of buyers to negotiate prices down.

• Bargaining Power of Suppliers: Bargaining power of suppliers refer to the pressure put by the
suppliers on the company for their raw materials. The power of bargaining of suppliers decreases
when there are more suppliers in order to attract companies. The power of bargaining of
suppliers increases when there are less suppliers as the demand of suppliers are high. It is often
determined by how much value addition does a supplier do in the raw material or finished
product that is sold by them. The cost of switching from one supplier to another, for a particular
raw material, determines the bargaining power of that supplier. When suppliers have limited
bargaining power, it can benefit investors. If a company can control its input costs or switch
easily between suppliers without affecting quality or price, it creates stability and potentially
higher margins for the invested company.

• Rivalry among Existing Competitors: Companies having same idea or moto will be having
rivalry between themselves. There are many advantages by this factor. Companies will have
price wars and discounts for products to attract customers. The quality of service and interaction
with customer increases to get attention from consumers. These rivalries will influence positively
in new innovation and marketing attempts. High rivalry can lead to reduced profitability. If
competitive rivalry is low, it can be beneficial for investors. In industries where a few dominant
players control the market, they often enjoy higher profits due to limited competition, provided
they maintain their market position.

• Threats of Substitutes products: Substitute products are products that have functions and use
same as the product produced by a company. Working on a business that has high chance of
substitute products increase the risk on marketing. An industry that has less differentiated
products has the highest risk. When there are few viable substitutes, it can be positive for
investors. Companies in such industries are often protected from losing market share to
alternative products or
services, allowing for more consistent revenue and profits.

• Threat of New Entrants: Threat of new entrants refers to the risk by the newly formed
competitors on company’s business. Studies and understand the probability of new competitors
in the workspace. If a competitor can enter easily, it increases the risk of the business we are in.
Barriers to entry include absolute cost advantages, access to inputs, economies of scale, and
strong brand identity. High barriers to entry can be beneficial for investors as they imply lower
chances of new competition entering the market. High capital requirements, proprietary
technology, or strong brand loyalty can deter new entrants, ensuring existing companies maintain
their market share and profitability

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