Security Analysis & Portfolio Management
Module 2: Security Analysis
Introduction to Fixed and Variable Income Securities
What are Fixed Income Securities?
Fixed income securities are a type of debt instrument that provides returns in the form of
regular, or fixed, interest payments and repayments of the principal when the security reaches
maturity. The instruments are issued by governments, corporations, and other entities to finance
their operations. They differ from equity, as they do not entail an ownership interest in a
company, but they confer a seniority of claim, as compared to equity interests, in cases of
bankruptcy or default.
How Does Fixed Income Work?
The term fixed income refers to the interest payments that an investor receives, which are based
on the creditworthiness of the borrower and current interest rates. Generally speaking, fixed
income securities such as bonds pay a higher interest, known as the coupon, the longer their
maturities are.
The borrower is willing to pay more interest in return for being able to borrow the money for
a longer period of time. At the end of the security’s term or maturity, the borrower returns the
borrowed money, known as the principal or “par value.”
Examples of Fixed Income Securities
Many examples of fixed income securities exist, such as bonds (both corporate and
government), Treasury Bills, money market instruments, and asset-backed securities, and they
operate as follows:
1. Bonds
The topic of bonds is, by itself, a whole area of financial or investing study. In general terms,
they can be defined as loans made by investors to an issuer, with the promise of repayment of
the principal amount at the established maturity date, as well as regular coupon payments
(generally occurring every six months), which represent the interest paid on the loan. The
purpose of such loans ranges widely. Bonds are typically issued by governments or
corporations that are looking for ways to finance projects or operations.
2. Treasury Bills
Considered the safest short-term debt instrument, Treasury bills are issued by the US federal
government. With maturities ranging from one to 12 months, these securities most commonly
involve 28, 91, and 182-day (one month, three months, and six months) maturities. These
instruments offer no regular coupon, or interest, payments. Instead, they are sold at a discount
to their face value, with the difference between their market price and face value representing
the interest rate they offer investors. As a simple example, if a Treasury bill with a face value,
or par value, of $100 sells for $90, then it is offering roughly 10% interest.
3. Money Market Instruments
Money market instruments include securities such as commercial paper, banker’s acceptances,
certificates of deposit (CD), and repurchase agreements (“repo”). Treasury bills are technically
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included in this category, but due to the fact that they are traded in such high volume, they have
their own category here.
4. Asset-Backed Securities (ABS)
Asset-backed Securities (ABS) are fixed income securities backed by financial assets that have
been “securitized,” such as credit card receivables, auto loans, or home-equity loans. ABS
represents a collection of such assets that have been packaged together in the form of a single
fixed-income security. For investors, asset-backed securities are usually an alternative to
investing in corporate debt.
Risks of Investing in Fixed Income Securities
Principal risks associated with fixed-income securities concern the borrower’s vulnerability to
defaulting on its debt. Such risks are incorporated in the interest or coupon that the security
offers, with securities with a higher risk of default offering higher interest rates to investors.
Additional risks include exchange rate risk for securities denominated in a currency other than
the US dollar (such as foreign government bonds) and interest rate risk – the risk that changes
in interest rates may reduce the market value of a fixed-income security that an investor holds.
For example, if an investor holds a 10-year bond that pays 3% interest, but then later on interest
rates rise and new 10-year bonds being issued offer 4% interest, then the bond the investor
holds that pays only 3% interest becomes less valuable
Variable-Income Securities
Definition
The term variable-income security refers to investments that provide their owners with a rate
of return that is dynamic and determined by market forces. Variable-income securities provide
investors with both greater risks as well as rewards
Explanation
Variable-income securities, also known as variable-rate securities, are typically valued by
investors looking for higher returns than those offered by fixed-income securities. The classic
example of a variable-income security is common stock, which can offer investors virtually
unlimited up-side growth as well as the complete loss of principal. In exchange for this risk,
investors in these securities demand higher returns than their fixed-income counterparts. In
addition to common stocks, examples of variable-income securities include:
• Variable Rate Demand Obligations (VRDO): municipal bonds that have long-term
maturities that reset on a relatively short-term basis.
• Floating Rate Notes (FRN): bonds that feature a variable rate coupon, typically indexed
to a money market rate such as federal funds or LIBOR plus a margin spread. The rate
of interest on FRNs will increase or decrease quarterly based on the auction rates of 13-
week Treasury bills.
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Equity Valuation Models,
• Analysts often use more than one valuation model because of concerns about the
applicability of any particular model and the variability in estimates that result from
changes in inputs.
• Three major categories of equity valuation models are present value, multiplier, and
asset-based valuation models.
Bonds
A bond is a contract that requires the borrower to pay an interest income to the lender. It
resembles the promissory note and is issued by governments and / or corporations.
Bond value: The value of the bond depends upon three factors namely the coupon rate, years
to maturity and the expected yield to maturity or the required rate of them. On the basis of this,
bond value theorems have evolved.
Theorem 1: If market price of bond increases the yield would decline and vice versa.
Example:
Factors Bond A Bond B
Par value Rs. 1000 Rs. 1000
Coupon rate 10% 10%
Maturity period 2 years 2 years
Market price Rs. 874.75 Rs. 1035.66
Yield 18% 8%
Even though the bonds A and B are of same maturity and bear the same coupon rate, the
difference in the market price leads to a difference in yields. The bond with a low price has
high yield because with less money more return is earned.
Theorem 2: If a bond’s yield remains constant over its life the discount or the premium depends
on maturity period of bond. That is if a bond with a short-term maturity will be sold at a lower
than the bond with long term maturity.
Example:
Factors Bond A Bond B
Par value Rs. 1000 Rs. 1000
Coupon rate 10% 10%
Yield 15% 15%
Maturity period 2 years 3 years
Market price RS. 918.71 Rs. 885.86
Discount Rs. 81.29 Rs. 114.14
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This means, A bond with a short term to maturity sells at a lower discount than B bond with a
long term to maturity.
Theorem 3: The rise or increase in bond price or a decline in the bond yield is greater than the
fall in bond price for a rise in the yield.
Example:
Take a bond with a 10% coupon rate, maturity period of 5 years and a face value of Rs. 1000.
If the yield declines by 2% that is to 8% then the bond price will be Rs. 1079.87
= 100(PVIF 8%, 5 years) + 1000(PVIF 8%, 5 years)
=100*3.9927+1000*0.6806
=Rs. 1079.87
If the yield increases by 2%, the bond price will be Rs. 927.88
=100(PVIF 12%, 5 years) + 1000 (PVIF 12%, 5 years)
=100*3.6048 + 1000*0.5674
=Rs. 927.88
Now the fall in yield has resulted in a rise of Rs. 79.86 but the rise in yield caused a variation
of Rs. 72.22 in the price.
Theorem 4: The change in the price will be less for a percentage change in bonds yield if its
coupon rate is higher.
Example:
Factors Bond A Bond B
Coupon rate 10% 8%
Yield 8% 8%
Maturity period 3 years 3 years
Price Rs. 105.15 Rs. 100
Face value Rs. 100 Rs. 100
Yield increase 1% 1%
Price after yield increases Rs. 102.53 Rs. 97.47
Percentage change in 2.4% 2.53%
price
Theorem 5: If the bond yield remains constant over its life the discount or premium will
decrease at an increasing rate as its life get shorter.
Example:
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Consider a bond with a face value of RS. 1000 and maturity period of 5 years with 10% yield
to maturity.
Years to maturity Present value
5 620.9
4 683.0
3 751.3
2 826.4
1 909.1
The above example shows that the discount rate declines at a lower when the bond
approaches maturity.
Bonds usually have a maturity period. Yield on them can be calculated either for the current
period or to maturity. While it is advisable to find out yield to maturity and it is also the
common practice, yet current yield on bonds can also be found out. The current yield on a bond
is the annual coupon return divided by the bond’s purchase price
Introduction to Fundamental Analysis
Fundamental analysis is the analysis of critical factors that affect the value of a stock. The
intrinsic value of an equity share depends on a multitude of factors. These factors in turn rely
on a host of other factors like economic environment in which they operate, the industry they
belong to, and companies own performance. The appraisal of the intrinsic value of shares in
this school of thought is done through:
(a) Economic analysis
(b) Industry analysis
(c) Company analysis
Objectives of Fundamental Analysis
✓ To conduct an asset valuation and predict where its price will go.
✓ To make a projection on its business performance.
✓ To evaluate the management of the property and make internal financial decisions.
✓ To help determine future prices and market developments.
Steps in Fundamental Analysis
Step 1: Economic and Market Analysis
Step 2: Analysis of Financial Statements
Step 3: Forecasting relevant payoffs
Step 4: Formulating a security value
Step 5: Making a recommendation
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In security selection process, a traditional approach of Economic- Industry- Company analysis
is employed. EIC analysis is the abbreviation of Economic, Industry, and Company. In this,
finally the most attractive companies within the attractive industries are pointed out by the
analyst.
Economy
Industry STOCK VALUE
Company
Economic analysis: It is a study of the general economic factors that go into an evaluation of
security’s value. The stock market is an integral part of economy. When the level of economic
activity changes even the stock prices fluctuate.
An analysis of the macroeconomic environment is essential to understand the behaviour of
stock prices. The commonly analysed macroeconomics factors are as follows:
• Gross domestic product
• Savings and investment
• Inflation
• Interest rates
• Budget and fiscal deficit
• Balance of payments
• Foreign direct investment
• Investment by foreign institutional investors
• International economic conditions
• Business cycle
• Monsoon agriculture
• Infrastructure facilities
• Demographic factors
Gross domestic product: The GDP represents the aggregate monetary value of the goods and
services produced in the economy during a specified period.
GDP= consumption + investment +exports – imports
Inflation: It refers to a situation where too much money is chasing too few goods. Inflation
indicates a rise in the price of goods and services. Inflation and stock markets have a very close
relationship. If there is inflation, the stock market is adversely affected. The price of stock is
directly related to company performance.
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Inflation typically results in the
following-
1. High raw material cost
2. Non availability of cheap credit to rise in interest rates
3. Low earnings.
Balance of payments: The balance of payments is the record of a country’s money receipts
from abroad and payments to foreign countries. The difference between receipts and
payments may be surplus and deficit. Balance of payments is a measure of the strength of the
rupee on the external account. A favourable balance of payments has a positive effect on the
stock market.
Foreign direct investment: It includes different elements like equity capital, reinvested
earnings of foreign companies, intercompany debt transactions and so on. FDIs help in
upgrading of technology, skills and managerial capabilities and bring much need capital into
the economy. Inflow of capital helps the economy grow and has a positive impact on the stock
market.
Industry Analysis: An industry is a group of firms that have a similar technological structure
of production and produce similar products.
An analysis of the performance, prospects and problems of an industry of interest is known as
industry analysis. It is required because the return and risk level of industries differ. The risk
factors related to the automobile industry are different from those related to the information
technology industry.
Industry life cycle:
The industry life cycle of the industry is separated into 4 well defined stages as given below:
1. Pioneering stage
2. Rapid growth stage
3. Maturity and stabilization stage
4. Declining stage
Apart from industry life cycle analysis, an investor must also analyse factors for selection of
securities like:
1. Growth of the industry
2. Cost structure and profitability
3. Nature of the product
4. Nature of the competition
5. Government policy
6. Labour
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7. Research and development
Company Analysis: Evaluating the financial performance of a company on the basis of
qualitative and quantitative factors is called company analysis. Qualitative factors that
represent certain aspects of a company’s business. Integrating such information into evaluation
of stock prices can be quite difficult.
By seeing qualitative and quantitative factors selection of securities can be made:
Qualitative factors
1. Business model
2. Management
3. Corporate governance
4. Corporate culture
Quantitative factors
1. Earnings
2. Competitive edge
3. Financial leverage
4. Operational leverage
5. Production efficiency.
Technical Analysis
Technical analysis existed and was practiced before computers were common, and some of the
pioneers in technical analysis were long-term investors and traders, not day traders. Technical
analysis is used by traders on all time frames, from 1-minute charts to weekly and monthly
charts.
Charles Dow (1851-1902) was the first to reintroduce and comment on it in recent times. He is
considered the father of “modern” technical analysis.
A core principle of technical analysis is that a market's price reflects all relevant information
impacting that market. A technical analyst therefore looks at the history of a security or
commodity's trading pattern rather than external drivers such as economic, fundamental and
news events
Modern Tools for Technical Analysis
Line Chart
Line charts are the most basic form of charts, They are composed of a single line from left to
right that links the closing prices. Generally, only the closing price is graphed, presented by a
single point
This is a popular type of chart used in presentations and reports to give a very general view of
the historical and current direction.
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Point and Figure
What Is a Point-and-Figure (P&F) Chart?
A point-and-figure chart plots price movements for stocks, bonds, commodities, or futures
without taking into consideration the passage of time.
Contrary to some other types of charts, like candlesticks, which mark the degree of an asset's
movement over set time periods, P&F charts utilize columns consisting of stacked X's or O's,
each of which represents a set amount of price movement. The X's illustrate rising prices, while
O's represent a falling price.
Technical analysts still utilize concepts such as support and resistance, as well as other patterns,
when viewing P&F charts. Some argue that support and resistance levels, as well as breakouts,
are more clearly defined on a P&F chart since it filters out tiny price movements and is less
susceptible to false breakouts.
Candlestick
Another kind of chart used in the technical analysis is the candlestick chart, so-called because
the main component of the chart which represents prices looks like a candlestick, with a thick
‘body’ and usually, a line extending above and below it, called the upper shadow and lower
shadow, respectively.
The top of the upper shadow represents the high price, while the bottom of the lower shadow
shows the low price. Patterns are formed both by the real body and the shadows. Candlestick
patterns are most useful over short periods of time, and mostly have significance at the top of
an uptrend or the bottom of a downtrend, when the patterns most often indicate a reversal of
the trend
The wider part of the candlestick is shown between the opening and closing price. It is usually
coloured in black/red when the security closes on a lower price and white/green the other way
around.
The thinner parts of the candlestick are commonly referred to as the upper/lower wicks or as
shadows. These show us the highest and/or lowest prices during that timeframe, compared to
the closing as well as opening price.
The relationship between the bodies of candlesticks is important to candlestick patterns.
Candlestick charts make it easy to spot gaps between bodies.
A slight drawback of the candlestick chart is that candlesticks take up more space than OHLC
bars. In most charting platforms, the most you can display with a candlestick chart is less than
what you can with a bar chart.
Renko Chart
Unlike the other Charts, the Renko Chart is a noise-less charting technique that concentrates
merely on price movements, completely disregarding time and the usage of volumes.
This Chart consists of white/green and black/red bricks. These are placed depending on
whether the price rose or not compared with the previous brick. If it did by enough value,
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established by the brick size, a new one is placed. White/Green bricks are used when the price
of the security goes up and black/red bricks when they go down.
It is important to mention the fact that a new brick is only placed under certain volatility criteria,
either resulting in a major advantage or disadvantage for traders. It can be placed in a matter of
minutes or take more than a day depending on market conditions. On the one hand, this may
be advantageous. Specifically for traders who desire a simple way of identifying supports and
resistances, the overall trend and filter noise. On the other hand, this can make market sentiment
hard to determine. Consequently, rendering the usage of other analysis tools useless.
Heikin Ashi
It is a kind of trading chart that originated in Japan. Heikin Ashi charts are similar to candlestick
charts in that the color of the candlestick denotes the direction the price is moving.
Heiken Ashi charts are able to show the uptrend and downtrend more clearly. A strong uptrend
exists when there are continuous green HA candles without the lower shadow. A strong
downtrend exists when there are continuous red HA candles without the upper shadow.
The main difference between candlestick and Heikin Ashi charts is that the HA charts average
price moves, creating a better appearance. Because the HA price bars are averaged, they don’t
show the exact open and close prices for a particular time period.
Heikin Ashi charts can be used independently though, especially by swing traders or investors.
Day traders tend to use Heikin Ashi charts more as an indicator.
Price Patterns of Stock
1. Ascending triangle
The ascending triangle is a bullish ‘continuation’ chart pattern that signifies a breakout is likely
where the triangle lines converge. To draw this pattern, you need to place a horizontal line (the
resistance line) on the resistance points and draw an ascending line (the uptrend line) along the
support points.
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2. Descending triangle
Unlike ascending triangles, the descending triangle represents a bearish market
downtrend. The support line is horizontal, and the resistance line is descending,
signifying the possibility of a downward breakout.
3. Symmetrical triangle
For symmetrical triangles, two trend lines start to meet which signifies a breakout in
either direction. The support line is drawn with an upward trend, and the resistance
line is drawn with a downward trend. Even though the breakout can happen in either
direction, it often follows the general trend of the market.
4. Pennant
Pennants are represented by two lines that meet at a set point. They are often formed
after strong upward or downward moves where traders pause and the price
consolidates, before the trend continues in the same direction.
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5. Flag
The flag stock chart pattern is shaped as a sloping rectangle, where the support and
resistance lines run parallel until there is a breakout. The breakout is usually the
opposite direction of the trendlines, meaning this is a reversal pattern. Learn more
about breakout stock patterns.
6. Wedge
A wedge pattern represents a tightening price movement between the support and
resistance lines, this can be either a rising wedge or a falling wedge. Unlike the
triangle, the wedge doesn’t have a horizontal trend line and is characterised by either
two upward trend lines or two downward trend lines.
For a downward wedge, it is thought that the price will break through the resistance
and for an upward wedge, the price is hypothesised to break through the support. This
means the wedge is a reversal pattern as the breakout is opposite to the general trend.
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7. Double bottom
A double bottom looks similar to the letter W and indicates when the price has made
two unsuccessful attempts at breaking through the support level. It is a reversal chart
pattern as it highlights a trend reversal. After unsuccessfully breaking through the
support twice, the market price shifts towards an uptrend.
8. Double top
Opposite to a double bottom, a double top looks much like the letter M. The trend
enters a reversal phase after failing to break through the resistance level twice. The
trend then follows back to the support threshold and starts a downward trend breaking
through the support line.
Read more about trading with double top and bottom patterns.
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9. Head and shoulders
The head and shoulders pattern tries to predict a bull to bear market reversal.
Characterised by a large peak with two smaller peaks either side, all three levels fall
back to the same support level. The trend is then likely to breakout in a downward
motion.
10. Rounding top or bottom
A rounding bottom or cup usually indicates a bullish upward trend, whereas a rounding
top usually indicates a bearish downward trend. Traders can buy at the middle of the
U shape, capitalising on the trend that follows as it breaks through the resistance levels.
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11. Cup and handle
The cup and handle is a well-known continuation stock chart pattern that signals a
bullish market trend. It is the same as the above rounding bottom, but features a handle
after the rounding bottom. The handle resembles a flag or pennant, and once
completed, you can see the market breakout in a bullish upwards trend.
Practical explanation on technical Indicators used in Stock Market- Dow
Theory & Efficient Market Hypothesis (EMH) Meaning and Types
What is Technical Analysis?
Technical analysis is a tool, or method, used to predict the probable future price
movement of a security – such as a stock or currency pair – based on market data.
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The theory behind the validity of technical analysis is the notion that the collective
actions – buying and selling – of all the participants in the market accurately reflect all
relevant information pertaining to a traded security, and therefore, continually assign
a fair market value to the security.
Key Takeaways
• Dow theory trading strategy is primarily based on the ideas about stock price
movement put forth by Charles H. Dow through his editorials in the Wall Street
Journal back in the 19th century.
• It mainly states that multiple indices should provide the same signal to confirm
a trend.
• It lists a set of fundamental tenets. Identifying and following a trend should be
in line with these tenets.
• It is the core principle of modern technical analysis. Traders use the Dow
theory forecast to confirm between uptrend and downtrend.
Dow Theory Explained
The Dow theory developed from the market price action analysis, views on
speculation, etc., put forth by Charles H. Dow formed a foundational step for technical
analysis when the software’s aided technical analysis like today didn’t exist. Its
evolution and usefulness in speculation are well portrayed by Robert Rhea in his book
“The Dow Theory” by meticulously examining the Wall Street Journal editorials by
Charles H. Dow and William Peter Hamilton in the 19th century. It was among the
earliest attempts to understand the market by using fundamentals that indicated future
trends.
The original version of the theory focused on comparing the closing prices of two
averages: the Dow Jones Rail (or Transportation) (DJT) and the Dow Jones Industrial
(DJI). The argument was that if one rose above a certain threshold, the other would
follow it. To illustrate it, Dow’s compared the market to the ocean. According to the
economist, if you are on one side of the beach and the waves go up until a point, waves
in another part of the beach will eventually reach the same point. The same happens
with markets because they’re also a part of a whole.
The Paradigms of Dow Theory
To explain the theory, understanding the several rules devised by Dow is vital. These
paradigms are generally known as the tenets or principles of Dow theory.
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Three significant market trends: They are primary, secondary, and minor trends
defined by their duration. Primary trends can be uptrend or downtrend lasting months
to years, while secondary one moving opposite to the primary will last weeks or a few
months. Minor trends are treated as insignificant variations lasting from a few hours
to weeks, and they are not as important as the others.
Primary trends have three distinct phases: The different phases in bear markets are
distribution, public participation, and panic. Bull markets on the other, have
accumulation, public participation, and excess phase.
Stock market discount everything: The market indexes react quickly to all forms of
information. It can be related to the entity or economy as a whole. For instance, any
economic shock or issues in the company management will affect stocks and move the
indices upward or downward.
Volume confirms the trend: Trading volume increases during an uptrend and
decrease during depressions.
Indices confirm each other: Multiple indices moving in an identical pattern reveal a
trend since they give the same signal. Whereas if two indices move in the opposite
direction, it is difficult to deduct a trend.
Trends continue until solid clues imply the reversal: Traders should be aware of
trend reversals. It’s easy to confuse them with secondary trends, so Dow cautions the
investor to be careful and confirm trends with several sources before believing it’s a
reversal.
How Does Dow Theory Work in Technical Analysis?
The Dow theory was fundamental to technical stock market analysis and acted as the
underlying principle for its continued advancement. The technical framework of the
analysis emphasizes the need to pay close attention to market data to discern trends,
reversals and determine when to buy or sell an asset for maximum profit since the
market is the indicator of future performance. In this way, technical analysis in
accordance with theory assists investors in making profitable trading decisions by
detecting established long, mid, or short-term trends.
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Security Analysis & Portfolio Management
What is the Efficient Markets Hypothesis?
The Efficient Markets Hypothesis (EMH) is an investment theory primarily derived
from concepts attributed to Eugene Fama’s research as detailed in his 1970 book,
“Efficient Capital Markets: A Review of Theory and Empirical Work.” Fama put forth
the basic idea that it is virtually impossible to consistently “beat the market” – to make
investment returns that outperform the overall market average as reflected by major
stock indexes such as the S&P 500 Index.
Variations of the Efficient Markets Hypothesis
There are three variations of the hypothesis – the weak, semi-strong, and strong forms
– which represent three different assumed levels of market efficiency.
1. Weak Form
The weak form of the EMH assumes that the prices of securities reflect all available
public market information but may not reflect new information that is not yet publicly
available. It additionally assumes that past information regarding price, volume, and
returns is independent of future prices.
The weak form EMH implies that technical trading strategies cannot provide
consistent excess returns because past price performance can’t predict future price
action that will be based on new information. The weak form, while it discounts
technical analysis, leaves open the possibility that superior fundamental analysis may
provide a means of outperforming the overall market average return on investment.
2. Semi-strong Form
The semi-strong form of the theory dismisses the usefulness of both technical and
fundamental analysis. The semi-strong form of the EMH incorporates the weak form
assumptions and expands on this by assuming that prices adjust quickly to any new
public information that becomes available, therefore rendering fundamental analysis
incapable of having any predictive power about future price movements. For example,
when the monthly Non-farm Payroll Report in the U.S. is released each month, you
can see prices rapidly adjusting as the market takes in the new information.
3. Strong Form
The strong form of the EMH holds that prices always reflect the entirety of both public
and private information. This includes all publicly available information, both
historical and new, or current, as well as insider information. Even information not
publicly available to investors, such as private information known only to a company’s
CEO, is assumed to be always already factored into the company’s current stock price.
So, according to the strong form of the EMH, not even insider knowledge can give
investors a predictive edge that will enable them to consistently generate returns
that outperform the overall market average.
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