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Security Analysis
The investor while buying stock has the primary purpose of gain. If he invests for a
short period of time it is speculative but when he holds it for a fairly long period of
time the anticipation is that he would receive some return on his investment. There
are basically two approaches in analyze share price movement. They are
fundamental approach and technical approach.
Industry analysis also involves life cycle analysis which involves four stage. Viz
introduction stage. Growth stage, maturity stage, and finally decline stage. This is
similar to product life cycle. The firm which has introduced a new product has
distinct advantages over others. It can establish its brand name widely and create a
good product image. It can adopt skimming the cream pricing policy to make huge
profits by fixing prices at a high level.
In the growth stage many firms enter the market with their products, posing severe
competition to the pioneering firm. All companies have more or less stable growth
rate and declare dividends to their share holders. Firms in information technology
have achieved a higher growth rate than the industrys average.
In maturity stage growth rate tends to be moderate with technology becoming
obsolete. The firms in order to survive have to bring innovation in technology.
The last stage is decline stage in which the product becomes liability to a firm as the
earnings of the companies tend to fall rapidly. The investors have to avoid investing
in such firms even in the boom conditions.
The industry cycle analysis apart an investor has to take into consideration certain
other factors which are discussed as follows:
Industrial Growth: the performance of industries over the past few years to be
analysed to drive home the point. For instance Indian industry has achieved an
impressive growth of 9.4% in April 2004 with mining sector achieving 9.5% increase
up from 6.3%in the same month last year. Electricity generation was at a record high
of 10.7%. Use based data released by the CSO show that basic goods production was
higher by 8.2 %, capital goods by 23.2% and intermediate goods by 9.4%. consumer
durables achieved a growth rate 17.7%. the highest growth of 88% was achieved in
the case of wool, silk and man made fiber textile, followed by 24.9% in the case of
chemicals and chemical products. Food products showed a decline of 21.9% and wood
products had a decline of 9.7% during April 2004.
Nature of the product: The products may be classifies into industrial and consumer
goods. The consumer goods can further classified into durables and non durables.
Industrial goods like iron sheet, cranes, trucks, steel wires and coils are demanded
by engineering industry. The investor has to determine the condition of related goods
manufacturing units to ascertain the demand for industrial goods.
Cost structure and profitability: The investor has to analyze the cost structure of
Level competition: Market share of a firm indicates the market standing of the
SWOT Analysis: The investor has to make SWOT analysis of the industry. It
means strength, weakness, opportunities and threats analysis. In order to make
such an analysis the investor has to possess adequate knowledge of the industry. For
example brand equity is the strength of coco cola, weaknesses may include poor
financial strength, inadequate promotional measures, irregular supply of products to
the markets etc. the investor has to see that how far an industry makes uses of
opportunities available. Threats may come in the form of competition, import
restrictions followed by importing countries. The industry has to survive all these to
emerge successful and boost the confidence of investors.
Government policy: In order to augment exports, tax holidays, and tax concessions
are provided to export oriented products. Government regulates the size of
production and of certain products. The sugar, fertilizers and pharmaceuticals
industries are very often affected by the inconsistent govt policies. Hence it becomes
essential to make careful evaluation of govt policies regarding a particular industry.
Supply of Labour: The investor has to ensure that abundant supply of labour is
available for the industry concerned. The firms have to establish cordial relationship
with the trade unions to bring in new measures. Industrial disputes lead to loss of
man days and there would be fall in industrial production. This situation has to be
avoided to achieve labour productivity. Availability of required type of labour in
adequate size at cheaper rates is a welcome measure and this is the reason as to why
many MNC prefer to make investments in India.
in rupee terms and physical units. When a firm grows in size that will delight the
investors as the firm will gain strength to withstand changes in the business cycle.
The investors are very much concerned with the present sales and as also the future
one. This requires an investor to make a rather accurate sales forecast by adopting
mathematical techniques like the method of least squares. The different components
of demand for the companys product demand for the substitutes and competitors
products have to be analyzed.
The earnings of a company have to increase in the same proportion as that of sales.
When sales alone shows increasing trend with earnings not matching the increase it
is cause for worry as the expenses start increasing in the concern. Analysis of both
sales and earnings by an investor helps him to get a real picture of the concern. It is
the precaution to be taken by the investor to see whether the income generated is out
of sale of assets or from investments.
Income of the company is affected due to the following reasons viz changes in costs
and sales, depreciation method adopted, stock valuation, depletion of resources,
income taxes, wages, salaries and fringe benefits etc.
Capital structure
Style of management
The performance of any firm depends on the way it is managed. The managers
abilities to plan, organize, direct and control have great impact in the functioning of
an enterprise. The symptoms of well managed concern can be summarized as follows
1. There is steady growth in sales and earnings of the firm. Market share tends
to increase steadily.
2. Customers are well satisfied with the products offered by the firms. The
products with proven quality are offered at the right prices at the right time
to the customers to force them to make repeat purchases.
3. There is optimum utilization of plant and equipment. When the percentage
utilization of capacity increases the cost gets decreased leading to increased
profitability.
4. Constant endeavour is made to make innovations in products design and
performance and processes to achieve technical supremacy over the
competitors.
5.
11. All the factors that lead to increase in cost have to be taken into account.
Cost reduction techniques like value analysis of inventory control etc have to
be followed to effect cost control.
All the above depend on the educational back ground, skills and experience of
management personnel apart from their abilities to keep the firm flexible enough to
accommodate changes in the environment.
Operating efficiency
High operating efficiency is the need of the hour for a company aiming at expansion.
The production resources like machinery and equipment, materials and labour have
to be effectively utilized to derive more income from sales.
Operating leverage
A firm is said to have high degree of operating leverage when a small change in sales
leads to a big change is return on equity. Companies which invest heavily on fixed
assets experience high operating leverage. On the other hand production of
consumer non durables especially cosmetics does not have huge fixed assets thus
experiencing lower operating leverage.
Financial Analysis:
Technical analysis
4.. Separation of income from capital gains is not undertaken: Technicians do not
hold high dividend paying stock years together. Instead they look for total returns
that are the price realized minus price paid plus dividends received.
5. The activities of technician are quick whether to make commitments or to
make profit and losses: The technicians show willingness to assume smaller
gains in the up market and accept quick losses when the market shows a
declining trend.
6. Technical analysis calls for more experience: Technical analysis requires
attention and discipline keeping the quality stocks for long terms. They use
technical indicators to gain experience in facing pitfalls.
7. Technical analyst believe in historic performance: Current movements in
stock prices would repeat in the future thus being used for future projection.
The charts used in technical analysis provide the most convenient method of
comparison.
8. Technical analysis recognizes even small breakouts that would have
important impact: Any shift in the supply and demand is considered as an
important signal by the technicians.
9. Charts are used to confirm fundamentals: When the trend of overall stock
market is favorable both fundamental and technical analysis agrees leading
to favorable profitable movement.
10. Technical analysis recognizes that securities of strong companies are often
weak and vice versa.
Fundamentalists are generally conservatives who invest for the long term where
as the technicians are traders who buy and sell for short term profits.
Fundamentalists make their decisions based on quality and value. They take the
corporations financial strength past growth in sales and earnings, profitability,
investment acceptance etc into account.
Fundamentalists select quality stocks when they are undervalued and sell them
when they become fully priced thus making huge profit. Technicians are in
general interested in keeping their money working as profitably as possible at all
times. They want to make profits quickly and if the market does not perform well
they are willing to take a small fast loss. Investors with technical orientation
check the market action of the stock and when it is favorable they examine the
fundamentals to ensure the strength and profitability of the company.
Technical analysis measure supply and demand of the stock and forecast prices of
securities, suing the following tools.
FIBONACCI Numbers
Fibonacci Ratios
0.618
0.618
1.000
1.618
2.618
1.618
1.618
1.618
1.618
1.618
1.618
0.382
0.618
1.000
1.618
2.618
4.236
Those who follow Fibonacci ratios for the investment purpose, use the first two ratios
viz., 0.382 and 0.618 for completing retracement levels of a previous move. For
instance, a stock falling from Rs. 50 to Rs. 35 (30 percent drop) encounters resistance
to further advances after it checks the loss to the extent of 38.2 percent.
A male bee has only a mother; it comes from an unfertilized egg. A female bee (a
queen) comes from a fertilized egg and has both a mother and father. This means one
drone has one parent two grandparents, three great grand parents, and five great
great grand parents and so on. The number of ancestors at each generation is the
Fibonacci ratios.
Dow Theory
The theory advocated by Charles Dow is one of the oldest technical methods, being
widely followed. The theory consists of three types of market movements, namely
the major market trend lasting a year or more; a secondary intermediate trend,
moving against the primary trend for one of several months; and minor movements
lasting for hours to a few days.
Dow Theory asserts that stock prices demonstrate patterns for over four to five years
and these patterns are reflected by stock price indices. The Dow Theory employs the
industrial average and the transportation average, two of the Dow Jones Averages.
Dow Theory believes that its measures of stock prices tend to move together. When
the Dow Jones industrial average is on the rise, the transportation average will also
tend to rise. Such simultaneous movements in prices signify a strong bull market.
When the industrial average is rising and the transportation average is falling, the
industrials may not continue to rise, with the result, that the market investor starts
selling the securities and converts them into cash. The reverse occurs when one of
the averages starts to rise after a period of falling, while the other continues falling.
The Dow Theory suggests that this divergent phase is over and the security prices
will soon start to rise in general. The shrewd investor will then start purchasing
securities in anticipation of increase in prices.
Figure A illustrates a buy signal. When the industrial starts to rise, both the
industrial and transportation averages have been declining. The increased
industrial average even there is a decline in the transportation index, suggests
that the declining market is over. The above change is confirmed when the
transportation average also starts to rise.
The sell signal is illustrated in figure (B). Here, both the industrial and
transportation averages are on the rise. The industrial average continues rising.
This implies that the market is witnessing an unsettled period, signifying
uncertainty regarding the future direction of stock prices.
The falling
transportation average confirms the direction of industrial average, indicating
the bear market underway.
When there is a sell signal, the believer (investor) of this theory will try to
liquidate, thus driving down prices. Buy signals force investors to purchase
securities, which will ultimately drive up their prices.
There are certain criticisms of the Dow Theory. The Dow theory does not explain
why the two averages should be able to forecast future stock prices. Further,
there may be time lag between actual turning points and those determined by
the forecast. The Dow theory was well only when a long, wide movement is found
in the market. When the market trend frequently reverses itself in the short
term, this theory is not found useful. Another drawback is that this theory does
not make attempt to explain consistent pattern of stock price movements .
Stock
Price
Time
The above figure is a simple demonstration of Elliot Wave Principle (EWP). The
EWP can be applied to real situations by recording past movements in stock prices
at different points of time. The EWP offers investors a basis for developing
important market strategies. However, it is difficult to identify the turning point of
each stage. Further, an investor cannot differentiate major movement from a minor
movement.
decision cycle less predictable, the market analysts consider the work of Kondratev
commendable.
Neutral Networks
Neutral network is a trading system in which desired output from past trading data is obtained by
trying a forecasting model. If the desired output is not found, more volume of data are included.
It has feedback mechanism to gain experience from past errors. However, the stock market is not
always deterministic. The changes in situations would affect the stock market, making neutral
network vulnerable
Charts
Charts of prices and trading volume are used for analysis by the technicians. The
chart analysis is used to determine the probable strength of demand in relation to
supply at various price levels so that prediction of direction of stock movement is
made possible. Technical analysts believe that stock price fluctuations generally
form characteristic pattern, having important predictive value.
Types of charts
1.
Line Chart
The closing prices of successive time periods are connected by means of straight
lines, without taking note of high or low prices of stock for each period as shown
below:
2.
Bar chart
Bar chart is drawn with time taken in the X axis and stocl prices in the Y axis. It
can be drawn for different time periods, a day, a week, a month or even a year.
The bar chart as shown below shows the high price, low price and the closing
price represented by a small horizontal line projected from the vertical line.
The below chart shows weekly stock price movements for a 5-week period. The
trading volume can be placed at the bottom of the chart, thus giving move details
about the stock.
The advocates of point and figure chart believe that the changes in prices need
only be analysed to predict future price fluctuations. They ignore both volume
action and time dimension. Point and figure chart starts with putting X in the
appropriate price column of a graph. Successive price increases are entered in
the upward. Column by putting X, if the price drops, the figures move to the next
The figure (a) is a bar chart that exhibit head and shoulders pattern. It can be
inferred form the figure that when time passed, the price of stock rises to the point A
only to fall down to B. It starts recovering by reaching the point C and falls again to
the bottom (D). It once again rises to the peak of E and shows declining trend finally.
The figure (b) shows the inverted head and shoulders pattern which starts with
falling trend and finally results in a forecast that its stock is about to rise to a
great extent.
Trend Analysis
A technical analyst very often confronts the problem of establishing a major
trend. Any reversal in trend is termed as major when there is a move between 20
and 45. Advancement in price generally precedes a major trend. The analyst has
to check whether there is an occurrence of trend violation. Trend violation is an
indication of reversal in the major direction of stock price movement. The
technical analyst has to watch out the signs of distribution or accumulation.
Accumulation is followed by a major up trend, whereas unusual price and or
volume action.
There are certain price configurations which are more easily identified than
head and shoulders configurations. These include triangles, pennants, wedges
and flags.
Ascending Triangle
The above figure shows a falling wedge, which usually occurs in a major uptrend
pattern. Line A shows steep decline, since the sellers are found aggressive. The
charts, though are found useful, have a few limitations. Charts need proper
interpretation. Further, analysis give their options to buy stock at a time only to
change their decisions in the immediate future. This makes the investors to be
in an doubt of the market time and again. The buyers are totally relying on
actions of the stock, assuming that investors who are causing changes, have
thorough knowledge of the company. They make decisions on the basis of chart
patterns, instead of analyzing the real causes of stock price movements.
Limitations of chart
The technical analyst may have charts of all the principal shares in the market.
But all that is necessary is a proper interpretation of charts. Interpretation of
charts is very much like a personal offer. Ina way it is like abstract art. Take an
abstract painting and show it to ten people and you will get at least eight
interpretations of what is seen. Take one set for chart figures and show it to ten
chartist and you are liable to get almost as many interpretations of which way
the stock is going .
The trouble with most chart patterns is that they cause their followers to change
their opinion so frequently. Most chart service change like the wind. One day
they put out a strong buy signal two weeks later they see a change in the pattern
and tell their clients to sell then two weeks later they tell them to buy again. The
result is that these patterns force their followers in and out of the market time
and time again. Though this is great for brokers commission but not so great for
the investor.
Another disadvantage and a great one which exists in charting is that decisions
are almost always made on the basis of the chart alone. Most buyers under this
method have no idea why they are buying companys stock. They rely alone on a
stocks action assuming that the people who have caused or are currently causing
this action really know something about the company. This is generally negative
thinking simply because as more and more chartists are attracted to a stock
there are simply more and more owners who know little or nothing about the
company.
Technical Indicators
The short interest ratio is derived by dividing the number of shares sold short by
the average volume for about 30 days. The ratio has the logic that speculators
and other investors sell stocks at high prices in anticipation of buying them back
at lower prices.
2. Confidence Index
It is the ratio of a group of lower grade bonds to a group of higher grade bonds.
When the ratio is high, investors confidence is high, reflecting in the purchase of
relatively more of lower grade securities.
3. Spreads
Large spreads between yields indicated low confidence among investors, leading
to bearish market. Small spreads indicate high confidence and are bullish in
nature.
When advances are more than the decline, the ratio increases. Such a situation
will lead to bullish condition.
It is computed by taking the net difference between the number of stocks rising
and number of stocks falling and adding it to (or subtracting from) the previous
one. If both the stock index and the market breadth index increase, the market
leads to bullish condition.
5. Insider Transactions
Insiders (people who are connected with the company) have knowledge about
performance of the company, future earnings, dividend and stock price
performance. It is bearish indicator when insiders start selling heavily.
Moving Average
It is a statistical technique, making use of the historical data. For instance, a ten
day moving average measures the average over the previous en trading days.
Under this method, the changes in the slope of the line are important
There are certain witchcraft indictors like super bowl indicator, sunspots, and
hemline indicator, attracting the attention of investment personnel.
For
instance, super bowl indicator states that stock market will register advances if
the super bowl foot ball game is won by a team from the original national foot
ball league in U.S. The sunspot theory is based on the principle that increased
sunspots lead to more rains finally resulting in higher stock prices.
4.
The technical analysis assume that past prices predict the future. For
instance, the rising market leads to increased purchases and the
downtrend causes large scale selling of shares.
In the words of James Lorie efficiency of market means the ability of capital market
to new information. Such efficiency will produce prices that are appropriate in terms
of current knowledge and investors will be less likely to make unwise investments.
Efficient market theory states that fluctuations in share process are random and
they do not follow any regular pattern.
Future performance does not have past performance as any indicator: Investors who
fared better in the past may end up with failure now. Some might had an element of
luck whereas others suffered due to misfortune.
6. Only when the equilibrium level shifts market process tend to change only as
information relating to the fundamentals
7. There is no undue pressure or manipulation acting on the prices as the latter
move independently.
8. Nobody has better knowledge or inside information.
9. Investors are rational and the demand and supply forces are the result of
rational investment decisions.
10. Institutional investors have to follow the market and market cannot be
influenced by them.
11. There is a large number of buyers and sellers leading to perfect competition.
According to Fama the efficient market hypothesis can be divided in to three
categories namely weak form, semi strong form, and the strong from. The level of
information considered in the market is the basis for this classification represented
by the following figure:
Strongly efficient market that all information is reflected on
security prices
Thus efficient market hypothesis is based on the flow of free and correct information
and the absorption of it by the market. There are three types of information affecting
the market as shown in the figures viz, past prices, and trends, other public
information and inside information. As indicated by the figure the analysis have
placed the market absorption and the related theory under the following head viz,
weak form of efficient market hypothesis, semi strong form and strong form.
Empirical Test:
Empirical Test were conducted both in the past and present on the validity of
Random Walk Hypothesis. Cowles, Jones and Kendall conducted research and
showed that security prices moved in a random fashion. Investors who made analysis
of the past fundamental involving price behavior of the past went on to pick up blue
chips in their portfolio but did not show up superior portfolio performance.
Filter Test:
These tests are based on the principle of fixing a filter level varying from 0.5 % to
50% and examining how well price changes pick up both trends and reversal. For
instance when a stock moves up a filter point to 5% the stock is bought and is held
for long. When it reverses by the same filter point 5% it is sold and a short position is
taken. A short position is one sells even without holding shares to deliver.
Filtering is thus screening of the important information affecting the prices from
unimportant and to see how well the price changes picking up the trends and
reversals.
When the filter level is slow the market fluctuations capture these levels and when
the filter level is taken as large the results do not prove the hypothesis. Even in case
of small filters the investors do not gain by using filter tests when the transactions
costs and charges are taken into account.
Stock prices do not move in an unexpected movement and reversals. Hence one
cannot make return in excess of the results warranted by the risks assumed by the
investors. All theses prove that the weak form of market efficiency holds food since it
is not possible to gain more price information of the market.
These test were conducted by Moore to study the movement of stock prices. Serial
correlation was used for the study. He measures correlation coefficient of changes in
prices for a week with the price changes a week later and so on down the line. The
result indicated that there is very low correlation coefficient implying that a price
increases not showing the tendency to the price fall and vice versa in any predictable
manner. Hence the price changes of the current week do not depend on the past price
changes to any significant extent.
Fama conducted the correlation tests on daily price changes taking into account the
companies included in the Dow Jones industrial average for five years. Serial
correlation price data of different periods of time did not show any significant
positive results. Thus it is proved that the prices move in an independent fashion in
a large extent.
Run Test:
A run is a set of consecutive price changes in the same direction. The time series
data on price changes of stocks are used to study whether there are dependencies
among these series in terms of signs and reversal of signs. Fama used run tests to
examine whether the changes in prices were likely to be followed by further price
changes in the same direction.
There are certain other tests conducted in this regard. For instance the research
conducted by Osborne indicated that stock prices moved in a Brownian fashion. It
means that simulation tests conducted by a few authors showed that the mechanism
of Random Walk generated variables which are similar to movement of stock prices.
Sharpe and Jensen studied relative performance of mutual funds. The hypothesis
that the mutual funds could earn extraordinary returns and constantly achieve a
higher average performance as they have better access to insider information was
tested and was found void. Blume and William in the studies proved that the mutual
fund performance was not extraordinary or superior to average market performance.
In the strong form of market it is stated that all information is represented in the
security prices in such a way that there is no opportunity for any person to make an
abnormal gain on the basis of any information. The strong form of efficient market
hypothesis maintains that all available information including the publicly available
us useless to an investor. Most of the research work indicate that efficient market
hypothesis in the strongest form does not hold good. Collins listed the strong form of
market in 1975 and showed that the consolidated earnings of multi product firm
would be accurately predicted by using data as segment and profit rather than
making use of consolidated historical earnings data.
Friend, Sharke and Jensen tested the performance of mutual funds. The hypothesis
was that mutual funds could earn extraordinary return and constantly achieve
higher than average performance as they are likely to have access to inside
information not publicly known different samples of firms and time periods were
chosen for the study. However it was inferred that the mutual funds were not better
in performance than the individual investor who makes purchase of same securities
with the same risk. Mutual funds are expected to earn extraordinary return but
empirical evidence shows otherwise.
There are studies to prove that their stocks with low price earning ratios yield
higher returns than stocks with high price earnings. Several studies confirmed the
existence of small firms effect which maintains that investing in small firms that us
those with low capitalization offers superior risk adjusted returns. The average
returns for the smallest firms and largest firms were computed with small firm
portfolio gaining upper hand over that of large firm. There is also weekend effect as
in Bombay Stock Exchange it was observed in the part that Mondays were
characterized by trading blue chips where as Fridays experience heavy rush.
Portfolio Management
Measure of risk
Actual return from a security may not be equal to the expected return. There is an
element of probability of loss. A useful measure of risk has to be considered in order
to take into account various possible outcomes of losses and their magnitude. The
standard deviation may serve the purpose.
Standard deviations of returns of securities are used to determine the standard
deviations of portfolios return. Hence it is preferred for investment analysis.
Portfolio risk
The portfolio risk has to be estimated using the variance of each individual security
in the portfolio and the correlation coefficient of each security with each other
securities.
where
Portfolio Analysis
Traditional Versus Modern Porfolio Analysis
Traditional portfolio analysis has been of a very subjective nature but is has
provided success to some persons who have made their investments by making
analysis of individual securities through the evaluation of return and risk conditions
in each security. Infact, the investor has be able to get the maximum return at the
minimum risk or achieve his return position at that indifferent curve which states
his risk condition. The normal method of calculating the return on an individual
security was by finding out the amount of dividends that have been given by the
company, the price earning ratios, the common holding period and by an estimation
of the market value of the shares.
The modern portfolio theory believes in the maximization of return through a
combination of securities. The modern portfolio theory discusses the relationship
between different securities and then draws inter-relationships of risks between
them. It is not necessary to achieve success only by trying to get all securities of
minimum risk. The theory states that by combining a security if low risk with
another security of high risk. The theory states that by combining a security of low
risk with another security of high risk, success can be achieved by an investor in
making a choice of investment outlets.
Traditional theory was based on the fact that risk could be measured on each
individual security through the process of finding out the standard deviation and
that security should be chosen where the deviation was the lowest. Greater
variability and higher deviations showed more risk than those securities which had
lower variation. The modern theory is of the view that by diversification, risk can be
reduced. Diversification can be made by the investor either by having a large
number of companies in different regions, in different industries or those producing
different types of product lines. Diversification is important but the modern theory
states that there cannot be only diversification to achieve the maximum return. The
securities have to be evaluated and thus diversified to some limited extent within
which the maximum achievement can be sought by the investor. The theory of
diversification was based on the research work of Harry Markowitz. Markowitz is of
the view that a portfolio should be analysed depending upon
a.
The attitude of the investor towards risk and return and
b.
The quantification of risk.
Thus, traditional theory and modern theory are both framed under the constraints of
risk and return, the former analyzing individual securities and the latter believing
in the perspective of combination of securities.
Traditional theory believes that the market is inefficient and the fundamental
analyst can take advantage of the situation. By analyzing internal financial
statements of the company, he can make superior profits through higher returns.
The technical analyst believed in the market behaviour and past trends to forecast
the future of the securities. These analysis were mainly under the risk and return
criteria of single security analysis.
Modern portfolio theory, as brought out by Markowitz and Sharpe, is the
combination of the securities to get the most efficient portfolio. Combination of
securities can be made in many ways. Markowitz developed the theory of
diversification through scientific reasoning and method .
An investor may either add new securities or remove from his investment some other
security. In this case, the cut-off rate will change and this would lead to a change in
the optimum portfolio. Cot-off rate determines not only the vale of the existing
securities with the change in beta. An example may be given to illustrate this. If
cut-off rate was equal to a given amount at he existing moment, with the change in
the securities, the return to risk ratio may be more or less other than the previous
cut-off rate. This may or may not enter in the optimum portfolio to determine
whether it enters the portfolio again the same process or ranking the securities and
finding out the excess to beta ratios above the cut-off rate would have to be chosen to
find out the optimum portfolio.
A new security whenever it is introduced in a portfolio will have its importance. It
will have the effect on either adding to the result of the existing portfolio or making a
change from it. The results will show whether with the addition of the new security,
the optimum portfolio will also affect the change in those securities which were quite
close to he existing cut-off rate.
The portfolio is selected by the introduction of a borrowing and lending line making the
efficient frontier a straight line. Illustration 16.7 shows a risk-free security of 6% with a
standard deviation of 6.90. The graph represents a portfolio return and risk and he best
portfolio is the corner portfolio of 9. The corner which is beyond 9 with an addition of the
fact of leading. The choice of portfolio which are on the right side of 9 i,e from 1 to 8 are
seen to show borrowing and are in some way dominated by 9. 9 is the stage in which the
maximum benefit can be derived after using the formula (Rp Rt/bp).
Sharpe finds the beta relationship to be the most significant in the portfolios, it shows the
activity or movement of stock ,as sown in example. According to him, a portfolio has
unsystematic risk as well as systematic risk but although unsystematic risk can be reduced
to zero the systematic portion of the risk is determined by the behaviour of stocks in the
market and can in no way be absolutely reduced or dominated to zero. Sharpe also gives
importance to the presence of both beta coefficient () and systematic risk. In the selection of
a portfolio on beta, the negative and positive betas should be considered. While assessing a
portfolio on beta, the negative beta should be preferred to positive beta. The presence of
negative beta in a portfolio is efficient. Also, there is reduced or eliminated amount of risk
when the negative betas are present.
Portfolio betas are used to measure risk in a portfolio but with proper diversification and
elimination of unsystematic risk, the portfolio can become efficient. Betas on a portfolio, are
therefore, the weighted average of the betas of each of the securities on the portfolio. Beta
can be used to move systematic risk above or below and since beta is measured by the
market. If there is a presence of a high beta, ten the investor can be expected to be
aggressive as this indicates an aggressive portfolio. When the market price rises and moves
up the corner, portfolio 9 also shows a rise. But the value of the portfolio alls whenever he
market prices fall.
We have just send that beta is a measure which has been used for reducing risk or
determining the risk and return for stocks and portfolios. A number of research studies have
been made to give indications of beta co-efficient for selection of stock. When beta is used
significantly for stock selection it is to be compared with the market. The investor can
construct his portfolio by drawing the relationship of beta coefficient with the prices
prevailing in the market. When there is buoyance in the market , then beta coefficient which
are large can be selected. These betas would also carry with them a high risk but during the
boom period, high risk is expected to give a maximim of return. If the market is bear market
and the prices are falling, then it is possible to sell short stocks which have high positive
beta coefficient. The stocks which have a negative beta would withstand the tag in the prices
in the market. For example, when the beta is +1.0, the volatility which is relative to the
market would indicate an average sock. But when the beta changes o +2.0 , it is excluding
the value which is provided by alpha, the stock would be estimated to show a return of 20%
when the market return is forecasted at 10%. This is in the case of a rising market. But
when the prices shows a decline and the future is expected to provide a decline of 10%, then a
beta which shows +2.0 would show that it is providing a negative return of 20% if the stock is
held by the investor for very long. But if the investor sells short stock, then he can plan to
gain 20%. But if the beta is negative 1.0, then there would be a gain of a positive 10%, I,e (1.0 X.10).
Although betas help in selecting stock, care should be taken to select he stock with
the beta approach because selection of portfolio with beta is followed only when the
following assumptions are considered:
a.
b.
a.
b.
c.
The relative response coefficient depends on the events that are happening in the
economy and a reaction in favour of inflation shows high relative response coefficient.
Also, betas in order to be useful have to be predictive and cannot be upward looking.
A well diversified portfolio is linked with securities with the market movement. But
the market movement can be considered only when a survey of fundamental factors
is taken into consideration. The fundamental factors are the following:
a.
b.
c.
d.
stock to move together. It also shows the co-variance of a homogenous group of the
finance group. It is in between the systematic and specific risk. The specific risk
covers about 50% of the total risk and the co-variance and systematic risk together
comprise the other half of 50% . While systematic risk covers all the firms, the extra
market co-variance is in between and covers one group classification of industries. A
portfolio which is properly selected and is well diversified usually consists of 8090%of the systematic risk involved in those securities.
Internal Diversification
Diversification, as expected, reduces the risk and also the co-variance between
the asset and the market portfolio of all risky assets in the economy.
Diversification internationally has become from he point of view of lowering the
co-variance of he securities. Securities should be purchased generally from the
domestic investments but international investments diversify assets to a greater
extend and help he investor to reduce the systematic risk. Real estate
investment has been used by investors for reducing risk.
International
diversification is possible by investing in multinational companies or in foreign
companies, as this will induce investor to make a combination of risk and return
in a manner to make he portfolio superior to the stocks which are confined only
to one stock market.
International investment of money means to investors to combat inflationary
trends because the markets in different countries do not move together. Each
market has its own constraints, environmental factors, socio-economic and
political factors and the gains in one stock purchase in country A is offset by
losses in country B. This reduces the uncertainty of portfolio return. Before an
investor diversifies his portfolio through international diversification, he must
make a careful consideration of the economic, fundamental and social factors of
the countries in which he is interested in gaining in the stock market .
The gain to an investor by international diversification will depend on the interrelationship of the markets of his domestic country as well as the international
market in which he is investing. Correlation between the markets is measured to
find out the risk constraints. When there is low correlation between the domestic
and foreign investments then there will be considerable reduction in risk but a
high correlation in the movement of markets in both the countries will show that
it is risky and beneficial not to diversify.
There are many constraints in international investments. These are: (a) political
risks, (b) liquidity of markets and (c) the currency effects .
a. Political Risks:
favorable climate for investors. The United States Stock Market is highly
liquid but there are many other countries which lack this liquidity. United
Kingdom, West Germany, Japan, Australia and India may be considered to be
markets having less liquidity and governed by certain political and economic
factors. These bring about some constraints in international investment .
Markowitz Model
Dr. Harry M. Markowitz is credited with developing the first modern portfolio
analysis model since the basic elements of modern portfolio theory emanate from a
series of propositions concerning rational investor behaviour set forth by Markowitz
then of the Rand Corporations in 1952 and later in a more complete monograph
sponsored by the Cowles foundation. It was this work that has attracted everyones
perspective regarding portfolio management. Markowitz used mathematical
programming and statistical analysis in order to arrange for the optimum allocation
of assets with portfolio. To reach this objective Markowitz generated portfolios
within a reward risk context. In other words he considered the variance in the
expected returns from investments and their relationship to each other in
constructing portfolios. In so directing the focus Markowitz and others following the
same reasoning recognized the function of portfolio management as one of
composition and not individual security selection as it is more commonly practiced.
Decisions as to individual security additions to and deletions from an existing
portfolio are then predicted on the effect such a maneuver has on the delicate
diversification balance. In essence Markowitzs model is a theoretical framework for
the analysis of risk return choices. Decisions are based on the concept of efficient
portfolio.
A portfolio is efficient when it is expected to yield the highest return for the level of
risk accepted or alternatively the smallest portfolio risk for a specified level of
expected return. To build an efficient portfolio an expected return level is chosen and
assets are substituted until the portfolio combination with the smallest variance at
the return level is found. As this process is repeated for other expected returns set of
efficient portfolios is generated.
2.
3.
4.
5.
6.
7.
8.
9.
management or by finding out the intrinsic value of shares. Thus all investors
are in equal category.
All investors before making any investment have a common goal. This is the
avoidance of risk because they risk averse.
All investors would like to earn the maximum rate of return that they can
achieve from their investment.
The investors base their decisions on the expected rate of return of an
investment. The expected rate of return can be found out by finding out the
purchase price of a security divided by the income per year and by adding
annual capital gains. It is also necessary to know the standard deviation of
the rate of return expected by an investor and the rate of return which is
being offered on the investment. The rate of return and standard deviation
are important parameters for finding out whether the investment is
worthwhile for a person.
Markowitz brought out the theory that it was a useful insight to find out how
the security returns are correlated to each other. By combining the assets in
such a way that they give the lowest risk, maximum returns could be brought
out by the investor.
From the above it is clear that every investor assumes that while making an
investment he will combine his investments in such a way that he gets a
maximum return and is surrounded by minimum risk.
The investor assumes that greater or larger the return that he achieves on
his investments the higher the risk factor that surrounds him. On the
contrary when risks are low, the return can also be expected to be low.
The investor can reduce his risk if he adds investments to his portfolio.
An investor should be able to get higher returns for each level of risk by
determining the efficient set of securities.
By intelligent balancing of proportion of investments in different
Securities the portfolio risk can be minimized. For different values of
correlation coefficients and different proportions of securities ABC and XYZ
expected returns and portfolio risks can be calculated. The results
Securities the portfolio risk can be minimized. For different values of
correlation coefficients and different proportions of securities ABC and XYZ
expected returns and portfolio risks can be calculated. The results Can be
presented in the form of a graph as shown below
r=
expected
return 10
P
B
r= 0
r =+1
r= +.5
Q
r= -1
A
Portfolio risk
The portfolio risk (p) is shown in the X axis and portfolio return (Rp) in the Y axis.
Point A represents 100% investment on security X and point D represents 100%
holdings on Y. the straight line (AD)r=+1 shows that there is an increased portfolio
risk when there is an increase in portfolio return. In the line segment ACD, rxy= 0,
CD contains portfolios which are superior to those along the line segment AC.
According to Markowitz all portfolios along the ACD line segment are possible. The
line segment ABD (rxy=-1) shows perfect inverse correlation. Portfolios on line
segment BD shows superior returns to those on line segment AB. For instance with
the portfolio risk remaining the same point p on BD has higher returns than point Q
on AB. Thus it can be concluded that Markowitz diversification can lower the risk if
the securities in the portfolio have low correlation coefficients.
The portfolios which offer the highest return at particular level of risk are known as
efficient portfolios. It can be illustrated by means of the following table and diagram.
Expected return(Rp)%
Risk (p)
18
13
15
10
10
10
All the portfolios fall along or within the line ABCDEFGH. Outside this perimeter
portfolios do not fall as there is no existence of expected return and risk combination.
In the above diagram B is more attractive than H as for the same level or risk or 6,
there is higher return for B (15%) C and F have same returns like E and G but is
found superior to both it has the lowest risk of all. Hence in the above diagram A,
B,C and D are efficient portfolios. ABCD line is thus considered as efficient frontier
on which all attachable and efficient portfolios are plotted.
Utility analysis
It is essential to make utility analysis to determine the portfolio which maximizes its
utility. It is the satisfaction, the investor enjoys from the returns of the portfolio.
Utility increases with an increase in the return. There are three types of investors as
assumed by this analysis viz investor avoiding risk, investor who is indifferent and
risk seeking investor. For instance in a gamble costing Rs.2 winner will get Rs. 4 and
the loser will get nothing. The chances of occurrence of both are 50% each. The
expected value of investment is (.5x4)+(.5x0)=2. Hence it is a fair gamble. But it is
rejected by the investor who avoids risk as disutility of loss is greater for him. The
indifferent investor is risk neutral. Risk seeker will select such a fair gamble.
According to him the utility of investment is more than utility of non investment.
This can be illustrated by means of utility curve.
There are three utility curves viz A, B, and c. A shows upward sloping, implying
increased marginal utility, obviously the risk seeker B shows constant utility,
preferred by indifferent investor and c represents diminishing marginal utility (the
risk avoider)
The utility curve of risk seeker is negatively sloped and coverges towards the origin.
Lower the risk of the portfolio happier will be the risk avoider. The risk seeker is
willing to undertake greater risk for smaller returns .
Risk free assets have no default risk and interest risk there is full payment of
principal and interest amount. The risk free asset has certainly of return and has
zero standard deviation. Generally they are fixed income securities.
When the risk free asset is introduced and the investor invests a portion of his
investment on risk free asset and the rest in risky assets, efficient set of portfolios
will witness a change. It is assumed that investor is able to borrow money at risk
free rate of interest.
Return
Rp
In the above diagram OP is the return with zero risk. As one moves along PQ
combinations of risky and risk less assets are found. The investor up to PQ makes
investments in both fixed income securities by lending some amount of money and
risky investments within the point PQ that is he uses his own funds. But if goes
beyond Q he has to make the borrowings. So portfolios between P and Q are lending
portfolios and beyond Q are borrowing portfolios, risk free securities fall on PQ
segment which reduces the risk more than the reductions as far as returns are
concerned.
William F. Sharpe brought out a model simplifying the one advocated by Markowitz.
Markowitz model relates each security to every other one in portfolios requiring
sophistication and great volume of work. Sharpe assumed that the return on a
security can be regarded as linearly related to a single index known as the market
index.
According to Sharpe the market index eliminates the need for calculating large
number of co variances between individual securities as any movements in securities
is attributed to movements in a single underlying factor measured by the market
index. This is known as Single Index Model or Market Model.
Characteristic line
Market is divided into pessimists (bear- selling the stock fearing the fall in prices)
and optimists (bulls). When the market moves many securities move in the same
direction though at different rates. The relationship between returns on individual
securities and returns on market portfolio is expressed with the use of a
characteristic line.
Y
Excess returns on security
Z
im
X
Excess return on market
Portfolio
Market portfolio includes all securities each in proportion to market value. The
characteristic line showing the relationship between the excess return as security
and excess return on market portfolio can be written as
Ri T= i+m( - T) +i
R
m
i indicates vertical intercept and im indicates the slope of the line. The value of
is an excess return on the security that corresponds with an excess return of zero on
the market portfolio whereas im is the ratio of a change in the excess returns of the
security to a change in market portfolio. A Beta of indicates that if the excess return
of market portfolio is 1% larger than expected.
Aggressive securities have higher beta values (greater than one). In up markets their
prices rise at a faster rate than the average security. In down markets they tend to
fall rapidly defensive securities have beta value lesser than one.
The nature of residual component of unsystematic return is known as error termi
which represents uncertain portion of non market of excess return on security i.
Excess return on security
Ri T = im (Rm T) + i + i where
im (
Rm-T) is the systematic market component of excess return and i+i is the
non market (unsystematic) component of excess return. The former is market related
portion of excess return and the latter is the non market portion.i represent
expected non market excess return whereas represents
4. Beta is the relevant measure of risk for investors with diversified portfolios.
5. Risk and return are linearly related by beta that is risk and returns are in
equilibrium.
6. Return is total return.
7. An investor holds portion of two portfolios. The risk-free asset and the market
portfolio.
8. The return that an investor actually receives is derived from only two sources:
risk proportional market return plus non systematic random return. No other
factor is consistent in its effect on security returns .
FIG1
(Sm - O)
Em
(Em -7)
Expected p
Return
Sm
Risk (Standard Deviation of return)
In the above figure point M represents the market portfolio and point T the riskless
rate of interest. Preferred investment strategies plot along line TMZ representing
alternative combinations of risk and return obtainable by combining the market
portfolio with borrowing or lending. This is known as the Capital Market Line CML.
All investment strategies other than those employing the market portfolio and
borrowing or lending below the capital line in an efficient market although some may
plot very close to it.
The slope of the capital market line can be regarded as the reward per unit of risk
borne. As figure 1 shows this equals the difference between the expected return on
the market portfolio and that of riskless security (Em-T) divided by the difference in
their risks( SDm-0).
Equilibrium in the capital market can be characterized by the key numbers. The first
is the reward for waiting or riskless interest rate shown by the vertical intercept of
the capital market line (point T in the above figure). The second is the reward per
unit of risk borne shown by the slope line. In essence the capital market line
provides a place where time and risk can be traded and their prices determined by
the forces of demand and supply. The internal rate can be thought of as the price of
time and the slope of the capital market line as the price of the risk.
The selection of a portfolio intended to act as a surrogate for the market portfolio can
be considered a passive strategy for it requires no security analysis. In a completely
efficient market it may constitute the most reasonable approach to investment. In
real world one hopes to beat such a strategy. But the odds are not favorable. by
investing in proportion to values outstanding an investor can be assured pf
performance equal to that of the average in the market. If one advisor or investor is
to consistently outperform this average without taking on disproportionate amounts
of risks, others must consistently under perform it. Investors of this latter variety
may exist but they are not likely to be masochists or completely oblivious to their
situation. Eventually they should realize that they would be better off following a
passive strategy or paying one of the winners of the game to play for them.
Managers employing passive strategies can provide a number of valuable services,
risk control, diversification at low cost , convenient ways to ass or withdraw funds
etc. but some managers and some investors prefer to go beyond this actively
managing a portfolio to try to beat the market. Fig2 analyst owns opinions are
shown here not the consensus of professional analysts opinion. Realistically even
superior analysts must assume that combinations of the market portfolio and
borrowing or lending (shown by line TMZ) dominates most alternative strategies.
However truly superior analyst might find a few combinations that offer higher
expected returns than naives strategies of comparable risk. Such combinations are
shown by the points above the line TMZ in fig2
Active investment management can have its benefits. But it brings costs as well. In the
real world trading costs money and may impact price adversely. Moreover even a
superior analyst cannot hope to identify large numbers of seriously +
securities. Often an investors circumstances restrict the alternative that can be
considered. Many institutions are required to avoid certain classes of securities. Others
can spend only out of dividend and interest income. Taxes do matter in the real world
and different investors are affected differently by them. These factors make investment
management more complicated than the CAMP would suggest. Accepting the inability of
most managers to consistently beat the market one still must accept the need for
potentially rather complicated procedures designed to tailor an investment strategy to
fit the circumstances of a particular individual or institution.
FIG2
Expected
Return
EM
Sm
Risk (standard Deviation of return)
The CML defines the relationship between total risk and expected return for
portfolios consisting of the risk free asset and the market portfolio. The capital asset
pricing model identifies security return net of the risk free rate as proportional to
the expected net return where beta serves as the constant if proportionality. As a
consequence of this relationship all securities in equilibrium plot along a straight
line called the security market line (SML). Since the unsystematic risk tends to be
diversified away by the construction of an efficient portfolio it is desirable to develop
an alternative to CML which will use beta as he independent variable and will
accommodate both portfolios and individual assets. Such a line is called Securities
Market Line (SML). In other words SML is a linear relationship between expected
return and beta or systematic risk on which both portfolio s and individual securities
can lie where as capital market line is a linear relationship between the expected
return of a portfolio and the total risk associated with it; it generates a line on which
efficient portfolio can lie. Fig 3 presents a SML which has beta as the independent
variable and the expected return of portfolios and the individual securities as the
dependent variable.
The SML has a positive slope indicating that the expected return increases with risk
(beta). By definition the risk of a risk less asset, T is zero therefore T is the point at
which the SML crosses the vertical axis the Y intercept point. The beta of the market
portfolio which measures the systematic risk of the market relative to it self, is 1.
Therefore the point where beta equals 1 is associated with the expected market
return. This is an important point since all securities and portfolios with a beta of
less than 1 lie to the left of M on the SML and is called defensive securities. Likewise
securities with a beta of more than 1 are riskier than the market and are called
aggressive securities. In addition the expected return of a security on the SML is
determined by the risk less rate plus a systematic risk premium which is
proportional to its beta.
MODULE - II
Capital market securities: types ; valuation of securities: Investment
Hedgers face risk associated with the price of an asset. They use futures or
options markets to reduce/ eliminate this risk. Speculators wish to bet on
future and option contracts can give them an extra leverage that is they can
increase both the potential gains and potential losses in a speculative
venture. Arbitrageurs are
Debentures:
According to Sec 2(10) of the companies Act Debentures includes debenture
Stock bonds and any other security of a company whether constituting a
charge on the assets of the company or not to make it more clear debenture is
acknowledgement of debt, given under the seal of the company and contain a
contract for the repayment of the principal sum at a specified date and for the
payment of interest at a fixed rate per cent until the principal sum is repaid,
and it mayor may not give charge on the assets to the company as security of
the loan.
A debenture is a marketable legal contract whereby the company promises to
pay its owner a specified rate of interest for a defined period of time and to
repay the principal at the specific date of maturity. Debentures are usually
secured by a charge on the immovable properties of the company.
The interest of the debenture holders is usually represented by a trustee and
this trustee is responsible for ensuring that the borrowing company fulfills
the contractual obligation embodied in the contract. If the company issues
debentures with a maturity period of more than 18 months, then it has to
1.
4.
specified period of time on the expiry of that specified time the company has
the right to pay back the debenture holders and have its properties based
from the mortgage or charge. Generally debentures are redeemable.
5.
6.
7.
Drawback
There is a limit to the extent to which funds can be raised through long
term debt.
Since long term debt is a commitment for a long period it involves risk
during that time the debt may prove a burden or it may prove to have
been advantageous.
Interest rate
The interest rate is an important consideration for a modern financial
manager in taking the investment and finance decisions. Interest rate are
the measure of cost of borrowing. The interest rates of a country will
influence the foreign exchange value of its own currency. Interest rates are
taken as a guide in making investments into shares, debentures deposits, real
estates, loan lending etc. The interest rates differ in different market
segments due to the following reasons.
Risk: Borrowers carrying high risk will pay higher rates of interest
than the borrowers with less risk.
Real rates interest will usually e positive although when the rate of
inflation is very high because the lenders will want to earn a real return
and will therefore want nominal rates of interest to exceed the inflation
rate. A positive real rate of interest adds to an investors real wealth from
the income he earns from his investment.
Interest rate and share prices
The shares and debt instruments are alternative ways of investment. If
the interest rates on debt instrument fall, shares become more attractive
to buy. As demand for shares increases their prices rise too; and so the
dividend return gained from them fall in percentage terms. If interest
rates went up the share holder would probably wait a higher return from
his shares ad prices would fall.
Raise funds by issue of equity shares and to stay away from raising
debt finances.
Debt finance can be taken from short term rather than long term.
Surplus liquid assets can profitably be invested by switching of
investments fro equity shares to interest bearing investments.
Reduce the need to borrow funds by selling unwanted and inefficient
assets keeps the stocks and debtors balances at lower levels etc.
New projects need to be given careful consideration, which must be
able to earn the increased cost of financing the projects.
The risk is more in holding securities for a longer period than short
period. This is due to the conditions of business which cannot be
predicted with accuracy and hence the investors holding long-term
3.
4.
5.
The Government offers absolute security for its debts so that yields
on gilt edged security are finest in the market and establish all
standard for other yields. Since the standing of other borrowers is
lower. Investors expect higher yields. The difference is known as
the yield differential or yield gap.
Duration of the loan
2.
6.
The element of the risk increases with the duration of the loan so
that, investors expect higher yields on long term bonds than for
short by way of compensation.
General outlook of economy:
A bullish outlook for industry or the prospect of inflation and high
rates of interest will cause investors to switch to equities to depress
the prices of gilts and to raise their yields.
7.
Political events:
Prices and yields are also influenced by political events Eg: change
of government, industrial unrest, publication of trade figures
international crisis or any events likely to effect business confidents
etc.
Residual Claim to income: The equity share holders have a residual claim to
the income of the company. They are entitled to the remaining income/profits
of the company after all outsider claims are met. The income available to
share holders equal profit after tax minus preference dividend. PAT is equal
to operating profit (EBIT). However residual claim is only a theoretical
entitlement as the amount actually received by the share holders in the form
of dividend will depend on the division of the Board of Directors.
Residual Claim on Assets: The ordinary share holders claim in the assets
of the company is also residual in that their claim would rank after the claims
of the creditors and preference. Share holders in the event of liquidation if
the liquidation value of the asset is insufficient their claims may remain
unpaid.
Right to control: As owners of the company equity holders have the right to
control the operation to participate in the management of the company. Their
control is however indirect. The major policies or decision are approved by
the Board of Directors and the Board appointed Management carries out the
day to day operations. The share holders have the legal power to elect the
Board of Directors as well as vote on every resolution placed in various
meetings of the company. Though in theory they have indirect right to control
or participate with the management. In actual practice it is weak and
ineffective partly because of the apathy and indifference of the majority of the
share holders who rarely bother to cast their votes and partly because
scattered and by and large unorganized equity share holders are unable to
exercise their collective powers effectively.
Voting System: The ordinary shareholders exercise their rights to control
through voting. In the meeting of the company, according to the most
commonly used system of voting in India viz majority rule voting is elected
individually. Therefore a share holder can cast the total number of shares
held by him separately. Shareholders or groups holding more than 50% of the
voting right would be able to elect all the directors of their choice.
Pre-emptive rights: The ordinary shareholders of a company enjoy preemptive rights in the sense that they have a legal right to be offered by the
company. The first opportunity to purchase additional issues of equity capital
in proportion to pro rata basis their existing or current holdings/ownership.
The option to the share holders to purchase a specified number of equity
shares at a stated price during a given period is called rights. The share
holders can exercise, sell in the market and renounce or forefeit their preemptive right partially or completely. The pre-emptive rights ensures that
the management cannot issue additional shares to strengthen its control by
selling them to persons or groups favourably inclined to it. On the other hand
it protects the existing share holders from deletion of their financial interest
as a result of new equity issue on the other.
Although the equity holders share the ownership risk their liability is limited
to the extent of their investment in the share capital of the company.
While evaluating the equity share holding it has got its own merit and
demerit.
Advantages:
1.
2.
3.
4.
5.
Disadvantages:
1. The sale of ordinary shares extended voting rights to control to the
additional share holders who are brought into the company..
2. More ordinary shares give more people the right to share with the existing
owners in the company profit
3.
The cost of underwriting and distributing new issues of ordinary
shares are usually higher than those for underwriting and distributing new
issues of ordinary shares are usually higher than those for underwriting and
distributing preference shares or debentures.
4. If the firm has more equity or less debt that is called for in the optimum
capital structure the average cost of capital will e higher than necessary.
5. Dividends payable to ordinary shares holders are not deductible as
expense for the purpose of corporation tax but debenture interest is
deductable.
In brief equity share capital is a high risk high reward permanent capital
market instrument or sources of long term finance for corporate enterprises.
Share holders who desire to share the risk, return and control associated
RISK
Risk and uncertainty are an integral part of an investment decision. Technically
risk can be defined as a situation where the possible consequences of the decision
that is to be taken are known. Uncertainty is generally defined to apply to
situations where the probabilities cannot be estimated. However risk, and
uncertainty are used interchangeably.
Risk is composed of the demands that bring in variations in return of income. The
main forces contributing to the risk are price and interest. Risk is also influenced by
external and internal considerations. External risks are uncontrollable and broadly
affect investments. These external risks are called systematic risk. Risk due to
internal environment of a firm or those affecting a particular industry are referred
to as unsystematic risk.
Systematic risk is non diversifiable and is associated with the securities market as
well as the economic, sociological, political and legal considerations of the prices of
all securities in the economy. The effect of these factors is to put pressure on all the
securities in such a way that the prices of all stocks will move in the same direction.
Unsystematic risk is unique to a firm or industry. It does not affect an average
investor. Unsystematic risk is caused by factors like labour strikes, irregular
disorganized management policies and consumer preferences. These factors are
independent of the price mechanism operating in the securities market. The
problems of both systematic and unsystematic risk are inherent in industries
dealing with basic raw materials as well as in consumer goods industries.
Those industries producing industrial products and dealing with basic raw materials
follow the level of economic activity and price levels of the securities markets. High
degree of systematic risk can be discerned in such industries and low degree of
unsystematic risk. Example rubber, glass, automobile etc.
Classification of risk
1.
2.
3.
4.
Systematic
Economic
Sociological
Political
Legal Risk
1. Securities Market
2. Economy
unsystematic
1. Industry Risks
Unique Risks
1. Labour strikes
2. Weak Marginal Policies
3. Consumer Preferences
Internal Risks
1. Business Risk
2. Financial Risk
1. Market Risk
2. Interest Rate Risk
3. Purchasing Power Risk
Systematic Risk
As defined earlier systematic risk is uncontrolled and it indicates the direction of the
movement of stock market. When the stock market is in the hands of bulls, it implies
that there is an upward trend. The reasons beyond the control of an industry include
economic conditions, political situations and sociological changes. For example the
recessions experienced by the world in 1998 affected the stock market all over the
world. An individual investor cannot avoid the systematic risks. The systematic risk
can be classified into
a. market risk
b. interest rate risk and
c. purchasing power risk
1. Market Risk
The market risk can be defined in the words of Francis as that portion of total
variability of return caused by the alternative forces of bull and bear markets. Bear
market has the index declining from the peak to a low point for a considerable point
of time. The bull market is characterized by the moving index from a low level to the
peak. There are many events which cause buoyancy and debacles in stock market.
These include war, earthquake, political uncertainty, depreciation in the value of
currency, trade protectionist measures followed by importing countries etc. when
political turmoil and recession cause havoc in the economy there would be a rush to
sell the share and the stocks which are floated in the primary market, do not get
adequate market reception. Further when a leading financial institution starts
disposing the stocks the investors get panic and start selling the stocks. Such an over
reaction
of
the
market
is
beyond
the
control
of
investors.
Unsystematic Risk
1. Business Risk
Business risk arises from the inability of a firm to maintain its competitive edge over
other firms and maintain the growth or the stability of the earnings. The variations
in the expected operating income indicate the business risk. It is concerned with the
difference between revenue and earnings before interest and tax. Business can be
classified into internal risk and external business risk.
Internal business risk is associated with the operational efficiency of a firm. The
operational efficiency is affected by sales fluctuations, research and development
measures of the firm, management of human resources, fixed cost, product
diversification, industrial relations, credit policy etc.
Firms having several products lines are facing lesser business risk than those which
have single product line. It is because some products are more vulnerable to the
business cycle while others withstand and start achieving growth against the tide.
However diversification must be limited to the known path of the company as
unwieldy diversification would land the firm in deep trouble.
2. External Risk
The factors in the external environment of a firm have strong impact on the
operations. These include monetary and fiscal policies of the government, various
phases of business cycle , social and regulatory factors, general economic
environment, political situation others.
Regulatory measures followed by the govt would affect business operations. For
example the govt may exercise price control volume control etc. The pollution control
board has brought 0ut strict guidelines for safe guarding the natural environment
and asked many tanneries in Tamilnadu to close down the business for falling to set
up effluent treatment plants.
Political stability has to be ensured as political uncertainties would lead to crash in
stock prices. For instance immediately on assuming power, the congress govt at the
centre ruled out disinvestment of companies in oil sector. When there is a change in
the ruling party changes are expected in the economic policies which would affect
share market operations. The business cycle fluctuations lead to fluctuations in the
fortunes of a company. Almost all industries would suffer when the recessions sets
in. During the boom period the development of economy would be witnessed in the
form of increased earnings and consumptions. Many firms may be forced to close
down others witness fall in profits.
3. Financial Risk
The investor has to understand nature of risk and take suitable precautions to
minimize the dangers caused by various risks.
3. The information on the standard deviation and beta values of the stock
provided by the National Stock Exchange bulletin is useful in gauging the risk
factor to take correct decisions.
2. Investment in short term securities would minimize the risk associated with
the inflation. It is because rising consumer price index would eat away the
real rate of interest in the long run.
3. Diversified investment would to a great extent provide a hedge against
inflation. The effect of fall in purchasing power can be minimized.
Beta
The most important part of equation is b or beta. It is used to describe the
relationship between the stocks return and market indexs returns. If the
regression line is at an exact 45 angle, beta will be equal to +1.0. A 1% change in
the market index (horizontal axis) shows that it is on an average accompanied by
a 1% change in the stock on the vertical axis. The percentage changes in the price
of the stock are regressed against the percentage change in the price of a market
index. Usually in the S&P 500 price index, Beta may be positive or negative.
Usually betas are found to be positive. We rarely find a negative beta which
reflects a movement contrary to the market. A .5 beta indicates that the market
index change of 1% was reflected by a .5% price change in stocks. Similarly a 1.5
betas would reflect that whenever the market index rose or fell by 1%, the stock
would rise and fall by 1.5%. Beta is referred to as systematic risk to the market
and a +E the unsystematic risk. Beta us useful piece of information both for
individual stock as well as portfolios, but as a measure of risk it is better used in
the analysis of portfolios. Also beta measures risk satisfactorily for diversified
efficient portfolios but not inefficient portfolios. In the present concept Beta is
satisfactory measure for portfolios because risk other than that reflected by beta
is diversified.
Beta has certain limitations within which it must be considered. While
calculating past betas, the length of time will affect beta size. When estimating
future betas, the markets expected return should also be estimated. If high beta
is accurately predicted and the market also goes up as predicted the relationship
will work. On the contrary high beta estimation and low market or downward
market will show that the beta will drop much faster than the market. Finally its
shortcomings as a measure for individual stock should be realized while
calculating stock. For the total portfolio beta is effective.
Alpha
The distance between the intersection and the horizontal axis called alpha
( ). The size of the alpha exhibits the stocks unsystematic return and its average
return independent of the markets return. If alpha gives a positive value, it is a
healthy sign but alphas expected value is zero. The belief of many of the investors is
that they find stocks with positive alphas and have a profitable return. It must be
recalled however that in an efficient market positive alphas cannot be predicted in
advance. The portfolio theory also maintains that the alphas of stock will average
out to 0 in a properly diversified portfolio. The third factor besides alpha and beta is
Rho
Rho ()
Co variance
While standard deviation is an excellent measure for calculation of risk of individual
stocks. It has its limitations as a measure of a total portfolio. With the correlation
the covariance approach should also be considered when there are two or three
stocks on the portfolio; co variance approach should also be considered when there
are two or three stocks on the portfolio. Co variance can be used to achieve the
highest portfolio expected return for a predetermined portfolio variance level or the
lowest portfolio return.
An individual securitys expected return and variance express return and risk for
portfolio of stocks the expected return on the individual securities. This is weighted
according to each securities rupee proportion in the portfolio. Since stocks tend to
cover or move together portfolio risk cannot be expressed for an individual stock. The
formulae for calculation of covariance of two stocks I and J and the covariance of
stocks with beta coefficients are
Cov. ij = p ij i j
P ij = joint probability that ij will move simultaneously
i = standard deviation of i
= standard deviation j
Most investors are risk averse and attempt to maximize their wealth at
the
minimum risk. Risk it is established can be reduced to a minimum but cannot be
completely erased or eliminated. Risk and return are related.
The study of investment is concerned with the purchase and sale of financial
assets and the attempt of the investor to make logical decisions about the various
alternatives in order to earn returns on them. The returns are further dependent on the
varying degrees of risk. A functional definition as defined by Amling is, Investment
may be defined as the purchase by an individual or institutional investor of a financial or
real asset that produces a return proportional to the risk assumed over some future
investment period.
Fisher and Jordan describe it in a similar manner An investment is a commitment of
funds made in the expectation of some positive rate of return. If the investment is
properly undertaken the return will be commensurate with the risk of the investor
assumes.
An investor takes a lot of decisions before he selects the right assets for making
investment. He considers the level of risk he can assume and the nature of assets
available. He has investment options like bonds, stocks, and real estates. Once he decides
the type of assets for instance common stock he has to decide which companys equity he
has to look for. He should possess large volume of funds to make investment on the stock
of companies like Reliance or Infosys. A part from that his decision should be based on
the return and risk associated with the assets.
The valuation does not pose much problems in the case of bond and preserved sotck as
the benefits are generally constant and certain. Equity valuation is difficult in the sense
the return on equity is not certain and high fluctuations are experienced frequently. Hence
the size of the return and risk determine the value of a share to an investor. An equity
manager performs three important activities viz deciding the equity to buy or sell, trading
of securities, and monitoring the performance of portfolio.
Basic valuation Models: Fundamental Approaches
Time value of money
The Basic Valuation Models are based on the idea that money has a time value. An
amount of Rs. 100 received today is worth more than a 100 rupee note two years later,
since Rs. 100 can be invested today at 6% interest. It will fetch then Rs. 106 in a year. For
different securities, future benefits may be received at different times. Even when the
amount of future payment is the same differences in the timing of receiving them will
create different values. The time value theory states that money received earlier is of
greater value then money received later even both are equal in amount and certainty
because money received earlier can be used for reinvestment to bring in greater returns
before the later returns can be received. The principle which works in time value of
money is interest. The technique used to find out the total value of money is
1. Compounding and
2. Discounting
1. Compounding
An initial investment or input will grow over a period of time. The terminal value can be
seen as
S = P (1+i)
S= Terminal value
i = Time Preference or interest rate
n = number of years
p = initial value
Yield to maturity
The yield to measure most commonly used for bonds is not current yield but yield to
maturity (YTM) the percentage yield that will be earned on the bonds from purchase date
to maturity date. The yield to maturity puts bonds income into a common denominator
that permits investors to make yield comparisons. The yield to maturity need not consider
capital gains; bonds are redeemed at their face value at maturity. Indeed the yield to
maturity has several other virtues. It considers the time value of money market discounts
and premium and is the return earned over the remaining life of a bond issue.
The yield to maturity is a complex computation based upon a rather simple ides. It is the
discount rate that equals the present value of all cash flows from a bond to the cost
(current market prices).
n
t
n
Po = It/ (1+r) + Pt / (1+r)
t=1
Po= cost of bond
Pt = Terminal price or value
It = Annual interest in rupees
r= Discount rate which is the yield to maturity.
t= time period
To avoid these cumbersome calculations yields to maturity have been reduced to tables.
However bond tables are not complete. Complete table would show the net yield on
every amount invested at every possible rate of yield for every possible maturity. A large
assortment of tables is available with wide range in coupon rates, maturities and prices.
The more modern tables reflect the use of low and fractional coupon rates and provide
means by which prices and yields for maturities involving monthly periods can be
determined with a minimum of interpolation. Interpolation is a matter of proportion as it
is based upon the assumption that the changes in the bond values are proportionate. The
assumption is not absolutely correct but the degree of variance is too small too be serious.
The formula for approximating the YTM
Annual coupon interest + (Discount /Number of years to maturity)
(Current price+ Par value) / 2
Or
Annual coupon interest (premium/ number of years to maturity)
(Current price + par value) / 2
The yield to maturity calculation may not be an appropriate measure of the issues
expected rate of return if a bond is callable for refunding purposes. The corporation may
exercise the call privilege in case there is a significance chance that interest rates may fall
to level which makes refunding attractive to the issuer. Then the investment manger will
be faced with the necessity of reinvesting at lower rates if the quality not to be so
reduced. In addition to reinvesting at lower rates he will incur the annoyance and
expenses of having to make a new search for an acceptable issue. At offset against this
expenses will be the call premium which the issuer must pay in order to exercise the
call privilege. The end results of all these factors may be a realized yield that is
substantially different from the originally calculated yield to maturity.
Bond volatility
Price of bond changes according to the interest rate. Price changes in the bond are
generally called as bond volatility. The relationship between the duration of a bond and
the price volatility for a change in the market interest rate is given by the following
formula.
Percentage change in price = -MD [BP]
100
Where MD = modified Duration
BP = is the basis point which is 0.01% of 1%
Modified duration can be calculated as follows:
MD =
D
1+MY/I
D = duration
MY = market yield and
I = interest payment per year.
Immunization
Immunization is a technique which makes the bond holder t be certain of promised cash
flows. The changes in the market interest rate affect the bond interest rate. The coupon
rate and price bond thus get affected by market rate. However in the process of
immunization the coupon rate risk and the price risk are made to offset each other. When
there is an increase in market interest rate the prices of bonds fall. But at the same time
newly issued bonds fetch higher interest rates. The coupon can vary well be reinvested in
the bonds which offer higher interest rates and losses that occur due to fall in the price of
bond can be offset resulting in the immunization of portfolio. The money to be invested
in different bonds can be found by using the equation
Outflow of investment = (X1) (duration of bond 1) +(X2) (duration of bond 2)
Where X1 and X2 are the proportions of investment on bond 1 and bond 2
The process of immunization is criticized under the following grounds:
1. Immunization and duration are based on the assumption that change in interest
rates would occur before payments are received. However it may not be true
always. The change may occur even after the cash flow is received.
2. The assumption that the bonds have same yield may not hold good always.
3. The shift in the interest rate affects different bonds differently. This is in variation
with the assumption that the shift affects all the bonds equally.
4. The assumption that there will not be any call risk or default risk does not also
hold good.
Value of preference shares
Preference shares give a fixed rate of dividend but without a maturity date. They are
usually perpetuities but some times they have maturity dates also. The value of a
preference share as a perpetuity is calculated thus
V= D where
i
V= Value of preference shares
D= Annual dividend per preference share
i = Discount Rate on preference shares.
Yield on preference shares
The yield on preference shares is calculated as follows
i=D
V
Derivatives Market
Assignment
Options
In the world of investments, an option is a type of a contract between two parties
when one person grants the other person the right to buy a specific asset at a specific
price within a specific time period. Alternatively the contract may grant the other
party the right to sell specific assets at a specific price within a specific time period.
The person who has received the right and thus has a decision to make is known as
the option buyer since he or she must pay for the right. The person who has sold the
right to the buyer and thus must respond to the buyers decision is known as the
option writer
Uses of options
There are number of reasons for being either a writer or a buyer of options. The
writer assures an uncertain amount of risk for a certain amount of money where as
the buyer assures an uncertain potential gain for a fixed cost, such a situation can
lead to a number of reasons for using options. However fundamental to either
writing or buying an option is mere promise that option is fairly valued in terms of
the possible outcomes. If the option is not fairly priced then of course an additional
source of profit or loss is introduced and the writer or buyer of such a contract may
be subject to an additional handicap that will reduce his or her return.
The reasons for writing option contract are varied but three of the most common are
to cash additional income on a securities portfolio, the fact that option buyers are not
as sophisticated as writers and to hedge along position. It is sometimes argued that
option writing is a source of additional income for the portfolio of an investor with a
large portfolio of securities. Such an approach assumes that the portfolio manager
can guess the direction of specific stock prices closely rough to make this strategy
worth while. What cannot be overlooked is that the writer gives up certain rights
when the option is written.
Second it is believed by some that the buyers of options are not as sophisticated as
the writers. The proponents of this view argue that option writers are the most
sophisticated participants in the securities market and view the option premiums
simply as additional income.
The third reason for writing options is to hedge a long term positions in a stock
portfolio. A typical situation would be where the portfolio manager is concerned that
a stock may decline if the stock is sold he or she will have to pay a capital gains tax.
Selling a option would involve a minimum risk of having the stock called away.
There are a number of reasons for buying options two of the most common are
leverage and changing the risk complexion of portfolio. The term leverage in
connection with options indicates buyer being able to control more securities than
could be done with realistic margin requirements. In other words with the use of
margins the buyer of securities can buyer more securities and hopefully make a
greater profit than could be done by taking a basic long position. Puts and calls can
be used in much the same fashion and perhaps provided higher return.
Another reason for buying options is to change the risk complexion of a portfolio of
securities. It should be noted that this benefit of options is available not only to the buyers
but also to writes. Therefore they permit the portfolio manager to undertake as much or as
little risk as he or she feels is appropriate at a point of time. They also give additional
flexibility insetting the amount of risk the portfolio manager is willing to accept with
respect to a specific portfoli
Types of option
There are two basic types of stock option, which can be used
separately or combined to derive two additional types of options.
Fundamentally the holder of an option merely possesses the right to
buy or sell a specific asset. The option contract specifies between the
period of time allowed to exercise this right and the price. The main
types of stock option are
1. Put option
A put is an option to sell. A put gives its holder the privilege of selling
or putting to a second party a fixed amount of some stock at a stated
price on or before a predetermined date.
2. Call option
A call is an option to purchase; its holders has the privilege of
purchasing or calling from a second party a fixed amount of some
stock at a stated price on or before a predetermined day. The standard
call contract is not by the individual originating the contract, but his
broker who by market practice must be a member firm of the stock
exchange. This endorsement guarantees that the contract will be
fulfilled and considerably enhances its status as a negotiable
instrument.
Therefore puts and calls are securities in end of them and can be
traded as any other security is traded. Puts and calls are almost written
on equities although occasionally preference shares, bonds and
warrants become the subject of options. Warrants are themselves a
kind of call option.
Puts and calls are the basic options forms. In addition there are other
kinds of options present in todays trading, which are combination of
puts and calls. These are
a. Spread
A spread consists of both a put and a call contract. The option price at
which the put or call is executed is specified in terms of a number of
rupees away from the market price of the stock at a time the option is
granted. The put may be exercised at a specified number of rupees
below the market and the call at the corresponding number of rupees
above the market. If the fluctuation is less than this spread either on
the upside or the downside the investment is valueless and results in a
complete loss to the purchaser.
b. Straddle
A straddle is similar to a spread except that the execution price of
either the put or call option is at the market price of stock at the time
of straddle is granted. In essence both the straddle and spread
accomplish the same thing.
Two recent additions to the family of options in current trading
are the strips and straps. A strip is a straddle with a second put
added to it having the same dimensions as the first put. A strap is a
straddle with a second call added to it. These combination options
appear for the most part on the supplying side of the put and the call
market.