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Unit-1

Introduction
Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly 200 years ago.
The earliest records of security dealings in India are meager and obscure. The East India
Company was the dominant institution in those days and business in its loan securities used to
be transacted towards the close of the eighteenth century.
By 1830's business on corporate stocks and shares in Bank and Cotton presses took place in
Bombay. Though the trading list was broader in 1839, there were only half a dozen brokers
recognized by banks and merchants during 1840 and 1850.
The 1850's witnessed a rapid development of commercial enterprise and brokerage business
attracted many men into the field and by 1860 the number of brokers increased into 60.
In 1860-61 the American Civil War broke out and cotton supply from United States of Europe was
stopped; thus, the 'Share Mania' in India begun. The number of brokers increased to about 200 to
250. However, at the end of the American Civil War, in 1865, a disastrous slump began (for
example, Bank of Bombay Share which had touched Rs 2850 could only be sold at Rs. 87).
At the end of the American Civil War, the brokers who thrived out of Civil War in 1874, found a
place in a street (now appropriately called as Dalal Street) where they would conveniently
assemble and transact business. In 1887, they formally established in Bombay, the "Native Share
and Stock Brokers' Association" (which is alternatively known as " The Stock Exchange "). In
1895, the Stock Exchange acquired a premise in the same street and it was inaugurated in 1899.
Thus, the Stock Exchange at Bombay was consolidated.

Structure of Capital Market in India

Securities market / Stock Market

Securities market is an economic institute within which takes place the sale and purchase
transactions of securities between subjects of the economy, on the basis of demand and supply.
Also we can say that securities market is a system of interconnection between all participants
(professional and nonprofessional) that provides effective conditions: to buy and sell securities,
and also
1. to attract new capital by means of issuance new security (securitization of debt),
2. to transfer real asset into financial asset,
3. to invest money for short or long term periods with the aim of deriving profit.
4. commercial function (to derive profit from operation on this market)
5. price determination (demand and supply balancing, the continuous process of prices
movements guarantees to state correct price for each security so the market corrects
mispriced securities)
6. informative function (market provides all participants with market information about
participants and traded instruments)
7. regulation function (securities market creates the rules of trade).

Role of Stock Market

Raising capital for businesses


The Stock Exchange provide companies with the facility to raise capital for expansion through selling shares to
the investing public
Common forms of capital raising
Besides the borrowing capacity provided to an individual or firm by the banking system, in the form of credit or
a loan, there are four common forms of capital raising used by companies and entrepreneurs. Most of these
available options, might be achieved, directly or indirectly, involving a stock exchange.
Mobilizing savings for investment
When people draw their savings and invest in shares (through an IPO or the issuance of new company shares of
an already listed company), it usually leads to rational allocation of resources because funds, which could have
been consumed, or kept in idle deposits with banks, are mobilized and redirected to help companies'
management boards finance their organizations. This may promote business activity with benefits for several
economic sectors such as agriculture, commerce and industry, resulting in stronger economic growth and higher
productivity levels of firms. Sometimes it is very difficult for the stock investor to determine whether or not the
allocation of those funds is in good faith and will be able to generate long-term company growth, without
examination of a company's internal auditing.
Facilitating company growth
Companies view acquisitions as an opportunity to expand product lines, increase distribution channels, hedge
against volatility, increase its market share, or acquire other necessary business assets. A takeover bid or a
merger agreement through the stock market is one of the simplest and most common ways for a company to
grow by acquisition or fusion.

Profit sharing
Both casual and professional stock investors, as large as institutional investors or as small as an ordinary
middle-class family, through dividends and stock price increases that may result in capital gains, share in the
wealth of profitable businesses. Unprofitable and troubled businesses may result in capital losses for
shareholders.
Corporate governance
By having a wide and varied scope of owners, companies generally tend to improve management standards and
efficiency to satisfy the demands of these shareholders, and the more stringent rules for public corporations
imposed by public stock exchanges and the government. Consequently, it is alleged that public companies
(companies that are owned by shareholders who are members of the general public and trade shares on public
exchanges) tend to have better management records than privately held companies (those companies where
shares are not publicly traded, often owned by the company founders and/or their families and heirs, or
otherwise by a small group of investors).
Creating investment opportunities for small investors
As opposed to other businesses that require huge capital outlay, investing in shares is open to both the large and
small stock investors because a person buys the number of shares they can afford. Therefore the Stock
Exchange provides the opportunity for small investors to own shares of the same companies as large investors.

Levels of securities market


Primary market
The primary market s that part of the capital markets that deals with the issue of new securities. Companies,
governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This
is typically done through a syndicate of securities dealers. The process of selling new issues to investors is
called underwriting. In the case of a new stock issue, this sale is a public offering. Dealers earn a commission
that is built into the price of the security offering, though it can be found in the prospectus. Primary markets
creates long term instruments through which corporate entities borrow from capital market.
Features of primary markets are:
This is the market for new long term equity capital. The primary market is the market where the
securities are sold for the first time. Therefore it is also called the new issue market (NIM).
In a primary issue, the securities are issued by the company directly to investors.
The company receives the money and issues new security certificates to the investors.
Primary issues are used by companies for the purpose of setting up new business or for expanding or
modernizing the existing business.
The primary market performs the crucial function of facilitating capital formation in the economy.
The new issue market does not include certain other sources of new long term external finance, such as
loans from financial institutions. Borrowers in the new issue market may be raising capital for
converting private capital into public capital; this is known as "going public."
Primary market Primary Functions
1. Origination- Deals with Origin of new Issue. The proposal is analyzed in terms of
the nature of the security, the size of the issue, time of the issue and floatation
method of the issue.

2. Underwriting- Contract Between Issuing Company and Underwriter. Underwriter


gives assurance that, in case investor will not subscribe minimum number of share
then they will subscribe. They also increases Investor confidence.
3. Distribution

Public Placement
Private Placement
Right Issue
Offer of Sale

Primary market Secondary Functions


1. To promote a new company
2. To help to expand a new company
3. To help in diversification of the product
4. To channelize the savings of the investors.
5. To help the companies to raise capital
6. To help the secondary market in helping in trading of the securities.
Participant in Primary Market
1. Manager to the issue Construction of the prospectus.
Appointment of the registrar
Appointment of the banker
Appointment of the underwriter.
Budget for the Issue
2. Registrar to the issue Receive the share application from various collection centers.
Recommend the basis of allotment
Dispatching the share certificates
Share allocation
Approval of the prospectus.
3. Underwriter
4. Banker to the issue
Collection of the application form and application money
Takes commission beside brokerage.
May be a financial institution or a bank or a NBFC.
5. Advertising AgenciesPrepare Advertisement and promote the companies Issue in various media.
6. The financial Institution.
Generally underwrite the issues of the companies.
Primary market Secondary market Relation

the new issue Market and stock exchanges are inseparably connected:
1. The securities issued in the New Issue Market are invariably listed on a recognised stock exchange,
subsequent to their issue. This is of immense utility to potential investors who feel assured that should they
receive an allotment of new issues, they will subsequently be able to dispose them of at any time. The facilities
provided by the secondary markets, thus, widen the initial market for them.
2. Secondly, the stock exchanges exercise considerable control over the organisation of new issues. In terms of
the regulatory framework relating to dealings in securities, new issues, which seek stock exchange quotation

have to comply with statutory rules as well as regulations framed by the stock exchanges with the object of
ensuring fair dealings in them.
3. Fundamentally, the markets for new and old securities are, economically, an integral part of a single market
the industrial securities market. Thus they are susceptible to common influence and act and react upon each
other. Broadly, new issues increase when stock values are rising and vice versa.
Also, the quantitative predominance of old securities in the market usually ensures that it is these which set the
tone of the market as a whole and govern the prices and acceptability of new issues.
Thus, we see that the capital market, with particular reference to company scraps, performs two distinct
functions providing funds for trading in existing securities and funds for fresh issues of capital by the
companies either through public issue or right issue or by private placement.
While in many respects, the market mechanism for capital markets is the same as for commodities, there is a
fundamental difference that renders the former more complex, i.e. in the case of an ordinary commodity, it may
be bought or sold several times, but it is used up in consumption after some time. In the case of the capital
market nothing is consumed away.
Every year there is new supply and so the cumulative total of funds dealt with goes on rising and the New Issue
Market provides a common ground for facilitating this transfer process of funds from the suppliers (comprising
investors, individual, corporate and institutional) to the companies attempting to raise fresh capital.
The exact amount available for investment in a particular company, however, depends on macro factors like rate
of growth of the economy, total money supply, savings potential and the marginal propensity to save; and micro
factors like performance of a particular class of companies, facilities available for liquidation of investment and
the individual preference of an investor, etc.
Primary market Secondary market Differences
1. In the first place, New Issue Market deals with new securities, i.e. securities which were
not previously available and are offered to the investing public for the first time. The
market, therefore, derives its name from the fact that it makes available a new block of
securities for public subscription.
2. The stock market on the other hand, is a market for old securities i.e. those which have
already been issued and have been granted stock exchange listing. These are purchased
and sold continuously among investors without involvement of the companies whose
securities constitute the stock-in-trade except in the strictly limited sense of having to
register the transfer of ownership of the securities.
3. A related aspect of these two parts is the nature of their contribution to industrial
financing. The New Issue Market provides the issuing company with additional funds for
starting a new enterprise or for either expansion or diversification of an existing one, and
thus its contribution to company financing is direct. The role of the stock exchange vis-avis supply of capital is indirect.
4. Apart from this, the two parts of the market differ organisationally, e.g. the stock
exchanges have physical existence and are located in particular geographical areas. The
New Issue Market enjoys neither any tangible form nor any administrative organisational
setup, and nor is subject to any centralised control and administration for the execution of
its business it is recognised by the services that it renders to the lenders and borrowers of
capital funds at the time of any particular operation.
Investor Protection in Primary market
1. Provision of all the relevant Information
2. Provision of Accurate information
3. Transparent allotment procedure without any bias.
In order to observe above the following are done.

1.
2.
3.
4.
5.
6.
7.

Project Appraisal
Underwriting
Disclosure of the Prospectus
Clearance by the stock Exchange
Signing by the board of directors
Redressal of the Investors grievances
SEBIs Role

Secondary Market
A stock exchange is a form of exchange which provides services for stock brokers and traders
to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and
redemption of securities and other financial instruments, and capital events including the
payment of income and dividends. Securities traded on a stock exchange include shares issued
by companies, unit trusts, derivatives, pooled investment products and bonds.
To be able to trade a security on a certain stock exchange, it must be listed there. Usually, there
is a central location at least for record keeping, but trade is increasingly less linked to such a
physical place, as modern markets are electronic networks, which gives them advantages of
increased speed and reduced cost of transactions. Trade on an exchange is by members only.
The initial offering of stocks and bonds to investors is by definition done in the primary market
and subsequent trading is done in the secondary market. A stock exchange is often the most
important component of a stock market. Supply and demand in stock markets are driven by
various factors that, as in all free markets, affect the price of stocks (see stock valuation.
There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be
subsequently traded on the exchange. Such trading is said to be off exchange or over-thecounter. This is the usual way that derivatives and bonds are traded. Increasingly, stock
exchanges are part of a global market for securities.
Role and Functions of Secondary Market
Role
Creating investment opportunities for small investors
Profit sharing
Facilitating company growth
Mobilizing savings for investment
Common forms of capital raising
Raising capital for businesses
Functions
Maintain Active Trading
Fixation of Price
Ensure safe and Fair trade Practices
Aids in Financing the Industry
Dissemination of the information
Performance Inducer

Regulatory Mechanism in Secondary Market


Three tier structure
1. Ministry of finance
2. SEBI
3. Governing Board
Ministry of finance
1. Supervisory function over SEBI
2. Appellate function against SEBI
3. Licensing of dealers

4. Recognition to stock exchange


5. Appointment of the board of governors
SEBI
1. Regulation of Business
2. Investor Protection
3. Prevent Fraudulent trade practices
4. Takeover and Amalgamation
5. Other powers
Governing Board
1. Consist of 13 members.
2. 6 members from within
3. 3 public representatives nominated by the board of governors
4. Not more than3 members appointed by the central government
5. Not more than three by SEBI.
6. Executive directors by the stock exchange.
7. One third of the elected members are retires at AGM. They can be re elected.
8. There are also Presidents and Vice president elected by the governing board.
Functioning of Stock Market
Trading in Indian stock exchanges are limited to listed securities of public limited companies.
They are broadly divided into two categories, namely, specified securities (forward list) and nonspecified securities (cash list). Equity shares of dividend paying, growth-oriented companies with
a paid-up capital of at least Rs.50 million and a market capitalization of at least Rs.100 million
and having more than 20,000 shareholders are, normally, put in the specified group and the
balance in non-specified group.
Two types of transactions can be carried out on the Indian stock exchanges: (a) spot delivery
transactions "for delivery and payment within the time or on the date stipulated when entering
into the contract which shall not be more than 14 days following the date of the contract" : and
(b) forward transactions "delivery and payment can be extended by further period of 14 days
each so that the overall period does not exceed 90 days from the date of the contract". The
latter is permitted only in the case of specified shares. The brokers who carry over the out
standings pay carry over charges which are usually determined by the rates of interest
prevailing.
A member broker in an Indian stock exchange can act as an agent, buy and sell securities for his
clients on a commission basis and also can act as a trader or dealer as a principal, buy and sell
securities on his own account and risk, in contrast with the practice prevailing on New York and
London Stock Exchanges, where a member can act as a jobber or a broker only.
The nature of trading on Indian Stock Exchanges are that of age old conventional style of face-toface trading with bids and offers being made by open outcry. However, there is a great amount of
effort to modernize the Indian stock exchanges in the very recent times.
Over The Counter Exchange of India (OTCEI)
The traditional trading mechanism prevailed in the Indian stock markets gave way to many
functional inefficiencies, such as, absence of liquidity, lack of transparency, unduly long
settlement periods, which affected the small investors to a great extent. To provide improved
services to investors, the country's first electronic stock exchange - OTCEI - was created in 1992
by country's premier financial institutions - Unit Trust of India, Industrial Credit and Investment
Corporation of India, Industrial Development Bank of India, SBI Capital Markets, Industrial Finance
Corporation of India, General Insurance Corporation and its subsidiaries and Canara Bank
Financial Services.
OTC has a unique feature of trading compared to other traditional exchanges. That is, certificates
of listed securities and initiated debentures are not traded at OTC. The original certificate will be

safely with the custodian. But, a counter receipt is generated out at the counter which
substitutes the share certificate and is used for all transactions.
In the case of permitted securities, the system is similar to a traditional stock exchange. The
difference is that the delivery and payment procedure will be completed within 14 days.
Compared to the traditional Exchanges, OTC Exchange network has the following advantages:
OTCEI has widely dispersed trading mechanism across the country which provides greater
liquidity and lesser risk of intermediary charges.
Greater transparency and accuracy of prices is obtained due to the screen-based scripless
trading.
Since the exact price of the transaction is shown on the computer screen, the investor
gets to know the exact price at which s/he is trading.
Faster settlement and transfer process compared to other exchanges.
In the case of an OTC issue (new issue), the allotment procedure is completed in a month
and trading commences after a month of the issue closure, whereas it takes a longer
period for the same with respect to other exchanges.
Benefits and limitations of Stock Market
Benefits
1. Creating a market for the company's shares
2. Enhancing the status and financial standing of the company
3. Increasing public awareness and public interest in the company and its products
4. Providing the company with an opportunity to implement share option schemes for their
employees
5. Accessing to additional fund raising in the future by means of new issues of shares or
other securities
6. Facilitating acquisition opportunities by use of the company's shares
7. Offering existing shareholders a ready means of realizing their investments
Limitations
Increasing accountability to public shareholders
Need to maintain dividend and profit growth trends
Chances of possible takeover and merger.
Need to observe and adhere strictly to the rules and regulations by governing bodies
Increasing costs in complying with higher level of reporting requirements
Suffering a loss of privacy as a result of media interest
The Security and Exchange Board of India
It was officially act by The Government of India in the year 1988 and given statutory
powers in 1992 with SEBI Act 1992 being passed by the Indian Parliament. SEBI has it's
Headquarter at the business district of Bandra Kurla Complex in Mumbai, and has
Northern, Eastern, Southern and Western Regional Offices in New Delhi, Kolkata, Chennai
and Ahmedabad respectively.
Controller of Capital Issues was the regulatory authority before SEBI came into existence;
it derived authority from the Capital Issues (Control) Act, 1947.

Initially SEBI was a non statutory body without any statutory power. However in the year of
1995, the SEBI was given additional statutory power by the Government of India through
an amendment to the Securities and Exchange Board of India Act 1992. In April, 1998 the
SEBI was constituted as the regulator of capital markets in India under a resolution of the
Government of India.

The SEBI is managed by its members, which consists of following: a) The chairman who is
nominated by Union Government of India. b) Two members, i.e. Officers from Union
Finance Ministry. c) One member from The Reserve Bank of India. d) The remaining 5
members are nominated by Union Government of India, out of them at least 3 shall be
whole-time members.

Objectives of Security and Exchange Board of India


To promote and develop stock market
To protect the interest of the investors in stock market.
To regulate the stock market
Functions of Security and Exchange Board of India
In order to pursue the objectives SEBI has the following functions:
1. Regulate the working of the stock market.
2. Registration and licensing of the participants.
3. Registration and regulation of the collective investment schemes.
4. Promotion of self regulatory organization
5. Preventing unfair trade practices.
6. Promoting investor education.
7. Training of the intermediaries.
8. Preventing Insider trading, circular trading.
9. Regulating Mergers, takeovers, Amalgamations etc.
10.Undertaking Inspections, Calling for the information, audits of the stocks, seizure of the
accounts.
The Security and Exchange Board of India Organization
Primary Department- For Primary market Regulation
Issue Management and Intermediary Department- For Intermediaries regulation
Secondary Market Department- For secondary market regulation
Institutional Department- For the regulation of Merger, takeovers, Amalgamations ets.
Investigation Department- For Investigation purpose.
Advisory Committee- For advice regarding regulation of primary and secondary market.

SEBIs Role in Primary Market


1.

2.

3.
4.
5.

Entry Norms
3 year of Dividend Payment
For existing company should fullfil norms if the issue is five time s the pre issue.
If a company does not have a track record, it could go of public issue but its project must
be appraised by a public financial institution.
For a public issue a company must have 5 promotes of Rs 1 lac of the net capital offer
made to public.
Promoter Contribution
Not less than 20% of the issued capital.
Entire promoter contribution should be received before the issue.
The promoter issue should not be more than 20% and it will be locked for 5 years.
Disclosure
Allocation of shares
Market intermediaries

SEBIs Role in Secondary Market


1. Governing Board
2. Infrastructure
3. Settlement and clearing
4. Price stabilization
5. Delisting

Unit-2
Concept of Risk
Risk is the potential of loss (an undesirable outcome, however not necessarily so)
resulting from a given action, activity and/or inaction. The notion implies that a
choice having an influence on the outcome sometimes exists (or existed).

Potential losses themselves may also be called "risks". Any human endeavor
carries some risk, but some are much riskier than others.
Risk can be defined in different ways
1. A probability or threat of damage, injury, liability, loss, or any other negative
occurrence that is caused by external or internal vulnerabilities, and that may be
avoided through preemptive action.
2. Finance: The probability that an actual return on an investment will be lower
than the expected return. Financial risk can be divided into the following
categories: Basic risk, Capital risk, Country risk, Default risk, Delivery risk,
Economic risk, Exchange rate risk, Interest rate risk, Liquidity risk, Operations risk,
Payment system risk, Political risk, Refinancing risk, Reinvestment risk, Settlement
risk, Sovereign risk, and Underwriting risk.
3. Food industry: The possibility that due to a certain hazard in food there will be
an negative effect to a certain magnitude.

Measures of risk and return and Calculation


Variance and Standard Deviation
Risk reflects the chance that the actual return on an investment may be very different than the expected return.
One way to measure risk is to calculate the variance and standard deviation of the distribution of returns.
Consider the probability distribution for the returns on stocks A and B provided below.
Return on Return on
State Probability Stock A
Stock B
1

20%

5%

50%

30%

10%

30%

30%

15%

10%

3
20%
20%
-10%
The expected returns on stocks A and B were calculated on the Expected Return page. The expected return on
Stock A was found to be 12.5% and the expected return on Stock B was found to be 20%.
Given an asset's expected return, its variance can be calculated using the following equation:
where
N = the number of states,
pi = the probability of state i,
Ri = the return on the stock in state i, and
E[R] = the expected return on the stock.
The standard deviation is calculated as the positive square root of the variance.

Variance and Standard Deviation on Stocks A and B


Note: E[RA] = 12.5% and E[RB] = 20%
Stock A

Stock B

Although Stock B offers a higher expected return than Stock A, it also is riskier since its variance and standard
deviation are greater than Stock A's. This, however, is only part of the picture because most investors choose to
hold securities as part of a diversified portfolio.

Risk and Return Trade off


A fundamental investment concept is the tradeoff between risk and return. The concept is based on two realities
of investments and investment performance.
First, all investments carry some degree of risk the reality that you could lose some or all of your money when
you buy stocks, bonds, mutual funds or other investments. Second, not only do different types of investments
carry different levels of risk, but the more risk you assume, the greater the investment return you are likely to
achieve.
Risk comes in many forms, but when talking about the risk-return tradeoff, the primary measure of risk is
volatility, or the degree to which an investment fluctuates in price. Different asset categories are subject to
different levels of price fluctuation. For instance, stocks can fluctuate widely from one year to the next (or even
from one day to the next), whereas the swing in bond prices tends to be less dramatic, and price fluctuations for
money market or so-called capital preservation investments are even lower.
Whats Your Time Horizon?
Since the investments with the highest potential for return also tend to fluctuate most widely, your investment
time horizon when you will need your money is an important consideration and is tied closely to the riskreturn tradeoff.
For example, while it is true that stocks have returned more than 10 percent on average per year during the
course of the eight decades in which Ibbotson Associates has tracked performance, it is also true that stocks
have experienced sharp ups and downs, and the major stock indices have actually lost money during many
periods of one year or longer.
For this reason, stocks tend to be prudent investments for those with a long-term investment time horizon. The
Securities and Exchange Commission notes in its brochure, Beginners' Guide to Asset Allocation,
Diversification and Rebalancing: As an asset category, stocks are a portfolio's heavy hitter, offering the
greatest potential for growth. Stocks hit home runs, but also strike out. The volatility of stocks makes them a
very risky investment in the short term.
As your time horizon shortens, you generally need more stable investments. As you age, adjusting your
portfolio to include a greater percentage of bonds is usually recommended not only because bond prices
fluctuate less than stock prices, but because bonds and stocks tend to move in different directions. In other
words, when stock prices rise, bond interest rates often fall, and vice versa.
Evaluate Your Tolerance For Risk
Your risk tolerance will depend in part on how much money you can afford to lose which, for most investors,
is not a large percentage of ones total investment amount. But risk tolerance also involves how well you
emotionally handle the ups and downs of the market. If the markets short-term peaks and valleys dont bother
you, you have a higher tolerance for risk and probably are more likely to risk losing money to achieve better
results. On the other hand, if youre prone to worrying about fluctuations in the value of your investments, you
have a lower tolerance for risk and may feel better about allocating your investments to assets that do not
fluctuate as much, such as bonds, even when you have a relatively long investment time horizon.
Even if you shrink from market risk, remember that there is also the risk that low-return investments wont
provide the long-term growth you need to build investment value over time, especially during periods of high
inflation where your rate of return may be less than the rate of inflation.

Systematic and unsystematic risk components


In finance, different types of risk can be classified under two main groups, viz.,
1. Systematic risk.
2. Unsystematic risk.
Two main groups under which types of risk are classified is depicted below.

Image Credits Moon Rodriguez.


Now let's discuss the simple meaning of systematic and unsystematic risk.
Systematic risk is uncontrollable by an organization and macro in nature.
Unsystematic risk is controllable by an organization and micro in nature.

Systematic Risk
Systematic risk is due to the influence of external factors on an organization. Such factors are normally
uncontrollable from an organization's point of view.
Systematic risk is a macro in nature as it affects a large number of organizations operating under a similar
stream or same domain. It cannot be planned by the organization.
Types of risk under the group of systematic risk are listed as follows:
1. Interest rate risk.
2. Market risk.
3. Purchasing power or Inflationary risk.
The types of risk grouped under systematic risk are depicted below.

Image Credits Moon Rodriguez.


Now let's discuss each risk classified under the group of systematic risk.
1. Interest rate risk
Interest-rate risk arises due to variability in the interest rates from time to time. It particularly affects debt
securities as they carry the fixed rate of interest.
The interest-rate risk is further classified into following types.
1. Price risk.
2. Reinvestment rate risk.
The types of interest-rate risk are depicted below.

Image Credits Moon Rodriguez.


The meaning of various types of interest-rate risk is discussed below.
Price risk arises due to the possibility that the price of the shares, commodity, investment, etc. may decline or
fall in the future.
Reinvestment rate risk results from fact that the interest or dividend earned from an investment can't be
reinvested with the same rate of return as it was acquiring earlier.
2. Market risk
Market risk is associated with consistent fluctuations seen in the trading price of any particular shares or
securities. That is, it is a risk that arises due to rise or fall in the trading price of listed shares or securities in the
stock market.
The market risk is further classified into following types.
1. Absolute risk.
2. Relative risk.
3. Directional risk.
4. Non-directional risk.

5. Basis risk.
6. Volatility risk.
The types of market risk are depicted in the following diagram.

Image Credits Moon Rodriguez.


The meaning of different types of market risk is briefly discussed below.
Absolute Risk is the risk without any content. For e.g., if a coin is tossed, there is fifty percentage chance of
getting a head and vice-versa.
Relative risk is the assessment or evaluation of risk at different levels of business functions. For e.g. a relative
risk from a foreign exchange fluctuation may be higher if the maximum sales accounted by an organization are
of export sales.
Directional risks are those risks where the loss arises from an exposure to the particular assets of a market. For
e.g. an investor holding some shares experience a loss when the market price of those shares falls down.
Non-Directional risk arises where the method of trading is not consistently followed by the trader. For e.g. the
dealer will buy and sell the share simultaneously to mitigate the risk.
Basis risk is due to the possibility of loss arising from imperfectly matched risks. For e.g. the risks which are in
offsetting positions in two related but non-identical markets.
Volatility risk is the risk of a change in the price of securities as a result of changes in the volatility of a risk
factor. For e.g. volatility risk applies to the portfolios of derivative instruments, where the volatility of its
underlying is a major influence of prices.
3. Purchasing power or inflationary risk
Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates) from the fact that it
affects a purchasing power adversely. It is not desirable to invest in securities during an inflationary period.
The purchasing power or inflationary risk is classified into following types.
1. Demand inflation risk.
2. Cost inflation risk.
The types of purchasing power or inflationary risk are depicted below.

Image Credits Moon Rodriguez.


Demand inflation risk arises due to increase in price, which result from an excess of demand over supply. It
occurs when supply fails to cope with the demand and hence cannot expand anymore. In other words, demand
inflation occurs when production factors are under maximum utilization.
Cost inflation risk arises due to sustained increase in the prices of goods and services. It is actually caused by
higher production cost. A high cost of production inflates the final price of finished goods consumed by people.

Unsystematic Risk
Unsystematic risk is due to the influence of internal factors prevailing within an organization. Such factors are
normally controllable from an organization's point of view.
Unsystematic risk is a micro in nature as it affects only a particular organization. It can be planned, so that
necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk.
The types of risk grouped under unsystematic risk are depicted below.
1. Business or liquidity risk.
2. Financial or credit risk.
3. Operational risk.
The types of risk grouped under unsystematic risk are depicted below.

Image Credits Moon Rodriguez.


Now let's discuss each risk classified under the group of unsystematic risk.
1. Business or liquidity risk
Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the sale and purchase of
securities affected by business cycles, technological changes, etc.
The business or liquidity risk is further classified into following types.
1. Asset liquidity risk.
2. Funding liquidity risk.
The types of business or liquidity risk are depicted and explained below.

Image Credits Moon Rodriguez.


Asset liquidity risk is the risk of losses arising from an inability to sell or pledge assets at, or near, their
carrying value when needed. For e.g. assets sold at a lesser value than their book value.
Funding liquidity risk is the risk of not having an access to sufficient funds to make a payment on time. For
e.g. when commitments made to customers are not fulfilled as discussed in the SLA (service level agreements).

2. Financial or credit risk


Financial risk is also known as credit risk. This risk arises due to change in the capital structure of the
organization. The capital structure mainly comprises of three ways by which funds are sourced for the projects.
These are as follows:
1. Owned funds. For e.g. share capital.
2. Borrowed funds. For e.g. loan funds.
3. Retained earnings. For e.g. reserve and surplus.
The financial or credit risk is further classified into following types.
1. Exchange rate risk.
2. Recovery rate risk.
3. Credit event risk.
4. Non-Directional risk.
5. Sovereign risk.
6. Settlement risk.
The types of financial or credit risk are depicted and explained below.

Image Credits Moon Rodriguez.


Exchange rate risk is also called as exposure rate risk. It is a form of financial risk that arises from a potential
change seen in the exchange rate of one country's currency in relation to another country's currency and viceversa. For e.g. investors or businesses face an exchange rate risk either when they have assets or operations
across national borders, or if they have loans or borrowings in a foreign currency.
Recovery rate risk is an often neglected aspect of a credit risk analysis. The recovery rate is normally needed to
be evaluated. For e.g. the expected recovery rate of the funds tendered (given) as a loan to the customers by
banks, non-banking financial companies (NBFC), etc.
Sovereign risk is the risk associated with the government. In such a risk, government is unable to meet its loan
obligations, reneging (to break a promise) on loans it guarantees, etc.
Settlement risk is the risk when counterparty does not deliver a security or its value in cash as per the
agreement of trade or business.
3. Operational risk
Operational risks are the business process risks failing due to human errors. This risk will change from industry
to industry. It occurs due to breakdowns in the internal procedures, people, policies and systems.
The operational risk is further classified into following types.
1. Model risk.
2. People risk.
3. Legal risk.
4. Political risk.
The types of operational risk are depicted and explained below.

Image Credits Moon Rodriguez.


Model risk is the risk involved in using various models to value financial securities. It is due to probability of
loss resulting from the weaknesses in the financial model used in assessing and managing a risk.
People risk arises when people do not follow the organizations procedures, practices and/or rules. That is, they
deviate from their expected behavior.
Legal risk arises when parties are not lawfully competent to enter an agreement among themselves.
Furthermore, this relates to regulatory risk, where a transaction could conflict with a government policy or
particular legislation (law) might be amended in the future with retrospective effect.
Political risk is the risk that occurs due to changes in government policies. Such changes may have an
unfavorable impact on an investor. This risk is especially prevalent in the third-world countries.
Nature of equity instruments
There are two principal ways in which a company can obtain additional finances necessary to operate or
expand. One is by selling equity and the other is by taking on debt. Selling equity can be accomplished through
the sale of common stock. Preferred stock has characteristics of both debt and equity. Debt can be taken on in
the form of short-term and long-term loans or through the issuing of bonds.
Risk
Equity holders take on a greater risk than debt holders. This is because by investing in a company, you
are in effect tying your fate to the fate of the company. Bondholders do not make this same commitment,
and only stand to lose if the company does so poorly, it is unable to pay back its creditors.
Legal Rights in Bankruptcy
In a bankruptcy, debt holders have a first priority over equity holders. This is because people who loaned
money to the company have a greater expectation of return than those who invested in the company.
Potential Return
If a company shatters expectations and does very well, equity holders are in a better position than debt
holders. This is because debt holders have an agreement with the company that they will be paid back a
set amount of interest for their loan. Equity holders on the other hand have no guaranteed return, but the
potential to reap big dividends if the company does well.
Control
Because equity should be thought of as ownership, it also comes with some measure of control. With
commons stocks, this takes the form of voting rights. Each share is entitled to one vote, and this allows
shareholders in publicly traded companies to have a say in who is on the board of directors. The board of
directors is responsible for picking the CEO and other managers and determining the major direction of
the company. Bondholders and other equity holders do not have this ability because they are merely
lenders.
Personal Investment Strategy
Some people are more inclined toward risk than others. Therefore, some people may be more inclined to
purchase debt instruments like bonds than equity instruments like common stocks. However, most
investment professionals recommend a portfolio with both stocks and bonds. Equity instruments are
expected to have greater returns in the long run, but have much greater swings, while debt instruments

produce lower returns with fewer swings. It is recommended that as you get older, you put more of your
investments into debt and less into equity.

Equity Valuation Models


Stock Valuation Methods
Stocks have two types of valuations. One is a value created using some type of cash flow, sales or
fundamental earnings analysis. The other value is dictated by how much an investor is willing to pay for
a particular share of stock and by how much other investors are willing to sell a stock for (in other
words, by supply and demand). Both of these values change over time as investors change the way they
analyze stocks and as they become more or less confident in the future of stocks.
The fundamental valuation is the valuation that people use to justify stock prices. The most common
example of this type of valuation methodology is P/E ratio, which stands for Price to Earnings Ratio.
This form of valuation is based on historic ratios and statistics and aims to assign value to a stock based
on measurable attributes. This form of valuation is typically what drives long-term stock prices.
The other way stocks are valued is based on supply and demand. The more people that want to buy the
stock, the higher its price will be. And conversely, the more people that want to sell the stock, the lower
the price will be. This form of valuation is very hard to understand or predict, and it often drives the
short-term stock market trends.
There are many different ways to value stocks. The key is to take each approach into account while
formulating an overall opinion of the stock. If the valuation of a company is lower or higher than other
similar stocks, then the next step would be to determine the reasons.

Earnings Per Share (EPS).


EPS is the net income available to common shareholders of the company divided by the number of
shares outstanding. They usually have a GAAP EPS number (which means that it is computed using all
of mutually agreed upon accounting rules) and a Pro Forma EPS figure (which means that they have
adjusted the income to exclude any one time items as well as some non-cash items like amortization of
goodwill or stock option expenses). The most important thing to look for in the EPS figure is the overall
quality of earnings. Make sure the company is not trying to manipulate their EPS numbers to make it
look like they are more profitable. Also, look at the growth in EPS over the past several quarters / years
to understand how volatile their EPS is, and to see if they are an underachiever or an overachiever. In
other words, have they consistently beaten expectations or are they constantly restating and lowering
their forecasts?
The EPS number that most analysts use is the pro forma EPS. To compute this number, use the net
income that excludes any one-time gains or losses and excludes any non-cash expenses like stock
options or amortization of goodwill. Then divide this number by the number of fully diluted shares
outstanding. Historical EPS figures and forecasts for the next 12 years can be found by visiting free
financial sites such as Yahoo Finance (enter the ticker and then click on "estimates").
Through fundamental investment research, one can determine their own EPS forecasts and apply other
valuation techniques below.

Price to Earnings (P/E)


. Now that you have several EPS figures (historical and forecasts), you'll be able to look at the most
common valuation technique used by analysts, the price to earnings ratio, or P/E. To compute this figure,
take the stock price and divide it by the annual EPS figure. For example, if the stock is trading at $10
and the EPS is $0.50, the P/E is 20 times. To get a good feeling of what P/E multiple a stock trades at, be
sure to look at the historical and forward ratios.

Historical P/Es are computed by taking the current price divided by the sum of the EPS for the last four
quarters, or for the previous year. You should also look at the historical trends of the P/E by viewing a
chart of its historical P/E over the last several years (you can find on most finance sites like Yahoo
Finance). Specifically you want to find out what range the P/E has traded in so that you can determine if
the current P/E is high or low versus its historical average.
Forward P/Es reflect the future growth of the company into the figure. Forward P/Es are computed by
taking the current stock price divided by the sum of the EPS estimates for the next four quarters, or for
the EPS estimate for next calendar or fiscal year or two.
P/Es change constantly. If there is a large price change in a stock you are watching, or if the earnings
(EPS) estimates change, the ratio is recomputed.
The p/E has the following advantages:
1. P/E ratio indicates price per rupee of the share earning. This would help to compare the prices of stocks,
which have different EPS.
2. P/E ratio are helpful in analysing the stocks of the companies that do not pay dividend but have
earnings. It should be noted that when there is loss, P/E ratio analyses is difficult to use.
3. The variables used in P/E ratio model are easier to estimate than the variables in the discounting models.
With this ratio model the investor can only find the relative position of the different stocks. It does not
indicate what price is appropriate for a particular stock.
The anticipated return model
The expected return can be determined with the help of the following formula:
E(r)= Summation Pi * Ri
Where Pi is the associated probability
Ri are the returns in different years.
Holding period return model
Return can be calculated with the help of the following formula:
R= (Price change+ Cash dividend)/ Purchase price
R= (D + Pt+1 Pt)/ Pt
Where,
R is the returns
D is the dividends
Pt+1 is the Price at the end of the period
Pt is the initial price
Present Value of the Return Model
Price of the share,
Po= D1/1+r + P1/1+r
Where,
Po is the price of the share
D1 is the next year dividend
R is Expected rate of return
P1 is Selling price at the end of one year period
With this model price of the share and also selling price of the share can be determined.

Constant Growth rate model


Price of the share is given by the formula:
Po= D1/r-g
Where
Po is the price of the share
D1 is the dividend of the next year
R is the expected rate of return
G is the constant growth
Assumption- Stable dividend policy and constant stable rate of return
* Note= if theoretical value > Actual Price then Buy
If theoretical value < Actual Price then sell
If Present rate of return > required rate of return then Buy
If Present rate of return < required rate of return then Sell

Bonds, Nature and Evaluation of Bonds

A bonds price and yield determine its value in the secondary market. Obviously, a bond
must have a price at which it can be bought and sold (see Understanding Bond Market
Prices below for more), and a bonds yield is the actual annual return an investor can
expect if the bond is held to maturity. Yield is therefore based on the purchase price of
the bond as well as the coupon.
A bonds price always moves in the opposite direction of its yield, as illustrated above.
The key to understanding this critical feature of the bond market is to recognize that a
bonds price reflects the value of the income that it provides through its regular coupon
interest payments. When prevailing interest rates fall notably rates on government
bonds older bonds of all types become more valuable because they were sold in a
higher interest-rate environment and therefore have higher coupons. Investors holding
older bonds can charge a premium to sell them in the secondary market. On the other
hand, if interest rates rise, older bonds may become less valuable because their coupons
are relatively low, and older bonds therefore trade at a discount.
Since governments began to issue bonds more frequently in the early twentieth century
and gave rise to the modern bond market, investors have purchased bonds for several
reasons: capital preservation, income, diversification and as a potential hedge against
economic weakness or deflation. When the bond market became larger and more diverse
in the 1970s and 1980s, bonds began to undergo greater and more frequent price
changes and many investors began to trade bonds, taking advantage of another
potential benefit: price, or capital, appreciation.
Capital preservation: Unlike equities, bonds should repay principal at a specified date,
or maturity. This makes bonds appealing to investors who do not want to risk losing
capital and to those who must meet a liability at a particular time in the future. Bonds
have the added benefit of offering interest at a set rate that is often higher than shortterm savings rates.
Income: Most bonds provide the investor with fixed income. On a set schedule,
whether quarterly, twice a year or annually, the bond issuer sends the bondholder an
interest payment, which can be spent or reinvested in other bonds. Stocks can also
provide income through dividend payments, but dividends tend to be smaller than bond
coupon payments, and companies make dividend payments at their discretion, while
bond issuers are obligated to make coupon payments.

Capital appreciation: Bond prices can rise for several reasons, including a drop in
interest rates and an improvement in the credit standing of the issuer. If a bond is held to
maturity, any price gains over the life of the bond are not realized; instead, the bonds
price typically reverts to par (100) as it nears maturity and repayment of the principal.
However, by selling bonds after they have risen in price and before maturity investors
can realize price appreciation, also known as capital appreciation, on bonds. Capturing
the capital appreciation on bonds increases their total return, which is the combination of
income and capital appreciation. Investing for total return has become one of the most
widely used bond strategies over the past 40 years. (For more, see Bond Investment
Strategies.)
Diversification: Including bonds in an investment portfolio can help diversify the
portfolio. Many investors diversify among a wide variety of assets, from equities and
bonds to commodities and alternative investments, in an effort to reduce the risk of low,
or even negative, returns on their portfolios.
Bond Risk
Interest Rate Risk
Variability in return from the debt to investors is caused by the changes is in the market
interest rate.
Default Risk
The failure to pay the agreed amount of the debt instrument by the issuer in full, on
time or both are default risk.
Marketability Risk
Variability in return caused by the difficulty in selling the bonds quickly without having to
make a substantial concession is known as marketability risk.
Callability Risk
The uncertainty created in the investors return by the issuer ability to call the bonds at
any time.
Bond Return:
Holding Period Return= (Price gain or Loss during the holding period + Coupon interest
rate) / Price at the beginning of the holding period
Yield To Maturity
YTM is the single discount factor that present value of the future cash flows from a bond
equal to the current price of the bond. We can also say that YTM is the rate of the return
an investor can expect to earn if the bond is held till maturity.
Assumption:
1. There should not be any default.
2. The investor hold the bond till maturity.
3. All the coupon should be reinvested immediately at the same time interest rate
as the same time yield to maturity of the bond.
The formula is :
Y = C + (P or D/ Year of Maturity)/ (Po + F)/ 2
Where
Y =YTM
C= Coupon Rate
P or D= Premium or Discount
Po= Present Value
F= Face Value

Present Value= C1/(1+y)1


(1+y)n

+ C2/(1+y)2 +..+ (Couponn + face value)/

Bond Value theorem


Theorem-1 : Price and interest rates move inversely
Lets assume 3 year 10% coupon paying bond for illustration
When YTM = 10%
Price = 100
When YTM = 11%
Price = 97.55
When YTM = 9%
Price = 102.53
Hence it can be concluded that as yield increase price of the bond decline and vice-versa.
Theorem-2 : A decrease in interest rates raises bond prices by more than a corresponding increase in
rates lowers price
Lets assume 3 year 10% coupon paying bond for illustration
When YTM = 10%
Price = 100
When YTM = 11%
Price = 97.55
Change in price = -2.45%
When YTM = 9%
Price = 102.53
Change in price = +2.53%
This the most important theorem of bond which says that price movement of bond with change is interest rate
either side is not equal. Price of the bond increases more than it declines when equal change in interest rate is
given. In above illustration you can clearly see that when yield declines by 1% price increases by 2.53% while
in case of increase in yield by 1%, price decline is 2.45%. As price curve of the bond is convex, you gain more
than you lose.

Theorem 3:
If the bond yields remain same then same over its life, the discount or premium
depends on the maturity period.
Example
Bond A
Bond B
Par Value
Rs 1000
Rs 1000
Coupon Rate
10%
10%
Yield
15%
15%
Maturity Period
2
3
Market Price
918.71
885.86
This means, the bond with a short term to maturity sells at a lower discount than
the bond with a long term to maturity.

Theorem 4
If the bond yield remain constant over its life, the discount or premium amount
will decrease at an increasing rate as its life gets shorter. Consider a bond with
the face value Rs. 1000, and maturity period of 5 years with yield to maturity 10%
.

Yield to Maturity
5
4
3
2
1

The Present Value


620.9
683.0
751.3
826.4
909.1

Price

Years
The above example shows that rate declines when the bond approaches to
maturity.

Theorem 5
A raise in the bond price for a decline in the bond yield is greater than the fall in
bond price for a raise in the yield . take a bond of 10% coupon rate, maturity
period of 5 years with the face value of Rs 1000. If the yield declines by 2%, that
is to 8% then the bond price will be 1079.87.
= Rs. 100(PVIFA 8%, 5 years) + Rs1000( PVIF 8%, 5 years.)
= Rs 100* 3.9927 + Rs1000 *.6806
= Rs. 1079.87
If, the yield increases by 2% then, the bond price will be Rs. 927.88.
= Rs. 100 (PVIFA 12%, 5 Years) + Rs.1000 (PVIF 12%, 5 Years)
=Rs. 100*3.6048 + Rs 1000*.05674
=Rs. 927.88
. Now the fall in the yield has resulted in a raise Rs 79.86 but the raise in the yield
caused a variation of Rs. 72.22 in the price.

Convexity of Yield Curve


Theorem-1 : Price and interest rates move inversely
When YTM = 10%
Price = 100

When YTM = 11%


Price = 97.55
When YTM = 9%
Price = 102.53
Theorem-2 : A decrease in interest rates raises bond prices by more than a corresponding increase in rates lowers price
When YTM = 10%
Price = 100
When YTM = 11%
Price = 97.55
Change in price = -2.45%
When YTM = 9%
Price = 102.53
Change in price = +2.53%
This the most important theorem of bond which says that price movement of bond with change is interest rate either
side is not equal. Price of the bond increases more than it declines when equal change in interest rate is given. In above
illustration you can clearly see that when yield declines by 1% price increases by 2.53% while in case of increase in yield
by 1%, price decline is 2.45%. As price curve of the bond is convex, you gain more than you lose.

The term Structure of the Interest rate (Yield Curve)


The bond porfolio manager is often concerned with two aspects of the interest rate: the level of the interest rate
the term structure of the interest rate. The relationship between the yield and the time or years to maturity is
called the term structure. The term structure is also known as yield curve. In analyzing the effect of maturity on
yield curve other influences held constant. Usually pure discount instrument are selected to eliminate the effect
of coupon payment. The bond chosen do not have early redemption features. The maturity dates are different
but the risks, tax liabilities and redemption possibilities are similar.

Duration
Duration measures the time structure of the bond and the bond interest rate risk. The time structure of the
investment in bonds is expressed in two ways. The common way to state is how many years he has to wait until
the bond matures and the principles money is paid back. This is known as asset time to maturity or its years to
maturity. The other way is to measure the average time until all the interest coupons and the principle is
recovered. This is called Macaulays duration. Duration is defined as the weighted average of the time period to
the maturity, weights present values of the cash flow in each time period. The formula is.
D= C1/(1+r)/ P0 + C2/(1+r)2/P0+Ct/(1+r)t/P0*T
Duration =D

C= Cash flows
R = Current YTM
T= number of years
PV (C)= Present value of the cash flow
P0= Sum of the present value of the cash flows.
General Rules:
Larger the coupon rate, lower the duration and less volatile the bond price.
Longer the term to maturity, longer the duration and more the volatile bond.
Higher the YTM, lower the bond duration and bond volatility, and vice versa.
In a zero coupon bond, the bonds term to maturity and Duration are the same.
Importance of the duration:
The concept of the duration is important because it provide the length of a bond, helpful in evolving
immunization( the technique that make the bond portfolio holder to be relatively certain about the promised
stream of the cash flows.) strategies for the portfolio management and measures the sensitivity of the bond
price to changes in the interest rate.
Fundamental analysis
1. Economic Analysis
2. Industry analysis
3. Company Analysis
1. Economic Analysis
Economic Indicators
GDP
National Income
Employment
Inflation
Regression Model
2. Industry Analysis
Growth
Cost Structure and Profitability
Nature of the Industry
Nature of the Competition
Government policy
Labor market condition
Research and development
Fundamental analysis / Technical Analysis
. Company analysis
Capital structure
Growth of the company and sales
Stability of the sales
Earning of the company
Financial statement
Technical Analysis
It is the process of identifying the time reversal at an earlier stage to formulate buying and selling strategies.
With the help of many indicators we can prdict the price volume and demand supply of the stocks.
Assumptions:
1. The market discount everything.
2. The market value is determined by the demand and supply.
3. The market always moves in trend
Technical Analysis

Technical tools:
1. Dow theory
2. Volume Trade
3. Moving Average
4. Odd Lot Trading
Dow theory
Based on Hypothesis
No individual buyer or seller influence the major trend in market.
Market discounts everything.
It is not a tool to beat the market. It provide a way to understand it better.
According to this theory the trend are divided into primary, intermediate and short term trend. The primary trend
is upward or downward movement last for a year or two. The intermediate trends are corrective movements,
which may last for three weeks to three months. The short term refers to the day to day price movement. It is
also known as oscillators or fluctuations.

Technical Analysis
Primary Trends:
1. The security price trend may be either increasing or decreasing. When the market exhibit the increasing
trend it is called bull market. The bull market shows three clear cut peaks. Each peak is higher than the
previous one.. The bottoms are also higher then the previous ones.
First Phase is Revival of the market
Good corporate earning
Speculation Phase
2. The reverse is also true with the bear market.
Loss of hopes
Recession phase
Distress selling.
Secondary Trends:
The secondary trends are the Immediate trends moves against the main trends and leads to correction. In the
bull market the secondary trends would result in fall of about 33-66% of the earlier rise.
Intermediate trends correct the overbought and oversold condition. It provide the breathing condition to the
market. Compared to the primary trend, secondary trend is swift and quicker.
Minor Trend-

Minor trend or tertiary moves are called as random wriggles. They are simply the daily price fluctuations.
Minor trends tries to correct the secondary trend movement. It is better for the investors to concentrate on the
primary and secondary trends.
Technical Analysis
Volume of trade
Dow gave special emphasis on volume. Volume expands along with the bull and bear market and narrows down
in the bear market. If the volume falls with the rise or vice versa, it is the matter of concern for the investors and
the trend may not persist for the longer time. Technical analyst used volume as an excellent method of
confirming the trend. The market is said to be bullish when small volume of trade and large volume trade follow
fall in price and the rise in price.
Large rise in price or large fall in price leads to large increase in volume . Large volume with rise in price
indicates that bull market and the large volume with fall in price indicates bear market.
If the volume declines for consecutive five days, then it will be continue for another four days and the same is
true in increasing volume.
Odd lot tradingShares are generally sold in lot of hundreds. Share which are sold in smaller lot fewer than 100 are called odd
lot. Such buyers and sellers are also called odd lotters. Odd lot purchase to odd lot sale (Purchase % sales) is
called as lot index. The increase in odd lot purchase results in an increase in the index. Relatively more selling
leads to fall in the index. It is generally considered that the professional investors is more informed and stronger
than odd lotters. When the professional investors dominate the market, the market is considered weak. The
notion behind is that odd lot purchase is concentrated at the top of the market cycle and selling at the bottom.
High odd lot purchase forecast fall in the market price and low purchase\sales ratio are presumed to occur
towards the end of bear market.
Moving averageThe market indices do not rise or fall in straight line. The upward and downward movements are interrupted by
the counter moves. The underlying trend can be studied by smoothing of the data. To smooth the data moving
average technique is used.
The word moving means that the body of the data moves ahead to include the recent observations. If it is five
day moving average, on the sixth day the body of the data moves to include the sixth day observation
eliminating the first days observation. Likewise it continues. In this method, closing price of the stock is used.
The moving average are used to study the movement of the market as well as the individual scrip prices. The
moving average indicates that the underlying trend in the scrip. The period of average determines the period of
the trend that is being identified. Fro underlying short term trend, a10 day or 30 day moving average are used.
In the case of medium term trend 50 day to 125 day are adopt. 200 day moving average is used to identify the
long term trend.
Difference between Fundamental and Technical Analysis
Basis
Fundamental Analysis

Technical Analysis

Definition:

Calculates stock value using economicUses price movement of security to


factors, known as fundamentals.
predict future price movements

Data gathered from:

Financial statements

Charts

Stock bought:

When price falls below intrinsic value

When trader believes they can sell it


on for a higher price

Time horizon:

Long-term approach

Short-term approach

Function:

Investing

Trade

Concepts used:

Return on Equity (ROE) and Return on


Dow Theory, Price Data
Assets (ROA)

Vision:

looks backward as well as forward

looks backward

Unit-3
Derivatives
Derivatives are a contract between two parties that specify conditions (especially the dates, resulting values and
definitions of the underlying variables, the parties' contractual obligations, and the notional amount) under
which payments are to be made between the parties. The most common underlying assets include commodities,
stocks, bonds, interest rates and currencies, but can also be other derivatives, which adds another layer of
complexity to proper valuation.
Importance-There are several risks inherent in financial transactions. Derivatives are used to separate risks
from traditional instruments and transfer these risks to parties willing to bear these risks. The fundamental risks
involved in derivative business includes:
Credit Risk
This is the risk of failure of a counterparty to perform its obligation as per the contract. Also known as default or
counterparty risk, it differs with different instruments.
Market Risk
Market risk is a risk of financial loss as a result of adverse movements of prices of the underlying
asset/instrument.
Liquidity Risk
The inability of a firm to arrange a transaction at prevailing market prices is termed as liquidity risk. A firm
faces two types of liquidity risks
Related to liquidity of separate products
Related to the funding of activities of the firm including derivatives.
Legal Risk
Derivatives cut across judicial boundaries, therefore the legal aspects associated with the deal should be looked
into carefully.
1. Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly
between two parties, without going through an exchange or other intermediary. Products such as swaps, forward
rate agreements, exotic options and other exotic derivatives are almost always traded in this way. The OTC
derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of
information between the parties, since the OTC market is made up of banks and other highly sophisticated
parties, such as hedge funds. Reporting of OTC amounts is difficult because trades can occur in private, without
activity being visible on any exchange.
2.Exchange-traded derivatives (ETD) are those derivatives instruments that are traded via specialized
derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary
to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.
What are the various types of derivatives?
Derivatives can be classified into three types:
1. Futures
2. Options
3. Swaps
The Basic Concept of Options
An options contract, whether a call (buy an asset) or put (sell an asset), grants the holder the right but not the
obligation to exercise the option. The holder is entitled to simply let the option expire without investing
further. .
An option is linked to a specific stock. The price of the option is much less than the price of the underlying
stock, which is a major reason for the attractiveness of options. If the price of the stock changes, the price of the
option also changes, although by a smaller amount. As the price of a stock goes through its daily ups and
downs, the price of an associated option undergoes related fluctuations.

Feature of the options:


1. The option is exercisable by the owner / buyer only.
2. The owner has limited liability.
3. Option owners has no voting right.
4. Options have high degree Of risk to the option writer.
5. These are popular they allow the profit from favourable movement in exchange rate.
6. Flexibility in investors needs.
7. No certificate issued by the company
Call options
The call option that gives the right to buy in its contract gives the particulars of the following:
1. The name of the company whose shares are to be purchased.
2. The number of the shares to be purchased.
3. The purchase price or the exercise price or the strike price of the shares to be bought.
4. The expiration date.
Example:
Let us A who owns 100 shares of Reliance Industries, which on 10 Dec, 2012 sold for Rs 119 Per share. He
could give (or sell) to B the right to buy that 100 shares at any time during the next 2 months at a price of Rs
125 per share. The price Rs125 is called the exercise price.. Now the seller of the option, A is the option seller
or write. For providing the option, A will charge premium from B. Let us assume the premium of Rs 3. In this
condition B has to pay Rs. 100*3= 300 as premium to A to make him sign the contract. When the exercise price
is less than the current market price of the underlying stock the option is in the money. For example the price of
the reliance share after 2 months is Rs130 it is said to be in the money. But if the price falls to the Rs 120 the
option is said to be out of the money. The advantage is that B has to pay only Rs. 300 and get more profit if the
price rise beyond Rs. 125.
Put options
The put option gives the right to sell an asset or security to someone else. It is not an obligation but an
option, in its contract gives the particulars of the following:
1. The name of the company whose shares are to be sold.
2. The number of the shares to be sold.
3. The purchase price or the exercise price or the strike price of the shares to be sold.
4. The expiration date.
Example:
Let us assume that A thinks that Reliance industries stock price can decline from its current level of Rs 119 per
share during the next two months. He could buy a put option to sell the 100 shares at Rs 125 which is the
striking price. A being the buyer of the option to sell the shares, has to pay premium in order to get the writer B
to sign the contract and to assume risk.
Let us take the premium as Rs 5 per share. Now A has to pay Rs 100*5=500 to B. If the price falls to Rs 115, A
stands gain because he can sell it at Rs 125 i.e. 100*125=12500. The gain is Rs. 12500-11500 (Present value)500 premium. At the same time if the price has increased to Rs 130 per share, A will not exercise the option and
his loss is only Rs. 500.

Option Pricing Model


The Black-Scholes model for calculating the premium of an option was introduced in 1973 in a paper entitled,
"The Pricing of Options and Corporate Liabilities" published in the Journal of Political Economy. The formula,
developed by three economists Fischer Black, Myron Scholes and Robert Merton is perhaps the world's
most well-known options pricing model. Black passed away two years before Scholes and Merton were
awarded the 1997 Nobel Prize in Economics for their work in finding a new method to determine the value of
derivatives (the Nobel Prize is not given posthumously; however, the Nobel committee acknowledged Black's
role in the Black-Scholes model).

The Black-Scholes model is used to calculate the theoretical price of European put and call options,
ignoring any dividends paid during the option's lifetime. While the original Black-Scholes model did not take
into consideration the effects of dividends paid during the life of the option, the model can be adapted to
account for dividends by determining the ex-dividend date value of the underlying stock..
The model makes certain assumptions, including:
The options are European and can only be exercised at expiration
No dividends are paid out during the life of the option
Efficient markets (i.e., market movements cannot be predicted)
No commissions
The risk-free rate and volatility of the underlying are known and constant
Follows a lognormal distribution; that is, returns on the underlying are normally distributed.
The formula, shown in Figure in next slide, takes the following variables into consideration:
Current underlying price
Options strike price
Time until expiration, expressed as a percent of a year
Implied volatility
Risk-free interest rates

Advantages and disadvantages of Black -scholes Model


Advantages:
The main advantage of the black scholes model is speed- it let you to calculate a very large number of
option in a very short time.
Disadvantages:
It calculate the price at one point of time therefore it can be used for only American style exercise
option.
Most of the options traded in stock exchanges are American style. Therefore its use is limited.
Its is used for call option pricing only.

Binomial Model for option Pricing


The Cox-Rubenstein (or Cox-Ross-Rubenstein) binomial option pricing model is a variation of the
original Black-Scholes option pricing model. It was first proposed in 1979 by financial
economists/engineers John Carrington Cox, Stephen Ross and Mark Edward Rubenstein. The model is
popular because it considers the underlying instrument over a period of time, instead of just at one
point in time.

This model takes into account expected changes in various parameters over an option's life,
thereby producing a more accurate estimate of option prices than created by models that consider only
one point in time. Because of this, the Cox-Ross-Rubenstein model is especially useful for analyzing
American style options, which can be exercised at any time up to expiration (European style options
can only be exercised upon expiration).
The Cox-Ross-Rubenstein model uses a risk-neutral valuation method. Its underlying principal
purports that when determining option prices, it can be assumed that the world is risk neutral and that
all individuals (and investors) are indifferent to risk. In a risk neutral environment, expected returns are
equal to the risk-free rate of interest.
The Cox-Ross-Rubenstein model makes certain assumptions, including:

No possibility of arbitrage; a perfectly efficient market


At each time node, the underlying price can only take an up or a down move and never both
simultaneously
The Cox-Ross-Rubenstein model employs and iterative structure that allows for the
specification of nodes (points in time) between the current date and the option's expiration date.
The model is able to provide a mathematical valuation of the option at each specified time,
thereby creating a "binomial tree" - a graphical representation of possible values at different
nodes.

The Cox-Ross-Rubenstein model is a two-state (or two-step) model in that it assumes the
underlying price can only either increase (up) or decrease (down) with time until expiration.
Valuation begins at each of the final nodes (at expiration) and iterations are performed
backwards through the binomial tree up to the first node (date of valuation). In very basic terms,
the model involves three steps:
The creation of the binomial price tree
Option value calculated at each final node
Option value calculated at each preceding node
While the math behind the Cox-Ross-Rubenstein model is considered less complicated than the
Black-Scholes model (but still outside the scope of this tutorial), traders can again make use of online
calculators and trading platform-based analysis tools to determine option pricing values.

Futures
In finance, a futures contract (more colloquially, futures) is a standardized contract between two parties to buy
or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures price or
strike price) with delivery and payment occurring at a specified future date, the delivery date. The contracts are
negotiated at a futures exchange, which acts as an intermediary between the two parties. The party agreeing to
buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to
sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the
expectations of the partiesthe buyer hopes or expects that the asset price is going to increase, while the seller
hopes or expects that it will decrease in near future.
In many cases, the underlying asset to a futures contract may not be traditional commodities at all that
is, for financial futures the underlying item can be any financial instrument (also including currency, bonds, and
stocks); they can be also based on intangible assets or referenced items, such as stock indexes and interest rates.
Unlike an option both parties of a futures contract must fulfill the contract on the delivery date. The seller
delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from
the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the
settlement date, the holder of a futures position can close out its contract obligations by taking the opposite
position on another futures contract on the same asset and settlement date. The difference in futures prices is
then a profit or loss.

Marking to marketWhile the futures contract specifies a trade taking place in the future, the purpose of the futures exchange
institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires
both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally
change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also
(variation margin). The exchange will draw money out of one party's margin account and put it into the other's
so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then
a margin call is made and the account owner must replenish the margin account. This process is known as
marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract
but the spot value (i.e. the original value agreed upon, since any gain or loss has already been previously settled
by marking to market).

Features OF Future
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term
interest rate.
The type of settlement, either cash settlement or physical settlement.
The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a
fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which
the short term interest rate is traded, etc.
The currency in which the futures contract is quoted.
The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the
case of physical commodities, this specifies not only the quality of the underlying goods but also the
manner and location of delivery.
The delivery month.
The last trading date.
Other details such as the commodity tick, the minimum permissible price fluctuation.

Futures vs Options
Basis

Futures

Options

Obligation

Both the parties are obliged to perform


the contract.

Both the parties are not obliged to perform.

Premium

No premium is paid

The buyer paid premium to the seller.

Risk

The holder of the contract is exposed to The buyers loss is restricted to the option
the entire spectrum of the risk.
premium.

Exercise date.

The parties of the contract must perform The buyer can exercise option any time prior
at the settlement date.
to the expiary date.

Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy
or to sell an asset at a specified future time at a price agreed upon today. This is in contrast to a spot contract,
which is an agreement to buy or sell an asset today.
With a forward contract the transfer of the ownership takes place on the spot, but the delivery of the commodity
takes place does not occur until some future date.
Therefore in forward contract the parties agrees to do trade at some future date, at a stated price and quantity.
No money changes hands at the time deal is signed.
For example, a wheat farmer may wish to contract to sell their harvest at a future date to eliminate the risk of a
change in price by that date. Such transaction would take place through a forward market.
These are not traded on an stock exchange , they are buy and sold over the counter. These quantities of the
underlying asset and terms of the contracts are fully negotiable. The secondary market does not exist for the
forward contract and faces the problem of liquidity and negotiability.
Difference between Forwards and Futures
Basis

Forward Contract

Futures Contract

A forward contract is an agreement between two parties A futures contract is a standardized contract, traded on a
Definition: to buy or sell an asset (which can be of any kind) at a
futures exchange, to buy or sell a certain underlying
pre-agreed future point in time at a specified price.
instrument at a certain date in the future, at a specified price.
Structure & Customized to customer needs. Usually no initial
Purpose:
payment required. Usually used for hedging.

Standardized. Initial margin payment required. Usually used


for speculation.

Transaction
Negotiated directly by the buyer and seller
method:

Quoted and traded on the Exchange

Market
Not regulated
regulation:

Government regulated market (the Commodity Futures


Trading Commission or CFTC is the governing body)

Institutional
The contracting parties
guarantee:
Risk:
High counterparty risk
No guarantee of settlement until the date of maturity
Guarantees: only the forward price, based on the spot price of the
underlying asset is paid

Clearing House
Low counterparty risk
Both parties must deposit an initial guarantee (margin).
The value of the operation is marked to market rates with
daily settlement of profits and losses.

Contract
Forward contracts generally mature by delivering the
Maturity:
commodity.
Expiry date: Depending on the transaction

Future contracts may not necessarily mature by delivery


of commodity.
Standardized

Method of Opposite contract with same or different counterparty.


preCounterparty risk remains while terminating with
termination: different counterparty.

Opposite contract on the exchange.

Contract
size:

Depending on the transaction and the requirements of the


Standardized
contracting parties.

Gain or loss of the option Player


Gain or Loss of the Call BuyerWhen a market price just enough to exceed the strike price by just to cover the premium, the profit is 0 to the
buyer, if he exercises the option. This is the point of no profit and no loss and this will be called as Break-even
point. If the investor feels that there will not be any further price rise in the stock price, to make up the premium
charges, he has to buy the break even point. If there is a rise in the price of the stock beyond the break even
point, he would gain profit. By making the option writer to sell the share to him at the strike price and reselling
it in the market, he can earn profit.
Gain or Loss of the Call WriterWhen the market price is lower than the strike price, the call buyer may not exercise the option, hence the
premium is the only profit the call writer can gain. If the price increases further it would be a loss to the call
writer.
Gain or loss of the option Player
Gain or Loss of the put BuyerThe put buyer gets gain, if the market price of the optioned security is below the strike price and incur
losses, when the price is higher than the strike price.
Gain or Loss of the put WriterThe gains of the put buyer are the losses of the put writer. The put writer. The put writer has to be buy
at an agreed price even if the market price is lower than the strike price. Fpr example, the strike price of the put
option is Rs 50 but the market price is Rs 35, now the put writer has to buy it at Rs 50 and incur a loss of Rs 15
less premium per share. But if the market price of the share increases the put writer will gain the premium
because the put buyer may not be willing to sell the share at the lower rate. The strike price are lower than the
market price.
Option trading strategies
Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that
differ in one or more of the options' variables. This is often done to gain exposure to a specific type of
opportunity or risk while eliminating other risks as part of a trading strategy. A very straight forward
strategy might simply be the buying or selling of a single option, however option strategies often refer to
a combination of simultaneous buying and or selling of options.
Options strategies allow to profit from movements in the underlying that are bullish, bearish or neutral.
In the case of neutral strategies, they can be further classified into those that are bullish on volatility and
those that are bearish on volatility. The option positions used can be long and/or short positions in calls.
Bullish strategies
Bullish options strategies are employed when the options trader expects the underlying stock price to
move upwards. It is necessary to assess how high the stock price can go and the time frame in which the
rally will occur in order to select the optimum trading strategy.

The most bullish of options trading strategies is the simple call buying strategy used by most novice
options traders.
Stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target price
for the bull run and utilize bull spreads to reduce cost. (It does not reduce risk because the options can
still expire worthless.) While maximum profit is capped for these strategies, they usually cost less to
employ for a given nominal amount of exposure. The bull call spread and the bull put spread are
common examples of moderately bullish strategies.
Mildly bullish trading strategies are options strategies that make money as long as the underlying stock
price does not go down by the option's expiration date.

Bearish strategies
Bearish options strategies are employed when the options trader expects the underlying stock price to
move downwards. It is necessary to assess how low the stock price can go and the time frame in which
the decline will happen in order to select the optimum trading strategy.
The most bearish of options trading strategies is the simple put buying strategy utilized by most novice
options traders.
Stock prices only occasionally make steep downward moves. Moderately bearish options traders usually
set a target price for the expected decline and utilize bear spreads to reduce cost. While maximum profit
is capped for these strategies, they usually cost less to employ. The bear call spread and the bear put
spread are common examples of moderately bearish strategies.
Mildly bearish trading strategies are options strategies that make money as long as the underlying stock
price does not go up by the options expiration date. These strategies may provide a small upside
protection as well. In general, bearish strategies yield less profit with less risk of loss.
Neutral or non-directional strategies
Neutral strategies in options trading are employed when the options trader does not know whether the
underlying stock price will rise or fall. Also known as non-directional strategies, they are so named because the
potential to profit does not depend on whether the underlying stock price will go upwards. Rather, the correct
neutral strategy to employ depends on the expected volatility of the underlying stock price.
Guts- sell ITM (in the money) put and call
Butterfly- buy ITM (in the money) and OTM (out of the money) call, sell two at the money calls, or vice versa.
Strangle- the simultaneous buying or selling of out-of-the-money put and an out-of-the-money call, with the
same expiration. Similar to the straddle, but with different strike prices.
Option Greeks
In mathematical finance, the Greeks are the quantities representing the sensitivity of the price of derivatives
such as options to a change in underlying parameters on which the value of an instrument or portfolio of
financial instruments is dependent. The name is used because the most common of these sensitivities are often
denoted by Greek letters. Collectively these have also been called the risk sensitivities, risk measures or
hedge parameters.
The Greeks are vital tools in risk management. Each Greek measures the sensitivity of the value of a portfolio to
a small change in a given underlying parameter, so that component risks may be treated in isolation, and the
portfolio rebalanced accordingly to achieve a desired exposure; see for example delta hedging.
Delta
Delta,, measures the rate of change of option value with respect to changes in the underlying asset's price. Delta
is the first derivative of the value of the option with respect to the underlying instrument's price .
Vega
Vega measures sensitivity to volatility. Vega is the derivative of the option value with respect to the volatility of
the underlying asset.
Theta

Theta , measures the sensitivity of the value of the derivative to the passage of time (see Option time value): the
"time decay."
Rho
Rho measures sensitivity to the interest rate: it is the derivative of the option value with respect to the risk free
interest rate (for the relevant outstanding term).
Except under extreme circumstances, the value of an option is less sensitive to changes in the risk free interest
rate than to changes in other parameters. For this reason, rho is the least used of the first-order Greeks.
Lambda
Lambda, , omega, , or elasticity is the percentage change in option value per percentage change in the
underlying price, a measure of leverage sometimes called gearing.
Unit-4
Capital asset pricing model
The Capital Asset Pricing Model: An Overview
No matter how much we diversify our investments, it's impossible to get rid of all the risk. As investors,
we deserve a rate of return that compensates us for taking on risk. The capital asset pricing model (CAPM)
helps us to calculate investment risk and what return on investment we should expect.
The CAPM specifies that the expected return of an asset, E(Ri) is linearly related to its risk when risk is
measured in terms of the assets beta, i
Birth of a Model
The capital asset pricing model was the work of financial economist (and, later, Nobel laureate in economics)
William Sharpe, set out in his 1970 book "Portfolio Theory And Capital Markets." His model starts with the
idea that individual investment contains two types of risk:
Systematic Risk - These are market risks that cannot be diversified away. Interest rates, recessions and wars are
examples of systematic risks.
Unsystematic Risk - Also known as "specific risk," this risk is specific to individual stocks and can be
diversified away as the investor increases the number of stocks in his or her portfolio.
Modern portfolio theory shows that specific risk can be removed through diversification. The trouble is that
diversification still doesn't solve the problem of systematic risk; even a portfolio of all the shares in the stock
market can't eliminate that risk. Therefore, when calculating a deserved return, systematic risk is what plagues
investors most. CAPM, therefore, evolved as a way to measure this systematic risk.
The Formula

Assumptions of CAPM
All investors:
Aim to maximize economic utilities.

Are rational and risk-averse.


Are broadly diversified across a range of investments.
Are price takers, i.e., they cannot influence prices.
Can lend and borrow unlimited amounts under the risk free rate of interest.
Trade without transaction or taxation costs.
Deal with securities that are all highly divisible into small parcels.
Assume all information is available at the same time to all investors.

The CAPM or the Security Market L


The graphical representation of the CAPM is called the Security Market Line (SML)
The SML gives the relationship or trade-off, between the required return of any asset or security i, E(Ri), and its
beta risk i, as shown by the equation above:
This equation implies that,
(i) Expected returns of securities are a positive linear function of their s.
(ii) Security s suffice to describe the cross section of expected returns of securities.
(iii) Slope of the SML measures the expected market risk premium E(Rm) Rf
(iv) The intercept of the SML is the risk free rate.
(v) The market portfolio has a beta of 1.

Required Return

Security Market
Line

E(Rm)
Rm-Rf
Rf
Beta
1
Some Applications of the Security Market Line
1.To determine the market price of risk, E(Rm) - Rf
2.To identify over or under-priced securities. stock.

If the required return > expected return Stock is overpriced

If the required return < expected return Stock is underpriced

3. To measure the performance of portfolio managers

If the realised return plots above the SML Portfolio has overperformed

If the realised return plots below the SML Portfolio has underperformed

Problems of CAPM
1. The model assumes that the variance of returns is an adequate measurement of risk.

2. The model assumes that all active and potential shareholders have access to the same information and
agree about the risk and expected return of all assets (homogeneous expectations assumption).
3. The model does not appear to adequately explain the variation in stock returns. Empirical studies show
that low beta stocks may offer higher returns than the model would predict.
4. The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed
with more complicated versions of the model.
5. Empirical tests show market anomalies like the size and value effect that cannot be explained by the
CAPM.
Portfolio
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund,
financial institution or individual.
The term portfolio refers to any collection of financial assets such as stocks, bonds, and cash. Portfolios may be
held by individual investors and/or managed by financial professionals, hedge funds, banks and other financial
institutions. It is a generally accepted principle that a portfolio is designed according to the investor's risk
tolerance, time frame and investment objectives. The monetary value of each asset may influence the
risk/reward ratio of the portfolio and is referred to as the asset allocation of the portfolio
Portfolio Expected Return
The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the stocks
which comprise the portfolio. The weights reflect the proportion of the portfolio invested in the stocks. This can
be expressed as follows:
where

E[Rp] = the expected return on the portfolio,

N = the number of stocks in the portfolio,

wi = the proportion of the portfolio invested in stock i, and

E[Ri] = the expected return on stock i.

For a portfolio consisting of two assets, the above equation can be expressed as

Expected Return on a Portfolio of Stocks A and B


Note: E[RA] = 12.5% and E[RB] = 20%
Portfolio consisting of 50% Stock A and 50% Stock B

Beta: As a measure of Risk


Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual
stocks are ranked according to how much they deviate from the market. Beta is also referred to as financial elasticity or
correlated relative volatility, its non-diversifiable risk, its systematic risk, or market risk. On an individual asset level,
measuring beta can give clues to volatility and liquidity in the marketplace..
Advantages of Beta
To followers of CAPM, beta is a useful measure. A stock's price variability is important to consider when assessing risk.
Indeed, if you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.
Disadvantages of Beta
Another troubling factor is that past price movements are very poor predictors of the future. Betas are merely rear-view
mirrors, reflecting very little of what lies ahead.
Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable. Granted, for
traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric. However, for investors
with long-term horizons, it's less useful.

Interpretation of Beta
Value of Beta Interpretation

Example

Asset generally moves in the opposite direction

An inverse exchange-traded fund or a

as compared to the index

short position

<0
Fixed-yield asset, whose growth is
Movement of the asset is uncorrelated with the
=0

unrelated to the movement of the


movement of the benchmark
stock market

Stable, "staple" stock such as a


Movement of the asset is generally in the
company that makes soap. Moves in the same direction
0<<1

same direction as, but less than the movement


as the market at large, but less susceptible to
of the benchmark
day-to-day fluctuation.
Movement of the asset is generally in the
A representative stock, or a stock that is a

=1

same direction as, and about the same amount


strong contributor to the index itself.
as the movement of the benchmark

>1

Movement of the asset is generally in the

Volatile stock, such as a tech stock, or stocks

same direction as, but more than the

which are very strongly influenced by

movement of the benchmark

day-to-day market news.

Harry Markowitz Theory

Harry Max Markowitz (born August 24, 1927) is an American economist, and a recipient of the 1989 John von
Neumann Theory Prize and the 1990 Nobel Memorial Prize in Economic Sciences.

Markowitz is a professor of finance at the Rady School of Management at the University of California, San Diego
(UCSD). He is best known for his pioneering work in Modern Portfolio Theory, studying the effects of asset risk,
return, correlation and diversification on probable investment portfolio returns.

Harry Markowitz put forward this model in 1952. It assists in the selection of the most efficient by analyzing various
possible portfolios of the given securities. By choosing securities that do not 'move' exactly together, the HM model
shows investors how to reduce their risk. The HM model is also called Mean-Variance Model due to the fact that it is
based on expected returns (mean) and the standard deviation (variance) of the various portfolios. Harry Markowitz made
the following assumptions while developing the HM model:

Assumptions
Risk of a portfolio is based on the variability of returns from the said portfolio.
2. An investor is risk averse.
3. An investor prefers to increase consumption.
4. The investor's utility function is concave and increasing, due to his risk aversion and consumption preference.
5. Analysis is based on single period model of investment.
6. An investor either maximizes his portfolio return for a given level of risk or maximizes his return for the minimum risk.
7. An investor is rational in nature.

To choose the best portfolio from a number of possible portfolios, each with different return and
risk, two separate decisions are to be made:

1. Determination of a set of efficient portfolios.


2. Selection of the best portfolio out of the efficient set
Determining the Efficient Set
A portfolio that gives maximum return for a given risk, or minimum risk for given return is an efficient
portfolio. Thus, portfolios are selected as follows:
(a) From the portfolios that have the same return, the investor will prefer the portfolio with lower risk,
and
(b) From the portfolios that have the same risk level, an investor will prefer the portfolio with higher
rate of return.

As the investor is rational, they would like to have higher return. And as he is risk averse, he
wants to have lower risk. In Figure in last slide, the shaded area PVWP includes all the possible
securities an investor can invest in. The efficient portfolios are the ones that lie on the boundary
of PQVW. For example, at risk level x2, there are three portfolios S, T, U. But portfolio S is
called the efficient portfolio as it has the highest return, y2, compared to T and U. All the
portfolios that lie on the boundary of PQVW are efficient portfolios for a given risk level.

The boundary PQVW is called the Efficient Frontier. All portfolios that lie below the Efficient
Frontier are not good enough because the return would be lower for the given risk. Portfolios
that lie to the right of the Efficient Frontier would not be good enough, as there is higher risk for
a given rate of return. All portfolios lying on the boundary of PQVW are called Efficient
Portfolios. The Efficient Frontier is the same for all investors, as all investors want maximum
return with the lowest possible risk and they are risk averse.

Choosing the best Portfolio

For selection of the optimal portfolio or the best portfolio, the risk-return preferences are analyzed. An
investor who is highly risk averse will hold a portfolio on the lower left hand of the frontier, and an
investor who isnt too risk averse will choose a portfolio on the upper portion of the frontier.
Figure 2 shows the risk-return indifference curve for the investors. Indifference curves C1, C2 and C3
are shown. Each of the different points on a particular indifference curve shows a different combination
of risk and return, which provide the same satisfaction to the investors. Each curve to the left represents
higher utility or satisfaction. The goal of the investor would be to maximize his satisfaction by moving
to a curve that is higher. An investor might have satisfaction represented by C 2, but if his
satisfaction/utility increases, he/she then moves to curve C3 Thus, at any point of time, an investor will
be indifferent between combinations S1 and S2, or S5 and S6..

The investor's optimal portfolio is found at the point of tangency of the efficient frontier with the
indifference curve. This point marks the highest level of satisfaction the investor can obtain. This is
shown in Figure 3. R is the point where the efficient frontier is tangent to indifference curve C 3, and is
also an efficient portfolio. With this portfolio, the investor will get highest satisfaction as well as best
risk-return combination. Any other portfolio, say X, isn't the optimal portfolio even though it lies on the
same indifference curve as it is outside the efficient frontier. Portfolio Y is also not optimal as it does
not lie on the indifference curve, even though it lies in the portfolio region. Another investor having
other sets of indifference curves might have some different portfolio as his best/optimal portfolio.

Efficient market hypothesis


A market theory that evolved from a 1960's Ph.D. dissertation by Eugene Farma, the efficient market
hypothesis states that at any given time and in a liquid market, security prices fully reflect all available
information. The EMH exists in various degrees: weak, semi-strong and strong, which addresses the
inclusion of non-public information in market prices. This theory contends that since markets are
efficient and current prices reflect all information, attempts to outperform the market are essentially a
game of chance rather than one of skill.

The weak form of EMH assumes that current stock prices fully reflect all currently available
security market information. It contends that past price and volume data have no relationship
with the future direction of security prices. It concludes that excess returns cannot be achieved
using technical analysis.

The semi-strong form of EMH assumes that current stock prices adjust rapidly to the release of
all new public information. It contends that security prices have factored in available market and
non-market public information. It concludes that excess returns cannot be achieved using
fundamental analysis.

The strong form of EMH assumes that current stock prices fully reflect all public and private
information. It contends that market, non-market and inside information is all factored into
security prices and that no one has monopolistic access to relevant information. It assumes a
perfect market and concludes that excess returns are impossible to achieve consistently.

Elliott wave principle

The Elliott wave principle is a form of technical analysis that some traders use to analyze financial
market cycles and forecast market trends by identifying extremes in investor psychology, highs and
lows in prices, and other collective factors. Ralph Nelson Elliott (18711948), a professional
accountant, discovered the underlying social principles and developed the analytical tools in the 1930s.

He proposed that market prices unfold in specific patterns, which practitioners today call Elliott waves,
or simply waves. Elliott published his theory of market behavior in the book The Wave Principle in
1938, summarized it in a series of articles in Financial World magazine in 1939, and covered it most
comprehensively in his final major work, Natures Laws: The Secret of the Universe in 1946. Elliott
stated that "because man is subject to rhythmical procedure, calculations having to do with his
activities can be projected far into the future with a justification and certainty heretofore unattainable.
The Elliott Wave Principle posits that collective investor psychology, or crowd psychology, moves
between optimism and pessimism in natural sequences. These mood swings create patterns evidenced
in the price movements of markets at every degree of trend or time scale.
In Elliott's model, market prices alternate between an impulsive, or motive phase, and a corrective
phase on all time scales of trend, as the illustration shows. Impulses are always subdivided into a set of
5 lower-degree waves, alternating again between motive and corrective character, so that waves 1, 3,
and 5 are impulses, and waves 2 and 4 are smaller retraces of waves 1 and 3. Corrective waves
subdivide into 3 smaller-degree waves starting with a five-wave counter-trend impulse, a retrace, and
another impulse. In a bear market the dominant trend is downward, so the pattern is reversedfive
waves down and three up. Motive waves always move with the trend, while corrective waves move
against it.

Elliott Wave personality and characteristics


Five wave pattern (dominant trend)

Three wave pattern (corrective trend)

Wave 1: Wave one is rarely obvious at its


inception. When the first wave of a new bull
market begins, the fundamental news is almost
universally negative. The previous trend is
considered still strongly in force. Fundamental

Wave A: Corrections are typically harder to identify


than impulse moves. In wave A of a bear market,
the fundamental news is usually still positive.

analysts continue to revise their earnings


estimates lower; the economy probably does
not look strong

Most analysts see the drop as a correction in a still-active


bull market.

Wave 2: Wave two corrects wave one, but Wave B: Prices reverse higher, which many see as a
can never extend beyond the starting point
of wave one. Typically, the news is still
bad. As prices retest the prior low, bearish
sentiment quickly builds, and "the crowd"
haughtily reminds all that the bear market
is still deeply ensconced.

Wave 3: Wave three is usually the largest

resumption of the now long-gone bull market. The


volume during wave B should be lower than in wave A.
By this point, fundamentals are probably no longer
improving, but they most likely have not yet turned negative.
Wave C: Prices move impulsively lower in five waves.

and most powerful wave in a trend


Volume picks up, and by the third leg of wave C,
(although some research suggests that in
commodity markets, wave five is the
almost everyone realizes that a bear market is
largest). The news is now positive and
fundamental analysts start to raise earnings firmly entrenched.
estimates. Prices rise quickly, corrections
are short-lived and shallow.

Wave 4: Wave four is typically clearly


corrective. Prices may meander sideways for an
extended period, and wave four typically
retraces less than 38.2% of wave three (see
Fibonacci relationships below). Volume is well
below than that of wave three. This is a good
place to buy a pull back if you understand the
potential ahead for wave

Wave 5: Wave five is the final leg in the


direction of the dominant trend. The news is
almost universally positive and everyone is
bullish. Unfortunately, this is when many
average investors finally buy in, right before
the top. Volume is often lower in wave five
than in wave three, and many momentum
indicators start to show divergences (prices
reach a new high but the indicators do not reach
a new peak).

Arbitrage Pricing Theory.


This theory is one of the tools used by the investors and portfolio managers. The capital asset
pricing theory explains the return of the securities on the basis of their respective betas.
According to the previous models, the investor chooses the investment on the basis of expected
return and variance. The alternative to this theory developed in the asset pricing by Stephen ross
is known as Arbitrage pricing theory. The APT theory explains the nature of equilibrium in the
asset pricing in a less complicated manner with fewer assumptions compared to CAPM.
Arbitrage is a process of earning profit by taking advantage of differential pricing for the same
asset. The process generates riskless profit. On the security market, it is of selling security at a
high price and the simultaneous purchase of the same security at a relatively lower price. Since
the profit earned through arbitrage is riskless, the investors have the incentive to undertake this
whenever an opportunity arises. In general, some investors indulge more in this type of activities
than others. However, the buying and selling activities of the arbitragers reduces and eliminates
the profit margin, bringing the market price to the equilibrium level.
The assumptions

The investors have homogenous expectations


The investors are risk averse
Perfect market competition
No transaction cost

But it does not assume

Single period investment horizon


No taxes
Investor can borrow and lend at risk free rate of interest
The selection of the portfolio is based on the mean and variance analysis.

The theory was proposed by the economist Stephen Ross in 1976.


Risky asset returns are said to follow a factor structure if they can be expressed as:
where
is a constant for asset

is a systematic factor

is the sensitivity of the th asset to factor , also called factor loading,


and is the risky asset's idiosyncratic random shock with mean zero.
Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated with the factors.
The APT states that if asset returns follow a factor structure then the following relation exists between expected
returns and the factor sensitivities:

where
is the risk premium of the factor,
is the risk-free rate,
That is, the expected return of an asset j is a linear function of the asset's sensitivities to the n factors.
Note that there are some assumptions and requirements that have to be fulfilled for the latter to be correct: There
must be perfect competition in the market, and the total number of factors may never surpass the total number
of assets (in order to avoid the problem of matrix singularity),

Unit-5
Review the existing asset portfolio
Undertaking periodic evaluations of its asset portfolio, based on size and complexity, as part of its strategic
asset management helps an entity to confirm that its assets continue to be appropriate to meet its program
delivery requirements. As part of the evaluation of the existing asset portfolio the entity may consider:
using asset performance indicators to identify if existing assets are being appropriately used, maintained,
and are fit-for-purpose;
monitoring the performance of the asset portfolio in terms of laws, codes and benchmarks, and financial
performance; and
maintaining a detailed asset register, and accounting for the assets in accordance with Australian
Accounting Standards.

Performance evaluation of existing portfolio


Portfolio evaluating refers to the evaluation of the performance of the portfolio. It is essentially the process of
comparing the return earned on a portfolio with the return earned on one or more other portfolio or on a
benchmark portfolio. Portfolio evaluation essentially comprises of two functions, performance measurement
and performance evaluation. Performance measurement is an accounting function which measures the return
earned on a portfolio during the holding period or investment period. Performance evaluation , on the other
hand, address such issues as whether the performance was superior or inferior, whether the performance was
due to skill or luck etc.
The ability of the investor depends upon the absorption of latest developments which occurred in the market.
The ability of expectations if any, we must able to cope up with the wind immediately. Investment analysts
continuously monitor and evaluate the result of the portfolio performance. The expert portfolio constructer shall
show superior performance over the market and other factors. The performance also depends upon the timing of
investments and superior investment analysts capabilities for selection. The evolution of portfolio always
followed by revision and reconstruction. The investor will have to assess the extent to which the objectives are
achieved. For evaluation of portfolio, the investor shall keep in mind the secured average returns, average or
below average as compared to the market situation. Selection of proper securities is the first requirement. The
evaluation of a portfolio performance can be made based on the following methods:
a) Sharpes Measure
b) Treynors Measure
c) Jensens Measure

Treynor measuresThe Treynor ratio (sometimes called the reward-to-volatility ratio or Treynor measure, named after Jack L.
Treynor, is a measurement of the returns earned in excess of that which could have been earned on an
investment that has no diversifiable risk (e.g., Treasury Bills or a completely diversified portfolio), per each unit
of market risk assumed.
The Treynor ratio relates excess return over the risk-free rate to the additional risk taken; however, systematic
risk is used instead of total risk. The higher the Treynor ratio, the better the performance of the portfolio under
analysis.

where:
Treynor ratio,
portfolio i's return,
risk free rate
portfolio i's beta

Limitations
Like the Sharpe ratio, the Treynor ratio (T) does not quantify the value added, if any, of active portfolio
management. It is a ranking criterion only. A ranking of portfolios based on the Treynor Ratio is only useful if
the portfolios under consideration are sub-portfolios of a broader, fully diversified portfolio. If this is not the
case, portfolios with identical systematic risk, but different total risk, will be rated the same. But the portfolio
with a higher total risk is less diversified and therefore has a higher unsystematic risk which is not priced in the
market.
An alternative method of ranking portfolio management is Jensen's alpha, which quantifies the added return as
the excess return above the security market line in the capital asset pricing model. As these two methods both
determine rankings based on systematic risk alone, they will rank portfolios identically.

Sharpe Ratio
Sharpe ratio evaluates the performance of a portfolio based on the total risk of a portfolio. It measures the
excess return generated by a portfolio over the risk free rate in relation to the total risk or standard deviation of a
portfolio.
Sharpe Ratio= (Rp - Rf)/s
Where, Rp=return on the portfolio, Rf= risk free rate and s= standard deviation of the return of the portfolio
Higher the Sharpe ratio, better is the fund.
Illustration: Consider two funds A and B. Let return of fund A be 30% and that of fund B be 25%. On the outset,
it appears that fund A has performed better than Fund B. Let us now incorporate the risk factor and find out the
Sharpe ratios for the funds. Let risk of Fund A and Fund B be 11% and 5% respectively. This means that the
standard deviation of returns - or the volatility of returns of Fund A is much higher than that of Fund B.
If risk free rate is assumed to be 8%,
Sharpe ratio for fund A= (30-8)/11=2% and
Sharpe ratio for fund B= (25-8)/5=3.4%
Higher the Sharpe Ratio, better is the fund on a risk adjusted return metric. Hence, our primary judgement based
solely on returns was erroneous. Fund B provides better risk adjusted returns than Fund A and hence is the
preferred investment. Producing healthy returns with low volatility is generally preferred by most investors to
high returns with high volatility. Sharpe ratio is a good tool to use to determine a fund that is suitable to such
investors.

Difference Between Sharpes Measure and Treynor Measure


Both Sharpe ratio and Treynor ratio measure risk adjusted returns. The difference lies in how risk is defined in
either case. In Sharpe ratio, risk is determined as the degree of volatility in returns - the variability in month-onmonth or period-on-period returns - which is expressed through the standard deviation of the stream of returns
numbers you are considering. In Treynor ratio, you look at the beta of the portfolio - the degree of "momentum"
that has been built into the portfolio by the fund manager in order to derive his excess returns. High momentum
- or high beta (where beta is > 1) implies that the portfolio will move faster (up as well as down) than the
market.
While Sharpe ratio measures total risk (as the degree of volatility in returns captures all elements of risk systematic as well as unsystemic), the Treynor ratio captures only the systematic risk in its computation.
When one has to evaluate the funds which are sector specific, Sharpe ratio would be more meaningful. This is
due to the fact that unsystematic risk would be present in sector specific funds. Hence, a truer measure of
evaluation would be to judge the returns based on the total risk.
On the contrary, if we consider diversified equity funds, the element of unsystematic risk would be very
negligible as these funds are expected to be well diversified by virtue of their nature. Hence, Treynor ratio
would me more apt here.

It is widely found that both ratios usually give similar rankings. This is based on the fact that most of the
portfolios are fully diversified. To summarize, we can say that when the fund is not fully diversified, Sharpe
ratio would be a better measure of performance and when the portfolio is fully diversified, Treynor ratio would
better justify the performance of a fund.
(c) Jensens Measure:
Jensen attempts to construct a measure of absolute performance on a risk adjusted basis. This measure is based
on CAPM model. It measures the portfolio managers predictive ability to achieve higher return than expected
for the accepted riskiness. The ability to earn returns through successful prediction of security prices on a
standard measurement. The Jensen measure of the performance of portfolio can be calculated by applying the
following formula:
Rp = Rf + (RMI Rf) x
Where,
Rp = Return on portfolio
RMI = Return on market index
Rf = Risk free rate of return

Portfolio Management
First let's understand the meaning of terms Portfolio and Management.
1. Portfolio is a group of financial assets such as shares, stocks, bonds, debt instruments, mutual funds,
cash equivalents, etc. A portfolio is planned to stabilize the risk of non-performance of various pools of
investment.
2. Management is the organization and coordination of the activities of an enterprise in accordance
with well-defined policies and in achievement of its pre-defined objectives.
Now let's comprehend the meaning of term Portfolio Management.
1. Portfolio Management (PM) guides the investor in a method of selecting the best available
securities that will provide the expected rate of return for any given degree of risk and also to mitigate
(reduce) the risks. It is a strategic decision which is addressed by the top-level managers.
For example, Consider Mr. John has $100,000 and wants to invest his money in the financial market other than
real estate investments. Here, the rational objective of the investor (Mr. John) is to earn a considerable rate of
return with less possible risk.
So, the ideal recommended portfolio for investor Mr. John can be as follows:-

Objectives of Portfolio Management


The main objectives of portfolio management in finance are as follows:-

1. Security of Principal Investment : Investment safety or minimization of risks is one of the


most important objectives of portfolio management. Portfolio management not only involves keeping
the investment intact but also contributes towards the growth of its purchasing power over the period.
The motive of a financial portfolio management is to ensure that the investment is absolutely safe. Other
factors such as income, growth, etc., are considered only after the safety of investment is ensured.
2. Consistency of Returns : Portfolio management also ensures to provide the stability of returns
by reinvesting the same earned returns in profitable and good portfolios. The portfolio helps to yield
steady returns. The earned returns should compensate the opportunity cost of the funds invested.
3. Capital Growth : Portfolio management guarantees the growth of capital by reinvesting in growth
securities or by the purchase of the growth securities. A portfolio shall appreciate in value, in order to
safeguard the investor from any erosion in purchasing power due to inflation and other economic
factors. A portfolio must consist of those investments, which tend to appreciate in real value after
adjusting for inflation.
4. Marketability : Portfolio management ensures the flexibility to the investment portfolio. A portfolio
consists of such investment, which can be marketed and traded. Suppose, if your portfolio contains too
many unlisted or inactive shares, then there would be problems to do trading like switching from one
investment to another. It is always recommended to invest only in those shares and securities which are
listed on major stock exchanges, and also, which are actively traded.
5. Liquidity : Portfolio management is planned in such a way that it facilitates to take maximum
advantage of various good opportunities upcoming in the market. The portfolio should always ensure
that there are enough funds available at short notice to take care of the investors liquidity requirements.
6. Diversification of Portfolio : Portfolio management is purposely designed to reduce the risk of
loss of capital and/or income by investing in different types of securities available in a wide range of
industries. The investors shall be aware of the fact that there is no such thing as a zero risk investment.
More over relatively low risk investment give correspondingly a lower return to their financial portfolio.
7. Favorable Tax Status : Portfolio management is planned in such a way to increase the effective
yield an investor gets from his surplus invested funds. By minimizing the tax burden, yield can be
effectively improved. A good portfolio should give a favorable tax shelter to the investors. The portfolio
should be evaluated after considering income tax, capital gains tax, and other taxes.
The objectives of portfolio management are applicable to all financial portfolios. These objectives, if
considered, results in a proper analytical approach towards the growth of the portfolio. Furthermore, overall risk

needs to be maintained at the acceptable level by developing a balanced and efficient portfolio. Finally, a good
portfolio of growth stocks often satisfies all objectives of portfolio management.

PASSIVE MANAGEMENT
Passive management is an process is a holding a well diversified portfolio for a long term with the buy
and hold approach. Passive management refers to the investors attempt to construct a portfolio that
resembles the overall market returns. The simplest form of passive management is holding the index
fund that is designed to replicate a good and well defined index of the common stock such as BSE
sensex or NSE nifty. The fund manager buys every stock in the index in exact proportion of the stock
in that index. If reliance industry stock constitutes 5% of the index, the fund also invests 5% in reliance
industry stock.

ACTIVE MANAGMENT
Active management is holding securities based on the forecast about the future. The portfolio
managers vary their cash position or beta of the equity portion of the portfolio based on the
market forecast. The managers may indulge in group rotations. Here, group rotation means
changing the investment in different industries stocks depending on the assessed expectation
regarding their future performance.

The formula plan


The formula plan provide the basic rules and regulations for the purchase and sales of securities.
The amount to be spent on the different types securities is fixed. The amount may be fixed
either in constant or variable ratio. This depends on the investors attitude towards risk and
return. The commonly used formula plans are rupee cost averaging, constant rupee value, the
constant ratio and the variable ratio plan.

Assumption of the formula plan


1. The first assumption is that certain percentage of the investor fund is allocated to fixed
income securities and common stock.
2. The second assumption is that if the market moves higher, the proportion of the stocks in
the portfolio may either be decline or remain constant. The portfolio is more aggressive
in low market and defensive when the market is on the rise.
3. The third assumption is that the stocks are bought and sold whenever there is a significant
change in price.
4. The fourth one is that the investor should strictly follow the formula plan once he chosen
it.

Advantage of the formula plan

Basic rule and regulation for the purchase and sale of securities are provided.
The rules and regulations are rigid and help to overcome human emotion.
The investor can earn higher profits by adopting the plan.
A course of action is formulated according to the investors objectives.
It controls the buying and selling of securities by the investors.

Disadvantages of the formula plan


The formula plan does cot help the selection of the securities.
It is strict and not flexible with the inherent problem of adjustment.
This should be applied for long periods, otherwise the transaction coat may be high.

Mutual Fund Industry


A mutual fund is a type of professionally managed collective investment vehicle that pools money from many
investors to purchase securities.
The first introduction of a mutual fund in India occurred in 1963, when the Government of India launched Unit
Trust of India (UTI). Until 1987, UTI enjoyed a monopoly in the Indian mutual fund market. Then a host of
other government-controlled Indian financial companies came up with their own funds. These included State
Bank of India, Canara Bank, and Punjab National Bank. This market was made open to private players in 1993,
as a result of the historic constitutional amendments brought forward by the then Congress-led government
under the existing regime of Liberalization, Privatization and Globalization (LPG). The first private sector fund
to operate in India was Kothari Pioneer, which later merged with Franklin Templeton.
Despite being available in the market for over two decades now with assets under management equaling Rs
7,81,71,152 Lakhs (as of 28 February 2010) (Source: Association of Mutual Funds, India), less than 10% of
Indian households have invested in mutual funds. A recent report on Mutual Fund Investments in India
published by research and analytics firm, Boston Analytics, suggests investors are holding back from putting
their money into mutual funds due to their perceived high risk and a lack of information on how mutual funds
work. This report is based on a survey of approximately 10,000 respondents in 15 Indian cities and towns as of
March 2010. There are 43 Mutual Funds recently.
The primary reason for not investing appears to be correlated with city size. Among respondents with a high
savings rate, close to 40% of those who live in metros and Tier I cities considered such investments to be very
risky, whereas 33% of those in Tier II cities said they did not know how or where to invest in such assets.

Reasons for not investing in mutual funds in India


On the other hand, among those who invested, close to nine out of ten respondents did so because they felt these
assets were more professionally managed than other asset classes. Exhibit 2 lists some of the influencing factors
for investing in mutual funds. Interestingly, while non-investors cite "risk" as one of the primary reasons they do
not invest in mutual funds, those who do invest consider that they are "professionally managed" and "more
diverse" most often as their reasons to invest in mutual funds versus other investments.
A mutual fund is a type of professionally managed collective investment vehicle that pools money from many
investors to purchase securities.While there is no legal definition of the term "mutual fund", it is most
commonly applied only to those collective investment vehicles that are regulated and sold to the general public.
They are sometimes referred to as "investment companies" or "registered investment companies." Most mutual
funds are "open-ended," meaning investors can buy or sell shares of the fund at any time. Hedge funds are not
considered a type of mutual fund.

Finding alternatives and revision of portfolio


Types of alternatives
Rupee Cost Averaging Plan
Constant Rupee Value Plan
Constant Ration Plan
Value ration Plan
Systematic plan

Rupee Cost Averaging Plan

The simplest and most effective formula plan is the rupee cost averaging plan. First, stock are with the good
fundamentals and long term growth prospects should be selected. Such stock price tends to be volatile in the
market and provide maximum benefit from rupee cost averaging. Secondly, the investors should make a regular
commitment of buying shares at regular intervals. Once he makes a commitment, he should purchase the shares
regardless of the stock price, company short term performance and economic factors affecting the stock market.

Advantages
Reduces the average cost per share and improves the possibility of gain over long period.
Takes away the pressure of timing the stock purchase from investors.
Applicable for both falling and rising market.

Disadvantages
Extra transaction cost with small and frequent purchase of shares
This does not indicate when to sell.
There is no indication of appropriate interval between the sales.
It is strictly for buying.

Market
Price

Share
Purchased

Cumulative Market
Investment Value

1
2
3
4

100
90
100
100

10
11
10
9

1000
1990
2990
3980

1000
1890
3100
4400

Unrealized
Profit or
Loss
0
(100)
110
420

Average
cost
Per
share
100
94.76
95
100

Constant Rupee Plan


Constant rupee, constant ratio and variable ratio are considered to be true formula timing plans. These plans force the
investor to sell when the price and purchase as price falls. Forecasts are not required to guide buying and selling. The
actions suggested by the formula plan automatically helps the investor to reap the benefits of the fluctuations in the
stock price.
The essential feature of this plan is that the portfolio is divided is divided into two parts, which consists of aggressive
and defensive or conservative portfolios. The portfolio mix facilitates the automatic selling and buying of bonds and
stocks.
The plan enables the shift of investment from bonds to stocks and vice versa by maintain a constant amount invested
in the stock portion of the portfolio. The constant rupee plan starts with a fixed amount of money invested in selected
stocks and bonds. When the price of the stocks increases, the investor sells sufficient amount of stocks to return to the
original amount of the investment in stocks. By keeping the value of aggressive portfolio constant, remainder is
invested in the conservative portfolio..
The investors must choose action points or revaluation points. The action points are the times at which the investor
has to readjust the value of the stocks in the portfolio. Stocks values cannot be continuously the same and the investor
has to be watchful of the price movements. Stocks value in the portfolio can be allowed to fluctuate to a certain
extent. Percentage change in price like 5%, 10%, 20% can be fixed by the investor. Allowing only small percentage
change would result un an lot of transaction cost and would not be beneficial to the investor.

Constant ratio plan


Constant ratio plan attempts to maintain a constant ratio between the aggressive and conservative portfolios.
The ratio is fixed by the investor. The investor attitude towards risk and return plays a major role in fixing

the ratio. The conservative investor may like to have more of bond and the aggressive investor, more of
stocks. Once the ratio is fixed, it is maintained as the market moves up and down. As usual, action points
may be may be the investor. It may vary from investor to investor. The advantage of constant ratio plan is
the enthusiasm with which it forces the manager to counter adjust his portfolio cyclically. But this approach
does not eliminate the necessity of selecting individual security.
The limitation of the plan is that the money is shifted from the stocks portion to bond portion. Bond is also a
capital market instrument and responds to market pressures. Bond and share prices may both rise and gall at
the same time, in the downtrend both prices decline and them gain.