SECUARITY ANALYSIS AND

INVESTMENT MANAGEMENT
(NMBA FM 01)
By
Sarvendu Tiwari
PhD(P), M.Phil, MBA , M.Com, UGC-NET

Meaning of security
-The state of being free from danger or threat.
-A thing deposited or pledged as a guarantee of the fulfilment of an
undertaking or the repayment of a loan, to be forfeited in case of
default.
-Investment in capital market is made in various financial instruments, which are
all claims on money. These instruments may be of various categories with
different characteristics. These are all called securities in the market parlance. In
a legal sense also, the Securities Contracts Regulation Act, (1956) has defined
the security as inclusive of shares, stocks, bonds, debentures or any other
marketable securities of a like nature or of any debentures of a company or body
corporate, the Government and semi-Government body etc. It includes all rights
and interests in them including warrants, and loyalty coupons etc., issued by any
of the bodies, organisations or the Government. The derivatives of securities and
Security Index are also included as securities in the above definition in 1998.

Definition of analysis
For making proper investment involving both risk and
return, the investor has to make a study of the alternative
avenues of investment their risk and return characteristics
and make proper projection or expectation of the risk and
return of the alternative investments under consideration. He
has to tune the expectations to his preferences of the risk and
return for making a proper investment choice

Definition of security analysis

The process of analysing the individual securities and the
market as a whole and estimating the risk
and return expected from each of the investments with a view to
identifying undervalued securities for buying and overvalued
securities for selling is both an art and a science and this is
what is called security analysis.

Meaning of portfolio
management
A combination of such securities with different risk-return characteristics will
constitute the portfolio of the investor. Thus, a portfolio is a combination of
various assets and/or instruments of investments. The combination may have
different features of risk and return, separate from those of the components. The
portfolio is also built up out of the wealth or income of the investor over a period
of time, with a view to suit his risk or return preferences to that of
the portfolio that he holds.
The portfolio analysis is thus an analysis of the risk-return characteristics of
individual securities in the portfolio and changes that may take place in
combination with other securities due to interaction among themselves and
impact of each one of them on others.

Investments: meaning
Investment may be defined as an activity that commits funds in
any financial/physical form in the present with an expectation of
receiving additional return in the future.
Investment is an activity that is undertaken by those who have
savings. Savings can be defined as the excess of income over
expenditure.
:-Type: Economic and Financial investments
:-Characteristics of investment
The features of economic and financial investments
can be
summarised as:
Return,
Risk,

Investment vs.
Speculation
Investment can be distinguished from speculation by risk bearing
capacity, return expectations, and duration of trade. The capacity to
bear risk distinguishes an investor from a speculator.
An investor prefers low risk investments, whereas a speculator is
prepared to take higher risks for higher returns. Speculation focuses
more on returns than safety, thereby encouraging frequent trading
without any intention of owning the investment. The speculators
motive is to achieve profits through price change, that is, capital
gains are more important than the direct income from
an investment. Thus, speculation is associated with buying low and
selling high with the hope of making large capital gains

Investment Vs Gambling
Investment can also to be distinguished from gambling.
Examples of gambling are horse race, card games,
lotteries, and so on.
Gambling involves high risk not only for high returns but
also for the associated excitement. Gambling is unplanned
and unscientific, without the knowledge of the nature of
the risk involved. It is surrounded by uncertainty and a
gambling decision is taken on unfounded market tips and
rumours. In gambling, artificial and unnecessary risks are
created for increasing the returns.

Capital MarketIntroduction

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.

Introduction Continued.

In 1860-61 the American Civil War broke out and cotton supply
from United States to 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

Securities market is an economic institute within which
Market
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

Securities market / Stock

1. to attract new capital by means of issuance new
Market
security (securitization of debt),
2.
3.
4.
5.

6.

7.

to transfer real asset into financial asset,

to invest money for short or long term periods with
the aim of deriving profit.
commercial function (to derive profit from operation
on this market)
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)
informative function (market provides all participants
with market information about participants and
traded instruments)
regulation function (securities market creates the
rules of trade).

Role of Stock Market

Raising

capital for businesses

Mobilizing savings for investment
Facilitating company growth
Corporate governance
Creating investment opportunities
small investors

for

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 new issue market for securities is the
primary securities market which brings
together the supply and demand or source
and uses for new capital funds. In this market
the principal source of funds is the domestic
savings of individuals and businesses; other

Levels of securities market

Primary market
The principal uses of funds are: the long-term
financing
of
the
investment
in
housing
(mortgages),
the
long-term
investment
of
corporations and other businesses, and the longterm borrowing of government.

The ultimate suppliers of funds are those sectors

with a surplus of current income over expenditure
(savings); and these funds flow to their ultimate
users, namely, economic units which issue
securities to finance a surplus of expenditures over
their current incomes.
In a highly developed capital market by far the
largest proportion of individuals savings reaches
the new issues market indirectly via a financial
intermediary. For example, the savings of most
individuals are channeled to an ultimate user, say a
corporation desiring to finance an expansion of its

1.

2.
3.
4.

5.
6.

Primary market Features

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

1. Origination- Deals with Origin of new Issue. The
Functions
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

1. To promote a new company
Functions
2.
3.
4.
5.
6.

To help to expand a new company

To help in diversification of the product
To channelize the savings of the
investors.
To help the companies to raise capital
To help the secondary market in
helping in trading of the securities.

1.

Participant in Primary
Market
Manager to the issueConstruction 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
1. The securities issued in the New Issue Market are
invariably
listed on market
a recognised Relation
stock exchange,
Secondary
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.

Primary market Secondary

market
Differences
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 stockin-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-a-vis 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.
1.

Investor Protection in
Primary
market
1. Provision
of
all
the

relevant

Information
2. Provision of Accurate information
3. Transparent
allotment
procedure
without any bias.

Investor Protection in Primary

1. Project Appraisal
market
2.
3.
4.
5.
6.
7.

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.

Secondary Market Continued.

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-the-counter. 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

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

for

small

Regulatory Mechanism in Secondary Market

Three tier structure

1.Ministry of finance
2.SEBI
3.Governing Board

Regulatory Mechanism in Secondary Market

Ministry of finance
1.
2.
3.
4.
5.

Supervisory function over SEBI

Appellate function against SEBI
Licensing of dealers
Recognition to stock exchange
Appointment of the board of governors

SEBI
1.
2.
3.
4.
5.

Regulation of Business
Investor Protection
Prevent Fraudulent trade practices
Takeover and Amalgamation
Other powers

Regulatory Mechanism in Stock Market

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.

Trading
in Indian stock of
exchanges
areMarket
limited to listed securities of
Functioning
Stock
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 Functioning
member broker in of
an Indian
stock
exchange can act as an
Stock
Market
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-to-face 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
(OTCEI)

Counter

Exchange

of

India

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

OTC
has a unique of
feature
of trading
compared to other
Functioning
Stock
Market
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

Benefits and limitations of Stock

Benefits
Market
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

Benefits and limitations of Stock

Limitations
Market accountability to public shareholders
Increasing
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

It was officially act by The Government of India in the year 1988 and given
India
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

To of
promote
Board
India

and

develop

market
To
protect the interest of
investors in stock market.
To regulate the stock market

stock
the

Functions of Security and Exchange

In order
to pursue the objectives SEBI
Board
of India
has the following functions:

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.
1.

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
regulation of primary and secondary market.

regarding

SEBIs Role in Primary Market

1.

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.

2. 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.

3. Disclosure
4. Allocation of shares
5. Market intermediaries.

SEBIs Role in Secondary Market

1.
2.
3.
4.
5.

Governing Board
Infrastructure
Settlement and clearing
Price stabilization
Delisting

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.

Types of Risk
Systematic and unsystematic risk components
In finance, different types of risk can be classified under
two main groups, viz.,
Systematic risk.
Unsystematic risk.
Two main groups under which types of risk are classified
is depicted below.

Types of Risk
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:

Interest rate risk.

Market risk.

Purchasing power or Inflationary risk.

Types of Risk
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:
Interest rate risk.
Market risk.
Purchasing power or Inflationary risk.

Types of 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.
Price risk.
Reinvestment rate risk.
The types of interest-rate risk are depicted below.
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.

Types of Risk
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.
Absolute risk.
Relative risk.
Directional risk.
Non-directional risk.
Basis risk.
Volatility risk.
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.

Types of Risk
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.
Demand inflation risk.
Cost inflation risk.
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.

Types of Risk
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.
Business or liquidity risk.
Financial or credit risk.
Operational risk.

Types of Risk
1. Business or liquidity risk
Business risk is also known as liquidity risk. It is internal to
the organization it is due to the factors like quality of the
products, poor management policies, unavailability of the
raw material, poor management skill, unskilled workforce
etc.
The business or liquidity risk is further classified into
following types.
Asset liquidity risk.
Funding liquidity risk.
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).

Types of Risk
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:
Owned funds. For e.g. share capital.
Borrowed funds. For e.g. loan funds.
Retained earnings. For e.g. reserve and surplus.
The financial or credit risk is further classified into following types.
Exchange rate risk.
Recovery rate risk.
Credit event risk.
Non-Directional risk.
Sovereign risk.
Settlement risk.
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 vice-versa. 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.

Types of Risk
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.
Model risk.
People risk.
Legal risk.
Political risk.
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.

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.
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:

State
1

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
Return
on Return
asProbability
the positive square
root
of
the
Stock A
Stock B
variance.
20%
5%
50%

30%

10%

30%

30%

15%

10%

20%

20%

-10%

on

Measures of risk and return and

Calculation
Variance and Standard Deviation on Stocks A and B
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 risk-return 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.

Risk and Return Trade off

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 lowreturn 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.

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

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,

Equity Valuation Models

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.

Equity Valuation Models

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

Equity Valuation Models

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

Bonds, Nature and Evaluation of

The bond market is by far the largest securities market in the
Bonds
world, providing investors with virtually limitless investment
options. Many investors are familiar with aspects of the market,
but as the number of new products grows, even a bond expert is
challenged to keep pace. Once viewed as a means of earning
interest while preserving capital, bonds have evolved into a $90
trillion global marketplace that can offer many potential benefits to
investment portfolios, including attractive returns.
Bonds can be bought and sold in the secondary market after
they are issued. While some bonds are traded publicly through
exchanges, most trade over the counter between large brokerdealers acting on their clients or their own behalf.

Bonds, Nature and Evaluation of

A bonds price and yield determine its value in the secondary
Bonds
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.

The role of bonds in a portfolio

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 short-term 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

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)
Where
Y =YTM
C= Coupon Rate
P or D= Premium or Discount
Po= Present Value
F= Face Value
Present Value= C1/(1+y)1

/ (Po + F)/ 2

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

BondTheorems, term structure and

Interest Rate

Theorem-1 : Price and interest rates move inversely

Lets assume 3 year 10% coupon paying bond for illustration
Hence it can be concluded that as yield increase price of the bond decline and vice-versa.

When YTM = 10%

When YTM = 11%
When YTM = 9%

Price = 100
Price = 97.55
Price = 102.53

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%
When YTM = 11%
When YTM = 9%

Price = 100
Price = 97.55
Price = 102.53

Change in price = -2.45%

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.

BondTheorems, term structure and

Interest
Rate
Theorem
3:
If the bond yields remain same over its life, the discount or premium depends on the maturity
period.

Example
Par Value
Coupon Rate
Yield
Maturity Period
Market Price

Bond A
Rs 1000
10%
15%
2
918.71

Bond B
Rs 1000
10%
15%
3
885.86

Discount

Rs. 1000- 918.71

Rs.1000- 855.86

This means, the bond with a short term to maturity sells at a lower discount than the bond
with a long term to maturity.

BondTheorems, term structure and

Interest Rate
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

BondTheorems, term structure and Interest

Theorem
5
Rate

The change in price will be lesser for a percentage change in bonds yield if its coupon rate is higher. It is
explained by the following examples:

Example

Bond A

Bond B

Coupon rate

10%

8%

Yield

8%

8%

Maturity Period

Price

Rs. 105.15

Face value

Rs 100

Rs100

Yield raise

1%

1%

Price after Yield

raise

Rs. 102.53

Rs 97.47

Percentage
Change in Price

2.4%

2.53%

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

Macaulay Duration

For bonds with fixed cash flows a price change can come from two
sources:
1.The passage of time (convergence towards par). This is of course totally
predictable, and hence not a risk.
2.A change in the yield. This can be due to a change in the benchmark
yield, and/or change in the yield spread.
3.The yield-price relationship is inverse, and we would like to have a
measure of how sensitive the bond price is to yield changes. The modified
duration is a measure of the price sensitivity to yields and provides a
linear approximation. For large yield changes convexity can be added to
provide a quadratic or second-order approximation. Alternatively, and
often more usefully, convexity can be used to measure how the modified
duration changes as yields change. Similar risk measures (first and
second order) used in the options markets are the delta and gamma.
4.Macaulay duration and modified duration are both termed "duration"
and have the same (or close to the same) numerical value, but it is
important to keep in mind the conceptual distinctions between them.
Macaulay duration is a time measure with units in years, and really makes
sense only for an instrument with fixed cash flows. For a standard bond
the Macaulay duration will be between 0 and the maturity of the bond. It
is equal to the maturity if and only if the bond is a zero-coupon bond.

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

3. Company analysis
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.
2.
3.
4.

Dow theory
Volume Trade
Moving Average
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 TrendMinor trend or tertiary moves are called as random wriggles. They are simply the

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

economic factors, known as
fundamentals.

Uses price movement of

security to predict future
price movements

Data
gathered
from:

Financial statements

Charts

Stock
bought:

When trader believes they

When price falls below intrinsic
can sell it on for a higher
value
price

Time
horizon:

Long-term approach

Short-term approach

Function:

Investing

Trade

Concepts
used:

Return on Equity (ROE) and

Return on Assets (ROA)

Dow Theory, Price Data

Vision:

looks backward as well as

forward

looks backward

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.

Derivatives

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.

Derivatives

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 exdividend date value of the underlying stock..

Option Pricing Model

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

Option Pricing Model

Advantages and
disadvantages of Black
Advantages:
-scholes
Model
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.

Binomial Model
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 platformbased analysis tools to determine option pricing values.

Binomial Model Method

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.

Features
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 cashsettled 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 Feature
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

Obligatio Both the parties are

n
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

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

Exercise
date.

The parties of the

contract must
perform at the
settlement date.

The buyer can

exercise option any
time prior to the
expiary date.

Forward contract
In finance, a forward contract or simply a forward is a nonstandardized 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.

Basis

Difference between Forwards

and Futures

Forward Contract
A forward contract is an agreement between
Definition two parties to buy or sell an asset (which
:
can be of any kind) at a pre-agreed future
point in time at a specified price.
Structure Customized to customer needs. Usually no
&
initial payment required. Usually used for
Purpose: hedging.
Transactio
n
Negotiated directly by the buyer and seller
method:
Market
regulation Not regulated
:
Institution
al
The contracting parties
guarante
e:
Risk:
High counterparty risk

Futures Contract
A futures contract is a standardized contract,
traded on a futures exchange, to buy or sell a
certain underlying instrument at a certain date
in the future, at a specified price.
Standardized. Initial margin payment required.
Usually used for speculation.
Quoted and traded on the Exchange
Government regulated market (the Commodity
Futures Trading Commission or CFTC is the
governing body)
Clearing House

Low counterparty risk

Both parties must deposit an initial guarantee
No guarantee of settlement until the date of
Guarante
(margin). The value of the operation is marked
maturity only the forward price, based on
es:
to market rates with daily settlement of profits
the spot price of the underlying asset is paid
and losses.
Contract Forward contracts generally mature by
Future contracts may not necessarily mature by
Maturity: delivering the commodity.
delivery of commodity.
Expiry
Depending on the transaction
Standardized
date:
Method of Opposite contract with same or different
precounterparty. Counterparty risk remains
Opposite contract on the exchange.
terminati while terminating with different
on:
counterparty.