Decision Support System : Overview, components and classification, steps in
constructing a dss, role in business, group decision support system. UNIT - II Information system for strategic advantage, strategic role for information system, breaking business barriers, reengineering business process, improving business qualities. UNIT - III Information system analysis and design, information SDLC, hardware and software acquisition, system testing, documentation and its tools, conversion methods. UNIT - IV Marketing IS, Manufacturing IS, Accounting IS, Financial IS. MBA3rd SEMESTER, M.D.U., ROHTAK SYLLABUS External Marks : 70 Time : 3 hrs. Internal Marks : 30 SECURITY ANALYSIS & INVESTMENT MANAGEMENT 73 Z A D
C O M P U T E R S SECURITY ANALYSIS & INVESTMENT MANAGEMENT FINANCE : SPECIALIZATION PAPERS UNIT I 74 Q. Define Investment. Ans. Meaning of Investment : Investment involves making of a sacrifice in the present with the hope of deriving future benefits. Investment has many meanings and facets. The two most important features of an investment are current sacrifice and future benefit. We can now give a simple yet a broad definition of investment. We can define investment as postponed consumption. When you postpone consumption, sacrifice takes place n the present and is certain whereas the benefits occur n future and are uncertain. Therefore, risk and expected return from the investment are the two key determinants of investment process. Investment Process : A typical investment decision undergoes a five step procedure which, in turn, forms the basis of the investment process. These steps are: (1) Determine the investment objectives and policy (2) Undertake Security Analysis. (3) Construct a portfolio. (4) Review the Portfolio. (5) Evaluate the performance of the portfolio. Investment Attributes/ Factors Influencing Selection of Investment : In chossing specific investments, investors will need definite ideas regarding features which their portfolios should possess. For evaluation of investment avenue, the following attributes are relevant: (1) Returns (2) Capital Appreciation (3) Safety and Security of Funds. (4) Tax Benefits (5) Concealability (6) Adequate Liquidity (7) Stability of Income (8) Risk. Z A D
C O M P U T E R S 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Q. Define Risk. What are the different types of risk influences on investment? Ans : Meaning of Risk : Risk can be defined as the probability that the expected return from the security will not materialize. Every investment involves uncertainties that make future investment returns risk-prone. Uncertainties could be due to the political, economic and industry factors. Types of Investment Risk: Investment Risks are: Types of Investment Risk Systematic Risk Non-Systematic Risk Market Risk Regulation Risk Interest Rate Risk Regulation Risk Purchasing Power Risk Regulation Risk Business Risk Bull-Bear Risk Exchange Rate Risk Management Risk Default Risk International Risk Industry Risk Country Risk Liquidity Risk Dividing total risk into its two components, a general (market) component and a specific (issuer) component, we have systematic risk and non-systematic risk, which are additive: Total Risk = General Risk + Specific Risk = Market Risk + Issuer Risk = Systematic Risk + Non -Systematic Risk (A) Systematic Risk : Variability in a securitys total returns that is directly associated with overall movements in the general market or economy is called systematic risk. Virtually all securities have some systematic risk because systematic risk directly Z A D
C O M P U T E R S encompasses interest rate, market, and inflation risks. Systematic risk is attributable to broad macro factors affecting all securities. Different types of systematic risk are explained as under: (1) Market Risk : The variability in a securitys returns resulting from fluctuation in the aggregate market is known as market risk. Market risk is sometimes used synonymously with systematic risk. All securities are exposed to market risk including : Recession Wars Structural changes in the economy Tax law Changes Changes in Consumer Preferences. (2) Interest Rate Risk : The variability in a securitys return resulting from changes in the level of interest rates is referred to as interest rate risk. Such changes generally affect securities inversely; that is, other things being equal, security prices move inversely to interest rates. (3) Purchasing Power Risk : A factor affecting all securities is purchasing power risk, also known as inflation risk. With uncertain inflation, the real (inflation- adjusted) return involves risk even if the nominal return is safe. This risk is related to interest rate risk, since interest rates generally rise as inflation increases, because lenders demand additional inflation premiums to compensate for the loss of purchasing power. (B) Non-Systematic Risk : The variability in a securitys total returns not related to overall market variability is called the non-systematic (non-market) risk. Non-systematic risk is specific to an industry or the company individually. This risk is unique to a particular security and is associated with such factors as business and financial risk as well as liquidity risk. Different types of non-systematic risks are explained as under: (1) Regulation Risk : Some investments can be relatively attractive to other investments because of certain regulations or tax laws that give them an advantage of some kind. Municipal bonds, for example, pay interest that is exempt from local, state and federal taxation. As a result of that specific tax exemption, municipals can price bonds to yield a lower interest rate since the net after-tax yield may still make them attractive to investors. (2) Business Risk : The risk of doing business in a particular industry or environment is called business risk. For example, as one of the largest steel producers, U.S. Stee faces unique problems. (3) Bull-Bear Market Risk : This risk arises form the variability in the market returns resulting from alternating bull and bear market forces. When security index rises fairly consistently from a low point, this upward trend is called a bull market. The bull market ends when the market index reaches a peak and starts a downward trend. 74 Z A D
C O M P U T E R S The period during which the market declines, this downward trend is called a bear market. (4) Management Risk : Management, all said and done, is made of people who are mortal, fallible and capable of making a mistake or a poor decision. Errors made by the management can harm those who invested in their firms. (5) Default Risk : It is that portion of an investments total risk that results from changes in the financial integrity of the investment. For example, when c company that issues securities moves either further away from bankruptcy or closer to it, these changes in the firms financial integrity will be reflected in the market price of its securities. The variability of return that investors experience, as a result of changes in the credit worthiness of a firm in which they invested, is their default risk. (6) International Risk : International risk can include country risk and exchange rate risk. (i) Exchange Rate Risk : All investors who invest internationally in todays increasingly global investment arena face the prospect of uncertainty in the returns after the convert the foreign gains back to their own currency. (ii) Country Risk : Country risk, also referred to as political risk, is an important risk for investors today. With more investors investing internationally, both directly and indirectly, the political and therefore economic stability and viability of a countrys economy need to be considered. (7) Industry Risk : An industry may be viewed as group of companies that compete with each other to market a homogeneous product. Industry risk is that portion of an investment s total variability of return caused by events that affect the products and firms that make up an industry. (8) Liquidity Risk : Liquidity risk is the risk associated with the particular secondary market in which a security trades. An investment that can be bought or sold quickly and without significant price concession is considered liquid. The more uncertainty about the time element and the price concession, the greater the liquidity risk. Measurement of Risk : There are three methods: (1) Volatility : Volatility may be described as the range of movement (or price fluctuation) from the expected level of return. For example, the more a stock goes up and down in price, the more volatile that stock is. (2) Standard Deviation : Investors and analysts should be at least somewhat familiar with the stud of probability distributions. Since the return an investor will earn from investing is not known, it must be estimated. An investor may expect the total return on a particular security to be 10% for the coming year but in truth this is only a point estimate. The formulas of measuring risk with the help of standard deviation are: 77 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (i) Risk of Portfolio (two assets): ss= W s + W +2 W W rss sP = Standard deviation of portfolio consisting securities A and B WA WB = Proportion of funds invested in Security A and B sA sB = Standard deviation of returns of Security A and Security B AB = Correlation coefficient between returns of Security A and Security B The correlation coefficient can be calculated as follows: Cov AB AB = ss B A (ii) Risk of Portfolio (three assets): sP = W 2 s2 + W 2 s2 + W 2 s 2 +2 WxWy ryz sy sz+ WxWz rxz sx sz W 1, W2, W3= Proportion of amount invested in securities X, Y and Z sxsy sz = Standard deviation of Securities X, Y and Z rxy = Correlation coefficient between Securities X and Security Y ryz = Correlation coefficient between Securities Y and Security Z rxz = Correlation coefficient between Securities X and Security Z (3) Beta : Beta is a measure of the systematic risk of a security that cannot be avoided through diversification. Beta is a relative measure of risk- the risk of an individual stock relative to the market portfolio of all stocks. For example, a security with a beta of 1.5 indicates that, on average, security returns are 1.5 times as volatile as market returns, both up and down. Q. Define Return. Also explain its component and types. Ans. Meaning of Return : Return is the amount or rate of produce, proceeds, profits which accrues to an economic agent from an undertaking or investment. It is a reward for and a motivating force behind investment, the objective of which is usually to maximize return. Determinants of Return : Three major determinants of the rate of return expected by the investor are: (i) The time preference risk-free real rate. (ii) The expected rate of inflation (iii) The risk associated with the investment, which is unique to the investment. Required Return = Risk-free real rate + Inflation premium + Risk Premium 2 2 2 2 sA B AB A B 74 s s Z A D
C O M P U T E R S Component of Return : The rate of return from an investment consists of the two: (i) Yield : The interest or dividend received is called yield. (ii) Capital Appreciation : The difference between the sale price and the purchased price is the capital appreciation. Formula: It + [Pt Pt-1] Rate of Return (Rt) = - Pt-1 Rt = Rate of return per time period t It = Income for the period t Pt = Price at the end of time period t Pt-1 = Initial price, i.e., price at the beginning of the period t The above equation can be split into two components: It [Pt Pt-1] Rate of Return (Rt) = + Pt-1 Pt-1 It Where is called the current yield, Pt-1 [Pt Pt-1] And is called the capital gain yield Pt-1 Or ROR = Current Yield + Capital Gain Yield Example : The following information s given for a corporate bond. Price of the bond at the beginning of the year = Rs. 90 Price of the bond at the end of the year = Rs. 95.40 Interest received for the year = Rs. 13.50 Compute the rate of return. Solution: The rate of return can be computed as follows: It + [Pt Pt-1] Rate of Return (Rt) = - Pt-1 13.50 + [95.40 90] Rate of Return (Rt) = = 21% per annum 90 79 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S The return of 21% consists of 15% current yield and 6% capital gain yield Return of Portfolio (Two Assets) : The expected return from a portfolio of two or more securities s equal to the weighted average of the expected returns from the individual securities. S(R ) = W (R ) + W (R ) S(Rp) = Expected return from a portfolio of two securities WA = proportion of funds invested in Security A WB = Proportion of funds invested in Security B RA = Expected return of Security A RB = Expected return of Security B WA+WB = 1 Example : A Ltd.s share gives a return of 20% and B Ltd.s share gives 32% return. Mr. Gotha invested 25% in A Ltd.s share and 75% of B Ltd.s shares. What would be the expected return of the portfolio? Solution : Portfolio Return = .25 (20) + .75 (32) = 29% Types of Return : (1) Internal Rate of Return : The internal rate of return (IRR) is the rate of discount which makes the present value of all the revenues (cash flows) from the investment equal to the total cost of that investment. This is also known as the yield or yield rate. (2) Bond Rate : It is the interest rate received on the face value or the par value of the bond. If a company or the government issues a 10-ear bond with Rs. 100 as face value and 15 per cent rate of interest, it would be described as 15 per cent bond. (3) Realised and Expected Return : Return is not as simple a concept as it appears to be because it is not guaranteed, it is mostly expected, and it may or may not be realized. Thus expected return is an anticipated, predicted, desired which is subject to uncertainty. Realised return, on the other hand, is actually earned. (4) Holding Period Return/Return : Holding period yield (HPY) measures the total return from an investment during a given time period in which the asset is held b the investor. It is to be noted that HP does not mean that the security is actually sold and the gain or loss is actually realised by the investor. The concept of HPY is applicable whether one is measuring the realized return or estimating the future return. It can be calculated as follows: Any cash payments received + price change over the holding period HPY = Price at which the asset is purchased (beginning price) p A A B B 74 Z A D
C O M P U T E R S (5) Redemption Yield or Yield to Maturity (YTM) : Redemption yield is the indicated or promised rate of return an investor will receive from a bond purchased at the current market price and held till maturity. Annual Interest + Average annual appreciation or depreciation YTM = Redemption or face value (6) Dividend Yield : Dividend yield is the ratio of per share expected dividends, to the current market price of the share. (7) Earnings Yield : Earnings yield is the ratio of expected earnings per share of the firm to the current marker price of the share. The dividend yield and earnings yield do not differ if the firm distributes all net earnings in the form of dividends i.e. if it practices 100 per cent dividend payout ratio. (8) Nominal and Real Return : While the nominal return is the return in nominal rupees, the real return is equal to the nominal return adjusted for changes in prices i.e. rate of inflation. (9) Gross and Net Yield : While gross yield refers to the yield realized by the investor before paying taxes, the net yield is what remains with him after paying the taxes. The net yield can be calculated as follows: Net Yield = Gross Yield (1- Tax Rate) Q. Explain the Operations of Indian Stock Market. Ans. Meaning of Stock Exchange : Stock exchange means an organized market where securities issued by companies, government organizations and semi-organisations are sold and purchased. Securities include: (i) Shares (ii) Debentures (iii) Bonds etc. Definition of Stock Exchange : According to Pyle : Stock Exchange are market places where securities that have been listed thereon, may be bought and sold for either investment or speculation. Features of Stock Exchange : The main features of stock exchange are as follows: (1) Organised Market : Stock Exchange is an organized market. Every stock exchange has a management committee, which has all the rights related to management and control of exchange. All the transactions taking place in the stock exchange are done as per the prescribed procedure under the guidance of management committee. (2) Dealing in Securities issued by various concerns : Only those securities are traded in the stock exchanges which are listed there. After fulfilling certain terms and conditions, a company gets it security listed on stock exchange. 81 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (3) Dealing only through Authorised Members : Investors can sale and purchase securities in stock exchange only through authorized members. Stock exchange is a specified market place where only the authorized members can go. Investor has to take their help to sale and purchase. (4) Necessary to obey the Rules and Bye-Laws : While transacting in stock exchange, it is necessary to obey the rules and bye-laws determined by stock exchange. Functions of Stock Exchange : The main functions performed b stock exchange are as follows: (1) Providing Liquidity and Marketability to existing securities : Stock exchange is a market place where previously issued securities are traded. Various types of securities are traded here on regular basis. Whenever required, investor can invest his money through this market into securities and can reconvert this investment into cash. (2) Pricing of Securities : A stock exchange provides platform to deal in securities. The forces of demand and supply work freely in the stock exchange. In this way, prices of securities are determined. (3) Safety of Transactions : Stock exchanges are organized markets. The fully protect the interest of investors. Each stock exchange has its own laws and be-laws. Each member of stock exchange has to follow them and any member found violating them, his membership is cancelled. (4) Contributes to Economic Growth : Stock exchange provides liquidity to securities. This gives the investor a double benefit-first, the benefit of the change in the market price of securities and secondly, n case of need for money they can be sold at the existing market price at any time. (5) Spreading Equity Cult : Share market collects every types of information in respect of the listed companies. Generally this information is published or otherwise n case of need anybody can get it from the stock exchange free of any cost. In this way, the stock exchange guides the investors by providing various types of information. (6) Providing Scope for Speculation : When securities are purchased with a view to getting profit as a result of change in their market price, it s called speculation. It is allowed or permitted under the provisions of the relevant Act. It is accepted that in order to provide liquidity to securities, some scope for speculation must be allowed. The share market provides this facility. Stock Exchange in India : There are 24 stock exchanges functioning currently in India. The names are given below: (1) Mumbai Stock Exchange OR (13) Cochin Stock Exchange Bombay Stock Exchange-BSE (2) National Stock Exchange (NSE) (14) Coimbatore Stock Exchange (3) Over the Counter Exchange of India (OTCEI) (15) Guwahati Stock Exchange 74 Z A D
C O M P U T E R S (4) Calcutta Stock Exchange(CSE) (5) Delhi Stock Exchange (DSE) (17) Kanpur Stock Exchange (6) Chennai Stock Exchange (18) Ludhiana Stock Exchange (7) Ahmedabad Stock Exchange (19) Mangalore Stock Exchange (8) Hyderabad Stock Exchange (20) Meerut Stock Exchange (9) Bangalore Stock Exchange (21) Patna Stock Exchange (10) Indore Stock Exchange (22) Pune Stock Exchange (11) Baroda Stock Exchange (23) Rajkot Stock Exchange (12) Bhubaneswar Stock Exchange (24) Capital Stock Exchange Kerala Ltd. Q. Define of New Issue Market. Write on functions of new issue market. Ans. New Issue Market OR Primary Market : New issue market is the segment in which new issues are made. In the new issue market, new issues may be made in three ways namely: (i) Public Issue (ii) Rights Issue (iii) Private Issue. Classification of New Issue Market : The new market can be classified as: (i) A market where firms go to the public for the first time through initial public offering (IPO). (ii) A market where firms which are already trade raise additional capital through seasoned equity offering (SEO). Functions of New Issue Market : The main function of new issue market is to facilitate transfer resources from savers to the users. The savers are individuals, commercial banks, insurance company etc. the users are public limited companies and the government. The new issue market plays an important role in mobilizing the funds from the savers and transferring them to borrowers for production purposes, an important requisite of economic growth. The main function of new issue market can be divided into three service functions: (1) Origination (2) Underwriting (3) Distribution (1) Origination : Origination offers to the work of investigation, analysis and processing of new project proposals. Origination starts before an issue is actually floated in the market. There are two aspects in these functions: (i) Technical, Economic and Financial AnalysisH : A careful study of the technical, economic and financial viability to ensure soundness of the project. This is a preliminary investigation undertaken b the sponsors of the issue. (16) Jaipur Stock Exchange 83 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (ii) Advisory Services : Advisory services which improve the quality of capital issues and ensure its success. The advisor services include: Type of issue Magnitude of issue Time of floating an issue Pricing of an issue- whether shares are to be issue at par or at premium Methods of issue. Technique of selling securities The function of origination is carried out by merchant banker, who may be commercial banks, and Indian financial institutions, or private firms. (2) Underwriting : Underwriting is an agreement whereby the underwriter promises to subscribe to a specified number of shares or debentures or a specified amount of stock in the event of public not subscribing to the issue. If the issue is fully subscribed then there is no liability for the underwriter. If a part of share issues remains unsold, the underwriter will buy these shares. Thus underwriting is a guarantee for the marketability of shares. Methods of Underwriting : An underwriting agreement may take any of the following three forms: (i) Standing behind the issue: Under this method, the underwriter guarantees the sale of a specified number of shares within a specified period. If the public do not subscribe to the specified amount of issue, the underwriter buys the balance in the issue. (ii) Consortium Method: Underwriter is jointly done by a group of underwriters in this method. This method is adopted for large issue. Advantages of Underwriting : Underwriting assumes great significance as it offers the following advantages to the issuing company: (i) The issuing company is relied from the risk of finding buyers for the issue offered to the public. The company is assured of raising adequate capital (ii) The company is assured of getting minimum subscription within the stipulated time, a statutory time, and statutory obligation to be fulfilled by the issuing company. (iii) Underwriters undertake the burden of highly specialized function of distributing securities. (iv) Provide expect advice with regard to timing of security issue, the pricing of issue, the size and type of securities to be issued etc. (v) Public confidence on the issue enhances when underwritten by reputed underwriter. 74 Z A D
C O M P U T E R S Underwriter in India : The underwriters in India may be classified into two categories: (i) Institutional Underwriters: Life Insurance Corporation of India (LIC) Unit Trust of India (UTI) Industrial Development Bank of India (IDBI) Industrial Credit and Investment Corporation of India (ICICI) Commercial Banks and general insurance companies. (ii) Non-Institutional Underwriters (3) Distribution : Distribution is the function of sale of securities to ultimate investors, Brokers and agents, who maintain regular and direct contact with the ultimate investors, perform this service. Q. Define New Issue Market. What are the methods of floating new issues? Explain in detail. Ans : New Issue Market OR Primary Market : New issue market is the segment in which new issues are made. Classification of New Issue Market : The new market can be classified as: (i) A market where firms go to the public for the first time through initial public offering (IPO). (ii) A market where firms which are already trade raise additional capital through seasoned equity offering (SEO). Methods of Floating New Issues : The various methods which are used in the floating of securities in the new issue market are: (1) Public Issues : Under this method, the issuing company directly offers to the general public/institutions a fixed number of shares at a stated price through a document called prospects. This is the most common method followed by join stock companies to raise capital through the issues of securities. The following information are given in the prospectus: (i) Name of the Company (ii) Address of the registered office of the company (iii) Existing and proposed activities (iv) Location of the industry (v) Name of Directors (vi) Authorized and proposed issue capita to the public (vii) Dates of opening and closing the subscription list (viii) Minimum Subscription 85 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (ix) Names of brokers/underwriter/bankers/managers and registrars to the issue. (x) A statement b the company that it will apply to stock exchange for quotations of its shares. According to the Companies Act, 1956 every application form must be accompanies by a prospectus. (2) Offer of Sale: The method of offer of sale consists in outright sale of securities through the intermediary of issue houses or share brokers. In other words, the shares are not offered to the public directly. This methods consists of two stages: (i) The first stage is a direct sale by the issuing company to the issue house and brokers at an agreed price. (ii) In the second stage, the intermediaries resell the above securities to the ultimate investors. The issue houses or stockbrokers purchase the securities at a negotiated price and resell at a higher price. The difference between in the purchase and sale price is called turn or spread. Advantages : One chief advantage of this method is that the company is relieved from the problem of printing and advertisement of prospectus and making allotment of share. Offer of sale is not common in India. (3) Placement : Under this method, the issue houses or brokers buy the securities outright with the intention of placing them with their clients afterwards. Here, the brokers act as almost wholesaler selling them in retail to the public. The brokers would make profit in the process of reselling to the public. The issue houses or brokers maintain their own list of client and through customer contact sell the securities. Advantages : Placement has the following advantage: (i) Timing of issue is important for successful floatation of shares. In a depressed market conditions when the issues are not likely to draw public response though prospectus, placement method is a useful method of floatation of shares. (ii) This method is suitable when small companies issue their shares. (4) Right Issues : If an existing company intends to raise additional funds, it can do so by borrowing or b issuing new shares. One of the most common methods for a public company to use is to offer existing shareholder the opportunity to subscribe further shares. This mode of finance is called Right Issues. The existing shareholders have right ot entitlement of further shares in proportion to their existing shareholding. The rights of entitlement of a shareholder, who does not want to buy the right share, can be sold to someone else. Number of outstanding shares N = - Number of new shares to be offered Where N= Number of rights needed to buy one new share 74 Z A D
C O M P U T E R S Provisions regarding Right Issues : Section 81 of the Companies Act, 1956 deals with the provisions relating to rights issues: Any company (i) Which has completed two years after its incorporation or (ii) Which has completed one year from the first allotment of shares after its incorporation Whichever is earlier, if it proposes to increase its subscribed capital by allotment of further shares, then the subsequent provisions shall apply. Those further shares shall be first be offered to the existing shareholder in proportion to the shares held by them in the paid up capital, on the date of such offer. At least 15 days notice shall be given from the date of offer. The notice shall specify the number of shares offered and the limiting time of the offer. The notice shall mention that if the offer is not accepted within the time of offer, will be deemed to have been declined. Advantages of Right Issue : (i) To Companies : The company benefits from lower issue costs, in that administration and underwriting costs are lower and the issue is made at the discretion of the directors rather than via a general meeting of the company. (ii) To the Shareholders : The main attraction of the rights issue for current shareholders is that they are able to maintain their original proportion of share ownership. Q. What do you mean listing of securities? Explain. Ans. Listing of Securities : Listing means admission of the securities to dealings on a recognized stock exchange. The securities of any public limited company, central or state government, quasi government and other financial institutions/corporations, municipalities, etc. When listing is granted to a company, it means that the securities are included in the official list of the stock exchange for the purpose of trading. Security listing ensures that a company is solvent and its existence is legal. Government security is not required to be listed. Objectives of Listing : The objectives of listing are mainly to: (i) Provide liquidity to securities. (ii) Mobilize savings for economic growth. (iii) Protect interest of investors by ensuring full disclosures. Advantages of Listing on Stock Exchange : (i) Detailed information about the company is available. (ii) Information increases the activity of purchase and sale of the security of that organization. 87 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (iii) Continuous dealing raises the value of security. (iv) Convenience of sale of security, lending liquidity to the shares. (v) There is safety in dealing. (vi) It ensures creditworthiness. (vii) Widens the market of the security. Rules for Listing of Securities : The following statutory rules have been laid down for the listing of securities under SEBI. A company requiring a quotation for its shares must apply in the prescribed form supported b the documentary evidence given below: (1) Documents to be Attached : (i) Copies of Memorandum and Articles of Association, Prospectus or Statement in lieu of Prospectus, Directors reports, Balance Sheets and Agreement with Underwriters etc. (ii) Specimen copies of share and debentures Certificates, letter of allotment, etc. (iii) Particulars regarding its capital structure. (iv) A statement showing the distribution of shares. (v) Particulars of dividends and cash bonuses during the last ten years. (vi) A brief history of the companys activities since its incorporation. (2) Criteria for Listing : The stock exchange has to direct special attention to the following particulars while scrutinising the application: (i) Articles: (a) Whether the Articles contain the following provisions: A common form of transfer shall be used. Fully paid shares will be free from lien Calls paid in advance may carry interest, but shall not confer aw right to dividend. Unclaimed dividends shall not be forfeited before the claim becomes time barred. (b) Whether at least 49% of each class of securities issued was offered to the public for subscription through newspapers for not less than three years. (c) Whether the company is of a fair size, has a broad-based capital structure and there is sufficient public interest in its securities. (3) Listing of Agreement : After scrutiny of the application, the stock exchange authorities may, if they are satisfied call upon the company to execute a listing agreement, which contains the obligations and restrictions which listing will entail. This agreement contains 39 clauses with a number of sub-clauses. These covers various aspects of : (i) Issue of letters of allotment (ii) Share Certificates 74 Z A D
C O M P U T E R S (iii) Transfer if Shares (iv) Information to be given to the stock exchanges regarding closure of register of members for the purpose of payment of dividend (v) Issue of bonus and right shares and convertible debentures (vi) Holding of meeting of the board of directors for recommendation or declaration of dividend or issue of rights, bonus shares or convertible debentures (vii) Submission of copies of directors report (viii) Submission of copies of annual accounts. (ix) Submission of other notices (x) Resolution and so on to the shareholders. A company enlisting the securities of a company for the purpose of trading insists that all applicants for shares will be treated with equal fairness in the matter of allotment. Infact, in the event of over-subscription, the stock exchange will advise the company regarding the basis for allotment of shares. It will try to ensure that applicants for large blocks of shares are not given undue preference over others. Q. What are the main features of OTCEI? Explain the trading process of OTCEI. Ans. Over the Counter Exchange of India (OTCEI): The OTCEI is a completely computerized and special ringless stock exchange which is different from the traditional stock exchange and on which the buying and selling of securities is absolutely transparent and moves at a great speed. Its counters are spread all over the country where transactions are made with the help of telephone. The OTCEI was established under section 25 of the Companies Act, 1956 in October, 1990. The promoters of the OTCEI are the following financial and other institutions: The Unit Trust of India The Industrial Credit and Investment Corporation of India. The Industrial Development Bank of India The Industrial Finance Corporation of India The Life Insurance Corporation of India The General Insurance Corporation of India The SBI Capital Market Limited The Canbank Financial Services Limited. Features or Nature of OTCEI : The main features of the OTCEI are the following: (1) Ringless Trading : There s no particular place for transacting business in securities under the OTCEI. This exchange has its counters/offices throughout the country. Any buyer or seller of securities can go the counter/officer and have transaction through the medium of the operator. 89 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (2) Nation Network : The OTCEI has its network all over the country. All the counters are linked with the central terminal through the medium of computers. Therefore, the facility of nationwide listing is available here. In other words by listing on one exchange, one can have transactions with all the counters in the whole country. (3) Exclusive List of Companies : On the OTCEI only those companies are listed whose issued capital is 30 lakhs or more. In the old share markets this amount used to be ten crores on the BSE and three crores on the other exchanges and hence, listing was not possible in case the issued capital was less than three crores. Those companies which have been listed on the old share markets cannot be listed on the OTCEI. (4) Fully Computerised : This exchange is fully computerized. It means that all the transactions done on this exchange are done through the medium of computers. (5) Sponsorship : In order to get listed on the OTCEI, a company has to find a member to sponsor it. The main job of a sponsor is market making. T means a sponsor has to be read to buy or sell the shares of that company at least for a period of 18 months. In this way, a sponsor creates liquidity in securities. (6) Investors Registration : All the investors doing transactions on the OTCEI have got to register themselves compulsorily. Registration can be got done b giving an application at an counter. The registration is called the INVESTOTC CARD. On the basis of this card, one can do transactions of securities at any counter throughout the country. (7) Greater Liquidity : There is greater liquidity in securities because of the sponsors job of market making. (8) Transparency in Transactions : All the transactions are done in the presence of the investor. The rates of buying and selling can be seen on the computer screen. The operator cannot do any fraud or mischief with the transactions. (9) Faster Delivery and Payment : On the OTCEI, delivery in case of buying and payment in case of selling are both very fast. The work of delivery and payment in case of listed securities and permitted securities is completed within seven days and 15 days respectively. (10) Two ways of Public Offer : A company listed on the OTCEI can issue security n two was. Firstly, the company can go directly to the public. This is called Direct Offer System. Secondly, the company sells its securities to the sponsor at a particular price. Then the sponsor sells them to the public. This is called Indirect Offer System. (11) Easy Access : In the big cities the counters of the OTCEI can be seen like ordinary shops. Any body can go the counter and do buying and selling of securities. Trading Process : One can trade in securities b going to any counter of the OTCEI. All the counters are linked with the central computer at the OTCEI headquarter. This office is in Mumbai. There can be three types of trading on the OTCEI: 74 Z A D
C O M P U T E R S (1) Initial Allotment : When an investor is allotted shares through the medium of OTCEI, he is given a receipt which is called counter receipt-CR. This receipt is just like the share certificate. Selling and buying can be done through the medium of this receipt. (2) Buying in the Secondary Market : For the purpose of buying shares listed on the OTCEI, a person has to get himself registered (if he is not already registered). After this, he informs the counter operator about the number of the shares to be purchased. The counter operator displays the rates on the screen. After getting himself satisfied with the rate, the investor hands over the cheque to the operator. On the encashment of the cheque, the CR is handed over to the investor. This procedure takes about a week. (3) Selling in the Secondary Market : An investor who has purchased shares from the OTCEI can sell his shares at any counter of the OTCEI. After getting himself satisfied with the rate displayed on the screen, the investor hands over the Counter Receipt and the Transfer Deed to the Operator. The operator prepares the Sales Confirmation Slip (SCS) and a copy of it is handed over to the seller. The operator sends the CR, TD and SCS to the Registrar for confirmation. After confirming every detail the Registrar sends them back to the counter operator. In the end the operator issues a cheque to the seller and receives back the SCS from the seller. Purposes of OTCEI : The objects of the establishment of the OTCEI may be described as under: (1) Liquidity : The first object for the establishment of the OTCEI is o maintain liquidity in the securities of the small companies. The sponsor has got to do the job of market making. (2) Transparency : The second aim of this share market is to maintain transparency of transactions. Here all the transactions are made on the computer screen. This eliminates any chance of fraud. (3) Investors Grievances : An important aim of the establishment of the OTCEI is the speed solution of the problems of the investors. (4) Quick Settlement : In the traditional share markets both the delivery and payment take time. This problem has been overcome with the help of the OTCEI. (5) Listing of Small Companies : Small companies remain deprived of being listed because they are unable to fulfil the conditions laid down by the old share markets. (6) Access : This stock exchange is of the ringless type and therefore, has its counters all over the country. 91 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S SECURITY ANALYSIS & INVESTMENT MANAGEMENT FINANCE : SPECIALIZATION PAPERS UNIT II Q. Explain the Mechanics of security trading in Stock Exchange OR Q. Explain the mechanics of Investing in Securities. Ans. Introduction : An investor must have some knowledge of how the securities markets operate. The marketing of old or new securities on the stock markets can be done only through members of the Stock Exchange. These members are either individuals or partnership firms. An individual; must use the facilities of these members for trading insecurities unless he himself is a registered dealer or member of an organized stock exchange. Trading among the members of a recognized stock exchange is to be done under the statutory regulations of the stock exchange. The members carrying on business are known as brokers and can trade only on listed securities. These members execute customers orders to buy and sell on the exchange and their firms receive negotiated commissions on those transactions. Process of Investing in Securities : There are the following steps involved in the process of investing in securities: (1) Finding a Broker: The selection of a broker depends largely on the kind of services rendered by a particular broker as well as upon the kind of transaction that a person wishes to undertake. An individual usually prefers to select a broker who can render the following services: (i) Provide information (ii) Availability of Investment literature. (iii) Appoint competent representatives (2) Selection of Brokers : There are following types of brokers: (i) Commission Broker : All brokers buy and sell securities for earning a commission. From the investors point of view, he is the most important member of the exchange because his main function and responsibility is to buy and sell stock for his customers. He acts as an agent for his customer and earns a 74 Z A D
C O M P U T E R S commission for the service performed. He is independent dealer in securities. He purchases and sells securities in his own name. He is not allowed to deal with the non-members. He can either deal with a broker or another jobber. (ii) Floor Broker : Floor brokers are not many in number. They execute orders for fellow members and receive a share brokerage commission charged by a commission broker to his/her constituent. He helps other brokers when they are busy. (iii) Tarniwala : He/she is a jobber or specialist in selected shares. He/she makes the market i.e. provide continuity to dealings. They specialize in stocks which are traded inactively. (iv) Dealer in Non-cleared Securities : He/she deals in securities that are not on the active list. (v) Odd-lot Dealer : He/she specializes in buying and selling in amounts that are less than present trading units. They buy and sell odd lots, make them up into marketable trading units. These dealers receive commission. The odd-lot dealer has become an important operator since the growth of new issues. (vi) Budiwalas : He/she specializes in buying and selling simultaneously in different markets. The difference between the buying prices in other markets constitutes his profit. (vii) Security Dealer : This dealer specializes in trading in government securities. He/she many acts as a jobber and takes risks inherent in ready purchase and sale of securities. They maintain daily contacts with the Reserve Bank of India as well as commercial banks and other financial institutions. (3) Opening an Account with Broker : After a broker has been selected, the investor has to place an order on the broker. The broker will open an account n the name of the investor in his books. He will also ask the investor for a small sum of money called margin money advance. In case, the investor wishes to sell his securities, he will have to deposit with the broker share certificates and transfer deeds. He will also have to sign in the transferors column on the transfer deed. The physical preference of share certificates is not required any more in India if shares have been through the demat process. (4) Order: Brokers receive a number of different types of buying and selling orders from their customers. Brokerage orders very as to the price at which the order may be filled, the time for which the order is valid, and contingencies which affect the order. The customers specifications are strictly followed. The broker is responsible for getting the best price for his customer at the time of the order is placed. (5) Exercising Choice of Orders : Types of orders are: (i) Spot Delivery : Spot delivery means delivery and payment on the same day as the date of the contract or on the next day. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (ii) Hand Delivery : Hand delivery is the transaction involving delivery and payment within the time of the contract or on the date stipulated when entering into the bargain, which time or date is usually not more than 14 days following the date of the contract. (iii) Special Delivery : Special deliver is the delivery and payment exceeding 14 days. (iv) Market Orders : Market orders are instruction to a broker to buy or sell at the best price immediately available. Market orders are commonly used when trading in active stocks or when a desire to buy or sell is urgent. (6) Giving Margin Money to Broker : Marin is the amount of money provided by customer to the brokers who have agreed to trade their securities. It may also be called a provision to absorb any probable loss when a customer bus on margin, the customer pays only part of the margin, the broker lend the remainder. (7) Execution of order in the Stock Exchange : When the broker receives the margin money and is clear about the order received by him, he puts the details n the order book. The broker in the beginning of his career makes the deal himself. Once his business grows, he employs clerks to transact his orders. (8) Preparing Contract Note in the Stock Exchange : The clerk takes the details of the days transaction to the broker at the end of the working day. The broker scrutinizes all transactions of the day and prepares a contract note and signs it on a prescribed form. The contract note gives the details of the contract for the purchase or sale of securities. It records the number of shares, rate and date of purchase or sale. (9) Settlement of Contracts : The last step is the settlement of the contract by the broker for his client. The procedure for settlement is to be made for (a) ready delivery contracts and (b) for forward delivery contracts. (i) Ready Delivery Contracts : A ready delivery contract s to be settled within three days in Kolkata Stock Exchange and 7 days at the Mumbai and Chennai Stock Exchange. A read delivery contract is also called a spot contract. The settlement under this contract can be made on the same day or during the maximum period of 7 days and there can be no extension or postponement of the time of settlement. (ii) Forward Delivery Contracts : Forward dealings can be made n stock exchange only n those securities which are placed on the forward list by an exchange. Forward delivery contracts are done with the object of making profit. These forward delivery contracts are settled on a fixed settlement day occurring at fortnightly intervals. The date of transaction can be postponed. 74 Z A D
C O M P U T E R S Q. Write a brief note on different types of brokers. Ans. Broker : Stock broker means a member of a stock exchange. Trading on stock exchanges is carried out through brokers and dealers. All members can act as brokers and for this purpose the have to maintain security deposits. Brokers act as agents buying and selling or other for which they receive brokerage commission at stipulated rates. Dealers act as principals and sell securities on ther own accounts. Types of Brokers : Types of brokers are: (1) Commission Broker : All brokers buy and sell securities for earning a commission. From the investors point of view, he is the most important member of the exchange because his main function and responsibility is to buy and sell stock for his customers. He acts as an agent for his customer and earns a commission for the service performed. He is independent dealer in securities. He purchases and sells securities in his own name. He is not allowed to deal with the non-members. He can either deal with a broker or another jobber. (2) Floor Broker : Floor brokers are not many in number. They execute orders for fellow members and receive a share brokerage commission charged by a commission broker to his/her constituent. He helps other brokers when they are busy and as compensation, receives a portion of the brokerage charged by the commission agent to his customer. (3) Tarniwala : He/she is a jobber or specialist in selected shares. He makes an orderly and continuous auction in the market n the stock n which he specializes He/she makes the market i.e. provide continuity to dealings. They specialize in stocks which are traded inactively. (4) Dealer in Non-cleared Securities : He/she deals in securities that are not on the active list. (5) Odd-lot Dealer : He/she specializes in buying and selling in amounts that are less than present trading units. They buy and sell odd lots, make them up into marketable trading units. These dealers receive commission. The odd-lot dealer has become an important operator since the growth of new issues. (6) Budiwalas : He/she specializes in buying and selling simultaneously in different markets. The difference between the buying prices in other markets constitutes his profit. (7) Security Dealer : This dealer specializes in trading in government securities. The purchase and sale of government securities is carried on the stock exchange by Security Dealers. He/she many acts as a jobber and takes risks inherent in ready purchase and sale of securities. They maintain daily contacts with the Reserve Bank of India as well as commercial banks and other financial institutions. Dealings in government securities are transacted between 12 p.m. and 3 p.m. on the Bombay Stock Exchange. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S Q. Write a note on Investment Companies. Ans. Meaning of Investment Companies : Investment companies are firms that invite individual investors to subscribe to their capital, combine the capital thus collected into a common pool of investible resources and then seek to accomplish the investment objectives of the investors by investing these resources in an appropriate portfolio of securities. Investment companies may have a number of different schemes catering to the specific investment objectives of different classes of investors. Portfolio Management Process in Investment Companies : Portfolio management in investment companies is a four stage process comprising the following stages: Stage 1 : Identifying the objectives, and level of risk acceptable to, the target group of investors and setting goals and objectives for the scheme so as to meet the objectives of this target group of investors. Stage 2 : Evaluating individual securities with respect to their risk-return characteristics. Stage 3 : Identifying the set of efficient portfolios and selecting an optimal (with respect to the expectations of the target group of investors) portfolio out of this set of efficient portfolios. Stage 4 : Reviewing the portfolio on a continuous basis and reforming it as and when required. Investment Companies in India : By our definition of investment companies, we can identify quite a large number of investment companies in India. The Investment Companies in India are: (1) Unit Trust of India (UTI) : The UTI was established in 1964 with the objective of making available the benefits of industrial growth to small savers. The UT collects investible resources from investors through the sale of securities called units. These funds arte then invested by UTI in various financial assets. Holders of units received dividends from UTI. Since its inception, UTI has offered various schemes to cater to the need of different classes of nvestors. Most of these schemes are: (i) Income Oriented Schemes : These funds offer a return much higher than the bank deposits but with less capital appreciation. The emphasis being on regular returns, the pattern of investment in general is oriented towards fixed income yielding securities like non-convertible debentures of consistently good dividend paying companies, etc. Example : Income-Oriented Scheme issued by UTI: Units Scheme of 1964 Growing Income Unit Scheme of 1987 (ii) Growth Oriented Schemes : These funds do not offer fixed regular returns but provide substantial capital appreciation in the long run. The pattern of investment in general is oriented towards shares of high growth companies. 74 Z A D
C O M P U T E R S Example: Growth-Oriented Scheme issued b UTI: Master Share Master Share Plus Master Gain UGS-200 (iii) Open-Ended Scheme : In open-ended funds, there is no limit to the size of the funds. Investors can invest as and when the like. (iv) Close-ended Scheme : These funds are fixed in size as regards the corpus of the fund and the number of shares. In close-ended funds, no fresh units are created after the original offer of the scheme, expires. (v) Tax Planning Schemes : The investments made under these schemes are deductible from the taxable income up to certain limits, thus providing substantial tax relief to the investors. Example: Tax planning schemes issued by UTI is Unit Linked Insurance Plan of UTI. (2) Mutual Funds of Commercial Banks (MFS) : Since 1987, the nationalized commercial banks like the Canara Bank, State Bank of India, Indian Bank etc. have been floating mutual fund schemes. Over the ears, the merchant banking subsidiaries of these banks have been offering numerous schemes catering to the investment needs of a wide variety of investors. There are various schemes issued by Commercial Banks such as : (i) Open-ended schemes (ii) Close-ended schemes (iii) Income-oriented Schemes : Example of Income-oriented schemes are: Magnum Monthly Income Schemes SBI Mutual Fund Rising Monthly Income Schemes BOI Mutual Fund Swarna Pushpa Indbank Mutual Fund PNBRIPS PNB Mutual Fund (iv) Growth Oriented Schemes : Example of Growth Schemes are: (a) Magnum Express, Magnum Multiplier SBI Mutual Fund (b) Cabshare, Canstar Cap, Cangrowth, Canbonus Canbank Mutual Fund. (c) Ind Ratna, Ind Sagar, Ind Moti Indbank Mutual Fund (v) Growth and Income Funds : Example of Growth and Income Funds are: Canstock, Can Double Canbank Mutual Fund PNB Premium Plus-91 PNB Mutual Fund 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (vi) Tax Planning Schemes : Example of tax planning schemes are: PNB ESS PNB Mutual Fund MELS-91 SBI Mutual Fund Ind Shelter Indbank Mutual Fund (vii) Schemes targeted at small individual investors, large individual investors and corporate investors. (3) Life Insurance Corporation (LIC) : The premium collected by the LIC from its insurance policy holders is administered b LIC and invested in the capital markets. LIC has been one of the largest players in the stock market of India. Of late, it has started floating specific investment schemes targeted at different investors groups, which provide both an insurance cover and a share in the returns from the investments made by LIC. Schemes issued by LIC are: Tax Planning Schemes : Tax planning Scheme issued by LIC: Schemes of LIC Mutual Fund : These offer some or all of the following benefits: (a) Life Insurance Cover (b) Accident Insurance Cover (c) Safety of Capital (d) Reasonable Capital Appreciation (e) Units are not transferable, but bank loan facility is available (f) Tax exemption on dividends Q. Define Market Indices. How are stock market indices useful? Ans. Indices : An index is used to provide information about the price movements of products in the financial, commodities or any other markets. Financial indices are constructed to measure price movements of stocks, bonds, T-bills and other forms of investments. Stock market indices are meant to capture the overall behaviour of equity markets. A stock market index is created by selecting a group of stocks that are representative of the whole market or a specified sector or segment of the market. An index is calculated with reference to a base period and a base index value. Usefulness of Stock Market Indices : Stock market indices are useful for a variety of reasons. Some of them are: (1) Historical Comparison of Returns : The provide a historical comparison of returns on money invested n the stock market against other forms of investments such as gold or debt. (2) Comparison of Performance of Equity Fund : They can be used as a standard against which to compare the performance of an equity fund. 74 Z A D
C O M P U T E R S (3) Indicator of the Performance of the Overall Economy : It is a lead indicator of the performance of the overall economy or a sector of the economy. (4) Up to date Information : Stock indexes reflect highly up to date information. (5) Important role in Financial Investment and Risk Management : Modern financial applications such as Index Funds, index Futures, index Options play an important role in financial investments and risk management. The stock market index captures the behaviour of the overall market. The ups and downs of an index reflect the changing expectations of the stock market about future dividends of the corporate sector. When the index goes up, it is because the stock market thinks that the prospective returns in the future will be better than previously anticipated. When the prospects of dividends in the future become pessimistic, the index drops. Every stock price moves for two possible reasons : (a) News about the company e.g. a product launch, closure of the factory etc. (b) News about the country e.g. budget announcement etc. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S SECURITY ANALYSIS & INVESTMENT MANAGEMENT FINANCE : SPECIALIZATION PAPERS UNIT III Q. Define Investment. Write a brief note on investment avenues OR Investment Alternatives. Ans. Meaning of Investment : Investment involves making of a sacrifice in the present with the hope of deriving future benefits. Investment has many meanings and facets. The two most important features of an investment are current sacrifice and future benefit. We can now give a simple yet a broad definition of investment. We can define investment as postponed consumption. When you postpone consumption, sacrifice takes place n the present and is certain whereas the benefits occur n future and are uncertain. Therefore, risk and expected return from the investment are the two key determinants of investment process. Investment Alternatives/Investment Avenues : Two basic investment avenues are: (A) Investment in Financial Assets (B) Investment in Physical Assets Further classification of Investment can be presented with the help of following diagram Investment Alternatives Investment in Investment in Financial Assets Physical Assets Securitized Non-Securitized Gold, Real Investment Investment Silver, Estate Fixed Income Preference Shares Equity Bond Money Market Instruments Government Securities 74 Z A D
C O M P U T E R S Bank Deposit Diamond etc. Post office Scheme Small Saving Certificate Mutual Funds Others (A) Investment in Financial Assets : Investment in financial assets consists of: (1) Securitized Investment (2) Non-Securitized Investment (1) Securitized Investment : The term securities is used in the broadest sense, consisting of those papers that are quoted and are transferable. Securitized investment are divided into three categories: (a) Fixed Income Securities : In fixed income securities we include those securities on which rate of return are fixed. Fixed income securities includes: (i) Preference Shares : Preference shares are a hybrid security. They have some features of bonds and some of equity shares. Preference dividends are specified like bonds. This has to be done because they rank prior to equity share for dividends. Preference shares are less risky than equity because their dividends are specified and all arrears must paid before equity holders get dividends. They are, however, more risky than bonds because the latter earn priority in payment and liquidation. (ii) Bonds : Bond contains a promise to pay a stated rate of interest for a defined period and then to repay the principal at a given date of maturity. (iii) Government Securities : Government securities or gilts are sovereign securities, which are issued by the Reserve Bank of India (RBI) on behalf of the Government of India (GOI). The GOI uses these funds to meet its expenditure commitments. Dated Securities : These securities generally carry a fixed interest rate and have a fixed maturity period. Zero Coupon Bonds : These securities are issued at discount to the face value and redeemed at the par i.e. they are issued at below face value and redeemed at face value. Partly Paid Stock : In these securities, the payment of principal is made in installment over a given period of time. Floating Rate Bonds : These types of securities have a variable interest rate, which is calculated as a fixed percentage over a benchmark rate. Capital Indexed Bonds:These securities carry an interest rate, which is calculated as a fixed percentage over the wholesale price index. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (b) Equity : On equity shares, there is no fixed rate of dividend. First of all dividends are paid on preference share, after that dividend is paid on equity shares. Equity share are more risky in comparison to bonds and preference shares. (c) Money Market Instruments : A money market is the market in which short-term funds are borrowed and lent. The money market does not deal in cash or money but in trade bills, promissory notes and government papers, which are drawn for short periods. These short-term bills are known as near money. Types of Money Market Instruments : The major short-term credit instruments dealt with in a money market include: Trade Bills : These are bills exchange arising out of bona fide commercial transactions. They include both inland bills and foreign bills. Bankers Acceptance : These are bills of exchange accepted b commercial banks on behalf of their customers. The fact that a bank of repute accepts a bill increases its creditworthiness, which, in turn, means that t can easily be discounted. Short-dated Government Securities : These are securities issued by the government for short periods. Long-term government securities that are nearing maturity are also sometimes included in this category. Commercial Papers : These are short-term unsecured securities issued b highly creditworthy large companies. Commercial papers are regulated by RBI. Zero Coupon Bonds : These securities are issued at discount to the face value and redeemed at the par i.e. they are issued at below face value and redeemed at face value. (2) Non-Securitized Investments : In India, the household sectors investment in non- security forms constitutes a major proportion of its total investment in financial assets. There are a large number of non-security forms of financial assets that are available to investors in India. Most of the investments are illiquid but are generally accepted as good collateral for borrowing from banks. Bank Deposit Post office Scheme Small Saving Certificate Mutual Funds Others (B) Investment in Physical Assets : Another popular investment avenue is the investment in physical assets such as (1) Gold (2) Silver (3) Diamonds (4) Real Estate : In real estate assets we include: 74 Z A D
C O M P U T E R S Residential House Source of Housing Finance Features of Housing Finance Guidelines for buying a flat Commercial Property. Agricultural Land. Suburban Land Time share in a holiday resort Unimproved Land Improved real Estate New and used residential property Vacation homes Other Income-Producing real estate such as: Office Buildings Shopping Centres Industrial or Commercial Properties. Q. What are the various models of valuation of fixed income securities? Ans. Fixed Income Securities : Fixed income securities contains a promise to pay a stated rate of interest for a defined period and then to repay the principal at a given date of maturity. Therefore, their primary role in an investment portfolio is to provide continuity of income under all reasonably conceivable conditions. Valuation of Fixed Income Securities : For the purpose of valuation we include the following two securities: 1) Valuation of Bond : Meaning of Bond : A Bond contains a promise to pa a stated rate of interest for a defined period and then to repay the principal at a given date of maturity. Bond Features : Maturities : Maturities vary widely. Bonds are usually grouped by their maturity classes. Interest Payments : Bond interest is usually paid sem-annually, though annual payments are also popular. Types of Bonds : Convertible Bonds Non-Convertible Bonds Income Bonds 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S Redeemable Bonds Irredeemable Bonds Participating Bonds Secured Bonds Bond Valuation : Debt securities issued by governments, government and quasi- govrnment organizations, and private business firms are fixed income securities. Bonds and debentures are the most common examples. The intrinsic value of bond or debenture is equal to the present value of its expected cash flows. The coupon interest payment, and the principal repayment are known and the present value is determined by discounting these future payments from the issuer at an appropriate discount rate. Preference Shares Formula : The usual present value calculation are made with the help of the following equation: n C C PV = S + t = 1 (1+r)t (1+r) n Where PV = Present value of the security today C = Coupon or interest payment pr time periodt R = Appropriate discount rate N = number of years to maturity Example : Consider a Rs. 1000 bond issued with a maturity of five years at par to yield 10%. Nterest s paid annually and the bond is newly issued. Solution: The value of the bond would be as follows: 100 100 100 100 100 PV = + + + + 1 2 3 4 5
(1+.10) (1+.10) (1+.10) (1+.10) (1+.10) = 100 x .90.91 + 100 x .8264 + 100 x .7513 + 100 x .6830 + 100 x .6209 = 90.91 + 82.6 + 75.13 + 68.30 + 682.99 = 999.97 or approx. Estimating returns on Fixed Income Securities: Stated (coupon) interest per year Current Yield = Current market price 74 Z A D
C O M P U T E R S Example : 15% Rs. 200 debenture is currently selling for Rs. 220, the annual current yield would be : 30 Current Yield = = 13.64% 220 2) Valuation of Preference Shares : Meaning of Preference Shares : Preference shares are a hybrid security. They have some features of bonds and some of equity shares. Preference dividends are specified like bonds. This has to be done because they rank prior to equity share for dividends. Preference shares are less risky than equity because their dividends are specified and all arrears must paid before equity holders get dividends. They are, however, more risky than bonds because the latter earn priority in payment and liquidation. Valuation Formula : The intrinsic value of shares will be estimated from the following equation: D VP = Kps VP = Value of Preference Share D = Dividend Kps = Required rate of return Example : What s the value of a preference share where the dividend rate is 18% on a Rs. 100 par value. The appropriate discount rate for a stock of this risk level is 15%. Solution : 18 VP = = 120 0.15 Q. What are the various models of valuation of variable income securities? Ans. Variable Income Securities : Variable income securities are those on which rate of return is not fixed. In variable income securities we include equity shares because return on equity shares is depend on the volume of profitability after taxes. If profits are more, then more dividend is paid on equity and vice-versa. Equity Valuation Model : The actual models of equity valuation are: (1) Dividend Valuation Model : A difficult problem in using the dividend valuation model is the timing of cash flows from dividends. Since equity shares have no finite measure, the investor must forecast all future dividends. This might imply a forecast of intently long stream of dividends. Clearly, this would be almost impossible. An therefore, in 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S order to manage the problem, assumptions are made with regard to the future growth of the dividend of the immediately previous period available at the time the investor wants to determine the intrinsic value of his/her equity shares. The assumptions can be: (i) Dividends do not grow in future i.e., the constant or zero growth assumption. (ii) Dividends grow at a constant rate in future i.e., the constant assumption. The dividend valuation model is now discussed with these assumptions: (a) The Zero-growth Case : In zero-growth case, the formula will be: D1 V = K V = Value of Share D 1 = Dividend per share K = Required rate of return Example : Assume that the dividend per share is estimated to be Rs. 4.00 per year indefinitely and the investor requires a 20% of return. 4 V = - = Rs. 20 0.20 (b) Constant Growth Case : When dividends grow in all future periods at a uniform rate g, the formula will be : D1 V = K-g V = Value of Share D 1 = Dividend per share K = Required rate of return g = Growth Rate Example : A ltd. Paid a dividend of Rs. 2.00 per share for the year ending March 31, 1991. A constant growth of 10% income has been forecast for an indefinite future period. Investors required rate of return has been estimated to 15%. You want to buy the share at a market price quoted on July1, 1991 in the stock market at Rs. 60.00. What would be our decision? Solution : This is a case of constant growth rate situation. The above equation can be used to find out the intrinsic value of the equity share as under: D1 2(1.10) 2.20 V = - = = = Rs. 44.00 K-g 0.15-0.10 0.05 74 Z A D
C O M P U T E R S The intrinsic value of Rs. 44 is less than the market price of Rs. 60.00. Hence, the share is overvalued and you should not buy. (2) Models Based on Price Ratio Analysis : According to this method, the price of an equit share is calculated by the following formula: P = EPS X P/E ratio The P/E ratio is an important ratio frequently used by analyst in determining the value of an equity share. It is frequently reported in the financial press and widely quoted in the investment community. This approach seems quite straight and simple. There are, however important problems with respect calculation of both P/E ratio and EPS. Pertinent question often asked are: (i) How to calculate the P/E ratio? (ii) What is the normal P/E ratio? (iii) What determines P/E ratio? (iv) How to relate company P/E? Decision Rule : (i) Higher the P/E ratio, other things remaining the same, higher would be the value of an equity share. (ii) Lower the P/E ratio, other things remaining the same, lower would be the value of an equity share. Q. Explain the Risk-Return Trade-Off. OR Q. Explain the Risk-Return Relationship in Investment Decision. Ans. Meaning of Risk : Risk can be defined as the probability that the expected return from the security will not materialize. Every investment involves uncertainties that make future investment returns risk-prone. Uncertainties could be due to the political, economic and industry factors. Meaning of Return : Return is the amount or rate of produce, proceeds, profits which accrues to an economic agent from an undertaking or investment. It is a reward for and a motivating force behind investment, the objective of which is usually to maximize return. Risk-Return Relationship : The objective of maximizing return can be pursued only at the cost of incurring higher risk. The financial markets offer a wide range of assets from very safe to very risky. While selecting the asset for investment, the investor has to consider both its return potential and the risk involved. The empirical evidence shows that generally there is a high correlation between risk and return over longer periods of time. The securities are generally priced such that high risk is rewarded with high return, and low risk is accompanied by a corresponding low return. This relationship is known as risk-return trade-off. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S R a t e
o f
R e t u r n Ordinary Shares Preference Shares Subordinate loan stock Unsecured loan Debenture with floating charge Mortgage loan Government Stock (risk-free) 0 Degree of Risk R e t u r n Low Risk Average Risk M High Risk Degree of Risk The risk and return are directly variable, i.e., an investment with higher risk should produce higher return. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk-return trade-of is the balance between the desire for the lowest possible risk and the highest possible return. Graphic Presentation of Risk-Return Relationship : The figure below represents the relationship between risk and return. The slope of market line indicates the return per unit of risk required by all investors. Highly risk-averse investors would have a steeper line, and vice-versa. Risk-Return Relationship of Different Stocks : 74 Z A D
C O M P U T E R S The risk-return trade-off tells us that the higher risk gives us the possibility of higher returns. But there are no guarantees. Just as risk means higher potential returns, it also means higher potential losses. Q. Explain Government Securities (G-secs). OR Q. Explain Gilts. Ans. Meaning of Government Securities (G-secs) : Government securities or gilts are sovereign securities, which are issued by the Reserve Bank of India (RBI) on behalf of the Government of India (GOI). The GOI uses these funds to meet its expenditure commitments. Types of Government Securities : 1) Dated Securities : These securities generally carry a fixed interest rate and have a fixed maturity period. For example an 11.40% GOI 2010 G-sec. In this case, 11.40 is the interest rate and it is maturing in the year 2010. Features of Dated Securities : The salient features of dated securities are: (i) These are issued at the face value. (ii) The rate of interest and tenure of the security is fixed at the time of issuance and does not change till maturity. (iii) The interest payment is made on half yearly rest. (iv) On maturity the security is redeemed at face value. 2) Zero Coupon Bonds : These securities are issued at discount to the face value and redeemed at the par i.e. they are issued at below face value and redeemed at face value. Features of Zero Coupon Bonds : The salient features of zero coupon bonds are: The tenure of these securities is fixed. No interest is paid on these securities. 3) Partly Paid Stock : In these securities, the payment of principal is made in installment over a given period of time. Features of Partly Paid Stock : The salient features of partly paid stock are: (i) These types of securities are issued at face value and the principal amount is paid in installment over a period of time. (ii) The rate of interest and tenure of the security is fixed at the time of issuance and does not change till maturity. (iii) The interest payment is made on half yearly rest. (iv) These are redeemed at par on maturity. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S 4) Floating Rate Bonds : These types of securities have a variable interest rate, which is calculated as a fixed percentage over a benchmark rate. Features of Floating Rate Bonds : The salient features of floating rate bonds are: (i) These are issued at the face value. (ii) The interest rate is fixed as a percentage over a predefined benchmark rate. The benchmark rate may be a bank rate, Treasury bill rate etc. (iii) The interest payment is made on half yearly rests. (iv) The security is redeemed at par on maturity, which is fixed. 5) Capital Indexed Bonds : These securities carry an interest rate, which is calculated as a fixed percentage over the wholesale price index. Features of Capital Indexed Bonds : The salient features of capital indexed bonds are: These securities are issued at face value. The interest rate changes according to the change in the wholesale price index, as the interest rate is fixed as a percentage over the wholesale price index. The maturity of these securities is fixed and the interest is payable on half yearly rates. The principal redemption is linked to the wholesale price index. Invest in Government Securities : Entities registered in India including: (i) Banks (ii) Financial Institutions (iii) Primary Dealers (iv) Partnership firms (v) Mutual Funds (vi) Foreign Institutional Investors (vii) State Governments (viii) Provident funds (ix) Trusts (x) Research Organizations (xi) Nepal Rashtra Bank And Individuals can invest in government securities. Advantages of Investing in Government Securities : (1) Minimal Default Risk : The main advantage of investing in G-secs is that there is a minimal default risk, as the instrument is issued b the GOI. 74 Z A D
C O M P U T E R S (2) Long-term Debt : G-secs especially dated securities, offer investors the opportunity to invest in very long-term debt (at times with maturity over 20 years), which is usually not available from the private sector. (3) Liquidity : Although some issues of G-secs tend to be illiquid, there is adequate liquidity in most other issues. Disadvantages of Investing in Government Securities : The main disadvantage of investing in G-sec is the same as in the case of investing in any other debt instrument i.e. possibility of higher interest rates and inflation. Tax Benefits by Investing in Government Securities : There is no tax deducted at source and the investor can avail tax benefit u/s 80C. Minimum amount for investing in Government Securities : The minimum amount for investing in G-secs varies depending on the primary dealer. For example, in case of IDBI Capital markets, which are primary dealers, the minimum amount for investing in G-secs is Rs. 10,000. Commonly used Terms : (1) Coupon Rate : Every government security carries a coupon rate also called interest rate, which is fixed. (2) Face Value : The par value of the security is the face value. (3) Current Price : As these G-secs traded in the secondary market, the price of these G- sec fluctuations according to the demand/supply in the market for that security. The current price is the prevailing price in the secondary market. (4) Wholesale price index : A wholesale price index is an index of prices of select commodities. The percentage in the index reflects the inflation/deflation. (5) Primary Dealer : Primary dealer is an intermediary who buys and sells government securities and treasury bills, He is authorized by the RBI. (6) Secondary Market : Like the stock market where stocks are traded there is a secondary market where the debt instruments like gilts, bonds and treasury bills can be bought and sold. Q. Explain Non-Security Forms of Investment. Ans. Non-Security Forms of Investment : In India, the household sectors investment in non-security forms constitutes a major proportion of its total investment in financial assets. There are a large number of non-security forms of financial assets that are available to investors in India. Most of the investments are illiquid but are generally accepted as good collateral for borrowing from banks. The following table describes the main features of these investments 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S Non-Security Forms of Investment Avenues S.No. Name of Investment Rate of Interest (P.a.) Term 1. Bank Deposit: (i) Saving Bank A/c 5% Short (ii) Fixed Deposits 9-12% Medium (iii) Recurring Deposits 9-12% Medium 2. Post Office Schemes : (i) P.O. Savings Bank 5.5% Short (ii) Public Provident Fund (PPF) 12% Long (iii) Recurring Deposits (RD) 11% Long (iv) Time Deposits 9-11% Long (v) Monthly Income Schemes (MIS) 13% Long (vi) National Saving Scheme (NSS) 11% Long 3. Small Saving Certificates : (i) NSC 12% Long 4. UTI/Mutual Funds: (i) US 64 Variable Long (ii) Units of Mutual Funds Variable Long (iii) ELSS Variable Long 5. Others : Life Insurance Policy Variable Long Q. Explain Real Estate Investment. Ans. Meaning of Real Estate Investment : Real estate has historically has been useful n a portfolio for both income and capital gains. Home ownership, in itself, is a form of equity investment, as is the ownership of a second or vacation home, since these properties generally appreciate in value. Other types of real estate, such as residential and commercial rental property, can create income streams as well as potential long term capital gains. Real estate investments can be made directly, with a purchase n your own name or through investments in limited partnerships, mutual funds, or Real Estate Investment Trusts. Real Estate Investment Trust s a company organized to invest in real estate. Types of Real Estate Investments : There are many kinds of investments. Some are very speculative while others are more conservative. The major classifications are: 74 Z A D
C O M P U T E R S 1. Residential House 2. Source of Housing Finance 3. Features of Housing Finance 4. Guidelines for buying a flat. 5. Commercial Property. 6. Agricultural Land. 7. Suburban Land 8. Time share in a holiday resort 9. Unimproved Land 10. Improved real Estate 11. New and used residential property 12. Vacation homes 13. Other Income-Producing real estate such as: 14. Office Buildings 15. Shopping Centres 16. Industrial or Commercial Properties. Advantages of Real Estate Investment : (1) Potential for High Return : The potential for high return in real estate exists due, in part to the frequent use of financial leverage. Financial leverage is the use of borrowed funds, as in a long-term mortgage, to try to increase the rate of return that can be earned on the investment. When the cost of borrowing is less than what can be earned on the investment, it is considered favourable leverage, but when the reverse is true, it is considered unfavourable leverage. (2) Potential Tax Advantage : There are potential tax advantages in real estate. First, for personal use residential property, there is the opportunity to deduct interest paid. There may also be a deduction for property taxes. If the property is income producing, other expenses may be deductible as well, such as depreciation, insurance, and repairs. (3) Hedge against Inflation : Some consider real estate a good hedge against inflation. (4) Positive Cash Flow : Good quality carefully selected income property will generally produce a positive cash flow. Disadvantages of Real Estate Investment : (1) Limited Marketability : There is generally limited marketability in real estate (depending on the nature and location of the property). (2) Lack of Liquidity : There s also a lack of liquidity, in that there is no guarantee that the propert can be disposed of at its original value, especially if it must be done within a short period of time. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (3) Large Initial Investment : A relatively large initial investment often is required to buy real estate. (4) High Risk : Real estate is often considered high risk because it is fixed in location and character. (5) The Tax Reform Act of 1986 eliminated many of the previously-available tax advantages relating to real estate. Q. Explain the Investment Instruments of the Money Market. Ans. Meaning of Money Market : A money market is a mechanism that makes it possible for borrows and lenders to come together. Essentially it refers to a market for short-term funds. It meets the short-term requirements of the borrowers and provides liquidity of cash to the lenders. A money market is the market in which short-term funds are borrowed and lent. The money market does not deal in cash or money but in trade bills, promissory notes and government papers, which are drawn for short periods. These short-term bills are known as near money. Types of Money Market Instruments : The major short-term credit instruments dealt with in a money market include: (1) Trade Bills : These are bills exchange arising out of bona fide commercial transactions. They include both inland bills and foreign bills. (2) Bankers Acceptance : These are bills of exchange accepted b commercial banks on behalf of their customers. The fact that a bank of repute accepts a bill increases its creditworthiness, which, in turn, means that t can easily be discounted. (3) Treasury Bills (T-Bills) : Treasury bills are short-term money market instruments, which are issued by RBI on behalf of the GOI. The GOI uses these funds to meet its short-term financial requirements of the government. Features of Treasury Bills: The salient features on T-Bills are: (i) These are zero coupon bonds, which are issued at discount to face value and are redeemed at par. (ii) No tax is deducted at source and there is minimal default risk. (iii) The maximum tenure of these securities is one year. (4) Short-dated Government Securities : These are securities issued by the government for short periods. Long-term government securities that are nearing maturity are also sometimes included in this category. (5) Commercial Papers : These are short-term unsecured securities issued b highly creditworthy large companies. Commercial papers are regulated by RBI. 74 Z A D
C O M P U T E R S Features : The main features of commercial papers are: (i) Only those companies are allowed to issue commercial papers which have a net worth of Rs. 10 crore or more (ii) The minimum size of an issue is Rs. 25 lac and the size of each commercial paper should not be less than Rs. 5 lacs. (iii) Their maturity period ranges between 90 to 180 days. Advantages : The main advantages of commercial papers are: (i) It s a cheaper source of short-term finance as compared to bank credit (ii) It is an useful source of finance during period of tight bank credit. Limitations : The limitations of commercial papers are: (i) It can be used only by large and financially sound companies. (ii) Commercial papers cannot be redeemed before maturity date even if the issuing firm has surplus funds. (iii) Maturity date of commercial papers cannot be extended even is the issuing firm is facing financial difficulties. (6) Zero Coupon Bonds : These securities are issued at discount to the face value and redeemed at the par i.e. they are issued at below face value and redeemed at face value. Features of Zero Coupon Bonds : The salient features of zero coupon bonds are: (i) The tenure of these securities is fixed. (ii) No interest is paid on these securities. New Instruments Introduced : (i) Non-Convertible Debentures (ii) Zero Interest Fully Convertible Debentures (iii) Fully Convertible Cumulative Preference Shares (iv) Fully Convertible Bonds with Interest (v) Discount Bonds (vi) Deep Discount Bonds. Issuer of Money Market Instruments : Issuers of money market instruments are: (i) Government of India and other sovereign bodies (ii) Banks and development financial institutions. (iii) Public Sector Undertakings. (iv) Private Sector Companies (v) Government or quasi-government owned non-corporate entities. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S SECURITY ANALYSIS & INVESTMENT MANAGEMENT FINANCE : SPECIALIZATION PAPERS UNIT IV Q. Explain Fundamental Approach in detail. Ans. Introduction : Investment decisions are a part of our economic life. Everybody makes such decisions in different contexts at different times. Some are able to reap more profits through them; while other simply lose their money. Attempts should, therefore, be made to understand and know the way sound investments decision can be made in order to improve the change of making profit through them. Thus, investment decision-making is an important area probing further. Investment decision-making being continuous in nature should attempt systematically. Broadly approaches are suggested in the literature. These are: (A) Fundamental Analysis. (B) Technical Analysis. (A) Fundamental Analysis : In the fundamental approach an attempt is made to analyze various fundamental or basic factors that affect the risk-return of the securities. The effort here is to identify those securities that on perceives as mispriced in the stock market. The assumption in this case is that the market price of security and the price is justified by its fundamental factors called intrinsic value are different and their market place provides an opportunity for a discerning investor to detect such discrepancy. The moment such a description is identified, a decision to invest or disinvest is made. The price prevailing in market is called market price (MP) and the one justified b its fundamentals is called intrinsic value (IV). Criteria for selecting an Investment : (1) If IV > MP, buy the security (2) If IV < MP, sell the security (3) If IV = Mp, no action. The fundamental factors mentioned above may relate to the economy or industry or company or all some of this. Thus Fundamental Approach includes three analysis: 74 Z A D
C O M P U T E R S (1) Economic Analysis (2) Industry Analysis (3) Company Analysis Fundamental Analysis :
(1) Economic Analysis : In actual practice, you must have noticed that investment decisions of individuals and the institutions made in the economy set-up of a particular country. It becomes essential, therefore, to understand the star economy of that country at the macro level. The analysis of the state of the economy at the macro level incorporates the performance of the economy in the past, how it is performing in the present and how it is expected to perform in future. Macro Economic Analysis : The analysis of the following factors indicates the trends in macro economic changes that effect the risk and return on investment: (i) Growth Rate of Gross Domestic Product : The gross domestic product is a measure of the total production of final goods and services in the economy during a specified period usually a year. The growth rate of GDP is the most important indicator of the performance of the economy. The higher the growth rate of GDP, other things being equal, the more favourable it is for the stock market. (ii) Industrial Growth Rate : The GDP growth rate represents the average of the growth rates of the three principal sectors of the economy, viz. the services sector, the industry sector, and the agricultural sector. Publicly listed companies play a major role in the industrial sector but only a minor role in the service sector and the agricultural sector. Hence stock market analyst focus more on the industrial sector. They look at the overall industrial growth rate as well as the growth rates of different industries. Economic Analysis Industry Company Analysis 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S The higher the growth rate of the industrial sector, other things being equal, the more favourable it is for the stock market. (iii) Monsoons : Agriculture accounts for about a quarter of the Indian economy and has important linkages, direct and indirect, with industry. Hence, the increase or decrease of agricultural production has a significant bearing in industrial production and corporate performance. Companies using agricultural raw materials as inputs or supplying inputs to agriculture are directly affected by the changes in agricultural production. Other companies also tend to be affected due to indirect linkages. A spell of good and monsoons imparts dynamism to the industrial sector and buoyancy to the stock market. Likewise, a streak of bad monsoons casts its shadow over the industrial sector and the stock market. (iv) Fiscal Deficit : Government play an important role in most economies, including the Indian economy. The central budget as well as the state budgets prepared annually provides information on revenues, expenditures and deficit or surplus. In India, governmental revenues come more from indirect taxes such as excise duty and custom duty and less from direct taxes such as income tax. Th bulk of the government expenditures goes toward administration, interest pament, defence and subsidies etc. If Government Expenditure > Government Revenues Deficit If Government Revenues > Government ExpenditureSurplus Investment analyst examines the government budget to assess how it is likely to impact on the stock market. They generally classify favourable and unfavourable influences as follows: Favourable Unfavourable A reasonably balanced budget A budget with a high surplus or deficit A level of debt which can be A level of debt which is difficult serviced comfortably to service A tax structure which provides A tax structure which provides incentive for stock market investment disincentive for stock market investment. (v) Interest Rate : A rise in interest rates depresses corporate profitability and also leads to an increase in the discount rate applied by equity investors, both of which have an adverse impact on stock prices. On the other hand, a fall in 74 Z A D
C O M P U T E R S interest rates improves corporate profitability and also leads to a decline in the discount rate applied by equity investors, both of which have a favourable impact on stock prices. (vi) Inflation : The effect of inflation on the corporate sector tends to be uneven. While certain industries ma benefit, others tend to suffer. Industries that enjoy a strong market for their products and which do not come under the purview of price control may benefit. On the other hand, industries have a weak and which come under the purview of price control tend to lose. (vii) Balance of Payments, Forex Reserves, and Exchange Rates : Balance of Payment Deficit = Balance of Trade Deficit (Imports minus exports) + Balance on invisible like tourism and interest rates (payment on account of invisibles minus receipts on account of invisibles) + Balance on account of capital account ( Repayment on account of loans minus receipt of loans) A balance of payments deficit depletes the forex reserves of the country and has an adverse impact on the exchange rate; on the other hand a balance of payments surplus augments the force reserves of the country and has a favourable impact on the exchange rate. (viii) Capacity Utilisation (ix) Unemployment (x) Institutional Lending (xi) Productivity of factors of production. (xii) Industrial Wages (xiii) Status of political and economic stability (xiv) Technological innovations (xv) Infrastructural facilities (xvi) Economic and industrial policies of the government (xvii) Debt recovery and loans outstanding. (xviii) Trends in capital market (xix) Foreign Investment. (xx) Stage of the business cycle (2) Industry Analysis : After conducting an analysis of the economy, the analyst must look into various sectors of the economy in terms of various industries. An industry is a homogeneous group of companies. That is, companies with similar characteristic can be divided into one industrial group. There are man bases on which grouping of companies can be done. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S Classification of Industries : (i) Growth Industry : This is an industry that s expected to grow consistently and its growth may exceed the average growth of the economy. (ii) Cyclical Industry : In this category of the industry, the firms included are those that move closely with the rate of industrial growth of the economy and fluctuate cyclically as the economy fluctuates. (iii) Defensive Industry : It is a grouping that includes firms, which move steadily with the economy and less than the average decline of the economy in a cyclical downturn. Key Indicators in Analysis : The analyst is free to choose his or her own indicators for analyzing the prospectus of an industry. However, many commonly adopt the following factors. (i) Performance Factors : Performance factors like: Past Sales Past Earnings (ii) Environment Factors : Environment factors like: Attitude of government Labour conditions Competitive conditions Technological progress (iii) Outcome factors : Outcome factors lime: Industry share prices Strengths and weaknesses Opportunities and threats Analytical Framework : We have identified various factors and questions relating to industry analysis. Now, we shall consider the frameworks within which the analysis may be carried out. Industry Life-Cycle Stages : Ever industry passes through different stages in its lifetime. Th stages can be identified as follows: (i) Pioneering Stage : This stage is characterized by introduction of a new product, and an uptrend in business cycle that encourages new product introductions. Demand keeps on growing at an increasing rate. Competition is generated b the entry of new firms to grab the market opportunities. Weaker firms face premature death while stronger one survives to grow and expand. (ii) Expansion Stage : This is characterized by the hectic activity of firms surviving the pioneering stage. The market continues to grow but slowly, offering steady and slow growth in sales of the industry. It is a phase of consolidation wherein companies establish durable policies relating to dividends and investments. (iii) Stabilization Stage : This stage shows signs of slow progress and also prospects of decay. 74 Z A D
C O M P U T E R S (iv) Decay Stage : An industry reaches this stage when it fails to detect the death signal and implement- proactively or reactively-appropriate strategies. Obsolescence manifests itself, effecting a decline in sales, profit, dividends and share prices. Implications to the Investor : This approach is useful to the analyst as it gives insights, not apparent merits and demerits of investment in a given industry at a given time. What the investor has to do is. (i) Collect relevant data to identify the industry life cycle stage. (ii) Forecast the probable life period of the stage. (iii) Decide whether to buy, hold or sell. Although the industry life cycle theory appears to be very simple, it is no so in practice. Proper identification of the life cycle stage is difficult. The internal analysis can be done periodically to evaluate strengths and weaknesses either by inside company executives or outside consultants. This can be done b using a form such as the on shown in the following table: Strengths Weaknesses Analysis Factor Performance Importance Neutral Minor Major High Medium (A) MARKETING : (i) Popularity and regard (ii) Relative market share (iii) Quality image (iv) Service reputation (v) Distribution costs (vi) Sales force (vii) Market location (B) FINANCE : (i) Cost of Capital (ii) Funds availability (iii) Financial Stability (iv) Profitability (C) MANUFACTURING : (i) Facilities (ii) Economies of scale (iii) Capacity Utilisation 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (iv) Labour productivity. (v) Manufacturing costs (vi) Raw material availability (vii) Technology of process (D) HUMAN RESOURCES : (i) Leadership (ii) Management capabilities (iii) Worker attitudes (iv) Skill development (v) Structural flexibility (vi) Industrial Relations (3) Company Analysis : The two major components of company analysis are: (i) Financial Analysis: Financial analysis includes: (a) Assets Value vs. Earning Value Assets Value : The asset value of a security is determined b estimating the liquidating value of the firm, deducting the claims of firms creditors and allocating the remaining net asset value of the firm over the outstanding shares of stock. The asset value is usually estimated by consultation with: A specialist who appraises assets values and/or An accountant who gives book value of the firm. Earnings Analysis : Investment analysis focus their attention on the trends of earnings and the related factors like dividends, bonus shares, right shares, and appreciation of the market value of the share. It is believed that the appropriate indices for a companys performance are market price per share (MPS) and earnings per share (EPS) Net Profit Dividend on Preference Shares EPS = - Number of Equity Shares (b) Quantitative Analysis : This approach helps us to provide a measure of future value of equity share based on quantitative factors. The methods commonly used under this approach are: Dividend Discounted Method : Dividend discounted method is based on the premise that the value of an investment is the present value, its future returns. The present value calculated by discounting the future returns, which are divided in the formula, thus, is The Zero-growth Case : In zero-growth case, the formula will be: 74 Z A D
C O M P U T E R S D1 V = K V = Value of Share D1 = Dividend per share K = Required rate of return Constant Growth Case : When dividends grow in all future periods at a uniform rate g, the formula will be : D1 V = K-g V = Value of Share D 1 = Dividend per share K = Required rate of return g = Growth Rate Models Based on Price Ratio Analysis : According to this method, the price of an equit share is calculated by the following formula: P = EPS X P/E ratio The P/E ratio is an important ratio frequently used by analyst in determining the value of an equity share. It is frequently reported in the financial press and widely quoted in the investment community. Decision Rule : Higher the P/E ratio, other things remaining the same, higher would be the value of an equity share. Lower the P/E ratio, other things remaining the same, lower would be the value of an equity share. (c) Ratio Analysis : Based in the financial data available in income statement and balance sheets relevant ratios ma be calculated and analyzed to appraise the financial soundness of a company S. No. Indicator Ratios (A) Technical Solvency (i) Current Ratio (ii) Liquid Ratio (B) Actual Solvency (i) Debt-equity Ratio (ii) Return on Investment (iii) Profit Margin (iv) Fixed assets to total assets 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (C) Profitability (i) Gross profit margin (ii) Net Profit Margin (iii) Return on Investment (iv) Earning per share (v) Dividend yield ratio (vi) P/E Ratio (ii) Non-Financial Analysis : Non-financial analysis is also important in evaluating the worth of a company for investing in securities. This could be obtained b gathering and analyzing information about companies, publized in the media, the stock exchange director, annual reports and prospectus. Non-financial analysis includes internal factors as well as external factors. (a) Internal Factors : Internal factors include analysis of the following factors: History and business of the company To management team Collaboration agreements Product range Future plans of expansion/diversification Research & development Market standing-competition and market share Corporate social responsibility Industrial relations scenario Corporate image etc. (b) External Factors : Besides these internal factors, the external environment related to the company survival and image: Statutory Controls Government Policy Industry life cycle stage Business cycle stage Environmentalism Consumerism, etc. Q. What is Technical Analysis? What are the tools or techniques of technical analysis? Ans. Meaning of Technical Analysis : Technical analysis is a method of evaluating securities b analyzing the statistics generated b market activity, such as past prices and volume. Technical analysts do not attempt to measure a securitys intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. 74 Z A D
C O M P U T E R S Unlike fundamental analysts, technical analysts dont care whether a stock is undervalued- the only thing that matters is a securitys past trading data and what information this data can provide about where the security might move in the future. Basic Technical Assumptions : The basic technical assumptions are: (i) The market Discounts Everything : A major criticism of technical analysis s that it only considers price movement, ignoring the fundamental factors of the company. However, technical analysis assumes that, at an given time, a stocks price reflects everything that has or could affect the company-including fundamental factors. (ii) Price Moves in Rrends : In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement s more likely to be in the same direction as the trend than to be against it. Most technical strategies are based on this assumption. (iii) History Tends to Repeat Itself : Another important postulate in technical analysis s that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Tools of Technical Analysis : The tools of technical analysis are: (1) Dow Theory : The Dow Theory is one of the oldest and most famous technical tools. T was originated by Charles Dow, who founded the Dow Jones company and was the editor of The Wall Street. According to Dow The market is always considered as having three movements, all going at the same time. The first is the narrow movement from day-to-day. The second is the short swing running from two weeks to a month or more, the third is the main movement covering at least four years in duration. These movements are called : (a) Daily Fluctuations (Minor Trends) :The minor trends have little analytical value, because of their short duration and variations in amplitude. (b) Secondary Movements (trends) : The secondary trend acts as a restraining force on the primary trend. It ends to correct deviations from its general boundaries. (c) Primary Trends : The primary trends are the long range cycle that carries the entire market up or down (bull or bear markets). Types of Averages : The Dow Theory is build upon the assertion that measured of stock prices tend to move together. It employs two of the Dow Jones Averages. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (a) Dow-jones Industrial Average (b) Dow-jones Transportation Average Types of Market : There are three types of market: (a) Bull Market: If both the averages are rising. (b) Bear Market: If both the averages are falling (c) Uncertain: If one rising and other is falling Criticism of Dow Theory : Several criticisms are leveled against the Dow Theory: (a) It is not a theory but an interpretation of known data. A theory should be able to explain why a phenomenon occurs. No attempt was made by Dow or his followers to explain why the two averages should be able to forecast future stock prices. (b) It has poor predictive power. (2) Trend Analysis : There are three types of trend: (a) Upward Trend : As the name imply, when each successive peak and trough s higher, its referred to as an upward trend. (b) Downward Trend : If the peaks and troughs are getting lower, its a downtrend. (c) Horizontal Trend : When there is little movement up or down in the peaks and troughs, its a sideways or horizontal trend. (3) Charts Types : Technical analysts use three basic types of charts: (a) Line Charts : The most basic chart is the line chart because it represents only the closing prices over a set period of time. The line of formed by connecting the closing prices over the time frame. Line charts do not provide visual information of the trading range for the individual points such as the high, low and opening prices. However, the closing price is often considered to be the most important price in stock data compared to the high and low for the day and this is why t is the only value used in line charts. (b) Bar Charts : Most investors interested in charting use bar charts-primarily because the have meanings familiar to a technical analysts, but also because these charts are east to draw. The procedure for preparing a vertical line or bar chart is simple. The vertical dimensions of the line represent price, the horizontal dimension indicates the time involved by the chart as a whole. (4) Chart Pattern : A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future price movements. Chartists use these patterns to identify current trends and trend reversals and to trigger buy and sell signals. There are various types of chart patterns: 74 Z A D
C O M P U T E R S (a) Head and Shoulders : This is one of the most popular and reliable chart patterns n technical analysis. Head and shoulders are a reversal chart pattern that when formed, signals that the security likely to more against the previous trend. There are two types of Head and Shoulders Chart patterns: Head and Shoulders Top : Head and Shoulders Bottom : (e) Double Top : It represents a bearish development, signaling that the price is expected to fall. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (f) Double Bottom : It reflects a bullish development signaling that the price is expected to rise. (g) Triangles : Triangles are some of the most well-known chart patterns used in technical analysis. (5) Moving Averages : Most chart patterns show a lot of variation in price movement. This can make it difficult for traders to get an idea of a securitys overall trend. One simple method traders use to combat this is to apply moving averages. A moving average is the average price of a security over a set amount of time. It simple takes the sum of all of the past closing prices over the time period and divides the results by the number of prices used in the calculation. For instance, in a 10-day moving average, the last 10 closing prices are added together and then divided by 10. Criticism of Technical Analysis : The various limitations of technical analysis were pointed out by its critics are as given under: (i) Difficult in interpretation : Technical analysis is not as simple as it appears to be. While the charts are fascinating to look at, interpreting them correctly is very difficult. (ii) Frequent Changes : With changes in market, chart patterns keep on changing. Accordingly, technical analysts change their opinions about a particular investment frequently. One day they put signal. A couple of weeks later, the see a change pattern and put up a sell signal. 74 Z A D
C O M P U T E R S (iii) Unreliable Changes : hanges in market behaviour observed and studied by technical analysts man not always be reliable owing to ignorance or intelligence or manipulative tendencies of some participants. (iv) History does not repeat itself : One of the major limitations of technical analysis is that the entire data s based on the past. It is presumed that future resembles the past. There s no guarantee that history repeats itself. (v) False signals can occur : Technical analysis is a signaling device. Like a thermometer, it may give a false indication when there is no alarm. Q. What is the difference between technical and fundamental analysis? Ans. Meaning of Fundamental Analysis : In the fundamental approach an attempt is made to analyze various fundamental or basic factors that affect the risk-return of the securities. The effort here is to identify those securities that on perceives as mispriced in the stock market. The assumption in this case is that the market price of security and the price is justified by its fundamental factors called intrinsic value are different and their market place provides an opportunity for a discerning investor to detect such discrepancy. The moment such a description is identified, a decision to invest or disinvest is made. Meaning of Technical Analysis : Technical analysis is a method of evaluating securities b analyzing the statistics generated b market activity, such as past prices and volume. Technical analysts do not attempt to measure a securitys intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. Difference between Fundamental and Technical Analysis : S. No. Basis of Fundamental Technical Difference Analysis Analysis 1. Nature His perspective is long-term His outlook is short-term in nature. He is conservative oriented. He is aggressive. in his approach. He acts on He acts on what is What should be 2. Difference He considers total gain from He does not distinguish between equity investment consists of between current income and current current yield by way of capital gains. He is interested income dividends and long-term in short-term profits. and capital gains by way of capital gains appreciation. 3. Base of He forecasts stock prices on He forecasts security prices byy Analysis the basis of economic, studying patterns of supply of industry and company and demand for securities. statistics. The principal Technical analysis is study of decision variables take the stock exchange information. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S form of earnings and dividends. He makes a judgment of the stocks value with a risk-return. 4. Tools He uses tools of financial He uses mainly changes of analysis and statistical financial variables besides forecasting techniques. some quantitative tools. Q. Explain the Efficient Market Theory. Ans. Introduction : An efficient capital market is one in which security prices adjust rapidly to the arivale of new information and, therefore, the current prices of securities reflect all information about the security. You need to understand the meaning of the terms efficient capital market and efficient market hypothesis because of its importance and controversy associated with it. Why Should Capital Market be Efficient : As noted earlier, in an efficient capital market, security prices adjust rapidly to the infusion of new information, and therefore currency security prices fully reflect all available information. To be absolutely correct, this is referred to as an informationally efficient market. Although the idea of an efficient capital market is relatively straightforward, we often fail to consider why capital markets should be efficient. What set of assumptions imply an efficient capital market? (1) An initial and important premise of an efficient market requires that a large number of profit maximizing participants analyze and value securities, each independently of the others. (2) A second assumption is that new information regarding securities comes to the market in a random fashion, and timing of one announcement is generally independent of others. (3) The third assumption is especially crucial: profit maximizing investors adjust security pries rapidly to reflect the effect of new information. Alternative Efficient Market Hypotheses (EMH) : There are three types of efficient market hypotheses: (1) Weak-form EMH : The weak form EMH assumes that current stock prices full reflect all security market information, including Historical sequence of prices Rates of Return Trading volume data Other market generated informations. This hypotheses implies that past rates of return and other historical market data should have no relationship with future rates of return (that is, rates of return should be independent). 74 Z A D
C O M P U T E R S (2) Semi Strong-form EMH : The semi strong-form asserts that security prices adjust rapidly to the release of all public information, that is, current security prices full reflect all public information. The semi strong-form hypotheses encompasses the weak form hypotheses because a the market information considered by the weak form hypotheses such as stock prices, rate of return and trading volume, is public information. Public information also includes all non market information such as: Earnings and dividend announcements P/E ratio Dividend payout ratio News about the economy Political news. (3) The Strong-form EMH : The strong form EMH contends that stock prices full reflect all information from public and private sources. The strong form EMH extends both the weak form and the semi-strong form EMH. Q. Explain recent developments in the Indian Stock Market. Ans. Recent Development in Indian Stock Market : The recent development in Indian Stock Market are studied in two section: A. Financial Reforms : The globalization of financial markets and the consequential changes in the Indian segment have created a new thrust for desirable reforms. Developed financial markets allocate capital through a supply and demand mechanism, establishing the cost of capital at the equilibrium of supply and demand for the securities. The financial services industry has assumed a key position by providing means for transfer of goods and services and payment thereof. In the process, they act as intermediaries between the countries with excess funds and those in need of funds, both for capital and trade purposes. Financial reforms have brought about many changes: (1) Free flow of Investment : These reforms have removed the shackles of control and have promoted the free flow of investment, new instruments of investments and state of the art technologies and procedures that are n operation in the other developed markets. (2) Industrial Growth : With the larger availability of resources, industrial activity has received a boost. (3) Growth in Indian Economy : The active participation of foreign investors with resources and modern know-how has opened new vistas of growth and development in the Indian economy. (4) Removal of Restrictions and Constraints : Removal of restrictions and constraints, freedom to work within broad government guidelines and supportive policies that are investor-friendly, are the chief distinguishing features of the financial reforms. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D
C O M P U T E R S (5) Modification in Foreign Exchange Control Act : The Foreign Exchange Control Act has been modified and rechristened the Foreign Exchange Management Act, symbolic of the present times, which seek to promote development rather than control of inflow and outflow of investments. (6) Delegation of Powers : The laws of securities in India were originally contained in the Capital Issues (Control) Act, 197, Securities Contracts (Regulation) Act, 1956 and the Companies Act, 1956. The Government exercising the delegated powers under these laws, prescribed detailed procedures n rules and regulations. With the promulgation of the securities of the Securities and Exchange Board of India Act, 1992, the Capital Issue Act, 1947 and delegated legislation thereunder were repealed and SEBI was empowered to regulate all matter relating to capital issue in respect of listed companies. These developments significantly changed the face of the Indian Capital Market. (7) The market was thrown open to foreign investors with Indian Companies being allowed to raise capital abroad and receive investments from foreign institutional investors, in order to integrate Indian capital market with the global market, many evolutionary efforts have been taken. (8) The changes in the capital market are not a one-shot affair and have to go through a learning curve. Conclusion : The process of financial reforms is still under way and is likely to brng about even more drastic changes that ma make the markets healthier and stronger. Indias approach to financial sector reforms, in general and to the management of the external sector, n particular has erved the country well, in terms of Aiding Growth Avoiding Crisis Enhancing Efficiency and Imparting resilience to the system. B. Impact of Liberalisation : It is needless to say that liberalisaton has had a remarkable effect on both the economy in general and the capital market in particular. These measures for liberalisation initiated in 1991 by the government led to restoring of both domestic and international confidence in the Indian economy. The balance of payment position, which had reached alarming levels showed stead improvement, which was reflected in the growth of foreign exchange reserves. Trade deficit and inflation have also been brought under control. The private sector has been given a place of pride in allocating resources for the governments five year plans. (1) The private sector, in turn will be tapping the capital market to meet its requirements. 74 Z A D
C O M P U T E R S (2) A key role in the growth of capital market is assigned to the household sector, which earlier hoarded the savings and invested in jewellery and fixed income securities like UTI units, bank fixed deposits etc. (3) Since the mid-1990s, equity prices showed a sharp rise in the market, leading to substantial increase in market capitalization and diversion of attention by the household sector from traditional targets towards since capital market. The ratio of shares and debenture held by the household sector has increased substantially since 1990. (4) Alongside these developments, a number of recognized stock exchanges have grown in India. (5) Mutual Funds came to play a significant role in the mobilization of resources for the corporate sector. Earlier there were only 8 players in the mutual fund segment, comprising of UTI and subsidiaries of investment institutions and nationalized banks, prior to the entry of the private sector. More players arrived on the mutual fund scene to mop up savings from the household sector and invest them in corporate securities. (6) Listed companies operate substantially under stock exchanges in India. The market capitalization of listed companies has grown manifold and the market trends have been on the upswing as reflected in the BSE sensitive index and NSE index. The new policy of the government to privatize the public sector enterprises by offloading part of the government holdings to mutual funds and financial institutions has opened up new opportunities for growth in the capital market. 75 SECURITY ANALYSIS & INVESTMENT MANAGEMENT Z A D