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Introduction
Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly 200 years ago.
The earliest records of security dealings in India are meager and obscure. The East India
Company was the dominant institution in those days and business in its loan securities used to
be transacted towards the close of the eighteenth century.
By 1830's business on corporate stocks and shares in Bank and Cotton presses took place in
Bombay. Though the trading list was broader in 1839, there were only half a dozen brokers
recognized by banks and merchants during 1840 and 1850.
The 1850's witnessed a rapid development of commercial enterprise and brokerage business
attracted many men into the field and by 1860 the number of brokers increased into 60.
In 1860-61 the American Civil War broke out and cotton supply from United States of Europe was
stopped; thus, the 'Share Mania' in India begun. The number of brokers increased to about 200 to
250. However, at the end of the American Civil War, in 1865, a disastrous slump began (for
example, Bank of Bombay Share which had touched Rs 2850 could only be sold at Rs. 87).
At the end of the American Civil War, the brokers who thrived out of Civil War in 1874, found a
place in a street (now appropriately called as Dalal Street) where they would conveniently
assemble and transact business. In 1887, they formally established in Bombay, the "Native Share
and Stock Brokers' Association" (which is alternatively known as " The Stock Exchange "). In
1895, the Stock Exchange acquired a premise in the same street and it was inaugurated in 1899.
Thus, the Stock Exchange at Bombay was consolidated.
Securities market is an economic institute within which takes place the sale and purchase
transactions of securities between subjects of the economy, on the basis of demand and supply.
Also we can say that securities market is a system of interconnection between all participants
(professional and nonprofessional) that provides effective conditions: to buy and sell securities,
and also
1. to attract new capital by means of issuance new security (securitization of debt),
2. to transfer real asset into financial asset,
3. to invest money for short or long term periods with the aim of deriving profit.
4. commercial function (to derive profit from operation on this market)
5. price determination (demand and supply balancing, the continuous process of prices
movements guarantees to state correct price for each security so the market corrects
mispriced securities)
6. informative function (market provides all participants with market information about
participants and traded instruments)
7. regulation function (securities market creates the rules of trade).
Profit sharing
Both casual and professional stock investors, as large as institutional investors or as small as an ordinary
middle-class family, through dividends and stock price increases that may result in capital gains, share in the
wealth of profitable businesses. Unprofitable and troubled businesses may result in capital losses for
shareholders.
Corporate governance
By having a wide and varied scope of owners, companies generally tend to improve management standards and
efficiency to satisfy the demands of these shareholders, and the more stringent rules for public corporations
imposed by public stock exchanges and the government. Consequently, it is alleged that public companies
(companies that are owned by shareholders who are members of the general public and trade shares on public
exchanges) tend to have better management records than privately held companies (those companies where
shares are not publicly traded, often owned by the company founders and/or their families and heirs, or
otherwise by a small group of investors).
Creating investment opportunities for small investors
As opposed to other businesses that require huge capital outlay, investing in shares is open to both the large and
small stock investors because a person buys the number of shares they can afford. Therefore the Stock
Exchange provides the opportunity for small investors to own shares of the same companies as large investors.
Public Placement
Private Placement
Right Issue
Offer of Sale
the new issue Market and stock exchanges are inseparably connected:
1. The securities issued in the New Issue Market are invariably listed on a recognised stock exchange,
subsequent to their issue. This is of immense utility to potential investors who feel assured that should they
receive an allotment of new issues, they will subsequently be able to dispose them of at any time. The facilities
provided by the secondary markets, thus, widen the initial market for them.
2. Secondly, the stock exchanges exercise considerable control over the organisation of new issues. In terms of
the regulatory framework relating to dealings in securities, new issues, which seek stock exchange quotation
have to comply with statutory rules as well as regulations framed by the stock exchanges with the object of
ensuring fair dealings in them.
3. Fundamentally, the markets for new and old securities are, economically, an integral part of a single market
the industrial securities market. Thus they are susceptible to common influence and act and react upon each
other. Broadly, new issues increase when stock values are rising and vice versa.
Also, the quantitative predominance of old securities in the market usually ensures that it is these which set the
tone of the market as a whole and govern the prices and acceptability of new issues.
Thus, we see that the capital market, with particular reference to company scraps, performs two distinct
functions providing funds for trading in existing securities and funds for fresh issues of capital by the
companies either through public issue or right issue or by private placement.
While in many respects, the market mechanism for capital markets is the same as for commodities, there is a
fundamental difference that renders the former more complex, i.e. in the case of an ordinary commodity, it may
be bought or sold several times, but it is used up in consumption after some time. In the case of the capital
market nothing is consumed away.
Every year there is new supply and so the cumulative total of funds dealt with goes on rising and the New Issue
Market provides a common ground for facilitating this transfer process of funds from the suppliers (comprising
investors, individual, corporate and institutional) to the companies attempting to raise fresh capital.
The exact amount available for investment in a particular company, however, depends on macro factors like rate
of growth of the economy, total money supply, savings potential and the marginal propensity to save; and micro
factors like performance of a particular class of companies, facilities available for liquidation of investment and
the individual preference of an investor, etc.
Primary market Secondary market Differences
1. In the first place, New Issue Market deals with new securities, i.e. securities which were
not previously available and are offered to the investing public for the first time. The
market, therefore, derives its name from the fact that it makes available a new block of
securities for public subscription.
2. The stock market on the other hand, is a market for old securities i.e. those which have
already been issued and have been granted stock exchange listing. These are purchased
and sold continuously among investors without involvement of the companies whose
securities constitute the stock-in-trade except in the strictly limited sense of having to
register the transfer of ownership of the securities.
3. A related aspect of these two parts is the nature of their contribution to industrial
financing. The New Issue Market provides the issuing company with additional funds for
starting a new enterprise or for either expansion or diversification of an existing one, and
thus its contribution to company financing is direct. The role of the stock exchange vis-avis supply of capital is indirect.
4. Apart from this, the two parts of the market differ organisationally, e.g. the stock
exchanges have physical existence and are located in particular geographical areas. The
New Issue Market enjoys neither any tangible form nor any administrative organisational
setup, and nor is subject to any centralised control and administration for the execution of
its business it is recognised by the services that it renders to the lenders and borrowers of
capital funds at the time of any particular operation.
Investor Protection in Primary market
1. Provision of all the relevant Information
2. Provision of Accurate information
3. Transparent allotment procedure without any bias.
In order to observe above the following are done.
1.
2.
3.
4.
5.
6.
7.
Project Appraisal
Underwriting
Disclosure of the Prospectus
Clearance by the stock Exchange
Signing by the board of directors
Redressal of the Investors grievances
SEBIs Role
Secondary Market
A stock exchange is a form of exchange which provides services for stock brokers and traders
to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and
redemption of securities and other financial instruments, and capital events including the
payment of income and dividends. Securities traded on a stock exchange include shares issued
by companies, unit trusts, derivatives, pooled investment products and bonds.
To be able to trade a security on a certain stock exchange, it must be listed there. Usually, there
is a central location at least for record keeping, but trade is increasingly less linked to such a
physical place, as modern markets are electronic networks, which gives them advantages of
increased speed and reduced cost of transactions. Trade on an exchange is by members only.
The initial offering of stocks and bonds to investors is by definition done in the primary market
and subsequent trading is done in the secondary market. A stock exchange is often the most
important component of a stock market. Supply and demand in stock markets are driven by
various factors that, as in all free markets, affect the price of stocks (see stock valuation.
There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be
subsequently traded on the exchange. Such trading is said to be off exchange or over-thecounter. This is the usual way that derivatives and bonds are traded. Increasingly, stock
exchanges are part of a global market for securities.
Role and Functions of Secondary Market
Role
Creating investment opportunities for small investors
Profit sharing
Facilitating company growth
Mobilizing savings for investment
Common forms of capital raising
Raising capital for businesses
Functions
Maintain Active Trading
Fixation of Price
Ensure safe and Fair trade Practices
Aids in Financing the Industry
Dissemination of the information
Performance Inducer
safely with the custodian. But, a counter receipt is generated out at the counter which
substitutes the share certificate and is used for all transactions.
In the case of permitted securities, the system is similar to a traditional stock exchange. The
difference is that the delivery and payment procedure will be completed within 14 days.
Compared to the traditional Exchanges, OTC Exchange network has the following advantages:
OTCEI has widely dispersed trading mechanism across the country which provides greater
liquidity and lesser risk of intermediary charges.
Greater transparency and accuracy of prices is obtained due to the screen-based scripless
trading.
Since the exact price of the transaction is shown on the computer screen, the investor
gets to know the exact price at which s/he is trading.
Faster settlement and transfer process compared to other exchanges.
In the case of an OTC issue (new issue), the allotment procedure is completed in a month
and trading commences after a month of the issue closure, whereas it takes a longer
period for the same with respect to other exchanges.
Benefits and limitations of Stock Market
Benefits
1. Creating a market for the company's shares
2. Enhancing the status and financial standing of the company
3. Increasing public awareness and public interest in the company and its products
4. Providing the company with an opportunity to implement share option schemes for their
employees
5. Accessing to additional fund raising in the future by means of new issues of shares or
other securities
6. Facilitating acquisition opportunities by use of the company's shares
7. Offering existing shareholders a ready means of realizing their investments
Limitations
Increasing accountability to public shareholders
Need to maintain dividend and profit growth trends
Chances of possible takeover and merger.
Need to observe and adhere strictly to the rules and regulations by governing bodies
Increasing costs in complying with higher level of reporting requirements
Suffering a loss of privacy as a result of media interest
The Security and Exchange Board of India
It was officially act by The Government of India in the year 1988 and given statutory
powers in 1992 with SEBI Act 1992 being passed by the Indian Parliament. SEBI has it's
Headquarter at the business district of Bandra Kurla Complex in Mumbai, and has
Northern, Eastern, Southern and Western Regional Offices in New Delhi, Kolkata, Chennai
and Ahmedabad respectively.
Controller of Capital Issues was the regulatory authority before SEBI came into existence;
it derived authority from the Capital Issues (Control) Act, 1947.
Initially SEBI was a non statutory body without any statutory power. However in the year of
1995, the SEBI was given additional statutory power by the Government of India through
an amendment to the Securities and Exchange Board of India Act 1992. In April, 1998 the
SEBI was constituted as the regulator of capital markets in India under a resolution of the
Government of India.
The SEBI is managed by its members, which consists of following: a) The chairman who is
nominated by Union Government of India. b) Two members, i.e. Officers from Union
Finance Ministry. c) One member from The Reserve Bank of India. d) The remaining 5
members are nominated by Union Government of India, out of them at least 3 shall be
whole-time members.
2.
3.
4.
5.
Entry Norms
3 year of Dividend Payment
For existing company should fullfil norms if the issue is five time s the pre issue.
If a company does not have a track record, it could go of public issue but its project must
be appraised by a public financial institution.
For a public issue a company must have 5 promotes of Rs 1 lac of the net capital offer
made to public.
Promoter Contribution
Not less than 20% of the issued capital.
Entire promoter contribution should be received before the issue.
The promoter issue should not be more than 20% and it will be locked for 5 years.
Disclosure
Allocation of shares
Market intermediaries
Unit-2
Concept of Risk
Risk is the potential of loss (an undesirable outcome, however not necessarily so)
resulting from a given action, activity and/or inaction. The notion implies that a
choice having an influence on the outcome sometimes exists (or existed).
Potential losses themselves may also be called "risks". Any human endeavor
carries some risk, but some are much riskier than others.
Risk can be defined in different ways
1. A probability or threat of damage, injury, liability, loss, or any other negative
occurrence that is caused by external or internal vulnerabilities, and that may be
avoided through preemptive action.
2. Finance: The probability that an actual return on an investment will be lower
than the expected return. Financial risk can be divided into the following
categories: Basic risk, Capital risk, Country risk, Default risk, Delivery risk,
Economic risk, Exchange rate risk, Interest rate risk, Liquidity risk, Operations risk,
Payment system risk, Political risk, Refinancing risk, Reinvestment risk, Settlement
risk, Sovereign risk, and Underwriting risk.
3. Food industry: The possibility that due to a certain hazard in food there will be
an negative effect to a certain magnitude.
20%
5%
50%
30%
10%
30%
30%
15%
10%
3
20%
20%
-10%
The expected returns on stocks A and B were calculated on the Expected Return page. The expected return on
Stock A was found to be 12.5% and the expected return on Stock B was found to be 20%.
Given an asset's expected return, its variance can be calculated using the following equation:
where
N = the number of states,
pi = the probability of state i,
Ri = the return on the stock in state i, and
E[R] = the expected return on the stock.
The standard deviation is calculated as the positive square root of the variance.
Stock B
Although Stock B offers a higher expected return than Stock A, it also is riskier since its variance and standard
deviation are greater than Stock A's. This, however, is only part of the picture because most investors choose to
hold securities as part of a diversified portfolio.
Systematic Risk
Systematic risk is due to the influence of external factors on an organization. Such factors are normally
uncontrollable from an organization's point of view.
Systematic risk is a macro in nature as it affects a large number of organizations operating under a similar
stream or same domain. It cannot be planned by the organization.
Types of risk under the group of systematic risk are listed as follows:
1. Interest rate risk.
2. Market risk.
3. Purchasing power or Inflationary risk.
The types of risk grouped under systematic risk are depicted below.
5. Basis risk.
6. Volatility risk.
The types of market risk are depicted in the following diagram.
Unsystematic Risk
Unsystematic risk is due to the influence of internal factors prevailing within an organization. Such factors are
normally controllable from an organization's point of view.
Unsystematic risk is a micro in nature as it affects only a particular organization. It can be planned, so that
necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk.
The types of risk grouped under unsystematic risk are depicted below.
1. Business or liquidity risk.
2. Financial or credit risk.
3. Operational risk.
The types of risk grouped under unsystematic risk are depicted below.
produce lower returns with fewer swings. It is recommended that as you get older, you put more of your
investments into debt and less into equity.
Historical P/Es are computed by taking the current price divided by the sum of the EPS for the last four
quarters, or for the previous year. You should also look at the historical trends of the P/E by viewing a
chart of its historical P/E over the last several years (you can find on most finance sites like Yahoo
Finance). Specifically you want to find out what range the P/E has traded in so that you can determine if
the current P/E is high or low versus its historical average.
Forward P/Es reflect the future growth of the company into the figure. Forward P/Es are computed by
taking the current stock price divided by the sum of the EPS estimates for the next four quarters, or for
the EPS estimate for next calendar or fiscal year or two.
P/Es change constantly. If there is a large price change in a stock you are watching, or if the earnings
(EPS) estimates change, the ratio is recomputed.
The p/E has the following advantages:
1. P/E ratio indicates price per rupee of the share earning. This would help to compare the prices of stocks,
which have different EPS.
2. P/E ratio are helpful in analysing the stocks of the companies that do not pay dividend but have
earnings. It should be noted that when there is loss, P/E ratio analyses is difficult to use.
3. The variables used in P/E ratio model are easier to estimate than the variables in the discounting models.
With this ratio model the investor can only find the relative position of the different stocks. It does not
indicate what price is appropriate for a particular stock.
The anticipated return model
The expected return can be determined with the help of the following formula:
E(r)= Summation Pi * Ri
Where Pi is the associated probability
Ri are the returns in different years.
Holding period return model
Return can be calculated with the help of the following formula:
R= (Price change+ Cash dividend)/ Purchase price
R= (D + Pt+1 Pt)/ Pt
Where,
R is the returns
D is the dividends
Pt+1 is the Price at the end of the period
Pt is the initial price
Present Value of the Return Model
Price of the share,
Po= D1/1+r + P1/1+r
Where,
Po is the price of the share
D1 is the next year dividend
R is Expected rate of return
P1 is Selling price at the end of one year period
With this model price of the share and also selling price of the share can be determined.
A bonds price and yield determine its value in the secondary market. Obviously, a bond
must have a price at which it can be bought and sold (see Understanding Bond Market
Prices below for more), and a bonds yield is the actual annual return an investor can
expect if the bond is held to maturity. Yield is therefore based on the purchase price of
the bond as well as the coupon.
A bonds price always moves in the opposite direction of its yield, as illustrated above.
The key to understanding this critical feature of the bond market is to recognize that a
bonds price reflects the value of the income that it provides through its regular coupon
interest payments. When prevailing interest rates fall notably rates on government
bonds older bonds of all types become more valuable because they were sold in a
higher interest-rate environment and therefore have higher coupons. Investors holding
older bonds can charge a premium to sell them in the secondary market. On the other
hand, if interest rates rise, older bonds may become less valuable because their coupons
are relatively low, and older bonds therefore trade at a discount.
Since governments began to issue bonds more frequently in the early twentieth century
and gave rise to the modern bond market, investors have purchased bonds for several
reasons: capital preservation, income, diversification and as a potential hedge against
economic weakness or deflation. When the bond market became larger and more diverse
in the 1970s and 1980s, bonds began to undergo greater and more frequent price
changes and many investors began to trade bonds, taking advantage of another
potential benefit: price, or capital, appreciation.
Capital preservation: Unlike equities, bonds should repay principal at a specified date,
or maturity. This makes bonds appealing to investors who do not want to risk losing
capital and to those who must meet a liability at a particular time in the future. Bonds
have the added benefit of offering interest at a set rate that is often higher than shortterm savings rates.
Income: Most bonds provide the investor with fixed income. On a set schedule,
whether quarterly, twice a year or annually, the bond issuer sends the bondholder an
interest payment, which can be spent or reinvested in other bonds. Stocks can also
provide income through dividend payments, but dividends tend to be smaller than bond
coupon payments, and companies make dividend payments at their discretion, while
bond issuers are obligated to make coupon payments.
Capital appreciation: Bond prices can rise for several reasons, including a drop in
interest rates and an improvement in the credit standing of the issuer. If a bond is held to
maturity, any price gains over the life of the bond are not realized; instead, the bonds
price typically reverts to par (100) as it nears maturity and repayment of the principal.
However, by selling bonds after they have risen in price and before maturity investors
can realize price appreciation, also known as capital appreciation, on bonds. Capturing
the capital appreciation on bonds increases their total return, which is the combination of
income and capital appreciation. Investing for total return has become one of the most
widely used bond strategies over the past 40 years. (For more, see Bond Investment
Strategies.)
Diversification: Including bonds in an investment portfolio can help diversify the
portfolio. Many investors diversify among a wide variety of assets, from equities and
bonds to commodities and alternative investments, in an effort to reduce the risk of low,
or even negative, returns on their portfolios.
Bond Risk
Interest Rate Risk
Variability in return from the debt to investors is caused by the changes is in the market
interest rate.
Default Risk
The failure to pay the agreed amount of the debt instrument by the issuer in full, on
time or both are default risk.
Marketability Risk
Variability in return caused by the difficulty in selling the bonds quickly without having to
make a substantial concession is known as marketability risk.
Callability Risk
The uncertainty created in the investors return by the issuer ability to call the bonds at
any time.
Bond Return:
Holding Period Return= (Price gain or Loss during the holding period + Coupon interest
rate) / Price at the beginning of the holding period
Yield To Maturity
YTM is the single discount factor that present value of the future cash flows from a bond
equal to the current price of the bond. We can also say that YTM is the rate of the return
an investor can expect to earn if the bond is held till maturity.
Assumption:
1. There should not be any default.
2. The investor hold the bond till maturity.
3. All the coupon should be reinvested immediately at the same time interest rate
as the same time yield to maturity of the bond.
The formula is :
Y = C + (P or D/ Year of Maturity)/ (Po + F)/ 2
Where
Y =YTM
C= Coupon Rate
P or D= Premium or Discount
Po= Present Value
F= Face Value
Theorem 3:
If the bond yields remain same then same over its life, the discount or premium
depends on the maturity period.
Example
Bond A
Bond B
Par Value
Rs 1000
Rs 1000
Coupon Rate
10%
10%
Yield
15%
15%
Maturity Period
2
3
Market Price
918.71
885.86
This means, the bond with a short term to maturity sells at a lower discount than
the bond with a long term to maturity.
Theorem 4
If the bond yield remain constant over its life, the discount or premium amount
will decrease at an increasing rate as its life gets shorter. Consider a bond with
the face value Rs. 1000, and maturity period of 5 years with yield to maturity 10%
.
Yield to Maturity
5
4
3
2
1
Price
Years
The above example shows that rate declines when the bond approaches to
maturity.
Theorem 5
A raise in the bond price for a decline in the bond yield is greater than the fall in
bond price for a raise in the yield . take a bond of 10% coupon rate, maturity
period of 5 years with the face value of Rs 1000. If the yield declines by 2%, that
is to 8% then the bond price will be 1079.87.
= Rs. 100(PVIFA 8%, 5 years) + Rs1000( PVIF 8%, 5 years.)
= Rs 100* 3.9927 + Rs1000 *.6806
= Rs. 1079.87
If, the yield increases by 2% then, the bond price will be Rs. 927.88.
= Rs. 100 (PVIFA 12%, 5 Years) + Rs.1000 (PVIF 12%, 5 Years)
=Rs. 100*3.6048 + Rs 1000*.05674
=Rs. 927.88
. Now the fall in the yield has resulted in a raise Rs 79.86 but the raise in the yield
caused a variation of Rs. 72.22 in the price.
Duration
Duration measures the time structure of the bond and the bond interest rate risk. The time structure of the
investment in bonds is expressed in two ways. The common way to state is how many years he has to wait until
the bond matures and the principles money is paid back. This is known as asset time to maturity or its years to
maturity. The other way is to measure the average time until all the interest coupons and the principle is
recovered. This is called Macaulays duration. Duration is defined as the weighted average of the time period to
the maturity, weights present values of the cash flow in each time period. The formula is.
D= C1/(1+r)/ P0 + C2/(1+r)2/P0+Ct/(1+r)t/P0*T
Duration =D
C= Cash flows
R = Current YTM
T= number of years
PV (C)= Present value of the cash flow
P0= Sum of the present value of the cash flows.
General Rules:
Larger the coupon rate, lower the duration and less volatile the bond price.
Longer the term to maturity, longer the duration and more the volatile bond.
Higher the YTM, lower the bond duration and bond volatility, and vice versa.
In a zero coupon bond, the bonds term to maturity and Duration are the same.
Importance of the duration:
The concept of the duration is important because it provide the length of a bond, helpful in evolving
immunization( the technique that make the bond portfolio holder to be relatively certain about the promised
stream of the cash flows.) strategies for the portfolio management and measures the sensitivity of the bond
price to changes in the interest rate.
Fundamental analysis
1. Economic Analysis
2. Industry analysis
3. Company Analysis
1. Economic Analysis
Economic Indicators
GDP
National Income
Employment
Inflation
Regression Model
2. Industry Analysis
Growth
Cost Structure and Profitability
Nature of the Industry
Nature of the Competition
Government policy
Labor market condition
Research and development
Fundamental analysis / Technical Analysis
. Company analysis
Capital structure
Growth of the company and sales
Stability of the sales
Earning of the company
Financial statement
Technical Analysis
It is the process of identifying the time reversal at an earlier stage to formulate buying and selling strategies.
With the help of many indicators we can prdict the price volume and demand supply of the stocks.
Assumptions:
1. The market discount everything.
2. The market value is determined by the demand and supply.
3. The market always moves in trend
Technical Analysis
Technical tools:
1. Dow theory
2. Volume Trade
3. Moving Average
4. Odd Lot Trading
Dow theory
Based on Hypothesis
No individual buyer or seller influence the major trend in market.
Market discounts everything.
It is not a tool to beat the market. It provide a way to understand it better.
According to this theory the trend are divided into primary, intermediate and short term trend. The primary trend
is upward or downward movement last for a year or two. The intermediate trends are corrective movements,
which may last for three weeks to three months. The short term refers to the day to day price movement. It is
also known as oscillators or fluctuations.
Technical Analysis
Primary Trends:
1. The security price trend may be either increasing or decreasing. When the market exhibit the increasing
trend it is called bull market. The bull market shows three clear cut peaks. Each peak is higher than the
previous one.. The bottoms are also higher then the previous ones.
First Phase is Revival of the market
Good corporate earning
Speculation Phase
2. The reverse is also true with the bear market.
Loss of hopes
Recession phase
Distress selling.
Secondary Trends:
The secondary trends are the Immediate trends moves against the main trends and leads to correction. In the
bull market the secondary trends would result in fall of about 33-66% of the earlier rise.
Intermediate trends correct the overbought and oversold condition. It provide the breathing condition to the
market. Compared to the primary trend, secondary trend is swift and quicker.
Minor Trend-
Minor trend or tertiary moves are called as random wriggles. They are simply the daily price fluctuations.
Minor trends tries to correct the secondary trend movement. It is better for the investors to concentrate on the
primary and secondary trends.
Technical Analysis
Volume of trade
Dow gave special emphasis on volume. Volume expands along with the bull and bear market and narrows down
in the bear market. If the volume falls with the rise or vice versa, it is the matter of concern for the investors and
the trend may not persist for the longer time. Technical analyst used volume as an excellent method of
confirming the trend. The market is said to be bullish when small volume of trade and large volume trade follow
fall in price and the rise in price.
Large rise in price or large fall in price leads to large increase in volume . Large volume with rise in price
indicates that bull market and the large volume with fall in price indicates bear market.
If the volume declines for consecutive five days, then it will be continue for another four days and the same is
true in increasing volume.
Odd lot tradingShares are generally sold in lot of hundreds. Share which are sold in smaller lot fewer than 100 are called odd
lot. Such buyers and sellers are also called odd lotters. Odd lot purchase to odd lot sale (Purchase % sales) is
called as lot index. The increase in odd lot purchase results in an increase in the index. Relatively more selling
leads to fall in the index. It is generally considered that the professional investors is more informed and stronger
than odd lotters. When the professional investors dominate the market, the market is considered weak. The
notion behind is that odd lot purchase is concentrated at the top of the market cycle and selling at the bottom.
High odd lot purchase forecast fall in the market price and low purchase\sales ratio are presumed to occur
towards the end of bear market.
Moving averageThe market indices do not rise or fall in straight line. The upward and downward movements are interrupted by
the counter moves. The underlying trend can be studied by smoothing of the data. To smooth the data moving
average technique is used.
The word moving means that the body of the data moves ahead to include the recent observations. If it is five
day moving average, on the sixth day the body of the data moves to include the sixth day observation
eliminating the first days observation. Likewise it continues. In this method, closing price of the stock is used.
The moving average are used to study the movement of the market as well as the individual scrip prices. The
moving average indicates that the underlying trend in the scrip. The period of average determines the period of
the trend that is being identified. Fro underlying short term trend, a10 day or 30 day moving average are used.
In the case of medium term trend 50 day to 125 day are adopt. 200 day moving average is used to identify the
long term trend.
Difference between Fundamental and Technical Analysis
Basis
Fundamental Analysis
Technical Analysis
Definition:
Financial statements
Charts
Stock bought:
Time horizon:
Long-term approach
Short-term approach
Function:
Investing
Trade
Concepts used:
Vision:
looks backward
Unit-3
Derivatives
Derivatives are a contract between two parties that specify conditions (especially the dates, resulting values and
definitions of the underlying variables, the parties' contractual obligations, and the notional amount) under
which payments are to be made between the parties. The most common underlying assets include commodities,
stocks, bonds, interest rates and currencies, but can also be other derivatives, which adds another layer of
complexity to proper valuation.
Importance-There are several risks inherent in financial transactions. Derivatives are used to separate risks
from traditional instruments and transfer these risks to parties willing to bear these risks. The fundamental risks
involved in derivative business includes:
Credit Risk
This is the risk of failure of a counterparty to perform its obligation as per the contract. Also known as default or
counterparty risk, it differs with different instruments.
Market Risk
Market risk is a risk of financial loss as a result of adverse movements of prices of the underlying
asset/instrument.
Liquidity Risk
The inability of a firm to arrange a transaction at prevailing market prices is termed as liquidity risk. A firm
faces two types of liquidity risks
Related to liquidity of separate products
Related to the funding of activities of the firm including derivatives.
Legal Risk
Derivatives cut across judicial boundaries, therefore the legal aspects associated with the deal should be looked
into carefully.
1. Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly
between two parties, without going through an exchange or other intermediary. Products such as swaps, forward
rate agreements, exotic options and other exotic derivatives are almost always traded in this way. The OTC
derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of
information between the parties, since the OTC market is made up of banks and other highly sophisticated
parties, such as hedge funds. Reporting of OTC amounts is difficult because trades can occur in private, without
activity being visible on any exchange.
2.Exchange-traded derivatives (ETD) are those derivatives instruments that are traded via specialized
derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary
to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.
What are the various types of derivatives?
Derivatives can be classified into three types:
1. Futures
2. Options
3. Swaps
The Basic Concept of Options
An options contract, whether a call (buy an asset) or put (sell an asset), grants the holder the right but not the
obligation to exercise the option. The holder is entitled to simply let the option expire without investing
further. .
An option is linked to a specific stock. The price of the option is much less than the price of the underlying
stock, which is a major reason for the attractiveness of options. If the price of the stock changes, the price of the
option also changes, although by a smaller amount. As the price of a stock goes through its daily ups and
downs, the price of an associated option undergoes related fluctuations.
The Black-Scholes model is used to calculate the theoretical price of European put and call options,
ignoring any dividends paid during the option's lifetime. While the original Black-Scholes model did not take
into consideration the effects of dividends paid during the life of the option, the model can be adapted to
account for dividends by determining the ex-dividend date value of the underlying stock..
The model makes certain assumptions, including:
The options are European and can only be exercised at expiration
No dividends are paid out during the life of the option
Efficient markets (i.e., market movements cannot be predicted)
No commissions
The risk-free rate and volatility of the underlying are known and constant
Follows a lognormal distribution; that is, returns on the underlying are normally distributed.
The formula, shown in Figure in next slide, takes the following variables into consideration:
Current underlying price
Options strike price
Time until expiration, expressed as a percent of a year
Implied volatility
Risk-free interest rates
This model takes into account expected changes in various parameters over an option's life,
thereby producing a more accurate estimate of option prices than created by models that consider only
one point in time. Because of this, the Cox-Ross-Rubenstein model is especially useful for analyzing
American style options, which can be exercised at any time up to expiration (European style options
can only be exercised upon expiration).
The Cox-Ross-Rubenstein model uses a risk-neutral valuation method. Its underlying principal
purports that when determining option prices, it can be assumed that the world is risk neutral and that
all individuals (and investors) are indifferent to risk. In a risk neutral environment, expected returns are
equal to the risk-free rate of interest.
The Cox-Ross-Rubenstein model makes certain assumptions, including:
The Cox-Ross-Rubenstein model is a two-state (or two-step) model in that it assumes the
underlying price can only either increase (up) or decrease (down) with time until expiration.
Valuation begins at each of the final nodes (at expiration) and iterations are performed
backwards through the binomial tree up to the first node (date of valuation). In very basic terms,
the model involves three steps:
The creation of the binomial price tree
Option value calculated at each final node
Option value calculated at each preceding node
While the math behind the Cox-Ross-Rubenstein model is considered less complicated than the
Black-Scholes model (but still outside the scope of this tutorial), traders can again make use of online
calculators and trading platform-based analysis tools to determine option pricing values.
Futures
In finance, a futures contract (more colloquially, futures) is a standardized contract between two parties to buy
or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures price or
strike price) with delivery and payment occurring at a specified future date, the delivery date. The contracts are
negotiated at a futures exchange, which acts as an intermediary between the two parties. The party agreeing to
buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to
sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the
expectations of the partiesthe buyer hopes or expects that the asset price is going to increase, while the seller
hopes or expects that it will decrease in near future.
In many cases, the underlying asset to a futures contract may not be traditional commodities at all that
is, for financial futures the underlying item can be any financial instrument (also including currency, bonds, and
stocks); they can be also based on intangible assets or referenced items, such as stock indexes and interest rates.
Unlike an option both parties of a futures contract must fulfill the contract on the delivery date. The seller
delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from
the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the
settlement date, the holder of a futures position can close out its contract obligations by taking the opposite
position on another futures contract on the same asset and settlement date. The difference in futures prices is
then a profit or loss.
Marking to marketWhile the futures contract specifies a trade taking place in the future, the purpose of the futures exchange
institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires
both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally
change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also
(variation margin). The exchange will draw money out of one party's margin account and put it into the other's
so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then
a margin call is made and the account owner must replenish the margin account. This process is known as
marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract
but the spot value (i.e. the original value agreed upon, since any gain or loss has already been previously settled
by marking to market).
Features OF Future
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term
interest rate.
The type of settlement, either cash settlement or physical settlement.
The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a
fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which
the short term interest rate is traded, etc.
The currency in which the futures contract is quoted.
The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the
case of physical commodities, this specifies not only the quality of the underlying goods but also the
manner and location of delivery.
The delivery month.
The last trading date.
Other details such as the commodity tick, the minimum permissible price fluctuation.
Futures vs Options
Basis
Futures
Options
Obligation
Premium
No premium is paid
Risk
The holder of the contract is exposed to The buyers loss is restricted to the option
the entire spectrum of the risk.
premium.
Exercise date.
The parties of the contract must perform The buyer can exercise option any time prior
at the settlement date.
to the expiary date.
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy
or to sell an asset at a specified future time at a price agreed upon today. This is in contrast to a spot contract,
which is an agreement to buy or sell an asset today.
With a forward contract the transfer of the ownership takes place on the spot, but the delivery of the commodity
takes place does not occur until some future date.
Therefore in forward contract the parties agrees to do trade at some future date, at a stated price and quantity.
No money changes hands at the time deal is signed.
For example, a wheat farmer may wish to contract to sell their harvest at a future date to eliminate the risk of a
change in price by that date. Such transaction would take place through a forward market.
These are not traded on an stock exchange , they are buy and sold over the counter. These quantities of the
underlying asset and terms of the contracts are fully negotiable. The secondary market does not exist for the
forward contract and faces the problem of liquidity and negotiability.
Difference between Forwards and Futures
Basis
Forward Contract
Futures Contract
A forward contract is an agreement between two parties A futures contract is a standardized contract, traded on a
Definition: to buy or sell an asset (which can be of any kind) at a
futures exchange, to buy or sell a certain underlying
pre-agreed future point in time at a specified price.
instrument at a certain date in the future, at a specified price.
Structure & Customized to customer needs. Usually no initial
Purpose:
payment required. Usually used for hedging.
Transaction
Negotiated directly by the buyer and seller
method:
Market
Not regulated
regulation:
Institutional
The contracting parties
guarantee:
Risk:
High counterparty risk
No guarantee of settlement until the date of maturity
Guarantees: only the forward price, based on the spot price of the
underlying asset is paid
Clearing House
Low counterparty risk
Both parties must deposit an initial guarantee (margin).
The value of the operation is marked to market rates with
daily settlement of profits and losses.
Contract
Forward contracts generally mature by delivering the
Maturity:
commodity.
Expiry date: Depending on the transaction
Contract
size:
The most bullish of options trading strategies is the simple call buying strategy used by most novice
options traders.
Stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target price
for the bull run and utilize bull spreads to reduce cost. (It does not reduce risk because the options can
still expire worthless.) While maximum profit is capped for these strategies, they usually cost less to
employ for a given nominal amount of exposure. The bull call spread and the bull put spread are
common examples of moderately bullish strategies.
Mildly bullish trading strategies are options strategies that make money as long as the underlying stock
price does not go down by the option's expiration date.
Bearish strategies
Bearish options strategies are employed when the options trader expects the underlying stock price to
move downwards. It is necessary to assess how low the stock price can go and the time frame in which
the decline will happen in order to select the optimum trading strategy.
The most bearish of options trading strategies is the simple put buying strategy utilized by most novice
options traders.
Stock prices only occasionally make steep downward moves. Moderately bearish options traders usually
set a target price for the expected decline and utilize bear spreads to reduce cost. While maximum profit
is capped for these strategies, they usually cost less to employ. The bear call spread and the bear put
spread are common examples of moderately bearish strategies.
Mildly bearish trading strategies are options strategies that make money as long as the underlying stock
price does not go up by the options expiration date. These strategies may provide a small upside
protection as well. In general, bearish strategies yield less profit with less risk of loss.
Neutral or non-directional strategies
Neutral strategies in options trading are employed when the options trader does not know whether the
underlying stock price will rise or fall. Also known as non-directional strategies, they are so named because the
potential to profit does not depend on whether the underlying stock price will go upwards. Rather, the correct
neutral strategy to employ depends on the expected volatility of the underlying stock price.
Guts- sell ITM (in the money) put and call
Butterfly- buy ITM (in the money) and OTM (out of the money) call, sell two at the money calls, or vice versa.
Strangle- the simultaneous buying or selling of out-of-the-money put and an out-of-the-money call, with the
same expiration. Similar to the straddle, but with different strike prices.
Option Greeks
In mathematical finance, the Greeks are the quantities representing the sensitivity of the price of derivatives
such as options to a change in underlying parameters on which the value of an instrument or portfolio of
financial instruments is dependent. The name is used because the most common of these sensitivities are often
denoted by Greek letters. Collectively these have also been called the risk sensitivities, risk measures or
hedge parameters.
The Greeks are vital tools in risk management. Each Greek measures the sensitivity of the value of a portfolio to
a small change in a given underlying parameter, so that component risks may be treated in isolation, and the
portfolio rebalanced accordingly to achieve a desired exposure; see for example delta hedging.
Delta
Delta,, measures the rate of change of option value with respect to changes in the underlying asset's price. Delta
is the first derivative of the value of the option with respect to the underlying instrument's price .
Vega
Vega measures sensitivity to volatility. Vega is the derivative of the option value with respect to the volatility of
the underlying asset.
Theta
Theta , measures the sensitivity of the value of the derivative to the passage of time (see Option time value): the
"time decay."
Rho
Rho measures sensitivity to the interest rate: it is the derivative of the option value with respect to the risk free
interest rate (for the relevant outstanding term).
Except under extreme circumstances, the value of an option is less sensitive to changes in the risk free interest
rate than to changes in other parameters. For this reason, rho is the least used of the first-order Greeks.
Lambda
Lambda, , omega, , or elasticity is the percentage change in option value per percentage change in the
underlying price, a measure of leverage sometimes called gearing.
Unit-4
Capital asset pricing model
The Capital Asset Pricing Model: An Overview
No matter how much we diversify our investments, it's impossible to get rid of all the risk. As investors,
we deserve a rate of return that compensates us for taking on risk. The capital asset pricing model (CAPM)
helps us to calculate investment risk and what return on investment we should expect.
The CAPM specifies that the expected return of an asset, E(Ri) is linearly related to its risk when risk is
measured in terms of the assets beta, i
Birth of a Model
The capital asset pricing model was the work of financial economist (and, later, Nobel laureate in economics)
William Sharpe, set out in his 1970 book "Portfolio Theory And Capital Markets." His model starts with the
idea that individual investment contains two types of risk:
Systematic Risk - These are market risks that cannot be diversified away. Interest rates, recessions and wars are
examples of systematic risks.
Unsystematic Risk - Also known as "specific risk," this risk is specific to individual stocks and can be
diversified away as the investor increases the number of stocks in his or her portfolio.
Modern portfolio theory shows that specific risk can be removed through diversification. The trouble is that
diversification still doesn't solve the problem of systematic risk; even a portfolio of all the shares in the stock
market can't eliminate that risk. Therefore, when calculating a deserved return, systematic risk is what plagues
investors most. CAPM, therefore, evolved as a way to measure this systematic risk.
The Formula
Assumptions of CAPM
All investors:
Aim to maximize economic utilities.
Required Return
Security Market
Line
E(Rm)
Rm-Rf
Rf
Beta
1
Some Applications of the Security Market Line
1.To determine the market price of risk, E(Rm) - Rf
2.To identify over or under-priced securities. stock.
If the realised return plots above the SML Portfolio has overperformed
If the realised return plots below the SML Portfolio has underperformed
Problems of CAPM
1. The model assumes that the variance of returns is an adequate measurement of risk.
2. The model assumes that all active and potential shareholders have access to the same information and
agree about the risk and expected return of all assets (homogeneous expectations assumption).
3. The model does not appear to adequately explain the variation in stock returns. Empirical studies show
that low beta stocks may offer higher returns than the model would predict.
4. The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed
with more complicated versions of the model.
5. Empirical tests show market anomalies like the size and value effect that cannot be explained by the
CAPM.
Portfolio
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund,
financial institution or individual.
The term portfolio refers to any collection of financial assets such as stocks, bonds, and cash. Portfolios may be
held by individual investors and/or managed by financial professionals, hedge funds, banks and other financial
institutions. It is a generally accepted principle that a portfolio is designed according to the investor's risk
tolerance, time frame and investment objectives. The monetary value of each asset may influence the
risk/reward ratio of the portfolio and is referred to as the asset allocation of the portfolio
Portfolio Expected Return
The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the stocks
which comprise the portfolio. The weights reflect the proportion of the portfolio invested in the stocks. This can
be expressed as follows:
where
For a portfolio consisting of two assets, the above equation can be expressed as
Interpretation of Beta
Value of Beta Interpretation
Example
short position
<0
Fixed-yield asset, whose growth is
Movement of the asset is uncorrelated with the
=0
=1
>1
Harry Max Markowitz (born August 24, 1927) is an American economist, and a recipient of the 1989 John von
Neumann Theory Prize and the 1990 Nobel Memorial Prize in Economic Sciences.
Markowitz is a professor of finance at the Rady School of Management at the University of California, San Diego
(UCSD). He is best known for his pioneering work in Modern Portfolio Theory, studying the effects of asset risk,
return, correlation and diversification on probable investment portfolio returns.
Harry Markowitz put forward this model in 1952. It assists in the selection of the most efficient by analyzing various
possible portfolios of the given securities. By choosing securities that do not 'move' exactly together, the HM model
shows investors how to reduce their risk. The HM model is also called Mean-Variance Model due to the fact that it is
based on expected returns (mean) and the standard deviation (variance) of the various portfolios. Harry Markowitz made
the following assumptions while developing the HM model:
Assumptions
Risk of a portfolio is based on the variability of returns from the said portfolio.
2. An investor is risk averse.
3. An investor prefers to increase consumption.
4. The investor's utility function is concave and increasing, due to his risk aversion and consumption preference.
5. Analysis is based on single period model of investment.
6. An investor either maximizes his portfolio return for a given level of risk or maximizes his return for the minimum risk.
7. An investor is rational in nature.
To choose the best portfolio from a number of possible portfolios, each with different return and
risk, two separate decisions are to be made:
As the investor is rational, they would like to have higher return. And as he is risk averse, he
wants to have lower risk. In Figure in last slide, the shaded area PVWP includes all the possible
securities an investor can invest in. The efficient portfolios are the ones that lie on the boundary
of PQVW. For example, at risk level x2, there are three portfolios S, T, U. But portfolio S is
called the efficient portfolio as it has the highest return, y2, compared to T and U. All the
portfolios that lie on the boundary of PQVW are efficient portfolios for a given risk level.
The boundary PQVW is called the Efficient Frontier. All portfolios that lie below the Efficient
Frontier are not good enough because the return would be lower for the given risk. Portfolios
that lie to the right of the Efficient Frontier would not be good enough, as there is higher risk for
a given rate of return. All portfolios lying on the boundary of PQVW are called Efficient
Portfolios. The Efficient Frontier is the same for all investors, as all investors want maximum
return with the lowest possible risk and they are risk averse.
For selection of the optimal portfolio or the best portfolio, the risk-return preferences are analyzed. An
investor who is highly risk averse will hold a portfolio on the lower left hand of the frontier, and an
investor who isnt too risk averse will choose a portfolio on the upper portion of the frontier.
Figure 2 shows the risk-return indifference curve for the investors. Indifference curves C1, C2 and C3
are shown. Each of the different points on a particular indifference curve shows a different combination
of risk and return, which provide the same satisfaction to the investors. Each curve to the left represents
higher utility or satisfaction. The goal of the investor would be to maximize his satisfaction by moving
to a curve that is higher. An investor might have satisfaction represented by C 2, but if his
satisfaction/utility increases, he/she then moves to curve C3 Thus, at any point of time, an investor will
be indifferent between combinations S1 and S2, or S5 and S6..
The investor's optimal portfolio is found at the point of tangency of the efficient frontier with the
indifference curve. This point marks the highest level of satisfaction the investor can obtain. This is
shown in Figure 3. R is the point where the efficient frontier is tangent to indifference curve C 3, and is
also an efficient portfolio. With this portfolio, the investor will get highest satisfaction as well as best
risk-return combination. Any other portfolio, say X, isn't the optimal portfolio even though it lies on the
same indifference curve as it is outside the efficient frontier. Portfolio Y is also not optimal as it does
not lie on the indifference curve, even though it lies in the portfolio region. Another investor having
other sets of indifference curves might have some different portfolio as his best/optimal portfolio.
The weak form of EMH assumes that current stock prices fully reflect all currently available
security market information. It contends that past price and volume data have no relationship
with the future direction of security prices. It concludes that excess returns cannot be achieved
using technical analysis.
The semi-strong form of EMH assumes that current stock prices adjust rapidly to the release of
all new public information. It contends that security prices have factored in available market and
non-market public information. It concludes that excess returns cannot be achieved using
fundamental analysis.
The strong form of EMH assumes that current stock prices fully reflect all public and private
information. It contends that market, non-market and inside information is all factored into
security prices and that no one has monopolistic access to relevant information. It assumes a
perfect market and concludes that excess returns are impossible to achieve consistently.
The Elliott wave principle is a form of technical analysis that some traders use to analyze financial
market cycles and forecast market trends by identifying extremes in investor psychology, highs and
lows in prices, and other collective factors. Ralph Nelson Elliott (18711948), a professional
accountant, discovered the underlying social principles and developed the analytical tools in the 1930s.
He proposed that market prices unfold in specific patterns, which practitioners today call Elliott waves,
or simply waves. Elliott published his theory of market behavior in the book The Wave Principle in
1938, summarized it in a series of articles in Financial World magazine in 1939, and covered it most
comprehensively in his final major work, Natures Laws: The Secret of the Universe in 1946. Elliott
stated that "because man is subject to rhythmical procedure, calculations having to do with his
activities can be projected far into the future with a justification and certainty heretofore unattainable.
The Elliott Wave Principle posits that collective investor psychology, or crowd psychology, moves
between optimism and pessimism in natural sequences. These mood swings create patterns evidenced
in the price movements of markets at every degree of trend or time scale.
In Elliott's model, market prices alternate between an impulsive, or motive phase, and a corrective
phase on all time scales of trend, as the illustration shows. Impulses are always subdivided into a set of
5 lower-degree waves, alternating again between motive and corrective character, so that waves 1, 3,
and 5 are impulses, and waves 2 and 4 are smaller retraces of waves 1 and 3. Corrective waves
subdivide into 3 smaller-degree waves starting with a five-wave counter-trend impulse, a retrace, and
another impulse. In a bear market the dominant trend is downward, so the pattern is reversedfive
waves down and three up. Motive waves always move with the trend, while corrective waves move
against it.
Wave 2: Wave two corrects wave one, but Wave B: Prices reverse higher, which many see as a
can never extend beyond the starting point
of wave one. Typically, the news is still
bad. As prices retest the prior low, bearish
sentiment quickly builds, and "the crowd"
haughtily reminds all that the bear market
is still deeply ensconced.
is a systematic factor
where
is the risk premium of the factor,
is the risk-free rate,
That is, the expected return of an asset j is a linear function of the asset's sensitivities to the n factors.
Note that there are some assumptions and requirements that have to be fulfilled for the latter to be correct: There
must be perfect competition in the market, and the total number of factors may never surpass the total number
of assets (in order to avoid the problem of matrix singularity),
Unit-5
Review the existing asset portfolio
Undertaking periodic evaluations of its asset portfolio, based on size and complexity, as part of its strategic
asset management helps an entity to confirm that its assets continue to be appropriate to meet its program
delivery requirements. As part of the evaluation of the existing asset portfolio the entity may consider:
using asset performance indicators to identify if existing assets are being appropriately used, maintained,
and are fit-for-purpose;
monitoring the performance of the asset portfolio in terms of laws, codes and benchmarks, and financial
performance; and
maintaining a detailed asset register, and accounting for the assets in accordance with Australian
Accounting Standards.
Treynor measuresThe Treynor ratio (sometimes called the reward-to-volatility ratio or Treynor measure, named after Jack L.
Treynor, is a measurement of the returns earned in excess of that which could have been earned on an
investment that has no diversifiable risk (e.g., Treasury Bills or a completely diversified portfolio), per each unit
of market risk assumed.
The Treynor ratio relates excess return over the risk-free rate to the additional risk taken; however, systematic
risk is used instead of total risk. The higher the Treynor ratio, the better the performance of the portfolio under
analysis.
where:
Treynor ratio,
portfolio i's return,
risk free rate
portfolio i's beta
Limitations
Like the Sharpe ratio, the Treynor ratio (T) does not quantify the value added, if any, of active portfolio
management. It is a ranking criterion only. A ranking of portfolios based on the Treynor Ratio is only useful if
the portfolios under consideration are sub-portfolios of a broader, fully diversified portfolio. If this is not the
case, portfolios with identical systematic risk, but different total risk, will be rated the same. But the portfolio
with a higher total risk is less diversified and therefore has a higher unsystematic risk which is not priced in the
market.
An alternative method of ranking portfolio management is Jensen's alpha, which quantifies the added return as
the excess return above the security market line in the capital asset pricing model. As these two methods both
determine rankings based on systematic risk alone, they will rank portfolios identically.
Sharpe Ratio
Sharpe ratio evaluates the performance of a portfolio based on the total risk of a portfolio. It measures the
excess return generated by a portfolio over the risk free rate in relation to the total risk or standard deviation of a
portfolio.
Sharpe Ratio= (Rp - Rf)/s
Where, Rp=return on the portfolio, Rf= risk free rate and s= standard deviation of the return of the portfolio
Higher the Sharpe ratio, better is the fund.
Illustration: Consider two funds A and B. Let return of fund A be 30% and that of fund B be 25%. On the outset,
it appears that fund A has performed better than Fund B. Let us now incorporate the risk factor and find out the
Sharpe ratios for the funds. Let risk of Fund A and Fund B be 11% and 5% respectively. This means that the
standard deviation of returns - or the volatility of returns of Fund A is much higher than that of Fund B.
If risk free rate is assumed to be 8%,
Sharpe ratio for fund A= (30-8)/11=2% and
Sharpe ratio for fund B= (25-8)/5=3.4%
Higher the Sharpe Ratio, better is the fund on a risk adjusted return metric. Hence, our primary judgement based
solely on returns was erroneous. Fund B provides better risk adjusted returns than Fund A and hence is the
preferred investment. Producing healthy returns with low volatility is generally preferred by most investors to
high returns with high volatility. Sharpe ratio is a good tool to use to determine a fund that is suitable to such
investors.
It is widely found that both ratios usually give similar rankings. This is based on the fact that most of the
portfolios are fully diversified. To summarize, we can say that when the fund is not fully diversified, Sharpe
ratio would be a better measure of performance and when the portfolio is fully diversified, Treynor ratio would
better justify the performance of a fund.
(c) Jensens Measure:
Jensen attempts to construct a measure of absolute performance on a risk adjusted basis. This measure is based
on CAPM model. It measures the portfolio managers predictive ability to achieve higher return than expected
for the accepted riskiness. The ability to earn returns through successful prediction of security prices on a
standard measurement. The Jensen measure of the performance of portfolio can be calculated by applying the
following formula:
Rp = Rf + (RMI Rf) x
Where,
Rp = Return on portfolio
RMI = Return on market index
Rf = Risk free rate of return
Portfolio Management
First let's understand the meaning of terms Portfolio and Management.
1. Portfolio is a group of financial assets such as shares, stocks, bonds, debt instruments, mutual funds,
cash equivalents, etc. A portfolio is planned to stabilize the risk of non-performance of various pools of
investment.
2. Management is the organization and coordination of the activities of an enterprise in accordance
with well-defined policies and in achievement of its pre-defined objectives.
Now let's comprehend the meaning of term Portfolio Management.
1. Portfolio Management (PM) guides the investor in a method of selecting the best available
securities that will provide the expected rate of return for any given degree of risk and also to mitigate
(reduce) the risks. It is a strategic decision which is addressed by the top-level managers.
For example, Consider Mr. John has $100,000 and wants to invest his money in the financial market other than
real estate investments. Here, the rational objective of the investor (Mr. John) is to earn a considerable rate of
return with less possible risk.
So, the ideal recommended portfolio for investor Mr. John can be as follows:-
needs to be maintained at the acceptable level by developing a balanced and efficient portfolio. Finally, a good
portfolio of growth stocks often satisfies all objectives of portfolio management.
PASSIVE MANAGEMENT
Passive management is an process is a holding a well diversified portfolio for a long term with the buy
and hold approach. Passive management refers to the investors attempt to construct a portfolio that
resembles the overall market returns. The simplest form of passive management is holding the index
fund that is designed to replicate a good and well defined index of the common stock such as BSE
sensex or NSE nifty. The fund manager buys every stock in the index in exact proportion of the stock
in that index. If reliance industry stock constitutes 5% of the index, the fund also invests 5% in reliance
industry stock.
ACTIVE MANAGMENT
Active management is holding securities based on the forecast about the future. The portfolio
managers vary their cash position or beta of the equity portion of the portfolio based on the
market forecast. The managers may indulge in group rotations. Here, group rotation means
changing the investment in different industries stocks depending on the assessed expectation
regarding their future performance.
Basic rule and regulation for the purchase and sale of securities are provided.
The rules and regulations are rigid and help to overcome human emotion.
The investor can earn higher profits by adopting the plan.
A course of action is formulated according to the investors objectives.
It controls the buying and selling of securities by the investors.
The simplest and most effective formula plan is the rupee cost averaging plan. First, stock are with the good
fundamentals and long term growth prospects should be selected. Such stock price tends to be volatile in the
market and provide maximum benefit from rupee cost averaging. Secondly, the investors should make a regular
commitment of buying shares at regular intervals. Once he makes a commitment, he should purchase the shares
regardless of the stock price, company short term performance and economic factors affecting the stock market.
Advantages
Reduces the average cost per share and improves the possibility of gain over long period.
Takes away the pressure of timing the stock purchase from investors.
Applicable for both falling and rising market.
Disadvantages
Extra transaction cost with small and frequent purchase of shares
This does not indicate when to sell.
There is no indication of appropriate interval between the sales.
It is strictly for buying.
Market
Price
Share
Purchased
Cumulative Market
Investment Value
1
2
3
4
100
90
100
100
10
11
10
9
1000
1990
2990
3980
1000
1890
3100
4400
Unrealized
Profit or
Loss
0
(100)
110
420
Average
cost
Per
share
100
94.76
95
100
the ratio. The conservative investor may like to have more of bond and the aggressive investor, more of
stocks. Once the ratio is fixed, it is maintained as the market moves up and down. As usual, action points
may be may be the investor. It may vary from investor to investor. The advantage of constant ratio plan is
the enthusiasm with which it forces the manager to counter adjust his portfolio cyclically. But this approach
does not eliminate the necessity of selecting individual security.
The limitation of the plan is that the money is shifted from the stocks portion to bond portion. Bond is also a
capital market instrument and responds to market pressures. Bond and share prices may both rise and gall at
the same time, in the downtrend both prices decline and them gain.