SECURITY ANALYSIS AND

PORTFOLIO MANAGEMENT
FACULTY: DR. S. K. CHAUDHURI

1
 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

Instructor: Dr. S K Chaudhuri

Email: skchaudhuri@ipeglobal.com

Course Objectives

The course is designed to provide a perspective on modern portfolio management of financial

assets and derivatives. The students will learn basic tools and techniques of security analysis
and portfolio management and their practical applications including applications based on Excel
spread sheet and other available packages.
In particular, they will be exposed to technical analysis, stock and bond valuation (including
simulation models), portfolio construction (based on no-linear programming techniques), and
portfolio performance evaluation.

Pedagogy

The course will be delivered through lecture, exercises, and available empirical studies. About
one-third of the sessions will be devoted to analysis of real life data in the computer lab, which
will facilitate ‘learning by doing’.
The students will be required to undertake individual assignment on stock analysis and
valuation. This will help develop their analytical skills for empirical research.

Course Contents

See next page

Evaluation

Components Weight (%)

Individual Assignment* 10
Quiz I 5
Quiz II 5
Practical Test I 10
Practical Test II 10
Term-End Examination Written exam: 25
Computer based exam: 35
* No assignment will be accepted for evaluation beyond the scheduled date.

2
Study Materials

The study materials will consist of select papers/exercises. In addition, the students may refer to
the following text books:
1. Fisher and Jordon, Security Analysis and Portfolio Management
2. Zvi Bodie, Alex Kane and Alan J. Marcus, Investments
3. E. J. Elton and M. J. Grubber, Modern Portfolio Theory and Investment Analysis
4. Gordon J. Alexander and William F. Sharpe, Fundamentals of Investments

Course Contents

Sessions 1-8 • Main themes of security analysis and portfolio management

• Return-risk concepts and measurement*
• Securities Market - organisation, operations and emerging trends
(self study)
• Stock market indices and derived series
• Efficient market hypothesis - concepts, evidence and implication

Sessions 9 - 13 • Technical analysis - basic tools and applications*

Sessions 14 - 17 • Investment in equity shares – basic analysis including industry &

company analysis
• Share valuation models (including a simulation model)*

Sessions 18 – 22 • Debt instruments – pricing, yield measurement and yield curves*

• Price-yield relationship - duration and convexity*
• Bond portfolio management*

Sessions 23 – 27 • Modern portfolio theory - Markowitz Model/CAPM/APT

• Construction of optimal portfolios using optimization techniques*
• Estimation of share beta*

Sessions 28 - 30 • Mutual Funds

• Portfolio performance measurement*

* Requires working in comp lab.

3
Individual Assignment (Weight: 10%)

You are required to prepare an analytical report on a corporate stock, which must contain, inter
alia, the following components:
1. Brief industry analysis as a backdrop to appreciate the company’s business performance
2. Brief background of the company
 Products/business portfolio
 Market structure and competitive profile of the company (key factors)
 Future prospects
3. Financial performance analysis
 Analysis of recent trends (3-year) in financial performance (develop an appropriate
format for the purpose)
 Projected financials for next 3-year period
4. Valuation of the stock (use different approaches including simulation model)
5. Technical analysis
6. Investment arguments and recommendations
7. Design a front page to present the executive summary of your report
Mention clearly the sources of all data and information. Also note that cut-paste from available
reports will be penalized heavily. It might even lead to rejection of the report.

4
 INVESTMENT VS SPECULATION
Features Investment Speculation
Return Seeks returns that commensurate with the Seeks abnormal returns without regard for
investment risk including the risk of investment risk
inflation
Risk Limits risk exposure Sets no limit to risk exposure
Time Spans over longer time horizon Operates over a shorter time interval
Process Follows rigours of investment process, Acts on market sentiments and inside
acts on market opportunities, shows information, tries to manipulate prices,
patience of a hunter, involves actual always on run for a killing, does not
delivery of securities involve actual delivery of securities

THE PROCESS OF PORTFOLIO MANAGEMENT

Five logical steps to follow:
1. Setting investment policies in terms of (a) objectives (e.g., “stability of income”,
“growth in income”, “capital appreciation”) and (b) constraints (e.g., “restrictions on
investment”, “diversification constraints”, “liquidity constraints”, “taxation issues”)
2. Performing security analysis, both (a) fundamental analysis and (b) “technical
analysis
3. Portfolio allocations to assets (optimization models) and time-to-time rebalancing
4. Hedging portfolios
5. Evaluation of portfolio performance

TYPES OF INVESTMENT RISK

Total risk = systematic risk (non-diversifiable risk) +

unsystematic risk (diversifiable risk)
Investment risk

Systematic risk Unsystematic risk

Country/political
risk Industry/business
risk
Economy/market
risk Financial risk
Interest rate risk
Liquidity risk
Inflation risk

Exchange risk

5
 CALCULATION OF MONTHLY RETURN FROM DAILY SENSEX DATA
Sensex Return Cumulative
Day pt rt = pt / pt-1 - 1 (1 + rt) Product
0 3244.80
1 3226.10 -0.58% 0.9942 0.9942
2 3190.35 -1.11% 0.9889 0.9832
3 3153.06 -1.17% 0.9883 0.9717
4 3125.88 -0.86% 0.9914 0.9633
5 3154.91 0.93% 1.0093 0.9723 Monthly Return based on Equation 1.3
6 3110.08 -1.42% 0.9858 0.9585 = .9397 - 1 = -0.0603 or -6.03 %
7 3108.24 -0.06% 0.9994 0.9579
8 3084.91 -0.75% 0.9925 0.9507 Monthly Return based on poin-to-point data
9 3121.18 1.18% 1.0118 0.9619 = (3048.72 / 3244.80) - 1 = -0.0604 or -6.04 %
10 3192.93 2.30% 1.0230 0.9840
11 3200.15 0.23% 1.0023 0.9863
12 3218.73 0.58% 1.0058 0.9920
13 3140.36 -2.43% 0.9757 0.9679
14 3140.42 0.00% 1.0000 0.9679
15 3143.58 0.10% 1.0010 0.9689
16 3116.79 -0.85% 0.9915 0.9607
17 3115.44 -0.04% 0.9996 0.9603
18 3048.72 -2.14% 0.9786 0.9397

HISTORICAL RETURNS ON SENSEX

No
Re
Year
1979-80 2
1980-81 33
6
 CUMULATIVE WEALTH

100

Value of Re.1 Investment

Stock (Sensex) Inflation
18.21
GOI-Security 15.33

9.86
10
Gold 6.40
2.97
6.09

4.51

91-Day T-Bills
1
1979-80

2002-03
1980-81
1981-82
1982-83
1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02

2003-04
DESCRIPTIVE STATISTICS OF RETURN DISTRIBUTIONS (1979-80 TO 2003-04)

Arithme
Series Mean

BSE Sensex Day-to-day movement of Sensex and Nifty

19.46%
7
 STOCK PRICE INDEX
 S&P CNX Nifty (NSE Futures Index)
• Comprises of 50 stocks
• Selection criteria:
– Market capitalization: each share with market capitalization of Rs.5 bn
(US$111m) or more
– Liquidity: each share should have traded 85% of trading days at an
impact cost of less than 1.5%
– Impact cost: percentage mark up suffered while buying/selling a desired
quantity of the share compared to its ideal price, which is the average of
best bid and best ask price
 Example: Order book (of a broker)

Bid (Buy) Ask (Sell)

Qty. Price (Rs.) Qty. Price (Rs.)

1000 98.00 1000 99.00 Calculate Impact cost to buy 1500 share
2000 97.00 1500 100.00
1000 96.00 1000 101.00 Ideal Price
= (99+98)/2 = Rs.98.50
Actual Buy Price = (1000 * 99 + 500*100) / 1500 = Rs.99.33
Impact cost = {(99.33 – 98.50) / 98.50} * 100 = 0.84%
Buy price for an investor is the selling price of a broker.

 Shares bear a weight in the index in proportion of their market capitalization

 Example:
Base Period Index = 1.000 x 1000 = 1000

Share Price (Rs.) Issue Size Capitalization Weight

A 20.00 4,000 80,000 0.098
B 60.00 5,000 3,00,000 0.366
C 145.00 2,000 2,90,000 0.354
D 15.00 10,000 1,50,000 0.0183
Total 8,20,000 1.000

Current Period Market Capitalization (only prices changed) = Rs.8,80,000

Current Index = (Current capitalization / Base capitalization) * 1000
= 1.073 x 1000
= 1073
 (Index Maintenance replacement of shares) – index should remain constant

8
 It = (Mt / M0) x I0
M0 = Mt x (I0 / It)
∆ M0 = ∆ Mt x (I0 / It)
M'0 (New Base Capitalization) = M0 + ∆ M0
= M0 + ∆ Mt x (I0 / It)
Example:
On 5 April

M0 = Rs. 1,95,000 crores and

Mt = Rs.1,97,500 crores
It = (Mt / M0) x I0 = (1,97,500/1,95,000) x1000 = 1012.8205

Scrip A with capitalization of Rs.1000 crores being replaced by Scrip B with

capitalization of Rs.900 crores

M'0 (New Base Capitalization) = M0 + ∆ Mt x (I0 / It)

= 1,95,000 + (900 – 1000) x (1000 / 1012.8205)
= Rs.1,94,901 crores
Mt = 1,97,500 – 100 = 1,97,400
It = (1,97,400 / 1,94,901) x 1000 = 1012.82

 S&P CNX Nifty

• Base period selected: close prices of Nifty shares on 03 Nov. 1995
(Date marks the completion of one year of operations of NSE)
• Hedging Effectiveness: Exhaustive calculations have been carried out to
determine the hedging effectiveness of the 50-security index against numerous
randomly chosen equally-weighted portfolios of different sizes varying from 1 to
100 of smallcap, madcap and largecap companies as well as many industry
indices/sub-indices provided by CMIE. It was observed that R2 for various
portfolios and indices using monthly returns data on the NSE-50 vis-à-vis other
indices was significantly higher indicating that the NSE-50 had higher hedging
effectiveness

9
 EFFICIENT MARKET HYPOTHESIS

 EMH states that:

• Security prices incorporate all past/new information in a rapid and unbiased
manner
• Investors will not be able to systematically outperform the market by following
conventional approaches (like using chart/trend analysis or searching for
‘mispriced’ securities
• Refers to only informational efficiency
 Three forms of EMH
Information associated with different forms of EMH

All available information

including private information

All public information

All public information
Past price &
Past price & volume
Past price & volume
volume information
information
information

Weak form of Semi-strong form of Strong form of

market efficiency market efficiency market efficiency

• Weak form:
– successive price movements are independent
– also known as Random Walk Hypothesis
– common testable form of random walk model
lnPt = lnPt-1 + et where E(et) = 0 & cov. (et, et – s) = 0 for all s = 0
or, ln (Pt/Pt-1) = et
– model considers only the linear independence - meaning thereby that
investors immediately react to new information, investors do not react in a
cumulative fashion to a series of events
– stock process follows Brownian motion
• Semi-strong form: security prices reflect fully all publicly available information –
not possible to consistently outperform market by analysing published data
• Strong form: security prices not only reflect fully the published information but
also privileged information – even insiders cannot consistently beat the market
 Traditional Tests of RWH
• Serial Correlation test
• Runs test
• Filter test

10
 MARKET ANOMALIES

The portfolios consisting of stocks with low price-earnings

P/E effect
Small-firm effect
Neglected-firm effect
January effect
Week-of-the-month effect
Day-of-the-week effect
ratios have a higher average return than portfolios with higher
price-earnings ratios.
The risk-adjusted returns of small size (or small capitalisation)
firms tend to exceed the returns of large size (or, large cap)
stocks; that is returns tend to diminish as the size of the firm
rises.
The stocks of small firms that are neglected by institutional
investors (mutual funds, insurance companies, pension funds,
etc.) tend to generate higher returns than stocks of those firms
in which the institutional investors put money.
Mean monthly return in January exceeds the mean returns of
the other months.
Positive market advances occur in the first part of the month
and almost never in the second half
Stocks do poorer on Monday than any other days.

Daily returns on Sensex for different week days (June 1998 – January 1991)
Monday Tuesday Wednesday Thursday Friday
Mean -0.114 -0.170 -0.029 0.110 0.175
% Days Positive 45.6 45.2 48.5 52.6 50.6
Standard Dev. 0.176 0.145 0.113 0.126 0.131
Kurtosis 6.1 5.8 3.9 12.4 3.6
Skewness 0.941 -0.114 -0.511 1.892 0.227
H (KRUSKAL – WALLIS) = 10.57

Correlations between returns of different days (June 1988 – January 1991)

Monday Tuesday Wednesday Thursday Friday

Monday -

Tuesday .152 -

Wednesday .420 .073 -

Thursday .050 .103 .530 -

Friday .174 .501 .013 .239 -

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 TECHNICAL ANALYSIS
Dow Theory

Dow was a member of NYSE between 1885 and 1891 and during this tenure he formulated
what is now knows as Dow theory. This theory is less popular today, but its basic principles
underlie the contemporary approaches to technical analysis. Dow formulated six basic principles
as follows: (1) average prices discount everything; (2) market moves in trends – primary,
secondary and minor trends; (3) major trends have three phases – accumulation, up-trend
through corrections or pullbacks, and peak; (4) averages (railroad/transportation average and
industrial average) must confirm each other; (5) volume must confirm the trend; and (6) a trend
remains in effect until signals confirm reversal. These principles are briefly discussed below.
The essence of Dow theory is that prices subsume every aspect of trading, and that three types
of trend are always at work in the market place. The primary trend, which may last a year or
more, is commonly known as bullish or bearish trend. This reflects the long run direction of the
market. However, the market can depart from its primary direction for limited periods of time,
say from a few weeks to a few months. These departures are secondary reactions or trends.
The minor trends are short-term price fluctuations and are often of no real importance.
Every trend builds on phases. During initial phase of accumulation, prices move sideways and
buying of securities remain at low ebb. As more investors begin to participate based on analysis
and market news, the second phase begins with an uptrend. Even though the trend is up,
security prices zigzag reflecting market corrections and pullbacks. After the price movement
reaches its peak, another period of accumulation begins when more investors participate since
market news become more widely available. This third phase culminates in a downtrend and
price movements return to a period accumulation.
Dow theory also provides signals for changes in the market trends. If one of the averages –
transportation average and industrial average – departs from the primary trend, the price
movement is viewed as secondary. However, if departure in one is followed by a departure in
the other, then this is taken as a confirmation that the primary trend has changed. The trend
reversals are further confirmed by increased volume of trading in the direction of the trend.
It may be noted here that Dow principles are never intended to indicate which specific stocks to
buy or sell, they are meant for identifying the market trends only. As a matter of fact, Dow theory
cannot even predict exact beginnings and reversals of trends. Nor can charting the activity
predict the exact duration and extent of trends. Despite these limitations, however, the Dow
theory has been used to give 40 correct signals in the period 1897 – 1991. During this period,
only five incorrect signals were given.

Elliott’s wave theory

Ralph Nelson Elliott studied the events in numerous Dow major trends and devised his wave
theory to help explain why and where certain chart patterns develop and what they signalled.
Beginning with Dow’s original three phases of a trend, he considered a repetitive rhythm of five
waves advancing (bullish) and three waves declining (bearish) as shown in the figure.
Elliott’s wave theory suggests that bullish trend forms through a five-wave movement
comprising of: (i) an advancing phase with peaks 1, 3 and 5, which are called impulsive waves;
and (ii) troughs at 2 and 4, which are termed as corrective waves. Apparently, two corrective
interruptions or waves are a prerequisite for overall directional movement to occur. Once the

12
five-wave movement is complete, the market moves into bearish trend through corrective
movements a, b and c.
Elliott’s wave

The wave structure in practice is not as simple as depicted in Fig. There are many complex
structures of Elliott waves.

Support and resistance

Support is the price level where buying interest is strong enough to overcome selling pressure.
The result is that the market does not fall below that level. Resistance is the opposite of support
and represents the price level that resists market price action for a period of time. It is the level

x/y = 0.61
where selling interest is strong enough to overcome buying pressure so the market does not
exceed that level.
Role reversal of support and resistance

Resistance Satyam (weekly chart) Nov 2000 - Jan 2003

Support level broken-

line becomes resistance
in the next phase Resistance

y/x =1.618
Support

Support

13
The effect of support and resistance can be seen in all time frames, with the longer term
(weekly) charts showing more solid support or resistance than the shorter term charts. As a
basic premise, once a resistance level has developed, it will continue to provide resistance.
Similarly, once support has been established, it will continue to provide support. However, once
these levels are breached, their roles are reversed. That is, once resistance is breached, it will
subsequently provide support; once support is breached, it will provide resistance. Figure 5.9
explains support and resistance role reversals.

Trend Lines

Panels (a) and (b) in the Figure show downtrend and uptrend channels respectively. Another
type of channel formation is sideways move. Panel (c) in the figure depicts such a channel. The
sideways trend is generally an indication of a temporary pause in the prevailing trend. Longer a
market moves sideways, which is not the case shown in panel (c) in the figure, the more energy
it tends to store up. We, therefore, need to analyse sideways moves carefully.
Trend lines and some continuation patterns

(d)

(e)

(a)

(b)
(c)

Continuation patterns occur during periods of consolidation when prices are moving sideways
following an up or down trend. The patterns are not always easy to recognise and do not always
have the regular shapes as will be described now. Continuation patters have names based on
geometric shapes such as: (a) triangles; (b) rectangles; (c) flags and pennants; (d) wedges; and
(e) rounding bottoms/tops. The names pretty well describe how the formations look like.
Market players use continuation patterns to determine a target price for their trading strategy.
This target price is the level they expect the market to reach following breakout of the
consolidation and resumption of the continuation trend. We would not get into details of target
price calculations, but certainly endeavour understanding different patterns.

14
 Head and shoulders
MTNL(dailychart) Feb- Oct 2003 Head
Right shoulder
Left shoulder

H
RS
LS
Neckline

Neckline

The first or the left shoulder represents the penultimate advance in the bull market to reach a
head, and the second or the right shoulder is, in effect, the first bear market rally. Trading
volume is normally heaviest during the formation of left shoulder and head. The traders often
stretch to see a head and shoulders pattern but the real tip-off that such a pattern is developing
comes with the formation of the right shoulder, which is invariably accompanied by distinctly
lower volume.
The line joining the bottoms of the two shoulders is called the neckline. The breaking of a
neckline tends to provide a good indication the market will follow through in the direction of the
break out. In the above, as prices move down from the right shoulder and penetrate below the
neckline we get a strong indication that prices will now trend downwards. Thus, breaking of
neckline is generally a signal to sell. Some analysts measure the distance from the top of the
head to the neckline and project that the bottom will be the same distance below the neckline.
We also find formation of head and shoulders in down trends. Such formation is called inverse
head and shoulders.
Inverse head and shoulder

Hero Honda (weekly chart) Oct 2001 - Oct 2003

Neckline

Right shoulder
Left shoulder

Head

15
 Simple & Exponential Moving Average

A
1
2 Day
•
•
3 04/01/2003
Buy and sell signals: We get buy signals when any of the following occurs:
The price line moves up through MA, which itself is rising.
The price line moves down towards MA, fails to go through, and then bounces off as it

4 04/02/2003
touches MA. This could be a strong bullish indicator.
• The price line temporarily falls through MA, which itself is rising, and then bounces back
through it. This is often a strong buy signal.
The sell signals work in exactly the same way as buy signals but in reverse. Thus, we get sell
signals when any of the following occurs:
•

5
The price line moves down through MA, which itself is falling.
•

• 04/03/2003
The price line moves up towards MA, fails to go through, and then bounces off as it
touches MA. This could be a strong bearish indicator.
The price line temporarily rises through MA, which itself is falling, and then bounces
back through it. This is often a strong sell signal.
However, close observations of any price and MA chart will usually reveal a number of whipsaw

6 04/04/2003
or false signals.

16
 Moving averages on a daily chart for SBI stock

700
In general, 10-day and 30-day moving averages are applied for short-term trend analysis; and
for intermediate period, it is quite common to use 100-day (20 week) or 200-day (40-week)

650
moving average.
SBI stock entered into correction phase after attaining the peak (at Rs 674.50) it received both
support and resistance from 10-day and 30-day MAs. Another interesting point to note is that
100-day MA has so far provided support to SBI stock whenever price reactions moved
southward in the uptrend. Usually, when price line crossovers longer moving average, such as
100-day MA or 200-day MA, it indicates a change in the major trend. Since southward stock

600
price movement of SBI has not yet crossed 100-day MA, we do not expect a major bearish
trend to set in; rather, the stock is likely to gain when the market rises.
Use of two moving averages
• When shorter and longer MAs crossover and both point upward, with shorter MA rising

• Daily clos
above longer MA from below, then this a strong buy indicator, known as golden cross.

550
Similarly, when shorter and longer MAs crossover and both point downward, with shorter
MA falling below longer MA from above, then this is a strong sell indicator, known as
dead cross.

17

500
 Computation of MACD and signal line

A B
1
2 Day Sl.
3 08/12/2003 1
4 08/13/2003 2

5 08/14/2003 3
6 08/18/2003
MACD shows the difference between two exponential moving averages, one with short and the
other one with long time intervals. Though 12-day and 25-day EMAs are commonly used, any
other combination of time intervals may be used in the calculation of MACD.
Since MACD represents the absolute difference between two EMAs and, therefore, could be
4
7
either positive, negative or zero values. The zero line, also known as equilibrium line, shows the

08/19/2003 5
complete convergence of the two EMAs and, thus, lies at the centre of the chart. On the other

18
hand, MACD line with positive or negative values reflects divergence between the two EMAs
and, hence, it oscillates above and below the zero line.
A positive, rising momentum indicates that the price is not only rising but that it is also
accelerating. This is bullish and indicates that the prices are ensconced in a strong up trend. A
falling MACD in the positive area, however, indicates that the price trend is still rising but at a
decelerating rate. It is during this phase that momentum warns us that prices are ready to fall.
A negative, falling momentum value indicates that the price trend is not only falling but that it is
falling at a faster rate. This reflects a strong bearish trend. A rising momentum in the negative
area indicates that the price trend is still falling but at a decelerating rate. It is during this phase
that momentum tells us that prices are ready to rise.
MACD is also used to determine buy/sell signals. For that purpose, a second line, designated as
slow MACD or signal line, is commonly displayed in the chart. This line is an exponential moving
average of MACD values. The 9-day EMA is often used as signal line. We get buy signal when
the fast MACD line crosses from below to above the signal line and when both have negative
values. Similarly, we get sell signal when the fast MACD line crosses from above to below the
signal line and when both have positive values.
MACD on a daily chart

HDFC
(Oct. 2003 - March
It can be seen from Fig. 5.24 that HDFC stock is currently in the negative territory and has come
into buy mode. The crossover of MACD and 9-day EMA (signal line) gives this buy signal.

Price lin
19
 Computation of ROC

A
1
2 Date S
3 09/07/2001
When ROC is above the equilibrium line (i.e., 100) and rising, it indicates a bullish trend. In case
ROC starts falling while still in the area above the 100 line (i.e., in the positive area), it indicates
that market is advancing but more slowly than before. Similar kind of interpretations applies in
reverse when ROC is below the equilibrium line and reflects bullish trend.

4 09/14/2001
5 09/21/2001
6 09/28/2001
Rs 275
7 10/05/2001
The current position of the stock in the figure shows a sign of possible revival because prices

300
has crossed 20-week moving average; so long this moving average has acted as a resistance
line. Besides, the 12-week ROC that has so long hovered around the equilibrium line has now
moved into positive zone after showing positive divergence.

20

8
250 10/12/2001
 Overbought/oversold lines in ROC chart
SBI
(May2003 - March 2004)
140

130 Overbought line

120 12-day ROC

110

100

90 Oversold line

80

70

Relative Strength Index

A B C D
1 Price
2 Date Sl. no. close (Rs) clo
3 04/09/2003 0 231.31
4 04/10/2003 1 232.16 232
5 04/11/2003 2 234.66 234
6 04/15/2003 3 228.50 0.
7 04/16/2003 4 226.95 0.
8 04/17/2003 5 231.35 231
9 04/21/2003 6 234.70 234
J. Welles Wilder, Jr. introduced the most commonly known momentum indicator, namely relative
strength index (RSI). RSI formula is so designed that its absolute value ranges between 0 and

10 04/22/2003 7 233.00
21 0.
11 04/23/2003 8 233.10 233
100. As a thumb rule, when RSI goes above70/80 the underlying stock is considered
overbought and one would expect a downturn soon. Similarly, when RSI goes below 30/20 the
underlying stock is labeled as oversold and one would expect prices to move up. There is
nothing sacrosanct about this 70-30 or 80-20 rule; typical stock overbought or oversold lines
may appear at different values. In the BPCL chart shown in the figure, the 70-30 rule for defining
overbought and oversold zones seem to have worked.
RSI in daily chart

400

350 Pr

300

250 22
 Computation of William’s %R

A B
C D
1 Daily pric
2 Date Sl. no. High Low
3 26-Dec-03 1 377.45 363.0
4 29-Dec-03 2 384.90 378.0
5 30-Dec-03 3 396.00 372.0
6 31-Dec-03 4 390.90 375.2
7 01-Jan-04 5 397.70 390.5
8 02-Jan-04 6
Williams %R in daily chart
397.00 392.0
9 05-Jan-04 7 402.00 388.0
10 06-Jan-04 8 397.00 387.2
11 525
07-Jan-04 9 392.00 381.2
12 08-Jan-04 10 406.00 392.1
13 09-Jan-04 11 426.00 404.2
14
500
12-Jan-04 12 425.00 390.0
15 13-Jan-04 13 432.00 406.0
16
475
14-Jan-04 14 Price c
23

440.00 431.0
Putting the indicators together
It is now appropriate to undertake an integrated technical analysis putting all the indicators
together that we have learnt so far1. For that purpose, we consider the recent movement of BSE
Sensex. All the technical charts, both daily and weekly, are summarised in the figures.
EMA and MACD for Sensex

EMA
(1 October
6500
Daily price chart clearly shows that Sensex has broken the support level (ranging from 5,568 to

10-da
5,621) giving a strong bearish signal. The signal is strong because the price line has not only
penetrated the short-term moving average (10-day EMA) but has just crossed long-term moving
averages (10-week and 20-week EMAs). It appears that the bulls are on the back-foot and
Sensex would continue to stay under pressure. The support line that Sensex has just broken is

6000
going to become a tough resistance line.
On the momentum charts, the indicators are now showing weakness. MACD on daily chart is
moving southward in the negative territory reflecting sell mode. Though the long-term MACD is
still in the positive zone, it has started showing weakness with its southward movement and
thereby confirms sell mode.
The 12-day ROC has given a bearish signal. It is currently placed in the negative territory and
moving southward after repeated failures to crossover the equilibrium line into positive territory.

5500 Price
The long-term ROC is also showing similar kind of weakness. The 12-week ROC has already
moved into negative territory and the 5-week has followed the suit after a few failed attempts to
crossover to positive zone.
The 14-day RSI is placed near the oversold territory but is still far from giving a buy signal. The
14-week RSI, however, continues to be in sell mode as it moves southward in the equilibrium
territory. Both the 14-day and 14-week Williams %R are currently reflecting oversold position but
have not yet given buy signals.

5000
The analysis presented here is based on one of the regular technical items of Economic Times.

24
On the whole, Sensex is likely to stay under pressure for some more time before it tries to make
an attempt to move upward in a range.
ROC, RSI and Williams %R for Sensex

1
(1 October
120
115
110
105
100
95 25

90
 POPULAR STOCK SELECTION MODELS

 Stock selection attributes

Sales-to-Price Ratio= sales per share / price per share
Dividend Yield = dividend per share / price per share
Earnings Yield = earnings per share / price per share
Book Value-to-Price Ratio= book value per share / price per share
Free Cash Flow Ratio = (cashflow / share- capex/share) / price per share
Cash Flow-to-Capex Ratio = (cash flow/capex) / price per share
 Rank stocks on each attribute and then determine combined rank order of individual stocks
 Stock may be combined into portfolios based on combined rank order (e.g. top-ranked stocks
may form the most "attractive" portfolios)
 Does Model Indexation provide a useful alternative to select and manage portfolios?
(Ref: Allan Twark & James P D'Mello, "Model Indexation: A Portfolio Management Tool",
Journal of Portfolio Management, 1991)

 Dividend Discount Model (DDM)

Constant dividend growth model (Contd.)

If k >g and n →∞ (perpetuity), xn+1 → 0
P = D0x / (1 – x)
P = D0 (1 + g) / (k – g) = D1 / (k – g)
Discount rate may be estimated using CAPM
k = rf + β (rm – rf)
Growth rate may be estimated using the following relationship:
g = (1 – b) x ROE, where b = payout ratio, ROE = return on equity capital

 A simulation model

One-period investment horizon

P = {D1 + EPS x (P/E)} / (1 + k)
EPS = {S0 (1 + g) x M} / N
Assign probability to five variable: D, g, M, N, P/E
(Use relevant probability distribution)
Carryout large no. of trials – estimate mean, std. Deviation and confidence limit

26
SHARE VALUATION -
HLL
Currennt Income (Rs.

Sales Growth Rate

Randcumulative
RiskSim 2.40 Tryout for Evaluation - Cumulative Chart
1.0
0.9
0.8
0.7
0.6
0.5
0.4
0.3
be
ro
yP m
C
u
la
tiv

0.2
0.1
0.0
90.00 100.00 110.00 120.00 130.00 140.00 150.00 160.00 170.00

Output

27
 BOND PRICING FUNCTIONS IN EXCEL

2 BOND PRICE
3
Day Count Basis: "30/360" = 0; "Actual/Actual" = 1; "Actual/360" = 2; "Actual/365" = 3; "European 30/360" = 4

Bond pricing at spot rates

4 Settlement
A
51 6.65%Maturity
GOI 2
62 An
Settlement
73
Bond yield function in Excel

Coupon r
84 Redemption
Basis v
9520 BOND YIELD
Frequ 28
29
 Price-Yield Relationship - An Illustration

As on 6 August, 2002
10.25% GOI 11.19%
Required Change in
2021 GOI 2005
Basis
Yield Points Price % Change Price % Change
7.0 -300 135.5660 30.41% 116.6245 7.55%
7.5 -250 129.3494 24.43% 115.2045 6.24%
8.0 -200 123.5529 18.86% 113.8073 4.95%
8.5 -150 118.1438 13.65% 112.4326 3.68%
9.0 -100 113.0918 8.79% 111.0798 2.44%
9.5 -50 108.3695 4.25% 109.7486 1.21%
9.9 -10 104.8120 0.83% 108.6989 0.24%
10.0 0.00 103.9516 0.00% 108.4385 0.00%
10.1 10 103.1025 -0.82% 108.1790 -0.24%
10.5 50 99.8149 -3.98% 107.1493 -1.19%
11.0 100 95.9383 -7.71% 105.8804 -2.36%
11.5 150 92.3022 -11.21% 104.6316 -3.51%
12.0 200 88.8887 -14.49% 103.4025 -4.64%
12.5 250 85.6815 -17.58% 102.1926 -5.76%
13.0 300 82.6655 -20.48% 101.0016 -6.86%

Price - Yield Relationship

(As on 6 August, 2002)

140
130
120
110
100
(R
se P
ric

90
.)

80
70
6% 8% 10% 12% 14%
Required Yield

30
 PRICE VOLATILITY OF BONDS: DURATION AND CONVEXITY

 Price volatility depends on duration and convexity

P = f (y) , y = YTM (discount rate)

dp 1d P 2
1 d 3p 3
.dy + .( dy ) + .(dy) + .....
2
dp = (Taylor series)
dy 2 dy 2
6 dy 3

 dp 1  1 d p 1
2

dp/p =  .  . (dy) +  .  . (dy) 2

(considering only two terms)
 dy p  2  dy p 2

Duration
Convexityy

 Duration – weighted average term-to-maturity of a bond’s cashflows

n Ct dp 1 n t.C t
p= ∑ − ∑
t =1 (1+ y)t +
dy (1 y ) t
t =1 (1+ y)
 
dp . 1 = - 1  n t.C t x 1  = - 1 .D = - D *
dy p (1 + y)  ∑ (1+ y) t p  (1 + y)
t =1 
Where D = Macauly Duration , D* = Modified Duration
dp/p = - D*. dy = approximate percentage change in bonds price

 Convexity : measures rate of change of duration as yield changes

n
n C ∑ (-t).C t
p = ∑ t dp t =1
=
t =1 (1 + y) t dy (1 + y) t +1
n
∑ t (t +1)C t
d p t =1
2

=
dy (1 + y) t +2
2

d 2P 1
Convexity = 2 . p
dy
 2 
dp/p(due to convexity) = 0.5 x  d P2 . 1  . (dy) 2
 dy
 P 
31
 Immunization of bond portfolio

Principle of immunization:
∑ w i Di = ∑w D
,A i i, L

 Efficient frontier of bond portfolios

• Application of Excel Solver

• Illustration

32
Exhibit 2: Calculatio

11.19% GOI 2005

Exhibit 3: Calculatio
Cash
Period Flows
11.19% GOI 2005 (Rs.)
(1) (2)
0.03 5.595
Cash
1.03 Flows5.595
Period (Rs.)
2.03(t) 5.595
(CF)
3.03
(1) 5.595
33

(2)
 PORTFOLIO SELECTION AND DIVERSIFICATION

Return and risk measures for select stocks

A B
1 Monthly Return D
Month
2 Ending
Calculation of risk and return of four-asset portfolio
HD
3 29-Sep-00
A -0.1
4
1 31-Oct-00 0.0
Variance - Covaria
5
2 30-Nov-00 0.1
6
3 29-Dec-00
HDFC 0.0 34
 Variance-covariance matrix for four-asset portfolio

A
1 Monthly - Return
2 Month Ending
3 29-Sep-00
4 31-Oct-00
Figure 1: Diversification of Portfolio Risk

5
Figure 1: Indifference Curves For Risk-

30-Nov-00
TotalRis k(σ p )
Averse Investors

I3
Re turn( rp )

I2

6
I1

Diversifiable
Risk
29-Dec-00
7
Non-Diversifiable

31-Jan-01
Risk

Ris k (σ p )
Number of Assets (n)

8 28-Feb-01
35
 Figure 2: Indifference Curves For Risk-
Seeking and Risk-Neutral Investors
Return ( rp )

Risk-Neutral
I3 '
I2 '

I1 '

I3

I2

Risk-Seeking I1

Risk (σ p )

Figure 3: Efficient Frontier and Selection of

Optimal Risky Portfolio
Return ( rp )
I4 I3 I2
I1
F
H

Optimal Risky
Portfolio
E

Global-Minimum
Variance Portfolio
G

Risk (σ p )

36
Efficient portfolio for a target return (no short sales)

A
1
2 Variance - Cova
3
4 HDFC
5 L&T
6 Dr. Reddy's
7 Nestle
8 37
Efficient portfolio for a target return (with short sales)

A
1
2 Variance - Cova
3
4 HDFC
5 L&T
6 Dr. Reddy's
7 Nestle
8
38
Global minimum-variance portfolio (no short sales)

A
2 Variance - Covar
3
4 HDFC
5 L&T
6 Dr. Reddy's
7 Nestle
8
9
39

Port-Weights (
Efficient portfolio for a given risk level (no short sales)

A
1 Eff
2 Variance - Covar
3
4 HDFC
5 L&T
6 Dr. Reddy's
7 Nestle
8
40
Efficient portfolio to maximize return-to-risk ratio (no short sales)

A
2 Variance - Covar
3
4 HDFC
5 L&T
6 Dr. Reddy's
7 Nestle
8
41

9 Port-Weights (
Efficient portfolio to maximize return-to-risk ratio (with short sales)

A
2 Variance - Covar
3
4 HDFC
5 L&T
6 Dr. Reddy's
7 Nestle
8
9
42

Port-Weights (
 Figure 1

Return(rp )
Composition of tangency portfolio

A B
1 Variance - Covariance
2
3 HDFC
4 L&T
5 Dr. Reddy's
r 43

t
44
 BETA ESTIMATION

A B
1 Sl. Month
2 No. Ending S
3 1 31-Jan-00
4 2 29-Feb-00
5 3 31-Mar-00
6 4 28-Apr-00
7 5 31-May-00
8 6 30-Jun-00
9 7 31-Jul-00
10 8 31-Aug-00
45
 Regression analysis to estimate beta

A
1 Month
2 Ending S&
3 31-Jan-00
4 29-Feb-00
5 31-Mar-00
6 28-Apr-00
7 31-May-00
8 30-Jun-00
9 31-Jul-00
10 31-Aug-00
11 29-Sep-00 46

12 31-Oct-00
 RISK-ADJUSTED PERFORMANCE MEASURES

♦ Sharpe’s Measure: (rp - r ) / σp (reward to volatility trade-off)

f
♦ Treynor’s Measure: (rp - r ) / βp (systematic risk instead of total risk)
f
♦ Jensen’s Measure: αp = r p - [rf +βp (rm - r )] (portfolio return compared to
f
CAPM based return)
αp > 0 abnormal gain

αp < 0 abnormal loss

αp = 0 average performance

♦ Appraisal Ratio : α p / σ (e p ) (abnormal return per unit of non-systematic risk)

47
Performance Eval

Table 1: Sharpe's, T

Sl. R
No. Month
1 Jan-00
2 Feb-00
3 Mar-00
4 Apr-00 48