Security Analysis and Portfolio Management

INTRODUCTION LECTURE

BIRLA INSTITUTE OF TECHNOLOGY AND SCIENCE, PILANI-HYD INSTRUCTION DIVISION FIRST SEMESTER 2012-2013 Course Handout Part II
In addition to part -I (General Handout for all courses appended to the time table) this portion gives further specific details regarding the course. Course No. : ECON C412 Course Title : Security Analysis & Portfolio Management Instructor-in-charge : Dr. Hussain Yaganti , Email: hussain@bits-hyderabad.ac.in Mr Kodali Sivarama Krishna 1. Scope and Objective of the Course: The objective and focus of the course is to give an insight into evaluation and analysis of a wide range of financial securities and thereby developing techniques for designing an optimal portfolio. The main emphasis of the course is to impart an understanding of the methods and techniques of Risk Quantification, Security Valuation, Fundamental Analysis, and Technical Analysis required for security selection for designing an optimal portfolio. 2. Text book: 1. Reilly Frank K and Keith C. Brown, Investment Analysis and Portfolio Management, , 8th edition Thomson Learning, 2008 2. Chandra Prasanna, , Investment Analysis and Portfolio Management ,Tata McGraw Hill , New Delhi 3. Reference books: 1.D.E. Fisher and R.J. Jordan - Security Analysis and Portfolio Management, Prentice-Hall, 6th Edition. 2.J.C. Francis, Investments: Analysis and management, 5 th Ed., 1991, McGraw Hill, Singapore 3. M.Ranganatham & R. Madhumathi: Investment Analysis & Portfolio Management, Pearson Education

TOPICS TO BE COVERED/ LECTURE PLAN

Exposure to investment climate, different kinds of securities, security markets. Investment, speculation, securities and its various types, security markets. Learning about basic primary market operations. Learning basic stock market operations. Types of orders, trading mechanism, common stock exchange problems, margin trading. Understanding risk return characteristics of securities. Types of risks and returns, measurement of Beta. Exposure to Fundamental Analysis technique of Security valuation. Economy, Industry & Company Analysis

 Learning Technical Analysis. Basic features, patterns and parameters Learning Efficient Market Theory. Various forms of Market efficiencystrong, semi strong & weak. Exposure to Bond valuation. Bond Analysis & Bond management. Bond Strategies, Duration, Immunization etc. Understanding intricacies of portfolio mgt. Markowitz model, Sharpes Single Index model, Capital Asset Pricing model Learning about financial derivatives. Options, Futures, swaps, warrants, derivative strategies, Black Scholes model for Option Pricing EVALUATION SCHEME: TEST I TEST II TEST III OR SURPRISE QUIZ COMPREHENSIVE EXAMINATION

After completing this course the students shall be able to: A/ Appreciate and apply the concepts of Investment analysis in theory as well as in a real-life situation.

B/ Identify numerous investments related risks that an investor is subject to while investing in financial securities.
C/ Differentiate between various classes of financial securities such as Equities, Fixed Income Securities and learn various techniques to value and analyze these securities. D/ Carry out Fundamental Analysis (that involves Economy Analysis, Industry Analysis and Company Analysis) to study the intrinsic strength of a firm and make investment decisions based on the study. E/ Analyze and interpret various technical charts related to stock price movements and predict future price movements to comment on Buy/Sell/Hold decisions. F/ Understand the mechanics of Derivatives trading and develop various strategies for hedging or speculation using derivatives.

What do we do with the money?

When do you consume? When do you save? How do you save?
At a secure place(home) Banking

Consume

Saving

Investment is commitment of funds made in expectation of positive return Investing is risky but saving is not
Investment

Three Reasons for Investing

Why invest ???
People invest to supplement their income earn capital gains Appreciation refers to an increase in the value of an investment. experience the excitement of the investment process

Defining an Investment
An investment is a commitment of funds made in expectation of some positive rate of return:
Criteria used to determine whether an investment of money is investing or something else, including:

Is it short-term or long-term? Is it productive or unproductive? Is it legal or illegal? Is it rational or irrational

Investment objectives
Current income not sufficient
Capital Appreciation

Excitement of being a trader

Who Invests: Individuals , companies, banks , trader, Institutional investors , government

Investment Vs Speculation
Time Horizon
Motive Information

Gambling vs. Speculating

Gambling occurs when Outcome is determined very quickly (a roll of the dice, for instance) A source of entertainment Outcome is not based on an economic endeavor, but, rather, random outcomes Creates risk without expectation of economic benefit Speculation occurs when An asset is purchased with hope that price will rise rapidly, leading to quick profit Not based on random outcomes Example: Buying an IPO of a stock on the first day hoping to sell it in several days at a higher price

INVESTMENT VS. SPECULATION INVESTOR

PLANNING HORIZON RISK DISPOSITION RETURN EXPECTATION BASIS FOR DECISIONS

SPECULATOR

LONG MODERATE MODEST FUNDAMENTAL

SHORT HIGH HIGH TECHNICAL

LEVERAGE

NO

HIGH

Investment Alternatives
Assets are things that people own.

Financial assets have a corresponding liability, while real assets do not. Assets
Financial Assets e.g. bond, stock Real Assets e.g. land

Security
What is a Security? What is Security Analysis? - Risk - Return Analysis What is a Portfolio?

 The standard definition of a security is: "A legal contract representing the right to receive future benefits under a stated set of conditions" The piece of paper defining the property rights held by the owner is the security

Investment categories
Investment
Real Financial

Debt Instruments
Real Estate, Jewelry, Automobiles and other tangibles

Equities

Investment Companies Derivatives

INVESTMENT ALTERNATIVES
Investment Avenues Nonmarketable Financial Assets Bonds

Equity Shares

Money Market Instruments

Mutual Fund Schemes Real Estate

Life Insurance Policies Precious Objects

Financial Derivatives

Investment Alternatives
There are three broad categories of securities. Securities Equity Securities e.g. common stock Fixed Income Securities e.g. bonds, preferred stock Derivative Assets e.g. futures, options

Approach to Investment Analysis

Economic Analysis Industry Analysis Company Analysis
Studying price movements Forecasting methods Charting

Fundamental Analysis Technical Analysis

Portfolio
A portfolio is a combination of different investment assets mixed and matched for the purpose of achieving an investor's goal(s) Eg: real items such as art and real estate, to equities, fixed-income instruments and their cash and equivalents.

Diversification

Dont put all your eggs in one basket

Criteria For Evaluation RETURN RISK LIQUIDITY TAX SHELTER

CONVENIENCE

EVALUATION OF VARIOUS INVESTMENT AVENUES

Return Current yield Capital appreciation Equity Shares Nonconvertible Debentures Equity Schemes Debt Schemes Bank Deposits Public Provident Fund Life Insurance Policies Residential House Gold and Silver Low High Low Moderate Moderate Nil High Negligible High Low Nil Moderate Risk High Low High Low Negligible Nil Marketability/ Liquidity Fairly high Average High High High Average Tax Shelter High Nil High No tax on dividends Nil Section 80 C benefit Section 80 C benefit High Nil Convenience High High Very high Very high Very high Very high

Nil Moderate Nil

Moderate Moderate Moderate

Nil

Average Low Average

Very High Fair Average

Negligible Average

Derivatives Defined
A derivative is a financial instrument whose value is derived from underlying asset. Is has no independent value. It has to be derived from underlying asset. The underlying assets could be financial instruments, share price index, metals, agricultural products, oil price, interest rate etc.

Players in Derivatives Markets

Hedgers Framers, traders(Hedger is a person whose objective is to reduce risk) Speculators- investors, fund managers(Risk takers) Arbitrageurs-(simultaneously trading in two or three markets) investors, fund managers

Forward Contract
Agreement to buy/sell (transact) an asset at a predetermined price and quantity on a pre-specified date in future Price, quantity and date are pre-specified at the time of entering into the contract (generally spot unless and otherwise specified) The contract is obligatory in nature and default warrants legal action

Terminologies
Technically speaking:
The party agreeing to buy the asset assumes a Long position The party agreeing to sell the asset assumes a Short position

Futures Contract
Agreement to buy/sell (transact) an asset at a predetermined price and quantity on a pre-specified date in future

Price, quantity and date are pre-specified at the time of entering into the contract
The contract is obligatory in nature and default warrants for legal action

Understanding Futures Contract w.r.t. Forward Contracts

Exchange traded forward contracts Standardized forward contracts Attractive for large set of market participants High liquidity No counter-party risk or default risk as counterparty is the exchange itself

Commonly Traded futures contracts

Index Futures Single stock futures Interest Rate Futures Commodity Futures

Options
An optional contract !! Gives the right but no obligation to honor the contract

Define: Right but not an obligation to buy/sell an asset at a pre-determined price on a pre-specified date Forwards and Futures are obligatory in nature

 The one who buys the option is called Holder of the option long position The one who sells the option is called Writer of the option short position Contract becomes optional for the holder but obligatory for the writer

 Asset price movement and pay-off amount become the deciding factor for the holder to exercise the option or let it expire

Since the writer is taking higher risk by selling the optional contract some amount as compensation is charged on selling the contract called as Premium Premium is the maximum profit a seller can generate whereas the downside risk exposure is unlimited

 Call Option Right but not obligation to buy an asset in future Put Option Right but not obligation to sell an asset in future Remember The writer of the option has to oblige if the holder wants to exercise the option

Types of Options
American Option can be exercised any day on or before expiry European Option exercisable only on expiry date The price on which option is exercisable is called the strike price or exercise price The date on which option expires is called expiration date (expiry / maturity) The price that option holder (buyer) pays the writer (seller) as compensation is called as Option Premium Option Premium is the positive cash inflow for the writer of the option irrespective of whether the option holder exercises his option or not