Mf0010 – security analysis and portfolio managementDocument Transcript
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MF0010 – Security Analysis and Portfolio Management
Q1. Explain the characteristics of investment. Differentiate between investment and
Ans. Characteristics of Investment
While choosing an investment, an investor should know the features to look for. The
prominent features are:
Rate of return
When we invest, we defer current consumption in order to accumulate our wealth. Return on
investment is the change in the wealth either resulting from an investment , due to cash
inflow (annual income in the form of dividends / interest) or caused by a change in the price
of the asset (capital appreciation / depreciation).
Risk is the likelihood that your investment may fail and you lose the money. It is the degree
of uncertainty about the return you expect from the investment, and about the final return of
that investment. No investment, (domestic or international) is risk-free. That is a fact you
should not ignore. Even money lying securely in a savings account is at risk from inflation.
Marketability of an investment is measured on various parameters such as:
How quickly the instrument can be transacted i.e., can be bought or sold.
The transaction cost of buying and selling it
The price change between two successive transactions.
Tax planning is essential for those investors who are in high tax brackets. Tax benefits are of
three forms – initial tax benefit, continuing tax benefit and terminal tax benefit.
An initial tax benefit refers to the tax relief enjoyed at the time of making the
Continuing tax benefit refers to the tax shield associated with periodic returns from
Terminal tax benefit refers to relief from taxation when an investment is realised on
maturity or when it is sold.
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It is the ease of buying or selling an investment in the market. You can buy or sell blue chip
stocks very quickly due to high liquidity while „Z‟ category stocks will take much longer to
Investment and Speculation
Benjamin Graham in his book 'Security Analysis' makes a distinction between speculation
and investing. “An investment operation is one which, upon thorough analysis, promises
safety of principal and an adequate return. Operations not meeting these requirements are
Speculation occurs when an asset is purchased with the hope that price will rise rapidly,
leading to quick profit. In speculation, significant risks are taken for obtaining quick gains.
For example, you buy an IPO of a stock on the first day of issue with the intention of selling
it after receiving a higher price.
Do not consider speculation as a form of gambling. Gambling is based on random outcomes
while speculation is not. Gambling is taking risk purely for the enjoyment of risk itself.
Speculation is undertaking the risk because of a favourable risk-return trade-off. Speculators
make informed decisions before taking on risk. However, speculation cannot be categorised
as a traditional investment, because the risk level is higher than average.
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Q2. What do you understand risk and measurement of risk? Explain the factors that
Ans. Meaning of Risk
Risk is the likelihood that your investment will either earn money or lose money. It is the
degree of uncertainty regarding your expected returns from your investments, including the
possibility of losing some or all of your investment. Risk includes not only adverse
outcomes (lower returns than expected) but good outcomes (higher returns). Both downside
and upside risks are considered while measuring risk.
Measurement of risk
The thumb rule for all investments is smaller the risk smaller the return; and higher the risk,
higher the return. Higher returns compensate for the percent of risk taken. The risk is
dependent largely on your risk appetite, which in turn changes with your age, personality
and environment. The daily fluctuations of the market tend to smoothen out your long term
investment (Historically the stock market has always shown a gradually increasing trend
irrespective of short-term declines). But when you are old or close to your monetary goal,
you cannot afford to make losses.
Factors that affect Risk
Business risk: As a security holder you get dividends, interest or principal (on maturity in
case of securities like bonds) from the firm. But there is a possibility that the firm may not
be able to pay you due to poor financial performance. This possibility is termed as business
risk. The poor financial performance could be due to economic slowdown, poor demand for
the firm‟s goods and services and large operating expenses.
Inflation risk: It is the possibility that the money you invested will have less purchasing
power when your financial goal is met. This means, the rupee you get when you sell your
asset buys lesser than the rupee you originally invested in the asset.
Interest rate risk: The variability in a security‟s return resulting from changes in the level
of interest rates is referred to as interest rate risk. For example the value of a bond may
reduce due to rising interest rates. When the interest rate rises, the market price of existing
fixed income securities fall, and vice versa. This happens because the buyer of a fixed
income security would not buy it at its par value or face value if its fixed interest rate is
lower than the prevailing interest rate on a similar security.
Market risk: Market risk is the changes in returns from a security resulting from ups and
downs in the aggregate market (like stock market). This type of risk arises when unit price
or value of investment decreases due to market decline. The market tends have a cyclic
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Q3. Compare and contrast the fundamental and technical analysis.
Ans. Fundamental and Technical Analysis – A Comparison
Technical analysis looks at the price movement of a security and uses this data to predict its
future price movements. Fundamental analysis analyses fundamental performance and
economic factors to find undervalued securities.
Differences between fundamental and technical analysis:
1. Charts vs. financial statements: A technical analyst approaches a security via the charts,
while a fundamental analyst studies the financial statements. Technical analysis is the study
of price action and trend, while fundamental analysis focuses the company‟s performance in
the backdrop of industry and economy conditions.
2. Time horizon: Fundamental analysts take a longer term view of the market when
compared to the technical analysts. Technical analysis has a timeframe of weeks or even days
whereas fundamental analysis often looks at data over a number of years. The difference in
the timeframes is because of the different investing styles of fundamental and technical
analysis. It can take a long time for an undervalued stock, uncovered by fundamental
analysis, to reach its “correct” value. Fundamental analysis assumes that if the short-term
market is wrong (in valuing a stock at less than its intrinsic value) the price of the stock will
correct itself over a longer period.
3. Trading vs. investing: The goals of technical and fundamental analysis are often different.
Generally fundamental analysis is oriented to investment decisions, while technical analysis
is more relevant for trading decisions. Investors buy assets that they believe can increase in
value and yield returns over longer periods. Traders buy assets that they believe they can sell
quickly at a higher price.
4. Cause vs. effect: While both approaches have the same objective of predicting the
direction of prices, the fundamental analyst studies the causes of market movements, while
the technical analyst studies the effect of market movements. The fundamental analyst needs
to know why the prices have changed. The technical analyst, on the other hand, attempts to
find where the prices can be expected to change.
Although technical analysis and fundamental analysis may seem to be poles apart, many
market participants have achieved success by combining both. Thus a fundamental analyst
may use technical analysis to figure out the best time to enter into an undervalued security.
Often this opportunity is present when the security is severely oversold. By timing entry into
a security, the gains on the investment can be greatly improved. Similarly, some technical
traders might look at fundamentals to add strength to a technical signal. For example, if a sell
signal is obtained after technical analysis, a technical trader might look at fundamental data
before going ahead with the decision.
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Q4.Write the assumptions of CAPM. Explain the limitations of CAPM.
Ans. Assumptions of CAPM
1. All investors are assumed to follow the mean-variance approach, i.e. the risk-averse
investor will ascribe to the methodology of reducing portfolio risk by combining
assets with counterbalancing correlations.
2. Assets are infinitely divisible.
3. There is a risk-free rate at which an investor may lend or borrow. This risk-free rate is
the same for all investors.
4. Taxes and transactions costs are irrelevant.
5. All investors have same holding period.
6. Information is freely and instantly available to all investors.
7. Investors have homogeneous expectations i.e. all investors have the same expectations
with respect to the inputs that are used to derive the Markowitz efficient portfolios
(asset returns, variances and correlations).
8. Markets are assumed to be perfectly competitive i.e. the number of buyers and sellers
is sufficiently large, and all investors are small enough relative to the market, so that
no individual investor can influence an asset‟s price.
Limitations of Capital Asset Pricing Model
1. CAPM is a single period model.
2. It is a single factor linear model. It defines risky asset returns solely as a function of
the asset‟s contribution to the systematic risk of the market portfolio.
3. The true market portfolio defined by the theory behind the CAPM is unobservable.
Therefore, one has to select and use a market portfolio such as Nifty or Sensex as
4. If we use historical data to estimate the inputs for the basic CAPM (risk-free rate, beta
and market risk premium), we are making the assumption that the past (specifically
the period that we select for the historical data) is the best predictor of the future.
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Q5. Write about emerging markets. Explain the risks involved in international
Ans. Emerging Markets
Investing in emerging markets offers high returns but with equally high risk. These are
capital markets in developing countries, typically with low per capita GDP. While developing
countries make up over 80% of the world‟s population, they make up less than 10% of the
stock market capitalization. There is low correlation between emerging market returns and
returns elsewhere in the world and this aids diversification. However, as impediments to
capital market mobility fall, correlations will increase.
The following are the common features of an emerging market, however these
characteristics differ from country to country:
Economic growth is high
Exchange rate risk is high
Political risk is high
Weak legal systems and lack of effective regulation
Minority shareholders are not protected enough
A single majority shareholder or a group of connected shareholder(e.g. a
family) controlling a large numbers of companies The presence of large
There are risks involved in international investing. Some of the risks are:
1) Changes in currency exchange rates
When the exchange rate between the foreign currency (in which the international investment
is denominated) and the home currency (say, Rupee for an Indian) changes, it can increase or
decrease the investment return. Foreign securities trade and pay dividends in the currency of
their local market. When an investor receives dividends or sells his international investment,
he will need to convert the cash that he receives into his home currency.
During a period when the foreign currency is strong compared to the home currency, this
strength increases his investment return because his foreign earnings translate into more units
of local currency. Thus for an Indian who has made investments in the US, if the dollar
appreciates it is good news since the dollar earnings would convert into more Indian rupees.
By the same token if the US dollar depreciates, it reduces his investment return because his
earnings translate into fewer rupees. In addition to this exchange rate risk, there is the risk
that the country may impose controls that restrict or delay moving money out of the country.
2) Dramatic changes in market value
There can be dramatic changes in market value in Foreign markets as well like any other
market. By investing for long term and by trying to ride out the short term downturns in the
market can help reduce the impact of these price changes. When individual investors try to
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"time" the market in the domestic markets and sometimes in the foreign markets as well, they
fail in their attempt. Two decisions need to be make when one times the market-– deciding
when to get out before prices fall and when to get back in before prices rise again.
3) Political, economic and social events
Political, economic and social factors that influence foreign markets are difficult to
understand by the investors. Although these factors provide diversification, they also
contribute to the risk of international investing..
4) Lack of liquidity
Foreign markets may have lower trading volumes, fewer listed companies and may be open
only for a few hours in a day. In some countries there are restrictions on the amount or type
of stocks that foreign investors may purchase. To buy a foreign security an investor may have
to pay premium prices and may also have difficulty finding a buyer when he wants to sell the
5) Less information
In many cases investors don‟t get the same type of information in the case of foreign
companies as in the case of domestic companies. The investors may not be able to find up-to-
date information and the investor may not be able to understand the language used by the
6) Reliance on foreign legal remedies
The investor may not be able to sue the company in his own country‟s courts and even if he is
able to sue successful in a domestic court he may not be able to collect on a home country
judgment against a foreign company. The investor will have to rely on legal remedies are
available in the company's country.
7) Different market operations
The operations in the domestic country‟s trading markets will be different from that of
foreign markets. For example, there may be different periods for clearance and settlement of
security transactions. Home markets may report stock trades much faster than foreign
markets. Rules providing for the safekeeping of shares held by custodian banks or
depositories may not be as well-developed in some foreign markets, with the risk that the
investor‟s shares may not be protected if the custodian has credit problems or fails.
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Q6. What is economy analysis? Explain the factors to be considered in economy
Ans. Economy Analysis
Economic analysis is done for two reasons:
1. A company‟s growth prospects are dependent on the economy in which it operates.
2. Most companies‟ shares and stocks generally perform well when the economy is in
Factors to be considered in economy analysis
The economic variables that are considered include:
1. gross domestic product (GDP) growth rate
2. exchange rates
3. balance of payments (BOP)
4. current account deficit
5. government policy (fiscal and monetary policy)
6. domestic legislation (laws and regulations)
7. unemployment rates
8. public attitude (consumer confidence)
10. interest rates
11. productivity (output per worker)
12. capacity utilisation (output by the firm).