MBA 3rd semester FM01 Notes

1. Technical Analysis

2. Introduction
 Technical analysis is the attempt to forecast
stock prices on the basis of market-derived data.
 Technicians (also known as quantitative analysts
or chartists) usually look at price, volume and
psychological indicators over time.
 They are looking for trends and patterns in the
data that indicate future price movements.

3. Charting the Market
 Chartists use bar charts, candlestick, or point and
figure charts to look for patterns which may
indicate future price movements.
 They also analyze volume and other
psychological indicators (breadth, % of bulls vs
% of bears, put/call ratio, etc.).
 Strict chartists don’t care about fundamentals at
all.

4.  Each bar is composed of 4
elements:
 Open
 High
 Low
 Close
 Note that the candlestick body
is empty (white) on up days,
and filled (some color) on
down days
 Note: You should print the
example charts (next two
slides) to see them more
clearly
Open
Close
High
Low
Standard
Bar Chart
Japanese
Candlestick
Open
Close
High
Low
Standard
Bar Chart
Japanese
Candlestick

5. Types of Charts: Bar Charts
 This is a bar (open, high, low, close or OHLC) chart of
AMAT from early July to mid October 2001.

6. Types of Charts: Japanese Candlesticks
 This is a Japanese Candlestick (open, high, low, close)
chart of AMAT from early July to mid October 2001

7. Trend Lines
 There are three basic
kinds of trends:
 An Up trend where prices
are generally increasing.
 A Down trend where
prices are generally
decreasing.
 A Trading Range.

8. Support & Resistance
 Support and resistance lines
indicate likely ends of trends.
 Resistance results from the
inability to surpass prior
highs.
 Support results from the
inability to break below to
prior lows.
 What was support becomes
resistance, and vice-versa.
Support Resistance
Breakout

9. Price Patterns
 Technicians look for many patterns in the
historical time series of prices.
 These patterns are reputed to provide
information regarding the size and timing of
subsequent price moves.
 But don’t forget that the EMH says these
patterns are illusions, and have no real meaning.
In fact, they can be seen in a randomly generated
price series.

10. Head and Shoulders
 This formation is
characterized by two
small peaks on either
side of a larger peak.
 This is a reversal pattern,
meaning that it signifies
a change in the trend.
Head
Head
Left Shoulder
Left Shoulder
Right Shoulder
Right Shoulder
Neckline
Neckline
H&S Top
H&S Bottom

11. Head & Shoulders Example
Sell Signal
Minimum Target Price
Based on measurement rule

12. Double Tops and Bottoms
 These formations are
similar to the H&S
formations, but there is
no head.
 These are reversal
patterns with the same
measuring implications
as the H&S.
Target
Double Top
Double Bottom
Target

13. Double Bottom Example

14. Triangles
 Triangles are
continuation formations.
 Three flavors:
 Ascending
 Descending
 Symmetrical
 Typically, triangles
should break out about
half to three-quarters of
the way through the
formation.
Ascending
Descending
Symmetrical
Symmetrical

15. Broadening Formations
 These formations are like
reverse triangles.
 These formations usually
signal a reversal of the
trend.
Broadening Tops
Broadening Bottoms

16. Trend Lines
 There are three basic
kinds of trends:
 An Up trend where prices
are generally increasing.
 A Down trend where
prices are generally
decreasing.
 A Trading Range.

17. Dow Theory
 This theory was first stated by Charles Dow in a
series of columns in the WSJ between 1900 and
1902.
 Dow (and later Hamilton and Rhea) believed that
market trends forecast trends in the economy.

18. Dow Theory Trends (1)
 Primary Trend
 Called “the tide” by Dow, this is the trend that
defines the long-term direction (up to several years).
Others have called this a “secular” bull or bear
market.
 Secondary Trend
 Called “the waves” by Dow, this is shorter-term
departures from the primary trend (weeks to months)
 Day to day fluctuations
 Not significant in Dow Theory

19. Dow Theory Trends (2)

20. Gaps
• Gaps are those points or price levels where the
scrip has not changed hands. They are formed
in rising or falling price level.
• If the prices are moving upwards and the high
of any day is lower than the next day’s low, a
gap is said to have occurred.
• Similarly, if the prices are falling, a gap is
formed if the low price on a day is higher than
the high price of next day.

21. Gap up

22. Gap Down

23. Elliott Wave Theory
•
•
Ralph Nelson Elliott developed the
Elliott Wave Theory in the late
1920s by discovering that stock
markets, thought to behave in a
somewhat chaotic manner, in fact
traded in repetitive cycles.
Elliott discovered that these market
cycles resulted from investors'
reactions to outside influences, or
predominant psychology of the
masses at the time. He found that the
upward and downward swings of the
mass psychology always showed up
in the same repetitive patterns, which
were then divided further into
patterns he termed "waves"

24. Market Predictions Based on Wave Patterns
•
•
Elliott made predictions based on unique characteristics he
discovered in the wave patterns. An impulsive wave, which
goes with the main trend, always shows five waves in its
pattern. On a smaller scale, within each of the impulsive
waves, five waves can again be found. In this smaller pattern,
the same pattern repeats itself infinitely. These ever-smaller
patterns are labeled as different wave degrees in the Elliott
Wave Principle.
In the financial markets we know that "every action creates an
equal and opposite reaction" as a price movement up or down
must be followed by a contrary movement. Price action is
divided into trends and corrections or sideways movements.
Trends show the main direction of prices while corrections
move against the trend. Elliott labeled these "impulsive" and
"corrective" waves

25. Theory Interpretation
•
•
•
•
•
•
•
The Elliott Wave Theory is interpreted as
follows: Every action is followed by a reaction.
Five waves move in the direction of the main
trend followed by three corrective waves (a 5-3
move.)
A 5-3 move completes a cycle.
This 5-3 move then becomes two subdivisions of
the next higher 5-3 wave.
The underlying 5-3 pattern remains constant,
though the time span of each may vary.
Let's have a look at the following chart made up
of eight waves (five up and three down) labeled
1, 2, 3, 4, 5, A, B and C.
We can see that the three waves in the direction
of the trend are impulses, so these waves also
have five waves within them. The waves against
the trend are corrections and are composed of
three waves.

26. Relative Strength Index (RSI)
•
•
RSI was developed by Wells Wilder.
It identifies the inherent technical strength and weakness of a
particular scrip or market. RSI can be calculated for a scrip by
adopting the following formula. RSI can be calculated for 5,7,9 and
14 days.
100 
RSI =100  1 Rs
Rs =
Average gain per day
Average loss per day
 If RSI crosses 70 there may be down turn. If RSI falls below 30,
there may be an uptrend.
 If the share price is falling and RSI is rising, a divergence is said to
have occurred. Divergence indicates the turning point of the
market.
 If RSI is rising in overbought zone, it indicates a fall in prices.
 If RSI is in oversold zone, it indicates a rise in prices.

28. Technical Analysis and
Fundamental Analysis
1. Fundamental analysts analyses financial strength of
corporate, growth of sales, earnings and profitability.
 The technical analysts mainly focus the attention on the past
history of prices.
1. Fundamental analysts estimate the intrinsic value of the
shares.
 Technical analysts mainly predict the short term price
movement.
1. Fundamentalists are of the opinion that supply and
demand for stocks depend on the underlying factors.
 Technicians opine that they can forecast supply and demand
by studying the prices and volume of trading.

29. 1
Portfolio Management

30. 2
 The group of assets - such as stocks, bonds and mutual -
held by an investor.
 The art and science of making decisions about investment
mix and policy, matching investments to objectives, asset
allocation for individuals and institutions, and balancing
risk vs. performance
Equity
Debt
Preference
FD

31. 3
Defined
Portfolio management is all about strengths, weaknesses,
opportunities and threats-SWOT in the choice of debt vs.
equity, domestic vs. international, growth vs. safety, and
numerous other tradeoffs encountered in the attempt to
maximize return at a given appetite for risk.

32. 4
Notions of Portfolio Management
1) Notion of Diversification
2) Notion of Negative Co-relation

33. 5
Functions/Advantages/objectives of
Portfolio Management
 To frame an investment strategy and select an
investment mix to achieve the desired investment
objectives.
 To provide a balanced portfolio which not only can
hedge against the inflation but can also optimize returns
with the associated degree of risk
 To make timely buying and selling of securities
 To maximize the after tax return by investigating in
various tax saving instruments.
 Portfolio Management provides marketability and
liquidity to the investment

34. 6
Portfolio Manager
 Person who in pursuance of a
contract with clients,
advise/direct/undertake, the
management/administration
of portfolio of
securities/funds of client on
behalf of the latter
 Discretionary Portfolio
Management
 Non-Discretionary Portfolio
Management

35. 7
The Portfolio Manager’s Job
 Begins with a statement of investment
policy, which outlines:
• Return requirements
• Investor’s risk tolerance
• Constraints under which the portfolio must
operate

36. 8
 Deciding about investment Objectives
 Selection of Investment and the Timing of
Investment
 Investment Strategy
 Portfolio Execution
 Alignment of Portfolio
 Performance evaluation of Portfolio
The Process- Explained

37. 9
The Six Steps of Portfolio
Management (cont’d)
Learn the Basic
Principles of Finance
Set Portfolio Objectives
And Constraints
Formulate an
Investment Strategy
Have a Game Plan for
Portfolio Revision
Protect the
Portfolio When
Appropriate
Evaluate
Performance

38. 10
Portfolio Expected Return and Risk
Expected Return Risk
The Expected
Returns
of the
Securities
The
Portfolio
Weights
The Risk
of the
Securities
The
Portfolio
Weights
The
Correlation
Coefficients

39. 11
Grouping Individual Assets into
Portfolios
 The riskiness of a portfolio that
is made of different risky assets
is a function of three different
factors:
• the riskiness of the individual
assets that make up the
portfolio
• the relative weights of the
assets in the portfolio
• the degree of comovement of
returns of the assets making up
the portfolio
 The standard deviation of a
two-asset portfolio may be
measured using the Markowitz
model:
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40. 12
Risk of a Three-asset Portfolio
The data requirements for a three-asset portfolio grows
dramatically if we are using Markowitz Portfolio selection formulae.
We need 3 (three) correlation coefficients between A and B; A and
C; and B and C.
A
B C
ρa,b ρa,c
ρb,c
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41. Computation of the Expected Return
for a Portfolio of Risky Assets
13
0.20 0.10 0.0200
0.30 0.11 0.0330
0.30 0.12 0.0360
0.20 0.13 0.0260
E(Rpor i) = 0.1150
Expected Portfolio
Return (Wi X Ri)(Percent of Portfolio)
Expected Security
Return (Ri)
Weight (Wi)
iassetforreturnofrateexpectedthe)E(R
iassetinportfoliotheofpercenttheW
:where
RW)E(R
i
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ipor
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ii

42. 14
Diversification Potential
 The potential of an asset to diversify a portfolio is
dependent upon the degree of co-movement of
returns of the asset with those other assets that
make up the portfolio.
 In a simple, two-asset case, if the returns of the
two assets are perfectly negatively correlated it is
possible (depending on the relative weighting) to
eliminate all portfolio risk.
 This is demonstrated through the following chart.

43. 15
Portfolio Programming in a Nut shell
Welcome

44. 16
Various portfolio combinations may result
in a given return
The investor wants to choose the portfolio
combination that provides the least amount
of variance

45. 17
Example
Assume the following statistics for Stocks A, B, and C:
Stock A Stock B Stock C
Expected return .20 .14 .10
Standard deviation .232 .136 .195

46. 18
Example (cont’d)
The correlation coefficients between the three stocks are:
Stock A Stock B Stock C
Stock A 1.000
Stock B 0.286 1.000
Stock C 0.132 -0.605 1.000

47. 19
Example (cont’d)
An investor seeks a portfolio return of 12%.
Which combinations of the three stocks accomplish this
objective? Which of those combinations achieves the least
amount of risk?

48. 20
Example (cont’d)
Solution: Two combinations achieve a 12% return:
1) 50% in B, 50% in C: (.5)(14%) + (.5)(10%) = 12%
2) 20% in A, 80% in C: (.2)(20%) + (.8)(10%) = 12%

49. 21
Example (cont’d)
Solution (cont’d): Calculate the variance of the B/C
combination:
2 2 2 2 2
2 2
2
(.50) (.0185) (.50) (.0380)
2(.50)(.50)( .605)(.136)(.195)
.0046 .0095 .0080
.0061
p A A B B A B AB A Bx x x x       
 
 
  


50. 22
Example (cont’d)
Solution (cont’d): Calculate the variance of the A/C
combination:
2 2 2 2 2
2 2
2
(.20) (.0538) (.80) (.0380)
2(.20)(.80)(.132)(.232)(.195)
.0022 .0243 .0019
.0284
p A A B B A B AB A Bx x x x       
 

  


51. 23
Example (cont’d)
Solution (cont’d): Investing 50% in Stock B and 50% in
Stock C achieves an expected return of 12% with the
lower portfolio variance. Thus, the investor will likely
prefer this combination to the alternative of investing
20% in Stock A and 80% in Stock C.

52. Markowitz Portfolio Theory
• Quantifies risk
• Derives the expected rate of return for a portfolio of
assets and an expected risk measure
• Shows that the variance of the rate of return is a
meaningful measure of portfolio risk
• Derives the formula for computing the variance of a
portfolio, showing how to effectively diversify a
portfolio
1

53. Assumptions of
Markowitz Portfolio Theory
1. Investors consider each investment
alternative as being presented by a
probability distribution of expected returns
over some holding period.
2. Investors minimize one-period expected utility,
and their utility curves demonstrate
diminishing marginal utility of wealth.
2

54. Assumptions of
Markowitz Portfolio Theory
3. Investors estimate the risk of the portfolio on
the basis of the variability of expected returns.
4. Investors base decisions solely on expected
return and risk, so their utility curves are a
function of expected return and the expected
variance (or standard deviation) of returns
only.
3

55. Assumptions of
Markowitz Portfolio Theory
5. For a given risk level, investors prefer higher
returns to lower returns. Similarly, for a given
level of expected returns, investors prefer less
risk to more risk.
4

56. Markowitz Portfolio Theory
Using these assumptions, a single asset or
portfolio of assets is considered to be efficient
if no other asset or portfolio of assets offers
higher expected return with the same (or
lower) risk, or lower risk with the same (or
higher) expected return.
5

57. Efficient Frontier
• Every possible combination of assets that
exists can be plotted on a graph, with the
portfolio's risk on the X-axis and the
expected return on the Y-axis. This plot
reveals the most desirable portfolios.
6

58. Efficient Frontier
• For example, assume Portfolio A has an expected return of
8.5% and a standard deviation of 8%, and that Portfolio B has
an expected return of 8.5% and a standard deviation of 9.5%.
Portfolio A would be deemed more "efficient" because it has
the same expected return but a lower risk. It is possible to
draw an upward sloping hyperbola to connect all of the most
efficient portfolios, and this is known as the efficient frontier.
Investing in any portfolio not on this curve is not desirable.
7

59. Efficient Frontier
8

60. Single Index Model
• Need for Sharpe Model(Single Index)
In Markowitz model a number of co-
variances have to be estimated.
If a financial institution buys 150 stocks, it
has to estimate 11,175 i.e., (N2 – N)/2
correlation co-efficients.
Sharpe assumed that the return of a
security is linearly related to a single index
like the market index.
9

61. Single Index Model
• To simplify analysis, the single-index
model assumes that there is only 1
macroeconomic factor that causes
the systematic risk affecting all stock returns
and this factor can be represented by the rate
of return on a market index, such as the S&P
500.
10

62. Single Index Model
• According to this model, the return of any stock can
be decomposed into the expected excess return of
the individual stock due to firm-specific factors,
commonly denoted by its alpha coefficient α , which
is the return that exceeds the risk-free rate, the
return due to macroeconomic events that affect the
market, and the unexpected microeconomic events
that affect only the firm. Specifically, the return of
stock i is:
11

63. Single Index Model
• ri = αi + βirm + ei
• The term βirm represents the stock's return
due to the movement of the market modified
by the stock's beta βi), while ei represents
the residual variance
12

64. Efficient Market Hypothesis

65. Introduction
 An efficient capital market is a market that is
efficient in processing information.
 In other words, the market quickly and correctly
adjusts to new information.
 In an information of efficient market, the
prices of securities observed at any time are
based on “correct” evaluation of all information
available at that time.
 Therefore, in an efficient market, prices
immediately and fully reflect available information.

66. Definition
• "In an efficient market, competition among the
many intelligent participants leads to a
situation where, at any point in time, actual
prices of individual securities already reflect
the effects of information based both on
events that have already occurred and on
events which, as of now, the market expects
to take place in the future. In other words, in
an efficient market at any point in time the
actual price of a security will be a good
estimate of its intrinsic value."
- Professor Eugene Fama,

67. The Efficient Markets Hypothesis
 The Efficient Markets Hypothesis (EMH) is made
up of three progressively stronger forms:
 Weak Form
 Semi-strong Form
 Strong Form

68. The EMH Graphically
 In this diagram, the circles
represent the amount of
information that each form of
the EMH includes.
 Note that the weak form
covers the least amount of
information, and the strong
form covers all information.
 Also note that each
successive form includes the
previous ones.
Strong Form
Semi-Strong
Weak Form
All information, public and private
All public information
All historical prices and returns

69. The Weak Form
 The weak form of the EMH says that past prices,
volume, and other market statistics provide no
information that can be used to predict future prices.
 If stock price changes are random, then past prices
cannot be used to forecast future prices.
 Price changes should be random because it is
information that drives these changes, and
information arrives randomly.
 Prices should change very quickly and to the correct
level when new information arrives (see next slide).
 This form of the EMH, if correct, repudiates technical
analysis.
 Most research supports the notion that the markets
are weak form efficient.

70. The Semi-strong Form
 The semi-strong form says that prices fully reflect all
publicly available information and expectations about
the future.
 This suggests that prices adjust very rapidly to new
information, and that old information cannot be used
to earn superior returns.
 The semi-strong form, if correct, repudiates
fundamental analysis.
 Most studies find that the markets are reasonably
efficient in this sense, but the evidence is somewhat
mixed.

71. The Strong Form
 The strong form says that prices fully reflect all
information, whether publicly available or not.
 Even the knowledge of material, non-public
information cannot be used to earn superior
results.
 Most studies have found that the markets are not
efficient in this sense.

72. Summary of Tests of the EMH
 Weak form is supported, so technical analysis cannot
consistently outperform the market.
 Semi-strong form is mostly supported , so
fundamental analysis cannot consistently outperform
the market.
 Strong form is generally not supported. If you have
secret (“insider”) information, you CAN use it to earn
excess returns on a consistent basis.
 Ultimately, most believe that the market is very
efficient, though not perfectly efficient. It is
unlikely that any system of analysis could
consistently and significantly beat the market
(adjusted for costs and risk) over the long run.

73. CAPM-Capital asset Pricing Model
A model that describes the relationship between
risk and expected return and that is used in the
pricing of risky securities
The CAPM says that the required return of a
security or a portfolio equals the rate on a risk-free
security plus a risk premium. If this expected
market return does not meet or beat the required
return, then the investment should not be
undertaken.
Risk Free rate-Yield on long term Govt Bonds
Risk Premium-The reward for taking on additional
Risk

74. CAPM

75. CAPM
The general idea behind CAPM is that investors
need to be compensated in two ways: time value of
money and risk. The time value of money is
represented by the risk-free (rf) rate in the formula
and compensates the investors for placing money in
any investment over a period of time. The other half
of the formula represents risk and calculates the
amount of compensation the investor needs for
taking on additional risk. This is calculated by
taking a risk measure (beta) which is a measure of
the systematic risk. Unsystematic Risk need not be
rewarded.

76. Application of CAPM
Lets assume that a stock has a Beta of 1.2, the risk free rate
is 4% and the market return is expected to be 12 %, the
expected return of the stock considering the dividend and
capital gain expectations is assumed to be 9 %
Substituting in the CAPM formula we get the required
return as 13.6 %
As the Required return[ 13.6%] is more than the expected
return of 9% the investment cannot be undertaken and if it
has already been undertaken , needs to be disposed off/sold
Thus for the non diversifiable risk [Beta of 1.2 , the
required return is 13.6 %, if the Beta is increased to 1.5 ,
the required return comes to 16 %, thus higher the Beta
[Risk] higher the return.