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SET - 1
Q.1 Discuss the different forms of market efficiency.
Answer:
Forms of Market Efficiency
A financial market displays informational efficiency when market prices reflect all available
information about value. This definition of efficient market requires answers to two questions:
„what is all available information?‟ & „what does it mean to reflect all available information?‟
Different answers to these questions give rise to different versions of market efficiency.
What information are we talking about? Information can be information about past prices,
information that is public information and information that is private information. Information
about past prices refers to the weak form version of market efficiency, information that consists
of past prices and all public information refers to the semi-strong version of market efficiency
and all information (past prices, all public information and all private information) refers to the
strong form version of market efficiency.
―Prices reflect all available information‖ means that all financial transactions which are carried
out at market prices, using the available information, are zero NPV activities.
The weak form of EMH states that all past prices, volumes and other market statistics (generally
referred to as technical analysis) cannot provide any information that would prove useful in
predicting future stock price movements. The current prices fully reflect all security-market
information, including the historical sequence of prices, rates of return, trading volume data, and
other market-generated information. This implies that past rates of return and other market data
should have no relationship with future rates of return. It would mean that if the weak form of
EMH is correct, then technical analysis is fruitless in generating excess returns.
The semi-strong form suggests that stock prices fully reflect all publicly available information
and all expectations about the future. ―Old‖ information then is already discounted and cannot be
used to predict stock price fluctuations. In sum, the semi-strong form suggests that fundamental
analysis is also fruitless; knowing what a company generated in terms of earnings and revenues
in the past will not help you determine what the stock price will do in the future. This implies
that decisions made on new information after it is public should not lead to above-average risk-
adjusted profits from those transactions.
Lastly, the strong form of EMH suggests that stock prices reflect all information, whether it be
public (say in SEBI filings) or private (in the minds of the CEO and other insiders). So even with
material non-public information, EMH asserts that stock prices cannot be predicted with any
accuracy.
Q.2 Compare Arbitrage pricing theory with the Capital asset pricing model.
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Answer:
Arbitrage Pricing Theory (APT)
Arbitrage Pricing Theory (APT) are two of the most commonly used models for pricing all risky
assets based on their relevant risks. Capital Asset Pricing Model (CAPM) calculates the required
rate of return for any risky asset based on the security‘s beta.
Beta is a measure of the movement of the security‘s return with the return on the market
portfolio, which includes all the securities that are available in the world and where the
proportion of each security in the portfolio is its market value as a percentage of total market
value of all the securities. The problem with CAPM is that such a market portfolio is
hypothetical and not observable and we have to use a market index like the S&P 500 or Sensex
as a proxy for the market portfolio.
However, indexes are imperfect proxies for overall market as no single index includes all capital
assets, including stocks, bonds, real estate, collectibles, etc. Another criticism of the CAPM is
that the various different proxies that are used for the market portfolio do not fully capture all of
the relevant risk factors in the economy.
An alternative pricing theory with fewer assumptions, the Arbitrage Pricing Theory (APT), has
been developed by Stephen Ross. It can calculate expected return without taking recourse to the
market portfolio. It is a multi-factor model for determining the required rate of return which
means that it takes into account a number of economy wide factors that can affect the security
prices. APT calculates relations among expected returns that will rule out arbitrage by investors.
The APT requires three assumptions:
1) Returns can be described by a factor model.
2) There are no arbitrage opportunities.
3) There are large numbers of securities that permit the formation of portfolios that diversify the
firm-specific risk of individual stocks.
The Capital Asset Pricing Model (CAPM) is a model to explain why capital assets are priced
the way they are. William Sharpe, Treynor and Lintner contributed to the development of this
model. An important consequence of the modern portfolio theory as introduced by Markowitz
was that the only meaningful aspect of total risk to consider for any individual asset is its
contribution to the total risk of a portfolio. CAPM extended Harry Markowitz‘s portfolio theory
to introduce the notions of systematic and unsystematic (or unique) risk.
Arbitrage Pricing Theory vs. the Capital Asset Pricing Model
The Arbitrage Pricing Theory (APT) and the Capital Asset Pricing Model are the two most
influential theories on stock and asset pricing today. The APT model is different from the CAPM
in that it is far less restrictive in its assumptions. APT allows the individual investor to develop
their model that explains the expected return for a particular asset.
Intuitively, the APT makes a lot of sense because it removes the CAPM restrictions and basically
states that the expected return on an asset is a function of many factors and the sensitivity of the
stock to these factors. As these factors move, so does the expected return on the stock - and
therefore its value to the investor. However, the potentially large number of factors means that
more factor sensitivities have to be calculated. There is also no guarantee that all the relevant
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factors have been identified. This added complexity is the reason arbitrage pricing theory is far
less widely used than CAPM.
In the CAPM theory, the expected return on a stock can be described by the movement of that
stock relative to the rest of the stock market. The CAPM theory is really just a simplified version
of the APT, where the only factor considered is the risk of a particular stock relative to the rest of
the stock market - as described by the stock's beta.
From a practical standpoint, CAPM remains the dominant pricing model used today. When
compared to the Arbitrage Pricing Theory, the Capital Asset Pricing Model is both elegant and
relatively simple to calculate.
Q.3 Perform an economy analysis on Indian economy in the current situation.
Answer:
Economic analysis is done for two reasons: first, a company‘s growth prospects are, ultimately,
dependent on the economy in which it operates; second, share price performance is generally tied
to economic fundamentals, as most companies generally perform well when the economy is
doing the same.
1 Factors to be considered in economy analysis
The economic variables that are considered in economic analysis are gross domestic product
(GDP) growth rate, exchange rates, the balance of payments (BOP), the current account deficit,
government policy (fiscal and monetary policy), domestic legislation (laws and regulations),
unemployment (the percent of the population that wants to work and is currently not working),
public attitude (consumer confidence) inflation (a general increase in the price of goods and
services), interest rates, productivity (output per worker), capacity utilization (output by the firm)
etc .
GDP is the total income earned by a country. GDP growth rate shows how fast the economy is
growing. Investors know that strong economic growth is good for companies and recessions or
full-blown depressions cause share prices to decline, all other things being equal.
Inflation is important for investors, as excessive inflation undermines consumer spending power
(prices increase) and so can cause economic Security Analysis and Portfolio Management
stagnation. However, deflation (negative inflation) can also hurt the economy, as it encourages
consumers to postpone spending (as they wait for cheaper prices).
The exchange rate affects the broad economy and companies in a number of ways. First,
changes in the exchange rate affect the exports and imports. If exchange rate strengthens, exports
are hit; if the exchange rate weakens, imports are affected. The BOP affects the exchange rate
through supply and demand for the foreign currency.
BOP reflects a country‘s international monetary transactions for a specific time period. It
consists of the current account and the capital account. The current account is an account of the
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trade in goods and services. The capital account is an account of the cross-border transactions in
financial assets. A current account deficit occurs when a country imports more goods and
services than it exports.
A capital account deficit occurs when the investments made in the country by foreigners is less
than the investment in foreign countries made by local players. The currency of a country
appreciates when there is more foreign currency coming into the country than leaving it.
Therefore, a surplus in the current or capital account causes the currency to strengthen; a deficit
causes the currency to weaken.
The levels of interest rates (the cost of borrowing money) in the economy and the money supply
(amount of money circulating in the economy) also have a bearing on the performance of
businesses. All other things being equal, an increase in money supply causes the interest rates to
fall; a decrease causes the interest rates to rise. If interest rates are low, the cost of borrowing by
businesses is not expensive, and companies can easily borrow to expand and develop their
activities.
On the other hand, when the cost of borrowing becomes too high (when the interest rates go up),
borrowing may become too costly and plans for expansion are postponed. Interest rates also have
a significant effect on the share markets. In very broad terms, share prices improve when interest
rates fall and decline when interest rates increase. There are two reasons for that: the ―intrinsic
value‖ estimate will increase as interest rates (and the linked discount rate) fall and underlying
company profitability will improve, if interest payments reduce.
2 Business cycle and leading coincidental and lagging indicators
All economies experience recurrent periods of expansion and contraction. This recurring pattern
of recession and recovery is called the business cycle. The business cycle consists of
expansionary and recessionary periods. When business activity reaches a high point, it peaks; a
low point on the cycle is a trough. Troughs represent the end of a recession and the beginning of
an expansion. Peaks represent the end of an expansion and the beginning of a recession.
In the expansion phase, business activity is growing, production and demand are increasing, and
employment is expanding. Businesses and consumers normally borrow more money for
investment and consumption purposes. As the cycle moves into the peak, demand for goods
overtakes supply and prices rise. This creates inflation. During inflationary times, there is too
much money chasing a limited amount of goods.
Therefore, businesses are able to charge more for their items causing prices to rise. This, in turn,
reduces the purchasing power of the consumer. As prices rise, demand slackens which causes
economic activity to decrease. The cycle then enters the recessionary phase. As business activity
contracts, employers lay off workers (unemployment increases) and demand further slackens.
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Usually, this causes prices to fall. The cycle enters the trough. Eventually, lower prices stimulate
demand and the economy moves into the expansion phase.
The performance of an investment is influenced by the business cycle. The direction in which an
economy is heading has a significant impact on companies‟ performance and ability to deliver
earnings. If the economy is in a recession, it is likely that many business sectors will fail to
generate profits. This is because the demand for most products decreases during economic
declines, since people have less money with which to purchase goods and services (since high
levels of unemployment are common during economic crises). On the other hand, during times
of economic prosperity, companies tend to expand their operations and in turn generate higher
levels of earnings, as the demand for goods tends to grow. Security Analysis and Portfolio To
some extent the business cycle can be predicted as it is cyclical in nature. The prediction can be
done using economic indicators. Economic indicators are quantitative announcements (released
as data), released at predetermined times according to a schedule, reflecting the financial,
economical and social atmosphere of an economy. They are published by various agencies of the
government or by the private sector. They are used to monitor the health and strength of an
economy and they help to evaluate the direction of the business cycle.
Economists use three types of indicators that provide data on the movement of the economy as
the business cycle enters different phases. The three types are leading, coincident, and lagging
indicators.
Leading indicators tend to precede the upward and downward movements of the business cycle
and can be used to predict the near term activity of the economy. Thus they can help anticipate
rising corporate profits and possible stock market price increases. Examples of leading indicators
are: Average weekly hours of production workers, money supply etc.
Coincident indicators usually mirror the movements of the business cycle. They tend to change
directly with the economy. Example includes industrial production, manufacturing and trade
sales etc.
Lagging Indicators are economic indicators that change after the economy has already begun to
follow a particular pattern or trend. Lagging Indicators tend to follow (lag) economic
performance. Examples: ratio of trade inventories to sales, ratio of consumer installment credit
outstanding to personal income etc.
Q.4 Identify some technical indicators and explain how they can be used to decide purchase
of a company’s stock.
Answer:
A technical indicator is a series of data points that are derived by applying a formula to the price
and/or volume data of a security. Price data can be any combination of the open, high, low or
closing price over a period of time. Some indicators may use only the closing prices, while others
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incorporate volume and open interest into their formulae. The price data is entered into the
formula and a data point is produced. For example, say the closing prices of a stock for 3 days
are Rs. 41, Rs. 43 and Rs. 43.
If a technical indicator is constructed using the average of the closing prices, then the average of
the 3 closing prices is one data point ((41+43+43)/3=42.33). However, one data point does not
offer much information. A series of data points over a period of time is required to enable
analysis. Thus we can have a 3 period moving average as a technical indicator, where we drop
the earliest closing price and use the next closing price for calculations. By creating a time series
of data points, a comparison can then be made between present and past levels. Technical
indicators are usually shown in a graphical form above or below a security‘s price chart for
facilitating analysis. Once shown in graphical form, an indicator can then be compared with the
corresponding price chart of the security. Sometimes indicators are plotted on top of the price
plot for a more direct comparison.
Technical indicators measure money flow, trends, volatility and momentum etc. They are used
for two main purposes: to confirm price movement and the quality of chart patterns, and to form
buy and sell signals. A technical indicator offers a different perspective from which to analyze
the price action. Some, such as moving averages, are derived from simple formulae and they are
relatively easy to understand. Others, like stochastics have complex formulae and require more
effort to fully understand and appreciate. Technical indicators can provide unique perspective on
the strength and direction of the underlying price action.
Indicators filter price action with formulae. Therefore they are derivative measures and not direct
reflections of the price action. This should be taken into account when analyzing the indicators.
Any analysis of an indicator should be taken with the price action in mind. There are two main
types of indicators: leading and lagging. A leading indicator precedes price movements;
therefore they are used for prediction. A lagging indicator follows price movement and therefore
is a confirmation.
The main benefit of leading indicators is that they provide early signaling for entry and exit.
Early signals can forewarn against a potential strength or weakness. Leading indicators can be
used in trending markets. In a market that is trending up, the leading indicator helps identify
oversold conditions for buying opportunities. In a market that is trending down, leading
indicators can help identify overbought situations for selling opportunities. Some of the more
popular leading indicators include Relative Strength Index (RSI) and Stochastic Oscillator.
Lagging indicators follow the price action and are commonly referred to as trend-following
indicators. Lagging indicators work best when the markets or securities develop strong trends.
They are designed to get traders in and keep them in as long as the trend is intact. As such, these
indicators are not effective in trading or sideways markets. Some popular trend-following
indicators include moving averages and Moving Average Convergence Divergence (MACD).
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Technical indicators are constructed in two ways: those that fall in a bounded range and those
that do not. The technical indicators that are bound within a range are called oscillators.
Oscillators are used as an overbought / oversold indicator. A market is said to be „overbought‟
when prices have been trending higher in a relatively steep fashion for some time, to the extent
that the number of market participants „long‟ of the market significantly outweighs those on the
sidelines or holding „short‟ positions. This means that there are fewer participants to jump onto
the back of the trend. The „oversold‘ condition is just the opposite. The market has been trending
lower for some time and is running out of „fuel‟ for further price declines.
Oscillator indicators move within a range, say between zero and 100, and signal periods where
the security is overbought (near 100) or oversold (near zero). Oscillators are the most common
type of technical indicators. The technical indicators that are not bound within a range also form
buy and sell signals and display strength or weakness in the market, but they can vary in the way
they do this.
The two main ways that technical indicators are used to form buy and sell signals is through
crossovers and divergence. Crossovers occur when either the price moves through the moving
average, or when two different moving averages cross over each other. Divergence happens
when the direction of the price trend and the direction of the indicator trend are moving in the
opposite direction. This indicates that the direction of the price trend is weakening.
Technical indicators provide an extremely useful source of additional information. These
indicators help identify momentum, trends, volatility and various other aspects in a security to
aid in the technical analysis of trends. While some traders just use a single indicator for buy and
sell signals, it is best to use them along with price movement, chart patterns and other indicators.
A number of technical indicators are in use. Some of the technical indicators are discussed below
for the purpose of illustration of the concept:
Moving average
The moving average is a lagging indicator which is easy to construct and is one of the most
widely used. A moving average, as the name suggests, represents an average of a certain series
of data that moves through time. The most common way to calculate the moving average is to
work from the last 10 days of closing prices. Each day, the most recent close (day 11) is added to
the total and the oldest close (day 1) is subtracted. The new total is then divided by the total
number of days (10) and the resultant average computed. The purpose of the moving average is
to track the progress of a price trend. The moving average is a smoothing device. By averaging
the data, a smoother line is produced, making it much easier to view the underlying trend. A
moving average filters out random noise and offers a smoother perspective of the price action.
Moving Average Convergence Divergence (MACD):
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MACD is a momentum indicator and it is made up of two exponential moving averages. The
MACD plots the difference between a 26-day exponential moving average and a 12-day
exponential moving average. A 9-day moving average is generally used as a trigger line. When
the MACD crosses this trigger and goes down it is a bearish signal and when it crosses it to go
above it, it's a bullish signal. This indicator measures short-term momentum as compared to
longer term momentum and signals the current direction of momentum. Traders use the MACD
for indicating trend reversals.
Relative Strength Index:
The relative strength index (RSI) is another of the well-known momentum indicators.
Momentum measures the rate of change of prices by continually taking price differences for a
fixed time interval. RSI helps to signal overbought and oversold conditions in a security. RSI is
plotted in a range of 0-100. A reading above 70 suggests that a security is overbought, while a
reading below 30 suggests that it is oversold. This indicator helps traders to identify whether a
security‘s price has been unreasonably pushed to its current levels and whether a reversal may be
on the way.
Stochastic Oscillator:
The stochastic oscillator is one of the most recognized momentum indicators. This indicator
provides information about the location of a current Security Analysis and Portfolio Management
closing price in relation to the period's high and low prices. The closer the closing price is to the
period's high, the higher is the buying pressure, and the closer the closing price is to the period's
low, the more is the selling pressure. The idea behind this indicator is that in an uptrend, the
price should be closing near the highs of the trading range, signaling upward momentum in the
security. In downtrends, the price should be closing near the lows of the trading range, signaling
downward momentum. The stochastic oscillator is plotted within a range of zero and 100 and
signals overbought conditions above 80 and oversold conditions below 20.
Q.5 From the website of BSE India, explain how the BSE Sensex is calculated.
Answer:
SENSEX: Sensex is the stock market index for BSE. It was first compiled in 1986. It is made of
30 stocks representing a sample of large, liquid and representative companies. The base year of
SENSEX is 1978-79 and the base value is 100.
The Bombay Stock Exchange SENSEX (acronym of Sensitive Index) more commonly referred
to as SENSEX or BSE 30 is a free-float market capitalization-weighted index of 30 well-
established and financially sound companies listed on Bombay Stock Exchange. The 30
component companies which are some of the largest and most actively traded stocks, are
representative of various industrial sectors of the Indian economy. Published since January 1,
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1986, the SENSEX is regarded as the pulse of the domestic stock markets in India. The base
value of the SENSEX is taken as 100 on April 1, 1979, and its base year as 1978-79. On 25 July,
2001 BSE launched DOLLEX-30, a dollar-linked version of SENSEX. As of 21 April 2011, the
market capitalisation of SENSEX was about 29,733 billion (US$660 billion) (42.34% of market
capitalization of BSE), while its free-float market capitalization was 15,690 billion (US$348
billion).
The Bombay Stock Exchange (BSE) regularly reviews and modifies its composition to be sure it
reflects current market conditions. The index is calculated based on a free float capitalization
method—a variation of the market capitalisation method. Instead of using a company's
outstanding shares it uses its float, or shares that are readily available for trading. The free-float
method, therefore, does not include restricted stocks, such as those held by promoters,
government and strategic investors.
Initially, the index was calculated based on the ‗full market capitalization‘ method. However this
was shifted to the free float method with effect from September 1, 2003. Globally, the free float
market capitalization is regarded as the industry best practice.
As per free float capitalization methodology, the level of index at any point of time reflects the
free float market value of 30 component stocks relative to a base period. The market
capitalization of a company is determined by multiplying the price of its stock by the number of
shares issued by the company. This market capitalization is multiplied by a free float factor to
determine the free float market capitalization. Free float factor is also referred as adjustment
factor. Free float factor represent the percentage of shares that are readily available for trading.
The calculation of SENSEX involves dividing the free float market capitalization of 30
companies in the index by a number called index divisor. The divisor is the only link to original
base period value of the SENSEX. It keeps the index comparable over time and is the adjustment
point for all index adjustments arising out of corporate actions, replacement of scrips, etc.
The index has increased by over ten times from June 1990 to the present. Using information
from April 1979 onwards, the long-run rate of return on the BSE SENSEX works out to be
18.6% per annum, which translates to roughly 9% per annum after compensating for inflation.
Following is the list of the component companies of SENSEX as on Feb 26, 2010.
Code Name Sector
Adj.
Factor
Weight in
Index(%)
500410ACC Housing Related 0.55 0.77
500103BHEL Capital Goods 0.35 3.26
532454Bharti Airtel Telecom 0.35 3
532868DLF Universal Limited Housing related 0.25 1.02
500300Grasim Industries Diversified 0.75 1.5
500010HDFC Finance 0.90 5.21
500180HDFC Bank Finance 0.85 5.03
500182Hero Honda Motors Ltd. Transport Equipments 0.50 1.43
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500440Hindalco Industries Ltd.
Metal, Metal Products &
Mining
0.7 1.75
500696Hindustan Lever Limited FMCG 0.50 2.08
532174ICICI Bank Finance 1.00 7.86
500209Infosys Information Technology 0.85 10.26
500875ITC Limited FMCG 0.70 4.99
532532Jaiprakash Associates Housing Related 0.55 1.25
500510Larsen & Toubro Capital Goods 0.90 6.85
500520
Mahindra & Mahindra
Limited
Transport Equipments 0.75 1.71
532500Maruti Suzuki Transport Equipments 0.50 1.71
532541NIIT Technologies Information Technology 0.15 2.03
532555NTPC Power 0.15 2.03
500304NIIT Information Technology 0.15 2.03
500312ONGC Oil & Gas 0.20 3.87
532712Reliance Communications Telecom 0.35 0.92
500325Reliance Industries Oil & Gas 0.50 12.94
500390Reliance Infrastructure Power 0.65 1.19
500112State Bank of India Finance 0.45 4.57
500900Sterlite Industries
Metal, Metal Products, and
Mining
0.45 2.39
524715
Sun Pharmaceutical
Industries
Healthcare 0.40 1.03
532540Tata Consultancy Services Information Technology 0.25 3.61
500570Tata Motors Transport Equipments 0.55 1.66
500400Tata Power Power 0.70 1.63
500470Tata Steel
Metal, Metal Products &
Mining
0.70 2.88
507685Wipro Information Technology 0.20 1.61
Q.6 Frame the investment process for a person of your age group.
Answer:
It is rare to find investors investing their entire savings in a single security. Instead, they tend to
invest in a group of securities. Such a group of securities is called a portfolio. Most financial
experts stress that in order to minimize risk; an investor should hold a well-balanced investment
portfolio. The investment process describes how an investor must go about making.
Decisions with regard to what securities to invest in while constructing a portfolio, how
extensive the investment should be, and when the investment should be made. This is a
procedure involving the following five steps:
• Set investment policy
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• Perform security analysis
• Construct a portfolio
• Revise the portfolio
• Evaluate the performance of portfolio
1. Setting Investment Policy
This initial step determines the investor‘s objectives and the amount of his investable wealth.
Since there is a positive relationship between risk and return, the investment objectives should be
stated in terms of both risk and return.
This step concludes with the asset allocation decision: identification of the potential categories of
financial assets for consideration in the portfolio that the investor is going to construct. Asset
allocation involves dividing an investment portfolio among different asset categories, such as
stocks, bonds and cash.
The asset allocation that works best for an investor at any given point in his life depends largely
on his time horizon and his ability to tolerate risk.
Time Horizon – The time horizon is the expected number of months, years, or decades that an
investor will be investing his money to achieve a particular financial goal. An investor with a
longer time horizon may feel more comfortable with a riskier or more volatile investment
because he can ride out the slow economic cycles and the inevitable ups and downs of the
markets. By contrast, an investor who is saving for his teen-aged daughter‘s college education
would be less likely to take a large risk because he has a shorter time horizon.
Risk Tolerance - Risk tolerance is an investor‘s ability and willingness to lose some or all of his
original investment in exchange for greater potential returns. An aggressive investor, or one with
a high-risk tolerance, is more likely to risk losing money in order to get better results. A
conservative investor, or one with a low-risk tolerance, tends to favour investments that will
preserve his or her original investment. The conservative investors keep a "bird in the hand,"
while aggressive investors seek "two in the bush."
While setting the investment policy, the investor also selects the portfolio management style
(active vs. passive management).
Active Management is the process of managing investment portfolios by attempting to time the
market and/or select „undervalued‟ stocks to buy and „overvalued‟ stocks to sell, based upon
research, investigation and analysis.
Passive Management is the process of managing investment portfolios by trying to match the
performance of an index (such as a stock market index) or asset class of securities as closely as
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possible, by holding all or a representative sample of the securities in the index or asset class.
This portfolio management style does not use market timing or stock selection strategies.
2. Performing Security Analysis
This step is the security selection decision: Within each asset type, identified in the asset
allocation decision, how does an investor select which securities to purchase. Security analysis
involves examining a number of individual securities within the broad categories of financial
assets identified in the previous step. One purpose of this exercise is to identify those securities
that currently appear to be mispriced. Security analysis is done either using Fundamental or
Technical analysis (both have been discussed in subsequent units).
Fundamental analysis is a method used to evaluate the worth of a security by studying the
financial data of the issuer. It scrutinizes the issuer's income and expenses, assets and liabilities,
management, and position in its industry. In other words, it focuses on the „basics‟ of the
business.
Technical analysis is a method used to evaluate the worth of a security by studying market
statistics. Unlike fundamental analysis, technical analysis disregards an issuer's financial
statements. Instead, it relies upon market trends to ascertain investor sentiment to predict how a
security will perform.
3. Portfolio Construction
This step identifies those specific assets in which to invest, as well as determining the proportion
of the investor‘s wealth to put into each one. Here selectivity, timing and diversification issues
are addressed.
Selectivity refers to security analysis and focuses on price movements of individual securities.
Timing involves forecasting of price movement of stocks relative to price movements of fixed
income securities (such as bonds). Diversification aims at constructing a portfolio in such a way
that the investor‘s risk is minimized.
The following table summarizes how the portfolio is constructed for an active and a passive
investor.
4. Portfolio Revision
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This step is the repetition of the three previous steps, as objectives might change and previously
held portfolio might not be the optimal one.
5. Portfolio performance evaluation
This step involves determining periodically how the portfolio has performed over some time
period (returns earned vs. risks incurred).
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SET - 2
Q.1 Show how duration of a bond is calculated and how is it used.
Answer:
Duration of Bonds
Bond Duration is a measure of bond price volatility, which captures both price and reinvestment
risk and which is used to indicate how a bond will react in different interest rate environments.
The duration of a bond represents the length of time that elapses before the average rupee of
present value from the bond is received. Thus duration of a bond is the weighted average
maturity of cash flow stream, where the weights are proportional to the present value of cash
flows. Formally, it is defined as:
Duration
= D = {PV (C1) x 1 + PV (C2) x 2+ ----- PV (Cn) x n} / Current Price of the bond
Where PV (Ci) is the present values of cash flow at time i.
Steps in calculating duration:
Step 1: Find present value of each coupon or principal payment.
Step 2: Multiply this present value by the year in which the cash flow is to be received.
Step 3: Repeat steps 1 & 2 for each year in the life of the bond.
Step 4: Add the values obtained in step 2 and divide by the price of the bond to get the Value of
Duration.
Example: Calculate the duration of an 8% annual coupon 5 year bond that is priced to yield 10%
(i.e. YTM = 10%). The face value of the bond is Rs.1000.
Annual coupon payment = 8% x Rs. 1000 = Rs. 80
At the end of 5 years, the principal of Rs. 1000 will be returned to the investor.
Therefore cash flows in year 1-4= Rs. 80.
Cash flow in year 5= Principal + Interest = Rs. 1000 + Rs. 80 = Rs. 1080
(t)
Annual
Cash
flow
PVIF
@10%
Present Value
of Annual
Cash Flow
PV(Ct)
Explanation
Time x
PV of
cash
flow
Explanation
1 80 0.90909 72.73 = 80 x 0.90909 72.73 =1 x 72.73
2 80 0.82645 66.12 = 80 x 0.82645 132.24 = 2 x 66.12
3 80 0.75131 60.10 = 80 x 0.75131 180.3 = 3 x 60.1
4 80 0.68301 54.64 = 80 x 0.68301 218.56 = 4 x 54.64
5 1080 0.62092 670.59 = 1080 x 0.62092 3352.95 = 5 x 670.59
Total 924.18 3956.78
15 | P a g e
Price of the bond= Rs 924.18
The proportional change in the price of a bond:
(ΔP/P) = - {D/ (1+ YTM)} x Δ y
Where Δ y =change in Yield, and YTM is the yield-to-maturity.
The term D / (1+YTM) is also known as Modified Duration.
The modified duration for the bond in the example above = 4.28 / (1+10%) = 3.89
years.
This implies that the price of the bond will decrease by 3.89 x 1% = 3.89% for a
1% increase in the interest rates.
Example
A bond having Rs.1000 face value and 8 % coupon bond with 4 years to maturity
is priced to provide a YTM of 10%. Find the duration of the bond.
Ans: P0 = 80 x PVIFA 10%, 4 years + 1000 x PVIFA 10%, 4 years
= 80 x 3.170 + 1000 x .683 = 937
rc = 80/937 = 0.857 (current yield)
rd = YTM
n = 4 years
Duration = × PVIFA (rd, n) (1+rd) + [1 –] n dc rr rd rc
= 3.170 (1.10) + [1 –] 4 .10 .0854 .10 .0854
= 2.977 + .584 = 3.561 years
Generally speaking, bond duration possesses the following properties:
– Bonds with higher coupon rates have shorter durations.
– Bonds with longer maturities have longer durations.
– Bonds with higher YTM lead to shorter durations.
– Duration of a bond with coupons is always less than its term to maturity because
duration gives weight to the interim payments. Zero-coupon bonds duration is equal to its
maturity.
Q.2 Using financial ratios, study the financial performance of any particular company of
your interest.
Answer:
Financial ratios illustrate relationships between different aspects of a small business's operations.
16 | P a g e
They involve the comparison of elements from a balance sheet or income statement, and are
crafted with particular points of focus in mind. Financial ratios can provide small business
owners and managers with a valuable tool to measure their progress against predetermined
internal goals, a certain competitor, or the overall industry. In addition, tracking various ratios
over time is a powerful way to identify trends as they develop. Ratios are also used by bankers,
investors, and business analysts to assess various attributes of a company's financial strength or
operating results.
Ratios are determined by dividing one number by another, and are usually expressed as a
percentage. They enable business owners to examine the relationships between seemingly
unrelated items and thus gain useful information for decision-making. "They are simple to
calculate, easy to use, and provide a wealth of information that cannot be gotten anywhere else,"
James O. Gill noted in his book Financial Basics of Small Business Success. But, he added,
"Ratios are aids to judgment and cannot take the place of experience. They will not replace good
management, but they will make a good manager better. They help to pinpoint areas that need
investigation and assist in developing an operating strategy for the future."
Virtually any financial statistics can be compared using a ratio. In reality, however, small
business owners and managers only need to be concerned with a small set of ratios in order to
identify where improvements are needed. "As you run your business you juggle dozens of
different variables," David H. Bangs, Jr. wrote in his book Managing by the Numbers. "Ratio
analysis is designed to help you identify those variables which are out of balance."
It is important to keep in mind that financial ratios are time sensitive; they can only present a
picture of the business at the time that the underlying figures were prepared. For example, a
retailer calculating ratios before and after the Christmas season would get very different results.
In addition, ratios can be misleading when taken singly, though they can be quite valuable when
a small business tracks them over time or uses them as a basis for comparison against company
goals or industry standards. As a result, business owners should compute a variety of applicable
ratios and attempt to discern a pattern, rather than relying on the information provided by only
one or two ratios. Gill also noted that small business owners should be certain to view ratios
objectively, rather than using them to confirm a particular strategy or point of view.
Perhaps the best way for small business owners to use financial ratios is to conduct a formal ratio
analysis on a regular basis. The raw data used to compute the ratios should be recorded on a
special form monthly. Then the relevant ratios should be computed, reviewed, and saved for
future comparisons. Determining which ratios to compute depends on the type of business, the
age of the business, the point in the business cycle, and any specific information sought. For
example, if a small business depends on a large number of fixed assets, ratios that measure how
efficiently these assets are being used may be the most significant. In general, financial ratios can
be broken down into four main categories—profitability or return on investment, liquidity,
leverage, and operating or efficiency—with several specific ratio calculations prescribed within
each.
17 | P a g e
Q.3 Show with the help of an example how portfolio diversification reduces risk.
Answer:
Portfolio diversification
'Don't put all your eggs in one basket' is a well-known proverb, which summarizes the message
that there are benefits from diversification. If you carry your breakable items in several baskets
there is a chance that one will be dropped, but you are unlikely to drop all your baskets on the
same trip. Similarly, if you invest all your wealth in the shares of one company, there is a chance
that the company will go bust and you will lose all your money. Since it is unlikely that all
companies will go bust at the same time, a portfolio of shares in several companies is less risky.
This may sound like the idea of risk-pooling, which we discussed earlier in this chapter, and risk-
pooling is certainly an important reason for diversification. We will use the notion of risk-
pooling to explain some forms of financial behaviour, but a full understanding of portfolio
diversification involves a slightly wider knowledge of the nature of risk than what is involved in
coin-tossing.
The key difference between risk in the real world of finance and the risk of coin-tossing is that
many of the potential outcomes are not independent of other outcomes. If you and I toss a coin,
the probability of yours turning up heads is independent of the probability of my throwing a
head. However, the return on an investment in, say, BP is not independent of the return on an
investment in Shell. This is because these two companies both compete in the same industry. If
BP does especially well in attracting new business, it may be at the expense of Shell. So high
profits at BP may be associated with low profits at Shell, or vice versa. On the other hand, all oil
companies might do well when oil prices are high and badly when they are low. The important
matter here is that the fortunes of these two companies are not independent of each other.
The fact that the risks of individual investments may not be independent has important
implications for investment allocations, or what is now called portfolio theory. Investments can
be combined in different proportions to produce risk and return characteristics that cannot be
achieved through any single investment. As a result, institutions have grown up to take
advantage of the benefits of diversification.
Diversified portfolios may produce combinations of risk and return that dominate no
diversified portfolios.
This is an important statement that requires a little closer investigation. That investigation will
help to identify the circumstances under which diversification is beneficial. It will also clarify
what we mean by the word 'dominate'.
Table 2 sets out two simple examples. In both there are two assets that an investor can hold, and
there are two possible situations which are assumed to be equally likely. Thus, there is a
probability of 0.5 attached to each situation and the investor has no advance knowledge of which
is going to happen. The two situations might be a high exchange rate and a low exchange rate, a
booming and a depressed economy, or any other alternatives that have different effects on the
earnings of different assets.
18 | P a g e
Table 2: Combinations of risk and return
Assets differ in expected return and variability in returns. Part (i) illustrates the return on two
assets in two different situations. Asset A has a high return in situation 2 and a low return in
situation 1. The reverse is true for asset B. A portfolio of both assets has the same expected
return but lower risk than a holding of either asset on its own. In (ii) both assets have a high
return in situation 2 and a low return in situation 1.For the risk-averse investor asset A dominates
asset B.
Consider part (i) of the table. In this case both assets have the same expected return (20 per cent)
and the same degree of risk. (The possible range of outcomes is between 10 and 30 per cent on
each asset.) If all that mattered in investment decisions were the risk and return of individual
shares, the investor would be indifferent between assets A and B. Indeed, if the choice were
between holding only A or only B, all investors should be indifferent (whether they were risk-
averse, risk-neutral, or risk-loving) because the risk and expected return are identical for both
assets. However, this is not the end of the story, because the returns on these assets are not
independent. Indeed, there is a perfect negative correlation between them: when one is high the
other is low, and vice versa.
What would a sensible investor do if permitted to hold some combination of the two assets?
Clearly, there is no possible combination that will change the overall expected return, because it
is the same on both assets. However, holding some of each asset can reduce the risk. Let the
investor decide to hold half his wealth in asset A and half in asset B. His risk will then be
reduced to zero, since his return will be 20 per cent whichever situation arises. This diversified
portfolio will clearly be preferred to either asset alone by risk-averse investors. The risk-neutral
investor is indifferent to all combinations of A and B because they all have the same expected
return, but the risk lover may prefer not to diversify. This is because, by picking one asset alone,
the risk lover still has a chance of getting a 30 per cent return and the extra risk gives positive
pleasure.
Risk-averse investors will choose the diversified portfolio, which gives them the lowest risk
for a given expected rate of return, or the highest expected return for a given level of risk.
Diversification does not always reduce the riskiness of a portfolio, so we need to be clear what
conditions matter. Consider the example in part (ii) of Table 2. As in part (i), both assets have an
expected return of 20 per cent. But asset B is riskier than asset A and it has returns that are
positively correlated with A's. Portfolio diversification does not reduce risk in this case. Risk-
averse investors would invest only in asset A, while risk-lovers would invest only in asset B.
19 | P a g e
Combinations of A and B are always riskier than holding A alone. Thus, we could say that for
the risk-averse investor asset A dominates asset B, as asset B will never be held so long as asset
A is available. The key difference between the example in part (ii) of Table 2 and that in part (i)
is that in the second example returns on the two assets are positively correlated, while in the
former they are negatively correlated [Note].
The risk attached to a combination of two assets will be smaller than the sum of the
individual risks if the two assets have returns that are negatively correlated.
Diversifiable and non-diversifiable risk
Not all risk can be eliminated by diversification. The specific risk associated with any one
company can be diversified away by holding shares of many companies. But even if you held
shares in every available traded company, you would still have some risk, because the stock
market as a whole tends to move up and down over time. Hence we talk about market risk and
specific risk. Market risk is non-diversifiable, whereas specific risk is diversifiable through risk-
pooling.
Box 3 discusses the issue of whether all firms should diversify the activities in order to reduce
risk.
Beta It is now common to use a coefficient called beta to measure the relationship between the
movements in a specific company's share price and movements in the market. A share that is
perfectly correlated with an index of stock market prices will have a beta of 1. A beta higher than
1 means that the share moves in the same direction as the market but with amplified fluctuations.
A beta between 1 and 0 means that the share moves in the same direction as the stock market but
is less volatile. A negative beta indicates that the share moves in the opposite direction to the
market in general. Clearly, other things being equal, a share with a negative beta would be in
high demand by investment managers, as it would reduce a portfolio's risk.
The capital asset pricing model, or CAPM, predicts that the price of shares with higher betas
must offer higher average returns in order to compensate investors for their higher risk. Two
stocks whose returns move in exactly together have a coefficient of +1.0. Two stocks whose
returns move in exactly the opposite direction have a correlation of -1.0. To effectively diversify,
you should aim to find investments that have a low or negative correlation. The banking stocks
(or the technology stocks) would have a high positive correlation as their share prices are driven
by common factors. As you increase the number of securities in your portfolio, you reach a point
where you have diversified as much as is reasonably possible. When you have about 30
securities in your portfolio you have diversified most of the risk.
Q.4 Differentiate between ADRs and GDRs
Answer:
20 | P a g e
1. Global depository receipt (GDR) is compulsory for foreign company to access in any other
country‘s share market for dealing in stock. But American depository receipt (ADR) is
compulsory for non –us companies to trade in stock market of USA.
2. ADRs can get from level -1 to level –III. GDRs are already equal to high preference receipt of
level –II and level –III.
3. Indian companies prefer to get GDR due to its global use for getting foreign investment for
own business projects.
4. ADRs up to level –I need to accept only general condition of SEC of USA but GDRs can only
be issued under rule 144 A after accepting strict rules of SEC of USA.
5. GDR is negotiable instrument all over the world but ADR is only negotiable in USA.
6. Many Indian Companies listed foreign stock market through foreign bank‘s GDR. Names of
these Indian Companies are following :- (A) Bajaj Auto (B) Hindalco (C) ITC ( D) L&T (E)
Ranbaxy Laboratories (F) SBI Some of Indian Companies are listed in USA stock exchange only
through ADRs: - (A) Patni Computers (B) Tata Motors.
7. Even both GDR & ADR is the proxy way to sell shares in foreign market by India companies
ADRs is not substitute of GDRs but GDRs can use on the place of ADRs.
8. Investors of UK can buy GDRs from London stock exchange and luxemberg stock exchange
and invest in Indian companies without any extra responsibilities. Investors of USA can buy
ADRs from New York stock exchange (NYSE) or NASDAQ (National Association of Securities
Dealers Automated Quotation).
9. American investors typically use regular equity trading accounts for buying ADRs but not for
GDRs.
10. The US dollar rate paid to holders of ADRs is calculated by applying the exchange rate used
to convert the foreign dividend payment (net of local withholding tax) to US dollars, and
adjusting the result according to the ordinary share but GDRs is calculated on numbers of Shares.
One GDR's Value may be on two or six shares
Q.5 Study the performance of any emerging market of your choice.
Answer:
Emerging market
With emerging market economies like India and China growing at nearly 10%, you may be
feeling pain from all the criticism from pundits and advisers that you are a myopic, short-sighted
American for not allocating enough to emerging market equities. According to Vanguard, the
average allocation to emerging market equities among US household investors is still only 6%.
21 | P a g e
Shouldn't the percentage of your equity portfolio invested in emerging markets equities be
roughly in line with the proportionate share of emerging-market stocks to total global stock-
market capitalization – or around 10% to 15% of an investor's total equity portfolio? It seems
natural to expect that the powerful economic growth of emerging markets such as Brazil and
China will lead to higher stock market returns than in the slower growing markets such as the
U.S. and Europe. So should emerging market equities be a bigger part of your portfolio?
In fact, US household investors may, at least for the moment, be properly weighted in emerging
markets. For the following reasons higher potential growth may not justify investing heavily
right now in emerging market equities and instead you may want to be gradually increasing your
allocation over time:
First, 12% economic growth in a country like India has not necessarily meant 12% market
returns. While there is certainly reasonable evidence to support expectations of long-term growth
in markets like India, China, Brazil, etc., as reported in this Wall Street Journal article - studies
suggest that strong economic growth often does not translate into strong stock returns.
One study, which looked at market returns in 32 nations since the 1970s, concluded that stock
gains and economic performance can diverge dramatically. University of Florida finance
professor Jay Ritter found, for example, that stocks in Sweden posted a mean return of better
than 8% a year from 1970 through 2002, even though GDP grew at an annualized pace of just
1.8%. In contrast, while GDP expanded more than 5% annually in South Korea from 1988 to
2002, the mean stock return was only 0.4% a year. 'A healthy economy isn't a guarantee that
established companies will attract enough capital and labor to expand sales and earnings
strongly—partly because they have to compete with newer ventures for resources,' Dr. Ritter
says.
More basically, since markets are largely efficient, investors have long ago anticipated potential
for equities in places like China. Right now, by many measures, it would appear that valuations
for US and MSCI Emerging Markets Index on a trailing P/E basis are roughly inline.
Second, even if average annual returns from emerging markets exceed developed markets,
emerging markets are still materially more volatile, and this volatility will not just keep you
awake at night, it will erode your returns over time through the process of volatility drag. My
colleague explains in this article how volatility drag will reduce your returns. Right now, the 3
year standard deviation of emerging market returns is 32.83 versus 24.27 for the S&P500, a
difference that translates into roughly a 3% drag on your cumulative return. And while the 60
day volatility on US Large-Cap Equities has now dropped all the way down to 10.99%, the 60-
day emerging market volatility actually rose slightly this quarter to 19.55% (see chart below for
period ending December 31, 2010):
22 | P a g e
Third, emerging market indexes are less efficient investment vehicles – which makes a big
difference over time for prudent, long-term investors. Most emerging market funds are
significantly more expensive than US funds - often hundreds of basis points more. Our firm
recommends low cost funds such as is hares MSCI Emerging Market Index (EEM), and
Vanguard Emerging Markets (VWO). But even these low-cost funds face higher costs than US
equity funds. Compare Vanguard's VWO at 0.27 expense ratio vs. Vanguard‘s S&P500 Index
Fund (VOO) at 0.06%. If you are investing within a fund family such as Fidelity, your choice for
emerging markets is an actively managed fund with an annual cost of 1.14% versus Fidelity's
S&P500 Index at only 0.10% (This is why if you really seek more exposure to emerging markets
economic growth, a more efficient way to gain exposure is through multinationals traded on US
exchanges – S&P500 companies derive about 50% of their revenue from abroad, with about a
third of that coming from emerging markets).
So higher economic growth may not lead to higher returns on emerging markets equities,
volatility drag is likely to erode much of this potential higher return, and higher investment costs
are certain to drag the return down even further. In our dynamic asset allocation process,
emerging markets allocations are likely to grow along with other equity allocations over the next
few years assuming volatility continues to decline. But, right now, it appears that the average
American household is not necessarily being naive and xenophobic when they choose to be
―underweighted‖ in emerging market equities.
Q.6 As an investor how would you select an equity mutual fund scheme?
Answer:
How do I choose a Scheme
Fundas and more fundas. There is no end to verbosity when educating on funds. But getting to
actually choose a fund may not be eased with more fundas. It often turns out, like with most
ventures in life, that picking your fund is like crossing the saddle point – the first time is always
23 | P a g e
the most difficult. There are more than 350 schemes and choosing one of them is not an easy
task. We will provide you an easy way to filter this huge number down to a more manageable
size so that you can look spend more time looking at schemes in greater detail.
But to begin your selection start from the very beginning:
Specify your investment needs
What are you looking for when investing in mutual funds? What are your investment needs? The
more well defined these answers are the easier it is to find schemes best for you. So how do you
assess your needs?
The answers obviously lie with you. But the questions investors ask to assess their needs are
possibly the same. You might ask yourself: At my age what am I expecting out of investing? To
assess the needs investors look at their lifestyles, financial independence, family commitments,
and level of income and expenses among other things. Questions can be many but to get cracking
ask yourself these two:
What are the returns you want on your investments?
Do you have well-defined time period for the returns you expect on your investment?
The father of an aspiring engineer who would have to shell out the boy's institute fees soon
enough, could reply: I want a fixed monthly income of about Rs.5000 per month. To the second
query he might say: Yes, for the next four years. When asked, the just out- of-B-school graduate
planning for his new Zen could reply: I should make about Rs. 60,000 by the end of one year.
Believe us, but getting the right answers to these questions does a lot to simply your fund picking
exercise. Having defined the needs that direct you to invest, one can find a category of funds that
come close to satisfy your needs with their objectives.
While we are on the topic of what returns to expect, someone might as well wish for a fund that
assures returns. Some of the mutual funds have floated "assured" return schemes that guarantee a
certain annual return or guarantee a buyback at a specified price after a specified period.
Examples of these include funds floated by the UTI, SBI Mutual Fund, etc. Many of these funds
have not earned returns that they promised and the asset management companies of the
respective mutual funds or their sponsors have made good their promises. Nowadays, there are
very few funds that come out with such schemes as the funds have realized it is not viable to
assure returns in a volatile market.
Assess the risk you can take
Contrary to the commonplace thinking, mutual funds do carry risks. And there are some that can
become as risky as stocks. Given the almost diverse objectives with which schemes operate,
there are some with more risks and some relatively safer.
Ask yourself if you are ready for a scheme whose investment value might fluctuate every week
or one that gives a minimum amount of risk? Or are you in for a short-term loss in order to
24 | P a g e
achieve a long-term potential gain? At this point it is good to ask oneself how will you take it if
your investment fails to deliver the returns you expected or makes losses. Knowing this will
reduce your chances (or even temptation) to select a fund that doesn‘t come close to your
objective.
Investors comfortable with numerical recipes do a technical check of what the returns of a
scheme would be in the worst case. They check is done with the Sharpe ratio. The higher the
Sharpe ratio, the better the fund's historical risk-adjusted performance.
Evaluate a scheme by looking at how its NAV has behaved over the past. Do you see the scheme
behaving rather erratically i.e., the NAV changes just too often? More the volatility more are the
risks involved.
Great returns are not the only thing to look for in a scheme. If you feel while researching a
scheme, which we will do later, that it‘s returns are modest and steady and good enough for your
needs, avoid other schemes that have recently delivered high returns. Because great returns in the
past are no guarantees for the fabulous performance to continue in the future. Never forget one of
the commonplace morals of investment: The schemes that are expected to give the highest
returns have the greatest probability to fall flat!
Ask: How long can you park your cash??
Is the cash you have earmarked for your investment meant to be spent for something else? Do
you need a regular cash flow? Or you don‘t mind locking your cash in the scheme so that your
assets can appreciate over time?
Settle this question upfront on what your cash flow requirements will be till the time your money
is invested in mutual funds getting the right Fund.
The success of your investment depends in a large measure on the objective you define. Having
defined that, choosing a fund isn‘t difficult. Through a search of schemes on our advanced search
you can draw up a list of schemes that come close to the objectives you have set. Our search
allows you to set criteria based on your objectives. The criteria you can set are:
The scheme‘s expense: All schemes have a minimum requirement for the total amount of money
you can invest. Usually they begin from a minimum of Rs.5000. Do a check for the expense ratio
and sales charges the fund has. The NAV is good enough to know what each unit of the scheme
will cost you. But, remember a low NAV (sometimes even below the usual offer price of Rs.10)
may make a scheme more affordable as you can acquire more units but chances are the scheme is
not performing well.
The scheme‘s performance: Returns from schemes are calculated over various periods from a
week to one year or more. For each time period specify the returns. While you enter returns
figures the maximum, minimum and average returns for all schemes in the category you have
chosen are also displayed.
25 | P a g e
The scheme‘s fund house: Over the years fund houses in India have established a name for
themselves for their investment style and their performance. Hence, some investors usually try to
satisfy their diverse investments through one fund house. If you have been recommended a fund
house choose the fund to list all schemes under it.
Investment mix: If you know of an industry that has been doing particularly well, you can select
schemes that have invested in that industry. You can also select schemes that have invested in
companies with a dazzling performance. A mixed basket for your diverse needs
Once again, back to the basic question. You came here looking for schemes that can suffice your
investment needs. You might be like many others who actually have multiple needs. Consider
going for a combination of schemes.
Yet another recap of the basics: one of the things that made these mutual funds great was
diversification. While you might have selected a scheme that has a diversified portfolio, you can
also go for more than one scheme to further diversify your investments.
It is well possible that just by picking more than one scheme from one fund house you can
achieve enough diversification. In fact many investors who have tried out a fund house for long
and developed a trust with the fund, prefer to pick another scheme from the fund's
But convenience sometimes leads to venerable prejudices that might deprive you of trying
something new and better. There could be a better-managed scheme in a different fund house
that you are missing out on if you decide to stick to your old fund house for convenience sake
basket for their new investment needs

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Security Analysis and Portfolio Theory

  • 1. 1 | P a g e SET - 1 Q.1 Discuss the different forms of market efficiency. Answer: Forms of Market Efficiency A financial market displays informational efficiency when market prices reflect all available information about value. This definition of efficient market requires answers to two questions: „what is all available information?‟ & „what does it mean to reflect all available information?‟ Different answers to these questions give rise to different versions of market efficiency. What information are we talking about? Information can be information about past prices, information that is public information and information that is private information. Information about past prices refers to the weak form version of market efficiency, information that consists of past prices and all public information refers to the semi-strong version of market efficiency and all information (past prices, all public information and all private information) refers to the strong form version of market efficiency. ―Prices reflect all available information‖ means that all financial transactions which are carried out at market prices, using the available information, are zero NPV activities. The weak form of EMH states that all past prices, volumes and other market statistics (generally referred to as technical analysis) cannot provide any information that would prove useful in predicting future stock price movements. The current prices fully reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information. This implies that past rates of return and other market data should have no relationship with future rates of return. It would mean that if the weak form of EMH is correct, then technical analysis is fruitless in generating excess returns. The semi-strong form suggests that stock prices fully reflect all publicly available information and all expectations about the future. ―Old‖ information then is already discounted and cannot be used to predict stock price fluctuations. In sum, the semi-strong form suggests that fundamental analysis is also fruitless; knowing what a company generated in terms of earnings and revenues in the past will not help you determine what the stock price will do in the future. This implies that decisions made on new information after it is public should not lead to above-average risk- adjusted profits from those transactions. Lastly, the strong form of EMH suggests that stock prices reflect all information, whether it be public (say in SEBI filings) or private (in the minds of the CEO and other insiders). So even with material non-public information, EMH asserts that stock prices cannot be predicted with any accuracy. Q.2 Compare Arbitrage pricing theory with the Capital asset pricing model.
  • 2. 2 | P a g e Answer: Arbitrage Pricing Theory (APT) Arbitrage Pricing Theory (APT) are two of the most commonly used models for pricing all risky assets based on their relevant risks. Capital Asset Pricing Model (CAPM) calculates the required rate of return for any risky asset based on the security‘s beta. Beta is a measure of the movement of the security‘s return with the return on the market portfolio, which includes all the securities that are available in the world and where the proportion of each security in the portfolio is its market value as a percentage of total market value of all the securities. The problem with CAPM is that such a market portfolio is hypothetical and not observable and we have to use a market index like the S&P 500 or Sensex as a proxy for the market portfolio. However, indexes are imperfect proxies for overall market as no single index includes all capital assets, including stocks, bonds, real estate, collectibles, etc. Another criticism of the CAPM is that the various different proxies that are used for the market portfolio do not fully capture all of the relevant risk factors in the economy. An alternative pricing theory with fewer assumptions, the Arbitrage Pricing Theory (APT), has been developed by Stephen Ross. It can calculate expected return without taking recourse to the market portfolio. It is a multi-factor model for determining the required rate of return which means that it takes into account a number of economy wide factors that can affect the security prices. APT calculates relations among expected returns that will rule out arbitrage by investors. The APT requires three assumptions: 1) Returns can be described by a factor model. 2) There are no arbitrage opportunities. 3) There are large numbers of securities that permit the formation of portfolios that diversify the firm-specific risk of individual stocks. The Capital Asset Pricing Model (CAPM) is a model to explain why capital assets are priced the way they are. William Sharpe, Treynor and Lintner contributed to the development of this model. An important consequence of the modern portfolio theory as introduced by Markowitz was that the only meaningful aspect of total risk to consider for any individual asset is its contribution to the total risk of a portfolio. CAPM extended Harry Markowitz‘s portfolio theory to introduce the notions of systematic and unsystematic (or unique) risk. Arbitrage Pricing Theory vs. the Capital Asset Pricing Model The Arbitrage Pricing Theory (APT) and the Capital Asset Pricing Model are the two most influential theories on stock and asset pricing today. The APT model is different from the CAPM in that it is far less restrictive in its assumptions. APT allows the individual investor to develop their model that explains the expected return for a particular asset. Intuitively, the APT makes a lot of sense because it removes the CAPM restrictions and basically states that the expected return on an asset is a function of many factors and the sensitivity of the stock to these factors. As these factors move, so does the expected return on the stock - and therefore its value to the investor. However, the potentially large number of factors means that more factor sensitivities have to be calculated. There is also no guarantee that all the relevant
  • 3. 3 | P a g e factors have been identified. This added complexity is the reason arbitrage pricing theory is far less widely used than CAPM. In the CAPM theory, the expected return on a stock can be described by the movement of that stock relative to the rest of the stock market. The CAPM theory is really just a simplified version of the APT, where the only factor considered is the risk of a particular stock relative to the rest of the stock market - as described by the stock's beta. From a practical standpoint, CAPM remains the dominant pricing model used today. When compared to the Arbitrage Pricing Theory, the Capital Asset Pricing Model is both elegant and relatively simple to calculate. Q.3 Perform an economy analysis on Indian economy in the current situation. Answer: Economic analysis is done for two reasons: first, a company‘s growth prospects are, ultimately, dependent on the economy in which it operates; second, share price performance is generally tied to economic fundamentals, as most companies generally perform well when the economy is doing the same. 1 Factors to be considered in economy analysis The economic variables that are considered in economic analysis are gross domestic product (GDP) growth rate, exchange rates, the balance of payments (BOP), the current account deficit, government policy (fiscal and monetary policy), domestic legislation (laws and regulations), unemployment (the percent of the population that wants to work and is currently not working), public attitude (consumer confidence) inflation (a general increase in the price of goods and services), interest rates, productivity (output per worker), capacity utilization (output by the firm) etc . GDP is the total income earned by a country. GDP growth rate shows how fast the economy is growing. Investors know that strong economic growth is good for companies and recessions or full-blown depressions cause share prices to decline, all other things being equal. Inflation is important for investors, as excessive inflation undermines consumer spending power (prices increase) and so can cause economic Security Analysis and Portfolio Management stagnation. However, deflation (negative inflation) can also hurt the economy, as it encourages consumers to postpone spending (as they wait for cheaper prices). The exchange rate affects the broad economy and companies in a number of ways. First, changes in the exchange rate affect the exports and imports. If exchange rate strengthens, exports are hit; if the exchange rate weakens, imports are affected. The BOP affects the exchange rate through supply and demand for the foreign currency. BOP reflects a country‘s international monetary transactions for a specific time period. It consists of the current account and the capital account. The current account is an account of the
  • 4. 4 | P a g e trade in goods and services. The capital account is an account of the cross-border transactions in financial assets. A current account deficit occurs when a country imports more goods and services than it exports. A capital account deficit occurs when the investments made in the country by foreigners is less than the investment in foreign countries made by local players. The currency of a country appreciates when there is more foreign currency coming into the country than leaving it. Therefore, a surplus in the current or capital account causes the currency to strengthen; a deficit causes the currency to weaken. The levels of interest rates (the cost of borrowing money) in the economy and the money supply (amount of money circulating in the economy) also have a bearing on the performance of businesses. All other things being equal, an increase in money supply causes the interest rates to fall; a decrease causes the interest rates to rise. If interest rates are low, the cost of borrowing by businesses is not expensive, and companies can easily borrow to expand and develop their activities. On the other hand, when the cost of borrowing becomes too high (when the interest rates go up), borrowing may become too costly and plans for expansion are postponed. Interest rates also have a significant effect on the share markets. In very broad terms, share prices improve when interest rates fall and decline when interest rates increase. There are two reasons for that: the ―intrinsic value‖ estimate will increase as interest rates (and the linked discount rate) fall and underlying company profitability will improve, if interest payments reduce. 2 Business cycle and leading coincidental and lagging indicators All economies experience recurrent periods of expansion and contraction. This recurring pattern of recession and recovery is called the business cycle. The business cycle consists of expansionary and recessionary periods. When business activity reaches a high point, it peaks; a low point on the cycle is a trough. Troughs represent the end of a recession and the beginning of an expansion. Peaks represent the end of an expansion and the beginning of a recession. In the expansion phase, business activity is growing, production and demand are increasing, and employment is expanding. Businesses and consumers normally borrow more money for investment and consumption purposes. As the cycle moves into the peak, demand for goods overtakes supply and prices rise. This creates inflation. During inflationary times, there is too much money chasing a limited amount of goods. Therefore, businesses are able to charge more for their items causing prices to rise. This, in turn, reduces the purchasing power of the consumer. As prices rise, demand slackens which causes economic activity to decrease. The cycle then enters the recessionary phase. As business activity contracts, employers lay off workers (unemployment increases) and demand further slackens.
  • 5. 5 | P a g e Usually, this causes prices to fall. The cycle enters the trough. Eventually, lower prices stimulate demand and the economy moves into the expansion phase. The performance of an investment is influenced by the business cycle. The direction in which an economy is heading has a significant impact on companies‟ performance and ability to deliver earnings. If the economy is in a recession, it is likely that many business sectors will fail to generate profits. This is because the demand for most products decreases during economic declines, since people have less money with which to purchase goods and services (since high levels of unemployment are common during economic crises). On the other hand, during times of economic prosperity, companies tend to expand their operations and in turn generate higher levels of earnings, as the demand for goods tends to grow. Security Analysis and Portfolio To some extent the business cycle can be predicted as it is cyclical in nature. The prediction can be done using economic indicators. Economic indicators are quantitative announcements (released as data), released at predetermined times according to a schedule, reflecting the financial, economical and social atmosphere of an economy. They are published by various agencies of the government or by the private sector. They are used to monitor the health and strength of an economy and they help to evaluate the direction of the business cycle. Economists use three types of indicators that provide data on the movement of the economy as the business cycle enters different phases. The three types are leading, coincident, and lagging indicators. Leading indicators tend to precede the upward and downward movements of the business cycle and can be used to predict the near term activity of the economy. Thus they can help anticipate rising corporate profits and possible stock market price increases. Examples of leading indicators are: Average weekly hours of production workers, money supply etc. Coincident indicators usually mirror the movements of the business cycle. They tend to change directly with the economy. Example includes industrial production, manufacturing and trade sales etc. Lagging Indicators are economic indicators that change after the economy has already begun to follow a particular pattern or trend. Lagging Indicators tend to follow (lag) economic performance. Examples: ratio of trade inventories to sales, ratio of consumer installment credit outstanding to personal income etc. Q.4 Identify some technical indicators and explain how they can be used to decide purchase of a company’s stock. Answer: A technical indicator is a series of data points that are derived by applying a formula to the price and/or volume data of a security. Price data can be any combination of the open, high, low or closing price over a period of time. Some indicators may use only the closing prices, while others
  • 6. 6 | P a g e incorporate volume and open interest into their formulae. The price data is entered into the formula and a data point is produced. For example, say the closing prices of a stock for 3 days are Rs. 41, Rs. 43 and Rs. 43. If a technical indicator is constructed using the average of the closing prices, then the average of the 3 closing prices is one data point ((41+43+43)/3=42.33). However, one data point does not offer much information. A series of data points over a period of time is required to enable analysis. Thus we can have a 3 period moving average as a technical indicator, where we drop the earliest closing price and use the next closing price for calculations. By creating a time series of data points, a comparison can then be made between present and past levels. Technical indicators are usually shown in a graphical form above or below a security‘s price chart for facilitating analysis. Once shown in graphical form, an indicator can then be compared with the corresponding price chart of the security. Sometimes indicators are plotted on top of the price plot for a more direct comparison. Technical indicators measure money flow, trends, volatility and momentum etc. They are used for two main purposes: to confirm price movement and the quality of chart patterns, and to form buy and sell signals. A technical indicator offers a different perspective from which to analyze the price action. Some, such as moving averages, are derived from simple formulae and they are relatively easy to understand. Others, like stochastics have complex formulae and require more effort to fully understand and appreciate. Technical indicators can provide unique perspective on the strength and direction of the underlying price action. Indicators filter price action with formulae. Therefore they are derivative measures and not direct reflections of the price action. This should be taken into account when analyzing the indicators. Any analysis of an indicator should be taken with the price action in mind. There are two main types of indicators: leading and lagging. A leading indicator precedes price movements; therefore they are used for prediction. A lagging indicator follows price movement and therefore is a confirmation. The main benefit of leading indicators is that they provide early signaling for entry and exit. Early signals can forewarn against a potential strength or weakness. Leading indicators can be used in trending markets. In a market that is trending up, the leading indicator helps identify oversold conditions for buying opportunities. In a market that is trending down, leading indicators can help identify overbought situations for selling opportunities. Some of the more popular leading indicators include Relative Strength Index (RSI) and Stochastic Oscillator. Lagging indicators follow the price action and are commonly referred to as trend-following indicators. Lagging indicators work best when the markets or securities develop strong trends. They are designed to get traders in and keep them in as long as the trend is intact. As such, these indicators are not effective in trading or sideways markets. Some popular trend-following indicators include moving averages and Moving Average Convergence Divergence (MACD).
  • 7. 7 | P a g e Technical indicators are constructed in two ways: those that fall in a bounded range and those that do not. The technical indicators that are bound within a range are called oscillators. Oscillators are used as an overbought / oversold indicator. A market is said to be „overbought‟ when prices have been trending higher in a relatively steep fashion for some time, to the extent that the number of market participants „long‟ of the market significantly outweighs those on the sidelines or holding „short‟ positions. This means that there are fewer participants to jump onto the back of the trend. The „oversold‘ condition is just the opposite. The market has been trending lower for some time and is running out of „fuel‟ for further price declines. Oscillator indicators move within a range, say between zero and 100, and signal periods where the security is overbought (near 100) or oversold (near zero). Oscillators are the most common type of technical indicators. The technical indicators that are not bound within a range also form buy and sell signals and display strength or weakness in the market, but they can vary in the way they do this. The two main ways that technical indicators are used to form buy and sell signals is through crossovers and divergence. Crossovers occur when either the price moves through the moving average, or when two different moving averages cross over each other. Divergence happens when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This indicates that the direction of the price trend is weakening. Technical indicators provide an extremely useful source of additional information. These indicators help identify momentum, trends, volatility and various other aspects in a security to aid in the technical analysis of trends. While some traders just use a single indicator for buy and sell signals, it is best to use them along with price movement, chart patterns and other indicators. A number of technical indicators are in use. Some of the technical indicators are discussed below for the purpose of illustration of the concept: Moving average The moving average is a lagging indicator which is easy to construct and is one of the most widely used. A moving average, as the name suggests, represents an average of a certain series of data that moves through time. The most common way to calculate the moving average is to work from the last 10 days of closing prices. Each day, the most recent close (day 11) is added to the total and the oldest close (day 1) is subtracted. The new total is then divided by the total number of days (10) and the resultant average computed. The purpose of the moving average is to track the progress of a price trend. The moving average is a smoothing device. By averaging the data, a smoother line is produced, making it much easier to view the underlying trend. A moving average filters out random noise and offers a smoother perspective of the price action. Moving Average Convergence Divergence (MACD):
  • 8. 8 | P a g e MACD is a momentum indicator and it is made up of two exponential moving averages. The MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average. A 9-day moving average is generally used as a trigger line. When the MACD crosses this trigger and goes down it is a bearish signal and when it crosses it to go above it, it's a bullish signal. This indicator measures short-term momentum as compared to longer term momentum and signals the current direction of momentum. Traders use the MACD for indicating trend reversals. Relative Strength Index: The relative strength index (RSI) is another of the well-known momentum indicators. Momentum measures the rate of change of prices by continually taking price differences for a fixed time interval. RSI helps to signal overbought and oversold conditions in a security. RSI is plotted in a range of 0-100. A reading above 70 suggests that a security is overbought, while a reading below 30 suggests that it is oversold. This indicator helps traders to identify whether a security‘s price has been unreasonably pushed to its current levels and whether a reversal may be on the way. Stochastic Oscillator: The stochastic oscillator is one of the most recognized momentum indicators. This indicator provides information about the location of a current Security Analysis and Portfolio Management closing price in relation to the period's high and low prices. The closer the closing price is to the period's high, the higher is the buying pressure, and the closer the closing price is to the period's low, the more is the selling pressure. The idea behind this indicator is that in an uptrend, the price should be closing near the highs of the trading range, signaling upward momentum in the security. In downtrends, the price should be closing near the lows of the trading range, signaling downward momentum. The stochastic oscillator is plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below 20. Q.5 From the website of BSE India, explain how the BSE Sensex is calculated. Answer: SENSEX: Sensex is the stock market index for BSE. It was first compiled in 1986. It is made of 30 stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100. The Bombay Stock Exchange SENSEX (acronym of Sensitive Index) more commonly referred to as SENSEX or BSE 30 is a free-float market capitalization-weighted index of 30 well- established and financially sound companies listed on Bombay Stock Exchange. The 30 component companies which are some of the largest and most actively traded stocks, are representative of various industrial sectors of the Indian economy. Published since January 1,
  • 9. 9 | P a g e 1986, the SENSEX is regarded as the pulse of the domestic stock markets in India. The base value of the SENSEX is taken as 100 on April 1, 1979, and its base year as 1978-79. On 25 July, 2001 BSE launched DOLLEX-30, a dollar-linked version of SENSEX. As of 21 April 2011, the market capitalisation of SENSEX was about 29,733 billion (US$660 billion) (42.34% of market capitalization of BSE), while its free-float market capitalization was 15,690 billion (US$348 billion). The Bombay Stock Exchange (BSE) regularly reviews and modifies its composition to be sure it reflects current market conditions. The index is calculated based on a free float capitalization method—a variation of the market capitalisation method. Instead of using a company's outstanding shares it uses its float, or shares that are readily available for trading. The free-float method, therefore, does not include restricted stocks, such as those held by promoters, government and strategic investors. Initially, the index was calculated based on the ‗full market capitalization‘ method. However this was shifted to the free float method with effect from September 1, 2003. Globally, the free float market capitalization is regarded as the industry best practice. As per free float capitalization methodology, the level of index at any point of time reflects the free float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is multiplied by a free float factor to determine the free float market capitalization. Free float factor is also referred as adjustment factor. Free float factor represent the percentage of shares that are readily available for trading. The calculation of SENSEX involves dividing the free float market capitalization of 30 companies in the index by a number called index divisor. The divisor is the only link to original base period value of the SENSEX. It keeps the index comparable over time and is the adjustment point for all index adjustments arising out of corporate actions, replacement of scrips, etc. The index has increased by over ten times from June 1990 to the present. Using information from April 1979 onwards, the long-run rate of return on the BSE SENSEX works out to be 18.6% per annum, which translates to roughly 9% per annum after compensating for inflation. Following is the list of the component companies of SENSEX as on Feb 26, 2010. Code Name Sector Adj. Factor Weight in Index(%) 500410ACC Housing Related 0.55 0.77 500103BHEL Capital Goods 0.35 3.26 532454Bharti Airtel Telecom 0.35 3 532868DLF Universal Limited Housing related 0.25 1.02 500300Grasim Industries Diversified 0.75 1.5 500010HDFC Finance 0.90 5.21 500180HDFC Bank Finance 0.85 5.03 500182Hero Honda Motors Ltd. Transport Equipments 0.50 1.43
  • 10. 10 | P a g e 500440Hindalco Industries Ltd. Metal, Metal Products & Mining 0.7 1.75 500696Hindustan Lever Limited FMCG 0.50 2.08 532174ICICI Bank Finance 1.00 7.86 500209Infosys Information Technology 0.85 10.26 500875ITC Limited FMCG 0.70 4.99 532532Jaiprakash Associates Housing Related 0.55 1.25 500510Larsen & Toubro Capital Goods 0.90 6.85 500520 Mahindra & Mahindra Limited Transport Equipments 0.75 1.71 532500Maruti Suzuki Transport Equipments 0.50 1.71 532541NIIT Technologies Information Technology 0.15 2.03 532555NTPC Power 0.15 2.03 500304NIIT Information Technology 0.15 2.03 500312ONGC Oil & Gas 0.20 3.87 532712Reliance Communications Telecom 0.35 0.92 500325Reliance Industries Oil & Gas 0.50 12.94 500390Reliance Infrastructure Power 0.65 1.19 500112State Bank of India Finance 0.45 4.57 500900Sterlite Industries Metal, Metal Products, and Mining 0.45 2.39 524715 Sun Pharmaceutical Industries Healthcare 0.40 1.03 532540Tata Consultancy Services Information Technology 0.25 3.61 500570Tata Motors Transport Equipments 0.55 1.66 500400Tata Power Power 0.70 1.63 500470Tata Steel Metal, Metal Products & Mining 0.70 2.88 507685Wipro Information Technology 0.20 1.61 Q.6 Frame the investment process for a person of your age group. Answer: It is rare to find investors investing their entire savings in a single security. Instead, they tend to invest in a group of securities. Such a group of securities is called a portfolio. Most financial experts stress that in order to minimize risk; an investor should hold a well-balanced investment portfolio. The investment process describes how an investor must go about making. Decisions with regard to what securities to invest in while constructing a portfolio, how extensive the investment should be, and when the investment should be made. This is a procedure involving the following five steps: • Set investment policy
  • 11. 11 | P a g e • Perform security analysis • Construct a portfolio • Revise the portfolio • Evaluate the performance of portfolio 1. Setting Investment Policy This initial step determines the investor‘s objectives and the amount of his investable wealth. Since there is a positive relationship between risk and return, the investment objectives should be stated in terms of both risk and return. This step concludes with the asset allocation decision: identification of the potential categories of financial assets for consideration in the portfolio that the investor is going to construct. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds and cash. The asset allocation that works best for an investor at any given point in his life depends largely on his time horizon and his ability to tolerate risk. Time Horizon – The time horizon is the expected number of months, years, or decades that an investor will be investing his money to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable with a riskier or more volatile investment because he can ride out the slow economic cycles and the inevitable ups and downs of the markets. By contrast, an investor who is saving for his teen-aged daughter‘s college education would be less likely to take a large risk because he has a shorter time horizon. Risk Tolerance - Risk tolerance is an investor‘s ability and willingness to lose some or all of his original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favour investments that will preserve his or her original investment. The conservative investors keep a "bird in the hand," while aggressive investors seek "two in the bush." While setting the investment policy, the investor also selects the portfolio management style (active vs. passive management). Active Management is the process of managing investment portfolios by attempting to time the market and/or select „undervalued‟ stocks to buy and „overvalued‟ stocks to sell, based upon research, investigation and analysis. Passive Management is the process of managing investment portfolios by trying to match the performance of an index (such as a stock market index) or asset class of securities as closely as
  • 12. 12 | P a g e possible, by holding all or a representative sample of the securities in the index or asset class. This portfolio management style does not use market timing or stock selection strategies. 2. Performing Security Analysis This step is the security selection decision: Within each asset type, identified in the asset allocation decision, how does an investor select which securities to purchase. Security analysis involves examining a number of individual securities within the broad categories of financial assets identified in the previous step. One purpose of this exercise is to identify those securities that currently appear to be mispriced. Security analysis is done either using Fundamental or Technical analysis (both have been discussed in subsequent units). Fundamental analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. It scrutinizes the issuer's income and expenses, assets and liabilities, management, and position in its industry. In other words, it focuses on the „basics‟ of the business. Technical analysis is a method used to evaluate the worth of a security by studying market statistics. Unlike fundamental analysis, technical analysis disregards an issuer's financial statements. Instead, it relies upon market trends to ascertain investor sentiment to predict how a security will perform. 3. Portfolio Construction This step identifies those specific assets in which to invest, as well as determining the proportion of the investor‘s wealth to put into each one. Here selectivity, timing and diversification issues are addressed. Selectivity refers to security analysis and focuses on price movements of individual securities. Timing involves forecasting of price movement of stocks relative to price movements of fixed income securities (such as bonds). Diversification aims at constructing a portfolio in such a way that the investor‘s risk is minimized. The following table summarizes how the portfolio is constructed for an active and a passive investor. 4. Portfolio Revision
  • 13. 13 | P a g e This step is the repetition of the three previous steps, as objectives might change and previously held portfolio might not be the optimal one. 5. Portfolio performance evaluation This step involves determining periodically how the portfolio has performed over some time period (returns earned vs. risks incurred).
  • 14. 14 | P a g e SET - 2 Q.1 Show how duration of a bond is calculated and how is it used. Answer: Duration of Bonds Bond Duration is a measure of bond price volatility, which captures both price and reinvestment risk and which is used to indicate how a bond will react in different interest rate environments. The duration of a bond represents the length of time that elapses before the average rupee of present value from the bond is received. Thus duration of a bond is the weighted average maturity of cash flow stream, where the weights are proportional to the present value of cash flows. Formally, it is defined as: Duration = D = {PV (C1) x 1 + PV (C2) x 2+ ----- PV (Cn) x n} / Current Price of the bond Where PV (Ci) is the present values of cash flow at time i. Steps in calculating duration: Step 1: Find present value of each coupon or principal payment. Step 2: Multiply this present value by the year in which the cash flow is to be received. Step 3: Repeat steps 1 & 2 for each year in the life of the bond. Step 4: Add the values obtained in step 2 and divide by the price of the bond to get the Value of Duration. Example: Calculate the duration of an 8% annual coupon 5 year bond that is priced to yield 10% (i.e. YTM = 10%). The face value of the bond is Rs.1000. Annual coupon payment = 8% x Rs. 1000 = Rs. 80 At the end of 5 years, the principal of Rs. 1000 will be returned to the investor. Therefore cash flows in year 1-4= Rs. 80. Cash flow in year 5= Principal + Interest = Rs. 1000 + Rs. 80 = Rs. 1080 (t) Annual Cash flow PVIF @10% Present Value of Annual Cash Flow PV(Ct) Explanation Time x PV of cash flow Explanation 1 80 0.90909 72.73 = 80 x 0.90909 72.73 =1 x 72.73 2 80 0.82645 66.12 = 80 x 0.82645 132.24 = 2 x 66.12 3 80 0.75131 60.10 = 80 x 0.75131 180.3 = 3 x 60.1 4 80 0.68301 54.64 = 80 x 0.68301 218.56 = 4 x 54.64 5 1080 0.62092 670.59 = 1080 x 0.62092 3352.95 = 5 x 670.59 Total 924.18 3956.78
  • 15. 15 | P a g e Price of the bond= Rs 924.18 The proportional change in the price of a bond: (ΔP/P) = - {D/ (1+ YTM)} x Δ y Where Δ y =change in Yield, and YTM is the yield-to-maturity. The term D / (1+YTM) is also known as Modified Duration. The modified duration for the bond in the example above = 4.28 / (1+10%) = 3.89 years. This implies that the price of the bond will decrease by 3.89 x 1% = 3.89% for a 1% increase in the interest rates. Example A bond having Rs.1000 face value and 8 % coupon bond with 4 years to maturity is priced to provide a YTM of 10%. Find the duration of the bond. Ans: P0 = 80 x PVIFA 10%, 4 years + 1000 x PVIFA 10%, 4 years = 80 x 3.170 + 1000 x .683 = 937 rc = 80/937 = 0.857 (current yield) rd = YTM n = 4 years Duration = × PVIFA (rd, n) (1+rd) + [1 –] n dc rr rd rc = 3.170 (1.10) + [1 –] 4 .10 .0854 .10 .0854 = 2.977 + .584 = 3.561 years Generally speaking, bond duration possesses the following properties: – Bonds with higher coupon rates have shorter durations. – Bonds with longer maturities have longer durations. – Bonds with higher YTM lead to shorter durations. – Duration of a bond with coupons is always less than its term to maturity because duration gives weight to the interim payments. Zero-coupon bonds duration is equal to its maturity. Q.2 Using financial ratios, study the financial performance of any particular company of your interest. Answer: Financial ratios illustrate relationships between different aspects of a small business's operations.
  • 16. 16 | P a g e They involve the comparison of elements from a balance sheet or income statement, and are crafted with particular points of focus in mind. Financial ratios can provide small business owners and managers with a valuable tool to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. In addition, tracking various ratios over time is a powerful way to identify trends as they develop. Ratios are also used by bankers, investors, and business analysts to assess various attributes of a company's financial strength or operating results. Ratios are determined by dividing one number by another, and are usually expressed as a percentage. They enable business owners to examine the relationships between seemingly unrelated items and thus gain useful information for decision-making. "They are simple to calculate, easy to use, and provide a wealth of information that cannot be gotten anywhere else," James O. Gill noted in his book Financial Basics of Small Business Success. But, he added, "Ratios are aids to judgment and cannot take the place of experience. They will not replace good management, but they will make a good manager better. They help to pinpoint areas that need investigation and assist in developing an operating strategy for the future." Virtually any financial statistics can be compared using a ratio. In reality, however, small business owners and managers only need to be concerned with a small set of ratios in order to identify where improvements are needed. "As you run your business you juggle dozens of different variables," David H. Bangs, Jr. wrote in his book Managing by the Numbers. "Ratio analysis is designed to help you identify those variables which are out of balance." It is important to keep in mind that financial ratios are time sensitive; they can only present a picture of the business at the time that the underlying figures were prepared. For example, a retailer calculating ratios before and after the Christmas season would get very different results. In addition, ratios can be misleading when taken singly, though they can be quite valuable when a small business tracks them over time or uses them as a basis for comparison against company goals or industry standards. As a result, business owners should compute a variety of applicable ratios and attempt to discern a pattern, rather than relying on the information provided by only one or two ratios. Gill also noted that small business owners should be certain to view ratios objectively, rather than using them to confirm a particular strategy or point of view. Perhaps the best way for small business owners to use financial ratios is to conduct a formal ratio analysis on a regular basis. The raw data used to compute the ratios should be recorded on a special form monthly. Then the relevant ratios should be computed, reviewed, and saved for future comparisons. Determining which ratios to compute depends on the type of business, the age of the business, the point in the business cycle, and any specific information sought. For example, if a small business depends on a large number of fixed assets, ratios that measure how efficiently these assets are being used may be the most significant. In general, financial ratios can be broken down into four main categories—profitability or return on investment, liquidity, leverage, and operating or efficiency—with several specific ratio calculations prescribed within each.
  • 17. 17 | P a g e Q.3 Show with the help of an example how portfolio diversification reduces risk. Answer: Portfolio diversification 'Don't put all your eggs in one basket' is a well-known proverb, which summarizes the message that there are benefits from diversification. If you carry your breakable items in several baskets there is a chance that one will be dropped, but you are unlikely to drop all your baskets on the same trip. Similarly, if you invest all your wealth in the shares of one company, there is a chance that the company will go bust and you will lose all your money. Since it is unlikely that all companies will go bust at the same time, a portfolio of shares in several companies is less risky. This may sound like the idea of risk-pooling, which we discussed earlier in this chapter, and risk- pooling is certainly an important reason for diversification. We will use the notion of risk- pooling to explain some forms of financial behaviour, but a full understanding of portfolio diversification involves a slightly wider knowledge of the nature of risk than what is involved in coin-tossing. The key difference between risk in the real world of finance and the risk of coin-tossing is that many of the potential outcomes are not independent of other outcomes. If you and I toss a coin, the probability of yours turning up heads is independent of the probability of my throwing a head. However, the return on an investment in, say, BP is not independent of the return on an investment in Shell. This is because these two companies both compete in the same industry. If BP does especially well in attracting new business, it may be at the expense of Shell. So high profits at BP may be associated with low profits at Shell, or vice versa. On the other hand, all oil companies might do well when oil prices are high and badly when they are low. The important matter here is that the fortunes of these two companies are not independent of each other. The fact that the risks of individual investments may not be independent has important implications for investment allocations, or what is now called portfolio theory. Investments can be combined in different proportions to produce risk and return characteristics that cannot be achieved through any single investment. As a result, institutions have grown up to take advantage of the benefits of diversification. Diversified portfolios may produce combinations of risk and return that dominate no diversified portfolios. This is an important statement that requires a little closer investigation. That investigation will help to identify the circumstances under which diversification is beneficial. It will also clarify what we mean by the word 'dominate'. Table 2 sets out two simple examples. In both there are two assets that an investor can hold, and there are two possible situations which are assumed to be equally likely. Thus, there is a probability of 0.5 attached to each situation and the investor has no advance knowledge of which is going to happen. The two situations might be a high exchange rate and a low exchange rate, a booming and a depressed economy, or any other alternatives that have different effects on the earnings of different assets.
  • 18. 18 | P a g e Table 2: Combinations of risk and return Assets differ in expected return and variability in returns. Part (i) illustrates the return on two assets in two different situations. Asset A has a high return in situation 2 and a low return in situation 1. The reverse is true for asset B. A portfolio of both assets has the same expected return but lower risk than a holding of either asset on its own. In (ii) both assets have a high return in situation 2 and a low return in situation 1.For the risk-averse investor asset A dominates asset B. Consider part (i) of the table. In this case both assets have the same expected return (20 per cent) and the same degree of risk. (The possible range of outcomes is between 10 and 30 per cent on each asset.) If all that mattered in investment decisions were the risk and return of individual shares, the investor would be indifferent between assets A and B. Indeed, if the choice were between holding only A or only B, all investors should be indifferent (whether they were risk- averse, risk-neutral, or risk-loving) because the risk and expected return are identical for both assets. However, this is not the end of the story, because the returns on these assets are not independent. Indeed, there is a perfect negative correlation between them: when one is high the other is low, and vice versa. What would a sensible investor do if permitted to hold some combination of the two assets? Clearly, there is no possible combination that will change the overall expected return, because it is the same on both assets. However, holding some of each asset can reduce the risk. Let the investor decide to hold half his wealth in asset A and half in asset B. His risk will then be reduced to zero, since his return will be 20 per cent whichever situation arises. This diversified portfolio will clearly be preferred to either asset alone by risk-averse investors. The risk-neutral investor is indifferent to all combinations of A and B because they all have the same expected return, but the risk lover may prefer not to diversify. This is because, by picking one asset alone, the risk lover still has a chance of getting a 30 per cent return and the extra risk gives positive pleasure. Risk-averse investors will choose the diversified portfolio, which gives them the lowest risk for a given expected rate of return, or the highest expected return for a given level of risk. Diversification does not always reduce the riskiness of a portfolio, so we need to be clear what conditions matter. Consider the example in part (ii) of Table 2. As in part (i), both assets have an expected return of 20 per cent. But asset B is riskier than asset A and it has returns that are positively correlated with A's. Portfolio diversification does not reduce risk in this case. Risk- averse investors would invest only in asset A, while risk-lovers would invest only in asset B.
  • 19. 19 | P a g e Combinations of A and B are always riskier than holding A alone. Thus, we could say that for the risk-averse investor asset A dominates asset B, as asset B will never be held so long as asset A is available. The key difference between the example in part (ii) of Table 2 and that in part (i) is that in the second example returns on the two assets are positively correlated, while in the former they are negatively correlated [Note]. The risk attached to a combination of two assets will be smaller than the sum of the individual risks if the two assets have returns that are negatively correlated. Diversifiable and non-diversifiable risk Not all risk can be eliminated by diversification. The specific risk associated with any one company can be diversified away by holding shares of many companies. But even if you held shares in every available traded company, you would still have some risk, because the stock market as a whole tends to move up and down over time. Hence we talk about market risk and specific risk. Market risk is non-diversifiable, whereas specific risk is diversifiable through risk- pooling. Box 3 discusses the issue of whether all firms should diversify the activities in order to reduce risk. Beta It is now common to use a coefficient called beta to measure the relationship between the movements in a specific company's share price and movements in the market. A share that is perfectly correlated with an index of stock market prices will have a beta of 1. A beta higher than 1 means that the share moves in the same direction as the market but with amplified fluctuations. A beta between 1 and 0 means that the share moves in the same direction as the stock market but is less volatile. A negative beta indicates that the share moves in the opposite direction to the market in general. Clearly, other things being equal, a share with a negative beta would be in high demand by investment managers, as it would reduce a portfolio's risk. The capital asset pricing model, or CAPM, predicts that the price of shares with higher betas must offer higher average returns in order to compensate investors for their higher risk. Two stocks whose returns move in exactly together have a coefficient of +1.0. Two stocks whose returns move in exactly the opposite direction have a correlation of -1.0. To effectively diversify, you should aim to find investments that have a low or negative correlation. The banking stocks (or the technology stocks) would have a high positive correlation as their share prices are driven by common factors. As you increase the number of securities in your portfolio, you reach a point where you have diversified as much as is reasonably possible. When you have about 30 securities in your portfolio you have diversified most of the risk. Q.4 Differentiate between ADRs and GDRs Answer:
  • 20. 20 | P a g e 1. Global depository receipt (GDR) is compulsory for foreign company to access in any other country‘s share market for dealing in stock. But American depository receipt (ADR) is compulsory for non –us companies to trade in stock market of USA. 2. ADRs can get from level -1 to level –III. GDRs are already equal to high preference receipt of level –II and level –III. 3. Indian companies prefer to get GDR due to its global use for getting foreign investment for own business projects. 4. ADRs up to level –I need to accept only general condition of SEC of USA but GDRs can only be issued under rule 144 A after accepting strict rules of SEC of USA. 5. GDR is negotiable instrument all over the world but ADR is only negotiable in USA. 6. Many Indian Companies listed foreign stock market through foreign bank‘s GDR. Names of these Indian Companies are following :- (A) Bajaj Auto (B) Hindalco (C) ITC ( D) L&T (E) Ranbaxy Laboratories (F) SBI Some of Indian Companies are listed in USA stock exchange only through ADRs: - (A) Patni Computers (B) Tata Motors. 7. Even both GDR & ADR is the proxy way to sell shares in foreign market by India companies ADRs is not substitute of GDRs but GDRs can use on the place of ADRs. 8. Investors of UK can buy GDRs from London stock exchange and luxemberg stock exchange and invest in Indian companies without any extra responsibilities. Investors of USA can buy ADRs from New York stock exchange (NYSE) or NASDAQ (National Association of Securities Dealers Automated Quotation). 9. American investors typically use regular equity trading accounts for buying ADRs but not for GDRs. 10. The US dollar rate paid to holders of ADRs is calculated by applying the exchange rate used to convert the foreign dividend payment (net of local withholding tax) to US dollars, and adjusting the result according to the ordinary share but GDRs is calculated on numbers of Shares. One GDR's Value may be on two or six shares Q.5 Study the performance of any emerging market of your choice. Answer: Emerging market With emerging market economies like India and China growing at nearly 10%, you may be feeling pain from all the criticism from pundits and advisers that you are a myopic, short-sighted American for not allocating enough to emerging market equities. According to Vanguard, the average allocation to emerging market equities among US household investors is still only 6%.
  • 21. 21 | P a g e Shouldn't the percentage of your equity portfolio invested in emerging markets equities be roughly in line with the proportionate share of emerging-market stocks to total global stock- market capitalization – or around 10% to 15% of an investor's total equity portfolio? It seems natural to expect that the powerful economic growth of emerging markets such as Brazil and China will lead to higher stock market returns than in the slower growing markets such as the U.S. and Europe. So should emerging market equities be a bigger part of your portfolio? In fact, US household investors may, at least for the moment, be properly weighted in emerging markets. For the following reasons higher potential growth may not justify investing heavily right now in emerging market equities and instead you may want to be gradually increasing your allocation over time: First, 12% economic growth in a country like India has not necessarily meant 12% market returns. While there is certainly reasonable evidence to support expectations of long-term growth in markets like India, China, Brazil, etc., as reported in this Wall Street Journal article - studies suggest that strong economic growth often does not translate into strong stock returns. One study, which looked at market returns in 32 nations since the 1970s, concluded that stock gains and economic performance can diverge dramatically. University of Florida finance professor Jay Ritter found, for example, that stocks in Sweden posted a mean return of better than 8% a year from 1970 through 2002, even though GDP grew at an annualized pace of just 1.8%. In contrast, while GDP expanded more than 5% annually in South Korea from 1988 to 2002, the mean stock return was only 0.4% a year. 'A healthy economy isn't a guarantee that established companies will attract enough capital and labor to expand sales and earnings strongly—partly because they have to compete with newer ventures for resources,' Dr. Ritter says. More basically, since markets are largely efficient, investors have long ago anticipated potential for equities in places like China. Right now, by many measures, it would appear that valuations for US and MSCI Emerging Markets Index on a trailing P/E basis are roughly inline. Second, even if average annual returns from emerging markets exceed developed markets, emerging markets are still materially more volatile, and this volatility will not just keep you awake at night, it will erode your returns over time through the process of volatility drag. My colleague explains in this article how volatility drag will reduce your returns. Right now, the 3 year standard deviation of emerging market returns is 32.83 versus 24.27 for the S&P500, a difference that translates into roughly a 3% drag on your cumulative return. And while the 60 day volatility on US Large-Cap Equities has now dropped all the way down to 10.99%, the 60- day emerging market volatility actually rose slightly this quarter to 19.55% (see chart below for period ending December 31, 2010):
  • 22. 22 | P a g e Third, emerging market indexes are less efficient investment vehicles – which makes a big difference over time for prudent, long-term investors. Most emerging market funds are significantly more expensive than US funds - often hundreds of basis points more. Our firm recommends low cost funds such as is hares MSCI Emerging Market Index (EEM), and Vanguard Emerging Markets (VWO). But even these low-cost funds face higher costs than US equity funds. Compare Vanguard's VWO at 0.27 expense ratio vs. Vanguard‘s S&P500 Index Fund (VOO) at 0.06%. If you are investing within a fund family such as Fidelity, your choice for emerging markets is an actively managed fund with an annual cost of 1.14% versus Fidelity's S&P500 Index at only 0.10% (This is why if you really seek more exposure to emerging markets economic growth, a more efficient way to gain exposure is through multinationals traded on US exchanges – S&P500 companies derive about 50% of their revenue from abroad, with about a third of that coming from emerging markets). So higher economic growth may not lead to higher returns on emerging markets equities, volatility drag is likely to erode much of this potential higher return, and higher investment costs are certain to drag the return down even further. In our dynamic asset allocation process, emerging markets allocations are likely to grow along with other equity allocations over the next few years assuming volatility continues to decline. But, right now, it appears that the average American household is not necessarily being naive and xenophobic when they choose to be ―underweighted‖ in emerging market equities. Q.6 As an investor how would you select an equity mutual fund scheme? Answer: How do I choose a Scheme Fundas and more fundas. There is no end to verbosity when educating on funds. But getting to actually choose a fund may not be eased with more fundas. It often turns out, like with most ventures in life, that picking your fund is like crossing the saddle point – the first time is always
  • 23. 23 | P a g e the most difficult. There are more than 350 schemes and choosing one of them is not an easy task. We will provide you an easy way to filter this huge number down to a more manageable size so that you can look spend more time looking at schemes in greater detail. But to begin your selection start from the very beginning: Specify your investment needs What are you looking for when investing in mutual funds? What are your investment needs? The more well defined these answers are the easier it is to find schemes best for you. So how do you assess your needs? The answers obviously lie with you. But the questions investors ask to assess their needs are possibly the same. You might ask yourself: At my age what am I expecting out of investing? To assess the needs investors look at their lifestyles, financial independence, family commitments, and level of income and expenses among other things. Questions can be many but to get cracking ask yourself these two: What are the returns you want on your investments? Do you have well-defined time period for the returns you expect on your investment? The father of an aspiring engineer who would have to shell out the boy's institute fees soon enough, could reply: I want a fixed monthly income of about Rs.5000 per month. To the second query he might say: Yes, for the next four years. When asked, the just out- of-B-school graduate planning for his new Zen could reply: I should make about Rs. 60,000 by the end of one year. Believe us, but getting the right answers to these questions does a lot to simply your fund picking exercise. Having defined the needs that direct you to invest, one can find a category of funds that come close to satisfy your needs with their objectives. While we are on the topic of what returns to expect, someone might as well wish for a fund that assures returns. Some of the mutual funds have floated "assured" return schemes that guarantee a certain annual return or guarantee a buyback at a specified price after a specified period. Examples of these include funds floated by the UTI, SBI Mutual Fund, etc. Many of these funds have not earned returns that they promised and the asset management companies of the respective mutual funds or their sponsors have made good their promises. Nowadays, there are very few funds that come out with such schemes as the funds have realized it is not viable to assure returns in a volatile market. Assess the risk you can take Contrary to the commonplace thinking, mutual funds do carry risks. And there are some that can become as risky as stocks. Given the almost diverse objectives with which schemes operate, there are some with more risks and some relatively safer. Ask yourself if you are ready for a scheme whose investment value might fluctuate every week or one that gives a minimum amount of risk? Or are you in for a short-term loss in order to
  • 24. 24 | P a g e achieve a long-term potential gain? At this point it is good to ask oneself how will you take it if your investment fails to deliver the returns you expected or makes losses. Knowing this will reduce your chances (or even temptation) to select a fund that doesn‘t come close to your objective. Investors comfortable with numerical recipes do a technical check of what the returns of a scheme would be in the worst case. They check is done with the Sharpe ratio. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance. Evaluate a scheme by looking at how its NAV has behaved over the past. Do you see the scheme behaving rather erratically i.e., the NAV changes just too often? More the volatility more are the risks involved. Great returns are not the only thing to look for in a scheme. If you feel while researching a scheme, which we will do later, that it‘s returns are modest and steady and good enough for your needs, avoid other schemes that have recently delivered high returns. Because great returns in the past are no guarantees for the fabulous performance to continue in the future. Never forget one of the commonplace morals of investment: The schemes that are expected to give the highest returns have the greatest probability to fall flat! Ask: How long can you park your cash?? Is the cash you have earmarked for your investment meant to be spent for something else? Do you need a regular cash flow? Or you don‘t mind locking your cash in the scheme so that your assets can appreciate over time? Settle this question upfront on what your cash flow requirements will be till the time your money is invested in mutual funds getting the right Fund. The success of your investment depends in a large measure on the objective you define. Having defined that, choosing a fund isn‘t difficult. Through a search of schemes on our advanced search you can draw up a list of schemes that come close to the objectives you have set. Our search allows you to set criteria based on your objectives. The criteria you can set are: The scheme‘s expense: All schemes have a minimum requirement for the total amount of money you can invest. Usually they begin from a minimum of Rs.5000. Do a check for the expense ratio and sales charges the fund has. The NAV is good enough to know what each unit of the scheme will cost you. But, remember a low NAV (sometimes even below the usual offer price of Rs.10) may make a scheme more affordable as you can acquire more units but chances are the scheme is not performing well. The scheme‘s performance: Returns from schemes are calculated over various periods from a week to one year or more. For each time period specify the returns. While you enter returns figures the maximum, minimum and average returns for all schemes in the category you have chosen are also displayed.
  • 25. 25 | P a g e The scheme‘s fund house: Over the years fund houses in India have established a name for themselves for their investment style and their performance. Hence, some investors usually try to satisfy their diverse investments through one fund house. If you have been recommended a fund house choose the fund to list all schemes under it. Investment mix: If you know of an industry that has been doing particularly well, you can select schemes that have invested in that industry. You can also select schemes that have invested in companies with a dazzling performance. A mixed basket for your diverse needs Once again, back to the basic question. You came here looking for schemes that can suffice your investment needs. You might be like many others who actually have multiple needs. Consider going for a combination of schemes. Yet another recap of the basics: one of the things that made these mutual funds great was diversification. While you might have selected a scheme that has a diversified portfolio, you can also go for more than one scheme to further diversify your investments. It is well possible that just by picking more than one scheme from one fund house you can achieve enough diversification. In fact many investors who have tried out a fund house for long and developed a trust with the fund, prefer to pick another scheme from the fund's But convenience sometimes leads to venerable prejudices that might deprive you of trying something new and better. There could be a better-managed scheme in a different fund house that you are missing out on if you decide to stick to your old fund house for convenience sake basket for their new investment needs