BA9257

SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

LT P C

3003

UNIT I

INVESTMENT SETTING

Financial and economic meaning of Investment Characteristics and objectives of Investment Types of Investment Investment alternatives Choice and Evaluation Risk and return concepts.

UNIT II

SECURITIES MARKETS

10

Financial Market - Segments Types - - Participants in financial Market Regulatory Environment, Primary Market Methods of floating new issues, Book building Role of primary market Regulation of primary market, Stock exchanges in India BSE, OTCEI , NSE, ISE, and Regulations of stock exchanges Trading system in stock exchanges SEBI. UNIT- III FUNDAMENTAL ANALYSIS 9

Economic Analysis Economic forecasting and stock Investment Decisions Forecasting techniques. Industry Analysis : Industry classification, Industry life cycle Company Analysis Measuring Earnings Forecasting Earnings Applied Valuation Techniques Graham and Dodds investor ratios.

UNIT IV

TECHNICAL ANALYSIS

Fundamental Analysis Vs Technical Analysis Charting methods Market Indicators. Trend Trend reversals Patterns - Moving Average Exponential moving Average Oscillators Market Indicators Efficient Market theory.

UNIT V

PORTFOLIO MANAGEMENT Revision

9 Portfolio

Portfolio analysis Portfolio Selection Capital Asset Pricing model Portfolio Evaluation Mutual Funds.

TOTAL: 45 PERIODS

Unit 1: Investment Setting Financial and economic meaning of Investment Characteristics and objectives of Investment Types of Investment Investment alternatives Choice and Evaluation Risk and return concepts.

1.1. Introduction: Investment is putting money into something with the expectation of profit. The word originates in the Latin "vestis", meaning garment, and refers to the act of putting things (money or other claims to resources) into others' pockets. The term "investment" is used differently in economics and in finance. Economists refer to a real investment (such as a machine or a house), while financial economists refer to a financial asset, such as money that is put into a bank or the market, which may then be used to buy a real asset. 1.2. Financial meaning of investment: Financial investment involves of funds in various assets, such as stock, Bond, Real Estate, Mortgages etc. Investment is the employment of funds with the aim of achieving additional income or growth in value. It involves the commitment of resources which have been saved or put away from current consumption in the hope some benefits will accrue in future. Investment involves long term commitment of funds and waiting for a reward in the future. From the point of view people who invest their finds, they are the supplier of Capital and in their view investment is a commitment of a persons funds to derive future income in the form of interest, dividend, rent, premiums, pension benefits or the appreciation of the value of their principle capital. To the financial investor it is not important whether money is invested for a productive use or for the purchase of secondhand instruments such as existing shares and stocks listed on the stock exchange. Most investments are considered to be transfers of financial assets from one person to another. 1.3. Economic meaning of investment:

Economic investment means the net additions to the capital stock of the society which consists of goods and services that are used in the production of other goods and services. Addition to the capital stock means an increase in building, plants, equipment and inventories over the amount of goods and services that existed.

The financial and economic meanings are related to each other because investment is a part of the savings of individuals which flow into the capital market either directly or through institutions, divided in new and secondhand capital financing. Investors as suppliers and investors as users of long-term funds find a meeting place in the market.

Investment refers to current commitment of funds for a specified time period to derive benefits in future. The future benefits derived from an investment are known as returns Giving loan: with an expectation to get the principal back along with the interest at a future date Buying gold: with an expectation of appreciation in its value in future Buying an insurance plan: for various benefits derivable in future &/or in case of an eventuality Buying shares of companies: for dividend &/ or capital appreciation CURRENT S CR!"!CE "UTURE RE# R$

s the reward would accrue only in future! it involves %ris&' "of reali#ed return being lower than that expected$

Box No: 1

1.4. Basic Investment Objectives Investment triangle three compromising objectives Any investment decision will be influenced by three objectives security, liquidity and yield. A best investment decision will be one, which has the best possible compromise between these three objectives.

Security Liquidity Yield

Individually these objectives are very powerful in influencing the investors. Collectively they work against each other forcefully, as can be seen below. Hence the acclaim A best investment decision will be one, which has the best possible sible compromise between these three objectives. When selecting where to invest our funds we have to analyze and manage these three objectives.

Security: Central to any investment objective, we have to basically ensure the safety of the principal. One can afford to lose the returns at any given point of time but s/he can ill afford to lose the very principal itself. By identifying the importance of security, we will be able to identify and select the instrument that meets this criterion. For example, when compared with corporate bonds, we can vouch safe the safety of return of investment in treasury bonds as we have more faith in governments than in corporations. Hence, treasury bonds are highly secured instruments. The safest investments are usually found in the money market and include such securities as Treasury bills (T-bills), bills), certificates of deposit (CD), commercial paper or bankers' acceptance slips; or in the e fixed income (bond) market in the form of municipal and other government bonds, and in corporate bonds

Liquidity: Because we may have to convert our investment back to cash or funds to meet our unexpected demands and needs, our investment should be highly liquid. They should be en cashable at short notice, without loss and without any difficulty. If they cannot come t to o our rescue, we may have to borrow or raise funds externally at high cost and at unfavorable terms and conditions. Such

liquidity can be possible only in the case of investment, which has always-ready market and willing buyers and sellers. Such instruments of investment are called highly liquid investment.

Yield: Yield is best described as the net return out of any investment. Hence given the level or kind of security and liquidity of the investment, the appropriate yield should encourage the investor to go for the investment. If the yield is low compared to the expectation of the investor, s/he may prefer to avoid such investment and keep the funds in the bank account or in worst case, in cash form in lockers. Hence yield is the attraction for any investment and normally deciding the right yield is the key to any investment.

Relationship:

There is a tradeoff between risk (security) and return (yield) on the one hand and liquidity and return (yield) on the other. Normally, higher the risk any investment carries, the greater will be the yield, to compensate the possible loss. That is why, fly by night operators, offer sky high returns to their investors and naturally our gullible investors get carried away by such returns and ultimately lose their investment. Highly secured investment does not carry high coupon, as it is safe and secured.

When the investment is illiquid, (i.e. one cannot get out of such investment at will and without any loss) the returns will be higher, as no normal investor would prefer such investment. These three points security, liquidity and yield in any investment make an excellent triangle in our investment decision-making. Ideally, with given three points of any triangle, one can say the center of the triangle is fixed. In our investment decision too, this center the best meeting point for S, L and Y is important for our consideration.

However, if any one or two of these three points are disturbed security, liquidity and yield in any investment the center of the triangle would be disturbed and one may have to revisit the investment decision either to continue the investment or exit the investment.

All these points security, liquidity and yield are highly dynamic in any market and they are always subject to change and hence our investor has to periodically watch his/her investment and make appropriate decisions at the right time.

If our investor fails to monitor her / his investment, in the worst circumstances, s/he may lose the very investment.

Thus, we will return to our original statement - A best investment decision will be one, which has the best possible compromise between these three objectives security, liquidity and yield.

1.5. Secondary Objectives:

Tax Minimization:

An investor may pursue certain investments in order to adopt tax minimization as part of his or her investment strategy. A highly-paid executive, for example, may want to seek investments with favorable tax treatment in order to lessen his or her overall income tax burden. Making contributions to an IRA or other tax-sheltered retirement plan, such as a 401(k), can be an effective tax minimization strategy.

Marketability / Liquidity:

Many of the investments we have discussed are reasonably illiquid, which means they cannot be immediately sold and easily converted into cash. Achieving a degree of liquidity, however, requires the sacrifice of a certain level of income or potential for capital gains. Common stock is often considered the most liquid of investments, since it can usually be sold within a day or two of the decision to sell. Bonds can also be fairly marketable, but some bonds are highly illiquid, or non-tradable, possessing a fixed term. Similarly, money market instruments may only be redeemable at the precise date at which the fixed term ends. If an investor seeks liquidity, money market assets and non-tradable bonds aren't likely to be held in his or her portfolio.

1.6. CHARACTERISTICS OF GOOD INVESTMENT a. Objective fulfillment An investment should fulfill the objective of the savers. Every individual has a definite objective in making an investment. When the investment objective is contrasted with the uncertainty involved with investments, the fulfillment of the objectives through the chosen investment avenue could become complex. b. Safety The first and foremost concern of any ordinary investor is that his investment should be safe. That is he should get back the principal at the end of the maturity period of the investment. There is no absolute safety in any investment, except probably with investment in government securities or such instruments where the repayment of interest and principal is guaranteed by the government.

c. Return The return from any investment is expectedly consistent with the extent of risk assumed by the investor. Risk and return go together. Higher the risk, higher the chances of getting higher return. An investment in a low risk - high safety investment such as investment in government securities will obviously get the investor only low returns. d. Liquidity Given a choice, investors would prefer a liquid investment than a higher return investment. Because the investment climate and market conditions may change or investor may be confronted by an urgent unforeseen commitment for which he might need funds, and if he can dispose of his investment without suffering unduly in terms of loss of returns, he would prefer the liquid investment. e. Hedge against inflation The purchasing power of money deteriorates heavily in a country which is not efficient or not well endowed, in relation to another country. Investors, who save for the long term, look for hedge against inflation so that their investments are not unduly eroded; rather they look for a capital gain which neutralizes the erosion in purchasing power and still gives a return. f. Concealabilty If not from the taxman, investors would like to keep their investments rather confidential from their own kith and kin so that the investments made for their old age/ uncertain future does not become a hunting ground for their own lives. Safeguarding of financial instruments representing the investments may be easier than investment made in real estate. Moreover, the real estate may be prone to encroachment and other such hazards. h. Tax shield Investment decisions are highly influenced by the tax system in the country. Investors look for front-end tax incentives while making an investment and also rear-end tax reliefs while reaping the benefit of their investments. As against tax incentives and reliefs, if investors were to pay taxes on the income earned from investments, they look for higher return in such investments so that their after tax income is comparable to the pre-tax equivalent level with some other income which is free of tax, but is more risky. 1.7. Different types of investors:

Conservative investors often invest in cash. THIS means that they put their money in interest bearing savings accounts, money market accounts, mutual funds, US Treasury bills, and Certificates of Deposit. These are very safe investments that grow over a long period of time. These are also low risk investments.

Moderate investors often invest in cash and bonds, and may dabble in the stock market. Moderate investing may be low or moderate risks. Moderate investors often also invest in real estate, providing that it is low risk real estate.

Aggressive investors commonly do most of THEIR investing in the stock market, which is higher risk. They also tend to invest in business ventures as well as higher risk real estate. For instance, if an aggressive investor puts his or her money into an older apartment building, then invests more money renovating the property, they are running a risk. They expect to be able to rent the apartments out for more money than the apartments are currently worth or to sell the entire property for a profit on their initial investments. In some cases, this works out just fine, and in other cases, it doesn't. It's a risk.

1.8. Types of investment: or various investment alternatives /avenues

Non-marketable Financial Assets: A good portion of financial assets is represented by non-marketable financial assets. A distinguishing feature of these assets is that they represent personal transactions between the investor and the issuer. For example, when you open a savings bank account at a bank you deal with the bank personally. In contrast when you buy equity shares in the stock market you do not know who the seller is and you do not care. These can be classified into the following broad categories: Post office deposits Company deposits Provident fund deposits Bank deposits

Equity Shares:

Equities are a type of security that represents the ownership in a company. Equities are traded (bought and sold) in stock markets. Alternatively, they can be purchased via the Initial Public Offering (IPO) route, i.e. directly from the company. Investing in equities is a good long-term investment option as the returns on equities over a long time horizon are generally higher than most other investment avenues. However, along with the possibility of greater returns comes greater risk. Equity shares are classified into the following broad categories by stock market analysts: Blue chip shares Growth shares Income shares Cyclical shares Speculative shares

Bonds: Bond is a debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. It is certificates acknowledging the money lend by a bondholder to the company. It states it maturity date, interest rate, and par value. The Federal government, states, cities, corporations, and many other types of institutions sell bonds. When an investor buys a bond, he/she becomes a creditor of the issuer. However, the buyer does not gain any kind of ownership rights to the issuer, unlike in the case of equities. On the hand, a bond holder has a greater claim on an issuer's income than a shareholder in the case of financial distress (this is true for all creditors). The yield from a bond is made up of three components: coupon interest, capital gains and interest on interest (if a bond pays no coupon interest, the only yield will be capital gains). A bond might be sold at above or below par (the amount paid out at maturity), but the market price will approach par value as the bond approaches maturity. A riskier bond has to provide a higher payout to compensate for that additional risk. Some bonds are tax-exempt, and these are typically issued by municipal, county or state governments, whose interest payments are not subject to federal income tax, and sometimes also state or local income tax. Bonds may be classified into the following categories: Government securities Government of India relief bonds Government agency securities

10

PSU bonds Debentures of private sector companies Preference shares

Money Market Instruments: Debt instruments which have a maturity of less than one year at the time of issue are called money market instruments. The important money market instruments are: Treasury bills Commercial paper Certificates of deposits

Mutual Funds: Instead of directly buying equity shares and/or fixed income instruments, you can participate in various schemes floated by mutual funds which, in turn, invest in equity shares and fixed income securities. A mutual fund is made up of money that is pooled together by a large number of investors who give their money to a fund manager to invest in a large portfolio of stocks and / or bonds Mutual fund is a kind of trust that manages the pool of money collected from various investors and it is managed by a team of professional fund managers (usually called an Asset Management Company) for a small fee. The investments by the Mutual Funds are made in equities, bonds, debentures, call money etc., depending on the terms of each scheme floated by the Fund. The current value of such

investments is now a day is calculated almost on daily basis and the same is reflected in the Net Asset Value (NAV) declared by the funds from time to time. This NAV keeps on changing with the changes in the equity and bond market. Therefore, the investments in Mutual Funds is not risk free, but a good managed Fund can give you regular and higher returns than when you can get from fixed deposits of a bank etc. There are three broad types of mutual fund schemes: Equity schemes Debt schemes Balanced schemes

Life Insurance:

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In a broad sense, life insurance may be viewed as an investment. Life insurance is a contract between the policy holder and the insurer, where the insurer promises to pay a designated beneficiary a sum of money (the "benefits") upon the death of the insured person. Depending on the contract, other events such as terminal illness or critical illness may also trigger payment. In return, the policy holder agrees to pay a stipulated amount (the "premium") at regular intervals or in lump sums. The important types of insurance policies in India are: Endowment assurance policy Money back policy Whole life policy Term assurance policy

Real Estate: For the bulk of the investors the most important asset in their portfolio is a residential house. In addition to a residential house, the more affluent investors are likely to be interested in the following types of real estate:

Agricultural land Semi-urban land Time share in a holiday resort

Precious Objects: Precious objects are items that are generally small in size but highly valuable in monetary terms. Some important precious objects are: Gold and silver Precious stones Art objects Financial Derivative: A financial derivative is an instrument whose value is derived from the value of an underlying asset. It may be viewed as a side bet on the asset. The most important financial derivatives from the point of view of investors are: Options

12

Futures

Non-financial Instruments Real estate With the ever-increasing cost of land, real estate has come up as a profitable investment proposition. Gold The 'yellow metal' is a preferred investment option, particularly when markets are volatile. Today, beyond physical gold, a number of products which derive their value from the price of gold are available for investment. These include gold futures and gold exchange traded funds. 1.9. Investment Risk and Return Characteristics The chart below provides some examples of common types of investments classified according to their potential return and investment risk.
Potential Return Investment Risk (Volatility)

Examples of Common Investments

High High

Aggressive growth funds Emerging markets mutual funds Foreign company stocks Global, international, sector, and precious metal mutual funds Penny stocks Small cap stocks and funds ariable annuities invested in aggressive growth sub! accounts

"oderate

"oderate

#onvertible bonds High!yield $%unk& bond funds 'arge!cap stocks and funds S(P )** ( +ilshire )*** stock inde, funds ariable annuities invested in large!cap stock sub!accounts

'ow

'ow

Fi,ed annuities Government agency securities $e-g-, Ginnie "aes& High .uality short! and intermediate!term municipal and corporate bonds and bond funds "oney market mutual funds /reasury bills and notes 0-S- savings bonds $Series 1 and EE& ariable annuities invested in high!.uality bond sub!

13

accounts

ery 'ow

ery 'ow

#ertificates of 2eposit "oney market deposit accounts 34+ checking accounts Passbook or statement savings accounts

Risk and return trade off: Investment return and risk are fundamental to understanding market behavior. Return on investment is essentially profit made by an investor. Profits and losses must be analyzed carefully, as simple percentage comparisons give misleading answers. Risk refers to the probability of depreciation as well as its potential magnitude, which can exceed original invested amount. Risk and return on investment are directly correlated; higher risk begets a smaller chance of high return and vice versa.

In the investing world, the dictionary definition of risk is the chance that an investment's actual return will be different than expected. Technically, this is measured in statistics by standard deviation. Risk means you have the possibility of losing some, or even all, of our original investment. The risk/return tradeoff could easily be called the "ability-to-sleep-at-night test." While some people can handle the equivalent of financial skydiving without batting an eye, others are terrified to climb the financial ladder without a secure harness. Deciding what amount of risk you can take while remaining comfortable with your investments is very important. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A higher standard deviation means a higher risk and higher possible return.

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A common misconception is that higher risk equals greater return. The risk/return tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses. On the lower end of the scale, the risk-free rate of return is represented by the return on U.S. Government Securities because their chance of default is next to nothing. If the risk-free rate is currently 6%, this means, with virtually no risk, we can earn 6% per year on our money. The common question arises: who wants to earn 6% when index funds average 12% per year over the long run? The answer to this is that even the entire market (represented by the index fund) carries risk. The return on index funds is not 12% every year, but rather -5% one year, 25% the next year, and so on. An investor still faces substantially greater risk and volatility to get an overall return that is higher than a predictable government security. We call this additional return the risk premium, which in this case is 6% (12% - 6%). Determining what risk level is most appropriate for you isn't an easy question to answer. Risk tolerance differs from person to person. Your decision will depend on your goals, income and personal situation, among other factors.

15

All investments are designed to make a return and are subject to risk. This means that, as well as making money, there's also a chance that you could lose it. You might also think of risk as the possibility that your investments don't achieve your financial objectives. As a general rule, the bigger the potential investment stment return, the higher the investment risk and the longer the suggested investment timeframe.

Determining Your Risk Preference With so many different types of investments to choose from, how does an investor determine how much risk he or she can handle? e? Every individual is different, and it's hard to create a steadfast model applicable to everyone, but here are two important things you should consider when deciding how much risk to take: Time Horizon Before you make any investment, you should always determine the amount of time you have to keep your money invested. If you have $20,000 to invest today but need it in one year for a down payment on a new house, investing the money in higher-risk higher risk stocks is not the best strategy. The riskier an investment is, the greater its volatility or price fluctuations, so if your time horizon is relatively short, and you may be forced to sell your securities at a significant a loss. With a longer time horizon, orizon, investors have more time to recoup any possible losses and are therefore theoretically be more tolerant of higher risks. For example, if that $20,000

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is meant for a lakeside cottage that you are planning to buy in ten years, you can invest the money into higher-risk stocks because there is be more time available to recover any losses and less likelihood of being forced to sell out of the position too early. Bankroll Determining the amount of money you can stand to lose is another important factor of figuring out your risk tolerance. This might not be the most optimistic method of investing; however, it is the most realistic. By investing only money that you can afford to lose or afford to have tied up for some period of time, you won't be pressured to sell off any investments because of panic or liquidity issues. The more money you have, the more risk you are able to take and vice versa. Compare, for instance, a person who has a net worth of $50,000 to another person who has a net worth of $5,000,000. If both invest $25,000 of their net worth into securities, the person with the lower net worth will be more affected by a decline than the person with the higher net worth. Furthermore, if the investors face a liquidity issue and require cash immediately, the first investor will have to sell off the investment while the second investor can use his or her other funds.

Investment Risk Pyramid After deciding on how much risk is acceptable in your portfolio by acknowledging your time horizon and bankroll, you can use the risk pyramid approach for balancing your assets.

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This pyramid can be thought of as an asset allocation tool that investors can use to diversify their portfolio investments according to the risk profile of each security. The pyramid, representing the investor's portfolio, has three distinct tiers: Base of the Pyramid The foundation of the pyramid represents the strongest portion, which supports everything above it. This area should be comprised of investments that are low in i risk and have foreseeable returns. It is the largest area and composes the bulk of your assets. Middle Portion This area should be made up of medium medium-risk risk investments that offer a stable return while still allowing for capital appreciation. Although more risky than the assets creating the base, these investments should still be relatively safe. Summit Reserved specifically for high-risk high risk investments, this is the smallest area of the pyramid (portfolio) and should be made up of money you can lose without a any serious repercussions. Furthermore, money in the summit should be fairly disposable so that you don't have to sell prematurely in instances where there are capital losses.

Personalizing the Pyramid Not all investors are created equally. While others prefer less risk, some investors prefer even more risk than others who have a larger net worth. This diversity leads to the beauty of the investment pyramid.

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Those who want more risk in their portfolios can increase the size of the summit by decreasing the other two sections, and those wanting less risk can increase the size of the base. The pyramid representing your portfolio should be customized to your risk preference. It is important for investors to understand the idea of risk and how it applies to them. Making informed investment decisions entails not only researching individual securities but also understanding your own finances and risk profile. To get an estimate of the securities suitable for certain levels of risk tolerance and to maximize returns, investors should have an idea of how much time and money they have to invest and the returns they are looking for. TYPES OF RISKS: Personal Risks This category of risk deals with the personal level of investing. The investor is likely to have more control over this type of risk compared to others. Timing risk is the risk of buying the right security at the wrong time. It also refers to selling the right security at the wrong time. For example, there is the chance that a few days after you sell a stock it will go up several dollars in value. There is no surefire way to time the market. Tenure risk is the risk of losing money while holding onto a security. During the period of holding, markets may go down, inflation may worsen, or a company may go bankrupt. There is always the possibility of loss on the company-wide level, too. Company Risks There are two common risks on the company-wide level. The first, financial risk is the danger that a corporation will not be able to repay its debts. This has a great affect on its bonds, which finance the company's assets. The more assets financed by debts (i.e., bonds and money market instruments), the greater the risk. Studying financial risk involves looking at a company's management, its leadership style, and its credit history. Management risk is the risk that a company's management may run the company so poorly that it is unable to grow in value or pay dividends to its shareholders. This greatly affects the value of its stock and the attractiveness of all the securities it issues to investors. Market Risks

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Fluctuation in the market as a whole may be caused by the following risks: Market risk is the chance that the entire market will decline, thus affecting the prices and values of securities. Market risk, in turn, is influenced by outside factors such as embargoes and interest rate changes. See Political risk below. Liquidity risk is the risk that an investment, when converted to cash, will experience loss in its value. When you want to sell the stock you are currently holding, there is nobody there to buy your stock, meaning that there is no volume in that stock. Interest rate risk is the risk that interest rates will rise, resulting in a current investment's loss of value. A bondholder, for example, may hold a bond earning 6% interest and then see rates on that type of bond climb to 7%. Inflation risk is the danger that the dollars one invests will buy less in the future because prices of consumer goods rise. When the rate of inflation rises, investments have less purchasing power. This is especially true with investments that earn fixed rates of return. As long as they are held at constant rates, they are threatened by inflation. Inflation risk is tied to interest rate risk, because interest rates often rise to compensate for inflation. Return of investment (ROI) is less than the market inflation rate. e.g. Return of investment (ROI) : 5%; Market Inflation rate (IR) : 8.5% Exchange rate risk is the chance that a nation's currency will lose value when exchanged for foreign currencies. Reinvestment risk is the danger that reinvested money will fetch returns lower than those earned before reinvestment. Individuals with dividend-reinvestment plans are a group subject to this risk. Bondholders are another. National And International Risks National and world events can profoundly affect investment markets. Economic risk is the danger that the economy as a whole will perform poorly. When the whole economy experiences a downturn, it affects stock prices, the job market, and the prices of consumer products. Industry risk is the chance that a specific industry will perform poorly. When problems plague one industry, they affect the individual businesses involved as well as the securities issued by those

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businesses. They may also cross over into other industries. For example, after a national downturn in auto sales, the steel industry may suffer financially. Tax risk is the danger that rising taxes will make investing less attractive. In general, nations with relatively low tax rates, such as the United States, are popular places for entrepreneurial activities. Businesses that are taxed heavily have less money available for research, expansion, and even dividend payments. Taxes are also levied on capital gains, dividends and interest. Investors continually seek investments that provide the greatest net after-tax returns. Political risk is the danger that government legislation will have an adverse affect on investment. This can be in the form of high taxes, prohibitive licensing, or the appointment of individuals whose policies interfere with investment growth. Political risks include wars, changes in government leadership, and politically motivated embargoes. Investors and speculators: Investors: The investors buy the securities with a view to invest their savings in profitable income earning securities. They generally retain the securities for a considerable length of time. They are assured of a profit in cash. They are also called genuine investors. Speculators: The speculators buy securities with a hope to sell them at a profit in future. They do not retain their holdings for a longer period. They buy the securities with the object of selling them and not to retain them. They are interested only in price differentials. They are not genuine investors. Differences between investors and speculators: S.No 1 Investors An investors is interested in safety of his investment A Speculators speculators is interested in

appreciation of capital and earning profits quickly

Seeks income from his investment

Seeks profit from sale and purchase of securities

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Makes payment and takes delivery of the securities on purchasing. Receives payment and delivers the securities on sales.

He neither delivers nor takes the delivery of the securities on sale or purchase.

Retains holding for longer period i.e. commitment is for longer period of time

Tries to sell the securities quickly ie his commitment is for shorter period.

6 7 8

Risk is low Stable income His income depends on the

Risk is high Earnings of profit is uncertain The profit earned by him depends on the fluctuation/change in the market price of securities.

earnings of the enterprise

Speculation: Speculation refers to the buying and selling of securities in the hope of making a profit from expected change in the price of securities. Those who engage in such activity are known as speculators. A speculator may buy securities in expectation of rise in price. If his expectation comes true, he sells the securities for a higher price and makes a profit. Similarly a speculator may expect a price to fall and sell securities at the current high price to buy again when prices decline. He will make a profit if prices decline as expected. The benefits of speculation are: 1. It leads to smooth change and prevents wide fluctuations in security prices at different times and places 2. Speculative activity and the resulting effect in the prices of securities provided a guidance to the public about the market situation. Differences between speculation and gambling: S.No 1 Speculation It is based on knowledge and foresight It is based Gambling on chance of events

happening.

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2 3 4

It is a lawful activity It performs economic functions Speculators bears the risk of loss on the basis of logical reasoning

It is an illegal activity It has no benefits to offer to the economy Gamblers bear the risk of loss on the basis of blind and reckless expectation.

UNIT II SECURITIES MARKETS Financial Market - Segments Types - - Participants in financial Market Regulatory Environment, Primary Market Methods of floating new issues, Book building Role of primary market Regulation of primary market, Stock exchanges in India BSE, OTCEI , NSE, ISE, and Regulations of stock exchanges Trading system in stock exchanges SEBI. FINANCIAL MARKETS In economics, a financial market is a mechanism that allows people to buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis. Financial markets can be domestic or they can be international. In finance, financial markets facilitate: The raising of capital (in the capital markets) The transfer of risk (in the derivatives markets) International trade (in the currency markets) - And are used to match those who want capital to those who have it. TYPES OF FINANCIAL MARKETS The financial markets can be divided into different subtypes:

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Financial Market

Capital Market

Money Market

Foreign Exchange Market Derivatives Market

Government securitites Market Insurance Market Commodity Market

(A) Capital Market: The capital market deals in long term funds (shares and debentures). Companies raise their capital through the issue of shares and debentures. Capital markets which consist of:

Capital Market Stock Market Bond Market

Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. Bond markets, which provide de financing through the issuance of bonds, and enable the subsequent trading thereof.

Another classification of capital market is as follows:

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Capital Market Primary Market

Primary Market: Primary market refers to the sale of shares, directly by the company at the time of promotion and the investors directly buy the shares from the company through application. Newly formed (issued) securities are bought or sold in primary markets. The share e price will be mostly at par.

Secondary Market

Secondary Market: Secondary markets allow investors to sell securities that they hold or buy existing securities. Here sale and purchase of securities will take place through the recognized stock exchanges. Only authorized persons are allowed to deal in the securities in the secondary market, who are known as brokers. Only listed securities will be traded in the stock exchanges.

(B) Money markets: Money market deals in short term funds which provide short term debt financing and an investment. In fact there is no fixed place as money market. The term money market refers to a collective name given to all the institutions which are dealing in short term funds. Money market provides working capital.

rganised Indian Money Market !norganised

25

Unorganised Money Mar et

!ndigenous "an ers

Money Lenders

#undies

$ro%issory &ote

rganised Money Market "rade Bills or Commercial Bills Finance Bills "reasury Bills Foreign Bills

26

(C) Commodity Market & Derivative market& Insurance Market: Commodity markets, which facilitate the trading of commodities Derivatives markets, which provide instruments for the management of financial risk. o Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market. Insurance markets, which facilitate the redistribution of various risks.

(D) Foreign exchange markets Foreign exchange markets, which facilitate the trading of foreign exchange. Foreign exchange is bought ght and sold and the different forms of foreign currency are dealt. In India, foreign exchange is held by Reserve bank of India which is the exchange control authority. We have then Foreign Exchange Regulation Act which is now renamed as Foreign Exchange Management anagement Act (FEMA) to deal with Foreign exchange.

$uthorised Dealers

Foreign %anks Foreign Exchange market #BI Importers Exporters&

Money Changers

(E) Government Securities Market: It can be divided as follows:

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Government securities Market

"reasury Bills Bonds

When government is in need of funds to meet its budgetary deficits, it goes for the issue of treasury bills and bonds. Treasury bills and bonds: Treasury bills are issued for raising short term funds and mainly to meet revenue expenditure. Bonds are issued for raising long term loans and these are repayable over a period of 15 or 20 years. Normally they are subscribed by financial institutio institutions ns as these securities carry attractive interest rates and they can be sold easily in the market. It is for this reason; they are called as liquid assets. The main functions of financial market are: 1) To facilitate creation and allocation of credit and liquidity. 2) To serve as intermediaries for mobilization of savings 3) To assist process of balanced economic growth; 4) To provide financial convenience Financial market slang Poison pill, measures taken by a company to prevent being bought out by another company by issuing a more number of shares, thereby increasing the no. of outstanding shares to be bought by the hostile company making the bid to establish majority. Quant, a quantitative analyst skilled in the black arts of PhD level (and above) mathematics and statistical methods. Rocket scientist, a financial consultant at the zenith of mathematical and computer programming skill. They are able to invent derivatives of frightening complexity and construct sophisticated pricing models. They generally handle the most advanced computing techniques adopted by the financial markets since the early 1980s. Typically, they are physicists and engineers by training; rocket scientists do not necessarily build rockets for a living.

28

White Knight, a friendly party in a takeover bid. Used to describe a party that buys the shares of one organization to help prevent against a hostile takeover of that organization by another party.

Financial market functions: Financial markets serve six basic functions. These functions are briefly listed below: Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes. Price Determination: Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets. Information Aggregation and Coordination: Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers. Risk Sharing: Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments. Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets. Efficiency: Financial markets reduce transaction costs and information costs.

Who are the Major Players in Financial Markets? In the financial markets, there is a flow of funds from one group of parties (funds-surplus units) known as investors to another group (funds-deficit units) which require funds. However, often these groups do not have direct link. The link is provided by market intermediaries such as brokers, mutual funds, leasing and finance companies, etc. In all, there is a very large number of players and participants in the financial market. Brokers: A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a seller (or buyer) to complete the desired transaction. A broker does not take a position in the assets he or she trades -that is, the broker does not maintain inventories in these assets. The profits of brokers are determined by the commissions they charge to the users of their services (the buyers, the sellers, or both). Examples of brokers include real estate brokers and stock brokers.

Diagrammatic Illustration of a Stock Broker:

Payment ----------------Payment

29

Stock Buyer

------------>| |-------------> | | Stock | Stock Broker | Seller <-------------|<----------------|<------------Stock | (Passed Thru) | Stock Shares ----------------Shares

Dealers: Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not engage in asset transformation. Unlike brokers, however, a dealer can and does "take positions" (i.e., maintain inventories) in the assets he or she trades that permit the dealer to sell out of inventory rather than always having to locate sellers to match every offer to buy. Also, unlike brokers, dealers do not receive sales commissions. Rather, dealers make profits by buying assets at relatively low prices and reselling them at relatively high prices (buy low - sell high). The price at which a dealer offers to sell an asset (the "asked price") minus the price at which a dealer offers to buy an asset (the "bid price") is called the bid-ask spread and represents the dealer's profit margin on the asset exchange. Real-world examples of dealers include car dealers, dealers in U.S. government bonds, and NASDAQ stock dealers.

Diagrammatic Illustration of a Bond Dealer:

Payment ----------------Payment ------------>| |-------------> Bond | Dealer | Bond Buyer | | Seller <-------------| Bond Inventory |<------------Bonds | | Bonds -----------------

Investment Banks: An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs = Initial Public Offerings) by engaging in a number of different activities: Advice: Advising corporations on whether they should issue bonds or stock, and, for bond issues, on the particular types of payment schedules these securities should offer; Underwriting: Guaranteeing corporations a price on the securities they offer, either individually or by having several different investment banks form a syndicate to underwrite the issue jointly; Sales Assistance: Assisting in the sale of these securities to the public.

30

Some of the best-known U.S. investments banking firms are Morgan Stanley, Merrill Lynch, Salomon Brothers, First Boston Corporation, and Goldman Sachs. Financial Intermediaries: Unlike brokers, dealers, and investment banks, financial intermediaries are financial institutions that engage in financial asset transformation. That is, financial intermediaries purchase one kind of financial asset from borrowers -- generally some kind of long-term loan contract whose terms are adapted to the specific circumstances of the borrower (e.g., a mortgage) -- and sell a different kind of financial asset to savers, generally some kind of relatively liquid claim against the financial intermediary (e.g., a deposit account). In addition, unlike brokers and dealers, financial intermediaries typically hold financial assets as part of an investment portfolio rather than as an inventory for resale. In addition to making profits on their investment portfolios, financial intermediaries make profits by charging relatively high interest rates to borrowers and paying relatively low interest rates to savers. Types of financial intermediaries include: Depository Institutions (commercial banks, savings and loan associations, mutual savings banks, credit unions);Contractual Savings Institutions (life insurance companies, fire and casualty insurance companies, pension funds, government retirement funds); and Investment Intermediaries (finance companies, stock and bond mutual funds, money market mutual funds).

Diagrammatic Example of a Financial Intermediary: A Commercial Bank

Lending by B Borrowing by B

Deposited Funds ------funds ------| |<............. | | <............. | | | F |.............> | B | ..............> | H | ------Loan ------deposit ------Contracts accounts ------Loan contracts issued by F to B are liabilities of F and assets of B Deposit accounts issued by B to H are liabilities of B and assets of H

NOTE: F=Firms, B=Commercial Bank, and H=Households

These can be grouped as follows : The individuals: These are net savers and purchase the securities issued by corporates. Individuals provide funds by subscribing to these security or by making other investments.

31

The Firms or corporates: The corporates are net borrowers. They require funds for different projects from time to time. They offer different types of securities to suit the risk preferences of investors Sometimes, the corporates invest excess funds, as individuals do. The funds raised by issue of securities are invested in real assets like plant and machinery. The income generated by these real assets is distributed as interest or dividends to the investors who own the securities. Government: Government may borrow funds to take care of the budget deficit or as a measure of controlling the liquidity, etc. Government may require funds for long terms (which are raised by issue of Government loans) or for short-terms (for maintaining liquidity) in the money market. Government makes initial investments in public sector enterprises by subscribing to the shares, however, these investments (shares) may be sold to public through the process of disinvestments. Regulators: Financial system is regulated by different government agencies. The relationships among other participants, the trading mechanism and the overall flow of funds are managed, supervised and controlled by these statutory agencies. In India, two basic agencies regulating the financial market are the Reserve Bank of India (RBI ) and Securities and Exchange Board of India (SEBI). Reserve Bank of India, being the Central Bank, has the primary responsibility of maintaining liquidity in the money market It undertakes the sale and purchase of T-Bills on behalf of the Government of India. SEBI has a primary responsibility of regulating and supervising the capital market. It has issued a number of Guidelines and Rules for the control and supervision of capital market and investors protection. Besides, there is an array of legislations and government departments also to regulate the operations in the financial system. Market Intermediaries: There are a number of market intermediaries known as financial intermediaries or merchant bankers, operating in financial system. These are also known as investment managers or investment bankers. The objective of these intermediaries is to smoothen the process of investment and to establish a link between the investors and the users of funds. Corporations and Governments do not market their securities directly to the investors. Instead, they hire the services of the market intermediaries to represent them to the investors. Investors, particularly small investors, find it difficult to make direct investment. A small investor desiring to invest may not find a willing and desirable borrower. He may not be able to diversify across borrowers to reduce risk. He may not be equipped to assess and monitor the credit risk of borrowers. Market intermediaries help investors to select investments by providing investment consultancy, market analysis and credit rating of investment instruments. In order to operate in secondary market, the investors have to transact through share brokers. Mutual funds and investment companies pool the funds(savings) of investors and invest the corpus in different investment alternatives. Some of the market intermediaries are: Lead Managers Bankers to the Issue Registrar and Share Transfer Agents Depositories

32

Clearing Corporations Share brokers Credit Rating Agencies Underwriters Custodians Portfolio Managers Mutual Funds Investment Companies These market intermediaries provide different types of financial services to the investors. They provide expertise to the securities issuers. They are constantly operating in the financial market. Small investors in particular and other investors too, rely on them. It is in their (market intermediaries) own interest to behave rationally, maintain integrity and to protect and maintain reputation, otherwise the investors would not be trusting them next time. In principle, these intermediaries bring efficiency to corporate fund raising by developing expertise in pricing new issues and marketing them to the investors.

PLAYERS OF FINANCIAL MARKETS

Financial institutions are institutions that participate in financial markets, i.e., in the creation and/or exchange BROKER A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a seller (or buyer) to complete the desired transaction. A broker does not take a position in the assets they trade. The profits of brokers are determined by the commissions they charge to the users of their services (the buyers, the sellers, or both). of financial assets. The following are the major players of financial markets

DEALERS Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not engage in asset transformation. Unlike brokers, however, a dealer can and does "take positions" (i.e., maintain

33

inventories) in the assets he or she trades that permit the dealer to sell out of inventory rather than always having to locate sellers to match every offer to buy. Also, unlike brokers, dealers do not receive sales commissions. Rather, dealers make profits by buying assets at relatively low prices and reselling them at relatively high prices (buy low - sell high). The price at which a dealer offers to sell an asset (the "asked price") minus the price at which a dealer offers to buy an asset (the "bid price") is called the bid-ask spread and represents the dealer's profit margin on the asset exchange.

INVESTMENT

BANKS

An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs = Initial Public Offerings) by engaging in a number of different activities: Advice: Advising corporate on whether they should issue bonds or stock, and, for bond issues, on the particular types of payment schedules these securities should offer; Underwriting: Guaranteeing corporate a price on the securities they offer, either individually or by having several different investment banks form a syndicate to underwrite the issue jointly; Sales Assistance: Assisting in the sale of these securities to the public.

FINANCIAL INTERMEDIERIES Unlike brokers, dealers, and investment banks, financial intermediaries are financial institutions that engage in financial asset transformation. That is, financial intermediaries purchase one kind of financial asset from borrowers - generally some kind of long-term loan contract whose terms are adapted to the specific circumstances of the borrower (e.g. a mortgage) - and sell a different kind of financial asset to savers, generally some kind of relatively liquid claim against the financial intermediary (e.g. a deposit account). In addition, unlike brokers and dealers, financial intermediaries typically hold financial assets as part of an investment portfolio rather than as an inventory for resale. In addition to making profits on their investment portfolios, financial intermediaries make profits by charging relatively high interest rates to

34

borrowers

and

paying

relatively

low

interest

rates

to

savers.

Types of financial intermediaries include: Depository Institutions (commercial banks, savings and loan associations, mutual savings banks, credit unions); Contractual Savings Institutions (life insurance companies, fire and casualty insurance companies, pension funds, government retirement funds); and Investment Intermediaries (finance companies, stock and bond mutual funds, money market mutual funds).

BOOK BUILDING PROCESS

BookBuilding is basically a capital issuance process used in Initial Public Offer (IPO) which aids price and demand discovery. It is a process used for marketing a public offer of equity shares of a company. It is a mechanism where, during the period for which the book for the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The process aims at tapping both wholesale and retail investors. The offer/issue price is then determined after the bid closing date based on certain evaluation criteria.

35

The Process: The Issuer who is planning an IPO nominates a lead merchant banker as a 'book runner'.

The Issuer specifies the number of securities to be issued and the price band for orders.

The Issuer also appoints syndicate members with whom orders can be placed by the investors.

Investors place their order with a syndicate member who inputs the orders into the 'electronic book'. This process is called 'bidding' and is similar to open auction.

36

A Book should remain open for a minimum of 5 days.

Bids cannot be entered less than the floor price.

Bids can be revised by the bidder before the issue closes.

On the close of the book building period the 'book runner evaluates the bids on the basis of the evaluation criteria which may include Price Aggression Investor quality Earliness of bids, etc.

The book runner the company concludes the final price at which it is willing to issue the stock and allocation of securities.

Generally, the numbers of shares are fixed; the issue size gets frozen based on the price per share discovered through the book building process.

Allocation of securities is made to the successful bidders. Book Building is a good concept and represents a capital market which is in the process of maturing. Book-building is all about letting the company know the price at which you are willing to buy the stock and getting an allotment at a price that a majority of the investors are willing to pay. The price discovery is made depending on the demand for the stock. The price that you can suggest is subject to a certain minimum price level, called the floor price. For instance, the floor price fixed for the Maruti's initial public offering was Rs 115, which means that the price you are willing to pay should be at or above Rs 115. In some cases, as in Biocon, the price band (minimum and maximum price) at which you can apply is specified. A price band of Rs 270 to Rs 315 means that you can apply at a floor price of Rs 270 and a ceiling of Rs 315. If you are not still very comfortable fixing a price, do not worry. You, as a retail investor, have the option of applying at the cut-off price. That is, you can just agree to pick up the shares at the final price fixed. This way, you do not run the risk of not getting an allotment because you have bid at a lower price. If you bid

37

at the cut-off price and the price is revised upwards, then the managers to the offer may reduce the number of shares allotted to keep it within the payment already made. You can get the application forms from the nearest offices of the lead managers to the offer or from the corporate or the registered office of the company.

Methods o' Marketing Securities 'ollo(ing are t)e *arious %et)ods +eing ado,ted +y cor,orate entities -or %ar eting t)e securities in t)e &e( !ssue Mar et. () $ure $ros,ectus Met)od *) /--er -or Sale Met)od +) $ri*ate $lace%ent Met)od ,) !nitial ,u+lic /--ers 0!$/s1 Met)od -) 2ig)ts !ssue Met)od .) "onus !ssue Met)od /) "oo 3+uilding Met)od 0) Stoc /,tion Met)od and 1) "oug)t3out 4eals Met)od Pure prospectus Method Meaning 5)e %et)od ()ere+y a cor,orate enter,rise %o,s u, ca,ital -unds -ro% t)e general ,u+lic +y %eans oan issue o- a ,ros,ectus is called 6$ure $ros,ectus Met)od78 !t is t)e %ost ,o,ular %et)od o- %a ing ,u+lic issue o- securities +y cor,orate enter,rises8 Features Exclusive su%scription. Under t)is %et)od9 t)e ne( issues o- a co%,any are o--ered -or e:clusi*e su+scri,tion o- t)e general ,u+lic8 Issue Price. 4irect o--icer is %ade +y t)e issuing co%,any to t)e general ,u+lic to su+scri+e to t)e securities as a stated ,rice8

38

!nder2riting3 $u+lic issue t)roug) t)e 6,ure ,ros,ectus %et)od7 is usually under(ritten8 5)is is to sa-eguard t)e interest o- t)e issuer in t)e e*ent o- an unsatis-actory res,onse -ro% t)e ,u+lic8 Prospectus3 ; docu%ent t)at contains in-or%ation relating to t)e *arious as,ects o- t)e issuing co%,any9 +esides ot)er details o- t)e issue is called a 6$ros,ectus78 5)e docu%ent is circulated to t)e ,u+lic8 5)e general details include t)e co%,any7s na%e and address o- its registered o--ice9 t)e na%es and addresses o- t)e co%,any7s ,ro%oters9 %anager9 %anaging director9 directors9 co%,any secretary9 legal ad*iser9 auditors9 +an ers9 +ro ers9 etc8 $dvantages 5)e ,ure ,ros,ectus %et)od o--ers t)e -ollo(ing ad*antages to t)e issuer and t)e in*estors ali e. Bene'its to investors. 5)e ,ure ,ros,ectus %et)od o- %ar eting t)e securities ser*es as an e:cellent %ode o- disclosure o- all t)e in-or%ation ,ertaining to t)e issue8 "esides9 it also -acilitates satis-actory co%,liance (it) t)e legal require%ents o- trans,arency9 etc8 Bene'its to issuers. 5)e ,ure ,ros,ectus %et)od is t)e %ost ,o,ular %et)od a%ong t)e larger issuers8 !n addition9 it ,ro*ides -or (ide di--usion o- o(ners)i, o- securities contri+uting to reduction in t)e concentration o- econo%ic and social ,o(er8 Dra2%acks 5)e raising o- ca,ital t)roug) t)e ,ure ,ros,ectus %et)od is -raug)t (it) a nu%+er o- dra(+ac s as s,eci-ied +elo(. 4igh issue costs. ; %a<or dra(+ac o- t)is %et)od is t)at it is an e:,ensi*e %ode o- raising -unds -ro% t)e ca,ital %ar et8 =osts o- *arious )ues are incurred in %o+ili>ing ca,ital8 "ime Consuming. 5)e issue o- securities t)roug) ,ros,ectus ta es %ore ti%e9 as its requires t)e due co%,liance (it) *arious -or%alities +e-ore an issue could ta e ,lace8 ''er 'or Sale Method Meaning

39

?)ere t)e %ar eting o- securities ta es ,lace t)roug) inter%ediaries9 suc) as issue )ouses9 stoc )olders and ot)ers9 it is a case o- 6/--er -or sale Met)od78 Features Under t)is %et)od9 t)e sale o- securities ta es ,lace in t(o stages8 ;ccordingly9 in t)e -irst stage9 t)e issuer co%,any %a es an en3+loc sale o- securities to inter%ediaries suc) as t)e issue )ouses and s)are +ro ers o- an agreed ,rice8 Under t)e second stage9 t)e securities are re3sold to ulti%ate in*estors at a %ar et3related ,rice8 5)e issue is also under(ritten to ensure total su+scri,tion o- t)e issue8 5)e +iggest ad*antage o- t)is %et)od is t)at it sa*es t)e issuing co%,any t)e )assles in*ol*ed in selling t)e s)ares to t)e ,u+lic directly t)roug) ,ros,ectus8

Private Placement Method Meaning ; %et)od o- %ar eting o- securities ()ere+y t)e issuer %a es t)e o--er o- sale o- indi*iduals and institutions ,ri*ately (it)out t)e issue o- a ,ros,ectus is no(n as 6$ri*ate $lace%ent Met)od87 Features Under t)is %et)od9 securities are o--ered directly to large +uyers (it) t)e )el, o- s)are +ro ers8 5)is %et)od (or s in a %anner si%ilar to t)e 6/--er -or Sale Met)od7 ()ere+y securities are -irst sold to inter%ediaries suc) as issues )ouses9 etc8 $dvantages $ri*ate ,lace%ent o- securities o--ers t)e -ollo(ing ad*antages. 18 Less e:,ensi*e as *arious ty,es o- costs associated (it) t)e issue are +orne +y t)e issue )ouses and ot)er inter%ediaries8 28 $lace%ent o- securities suits t)e require%ents o- s%all co%,anies8

40

38 5)e %et)od is also resorted to ()en t)e stoc %ar et is dull and t)e ,u+lic res,onse to t)e issue is dou+t-ul8 Disadvantages 5)e %a<or (ea nesses o- t)e ,ri*ate ,lace%ent o- securities are as -ollo(s. 18 =oncentration o- securities in a -e( )ands8 28 =reating arti-icial scarcity -or t)e securities t)us <ac ing u, t)e ,rices te%,orarily and %isleading general ,u+lic8 38 4e,ri*ing t)e co%%on in*estors o- an o,,ortunity to su+scri+e to t)e issue9 t)us a--ecting t)eir con-idence le*els8 Initial Pu%lic ''er 5IP 6 Method 5)e ,u+lic issue %ade +y a cor,orate entity -or t)e -irst ti%e in its li-e is called 6!nitial ,u+lic /--er7 0!$/19 Under t)is %et)od o- %ar eting9 securities are issue to success-ul a,,licants on t)e +asis o- t)e orders ,laced +y t)e%9 t)roug) t)eir +ro ers8 ?)en a co%,any ()ose stoc is not ,u+licly traded (ants to o--er t)at stoc to t)e general ,u+lic9 it ta es t)e -or% o- 6!nitial ,u+lic o--er78 5)e <o+ o- selling t)e stoc is entrusted to a ,o,ular inter%ediary9 t)e under(riter8 5)e under(riters c)arge a -ee -or t)eir ser*ices8 Stoc s are issued to t)e under(riter a-ter t)e issue o- ,ros,ectus ()ic) ,ro*ides details o- -inancial and +usiness in-or%ation as regards t)e issuer8 5)e issuer and t)e under(riting syndicate <ointly deter%ine t)e ,rice o- a ne( issue8 !$/ stoc at t)e release ,rice is usually not a*aila+le to %ost o- t)e ,u+lic8 @ood relations)i, +et(een9 t)e +ro er and t)e in*estor is a ,re3requisite -or t)e stoc +eing acquired8 'ull disclosure o- all %aterial in-or%ation in connection (it) t)e o--ering o- ne( securities %ust +e %ade as ,art o- t)e ne( o--erings8 ; state%ent and ,reli%inary ,ros,ectus 0also no(n as a red )erring1 containing t)e -ollo(ing in-or%ation is to +e -illed (it) t)e 2egistrar o- =o%,anies. 18 ; descri,tion o- t)e issuer7s +usiness8

41

28 5)e na%es and addresses o- t)e Aey co%,any o--icers9 (it) salary and a 5 year +usiness )istory on eac)8 38 5)e a%ount o- o(ners)i, o- t)e ey o--icers 48 ;ny legal ,roceedings t)at t)e co%,any is in*ol*ed in 5)e essential ste,s in*ol*ed in t)is %et)od o- %ar eting o- securities are as -ollo(s. 18 rder3 "ro er recei*es order -ro% t)e client and ,laces orders on +e)al- o- t)e client (it) t)e issuer8 28 Share $llocation. 5)e issuer -inali>es s)are allocation and in-or%s t)e +ro er regarding t)e sa%e8 38 "he Client3 5)e +ro er ad*ises t)e success-ul clients o- t)e s)are allocation8 =lients t)en su+%it t)e a,,lication -or%s -or s)ares and %a e ,ay%ent to t)e issuer t)roug) t)e +ro er8 48 Primary issue account. 5)e issuer o,ens a se,arate escro( account 0,ri%ary issue account1 -or t)e ,ri%ary %ar et issue8 5)e clearing )ouse o- t)e e:c)ange de+its t)e ,ri%ary issue account o- t)e +ro er and credits t)e issuer7s account8 58 Certi'icates3 =erti-icates are t)en deli*ered to in*estors8 /t)er(ise de,ository account %ay +e credited8 #ights issue Method ?)ere t)e s)ares o- an e:isting co%,any are o--ered to its e:isting s)are)olders8 !t ta es t)e -or% orig)ts issue8 Under t)is %et)od9 t)e e:isting co%,any issues s)ares to its e:isting s)are)older sin ,ro,ortion in t)e nu%+er o- s)ares already )eld +y t)e%8 5)e rele*ant guidelines issued +y t)e SB"! in t)is regard are as -ollo(s. 18 S)all +e issued only +y listed co%,anies8 28 ;nnounce%ent regarding rig)ts issue once %ade9 s)all not +e (it)dra(n and ()ere (it)dra(n9 no security s)all +e eligi+le -or listing u,to 12 %ont)s8 38 Under(riting as to rig)ts issue is o,tional and a,,oint%ent o- 2egistrar is co%,ulsory8 48 ;,,oint%ent o- category ! Merc)ant "an ers )olding a certi-icate o- registration issued +y SB"! s)all +e co%,ulsory8 58 2ig)ts s)are s)all +e issued only in res,ect o- -ully ,aid s)are8 42

68 Letter o- /--er s)all contain disclosures as ,er SB"! require%ents8 78 !ssue s)all +e e,t o,en -or a %ini%u% ,eriod o- 30 days and -or a %a:i%u% ,eriod o- 60 days8 88 ; 6&o co%,laints =erti-icate7 is to +e -iled +y t)e Legal Merc)ant "an er7 (it) t)e SB"! a-ter 21 days -ro% t)e date o- issue o- t)e docu%ent8 98 /+ligatory -or a co%,any ()ere increase in su+scri+ed ca,ital is necessary a-ter t(o years o- its -or%ation o- a-ter one year o- its -irst issue o- s)ares9 ()ic)e*er is earlier 0t)is require%ent %ay +e dis,ensed (it) +y a s,ecial resolution18

$dvantages #ights issue o''ers the 'ollo2ing advantages 18 Economy3 2ig)ts issue constitutes t)e %ost econo%ical %et)od o- raising -res) ca,ital9 as it in*ol*es no under(riting and +ro erage costs8 28 Easy3 5)e issue %anage%ent ,rocedures connected (it) t)e rig)ts issue are easier as only a li%ited nu%+er o- a,,lications are to +e )andled8 38 $dvantage to shareholders. !ssue o- rig)ts s)ares does not in*ol*e any dilution o- o(ners)i, oe:isting s)are)olders8 Dra2%acks "he method su''ers 'rom the 'ollo2ing limitations3 18 #estrictive3 5)e -acility o- rig)ts issue is a*aila+le only to e:isting co%,anies and not to ne( co%,anies8 28 $gainst society. t)e issue o- rig)ts s)ares runs counter to t)e o*erall societal consideration odi--usion o- s)are o(ners)i, -or ,ro%oting dis,ersal o- (ealt) and econo%ic ,o(er8 Bonus Issues Method ?)ere t)e accu%ulated reser*es and sur,lus o- ,ro-its o- a co%,any are con*erted into ,aid u, ca,ital9 it ta es t)e -or% o- issue o- +onus s)ares8 !t %erely i%,lied ca,itali>ation o- e:isting reser*es and sur,lus o- a co%,any8 43

!ssue under Section 205 031 o- t)e co%,anies ;ct9 suc) s)ares is go*erned +y t)e guidelines issued +y t)e SB"! 0a,,lica+le o- listed co%,anies only1 as -ollo(s. SEBI Guidelines 'ollo(ing are t)e guidelines ,ertaining to t)e issue o- +onus s)ares +y a listed cor,orate enter,rise. 18 #eservation3 !n res,ect o- '=4s and $=4s9 +onus s)ares %ust +e reser*ed in ,ro,ortion to suc) con*erti+le ,art o- '=4s and $=4s8 5)e s)ares so reser*ed %ay +e issued at t)e ti%e ocon*ersion0s1 o- suc) de+entures on t)e sa%e ter%s on ()ic) t)e +onus issues (ere %ade8 28 #eserves3 t)e +onus issue s)all +e %ade out o- -ree reser*es +uilt out o- t)e genuine ,ro-its or s)are ,re%iu% collected in cas) only8 38 Dividend mode. t)e declaration o- +onus issue9 in lieu o- di*idend9 is not %ade8 48 Fully paid3 5)e +onus issue is not %ade unless t)e ,artly ,aid s)ares9 i- any are %ade -ully ,aid3 u,8 58 7o de'ault. 5)e =o%,any )as not de-aulted in ,ay%ent o- interest or ,rinci,al in res,ect o-i:ed de,osits and interest on e:isting de+entures or ,rinci,al on rede%,tion t)ereo- and )as su--icient reason to +elie*e t)at it )as not de-aulted in res,ect o- t)e ,ay%ent o- statutory dues o- t)e e%,loyees suc) as contri+ution to ,ro*ident -und9 gratuity9 +onus9 etc8 68 Implementation3 ; co%,any t)at announces its +onus issue a-ter t)e a,,ro*al o- t)e "oard o4irectors %ust i%,le%ent t)e ,ro,osal (it)in a ,eriod o- 6 %ont)s -ro% t)e date o- suc) a,,ro*al and s)all not )a*e t)e o,tion o- c)anging t)e decision8 78 "he articles. 5)e articles o- ;ssociation o- t)e co%,any s)all contain a ,ro*ision -or

ca,itali>ation o- reser*es9 etc8 i- t)ere is no suc) ,ro*ision in t)e articles9 t)e co%,any s)all ,ass a resolution at is general +ody %eeting %a ing ,ro*ision in t)e ;rticles o- ;ssociation -or ca,itali>ation8 88 #esolution3 consequent to t)e issue o- +onus s)ares i- t)e su+scri+ed and ,aid3u, ca,ital e:ceeds t)e aut)ori>ed s)are ca,ital9 t)e co%,any at its general +ody %eeting -or increasing t)e aut)ori>ed ca,ital s)all ,ass a resolution8 Book8%uilding Method

44

; %et)od o- %ar eting t)e s)ares o- a co%,any ()ere+y t)e quantu% and t)e ,rice o- t)e securities to +e issued (ill +e decided on t)e +asis o- t)e 6+ids7 recei*ed -ro% t)e ,ros,ecti*e s)are)olders +y t)e lead %erc)ant +an ers is no(n as 6+oo 3+uilding %et)od78 5)e o,tion o- +oo 3+uilding is a*aila+le to all +ody cor,orate9 ()ic) are ot)er(ise eligi+le to %a e an issue o- ca,ital o- t)e ,u+lic8 5)e initial %ini%u% si>e o- issue t)roug) +oo 3+uilding route (as -i:ed at 2s8100 crores8 5)e +oo 3+uilding ,rocess in*ol*es t)e -ollo(ing ste,s. 18 $ppointment o' %ook8runners. t)e -irst ste, in t)e +oo 3+uilding is t)e a,,oint%ent +y t)e issuer co%,any9 o- t)e +oo 3runner9 c)osen -ro% one o- t)e lead %erc)ant +an ers8 5)e +oo 3runner in t)e -or%s a syndicate -or t)e +oo +uilding8 ; syndicate %e%+er s)ould +e a %e%+er o- &ational Stoc B:c)ange 0&SB1 or /*er3t)e3=ounter B:c)ange o- !ndia 0/5=B!18 /--ers o- 6+ids7 are to +e %ade +y in*estors to t)e syndicate %e%+ers9 ()o register t)e de%ands o- in*estors8 28 Dra'ting prospectus. 5)e dra-t ,ros,ectus containing all t)e in-or%ation e:ce,t t)e

in-or%ation regarding t)e ,rice at ()ic) t)e securities are o--ered is to +e -iled (it) SB"! as ,er t)e ,re*ailing SB"! guidelines8 5)e o--er o- securities t)roug) t)is ,rocess %ust se,arately +e disclosed in t)e ,ros,ectus9 under t)e ca,tion 6,lace%ent ,ortion category78 38 Circulating dra't prospectus. ; co,y o- t)e dra-t ,ros,ectus -iled (it) SB"! is to +e circulated +y t)e +oo 3runner to t)e ,ros,ecti*e institutional +uyers ()o are eligi+le -or -ir% allot%ent and also to t)e inter%ediaries ()o are eligi+le to act as under(riters8 48 Maintain o''er records. 5)e +oo 3runner %aintain a record to t)e o--ers recei*ed8 4etails suc) as t)e na%e and t)e nu%+er o- securities ordered toget)er (it) t)e ,rice at ()ic) eac) institutional +uyer or under(riter is (illing to su+scri+ed to securities under t)e ,lace%ent ,ortion %ust -ind ,lace in t)e record8 SB"! )as t)e rig)t to ins,ect suc) records8 58 Intimation a%out aggregate orders. 5)e under(riters and t)e institutional in*estors s)all gi*e inti%ation on t)e aggregate o- t)e o--ers recei*ed to t)e +oo 3runner8 68 Bid analysis. 5)e +id analysis is carried out +y t)e +oo 3runner i%%ediately a-ter t)e closure o- t)e +id o--er date8 ;n a,,ro,riate -inal ,rice is arri*ed at a-ter a care-ul e*aluation ode%ands at *arious ,rices and t)e quantity8 45

78 Mandatory under2riting. ?)ere it )as +een decided to %a e o--ers o- s)ares to ,u+lic under t)e category o- 6&et o--er o- t)e $u+lic79 it is incu%+ent t)at t)e entire ,ortion o--ered to t)e ,u+lic is -ully under(ritten8 88 Filling 2ith # C3 ; co,y o- t)e ,ros,ectus as certi-ied +y t)e SB"! s)all +e -iled (it) t)e 2egistrar o- =o%,anies (it)in t(o days o- t)e recei,t o- t)e ac no(ledge%ent card -ro% t)e SB"!8 98 Bank accounts. 5)e issuer co%,any )as to o,en t(o se,arate accounts -or collection oa,,lication %oney9 one -or t)e ,ri*ate ,lace%ent ,ortion and t)e ot)er -or t)e ,u+lic su+scri,tion8 108 Collection o' completed applications. 5)e +oo 3runner collects -ro% t)e institutional +uyers and t)e under(riters t)e a,,lication -or%s along (it) t)e a,,lication %oney to t)e e:tent ot)e securities ,ro,osed to +e allotted to t)e% or su+scri+ed +y t)e%8 118 $llotment o' securities. ;llot%ent -or t)e ,ri*ate ,lace%ent ,ortion %ay +e %ade on t)e second day -ro% t)e closure o- t)e issue8 5)e issuer co%,any9 )o(e*er9 )as t)e o,tion to c)oose one date -or +ot) t)e ,lace%ent ,ortion and t)e ,u+lic ,ortion8 128 Payment schedule and listing. 5)e +oo 3runner %ay require t)e under(riters to t)e 6net o--er to t)e ,u+lic7 to ,ay in ad*ance all %oneys required to +e ,aid in res,ect o- t)eir under(riting co%%it%ent +y t)e ele*ent) day o- t)e closure o- t)e issue8 138 !nder8su%scription. !n t)e case o- under3su+scri,tion in t)e 6net o--er to t)e ,u+lic7 category9 any s,illo*er to t)e e:tent o- under su+scri,tion is to +e ,er%itted -ro% t)e 6,lace%ent ,ortion7 category su+<ect to t)e condition t)at ,re-erence is gi*en to t)e indi*idual in*estors8 $dvantages o' %ook8%uilding "oo +uilding ,rocess is o- i%%ense use in t)e -ollo(ing (ays. 18 2eduction in t)e duration +et(een allot%ent and listing 28 2elia+le allot%ent ,rocedure 38 Cuic listing in stoc e:c)anges ,ossi+le 48 &o ,rice %ani,ulation as t)e ,rice is deter%ined on t)e +asis o- t)e +ids recei*ed8 Stock ption or employees Stock ption Scheme 5ES P6

46

; %et)od o- %ar eting t)e securities o- a co%,any ()ere+y its e%,loyees are encouraged to ta e u, s)ares and su+scri+e to it is no(n as 6stoc o,tion78 !t is a *oluntary sc)e%e on t)e ,art o- t)e co%,any to encourage e%,loyees7 ,artici,ation in t)e co%,any8 5)e sc)e%e also o--ers an incenti*e to t)e e%,loyees to stay in t)e co%,any8 SEBI Guidelines =o%,any ()ose securities are listed on any stoc e:c)ange can introduce t)e sc)e%e o- e%,loyees7 stoc o,tion8 5)e o--er can +e %ade su+<ect to t)e conditions s,eci-ied +elo(. 18 Issue at discount. !ssue o- stoc o,tions at a discount to t)e %ar et ,rice (ould +e regarded as anot)er -or% o- e%,loyee co%,ensation and (ould +e treated as suc) in t)e -inancial state%ents o- t)e co%,any regardless t)e quantu% o- discount on t)e e:ercise ,rice o- t)e o,tion8 28 $pproval3 5)e issue o- BS/$7s is su+<ect to t)e a,,ro*al +y t)e s)are)olders t)roug) a s,ecial resolution8 38 Maximum limit. 5)ere (ould +e no restriction on t)e %a:i%u% nu%+er o- s)ares to +e issued to a single e%,loyee8 48 Minimum period. ; %ini%u% ,eriod o- one year +et(een grant o- o,tions and its *esting )as +een ,rescri+ed8 ;-ter one year9 t)e co%,any (ould deter%ine t)e ,eriod during ()ic) t)e o,tion can +e e:ercised8 58 Superintendence3 5)e o,eration o- t)e BS/$ Sc)e%e (ould )a*e to +e under t)e

su,erintendence and direction o- a =o%,ensation =o%%ittee o- t)e "oard o- 4irectors in ()ic) t)ere (ould +e a %a<ority o- inde,endent directors8 68 Eligi%ility3 BS/$ sc)e%e is o,en to all ,er%anent e%,loyees and to t)e directors o- t)e co%,any +ut not to ,ro%oters and large s)are)olders8 78 Director9s report. 5)e 4irector7s re,ort s)all %a e a disclosure o- t)e -ollo(ing.

a8 5otal nu%+er o- s)ares as a,,ro*ed t)e s)are)olders +8 5)e ,ricing -or%ula ado,ted c8 4etails as to o,tions grated9 o,tions *ested9 o,tions e:ercised and o,tions -or-eited9 e:tinguis)%ents or %odi-ication o- o,tions9 %oney reali>ed +y e:ercise o- o,tions9 total 47

nu%+er o- o,tions in -orce9 e%,loyee3(ise details o- o,tions granted to senior %anagerial ,ersonnel and to any ot)er e%,loyee ()o recei*ed a grant in anyone year o- o,tions a%ounting to 5 ,ercent or %ore o- o,tions granted during t)at year8 d8 'ully diluted B$S co%,uted in accordance (it) t)e !;S 88 IP 3 SB"!7s sti,ulations ,ro)i+iting initial ,u+lic o--erings +y co%,anies )a*ing outstanding o,tions s)ould not a,,ly to BS/$8 Stock ption 7orms 'or So't2are Companies 5)e rele*ant guidelines issued +y t)e SB"! as regards 6e%,loyees7 stoc o,tion7 -or so-t(are co%,anies are as -ollo(s. 18 Minimum issue. ; %ini%u% issue o- 10 ,ercent o- its ,aid3u, ca,ital can +e %ade +y a so-t(are co%,any ()ic) )as already -loated ;%erican 4e,ository 2ecei,ts 0;42s1 and @lo+al 4e,ository 2ecei,ts 0@42s1 or a co%,any ()ic) is ,ro,osing to -loat t)ese is entitled to issue ;42D@42 lin ed stoc o,tions to its e%,loyees8 28 Mode o' Issue. Listed stoc o,tions can +e issued in -oreign currency con*erti+le +onds and ordinary s)ares 0t)roug) de,ository recei,t %ec)anis%1 to t)e e%,loyees o- su+sidiaries o- !n-o 5ec) =o%,anies8 38 Permanent employees. !ndian !5 co%,anies can issue ;42D@42 lin ed stoc o,tions to

,er%anent e%,loyees9 including !ndian and o*erseas directors9 o- t)eir su+sidiary co%,anies incor,orated in !ndia or outside8 48 Pricing3 5)e ,ricing ,ro*isions o- SB"!7s ,re-erential allot%ent guidelines (ould not co*er t)e sc)e%e8 5)e ,ur,ose is to +e ena+le t)e co%,anies to issue stoc o,tions to its e%,loyees at a discount to t)e %ar et ,rice ()ic) ser*es as anot)er -or% o- co%,ensation8 58 $pproval3 S)are)olders7 a,,ro*al t)roug) a s,ecial resolution is necessary -or issuing t)e BS/$s8 ; %ini%u% ,eriod o- one year +et(een grant o- o,tion and its *esting )as +een ,rescri+ed8 ;-ter one year9 t)e co%,any (ould deter%ine t)e ,eriod in ()ic) o,tion can +e e:ercised8 Bought8out Deals Meaning 48

; %et)od -or %ar eting o- securities o- a +ody cor,orate ()ere+y t)e ,ro%oters o- an unlisted co%,any %a e an outrig)t sale o- a c)un o- equity s)ares to a single s,onsor or t)e lead s,onsor is no(n as 6+oug)t3out deals78 Features 18 Parties3 5)ere are t)ree ,arties in*ol*ed in t)e +oug)t3out deals8 5)ey are ,ro%oters o- t)e co%,any s,onsors and co3s,onsors ()o are generally %erc)ant +an ers and in*estors8 28 utright Sale3 Under t)is arrange%ent9 t)ere is an outrig)t sale o- a c)un o- equity s)ares to a single s,onsor or t)e lead s,onsor8 38 Syndicate3 S,onsor -or%s a syndicate (it) ot)er %erc)ant +an ers -or %eeting t)e resource require%ents and -or distri+uting t)e ris 8 48 Sale price3 5)e sale ,rice is -inali>ed t)roug) negotiations +et(een t)e issuing co%,any and t)e ,urc)aser9 t)e sale +eing in-luenced +y suc) -actors as ,ro<ect e*aluation9 ,ro%oters7 i%age and re,utation9 current %ar et senti%ents9 ,ros,ects o- o--3loading t)ese s)ares at a -uture date9 etc8 58 :isting3 5)e in*estor3s,onsor %a e a ,ro-it9 ()en at a -uture date9 t)e s)ares get listed and )ig)er ,rices ,re*ail8 Listing generally ta es ,lace at a ti%e ()en t)e co%,any is ,er-or%ing (ell in ter%s o- )ig)er ,ro-its and larger cas) generations -ro% ,ro<ects8 68 "CEI3 Sale o- t)ese s)are at /*er3t)e3=ounter B:c)ange o- !ndia 0/5=B!1 or at a recogni>ed stoc e:c)anges9 t)e ti%e o- listing t)ese securities and o--3loading t)e% si%ultaneously are +eing generally decided in ad*ance8

49

!nit + Fundamental $nalysis Explain 'undamental analysis o' stock in detail)

'unda%ental analysis is used to deter%ine t)e intrinsic *alue o- t)e s)are +y e:a%ining t)e underlying -orces t)at a--ect t)e (ell +eing o- t)e econo%y9 !ndustry grou,s and co%,anies8 'unda%ental analysis is to -irst analy>e t)e econo%y9 t)en t)e !ndustry and -inally indi*idual co%,anies8 5)is is called as to, do(n a,,roac)8 (5)e actual *alue o- a security9 as o,,osed to its %ar et ,rice or +oo *alue is called intrinsic *alue8 5)e intrinsic *alue includes ot)er *aria+les suc) as +rand

na%e9 trade%ar s9 and co,yrig)ts t)at are o-ten di--icult to calculate and so%eti%es not accurately re-lected in t)e %ar et ,rice8 /ne (ay to loo at it is t)at t)e %ar et ca,itali>ation is t)e ,rice 0i8e8 ()at in*estors are (illing to ,ay -or t)e co%,any1 and intrinsic *alue is t)e *alue 0i8e8 ()at t)e co%,any is really (ort)18

50

5)e to, do(n a,,roac) o- -unda%ental analysis ;t t)e econo%y le*el9 -unda%ental analysis -ocus on econo%ic data 0suc) as @4$9 'oreign e:c)ange and !n-lation etc81 to assess t)e ,resent and -uture gro(t) o- t)e econo%y8 ;t t)e industry le*el9 -unda%ental analysis e:a%ines t)e su,,ly and de%and -orces -or t)e ,roducts o--ered8 ;t t)e co%,any le*el9 -unda%ental analysis e:a%ines t)e -inancial data 0suc) as +alance s)eet9 inco%e state%ent and cas) -lo( state%ent etc819 %anage%ent9 +usiness conce,t and co%,etition8

51

!n order to -orecast t)e -uture s)are ,rice9 -unda%ental analysts co%+ines t)e econo%ic9 industry and co%,any analysis8 !- t)e intrinsic *alue is lo(er t)an t)e current *alue9 -unda%ental analysis reco%%ends to +uy t)e s)are and t)e *ice *ersa is also true8 Economic analysis Bcono%ic analysis occu,ies t)e -irst ,lace in t)e -inancial analysis to, do(n a,,roac)8 ?)en t)e econo%y is )a*ing sustaina+le gro(t)9 t)en t)e industry grou, 0Sectors1 and co%,anies (ill get +ene-it and gro( -aster8 5)e analysis o- %acroecono%ic en*iron%ent is essential to understand t)e +e)a*ior o- t)e stoc ,rices8 5)e co%%only analysed %acro econo%ic -actors are as -ollo(s8 Gross domestic product 5GDP63 @4$ indicates t)e rate o- gro(t) o- t)e econo%y8 @4$ re,resents t)e *alue o- all t)e goods and ser*ices ,roduced +y a country in one year8 5)e )ig)er t)e gro(t) rate is %ore -a*oura+le to t)e s)are %ar et8 Savings and investment3 5)e econo%ic gro(t) results in su+stantial a%ount o- do%estic sa*ings8 Stoc %ar et is a c)annel t)roug) ()ic) t)e sa*ings o- t)e in*estors are %ade a*aila+le to t)e industries8 5)e sa*ings and in*est%ent ,attern o- t)e ,u+lic a--ect stoc %ar et8 In'lation3 ;long (it) t)e gro(t) o- @4$9 i- t)e in-lation rate also increases9 t)en t)e real rate o- gro(t) (ould +e *ery little8 5)e decreasing in-lation is good -or cor,orate sector8 Interest rates3 5)e interest rate a--ects t)e cost o- -inancing to t)e -ir%s8 ; decrease in interest rate i%,lies lo(er cost o- -inance -or -ir%s and %ore ,ro-ita+ility8 Budget3 "udget is t)e annual -inancial state%ent o- t)e go*ern%ent9 ()ic) deals (it) e:,ected re*enues and e:,enditures8 ; de-icit +udget %ay lead to )ig) rate o- in-lation and ad*ersely a--ect t)e cost o- ,roduction8 Sur,lus +udget %ay result in de-lation8 #ence9 +alanced +udget is )ig)ly -a*oura+le to t)e stoc %ar et8 "he tax structure3 5)e ta: structure ()ic) ,ro*ides incenti*es -or sa*ings and in*est%ents8

52

"he %alance o' payment3 5)e +alance o- ,ay%ent is t)e syste%atic record o- all %oney trans-er +et(een !ndia and t)e rest o- t)e (orld8 5)e di--erence +et(een recei,ts and ,ay%ents %ay +e sur,lus or de-icit8 !- t)e de-icit increases9 t)e ru,ee %ay de,reciate against ot)er currencies8 5)is (ould a--ect t)e industries9 ()ic) are dealing (it) -oreign e:c)ange8 Monsoon and agriculture3 !ndia is ,ri%arily an agricultural country8 5)e i%,ortance oagricultural in !ndian econo%y is e*ident8 ;griculture is directly and indirectly lin ed (it) t)e industries8 'or e:a%,le9 Sugar9 5e:tile and 'ood ,rocessing industries de,end u,on agriculture -or ra( %aterial8 'ertili>er and 5ractor industries are su,,lying in,ut to t)e agriculture8 ; good %onsoon leads +etter )ar*estingE t)is in turn i%,ro*es t)e ,er-or%ance o- !ndian econo%y8 In'rastructure3 !n-rastructure -acilities are essential -or gro(t) o- !ndustrial and agricultural sector8 !n-rastructure -acilities include trans,ort9 energy9 +an ing and co%%unication8 !n !ndia e*en t)oug) !n-rastructure -acilities )a*e +een de*elo,ed9 still t)ey are not adequate8 Demographic 'actors3 5)e de%ogra,)ic data ,ro*ides details a+out t)e ,o,ulation +y age9 occu,ation9 literacy and geogra,)ic location8 5)is is needed to -orecast t)e de%and -or t)e consu%er goods8 Political sta%ility3 ; sta+le ,olitical syste% (ould also +e necessary -or a good ,er-or%ance o- t)e econo%y8 $olitical uncertainties and ad*erse c)ange in go*ern%ent ,olicy a--ect t)e industrial gro(t)8

Industry or Sector analysis 5)e second ste, in t)e -unda%ental analysis o- securities is !ndustry analysis8 ;n industry or sector is a grou, o- -ir%s t)at )a*e si%ilar tec)nological structure o- ,roduction and ,roduce
53

si%ilar ,roducts8 5)ese industries are classi-ied according to t)eir reactions to t)e di--erent ,)ases o- t)e +usiness cycle8 5)ey are classi-ied into gro(t)9 cyclical9 de-ensi*e and cyclical gro(t) industry8 ; %ar et assess%ent tool designed to ,ro*ide a +usiness (it) an idea ot)e co%,le:ity o- a ,articular industry8 !ndustry analysis in*ol*es re*ie(ing t)e econo%ic9 ,olitical and %ar et -actors t)at in-luence t)e (ay t)e industry de*elo,s8 Ma<or -actors can include t)e ,o(er (ielded +y su,,liers and +uyers9 t)e condition o- co%,etitors and t)e li eli)ood o- ne( %ar et entrants8 5)e industry analysis s)ould ta e into account t)e -ollo(ing -actors8

Characteristics o' the industry3 ?)en t)e de%and -or industrial ,roducts is seasonal9 t)eir ,ro+le%s %ay s,oil t)e gro(t) ,ros,ects8 !- it is consu%er ,roduct9 t)e scale o- ,roduction and (idt) o- t)e %ar et (ill deter%ine t)e selling and ad*ertise%ent cost8 5)e nature oindustry is also an i%,ortant -actor -or deter%ining t)e scale o- o,eration and ,ro-ita+ility8 Demand and market3 !- t)e industry is to )a*e good ,ros,ects o- ,ro-ita+ility9 t)e de%and -or t)e ,roduct s)ould not +e controlled +y t)e go*ern%ent8 Government policy3 5)e go*ern%ent ,olicy is announced in t)e !ndustrial ,olicy resolution and su+sequent announce%ents +y t)e go*ern%ent -ro% ti%e to ti%e8 5)e go*ern%ent
54

,olicy (it) regard to granting o- clearances9 installed ca,acity9 ,rice9 distri+ution o- t)e ,roduct and reser*ation o- t)e ,roducts -or s%all industry etc are also -actors to +e considered -or industrial analysis8 :a%our and other industrial pro%lems3 5)e industry )as to use la+our o- di--erent categories and e:,ertise8 5)e ,roducti*ity o- la+our as %uc) as t)e ca,ital e--iciency (ould deter%ine t)e ,rogress o- t)e industry8 !- t)ere is a la+our ,ro+le% t)at industry s)ould +e neglected +y t)e in*estor8 Si%ilarly ()en t)e industries )a*e t)e ,ro+le%s o- %ar eting9 in*estors )a*e to +e care-ul ()en in*esting in suc) co%,anies8 Management3 !n case o- ne( industries9 in*estors )a*e to care-ully assess t)e ,ro<ect re,orts and t)e assess%ent o- -inancial institutions in t)is regard8 5)e ca,a+ilities o%anage%ent (ill de,end u,on ta: ,lanning9 inno*ation o- tec)nology9 %odernisation etc8 ; good %anage%ent (ill also insure t)at t)eir s)ares are (ell distri+uted and liquidity os)ares is assured8 Future prospects3 !t is essential to )a*e an o*erall ,icture o- t)e industry and to study t)eir ,ro+le%s and ,ros,ects8 ;-ter a study o- t)e ,ast9 t)e -uture ,ros,ects o- t)e industry are to +e assessed8 ?)en t)e econo%y e:,ands9 t)e ,er-or%ance o- t)e industries (ill +e +etter8 Si%ilarly ()en t)e econo%y contracts re*erse (ill )a,,en in t)e !ndustry8 Bac) !ndustry is di--erent -ro% t)e ot)er8 =e%ent !ndustry is entirely di--erent -ro% So-t(are !ndustry or 5e:tile !ndustry in its ,roducts and ,rocess8 Company or Corporate analysis =o%,any analysis is a study o- *aria+les t)at in-luence t)e -uture o- a -ir% +ot) qualitati*ely and quantitati*ely8 !t is a %et)od o- assessing t)e co%,etiti*e ,osition o- a -ir%9 its earning and ,ro-ita+ility9 t)e e--iciency (it) ()ic) it o,erates its -inancial ,osition and its -uture (it) res,ect to earning o- its s)are)olders8

55

5)e -unda%ental nature o- t)e analysis is t)at eac) s)are o- a co%,any )as an intrinsic *alue ()ic) is de,endent on t)e co%,anyFs -inancial ,er-or%ance8 !- t)e %ar et *alue o- a s)are is lo(er t)an intrinsic *alue as e*aluated +y -unda%ental analysis9 t)en t)e s)are is su,,osed to +e under*alued8 5)e +asic a,,roac) is analysed t)roug) t)e -inancial state%ents o- an organisation8 5)e co%,any or cor,orate analysis is to +e carried out to get ans(er -or t)e -ollo(ing t(o questions8 1 #o( )as t)e co%,any ,er-or%ed in co%,arison (it) t)e si%ilar co%,any in t)e sa%e !ndustryG 2 #o( )as t)e co%,any ,er-or%ed in co%,arison to t)e early yearsG

"e-ore %a ing in*est%ent decision9 t)e +usiness ,lan o- t)e co%,any9 %anage%ent9 annual re,ort9 -inancial state%ents9 cas) -lo( and ratios are to +e e:a%ined -or +etter returns8

56

Conclusion 'unda%ental analysis can +e used to identi-y co%,anies t)at re,resent good *alue8 #ence it is good -or long ter% in*est%ents8 Haluation tec)niques *ary de,ending on t)e industry grou,8 'or t)is reason9 a di--erent tec)niques or %odel is required -or di--erent industry8 5)is can get quite ti%e consu%ing and li%it t)e a%ount o- researc) t)at can +e ,er-or%ed8 !n -unda%ental analysis9 co%,anies s)ould +e co%,ared against ot)er co%,anies in t)e sa%e sector8 'or e:a%,le9 a so-t(are co%,any 0!n-osys 5ec)nologies1 s)ould +e co%,ared (it) a so-t(are co%,any 0?i,ro19 not to a +an 0!=!=! "an 18

Explain the 'undamental economic analysis o' stocks) 5 r6 Descri%e the various macroeconomic 'actors analysed in 'undamental analysis o' stocks)
Economic $nalysis 5)e le*el o- econo%ic acti*ity )as an i%,act in %any (ays8 !- t)e econo%y gro(s ra,idly9 t)e industry can also +e e:,ected to s)o( ra,id gro(t) and *ice *ersa8 ?)en t)e le*el o- econo%ic acti*ity is lo(9 stoc ,rices are lo(9 and ()en t)e le*el o- econo%ic acti*ity is )ig)9 stoc ,riced are )ig) re-lecting t)e ,ros,erous outloo -or sales and ,ro-its o- t)e -ir%s8 5)e analysis o%acroecono%ic en*iron%ent is essential to understand t)e +e)a*iour o- t)e stoc ,rices8 5)e co%%only analysed %acro econo%ic -actors are as -ollo(s Gross domestic product 5GDP6 @4$ indicates t)e rate o- gro(t) o- t)e econo%y8 @4$ re,resents t)e aggregate *alue o- t)e goods and ser*ices ,roduced in t)e econo%y8 @4$ consists o- ,ersonal consu%,tion e:,enditure9 gross ,ri*ate do%estic in*est%ent and go*ern%ent e:,enditure on goods and ser*ice and net e:,ort o- goods and ser*ices8 5)e esti%ates o- @4$ are a*aila+le on an annual +asis8 5)e rate o- gro(t) o- @4$ is around 6I in t)e nineties8 5)e @4$ gro(t) in 1998399 )as accelerated to 588 ,ercent co%,ared to 5 ,er cent o- t)e ,re*ious year8 5)e gro(t) rate o57

econo%y ,oints out t)e ,ros,ects -or t)e industrial sector and t)e return in*estors can e:,ect -ro% in*est%ent in s)ares8 5)e )ig)er gro(t) rate is %ore -a*oura+le to t)e stoc %ar et8 Saving and investment !t is o+*ious t)at gro(t) requires in*est%ent ()ic) in turn requires su+stantial a%ount odo%estic sa*ings8 Stoc %ar et is a c)annel t)roug) ()ic) t)e sa*ings o- t)e in*estors are %ade a*aila+le to t)e cor,orate +odies8 Sa*ings are distri+uted o*er *arious assets li e equity s)ares9 de,osits9 %utual -und units9 real estate and +ullion8 5)e sa*ing and in*est%ent ,atterns o- t)e ,u+lic a--ect t)e stoc to a great e:tent8 In'lation ; long (it) t)e gro(t) o- @4$9 i- t)e in-lation rate also increases9 t)en t)e real rate o- gro(t) (ould +e *ery little8 5)e de%and in t)e consu%er ,roduct industry is signi-icantly a--ected8 5)e industries ()ic) co%e under t)e go*ern%ent ,rice control ,olicy %ay lose t)e %ar et9 -or e:a%,le Sugar8 5)e go*ern%ent control o*er t)is industry9 a--ects t)e ,rice o- t)e sugar and t)ere+y t)e ,ro-ita+ility o- t)e industry itsel-8 !- t)ere is a %ild le*el o- in-lation9 it is good to t)e stoc %ar et +ut )ig) rate o- in-lation is )ar%-ul to t)e stoc %ar et8 Interest rates 5)e interest rate a--ects t)e cost o- -inancing to t)e -ir%s8 ; decrease in interest rate i%,lies lo(er cost o- -inance -or -ir%s and %ore ,ro-ita+ility8 More %oney is a*aila+le at a lo(er interest rate -or t)e +ro ers ()o are doing +usiness (it) +orro(ed %oney8 ;*aila+ility oc)ea, -und encourages s,eculation and rise in t)e ,rice o- s)ares8 Budget 5)e +udget dra-t ,ro*ides an ela+orate account o- t)e go*ern%ent re*enues and e:,enditures8 ; de-icit +udget %ay lead to )ig) rate o- in-lation and ad*ersely a--ect t)e cost o- ,roduction8 Sur,lus +udget %ay result in de-lation8 #ence9 +alanced +udget is )ig)ly -a*oura+le to t)e stoc %ar et8 5)e -iscal de-icit and t)e re*enue de-icit as a ,ercentage o- t)e @4$ are gi*en in 5a+le
58

"he tax structure B*ery year in Marc)9 t)e +usiness co%%unity eagerly a(aits t)e @o*ern%ent7s announce%ent regarding t)e ta: ,olicy8 =oncessions and incenti*es gi*en to a certain industry encourage in*est%ent in t)at ,articular industry8 5a: relie-s are gi*en to encourage sa*ings8 5)e Mini%u% ;lternati*e 5a: 0M;51 le*ied +y t)e 'inance Minister in 1996 ad*ersely a--ected t)e stoc %ar et8 5en years o- ta: )oliday -or all industries to +e set u, in t)e nort)east is ,ro*ided in t)e 1999 +udget8 5)e ty,e o- ta: e:e%,tion )as i%,act on t)e ,ro-ita+ility o- t)e industries8 "he %alance o' payment 5)e +alance o- ,ay%ent is t)e record o- a country7s %oney recei,ts -or% and ,ay%ents a+road8 5)e di--erence +et(een recei,ts and ,ay%ents %ay +e sur,lus or de-icit8 "alance o- ,ay%ent is a %easure o- t)e strengt) o- ru,ee o e:ternal account8 !- t)e de-icit increases9 t)e ru,ee %ay de,reciate against ot)er currencies9 t)ere+y9 a--ecting t)e cost o- i%,orts8 5)e industries in*ol*ed in t)e e:,ort and i%,ort are considera+ly a--ected +y t)e c)anges in -oreign e:c)ange rate8 5)e *olatility o- t)e -oreign e:c)ange rate a--ects t)e in*est%ents o- t)e -oreign institutional in*estors in t)e !ndian stoc %ar et8 ; -a*oura+le +alance o- ,ay%ent renders a ,ositi*e e--ect on t)e stoc %ar et8 Monsoon and agriculture ;griculture is directly and indirectly lin ed (it) t)e industries8 'or e:a%,le9 Sugar9 =otton9 5e:tile and 'ood ,rocessing industries de,end u,on agriculture -or ra(3%aterial8 'ertili>er and insecticide industries are su,,lying in,uts to t)e agriculture8 ; good %onsoon leads to )ig)er de%and -or in,ut and results in +u%,er cro,8 5)is (ould lead to +uoyancy in t)e stoc %ar et8 ?)en t)e %onsoon is +ad9 agricultural and )ydel ,o(er ,roduction (ould su--er8 5)ey cast a s)ado( on t)e s)are %ar et8 In'rastructure 'acilities

59

!n-rastructure -acilities are essential -or t)e gro(t) o- industrial and agricultural sector8 ; (ide net (or o- co%%unication syste% is a %ust -or t)e gro(t) o- t)e econo%y8 2egular su,,ly o,o(er (it)out any ,o(er cut (ould +oost t)e ,roduction8 "an ing and -inancial sectors also s)ould +e sound enoug) to ,ro*ide adequate su,,ort to t)e industry and agriculture8 @ood in-rastructure -acilities a--ect t)e stoc %ar et -a*oura+ly8 !n !ndia e*en t)oug) in-rastructure -acilities )a*e +een de*elo,ed9 still t)ey are not adequate8 5)e go*ern%ent )as li+eralised its ,olicy regarding t)e co%%unication9 trans,ort and ,o(er sector8 'or e:a%,le9 ,o(er sector )as +een o,ened u, to t)e -oreign in*estors (it) assured rates o- returns8 Demographic 'actors 5)e de%ogra,)ic data ,ro*ided details a+out t)e ,o,ulation +y age9 occu,ation9 literacy and geogra,)ic location8 5)is is needed to -orecast t)e de%and -or t)e consu%er goods8 5)e ,o,ulation +y age indicates t)e a*aila+ility o- a+le (or -orce8 5)e c)ea, la+our -orce in !ndia )as encouraged %any %ultinationals to start t)eir *entures8 !ndian la+our is c)ea,er co%,ared to ?estern la+our -orce8 $o,ulation9 +y ,ro*iding la+our and de%and -or ,roducts9 a--ects t)e industry and stoc %ar et8

Explain various economic 'orecasting techni;ues used in 'undamental analysis) 'or t)e ,ur,ose o- econo%ic analysis9 an analyst s)ould +e -a%iliar (it) t)e -orecasting tec)niques8 #e s)ould no( t)e ad*antages and disad*antages o- *arious tec)niques8 5)e co%%on tec)niques used are analysis o' key economic indicators< di''usion index< surveys and econometric model %uilding) 5)ese tec)niques )el, )i% to decide t)e rig)t ti%e to incest and t)e ty,e o- security )e )as to ,urc)ase i8e8 stoc s or +onds or so%e co%+ination o- stoc s and +onds8 EC 7 MIC I7DIC$" #S

60

5)e econo%ic indicators are statistics a+out t)e econo%y t)at indicate t)e ,resent status9 ,rogress or slo( do(n o- t)e econo%y8 5)ey are ca,ital in*est%ent9 +usiness ,ro-its9 %oney su,,ly9 @&$9 interest rate9 une%,loy%ent rate9 etc8 5)e econo%ic indicators are grou,ed into leading9 coincidental and lagging indicators8 5)e indicators are selected on t)e -ollo(ing criteria Bcono%ic signi-icance Statistical adequacy 5i%ing =on-or%ity

"he leading indicators3 5)e leading indicators indicate ()at is going to )a,,en in t)e econo%y8 !t )el,s t)e in*estor to ,redict t)e ,at) o- t)e econo%y8 5)e ,o,ular leading indicators are t)e -iscal ,olicy9 %onetary ,olicy9 ,roducti*ity9 rain-all9 ca,ital in*est%ent and t)e stoc indices8 5)e -iscal ,olicy s)o(s ()at t)e go*ern%ent ai%s at and t)e -iscal de-icit or sur,lus )as an e--ect on t)e econo%y8 5)e ta: ,olicy o- t)e go*ern%ent %ay act as a +oost or a deterrent to t)e industry8 5)e so,s gi*en to t)e e:,ort oriented industries %ay i%,ro*e t)e e:,orts o- t)e econo%y8 Li e(ise t)e c)ea, %oney or t)e tig)t %oney ,olicy ado,ted +y t)e %onetary aut)orities also indicates t)e -uture e--ects o- t)e ,olicy on t)e industry8 5)e rise o- "SB Sense: and &SB &i-ty s)o(s t)at t)e econo%y is )eading -or reco*ery8

"he coincidental indicators3 5)e coincidental indicators indicate ()at t)e econo%y is8 5)e coincidental indicators are gross national ,roduct9 industrial ,roduction9 interest rates and reser*e -unds8 @4$ is t)e aggregate a%ount o- goods and ser*ices ,roduced in t)e national econo%y8 5)e ga, +et(een t)e +udgeted @4$ and t)e actual @4$ attained indicates t)e ,resent situation8 !- t)ere is a large
61

ga, +et(een t)e actual gro(t) and ,otential gro(t)9 t)e econo%y is slo(ing do(n8 Lo( cor,orate ,ro-its and industrial ,roduction s)o( t)at t)e econo%y is )it +y recession8 "he lagging indicators3 5)e c)anges t)at are occurring in t)e leading and coincidental indicators are re-lected in t)e lagging indicators8 Lagging indicators are identi-ied as une%,loy%ent rate9 consu%er ,rice inde: and -lo( o- -oreign -unds8 5)ese leading9 coincidental and lagging indicators ,ro*ide an insig)t into t)e econo%y7s current and -uture ,osition8 DIFF!SI 7 I7DE= 4i--usion inde: is a co%,osite or consensus inde:8 5)e di--usion inde: consists o- leading9 coincidental and lagging indicators8 5)is ty,e o- inde: )as +een constructed +y t)e &ational "ureau o- Bcono%ic 2esearc) in US;8 "ut t)e di--usion inde: is co%,le: in nature to calculate and t)e irregular %o*e%ents t)at occur in indi*idual indicators cannot +e co%,letely eli%inated8 EC 7 ME"#IC M DE: B!I:DI7G 'or %odel +uilding se*eral econo%ic *aria+les are ta en into consideration8 5)e assu%,tions underlying t)e analysis are s,eci-ied8 5)e relations)i, +et(een t)e inde,endent and de,endent *aria+les is gi*en %at)e%atically8 ?)ile using t)e %odel9 t)e analyst )as to t)in clearly all t)e inter3relations)i, +et(een t)e *aria+les8 ?)en t)ese inter3relations)i,s are s,eci-ied9 )e can -orecast not only t)e direction +ut also t)e %agnitude8 "ut )is ,rediction de,ends on )is understanding o- econo%ic t)eory and t)e assu%,tions on ()ic) t)e %odel )ad +een +uilt8 5)e %odels %ostly use si%ultaneous equations8

Explain various tools o' 'undamental analysis o' stocks) Introduction3

62

'unda%ental analysis is t)e ,rocess o- loo ing at a +usiness at t)e +asic or -unda%ental -inancial le*el8 5)is ty,e o- analysis e:a%ines ey ratios o- a +usiness to deter%ine its -inancial )ealt) and gi*es an idea o- t)e *alue its stoc 8

Many in*estors use -unda%ental analysis alone or in co%+ination (it) ot)er tools to e*aluate stoc s -or in*est%ent ,ur,oses8 5)e goal is to deter%ine t)e current (ort) and9 %ore i%,ortantly9 )o( t)e %ar et *alues t)e stoc 8

Fundamental $nalysis "ools3

;lt)oug) t)e ra( data o- t)e 'inancial State%ent )as so%e use-ul in-or%ation9 %uc) %ore can +e understood a+out t)e *alue o- a stoc +y a,,lying a *ariety o- tools to t)e -inancial data8

() Earnings per Share > EPS *) Price to Earnings #atio > P?E +) Pro@ected Earnings Gro2th > PEG ,) Price to Sales > P?S -) Price to Book > P?B .) Dividend Payout #atio /) Dividend Aield 0) Book Balue per share 1) #eturn on E;uity

1. Earnings per Share 5)e o*erall earnings o- a co%,any is not in itsel- a use-ul indicator o- a stoc Fs (ort)8 Lo( earnings cou,led (it) lo( outstanding s)ares can +e %ore *alua+le t)an )ig) earnings (it) a )ig) nu%+er o- outstanding s)ares8 Barnings ,er s)are is %uc) %ore use-ul in-or%ation t)an earnings +y itsel-8 Barnings ,er s)are 0B$S1 is calculated +y di*iding t)e net earnings +y t)e nu%+er o- outstanding s)ares8
63

EPS C 7et Earnings ? utstanding Shares

'or e:a%,le. ;"= co%,any )ad net earnings o- J1 %illion and 1009000 outstanding s)ares -or an B$S o- 10 0190009000 D 1009000 K 1018 5)is in-or%ation is use-ul -or co%,aring t(o co%,anies in a certain industry +ut s)ould not +e t)e deciding -actor ()en c)oosing stoc s8 2. Price to Earnings Ratio 5)e $rice to Barnings 2atio 0$DB1 s)o(s t)e relations)i, +et(een stoc ,rice and co%,any earnings8 !t is calculated +y di*iding t)e s)are ,rice +y t)e Barnings ,er S)are8

P?E C Stock Price ? EPS

!n our e:a%,le a+o*e o- ;"= co%,any t)e B$S is 10 so i- it )as a ,rice ,er s)are o- J50 t)e $DB is 5 050 D 10 K 518 5)e $DB tells you )o( %any in*estors are (illing to ,ay -or t)at ,articular co%,anyFs earnings8 $DBFs can +e read in a *ariety o- (ays8 ; )ig) $DB could %ean t)at t)e co%,any is o*er,riced or it could %ean t)at in*estors e:,ect t)e co%,any to continue to gro( and generate ,ro-its8 ; lo( $DB could %ean t)at in*estors are (ary o- t)e co%,any or it could indicate a co%,any t)at %ost in*estors )a*e o*erloo ed8 Bit)er (ay9 -urt)er analysis is needed to deter%ine t)e true *alue o- a ,articular stoc 8 3. Projected Earnings Growth Rate-PEG Ratio

; ratio used to deter%ine a stoc Fs *alue ()ile ta ing into account earnings gro(t)8 5)e calculation is as -ollo(s.

64

$B@ is a (idely used indicator o- a stoc Fs ,otential *alue8 !t is -a*oured +y %any o*er t)e ,riceDearnings ratio +ecause it also accounts -or gro(t)8 Si%ilar to t)e $DB ratio9 a lo(er $B@ %eans t)at t)e stoc is %ore under*alued8 Aee, in %ind t)at t)e nu%+ers used are ,ro<ected and9 t)ere-ore9 can +e less accurate8 ;lso9 t)ere are %any *ariations using earnings -ro% di--erent ti%e ,eriods 0i8e8 one year *s8 -i*e year18 "e sure to no( t)e e:act de-inition your source is using8 4. Price to Sales Ratio ?)en a co%,any )as no earnings9 t)ere are ot)er tools a*aila+le to )el, in*estors <udge its (ort)8 &e( co%,anies in ,articular o-ten )a*e no earnings9 +ut t)at does not %ean t)ey are +ad in*est%ents8 5)e $rice to Sales ratio 0$DS1 is a use-ul tool -or <udging ne( co%,anies8 !t is calculated +y di*iding t)e %ar et ca, 0stoc ,rice ti%es nu%+er o- outstanding s)ares1 +y total re*enues8 ;n alternate %et)od is to di*ide current s)are ,rice +y sales ,er s)are8 $DS indicates t)e *alue t)e %ar et ,laces on sales8 5)e lo(er t)e $DS t)e +etter t)e *alue8

5. Price to Book Ratio

"oo *alue is deter%ined +y su+tracting lia+ilities -ro% assets8 5)e *alue o- a gro(ing co%,any (ill al(ays +e %ore t)an +oo *alue +ecause o- t)e ,otential -or -uture re*enue8 5)e ,rice to +oo ratio 0$D"1 is t)e *alue t)e %ar et ,laces on t)e +oo *alue o- t)e co%,any8 !t is calculated +y di*iding t)e current ,rice ,er s)are +y t)e +oo *alue ,er s)are 0+oo *alue D nu%+er o- outstanding s)ares18 =o%,anies (it) a lo( $D" are good *alue and are o-ten soug)t a-ter +y long ter% in*estors ()o see t)e ,otential o- suc) co%,anies8 ; lo(er $D" ratio could %ean t)at t)e stoc is under*alued8 #o(e*er9 it could also %ean t)at so%et)ing is
65

-unda%entally (rong (it) t)e co%,any8 ;s (it) %ost ratios9 +e a(are t)at t)is *aries +y

industry8 5)is ratio also gi*es so%e idea o- ()et)er youFre ,aying too %uc) -or ()at (ould +e le-t i- t)e co%,any (ent +an ru,t i%%ediately8 !t is also no(n as t)e L,rice3equity ratioL8

P?B C Share Price ? Book Balue per Share

. !i"idend #ield
So%e in*estors are loo ing -or stoc s t)at can %a:i%i>e di*idend inco%e8 4i*idend yield is use-ul -or deter%ining t)e ,ercentage return a co%,any ,ays in t)e -or% o- di*idends8 !t is calculated +y di*iding t)e annual di*idend ,er s)are +y t)e stoc Fs ,rice ,er s)are8 Usually it is t)e older9 (ell3esta+lis)ed co%,anies t)at ,ay a )ig)er ,ercentage9 and t)ese co%,anies also usually )a*e a %ore consistent di*idend )istory t)an younger co%,anies8 4i*idend yield is calculated as -ollo(s.

4i*idend yield is a (ay to %easure )o( %uc) cas) -lo( you are getting -or eac) dollar in*ested in an equity ,osition 3 in ot)er (ords9 )o( %uc) L+ang -or your +uc L you are getting -ro% di*idends8 !n*estors ()o require a %ini%u% strea% o- cas) -lo( -ro% t)eir in*est%ent ,ort-olio can secure t)is cas) -lo( +y in*esting in stoc s ,aying relati*ely )ig)9 sta+le di*idend yields8 5o +etter e:,lain t)e conce,t9 re-er to t)is di*idend yield e:a%,le. !- t(o co%,anies +ot) ,ay annual di*idends o- J1 ,er s)are9 +ut ;"= =o%,any7s stoc is trading at J20 ()ile MYN =o%,any7s stoc is trading at J409 t)en ;"= )as a di*idend yield o- 5I ()ile MYN is only yielding

66

285I8 5)us9 assu%ing all ot)er -actors are equi*alent9 an in*estor loo ing to su,,le%ent )is or )er inco%e (ould li ely ,re-er ;"=Fs stoc o*er t)at o- MYN.

$. !i"idend pa%o&t ratio

Dividend payout ratio is t)e -raction o- net inco%e a -ir% ,ays to its stoc )olders in di*idends.

5)e ,art o- t)e earnings not ,aid to in*estors is le-t -or in*est%ent to ,ro*ide -or -uture earnings gro(t)8 !n*estors see ing )ig) current inco%e and li%ited ca,ital gro(t) ,re-er co%,anies (it) )ig) 4i*idend ,ayout ratio8 #o(e*er in*estors see ing ca,ital gro(t) %ay ,re-er lo(er ,ayout ratio +ecause ca,ital gains are ta:ed at a lo(er rate8 #ig) gro(t) -ir%s in early li-e generally )a*e lo( or >ero ,ayout ratios8 ;s t)ey %ature9 t)ey tend to return %ore ot)e earnings +ac to in*estors8 &ote t)at di*idend ,ayout ratio is calculated as B$SD4$S8
Calculated as:

5)e ,ayout ratio ,ro*ides an idea o- )o( (ell earnings su,,ort t)e di*idend ,ay%ents8 More %ature co%,anies tend to )a*e a )ig)er ,ayout ratio8 !n t)e U8A8 t)ere is a si%ilar ratio9 ()ic) is no(n as di*idend co*er8 !t is calculated as earnings ,er s)are di*ided +y di*idends ,er s)are8

67

'. Ret&rn on E(&it%

#eturn on e;uity 02/B1 is a %easure o- )o( %uc)9 in earnings a co%,any generates in a ti%e ,eriod co%,ared to its s)are)oldersF equity8 8 !t is ty,ically calculated on a -ull3year -ull +asis 0eit)er t)e last -iscal year or t)e last -our quarters18 Expanded De'inition ?)en ca,ital is tied u, in a +usiness9 t)e o(ners o- t)e ca,ital (ant to see a good return on t)at ca,ital8 Loo ing at ,ro-it +y itsel- is %eaningless8 ! %ean9 i- a co%,any earns J1 %illion in net inco%e9 9 t)atFs o ay8 "ut its great i- t)e ca,ital in*ested to earn t)at is only J285 %illion %il 040I return1 and terri+le i- t)e ca,ital in*ested is J25 %illion 04I return18 2eturn on in*est%ent %easures )o( ,ro-ita+le t)e co%,any is -or t)e o(ner o- t)e in*est%ent8 !n t)is case9 return on e;uity %easures )o( ,ro-ita+le t)e co%,any is -or t)e equity uity o(ners9 a8 8a8 t)e s)are)olders8

5)e La*erageL is ta en o*er t)e ti%e ,eriod +eing calculated and is equal to Lt)e su% o- t)e +eginning equity +alance and t)e ending equity +alance9 di*ided +y t(o8L #eturn on e;uity is e:,ressed as a ,ercent and %ea %easures sures t)e return a co%,any recei*es on its s)are)olderFs equity8 !t is a %uc) si%,ler *ersion o- return on in*ested ca,ital8 ca,ital !n general9 t)e %ar et is (illing to ,ay a )ig)er %ulti,le -or stoc s (it) )ig)er 2/Bs8 ;s (it) e*ery ratio9 2/B s)ould +e co%,ared to t)e co%,anyFs industry and co%,etitors8 !$merican Eagle ut'itters is earning 35I 2/B9 t)at %ay sound great9 +ut i- t)e industry is

earning 40I on a*erage9 t)en t)e in*estor s)ould -ind out ()y ;%erican Bagle is -lying lo(er8 =ontrari(ise9 i- its co%,etitors are earning 25I9 t)en ;%erican Bagle %ay +e a )ig) -lyer8 #o(e*er9 donFt in*est +ased on <ust one ratio8 =o%,are se*eral ratios +e-ore %a ing a decision8

68

DuPont model 5)is +rea s 2/B do(n into se*eral co%,onents so t)at one can see )o( c)anges in one area ot)e +usiness c)anges return on equity8

2eturn on equity gro(s9 all else equal.

t)e %ore net %argin increases9 t)e %ore re*enue is generated -ro% a -ir%Fs assets9 5)e %ore le*eraged a -ir% +eco%es8

?)ile t)e -irst t(o see% -airly straig)t -or(ard9 t)e t)ird one doesnFt see% to +e9 +ut it really is8 !- re*enue3generating generating assets are ,urc)ased t)roug) t)e use o- de+t 0not equity19 equ t)en t)e increased a%ount o- net inco%e generated +y t)at greater a%ount o- assets (ill increase t)e return on t)e -i:ed a%ount o- equity8 Sustaina%le gro2th 2eturn on equity also ties into )o( %uc) gro(t) one can e:,ect -ro% a co%,any8 ?)en a -ir% rein*ests ein*ests its net inco%e9 t)en it can +e e:,ected to gro(8 5)e -astest t)is can +e e:,ected to occur is t)e return on equity8 5)is is calculated.

69

$ more re'ined de'inition =o%%on s)are)olders are interested in ()at return t)e co%,any is %a ing on t)eir sta e8 5o account -or t)is9 di*idends ,aid out to ,re-erred s)are)olders s)ould +e su+tracted -ro% net inco%e +e-ore calculating 2/B8 So9

). Book *al&e per Share

; %easure used +y o(ners o- co%%on s)ares in a -ir% to deter%ine t)e le*el o- sa-ety associated (it) eac) indi*idual s)are a-ter a all de+ts are ,aid accordingly8

S)ould t)e co%,any decide to dissol*e9 t)e +oo *alue ,er co%%on indicates t)e dollar *alue re%aining -or co%%on s)are)olders a-ter all assets are liquidated and all de+tors are ,aid8 !n si%,le ter%s it (ould +e t)e a%ount o- %oney t)at a )older o- a co%%on s)are (ould get i- a co%,any (ere to liquidate8

70

Unit 4
Technical Analysis What is Technical Analysis? Technical Analysis is the forecasting of future financial price movements based on an examination of past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is "likely" to happen to prices over time. Technical analysis uses a wide variety of charts that show price over time.

Technical analysis is applicable to stocks, indices, commodities, futures or any tradable instrument where the price is influenced by the forces of supply and demand. Price refers to any combination of the open, high, low, or close for a given security over a specific time frame. The time frame can be based on intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data and last a few hours or many years. In addition, some technical analysts include volume or open interest figures with their study of price action. The Basis of Technical Analysis 71

At the turn of the century, the Dow Theory laid the foundations for what was later to become modern technical analysis. Dow Theory was not presented as one complete amalgamation, but rather pieced together from the writings of Charles Dow over several years. Of the many theorems put forth by Dow, three stand out:

Price Discounts Everything Price Movements Are Not Totally Random What Is More Important than Why

Price Discounts Everything This theorem is similar to the strong and semi-strong forms of market efficiency. Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value, and should form the basis for analysis. After all, the market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view on the future. Prices Movements are not Totally Random Most technicians agree that prices trend. However, most technicians also acknowledge that there are periods when prices do not trend. If prices were always random, it would be extremely difficult to make money using technical analysis. In his book,Schwager on Futures: Technical Analysis, Jack Schwager states: "One way of viewing it is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior. The goal of the chartist is to identify those periods (i.e. major trends)."

72

A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different time frames, it is possible to spot both short-term and long-term trends. The IBM chart illustrates Schwager's view on the nature of the trend. The broad trend is up, but it is also interspersed with trading ranges. In between the trading ranges are smaller uptrends within the larger uptrend. The uptrend is renewed when the stock breaks above the trading range. A downtrend begins when the stock breaks below the low of the previous trading range. "What" is More Important than "Why" In his book, The Psychology of Technical Analysis, Tony Plummer paraphrases Oscar Wilde by stating, "A technical analyst knows the price of everything, but the value of nothing". Technicians, as technical analysts are called, are only concerned with two things: 1. What is the current price? 2. What is the history of the price movement? The price is the end result of the battle between the forces of supply and demand for the company's stock. The objective of analysis is to forecast the direction of the future price. By focusing on price and only price, technical analysis represents a direct approach. Fundamentalists are concerned with why the price is what it is. For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect. Technicians believe it is best to concentrate on what and never mind 73

why. Why did the price go up? It is simple, more buyers (demand) than sellers (supply). After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why? General Steps to Technical Evaluation Many technicians employ a top-down approach that begins with broad-based macro analysis. The larger parts are then broken down to base the final step on a more focused/micro perspective. Such an analysis might involve three steps: 1. Broad market analysis through the major indices such as the S&P 500, Dow Industrials, NASDAQ and NYSE Composite. 2. Sector analysis to identify the strongest and weakest groups within the broader market. 3. Individual stock analysis to identify the strongest and weakest stocks within select groups. The beauty of technical analysis lies in its versatility. Because the principles of technical analysis are universally applicable, each of the analysis steps above can be performed using the same theoretical background. You don't need an economics degree to analyze a market index chart. You don't need to be a CPA to analyze a stock chart. Charts are charts. It does not matter if the time frame is 2 days or 2 years. It does not matter if it is a stock, market index or commodity. The technical principles of support, resistance, trend, trading range and other aspects can be applied to any chart. While this may sound easy, technical analysis is by no means easy. Success requires serious study, dedication and an open mind. Chart Analysis Technical analysis can be as complex or as simple as you want it. The example below represents a simplified version. Since we are interested in buying stocks, the focus will be on spotting bullish situations.

74

Overall Trend: The first step is to identify the overall trend. This can be accomplished with trend lines, moving averages or peak/trough analysis. As long as the price remains above its uptrend line, selected moving averages or previous lows, the trend will be considered bullish. Support: Areas of congestion or previous lows below the current price mark support levels. A break below support would be considered bearish. 75

Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish. Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9day EMA (exponentialmoving average) or positive, then momentum will be considered bullish, or at least improving. Buying/Selling Pressure: For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure. When Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero. Relative Strength: The price relative is a line formed by dividing the security by a benchmark. For stocks it is usually the price of the stock divided by the S&P 500. The plot of this line over a period of time will tell us if the stock is outperforming (rising) or under performing (falling) the major index. The final step is to synthesize the above analysis to ascertain the following:

Strength of the current trend. Maturity or stage of current trend. Reward to risk ratio of a new position. Potential entry levels for new long position.

Top-Down Technical Analysis For each segment (market, sector and stock), an investor would analyze long-term and short-term charts to find those that meet specific criteria. Analysis will first consider the market in general, perhaps the S&P 500. If the broader market were considered to be in bullish mode, analysis would proceed to a selection of sector charts. Those sectors that show the most promise would be singled out for individual stock analysis. Once the sector list is narrowed to 3-4 industry groups, individual stock selection can begin. With a selection of 10-20 stock charts from each industry, a selection of 3-4 of the most promising stocks in each group can be made. How many stocks or industry groups make the final cut will depend on the strictness of the criteria set forth. Under this scenario, we would be left with 9-12 stocks from which to choose. These stocks could even be broken down further to find the 3-4 of the strongest of the strong. Strengths of Technical Analysis 76

Focus on Price If the objective is to predict the future price, then it makes sense to focus on price movements. Price movements usually precede fundamental developments. By focusing on price action, technicians are automatically focusing on the future. The market is thought of as a leading indicator and generally leads the economy by 6 to 9 months. To keep pace with the market, it makes sense to look directly at the price movements. More often than not, change is a subtle beast. Even though the market is prone to sudden knee-jerk reactions, hints usually develop before significant moves. A technician will refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline. Supply, Demand, and Price Action Many technicians use the open, high, low and close when analyzing the price action of a security. There is information to be gleaned from each bit of information. Separately, these will not be able to tell much. However, taken together, the open, high, low and close reflect forces of supply and demand.

The annotated example above shows a stock that opened with a gap up. Before the open, the number of buy orders exceeded the number of sell orders and the price was raised to attract more sellers. Demand was brisk from the start. The intraday high reflects the strength of demand (buyers). The intraday low reflects the availability of supply (sellers). The close represents the final price agreed upon by the buyers and the sellers. In this case, the close is well below the high and much closer to the low. This tells us that even though demand (buyers) was strong during the day, supply (sellers) ultimately prevailed and forced the price back down. Even after this selling pressure, the close remained above the open. By looking at 77

price action over an extended period of time, we can see the battle between supply and demand unfold. In its most basic form, higher prices reflect increased demand and lower prices reflect increased supply. Support/Resistance Simple chart analysis can help identify support and resistance levels. These are usually marked by periods of congestion (trading range) where the prices move within a confined range for an extended period, telling us that the forces of supply and demand are deadlocked. When prices move out of the trading range, it signals that either supply or demand has started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning. Pictorial Price History Even if you are a tried and true fundamental analyst, a price chart can offer plenty of valuable information. The price chart is an easy to read historical account of a security's price movement over a period of time. Charts are much easier to read than a table of numbers. On most stock charts, volume bars are displayed at the bottom. With this historical picture, it is easy to identify the following:

Reactions prior to and after important events. Past and present volatility. Historical volume or trading levels. Relative strength of a stock versus the overall market.

Assist with Entry Point Technical analysis can help with timing a proper entry point. Some analysts use fundamental analysis to decide what to buy and technical analysis to decide when to buy. It is no secret that timing can play an important role in performance. Technical analysis can help spot demand (support) and supply (resistance) levels as well as breakouts. Simply waiting for a breakout above resistance or buying near support levels can improve returns. It is also important to know a stock's price history. If a stock you thought was great for the last 2 years has traded flat for those two years, it would appear that Wall Street has a different opinion. If a stock has already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal. 78

Weaknesses of Technical Analysis Analyst Bias Just as with fundamental analysis, technical analysis is subjective and our personal biases can be reflected in the analysis. It is important to be aware of these biases when analyzing a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis. On the other hand, if the analyst is a disgruntled eternal bear, then the analysis will probably have a bearish tilt. Open to Interpretation Furthering the bias argument is the fact that technical analysis is open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different patterns. Both will be able to come up with logical support and resistance levels as well as key breaks to justify their position. While this can be frustrating, it should be pointed out that technical analysis is more like an art than a science, somewhat like economics. Is the cup half-empty or half-full? It is in the eye of the beholder. Too Late Technical analysis has been criticized for being too late. By the time the trend is identified, a substantial portion of the move has already taken place. After such a large move, the reward to risk ratio is not great. Lateness is a particular criticism of Dow Theory. Always another Level Even after a new trend has been identified, there is always another "important" level close at hand. Technicians have been accused of sitting on the fence and never taking an unqualified stance. Even if they are bullish, there is always some indicator or some level that will qualify their opinion. Trader's Remorse Not all technical signals and patterns work. When you begin to study technical analysis, you will come across an array of patterns and indicators with rules to match. For instance: A sell signal is given when the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be subject to other factors such as volume and momentum. In that same vein, what works for one particular stock may not work for another. A 50-day moving average may work great to identify support and 79

resistance for IBM, but a 70-day moving average may work better for Yahoo. Even though many principles of technical analysis are universal, each security will have its own idiosyncrasies. Conclusions Technical analysts consider the market to be 80% psychological and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80% logical. Psychological or logical may be open for debate, but there is no questioning the current price of a security. After all, it is available for all to see and nobody doubts its legitimacy. The price set by the market reflects the sum knowledge of all participants, and we are not dealing with lightweights here. These participants have considered (discounted) everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand at work. By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going? Even though there are some universal principles and rules that can be applied, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation. However, it is also flexible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort and dedication, but the rewards can be significant.

80

Unit 5

Capital asset pricing model !n -inance9 t)e capital asset pricing model 5C$PM6 is used to deter%ine a t)eoretically a,,ro,riate required rate o- return o- an asset9 i- t)at asset is to +e added to an already (ell3 di*ersi-ied ,ort-olio9 gi*en t)at assetFs non3di*ersi-ia+le ris 8 5)e %odel ta es into account t)e assetFs sensiti*ity to non3di*ersi-ia+le ris 0also no(n as syste%atic ris or %ar et ris 19 o-ten re,resented +y t)e quantity +eta 0O1 in t)e -inancial industry9 as (ell as t)e e:,ected return ot)e %ar et and t)e e:,ected return o- a t)eoretical ris 3-ree asset8 5)e %odel (as introduced +y Pac 5reynor 019619 196219Q1R ?illia% S)ar,e 0196419 Po)n

Lintner01965a9+1 and Pan Mossin 019661 inde,endently9 +uilding on t)e earlier (or o- #arry Mar o(it> ondi*ersi-ication and %odern ,ort-olio t)eory8 S)ar,e9 Mar o(it> and Merton Miller <ointly recei*ed t)e &o+el Me%orial $ri>e in Bcono%ics -or t)is contri+ution to t)e -ield o- -inancial econo%ics8 +he ,or-&la 5)e =;$M is a %odel -or ,ricing an indi*idual security or a ,ort-olio8 'or indi*idual securities9 (e %a e use o- t)e security %ar et line 0SML1 and its relation to e:,ected return and syste%atic ris 0+eta1 to s)o( )o( t)e %ar et %ust ,rice indi*idual securities in relation to t)eir security ris class8 5)e SML ena+les us to calculate t)e re(ard3to3ris ratio -or any security in relation to t)at o- t)e o*erall %ar et8 5)ere-ore9 ()en t)e e:,ected rate o- return -or any security is de-lated +y its +eta coe--icient9 t)e re(ard3to3ris ratio -or any indi*idual security in t)e %ar et is equal to t)e %ar et re(ard3to3ris ratio9 t)us.

5)e %ar et re(ard3to3ris ratio is e--ecti*ely t)e %ar et ris ,re%iu% and +y rearranging t)e a+o*e equation and sol*ing -or B02i19 (e o+tain t)e =a,ital ;sset $ricing Model 0=;$M18

81

()ere. is t)e e:,ected return on t)e ca,ital asset is t)e ris 3-ree -ree rate o- interest suc) as interest arising -ro% go*ern%ent +onds 0t)e beta1 is t)e sensiti*ity o- t)e e:,ected e:cess asset returns to t)e e:,ected

e:cess %ar et returns9 or also is t)e e:,ected return o- t)e %ar et is so%eti%es

no(n as t)e market premium0t)e di--erence

+et(een t)e e:,ected %ar et rate o- return and t)e ris 3-ree -ree rate o- return18 is also no(n as t)e risk premium 2estated9 in ter%s o- ris ,re%iu%9 (e -ind t)at.

()ic) states t)at t)e individual risk premium equals t)e market premium ti%es 8 &ote 1. t)e e:,ected %ar et rate o- return is usually esti%ated +y %easuring t)e @eo%etric ;*erage o- t)e )istorical returns on a %ar et ,ort-olio 0e8g8 SS$ 50018 &ote 2. t)e ris -ree rate o- return used -or deter%ining t)e ris ,re%iu% is usually t)e arit)%etic it)%etic a*erage o- )istorical ris -ree rates o- return and not t)e current ris -ree rate o- return8 'or t)e -ull deri*ation see Modern ,ort-olio t)eory8 Sec&rit% rit% -arket line 5)e SML essentially gra,)s t)e results -ro% t)e ca,ital asset ,ricing %odel 0=;$M1 -or%ula8 5)e x3a:is a:is re,resents t)e ris 0+eta19 and t)e y3a:is re,resents t)e

e:,ected return8 5)e %ar et ris ,re%iu% is deter%ined -ro% t)e slo,e o- t)e SML8
82

5)e relations)i, +et(een O and required return is ,lotted on t)e securities market line 0SML1 ()ic) s)o(s e:,ected return as a -unction o- O8 5)e interce,t is t)e no%inal ris 3-ree -ree rate a*aila+le -or t)e %ar et9 ()ile t)e slo,e is t)e %ar et ,re%iu%9 B0Rm1T Rf8 5)e securities %ar et line can +e regarded as re,resenting a single3-actor -actor %odel o- t)e asset ,rice9 ()ere "eta is e:,osure to c)anges in *alue ot)e Mar et8 5)e equation o- t)e SML is t)us.

!t is a use-ul tool in deter%ining i- an asset +eing considered -or a ,ort-olio o--ers a reasona+le e:,ected return -or ris 8 !ndi*idual securities are ,lotted on t)e SML gra,)8 !- t)e securityFs e:,ected return *ersus *ersus ris is ,lotted a+o*e t)e SML9 it is under*alued since t)e in*estor can e:,ect a greater return -or t)e in)erent ris 8 ;nd a security ,lotted +elo( t)e SML is o*er*alued since t)e in*estor (ould +e acce,ting less return -or t)e a%ount o- ris assu%ed8 assu%e

$sset pricing /nce t)e e:,ectedDrequired rate o- return9 E0Ri19 9 is calculated using =;$M9 (e can co%,are t)is required rate o- return to t)e assetFs esti%ated rate o- return o*er a s,eci-ic in*est%ent )ori>on to deter%ine ()et)er it (ould +e an a,,ro,riate in*est%ent8 5o %a e t)is co%,arison9 you need an inde,endent

83

esti%ate o- t)e return outloo -or t)e security +ased on eit)er 'undamental or technical analysis techni;ues9 including $DB9 MD" etc8 ;ssu%ing t)at t)e =;$M is correct9 an asset is correctly ,riced ()en its esti%ated ,rice is t)e sa%e as t)e ,resent *alue o- -uture cas) -lo(s o- t)e asset9 discounted at t)e rate suggested +y =;$M8 !- t)e o+ser*ed ,rice is )ig)er t)an t)e =;$M *aluation9 t)en t)e asset is under*alued 0and o*er*alued ()en t)e esti%ated ,rice is +elo( t)e =;$M *aluation18Qcitation neededR ?)en t)e asset does not lie on t)e SML9 t)is could also suggest %is3,ricing8 %is ,ricing8 Since t)e e:,ected

return o- t)e asset at ti%e t is

9 a )ig)er e:,ected

return t)an ()at =;$M suggests indicates t)at Pt is too lo( 0t)e asset is currently under*alued19 assu%ing t)at at ti%e t U 1 t)e asset returns to t)e =;$M suggested ,rice8Q2R .sset-speci,ic speci,ic re(&ired ret&rn 5)e =;$M returns t)e asset3a,,ro,riate asset a,,ro,riate required return or discount rateVi8e8 rate t)e rate at ()ic) -uture cas) -lo(s ,roduced +y t)e asset s)ould +e discounted gi*en t)at assetFs relati*e ris iness8 "etas e:ceeding one signi-y %ore t)an a*erage Lris inessLE +etas +elo( one indicate lo(er t)an a*erage8 5)us9 a %ore ris y stoc (ill )a*e a )ig)er +eta and (ill +e discounted at a )ig)er rateE less le sensiti*e stoc s (ill )a*e lo(er +etas and +e discounted at a lo(er rate8 @i*en t)e acce,ted conca*e utility -unction9 9 t)e =;$M is consistent (it) intuitionV intuition in*estors 0s)ould1 0s)ould1 require a )ig)er return -or )olding a %ore ris y asset8 Since +eta re-lects asset asset3s,eci-ic sensiti*ity to non3di*ersi-ia+le9 di*ersi-ia+le9 i8e8 %ar et ris 9 t)e %ar et as a ()ole9 +y de-inition9 )as a +eta o o- one8 Stoc %ar et indices are -requently used as local ,ro:ies -or t)e %ar et etVand and in t)at case 0+y de-inition1 )a*e a +eta o- one8 ;n in*estor in a large9 di*ersi-ied ,ort-olio 0suc) as a %utual -und19 19 t)ere-ore9 e:,ects ,er-or%ance in line (it) t)e %ar et8
84

Risk and di"ersi,ication 5)e ris o- a ,ort-olio co%,rises syste%atic ris 9 also no(n as undi*ersi-ia+le ris 9 and unsyste%atic ris ()ic) is also no(n as idiosyncratic ris or

di*ersi-ia+le ris 8 Syste%atic ris re-ers to t)e ris co%%on to all securitiesV i8e8 %ar et ris 8 Unsyste%atic ris is t)e ris associated (it) indi*idual assets8 Unsyste%atic ris can +e di*ersi-ied a(ay to s%aller le*els +y including a

greater nu%+er o- assets in t)e ,ort-olio 0s,eci-ic ris s La*erage outL18 5)e sa%e is not ,ossi+le -or syste%atic ris (it)in one %ar et8 4e,ending on t)e %ar et9 a ,ort-olio o- a,,ro:i%ately 30340 securities in de*elo,ed %ar ets suc) as UA or US (ill render t)e ,ort-olio su--iciently di*ersi-ied suc) t)at ris e:,osure is li%ited to syste%atic ris only8 !n de*elo,ing %ar ets a larger nu%+er is required9 due to t)e )ig)er asset *olatilities8 ; rational in*estor s)ould not ta e on any di*ersi-ia+le ris 9 as only non3 di*ersi-ia+le ris s are re(arded (it)in t)e sco,e o- t)is %odel8 5)ere-ore9 t)e required return on an asset9 t)at is9 t)e return t)at co%,ensates -or ris ta en9 %ust +e lin ed to its ris iness in a ,ort-olio conte:t 3 i8e8 its contri+ution to o*erall ,ort-olio ris iness 3 as o,,osed to its Lstand alone ris iness8L !n t)e =;$M conte:t9 ,ort-olio ris is re,resented +y )ig)er *ariance i8e8 less

,redicta+ility8 !n ot)er (ords t)e +eta o- t)e ,ort-olio is t)e de-ining -actor in re(arding t)e syste%atic e:,osure ta en +y an in*estor8

85

+he e,,icient ,rontier

5)e 0Mar o(it>1 e--icient -rontier8 =;L stands -or t)e ca,ital allocation line8 5)e =;$M assu%es t)at t)e ris 3return ,ro-ile o- a ,ort-olio can +e o,ti%i>edV an o,ti%al ,ort-olio dis,lays t)e lo(est ,ossi+le le*el o- ris -or its le*el oreturn8 ;dditionally9 since eac) additional asset introduced into a ,ort-olio -urt)er di*ersi-ies t)e ,ort-olio9 t)e o,ti%al ,ort-olio %ust co%,rise e*ery asset9 0assu%ing no trading costs1 (it) eac) asset *alue3(eig)ted to ac)ie*e t)e a+o*e 0assu%ing t)at any asset is in-initely di*isi+le18 ;ll suc) o,ti%al ,ort-olios9 i8e89 one -or eac) le*el o- return9 co%,rise t)e e--icient -rontier8 "ecause t)e unsyste%atic ris is di*ersi-ia+le9 t)e total ris o- a ,ort-olio can +e *ie(ed as +eta8 +he -arket port,olio ;n in*estor %ig)t c)oose to in*est a ,ro,ortion o- )is or )er (ealt) in a ,ort-olio o- ris y assets (it) t)e re%ainder in cas)Vearning interest at t)e ris -ree rate 0or indeed %ay +orro( %oney to -und )is or )er ,urc)ase o- ris y assets in ()ic) case t)ere is a negati*e cas) (eig)ting18 #ere9 t)e ratio o- ris y assets to ris -ree asset does not deter%ine o*erall returnVt)is relations)i, is
86

clearly linear8 !t is t)us ,ossi+le to ac)ie*e a ,articular return in one o- t(o (ays. 18 "y in*esting all o- oneFs (ealt) in a ris y ,ort-olio9 28 or +y in*esting a ,ro,ortion in a ris y ,ort-olio and t)e re%ainder in cas) 0eit)er +orro(ed or in*ested18 'or a gi*en le*el o- return9 )o(e*er9 only one o- t)ese ,ort-olios (ill +e o,ti%al 0in t)e sense o- lo(est ris 18 Since t)e ris -ree asset is9 +y

de-inition9 uncorrelated (it) any ot)er asset9 o,tion 2 (ill generally )a*e t)e lo(er *ariance and )ence +e t)e %ore e--icient o- t)e t(o8 5)is relations)i, also )olds -or ,ort-olios along t)e e--icient -rontier. a )ig)er return ,ort-olio ,lus cas) is %ore e--icient t)an a lo(er return ,ort-olio alone -or t)at lo(er le*el o- return8 'or a gi*en ris -ree rate9 t)ere is only one o,ti%al ,ort-olio ()ic) can +e co%+ined (it) cas) to ac)ie*e t)e lo(est le*el o- ris -or any ,ossi+le return8 5)is is t)e %ar et ,ort-olio8 .ss&-ptions o, /.P0 ;ll in*estors. 18 ;i% to %a:i%i>e econo%ic utilities8 28 ;re rational and ris 3a*erse8 38 ;re +roadly di*ersi-ied across a range o- in*est%ents8 48 ;re ,rice ta ers9 i8e89 t)ey cannot in-luence ,rices8 58 =an lend and +orro( unli%ited a%ounts under t)e ris -ree rate ointerest8 68 5rade (it)out transaction or ta:ation costs8 78 4eal (it) securities t)at are all )ig)ly di*isi+le into s%all ,arcels8 88 ;ssu%e all in-or%ation is a*aila+le at t)e sa%e ti%e to all in*estors8
87

'urt)er9 t)e %odel assu%es t)at standard de*iation o- ,ast returns is a ,er-ect ,ro:y -or t)e -uture ris associated (it) a gi*en security8 Pro1le-s o, /.P0 5)e %odel assu%es t)at eit)er asset returns are 0<ointly1 nor%ally distri+uted rando% *aria+les or t)at acti*e and ,otential s)are)olders e%,loy a quadratic -or% o- utility8 !t is )o(e*er -requently o+ser*ed t)at returns in equity and ot)er %ar ets are not nor%ally distri+uted8 ;s a result9 large s(ings 03 to 6 standard de*iations -ro% t)e %ean1 occur in t)e %ar et %ore -requently t)an t)e nor%al distri+ution assu%,tion (ould e:,ect8Q4R 5)e %odel assu%es t)at t)e *ariance o- returns is an adequate %easure%ent o- ris 8 5)is %ig)t +e <usti-ied under t)e assu%,tion onor%ally distri+uted returns9 +ut -or general return distri+utions ot)er ris %easures 0li e co)erent ris %easures1 (ill li ely re-lect t)e acti*e and ,otential s)are)oldersF ,re-erences %ore adequately8 !ndeed ris in

-inancial in*est%ents is not *ariance in itsel-9 rat)er it is t)e ,ro+a+ility olosing. it is asy%%etric in nature8 5)e %odel assu%es t)at all acti*e and ,otential s)are)olders )a*e access to t)e sa%e in-or%ation and agree a+out t)e ris and e:,ected return o- all assets 0)o%ogeneous e:,ectations assu%,tion18Qcitation neededR 5)e %odel assu%es t)at t)e ,ro+a+ility +elie-s o- acti*e and ,otential s)are)olders %atc) t)e true distri+ution o- returns8 ; di--erent ,ossi+ility is t)at acti*e and ,otential s)are)oldersF e:,ectations are +iased9 causing %ar et ,rices to +e in-or%ationally ine--icient8 5)is ,ossi+ility is studied in t)e -ield o- +e)a*ioral -inance9 ()ic) uses ,syc)ological assu%,tions to ,ro*ide alternati*es to t)e =;$M suc) as t)e o*ercon-idence3+ased asset

88

,ricing

%odel

o-

Aent

4aniel9 4a*id

#irs)lei-er9

and

;*anid)ar

Su+ra)%anya% 0200118Q5R 5)e %odel does not a,,ear to adequately e:,lain t)e *ariation in stoc returns8 B%,irical studies s)o( t)at lo( +eta stoc s %ay o--er )ig)er returns t)an t)e %odel (ould ,redict8 So%e data to t)is e--ect (as ,resented as early as a 1969 con-erence in "u--alo9 &e( Yor in a ,a,er +y 'isc)er "lac 9 Mic)ael Pensen9 and Myron Sc)oles8 Bit)er t)at -act is itselrational 0()ic) sa*es t)e e--icient3%ar et )y,ot)esis +ut %a es =;$M (rong19 or it is irrational 0()ic) sa*es =;$M9 +ut %a es t)e BM# (rong W indeed9 t)is ,ossi+ility %a es*olatility ar+itrage a strategy -or relia+ly +eating t)e %ar et18Qcitation neededR 5)e %odel assu%es t)at gi*en a certain e:,ected return9 acti*e and ,otential s)are)olders (ill ,re-er lo(er ris 0lo(er *ariance1 to )ig)er ris and con*ersely gi*en a certain le*el o- ris (ill ,re-er )ig)er returns to lo(er ones8 !t does not allo( -or acti*e and ,otential s)are)olders ()o (ill acce,t lo(er returns -or )ig)er ris 8 =asino ga%+lers ,ay to ta e on %ore ris 9 and it is ,ossi+le t)at so%e stoc traders (ill ,ay -or ris as (ell8Qcitation
neededR

5)e %odel assu%es t)at t)ere are no ta:es or transaction costs9 alt)oug) t)is assu%,tion %ay +e rela:ed (it) %ore co%,licated *ersions o- t)e %odel8Qcitation neededR 5)e %ar et ,ort-olio consists o- all assets in all %ar ets9 ()ere eac) asset is (eig)ted +y its %ar et ca,itali>ation8 5)is assu%es no ,re-erence +et(een %ar ets and assets -or indi*idual acti*e and ,otential s)are)olders9 and t)at acti*e and ,otential s)are)olders c)oose assets solely as a -unction ot)eir ris 3return ,ro-ile8 !t also assu%es t)at all assets are in-initely di*isi+le as to t)e a%ount ()ic) %ay +e )eld or transacted8Qcitation neededR

89

5)e %ar et ,ort-olio s)ould in t)eory include all ty,es o- assets t)at are )eld +y anyone as an in*est%ent 0including (or s o- art9 real estate9 )u%an ca,ital8881 !n ,ractice9 suc) a %ar et ,ort-olio is uno+ser*a+le and ,eo,le usually su+stitute a stoc inde: as a ,ro:y -or t)e true %ar et ,ort-olio8 Un-ortunately9 it )as +een s)o(n t)at t)is su+stitution is not innocuous and can lead to -alse in-erences as to t)e *alidity o- t)e =;$M9 and it )as +een said t)at due to t)e ino+ser*a+ility o- t)e true %ar et ,ort-olio9 t)e =;$M %ig)t not +e e%,irically testa+le8 5)is (as ,resented in greater de,t) in a ,a,er +y 2ic)ard 2oll in 19779 and is generally re-erred to as 2ollFs critique8Q6R 5)e %odel assu%es <ust t(o dates9 so t)at t)ere is no o,,ortunity to consu%e and re+alance ,ort-olios re,eatedly o*er ti%e8 5)e +asic insig)ts o- t)e %odel are e:tended and generali>ed in t)e interte%,oral =;$M 0!=;$M1 o- 2o+ert Merton9 and t)e consu%,tion =;$M 0==;$M1 o- 4ouglas "reeden and Mar 2u+instein8Qcitation neededR =;$M assu%es t)at all acti*e and ,otential s)are)olders (ill consider all ot)eir assets and o,ti%i>e one ,ort-olio8 5)is is in s)ar, contradiction (it) ,ort-olios t)at are )eld +y indi*idual s)are)olders. )u%ans tend to )a*e -rag%ented ,ort-olios or9 rat)er9 %ulti,le ,ort-olios. -or eac) goal one ,ort-olio V see +e)a*ioral ,ort-olio t)eory and Maslo(ian $ort-olio 5)eory8

$r%itrage Pricing "heory

!n -inance9 ar%itrage pricing theory 0$P"1 is a general t)eory o- asset ,ricing9 t)at )as +eco%e in-luential in t)e ,ricing o- stoc s8 ;$5 )olds t)at t)e e:,ected return o- a -inancial asset can +e %odeled as a linear -unction o*arious %acro3econo%ic -actors or t)eoretical %ar et indices9 ()ere sensiti*ity to c)anges in
90

eac) -actor is re,resented +y a -actor3s,eci-ic -actor +eta coe--icient8 8 5)e %odel3deri*ed %odel rate oreturn (ill t)en +e used to ,rice t)e asset correctly 3 t)e asset ,rice s)ould equal t)e e:,ected end o- ,eriod ,rice discounted at t)e rate i%,lied +y t)e %odel8 !- t)e ,rice di*erges9 ar+itrage s)ould +ring it +ac into line8 5)e t)eory (as initiated +y t)e econo%ist Ste,)en 2oss in 19768 The APT model 2is y asset returns are said to -ollo( a factor structure i- t)ey can +e e:,ressed as.

()ere aj is a constant -or asset j Fk is a syste%atic -actor bjk is t)e sensiti*ity o- t)e jt) asset to -actor k9 also called -actor loading9 and Xj is t)e ris y assetFs idiosyncratic rando% s)oc (it) %ean >ero8 !diosyncratic s)oc s are assu%ed to +e uncorrelated across assets and uncorrelated (it) t)e -actors8 5)e ;$5 states t)at i- asset returns -ollo( a -actor structure t)en t)e -ollo(ing relation e:ists +et(een en e:,ected returns and t)e -actor sensiti*ities.

()ere RPk is t)e ris ,re%iu% o- t)e -actor9 rf is t)e ris 3-ree -ree rate9 rate 5)at is9 t)e e:,ected return o- an asset j is a linear -unction o- t)e assets sensiti*ities to t)e n -actors8

91

&ote t)at t)ere are so%e assu%,tions and require%ents t)at )a*e to +e -ul-illed -or t)e latter to +e correct. 5)ere %ust +e ,er-ect co%,etitionin t)e %ar et9 and t)e total nu%+er o- -actors %ay ne*er sur,ass t)e total nu%+er oassets 0in order to a*oid t)e ,ro+le% o- %atri: singularity19 edit!Arbitra"e and the APT ;r+itrage is t)e ,ractice o- ta ing ,ositi*e e:,ected return -ro% o*er*alued or under*alued securities in t)e ine--icient %ar et (it)out any incre%ental ris and >ero additional in*est%esnt8 $r%itrage in expectations 5)e ca,ital asset ,ricing %odel and its e:tensions are +ased on s,eci-ic assu%,tions on in*estors7 asset de%and8 'or e:a%,le. !n*estors care only a+out %ean return and *ariance8 !n*estors )old only traded assets8 $r%itrage mechanics !n t)e ;$5 conte:t9 ar+itrage consists o- trading in t(o assets W (it) at least one +eing %is,riced8 5)e ar+itrageur sells t)e asset ()ic) is relati*ely too e:,ensi*e and uses t)e ,roceeds to +uy one ()ic) is relati*ely too c)ea,8 Under t)e ;$59 an asset is %is,riced i- its current ,rice di*erges -ro% t)e ,rice ,redicted +y t)e %odel8 5)e asset ,rice today s)ould equal t)e su% o- all -uture cas) -lo(s discounted at t)e ;$5 rate9 ()ere t)e e:,ected return o- t)e asset is a linear -unction o- *arious -actors9 and sensiti*ity to c)anges in eac) -actor is re,resented +y a -actor3s,eci-ic +eta coe--icient8 ; correctly ,riced asset )ere %ay +e in -act a synthetic asset 3

a portfolio consisting o- ot)er correctly ,riced assets8 5)is ,ort-olio )as t)e sa%e e:,osure to eac) o- t)e %acroecono%ic -actors as t)e %is,riced asset8 5)e ar+itrageur creates t)e ,ort-olio +y identi-ying : correctly ,riced assets
92

0one ,er -actor ,lus one1 and t)en (eig)ting t)e assets suc) t)at ,ort-olio +eta ,er -actor is t)e sa%e as -or t)e %is,riced asset8 ?)en t)e in*estor is long t)e asset and s)ort t)e ,ort-olio 0or *ice *ersa1 )e )as created a ,osition ()ic) )as a ,ositi*e e:,ected return 0t)e di--erence +et(een asset return and ,ort-olio return1 and ()ic) )as a net3>ero e:,osure to any %acroecono%ic -actor and is t)ere-ore ris -ree 0ot)er t)an -or -ir% s,eci-ic ris 18 5)e ar+itrageur is t)us in a ,osition to %a e a ris 3-ree ,ro-it. ?)ere todayFs ,rice is too lo(. 5)e i%,lication is t)at at t)e end o- t)e ,eriod t)e portfolio (ould )a*e a,,reciated at t)e rate i%,lied +y t)e ;$59 ()ereas t)e %is,riced asset (ould )a*e a,,reciated at more t)an t)is rate8 5)e ar+itrageur could t)ere-ore. 5oday. 1 s)ort sell t)e portfolio 2 +uy t)e %is,riced asset (it) t)e ,roceeds8 ;t t)e end o- t)e ,eriod. 1 sell t)e %is,riced asset 2 use t)e ,roceeds to +uy +ac t)e portfolio 3 ,oc et t)e di--erence8 ?)ere todayFs ,rice is too )ig). 5)e i%,lication is t)at at t)e end o- t)e ,eriod t)e portfolio (ould )a*e a,,reciated at t)e rate i%,lied +y t)e ;$59 ()ereas t)e %is,riced asset (ould )a*e a,,reciated at less t)an t)is rate8 5)e ar+itrageur could t)ere-ore. 5oday. 1 s)ort sell t)e %is,riced asset 2 +uy t)e portfolio (it) t)e ,roceeds8
93

;t t)e end o- t)e ,eriod. 1 sell t)e portfolio 2 use t)e ,roceeds to +uy +ac t)e %is,riced asset 3 ,oc et t)e di--erence8 Relationship #ith the capital asset pricin" model ($AP%& 5)e ;$5 along (it) t)e ca,ital asset ,ricing %odel 0=;$M1 is one o- t(o in-luential t)eories on asset ,ricing8 5)e ;$5 di--ers -ro% t)e =;$M in t)at it is less restricti*e in its assu%,tions8 !t allo(s -or an e:,lanatory 0as o,,osed to statistical1 %odel o- asset returns8 !t assu%es t)at eac) in*estor (ill )old a unique ,ort-olio (it) its o(n ,articular array o+etas9 as o,,osed to t)e identical L%ar et ,ort-olioL8 !n so%e (ays9 t)e =;$M can +e considered a Ls,ecial caseL o- t)e ;$5 in t)at t)e securities %ar et line re,resents a single3-actor %odel o- t)e asset ,rice9 ()ere +eta is e:,osed to c)anges in *alue o- t)e %ar et8 ;dditionally9 t)e ;$5 can +e seen as a Lsu,,ly3sideL %odel9 since its +eta coe--icients re-lect t)e sensiti*ity o- t)e underlying asset to econo%ic -actors8 5)us9 -actor s)oc s (ould cause structural c)anges in assetsF e:,ected returns9 or in t)e case o- stoc s9 in -ir%sF ,ro-ita+ilities8 /n t)e ot)er side9 t)e ca,ital asset ,ricing %odel is considered a Lde%and sideL %odel8 !ts results9 alt)oug) si%ilar to t)ose o- t)e ;$59 arise -ro% a %a:i%i>ation ,ro+le% o- eac) in*estorFs utility -unction9 and -ro% t)e resulting %ar et equili+riu% 0in*estors are considered to +e t)e Lconsu%ersL o- t)e assets18

94

'sin" the APT Identi'ying the 'actors ;s (it) t)e =;$M9 t)e -actor3s,eci-ic +etas are -ound *ia a linear regression o- )istorical security returns on t)e -actor in question8 Unli e t)e =;$M9 t)e ;$59 )o(e*er9 does not itsel- re*eal t)e identity o- its ,riced -actors 3 t)e nu%+er and nature o- t)ese -actors is li ely to c)ange o*er ti%e and +et(een econo%ies8 ;s a result9 t)is issue is essentially e%,irical in nature8 Se*eral a priori guidelines as to t)e c)aracteristics required o- ,otential -actors are9 )o(e*er9 suggested. 18 t)eir i%,act on asset ,rices %ani-ests in

t)eir unexpected %o*e%ents 28 t)ey s)ould re,resent undiversifiable in-luences 0t)ese are9 clearly9 %ore li ely to +e %acroecono%ic rat)er t)an -ir%3 s,eci-ic in nature1 38 ti%ely and accurate in-or%ation on t)ese *aria+les is required 48 t)e relations)i, s)ould +e t)eoretically <usti-ia+le on econo%ic grounds =)en9 2oll and 2oss 019861 identi-ied t)e -ollo(ing %acro3econo%ic -actors as signi-icant in e:,laining security returns. sur,rises in in-lationE sur,rises in @&$ as indicated +y an industrial ,roduction inde:E sur,rises in in*estor con-idence due to c)anges in de-ault ,re%iu% in cor,orate +ondsE sur,rise s)i-ts in t)e yield cur*e8 ;s a ,ractical %atter9 indices or s,ot or -utures %ar et ,rices %ay +e used in ,lace o- %acro3econo%ic -actors9 ()ic) are re,orted at lo(
95

-requency 0e8g8 %ont)ly1 and o-ten (it) signi-icant esti%ation errors8 Mar et indices are so%eti%es deri*ed +y %eans o- -actor analysis8 More direct LindicesL t)at %ig)t +e used are. s)ort ter% interest ratesE t)e di--erence in long3ter% and s)ort3ter% interest ratesE a di*ersi-ied stoc inde: suc) as t)e SS$ 500 or &YSB =o%,osite !nde:E oil ,rices gold or ot)er ,recious %etal ,rices =urrency e:c)ange rates $P" and asset management 5)e linear -actor %odel structure o- t)e ;$5 is used as t)e +asis -or %any o- t)e co%%ercial ris syste%s e%,loyed +y asset %anagers8 5)ese include MS=! "arra9 ;$59 &ort)-ield and ;:io%a8 E''icient Market 4ypothesis3
In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally

e--icientL8 5)at is9 one cannot consistently ac)ie*e returns in e:cess o- a*erage %ar et returns on a ris 3ad<usted +asis9 gi*en t)e in-or%ation ,u+licly a*aila+le at t)e ti%e t)e in*est%ent is %ade8 5)ere are t)ree %a<or *ersions o- t)e )y,ot)esis. L(ea L9 Lse%i3strongL9 and LstrongL8 ?ea BM# clai%s t)at ,rices on traded assets 0e("() stoc s9 +onds9 or ,ro,erty1 already re-lect all ,ast ,u+licly a*aila+le in-or%ation8 Se%i3strong BM# clai%s +ot) t)at ,rices re-lect all ,u+licly a*aila+le in-or%ation and t)at ,rices instantly c)ange to re-lect ne( ,u+lic in-or%ation8 Strong BM# additionally clai%s t)at ,rices instantly re-lect e*en )idden or LinsiderL in-or%ation8 5)ere is e*idence -or and against t)e (ea and se%i3strong BM#s9 ()ile t)ere is ,o(er-ul e*idence against strong BM#8
96

Harious studies )a*e ,ointed out signs o- ine--iciency in -inancial %ar ets8 =ritics )a*e +la%ed t)e +elie- in rational %ar ets -or %uc) o- t)e late32000s -inancial crisis8 !n res,onse9 ,ro,onents o- t)e )y,ot)esis )a*e stated t)at %ar et e--iciency does not %ean )a*ing no uncertainty a+out t)e -uture9 t)at %ar et e--iciency is a si%,li-ication o- t)e (orld ()ic) %ay not al(ays )old true9 and t)at t)e %ar et is ,ractically e--icient -or in*est%ent ,ur,oses -or %ost indi*iduals8 "eyond t)e nor%al utility %a:i%i>ing agents9 t)e e--icient3%ar et )y,ot)esis requires t)at agents )a*e rational e:,ectationsE t)at on a*erage t)e ,o,ulation is correct 0e*en i- no one ,erson is1 and ()ene*er ne( rele*ant in-or%ation a,,ears9 t)e agents u,date t)eir e:,ectations a,,ro,riately8 &ote t)at it is not required t)at t)e agents +e rational8 BM# allo(s t)at ()en -aced (it) ne( in-or%ation9 so%e in*estors %ay o*erreact and so%e %ay under react8 ;ll t)at is required +y t)e BM# is t)at in*estorsF reactions +e rando% and -ollo( a nor%al distri+ution ,attern so t)at t)e net e--ect on %ar et ,rices cannot +e relia+ly e:,loited to %a e an a+nor%al ,ro-it9 es,ecially ()en considering transaction costs 0including co%%issions and s,reads18 5)us9 any one ,erson can +e (rong a+out t)e %ar etVindeed9 e*eryone can +eV+ut t)e %ar et as a ()ole is al(ays rig)t8 5)ere are t)ree co%%on -or%s in ()ic) t)e e--icient3 %ar et )y,ot)esis is co%%only statedV2eak8'orm e''iciency9 semi8strong8'orm

e''iciency and strong8'orm e''iciency9 eac) o- ()ic) )as di--erent i%,lications -or )o( %ar ets (or 8 !n 2eak8'orm e''iciency9 -uture ,rices cannot +e ,redicted +y analy>ing ,rices -ro% t)e ,ast8 B:cess returns cannot +e earned in the lon" run +y using in*est%ent strategies +ased on )istorical s)are ,rices or ot)er )istorical data8 5ec)nical analysis tec)niques (ill not +e a+le to consistently ,roduce e:cess returns9 t)oug) so%e -or%s o- -unda%ental analysis %ay still ,ro*ide e:cess returns8 S)are ,rices e:)i+it no serial de,endencies9 %eaning t)at t)ere are no L,atternsL to asset ,rices8 5)is i%,lies t)at -uture ,rice %o*e%ents are deter%ined entirely +y in-or%ation not contained in t)e ,rice series8 #ence9 ,rices %ust -ollo( a rando% (al 8 5)is Fso-tF BM# does not require t)at ,rices re%ain at or near equili+riu%9 +ut only t)at %ar et ,artici,ants not +e a+le to systematically ,ro-it -ro% %ar et Fine--icienciesF8 #o(e*er9 ()ile
97

BM# ,redicts t)at all ,rice %o*e%ent 0in t)e a+sence o- c)ange in -unda%ental in-or%ation1 is rando% 0i8e89 non3trending19 %any studies )a*e s)o(n a %ar ed tendency -or t)e stoc %ar ets to trend o*er ti%e ,eriods o- (ee s or longer and t)at9 %oreo*er9 t)ere is a ,ositi*e correlation +et(een degree o- trending and lengt) o- ti%e ,eriod studied 0+ut note t)at o*er long ti%e ,eriods9 t)e trending is sinusoidal in a,,earance18 Harious e:,lanations -or suc) large and a,,arently non3rando% ,rice %o*e%ents )a*e +een ,ro%ulgated8 5)e ,ro+le% o- algorit)%ically constructing ,rices ()ic) re-lect all a*aila+le in-or%ation )as +een studied e:tensi*ely in t)e -ield o- co%,uter science8 'or e:a%,le9 t)e co%,le:ity o-inding t)e ar+itrage o,,ortunities in ,air +etting %ar ets )as +een s)o(n to +e &$3)ard8 !n semi8strong8'orm e''iciency9 it is i%,lied t)at s)are ,rices ad<ust to ,u+licly a*aila+le ne( in-or%ation *ery ra,idly and in an un+iased -as)ion9 suc) t)at no e:cess returns can +e earned +y trading on t)at in-or%ation8 Se%i3strong3-or% e--iciency i%,lies t)at neit)er -unda%ental analysis nor tec)nical analysis tec)niques (ill +e a+le to relia+ly ,roduce e:cess returns8 5o test -or se%i3strong3-or% e--iciency9 t)e ad<ust%ents to ,re*iously un no(n ne(s %ust +e o- a reasona+le si>e and %ust +e instantaneous8 5o test -or t)is9 consistent u,(ard or do(n(ard ad<ust%ents a-ter t)e initial c)ange %ust +e loo ed -or8 !- t)ere are any suc) ad<ust%ents it (ould suggest t)at in*estors )ad inter,reted t)e in-or%ation in a +iased -as)ion and )ence in an ine--icient %anner8 !n strong8'orm e''iciency9 s)are ,rices re-lect all in-or%ation9 ,u+lic and ,ri*ate9 and no one can earn e:cess returns8 !- t)ere are legal +arriers to ,ri*ate in-or%ation +eco%ing ,u+lic9 as (it) insider trading la(s9 strong3-or% e--iciency is i%,ossi+le9 e:ce,t in t)e case ()ere t)e la(s are uni*ersally ignored8 5o test -or strong3-or% e--iciency9 a %ar et needs to e:ist ()ere in*estors cannot consistently earn e:cess returns o*er a long ,eriod o- ti%e8 B*en i- so%e %oney %anagers are consistently o+ser*ed to +eat t)e %ar et9 no re-utation e*en o- strong3 -or% e--iciency -ollo(s. (it) )undreds o- t)ousands o- -und %anagers (orld(ide9 e*en a nor%al distri+ution o- returns 0as e--iciency ,redicts1 s)ould +e e:,ected to ,roduce a -e( do>en LstarL ,er-or%ers8
98

Mutual 'unds3 ; mutual 'und is a ,ro-essionally %anaged ty,e o- collecti*e in*est%ent t)at ,ools %oney -ro% %any in*estors to +uy stoc s9 +onds9 s)ort3ter% %oney %ar et instru%ents9 andDor ot)er securities8 *vervie# !n t)e United States9 a %utual -und is registered (it) t)e Securities and B:c)ange =o%%ission 0SB=1 and is o*erseen +y a +oard o- directors 0i- organi>ed as a cor,oration1 or +oard o- trustees 0i- organi>ed as a trust18 5)e +oard is c)arged (it) ensuring t)at t)e -und is %anaged in t)e +est interests o- t)e -undFs in*estors and (it) )iring t)e -und %anager and ot)er ser*ice ,ro*iders to t)e -und8 5)e -und %anager9 also no(n as t)e -und s,onsor or -und %anage%ent co%,any9 trades 0+uys and sells1 t)e -undFs in*est%ents in accordance (it) t)e -undFs in*est%ent o+<ecti*e8 ; -und %anager %ust +e a registered in*est%ent ad*isor8 'unds t)at are %anaged +y t)e sa%e -und %anager and t)at )a*e t)e sa%e +rand na%e are no(n as a L-und -a%ilyL or L-und co%,le:L8 5)e !n*est%ent =o%,any ;ct o- 1940 0t)e 1940 ;ct1 esta+lis)ed t)ree ty,es o- registered in*est%ent co%,anies or 2!=s in t)e United States. o,en3end -unds9 unit in*est%ent trusts 0U!5s1E and closed3end -unds8 2ecently9 e:c)ange3traded -unds 0B5's19 ()ic) are o,en3 end -unds or unit in*est%ent trusts t)at trade on an e:c)ange9 )a*e gained in ,o,ularity8 ?)ile t)e ter% L%utual -undL %ay re-er to all t)ree ty,es o- registered in*est%ent co%,anies9 it is %ore co%%only used to re-er e:clusi*ely to t)e o,en3end ty,e8 #edge -unds are not considered a ty,e o- %utual -und8 ?)ile t)ey are anot)er ty,e oco%%ingled in*est%ent sc)e%e9 t)ey are not go*erned +y t)e !n*est%ent =o%,any ;ct o1940 and are not required to register (it) t)e Securities and B:c)ange =o%%ission 0t)oug) %any )edge -und %anagers no( %ust register as in*est%ent ad*isors18 Mutual -unds are not ta:ed on t)eir inco%e as long as t)ey co%,ly (it) certain require%ents esta+lis)ed in t)e !nternal 2e*enue =ode8 S,eci-ically9 t)ey %ust di*ersi-y t)eir in*est%ents9
99

li%it o(ners)i, o- *oting securities9 distri+ute %ost o- t)eir inco%e to t)eir in*estors annually9 and earn %ost o- t)e inco%e +y in*esting in securities and currencies8Q2R Mutual -unds ,ass ta:a+le inco%e on to t)eir in*estors8 5)e ty,e o- inco%e t)ey earn is unc)anged as it ,asses t)roug) to t)e s)are)olders8 'or e:a%,le9 %utual -und distri+utions o- di*idend inco%e are re,orted as di*idend inco%e +y t)e in*estor8 5)ere is an e:ce,tion. net losses incurred +y a %utual -und are not distri+uted or ,assed t)roug) to -und in*estors8 /utside o- t)e United States9 mutual fund is used as a generic ter% -or *arious ty,es ocollecti*e in*est%ent *e)icles a*aila+le to t)e general ,u+lic9 suc) as unit trusts9 o,en3ended in*est%ent co%,anies 0/B!=s9 ,ronounced Loy sL19 uniti>ed insurance

-unds9 U=!5S 0Underta ings -or =ollecti*e !n*est%ent in 5rans-era+le Securities9 ,ronounced LY/U3sitsL1 and S!=;Hs 0soci+t+ d,investissement - capital variable9 ,ronounced LSBB3ca*sL18 $dvantages o' mutual 'unds Mutual -unds )a*e ad*antages co%,ared to direct in*esting in indi*idual securities85)ese include. !ncreased di*ersi-ication 4aily liquidity $ro-essional in*est%ent %anage%ent ;+ility to ,artici,ate in in*est%ents t)at %ay +e a*aila+le only to larger in*estors Ser*ice and con*enience @o*ern%ent o*ersig)t Base o- co%,arison Disadvantages o' mutual 'unds Mutual -unds )a*e disad*antages as (ell9 ()ic) includeQ 'ees Less control o*er ti%ing o- recognition o- gains Less ,redicta+le inco%e
100

&o o,,ortunity to custo%i>e .eadin" mutual fund complexes ;t t)e end o- 20099 t)e to, 10 %utual -und co%,le:es in t)e United States (ere.Q14R 18 'idelity !n*est%ents 28 Hanguard @rou, 38 =a,ital 2esearc) S Manage%ent 0;%erican 'unds1 48 P$ Morgan =)ase S =o8 58 "lac 2oc 'unds 68 $!M=/ 'unds 78 'ran lin 5e%,leton !n*est%ents 88 'ederated !n*estors 98 "an o- &e( Yor Mellon 108 @old%an Sac)s S =o8 Types of mutual funds 5)ere are t)ree +asic ty,es o- registered in*est%ent co%,anies de-ined in t)e !n*est%ent =o%,any ;ct o- 1940. o,en3end -unds9 unit in*est%ent trusts 0U!5s1E and closed3end -unds8 e:c)ange3traded -unds 0B5's1are o,en3end -unds or unit in*est%ent trusts t)at trade on an e:c)ange8 pen8end 'unds /,en3end %utual -unds %ust +e (illing to +uy +ac t)eir s)ares -ro% t)eir in*estors at t)e end o- e*ery +usiness day at t)e net asset *alue co%,uted t)at day8 Most o,en3end -unds also sell s)ares to t)e ,u+lic e*ery +usiness dayE t)ese s)ares are also ,riced at net asset *alue8 ; ,ro-essional in*est%ent %anager o*ersees t)e ,ort-olio9 +uying and selling securities as a,,ro,riate8 5)e total in*est%ent in t)e -und (ill *ary +ased on s)are ,urc)ases9 rede%,tions and -luctuation in %ar et *aluation8=losed3end -unds
101

=losed3end -unds Q15R generally issue s)ares to t)e ,u+lic only once9 ()en t)ey are created t)roug) an initial ,u+lic o--ering8 5)eir s)ares are t)en listed -or trading on a stoc e:c)ange8 !n*estors ()o no longer (is) to in*est in t)e -und cannot sell t)eir s)ares +ac to t)e -und 0as t)ey can (it) an o,en3end -und18 !nstead9 t)ey %ust sell t)eir s)ares to anot)er in*estor in t)e %ar etE t)e ,rice t)ey recei*e %ay +e signi-icantly di--erent -ro% net asset *alue8 !t %ay +e at a L,re%iu%L to net asset *alue 0%eaning t)at it is )ig)er t)an net asset *alue1 or9 %ore co%%only9 at a LdiscountL to net asset *alue 0%eaning t)at it is lo(er t)an net asset *alue18 ; ,ro-essional in*est%ent %anager o*ersees t)e ,ort-olio9 +uying and selling securities as a,,ro,riate8 !nit investment trusts Unit in*est%ent trusts or U!5s issue s)ares to t)e ,u+lic only once9 ()en t)ey are created8 !n*estors can redee% s)ares directly (it) t)e -und 0as (it) an o,en3end -und1 or t)ey %ay also +e a+le to sell t)eir s)ares in t)e %ar et8 Unit in*est%ent trusts do not )a*e a ,ro-essional in*est%ent %anager8 5)eir ,ort-olio o- securities is esta+lis)ed at t)e creation o- t)e U!5 and does not c)ange8 U!5s generally )a*e a li%ited li-e s,an9 esta+lis)ed at creation8 Exchange8traded 'unds ; relati*ely recent inno*ation9 t)e e:c)ange3traded -und or B5' is o-ten structured as an o,en3 end in*est%ent co%,any9 t)oug) B5's %ay also +e structured as unit in*est%ent trusts9 ,artners)i,s9 in*est%ents trust9 grantor trusts or +onds 0as an e:c)ange3traded note18 B5's co%+ine c)aracteristics o- +ot) closed3end -unds and o,en3end -unds8 Li e closed3end -unds9 B5's are traded t)roug)out t)e day on a stoc e:c)ange at a ,rice deter%ined +y t)e %ar et8 #o(e*er9 as (it) o,en3end -unds9 in*estors nor%ally recei*e a ,rice t)at is close to net asset *alue8 5o ee, t)e %ar et ,rice close to net asset *alue9 B5's issue and redee% large +loc s ot)eir s)ares (it) institutional in*estors8 Most B5's are inde: -unds8Investments and classi'ication Mutual -unds %ay in*est in %any inds o- securities8 5)e ty,es o- securities t)at a ,articular -und %ay in*est in are set -ort) in t)e -undFs,ros,ectus9 ()ic) descri+es t)e -undFs in*est%ent
102

o+<ecti*e9 in*est%ent a,,roac) and ,er%itted in*est%ents8 5)e in*est%ent o+<ecti*e descri+es t)e ty,e o- inco%e t)at t)e -und see s8 'or e:a%,le9 a Lca,ital a,,reciationL -und generally loo s to earn %ost o- its returns -ro% increases in t)e ,rices o- t)e securities it )olds9 rat)er t)an -ro% di*idend or interest inco%e8 5)e in*est%ent a,,roac) descri+es t)e criteria t)at t)e -und %anager uses to select in*est%ents -or t)e -und8 ; %utual -undFs in*est%ent ,ort-olio is continually %onitored +y t)e -undFs ,ort-olio %anager or %anagers9 ()o are e%,loyed +y t)e -undFs %anager or s,onsor8 Mutual -unds are classi-ied +y t)eir ,rinci,al in*est%ents8 5)e -our largest categories o- -unds are %oney %ar et -unds9 +ond or -i:ed inco%e -unds9 stoc or equity -unds and )y+rid -unds8 ?it)in t)ese categories9 -unds %ay +e su+classi-ied +y in*est%ent o+<ecti*e9 in*est%ent a,,roac) or s,eci-ic -ocus8 5)e SB= requires t)at %utual -und na%es not +e inconsistent (it) a -undFs in*est%ents8 'or e:a%,le9 t)e L;"= &e( Persey 5a:3B:e%,t "ond 'undL (ould generally )a*e to in*est9 under nor%al circu%stances9 at least 80I o- its assets in +onds t)at are e:e%,t -ro% -ederal inco%e ta:9 -ro% t)e alternati*e %ini%u% ta: and -ro% ta:es in t)e state o- &e( Persey8 "ond9 stoc and )y+rid -unds %ay +e classi-ied as eit)er inde: 0,assi*ely3%anaged1 -unds or acti*ely3%anaged -unds8 Money market 'unds Money %ar et -unds in*est in %oney %ar et instru%ents9 ()ic) are -i:ed inco%e securities (it) a *ery s)ort ti%e to %aturity and )ig) credit quality8 !n*estors o-ten use %oney %ar et -unds as a su+stitute -or +an sa*ings accounts9 t)oug) %oney %ar et -unds are not

go*ern%ent insured9 unli e +an sa*ings accounts8 Money %ar et -unds stri*e to %aintain a J1800 ,er s)are net asset *alue9 %eaning t)at in*estors earn interest inco%e -ro% t)e -und +ut do not e:,erience ca,ital gains or losses8 !- a -und -ails to %aintain t)at J1800 ,er s)are +ecause its securities )a*e declined in *alue9 it is said to L+rea t)e +uc L8 /nly t(o %oney %ar et -unds )a*e e*er +ro en t)e +uc . =o%%unity "an erFs U8S8 @o*ern%ent Money Mar et 'und in 1994 and t)e 2eser*e $ri%ary 'und in 20088
103

;t t)e end o- 20099 %oney %ar et -unds accounted -or 30I o- t)e assets in all U8S8 %utual -unds Bond 'unds "ond -unds in*est in -i:ed inco%e securities8 "ond -unds can +e su+classi-ied according to t)e s,eci-ic ty,es o- +onds o(ned 0suc) as )ig)3yield or <un +onds9 in*est%ent3grade cor,orate +onds9 go*ern%ent +onds or %unici,al +onds1 or +y t)e %aturity o- t)e +onds )eld 0s)ort39 inter%ediate3 or long3ter%18 "ond -unds %ay in*est in ,ri%arily U8S8 securities 0do%estic or U8S8 -unds19 in +ot) U8S8 and -oreign securities 0glo+al or (orld -unds19 or ,ri%arily -oreign securities 0international -unds18 ;t t)e end o- 20099 +ond -unds accounted -or 20I o- t)e assets in all U8S8 %utual -unds8Q18R Stock or e;uity 'unds Stoc or equity -unds in*est in co%%on stoc s8 Stoc -unds %ay in*est in ,ri%arily U8S8 securities 0do%estic or U8S8 -unds19 in +ot) U8S8 and -oreign securities 0glo+al or (orld -unds19 or ,ri%arily -oreign securities 0international -unds18 5)ey %ay -ocus on a s,eci-ic industry or sector8 ; stoc -und %ay +e su+classi-ied along t(o di%ensions. 011 %ar et ca,itali>ation and 021 in*est%ent style 0i8e89 gro(t) *s8 +lendDcore *s8 *alue18 5)e t(o di%ensions are o-tened dis,layed in a grid no(n as a Lstyle +o:8L Mar et ca,itali>ation or %ar et ca, is t)e *alue o- a co%,anyFs stoc and equals t)e nu%+er os)ares outstanding ti%es t)e %ar et ,rice o- t)e stoc 8 Mar et ca,itali>ations are di*ided into t)e -ollo(ing categories. Micro ca, S%all ca, Mid ca, Large ca,
104

?)ile t)e s,eci-ic de-initions o- eac) category *ary (it) %ar et conditions9 large ca, stoc s generally )a*e %ar et ca,itali>ations o- at least J10 +illion9 s%all ca, stoc s )a*e %ar et ca,itali>ations +elo( J2 +illion9 and %icro ca, stoc s )a*e %ar et ca,itali>ations +elo( J300 %illion8 'unds are also classi-ied in t)ese categories +ased on t)e %ar et ca,s o- t)e stoc s t)at it )olds8 Stoc -unds are also su+classi-ied according to t)eir in*est%ent style. gro(t)9 *alue or +lend 0or core18 @ro(t) -unds see to in*est in stoc s o- -ast3gro(ing co%,anies8 Halue -unds see to in*est in stoc s t)at a,,ear c)ea,ly ,riced8 "lend -unds are not +iased to(ard eit)er gro(t) or *alue8 ;t t)e end o- 20099 stoc -unds accounted -or 45I o- t)e assets in all U8S8 %utual -unds8Q19R 4y%rid 'unds #y+rid -unds in*est in +ot) +onds and stoc s or in con*erti+le securities8 "alanced -unds9 asset allocation -unds9 target date or target ris -unds and li-ecycle or li-estyle -unds are all ty,es o)y+rid -unds8 #y+rid -unds %ay +e structured as -unds o- -unds9 %eaning t)at t)ey in*est +y +uying s)ares in ot)er %utual -unds t)at in*est in securities8 Most -und o- -unds in*est in a--iliated -unds 0%eaning %utual -unds %anaged +y t)e sa%e -und s,onsor19 alt)oug) so%e in*est in una--iliated -unds 0%eaning t)ose %anaged +y ot)er -und s,onsors1 or in a co%+ination o- t)e t(o8 ;t t)e end o- 20099 )y+rid -unds accounted -or 6I o- t)e assets in all U8S8 %utual -unds8Q20R Index 5passively8managed6 versus actively8managed ;n inde: -und or ,assi*ely3%anaged -und see s to %atc) t)e ,er-or%ance o- a %ar et inde:9 suc) as t)e SS$ 500 inde:9 ()ile an acti*ely %anaged -und see s to out,er-or% a rele*ant inde: t)roug) su,erior security selection8

105

%utual fund expenses !n*estors in %utual -unds ,ay -ees8 5)ese -all into -our categories. distri+ution c)arges 0sales loads and 12+31 -ees19 t)e %anage%ent -ee9 ot)er -und e:,enses9 s)are)older transaction -ees and securities transaction -ees8 So%e o- t)ese e:,enses reduce t)e *alue o- an in*estorFs accountE ot)ers are ,aid +y t)e -und and reduce net asset *alue8 2ecurring e:,enses are included in a -undFs e:,ense ratio8 Distri%ution charges 4istri+ution c)arges ,ay -or %ar eting and distri+ution o- t)e -undFs s)ares to in*estors8 Front8end load or sales charge ; -ront3end load or sales c)arge is a co%%ission ,aid to a +ro er +y a %utual -und ()en s)ares are ,urc)ased8 !t is e:,ressed as a ,ercentage o- t)e total a%ount in*ested 0including t)e -ront3 end load19 no(n as t)e L,u+lic o--ering ,rice8L 5)e -ront3end load o-ten declines as t)e a%ount in*ested increases9 t)roug) +rea ,oints8 'ront3end loads are deducted -ro% an in*estorFs account and reduce t)e a%ount in*ested8 Back8end load So%e -unds )a*e a +ac 3end load9 ()ic) is ,aid +y t)e in*estor ()en s)ares are redee%ed de,ending on )o( long t)ey are )eld8 5)e +ac 3end loads %ay decline t)e longer t)e in*estor )olds s)ares8 "ac 3end loads (it) t)is structure are called contingent de-erred sales c)arges 0or =4S=s18 Li e -ront3end loads9 +ac 3end loads are deducted -ro% an in*estorFs account8 (*%8( 'ees ; %utual -und %ay c)arge an annual -ee9 no(n as a 12+31 -ee9 -or %ar eting and distri+ution ser*ices8 5)is -ee is co%,uted as a ,ercentage o- a -undFs assets9 su+<ect to a %a:i%u% o- 1I oassets8 5)e 12+31 -ee is included in t)e e:,ense ratio8 7o8load 'unds

106

; no3load -und does not c)arge a -ront3end load under any circu%stances9 does not c)arge a +ac 3end load under any circu%stances and does not c)arge a 12+31 -ee greater t)an 0825I o-und assets8 Share classes ; single %utual -und %ay gi*e in*estors a c)oice o- di--erent co%+inations o- -ront3end loads9 +ac 3end loads and 12+31 -ees9 +y o--ering se*eral di--erent ty,es o- s)ares9 no(n as share classes8 ;ll o- t)e s)ares classes in*est in t)e sa%e ,ort-olio o- securities9 +ut eac) )as di--erent e:,enses and9 t)ere-ore9 a di--erent net asset *alue and di--erent ,er-or%ance results8 So%e ot)ese s)are classes %ay +e a*aila+le only to certain ty,es o- in*estors8 5y,ical s)are classes -or -unds sold t)roug) +ro ers or ot)er inter%ediaries are. Class $ s)ares usually c)arge a -ront3end sales load toget)er (it) a s%all 12+31 -ee8 Class B s)ares donFt )a*e a -ront3end sales load8 !nstead t)ey9 )a*e a )ig) contingent de-erred sales c)arge9 or =4S= t)at declines gradually o*er se*eral years9 co%+ined (it) a )ig) 12+31 -ee8 =lass " s)ares usually con*ert auto%atically to =lass ; s)ares a-ter t)ey )a*e +een )eld -or a certain ,eriod8 Class C s)ares )a*e a )ig) 12+31 -ee and a %odest contingent de-erred sales c)arge t)at is discontinued a-ter one or t(o years8 =lass = s)ares usually do not con*ert to anot)er class8 5)ey are o-ten called Lle*el loadL s)ares8 Class I are su+<ect to *ery )ig) %ini%u% in*est%ent require%ents and are9 t)ere-ore9 no(n as LinstitutionalL s)ares8 5)ey are no3load s)ares8 Class # are -or use in retire%ent ,lans suc) as 4010 1 ,lans8 5)ey do not c)arge loads9 +ut do c)arge a s%all 12+31 -ee8 &o3load -unds o-ten )a*e t(o classes o- s)ares. Class I s)ares do not c)arge a 12+31 -ee8 Class 7 s)ares c)arge a 12+31 -ee o- no %ore t)an 0825I o- -und assets8 &eit)er class o- s)ares c)arges a -ront3end or +ac 3end load8
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Management 'ee 5)e %anage%ent -ee is ,aid to t)e -und %anager or s,onsor ()o organi>es t)e -und9 ,ro*ides t)e ,ort-olio %anage%ent or in*est%ent ad*isory ser*ices and nor%ally lends its +rand na%e to t)e -und8 5)e -und %anager %ay also ,ro*ide ot)er ad%inistrati*e ser*ices8 5)e %anage%ent -ee o-ten )as +rea ,oints9 ()ic) %eans t)at it declines as assets 0in eit)er t)e s,eci-ic -und or in t)e -und -a%ily as a ()ole1 increase8 5)e %anage%ent -ee is ,aid +y t)e -und and is included in t)e e:,ense ratio8 ther 'und expenses ; %utual -und ,ays -or ot)er ser*ices including. "oard o- directorsF 0or +oard o- trusteesF1 -ees and e:,enses =ustody -ee. ,aid to a +an -or )olding t)e -undFs ,ort-olio in sa-e ee,ing 'und accounting -ee. -or co%,uting t)e net asset *alue daily $ro-essional ser*ices. legal and accounting -ees 2egistration -ees. ()en %a ing -ilings (it) regulatory agencies S)are)older co%%unications. ,rinting and %ailing required docu%ents to s)are)olders 5rans-er agent ser*ices. ee,ing s)are)older records and res,onding to custo%er inquiries 5)ese e:,enses are included in t)e e:,ense ratio8 Shareholder transaction 'ees S)are)olders %ay +e required to ,ay -ees -or certain transactions8 'or e:a%,le9 a -und %ay c)arge a -lat -ee -or %aintaining an indi*idual retire%ent account -or an in*estor8 So%e -unds c)arge rede%,tion -ees ()en an in*estor sells -und s)ares s)ortly a-ter +uying t)e% 0usually de-ined as (it)in 309 60 or 90 days o- ,urc)ase1E rede%,tion -ees are co%,uted as a ,ercentage o- t)e sale a%ount8 S)are)older transaction -ees are not ,art o- t)e e:,ense ratio8

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Securities transaction 'ees ; %utual -und ,ays any e:,enses related to +uying or selling t)e securities in its ,ort-olio8 5)ese e:,enses %ay include +ro erage co%%issions8 Securities transaction -ees increase t)e cost +asis o- t)e in*est%ents8 5)ey do not -lo( t)roug) t)e inco%e state%ent and are not included in t)e e:,ense ratio8 5)e a%ount o- securities transaction -ees ,aid +y a -und is nor%ally ,ositi*ely correlated (it) its trading *olu%e or Lturno*erL8 Expense ratio 5)e e:,ense ratio allo(s in*estors to co%,are e:,enses across -unds8 5)e e:,ense ratio equals t)e 12+31 -ee ,lus t)e %anage%ent -ee ,lus t)e ot)er -und e:,enses di*ided +y a*erage net assets8 5)e e:,ense ratio is so%eti%es re-erred to as t)e Ltotal e:,ense ratioL or 5B28 Controversy =ritics o- t)e -und industry argue t)at -und e:,enses are too )ig)8 5)ey +elie*e t)at t)e %ar et -or %utual -unds is not co%,etiti*e and t)at t)ere are %any )idden -ees9 so t)at it is di--icult -or in*estors to reduce t)e -ees t)at t)ey ,ay8 Many researc)ers )a*e suggested t)at t)e %ost e--ecti*e (ay -or in*estors to raise t)e returns t)ey earn -ro% %utual -unds is to reduce t)e -ees t)at t)ey ,ay8 5)ey suggest t)at in*estors loo -or no3load -unds (it) lo( e:,ense ratios8 /efinitions 4e-initions o- ey ter%s8 7et asset value or 7$B ; -undFs net asset *alue or &;H equals t)e current %ar et *alue o- a -undFs )oldings %inus t)e -undFs lia+ilities 0so%eti%es re-erred to as Lnet assetsL18 !t is usually e:,ressed as a ,er3s)are a%ount9 co%,uted +y di*iding +y t)e nu%+er o- -und s)ares outstanding8 'unds %ust co%,ute t)eir net asset *alue e*ery day t)e &e( Yor Stoc B:c)ange is o,en8

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Haluing t)e securities )eld in a -undFs ,ort-olio is o-ten t)e %ost di--icult ,art o- calculating net asset *alue8 5)e -undFs +oard o- directors 0or +oard o- trustees1 o*ersees security *aluation8 $verage annual total return 5)e SB= requires t)at %utual -unds re,ort t)e a*erage annual co%,ounded rates o- return -or 13year9 53year and 103year ,eriods using t)e -ollo(ing -or%ula.Q21R $01U51n K B2H ?)ere. $ K a )y,ot)etical initial ,ay%ent o- J190008 5 K a*erage annual total return8 n K nu%+er o- years8 B2H K ending redee%a+le *alue o- a )y,ot)etical J19000 ,ay%ent %ade at t)e +eginning o- t)e 139 539 or 103year ,eriods at t)e end o- t)e 139 539 or 103year ,eriods 0or -ractional ,ortion18 "urnover Turnover is a %easure o- t)e *olu%e o- a -undFs securities trading8 !t is e:,ressed as a ,ercentage o- net asset *alue and is nor%ally annuali>ed8 5urno*er equals t)e lesser o- a -undFs ,urc)ases or sales during a gi*en ,eriod 0o- no %ore t)an a year1 di*ided +y a*erage net assets8 !- t)e ,eriod is less t)an a year9 t)e turno*er -igure is annuali>ed8

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