MODULE 1

Investment is a sacrifice of current money or other resources for future benefits. It is a commitment of funds
(resources) made for a time period that will compensate the investor for The time the funds are committed. The expected rate of inflation. The uncertainty of future payments.

Two key aspects in investment are time and risk. The Essential Nature of Investment: Reduced Current Consumption. Planned Later Consumption. By saving money (instead of spending it) investors tradeoff between present consumption for a larger future consumption.

Objectives of investment:
Maximization of return Minimization of risk Liquidity Hedge against inflation Safety

Investment Attributes: i. Return iv. Tax benefits ii. Risk iii. Liquidity (Marketability)

v. Convenience vi. Safety

Investment Process
1. Investment Policy Investible Fund Objectives Knowledge

2. Security Analysis Economy (Market) Industry Company

3. Valuation Intrinsic Value Future Value

4. Portfolio Construction Diversification Selection and Allocation

5. Portfolio Evaluation Appraisal Revision

Investment Constraints:
Liquidity Age Need for regular income Time horizon Risk tolerance Tax liability

Types of Investors:
Risk seekers Risk avoiders Risk bearers. Individual Investors Institutional Investors Ordinary Investors Speculators Hedgers Arbitrageurs

Gambling - is usually putting money for a very short term in game or chance. Gamble is a way to entertain the player and earning incomes would be secondary a factor. Gambling, employees artificial risk where as commercial risk are present in investment activities.

Arbitrage - is a technique of making profit on stock exchange trading through difference in prices of two different markets. If advantages of price are taken between two markets in the same country it is called domestic arbitrage. Sometimes, arbitrage may also be between one country and another. It is called foreign arbitrage.

Investment v/s Speculation

Investment is the employment of funds with the aim of achieving additional income or growth in value. Whereas speculation means taking up the business risk in the hope of getting short term gain. For investment, marketable assets are not necessary. Speculation essentially involves buying and selling activities with the expectation of getting profit from the price fluctuations. Investment is comparatively lengthy. The speculator is more interested in the market action and its price movement.

Parameter Time horizon Risk Return expectation Analysis

Investments At least 1 year Moderate Risk Modest rate of return Fundamental

Speculation For few days or months High risk High rate of return(Capital gains) Technical, Charts, hearsay.

Leverage

Own funds

Own funds + Borrowed Funds

MODULE 2 INVESTMENT ALTERNATIVES 1. Non-marketable Financial Assets Bank Deposits It is the simple investment avenue open for the investors. He has to open an account & deposit the money. Traditionally the banks offered current account, savings account, & fixed deposits accounts. Current account does not offer any interest rate. The drawback of having large amounts in savings accounts is that the return is low. Post-office Time Deposits Monthly Income Scheme of the Post Office National Savings Certificates Company Deposits Employee Provident Fund Scheme. Public Provident Fund Scheme. NBFC Deposits Pension Funds

2. Money Market Instruments Treasury Bills A Treasury bill is basically an instrument of short term borrowing by the govt of India. To develop the Treasury bill market & provide investors with financial instruments of varying short-term maturities & to facilitate the cash mgmt requirements of various segments of the economy. Certificates of Deposits The certificate of deposit is a marketable receipt of funds deposited in a bank for a fixed period at a specified rate of interest. They are bearer documents & readily negotiable. The denominations of the CD & the interest rate on them are high. Commercial Paper Commercial paper is a short-term negotiable instrument with fixed maturity period. It is an unsecured promissory note issued by the company either directly or through bank/merchant banks. The maturity period of commercial paper was originally 3-6 months from the date of issue. Repos

Repo or repurchase agreement or ready forward agreement is a transaction in which one party (seller/lender of lender of security or borrower of cash) simultaneously agreeing to repurchase it in future at a specified date and time.

3.

Fixed Income Securities Government Securities RBI Savings Bonds Public Sector Undertaking Bonds Private Sector Debentures According to companies Act 1956 Debentures includes debenture stock , bonds & any other securities of company, whether constituting a charge on the assets of the company or not Debentures are issued by the private sector companies as a long term promissory note for raising loan capital. The company promises to pay interest & principal as stipulated. Types of Debentures: i. ii. iii. iv. Secured or Unsecured Fully convertible debenture Partly convertible debenture Non-convertible debenture

Preference Shares The preference shares induct some degrees of leverage in finance. The leverage effect of the preference shares is comparatively lesser than the debt because preference share dividends are not tax deductable. If the portion of preference share in the capital is larger, it tends to create instability in the earnings of the equity shares when the earnings of the company fluctuate. Types of preference share: i. ii. iii. iv. v. 4. Cumulative preference shares Non-cumulative preference shares Redeemable preference shares Irredeemable preference shares Convertible preference shares Equity Shares Equity Shares are commonly referred to common stock or ordinary shares. Even though the words shares & stocks are interchangeable used, there is a difference between them. Share capital of a company is divided into small units of equal value called shares. The term stock is the aggregate of members fully paid up shares of equal value merged in to one fund.

Types of equity share: Blue-chip Shares Growth Shares Income Shares Cyclical Shares Defensive Shares Speculative Shares 5. Mutual Fund schemes Investment companies or investment trust obtain funds from large number of investors through sale of units. The funds collected from the investors are placed under professional management for the benefit of the investors. The mutual funds are broadly classified in to open-ended scheme and close ended scheme. Classification of Mutual Funds:a) Open-ended schemes;- The open ended scheme offers its units on a continuous basis & accepts funds from investors continuously. b) Closed-ended Funds;- The close ended funds have a fixed maturity period. The first time investments are made when the close end scheme is kept open for a limited period. A. Equity Schemes Diversified Equity Schemes Index Schemes Sectoral Schemes Tax Planning Schemes

B. Hybrid (Balanced Schemes) Equity-oriented schemes Debt-oriented Schemes Variable Asset Allocation Schemes

C. Debt Schemes Gilt Schemes Mixed Schemes

Floating rate Debt Schemes Cash (Liquid) Schemes

6. Financial Derivatives Derivatives such as options and futures are financial contracts which derive their values from the underlying asset or securities. Futures Futures are a financial contract which derives its value from the underlying asset. For example sugar cane or wheat or cotton farmers may wish to have contracts to sell their harvest at a future date to eliminate the risk of change in price by that date. Options An option is the right, but not the obligation to buy or sell something on a specified date at a specified price. In the securities market, an option is a contract between two parties to buy or sell specified number of shares at a later date for an agreed price. There are two types of options namely; i. Call option - The call option that gives the right to buy in its contract ii. Put option The put option gives its owner to sell an asset or security to the writer of option Forward: In a forward contract, two parties agree to buy or sell some underlying asset on some future date at a stated price & quantity. The forward contract involves no money transaction at the time of signing the deal. 7. Life Insurance Policies Life Insurance is a contract for payment of a sum of money to the person assured on the happening of event insured against. Usually the contract provides for the payment of an amount on the date of maturity or at specified dates at periodic intervals or if unfortunate death occurs. Among other things, the contract also provides for the payment of premium periodically to the corporation by the policy holders. Schemes Endowment Assurance Money Back Plan Whole Life Assurance Unit Linked Plan

Term Assurance Immediate Annuity Deferred Annuity Riders

8. Real Estate The Real Estate market offers a high return the investors. The word real estate means land & buildings. There is a normal notion that the price of the real estate has increased more than 12% over the past ten years. The population growth & the exodus of people towards the urban cities have made the prices to increase manifold. Types Residential House Commercial Property Agricultural Land Suburban Land Time Share in a Holiday Resort

9. Precious and Valuable Items Gold and Silver Precious Stones Art Objects Paintings Antiques

MODULE 3

BOMBAY STOCK EXCHANGE The origin of the Bombay stock exchange dates back to 1875. It was organized under the name of the native stock and share brokers association as a voluntary and non-profit making association. It was recognized on a permanent basis in 1957. This premier stock exchange is the oldest stock exchange in Asia.

OBJECTIVES OF BOMBAY STOCK EXCHANGE are To safeguard the interest of investing public having dealings on the exchange To establish and promote honorable and just practices in securities transactions

 To promote, develop and maintain well-regulated market for dealing in securities. To promote industrial development in the country though efficient resources mobilization by

the way of investment in corporate securities.

THE TRADING SYSTEM In march 1995, the Bombay Stock exchange has introduced screen based trading called BOLT is designed to get best bids and offers from jobbers book as well as the best buy and sell orders from the order book. Slowly the network is being extended to other cities too. Now the BOLT has a nationwide network. Trading work station is connected with the main computer at Mumbai through wide area network (WAN). The capacity of the tandem hardware of BOLT is 500000 trades per day. After getting specific approval from SEBI, BOLT connections have been installed in ahmedabad, Rajkot, pune, vadodara and Calcutta. The number of scrips on BSE was 4702 in march 1995 and has increased to 5853 in march 1998.

SECURITIES TRADED The securities traded in the BSE are classified into three groups namely, specified shares or A group and nonspecified securities. The latter is sub-divided into B1 and B groups. A group contains the companies with large outstanding shares, good track record and large volume of business in the secondary market. Carry forward transactions for a period of 90 days are permitted in A group shares. A group contains 150 companies. Relatively liquid securities come under the B1 group. Settlement of all the shares are carried out through the clearing House. The settlement period is reduced from 14 days to 7 days for all scripts. NATIONAL STOCK EXCHANGE The national stock exchange (NSE) of India became operational in the capital market segment on 3rd, November 1994 in Mumbai. The genesis of the NSE lies in the recommendations of the pherwani committee(1991). Apart from NSE, it had recommended for the establishment of national stock market system also. Committee pointed out five major defects in the Indian stock market. The defects specified are Lack of liquidity in most of the markets in terms of depth and breadth Lack of ability to develop markets for debt. Lack of infrastructure facilities and outdated trading system. Lack of transparency in the operations that effect investors confidence.

 delays.

Outdated settlement system that are inadequate to cater to the growing volume, leading to

Lack of single market due to the inability of various stock exchanges to function cohesively

with legal structure and regulatory frame work. These factors led to the establishment of NSE.

THE MAIN OBJECTIVES OF NSE ARE AS FOLLOWS To establishment a nationwide trading facility for equities, debt instruments and hybrids To ensure equal access to investor all over the country appropriate communication network To provide a fair, efficient and transparent securities market to investors using an electronic

communication network. To enable shortersettlement cycle and book entry settlement system. To meet current international standards of securities market.

Promoters of NSE IDBI, ICICI, IFCI, LIC, GIC, SBI, bank of Baroda, Canara Bank, corporation bank, Indian bank, oriental bank of commerce, union bank of India, Punjab national bank, infrastructure leasing and financial services, stock holding corporation of India and SBI capital market are the promoters of NSE.

SEBI
SEBIs regulatory reach has been extended to more areas and there is a considerable change in the capital market. SEBIs annual report for 1997-98 has stated that throughout its ten year existence as a statutory body, it has sought to balance the twin objectives of investor protection and market development. It has formulated new rules and crafted regulations to foster development. Monitoring and surveillance was put in the stock exchanges in 1996-97 and strengthened in 1997-98. OBJECTIVES OF SEBI The promulgation of the SEBI ordinance in the parliament gave statutory status to SEBI in 1992. According to the preamble of the SEBI, the three main objectives are To protect the interests of securities To promote the development of securities market To regulate the securities market

FUNCTIONS OF SEBI The Main functions entrusted with SEBI are Regulating the business in stock exchange and any other securities market Registering and regulating the working of stock brokers, sub-brokers, share transfer agents,

bankers to the issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers and such other intermediaries who may be associated with securities market in any manner funds Promoting and regulating self-regulatory organizations Prohibiting fraudulent and unfair trade practices in the securities market Promoting investors education and training of intermediaries in securities market Prohibiting insiders trading in securities Regulating substantial acquisition of shares and take-over of companies Calling for information acquisition of shares and take-over of companies Calling for information, undertaking inspection, conducting enquiries and audits of the stock Registering and regulating the working of collective investment schemes including mutual

ex-changes, intermediaries and self-regulatory organizations in the securities market ORGANIZATION OF SEBI The organization of the SEBI is structured in such a manner to fulfill its objectives. To suit its scope of activities, it is divided into several departments. They are as given below

Department Primary department

Responsibility policy matters related to primary market, intermediaries and self regulatory organizations, redressal of investors grievances and guidance

Issue management & intermediaries department

Registration, regulation and monitoring of the

Secondary market department

intermediaries and scrutiny of offer document. Policy matters related to major stock exchanges, price monitoring market surveillance, prevention of insider trading and brokers registration. Mutual funds, FIIs, mergers, acquisitions.

Institutional investment

Apart from these departments SEBI has legal and investigation departments. It has got separate advisory committees for the primary and secondary market to assist the policy formulation.

Margin settlement Carry forward transaction were withdrawn and reintroduced by SEBI with modified regulations. SEBI notified all stock exchanges to introduce weekly settlement. Besides, auctions have to be conducted by stock exchanges within eight days of the settlement in case member fail to deliver the shares. The renewal of contract in cash groups from one settlement to another is not permitted. In case of short sales, in terms of recommendation of the B.D.Shaw committee, SEBI issued directives to all stock exchanges to submit scrip-wise information on net short sales position at the end of each trading day for dissemination of information to the public. Settlement process At present the settlement procedure has five days trading cycle. Forward trading is not permitted on OTCEI. Short sales and squaring up have to be done within the trading cycle and certificate to the investors must be delivered within a fortnight from the date of purchase. Thus, it avoids speculation. The settlement procedures are different for the listed securities and the permitted securities. In the listed securities once the deal is struck, temporary or permanent counter receipt as applicable is issued to the investor in the case of purchase or sale and confirmation slip in the case of sale by investor. The settlement agents verifies the signatures on the PCR and shall store and match the transfer deeds. The CR along with transfer deed is sent to the register for the transfer. The transfer of shares takes place within seven days. The request for transfer are closed seven days before the date of book closure or record date which-ever is applicable. Market indices

Market indices are barometers of the stock market. They mirror the stock market behavior. With some thousands of companies listed on the Bombay stock exchange, it is not possible to look at the prices of every stock to find out whether the market movement is upward or downward. The indices give a board outline of the market movement and represent the market. Some of the stock market indices are BSE Sensex, BSE-200, Dollex, NSE-50, CRISIL-500, business line 250 and RBI Indices of ordinary Shares.

Role of stock brokers

A stock broker is a professional who buys and sells stocks and other securities in the stock

market through the book makers from the stock investors. As per the law in United States one needs to pass the General Securities Representative Examination or the Series 7 exam for working as a stock broker. Brokers provide different types of services to their clients. Execution only - In this service the broker only carries out the trading according to the direction Advisory dealing - In this service the broker not only performs the buying and selling Discretionary dealing - This is the most comprehensive service that a broker provides. In this These are the basic services provided by the stock market brokers and it completely depends on of the investor. This is the basic and the most commonly used service of the brokers. instructions of the client but also advises the investor about which stock to buy and which stock to sell. case the broker has the discretionary power to take the investment decisions on behalf of the investor. you which service you will subscribe to. For example, if you are quite apt at stock market analysis and can regularly watch on the happenings of stock market and the stocks in which you invest, it is better to have a stockbroker to execute your buying and selling instructions. It will not only save the service charges but also give you full confidence in stock market trading. If you are relatively new to stock investment or if you do not have adequate knowledge of stock analysis or if you do not have the time or resource to do thorough research on the stock market the advisory service is effective for you. It will not only execute your trading directions but also provide you with effective tips and guidance for stock market investment. Though it will be a bit more expensive but then you can significantly gain from the technical knowledge and experience of the broker and its research and analysis team. The full service broker is the preferred solution for those who do not have the time or knowledge to maintain their portfolio. In this case the broker takes all the decisions for investing in the stock market. This is the most costly broking service but then it will not require you to spend any time for your stock market investment.

Just like the different types of stock broking services there are different categories of brokers as

well. While choosing your stock exchange broker, it is wise to select from the reputed stock trading companies as that will make sure you gain from their robust infrastructure from analysis and experience

in stock market. That also applies to selecting your online trading company who will carry out the online trading on your behalf.

Module 4
Risk and Uncertainty are an Integral par t of an Investment decision. Technically risk can be defined as a situation where the possible consequences of the decision that is to be taken are known. Uncertainty is generally defined to apply to situations where the probabilities cannot be estimated. However risk and uncertainty are used interchangeably. Risk is the measure of volatility; it means the difference between expected return and actual return. Higher the variation between expected return and actual return higher the is the degree of risk. Classification of Risk Systematic Risks are out of uncontrollable factors, arising out of the market, nature of the industry and the state of the economy and a host of other factors. The systematic risk affects the entire market. Often we read in the newspaper that the stock market is in the bear hug or in the bull grip. This indicates that the entire market is moving in a particular direction either downward or upward. The economic conditions, political situations and the sociological changes affect the security market. The recession in the economy affects the profit prospect of the industry and the stock market. I. Market Risk:

Market Risk is referred to as stock Variability due to changes in Investors attitudes and expectations. The Investors reaction towards tangible events is the chief cause affecting market risk. Jack Clark Francis has defined market risk as that portion of total variability of return caused by the alternating forces of bull and bear markets. When the security index moves upward haltingly for a significant period of time, it is known as bull market. In the bull market, the index moves from a low level to the peak. Bear market is just reverse to the bull market: During the bull market more than 80 per cent of the securities prices rise or fall along with the stock market indices. II. Interest Rate Risk:

The prices of securities will rise or fall, depending on the change in Interest rates. The longer the maturity period of a security the higher the yield on an investment and lower the fluctuations in prices. The fluctuations in the interest rates are caused by the changes in the government monetary policy and the changes in the government monetary policy and the changes that occur in the interest rates of treasury bills and the government bonds. III. Purchasing power Risk:

Purchasing power risk is also known as inflation risk. This risk arises out of change in the prices of goods and services and technically it covers both inflation and deflation periods. Inflation is the reason behind the loss of purchasing power. The level of inflation proceeds faster than the increase in capital value. Purchasing power risk is the probable loss in the purchasing power of the returns to be received. The rise in a price penalizes the returns to the investor, and every potential rise in a price is a risk to the investor. Unsystematic Risks emerge out of the known and controllable factors, internal to the issuer of the securities or companies. As already mentioned, UN systematic risk is unique and peculiar to a firm or an industry. Unsystematic risk from managerial efficiency, technological change in the production process, availability of raw material, changes in the consumer preference, and labour problems. The industry and magnitude of the above mentioned factors differ from industry to industry, and company to company. They have to be analyzed separately for each industry and firm. The changes in consumer preference affect consumer products like television sets, washing machines, refrigerators, etc. 1. Business risk:

Every corporate organization has its own objectives and goals and aims at a particular gross profit and operating income and also expects to provide a certain level of dividend income to its share holders. Business risk is the risk is that portion of the unsystematic risk caused by the operating environment of the business. Business risk arises from the inability of a firm to maintain its competitive edge and the growth or stability of the earnings. 2. Financial Risk:

Financial Risk in a Company is associated with the method through which it plans its financial structure of a company tends to make earnings Unstable, the company may fail financially. It refers to the variability of the income to the equity capital due to the debt capital. Financial risk in a company is associated with the capital structure of the company. Capital structure of the company consists of equity funds and borrowed funds. The presence of debt and preference capital results in a commitment of paying interest or pre fixed rate of dividend. Other types of risk a. Default risk or Insolvency Risk:

The borrower or issuer of securities may become insolvent or may default, or delay the payments due, such as interest installments or principle repayments. The borrowers credit rating might have fallen suddenly and he became default prone and in its extreme form it may take to solvency or bankruptcies. In such cases, the investor may get no return or negative returns. A short span, by the deliberate mistakes of management or acts of god He Company became sick and its share price tumbled below its face value. b. Industry Risk:

Changes in the environment of a particular industry may introduce a great deal of risk and cause securities connected to that industry to decline.Diversification can help to counter this risk because industries dont usually all underperform simultaneously. c. Stock-specific risk:

Events that impact a particular company can have a monumental effect on the companys stock. The potential problems that can arise at a given company can infuse a great deal of risk into a particular stock. Again, this type of risk can be combated by diversification because not all companies experience problems at the same time. d. Liquidity risk:

An investment may need to be sold before its maturity in order to extract the invested funds.Unfortunately, an sufficient secondary market may prevent the liquidation or limit the funds that can be generated from it. e. Inflation risk:

Although all investing decisions involve risk, simply not investing is not the answer. Inflation causes money to decrease in value at some rate.So inflation risk occurs whether you invest or not. f. Currency risk;

If the money must be exchanged to make a certain investment, changes in the value of the currency relative to the American dollar will affect the total loss or gain on the investment when the money is converted back.

CRISIL The Credit Rating Information Services of India Limited, although set up in 1987, started functioning in January 1988. As on 30 june 1993. CRISIL had assigned rating for 586 best instruments originated by 463 companies, covering the debt volumes of Rs 32,142 core. The CRISIL rating symbol for debentures are ranched into 3 categories. High investment grades (AAA pronounced as triple A)- highest safety. AA pronounced double A for high safety BBB for moderate risk B for high risk C for substantial risk

CRISIL is acronym for Credit Rating Information Services of India Limited. CRISIL is India's leading Ratings, Financial News, Risk and Policy Advisory company. Since 1987 when CRISIL was incorporated, CRISIL has played an integral role in India's development milestones. CRISIL Ratings is the only ratings agency in India to operate on the basis of sectoral specialisation. CRISIL Ratings plays a leading role in the development of the debt markets in India. The main functions of CRISIL can be classified into following subheads: 1.Ratings CRISIL Ratings: It is the only ratings agency in India with sectoral specialization. It has played a critical role in the development of the debt markets in India. The agency has developed new ratings methodologies for debt instruments and innovative structures across sectors. CRISIL Ratings provides technical know-how to clients all over the world and has helped set up ratings agencies in Malaysia (RAM), Israel (MAALOT) and in the Caribbean. 2.Research CRISIL Research: It provides research, analysis and forecasts on the Indian economy, industries and companies to over 500 Indian and international clients across financial, corporate, consulting and public sectors. CRISIL Fund Services: It provides fund evaluation services and risk solutions to the mutual fund industry. The Centre for Economic Research: It applies economic principles to live business applications and provide benchmarks and analyses for India's policy and business decision makers. Investment Research Outsourcing: CRISIL added equity research to its wide bouquet of services, by acquiring Irevna, a leading global equity research and analytics company. Irevna offers investment research services to the world's leading investment banks and financial institutions. 3.Advisory CRISIL Infrastructure Advisory: It provides policy, regulatory and transaction level advice to governments and leading organisations across sectors. Investment and Risk Management Services: CRISIL Risk Solutions offers integrated risk management solutions and advice to Banks and Corporates by leveraging the experience and skills of CRISIL in the areas of credit and market risk.

Module 5
Fundamental analysis: It is a method for forecasting the future behavior of investments and the rate of return on them is clearly through an analysis of the broad economic forces in which they operate the kind of industry to which they belong, and the analysis of the companys internal working through statements like income statement, balance sheet and settlement of changes of income. The significance of the economic indicators is primarily to try and form a strategy for making investments. Investors need not necessarily make their own economic forecasts but they must be able to find out the price movements in the economy to be able to invest effectively. Published forecasts may be used by the investor for this purpose. A look into the monitory, fiscal and demographic factors will give a basis idea into the trends in the economy. Three levels in Fundamental Analysis Economic Analysis Industry Analysis Company Analysis Economic Analysis: The various key economic variables include inflation, interest rate structure, Gross domestic product, price level changers, savings and investments agriculture smooth rate etc. The economic activity has an impact on investment in many ways. If the economy grows rapidly, the industry can also be expected to show rapid growth and vice versa. When the level of economic activity is low, stock prices are low, and when the level of economic activity is high, stock prices are high reflecting the prosperous outlook for sales and profits of the firms. The analysis of macroeconomic environment is essential to understand the behavior of the stock prices. 1. Gross Domestic Product: Its the value of total production of goods and services in an economy per year. This is the fundamental drive to stud the economy and sectorial analysis can be done, the higher the contribution to GDP the higher the development and the investment can be under the sector.GDP indicates the rate of growth of the economy.GDP represents the aggregate value of the goods and services produced in the economy.GDP consist of personal consumption expenditure, gross private domestic investment and government expenditure on goods and services and net export of goods and services. The estimates of GDP are available on an annual basis. The rate of growth of GDP is around 6% in the nineties. The GDP growth in1998-99 has accelerated to 5.8 percent compared to 5 percent of the previous year. The growth rate of the economy points out the prospects for the industrial sector and the return investors can expect from investment in shares. The higher growth rate is more favorable to the stock market.

2. Saving and investment: It is obvious that the growth requires investment which in turn requires\substantial amount of domestic savings. Stock market is a channel through which the savings of the investors are made available to the corporate bodies. Savings are distributed over various assets like equity shares, deposits, mutual funds, real estate and billion. The saving and investment patterns of the public\affect the stock to a great extent. The demand for corporate securities has an important bearing on stock market and price movements. 3. Inflation: Along with the growth of GDP, if the inflation rate also increases, then the real rate of growth would be very little. The demand in the consumer product industry is significantly affected. The industries which come under the government price control policy may lose the market, for example Sugar. The government control over this industry, affects the price of the sugar and the thereby the profitability of the industry itself. If there is the mild level of inflation, it is good to the stock market but high rate of inflation is harmful to the stock market. 4. Interest rates: The interest rate affects the cost of financing to the firms. Decrease in interest rate implies lower cost of finance for firms and more profitability. More money is available at a lower interest rate for the brokers who are doing business with borrowed money .Availability of cheap fund, encourages speculation and rise in the price of shares. Interest rates vary with maturity, default risk, inflation rate, productivity and capital. 5. Budget: The budget draft provides an elaborate account of the government revenues and expenditures. A deficit may lead to high rate of inflation and diversely affect the cost of production. Surplus budget may result in deflation. Here balanced budget is highly favorable to the stock market. The fiscal deficit and the revenue deficit as a percentage of the GDP are given. 6. The tax structure: Every year in March, the business community eagerly awaits the governments announcement regarding the tax policy the concessions and incentives given to a certain industry encourages investment in the particular industry. Tax reliefs given to savings encourage savings. The minimum Alternative Tax (MAT) levied by the finance Minister in 1996 adversely affected the stock market. Ten years of tax holiday for all industries to be set up in the northeast is provided in the 1999 budget. The type of tax exemption has impact on the profitability of the industries. 7.The balance of payment: The balance of payment is the record of a countrys money receipts from and payment is a measure of the strength of rupee on external account. If the deficit increases, the rupee may depreciate against other currencies, thereby, affecting the cost of imports. The industries involved in the export and import are considerably affected by the changes in the foreign exchange rate. The volatility of the foreign exchange rate affects the investment of the foreign institutional investors in the stock market. A favorable balance of payment renders a positive effect on the stock market. 8.Monsoon and agriculture: Agriculture is directly and indirectly linked with the industries. For example, Sugar, Cotton, Textile and Food processing industries depend upon agriculture for raw material, Fertilizer and insecticide industries are supplying inputs to the agriculture. A good monsoon leads to higher demand for input and results in

bumper crop. This would lead to buoyancy in the stock market. When the, monsoon is bad, agricultural and hydel power production would suffer. They cast a shadow on the share market. 9. Infrastructure facilities: Infrastructure facilities are essential for the growth of industrial and agricultural sector. A wide net work of communication system is a must for the growth of the economy. Regular supply of power without any power cut would boost the production. Banking and financial sectors also should be sound enough to provide adequate support to the industry and agriculture. Good infrastructure facilities affect the stock market favourably.In India even though infrastructure facilities have been developed, still they are not adequate. The government has liberalized its policy regarding the communication, transport and power sector. 10.Demographic factors: The demographic data provides details about the population by age, occupation, literacy and geographic location. This is needed to forecast the demand for the consumer goods. The population by age indicates the availability of able work force. Indian labour is cheaper compared to the Western labour force. Population, by providing labour and demand for products, affects the industry and stock market. Industry Analysis: 1. Industry Life Cycle Analysis Introduction stage Rapid growth stage Maturity stage Decline stage 2. Structure and Characteristics of Industry The number of firms in the industry and their market shares Entry barriers Pricing policies of the firms Degree of differentiation of products Technology stability Policy of government Suppliers bargaining power Buyers bargaining power

3. Company Analysis Return on equity Book value per share Earnings per share Dividend payout ratio Compounded annual ratio Price earnings ratio Market price to Book value ratio

Technical analysis: It has an important bearing on the study of price behavior and has its own method in predicting significant price behavior. The technical school of thought believes that it is a waste of time to look into the intricacies of the internal management of a firm. According to them the prices are determined in the following manner: Prices of securities are determined by the demand and supply of securities on the market. Demand & supply of securities are considered to be the main essence of the changes in security analysis. Technical analysis is a method of presenting financial data of the past behavior & to find out the history of price movements & depicts these on a chart. Typical charts are made for making prediction about a single security. Charts are also used to find out the total broad spectrum of the market. Charts also determine the individual security prices & show the total market index.

Assumptions of this theory: The market value of a security is related to demand & supply factors operating in the market. There are both rational & irrational factors which surround the supply & demand factor of a security.

Trends in stock prices have been seen to change when there is a shift in the demand & supply factors.

Dow Theory
Charles Dow who was editor of Wall Street Journal in 1990 is known for the most important theory developed with technical indicators. In fact, they gained so much significance that the theory named after him. This theory predicts trends in the market for individual and total existing securities. It also shows reversals in stock prices. These movements may be described as: Minor Trends - The narrow movement which occurs from day-to-day. Secondary Trends - The short swing which usually moves for short time like two weeks and extends up to a month. Primary Trends - The third movement is also a main movement and it covers four years in its duration. According to the type of movements, they have been given special names. The tools which the technical analysts use to predict the movement in index Technical analysis uses a variety of charts and calculations to spot trends in the market and individual stocks and try to predict what will happen next. Technical analyst doesnt bother looking at any of the qualitative data about a company. Technical analyst use different quantitative metrics in order to predict stock prices. 1)Moving average: The market indices do not rise or fall in straight line. The upward and downward movements are interrupted by counter moves. The underlying trend can be studied by smoothening of the data. To smooth the data moving average technique is used. The word moving means that the body of data moves ahead to include the recent observation. If it is five day moving average, on the sixth day the body of data moves to include the sixth day observation eliminating the first days observation. The moving averages are used to study the movement of the market as well as the individual scrip price. The moving average indicates the underlying trend in the scrip. 2.Relative strength: Relative strength index was developed by Wells Wilder. It is an oscillator used to identify the inherent technical strength and weakness of a particular scrip or market.

The relative strength index can be calculated for any number of days depending on the wish of the technical analyst and the time frame of trading adopted in a particular stock market. RSI is calculated for 5, 7, 9 and14 days. If the time period taken for calculation is more, the possibility of getting wrong signals is reduced. Reactionary or Sustained rise or fall in the price of the scrip is foretold by the RSI. 3.Charts: Charts are the valuable and easiest tools in the technical analysis. The graphic presentation of the data helps the investor to find out the trend of the price without any difficulty. The charts also have the following uses. Spots the current trend or buying and selling Indicates the probable future action of the market by

projection shows the past historic movement Indicates the important areas of support and resistance The chart do not lie interpretation differs from analyst to analyst according to their skills and

experience. A leading technician, James Dines said, Charts are like fire or electricity. They are brilliant tools if intelligently controlled to and handled but dangerous to a novice. Top and bottom: Formation is interesting to watch but what is more important, is the middle portion. The investor has to buy after up trend has stated and exit before the top is reached. Tops and bottoms are formed at the beginning or end of the new trends. The reversal from the tops and bottom indicate sell and buy signal. Head and shoulders: This pattern is easy to identify and the general generated by this pattern is considered to be reliable. In the head and shoulder pattern there are three rallies resembling the left shoulder, a head and a right shoulders A neckline is drawn connecting the lows of the tops. When the stock price cuts the neckline from above, it signals the bear market 4. Volume: volume is often times a better

Not all technical analysts focus exclusively on price. Many of them think that

indication of where a stock is heading. Volume is simply the number of shares of a stock that are traded over a particular period of time (e.g. 1 day to 30 days).volume expands along with the bull market and narrows down in the bear market. If the volume falls with rise in price or vice-versa, it is a matter of concern for the investor and the trend may not persist for a longer time. Technical analyst used volume as an excellent method of confirming the trend. The market is used to be bullish when small volume of trade and large volume of trade follow the fall in price and the rise in price. 5. Momentum:

Momentum investors seek to take advantage of upward or downward trends in stock prices or earnings. They believe that these stocks will continue to head in the same direction because of the momentum that is already behind them. Investors necessarily believe that momentum stock is will do well in the long run, but they do think that in the short run people will continue to buy them as they have in the immediate past. 6. Odd lot trading:

Shares are generally sold of hundred. Shares sold in smaller lots, fewer than 100 are called odd lot. Such buyers and sellers are called odd lotters. Odd lot purchases to odd lot sales (purchase% Sales)is the odd lot index. The increase in odd lot purchase results in an increase in the index. Relatively more selling leads to fall in the index. It is generally considered that the professional investor is more informed and strong. If the odd lotters dominate the market, the market is considered to be technically weak.The notion behinds is that odd lot purchase is concentrated at the top of the market cycle and selling at the bottom. High odd lot purchase forecast fall in the market price and low purchase/sales ratios are presumed to occur toward the end of bear market 7. Indicators:

Technical indicators are used to find out the direction of the overall market. The overall market movements affect the individual share price. Aggregate forecasting is considered to be more reliable than the individual forecasting. The indicators are price and volume of trade. The volume of trade is influenced by the behavior of price 8. The breadth of the market:

The breadth of the market is the term often used to study the advances and declines that have occurred in the stock market. Advances mean the number of shares whose prices have increased from the previous days trading. Declines indicate the number of shares whose prices have fallen from the previous days trading. This is easy to plot and watch indicator because data are available in all business dailies. The net difference between the number of stocks advanced and declined during the same period is the breadth of the market. A cumulative index of net differences measures the market breadth. 9. Short sales:

Short selling is a technical indicator known as short interest. Short sales refer to the selling of shares that are owned. He bears are the short sellers who sell now in the hope of purchasing at a lower price in the future to make profits. When the demand for a particular share increases, the outstanding short positions also increase and it indicates future rise of prices. These indications cannot be exactly correct, but they shown the general situations. 10. Oscillators:

Oscillators indicate the market momentum or scrip momentum. Oscillator shows the share price movement across a reference point from one extreme to another .Generally, oscillators are analyzed along with the price

chart. Oscillators indicate trend reversals that have to be confirmed with the price movement of the scrip. With the monthly, daily weekly or monthly closing prices oscillators are built. Dow gave special volume expands along with the bull market and narrows down in the bear market technical analyst use volume as an excellent method of confirming the trend. Large raise in price or large fall in price will leads to large increasing volume. Large volume with raise in price indicates bull market and the large volume with fall in price indicates bear market.

DIFFERENCES BETWEEN FUNDAMENTAL AND TECHNICAL ANALYSIS Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of a stock. Technical analysis is the evaluation of securities by means of studying statistics generated by market activity, such as past prices and volume. Fundamental analysis looks at economic factors, known as fundamentals, where as technical analysis looks at the price movement of a security and uses this data to predict its future price movements. Fundamental analysis starts with the financial statements where as technical analysis is done using the charts. Fundamental analysis takes a relatively long-term approach to analyzing the market compared to technical analysis. While technical analysis can be used on a timeframe of weeks, days or even minutes. Technical analysis is more short term in nature than fundamental analysis. Fundamental analysis is used to make an investment whereas technical analysis is used for a trade. Fundamental Analysis Study of cause Considers intrinsic value for analysis It considers economic, industry and company analysis Used to make an investment Technical Analysis Study of relationship Studies charts for analysis It considers price and volume analysis Used for a traded

1 2 3 4

5 6

It is to study the market in the long term Time consuming study

It is used to study the market in the short and intermediate term Quick study

Utility of technical analysis to a trader and a long term investor It is a process of identifying trend reversals at an earlier stage to formulate the buying and selling strategy. With the help of several indicators they analyse the relationship between price-volume and supply-demand for the overall market and the individual stock. 1. Long-term investors often shun technical analysis because it is thought to be a tool used solely for short-term speculation. In fact, a large part of the literature of technical analysis is devoted to short-term timing, which confirms this belief. Many individual investors have experimented with various charting techniques and have dropped the technical approach after a few bad experiences. 2. Professional long-term investors are often completely indoctrinated in the belief that the market is efficient and that technical analysis is of no practical value since the day-to-day fluctuations of stock prices are random. There can be little argument that the day-to-day movements of stock prices are random. And yet, the movements of individual stocks and the broad market demonstrate an uncanny ability to anticipate future fundamental developments and other factors that influence stock prices. Short-term randomness of stock prices does not seem to diminish the ability of the market to more-or-less consistently act as a long-term discounting mechanism. 3. The random nature of stock price movements has led to the development of a primarily academic theory called the Efficient Market Hypothesis. The EMH is highly critical of professional investment management and is often used to justify a passive indexed approach to portfolio management.

4. Most of the assumptions that make up the foundations of the efficient market hypothesis seem unrealistic
especially the ideas that new information is disseminated throughout the market instantly and that all investors interpret new information accurately and that stocks are always priced correctly. They have observed instances that are almost exactly opposite to this proposition so frequently as to represent a common occurrence. 5. And still, the conclusions of the efficient market hypothesis seem to be borne out by the almost universal inability of the majority of institutional investors to beat the market as measured by a popular market average such as the S&P 500. The academic community smugly points to the lack of performance as an almost direct proof of the efficient market hypothesis. That proof is almost totally damaging to the practice of technical analysis by long-term fundamental investors. The inability of institutional investors to achieve performance goals is used to justify avoiding a most important performance-enhancing tool. Basically the efficient market hypothesis says that you cannot predict the future of a stock price or the stock market by using technical analysis. The strong form says that you cant predict stock prices with technical analysis, fundamental analysis or anything else period!

The implied assumption in this argument is that investment success must be the result of superior predictive capability. It appears that investment success may in fact be the result of activities other than attempting to make more accurate predictions of the future and better market forecasts.

Long-term Technical Analysis

1. The most important application of technical analysis is not to attempt to predict future prices but to evaluate the strength of ongoing trends and more particularly to help portfolio managers adapt to trends that are changing direction. In essence, they will use price movement to verify our fundamental predictions and validate our expectations regarding the future performance of the shares under study. Should the trend change direction they need to critically reconsider our predictions and expectations regarding the future of the stock. In other words, if this stock is so great, why is it performing so badly? 2. It is well known that most predictions go awry not because of an incorrect analysis of the primary factors evaluated in the development of the forecast. The predictions fail, more often than not, because of variables that they didnt consider. They didnt take these items into account ether because they thought they didnt matter or they occurred in a completely unpredictable manner. They also suffer from an inability to anticipate changes in the relationships that tie the independent variables together. One way or another prediction may turn out to be wrong. The best evidence they can get that alerts us to a deteriorating fundamental prediction is price action counter to our expectations. 3. Their egos usually become involved in the predictions and forecasts and they are often unable to reverse our commitments by admitting that they are wrong. This seems to be especially true for highly intelligent, hard working, well-educated individuals that seem to occupy most investment portfolio management positions.

80/20 rules
The most important use for technical trend analysis is to verify our expectations about stocks they already own. This indicates that technical analysis is critical to our thinking when considering a sell decision in the portfolio. It is not surprising, therefore, that most fundamentally oriented portfolio managers confess difficulty with the sell decision. In their opinion, they have needlessly cut themselves off from a source of extremely valuable information though neglect of technical analysis. They believe portfolio managers should weight the buy decision about 80% fundamental and only about 20% technical. But the sell decision should reverse the weights of the two inputs, 80% technical and only 20% fundamental. The proven ability of stocks to discount changing fundamentals suggests that stocks will experience a downturn in price before the bad news comes out. Very Small negative divergences from consensus expectations can often have a devastating effect of the stock price. Therefore it seems appropriate to implement price analysis to anticipate bad news and therefore they suggest a heavy weighting of technical analysis when considering the sell decision in active portfolio management. Its not what you dont own that hurts your performance performance suffers because of the stocks that you hold because of a mistaken prediction - usually in the face of directly contrary price action.

Efficient market theory hypothesis developed by Fama

Efficient market theory states that the sharp price fluctuations are random and do not follow any regular pattern. Meanwhile technical analysts see meaningful patterns in their charts. This raises the question as to whether the intrinsic value of stocks has any meaning. Are they related to the security prices? The following section explains the process that determines the security price. The type of information used in the weak form of historical prices according to it current prices reflect all information found in the past prices and traded volumes future prices cannot be predicted by analyzing the prices from the past.

Weak efficient market Hypothesis: In the weak efficient market short term traders may earn positive return. Traders may earn by the nave and buy whole strategy while some incur losses the average buy and hold strategy cannot beaten Liquidity traders may sell their stocks without considering the intrinsic value of shares and cost price fluctuations. Buying and selling activities of the information traders lead the market price along with the intrinsic value. Weak form efficient market hypothesis assumes that the share prices fully reflect all security market information contained in past price movements, which includes rates of return, trading volume, other market-generated information, block traders etc. Semi strong form: It states that the security price adjust rapidly to all publicly available information. The prices not only reflect the past prices not only reflect the past price data, but also available information regarding the earnings of corporate dividend bonus issue mergers, acquisition and so on. In the semi strong efficient market a few insiders can earn profit on a short run price changes rather than the investors who adapt to nave and buy whole strategy whenever new information arrives at the market the supplying and demand factors react to it.

 price.

The semi-strong form of efficiency implies that there is no advantage in analyzing publicly

available information after it has been released, because the market has already absorbed it into the

This includes not only past price movements but also all the public information such as stock

prices, earnings and dividend announcements, right issues, technological breakthroughts, price to earnings ratios, dividend yield ratios,price to book value ratios, stock splits, news about the economy, political news, resignations of directors, and so on. In the case of a competitive market, price is fixed by the supply and demand force. If the market processes the new information quickly, a new price would come out of it. If the market has to be semi-strongly efficient, timely and correct dissemination of information

and assimilation of news are needed. Strong form: The strong form states that all information is fully reflected on security prices. It not only maintains that the publicly available information is useless to the investor but also all the information is useless. Information whether it is public or inside cannot be used constantly to earn superior investment or return in the strong form. This implies that the security analysts and portfolio managers who have access to information more quickly than the ordinary investors would not be able to use it to earn more profits. The essence of the theory: According to the theory, the successive price changes or changes in return are independent and these successive price changes are randomly distributed. Random walk model argues that all publicly available information is fully reflected on the stock prices and further the stock prices instantaneously adjust themselves to the available new information. The theory mainly deals with the successive changes rather than the price or return levels. According to them, the market may have imperfections like transaction cost and delays in disseminating relevant information to all market investors but these sources of inefficiency may not result in excess returns above the normal or equilibrium returns. The equilibrium return earned by nave by and holds strategy. Conclusion: According to random walk theory the successive price changes in return are independent and these successive price changes are normally distributed. Random walk theory module argues that all publicly available information is fully reflected on the stock prices and further stock prices and the stock price instantly adjust themselves to the available new information the theory mainly deals in the successive changes rather than price or written levels.

The market may have imperfection like transaction cost, and delays in disseminating relevant information to all market investors but these sources of inefficiency may not result in excess returns above the normal or equilibrium returns. The prices may move random but this does not indicate that there would not be any upward or down word movement of stock prices.

Module 7
Portfolio is a combination of securities such as stocks, bonds and money market instruments. The process of blending together the broad asset classes so as to obtain optimum return with minimum risk is called Portfolio Construction. APROACHES IN PORTFOLIO CONSTRUCTION A. Traditional Approach. B. Modern Approach. (A)Traditional Approach: In this approach. Investors needs in terms of income and capital appreciation are evaluated and appropriate securities are selected to meet the needs of the investors. The common practice in this approach is to evaluate the entire financial plan of the individual. The traditional approach basically deals with two major decisions. They are: a. Determining the objectives of the portfolio. b. Selection of securities to be included in the portfolio. STEPS IN TRADITIONAL APPROACH:

Analysis of constraints

Determination of Objectives

Selection of Portfolio

Bond and Common stock

Bond

Common stock

Diversification

Assessment of risk and return

1. ANALYSIS OF CONSTRAINTS: The constraints normally discussed are: Income needs Liquidity Time horizon Safety Tax consideration Temperament.

Income needs: This depends on the need for income in constant rupees and current rupees. The need for income in current rupees arises from the investors need to meet all or part of the living expenses. At the same time inflation may erode the purchasing power, the investor may like to offset the effect of the inflation and so, needs income in constant rupees. Liquidity: Liquidity need of the investment is highly individualistic of the investor. If the investor prefers to have liquidity, then funds should be invested in high quality short term debt maturity issues such as money market funds, commercial papers and shares that are widely traded. Keeping the funds in shares that are poorly traded or stocks in closely held business and real estate lack liquidity. The investor should plan his cash drain and the need for net cash inflows during the investment period. Time horizon: Time horizon is the investment planning period of the individuals. Individuals risk and return preferences are often described in terms of his life cycle. The stages of life cycle determine the nature of investment. In the first stage i.e., career starting point assets are lesser than liabilities. More goods purchased on credit. The priority towards investment may be in the form of savings for liquidity purposes. The investor is young at this stage and has long horizon of life expectancy with possibilities of growth in income, he can invest in high- risk and growth oriented investments.

Next stage is Mid career individual. At this stage, his assets are larger than his liabilities. Potential benefits are available to him. By this time he establishes his investment program. He may wish to reduce the overall risk exposure of the portfolio but, he may continue to invest in high risk and return securities. The final stage is the late career or the retirement stage. Here, the time horizon of the investment is very much limited. He needs stable income and once he retires, the size of income he needs from investment also increases. In this stage, most of his loans are repaid by him and his assets far exceed the liabilities. Safety of the principal: Another serious constraint to be considered by the investor is the safety of the principal value at the time of liquidation. Investing in bonds and debentures is safer then investing in stocks. Even among the stocks, the money should be invested in regularly traded companies of longstanding. Investing money in the unregistered finance companies may not provide adequate safety. Tax consideration: Investor in the income tax concessions they could get from their investments. For this they reduce the taxes. The tax is then at a concessional rate depending on the period for which the asset has been held before sold. If the investor cannot avoid taxes, he can delay the taxes. Investing in government bonds and NSC can avoid taxation. This constraint makes the investor to include the items which will reduce the tax. Temperament: The temperament of the investor himself poses a constraint on framing his investment objectives. Some investors are risk takers who would like to take up higher risk even for low return. While some investors are risk averse, who may not be willing to undertake higher level of risk even for higher return. The risk neutral investors match the return and the risk. 1. DETERMINATION OF OBJECTIVES: Portfolio has the common objective of financing present and future expenditures from a large pool of assets. The return that the investor requires and the degree of risk he is willing to take depend upon the constraints. The objectives of portfolio range from income to capital appreciation. The common objectives are: Current income Growth in income Capital appreciation Preservation of capital

It is not possible to achieve all the 4 objectives simultaneously. If the investor aims at capital appreciation, he should include risky securities where there is an equal likelihood of losing the capital. Thus, there is a conflict among the objectives. 2. SELECTION OF PORTFOLIO: The selection of portfolio depends on the various objectives of investor. The selection of portfolio under different objectives are dealt subsequently.

Objectives and asset mix: If the main objective is getting adequate amount of current income, 60% of the income is made on debts and 40% on equities. The proportions of investments on debt and equity differ according to the individuals preferences. Money is invested in short term debt and fixed income securities. Here the growth of income becomes the secondary objective and stability of principal amount may become the third. Even within the debt portfolio, the funds invested in short term bonds depends on the need for stability of principal amount in comparison with the stability of income. If the appreciation of capital is given third priority, instead of short term debt the investor opts for long term debt. The maturity period may not be a constraint. Growth of income and asset mix: Here the investor requires a certain percentage of growth in the income received from his investment. The investors portfolio may consist of 60-100% equities and 0-40% debt instrument. The debt portion of the portfolio may consist of concession regarding tax exemption. Appreciation of principal amount is given third priority. Capital appreciation and asset mix: Capital appreciation means that the value of the original investment increases over the years. Investment in real estates like land and house may provide a faster rate of capital appreciation but they lack liquidity. In the capital market, the values of shares are much higher than their original issue prices. The market capitalization also has increased. Next to real assets, the stock markets provide best opportunity for capital appreciation. Safety of principal and asset mix: Usually, the risk averse investors are very particular about the stability of principal. According to the life cycle theory, people in the third stage of life also give more importance to the safety of the principal. All the investors have this objective in their mind. No one like to lose money invested in different assets. But, the degree may differ. The investors portfolio may consist more of debt instruments and within the debt portfolio more would be on short term debts. 3. RISK AND RETURN ANALYSIS: The traditional to portfolio building has some basic assumptions. First, the individual prefers larger to smaller returns from securities. To achieve this goal, the investor has to take more risk. The ability to achieve higher returns is dependent upon his ability to judge risk and his ability to take specific risks. The risks are namely interest rate risk, purchasing power risk, financial risk and market risk. The investor analyses the varying degrees of risk and constructs his portfolio. At first, he establishes the minimum income that he must have to avoid hardships under most adverse economic condition and then he decides risk of loss of income that can be tolerated. The investor make a series of compromises on risk and non-risk factors like taxation and marketability after he has assessed the major risk categories, which he is trying to minimize. 4. DIVERSIFICATION: Once the asset mix is determined and the risk and return are analyzed, the final step is the diversification of portfolio. Financial risk can be minimized by commitments to top-quality bonds, but these securities offer poor resistance to inflation. Stocks provide better inflation protection than bonds, but are more vulnerable to financial risks. Good quality convertibles may balance the

financial risk and purchasing power risk. According to the investors need for income and risk tolerance level portfolio is diversified. In the bond portfolio, the investor has to strike a balance between the short term and long term bonds. Short term fixed income securities offer more risk to income and long term fixed income securities offer more risk to principal. In the stock portfolio, investor has to adopt the following steps which are shown in the following figure.

Selection of Industries

Selection of companies in the Industry

Determining the size of participation

The investor has to select the industries appropriate to his investment objectives. Each industry corresponds to specific goals of the investor. The selection of the company depends upon its growth, yield, expected earnings, past earnings, expected price earning ratio, dividend and the amount spent on research and development. Selecting of company is widely followed by all the investors but this depends upon the investors knowledge and perceptions regarding the company. The final step in this process is to determine the number of shares of each stock to be purchased. This involves determining the number of different stocks that is required to give adequate diversification. Depending upon the size of the portfolio, equal amount is allocated to each stock. The investor has to purchase round lots to avoid transaction costs.

(B) MODERN APPROACH: In the modern approach, the final step is asset allocation process that is to choose the portfolio that meets the requirement of the investor. The risk taker i.e. who are willing to accept a higher probability of risk for getting the expected return would choose high risk portfolio. Investor with lower tolerance for risk would choose low level risk portfolio. The risk neutral investor would choose the medium level risk portfolio. MANAGING THE PORTFOLIO: After establishing the asset allocation, the investor has to decide how to manage the portfolio over time. He can adopt passive approach or active approach towards the management of

the portfolio. In the passive approach the investor would maintain the percentage allocation for asset classes and keep the security holdings within its place over the established holding period. In the active approach, the investor continuously assess the risk and return of the securities within the asset classes and changes them accordingly. He would be studying the risks (1)market related (2) group related and (3) security specific and changes the components of the portfolio to suit his objectives.

Portfolios maintenance and periodic revision: Need:

Because the needs of the beneficiary will change Because the relative merits of the portfolio components will change To keep the portfolio in accordance with the investment policy statement and investment strategy

PASSIVE MANAGAMENT: is a process of holding a well diversified portfolio for a long term with the buy and hold approach. Passive management refers to the investors attempt to construct a portfolio that resembles the overall market return. The simplest form of passive management is holding the index fund that is designed to replicate a good and well defined index of the common stock such as BSE-Sensex or NSE-NIFTY. The problem in the index fund is the transaction cost. If it is NSE-Nifty, the manager has to buy all the 50 stocks in market proportion and cannot leave the stocks with smallest weights to save the transaction costs. Further, the reinvestment of the dividends also poses a problem. Here, the alternative is to keep the cash in hand or to invest the money in stocks incurring transaction cost. Keeping away the stock of smallest weights and the money in hand fail to replicate the index fund in the proper manner. The commonly used approaches in constructing index fund is as follows: -keeping each stock in proportion to its representation in the index -Holding a specified number of stocks for eg. 20, which historically track the index in the best manner. -Holding a similar set of stocks to match the index in a pre-specified set of characteristics.

ACTIVE MANAGEMENT: is holding securities based on the forecast about the future. The portfolio managers who pursue active strategy with respect to market components are called market timers. The portfolio managers vary their cash position or beta of the equity portion of the portfolio based on market forecast. The managers may indulge in group rotations. Here, the group rotation means changing the

investment in different industries stocks depending on the assessed expectations regarding their future performance.

THE FORMULA PLANS: It provide the basic rules and regulations for the purchase and sale of securities. The amount to be spent on the different types of securities is fixed. The commonly used formula plans are rupee cost averaging, constant rupee value, the constant ratio, and the variable ratio plans. It helps to divide the investible fund between the aggressive and conservative portfolios.

ASSUMPTIONS: Certain percentage of the investors fund is allocated to fixed income securities and common stocks. The proportion of money invested in each component depends on the prevailing market condition. If the market moves higher, the proportion of stocks in the portfolio may either decline or remain constant. The portfolio is more aggressive in the low market and defensive when the market is on the rise. The stocks are bought and sold whenever there is a significant change in the price. The changes in the level of market could be measured with the help of indices like BSE-Sensitive Index and NSE-Nifty. The investor should strictly follow the formula plan ince he chooses it. He should not abandon the plan but continue act on the plan. The investor should select good stocks that move along with the market. They should reflect the risk and return features of the market.

RUPEE COST AVERAGING: First, the stocks with good fundamentals and long term growth prospects should be selected. Such stocks prices tend to be volatile in the market and provide maximum benefit from rupee cost averaging. Secondly, the investor should make a regular commitment of buying shares at regular intervals. Once he makes a commitment, he should purchase the shares regardless of the stocks price, the companys short term performance and the economic factors affecting the stock market. Let us assume that an investor decides to buy Rs. 1000 worth of particular shares for four quarters in one particular year, ignoring the transaction cost. The details are given below in the table: Quarter Market price Shares purchase Cumu.invt Mkt value Unrealised Avg cost profit/loss per share Avg mkt price per

d 1 2 3 4 100 90 100 110 10 11 10 9 1,000 1,890 3,100 4,400 1,000 1,890 3,100 4,400 0 (100) 110 420 100 94.76 96.45 99.50

share 100 95 96.67 100

In the above eg. The stock price fell in the second quarter but recoveredin the third quarter. The investor was able to buy more stocks in the 2nd quarter than in the 1st quarter.

ADVANTAGES: Reduces the average cost per share and improves the possibility of gain over a long period. Takes away the pressure of timing the stock purchase from investors. Makes the investors to plan the investment programme thoroughly on the commitment of funds that has to be done periodically. Applicable to both falling and raising market, although it works best if the stocks are acquired in a declining market.

LIMITATIONS: Extra transaction costs are involved It doesnt indicate when to sell. It is strictly a strategy for buying It doesnt eliminate the necessity for selecting the individual stocks that are to be purchased. There is no indication of the appropriate interval between purchases. It seems to work better when stock prices have cyclical patterns.

CONSTANT RUPEE PLAN: Constant rupee, constant ratio and variable ratio plans are considered to be true formula timing plans. These plans force the investor to sell when the prices rise and purchase as price falls. Forecasts are not required to guide buying and selling. The actions suggested by the formula timing plan automatically help the investor to reap the benefits of the fluctuations in the stock prices.

The essential feature of this plan is that the portfolio is divided into two parts, which consists of aggressive and defensive or conservative portfolios. The major advantage of this plan is that purchase and sales are determined automatically. This facilitates the investor to earn capital gain by selling the stocks when the price increases and buying it at a relatively lower price. To make the plan operate effectively, at the extreme price level, the stock fund may be either too small or too large.

CONSTANT RATIO PLAN: It attempts to maintain a constant ratio between the aggressive and conservative portfolios. The ratio is fixed by the investor. the investors attitude towards risk and return plays a major role in fixing the ratio. The advantage of this plan is the automisation with which it forces the manager to counter adjust his portfolio cyclically. But this approach does not eliminate the necessity of selecting individual security. The limitation of this plan is that the money is shifted from the stock portion to bond portion. Bond is also a capital market instrument and responds to market pressures. Bond and share prices may both rise and fall at the same time. In the down trend both prices may decline and then gain.

VARIABLE RATIO PLAN: According to this plan, at varying levels of market price, the proportions of the stocks and bonds change. Whenever the price of the stock increases, the stocks are sold and new ratio is adopted by increasing the proportion of defensive or conservative portfolio. To adopt this plan, the investor is required to estimate a long term trend in the price of the stocks. Forecasting is very essential to this plan. In the given eg. The portfolio is adjusted for every 20% change in the stock price. This adjustment criterion may be different for different investors depending upon their attitude towards risk and return. The portfolio is divided into 2 equal portions as in the case of other plans, with 10,000 in each. Let us assume that there is a fall in the price of the stock, then, the % of stock in the portfolio declines. As the market price for the stock reaches a 20% decline, that is to Rs.80, the adjustment action takes place. The purchase of 58 shares raises the stock portion to 72.48 %. Once again, when there is a 20% change, the adjustment action is triggered. When the prices have increased to Rs 100, the investor sells 50 shares and the stock portion in the portfolio is reduced back to 50%. ADVANTAGES: The investor tends to correct his portfolio portions according to the price changes. The investor is not emotionally affected by the price changes in the market.

LIMITATIONS:

The investor has to construct the appropriate zones and tend for alterations of the proportions. The selection of security has to be done by the investor by analyzing the merits of the stock. The plan doesnt help in the selection of scrips.

Share

If the zones are too small frequent changes have to be done and it would limit portfolio performance. Val of stk portion (Rs) Val of defensive (Rs) Total portfolio val (Rs) Stock as a %age of portfolio (Rs) Portfolio Adjustment Shares in stk portion

price(Rs)

100 90 80 80 90 100 100

10000 9000 8000 12640 14220 15800 10800

10000 10000 10000 5400 5400 5400 10800

20000 19000 18000 18040 19620 21200 21600

50.00 47.37 44.4 70.06 72.48 74.53 50.00

Bought 58 shares Sold 50 shares -

100 100 100 158 158 158 108

REVISION AND THE COST: In revision of traded volumes, the portfolio manager has to incur brokerage commission, price impact and bid-ask spread. Price impact means the effects on the price of stock. In simple terms, if the size of the trade is heavy on the buying side, the prices of the stock may increase. The bid-ask spread is the difference between the price that the market maker is willing to buy and sell the stock. These stocks may be higher in small size stocks and the benefits of revision may be nullified by it. Usually revision is done with the view of either increasing the expected return of the portfolio or to reduce the risk (std deviation) of the portfolio. SWAPS: Swaps is a contract between two parties to exchange a set of cash flows over a pre-determined period of time. The two parties are known as counter parties. In an equity swap one counter party, say A, agrees to pay cash based on the rate of return of an agreed stock market index to the second counter party B. Since the payments are based on the market index, they vary according to index movements. The second counter party B agrees to pay the fixed amount of cash payments based on the current interest rate to the first counter party A. Thus, the payments depends upon the underlying security. This agreement means that A has sold stocks and bought bonds while B has sold bonds and bought stocks. Here, they have restricted their portfolios without the

transaction costs, even though they have to pay the swap fee to the swap bank that set up the contract between the two parties. The procedure developed by Markowitz for choosing the optimal portfolio of risky assets Most people agree that holding two stocks is less risky than holding one stock. For example, holding stocks from textile, banking, and electronic companies is better than investing all the money on the textile companys stock. But building up the optimal portfolio is very difficult. Markowitz provides an answer to it with the help of risk and return relationship. The modern portfolio theory emphasizes the need for maximization of returns through a combination of securities, whose total variability is lower. The risk of each security is different from that of others. Theory, expected returns, the variance of these returns and covariance of the returns of the securities within the portfolio are to be considered for the choice of a portfolio. SIMPLE DIVERSIFICATION Portfolio risk can be reduced by the simplest kind of diversification. Portfolio means the group of asset an investor owns. The investor may vary from stocks to different types of bonds. Sometimes the portfolio may consist of securities of different industries. When different assets are added to the portfolio, the total risk tends to decrease. In the case of common stocks, diversification reduces the unsystematic risk or unique risk. Analyst opinion that if 15 stocks are added a portfolio of the investor, the un systematic risk can be reduced to zero. But at the same time if the number exceeds 15, additional risk reduction cannot be gained. But diversification cannot reduce systematic or un diversification risk. The concept In developing his model, Markowitz had given up the single stock portfolio and introduced diversification. The single security portfolio would be preferable if the investor is perfectly certain that his expectation of highest return would turn out to be real. Take the stock of ABC Company and XYZ Company. The returns expected from each company and their probabilities of occurrence, expected returns and the variances are given. Assumptions of Markowitz Theory 1. 2. 3. 4. The individual investor estimate risk on the basis of variability of return and variance of return. The markets are efficient and absorb the information quickly and perfectly. Investors prefer higher returns to lower returns for a given level of risk. Investors are rational and behave in a manner as to maximize their utility with a given level of

income or money.

5.

Investors base decisions on expected returns and variance or standard deviation of these returns

from the mean The concept in developing his model, Markowitz had given up the single stock portfolio and introduced diversification. The single security portfolio would be preferable if the investor is perfectly certain that his expectation of highest return would turn out to be real. In the world of uncertainty most of the risk adverse investors would like to join than keeping a single stock, because diversification reduces the risk. For building up the efficient set of portfolio as laid down by Markowitz, we need to look into these important parameters. 1. 2. 3. Expected return Variability of returns as measured by standard deviation from the mean. Covariance or variance of one asset return to other asset returns

In general the higher the expected return, the lower .Is the standard deviation or variance and lower is the correlation the better will be the security for investor choice. Whatever is the risk of the individual securities in isolation, the total risk of the portfolio of all the securities may be lower, if the covariance of their returns is negative or negligible

Efficient Frontier The Capital Asset Pricing Model

The Capital Asset Pricing Model theory has been propounded by Sharpe. It indicates the behaviour pattern of investors. It draws on the results of the capital market theory & explains the price assets in the capital market. According to this theory, all investors have an efficient frontier but each investor has some difference in expectations. The concept of lending would introduce to an investor & his like of investment in a risk-less security. Borrowing for an investor is like the use of margin. When both borrowing and lending are combined the efficiency frontier is transformed into a straight line. In finance, the capital asset pricing model (CAPM) is used to determine a theoretically to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already welldiversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta () in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. The model was introduced by Jack Treynor (1961, 1962),[1] William Sharpe (1964), John Lintner (1965a,b) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz on diversification and

modern portfolio theory. Sharpe, Markowitz and Merton Miller jointly received the Nobel Memorial Prize in Economics for this contribution to the field of financial economics. A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (Rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). Assumptions of the theory: Decision of the investor depends on their judgement of risk & return of securities & these are measured by standard deviations. All investors are infinitely devisable units and can be freely purchased and sold. Shares can be sold short at any time in the stock market and without any limit. Individual investors do not affect the prices of security. All investors operate under perfect competition. Transaction costs are nil. At any time there is a risk-less rate at which investor can buy or lend any quantity of funds. Investors are risk averse. Security returns are normally is quadratic.

Capital Market Line

James Tobin (1958) added the notion of leverage to portfolio theory by incorporating into the analysis an asset which pays a risk-free rate. By combining a risk-free asset with a portfolio on the efficient frontier, it is possible to construct portfolios whose risk-return profiles are superior to those of portfolios on the efficient frontier.

A tangent linecalled the capital market linehas been drawn to the efficient frontier passing through the risk-free rate. The point of tangency corresponds to a portfolio on the efficient frontier. That portfolio is called the super-efficient portfolio. Using the risk-free asset, investors who hold the super-efficient portfolio may:

Leverage their position by shorting the risk-free asset and investing the proceeds in additional holdings in the super-efficient portfolio, or De-leverage their position by selling some of their holdings in the super-efficient portfolio and investing the proceeds in the risk-free asset.

The resulting portfolios have risk-reward profiles which all fall on the capital market line. Accordingly, portfolios which combine the risk free asset with the super-efficient portfolio are superior from a risk-reward standpoint to the portfolios on the efficient frontier.

Tobin concluded that portfolio construction should be a two-step process. First, investors should determine the super-efficient portfolio. This should comprise the risky portion of their portfolio. Next, they should leverage or de-leverage the super-efficient portfolio to achieve whatever level of risk they desire. Significantly, the composition of the super-efficient portfolio is independent of the investor's appetite for risk. The two decisions: The composition of the risky portion of the investor's portfolio, and The amount of leverage to use,

are entirely independent of one another. One decision has no effect on the other. This is called Tobin's separation theorem. William Sharpe's (1964) capital asset pricing model (CAPM) demonstrates that, given strong simplifying assumptions, the super-efficient portfolio must be the market portfolio. From this standpoint, all investors should hold the market portfolio leveraged or de-leveraged to achieve whatever level of risk they desire.

Security Market Line

Security market line or SML is the graphical representation of Capital Asset Pricing Model or CAPM. Know more about Capital Asset Pricing Model. Security market line is a straight sloppy line which gives the relationship between expected rate of return and market risk (or systematic risk) of over all market.

The X-axis of the security market line represents the market risk or beta and the Y-axis of SML represents expected market return in percentage at a point of time. Usually the rate of risk free investments is represented as a line parallel to X-axis and it is from here that the SML starts. For example if the risk-free ratio is 4%, the beta value of market is 3% and expected return from market is 10%, then expected return will be 4+3(10-4) = 22%; and SML will start from 4% at Y-axis and will pass through 22% when beta is 3. Security market line is a simple yet powerful tool for finding return and risk associated with a portfolio. Investors can plot individual stocks beta and expected return against SML. If the expected return from the stock is above

SML the stock is considered undervalued and is predicted to offer good return for the risk taken. If the expected return falls below SML, the stock is considered overvalued and is predicted to offer lesser return for the risk taken.

Arbitrage Pricing Theory Model

It is useful for investors and portfolio managers for evaluating securities. the capital asset pricing theory is explained through betas that show the return on the securities. Stephen Ross developed the arbitrage pricing theory explains the nature of equilibrium in pricing of assets in a simple manner. It has fewer assumptions in comparison to CAPM. Arbitrage is a techquine of making profits by differential pricing of an asset. It helps in earning a risk-less profit. Price is manipulated by selling at a high price and the simultaneous purchase of the same security at a relatively lower price. Trading activity creating price advantageous without any risk continues until the profit margin is reduced due to competition from other traders. When this occurs, a situation arises when the profit is nil. At this stage, the market price is at an equilibrium level. Arbitrage pricing theory (APT), in finance, is a general theory of asset pricing, that has become influential in the pricing of stocks. APT holds that the expected return of a financial asset can be modeled as a linear function of various macroeconomic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The model-derived rate of return will then be used to price the asset correctly the asset price should equal the expected end of period price discounted at the rate implied by model. If the price diverges, arbitrage should bring it back into line. The theory was initiated by the economist Stephen Ross in 1976. This theory helps to make profit by diffrential pricing of an assets. It helps in earning a risk-less profit. Price is manipulated by selling a security at a high price and simultaneous purchase of the same security at a lower price. It has a fewer assumption comparision to CAPM.

ASSUMPTIONS TO THIS THEORY All investors have homogeneous expectation Investors are generally interested in maximising their utility at minimum risk. There is a perfect competition in the market. There is no transaction cost in the market.

The APT model Risky asset returns are said to follow a factor structure if they can be expressed as:

where

E(rj) is the jth asset's expected return, Fk is a systematic factor (assumed to have mean zero), bjk is the sensitivity of the jth asset to factor k, also called factor loading, and j is the risky asset's idiosyncratic random shock with mean zero.

The implication is that at the end of the period the portfolio would have appreciated at the rate implied by the APT, whereas the mispriced asset would have appreciated at more than this rate. The arbitrageur could therefore: Today: 1 short sells the portfolio 2 buy the mispriced asset with the proceeds. At the end of the period: 1 sells the mispriced asset 2 use the proceeds to buy back the portfolio 3 pocket the difference. Where today's price is too high: The implication is that at the end of the period the portfolio would have appreciated at the rate implied by the APT, whereas the mispriced asset would have appreciated at less than this rate. The arbitrageur could therefore: Today: 1 short sells the mispriced asset 2 buy the portfolio with the proceeds. At the end of the period:

1 sells the portfolio 2 use the proceeds to buy back the mispriced asset 3 pocket the difference Assumptions: All investors have homogeneous expectations. Investors are generally interested in maximising their utility at minimum risk. There is a perfect competition in the market. There are no transactions costs in the market.

Relationship with the capital asset pricing model The APT along with the capital asset pricing model (CAPM) is one of two influential theories on asset pricing. The APT differs from the CAPM in that it is less restrictive in its assumptions. It allows for an explanatory (as opposed to statistical) model of asset returns. It assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical "market portfolio". In some ways, the CAPM can be considered a "special case" of the APT in that the securities market line represents a single-factor model of the asset price, where beta is exposed to changes in value of the market. Additionally, the APT can be seen as a "supply-side" model, since its beta coefficients reflect the sensitivity of the underlying asset to economic factors. Thus, factor shocks would cause structural changes in assets' expected returns, or in the case of stocks, in firms' profitabilities. On the other side, the capital asset pricing model is considered a "demand side" model. Its results, although similar to those of the APT, arise from a maximization problem of each investor's utility function, and from the resulting market equilibrium (investors are considered to be the "consumers" of the assets). Differences between CAPM and APT CAPM Considers only mean and variance in the market Considers risk reward ratio of security (SML) and that of a portfolio(CML) Factors considered for evaluation are limited Inputs required for CAPM are: Rf, Rm-Rf and beta APT Considers other systematic factors in the market Considers return evaluation by considering various systematic risk factors Factors considered for evaluation are not clearly specified Inputs required for APT are: riskless rate of return, sensitivity related to the factor(beta), sensitivity of

1 2 3 4

return to beta