Securities Analysis And Portfolio Management.pdf

SECURITIES ANALYSIS AND PORTFOLIO MANAGEMENT UNIT 1 INVESTMENT MANAGEMENT

What is an 'Investment?' An investment is an asset or item acquired with the goal of generating income or appreciation. In an economic sense, an investment is the purchase of goods that are not consumed today but are used in the future to create wealth. In finance, an investment is a monetary asset purchased with the idea that the asset will provide income in the future or will later be sold at a higher price for a profit. The term "investment" can refer to any mechanism used for generating future income. In the financial sense, this includes the purchase of bonds, stocks or real estate property. Additionally, a constructed building or other facility used to produce goods can be seen as an investment. The production of goods required to produce other goods may also be seen as investing.

Nature of Investment  Cash has as Investment opportunity when you decide to invest it you are deprived of this opportunity to earn a return on that ca sh.  When the general price level raises the Purcha sing power of ca sh declinesla rger the Incr ease in inflation, the grea ter the depletion in the buying power of cash.  Some investors buy government Securities or deposit thei r money in bank a ccounts that are a dequately secur ed.  IN contr a st, some others prefer to buy, hold and sell equity sha re seven when they know that they get exposed to risk  Risk is the probability that the actual return on an investment will be different from its expected return.  Using this definition of risk, you may classify va rious investments in to risk ca tegories.  Government sec urities would be seen as risk free investments beca use the probability of actua l return diverging f rom ex pected return is zero    

To understand various investment decision rules. To know what are the good investments decisions rules. To know the category of investment decision rules. You can take investment decision only after analyzing entire process of investment that starts with funds contribution and ends with getting expectations fulfilled.

Scope of investment  Identification of Investors Requirements:-Investors differ ro1n each other in terms of objectives, preferences and constraints. The foundation of investment management1n thus, collection of data relating to investors requirements. the analysis of this data gives an idea about the assets and securities to be selected

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 Formulation of Investment Policy and Strategy :-the policy will lay down the different asset classes of investment via shares, debentures, bonds etc. and the proportion of funds to be invested in each class. After formulating the investment policy. The next stage is to prepare the investment strategy. Investment strategy will be formulated for income and capital appreciation and for a level of risk tolerance. The investment strategy will have to be correlated with the expectation of the capital market and the individual sectors of industry  Execution of strategy:-Next strategy is the implementation and execution of investment process. This process requires a lot of research, analysis and judgment. The portfolio thus, constructed may relate to the needs of a given level of income liquidity, safety, high yielding growth stocks etc. The success of the portfo lio wou ld depend up on the initiative, innovation and judgment of the person contracting the portfolio.  Monitoring of Portfolio:- The performance of the portfo lio is evaluated and adjustments are made the portfolio composition from time to time.  Change in investment condition  Market condition  Industry performance or company This all taken into consideration in the portfolio adjustment.

Objective Of investment The primary objecti ve of i nvestment is to increase the rate of return and to reduce the risk. The other objectives are: Income:- m a i n o bjecti ve is to earn i ncome in form of dividend yield or interest. Investment should earn reasonable and expected return on the i nvestment. Capital appreci at ion:-The other important objecti ve of investment is appreciation in the capi tal i n vested over a period of time. Capital appreciation can be ach ieved by following: Conservative g r o w t h  Aggressive G rowth  Speculation = taking high risk Forms Of R eturn:-The returns expected from securities may be of two types: Periodical(game) Cash Receipts  Capital Gain Safety and Security of Funds:-Another important consideration in marking investment is that found so invested should be safe and secure. The investment should be capable for redemption as and when due. Liquidity :- Before marketing the investment, the investor should consider the degree of liquidity require. Certain securities are capable of being sold in the readily available market and some securities may not be so liquid. Tax considerations:-Before marketing the investment, investors should also take into consideration the provisions of income tax, capital gain tax and wealth tax to minimize this tax burden and avail all tax exemptions available to him.

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Elements of Investment The Elements of Investments are as follows: 1. Return: Investors buy or sell financial instruments in order to earn return on them. The return on investment is the reward to the investors. The return includes both current income and capital gain or losses, which arises by the increase or decrease of the security price. 2. Risk: Risk is the chance of loss due to variability of returns on an investment. In case of every investment, there is a chance of loss. It may be loss of interest, dividend or principal amount of investment. However, risk and return are inseparable. Return is a precise statistical term and it is measurable. But the risk is not precise statistical term. However, the risk can be quantified. The investment process should be considered in terms of both risk and return. 3. Time: Time is an important factor in investment. It offers several different courses of action. Time period depends on the attitude of the investor who follows a ‘buy and hold’ policy. As time moves on, analysis believes that conditions may change and investors may revaluate expected returns and risk for each investment. 4. Liquidity: Liquidity is also important factor to be considered while making an investment. Liquidity refers to the ability of an investment to be converted into cash as and when required. The investor wants his money back any time. Therefore, the investment should provide liquidity to the investor. 5. Tax Saving: The investors should get the benefit of tax exemption from the investments. There are certain investments which provide tax exemption to the investor. The tax saving investments increases the return on investment. Therefore, the investors should also think of saving income tax and invest money in order to maximize the return on investment.

INVESTMENT AVENUES Are you searching for investment alternatives for parking idle funds? This article provides a comprehensive list of such investment alternatives. Investment in any of the alternatives depends on the needs and requirements of the investor. Corporates and individuals have different needs. Before investing, these alternatives of investments need to be analyzed in terms of their risk, return, term, convenience, liquidity etc. EQUITY SHARES Equity investments represent ownership in a running company. By ownership, we mean share in the profits and assets of the company but generally, there are no fixed returns. It is considered as a risky investment but at the same time, they are most liquid investments due to the presence of stock markets. Equity shares of companies can be classified as follows:  Blue chip scrip  Growth scrip  Income scrip  Cyclical scrip  Speculative scrip DEBENTURES OR BONDS Debentures or bonds are long-term investment options with a fixed stream of cash flows depending on the quoted rate of interest. They are considered relatively less risky. An amount of risk involved in debentures or bonds is dependent upon who the issuer is. For example, if 3

the issue is made by a government, the risk is assumed to be zero. Following alternatives are available under debentures or bonds:  Government securities  Savings bonds  Public Sector Units bonds  Debentures of private sector companies  Preference shares MONEY MARKET INSTRUMENTS Money market instruments are just like the debentures but the time period is very less. It is generally less than 1 year. Corporate entities can utilize their idle working capital by investing in money market instruments. Some of the money market instruments are  Treasury Bills  Commercial Paper  Certificate of Deposits MUTUAL FUNDS Mutual funds are an easy and tension free way of investment and it automatically diversifies the investments. A mutual fund is an investment mix of debts and equity and ratio depending on the scheme. They provide with benefits such as professional approach, benefits of scale and convenience. In mutual funds also, we can select among the following types of portfolios:  Equity Schemes  Debt Schemes  Balanced Schemes  Sector Specific Schemes etc. LIFE INSURANCE AND GENERAL INSURANCE They are one of the important parts of good investment portfolios. Life insurance is an investment for the security of life. The main objective of other investment avenues is to earn a return but the primary objective of life insurance is to secure our families against unfortunate event of our death. It is popular in individuals. Other kinds of general insurances are useful for corporates. There are different types of insurances which are as follows:  Endowment Insurance Policy  Money Back Policy  Whole Life Policy  Term Insurance Policy  General Insurance for any kind of assets. REAL ESTATE Every investor has some part of their portfolio invested in real assets. Almost every individual and corporate investor invest in residential and office buildings respectively. Apart from these, others include:  Agricultural Land  Semi-Urban Land  Commercial Property  Raw House  Farm House etc

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Best Investment Avenues of 2018 Here is a list of the top 10 investment avenues chosen across holding period and risk category that you can invest in 2018. Saving and investing are the two pillars of financial stability. While we all work hard to earn money, saving and investment is an art to master. While saving is done to meet unplanned and planned expenses, Investment is all about making your money earn for you, and give you the rewards through future returns. Investment planning needs a careful analysis of the return and time frame to be done before the actual investment process. To make it an easier decision for you, here is a compilation of the Best Investment Avenues across categories that you can invest in 2018. 1. Savings Bank Account & Flexi Deposits 2. Bank Fixed Deposits 3. Mutual Funds 4. Post Office Savings Scheme 5. Public Provident Fund 6. Company Fixed Deposits 7. Gold Investment 8. Insurance Plans 9. Bonds 10. Real Estate 1. Savings Bank Account & Flexi Deposits Holding Period: Short Term Risk Involved: Low Surprised to find the savings bank account in this list? Well, funding your savings bank account is the first investment you can do. Bank accounts earn an interest of 4% and more depending on bank to bank. You can convert your savings account with a balance of above 25,000 to flexi deposit account, which is highly liquid and earns you the interest of an FD. Maintain a savings account for your short-term expenses and contingencies. 2. Bank Fixed Deposits Holding Period: Short/Long Term Risk Involved: Low Bank FD’s have attracted the maximum investment, primarily because it is a safe source of investment where the rate of returns is fixed. You can opt for a Bank FD ideally for 1 year, which gives the highest rate of interest. FDs allow premature withdrawal with an interest deduction making them a liquid investment. However, you cannot break a tax saving FD that is locked in for a period of 5 years. Before investing, compare the FD charts of different banks and invest in those which offer the highest interest rate. Also, don’t forget to fill 15 G/H to avoid interest deductions at maturity. 3. Mutual Funds Holding Period: Short/Long Term Risk Involved: Depends on the fund bought We all must have seen the ad “Mutual Fund Sahi hai” beaming from our TV screens. Mutual funds (MF) have grown as a lucrative investment, both for the short term (money market funds) or the long-term (tax saving or locked in mutual funds). You can invest in MF’s through SIP’s (Systematic Investment Plans) or in a lump sum as a single investment. The risk profile depends on the funds you invest in, while debt funds invite less risk, the risk is

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comparatively higher in equity funds. The investment amount and time period depending on your age and financial goals. 4. Post Office Savings Scheme Holding Period: Long Term Risk Involved: Low Post Office savings schemes offer a safer investment option, offering monthly income plans which are apt for the retired meeting their medical and other requirements. Here are all you need to know about Post Office Savings Schemes. 5. Public Provident Fund Holding Period: Long Term Risk Involved: Low Public Provident fund (PPF) is one of the safest and secure long-term investment avenues with the best part being it is a totally tax-free investment. PPF has a lock-in of 15 years which enables you to earn compound interest on your investments. If you want to extend your investment time frame, you can extend it for the next five years. The minimum period of investments is 6 years after which you can withdraw your investments. In case of financial emergencies, you can take a loan on the balance of your PPF account. The current interest rate effective from 1 January 2018 on PPF is 7.6% Per Annum (compounded annually). 6. Company Fixed Deposits Holding Period: Long Term Risk Involved: High Company FDs are a lucrative investment avenue in comparison to bank FD’s. These investments are placed with financial institutions and Non-Banking Finance Companies (NBFCs) for a fixed term and carry a prescribed rate of interest. Company FD’s are unsecured investments governed by the Companies Act under Section 58A. If the company defaults, the investor cannot sell the fixed deposits to recover the capital which makes company FD’s highly risky. While investing select the investment period very carefully as you are not allowed withdrawing money before the maturity date. This investment is not under any insurance benefits and is not under the control of the Reserve Bank of India, which adds to the risk exposure. 7. Gold Investment Holding Period: Long Term Risk Involved: Medium Investment in Gold is one of the most sought out investment options exercised since older times. The value of gold bears an inverse relation with the value of equity. Gold becomes a lucrative investment option when the stock markets are red. You can plan your investment in gold through a Gold deposit scheme, Gold ETF (exchange-traded fund), Gold mutual funds, Gold bar etc. Gold mutual funds and ETFs allow you to hold the gold in a paperless form and sell them in stock exchanges making them a highly liquid investment. 8. Insurance Plans Holding Period: Long Term Risk Involved: Depends on the plan bought Insurance plans are the preferred investment avenue in every household to save taxes. Insurance plans come in a fixed maturity time frame and urge the investor to invest a fixed premium every year. You should not see Insurance plans solely as an investment option; instead, buy it as your life cover. The most popular insurance plans are ULIPS (Unit Linked Insurance Plans) that invest in equity and give you tax benefit under Section 80C.ULIPs are the best combination of insurance and investment plans, where premium contribution goes to insurance (as mortality charges deduction) and investment(through equities) simultaneously. 6

9. Bonds Holding Period: Long Term Risk Involved: Low Bond investment can be divided into tax saving and capital appreciation bonds. Capital appreciation bonds like GOI savings (taxable) bonds will yield you 7.75% interest inviting tax on maturity under the Income-tax Act, 1961. Infrastructural bonds issued by NTPC, NHAI, REC etc. are tax saving yielding an interest of 6% p.a. The tax saving bonds come with a lock-in period of 3years, and allow a maximum investment limit of up to Rs.50 Lakhs in a Financial Year per individual. 10. Real Estate Holding Period: Long Term Risk Involved: High Real Estate is a lucrative investment avenue to invest for those who have an appetite for risk and are patient with time. Real estate involves investment in housing, commercial, hospitality infrastructure. Many buy a flat, shop or plot for investment purposes. The risk depends upon the development of the place, property prices, and accessibility. Keep your paperwork updated, and be careful with whom you deal in real estate, for this investment in this avenue is risky. At whatever age or earning bracket you are in, Don’t wait for the right time for beginning an investment. It is important to make a start, however small the amount is. The power of compounding will grow your investments thereby allowing you the experience to learn and build a corpus in the long run. TYPES of investment I. securities or Property  Securities: stocks, bond s, options  Real Property: land, buildings  Tangible Personal Property : gold , art work, antiques II. Direct or Indirect  Direct: investor directly acquires a claim  Indirect : investor owns part of a portfolio III. Debt, Equity or Derivative Securities  Debt: investor lends funds in excha nge for interest income and repayment of loan in future (bonds)  Equity: represents ongoing ownership in a business or property (common stocks)  Deriva tive Securities: neither debt nor equity; der ive va lue from an under lying asset (options) IV. Low Risk or High Risk  Risk : chance that actua l investment returns w ill differ from those expect V. Short-Term or Long-Term  Short-Term: matu re w ithin 1 year  Long-Term : matu rities of longer than a year

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The investment management process 1. Set investment policy: Investment policies provide raw material for the investment management, in this stage various investment assets are identified in their features are connected.  Determination of amount invested  Determination of invested objective  Identification of potential investment assets  Allocation investable funds to various investment categories 2. Conduct security analysis  this objective is to determine future risk & return in holding various blends of individual securities  it helps in general efficient portfolio  to determine efficient portfolio expected return level is choose 3. Valuation of securities: investment value is generally taken to be present worth to be owner of futures benefits from investment.  Comparison of the value with the current market price of the asset allows the determination of relative attraction of the asset. 4. Portfolio of construction  Deciding the diversification level  Considering the investment time  Selection of investment time  Allocation of investment funds for investment assets  Acquisition of funds 5. Portfolio evaluation & revision: it is a continuous process after selection of portfolio the next step is evaluation the asset & time depends upon the market condition Investment v/s speculation

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Meaning of speculation Speculation means taking business risk with anticipation of acquiring short term gain. It also involved practice of buying & selling activities in order to profit price fluctuations. An individual who under takes to activity of speculation is known as speculator. Gambling Gambling is quite the opposite of investment it consists in taking high risk not only for high return but also thrill and excitement It is unplanned and un scientific

Risk and return Returns are the gains or losses from a security in a particular period and are usually quoted as a percentage. Risk is the variability of the actual return from the expected return associated with a given investment. Risk Risk means you have the possibility of losing some, of your original investment.  Risk and return of an investment are related  Risk may be,loss of capital, delay in repayment, non-payment of interest , variability in return .  Low levels of uncertainty (low risk) are associated with low potential returns.  High levels of uncertainty (high risk) are associated with high potential returns. Return depends upon  nature of the investment  the monitory period  host of other factions

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A. Systematic risk : Systematic risk is due to the influence of external factors on an organization. Such factors are normally uncontrollable from an organization's point of view. It is a macro in nature as it affects a large number of organizations operating under a similar stream or same domain. It cannot be planned by the organization 1. 2. 3. 4.

Interest rate risk, Market risk and Purchasing power Inflationary risk

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Interest Rate Risk: Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks Market risk :The risk of investments declining in value because of economic developments or other events that affect the entire market. The main types of market risk are equity risk, interest rate risk and currency risk. Equity risk – applies to an investment in shares. The market price of shares varies all the time depending on demand and supply. Equity risk is the risk of loss because of a drop in the market price of shares. Interest rate risk – applies to debt investments such as bonds. It is the risk of losing money because of a change in the interest rate. For example, if the interest rate goes up, the market value of bonds will drop. Currency risk – applies when you own foreign investments. It is the risk of losing money because of a movement in the exchange rate. For example, if the U.S. dollar becomes less valuable relative to the Canadian dollar, your U.S. stocks will be worth less in Canadian dollars. Purchasing power risk. It is so, since it emanates (originates) from the fact that it affects a purchasing power adversely. It is not desirable to invest in securities during an inflationary period.

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Inflation risk:The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time – the same amount of money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or debt investments like bonds. Shares offer some protection against inflation because most companies can increase the prices they charge to their customers. Share prices should therefore rise in line with inflation. Real estate also offers some protection because landlords can increase rents over time. 10

B. Unsystematic Risk Unsystematic risk is due to the influence of internal factors prevailing within an organization. Such factors are normally controllable from an organization's point of view. It is a micro in nature as it affects only a particular organization. It can be planned, so that necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk. 1. liquidity risk, 2. Business risk 3. Financial 4. Credit risk and 5. Foreign investment risk. Liquidity risk The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. In some cases, such as exempt market investments, it may not be possible to sell the investment at all. Business risk Since it emanates (originates) from the sale and purchase of securities affected by business cycles, technological changes, etc. (types of business risk, market risk, strategic risk, sales risk, management risk, budget risk, Financial risk: It arises due to change in the capital structure of the organization. The capital structure mainly comprises of three ways by which funds are sourced for the projects. These are as follows: 1. Owned funds. For e.g. share capital. 2. Borrowed funds. For e.g. loan funds. 3. Retained earnings. For e.g. reserve and surplus Credit risk The risk that the government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit rating of the bond. For example, long-term Canadian government bonds have a credit rating of AAA, which indicates the lowest possible credit risk. Foreign investment risk The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the shares of companies in emerging markets, you face risks that do not exist in Canada, for example, the risk of nationalization.

Some other risk  Reinvestment risk The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bond paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest payments at 4%. Reinvestment risk will also apply if the bond matures and you have to reinvest the principal at less than 5%. Reinvestment risk will not apply if you intend to spend the regular interest payments or the principal at maturity.

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 Horizon risk The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell at a time when the markets are down, you may lose money.  Longevity risk The risk of outliving your savings. This risk is particularly relevant for people who are retired, or are nearing retirement.

Sources of Risk in Business Investment Sources of Risk in Business Investment:- If we talk only about return on investment without talking about the risk on investment, it will not be sensible. Return on investment and business risk always move together and at any stage of your business life cycle, your return may turn into loss. So it is really important to know about all the sources of risk that may impact your business. There are certain sources of risks that make financial asset quite risky. 1. 2. 3. 4. 5. 6. 7. 8.

Interest rate Risk Market Risk Inflation Risk Business Risk Financial Risk Liquidity Risk Exchange rate Risk Country Risk

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Unit 2 Fundamental analysis Fundamental analysis attempts to understand and predict the intrinsic value of stocks based on an in-depth analysis of various economic, financial, qualitative, and quantitative factors. Fundamental Analy sis is to ev aluate a lot information about the past performance and the ex pected future performance of companie s ,industries and the e conomy as a who le before taking the investment decision. Such evaluation or analysis Is called fundamental analy sis. F A is a method used to determine the value of a stock by analysing the financial data that is fundamental to the company. In simple, that uses financial and economic analysis to predict the movement of stock price. F A typically focuses on key statistics in a company’s financial statement to determine if the stock price is correctly valued. FUNDAMENTAL ANALYAIS INCLUDE  ECONOMY ANALYSIS  INDUSTRY ANALYSIS  COMPANY ANALYSIS

ECONOMIC ANALYSIS The economic is studied to determine over all conditions are good for stock market  The performance of a company depends much on the performance of the company.  if the economy is BOOM, the industries and companies in general said to be prosperous. On the other hand,  if the economy is in RECESSION, the performance of companies will be generally poor.  Investors are interested in studying those economic varieties, which affect the performance of the company in which they proposed to invest. An analyzed of those economic variable would give an idea about future corporate earnings and the payment of dividends and interest to investors 13

Classis of macro -economic policies • Fiscal policy - Government spending , stimulates the demand for goods. • Monetary policy - Manipulation of money supply in an economy. Techniques for Economic forecasting 1. GNP 2. SAVINGS AND INVESTMENT 3. INFLATION 4. AGRICULTURE 5. RATES OF INTEREST 6. GOVT. REVENUE, EXPENDITURE & DEFICITS 7. INFRASTRUCTURE 8. MONSOON 9. POLITICAL STABILITY  GNP/ Geometric Model: GNP represents the aggregate value of goods and services produced in the economy. It reflects the overall performance of the economy. The growth rate of GNP indicates the growth rate of the economy the higher the rate of growth of GNP, the more favourable is it for the stock market and vice versa  Saving & investment: Savings and investment denote that position of GNP, which is saved and invested savings increases in India since eighties now the rate of savings is 25% from 21% in 8o's, which indicates the growth of capital market. The higher the level of savings interest, the more favourable is it for the stock marketed vice versa  Inflation: Inflation has considerate impact on the performance of companies. Higher rates of inflation upset business plan and erode purchasing power in the hands of consumers. This will result in lower demand for products. Thus high rates of inflation in an economy are likely to affect the performance of companies adversely. However industries and companies prosper during periods of low inflation. Hence an investor has to evaluate the inflation rates prevailing in the economy currently as well as the trend of inflation likely to prevail in the future.  Agriculture: Agriculture forms a major part of the Indian economy. Some companies are using agricultural raw material as inputs and some others are supplying inputs to agriculture. Such companies are directly affected by changes in agricultural production. Hence, the increase/decrease in agricultural production has a significant bearing on the industrial production and corporate performance  Rate of interest: The cost and availability of credit for companies are determined by the rates of interest prevalent in an economy. A low interest rate stimulates investment by making credit available easily and cheaply. As a result cost of finance for companies decreases which assures higher profitability. On the other hand, higher interest rates result in higher cost of production, which may lead to lower profitability and lower demand. Hence an investor has to consider the interest rates prevailing in the economy and evaluate their impact on the performance and profitability of the companies.  GOVT. REVENUE, EXPENDITURE & DEFICITS:Government is the largest investor and spender of money. So the trends in government revenue expenditure deficits have a significant impact on the performance of industries and companies. So the investor has to evaluate these carefully to assess their impact on his investments.  Infrastructure:The development of an economy very much on the availability of infrastructure. It includes electricity, roads and railways, communication channels etc. 14

The availability of infrastructural facilities affects the performance of companies. Bas infrastructure leads to inefficiencies, lower productivity, wastage and delays and vice versa. Thus an investor should assess the status of infrastructural facilities available in the economy before finalizing his investment avenues.  Monsoon: The Indian economy is essentially an agrarian economy and agriculture forms a very important sector of the Indian economy. But the performance of agriculture to a very great extent depends upon the monsoon. The adequacy of the monsoon ensures the success of the agricultural activities in India and vice versa. Hence the progress and adequacy of the monsoon becomes a matter of great concern for an investor in India.  Political Stability: A stable political environment is necessary for steady and balanced growth. No industry or company can grow and prosper in the midst of political turmoil. Such long term economic policies are needed for industrial growth. Such stable policies can be framed only by stable political systems.

Industry Analysis Industry analysis indicates to an investor whether the industry is a growth industry or not. It gives an investor a choice of the industry in which the investments should be made. Industry analysis refers to an evaluation of the relative strength and weakness of particular industries which can be divided in to three parts, viz. 1. Life cycle of an industry 2. Characteristics of an industry 3. Profit potential of an industry  Life Cycle (a) Introduced Stage: Technology and product are newly (b) Expansion stage: Those companies which reached first stage grow further and become stronger. (c) Stagnation Stage: In this stage the growth of the industries Stabilizes. Sales increases at slower rate.  Characteristics of an industry (a)Relationship between Demand & supply: Excess supply reduces the profitability of the industry and insufficient supply tends to improve the profitability. Thus an investor should estimate the demand and supply gap in an industry. (b) Period of life: Life of the industry depends on the products and the technology used by the industry. Technological changes leads to product obsolete. No investment should be made in such industries. (c) State of labour: When there is labour revolution, industries cannot become bright. (d) Governments attitude: The Government may encourage the growth and development of certain industries by giving much assistance to such industries. (e) Availability of Raw Material: An industry may depend on internal / external country for raw material. Sometimes they depend on import of raw material. (f) Cost structure: It refers to the proportion of fixed costs to variable costs. (Discuss about Marginal Cost)  Profit potential of industry (1) Threat new entrants: New .entrants inflate cost, push down the prices and reduce creDifditetilf0, 7inAvnesittunsr which is well protected from the entry of new firms would 15

(2) Competitions among existing firms: The firm competes with each other on the basis of price, quality, promotion, service, warranties and so on. If the rivalry between the firms in an industry is strong average profitability of the industry may be discouraged. The rivalry in an industry is high when the following conditions prevail in the market: (a) There is a sustained competitive battle (b) The industry growth is dull (c) The level of fixed cost is high (d) There is over capacity in the industry continuing for a long time. (e) The industry product is considered as a commodity, which stimulates strong competition. (f) The industry struggles much to withstand. (3) Pressure from substitute products: Each firm in an industry face competition from other firms in the same industry producing substitute products. Substitute products may affect the profit potential of the industry badly. The pressure from the substitute products is found to be high under the following circumstances: (a) When the price of the products is attractive. (b) When the cost for the prospective buyers to switch over to a substitute product is minimum. (c) When the substitute products are earning greater profits. (4) Bargaining power of buyers: Buyers can bargain for price reduction asks for better quality and better service. The bargaining power of a buyer group is said to be high under the following conditions: (a) If its capacity to buy is more than the capacity of the seller to sell. (b) If the cost of the switch over to a substitute product is low. (c) If it poses a threat of backward integration strongly. (5) Bargaining power of sellers: Sellers also can exert a competitive force in an industry and bargain for rise in prices, lower quality, curtail some of the free services they offer etc. Powerful suppliers can affect the profitability of the buyer industry badly. Suppliers are said to be powerful under the following circumstances. (a) Few suppliers dominate the entire market. (b) There is no viable substitute for the products supplied. (c) The switching poses a strong threat of forward integration. (d) Suppliers also pose a strong threat of forward integration. Company Analysis It involves a close investigative scrutiny of the company’s financial and non financial aspects with a view to identifying its strength, weaknesses and future business prospects. The financial and non financial aspects are as follows: Marketing share: the marketing share of the company helps to determine a company’s relative position within the industry. If the market share is high, the company would abele to mean competition successfully. Growth of annual sale: investment generally prefers a study, the growth of sale because large size of the company may be able to with stand the business cycle. The raped growth keeps the investor in better position as growth in sale this followed by growth.

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Mktg. Success The success of the market of the firm depends on (a) The share of the company in the industry (b) Growth of its sales and stability of sales (c) Sales. Competitive edge: many industries in India are composed of hundreds of individual companies. The large competition or some companies right to position of eminence and dominance. The company who have obtained leadership in position have true one ability with stand competition and sizable share in the market. Earnings: the earning of the company should also be analysed along with sales level. The income of the company is generated through operating. The investor should be well aware with the facts that the earnings of the company. Following reasons  Change in the sales  Change in the cost  Depreciation method adopted  Inventory accounting method  Wages, salary,  Income tax and other tax SWOT ANALYSIS on company

Strengths

• Poor public image

• Latest Technology • Lower delivered Cost • Established products • Committed manpower • Advantageous location • Strong finances • Well- known brand names

Opportunities

Weaknesses

• Price War • Intensive competition • Undependable component • Suppliers • Infrastructure bottlenecks • Power cuts

• Growing domestic demand • Expanding export markets • Cheap labour • Low interest rates • Booming capital markets

Threats

• Loose controls • Untrained labour force • Strained cash flows • Poor product quality • Family funds

BOND VALULATION Bond valuation is a technique for determining the theoretical fair value of a particular bond. Bond valuation includes calculating the present value of the bond's future interest payments, also known as its cash flow, and the bond's value upon maturity, also known as its face value or par value. Feature of bonds  Interest payments  A sealed agreement  Call (rates)  Specification times period Floating bonds. Types of bonds Zero coupon bonds. Govt bonds. Secured bonds. Corporate bonds. Unsecured bonds. Junk bonds. Fixed rate bonds.

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Zero coupon bonds: A zero-coupon bond is a debt security that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value. Secured bonds: A secured bond is a type of bond that is secured by the issuer's pledge of a specific asset, which is a form of collateral on the loan. In the event of a default, the bond issuer passes title of the asset onto the bondholders. Secured bonds can also be secured with a revenue stream that comes from the project that the bond issue was used to finance. Unsecured bonds: Unsecured bonds are not secured by a specific asset, but rather by "the full faith and credit" of the issuer. In other words, the investor has the issuer's promise to repay but has no claim on specific collateral Fixed rate bonds: A fixed-rate bond is a bond that pays the same amount of interest for its entire term. An investor who wants to earn a guaranteed interest rate for a specified term could purchase a fixed-rate Treasury bond, corporate bond, or municipal bond. Floating bonds: A floating-rate note, also known as a floater or FRN, is a debt instrument with a variable interest rate. A floating rate notes interest rate, since it is not fixed, is tied to a benchmark such as the U.S. Treasury bill rate, LIBOR, the Fed funds or the prime rate. Floaters are mainly issued by financial institutions and governments, and they typically have a two- to five-year term to maturity. Govt bonds: A government bond or sovereign bond is a bond issued by a national government, generally with a promise to pay periodic interest payments and to repay the face value on the maturity date Corporate bonds: A corporate bond is a bond issued by a corporation in order to raise financing for a variety of reasons such as to ongoing operations, M&A, or to expand business. The term is usually applied to longer-term debt instruments, with maturity of at least one year. Junk bonds: A junk bond is a fixed-income instrument that refers to a high-yield or noninvestment-grade bond. Junk bonds carry a credit rating of BB or lower by Standard & Poor's (S&P), or Ba or below by Moody's Investors Service. Junk bonds are so called because of their higher default risk in relation to investment-grade bonds. BOND: a long term debt instruments in which a borrowing agrees to make payments of principal and interest on specific dates to the holders of the bond Types of bonds a. Bonds with maturity b. Pure discount bonds c. Perpetual bonds Bonds with maturity; The maturity date is the date on which the principal amount of a note, draft, acceptance bond or another debt instrument becomes due and is repaid to the investor and interest payments stop. It is also the termination or due date on which an installment loan must be paid in full.

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Bond value = present value of interest of “n” numbers of year +present value of maturity after “n” number of year Pure discount bonds: A pure discount instrument is a type of security that pays no income until maturity; upon expiration, the holder receives the face value of the instrument. The instrument is originally sold for less than its face value (at a discount) and redeemed at par. Value of pure discount bond = present value of maturity perpetual bonds: A perpetual bond is a fixed income security with no maturity date. One major drawback to these types of bonds is that they are not redeemable. Valuation of preference share-capital stock with provide a specific dividend that is paid before any dividend to common stock holders & which takes presidency over common stock in the event of liquidation.\ Coupon rate or yield : A coupon rate is the yield paid by a fixed-income security; a fixedincome security's coupon rate is simply just the annual coupon payments paid by the issuer relative to the bond's face or par value. The coupon rate is the yield the bond paid on its issue date. Yield to maturity: Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield, but is expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled.

THE YIELD TO BE MATURITY IS CALUCLATE IS BASED ON CERTAIN ASSUMPTIONS  There should not be any difficult coupon & principal amount should be paid as per schedule  The investor has to hold the bond till maturity  All the coupon payments should be reinvested immediately at the same interest rate as the same yield the maturity of the bond. To find out the YTM the present value technique is adopted. Current yield: is annual interest dividend by the bonds current value it is calculated as CY= annual principal amount / current value Yield to call: Yield to call is the yield of a bond or note if you were to buy and hold the security until the call date, but this yield is valid only if the security is called prior to maturity. The calculation of yield to call is based on the coupon rate, the length of time to the call date and the market price.

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UNIT 3 TECHNICAL ANALISIS “if you know apply it , don’t know then learn and apply it” Technical analysis is a methodology that makes buy and sell decisions using market statistics. It primarily involves studying charts showing the trading history and statistics for whatever security is being analyzed.  Technical analysis attempts to use past stock price and volume information to predict future price movements.  Technical analysis can be used for short-term trading or long-term position buying. We use if for both, and the two are closely related.

Fundamental Analysis: ADVANTAGES: 1. Use of Analytical methods: The methods and approaches used in Fundamental 2. Analyses are based on sound financial data. This eliminates the room for personal bias. 2. 360 Degree Focus: Fundamental analysis also considers long term economic, demographic, and technologic and consumer trends. 3. Systematic approach for deducing the Value: The statistical and analytical tools used, help in arriving at a proper Buy/Sell recommendation. 4. Better Understanding: Rigorous accounting and financial analysis, helps to gauge better understanding of everything. DISADVANTAGES: 1. Time consuming: Carrying out Industry analysis, financial modelling and valuation, is not a cup of tea. It can get complicated and may need lot of hard work to start with. 2. Assumptions centric: Assumptions play a vital role in forecasting the financials. So it is important to consider the best and the worst case scenario. Unexpected negative economic, political or legislative changes may cause problems.

Technical Analysis: ADVANTAGES: 1. Gives insights on Volume Trend: Demand & Supply governs the trading market. Thus it tells you a lot about Traders Sentiments. You can actually judge how the overall market is working. Usually High demand push up the prices, and high supply push down the prices. 2. Tell you when to Enter and Exit: Technical analysis is able to tell you when to enter or exit from the GAME. 3. Provides Current Information: Price reflects all the known information about an asset. Prices may increase or decrease, but ultimately the current price is the balancing point for all information. 4. Patterns give you direction: You can use patterns as a guide to direct your buy and sell decisions. DISADVANTAGES: 1. Too many Indicators spoil the Charts: Too many indicators can produce confusing signals which may affect your analysis. 2. Underlying Fundamentals ignored: Technical analysis does not take into account the underlying fundamentals of a company. This can prove risky in case of long time frames. 20

The main approaches to valuing stock  Risk return analysis  Fundamental analysis  Technical analysis State the basic assumption of technical analysis o A security market value is based on supply & demand is based on both rational and irrational factors. o Security price tend to moving persistent trade o Chance in trends occurs due to shifts in supply and demand o The market value of the scrip is determined by the interaction of supply and demand. o The market discounts everything. o The market always moves in trend. o History repeats itself. It is true to the stock market also. Typical stock market cycle

BASIC PRINCIPLES OF TECHNICAL ANALYSIS o The market value of a security is related to demand and supply factors. o Trends in stock prices have been seen to change when there is shift in the demand and supply factor. o Market price are determined by the interaction of supply and demand forces o Supply and demand are influence by various of factors both rational and irrational. o Shift in demand and supply bring about changes in trade. o Shift in demand and supply detected which help of charts of market action o Analyses of past market data can be used to predict the future price behaviour.

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The Dow Theory Originated by Charles Dow ... founder of the Dow Jones Company and editor of wall street journal Dow Theory presumes market moves in persistent ball and bear trends –often used for market as a whole, but uses for individual security also. Types of movements defined by Dow Theory. -primary trends (bull or bear market) -secondary trends (correction) *market collapse or upward surges lasting a few weeks or months. -tertiary means (little daily fluctuations) *meaningless random wiggles but should be studies to determine if relate to a primary trend. DOW THEORY Originated By Charles Dow. According To Dow "Market Is Considered As Having 3 Movements” ♦ Day To Day ♦ Two Weeks To A Few Month ♦ Main Movement Covering The Last 4 Years. Dow Theory Trends (1) ■ Primary Trend:

Called "the tide" by Dow, this is the trend that defines the long-term direction (up to several years). Others have called this a "secular" bull or bear market.

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■ Secondary Trend:

Called "the waves" by Dow, this is shorter-term departures from the primary trend (weeks to months) ■ Day to day fluctuations: Not significant in Dow Theory. Day to day fluctuations in the market Not significant and have to analytical value Very short duration

Trend  Trend is the direction of movement  Share price can either, increase, decrease or remain in flat  The three directions or types

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Share price do not rise or fall in a straight line Every rise or fall in price experience a counter Share price move in a zigzag manner Trend line Straight line draws connecting either the top or bottom of the price movement. To draw a trend line the technical analysis should have at least two tops or bottoms When the trend line begins to rise the technical analysis would recommend purchase of the share When the trend the investor should say a way from the movement The rising trend line will track an upward movement in the price of scrip and is formed by connecting the upwardly moving bottoms in a chart. The falling trend line represents a downward movement in the scrip price and is formed by connecting the falling tops as depicted by way of a price chart. In case of prices moving in a narrow band or remaining flat, the trend line is formed by connecting the even tops as well as even bottoms of the price of a scrip. Each of these market behaviour scenarios may be depicted by way of the following figures:

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Indicators Indicators represent a statistical approach to technical analysis as opposed to a subjective approach. By looking at money flow, trends, volatility, and momentum, they provide a secondary measure to actual price movements and help traders confirm the quality of chart patterns or form their own buy or sell signals. There are two primary types of indicators: 1. Leading Indicators. Leading indicators precede price movements and try to predict the future. These indicators are most helpful during periods of sideways or nontrending price movements since they can help identify breakouts or breakdowns. 2. Lagging Indicators. Lagging indicators follow price movements and act as a confirmation tool. These indicators are most useful during trending periods where they can be used to confirm that a trend is still in placing or if it’s weakening. Indicators can be further divided into two categories based on how they’re built: 1. Oscillator. Oscillators are the most common type of technical indicator and are generally bound within a range. For example, an oscillator may have a low of 0 and a high of 100 where zero represents oversold conditions and 100 represents overbought conditions. 2. Non-bounded. Non-bounded indicators are less common, but still help form buy and sell signals as well as show strength or weakness in trends. However, they accomplish this in many ways without the use of a set range. Indicators generate buy and sell signals through crossovers or divergence. Crossovers are the most popular technique whereby the price moves through a moving average or when two moving averages crossover. Divergence occurs when the direction of a price trend and the direction of an indicator are moving in opposite directions, which tends to suggest that the direction of the price trend is weakening. Indicators can be extremely helpful in identifying momentum, trends, volatility, and other aspects of a security. But, it’s important to note that indicators work best when combined with other forms of technical analysis to maximize the odds of success.

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Odd Lot Trading Shares are generally sold in a lot of hundreds • Shares are sold in smaller lots fewer than 100 are called odd lot. • Buyers & sellers of odd lots are called odd letters. • Odd lot purchases to odd lot sales ( purchase %) is the odd lot index. ( Odd lot purchases divided by odd lot sales) • Increases the odd lot purchases results in an increase in the index.(selling leads to fall the index) Chart: Charts are simply graphical representations of a series of prices over time. For example, a chart might show a stock’s price movement over a one-year period where each point represents an individual day’s closing price. Charts are the most fundamental tool for technical analysts, similar to financial statements for fundamental analysts. Types of charts • Line Chart

• Bar Charts

• Candlestick Charts

Line Chart • The most basic of the four charts — because it represents only the closing prices over a set period of time. • The line is foamed by connecting the closing prices over the time frame. • Do not provide visual information of the trading range for the individual points such as the high, low and opening prices. • The closing price is often considered to be the most important price in stock data compared to the high and low for the day and this is why it is the only value used in line charts. k,Asst Line charts are the most basic type of chart because it represents only the closing prices over a set period. The line is formed by connecting the closing prices for each period over the timeframe. While this type of chart doesn’t provide much insight into intraday price movements, many investors consider the closing price to be more important than the open, high, or low price within a given period.

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Bar Charts • The chart is made up of a series of vertical lines that represent each data point. This vertical line represents the high and low for the trading period, along with the closing price. • The close and open are represented on the vertical line by a horizontal dash. • The opening price on a bar chart is illustrated by the dash that is located on the left side of the vertical bar. • Conversely, the close is represented by the dash on the right. Generally, if the left dash (open) is lower than the right dash (close) then the bar will be shaded black, representing an up period for the stock, which means it has gained value. • A bar that is colored red signals that the stock has gone down in value over that period. When this is the case, the dash on the right (close) is lower than the dash on the left (open). Bar charts expand upon the line chart by adding the open, high, low, and close – or the daily price range, in other words – to the mix. The chart is made up of a series of vertical lines that represent the price range for a given period with a horizontal dash on each side that represents the open and closing prices. The opening price is the horizontal dash on the left side of the horizontal line and the closing price is located on the right side of the line. If the opening price is lower than the closing price, the line is often shaded black to represent a rising period.

Candlestick Charts • Similar to a bar chart, but it differs in the way that it is visually constructal. • The difference comes in the formation of a wide bar on the vertical line, which illustrates the difference between the open and close. And, like bar charts, candlesticks also rely heavily on the use of colors to explain what has happened during the trading period. • There are two color constructs for days up and one for days that the price falls. • When the price of the stock is up and closes above the opening trade, the candlestick will usually be white or clear. • If the stock has traded down for the period, then the candlestick will usually be red or black, depending on the site. If the stock's price has closed above the previous day's close but below the day's open, the candlestick will be black or filled with the color that is used to indicate an up day

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Candlestick charts originated in Japan over 300 years ago, but have since become extremely popular among traders and investors. Like a bar chart, candlestick charts have a thin vertical line showing the price range for a given period that’s shaded different colors based on whether the stock ended higher or lower. The difference is a wider bar or rectangle that represents the difference between the opening and closing prices.

Moving average rate of change Rate of change • Measures the percent change in price from one period to the next • Compares the current price with the price "n" periods ago • Moves from positive to negative • ROC signals include centre line crossovers, divergences and overbought-oversold readings ROC (Rate of Change Indicator) • ROC measures the rate of change of the current price as compared to the price a certain number of days or weeks back. • ROC = Current price /price 'n' period ago -1

Technical indicators What is a 'Technical Indicator' Technical indicators are mathematical calculations based on the price, volume, or open interest of a security or contract. By analyzing historical data, technical analysts use indicators to predict future price movements. Examples of common technical indicators include Relative Strength Index, Money Flow Index, Stochastic, MACD and Bollinger Bands®. Technical indicators, also known as "technical’s", are focused on historical trading data, such as price, volume, and open interest, rather than the fundamentals of a business, 28

like earnings, revenue, or profit margins. Technical indicators are commonly used by active traders, since they're designed to analyze short-term price movements, but long-term investors may also use technical indicators to identify entry and exit points. There are two basic types of technical indicators: 1. Overlays - Technical indicators that use the same scale as prices are plotted over the top of the prices on a stock chart. Examples include moving averages and Bollinger Bands®. 2. Oscillators - Technical indicators that oscillate between a local minimum and maximum are plotted above or below a price chart. Examples include the MACD or RSI. Traders often use many different technical indicators when analyzing a security. With thousands of different options, traders must choose the indicators that work best for them and familiarize themselves with how they work. Traders may also combine technical indicators with more subjective forms of technical analysis, such as looking at chart patterns, to come up with trade ideas. Technical indicators can also be incorporated into automated trading systems given their quantitative nature. Charting Techniques Aspen offers the following charting techniques:      

Bar charting Candlestick charting Continuation charts Equal Tick charts Multiple Instrument charts Point & Figure charting

Bar Charts By default, Aspen charts display bars. A bar is a line representing the trading range, with a hash mark on either side representing the open and last (or close):

Traditionally, bars are created temporally--that is, the time base of the chart controls bar formation. In a fifteen minute chart, the trading day is sliced into fifteen minute periods, and the ticks that occur in a given fifteen minute period form the bar for that period. When the fifteen minute period ends, a new bar begins. Candlestick Charting Candlestick charts are an ancient Japanese price prediction methodology. Candlesticks date back to the 1700's, when they were used for analyzing rice markets. At that time, Munehisa Homma, a legendary rice trader, gained a huge fortune using candlestick analysis and established candlestick popularity. 29

Aspen supports candlestick charting. Candles offer an alternate perspective on market data. Up Day

Down Day

The body of the candlestick is called the real body and represents the range between the open and closing prices. A "black," or filled-in, body represents that the close during that time period was lower than the open. When the body is "white," or hollow, the close is higher than the open. The thin vertical line above and/or below the real body is called the upper/lower shadow, representing the high/low price extremes for the period. Candlestick charting involves formation identification. Point & Figure If you are new to Point & Figure charting and are familiar with bar or candlestick charting, point and figure may appear strange at first. There is no time scale, just columns of Xs and Os. Point & Figure came into popularity long before computers, when all charting was done by hand. As a kind of short hand charting technique, Point & Figure made it possible to update charts on 50 or more instruments in less than an hour. In Point & Figure charting, Xs represent upward movement and Os represent downward movement. With a set box size and reversal amount (traditionally 1 and 3, respectively), Point & Figure asks two questions, depending on current market direction: X (Up Trend) 1. Is today's high higher by at least one box size?

O (Down Trend) 1. Is today's low lower by at least one box size?

2. Is today's low lower than the difference of the current high less the reversal amount?

2. Is today’s high higher than the sum of the current low plus the reversal amount?

On any day, one of three things can happen. If the answer to both questions is "no," no action is taken. If the answer to question one is "yes", the current plot is continued. If answer to question two is "yes", reversal occurs. By removing the time scale, Point & Figure charts remove the noise of insignificant price movement, and support and resistance levels become very apparent.

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Equal Tick Charts The easiest way to understand Equal Tick charts is to compare them to traditional bars. A traditional bar is based in time--that is, a fifteen minute chart slices the trading day into fifteen minute periods, and ticks that fall within a particular fifteen minute period contribute to the formation of the respective bar. By contrast, an Equal Tick bar consists of a fixed number of ticks (regardless of the time they occur). For example, a fifteen tick Equal Tick bar consists of fifteen ticks, and after every fifteen ticks, a new bar is created. (The final bar of the day may consist of one to fifteen ticks.) Naturally, sparsely traded instruments render different time scales than heavily traded instruments, but in either case, a time scale is present. To display an Equal Tick chart, follow these steps: 1. Right click on the chart and choose Properties... 2. Click the Scale tab. 3. In the Horizontal Scale group, open the Width combo box and choose Equal Tick. 4. In the Horizontal Scale group, set the Ticks field to the number of ticks you want in a bar. Continuation Charts Futures, by definition, have a limited life. They start trading and expire on a regular basis. The unfortunate result of this reality is that long term technical analysis on a given futures contract is not possible. Continuation charts solve this problem by chaining futures contracts together. Continuation charts chain futures contracts according to the criteria you set. Aspen provides two continuation methods. You can define the chaining behaviour of both methods by rightclicking on a chart and choosing Properties... Click the Continuations tab and modify either one or both of the continuation methods. Multiple Instrument Charts Have you ever tried to diversify a securities portfolio and wondered whether two securities trade together? Use a multiple instrument chart to make this judgment. The quickest way to create a multiple instrument chart is to click the Add Instrument icon in the tool bar. Then type the instrument you want to add and press Enter. The price scale is a major consideration in multiple instrument plotting. If one instrument trades at 90 and the other at 10, you will see bars drawn along the top and bottom of the chart. This is the normal behaviour of linear scaling (which is the default scale of charts). In such cases, you may want to resort to percent change or logarithmic scaling. To change the chart scale, follow these steps: 1. Right click on the chart and choose Properties... 2. Select the scaling you want from the Vertical Scale group.

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Efficient market hypothesis • Hypothesis states that the capital market is efficient in processing information. • Efficient capital market is one in which security prices equal their intrinsic value at all time, and where most securities are correctly priced. • According to Elton and Gruber," when some one refers to efficient capital markets, they mean that securities prices fully reflect all available information" Assumption Efficient market hypothesis • Information is free and quick to flow • All investors have the same access to information. • Every investor has access to lending and borrowing at the same rate. • Market absorbs the information quickly and the market responds to new technology, new trends change the tastes, etc efficiently and quickly. • Investors are rational and behave in a cost effective competitive manner for optimization of returns

Forms of market efficiency • There are three forms of the efficient market hypothesis • The "Weak" form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use. • The "Semi strong" form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use. • The "Strong" form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use. Random walk theory • Random walk theory states that market price evolve at random and do not follow any regular pattern. • According to this theory future stock price are completely independent of past stock prices. 32

• The Random Walk Hypothesis is a financial theory stating that stock market prices evolve according to a random walk and than the prices of the stock market cannot be predicted by analyzing the past stock prices. Random walk theory • Basic assumption of technical analyst is that price trends occur in an orderly manner & not random. • Random walk theory gained popularity in 1973 when Burton Malkiel wrote "A Random Walk Down Wall Street", a book that is now regarded as an investment classic. • Theory that states that the past movement or direction of the price of a stock or overall market cannot be used to predict its future movement. Assumption of Random walk theory ➢ Market is supreme and no investor or group can influence it. ➢ Stock price discount all information quickly. ➢ Markets are efficient and that the flow of information is free and unbiased. ➢ All investors have free access to the same information and nobody has superior knowledge or expertise. ➢ Market quickly adjusts itself to any deviations from equilibrium level due to the operations of free forces of demand and supply. ➢ Nobody has better knowledge or insider information. What is an 'Inefficient Market' An inefficient market, according to efficient market theory, is one in which an asset's market prices do not always accurately reflect its true value. Efficient market theory, or more accurately, the efficient market hypothesis (EMH) holds that in an efficient market, asset prices accurately reflect the asset's true value. In an efficient stock market, for example, all publicly available information about the stock is fully reflected in its price. In an inefficient market, in contrast, all the publicly available information is not reflected in the price, suggesting that bargains are available. The EMH takes three forms: weak, semi-strong, and strong. The weak form asserts that an efficient market reflects all historical publicly available information about the stock, including past returns. The sem-strong form asserts that an efficient market reflects historical as well as current publicly available information. And, according to the strong form, an efficient market reflects all current and historical publicly available information as well as non-public information. Implications of Efficient Markets EMH and Technical Analysis Technical analysis bases decisions on past results. EMH, however, believes past results cannot be used to outperform the market. As a result, EMH negates the use of technical analysis as a means to generate investment returns. With respect to fundamental analysis, the EMH also states that all publicly available information is reflected in security prices and as such, abnormal returns are not achievable through the use of this information. This negates the use of fundamental analysis as a means to generate investment returns 33

EMH and the Portfolio Management Process As we have discussed, the portfolio management process begins with an investment policy statement, including an investor's objectives and constraints. Given EMH, the portfolio management process should thus, not focus on achieving above-average returns for the investor. The portfolio management process should focus purely on risks given that above average returns are not achievable. A portfolio manager's goal is to outperform a specific benchmark with specific investment ideas. The EMH implies that this goal is unachievable. A portfolio manager should not be able to achieve above average returns. Why Invest in Index Funds? Given the discussion on the EMH, the overall assumption is that no investor is able to generate an abnormal return in the market. If that is the case, an investor can expect to make a return equal to the market return. An investor should thus focus on the minimizing his costs to invest. To achieve a market rate of return, diversification in a numerous amounts of stocks is required, which may not be an option for a smaller investor. As such, an index fund would be the most appropriate investment vehicle, allowing the investor to achieve the market rate of return in a cost effective manner. Conclusion Within this section we have discussed the organization and function of securities markets, the composition and characteristics of the various weighting schemes, and the various implications of the efficient market hypothesis.

Fundamental analysis v/s technical analysis Investors use techniques of fundamental analysis or technical analysis (or often both) to make stock trading decisions. Fundamental analysis attempts to calculate the intrinsic value of a stock using data such as revenue, expenses, growth prospects and the competitive landscape, while technical analysis uses past market activity and stock price trends to predict activity in the future. Fundamental Analysis versus Technical Analysis comparison chart Basic Fundamental Analysis Technical Analysis Calculates stock value using Uses price movement & patterns & Definition various economic factors, charts of security to predict future known as fundamentals. price movements Financial statements, economic Charts analysis. Data gathered report, events, industry from statistics. When price falls below(about) When trader sees a price formulation Stock bought intrinsic value that has a high probably of moving (assets ) into profit in near future or believes they can sell it on for a higher price Long-term approach Short-term approach Time horizon Investing Trade Function 34

Concepts used Types of trader

Return on Equity (ROE) and Return on Assets (ROA) Long-term position trader

Dow Theory, Price Data Generally selling trader & short term day trader looks backward

Data

looks backward as well as forward Financial statement

charts

Time

Long term

Short term

Goal

Investing

Trading

Focus

Quantitative and qualitative factors

Price and value

Vision

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Unit 4 Portfolio management Meaning What is a 'Portfolio' A portfolio is a grouping of financial assets such as stocks, bonds, commodities, currencies and cash equivalents, as well as their fund counterparts, including mutual, exchange-traded and closed funds. A portfolio can also consist of non publicly tradable securities, like real estate, art, and private investments. Portfolio refers to investment in a group of security rather to invest in signal security. “Don’t put all your eggs in one basket portfolio help in reducing risk without sacrificing return” Portfolio Management • Portfolio Management is the process of creation and maintenance of investment portfolio. • Portfolio management is a complex process which tries to make investment activity more rewarding and less risky. Major tasks involved with Portfolio Management 1. Taking decisions about investment mix and policy 2. Matching investments to objectives 3. Asset allocation for individuals and institution 4. Balancing risk against performance Types of Portfolio Management There are majorly four types of portfolio management methods: 1. Discretionary portfolio management: In this form, the individual authorizes the portfolio manager to take care of his financial needs on his behalf. 2. Non discretionary portfolio management: Here the portfolio manager can merely advise the client what is good or bad, correct / incorrect for him, but the client reserves the full right to take his own decisions. 3. Passive portfolio management: It is the form which involves only tracking the index. 4. Active portfolio management: This includes a team of members who take active decisions based on hard core research before investing the corpus into any investment avenue. (e.g. close ended funds). Objectives of Portfolio Management  

It is aptly put as the customization of the investment needs catered by the portfolio managers as per the defined requirements. Portfolio management helps in providing the best options for investments to individuals as per the defined criterions of their income, budget, age, holding period and risk taking capacity.

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

  

This is mainly done by the Portfolio managers who understand the investors’ financial needs and accordingly suggest the investment policy that would have maximum returns with minimum risks involved. Aptly put, it is risk reduction through diversification. This is the method preferred by those who believe in having liquidity in investments so that one can get the money back when needed. Some of the portfolio management schemes are also done for tax saving purposes. It helps the investors maintain the purchasing power

Need for Portfolio Management  Portfolio management presents the best investment plan to the individuals as per their income, budget, age and ability to undertake risks.  Portfolio management minimizes the risks involved in investing and also increases the chance of making profits.  Portfolio managers understand the client’s financial needs & suggest the best & unique investment policy for them with minimum risk involved.  Portfolio management enables the portfolio managers to provide customized investment solutions to clients as per their needs and requirements. Phases of Portfolio Management Portfolio management is a process of many activities that aimed to optimizing the investment. Five phases can be identified in the process: i. Security Analysis. 2. Portfolio Analysis. 3. Portfolio Selection. 4. Portfolio revision. 5. Portfolio evaluation. Each phase is essential and the success of each phase is depending on the efficiency in carrying pit out each phase. Security Analysis ► Security analysis is the initial phase of the portfolio management process. ► The basic approach for investing in securities is to sell the overpriced securities and purchase under priced securities ► The security analysis comprises of Fundamental Analysis and technical Analysis. Portfolio Analysis A large number of portfolios can be created by using the securities from desired set of securities obtained from initial phase of security analysis. . It involves the mathematically calculation of return and risk of each portfolio. Portfolio Selection The portfolios that yield good returns at a level of risk are called as efficient portfolios. The set of efficient portfolios is formed and from this set of efficient portfolios, the optimal portfolio is chosen for investment. Portfolio Revision Due to dynamic changes in the economy and financial markets, the attractive securities may cease to provide profitable returns. 37

Portfolio Evaluation This phase involves the regular analysis and assessment of portfolio performances in terms of risk and returns over a period of time. Process of Portfolio Management 1. Security Analysis: It is the first stage of portfolio creation process, which involves assessing the risk and return factors of individual securities, along with their correlation. 2. Portfolio Analysis: After determining the securities for investment and the risk involved, a number of portfolios can be created out of them, which are called as feasible portfolios. 3. Portfolio Selection: Out of all the feasible portfolios, the optimal portfolio, that matches the risk appetite, is selected. 4. Portfolio Revision: Once the optimal portfolio is selected, the portfolio manager keeps a close watch on the portfolio, to make sure that it remains optimal in the coming time, in order to earn good returns. 5. Portfolio Evaluation: In this phase, the performance of the portfolio is assessed over the stipulated period, concerning the quantitative measurement of the return obtained and risk involved in the portfolio, for the whole term of the investment.

Portfolio analysis TYPES OF PORTFOLIO ANALYSIS Portfolio level analysis is an important part of managing a derivatives portfolio. The common types of portfolio analysis are Total Value, Aggregated Cash Flows, Risk Sensitivity, Stress testing, and Value-at-Risk.  Total Value: Total Value is one of the simplest types of portfolio aggregation. Using this analysis, calculating the value of the portfolio simply requires iterating through the positions within the portfolio, valuing each one, and summing them. In other words the value of the portfolio, f(P), equals the sum of the individual trades, f(Ti). However, if f(Ti) represents the result of a particular analysis applied to an individual trade, then it is not usually true that the result for the portfolio, f(P), equals the sum of f(Ti).  Aggregated cash flows: The future cash flows for a portfolio sorted in chronological order are sometimes required. This aggregation is not difficult if the cash flows for each trade are available; it involves marshalling the data and applying a sort algorithm. Both total value and aggregated cash flow are relatively simple analyses and do not require sophisticated calculations at the portfolio level, as long as they are carried out at the trade level. But in other types of analysis, the aggregations are not so simple, and most require information about the risk factors that are shared by multiple positions within the portfolio.  Risk Sensitivity: This analysis is the rate of change of the value of the portfolio with respect to the market data. Being able to calculate this first order sensitivity is a vital component of any risk system. For example it can be used to calculate DV01 which is the sensitivity of the portfolio value to a small shift in interest rates - a parallel shift of the whole yield curve. It can also be used to calculate hedge factors which are the positions in liquid vanilla instruments that would be required to add to the portfolio to provide an instantaneous hedge of all market and credit risk. 38

 Stress Testing: This analysis involves revaluing the portfolio under a number of different scenarios for the market data to quantify the exposure to more extreme market movements than are captured using first order risk sensitivity.  Credit Value Adjustment and Potential Future Exposure: These are calculations performed on a set of trades with the same counterparty - CVA is an adjustment to the value of a portfolio to reflect the credit risk of the counterparty; PFE is a calculation of the maximum possible loss that would be realised if the counterparty were to default, for a given confidence level, such as 95%.  Value at Risk (VaR): This is the maximum possible loss over a given time horizon that is suffered as a result of market fluctuations again for a given confidence level. It is a measure of market risk whereas PFE is a measure of counterparty credit risk.  Security Selection: Security selection is the process of choosing specific securities within a given asset class that meet our screening qualifications.

Expected return is calculated as the weighted average of the likely profits of the assets in the portfolio, weighted by the likely profits of each asset class. Expected return is calculated by using the following formula:

Written another way, the same formula is as follows: E(R) = w1R1 + w2Rq + ...+ wnR

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Variance Variance (σ2) is a measure of the dispersion of a set of data points around their mean value. In other words, variance is a mathematical expectation of the average squared deviations from the mean. It is computed by finding the probability-weighted average of squared deviations from the expected value. Variance measures the variability from an average (volatility). Volatility is a measure of risk, so this statistic can help determine the risk an investor might take on when purchasing a specific security. Portfolio Variance Now that we've gone over a simple example of how to calculate variance, let's look at portfolio variance. The variance of a portfolio's return is a function of the variance of the component assets as well as the covariance between each of them. Covariance is a measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns move together. A negative covariance means returns move inversely. Covariance is closely related to "correlation," wherein the difference between the two is that the latter factors in the standard deviation. Modern portfolio theory says that portfolio variance can be reduced by choosing asset classes with a low or negative covariance, such as stocks and bonds. This type of diversification is used to reduce risk. Portfolio variance looks at the covariance or correlation coefficient for the securities in the portfolio.

Standard Deviation Standard deviation can be defined in two ways: 1. A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance. 2. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment's volatility. Standard deviation is also known as historical volatility and is used by investors as a gauge for the amount of expected volatility. Standard deviation is a statistical measurement that sheds light on historical volatility. For example, a volatile stock will have a high standard deviation while a stable blue chip stock will have a lower standard deviation. A large dispersion tells us how much the fund's return is deviating from the expected normal returns.

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Evolution of Modern Portfolio Theory • Efficient Frontier • Single Index Model • Capital Asset Pricing Model (CAPM) • Arbitrage Pricing Theory (APT) Evolution of modern portfolio theory Efficient frontier • Markowitz, H. M., "Portfolio Selection," Journal of Finance (December 1952). Rather than choose each security individually, choose portfolios that maximize return for given levels of risk (i.e., those that lie on the efficient frontier). Problem: When managing large numbers of securities, the number of statistical inputs required using the model is tremendous. The correlation or covariance between every pair of securities must be evaluated in order to estimate portfolio risk. Markowitz's Contribution • Harry Markowitz's "Portfolio Selection" Journal of Finance article (1952) set the stage for modern portfolio theory • The first major publication indicating the important of security return correlation in the construction of stock portfolios • Markowitz showed that for a given level of expected return and fora given security universe, knowledge of the covariance and correlation matrices are required Harry Markowitz Mode •Harry Max Markowitz (born August 24, 1927) is an American economist. •He is best known for his pioneering work in Modern Portfolio Theory. •Harry Markowitz put forward this model in 1952. • Studied the effects of asset risk, return, correlation and diversification on probable investment portfolio returns Essence of Markowitz Model

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Harry Markowitz   

An investor has a certain amount of capital he wants to invest over a single time horizon. He can choose between different investment instruments, like stocks, bonds, options, currency, or portfolio. The investment decision depends on the future risk and return. The decision also depends on if he or she wants to either maximize the yield or minimize the risk

Essence of Markowitz Model Markowitz model assists in the selection of the most efficient by analysing various possible portfolios of the given securities. 2. By choosing securities that do not 'move exactly together, the HM model shows investors how to reduce their risk. 3. The HM model is also called Mean-Variance Model due to the fact that it is based on expected returns (mean) and the standard deviation (variance) of the various portfolios. Diversification and Portfolio Risk

Assumptions     

An investor has a certain amount of capital he wants to invest over a single time horizon. He can choose between different investment instruments, like stocks, bonds, options, currency, or portfolio. The investment decision depends on the future risk and return. The decision also depends on if he or she wants to either maximize the yield or minimize the risk. The investor is only willing to accept a higher risk if he or she gets a higher expected return.

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Efficient Frontier  Construct a risk/return plot of all possible portfolios  Those portfolios that are not dominated constitute the efficient frontier

Efficient Frontier • When a risk-free investment is available, the shape of the efficient frontier changes • The expected return and variance of a risk-free rate/stock return combination are simply a weighted average of the two expected returns and variance • The risk-free rate has a variance of zero

Efficient Frontier  

The efficient frontier with a risk-free rate: Extends from the risk-free rate to point B The line is tangent to the risky securities efficient frontier Follows the curve from point B to point C

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Morkowitz portfolio selection There is no signal portfolio that is best for everyone The left cycle – different consumption preference Time horizons – deferent term preference Risk tolerance – different risk aversion Limited variety of portfolio – limited “ finished product “ in market Single Index Model • Sharpe, W. F., "A Simplified Model of Portfolio Analysis," Management Science (January 1963). • Substantially reduced the number of required inputs when estimating portfolio risk. Instead of estimating the correlation between every pair of securities, simply correlate each security with an index of all of the securities included in the analysis SHARPE'S SINGLE INDEX MODEL The return on securities should be related to a single market index. A popular average can however, be a surrogate for the market index. This method was conceptually very sound and theoretically very elegant, but it had serious practical limitation involved due to complexities involved in compiling the expected returns, standard deviation, variance, covariance of each security to every other security in the portfolio. RELATED TO SINGLE MARKET INDEX It will have the following implication 1. The market Index would consist of all the securities traded on the market. 2. Single market index will reduce and simplify the work involved in compiling elaborate matrices of variances as between individual securities. CHARACTERISTIC LINE A characteristic line expresses the relationship between on individual securities and returns on the market portfolio. The equation of the characteristic line is Ri - Rf = a + Bim (Rm - Rf) +Yi where Ri = Holding period return on Security Rf = Riskless rate of interest Excess Return on the Market Portfolio is = Ri - Rf a = Vertical intercept 44

Bim = Beta which indicates the slop Beta    

A "coefficient measuring a stock's relative volatility" Beta measures a stock's sensitivity to overall market movements In practice, Beta is measured by comparing changes in a stock price to changes in the value of the S&P 500 index over a given time period The S&P 50o index has a beta of

Beta and Risk Beta is a measure of volatility Volatility is associated with risk CAPM {CAPITAL ASSET PRICING MODEL}  The CAPM was developed in the mid 1960 The model has generally been attribute to williom sharpe but john lintner & jan massinalo CAPM is an framework for determining the equilibrium expected return for risky assets. • Relationship between expected return and systematic risk of individual assets or securities or portfolios. • William F Sharpe developed the CAPM. He emphasized that risk factor in portfolio theory is a combination of two risk , systematic and unsystematic risk. Uses 1. Used in through finance for the pricing of risky securities. 2. Generating expected return for assets as risk to those assets 3. Calculating cost of capital: Cost of capital refers to the opportunity cost marketing specific investment. It is the rate of return that could have for earned by putting the same money into a different investment with equal risk. Here is the formula:

Elements of CAPM 1. Capital Market Line — risk return relationship for efficient portfolios. 2. Security Market Line — Graphic depiction (representation) of CAPM and market price of risk in capital markets.  Systematic Risk  Unsystematic Risk 45

3. Risk Return Relationship 4. Risk Free Rate 5. Risk Premium on market portfolios 6. Beta - beta - Measure the risk of an individual asset value to market portfolio. AssetsA). Defensive Assets and B). Aggressive Assets.

• Systematic risk... — It cannot be eliminated through diversification — It can be measured in relation to the risk of a diversified portfolio or the market. — According to CAPM, the Non-Diversifiable risk of an investment or security or asset is assessed in terms of the beta co-efficient. • Unsystematic or Diversifiable Risk — Is that portion of the total risk of an investment that can be eliminated or minimized through diversification? — Eg. Management Capabilities and decisions, Strikes, unique government regulations, availability of raw materials, competition, etc. Assumption of CAPM 1. The investor aims at maximizing the wealth rather than wealth or return 2. Investors have similar risk and return. 3. Investors make investment in ratio basis depending on their asset of risk and return 4. Investors will have free access to all available information at no cost and no loss of time 5. Investors should have identical time horizons which again is highly unrealistic 6. Others o Aim to maximize economic utilities (Asset quantities are given and fixed). o Are rational and risk-averse. o Are broadly diversified across a range of investments. o Are price takers, i.e., they cannot influence prices. o Can lend and borrow unlimited amounts under the risk free rate of interest. o Trade without transaction or taxation costs. o Deal with securities that are all highly divisible into small parcels (All assets are perfectly divisible and liquid). o Have homogeneous expectations. o Assume all information is available at the same time to all investors.

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UN IT 5 Capitol asset pricing model (CAPM) Capital marketing line CML It is a theoretical concept that represents all the portfolios that optimally combine the risk-free rate of return and the market portfolio of risky assets. Under CAPM, all investors will choose a position on the capital market line, in equilibrium, by borrowing or lending at the risk-free rate, since this maximizes return for a given level of risk.

The Capital Market Line Equation The return on portfolio p, where RT and σT are tangency portfolio T’s return and standard deviation, is the risk-free rate of return plus the trade-off between risk and return, (RT- rf)/σT also known as the Sharpe ratio - multiplied by the standard deviation of portfolio

p.

Security market line (SML) The security market line (SML) is a line drawn on a chart that serves as a graphical representation of the capital asset pricing model (CAPM), which shows different levels of systematic, or market, risk of various marketable securities plotted against the expected return of the entire market at a given point in time. Also known as the "characteristic line," The formula for plotting the security market line is as follows: Required Return = Risk Free Rate of Return + Beta (Market Return - Risk Free Rate of Return)

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Different b/w the CML and SML SML

CML CML stands for Capital Market Line, The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels of risk for a specific portfolio. It is how the risk factors are measured. While standard deviation is the measure of risk for CML, The CML measures the risk through standard deviation, or through a total risk factor. While the Capital Market Line graphs define efficient portfolios, The expected return of the portfolio for CML is shown along the Y- axis. The standard deviation of the portfolio is shown along the X-axis for CML, Where the market portfolio and risk free assets are determined by the CML, Unlike the Capital Market Line, The CML determines the risk or return for efficient portfolios

SML stands for Security Market Line. SML, which is also called a Characteristic Line, is a graphical representation of the market’s risk and return at a given time. Beta coefficient determines the risk factors of the SML. The SML measures the risk through beta, which helps to find the security’s risk contribution for the portfolio. The Security Market Line graphs define both efficient and non-efficient portfolios. While calculating the returns. SML, the return of the securities is shown along the Y-axis. whereas, the Beta of security is shown along the X-axis for SML. all security factors are determined by the SML. the Security Market Line shows the expected returns of individual assets. , and the SML demonstrates the risk or return for individual stocks. SML, which is also called a Characteristic Line, is a graphical representation of the market’s risk and return at a given time. Beta coefficient determines the risk factors of the SML. the Security Market Line graphs define

The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels of risk for a specific portfolio. 48

While standard deviation is the measure of risk in CML, While the Capital Market Line graphs define efficient portfolios Where the market portfolio and risk free assets are determined by the CML

both efficient and non-efficient portfolios. all security factors are determined by the SML.

The Efficient Frontier with Risk-Free Lending and Borrowing In the previous discussion of portfolios of risky assets, the availability of a risk-free asset has been ignored. The introduction of a risk-free asset into the portfolio possibility set considerably simplifies the analysis. Assuming that an investor is interested in placing part of his funds in some portfolio A and either lending or borrowing, we can define

the expected return on the combined risk-free asset and risky portfolio as

The risk on the combination is

Since the return on the risk-free asset is known with certainty, the standard deviation of the risk-free asset must be zero. The above simplifies to

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Solving for X yields

Substituting this expression for X into the expression for expected return on the combination provides

Upon rearranging the terms

Thus all combinations of risk-free lending or borrowing with portfolio A lie on a straight line in expected return standard deviation space. The intercept of the line is RF and the slope is . Therefore, the existence of a risk-free lending and borrowing rate implies that there is a single portfolio of risky assets that is preferred to all other portfolios. Furthermore, in return standard deviation space, this portfolio plots on the ray connecting the risk-free asset and a risky portfolio that lies furthest in the direction. In figure 3.6, for example, the portfolios on the ray RF - B are preferred to both those on the ray RF - A, and all other portfolios of risky assets. The efficient frontier is the entire length of the ray extending through RF - B, with different points along the ray RF- B representing different amounts of borrowing and/or lending in combination with the optimum portfolio - B - of risky assets.

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Investors can lend at the risk-free rate by buying government bonds. However, they will probably pay a higher borrowing rate. Figure 3.7 plots the efficient frontier with different borrowing and lending rates. As shown, there are a small range of risky portfolios that investors may opt to hold. If RF and RB are close, the assumption of risk-free lending and borrowing at the same rate may provide a good approximation of the optimal range of risky portfolios that investors could hold. FACTOR MODELS Arbitrage pricing theory (APT) Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an asset's returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk. It is a useful tool for analyzing portfolios from a value investing perspective, in order to identify securities that may be temporarily mispriced. Mathematical Model of the APT While APT is more flexible than the CAPM, it is more complex. The CAPM only takes into account one factor — market risk — while the APT formula has multiple factors. And it takes a considerable amount of research to determine how sensitive a security is to various macroeconomic risks. Which factors, and how many of them are used, are subjective choices – which means investors will have varying results depending on their choice. However, four or five factors will usually explain most of a security's return. (For more on the differences between the CAPM and APT, read CAPM vs. Arbitrage Pricing Theory: How They Differ) APT factors are the systematic risk that cannot be reduced by the diversification of an investment portfolio. The macroeconomic factors that have proven most reliable as price predictors include unexpected changes in inflation, gross national product (GNP), corporate bond spreads and shifts in the yield curve. Other commonly used factors are gross domestic product (GDP), commodities prices, market indices and exchange rates.

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The Arbitrage Pricing Theory Model:

Where: E(rj) – Expected return on asset rf – Risk-free rate ßn – Sensitivity of the asset price to macroeconomic factor n RPn – Risk premium associated with factor n The beta coefficients in the APT model are estimated by using linear regression. In general, historical securities returns are regressed on the factor to estimate its beta. For example, the following four factors have been identified as explaining a stock's return, and its sensitivity to each factor and the risk premium associated with each factor have been calculated: Gross domestic product growth: ß = 0.6, RP = 4% Inflation rate: ß = 0.8, RP = 2% Gold prices: ß = -0.7, RP = 5% Standard and Poor's 500 index return: ß = 1.3, RP = 9% The risk-free rate is 3%. Using the APT formula, the expected return is calculated as: Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%

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Arbitrage Portfolio Theory (APT) – A Multifactor Macroeconomic Model  

Arbitrage Portfolio Theory (APT) came along after CAPM as a multifactor model to explain returns. APT explains returns under the construct where: o Multiple risks with an excess return above the risk free rate of return can be priced. o Any security or portfolio has its own beta coefficient to each of the priced risk variables in the model.

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o o

There is a linear relationship between the security’s return and the priced risk (a basic assumption of multi-variable regression). APT calculates the alpha value, or y-intercept of the model graph.

Comparing CAPM vs. APT APT is less restrictive in CAPM, as:   



 







Asset returns can be described using a multifactor model (CAPM being a single factor model). Diversification eliminates the security specific risk of the individual securities in a multi-asset portfolio. Assets are priced such that arbitrage profit does not exist. o The factor sensitivities of the assets in an arbitrage portfolio equal zero and the portfolios expected return is zero. Note: If the investor believes that the expected return on the arbitrage portfolio is not equal to zero, then a single factor or multifactor APT style model can be used to capture risk free profit. o Step 1: Identify and purchase the undervalued asset or portfolio. o Step 2: Finance the long position with a short sale of overvalued assets. o Step 3: Close the long and short positions once the assets return to their APT determined equilibrium model values for zero return. o Whenever two portfolios have the same risk but different expected returns or the same expected return, but different risks, an arbitrage opportunity may be possible. It is important to note a couple of key differences between CAPM and APT as these modeling techniques and their variations are extensive in financial research. CAPM assumes that investors agree on asset returns, risks, and correlations: E(R), σ, and ρ. o APT does not assume this, making the theory less restrictive than CAPM. CAPM assumes that all investors should construct a portfolio based on the risk free asset and the market portfolio. o APT does not necessarily assume this Other Challenges for CAPM vs. Reality: o CAPM ignores transaction costs and taxes, which is not realistic for investors. o Investors rarely can borrow at the risk free rate. o Not all investors can short sell. Risk Aversion as Common Ground: Both APT and CAPM assume that investors are risk averse and will take the highest return for a given amount of risk.

Pricing E(RP) with an APT Model An APT model can be thought of an equation where alphas (the excess return of the risk factors) are applied to betas (the sensitivity of the portfolio or security to the risk factor itself). E(RP) = RF + λiβP,i + λjβP,j 

λi = Factor risk premium return above the risk free rate; the compensation to the investor for accepting the risk. 55



βP,i = Coefficient representing the portfolio (or security) return’s sensitivity to the risk factor

Portfolio performance evaluation  The portfolio performance evaluation involves the determination of how a managed portfolio has performed relative to some comparison benchmark.  The evaluation can indicate the extent to which the portfolio has outperformed or under-performed, or whether it has performed at par with the benchmark. The evaluation of portfolio performance is important for several reasons: • First, the investor, whose funds have been invested in the portfolio, needs to know the relative performance of the portfolio. • The performance review must generate and provide information that will help the investor to assess any need for rebalancing of his investments. • Second, the management a the portfolio needs this information to evaluate the performance a the manager a the portfolio and to determine the manager's compensation, if that is tied to the portfolio performance. • The performance evaluation methods generally fall into two categories, namely conventional and risk-adjusted methods. CONVENTIONAL METHODS Benchmark Comparison • The most straightforward conventional method involves comparison of the performance of an investment portfolio against a broader market index. • The most widely used market index in the United States is the S&P 500 index, which measures the price movements of 500 U.S. stocks compiled by the Standard & Poor's Corporation. • If the return on the portfolio exceeds that of the benchmark index, measured during identical time periods, then the portfolio is said to have beaten the benchmark index. While this type of comparison with a passive index is very common in the investment world, it creates a particular problem. • The level of risk of the investment portfolio may not be the same as that of the benchmark index portfolio. • Higher risk should lead to commensurately higher returns in the long term. This means if the investment portfolio has performed better than the benchmark portfolio, it may be due to the investment portfolio being more risky than the benchmark portfolio.

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• Therefore, a simple comparison of the return on an investment portfolio with that of a benchmark portfolio may not produce valid results. Style Comparison • A second conventional method of performance evaluation called "style-comparison" involves comparison of return of a portfolio with that having a similar investment style. • While there are many investment styles, one commonly used approach classifies investment styles as value versus growth. • The "value style" portfolios invest in companies that are considered undervalued on the basis of yardsticks such as price-to-earnings and price-to-topic value multiples. • The "growth style" portfolios invest in companies whose revenue and earnings are expected to grow faster than those of the average company. RISK-ADJUSTED METHODS The risk-adjusted methods make adjustments to returns in order to take account of the differences in risk levels between the managed portfolio and the benchmark portfolio. While there are many such methods, the most notables are: • Sharpe Ratio • Treynor Ratio • Jensen's Alpha • Modigliani and Modigliani Measure Your Portfolio's Performance Many investors mistakenly base the success of their portfolios on returns alone (see "Gauge Portfolio Performance by Measuring Returns"). Few consider the risk that they took to achieve those returns. Since the 1960s, investors have known how to quantify and measure risk with the variability of returns, but no single measure actually looked at both risk and return together. Nowadays, we have three sets of performance measurement tools to assist us with our portfolio evaluations. The Treynor, Sharpe and Jensen ratios combine risk and return performance into a single value, but each is slightly different. Which one is best for you? Why should you care? Let's find out. Treynor Measure/ratio • The Treynor ratio computes the risk premium per unit of systematic risk. The risk premium is defined as in the Sharpe measure.

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• The difference in this method is in that it uses the systematic risk of the portfolio as the risk parameter. • The systematic risk is that part of the total risk of an asset which cannot be eliminated through diversification. • It is measured by the parameter known as 'beta' that represents the slope of the regression of the returns of the managed portfolio on the returns to the market portfolio. Further to see sharpe’s ratio illustration

Jack L. Treynor was the first to provide investors with a composite measure of portfolio performance that also included risk. Treynor's objective was to find a performance measure that could apply to all investors, regardless of their personal risk preferences. He suggested that there were really two components of risk: the risk produced by fluctuations in the stock market and the risk arising from the fluctuations of individual securities. Treynor introduced the concept of the security market line, which defines the relationship between portfolio returns and market rates of returns, whereby the slope of the line measures the relative volatility between the portfolio and the market (as represented by beta). The beta coefficient is simply the volatility measure of a stock portfolio to the market itself. The greater the line's slope, the better the risk-return tradeoff. The Treynor measure, also known as the reward-to-volatility ratio, can be easily defined as:

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The numerator identifies the risk premium and the denominator corresponds with the risk of the portfolio. The resulting value represents the portfolio's return per unit risk. To better understand how this works, suppose that the 10-year annual return for the S&P 500 (market portfolio) is 10%, while the average annual return on Treasury bills (a good proxy for the risk-free rate) is 5%. Then assume you are evaluating three distinct portfolio managers with the following 10-year results:

Now, you can compute the Treynor value for each: T(market) = (.10-.05)/1 = .05 T(manager A) = (.10-.05)/0.90 = .056 T(manager B) = (.14-.05)/1.03 = .087 T(manager C) = (.15-.05)/1.20 = .083 The higher the Treynor measure, the better the portfolio. If you had been evaluating the portfolio manager (or portfolio) on performance alone, you may have inadvertently identified manager C as having yielded the best results. However, when considering the risks that each manager took to attain their respective returns, Manager B demonstrated the better outcome. In this case, all three managers performed better than the aggregate market. Because this measure only uses systematic risk, it assumes that the investor already has an adequately diversified portfolio and, therefore, unsystematic risk (also known as diversifiable risk) is not considered. As a result, this performance measure should really only be used by investors who hold diversified portfolios. Sharpe Ratio The Sharpe ratio computes the risk premium of the investment portfolio per unit of total risk of the portfolio. The risk premium, also known as excess return, is the return of the portfolio less the risk-free rate of interest as measured by the yield of a Treasury security.

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The Sharpe ratio is almost identical to the Treynor measure, except that the risk measure is the standard deviation of the portfolio instead of considering only the systematic risk, as represented by beta. Conceived by Bill Sharpe, this measure closely follows his work on the capital asset pricing model (CAPM) and by extension uses total risk to compare portfolios to the capital market line. The Sharpe ratio can be easily defined as:

Using the Treynor example from above, and assuming that the S&P 500 had a standard deviation of 18% over a 10-year period, let's determine the Sharpe ratios for the following portfolio managers: S(market) = (.10-.05)/.18 = .278 S(manager X) = (.14-.05)/.11 = .818 S(manager Y) = (.17-.05)/.20 = .600 S(manager Z) = (.19-.05)/.27 = .519 Once again, we find that the best portfolio is not necessarily the one with the highest return. Instead, it's the one with the most superior risk-adjusted return, or in this case the fund headed by manager X. Unlike the Treynor measure, the Sharpe ratio evaluates the portfolio manager on the basis of both rate of return and diversification (as it considers total portfolio risk as measured by standard deviation in its denominator). Therefore, the Sharpe ratio is more appropriate for well-diversified portfolios, because it more accurately takes into account the risks of the portfolio.

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Jensen Measure /alpha • Jensen's alpha is based on the Capital Asset Pricing Model (CAPM). • The alpha represents the amount by which the average return of the portfolio deviates from the expected return given by the CAPM. • The CAPM specifies the expected return in toms of the risk-free rate, systematic risk, and the market risk premium. • The alpha can be greater than, less than, or equal to zero. An alpha greater than zero suggests that the portfolio earned a rate of return in excess of the expected return of the portfolio.

Like the previous performance measures discussed, the Jensen measure is also based on CAPM. Named after its creator, Michael C. Jensen, the Jensen measure calculates the excess 61

return that a portfolio generates over its expected return. This measure of return is also known as alpha. The Jensen ratio measures how much of the portfolio's rate of return is attributable to the manager's ability to deliver above-average returns, adjusted for market risk. The higher the ratio, the better the risk-adjusted returns. A portfolio with a consistently positive excess return will have a positive alpha, while a portfolio with a consistently negative excess return will have a negative alpha. The formula is broken down as follows: Jensen\'s Alpha = Portfolio Return – Benchmark Portfolio Return Where: Benchmark Return (CAPM) = Risk-Free Rate of Return + Beta (Return of Market – Risk-Free Rate of Return) So, if we once again assume a risk-free rate of 5% and a market return of 10%, what is the alpha for the following funds?

First, we calculate the portfolio's expected return: ER(D)= .05 + 0.90 (.10-.05) = .0950 or 9.5% return ER(E)= .05 + 1.10 (.10-.05) = .1050 or 10.50% return ER(F)= .05 + 1.20 (.10-.05) = .1100 or 11% return Then, we calculate the portfolio's alpha by subtracting the expected return of the portfolio from the actual return: Alpha D = 11%- 9.5% = 1.5% Alpha E = 15%- 10.5% = 4.5% Alpha F = 15%- 11% = 4.0% Which manager did best? Manager E did best because, although manager F had the same annual return, it was expected that manager E would yield a lower return because the portfolio's beta was significantly lower than that of portfolio F. 62

Of course, both rate of return and risk for securities (or portfolios) will vary by time period. The Jensen measure requires the use of a different risk-free rate of return for each time interval considered. So, let's say you wanted to evaluate the performance of a fund manager for a five-year period using annual intervals; you would have to also examine the fund's annual returns minus the risk-free return for each year and relate it to the annual return on the market portfolio, minus the same risk-free rate. Conversely, the Treynor and Sharpe ratios examine average returns for the total period under consideration for all variables in the formula (the portfolio, market and risk-free asset). Like the Treynor measure, however, Jensen's alpha calculates risk premiums in terms of beta (systematic, undiversifiable risk) and therefore assumes the portfolio is already adequately diversified. As a result, this ratio is best applied to something like a mutual fund.

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What is 'Market Timing' Market timing is the act of moving in and out of the market or switching between asset classes based on using predictive methods such as technical indicators or economic data. Because it is extremely difficult to predict the future direction of the stock market, investors who try to time the market, especially mutual fund investors, tend to underperform investors who remain invested.

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