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Investment Analysis and Portfolio Management
Investment Analysis and Portfolio Management
Where,
P = principal amount
R = Simple I nt erest Rat e for one period ( usually 1 year)
T = Number of periods ( years)
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Ex ampl e 3.1
What is t he amount an invest or will get on a 3-year fixed deposit of Rs. 10000 t hat pays
8% simple int erest ?
Answer: Here we have
P = 10000, R = 8% and T = 3 years
2400 3
*
% 8
*
10000
* *
T R P I
Amount = Principal + I nt erest = 10000+ 2400 = 12400.
3.2.2 Compound I nt er est Rat e
I n addit ion t o t he t hree paramet ers ( Principal amount ( P) , I nt erest Rat e ( R) , Time ( T) ) used
for calculat ion of int erest in case of simple int erest rat e met hod, t here is an addit ional paramet er
t hat affect s t he t ot al int erest payment s. The fourt h paramet er is t he compounding period,
which is usually represent ed in t erms of number of t imes t he compounding is done in a year
( m) . So for semi- annual compounding t he value for m = 2; for quart erly compounding, m = 4
and so on.
Let us consider an int erest rat e of 10% compounded semi - annually and an i nvest ment
of Rs. 100 f or a peri od of 1 year. The i nvest ment wi l l become Rs. 105 i n 6 mont hs
and for t he second half, t he int erest wil l be calculat ed on Rs. 105, which will come t o
105* 5% = 5.25. The t ot al amount t he invest or will receive at t he end of 1 year will become
105 + 5. 25 = 110. 25. The equi val ent i nt er est rat e, i f compounded annual ly becomes
( ( 110.25- 100) / 100) * 100 = 10.25%. The equivalent annual int erest rat e is
1 1
m
m
R
,
_
+
.
The formula used for calculat ing t ot al amount under t his met hod is as under:
P
m
R
P A
m T
1
*
,
_
+
Where
A = Amount on mat urit y
R = int erest rat e
m = number of compounding in a year
T = mat urit y in years
Ex ampl e 3.2
What is t he amount an invest or will get on a 3-year fixed deposit of Rs. 10000 t hat pay 8%
int erest compounded half yearly?
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Answer:
Here P = 10000, R = 8% and T = 3, m = 2. The t ot al int erest income comes t o:
P
m
R
P I nt erest
m T
1
*
1
1
]
1
,
_
+
20 . 2653 . 10000
2
08 . 0
1
*
10000
3 * 2
Rs
1
1
]
1
,
_
+
Amount = Principal + I nt erest = 10000+ 2653.20 = 12653.20.
Ex ampl e 3.3
Consider t he same invest ment . What is t he amount if t he int erest rat e is compounded mont hly?
Answer:
Here P = 10000, R = 8% and T = 3, m = 12. The t ot al int erest income comes t o:
P
m
R
P I nt erest
m T
1
*
1
1
]
1
,
_
+
37 . 2702 . 10000
12
08 . 0
1 * 10000
3 * 12
Rs
1
1
]
1
,
_
+
Amount = Principal + I nt erest = 10000+ 2702.37 = 12702.37.
Cont i nuous compoundi ng
Consider a sit uat ion, where inst ead of mont hly or quart erly compounding, t he int erest rat e is
compounded cont inuously t hroughout t he year i.e. m rises indefinit ely. I f m approaches infinit y,
t he equivalent annual int erest rat e is
1 1
,
_
+
R
, which can be shown ( using t ools from
different ial calculus) , t o t end t o
] 1 718 . 2 [
r
or
1
r
e
in t he limit , ( where e= 2.71828is t he
base for nat ural logarit hms) . Furt her, for convenience, we use r (in small let t ers) t o represent
cont inuously compound int erest rat e.
Thus, an invest ment of Re. 1 at 8% cont inuously compounded int erest becomes
0833 . 1
08 . 0
e
aft er 1 year and t he equivalent annual int erest rat e becomes 0.0833 or 8.33%. I f t he invest ment
is for T years, t he mat urit y amount is simply 1*
rT
e
, where e = 2.718.
Cont inuous compounding is widely assumed in finance t heory, and used in various asset pricing
modelst he famous Black- Scholes model t o price a European opt ion is an illust rat ive example.
Ex ampl e 3.4
Consider t he same invest ment ( Rs. 10000 for 3 years) . What is t he amount received on
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mat urit y if t he int erest rat e is 8% compounded cont inuously?
Answer:
Here P = 10000, e = 2.718, r = 8% and T = 3
The final value of t he invest ment is
rT
e P
*
.
I t comes t o
50 . 12712
*
10000
3 * 08 . 0
e
.
3.3 Real and Nomi nal I nt er est Rat es
The relat ionship bet ween int erest rat es and inflat ion rat es is very significant . Normally, t he
cash flow from bonds and deposit s are cert ain and known in advance. However, t he value of
goods and services in an economy may change due t o changes in t he general price level
( inflat ion) . This brings an uncert aint y about t he purchasing power of t he cash flow from an
invest ment . Take a small example. I f inflat ion ( say 12%) is rising and is great er t han t he
int erest rat e ( say 10% annually) in a part icular year, t hen an invest or in a bond wit h 10%
int erest rat e annually st ands t o lose. Goods wort h Rs. 100 at t he beginning of t he year are
wort h Rs. 112 by t he end of t he year but an invest ment of Rs. 100 becomes only Rs. 110 by
end of t he year. This implies t hat an invest or who has deposit ed money in a risk- free asset will
find goods beyond his reach.
An economist would look at t his in t erms of nominal cash flow and real cash flows. Nominal
cash flow measures t he cash flow in t erms of t odays prices and real cash flow measures t he
cash flow in t erms of it s base year s purchasing power, i.e., t he year in which t he asset was
bought / invest ed. I f t he int erest rat e is 10%, an invest ment of Rs. 100 becomes Rs. 110 at t he
end of t he year. However, if inflat ion rat e is 5% t hen each Rupee will be wort h 5% less next
year. This means at t he end of t he year, Rs. 110 will be wort h only 110/ 1.05 = Rs. 104.76 in
t erms of t he purchasing power at t he beginning of t he year. The real payoff is Rs. 104.76 and
t he real int erest rat e is 4.76%. The relat ionship bet ween real and nominal int erest rat e can be
est ablished as under:
) ( 1 rat e inflat ion
Flow Cash Nominal
Flow Cash Real
+
And
rat e t ion la inf
rat e int erest al nomin
rat e erest int real
+
+
+
1
1
1 (
I n our example, t he real int erest rat e can be direct ly calculat ed using t he formula:
4.76% or 0.0476 1
05 . 1
10 . 0 1
1
]
1
+
+
rat e erest int al Re
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3.4 Bond Pr i ci ng Fundament al s
The cash inflow for an invest or in a bond includes t he coupon payment s and t he payment on
mat urit y ( which is t he face value) of t he bond. Thus t he price of t he bond should represent t he
sum t ot al of t he discount ed value of each of t hese cash flows ( such a t ot al is called t he present
value of t he bond) . The discount rat e used for valuing t he bond is generally higher t han t he
risk- free rat e t o cover addit ional risks such as default risk, liquidit y risks, et c.
Bond Price = PV ( Coupons and Face Value)
Not e t hat t he coupon payment s are at different point s of t ime in t he fut ure, usually t wice each
year. The face value is paid at t he mat urit y dat e. Therefore, t he price is calculat ed using t he
following formula:
t
t
y
t C
Price Bond
) 1 (
) (
( 1)
Where C( t ) is t he cash flow at t ime t and y is t he discount rat e. Since t he coupon rat e is
generally fixed and t he mat urit y value is known at t he t ime of issue of t he bond, t he formula
can be re- writ t en as under:
+
+
+
T
t
T t
y
Value Face
y
Coupon
Price Bond
) 1 ( ) 1 (
( 2)
Here t represent s t he t ime left for each coupon payment and T is t he t ime t o mat urit y. Also
not e t hat t he discount rat e may differ for cash flows across t ime periods.
Ex ampl e 3.5
Calculat e t he value of a 3-year bond wit h face value of Rs. 1000 and coupon rat e being 8%
paid annually. Assume t hat t he discount rat e is 10%.
Here:
Face value = Rs. 1000
Coupon Payment = 8% of Rs. 1000 = Rs. 80
Discount Rat e = 10%
t = 1 t o 3
T = 3
26 . 950
) 1 . 0 1 (
1000
) 1 . 0 1 (
80
) 1 . 0 1 (
80
1 . 0 1
80
3 3 2
+
+
+
+
+
+
+
Pr ice Bond
Now let us see what happens if t he discount rat e is lower t han t he coupon rat e:
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Ex ampl e 3.6
Calculat e t he bond price if t he discount rat e is 6%.
46 . 1053
) 06 . 0 1 (
80
) 06 . 0 1 (
80
06 . 0 1
80
3 2
+
+
+
+
+
Pr ice Bond
Since t he discount rat e is higher t han t he coupon rat e, t he bond is t raded at a discount . I f t he
discount rat e is less t han t he coupon rat e, t he bond t rades at a premium.
3.4.1 Cl ean and di r t y pr i ces and accr ued i nt er est
Bonds are not t raded only on coupon dat es but are t raded t hroughout t he year. The market
price of t he bonds also includes t he accrued int erest on t he bond since t he most recent coupon
payment dat e. The price of t he bond including t he accrued int erest since issue or t he most
recent coupon payment dat e is called t he dirt y price and t he price of t he bond excluding t he
accrued int erest is called t he clean price. Clean price is t he price of t he bond on t he most
recent coupon payment dat e, when t he accrued int erest is zero.
Dirt y Price = Clean price + Accrued int erest
For report ing purpose ( in press or on t rading screens) , bonds are quot ed at clean price for
ease of comparison across bonds wit h differing int erest payment dat es ( dirt y prices j ump on
int erest payment dat es). Changes in t he more st able clean prices are reflect ive of macroeconomic
condit ions, usually of more int erest t o t he bond market .
3.5 Bond Yi el ds
Bond yield are measured using t he following measures:
3.5.1 Coupon yi el d
I t is calculat ed using t he following formula:
Value Face
Payment Coupon
Yield Coupon
3.5.2 Cur r ent Yi el d
I t is calculat ed using t he following formula:
Bond t he of Price Market Current
Payment Coupon
Yield Coupon
The main drawback of coupon yield and current yield is t hat t hey consider only t he int erest
payment ( coupon payment s) and ignore t he capit al gains or losses from t he bonds. Since t hey
consider only coupon payment s, t hey are not measurable for bonds t hat do not pay any
int erest , such as zero coupon bonds. The ot her measures of yields are yield t o mat urit y and
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yield t o call. These measures consider int erest payment s as well as capit al gains ( or losses)
during t he life of t he bond.
3.5.3 Yi el d t o mat ur i t y
Yield t o mat urit y ( also called YTM) is t he most popular concept used t o compare bonds. I t
refers t o t he int ernal rat e of ret urn earned from holding t he bond t ill mat urit y. Assuming a
const ant int erest rat e for various mat urit ies, t here will be only one rat e t hat equalizes t he
present value of t he cash flows t o t he observed market price in equat ion ( 2) given earlier. That
rat e is referred t o as t he yield t o mat urit y.
Ex ampl e 3.7
What is t he YTM for a 5-year, 8% bond ( int erest is paid annually) t hat is t rading in t he market
for Rs. 924.20?
Here,
t = 1 t o 5
T = 5
Face Value = 1000
Coupon payment = 8% of Rs. 1,000 = 80
Put t ing t he values in equat ion ( 1) , we have:
5
5
1
) 1 (
1000
) 1 (
80
20 . 924
y y
t
+
+
+
Solving for y, which is t he YTM, we get t he yield t o mat urit y for t he bond t o be 10%.
Yield and Bond Price:
There is a negat ive relat ionship bet ween yields and bond price. The bond price falls when yield
increases and vice versa.
Ex ampl e 3.8
What will be t he market price of t he above bond ( Example 3 7) if t he YTM is 12%.
t = 1 t o 5
T = 5
Face Value = 1000
Coupon payment = 8% of 1,000 = 80
Put t ing t he values in equat ion ( 1) , t he bond price comes t o:
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20 . 901
) 12 . 0 1 (
1000
) 12 . 0 1 (
80
5
5
1
+
+
+
t
Pr ice Bond
Furt her, for a long- t erm bond, t he cash flows are more dist ant in t he fut ure and hence t he
impact of change in int erest rat e is higher for such cash flows. Alt ernat ively, for short - t erm
bonds, t he cash flows are not far and discount ing does not have much effect on t he bond price.
Thus, price of long- t erm bonds are more sensit ive t o int erest rat e changes.
Bond equivalent yield and Effect ive annual yield: This is anot her import ant concept t hat is of
import ance in case of bonds and not es t hat pay coupons at t ime int erval which is less t han 1
year ( for example, semi- annually or quart erly) . I n such cases, t he yield t o mat urit y is t he
discount rat e solved using t he following formula, wherein we assume t hat t he annual discount
rat e is t he product of t he int erest rat e for int erval bet ween t wo coupon payment s and t he
number of coupon payment s in a year:
T
T
t
t
y
Value Face
y
Coupon
Price Bond
,
_
+
+
,
_
2
1
2
1
( 3)
YTM calculat ed using t he above formula is called bond equivalent yield.
However, if we assume t hat one can reinvest t he coupon payment s at t he bond equivalent
yield ( YTM) , t he effect ive int erest rat e will be different . For example, a semi- annual int erest
rat e of 10% p.a. in effect amount s t o
% 25 . 10 1025 . 1
2
10 . 0
1
2
or
,
_
+
.
Yield rat e calculat ed using t he above formula is called effect ive annual yield.
Ex ampl e 3.9
Calculat e t he bond equivalent yield (YTM) for a 5-year, 8% bond (semi-annual coupon payment s),
t hat is t rading in t he market for Rs. 852.80? What is t he effect ive annual yield for t he bond?
Here,
t = 1 t o 10
T = 10
Face Value = 1000
Coupon payment = 4% of 1,000 = 40
Bond Price = 852.80
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Put t ing t he values in equat ion ( 3) , we have:
,
_
+
+
,
_
10
1
10
2
1
1000
2
1
40
80 . 852
y y
t
Solving, we get t he Yield t o Mat urit y ( y) = 0.12 or 12%.
The effect ive yield rat e is
% 36 . 12 1236 . 0 1
2
12 . 0
1 1
2
1
2 2
or
y
,
_
,
_
+
3.5.4 Yi el d t o cal l
Yield t o call is calculat ed for callable bond. A callable bond is a bond where t he issuer has a
right ( but not t he obligat ion) t o call/ redeem t he bond before t he act ual mat urit y. Generally t he
callable dat e or t he dat e when t he company can exercise t he right , is pre- specified at t he t ime
of issue. Furt her, in t he case of callable bonds, t he callable price ( redempt ion price) may be
different from t he face value. Yield t o call is calculat ed wit h t he same formula used for calculat ing
YTM ( Equat ion 2) , wit h an assumpt ion t hat t he issuer will exercise t he call opt ion on t he
exercise dat e.
Ex ampl e 3.10
Calculat e t he yield t o call for a 5-year, 7% callable bond ( semi- annual coupon payment s) , t hat
is t rading in t he market for Rs. 877.05. The bond is callable at t he end of 3rd year at a call
price of Rs. 1040.
Here:
t = 1 t o 6
T = 6
Coupon payment = 3.5% of 1,000 = 35
Callable Value = 1040
Bond Price = 877.05
Put t ing t he values in t he following equat ion:
T
T
t
t
y
Value Callable
y
Coupon
Price Bond
,
_
+
+
,
_
2
1
2
1
we have:
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6
6
1
2
1
1000
2
1
35
05 . 877
,
_
+
+
,
_
y y
t
Solving for y, we get t he yield t o call = 12%
3.6 I nt er est Rat es
While comput ing t he bond prices and YTM, we assumed t hat t he int erest rat e is const ant
across different mat urit ies. However, t his may not be t rue for different reasons. For example,
invest ors may perceive longer mat urit y periods t o be riskier and hence may demand higher
int erest rat e for cash flow occurring at dist ant t ime int ervals t han t hose occurring at short t ime
int ervals. I n t his sect ion, we account for t he fact t hat t he int erest demanded by invest ors also
depends on t he t ime horizon of t he invest ment . Let us first int roduce cert ain common concept s.
3.6.1 Shor t Rat e
Short rat e for t ime t , is t he expect ed ( annualized) int erest rat e at which an ent it y can borrow
f or a gi ven t i me i nt er val st ar t i ng f r om t i me t . Shor t r at e i s usual l y denomi nat ed
as r
t
.
3.6.2 Spot Rat e
Yield t o mat urit y for a zero coupon bond is called spot rat e. Since zero coupon bonds of
varying mat urit ies are t raded in t he market simult aneously, we can get an array of spot rat es
for different mat urit ies.
Relat ionship bet ween short rat e and spot rat e:
I nvest ors discount fut ure cash flows using int erest rat e applicable for t hat period. Therefore,
t he PV of an invest ment of T years is calculat ed as under:
) 1 ...( ) 1 ( ) 1 (
) (
) (
2 1 T
r r r
I nvest ment I nit ial
I nvest ment PV
+ + +
Ex ampl e 3.11
I f t he short rat e for a 1-year invest ment at year 1 is 7% and year 2 is 8%, what is t he present
value of a 2-year zero coupon bond wit h face value Rs. 1000 :
35 . 865
1556 . 1
1000
08 . 1
*
07 . 1
1000
P
For a 2-year zero coupon bond t rading at 865.35, t he YTM can be calculat ed by solving t he
following equat ion:
2
2
) 1 (
1000
35 . 865
y +
The result ing value for y is 7.4988%, which is not hing but t he 2-year spot rat e.
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3.6.3 For w ar d Rat e
One can assume t hat all bonds wit h equal risks must offer ident ical rat es of ret urn over any
holding period, because if it is not t rue t hen t here will be an arbit rage opport unit y in t he
market . I f we assume t hat all equally risky bonds will have ident ical rat es of ret urn, we can
calculat e short rat es for a fut ure int erval by knowing t he spot rat es for t he t wo ends of t he
int erval. For example, we can calculat e 1-year short rat e at year 3, if we have t he 3-years spot
rat e and 4-years spot rat e ( or in ot her words are t here are 3-year zero coupon and a 4-year
zero coupon t reasury bonds t rading in t he market ) . This is because, t he proceeds from an
invest ment in a 3-year zero coupon bond on t he mat urit y day, reinvest ed for 1 year should
result in a cash flow equal t o t he cash flow from an invest ment in a 4-year zero coupon bond
( since t he holding period is t he same for bot h t he st rat egies) .
Ex ampl e 3.12
I f t he 3-year spot rat e and 4-year spot rat es are 8.997% and 9.371% respect ively, find t he
1-year short rat e at end of year 3.
Given t he spot rat es, proceeds from invest ment of Re. 1 in a 3-year zero coupon bond will be
1* 1.08997
3
= 1.2949.
I f we reinvest t his ( mat urit y) amount in a 1-year zero coupon bond, t he proceeds at year 4 will
be 1.2949* ( 1+ r
3
) .
This should be equal t o t he proceeds from an invest ment of Rs. 1 in a 4-year zero coupon
bond, assuming equal holding period ret urn.
Proceeds from invest ment of Re. 1 in a 4-year zero coupon bond is 1* 1.09371
4
= 1.4309
Solving,
4309 . 1 ) 1 (
*
2949 . 1
3
+ r
r
3
= 0.11 or 11%, which is not hing but t he 1 year short rat e at t he end of year 3.
Fut ure short rat es comput ed using t he market price of t he prevailing zero coupon bonds price
( or prevailing spot rat es) are called forward int erest rat es. We use t he not at ion f
i
t o represent
t he 1-year forward int erest rat e st art ing at year i. For example, f
2
denot es t he 1-year forward
int erest rat e st art ing from year 2.
3.6.4 The t er m st r uct ur e of i nt er est r at es
We have discussed various int erest rat es ( spot , forward, discount rat es) , and also seen t heir
behaviour, and connect ions wit h each ot her. The t erm st ruct ure of int erest rat es is t he set of
relat ionships bet ween rat es of bonds of different mat urit ies. I t is somet imes also called t he
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yield curve. Formally put , t he t erm st ruct ure of int erest rat es defines t he array of discount
fact ors on a collect ion of default - free pure discount ( zero- coupon) bonds t hat differ only in
t heir t erm t o mat urit y. The most common approximat ion t o t he t erm st ruct ure of int erest rat es
is t he yield t o mat urit y curve, which generally is a smoot h curve and reflect s t he rat es of
ret urn on various default - free pure discount ( zero- coupon) bonds held t o mat urit y along wit h
t heir t erm t o mat urit y.
The use of forward int erest rat es has long been st andard in financial analysis such as in pricing
new financial inst rument s and in discovering arbit rage possibilit ies. Yield curves are also used
as a key t ool by cent ral banks in t he det erminat ion of t he monet ary policy t o be followed in a
count ry. The forward int erest rat e is int erpret ed as indicat ing market expect at ions of t he t ime-
pat h of fut ure int erest rat es, fut ure inflat ion rat es and fut ure currency depreciat ion rat es.
Since forward rat es helps us indicat e t he expect ed fut ure t ime pat h of t hese variables, t hey
allow a separat ion of market expect at ions for t he short , medium and long t erm more easily
t han t he st andard yield curve.
The market expect at ions hypot hesis and t he liquidit y preference t heory are t wo import ant
explanat ions of t he t erm st ruct ure of int erest in t he economy. The market expect at ion hypot hesis
assumes t hat various mat urit ies are perfect subst it ut es of each ot her and t hat t he forward
rat e equals t he market expect at ion of t he fut ure short int erest rat e i.e. ) (
i i
r E f , where i is
a fut ure period. Assuming minimal arbit rage opport unit ies, t he expect ed int erest rat e can be
used t o const ruct a yield curve. For example, we can find t he 2-year yield if we know t he
1-year short rat e and t he fut ures short rat e for t he second year by using t he following formula:
) 1 (
*
) 1 ( ) 1 (
2 1
2
2
f r y + + +
Since, as per t he expect at ion hypot hesis ) (
2 2
R E f , t he YTM can be det ermined solely by y
current and expect ed fut ure one- period int erest rat es.
Liquidit y preference t heory suggest s t hat invest ors prefer liquidit y and hence, a short - t erm
invest ment is preferred t o a long-t erm invest ment . Therefore, invest ors will be induced t o hold
a long- t erm invest ment , only by paying a premium for t he same. This premium or t he excess
of t he forward rat e over t he expect ed int erest rat e is referred t o as t he liquidit y premium.
Therefore, t he forward rat e will exceed t he expect ed short rat e, i.e. ) (
2 2
r E f > , where ) (
2 2
r E f
represent t he liquidit y premium. The liquidit y premium causes t he yield curve t o be upward
sloping since long- t erm yields are higher t han short - t erm yields.
Ex ampl e 3.13
Calculat e t he YTM for year 2- 5 if t he 1-year short rat e is 8% and t he fut ure rat es for years
2- 5 is 8.5% ( f
2
) , 9% ( f
3
) , 9.5% ( f
4
) and 10%( f
5
) respect ively.
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Answer:
% 8
1 1
r y
0825 . 1 ) 085 . 1 * 08 . 1 ( ) ; 1 ( * ) 1 ( ) 1 (
2
2 2 1
2
2
+ + + + y f r y
, i.e. y
2
= 8.25%
0850 . 1 ) 09 . 1 * 0825 . 1 ( ) ; 1 ( * ) 1 ( ) 1 (
3 2
3 3
2
2
3
3
+ + + + y f y y
, i.e. y
3
= 8.50%
0875 . 1 ) 095 . 1 * 0850 . 1 ( ) ; 1 ( * ) 1 ( ) 1 (
4 3
4 4
3
3
4
4
+ + + + y f y y
, i.e. y
4
= 8.75%
09 . 1 ) 10 . 1 * 0875 . 1 ( ) ; 1 ( * ) 1 ( ) 1 (
5 4
5 5
4
4
5
5
+ + + + y f y y
, i.e. y
5
= 9.00%
I t can be seen t hat because of t he liquidit y premium, t he fut ure int erest rat e increases wit h
t ime and t his causes t he yield curve t o rise wit h t ime.
Box No. 3.1:
Rel at i onshi p bet w een spot , f or w ar d, and di scount r at es
Recall t hat discount fact ors are t he int erest rat es used at a given point in t ime t o discount
cash flows occurring in t he fut ure, in order t o obt ain t heir present value. So how do spot
rat es, forward rat es, and discount rat es relat e t o each ot her?
A discount funct ion ( d
t , m
) is t he collect ion of discount fact ors at t ime t for all mat urit ies
m. Spot rat es ( s
t , m
) , i.e., t he yields earned on bonds which pay no coupon, are relat ed t o
discount fact ors according t o:
m
S m
m t
e d
1
*
,
and
m t m t
nd
m
S
, ,
1
1
The est imat ion of a zero coupon yield curve is based on an assumed funct ional relat ionship
bet ween eit her par yields, spot rat es, forward rat es or discount fact ors on t he one hand
and mat urit ies on t he ot her. Par yield curves are t hose t hat reflect ret urn on bonds t hat
are priced at par, which j ust means t hat t he redempt ion yield is equal t o t he coupon rat e
of t he bond.
There is a different forward rat e for every pair of mat urit y dat es. The relat ion bet ween
t he yield- t o- mat urit y ( YTM) and t he implied forward rat e at mat urit y is analogous t o t he
relat ion bet ween average and marginal cost s in economics. The YTM is t he average cost
of borrowing for m periods whereas t he implied forward rat e is t he marginal cost of
ext ending t he t ime period of t he loan, i.e. it describes t he marginal one- period int erest
rat e implied by t he current t erm st ruct ure of spot int erest rat e. Because spot int erest
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rat es depend on t he t ime horizon, it is nat ural t o define t he forward rat es f
t,m
as t he
inst ant aneous rat es which when compounded cont inuously up t o t he t ime t o mat urit y,
yield t he spot rat es ( inst ant aneous forward rat es are t hus rat es for which t he difference
bet ween set t lement t ime and mat urit y t ime approaches zero) .
, ) (
1
0
,
m
m t
du u f
m
S
or we can sayy
1
1
]
1
m
m t
du u f d
0
,
) ( exp
Thus, knowing any of t he four means t hat t he ot her four can be readily comput ed.
However, t he real problem is t hat neit her of t hese curves is easily forecast able.
3.7 Macaul ay Dur at i on and Modi f i ed Dur at i on
The effect of int erest rat e risks on bond prices depends on many fact ors, but mainly on coupon
rat es, mat urit y dat e et c. Unlike in case of zero- coupon bonds, where t he cash flows are only at
t he end, in t he case of ot her bonds, t he cash flows are t hrough coupon payment s and t he
mat urit y payment . One needs t o average out t he t ime t o mat urit y and t ime t o various coupon
payment s t o find t he effect ive mat urit y for a bond. The measure is called as durat ion of a
bond. I t is t he weight ed ( cash flow weight ed) average mat urit y of t he bond.
T
t
t
w t Durat ion
1
*
The weight s ( Wt ) associat ed for each period are t he present value of t he cash flow at each
period as a proport ion t o t he bond price, i.e.
Price Bond
y
CF
Price Bond
flow cash of PV
W
t
t
t
) 1 ( +
This measure is t ermed as Macaulays durat ion
1
or simply, durat ion. Higher t he durat ion of t he
bond, higher will be t he sensit ivit y t owards int erest rat e fluct uat ions and hence higher t he
volat ilit y in t he bond price.
This t ool is widely used in fixed income analysis. Banks and ot her financial inst it ut ions generally
creat e a port folio of fixed income securit ies t o fund known liabilit ies. The price changes for
fixed income securit ies are dependent mainly on t he int erest rat e changes and t he average
1
The met hod was designed by Frederick Macaulay in 1856 and hence named as Macaulay Durat ion.
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mat urit y ( durat ion) . I n order t o hedge against int erest rat e risks, it is essent ial for t hem t o
mat ch t he durat ion of t he port folio of fixed income securit ies wit h t hat of t he liabilit ies. A bank
t hus needs t o rebalance it s port folio of fixed- income securit ies periodically t o ensure t hat t he
aggregat e durat ion of t he port folio is kept equal t o t he t ime remaining t o t he t arget dat e. One
should not e t hat t he durat ion of a short - t erm bond declines fast er t han t he durat ion of t he
long- t erm bond. When int erest rat es fall, t he reinvest ment of int erest s ( unt il t he t arget dat e)
will yield a lower value but t he capit al gain arising from t he bond is higher. The increase or
decrease in t he coupon income arising from changes in t he reinvest ment rat es will offset t he
opposit e changes in t he market values of t he bonds in t he port folios. The net realized yield at
t he t arget dat e will be equal t o t he yield t o mat urit y of t he original port folio. This is also called
bond port folio immunizat ion.
Ex ampl e 3.14
What is t he durat ion for a 5-year mat urit y, 7% ( semi- annual) coupon bond wit h yield t o
mat urit y of 12%?
Here:
t = 1 t o 10
T = 10
Coupon payment = 3.5% of 1,000 = 35
YTM = 12 % or 6% for half year.
Period Time t ill Cash PV of Cash Flow ( discount Weight s ( b)* ( e)
payment Flow = 6% per period)
( a) ( b) ( c ) ( d) ( e) ( f )
( 33.02/ 816)
1 0.5 35 33.02 = 0.0405 0.0202
2 1 35 31.15 0.0382 0.0382
3 1.5 35 29.39 0.0360 0.0540
4 2 35 27.72 0.0340 0.0679
5 2.5 35 26.15 0.0321 0.0801
6 3 35 24.67 0.0302 0.0907
7 3.5 35 23.28 0.0285 0.0998
8 4 35 21.96 0.0269 0.1076
9 4.5 35 20.72 0.0254 0.1142
10 5 1035 577.94 0.7083 3.5413
Sum 816.00 1.0000 4.2142
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The selling price of t he bond as calculat ed from column ( d) is Rs. 816.00. The durat ion of t he
bond is 4.2142 years.
Since for a zero coupon bond, t he cash flow is only on t he mat urit y dat e, t he durat ion equals
t he bond mat urit y. For coupon-paying bonds, t he durat ion will be less t han t he mat urit y period.
Since cash flows at each t ime are used as weight s, t he durat ion of a bond is inversely relat ed
t o t he coupon rat e. A bond wit h high coupon rat e will have lower durat ion as compared t o a
bond wit h low coupon rat e.
Ex ampl e 3.15
What is t he durat ion for a 5-year mat urit y zero coupon bond wit h yield t o mat urit y of 12%?
Answer: One does not need t o do any calculat ion for answering t his quest ion. All cash flows
are only on t he mat urit y dat e and hence t he durat ion for t his bond is t he mat urit y dat e.
Alt hough durat ion helps us in measuring t he effect ive mat urit y of t he bond, invest ors are
concerned more about t he bond price sensit ivit y wit h respect t o change in int erest rat es. I n
order t o measure t he price sensit ivit y of t he bond wit h respect t o t he int erest rat e movement s,
we need t o find t he so-called modified durat ion (MD) of t he bond. Modified durat ion is calculat ed
from durat ion ( D) using t he following formula:
n
y
D
MD
+
1
,
Where,
y = yield t o mat urit y of t he bond
n = number of coupon payment s in a year.
The price change sensit ivit y of modified durat ion is calculat ed using t he following formula:
Change Yield MD Change Price
*
( ) ( %)
Not e t he use of minus (- ) t erm. This is because price of a bond is negat ively relat ed t o t he yield
of t he bond.
Ex ampl e 3.16
Refer t o t he bond in Example 3 14 i.e. 5-year mat urit y, 7% ( semi- annual) coupon bond wit h
yield t o mat urit y of 12%. Calculat e t he change in bond price if t he YTM falls t o 11%.
Answer: I n Example 3 14, we calculat ed t he durat ion t o be 4.2142 and t he bond price t o be
816. The modified durat ion of t he bond is:
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976 . 3
06 . 1
2142 . 4
2
12 .
1
2142 . 4
1
+
n
y
D
MD
The price change will - 3.976* 1 = 3.976% or Rs. 816 * 3.976% = 32.45
New Price = 816 + 32.45 = 848.45
Check: The act ual market price of a 5-year mat urit y, 7% ( semi- annual) coupon bond wit h YTM
= 11% would be:
25 . 849
2
11 . 0
1
1000
2
11 . 0
1
35
2
1
2
1
10
1
10
,
_
+
+
,
_
,
_
+
+
,
_
t
t T
T
t
t
y
Value Face
y
Coupon
Price Bond
Not e t hat t here is st ill some minor differences in t he act ual price and t he bond price calculat ed
using t he modified durat ion formula, due t o what is called convexit y. However, we would not
be covering t he concept in t his chapt er.
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CHAPTER 4: Capi t al Mar k et Ef f i ci ency
4.1 I nt r oduct i on
The Efficient Market s Hypot hesis ( EMH) is one of t he main pillars of modern finance t heory,
and has had an impact on much of t he lit erat ure in t he subj ect since t he 1960s when it was
first proposed and on our underst anding about pot ent ial gains from act ive port folio management .
Market s are efficient when prices of securit ies assimilat e and reflect informat ion about t hem.
While market s have been generally found t o be efficient , t he number of depart ures seen in
recent years has kept t his t opic open t o debat e.
4.2 Mar k et Ef f i ci ency
The ext ent t o which t he financial market s digest relevant informat ion int o t he prices is an
import ant issue. I f t he prices fully reflect all relevant informat ion inst ant aneously, t hen market
prices could be reliably used for various economic decisions. For inst ance, a firm can assess
t he pot ent ial impact of increased dividends by measuring t he price impact creat ed by t he
dividend increase. Similarly, a firm can assess t he value of a new invest ment t aken up by
ascert aining t he impact on it s market price on t he announcement of t he invest ment decision.
Policymakers can also j udge t he impact of various macroeconomic policy changes by assessing
t he market value impact . The need t o have an underst anding about t he abilit y of t he market t o
imbibe informat ion int o t he prices has led t o count less at t empt s t o st udy and charact erize t he
levels of efficiency of different segment s of t he financial market s.
The early evidence suggest s a high degree of efficiency of t he market in capt uring t he price
relevant informat ion. Formally, t he level of efficiency of a market is charact erized as belonging
t o one of t he following ( i) weak- form efficiency ( ii) semi- st rong form efficiency ( iii) st rong-
form efficiency.
4.2.1 Weak - f or m Mar k et Ef f i ci ency
The weak- form efficiency or random walk would be displayed by a market when t he consecut ive
price changes ( ret urns) are uncorrelat ed. This implies t hat any past pat t ern of price changes
are unlikely t o repeat by it self in t he market . Hence, t echnical analysis t hat uses past price or
volume t rends do not t o help achieve superior ret urns in t he market . The weak- form efficiency
of a market can be examined by st udying t he serial correlat ions in a ret urn t ime series.
Absence of serial correlat ion indicat es a weak- form efficient market .
4.2.2 Semi - st r ong Mar k et Ef f i ci ency
The semi- st rong form efficiency implies t hat all t he publicly available informat ion get s reflect ed
in t he prices i nst ant aneously. Hence, in such market s t he impact of posi t ive ( negat ive)
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informat ion about t he st ock would lead t o an inst ant aneous increase ( decrease) in t he prices.
Semi- st rong form efficiency would mean t hat no invest or would be able t o out perform t he
market wit h t rading st rat egies based on publicly available informat ion.
The hypot hesis suggest s t hat only informat ion t hat is not publicly available can benefit invest ors
seeking t o earn abnormal ret urns on invest ment s. All ot her informat ion is account ed for in t he
st ocks price and regardless of t he amount of fundament al and t echnical analysis one performs,
above normal ret urns will not be had.
The semi- st rong form efficiency can be t est ed wit h event - st udies. A t ypical event st udy would
involve assessment of t he abnormal ret urns around a significant informat ion event such as
buyback announcement , st ock split s, bonus et c. Here, a t ime period close t o t he select ed
event including t he event dat e would be used t o examine t he abnormal ret urns. I f t he market
is semi-st rong form efficient , t he period aft er a favorable (unfavorable) event would not generat e
ret urns beyond ( less t han) what is suggest ed by an equilibrium pricing model ( such as CAPM,
which has been discussed lat er in t he book) .
4.2.3 St r ong Mar k et Ef f i ci ency
The level of efficiency ideally desired for any market is st rong form efficiency. Such efficiency
would imply t hat bot h publicly available informat ion and privat ely ( non- public) available
informat ion are fully reflect ed in t he prices inst ant aneously and no one can earn excess ret urns.
A t est of st rong form efficiency would be t o ascert ain whet her insiders of a firm are able t o
make superior ret urns compared t o t he market . Absence of superior ret urn by t he insiders
would imply t hat t he market is st rongly efficient . Test ing t he st rong- form efficiency direct ly is
difficult . Therefore, t he claim about st rong form efficiency of any market at t he best remains
t enuous.
I n t he years immediat ely following t he proposal of t he market efficiency, t est s of various forms
of efficiency had suggest ed t hat t he market s are reasonably efficient . Over t ime, t his led t o
t he gradual accept ance of t he efficiency of market s.
4.3 Depar t ur es f r om t he EMH
Evidence accumulat ed t hrough research over t he past t wo decades, however, suggest s t hat
during many episodes t he market s are not efficient even in t he weak form. The ret urns are
found t o be correlat ed bot h for short as well as long lags during such episodes. The downward
and upward t rending of prices is well document ed across different market s ( moment um effect ) .
Then t here is a whole host of ot her document ed deviat ions from efficiency. They include, t he
predict abilit y of fut ure ret urns based on cert ain event s and high volat ilit y of prices compared
t o volat ilit y of t he underlying fundament als. All t hese evidences have st art ed t o offer a challenge
t o t he earlier claim of efficiency of t he market . The lack of reliabilit y about t he level of efficiency
of t he market prices makes it less reliable as a guideline for decision- making.
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Alt ernat ive prescript ions about t he behaviour of market s are widely discussed t hese days.
Most of t hese prescript ions are based on t he irrat ionalit y of t he market s in eit her processing
t he informat ion relat ed t o an event or based on biased invest or preferences. For inst ance, if
t he invest ors on an average are overconfident about t heir invest ment abilit y, t hey would not
pay close at t ent ion t o new price relevant informat ion t hat arises in t he market . This leads t o
inadequat e price response t o t he informat ion event and possibly cont inuat ion of t he t rend due
t o t he under react ion. This bias in processing informat ion is claimed t o be t he cause of price
moment um. Biased invest or preferences include aversion t o t he realizat ion of losses incurred
in a st ock. This again would lead t o under react ion.
The market efficiency claim was based on t he assumpt ion t hat irrat ional ( biased) invest ors
would be exploit ed by t he rat ional t raders, and would event ually lose out in t he market ,
leading t o t heir exit . Therefore, even in t he presence of biased t raders t he market was expect ed
t o evolve as efficient . However, more recent evidence suggest t hat t he irrat ional t raders are
not exit ing t he market as expect ed, inst ead at many inst ances t hey appear t o make profit s at
t he expense of t he rat ional t raders.
Some of t he well-known anomaliesor depart ures from market efficiencyare calendar effect s
like t he January effect and various day- of- t he- week effect s and t he so- called size effect . The
January effect was first document ed in t he US market sst ock ret urns were found t o be higher
in January t han in any ot her mont h. Since t hen, it has been empirically t est ed in a number of
int ernat ional market s, like Tokyo, London, and Paris among ot hers. While t he evidence has
been mixed, t he fact t hat it exist s implies a persist ent deviat ion from market efficiency.
St ock ret urns are generally expect ed t o be independent across weekdays, but a number of
st udies have found ret urns on Monday t o be lower t han in t he rest of t he week. One of t he
reasons put forward t o explain t his anomaly is t hat ret urns on Monday are expect ed t o be
different , given t hat t hey are across Friday- end- t o- Monday- morning, a much longer period
t han any ot her day, and hence wit h more informat ion. This is why t his depart ure from market
efficiency is also somet imes called t he weekend effect .
The alt ernat ive prescript ions about t he behaviour of market s based on various sources and
forms of invest or irrat ionalit y are collect ively known as behavioral finance. I t implies t hat ( i)
t he est imat ion of expect ed ret urns based on met hods such as t he capit al asset pricing model
is unreliable, and ( ii) t here could be many profit able t rading st rat egies based on t he collect ive
irrat ionalit y of t he market s.
Depart ures from market efficiency, or t he delays in market s reaching equilibrium ( and t hus
efficiency) leave scope for act ive port folio managers t o exploit mispricing in securit ies t o t heir
benefit . A number of invest ment st rat egies are t ailored t o profit from such phenomena, as we
would see in lat er chapt ers.
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CHAPTER 5: Fi nanci al Anal y si s and Val uat i on
5.1 I nt r oduct i on
I nvest ment s in capit al market s primarily involve t ransact ions in shares, bonds, debent ures,
and ot her financial product s issued by companies. The decision t o invest in t hese securit ies is
t hus linked t o t he evaluat ion of t hese companies, t heir earnings, and pot ent ial for fut ure
growt h. I n t his chapt er we look at one of t he most import ant t ools used for t his purpose,
Valuat ion. The fundament al valuat ion of any asset ( and companies are indeed asset s int o
which we invest ) is an examinat ion of fut ure ret urns, in ot her words, t he cash flows expect ed
from t he asset . The value of t he asset is t hen simply what t hese cash flows are wort h t oday,
i.e., t heir present discount ed value. Valuat ion is all about how well we predict t hese cash flows,
t heir growt h in fut ure, t aking int o account fut ure risks involved.
5.2 The Anal y si s of Fi nanci al St at ement s
A companys financial st at ement s provide t he most accurat e informat ion t o it s management
and shareholders about it s operat ions, efficiency in t he allocat ion of it s capit al and it s earnings
profile. Three basic account ing st at ement s form t he backbone of financial analysis of a company:
t he income st at ement ( profit & loss) , t he balance sheet , and t he st at ement of cash flows. Let
us quickly summarize each of t hese.
5.2.1 I ncome St at ement ( Pr of i t & Loss)
A profit & loss st at ement provides an account of t he t ot al revenue generat ed by a firm during
a period ( usually a financial year or a quart er) , t he expenses involved and t he money earned.
I n it s simplest form, revenue generat ion or sales accrues from selling t he product s manufact ured,
or services rendered by t he company. Operat ing expenses include t he cost s of t hese goods
and services and t he cost s incurred during t he manufact ure. Beyond operat ing expenses are
int erest cost s based on t he debt profile of t he company. Taxes payable t o t he Government are
t hen debit ed t o provide t he Profit Aft er Tax ( PAT) or t he net income t o t he shareholders of t he
company.
Act ual P&L st at ement s of companies are usually much more complicat ed t han t his, wit h so-
called ot her income ( income from non- core act ivit ies) , negat ive int erest expenses ( from
cash reserves wit h t he company) , preferred dividends, and non- recurring, except ional income
or expenses. The example given below is t hat of a large company in t he Pharmaceut ical sect or
over t he period 2006- 2008.
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I l l ust r at i on 5.1
I ncome St at ement ( US$M) 2006 2007 2008
Net sales 16,380 21,340 33,565
Cost of sales ( 5,332) ( 6,584) ( 8,190)
SG&A ( 1,408) ( 1,771) ( 2,738)
Research & development ( 1,534) ( 2,440) ( 2,725)
Ot her operat ing it ems ( 3,650) ( 4,620) ( 5,369)
EBI T 4,457 5,926 14,543
Tot al ot her non- operat ing it ems 543 1,336 305
Associat es 0 0 0
Net int erest income/ expense 869 1,072 1,146
Except ional it ems 0 0 0
Pr et ax pr of i t 5,869 8,334 15,994
Taxat ion ( 239) 67 ( 485)
Minorit y int erest 3 ( 559) ( 640)
Preferred dividends 0 0 0
Net ext raordinary it ems 100 0 0
Repor t ed net i ncome 5,733 7,843 14,869
5.2.2 The Bal ance Sheet
Asset s owned by a company are financed eit her by equit y or debt and t he balance sheet of a
company is a snapshot of t his capit al st ruct ure of t he firm at a point in t ime; t he sources and
applicat ions of funds of t he company.
A company owns f i xed asset s ( machi ner y, and ot her i nf r ast r uct ur e) , cur r ent asset s
( manufact uring goods in progress, money it expect s t o receive from business part ners
receivables, invent ory et c.) , cash and ot her financial invest ment s. I n addit ion t o t hese t hree,
a company could also own ot her asset s which carry value, but are not direct ly market able, like
pat ent s, t rademarks, and goodwillvalue not linked t o asset s, but realized from acquisit ions.
These asset s are financed eit her by t he companys equit y (invest ment s by shareholders) or by
debt . The illust rat ive example shown below is t he balance sheet of a large Pharmaceut ical
company.
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I l l ust r at i on 5.2
Bal ance Sheet ( US$m) 2006 2007 2008
Cash and market able securit ies 15,628 14,106 17,290
Account s receivable 3,609 6,789 14,177
I nvent ory 5,117 6,645 7,728
Ot her current asset s 2,471 2,653 5,079
Cur r ent asset s 26,826 30,192 44,274
Net t angible fixed asset s 8,977 10,122 11,040
Tot al financial asset s 3,237 2,239 2,659
Net goodwill 507 697 1,729
Tot al asset s 39,547 43,250 59,701
Account s payable 2,279 2,966 3,722
Short - t erm debt 0 0 0
Tot al ot her current liabilit ies 1,236 80 2,651
Cur r ent l i abi l i t i es 3,515 3,046 6,373
Long- t erm debt 18,747 11,144 1,436
Tot al ot her non- current liabilit ies 1,053 895 92
Tot al provisions 0 0 0
Tot al l i abi l i t i es 23,314 15,085 7,901
Minorit y int erest accumulat ed 332 438 1,886
Shareholders equit y 15,902 27,728 49,915
Shar ehol der s f unds 16,233 28,166 51,800
Li abi l i t i es and shar ehol der s f unds 39,547 43,250 59,701
5.2.3 Cash Fl ow St at ement
The cash flow st at ement is t he most import ant among t he t hree financial st at ement s, part icularly
from a valuat ions perspect ive. As t he name implies, such a st at ement is used t o t rack t he cash
flows in t he company over a period. Cash flows are t racked across operat ing, invest ing, and
financing act ivit ies. Cash flows from operat ions include net income generat ion adj ust ed for
changes in working capit al ( like invent ories, receivables and payables) , and non- core accruals
(like depreciat ion, et c). A firms invest ment act ivit ies comprise fixed, and current asset s (capit al-
and operat ing expendit ure) , somet imes int o ot her firms ( like an acquisit ion) , and generally
represent negat ive cash flows. Cash flows in financing act ivit ies are t he net result of t he firms
borrowing, and payment s during t he period. The sum t ot al of cash flows from t hese t hree
heads represent s t he net change in cash balances of t he firm over t he period.
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Cash generat ion from operat ing act ivit ies of t he firm, when adj ust ed for it s capit al expendit ure
represent t he free cash available t o it , for pot ent ial invest ment act ivit ies, acquiring ot her
firms or businesses, or dist ribut ion among it s shareholders. As we will see in lat er t opics, free
cash flows are t he key t o calculat ing t he so- called int rinsic value of an asset in any discount ed
valuat ion model. Our illust rat ive example below shows t he cash flow st at ement ( and free cash
flows) of a large pharmaceut ical company over t he period 2006- 2008.
I l l ust r at i on 5.3
Cash Fl ow ( US$M) 2006 2007 2008
Report ed net income 5,733 7,843 14,869
Preferred dividends 0 0 0
Minorit y int erest ( 3) 559 640
Depreciat ion and amort izat ion 610 813 969
Cash t ax adj ust ment 75 ( 511) ( 1,337)
Tot al ot her operat ing cash flow ( 1,365) ( 2,156) ( 753)
Net change in working capit al ( 3,177) ( 4,154) ( 9,340)
Cash f r om oper at i ons 1,872 2,394 5,048
Capit al expendit ure ( 3,387) ( 2,000) ( 1,995)
Net acquisit ions/ disposals 3,511 1,367 ( 5,242)
Tot al ot her invest ing cash flows 634 1,272 1,177
Cash f r om i nvest i ng act i vi t i es 758 639 ( 6,060)
Change in borrowings 805 ( 1,742) 768
Equit y raised/ share buybacks 0 0 0
Dividends paid ( 793) ( 2,629) ( 18)
Tot al ot her financing cash flows ( 156) ( 127) ( 88)
Cash f r om f i nanci ng act i vi t i es ( 144) ( 4,498) 661
Change i n cash 3,518 ( 1,465) ( 352)
Fr ee cash f l ow ( 1,514) 394 3,052
5.3 Fi nanci al Rat i os ( Ret ur n, Oper at i ng and, Pr of i t abi l i t y Rat i os)
Financial rat ios are meaningful links bet ween different ent ries of financial st at ement s, as by
t hemselves t he financial ent ries offer lit t le t o examine a company. I n addit ion t o providing
informat ion about t he financial healt h and prospect s of a company, financial rat ios also allow
a company t o be viewed, in a relat ive sense, in comparison wit h it s own hist orical performance,
ot hers in it s sect or of t he economy, or bet ween any t wo companies in general. I n t his sect ion
we examine a few such rat ios, grouped int o cat egories t hat allow comparison of size, solvency,
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operat ing performance, growt h profile and risks. The list below is by no means exhaust ive,
and merely serves t o illust rat e a few of t he import ant ones.
5.3.1 Measur es of Pr of i t abi l i t y: RoA, RoE
Ret ur n on Asset s ( RoA) in it s simplest form denot es t he firms abilit y t o generat e profit s
given it s asset s :
RoA = ( Net I ncome + I nt erest Expenses) * ( 1- Tax Rat e) / Average Tot al Asset s
Ret ur n on Equi t y ( RoE) is t he ret urn t o t he equit y invest or :
RoE = Net I ncome / Shareholder Funds
Somet imes t his rat io is also calculat ed as RoAE, t o account for recent capit al raising by
t he firm
Ret urn on Average Equit y = Net I ncome / Average Shareholder Funds
Ret urn on Tot al Capit al = Net I ncome + Gross I nt erest Expense / Average t ot al capit al
5.3.2 Measur es of Li qui di t y
Short - t erm liquidit y is imperat ive for a company t o remain solvent . The rat ios below get
increasingly conservat ive in t erms of t he demands on a firm t o meet near- t erm payables.
Current rat io = Current Asset s / Current Liabilit ies
Quick Rat io = ( Cash + Market able Securit ies + Receivables) / Current Liabilit ies
Acid t est rat io = ( Cash + Market able Securit ies) / Current Liabilit ies
Cash Rat io = ( Cash + Market able Securit ies) / Current Liabilit ies
5.3.3. Capi t al St r uct ur e and Sol vency Rat i os
Tot al debt t o t ot al capit al = ( Current Liabilit ies + Long- t erm Liabilit ies) /
( Equit y + Tot al Liabilit ies)
Long- t erm Debt - Equit y = Long- t erm Liabilit ies / Equit y
5.3.4 Oper at i ng Per f or mance
Gross Profit Margin = Gross Profit / Net Sales
Operat ing Profit Margin = Operat ing I ncome / Net Sales
Net Profit Margin = Net I ncome / Net Sales
5.3.5 Asset Ut i l i zat i on
These rat ios look at t he effect iveness of a firm t o ut ilize it s asset s, especially it s fixed asset s.
A high t urnover implies opt imal use of asset s. I n addit ion t o t he t wo below t here are ot hers like
Sales t o invent ories, and Sales t o Working capit al.
Tot al Asset Turnover = Net Sales / Average Tot al Asset s
Fixed Asset Turnover = Net Sales / Average Net Fixed Asset s
There are many ot her cat egories, like t he common size rat ios, which serve t o present t he
company in t erms of one of it s own denominat ors, like Net Sales, or t he market capit alizat ion;
and ot hers t hat specifically look at t he risk aspect of t hings ( business, financial, and liquidit y) .
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We shall t ake a look at anot her t wo cat egories, t he market measures, and valuat ion rat ios,
aft er t he discussion on valuat ions.
5.4 The v al uat i on of common st ock s
I n chapt er 3, we examined a few of t he maj or valuat ion met hods for fixed income- generat ing
asset s. Using financial st at ement s and rat ios, we now examine some of t he concept s relat ing
t o share valuat ions and t o be more specific, we will deal wit h valuat ion of common st ocks.
Common shareholders are t he owners of t he firm, and as such are t he final st akeholders in it s
growt h, and risks; t hey appoint t he management t o run it s day- t o-day affairs and t he Board of
Dir ect ors t o oversee t he management s act i vit ies. The cash f lows ( r et ur n) t o common
shareholders from t he company are generally in t he form of current and fut ure dividends
dist ribut ed from t he profit s of t he firm. Alt ernat ively, an invest or can always sell her holdings
in t he mar ket ( secondary mar ket ) , get t he prevai ling mar ket price, and reali ze capit al
appreciat ion if t he ret urns are posit ive.
We now examine t he valuat ion of common shares in some det ail. As ment ioned above, t he
valuat ion of any asset is based on t he present value of it s fut ure cash flows. Such a met hodology
provides what is called t he int rinsic value of t he asset a common st ock in our case. The
problem of valuing t he st ock t hen t ranslat es int o one of predict ing t he fut ure free cash flow
profile of t he company, and t hen using t he appropriat e discount fact or t o measure what t hey
are wort h t oday. The appropriat ely named discount ed- cash flow t echnique is also referred t o
as absolut e valuat ion, part icularly when compared t o anot her widely- followed approach in
valuat ion, called relat ive valuat ion.
Relat ive valuat ion looks at pricing asset s on t he basis of t he pricing of ot her, similar asset s
inst ead of pricing t hem independent lyt he core assumpt ion being t hat asset s wit h similar
earnings and growt h profile, and facing t he same risks ought t o be priced comparably. Two
st ocks in t he same sect or of t he economy could t hus be compared, and t he same sect or ( and
it s st ocks) across count ries. The discussion on relat ive valuat ion follows t hat of absolut e or
int rinsic valuat ion.
5.4.1 Absol ut e ( I nt r i nsi c) Val uat i on
I nt rinsic value or t he fundament al value refers t o t he value of a securit y, which is int rinsic t o or
cont ained in t he securit y it self. I t is defined as t he present value of all expect ed cash flows t o
t he company. The est imat ion of int rinsic value is what we would be dealing wit h in det ails in
t his chapt er.
5.4.1.1 Di scount ed Cash Fl ow s
The discount ed cash flow met hod values t he share based on t he expect ed dividends from t he
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shares. The price of a share according t o t he discount ed cash flow met hod is calculat ed as
under:
1
0
) 1 (
t
t
t
r
Div
P
Since t he profit s of t he firm are not cert ain, t he act ual fut ure dividends are not known in
advance. However, t he market forms an expect at ion of t he fut ure dividends and t he value of a
share is t he present value of expect ed fut ure dividends of t he company. I t can be shown t hat
t he formula can be seen as an ext ension of t he formula
) 1 (
1 1
0
r
P Div
P
+
+
.
As explained above, we can writ e t he share price at t he end of t he year 1 as a funct ion of t he
2nd year dividend and price of share at t he end of t he year 2. Or,
) 1 (
2 2
1
r
P Div
P
+
+
Similarly,
) 1 (
3 3
2
r
P Div
P
+
+
and so on.
Put t ing t he values of P
1
, P
2
, P
3
, P
4
, we can writ e:
N
N
N
N
r
P
r
Div
r
Div
r
Div
r
Div
r
P Div
P
) 1 ( ) 1 (
....
) 1 ( ) 1 (
1 ) 1 (
3
3
2
2
1 1 1
0
+
+
+
+ +
+
+
+
+
+
+
+
1
0
) 1 (
t
t
t
r
Div
P
5.4.1.2 Const ant Di vi dend Gr ow t h
Let us see a special case of t he above model when it is assumed t hat amount paid as dividends
grows at a const ant rat e ( say g) every year. I n t his case, t he cash flows in various years will be
as under:
Year Cash Flow
0 - P
0
1 Div
1
2 Div
2
= Div
1
* ( 1+ g)
3 Div
3
= Div
2
* ( 1+ g) = Div
1
* ( 1+ g)
2
4 Div
4
= Div
3
* ( 1+ g) = Div
2
* ( 1+ g)
2
= Div
1
* ( 1+ g)
3
I n t his circumst ance, where t he dividend amount grows at a const ant rat e, t he const ant dividend
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growt h model st at es t hat t he share price can be obt ained using t he simple formula:
g r
Div
P
1
0
This formula can be used only when t he expect ed rat e of ret urn ( r) is great er t han t he growt h
rat e ( g). Ot herwise, t he present value of t he growing perpet uit y will reach infinit e. This is even
t rue in real world. I t is not possible for a st ocks dividend t o grow at a rat e g, which is great er
t han r for infinit e period. I t can only be for a limit ed number of years. This model is not
applicable in such cases.
Example: RNL has paid a dividend of Rs. 10 per share last year ( D
0
) and it is expect ed t o grow
at 5% every year. I f an invest or s expect ed rat e of ret urn from RNL share is 7%, calculat e t he
market price of t he share as per t he dividend discount model.
Answer: The following are given:
Div
0
= 10; g = 5% or 0.05; r = 7% or 0.07.
50 . 10 05 . 1 * 10 ) 1 ( *
0 1
+ + g Div Div
525
02 . 0
50 . 10
05 . 0 07 . 0
50 . 10
1
0
g r
Div
P
The market price of RNL share as per t he dividend discount model wit h const ant growt h rat e is
Rs. 525.
I f we know t he market price of t he share, t he dividend amount and t he dividend growt h rat e,
t hen we can comput e t he expect ed rat e of ret urn ( r) by using t he following formula:
g
P
Div
r +
0
1
5.4.1.3 Pr esent Val ue of Gr ow t h oppor t uni t i es ( PVGO)
One can split t he value of t he shares as comput ed in t he const ant growt h model int o t wo part s
t he present value of t he share assuming level st ream of earnings (a level st ream of earnings
is simply t he current income ext rapolat ed int o t he fut ure, wit h no growt h; in which case,
t heres no need t o ret ain any of t he earnings) and t he present value of growt h opport unit ies.
The value of growt h opport unit ies is posit ive if t he firm ( and t he market ) believes t hat t he firm
has avenues t o invest which will generat e a ret urn t hat is more t han t he market expect ed rat e
of ret urn. Now when t he firms income pot ent ial from addit ional invest ment is more t han t he
market expect ed rat e of ret urn, t hen for every penny re- invest ed ( plowbacked rat her t han
dist ribut ed as dividend) will generat e a ret urn t hat is higher t han t he market expect at ion. The
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value of such excess ret urn is referred t o as present value of growt h opport unit ies.
PVGO = Share Price Present value of level st ream of earnings
= Share price EPS / r
The growt h in t he fut ure dividend arises because t he firms, inst ead of dist ribut ing 100% of t he
earnings as dividends, plowbacks and invest s cert ain port ion of t he current year profit on
proj ect s whose yield will be great er t han t he market expect ed rat e of ret urn.
The growt h rat e in dividend ( g) , equals, t he Plowback rat io * ROE.
5.4.1.4 Di scount ed Fr ee- cash f l ow val uat i on model s
Using t he above concept s, we are now in a posit ion t o look at valuat ion using cash flows, wit h
t he discount ed free cash flow model. We first det ermine t he value of t he ent erprise and t hen
value t he equit y by deduct ing t he debt value from t he firm value. Thus:
Market value of equit y ( V
0
) = Value of t he firm + Cash in hand Debt Value
The price of t he share ( P
0
) is t he market value of t he equit y divided by t he number of shares
out st anding.
I t is simple t o calculat e t he debt value since t he payment s t o be made t o debt holders is
predet ermined and cert ain. However, t he real problem lies wit h det ermining t he value of t he
firm. As per t he discount ed free cash flow model, t he value of a firm is t he present value of t he
fut ure free cash flow of t he firm. The discount ing rat e is t he firms weight ed average cost of
capit al ( WACC) and not t he market expect ed rat e of ret urn on equit y invest ment . WACC is t he
cost of capit al t hat reflect s t he risk of t he overall business and not t he risk associat ed wit h t he
equit y invest ment alone. WACC is calculat ed using t he following formula:
E D
E
r
E D
D
T r WACC
E D
+
+
+
* * ) 1 (
where
r
D
and r
E
is t he expect ed rat e of ret urn on debt and equit y
T = I ncome Tax Rat e
D = t he market value of debt ; E = t he market value of equit y
The firm value ( V
0
) is calculat ed using t he following formula:
N
wacc
N
N
wacc
N
wacc wacc
wacc
r
e Valu minal Ter
r
FCF
r
FCF
r
FCF
r
FCF
V
) 1 (
) (
) 1 (
. . . .
) 1 ( ) 1 (
1
3
3
2
2 1
0
+
+
+
+ +
+
+
+
+
+
The t erminal value at year N is oft en comput ed by assuming t hat t he FCF will grow at a
const ant growt h rat e beyond year N, i.e.
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) ) ( (
) 1 ( *
) ) ( (
1
FCF WACC
FCF
FCF WACC
N
N
g r
g FCF
g r
FCF
Value Terminal
+
+
where g
FCF
is t he expect ed growt h rat e of t he firms free cash flow
What is free cash flow ( FCF) ? The free cash measures t he cash generat ed by t he firm t hat can
be dist ribut ed t o t he equit y shareholders aft er budget ing for capit al expendit ure and working
capit al requirement s. While comput ing FCF, we assume t hat t he firm is a 100% equit y owned
company and hence we do not consider any payment t o debt or equit y holders while calculat ing
t he free cash flow. Thus t he formula for comput ing FCF is:
Capit al Working in I ncrease e Expendit ur Capit al Depn T * EBI T VFCF Terminal + ) ( 1
where T in t he t ax rat e.
We st art wit h EBI T since we do not consider cash out flow in t he form of int erest payment s.
Depreciat ion lowers t he EBI T but is added back since it is a non- cash expendit ure ( does not
result in cash payment s) . Since t he firm has t o incur any planned capit al expendit ure and has
t o finance any working capit al requirement before dist ribut ing t he profit s t o t he shareholders
t he same is deduct ed while calculat ing t he free cash flows.
5.4.2 Rel at i ve Val uat i on
Relat ive valuat ion models do calculat e t he share price but t hey are generally based on t he
valuat ion of comparable firms in t he indust ry. Various valuat ion mult iples such as price-earning
rat io, ent erprise value mult iples, et c. are used by t he finance professionals which depends on
t he indust ry, current economic scenario, et c. Most of t hese models are generally used for
evaluat ion purpose as t o whet her a part icular st ock is overvalued or undervalued and less for
act ual valuat ion of t he shares.
As discussed in t he first chapt er, t he face value or nominal value of a share is t he price print ed
on t he share cert ificat e. One should not confuse a shares nominal value wit h t he price at
which t he company issues shares t o t he public. The price at which a company issues shares
may be more or less t han t he face value. The issue price is generally more t han t he face value
and t he difference bet ween t he issue price and t he face value is called as share premium.
Market price is t he price at which t he share is t raded in t he market . I t is det ermined by t he
demand and supply of t he share in t he market and depends on t he market ( buyers and sellers)
est imat ion of t he present value of all fut ure cash flows t o t he company. I n an efficient market ,
we assume t hat t he market is able t o gat her all informat ion about t he company and price
accordingly. Market capit alizat ion of a company is t he t ot al value of all shares of t he company
and is calculat ed by mult iplying t he market price per share wit h t he number of shares out st anding
in t he market .
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The book val ue or car r yi ng val ue in account ing, is t he value of an asset according t o it s
balance sheet account balance. For asset s, t he value is based on t he original cost of t he asset
less any depreciat ion, amort izat ion or impairment cost s made against t he asset . Book value
per share is calculat ed by dividing t he net asset s of t he company wit h t he number of shares
out st anding. The net asset of t he company is t he values of all asset s less values of all liabilit ies
out st anding in t he books of account s.
5.4.2.1 Ear ni ng per Shar e ( EPS)
Earning per share is t he firms net income divided by t he average number of shares out st anding
during t he year.
Calculat ed as:
year t he during g out st andin shares of number Average
Shares Preference on Dividend Proift Net
EPS
5.4.2.2 Di vi dend per Shar e ( DPS)
Dividends are a form of profit dist ribut ion t o t he shareholders. The firm may not dist ribut e t he
ent ire income t o t he shareholders, but decide t o ret ain some port ion of it for financing growt h
opport unit ies. Alt ernat ively, a firm may pay dividends from past years profit during years
where t here is insufficient income. I n t his case, t he dividends amount will be higher t han t he
earnings. The dividend per share is t he amount t hat t he firm pays as dividend t o t he holder of
one share i.e. t ot al dividend / number of shares in issue.
The dividend payout rat io ( DPR) measures t he percent age of income t hat t he company pays
out t o t he shareholders in t he form of dividends. The formula for calculat ing DPR is:
EPS
DPS
I ncome Net
Dividends
DPR
Ret ent ion rat io is t he opposit e of dividend payout rat io and measures t he percent age of net
income not paid t o t he shareholders in t he form of dividends. I t is not hing but ( 1- DPR) .
Ex ampl e: Th e f ol l owi ng i s t he f i gu r e f or Ash a I n t er n at i on al dur i ng t he y ear
2008- 09:
Net I ncome: Rs. 1,000,000
Number of equit y shares ( 2008) : 150,000
Number of equit y shares ( 2009) : 250,000
Dividend paid: Rs. 400,000
Calculat e t he earnings per share ( EPS) , dividend per share ( DPS) , dividend payout rat io and
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ret ent ion rat io for Asha I nt ernat ional.
Answer:
000 , 200
2
000 , 250 000 , 150
2
+
closing Opening
shar es of number Aver age
5
000 , 200
0000 , 000 , 1
shares of Number Average
I ncome Net
EPS
2
000 , 200
000 , 00 , 4
shares of Number Average
Dividends
DPS
% 40 4 . 0
5
2
or
EPS
DPS
DPR
Ret ent ion Rat io = 1- DPR = 0.6 or 60%
5.4.2.3 Pr i ce- ear ni ngs r at i o ( P/ E Rat i o)
Price earning rat io for a company is calculat ed by dividing t he market price per share wit h t he
earnings per share ( EPS) .
share per earning Annual
share per price Market
Rat io Earnings Price
The earning per share is usually calculat ed for t he last one year. Somet imes, we also calculat e
t he PE rat io using t he expect ed fut ure one-year ret urn. I n such case, we call forward PE or
est imat ed PE rat io.
Example: St ock XYZ, whose earning per share is Rs. 50 is t rading in t he market at Rs. 2000.
What is t he price t o earnings rat io for XYZ?
Answer:
40
50
2000
share per earning Annual
share per price Market
Rat io Earnings Price
We cannot draw any conclusion as t o whet her a st ock is undervalued or overvalued in t he
market by j ust considering t he PE rat io. A higher PE rat io implies t hat t he invest ors are paying
more for each unit of net income, which implies t hat t he invest ors are opt imist ic about t he
fut ure performance ( or fut ure growt h rat e) of t he company. St ocks wit h higher PE rat io are
also called growt h firms and st ocks wit h lower PE rat io are called as income firms.
5.4.2.4 Pr i ce- Book Rat i o
The price- book rat io is widely used as a conservat ive measure of relat ive valuat ion of an asset ,
where t he asset s of t he firm are valued at book. I nvest ors also widely use t he rat io t o j udge
whet her t he st ock is undervalued or overvalued, as it s less suscept ible t o fluct uat ions t han t he
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PE rat io. The formula t o calculat e t he rat io is:
Price- book rat io = Market price of t he share / Book Value per share.
5.4.2.5 Ret ur n on Equi t y
Ret urn on equit y measures profit abilit y from t he equit y shareholders point of view. I t is t he
ret urn t o t he equit y shareholders and is measured by t he following formula:
Capit al Share Preferred Excluding Equit y r Shareholde Average
Dividends Preferred Tax aft er I ncome Net
ROE
Example: XYZ Company net income aft er t ax for t he financial year ending 31
st
March, 2009
was Rs. 10 million and t he equit y share capit al as on 31
st
March, 2008 and 31
st
March 2009
was Rs. 80 mi ll ion and Rs. 120 mi ll ion respect i vely. Calcul at e t he ret urn on equi t y of
XYZ company for t he year 2008- 09.
Answer:
million
Equit y Closing Equit y Opening
Equit y Aver age 100
2
120 80
2
+
% 10 10 . 0
100
10
or
Equit y Average
Tax aft er Profit Net
Equit y on Ret urn
5.4.2.6 The DuPont Model
The Du Pont model is widely used t o decide t he det erminant s of ret urn profit abilit y of a company,
or a sect or of t he economy. Ret urns on shareholder equit y are expressed in t erms of a companys
profit margins, asset t urn, and it s financial leverage.
DuPont Model breaks t he Ret urn on equit y as under:
RoE = Ret urn on Equit y
= Net Profit s/ Equit y
= Net Profit s/ Sales * Sales/ Asset s * Asset s/ Equit y
= Profit Margin * Asset Turnover * Financial Leverage
The first component measures t he operat ional efficiency of t he firm t hrough it s net margin
rat io. The second component , called t he asset t urnover rat io, measures t he efficiency in usage
of asset s by t he firm and t he t hird component measures t he financial leverage of t he firm
t hrough t he equit y mult iplier. The analysis reflect s a firms efficiency in different aspect s of
business and is widely used now for cont rol purpose. I t shows t hat t he firm could improve it s
RoE by a combinat ion of profit abilit y ( higher profit margins), raising leverage ( by raising debt ) ,
by using it s asset s bet t er ( higher asset t urn) or a combinat ion of all t hree.
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The DuPont analysis could be easily ext ended t o ascert ain a sect or s profit abilit y met rics for
comparabilit y, or, for t hat mat t er, an ent ire market .
5.4.2.7 Di vi dend Yi el d
Dividend yield is t he rat io bet ween t he dividend paid during t he last 1-year period and t he
current price of t he share. The rat io could also be used wit h t he forward dividend yield inst ead
expect ed dividends, for eit her t he next 12 mont hs, or t he financial year.
Example: ABC Company paid a dividend of Rs. 5 per share in 2009 and t he market price of
ABC share at t he end of 2009 was Rs. 25. Calculat e t he dividend yield for ABC st ock.
Answer:
% 20 20 . 0
25
5
or
share per Price Current
dividend year Last
Yield Dividend
5.4.2.8 Ret ur n t o I nvest or
The ret urn what t he invest or earns during a year by holding t he share of a company is not
equal t o t he dividend per share or t he earnings per rat io. An invest or s earning is t he sum of
t he dividend amount t hat he received from t he company and t he change in t he market price of
t he share. The invest ment amount is equal t o t he market price of t he share at t he beginning of
t he year. An invest or s ret urn can be calculat ed using t he following formula:
Price Market Opening
share) t he of price ( market Dividends
Ret urn( r) Expect ed
+
Example: The share price of PQR Company on 1st April 2008 and 31st March 2009 is Rs. 80
and Rs. 84 respect ively. The company paid a dividend of Rs. 6 for t he year 2008- 09. Calculat e
t he ret urn for a shareholder of PQR Company in t he year 2008- 09.
Answer:
% 5 . 12
80
10
80
) 80 84 ( 6 ) (
+
P
P P Div
r
+
1 1
0
r
P Div
P
+
.
The t ot al available amount t hat can be invest ed, is Re. 1. The proport ional invest ment s in each
of t he st ocks are as below,
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St ock A = W
St ock B = ( 1 - W)
where W is bet ween 0 and 1.
Given t his informat ion, we can show t hat
) , ( ) 1 ( 2 ) 1 (
2 2 2 2 2
B A Cov W W W W
B A p
+ +
That is, we would show t hat t he variance of our port folio, as denot ed by t he left hand side of
t his equat ion, is dependent on t he variance of st ock A, t hat of st ock B, and a t hird t erm, called
Cov( A,B) . I t is t his t hird t erm t hat denot es t he int errelat ionship bet ween t he t wo st ocks. As
discussed before, such a relat ion could be posit ive, negat ive or zero. I n cases wit h negat ive
covariance, port folio variance would act ually be lower t han t he ( weight ed) sum of st ock
variances! I n ot her words, since variance ( or st andard deviat ion) is t he primary met ric of risk
measurement , t hen we can say t hat t he risk of t he port folio would be lower t han individual
st ocks considered separat ely.
So here is how we go about deriving t his expression:
Wit h t hese invest ment s t he port folio ret urn is,
B A P
R W R W R ) 1 ( + ( 1)
B A P
R W R W R ) 1 ( +
( 2)
wher e,
P
R = Ret ur n on t he por t f ol i o and
P
R
= Mean r et ur n on t he por t f ol i o. Let ,
P
= St d.deviat ion of port folio ret urns, t hen t he variance of t he port folio ret urns can be
derived as,
( )
2
2
1
P p P
R R
n
( 3)
wit h a st raight forward rearrangement and subst it ut ion for
P
R = and
P
R
= from t he expressions
( 1) and ( 2) , t he port folio variance is,
=
( ) ( ) ( ) ( ) ( )
B B A A B B A A
R R R R
n
W W R R
n
W R R
n
W
1
) 1 ( 2
1
1
1
2
2
2
2
+ +
We know t hat ,
( )
2
2
1
A A A
R R
n
,
( )
2
2
1
B B B
R R
n
) , (
1
B A Cov R R R R
n
B B A A
The covariance can be regarded as a measure of how much t wo variables change t oget her
from t heir means. I t can also be expressed as,
B A B A
B A Cov
,
) , ( , where
B A,
is t he
correlat ion bet ween ret urns of st ocks A and B. Therefore, if t he correlat ion is posit ive and t he
st ocks have high st andard deviat ions, t hen t he covariance would be posit ive and large. I t
would be negat ive if t he correlat ion is negat ive.
Subst it ut ing t hese, t he port folio variance can be expressed as,
( ) ) , ( ) 1 ( 2 1
2 2 2 2 2
B A Cov W W W W
B A P
+ +
. ( 4)
Equat ion ( 4) suggest s t hat t he t ot al port folio variance comprises t he weight ed sum of variances
and weight ed sum of t he covariances t oo. Let us examine t he insight s from expression ( 4) for
t he variance of combinat ions of st ocks ( or any ot her asset ) wit h varying level of correlat ions.
Given t he nat ure of t he ret urn relat ionship bet ween t he A and B ( in Table 6.1) , it is easy t o see
t hat t heir correlat ion is - 1.0. For t he port folio of st ock A and B, t he risk becomes zero, when
weight of st ock A ( W) = 0.6.
Tabl e 6.2 : Decomposi t i on of t he Tot al Por t f ol i o Var i ance
Element of variance Proport ion Sigma Var/ Covar
Var A 0.6 0.05 0.000864
Var B 0.4 0.07 0.000864
Covar - 0.001728
Alt hough t he t wo st ocks involved were risky ( indicat ed by t he st andard deviat ions) , one of
t heir possible combinat ions becomes t ot ally risk- free. The variances of t he individual st ocks
are offset by t heir covariance in t he port folio ( as shown in Table 6.2) .
When t he correlat ion bet ween t he t wo st ocks is 1.0, t he st andard deviat ion of t he port folio
shall be j ust a weight ed average of t he st andard deviat ion of t he t wo st ocks involved. This
implies t hat a port folio wit h t wo perfect ly posit ively correlat ed st ocks cannot reduce risk. The
minimum port folio st andard deviat ion would always correspond t o t hat of t he st ock wit h t he
least st andard deviat ion.
The st andard deviat ion of t he port folio wit h t wo uncorrelat ed ( correlat ion = 0) st ocks would
always be lower t han t he case wit h correlat ion 1.0. I t is possible t o choose a value for W in
such a way, so t hat t he port folio risk can be brought down below t hat of t he least less risky
st ock involved in t he port folio.
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However, in t he real world t he correlat ions almost always lie bet ween 0 and 1. I t is very
st raight forward t o underst and t hat t he variance of port folios wit h st ocks having correlat ion in
t he 0 t o 1 range would cert ainly be lower t han t hose wit h st ocks having correlat ion 1. At t he
same t ime, t he variance of t hese port folios shall be higher t han t hose wit h uncorrelat ed st ocks.
Let us examine if we can reduce t he port folio variance by combining st ocks wit h correlat ion in
t he range of 0 t o 1. Consider t he t wo st ocks, ACC and Dr. Reddys Laborat ories ( DRL) wit h
correlat ion around 0.21. As given in t he following t able, for a unique combinat ion, t he t ot al
variance ( st andard deviat ion) of t he port folio is less t han t hat of ACC, t he least risky st ock.
The det ails of t he risk of t his port folio are provided in t he following t able.
Tabl e 6.3 : Ret ur n and st andar d devi at i on of ACC, DRL and Por t f ol i o
Year ACC DRL Combinat ions
W= 0.25 W= 0.50 W= 0.75
2001 1.24 1.5 1.44 1.37 1.31
2002 0.98 0.84 0.88 0.91 0.95
2003 1.41 1.42 1.42 1.42 1.41
2004 1.37 0.49 0.71 0.93 1.15
2005 1.61 1.2 1.30 1.41 1.51
St d. deviat ion 0.23 0.42 0.33 0.26 0.22
Average Ret urn 1.322 1.09 1.148 1.206 1.264
Not e: W represent s t he invest ment in ACC
This suggest s t hat for cert ain values of W, t he variance of t he port folio can be brought down by
combining securit ies wit h correlat ion t he range of 0 t o 1.
A comparison of t he behaviour ( ret urn-variance) of port folios made wit h st ocks of varying
correlat ion is given in t he following figure:
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Fi gur e 6.1 : Por t f ol i o Ri sk and Ret ur n f or Asset s w i t h Di f f er ent Cor r el at i ons
Not e: t he port folio sigma is t he st andard deviat ion. The port folios are creat ed by using act ual
ret urn dat a and assumed correlat ions, except 0.4, which is t he act ual correlat ion bet ween t he
t wo st ocks.
Wit h t hese insight s we can now examine t he behaviour of port folios wit h a larger number of
asset s.
6.2.1 Por t f ol i o var i ance - Gener al case
Let us assume t hat t here are N st ocks available for generat ing port folios. Then, t he port folio
variance ( given by equat ion 4) can be expressed as,
+
ij i i i i P
W W W
2 2 2
( 5)
where W
i
is t he proport ional invest ment in each of t he asset s and
ij
ij i P
N N
+
2
2
2
2
1 1
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ij i
N N N
N
N N
+
) 1 (
1 1 1 1
2
ij i
N
N
N
+
1 1
2
) ( Covariance Avg.
N
Variance Avg
N
,
_
+
1
1 ) . (
1
we creat e an equally weight ed port folio ( equal invest ment in t he st ocks) of N asset s. Then,
The expression j ust above gives t he following insight s:
1. As N becomes a large number, t he port folio variance would be dominat ed by t he
covariances rat her t han variances. The variance of t he individual st ocks does not mat t er
much for t he t ot al port folio variance. This is one of t he most powerful argument s for
port folio diversificat ion.
2. Even by including a large number of asset s, t he port folio variance cannot be reduced
t o zero ( except when t hey are perfect ly negat ively correlat ed) . The part of t he risk
t hat cannot be eliminat ed by diversifying t hrough invest ment s across asset s is called
t he market risk ( also called t he syst emat ic risk or non- diversifiable risk) . This is
somet hing all of us commonly experience while invest ing in t he market . One can
reduce t he risk of exposure t o say HCL Technologies in t he I T indust ry, by including
ot her st ocks from t he I T indust ry, like I nfosys t echnologies, Tech Mahindra and so on.
I f you consider t he exposure t o I T indust ry alone is t roubling, you can also spread your
invest ment t o ot her indust ries like Banking, Telecom, Consumer product s and so on.
Going furt her, you can even invest across different market s, if you do not like t o be
exposed t o anyone economy alone. But even aft er int ernat ional diversificat ion a cert ain
amount of risk would remain. ( int ernat ional market s in t he globalize world t end t o
move t oget her) . This is t he market risk or syst emat ic risk or non- diversifiable risk.
3. Given t he above, it appears t hat t he relevant risk of an asset is what it cont ribut es t o
a widely- held port folio, in ot her words, it s covariance risk.
6.3 Equi l i br i um Model s: The Capi t al Asset Pr i ci ng Model
The most import ant insight from t he analysis of port folio risk is t hat a part of t he port folio
variance can be diversified away ( unsyst emat ic or diversifiable risk) by select ing securit ies
wit h less t han perfect correlat ion. This along wit h t he ot her insight s obt ained from t he analysis
would help us t o underst and t he pricing of risky asset s in t he equilibrium for any asset in t he
capit al market , under cert ain assumpt ions.
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These addit ional assumpt ions required are as follows:
Al l invest or s ar e mean- var iance opt i mi zers. Thi s impl ies t hat invest or s ar e
concerned only about t he mean and variance of asset ret urns. I nvest ors would
eit her prefer port folios which offer higher ret urn for t he same level of risk or
prefer port folios which offer minimum risk for a given level of ret urn ( t he indirect
assumpt ion of mean-variance invest ors is t hat all ot her charact erist ics of t he asset s
are capt ured by t he mean and variance) .
I nvest ors have homogenous informat ion about different asset s. The well-organized
f i nanci al mar ket s have r emar kabl e abi l i t y t o di gest i nf or mat i on al most
inst ant aneously ( largely reflect ed as t he price variat ion in response t o sensit ive
informat ion) .
Transact ion cost s are absent in t he market and securit ies can be bought and sold
wit hout significant price impact .
I nvest ors have t he same invest ment horizon.
Given t hese assumpt ions, it is not impossible t o see t hat subst ant ive arbit rage opport unit ies
would not exist in t he market . For inst ance, if t here is a port folio which gives a higher ret urn
for same level of risk, invest ors would prefer t hat port folio compared t o t he exist ing one.
I n light of t he behaviour of port folio risk and t he above assumpt ions, let us t ry t o visualize
what would be t he relat ionship bet ween risk and ret urn of asset s in t he equilibrium.
6.3.1 Mean- Var i ance I nvest or s and Mar k et Behavi our
We can use a so- called mean-variance space t o examine t he aggregat e behaviour of t he
market (as all invest ors are mean-variance opt imizers, t hese are t he only variables t hat mat t er).
Evident ly, all t he asset s in t he market can be mapped on t o a ret urn- st andard deviat ion space
as follows.
Fi gur e 6.2 : Ret ur n and Ri sk of Some of t he Ni f t y st ock s
Source: NSE
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All t hese st ocks ( in figure 6.2) have correlat ions bet ween 0 and 1. Therefore, t heir combinat ion
could t heoret ically be charact erized as given in figure 6.3.
Fi gur e 6.3 : Feasi bl e Set of Por t f ol i os
All t he feasible port folio combinat ions can be represent ed by t he space enclosed by t he curved
line and t he st raight - line. The curved line represent s combinat ions of st ocks or port folios
where correlat i ons are less t han 1, wher eas port foli os along t he st raight - line represent
combinat ions of st ocks or port folios wit h t he maximum correlat ion (+ 1.0) ( no port folios would
lie t o t he right of t he st raight - line) .
Obviously, a mean-variance invest or would prefer port folio A t o B, given t hat it has lower risk
for t he same level of ret urn offered by B. Similarly, port folio A would be preferred t o port folio
C, given t hat it offers higher ret urn for t he same level of risk. D is t he minimum variance
port folio among t he ent ire feasible set . A close examinat ion of t he feasible set of port folios
reveals t hat port folios t hat lie along D-E represent t he best available combinat ion of port folios.
I nvest ors wi t h var ious r isk t ol erance level s can choose one of t hese por t f oli os. These
port folios offer t he maximum ret urn for any given level of risk. Therefore, t hese are called t he
efficient port folios ( and t he set of all such port folios, t he efficient front ier) , as represent ed in
Figure 6.4.
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Fi gur e 6.4: Ef f i ci ent Fr ont i er
Ordinarily, t he invest or also has t he opport unit y t o invest in a risk- free asset . Pract ically, t his
could be a bank deposit , t reasury bills, Government securit ies or Government guarant eed
bonds. Wit h t he availabilit y of a risk- free securit y, t he choice facing t he mean-variance invest or
can be convenient ly charact erised as follows:
Fi gur e 6.5 : Ef f i ci ent Por t f ol i o i n t he Pr esence of a Ri sk - Fr ee Asset
As given in figure 6.5, wit h t he presence of t he risk-free asset , t hat has no correlat ion wit h any
ot her risky asset , t he invest or also get s an added opport unit y t o combine port folios along t he
efficient front ier wit h t he risk- free asset . This would imply t hat t he invest or could part ly put
t he money in t he risky securit y and t he remaining in any of t he risky port folios.
Apparent ly, t he port folio choice of t he mean-variance invest or is no more t he securit ies along
t he efficient front ier ( D- E) . I f an invest or prefers less risk, t hen rat her t han choosing D by
going down t he efficient front ier, he can choose G, a combinat ion of risky port folio M and t he
risk- free asset . G gives a higher ret urn for t he level of risk of D. I n fact , t he same applies for
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all t he port folios along t he efficient front ier t hat lie bet ween D and M ( t hey offer only lower
ret urns compared t o t hose which lie along t he st raight - line connect ing t he risk- free asset and
risky port folio M) .
This gives t he powerful insight t hat , wit h t he presence of t he risk- free securit y, t he most
preferred port folio along t he efficient front ier would be M ( port folios t o t he right of M along t he
st raight line indicat es borrowing at t he risk- free rat e and invest ing in M) .
An invest or who does not want t o t ake t he risk of M, would be bet t er off by combining wit h t he
risk- free securit y rat her t han invest ing in risky port folios wit h lower st andard deviat ion ( t hat
lie along t he M- D) .
I dent ificat ion of M as t he opt imal port folio, combined wit h t he assumpt ions ( 1) t hat all invest ors
have t he same informat ion about mean and variance of securit ies and ( 2) t hey all have t he
same invest ment horizon, suggest t hat all t he invest ors would hold only t he following port folios
depending on t he risk appet it e.
1. The port folio purely of risky asset s, which would be M.
2. The port folio of risky asset s and risk- free asset , which would be a combinat ion of
M and R
F
.
All ot her port folios are inferior t o t hese choices, for any level of risk preferred by t he invest ors.
Let us examine what would be t he nat ure of t he port folio M. I f all invest ors are mean-variance
opt imizers and have t he same informat ion, t heir port folios would invariably be t he same.
Then, all of t hem would ident ify t he same port folio as M. Obviously, it should be a combinat ion
of all t he risky st ocks ( asset s) available in t he market ( somebody should be willing t o hold all
t he asset s available on t he market ) . This port folio is referred t o as t he market port folio.
Pract ically, t he mar k et por t f ol i o can be regarded as one represent ed by a very liquid index
like t he NI FTY. The line connect ing t he market port folio t o t he risk- free asset is called t he
Capi t al Mar k et Li ne ( CML) . All point s along t he CML have superior risk- ret urn profiles t o any
port folio on t he efficient front ier.
Wit h t he underst anding about t he aggregat e behaviour of t he invest ors in t he securit ies market ,
we can est imat e t he risk premium t hat is required for any asset . Underst anding t he risk
premium dramat ically solves t he asset pricing problem t hrough t he est imat ion of t he discount ing
fact or t o be applied t o t he expect ed cash flows from t he asset . Wit h t he expect ed cash flows
and t he discount ing rat e, t he price of any risky asset can be direct ly est imat ed.
Let R
M
be t he required rat e of ret urn on t he market ( market port folio, M) , R
F
be t he required
rat e of ret urn on t he risk free asset and
M
be t he st andard deviat ion of t he market port folio. .
Fr om Figur e 6.5, t he rat e of r isk premi um requir ed f or unit vari ance of t he mar ket is
est imat ed as,
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2
M
F M
R R
( 6)
I n a very liquid market ( where asset s can be bought and sold wit hout much hassles) , invest or
has t he opport unit y t o hold st ocks as a port folio rat her t han in isolat ion. I f invest ors have t he
opport unit y t o hold a well- diversified port folio, t he only risk t hat mat t ers in t he individual
securit y is t he increment al risk t hat it cont ribut es t o a well- diversified port folio. Therefore, t he
risk relevant t o t he prospect ive invest or (or firm) is t he covariance risk. Then, one can comput e
t he risk premium required on t he securit y as follows
Risk premium on st ock =
) , (
2
M i Cov
R R
M
F M
where, Cov( i,M) , is t he covariance bet ween t he ret urns of st ock i and t he market ret urns
( ret urns on port folio M) . The quant it y represent ed by
2
) , (
M
M i Cov
S P Ke C
rt
+ +
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7.6 Bl ack - Schol es f or mul a
The main quest ion t hat is st ill unanswered is t he price of a call opt ion for ent ering int o t he
opt ion cont ract , i.e. t he opt ion premium. The premium amount is dependent on many variables.
They are:
- Share Price ( )
0
S
- Exercise Price ( K)
- The t ime t o expirat ion i.e. period for which t he opt ion is valid ( T)
- Prevailing risk- free int erest rat e ( r)
- The expect ed volat ilit y of t he underlying asset ( )
One of t he landmark invent ions in t he financial world has been t he Black- Scholes formula t o
price a European opt ion. Fischer Black and Myron Scholes2 in t heir seminal paper in 1973 gave
t he world a mat hemat ical model t o value t he call opt ions and put opt ions. The formula proved
t o be very useful not only t o t he academics but also t o pract it ioners in t he finance world. The
aut hors were lat er awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of
Alfred Nobel in 1997. The Black- Scholes formula for valuing call opt ions ( c) and value of put
opt ions ( p) is as under:
) ( ) ( ) , (
2
) (
1
d N ke d SN t S c
t T r
and
) ( ) ( ) , (
1 2
) (
d SN d N Ke t S p
t T r
Where
t T
t T r
K
S
d
) (
2
ln
2
1
,
_
+ +
,
_
t T d d
1 2
Where,
(.) N is t he cumulat ive dist ribut ion funct ion ( cdf ) of t he st andard normal dist ribut ion
T- t is t he t ime t o mat urit y
S is t he spot price of t he underlying asset
K is t he st rike price
r is t he cont inuously compounded annual risk- free rat e
is t he volat ilit y in t he log ret urns of t he underlying.
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Example: Calculat e t he value of a call opt ion and put opt ion for t he following cont ract :
St ock Price ( S) = 100
Exercise Price ( K) = 105
Risk- free, cont inuously compounded int erest Rat e ( r) = 0.10 ( 10%)
Time t o expirat ion ( T- t ) = 3 mont h = 0.25 years
St andard deviat ion ( ) = 0.30 per year
0836 . 0
25 . 0 * 3 . 0
) 25 . 0 (
2
3 . 0
10 . 0
105
100
ln
) (
2
ln
2 2
1
,
_
+ +
,
_
,
_
+ +
,
_
t T
t T r
K
S
d
0236 . 25 . 0 3 . 0 0836 . 0
1 2
t T d d
4667 . 0 ) 0836 . 0 ( ) (
1
N d N
4076 . 0 ) 0236 . 0 ( ) (
2
N d N
5333 . 0 ) 0836 . 0 ( ) (
1
N d N
5924 . 0 ) 0236 . 0 ( ) (
2
N d N
Value of call opt ion ( c) =
9225 . 4 4076 . 0 * * 105 4667 . 0 * 100 ) ( ) ( ) , (
25 . 0 * 10 .
2
) (
1
e d N ke d SN t S c
t T r
Value of Put opt ion ( p) =
33 . 7 5333 . 0 * 100 5924 . 0 * * 105 ) ( ) ( ) , (
25 . 0 * 10 . 0
1 2
) (
e d SN d N Ke t S p
t T r
2
Bl ack, Fischer ; Myron Scholes ( 1973) . "The Pri cing of Opt i ons and Corporat e Liabil it i es" . Jour nal of Poli t ical
Economy 81 ( 3) : 637- 654
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CHAPTER 8: I nv est ment Management
8.1 I nt r oduct i on
I n t he final chapt er of t his module we t ake a brief look at t he professional asset management
indust ry. Worldwide, t he last few decades have seen an increasing t rend away from direct
invest ment in t he market s, wit h t he ret ail invest or now preferring t o invest in funds or t he
index, rat her t han direct exposure int o equit ies. This has nat urally led t o a sharp increase in
t he asset s under management of such firms.
The asset management indust ry primarily consist s of t wo kinds of companies, t hose engaged
i n i nvest ment advi sor y or weal t h management act i vi t i es, and t hose i nt o i nvest ment
management . I n t he first cat egory, invest ment advisory firms recommend t heir client s t o t ake
posit ions in various securit ies, and wealt h management firm eit her recommend, or have cust ody
of t heir client s funds, t o be invest ed according t o t heir discret ion. I n bot h cases, t he engagement
wit h client s is at an account level, i.e., funds are separat ely managed for each client . I n
cont rast , invest ment management companies combine t heir client s asset s t owards t aking
posit ions in a single port folio, usually called a fund ( or a mut ual fund) . A unit of such a fund
t hen represent s posit ions in each of t he securit ies owned in t he port folio. I nst ead of t racking
ret urns on t heir own port folios, client s t rack ret urns on t he net asset value ( NAV) of t he fund.
I n addit ion t o t he perceived benefit s of professional fund management , t he maj or reason
of invest ment int o funds is t he diversificat ion t hey afford t he invest or. For inst ance, inst ead
of owni ng ever y l ar ge- cap st ock i n t he mar ket , an i nvest or could j ust buy uni t s of a
large- cap fund.
I n t his chapt er, we shall examine t he various t ypes of such funds, different iat ed by t heir
invest ment mandat es, choice of securit ies, and of course, invest ment performance, where we
would out line a few of t he key met rics used t o measure invest ment performance of funds.
8.2 I nv est ment Compani es
I nvest ment companies pool funds from various invest ors and invest t he accumulat ed funds in
various financial inst rument s or ot her asset s. The profit s and losses from t he invest ment
( aft er repaying t he management expenses) are dist ribut ed t o t he invest ors in t he funds in
proport ion t o t he invest ment amount . Each invest ment company is run by an asset management
company who simult aneously operat e various funds wit hin t he invest ment company. Each
fund is managed by a fund manager who is responsible for management of t he port folio.
I nvest ment companies are referred t o by different names in different count ries, such as mut ual
funds, invest ment funds, managed funds or simply funds. I n I ndia, t hey are called mut ual
funds. Our t reat ment would use t hese names int erchangeably, unless explicit ly st at ed.
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8.2.1 Benef i t s of i nvest ment s i n managed f unds
The main advant ages of invest ing t hrough collect ive invest ment schemes are:
- Choi ce of Schemes: There are various schemes wit h different invest ment t hemes.
Through each scheme an invest or has an opport unit y t o invest in a wide range of
invest able securit ies.
- Pr of essi onal Management : Professionally managed by t eam of expert s.
- Di ver si f i cat i on: Scope for bet t er diversificat ion of invest ment since mut ual fund asset s
are invest ed across a wide range of securit ies.
- Li qui di t y: Easy ent ry and exit of invest ment : invest ors can wit h ease buy unit s from
mut ual funds or redeem t heir unit s at t he net asset value eit her direct ly wit h t he
mut ual fund or t hrough an advisor / st ock broker.
- Tr anspar ency: The asset management t eam has t o on a regular basis publish t he
NAV of t he asset s and broad break- up of t he inst rument s where t he invest ment
is made.
- Tax benef i t s: Dividends received on invest ment s held in cert ain schemes, such as
equit y based mut ual funds, are not subj ect t o t ax.
8.3 Act i v e v s. Passi v e Por t f ol i o Management
I f asset prices always reflect t heir equilibrium values ( expect ed ret urns equal t o t he value
specified by an asset pricing model) , t hen an invest or is unlikely t o benefit from act ively
searching for mispriced ( overpriced/ underpriced) opport unit ies in asset s. I n ot her words, t he
invest or is bet t er off by simply invest ing in t he market , or a represent at ive benchmark. For
inst ance, under such assumpt ions, an I ndian equit y invest or would achieve t he best possible
out come by t rying t o replicat e t he Nift y 50 by invest ing in t he const it uent st ocks in t he same
proport ion as t hey are in t he index.
Such invest ment assumes t hat gains in t he market are t hose of t he benchmark, and not in t he
choice of individual securit ies, as opport unit ies in t heir select ion, or t iming of ent ry/ exit are
t oo short t o be t aken advant age of. This, passive approach t o invest ment rest s upon t he
t heory of market efficiency, which we saw in chapt er 4. Recall t hat t he EMH post ulat es t hat
prices always fully reflect all t he available informat ion and any deviat ion from t he full informat ion
price would be quickly arbit raged away. I n an efficient market , informat ion about fundament al
fact ors relat ed t o t he asset , or it s market price, volume or any ot her relat ed t rading dat a
relat ed has lit t le value for t he invest or.
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Passive fund managers t ry t o replicat e t he performance of a benchmark index, by replicat ing
t he weight s of it s const it uent st ocks. Given daily price movement in st ock prices, t he challenge
for such managers is t o minimize t he so- called t racking error of t he fund, which is calculat ed
as t he deviat ion in it s ret urns from t hat of t he index. The choice of t he index furt her different iat es
bet ween t he funds, for example, an equit y index fund would simply t ry t o maint ain t he ret urn
profile of t he benchmark index, say, t he NI FTY 50; but if invest ment s are allowed across asset
classes, t hen t he benchmark could well consist of a combinat ion of a equit y and a debt index.
Recent evidence of syst emat ic depart ures of asset prices in t he from equilibrium values, as
envisaged under t he market efficiency, has renewed int erest in act ive fund management ,
which ent ails t hat opt imal select ion of st ocks, and t he t iming of ent ry/ exit could lead t o market-
beat ing ret urns.
This represent s an opport unit y for invest ors t o engage in act ive st rat egies based on t heir
obj ect ive views about t he asset s. I n a generic sense, such views are about t he relat ive under
pricing or over pricing of an asset . Over pricing present s an opport unit y t o engage in short
selling, under pricing an opport unit y t o t ake a long posit ion, and combinat ions of t he t wo are
also possible, across st ocks, and port folios.
The obj ect ive of an act ive port folio manager is t o make higher profit s from invest ing, wit h
similar, or lower risks at t ached. The risk of a port folio, as not ed in an earlier chapt er, is usually
measured wit h t he st andard deviat ion of it s asset s. A good port folio manager should have
good forecast ing abilit y and should be able t o do t wo t hings bet t er t han his compet it ors:
market t iming and securit y select ion.
By market t iming, we refer t o t he abilit y of t he port folio manager t o gauge at t he beginning of
each period t he profit abilit y of t he market port folio vis--vis t he risk-free port folio of Government
bonds. The st rengt h of such a signal would indicat e t he level of invest ment required in t he
market .
By securit y select ion, we refer t o abilit y of a port folio manager in ident ifying mispricing in
individual securit ies and t hen invest ing in securit ies wit h t he maximum mispricing, which
maximizes t he so- called alpha. The alpha of a securit y refers t o t he expect ed excess ret urn of
t he securit y over t he expect ed rat e of ret urn (for example, est imat ed by an equilibrium asset -
pricing model like t he CAPM) . The mispricing may be eit her way: I f t he port folio manager
believes t hat a securit y is going t o generat e negat ive ret urn, his port folio should give a negat ive
weight for t he same i.e. short t he securit y and vice versa. The t radeoff for t he act ive invest or
is t he presence of nonsyst emat ic risk in t he port folio. Since t he port folio of an act ive invest or
is not fully diversified, t here is some nonsyst emat ic ( firm- specific) risk t hat is not diversified
away. Act ive fund management is a diverse businesst here are many ways t o make money in
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t he market almost all t he invest ment st yles we would examine furt her in t he chapt er are
illust rat ive examples.
Act ive and passive fund management are not always chalk and cheeset here are t echniques
t hat ut ilize bot h, like port folio t ilt ing. A t ilt ed port folio shift s t he weight s of it s const it uent s
t owards one or more of cert ain pre- specified market fact ors, like earnings, valuat ions, dividend
yields, or t owards one or more specific sect ors.
By t heir very nat ure of operat ions, act ive and passive invest ment s differ meaningfully in t erms
of t heir cost s t o t he invest ors. Passive invest ment is charact erized by low t ransact ion cost s
( given t heir low t urnover) , management expenses, and t he risks at t ached. Act ive fund
management is underst andably more expensive, but has seen cost s falling over t he years on
compet it ive pricing and increased liquidit y of t he market s, which reduced t ransact ion cost s.
8.4 Cost s of Management : Ent r y / Ex i t Loads and Fees
Running a mut ual fund involves cert ain cost s ( e.g. remunerat ion t o t he management t eam,
advert ising expenses et c.) which may be recurring or non- recurring in nat ure. These cost s are
recovered by t he fund from t he invest ors ( e.g. from redempt ion fees) or from charges on t he
asset s ( t ransact ion fees, management fees and commission et c.) of t he funds.
Generally, t he management t eam is paid a fixed percent age of t he asset under management
as t heir fees.
I nvest ment management companies can be broadly classified on t he basis of t he securit ies
t hey invest in and t heir invest ment obj ect ives. Before we look at eit her, we define t he core
measure of ret urn for a fund, t he NAV, and so- called open, and closed- ended funds.
8.5 Net Asset Val ue
The net asset value NAV is t he most i mport ant and widely f oll owed met ri c of a funds
performance. I t is calculat ed per share using t he following formula:
dign out s shares of Number
s liabilit ie of Value Market Asset s of Value Market
share per NAV
t an
) (
Net asset value ( NAV) is a t erm used t o describe t he per unit value of t he funds net asset s
( asset s less t he value of it s liabilit ies) . Hence t he NAV for a fund is
Fund NAV = ( Market Value of t he fund port folio Fund Expenses) / Fund Shares Out st anding
Just like t he share price of a common st ock, t he NAV of a fund would rise wit h t he value of t he
fund port folio, and is inst ant ly reflect ive of t he value of invest ment .
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8.6 Cl assi f i cat i on of f unds
8.6.1 Open ended and cl osed- ended f unds
Funds are usually open or closed- ended. I n an open- ended fund, t he unit s are issued and
redeemed by t he fund, at any t ime, at t he NAV prevalent at t he t ime of issue / redempt ion.
The fund discloses t he NAV on a daily basis t o facilit at e issue and redempt ion of unit s. Unlike
open- ended funds, closed- ended funds sell unit s only at t he out set and do not redeem or sell
unit s once t hey are issued. The invest ors can sell or purchase unit s t o ( or from) ot her invest ors
and t o facilit at e such t ransact ions, such unit s are t raded on st ock exchanges. Price of closed
ended schemes are det ermined based on demand and supply for t he unit s at t he st ock exchange
and can be more or less t han t he NAV of t he unit s.
We now examine t he different kind of funds on t he basis of t heir invest ment s. While we had
earlier ment ioned mut ual fund invest ment s represent ed as unit s in a single port folio, in real
life, fund houses float various schemes from t ime- t o- t ime, each a const it ut ing a port folio
where input s t ranslat e int o unit s. These schemes are different iat ed by t heir chart er which
mandat es t heir invest ment int o asset classes.
Beyond t he t ype of inst rument s t hey invest in, fund houses are also different iat ed in t erms of
t heir invest ment st yles. The approaches t o equit y invest ing could be diversified or undiversified,
growt h, income, sect or rot at ors, value, or market - t iming based.
Each mut ual fund scheme has a part icular invest ment policy and t he fund manager has t o
ensure t hat t he invest ment policy is not breached. The policy is laid right at t he out set when
t he fund is launched and is specified in t he prospect us, t he Offer Document of t he scheme.
The invest ment policy det ermines t he inst rument s in which t he money from a specific scheme
will be primarily invest ed. Based on t hese securit ies, mut ual funds can be broadly classified
int o equit y funds ( growt h funds and income funds) , bond funds, money market funds, index
funds, et c. Generally, fund houses have dozens of schemes float ing in t he market at any given
t ime, wit h separat e invest ment policies for each scheme.
8.6.2 Equi t y f unds
Equit y funds primarily invest in common st ock of companies. Equit y funds can be growt h
funds or income funds. Growt h funds focus on growt h st ocks, i.e., companies wit h st rong
growt h pot ent ial, wit h capit al appreciat ion being t he maj or driver, while income funds focus on
companies t hat have high dividend yields. I ncome funds focus on dividend income or coupon
payment s from bonds ( if t hey are not pure equit y) .
Equit y funds may also be sect or- specific wherein t he invest ment is rest rict ed t o st ocks from a
specific indust ry. For example, in I ndia we have many funds focusing on companies in power
sect or and infrast ruct ure sect or.
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8.6.3 Bond f unds
Bond funds invest primarily in various bonds t hat were described in t he earlier segment . They
have a st able income st ream and relat ively lower risk. They could pot ent ially invest in corporat e
bonds, Government . bonds, or bot h.
8.6.4 I ndex f unds
I ndex funds have a passive invest ment st rat egy and t hey t ry t o replicat e a broad market
index. A scheme from such a fund invest s in component s of a part icular index proport ionat e t o
t heir represent at ion in t he benchmark. I t is possible t hat a scheme t racks more t han one index
( in some pre- specified rat io) , in eit her equit y, or across asset classes.
8.6.5 Money mar k et f unds
Money market mut ual funds invest in money market inst rument s, which are short-t erm securit ies
issued by banks, non- bank cor porat i ons and Government s. The var ious money market
inst rument s have already been discussed earlier.
8.6.6 Fund of f unds
Fund of funds add anot her layer of diversificat ion bet ween t he invest or and securit ies in t he
market . I nst ead of individual st ocks, or bonds, t hese mut ual funds invest in unit s of ot her
mut ual funds, wit h t he fund managers mandat e being t he opt imal choice across mut ual fund
schemes given ext ant market condit ions.
8.7 Ot her I nv est ment Compani es
I n addit ion t o t he broad cat egories ment ioned here, t here are many ot her kinds of funds,
depending on market oppor t unit ies, and invest or appet i t e. Tot al r et ur n funds look at a
combinat ion of capit al appreciat ion and dividend income. Hybrid funds invest in a combinat ion
of equit y, bonds, convert ibles, and derivat ive inst rument s. These funds could be furt her
dist ribut ed as asset allocat ion, balanced, or flexible port folio funds, based on t he breadt h of
t heir invest ment in different asset classes, and t he frequency of modifying t he allocat ion.
Global, regional, or emerging market funds recognize invest ment opport unit ies across t he
world, and accordingly base t heir invest ment focus. Such funds could again comprise eit her, or
a combinat ion of equit y, debt , or hybrid inst rument s. We ment ion some ot her, specific t ypes of
invest ment vehicles below.
8.7.1 Uni t I nvest ment Tr ust s ( UI T)
Similar t o mut ual funds, UI Ts also pool money from invest ors and have a fixed port folio of
asset s, which are not changed during t he life of t he fund. Alt hough t he port folio composit ion is
act ively decided by t he sponsor of t he fund, once est ablished t he port folio composit ion is not
changed ( hence called unmanaged funds) .
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The way an UI T is est ablished is different from t hat of ot her mut ual funds. UI Ts are usually
creat ed by sponsors, who first make invest ment in t he port folio of securit ies. The ent ire port folio
is t hen t ransferred t o a t rust and t he t rust ees issue t rust cert ificat es t o t he public, which is
similar t o shares. The t rust ees dist ribut e t he incomes from t he invest ment and t he mat urit y
( capit al) amount t o t he shareholders on mat urit y of t he scheme.
8.7.2 REI TS ( Real Est at e I nvest ment Tr ust s)
REI TS are also similar t o mut ual funds, but t hey invest primarily in real est at es or loans
secured by real est at e. REI T can be of t hree t ypes equit y, mort gage or hybrid t rust s. Equit y
t rust s invest in real est at e asset s, mort gage t rust s invest in loans backed by mort gage and
hybrid t rust s invest in eit her.
8.7.3 Hedge Funds
Hedge funds are generally creat ed by a limit ed number of wealt hy invest ors who agree t o pool
t heir funds and hire experienced professionals ( fund managers) t o manage t heir port folio.
Hedge funds are privat e agreement s and generally have lit t le or no regulat ions governing
t hem. This gives a lot of freedom t o t he fund managers. For example, hedge funds can go
short ( borrow) funds and can invest in derivat ives inst rument s which mut ual funds cannot do.
Hedge funds generally have higher management fees t han mut ual funds as well as performance
based fees. The management fee ( paid t o t he fund managers) , in t he case of hedge funds is
dependent on t he asset s under management ( generally 2 - 4%) and t he fund performance
( generally 20% of t he excess ret urns over t he market ret urn generat ed by t he fund) .
8.8 Per f or mance assessment of managed f unds
Prior t o t he development of t he modern port folio t heory ( MPT) , port folio managers were
evaluat ed by comparing t he ret urn generat ed by t hem wit h some broad yardst ick. The risk
borne by t he port folio managers or t he source of performance such as market t iming, market
volat ilit y, t he securit y select ions and valuat ions were not considered. Wit h t he development of
t he MPT, t he goal of performance evaluat ion is t o st udy whet her t he port folio has provided
superior ret urns compared t o t he risks involved in t he port folio or compared t o an equivalent
passive benchmark.
The performance evaluat ion approach t ries t o at t ribut e t he performance t o t he following:
- Risk
- Timing: market or volat ilit y
- Securit y select ion of indust ry or individual st ocks
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Therefore:
a) The focus of evaluat ion should be on excess ret urns
b) The port folio performance must account for t he difference in t he risk
c) I t should be able t o dist inguish t he t iming skills from t he securit y select ion skills.
The assessment of managed funds involves comparison wit h a benchmark. The benchmark
could be based on t he Capit al Market Line ( CML) or t he Securit y Market Line ( SML) . When it is
based on capit al Market Line, t he relevant measure of t he port folio risk is and when based
on Securit y Market Line, t he relevant measure is . Various measures are devised t o evaluat e
port folio performance, viz. Sharpe Rat io, Treynor Rat io and Jensen Alpha.
8.8.1 Shar pe Rat i o
Sharpe rat io or excess ret urn t o variabilit y measures t he port folio excess ret urn over t he
sample period by t he st andard deviat ion of ret urns over t hat period. This rat io measures t he
effect iveness of a manager in diversifying t he t ot al risk ( ) . This measure is appropriat e if one
is evaluat ing t he t ot al port folio of an invest or or a fund, in which case t he Sharpe rat io of t he
port folio can be compared wit h t hat of t he market . The formula for measuring t he Sharpe
rat io is:
p f p
r r Rat io Shar pe / ) (
This will be compared t o t he Shape rat io of t he market port folio. A higher rat io is preferable
since it implies t hat t he fund manager is able t o generat e more ret urn per unit of t ot al risks.
However, managers who are operat ing specific port folios like a value t ilt ed or a st yle t ilt ed
port folio generally t akes a higher risks, and t herefore may not be willing t o be evaluat ed based
on t his measure.
8.8.2 Tr eynor Rat i o
Treynor s measure evaluat es t he excess ret urn per unit of syst emat ic risks ( ) and not t ot al
risks. I f a port folio is fully diversified, t hen becomes t he relevant measure of risk and t he
performance of a fund manager may be evaluat ed against t he expect ed ret urn based on t he
SML ( which uses t o calculat e t he expect ed ret urn) . The formula for measuring t he Treynor
Rat io is:
p f p
r r Rat io Theynor / ) (
8.8.3 Jensen measur e or ( Por t f ol i o Al pha)
The Jensen measure, also called Jensen Alpha, or port folio alpha measures t he average ret urn
on t he port folio over and above t hat predict ed by t he CAPM, given t he port folios bet a and t he
average market ret urns. I t is measured using t he following formula:
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) ] ( [
f M p f p p
r r r r +
The ret urns predict ed from t he CAPM model is t aken as t he benchmark ret urns and is indicat ed
by t he formula wit hin t he bracket s. The excess ret urn is at t ribut ed t o t he abilit y of t he managers
for market t iming or st ock picking or bot h. This measure invest igat es t he performance of
funds and especially t he abilit y of t he managers in st ock select ion in t erms of t hese cont ribut ing
aspect s.
This measure is widely used in evaluat ing mut ual fund performance. I f
P
is posit ive and
significant , it implies t hat t he fund managers are able t o ident ify st ocks wit h high pot ent ial for
excess ret urns. Market t iming would refer t o t he adj ust ment in t he bet a of t he port folio in
t andem wit h market movement s. Specifically, t iming skills call for increasing t he bet a when
t he market is rising and reducing t he bet a, when t he market declines, for example t hrough
fut ures posit ion. I f t he fund manager has poor market t iming abilit y, t hen t he bet a of t he
port folio would not have been significant ly different during a market decline compared t o t hat
during a market increase.
Example: The dat a relat ing t o market port folio and an invest or P port folio is as under:
I nvest or Ps Port folio Market Port folio ( M)
Average Ret urn 28% 18%
Bet a ( ) 1.4 1
St andard Deviat ion ( ) 30% 20%
Assumi ng t hat t he r i sk- f r ee r at e f or t he mar ket i s 8%, cal cul at e ( a) Shar pe Rat i o
( b) Treynor Rat io and ( c) Jensen Alpha for t he invest or P and t he market .
Answer:
I nvest or P Port folio Market Port folio ( M)
p f p
r r Rat io Shar pe / ) ( ( 28% - 8%) / 30% = 0.67 ( 18% - 8%) / 20% = 0.5
p f p
r r Rat io Tr eynor / ) ( ( 28% - 8%) / 1.4 = 5 ( 18% - 8%) / 1 = 10
Alpha Jensen 28% - [ 8% + 1.4* ( 18% - 8%) ] 18% - [ 8% + 1
) ] ( [ ) (
f M p f p p
r r r r + = 28% - 22% = 6% ( 18% - 8%) ] = 0
* * *
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MODEL TEST
I NVESTMENT ANALYSI S AND PORTFOLI O
MANAGEMENT MODULE
Q: 1. __________ would mean t hat no invest or would be able t o out perform t he market
wit h t rading st rat egies based on publicly available informat ion. [ 1 Mark]
( a) Semi st rong form efficiency
( b) Weak-form efficiency
( c) St rong form efficiency
Q: 2. A company' s __________ provide t he most accurat e informat ion t o it s management
and shareholders about it s operat ions. [ 1 Mark]
( a) advert isement s
( b) financial st at ement s
( c) product s
( d) vision st at ement
Q: 3. ______ fund managers t ry t o replicat e t he performance of a benchmark index, by
replicat ing t he weight s of it s const it uent st ocks. [ 2 Marks]
( a) Act ive
( b) Passive
Q: 4. Unlike t erm insurance, __________ ensure a ret urn of capit al t o t he policyholder on
mat urit y, along wit h t he deat h benefit s. [ 1 Mark]
( a) high premium or low premium policies
( b) fixed or variable policies
( c) assurance or endowment policies
( d) growt h or value policies
Q: 5. Gross Profit Margin = Gross Profit / Net Sales [ 2 Marks]
( a) FALSE
( b) TRUE
Q: 6. Securit y of ABC Lt d. t rades in t he spot market at Rs. 595. Money can be invest ed at
10% per annum. The fair value of a one- mont h fut ures cont ract on ABC Lt d. is ( using
cont inuously compounded met hod) : [ 2 Marks]
( a) 630.05
( b) 620.05
( c) 600.05
( d) 610.05
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Q: 7. Account s payable appears in t he Balance Sheet of companies. [ 2 Marks]
( a) TRUE
( b) FALSE
Q: 8. A port folio comprises of t wo st ocks A and B. St ock A gives a ret urn of 8% and st ock B
gives a ret urn of 7%. St ock A has a weight of 60% in t he port folio. What is t he
port folio ret urn? [ 2 Marks]
( a) 9%
( b) 11%
( c) 10%
( d) 8%
Q: 9. Evidence accumulat ed t hrough research over t he past t wo decades suggest s t hat
dur i ng many epi sodes t he mar ket s ar e not ef f i ci ent even i n t he weak f or m.
[ 2 Marks]
( a) FALSE
( b) TRUE
Q: 10. Mr. A buys a Put Opt ion at a st rike price of Rs. 100 for a premium of Rs. 5. On expiry
of t he cont ract t he underlying shares are t rading at Rs. 106. Will Mr. A exercise his
opt ion? [ 3 Marks]
( a) No
( b) Yes
Q: 11. Price movement bet ween t wo I nformat ion Technology st ocks would generally have a
______ co-variance. [ 1 Mark]
( a) zero
( b) posit ive
( c) negat ive
Q: 12. I n t he case of callable bonds, t he callable price ( redempt ion price) may be different
from t he face value. [ 2 Marks]
( a) FALSE
( b) TRUE
Q: 13. Term st ruct ure of int erest rat es is also called as t he ______. [ 2 Marks]
( a) t erm curve
( b) yield curve
( c) int erest rat e curve
( d) mat urit y curve
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Q: 14. Each invest ment company is run by an _______. [ 1 Mark]
( a) asset deployment company
( b) revenue management company
( c) asset management company
( d) asset reconst ruct ion company
Q: 15. A ________, is a t ime deposit wit h a bank wit h a specified int erest rat e. [ 1 Mark]
( a) cert ificat e of deposit ( CD)
( b) commercial paper ( CP)
( c) T- Not e
( d) T- Bill
Q: 16. Prices ( ret urns) which are not according t o CAPM shall be quickly ident ified by t he
market and brought back t o t he __________. [ 1 Mark]
( a) average
( b) st andard deviat ion
( c) mean
( d) equilibrium
Q: 17. Net acquisit i ons / disposals appears in t he Cash Flow St at ement of Companies.
[ 3 Marks]
( a) TRUE
( b) FALSE
Q: 18. ______ are a fixed income securit y. [ 1 Mark]
( a) Equit ies
( b) Forex
( c) Derivat ives
( d) Bonds
Q: 19. I nvest ment advisory firms manage ______. [ 1 Mark]
( a) each client ' s account seperat ely
( b) all client s account s in a combined manner
( c) only t heir own money and not client ' s money
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Q: 20. _______ measures t he percent age of net income not paid t o t he shareholders in t he
form of dividends. [ 1 Mark]
( a) Wit hholding rat io
( b) Ret ent ion rat io
( c) Preservat ion rat io
( d) Maint enance rat io
Q: 21. I n a Bond t he ____ is paid at t he mat urit y dat e. [ 1 Mark]
( a) face value
( b) discount ed value
( c) compounded value
( d) present value
Q: 22. Banks and ot her financial inst it ut ions generally creat e a port folio of fixed income
securit ies t o fund known _______ . [ 2 Marks]
( a) asset s
( b) liabilit ies
Q: 23. Which of t he following account ing st at ement s form t he backbone of financial analysis
of a company? [ 1 Mark]
( a) t he income st at ement ( profit & loss) ,
( b) t he balance sheet
( c) st at ement of cash flows
( d) All of t he above
Q: 24. The balance sheet of a company is a snapshot of t he ______ of t he firm at a point in
t ime. [ 2 Marks]
( a) t he sources and applicat ions of funds of t he company.
( b) expendit ure st ruct ure
( c) profit st ruct ure
( d) income st ruct ure
Q: 25. The need t o have an underst anding about t he abilit y of t he market t o imbibe informat ion
int o t he prices has led t o count less at t empt s t o st udy and charact erize t he levels of
efficiency of different segment s of t he financial market s. [ 1 Mark]
( a) TRUE
( b) FALSE
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Q: 26. I n invest ment decisions, _______ refers t o t he market abilit y of t he asset .
[ 2 Marks]
( a) value
( b) profit abilit y
( c) price
( d) liquidit y
Q: 27. Mr. A buys a Call Opt ion at a st rike price of Rs. 700 for a premium of Rs. 5. Mr. A
expect s t he price of t he underlying shares t o rise above Rs. ______ on expiry dat e in
order t o make a profit . [ 3 Marks]
( a) 740
( b) 700
( c) 720
( d) 760
Q: 28. The ______ refers t o t he lengt h of t ime for which an invest or expect s t o remain
invest ed in a part icular securit y or port folio, before realizing t he ret urns. [ 2 Marks]
( a) invest ment horizon
( b) credit cycle horizon
( c) durat ion horizon
( d) const raint horizon
Q: 29. A ________ provides an account of t he t ot al revenue generat ed by a firm during a
period ( usually a financial year, or a quart er) . [ 1 Mark]
( a) Account ing analysis st at ement
( b) financial re-engineering st at ement
( c) promot ional expenses st at ement
( d) profit & loss st at ement
Q: 30. New st ocks/ bonds are sold by t he issuer t o t he public in t he ________ . [ 1 Mark]
( a) fixed income market
( b) secondary market
( c) money market
( d) primary market
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94
Q: 31. Securit y of ABC Lt d. t rades in t he spot market at Rs. 525. Money can be invest ed at
10% per annum. The fair value of a one- mont h fut ures cont ract on ABC Lt d. is ( using
cont inously compounded met hod) : [ 2 Marks]
( a) 559.46
( b) 549.46
( c) 539.46
( d) 529.46
Q: 32. I f t he market is _______, t he period aft er a favorable ( unfavorable) event would not
generat e ret urns beyond ( less t han) what is suggest ed by an equilibrium model such
as CAPM. [ 1 Mark]
( a) weak- form efficient
( b) st rong form efficient
( c) semi- st rong form efficient
Q: 33. A sell order comes int o t he t rading syst em at a Limit Price of Rs. 120. The order will
get execut ed at a price of _______. [ 2 Marks]
( a) Rs. 120 or more
( b) Rs. 120 or less
Q: 34. __________ have precedence over common st ock in t erms of dividend payment s,
and t he residual claim t o it s asset s in t he event of liquidat ion. [ 1 Mark]
( a) Preferred shares
( b) Equit y shares
Q: 35. One needs t o average out t he t ime t o mat urit y and t ime t o various coupon payment s
t o find t he effect ive mat urit y for a bond. The measure is called as _____ of a bond.
[ 2 Marks]
( a) durat ion
( b) I RR
( c) YTM
( d) yield
Q: 36. I n case of compound i nt er est rat e, we need t o know t he _______ f or whi ch
compounding is done. [ 1 Mark]
( a) period
( b) frequency
( c) t ime
( d) durat ion
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95
Q: 37. Net change in Working Capit al appears in t he Cash Flow St at ement of Companies.
[ 3 Marks]
( a) FALSE
( b) TRUE
Q: 38. A company's net income for a period is Rs. 15,00,00,000 and t he average shareholder's
fund during t he period is Rs. 1,00,00,00,000. The Ret urn on Average Equit y is :
[ 3 Marks]
( a) 13%
( b) 12%
( c) 15%
( d) 16%
Q: 39. A port folio comprises of t wo st ocks A and B. St ock A gives a ret urn of 14% and st ock
B gives a ret urn of 1%. St ock A has a weight of 60% in t he port folio. What is t he
port folio ret urn? [ 2 Marks]
( a) 10%
( b) 9%
( c) 12%
( d) 11%
Q: 40. Average Ret urn of an invest or' s port folio is 10%. The risk free ret urn for t he market is
8%. The Bet a of t he invest or's port folio is 1.2. Calculat e t he Treynor Rat io. [ 3 Marks]
( a) 4
( b) 8
( c) 2
( d) 6
Q: 41. The share price of PQR Company on 1st April 2009 and 31st March 2010 is Rs. 20 and
Rs. 24 respect ively. The company paid a dividend of Rs. 5 for t he year 2009- 10.
Cal culat e t he r et ur n f or a shar eholder of PQR Company i n t he year 2009- 10.
[ 1 Mark]
( a) 45%
( b) 65%
( c) 75%
( d) 55%
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Q: 42. Port folio management is t he art of managing t he expect ed _______ requirement for
t he corresponding ________. [ 1 Mark]
( a) income, expendit ure
( b) gain, losses
( c) profit , loss t olerance
( d) ret urn, risk t olerance
Q: 43. Average Ret urn of an invest or' s port folio is 55%. The risk free ret urn for t he market is
8%. The Bet a of t he invest or' s port folio is 1.2. Calculat e t he Treynor Rat io.
[ 3 Marks]
( a) 41
( b) 39
( c) 43
( d) 45
Q: 44. I n addit ion t o t he perceived benefit s of professional fund management , t he maj or
reason of invest ment int o funds is t he ______ t hey afford t he invest or. [ 1 Mark]
( a) specialisat ion
( b) diversificat ion
( c) variet y
( d) expansion
Q: 45. ABC Lt d. has paid a dividend of Rs. 10 per share last year and it is expect ed t o grow
at 5% every year. I f an invest or' s expect ed rat e of ret urn from ABC Lt d. share is 7%,
cal cul at e t he mar ket pr i ce of t he shar e as per t he di vi dend di scount model .
[ 2 Marks]
( a) 540
( b) 530
( c) 525
( d) 535
Q: 46. The CAPM is founded on t he following t wo assumpt ions ( 1) in t he equilibrium every
mean variance invest or holds t he same market port folio and ( 2) t he only risk t he
invest or faces is t he bet a. [ 1 Mark]
( a) TRUE
( b) FALSE
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Q: 47. Market s are inefficient when prices of securit ies assimilat e and reflect informat ion
about t hem. [ 1 Mark]
( a) TRUE
( b) FALSE
Q: 48. St ock ret urns are generally expect ed t o be independent across weekdays, but a number
of st udies have found ret urns on Monday t o be lower t han in t he rest of t he week. This
depart ure from market efficiency is also somet imes called t he _____ effect . [ 2 Marks]
( a) Monday- Friday
( b) weekday
( c) Monday
( d) weekend
Q: 49. Over pr icing in a st ock present s an opport unit y t o engage in _____ t he st ock.
[ 2 Marks]
( a) short covering
( b) short selling
( c) act ive buying
( d) going long
Q: 50. What is t he amount an invest or will get on a 1-year fixed deposit of Rs. 10000 t hat
pays 8% int erest compounded quart erly? [ 1 Mark]
( a) 12824.32
( b) 13824.32
( c) 10824.32
( d) 11824.32
Q: 51. For longer invest ment horizons invest ors look at ______ . [ 2 Marks]
( a) riskier asset s like equit ies.
( b) low risk asset s like government securit ies.
Q: 52. Dividend Per Share = Tot al Dividend / Number of Shares in issue [ 1 Mark]
( a) TRUE
( b) FALSE
Q: 53. Price movement bet ween t wo St eel company st ocks would generally have a ______
co-variance. [ 1 Mark]
( a) posit ive
( b) negat ive
( c) zero
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98
Q: 54. The price of a derivat ive is dependent on t he price of anot her securit y, called t he
_____ . [ 1 Mark]
( a) basis
( b) variable
( c) underlying
( d) opt ions
Q: 55. Call Opt ions can be classified as : [ 1 Mark]
( a) European
( b) American
( c) All of t he above
Q: 56. I n I ndia, Commercial Papers ( CPs) can be issued by _____. [ 3 Marks]
( a) Mut ual Fund Agent s
( b) I nsurance Agent s
( c) Primary Dealers
( d) Sub- Brokers
Q: 57. An endowment fund is an inst it ut ional invest or. [ 1 Mark]
( a) FALSE
( b) TRUE
Q: 58. ______ orders are act ivat ed only when t he market price of t he relevant securit y
reaches a t hreshold price. [ 2 Marks]
( a) Limit
( b) Market - loss
( c) St op- loss
( d) I OC
Q: 59. A port folio comprises of t wo st ocks A and B. St ock A gives a ret urn of 9% and st ock B
gives a ret urn of 6%. St ock A has a weight of 60% in t he port folio. What is t he
port folio ret urn? [ 2 Marks]
( a) 11%
( b) 9%
( c) 10%
( d) 8%
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Q: 60. The issue price of T- bills is generally decided at an ______ . [ 3 Marks]
( a) OTC market
( b) int er- bank market
( c) exchange
( d) auct ion
________________________________________
Cor r ect Answ er s :
Quest i on No. Answ er s Quest i on No. Answ er s
1 ( a) 31 ( d)
2 ( b) 32 ( c)
3 ( b) 33 ( a)
4 ( c) 34 ( a)
5 ( b) 35 ( a)
6 ( c) 36 ( b)
7 ( a) 37 ( b)
8 ( d) 38 ( c)
9 ( b) 39 ( b)
10 ( a) 40 ( c)
11 ( b) 41 ( a)
12 ( b) 42 ( d)
13 ( b) 43 ( b)
14 ( c) 44 ( b)
15 ( a) 45 ( c)
16 ( d) 46 ( a)
17 ( a) 47 ( b)
18 ( d) 48 ( d)
19 ( a) 49 ( b)
20 ( b) 50 ( c)
21 ( a) 51 ( a)
22 ( b) 52 ( a)
23 ( d) 53 ( a)
24 ( a) 54 ( c)
25 ( a) 55 ( a)
26 ( d) 56 ( c)
27 ( b) 57 ( b)
28 ( a) 58 ( c)
29 ( d) 59 ( d)
30 ( d) 60 ( d)
________________________________________
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