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TYBMS INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT SEM V
ABOUT US…
EDUWIZ MANAGEMENT EDUCATION is the only coaching institute in Mumbai which is entirely
dedicated to BMS FINANCE coaching only. We do not spread out onto other electives simply because we
want to build a strong brand in Management Education in Finance. This helps us infuse quality teaching into
students.
WE at EDUWIZ MANAGEMENT EDUCATION, believe in the philosophy -
“Give a man a fish, and you feed him for a day; show him how to catch fish, and you feed him for a lifetime”
This idea of teaching and learning helps us to instill the core values and concepts of education in our students.
Making the student life ready than exam ready has always been at the foremost in our teaching methodology.
Enabling the student understand, why does he need to study a subject and how is it going to help him for his
future, is a necessary parameter in our pedagogy. We not only coach our students, but also mentor them for
life skills, career development; thereby contributing to the overall wellbeing and holistic development of our
students. Taking this further we provide career counseling, extracurricular activities and placement assistance,
which fosters the confidence and success approach of our fellow pupils.
And last but not the least,
THINK BMS…THINK EDUWIZ!!!
1|Page EDUWIZ MANAGEMENT EDUCATION

TABLE OF CONTENTS
PAGE
SR. NO TOPIC
NO.
0 SYLLABUS 3
1 INTRODUCTION TO INVESTMENT ENVIRONMENT 4
2 INVESTMENT ALTERNATIVES 9
3 CAPITAL MARKET IN INDIA 27
4 RISK AND RETURN 40
5 PORTFOLIO MANAGEMENT 59
6 FUNDAMENTAL ANALYSIS 66
7 TECHNICAL ANALYSIS 93
8 THEORIES OF TECHNICAL ANALYSIS 111
9 CAPITAL ASSET PRICING MODEL 134
10 PORTFOLIO EVALUATION 123
THINK BMS…THINK EDUWIZ!!!

SYLLABUS
UNIT I : INTRODUCTION TO INVESTMENT ENVIRONMENT
 Introduction to Investment Environment
Introduction, Investment Process, Criteria for Investment, Types of Investors, Investment V/s
Speculation V/s Gambling, Investment Avenues, Factors Influencing Selection of Investment
Alternatives
 Capital Market in India
Introduction, Concepts of Investment Banks its Role and Functions, Stock Market Index, The
NASDAQ, SDL, NSDL, Benefits of Depository Settlement, Online Share Trading and its Advantages,
Concepts of Small cap, Large cap, Midcap and Penny stocks
UNIT II : RISK - RETURN RELATIONSHIP

 Meaning, Types of Risk- Systematic and Unsystematic risk, Measurement of Beta, Standard
Deviation, Variance, Reduction of Risk through Diversification. Practical Problems on Calculation of
Standard Deviation, Variance and Beta.
UNIT III : PORTFOLIO MANAGEMENT AND SECURITY ANALYSIS

 Portfolio Management:
Meaning and Concept, Portfolio Management Process, Objectives, Basic Principles, Factors affecting
Investment Decisions in Portfolio Management, Portfolio Strategy Mix.
 Security Analysis:
Fundamental Analysis, Economic Analysis, Industry Analysis, Company Analysis, Technical Analysis
- Basic Principles of Technical Analysis., Uses of Charts: Line Chart, Bar Chart, Candlestick Chart,
Mathematical Indicators: Moving Averages, Oscillators.
UNIT IV : THEORIES, CAPITAL ASSET PRICING MODEL AND PORTFOLIO PERFORMANCE

MEASUREMENT
 Theories:
Dow Jones Theory, Elliott Wave Theory, Efficient Market Theory
 Capital Asset Pricing Model:

Assumptions of CAPM, CAPM Equation, Capital Market Line, Security Market Line
 Portfolio Performance Measurement:

Meaning of Portfolio Evaluation, Sharpe‟s Ratio (Basic Problems), Treynor‟s Ratio (Basic Problems),
Jensen‟s Differential Returns (Basic Problems)

INTRODUCTION TO INVESTMENT ENVIRONMENT
INVESTMENT
Investment is the employment of funds with the aim of getting return on it. Investment means "the current
commitment of funds for a period of time in order to derive a future flow of funds that will compensate
investor for the time the funds are committed, for the expected rate of inflation and also for uncertainty
involved in the future flow of funds". Investors expect return on his investment which should compensate
them for the risk they take in forgoing current consumption of money for future consumption and for
inflation.
There are two concepts of investment:

1) Economic Investment
The concept of economic investment means additions to the capital stock of the society. The capital stock of
society is the goods which are used in the production of other goods. The term investment, implies the
formation of new and productive capital in the form of new construction and producers durable instrument
such as Plant and Machinery. Inventories and human capital are also included in this concept. Thus, an
investment, in economic terms, means an increase in building, equipment, and inventory.
2) Financial Investment
This is an allocation of monetary resources to assets that are expected to yield some gain or return over a
given period of time. It means an exchange of financial claims such as shares and bonds, real estate, etc.
Financial investment involves contracts written on pieces of paper such as shares and debentures. People
invest their funds in shares, debentures, fixed deposits, National saving certificates, life insurance policies,
provident funds etc.
SPECULATION
"Speculation is an activity, quite contrary to its literal meaning, in which a person assumes high risks, often
without regard for the safety of his invested principal, to achieve large capital gains." The time span in
which the gain is sought to be made is usually very short.
ELEMENTS OF INVESTMENTS/CRITERIA FOR SELECTING INVESTMENTS

(a) Return
Investors buy or sell financial instruments in order to earn return on them. The return on investment is the
reward to the investors. The return includes both current income and capital gains or losses, which arises by
the increase or decrease of the security price.
(b) Risk
Risk is the chance of loss due to variability of returns on an investment. In case of every investment, there is
a chance of loss. Return is a precise statistical term and it is measurable. But the risk is not precise statistical

term. However, the risk can be quantified. The investment process should be considered in terms of both
risk and return.
(c) Time
Time is an important factor in investment. It offers several different courses of action. Time period depends
on the attitude of the investor who follows a 'buy and hold' Policy. As time moves on, analysts believe that
conditions may change and investors may revaluate expected return and risk for each investment.
(d) Liquidity
Liquidity is also important factor to be considered while making an investment. Liquidity refers to the
ability of an investment to be converted into cash as and when required. The investor wants his money back
any time. Therefore, the investment should provide liquidity to the investor.
(e) Tax Saving

The investors should get the benefit of tax exemption from the investments. There are certain investments
which provide tax exemption to the investor. The tax saving investments increases the return on investment.
Therefore, the investors should also think of saving income tax and invest money in order to maximize the
return on investment.
The following points are considered for selecting suitable investment avenue:
INVESTMENT PROCESS
Any rational investor has to go through certain steps to make sound investments. These steps can be
summarised as below :
i) Review of Investment avenues/alternatives :
The first step in investment process is to take a look at available options for making investment, for e.g. A
small investor will have Post Office, Bank, Mutual funds as his options, he will not consider real estate as
his option, due to his limited availability of funds.
ii) Determination Of investment objectives and constrains :

Investor has to consider the goal(s) he wants to achieve by making investment. Investment objectives would
include return on investment, safely of investment it may also include other goals such as need for
retirement benefit, need for purchasing own house etc. Investor also may have to face certain constrains like
lack of sufficient funds, irregular flow of income, high rates of tax, etc.
Every investor should review his Own objectives and constrains before choosing any investment alternative.
iii) Investment Analysis :

After reviewing available avenues and his own objectives, investor has to analyse the available avenues.
Investor has to study the nature of security, type of industry, regularity of return, chances of default, price of
security etc. Investors can use techniques like technical analysis and fundamental analysis to evaluate
securities.
iv) Portfolio Construction :

Portfolio refers to combined holding of multiple securities. Portfolio construction involves identifying
specific assets for investment, and also to determine the amount to be invested in each asset, for this an
investor can use inputs from earlier steps i.e. investment objectives and investment analysis. Investor has to
take a balanced decision to achieve various objectives. Investor should wait till suitable 'time for making
investment. Various strategies, theories and statistical tools are available to aid portfolio construction.
v) Portfolio Performance Evaluation :

An investor should evaluate the performance of his investments. Performance evaluation should be done
periodically and objectively. Performance evaluation provides meaningful inputs for improving the quality
of investment management. Investor would like to know how far his objectives were achieved by selecting a
particular investment.
vi) Portfolio Revision :

Every investor has to review his investment regularly. The market conditions, securities prices, interest rates
all keep on changing. Investor has to revise his portfolio accordingly. Investor‟s objectives may also change
over a period of time. There is a famous saying in investment analysis i.e. „never marry an investment‟.
Portfolio revision involves repetition of all earlier steps.
TYPES OF INVESTOR’S
All portfolio decisions are substantially affected by investors liking for risk. Common investors will have
three possible attitudes to undertake risky course of action (i) an aversion to risk (ii) a desire to take risk,
and (iii) an indifference to risk. The following example will clarify the risk attitude of the individual
investors.
i) Risk averse investors:

A rational investor would always like to maximise his returns at minimum possible risk. This category of
investor generally likes to avoid taking risk, he does not like to take extra risk' if he is offered same level of
expected returns. He will take extra risk only if he is offered extra returns by investing in a risky security.
Normally all investors are' risk averse because no one would like to incur extra risk for earning same level
of returns.
ii) Risk taking investors:

These are those investors like to take more risk, there main motive while investing money is not to earn
returns but to take risk. They like to take high risk with investing the funds available to them in risk>
investments to satisfy there urge to take risk and in hope of earnings huge returns.

iii) Risk indifferent investors :

This category of investors are not concerned with the level of risk they take by investing money in a
particular investment avenue.
Example : The possible outcomes of two alternative A and B, depending on the state of economy are as
follows :
State of Economy Possible outcome (%)
X Y
Recession 45 -25
Normal 50 75
Boom 55 100
If we assume that the three states of the economy are equally likely, then expected value for each alternative
is 50%.
a) A risk seeker is one who, given a choice between more or less risky alternatives with identical
expected values, prefers the riskier alternative i.e, alternative Y.
b) A risk averted would select the less risky alternative i.e, alternative X.
c) The person who is indifferent to risk (risk neutral) would be indifferent to both alternative X and Y
because they have same expected values.
The empirical evidence shows that majority of investors are risk-averse,
i) A risk averter is likely to prefer
ii) A risk-seeker is likely to prefer
iii) A risk-neutral investor

He may invest in any of the above options.
INVESTMENT V/S SPECULATION V/S GAMBLING

1. Investment
Investment is well planned activity of committing funds with the aim of achieving returns. Every investment
involves some risk, but it is a calculated risk taken after careful study of the investment avenue.
2. Speculation
Speculation is an activity in which a person assumes high risk, often without regard for safely of invested
amount, to achieve large capital gains in short duration, it is indulged in on the basis of some privileged
information or as known in stock market based on some “tips‟.

3. Gambling
on Gambling involves taking high risk without demanding high compensation in
the form of increased return, gambling is indulged into not for returns but for mere reason of fun and
satisfying the habit of taking risk and indulging in some kind of adventure. Therefore, it is unplanned, non-
scientific, and without knowledge of the nature of risk.
Both investment and speculation involve on element of risk. But an investor normally takes a limited risk
and expects to hold investment for a long term to earn stable return in form of interest or dividends, while a
speculator takes high end risk and expects to make money out of price fluctuations in the market.
Investment and Speculation may be distinguished as below :
BASIS FOR
INVESTMENT SPECULATION
COMPARISON
The purchase of an asset with the Speculation is an act of conducting a risky
Meaning hope of getting returns is called financial transaction, in the hope of
investment. substantial profit.
Basis for Fundamental factors, i.e. Hearsay, technical charts and market
decision performance of the company. psychology
Time horizon Longer term Short term
Risk involved Moderate risk High risk
Intent to profit Changes in value Changes in prices
Expected rate of
Modest rate of return High rate of return
return
Funds An investor uses his own funds. A speculator uses borrowed funds.
Income Stable Uncertain and Erratic
Behavior of
Conservative and Cautious Daring and Careless
participants
Investment requires an investor
peculation is usually based on wild rumours
to do some work before hand
Research and unsubstantiated hearsays which cannot
and decisions are made based on
be checked for accuracy.
known facts and figure.
Since speculation is not based on anything
Over a long period of time, true concrete, its result is not at all
Consequence investment tends to produce a predictable. Speculation can occasionally
positive result. produce very high gains just as it can
produce very high losses.

2 INVESTMENT ALTERNATIVES
A] NON MARKETABLE FINANCIAL ASSETS
1. POST OFFICE SAVINGS SCHEMES

Post office acts as one of the most important saving mobiliser in India. Post office has branches in all parts
of the country even in rural areas, this helps in mobilising savings from all corners of the country. The funds
are deposited with the Government hence it offers 100% safety in money. The post office also offers decent
rate of interest. Many of the postal schemes enjoy tax benefits also. Post office normally cannot provide
good service to the investors due to too much paper work, lack of staff, outdated procedures etc. Despite this
Post office schemes are one of the highly popular schemes in India.
Various post office schemes and there features are described in the table given below:
Investment
Interest Salient Tax
Scheme Tenure Denominat-
Rates Features Benefits
ions and limits
Min : 50 Max :
3.5% p.a. On
Post Office Rs. 1 lakh for
individual No specific or Cheque facility Interest is tax-free
Savings individual and
and joint fix tenure available u/s 10(11)
Account 2 lakhs for joint
account
account
One
withdrawal up to
50% of the
5-Year Post Min : Rs. 10 balance is
Office 7.5% 5 years. Can be per month or allowed after one
Recurring compounded renewed for multiples of Rs. year. Full No tax Benefit
Deposit quarterly another 5 years 5 Max : No maturity value
Account limit allowed on R.D.
6 & 12 months
advance deposits
earn rebate.

No tax deduction
Monthly 8.40% Min: Rs. 1500
at source and No tax deduction at
Incone payable 6 years and Max: Rs.
10% bonus at source
Scheme monthly 450,000
maturity.
6.25% 1 year
Long-term
Post Office
accounts could
Time Deposit
be closed after 1
Account 6.50% 2 years year for
7.25% 3 years discounted
Min: Rs. 200 interest. A/cs
Investment
and its multiple could be closed
qualifies for
thereof Max: after 6 months
deduction u/s 80C.
No limit but before a year
for no int.
Interest is
7.50% 5 years
calculated
quarterly but
payable yearly.
No limits.
Investment
8.4% denomination s A single holder
compounded available are of certificate can be
yearly. Rs. 100, Rs. purchased by an
Kisan Vikas Money 500, Rs. 1000, adult. A
No tax benefits
Patra doubles in 8 Rs. 5000, Rs. certificate can
years and 7 10,000, in all also be
months Post Offices purchased jointly
and Rs. 50,000 by two adults.
in all Head Post
Offices.
10 | P a g e EDUWIZ MANAGEMENT EDUCATION

Min : Rs. 100.

Also available Investment as well
8 % p. a.
National in denom- A single holder as the interest
compounded
Savings inations of Rs. certificate can be deemed to be re -
half-yearly 6 years
Certificate 100/-, 500/, purchased by an invested qualifies
but payable
(VIII issue) 1000/-, 5000 & adult. for deduction u/s
after maturity
Rs. 10,000/-. 80C
Max: no limit
Age should be
above 60 yrs. or
55 yrs above if
retired under
superannuation.
Account if
Only 1 deposit closed after 1
Senior
allowed in year will suffer a Investment
Citizens‟
9% p.a. 5 years multiple of Rs. deduction of qualifies for
Savings
1000. Max is 1.5% interest and deduction u/s 80C.
Scheme
Rs. 15 lakhs after 2 years will
suffer a
deduction of 1%
interest. TDS is
made on interest
if it exceeds
Rs.10000 p.a.
2. PUBLIC PROVIDENT FUND (PPF)

Public Provident Fund (PPF) is one attractive tax sheltered investment scheme for middle class and salaried
persons. It is even useful to businessmen and higher income earning people. The PPF scheme is very
popular among the marginal income tax payers. The scheme was introduced in 1969.

FEATURES
(1) PPF account may be opened at any branch of the SBI or its subsidiaries or at specified branches of
nationalised banks like the Bank of Maharashtra, Bank of Baroda etc. PPF account can be opened even in a
post office on the same terms and conditions. Such account can be opened by any individual or by HUF.
Even NRI can be opened PPF account.
(2)The PPF account is for a period of 15 years but can be extended for more years (5 years at a time) at the
desire of the depositor.
(3) The depositor is expected to make a minimum deposit of Rs. 100 every year.
(4) The PPF account is not transferable, but nomination facility is available.
(5) The deposits in a PPF account are qualified for tax exemption- under the Income-tax Act (Section 80 -
(6) A compound interest at 8% per annum is paid in the case of PPF account with effect from 1-3-2003. The
interest accumulated in the PPF account is also tax free.
(7) PPF A/c holder is eligible for one withdrawal per financial year after five years from the end of the year
in which the subscription is made. It is limited to 50% of the balance at the end of the fourth year.
(8) On maturity, the credit balance in the PPF account can be withdrawn or the subscriber can extend
account for five years more.
(9) The balance amount in a PPF account is fully exempted from the Wealth Tax. The PPF account is also
exempted from attachment from the court.
Scheme Interest Tenure Investment Salient Tax Benefits
Rates Denominations Features
And Limits
15-Year 8 % p. a. 15 Years Min: Rs. 500 In 1 Withdrawal Can Be Investment
Public Compoun Tenure Year Max: Rs. Made Every Year And Interest
Provident ded 70000 In 1 Year After The 7th Qualifies For
Fund Yearly Deposits Can Be Financial Year. From Deduction
Account Made In Lump- The 3rd Financial U/S 80C.
Sum Or 12 Year, Loan Can Be
Installments Availed Against
PPF. No Attachment
Under Court Decree
Order.
LIMITATIONS
(1) Low liquidity as one withdrawal is allowed in a year.
(2) The PPF account is for a period of 15 years which is a very long period.
3. BANK DEPOSITS
It is the simplest avenue of investment. A bank deposit can be made by opening a bank account and
depositing money in it. Different types of band deposit accounts are :
(i) Current Account

(ii) Savings Account

(iii) Fixed Deposit Account
(iv) Recurring Deposit.
A deposit in current account does not earn any interest while deposits in other kinds of bank accounts earn
interest.
FEATURES
(1) Any individual (of major age) can open a bank account by following simple procedure. An account
holder is treated as bank customer and all normal banking facilities and services are offered to him. A bank
account may be single or joint. Nomination facility is also given to account holders.
(2) Deposits in the banks are safe and secured. They can be withdrawn as per the terms and conditions of the
bank account. The benefit of deposit insurance scheme is also available to bank depositors.
(3) Money can be deposited at any time in the case of current and savings bank accounts. In the case of
fixed deposit account, it is deposited only once and money is deposited every month in the case of recurring
deposit account.
(4) Interest is paid on bank deposits (except current deposits).
The interest rate is decided by the RBI from time to time as per the money market situation. The co-
operative banks offer nearly one per cent higher interest rate as compared to commercial banks. Even senior
citizens are offered a little higher interest rate (normally one per cent).
(5) Interest is paid on quarterly or six monthly basis. However, if the deposit period is less than 90 days, the
interest is paid on maturity.
(6) Bank deposits have high liquidity. Banks even give loan on the security of fixed deposit receipts.
ADVANTAGES
(1) Investment is reasonably safe and secured with adequate liquidity.
(2) Banks offer reasonable return on the investment made and that too in a regular manner.
(3) Banks offer loan facility against the investments made.
(4) Procedures and formalities involved in bank investment are limited, simple and quick.
(5) Banks offer various services and facilities to their customers.
LIMITATIONS/DEMERITS
(1) The rate of return in the case of bank investment is low as compared to other avenues of investment.
(2) The return on investment is not adequate even to give protection against the present inflation rate in the
country.
(3) Capital appreciation is not possible in bank investment.
4. COMPANY FIXED DEPOSITS IN INDIA

1. Company fixed deposit (CFD) is a deposit with financial institutes and NBFCs for a fixed rate of return
over a fixed period of time. The rate of interest is determined by the tenure of the deposit as well as other
factors. The deposit made in a CFD is governed by section 58A of the Companies Act.
2. CFDs are a good option for investment as they provide higher rate of interest compared to bank deposits.
They are a good source of regular income by means of monthly, quarterly, half-yearly, or yearly interest
incomes.

3. However, these deposits are not secured like those in the bank. In case of default by a company, the
investor cannot sell the deposit documents to recover his amount. The investor has no claim over the assets
of the company in case the company is wound-up. This makes CFD a risky option.
4. In order to protect ones investment from the risk, the performance of the company must be reviewed
before investing. Also at the time of maturity, if you wish to reinvest your amount, check the company‟s
performance. Keep a regular check on the companies in which you plan to invest by keeping track of its
balance sheet and share prices. This shall enable you to decide your investment in CFD.
5. The NBFCs that offer CFD has to get themselves rated by the rating agencies such as CRISIL, CARE,
ICRA etc., but manufacturing firms have no such compulsion. Before you invest in any of the CFDs, check
the company‟s ratings. A company with the rating of AA is considered a good investment option.
BENEFITS
i) High rates of interest.
ii) Stable source of income.
iii) Sufficient safety as most companies are rated.
iv) Flexible tenure ranging from 6 months to 7 years.
v) Only 6 months lock-in period
vi) High liquidity - issuers offer loan against CFD and pre-mature withdrawal facility
vii) No TDS in case the interest is only ? 5000 in a year.
viii) Nomination facility.
ix) Regular interest incomes - monthly, quarterly, half-yearly, or yearly.
x) Simple operational process - PAN not required
5. UNIT LINKED INSURANCE PLANS [ULIPS]

A ULIP is a market-linked insurance plan. There is a difference between a ULIP and other insurance plans
viz. the way in which the premium money is invested. Premium from traditional insurance plan or an
endowment plan is invested mainly in risk-free instruments like government securities (Gsecs) and AAA
rated corporate paper, while in case of ULIP, the premiums can be invested in stock markets in addition to
corporate bonds and/or Gsecs. This option makes ULIPs an attractive investment for an individual.
BENEFITS
1. Transparency
ULIPs provide a transparent option to customers for planning their various life stage needs through market-
led investments as compared to the traditional investment plans.
2. Insurance cover plus savings
ULIPs serve 2 main purposes - of providing life insurance along with savings at market-linked returns.
Hence, ULIPs can be termed as a two-in-one plan in terms of offering an individual the twin benefits of life
insurance plus savings. This option is not available in comparable instruments such as mutual fund for
instance, that does not offer a life cover.
ULIPs offer a variety of investment options unlike traditional life insurance plans. ULIPs generally come in
3 broad variants :
• Aggressive ULIPs (invest 80% - 100% in equities and the balance in debt)

• Balanced ULIPs (invest about 40% - 60% in equities)

• Conservative ULIPs (invest up to 20% in equities)
Such allocation of debt/equity varies according to insurance companies. An investor also has the option of
choosing various options/funds available according to his risk appetite and return expectation.
1. Flexibility
Individuals may switch between the ULIP fund options in order to capitalize on investment opportunities
across the debt and equity markets. Some insurance companies also allow a certain number of free switches.
This is an extremely important feature which allows the investor to benefit from the vagaries of stock/debt
markets. Switching also helps individuals as they can shift from an aggressive to a balanced or conservative
ULIP as they are approaching retirement based on their risk appetite.
2. Works like a SIP
Rupee cost-averaging is an important benefit associated with ULIPs. The mutual fund industry offer SIP
options to investors where in individuals invest their monies regularly over a period of time and in intervals
of a month/quarter and don't need to be worried about „timing1 the stock markets. It is important to note that
these benefits are not peculiar to mutual funds only. Not many realize that ULIPs also tend to work in the
same manner, albeit on a quarterly or half- yearly basis.
3. ULIP - Important considerations
When buying a ULIP, one must select the plan that best suits your needs. The important thing is to look for
and understand the nuances that can considerably alter the manner in which the product works for you.
Consider the following :
i) Charges : A complete charge structure includes the initial charges, fixed administrative charges, fund
management charges, mortality charges and spreads, and that too, not only in the first year but throughout
the term of the policy.
ii) Fund Options and Management : One needs to understand the various fund options available and the
fund management objectives of the scheme. Facts like who manages the funds, how much experience do
they have, are there sufficient controls - need to be taken into consideration.
iii) Features : Most ULIPs are really good in providing features such as allowing one to top-up and/or
switch between funds, increase or decrease the protection level, or also premium holidays. The conditions
and charges associated for such features should be understood. For instance, is there any minimum amount
that must be switched? Are there any charges on the same?
iv) Company : Another important consideration is the brand that you are insuring with. The company must
be trustworthy and should be in a position to honor its commitments as per your needs.
B) MONEY MARKET
The money market is the market in which short term funds are borrowed and lent. The lending money
market institutions are:
• Government of India and other sovereign bodies.
• Banks and Development Financial Institutions.
• PSUs [Public Sector Undertakings].
• Private sector organizations
• The Government/Quasi government owned non-corporate entities.

INSTRUMENTS OF MONEY MARKET

1. CALL MONEY
a) Call or notice money is an amount borrowed or lent on demand for a very short period. If the period is
greater than one day and up to 14 days it is called Notice money; otherwise the amount is known as Call
money. No collateral security is needed to cover these transactions.
b) The call market enables the banks and institutions to even out their day-today deficits and surpluses of
money. Co-operative banks, commercial banks and primary dealers are allowed to borrow and lend in this
market for adjusting their cash reserve requirements.
c) This is a completely inter-bank market. Interest rates are market determined. In view of the short tenure
of these transactions, both borrowers and lenders are required to have current accounts with Reserve Bank
of India.
2. TREASURY BILLS
These are the lowest risk category instruments for the short term. RBI issues treasury bills [T-bills] at a
prefixed day and for a fixed amount. There are 4 types of treasury bills :
• 14-day T-bill : maturity is in 14 days, it is auctioned on every Friday of every week and the notified
amount for auction is Rs. 100 crores.
• 182-day T-bill : maturity is in 182 days, it is auctioned on every alternate Wednesday, which is not a
reporting week and the notified amount for auction is Rs. 100 crores.
• 364-day T-bill : maturity is 64 days, it is auctioned on every alternate Wednesday which is a reporting
week and the notified amount for the auction is Rs. 500 crores.
3. CERTIFICATES OF DEPOSITS
a) After treasury bills, the next lowest risk category investment option is certificate of deposit (CD) issued
by banks and Financial Institution (FI). A CD is a negotiable promissory note, secure and short term, of up
to a year, in nature.
b) A CD is issued at a discount to the face value, the discount rate being negotiated between the issuer and
the investor. Although RBI allows CDs up to one-year maturity, the maturity most quoted in the market is
for 90 days.
4. COMMERCIAL PAPERS
a) Commercial papers [CPs] are negotiable short-term unsecured promissory notes with fixed maturities,
issued by well-rated organizations. These are generally sold on discount basis.
b) Organizations can issue CPs either directly or through banks or merchant banks [called as dealers]. These
instruments are normally issued in the multiples of five crores for 30/45/60/90/120/180/270/364 days.
5. READY FORWARD CONTRACTS

a) These are transactions in which two parties agree to sell and repurchase the same security. Under such an
agreement the seller sells specified securities with an agreement to repurchase the same at a mutually
decided future date and price.
b) Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an
agreed date in future at a predetermined price.

c) Such a transaction is called Repo when viewed from the prospective of the buyer of securities that is the
party acquiring fund. It is called reverse repo when viewed from the prospective of supplier of funds.
6. COMMERCIAL BILLS
a) Bills of exchange are negotiable instruments drawn by the seller or drawer of the goods on the buyer or
drawee of the good for the value of the goods delivered. These bills are called trade bills.
b) These trade bills are called commercial bills when they are accepted by commercial banks. If the bill is
payable at a future date and the seller needs money during the currency of the bill then the seller may
approach the bank for discounting the bill.
7. PASS THROUGH CERTIFICATES

a) This is an instrument with cash flows derived from the cash flow of another underlying instrument or
loan. The issuer is a special purpose vehicle (SPV), which only receives money, from a multitude of may be
several hundreds or thousands, underlying loans and passes the money to the holders of the PTCs. This
process is called securitization.
b) Legally speaking PTCs are promissory notes and hence tradable freely with no stamp duty payable on
transfer. Most PTCs have 2-3 year maturity because the issuance stamp duty rate makes shorter duration
PTCs unviable.
8. DATED GOVERNMENT SECURITIES

a) These are securities issued by the Government of India and State Governments. The date of maturity is
specified in the securities therefore they are known as dated securities.
b) The Government borrows funds through the issue of long term dated securities, the lowest risk category
instruments in the economy.
c) They are issued through auctions conducted by RBI, where RBI decides the coupon or discount rate
based on the response received.
d) Most of these securities are issued as fixed interest bearing securities, although the government
sometimes issues zero coupon instruments and floating rate securities.
10. MONEY MARKET MUTUAL FUNDS [MMMFS]

a) The aim of money market funds is to provide easy liquidity, preservation of capital and moderate income.
These schemes generally invest in safer short-term instruments such as treasury bills, certificates of deposit,
commercial paper and inter-bank call money.
b) Returns on these schemes may fluctuate depending upon the interest rates prevailing in the market. These
are ideal for corporate and individual investors as a means, to park their surplus funds for short periods.
C] DEBENTURES AND BONDS/DEBT INSTRUMENTS

A Bond is a loan given by the buyer to the issuer of the instrument. Bonds can be issued by companies,
financial institutions, or even the government. Over and above the scheduled interest payments as and when
applicable, the holder of a bond is entitled to receive the par value of the instrument at the specified maturity
date.
Bonds can be broadly classified into :

a) Tax-Saving Bonds
b) Regular Income Bonds
Tax-Saving Bonds offer tax exemption up to a specified amount of investment.

Examples are :
a) ICICI Infrastructure Bonds under Section 80C of the Income Tax Act, 1961.
b) NABARD/ NHAI/REC Bonds under Section 54EC of the Income Tax Act, 1961.
c) RBI Tax Relief Bonds.
Regular-Income Bonds, as the name suggests, are meant to provide a stable source of income at regular, pre-
determined intervals.
Examples are :
a) Double Your Money Bond
b) Step-Up Interest Bond
c) Retirement Bond
d) Encash Bond
e) Education Bonds
f) Money Multiplier Bonds/Deep Discount Bond
Debentures are similar to Bonds the only difference is that they are issued by companies instead of
Government institutions.
FEATURES OF DEBENTURES/BONDS
1. Bonds are usually not suitable for an increase in your investment. However, in the rare situation where an
investor buys bonds at a lower price just before a decline in interest rates, the resultant drop in rates leads to
an increase in the price of the bond, thereby facilitating an increase in your investment. This is called capital
appreciation.
2. Bonds are suitable for regular income purposes. Depending on the type of bond, an investor may receive
interest semi-annually or even monthly, as is the case with monthly-income bonds. Depending on one's
capacity to bear risk, one can opt for bonds issued by top-ranking corporates, or that of companies with
lower credit ratings. Usually, bonds of top-rated corporates provide lower yield as compared to those issued
by companies that are lower in the ratings.
3. In times of falling inflation, the real rate of return remains high, but bonds do not offer any protection if
prices are rising. This is because they offer a pre-determined rate of interest.
4. One can borrow against bonds by pledging the same with a bank. However, borrowings depend on the
credit rating of the instrument. For instance, it is easier to borrow against government bonds than against
bonds issued by a company with a low credit rating.
5. Bonds are rated by specialized credit rating agencies. Credit rating agencies include CARE, CRISIL,
ICRA and Fitch. An AAA rating indicates highest level of safety while D or FD indicates the least. The
yield on a bond varies inversely with its credit (safety) rating.
D] INVESTMENT IN EQUITY & PREFERENCE SHARES

Equity capital represents ownership capital. Equity shareholders collectively own the company. They bear
the risk and enjoy the rewards of ownership. The potential rewards and the downsides of equity shares make
this an exciting, attractive and at the same time a risky proposition for investment.
In financial markets, the stock capital or equity capital of a corporation or a joint stock company is the
capital raised through the issuance, sale, and distribution of shares. A person or organization that holds at
least a partial share of stock is called a shareholder.
TYPES OF SHARE CAPITAL

The share capital or stock capital exists in 2 forms :
i) Equity/Ordinary Shares : Equity shares or Common stock is the most usual and commonly held form of
stock in a company. Common stock holders, typically have voting rights in corporate decision matters. In
order of priority for receipt of their investment in the event of liquidation of a corporation, the owners of
common stock are the last.
ii) Preference Shares : These have priority over common stock in the distribution of dividends and assets.
Most preferred shares do not provide voting rights in corporate decision matters. However, some preferred
shares have special voting rights to approve certain extraordinary events such as the issuance of new shares,
the approval of the acquisition of the company, or to elect directors.
ADVANTAGES OF EQUITY SHARES

1. Transferability/Liquidity : Equity stock may be purchased and sold in the stock market immediately
after purchase. The transferability clause gives great liquidity to the investor.
2. Liability : The liability of the stock holder is limited only to the extent of his investment, while he has the
right of being the owner of the company.
3. Tax Free Dividends : Equity shareholders earn income in form of dividends; such dividends earned are
totally tax free in the hands of the investor.
4. Capital Appreciation : Value of share appreciates in long term; therefore apart from dividend income
shareholders also earn returns in form of capital appreciation.
5. Participation in decision making of the company : Shareholders have right to vote at the general
meetings of the company, this gives them a right to participate in almost all major decisions taken by the
company.
6. Pre-emptive right to buy shares : Shareholders get pre-emptive right to apply for shares if the company
comes up with fresh issue of shares, this gives them the opportunity to increase there shareholding in the
company by purchasing shares at a relatively lower value as compared to the current market price.
DISADVANTAGES OF EQUITY SHARES

1. High Risk : Equity shares involve high degree of risk in form of loss in the value of share over time if the
company is not performing to well.
2. Uncertain dividend : Paying dividend is totally at the discretion of the management, even if company is
making profits the management may think not to pay dividends during some years. Although, this may lead
to capital appreciation in form of increased market price of the share but at the same time it also leads to too

much funds being available at the disposal of the management and may lead to over capitalisation in long
term.
3. Speculation : Not every investor takes an informed decision in the stock market, many of them take
investment decision based on some „tip‟ that they get from there so called investment consultant or even
friends, such activity is pure speculation. But this is most prevalent in Indian stock markets and because of
this investors often end up loosing money.
BLUE CHIP SHARES

a) Blue chip Stock in a well-known and highly respected publicly-traded company. Blue chip companies are
usually financially sound and are thought to be relatively low-risk investments. They tend to be less volatile
than other companies and to provide solid growth to portfolios.
b) There is a reason blue-chip shares are known as such - they‟re named after the top-end chips at the
casino. Opting to buy these types of shares mean you get to buy into some major companies - that is, if you
can afford it.
c) Blue-chip shares are investments in the bigger companies, usually listed in the stock market‟s top 20.
Generally, these types of shares have been trading for a long time and have a history of returning solid
profits - which means regular dividends for their shareholders.
d) One of the advantages of blue-chip investments is that the dividends can be expected to grow over time if
a business performs as forecast.
Some Blue Chip companies in India are :
1. Oil and Natural Gas Corporation (ONGC)
2. Reliance Industries
3. National Thermal Power Corporation (NTPC)
4. Indian Oil Corporation (IOC)
5. State Bank of India (SBI)
PREFERENCE SHARES
Preference shares represent a hybrid security that has some characteristics of equity shares and some
features of debentures. The relevant features of preference shares are as follows :
1. Preference shares carry a fixed rate of dividend. But the company has discretion of not paying such
dividend for a particular year.
2. Preference dividend is payable only out of distributable profits.
3. Dividend on preference shares is generally cumulative i.e. dividend skipped in the year has to be paid up
in the subsequent year before equity dividend can be paid.
4. Preference shares are redeemable.
5. Preference shares may be convertible into equity shares.
6. Dividend on Preference shares also totally exempt from tax.
E] MUTUAL FUNDS
a) A Mutual Fund is an intermediary that pools money from a number of investors and invests the same in a
variety of different financial instruments. The income earned through these investments and the capital

appreciation realized by the scheme is shared by the investors or Unit Holders, in proportion to the number
of units owned by them.
b) The organization that manages the investment is known as Asset Management Company [AMC].
c) In India, operations of AMC are supervised and regulated by the Securities and Exchange Board of India
(SEBI).
TYPES OF MUTUAL FUNDS

Based on structure Mutual Funds are classified into :
1. Open-ended schemes
An open-end fund is one that is available for subscription all through the year. These do not have a fixed
maturity. Investors can conveniently buy and sell units at Net Asset Value ("NAV") related prices. The key
feature of open-end schemes is liquidity.
2. Close ended schemes

A closed-end fund has a stipulated maturity period which generally ranging from 3 to 15 years. The fund is
open for subscription only during a specified period. Investors can invest in the scheme at the time of the
initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where
they are listed. In order to provide an exit route to the investors, some close-ended funds give an option of
selling back the units to the Mutual Fund through periodic repurchase at NAV related prices. SEBI
Regulations stipulate that at least one of the two exit routes is provided to the investor.
Based on the investment objective, the classification is as follows :

1. Equity Scheme/ Growth Oriented schemes
These schemes offer growth capabilities associated with investment in capital market namely : (i) high
source of income by way of dividend and (ii) rapid capital appreciation, both from holding good quality
scrips. These funds, with a view to satisfying the growth needs of investors, primarily concentrate on the
low risk and high yielding spectrum of equity scrips of the corporate sector.
2. Income oriented Schemes/debt Schemes

Debt Schemes invest a majority of their assets into fixed income bearing instruments such as bonds,
debentures, government securities, certificates of deposit, commercial papers and other money market
instruments. Debt funds are also called income funds as they normally provide a stable income to the
investors, while minimizing the element of risk.
3. Hybrid Scheme/Balance Scheme

Balanced or hybrid funds invest both in equity and fixed income based securities, therefore they cater to the
needs of both fixed income investors and Growth oriented investors. They aim to reduce the risk
component, while providing a steady return. In these funds, the equity portion provides growth and the debt
portion provides income.
4. Tax Saving Mutual Funds

Also called as ELSS (Equity Linked Savings Scheme) they provide tax benefits to the investors.

ADVANTAGES OF MUTUAL FUNDS

1. Diversification :
The best mutual funds design their portfolios so individual investments will react differently to the same
economic conditions. For example, economic conditions like a rise in interest rates may cause certain
securities in a diversified portfolio to decrease in value. Other securities in the portfolio will respond to the
same economic conditions by increasing in value. When a portfolio is balanced in this way, the value of the
overall portfolio should gradually increase over-time, even if some securities lose value.
2. Professional Management :
Most mutual funds pay topflight professionals to manage their investments. These managers decide what
securities the fund will buy and sell.
3. Convenient Administration :
Investing in a Mutual fund reduces paper work and helps investors to avoid many problems such as bad
deliveries, delayed payments and unnecessary follow up with brokers and companies. Mutual funds save
investors time and make investing easy and convenient.
4. Regulatory oversight :
Mutual funds are subject to many government regulations that protect investors from fraud.
5. Liquidity :
It's easy to get your money out of a mutual fund. Write a check, make a call, and you've got the cash.
6. Convenience :
You can usually buy mutual fund shares by mail, phone, or over the Internet.
7. Low cost :
Mutual fund expenses are often no more than brokerage in shares.
8. Transparency :
Investors get regular information on the value of their
9. Flexibility
10. Choice of schemes
11. Tax benefits
12. Well regulated (by SEBI in India)
RISKS INVOLVED IN MUTUAL FUNDS/ DISADVANTAGES OF INVESTING IN MUTUAL

FUNDS
1. No Guarantees :
No investment is risk free. If the entire stock market declines in value, the value of mutual fund shares will
go down as well, no matter how balanced the portfolio. Investors encounter fewer risks when they invest in

mutual funds than when they buy and sell stocks on their own. However, anyone who invests through a
mutual fund runs the risk of losing money.
2. Fees and commissions :

All funds charge administrative fees to cover their day-to-day expenses. Some funds also charge sales
commissions or "loads" to compensate brokers, financial consultants, or financial planners. Even if you
don't use a broker or other financial adviser, you will pay a sales commission if you buy shares in a Load
Fund.
3. Taxes :
During a typical year, most actively managed mutual funds sell anywhere from 20 to 70 percent of the
securities in their portfolios. If your fund makes a profit on its sales, you will pay taxes on the income you
receive, even if you reinvest the money you made.
4. Management risk :
When you invest in a mutual fund, you depend on the fund's manager to make the right decisions regarding
the fund's portfolio. If the manager does not perform as well as you had hoped, you might not make as much
money on your investment as you expected. Of course, if you invest in Index Funds, you forego
management risk, because these funds do not employ managers.
5. Excessive diversification of portfolio, losing focus on the securities of key segments.
6. Too much concentration on blue-chip securities which are high priced and which do not offer more than
average return.
F] LIFE INSURANCE
a) Life insurance business was nationalised in India since long (1956) and is run by the Life Insurance
Corporation of India. In addition, we have also Postal Life Insurance Scheme run by the Postal Department.
b) LIC is responsible for the expansion of life insurance business in India. In addition, it plays an important
role in collecting the savings of the people. It gives protection and acts as a method of compulsory savings.
c) LIC is one avenue for investment of money out of regular income. It also gives protection to the family
members of the policyholder. Life insurance business is no more the monopoly of LIC. Private sector is now
allowed to participate in the insurance business.
ADVANTAGES
(1) Protection to family members through financial support in the case of death of policyholder.
(2) Investment in life insurance scheme serves as a provision for old age (maintenance, medial expenses,
etc.).
(3) It acts as a method of compulsory saving over a long period out of regular income.
(4) Investment in life insurance provides loan facility from banks.
(5) LIC now gives bonus to policyholders on yearly>basis. This adds to the maturity value of policy.

(6) Investment in life insurance scheme gives tax benefit. This tax benefit is available even when the policy
is taken on the name of investor's wife, son or daughter.
(7) Investment in life insurance scheme gives mental peace to investors in this age when our life is exposed
to various risks, uncertainties and dangers.
(8) Investment in life iiisurance provides comfortable and financially independent life after retirement. This
is a special benefit during the old age to life insurance policyholders.
LIC issues different life policies such as whole life policy, endowment policy, money back policy, etc. An
investor can select any policy considering his age, monthly/ annual income and capacity to save. Investment
in LIC has wider significance. It is not merely for monetary benefit but for security of investor and his
family members. Recently, LIC has introduced "Jeevan Anand Retirement Benefit Package" which offers
many benefits to investors. Jeevan Shree-1 and LIC Bima Plus are two more beneficial investment plans
started recently by LIC.
G] INVESTMENT IN REAL ESTATE AND OTHER ASSETS

1. REAL ESTATE
a) Investment in the real estate is popular due to high saleable value after some years. Such properties
include buildings, commercial premises, industrial land, plantations, farmhouses, agricultural land near
cities and so on.
b) Such properties attract the attention of affluent investors and builders. They purchase such properties at
low prices and do not sale the same unless there is substantial increase in the market prices. The property
owners are willing to wait even for 20 to 30 years for attractive return. During this period, it is a type of
dead investment for the owners.
c) However, the resale price will be attractive in due course when they can recover four times (or even
more) the price paid. This is how real estate is one attractive as well as profitable avenue for investment
provided the property to be purchased is selected with proper care and foresight.
FEATURES
(1) Ownership of a residential house provides owned accommodation and gives satisfaction to the head as
well as family members. It acts as one useful family asset with saleable value.
(2) There is capital appreciation of residential buildings particularly in the urban areas.
(3) Loans are available from different agencies like banks, HDFC and so on for buying, construction or
renovation of owned residential building.
(4) Interest on such loans is tax deductible within certain limits.
(5) Wealth tax benefit is available in the case of residential building as the value is reckoned at its historical
cost and not at its present market price.
ADVANTAGES
(1) Real estate like house is a necessity of life and provides pleasure to all family members.
(2) Real estate property acts as an asset (financial security) which can be used in case of need. Moreover,
the asset value increases year after year.

(3) Profit in the real estate investment is substantial provided “the owner is willing to wait till appropriate
time.
(4) The chances of capital appreciation are usually bright in the case of real estate properties.
(5) Real estate properties can be used as security for raising loan. In addition tax benefit and protection
against inflation are available.
DISADVANTAGES
(1) Investment in real estate properties is normally substantial. Due to huge investment in one item, the
benefits of diversification of investment are not available.
(2) In real estate property, profitability is available at the cost of liquidity. Thus, liquidity is low.
(3) The risk in the investment is more as compared to investment in banks, UTI, etc.
(4) Tax burden in the form of stamp duty, capital gains tax, etc. is heavy as and when the property is sold
out.
(5) Repairs, maintenance, etc. constitute additional expenditure and botheration to the owner.
(6) Government rules and regulations regarding buying and selling are troublesome in the case of real estate
properties.
2. GOLD AND SILVER

In India, gold is an obsession, deep-rooted in mythology, religious rites and its very psyche. These two
precious metals are used for making ornaments and also for investment of surplus funds over a long period.
In every family, at least a little quantity of gold and silver is available. There is also a general tendency to
purchase gold or silver or gold ornaments as and when surplus money is available. The prices of both the
metals are continuously increasing. Moreover, they are easily saleable (liquidity) at the market price. This
brings safety, profitability and liquidity to the investment in gold and silver. As a result, investment in gold
and silver is popular in India.
MERITS/ADVANTAGES
(1) Gold and silver are useful as a store of wealth. They even act as secret assets.
(2) Both the metals are highly liquid. This facilitates easy convertibility into cash at any time and that too
without incurring any loss.
(3) The market price of both the metals is continuously rising. This makes investment normally profitable.
Investment in gold/silver acts as a hedge against inflation.
(4) Investment in gold and silver provides a sense of security to the investor as it has immediate liquidity.
(5) There is a high degree of prestige value for gold and silver in the society. The benefit of capital
appreciation is also available.
(6) Investment in gold and silver is quite safe and secured, (gold is also scam-free). The possibility of loss in
the investment is practically nil in the case of these metals.
LIMITATIONS
(1) Such investment is risky due to thefts, etc.
(2) It is a dead type of investment as profit will be available only when it is sold out and people rarely sell
gold.

(3) Regular income from the investment is not available.

(4) Huge amount of money is required for investment in gold/silver. The general trend is not favourable for
selling these metals. In this sense, investment in gold and silver is a dead investment.
(5) Investment in gold and silver is not useful for capital formation and economic growth. Even the
traditional attraction for gold and silver is gradually reducing in India.
(6) Import of gold is now free. As a result, investing funds in gold and silver is no more safe and profitable.
3. PRECIOUS STONES
Diamonds, rubies, emeralds, sapphires and pearls have appealed to investors from long time because of their
beauty and rarity. These stones have attracted interest because of their high per carat value. The quality of
these stones is basically judged in terms of carat, clarity. These stones only attract the few affluent investors,
who have skill in buying them. It is less appealing to the bulk of the investors due to the following reasons :
a) They do not provide regular current income source.
b) There is no tax advantage associated with them.
c) They are illiquid and trading commissions in them tend to be high.
d) The assessment of their value is controversial and subjective.
4. ART OBJECTS
Objects which possess aesthetic appeal because their production requires skill, taste, creativity, talent and
imagination may be referred to as art objects. These objects include paintings, sculptures, antiques,
sketching, coins, stamps, flower vases, watches and cars. It has been found that the longer the time of
holding this investment the greater the value of these assets. The basic advantage of an antique is that the
investor can sell it at any price which he profounds, but it is very difficult to find these antiques and to give
price for which is worthy.

3 CAPITAL MARKETS IN INDIA
COMPONENTS OF FINANCIAL MARKETS

The financial markets have two major components : the money market and the capital market.
1. Money Market
The money market refers to the market where borrowers and lenders exchange short-term funds to solve
their liquidity needs. Money market instruments are generally financial claims that have low default risk,
maturities under one year and high marketability.
2. Capital Market
The capital Market is a market for financial investments that are direct or indirect claims to capital. It is
wider than the Securities Market and embraces all forms of lending and borrowing, whether or not
evidenced by the creation of a negotiable financial instrument. The capital market comprises the complex of
institutions and mechanisms through which intermediate term funds and long term funds are pooled and
made available to business, government and individuals. The capital market also encompasses the process
by which securities already outstanding are transferred.
The capital market and in particular the stock exchange is referred to as the barometer of the economy.
Government‟s policy is so moulded that creation of wealth through products and services is facilitated and
surpluses and profits are channelised into productive uses through capital market operations. Reasonable
opportunities and protection are afforded by the Government through special measures in the capital market
to get new investments from the public and the institutions and to ensure their liquidity.
3. Securities Market
The securities market, however, refers to the markets for those financial instruments/claims/'obligations that
are commonly and readily transferable by sale.
The securities Market have two inter-dependent and inseparable segments, the New issue (primary market
and the stock (secondary) market.
a. Primary Market
The primary market provides the channel for sale of new securities, while the secondary market deals in
securities previously issued. The issuer of securities sells the securities in the primary market to raise funds
for investment and/or to discharge some obligation.
In other words, the market wherein resources are mobilized by companies through issue of new securities
is called the primary market. These resources are required for new projects as well as for existing
projects with a view to expansion, modernisation, diversification and upgradation.
The issue of securities by companies can take place in any of the following methods :
1. Initial Pubic Offer (IPO) [these are securities issued for the first time to the public by the company);
2. Further issue of capital [any issue of securities by the company to public after the IPO is known as further
issue of capital].
3. Rights issue to existing shareholders (On renunciation of rights, the shares can be sold by the company
to others also);
4. Offer of securities under reservation/firm allotment basis to :
i) Foreign partners and collaborators,

ii) Mutual Funds,

iii) Merchant Bankers,
iv) Banks and institutions,
v) Non Resident Indians and overseas corporate bodies,
vi) Employees, etc.
b. Secondary Market
A secondary market is a market where investors purchase securities or assets from other investors, rather
than from issuing companies themselves. The national exchanges - such as the National Stock Exchange and
the Bombay Stock Exchnage are secondary markets.
Secondary markets exist for other securities as well, such as when funds, investment banks, or entities such
as Fannie Mae purchase mortgages from issuing lenders. In any secondary market trade, the cash proceeds
go to an investor rather than to the underlying company/entity directly.
CONCEPT OF INVESTMENT BANKS, ITS ROLE AND FUNCTIONS

Investment banking is a specific division of banking related to the creation of capital for other companies.
Investment banks underwrite new debt and equity securities for all types of corporations. Investment banks
also provide guidance to issuers regarding the issue and placement of stock.
In addition to the services listed above, investment banks facilitate mergers and acquisitions, reorganizations
and broker trades for both institutions and private investors. They can also trade securities for their own
accounts.
Investment Banks help companies and governments issue securities, help investors purchase securities,
manage financial assets, trade securities and provide financial advice. Some of the top investment banks in
India include, Bank of America, Barclays Capital, B.N.P. Paribas, Citi Bank, Credit Suisse A.G., Deutsche
Bank, J.P. Morgan, Kotak Mahindra Bank, HSBC, Yes Bank.
ROLE AND FUNCTIONS OF INVESTMENT BANKS

Investment banks have many functions and roles to perform, some of the most important ones are listed
below:
1. Raising Capital
An investment bank can assist a firm in raising funds to achieve a variety of objectives, such as to acquire
another company, reduce its debt load, expand existing operations, or for specific project financing. Capital
can include some combination of debt, common equity, preferred equity, and hybrid securities such as
convertible debt or debt with warrants. Although many people associate raising capital with public stock
offerings, a great deal of capital is actually raised through private placements with institutions, specialized
investment funds, and private individuals. The investment bank will work with the client to structure the
transaction to meet specific objectives while being attractive to investors.
2. Mergers and Acquisitions

Investment banks often represent firms in mergers, acquisitions, and divestitures. Example projects include
the acquisition of a specific firm, the sale of a company or a subsidiary of the company, and assistance in
identifying, structuring, and executing a merger or joint venture. In each case, the investment bank should
provide a thorough analysis of the entity bought or sold, as well as a valuation range and recommended
structure.
3. Sales and Trading

These services are primarily relevant only to publicly traded firms, or firms which plan to go public in the
near future. Specific functions include making a market in a stock, placing new offerings, and publishing
research reports.
4. Investment Management
Investment banks provide advice to investors to purchase, manage and trade various securities like shares,
debentures, etc and other assets like real estate, hedge funds, mutual funds etc. Investors may range from big
fund houses to financial institutions to private investors. Generally there is a separate division for
investment Management in an investment bank which is further divided into Private wealth management
and Private client services.
5. Boutiques
Small investment banking firms providing financial services are called boutiques. They mainly specialize .
in trading, advising for Merger and Acquisitions, providing technical analysis etc.
6. Structuring of derivatives
This division is involved in creating complex structured derivative products which offer much greater
margin and returns as compared to traditional derivatives and cash securities.
7. Research
It is another important function of investment bank which does extensive research on financial and other
aspects of various companies and writes report on the same indicating/advising “buy” or “Sell” ratings for
the same. Although this division does not generate direct revenue but information generated by them is used
as a guide by investors for their investments, it also helps in merger and acquisition in some cases.
8. Risk Management
This is an ongoing activity which involves analyzing the market and credit risk that traders are taking onto
their books while conducting their trades on laily basis. This helps in setting limits on the amount of capital
that be able to trade in order to prevent „bad‟ trades which may have detrimental effect to the trading system
as a whole.
9. General Advisory Services

Advisory services include assignments such as strategic planning, business valuations, assisting in financial
restructurings, and providing an opinion as to the fairness of a proposed transaction.
10. Underwriting
If an entity decides to raise funds through an equity or debt offering, one or more investment banks will also
underwrite the securities. This means the institution buys a certain number of shares - or bonds - at a
predetermined price and re-sells them through an exchange.
In reality, the task of underwriting securities often falls on more than one investment bank. If it's a larger
offering, the managing underwriter will often form a syndicate of other banks that sell a portion of the
shares. This way, the firms can market the stocks and bonds to a larger segment of the public and lower their
risk. The manager makes part of the profit, even if another syndicate member actually sells the security.
11. Documentation and Compliance of Regulatory Requirements

Investment banks perform a less glamorous role in stock offerings as well. It's their job to create the
documentation that must go to the Securities and Exchange Board of India before the company can sell

shares. This means compiling financial statements, information about the company's management and
current ownership and a statement of how the firm plans to use the proceeds.
12. Asset Management

Large investment banks have huge portfolios for pension funds, foundations and insurance companies
through their asset management department. Their experts help select the right mix of stocks, debt
instruments, real estate trusts and other investment vehicles to achieve their clients' unique goals.
13. Wealth Management

Some of the banks that perform investment banking functions for cater to everyday investors. Through a
team of financial advisors, they help individuals and families save for retirement and other long-term needs.
14. Securitized Products

Presently, companies often pool financial assets - from mortgages to credit card receivables - and sell them
off to investors as a fixed-income products. An investment bank will recommend opportunities to
"securitize" income streams, assemble the assets and market them to institutional investors.
STOCK MARKET INDEX

A stock market index is a measure of the relative value of a group of stocks in numerical terms. An Index is
used to give information about the price movements of products in the financial, commodities or any other
markets. Financial indexes are constructed to measure price movements of stocks, bonds, T-bills and other
forms of investments. Stock market indexes are meant to capture the overall behavior of equity markets. A
stock market index is created by selecting a group of stocks that are representative of the whole market or a
specified sector or segment of the market. An Index is calculated with reference to a base period and a base
index value. The change in the market price of these shares is calculated on a daily basis. The shares
included in the index are those shares which are traded regularly in high volume. In case the trading in any
share stops or comes down then it gets excluded and another company's shares replaces it. Each stock
exchange have many indices such as in India, Sensex of BSE and Nifty of NSE and outside India is Dow
Jones, FTSE etc.
Stock market indexes are useful for a variety of reasons. Some of them are:
(1) They provide a historical comparison of returns on money invested in - the stock market against other
forms of investments such as gold or debt.
(2) They can be used as a standard against which to compare the performance of an equity fund.
(3) In It is a lead indicator of the performance of the overall economy or a sector of the economy
(4) Stock indexes reflect highly up to date information
(5) Modern financial applications such as Index Funds, Index Futures, Index Options play an important
role in financial investments and risk management
Indices can be broadly classified as

(1) Broad Market Indices.
(2) Sectoral Indices.
(3) Thematic Indices.
(4) Strategy Indices.
(5) Fixed Income Indices.
(1) BROAD MARKET INDICES

Broad-market indices, consist of the large, liquid stocks listed on the Exchange. They serve as a benchmark
for measuring the performance of the stocks or portfolios such as mutual fund investments.

(a) Nifty 50 Index:

The Nifty 50 is a well diversified 50 stock index accounting for 13 sectors of the economy. It is used for a
variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds.
(b) Nifty 500 Index:

It represents the top 500 companies based on full market capitalisation from the eligible universe.
(c) Nifty Midcap 50 Index:

The primary objective of the Nifty Midcap 50 Index is to capture the movement of the midcap segment of
the market. Nifty Midcap 50 includes top 50 companies based on full market capitalisation.
(d) Nifty Smallcap 50 Index:

The primary objective of the Nifty Smallcap 50 Index is to capture the movement of the smallcap segment
of the market. The index represents top 50 companies selected based on average daily turnover from the top
100 companies selected based on full market capitalisation.
(2) SECTORAL INDICES

Sector-based index are designed to provide a single value for the aggregate performance of a number of
companies representing a group of related industries or within a sector of the economy.
(a) Nifty Auto Index:

The Nifty Auto Index is designed to reflect the behaviour and performance of the Automobiles sector which
includes manufacturers of cars & motorcycles, heavy vehicles, auto ancillaries, tyres, etc. The Nifty Auto
Index comprises of 15 stocks that are listed on the National Stock Exchange.
(b) Nifty Bank Index:

Nifty Bank Index is an index comprised of the most liquid and large capitalised Indian Banking stocks. It
provides investors and market intermediaries with a benchmark that captures the capital market performance
of Indian Banks. The index has 12 stocks from the banking sector which trade on the National Stock
Exchange.
(c) Nifty FMCG Index:

FMCGs (Fast Moving Consumer Goods) are those goods and products, which are non¬durable, mass
consumption products and available off the shelf. The Nifty FMCG Index comprises of maximum of 15
companies who manufacture such products which are listed on the National Stock Exchange (NSE).
(d) Nifty IT Index:

A number of large, profitable Indian companies today belong to the IT sector and a great deal of investment
interest is now focused on the IT sector. In order to have a good benchmark of the Indian IT sector, IISL has
developed the Nifty IT sector index. Nifty IT provides investors and market intermediaries with an
appropriate benchmark that captures the performance of the IT segment of the market.
(e) Nifty Pharma Index:

Pharmaceuticals sector is one of the key sectors where Indian companies have created a global brand for
themselves besides software. Pharma outsourcing into India and low cost and healthcare services are
expected to be the key areas of growth in the near future. IISL has developed Nifty Pharma Index to capture
the performance of the companies in this sector.
(f) Nifty PSU Bank Index:

The public sector banks with their existing widespread branch network have been primarily increasing their
IT related expenditure. The core profitability of the public sector banks continue to rise on the back of
improving operating efficiencies. Consolidation would further improve PSU banks' competitive edge
against their private counterparts in servicing customers — both retail and corporate — in the international
and domestic markets. Recognizing these changing dynamics of Indian banking industry, IISL has
developed Nifty PSU Bank Index to capture the performance of the PSU banks.
(g) Nifty Realty Index:

Real estate sector in India is witnessing significant growth. Recent dynamics of the market reflected the
opportunity of creating wealth across real estate companies, as proven by recent listings of real estate
companies resulting into prominent growth in public funds and private equity. Further necessitated by the
thrust of redevelopment of old buildings, building townships and redeveloping mill lands, one can witness
plenty of opportunities in real estate sector backed by favourable tax regime. IISL has developed the Nifty
Realty Index to synergize these emerging opportunities along with their Index expertise creating new
investment avenues for investors.
(3) THEMATIC INDICES

Thematic indices are designed to provide a single value for the aggregate performance of a number of
companies representing a theme.
(a) Nifty Commodities Index:

The Nifty Commodities Index is designed to reflect the behaviour and performance of a diversified portfolio
of companies representing the commodities segment which includes sectors like Oil, Petroleum Products,
Cement, Power, Chemical, Sugar, Metals and Mining. The Nifty Commodities Index comprises of 30
companies that are listed on the National Stock Exchange (NSE).
(b) Nifty Infrastructure Index:

It is well recognized that quality infrastructure is one of the most important necessities for unleashing high
and sustained growth. Government outlay for infrastructure has increased significantly over the years.
Clearly, infrastructure has been a focus area. To meet the financial needs of this public-private partnership,
it is necessary to promote standards and raise capital in the most efficient and cost- effective manner while
ensuring long-term sustainability. Nifty Infrastructure Index will include companies belonging to Telecom,
Power, Port, Air, Roads, Railways, shipping and other Utility Services providers.
(c) Nifty MNC Index:

The Nifty MNC Index comprises 15 listed companies in which the foreign shareholding is over 50% and /
or the management control is vested in the foreign company.
(4) STRATEGY INDICES

Strategy indices are designed on the basis of quantitative models / investment strategies to provide a single
value for the aggregate performance of a number of companies.
(a) Nifty50 USD Index:

Almost every institutional investor and off-shore fund enterprise with an equity exposure in India would like
to have an instrument for measuring returns on their equity investment in dollar terms. To facilitate this, a
new index the Nifty50 USD; a US Dollar denominated Nifty 50 has been developed.
(b) Nifty Dividend Opportunities 50 Index:

The Nifty Dividend Opportunities 50 Index is designed to provide exposure to high yielding companies
listed on NSE while meeting stability and tradability requirements. The Nifty Dividend Opportunities 50
Index comprises of 50 companies. The methodology employs a yield driven selection criteria that aims to
maximize yield while providing stability and tradability.
(c) Nifty High Beta 50 Index:

Nifty High Beta Index aims to measure the performance of the stocks listed on NSE that have High Beta.
Beta can be referred to as a measure of the sensitivity of stock returns to market returns. The market is
represented by the performance of the Nifty50. In order to make the 50 stock index investible and
replicable, criteria's such as turnover and free float market capitalization are applied while selection of
securities.
(5) FIXED INCOME INDEX

Fixed income index is used to measure performance of the bond market. The fixed income indices are useful
tool for investors to measure and compare performance of bond portfolio. Fixed income indices also used
for introduction of Exchange Traded Fund.
(a) Nifty 8-13 yr G-Sec Index:

Nifty 8-13 yr G-Sec index is constructed using the prices of top 5 (in terms of traded value) liquid GOI
bonds with residual maturity between 8 to 13 years and have outstanding issuance exceeding Rs.5000
crores. The individual bonds are assigned weights considering the traded value and outstanding issuance in
the ratio of 40:60.The index measures the changes in the prices of the bond basket.
(b) Nifty 10 yr Benchmark G-Sec Index:

The Nifty 10 yr Benchmark G-Sec Index is constructed using the price of 10 year bond issued by the
Central Government, India. The index seeks to track the performance of the 10 year benchmark security.
(c) Nifty 11-15 yr G-Sec Index

Nifty 11-15 yr G-Sec index is constructed using the prices of top 3 (in terms of traded value) liquid GOI
bonds with residual maturity between 11 to 15 years and having outstanding issuance of over Rs.5000
crores. The individual bonds are assigned weights considering the traded value and outstanding issuance in
the ratio of 40:60. The index measures the changes in the dirty prices of the bond basket.
INDICES AT BSE
1. SENSEX
SENSEX, first compiled in 1986, was calculated on a "Market Capitalization- Weighted" methodology of
30 component stocks representing large, well- established and financially sound companies across key
sectors. The base year of SENSEX was taken as 1978-79. SENSEX today is widely reported in both
domestic and international markets through print as well as electronic media. It is scientifically designed and
is based on globally accepted construction and review methodology. Since September 1, 2003, SENSEX is
being calculated oh a free-float market capitalization methodology. The "free-float market capitalization-
weighted" methodology is a widely followed index construction methodology on which majority of global
equity indices are based; all major index providers like MSCI, FTSE, STOXX, S&P and Dow Jones use the
free-float methodology.
The growth of the equity market in India has been phenomenal in the present dect de. Right from early
nineties, the stock market witnessed heightened activity in terms of various bull and bear runs. In the late
nineties, the Indian market witnessed a huge frenzy in the 'TMT sectors. More recently, real estate caught
the fancy of the investors. SENSEX has captured all these happenings in the most judicious manner. One
can identify the booms and busts of the Indian equity market through SENSEX. As the oldest index in the

country, it provides the time series data over a fairly long period of time (from 1979 onwards). Small
wonder, the SENSEX has become one of the most prominent brands in the country.
2. Other Indices
a) BSE-100 Index
b) BSE-200 Index
c) Dollex Series of BSE Indices
d) BSE-500 Index
e) BSE IPO Index
f) BSE TECk Index
g) BSE PSU Index
h) BSE Mid-Cap and BSE Small-Cap Index
COMPUTATION OF INDEX
Index value can be computed using following steps:
1. Calculate market capitalization of each company‟s share listed in the index as per respective
company‟s opening share price.
2. Add market capitalization of all companies computed in the above step.
3. Repeat above two steps for closing share prices.
4. Closing Index value will be computed as follows:
Index Value = Index on Previous Day x Total market capitalisation for current day
Total capitalisation of the previous day
THE NASDAQ
The “National Association of Securities Dealers Automated Quotations” or NASDAQ Stock Market
commonly known as the NASDAQ is an American stock exchange. It is the second-largest exchange in the
world by market capitalization, behind only the New York Stock Exchange. The exchange platform is
owned by The NASDAQ OMX Group, which also owns the OMX stock market network and several other
US stock and options exchanges.
It was founded in 1971 by the National Association of Securities Dealers (NASD), which divested itself of
NASDAQ in a series of sales in 2000 and 2001. NASDAQ stock is listed on its own stock exchange
marketing July 2, 2002, under the ticker symbol NDAQ.
NASDAQ begin trading on February 8, 1971 and is world‟s first electronic stock market. At first, it was
merely a quotation system and did not provide a way to perform electronic trades. It helped lower the spread
(the difference between the bid price and the ask price of the stock), because of this it was unpopular among
brokers who made much of their money on the spread.
In 1992, NASDAQ joined with the London Stock Exchange to form the first intercontinental linkage of
securities markets. The National Association of Securities Dealers spun off NASDAQ in 2000 to form a
public company, the NASDAQ Stock Market, Inc.
To qualify for listing on the exchange, a company must be registered with the United States Securities and
Exchange Commission (SEC), must have at least three market makers (financial firms that act as brokers or
dealers for specific securities) and must meet minimum requirements for assets, capital, public shares, and
shareholders.

NASDAQ COMPOSITE
„NASDAQ Composite‟ is the main index of NASDAQ, which has been published since its inception.
However, its exchange-traded fund tracks the large-cap NASDAQ-100 index, which was introduced in 1985
alongside the NASDAQ 100 Financial Index.
The Nasdaq Composite Index is the market-capitalization weighted index of the more than 3,000 common
equities listed on the Nasdaq stock exchange. The types of securities in the index include American
depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The index
includes all Nasdaq listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds
(ETFs) or debentures.
Unlike other market indexes, the Nasdaq composite is not limited to companies that have U.S. headquarters.
It is very common to hear the closing price of the Nasdaq Composite Index reported in the financial press,
or as part of the evening news.
Some major companies listed on NASDAQ composite along with their ticker and percentage value are
Apple (AAPL) - 14.60%, Microsoft (MSFT) - 7.40%, Amazon (AMZN) - 3.84%, Google (GOOG) Class C
- 3.50%, Facebook (FB) - 3.41%, Gilead Sciences (GILD) - 3.22%, Intel (INTC) - 3.14%, Google
(GOOGL) Class A - 3.01%, etc.
AUTOMATED CONFIRMATION TRANSACTION SERVICE - ACT

ACT, or Automated Confirmation of Transactions, is a system for reporting and clearing trades in the over-
the-counter (OTC) and NASDAQ securities markets. ACT facilitates and simplifies the process of clearing
by providing a single counterparty to interact with.
Prior to using the ACT, the NASDAQ utilized the Trade Acceptance and Reconciliation Service, or TARS.
ACT replaced TARS and assumed its functionality in the third quarter of 1998.
ACT offers a risk management system that allows clearing firms to monitor the activity of their clients. This
tool is unique within the clearing business. The Financial Industry Regulatory Authority (FINRA) also
refers to ACT as the Trade Reporting Facility (TRF)
DEPOSITORIES
Till few years back, share trading was done in the form of physical certificates that the investor had to keep
safe and then forward to the buyer once sold. This process was highly time consuming and gave rise to
issues like fake securities and bad deliveries. All these reasons and the improvement in technology gave rise
to depositories and the electronic mode of holding securities.
A depository resembles a bank; however in case of a depository the deposits are securities, such as shares,
debentures, bonds and government securities, in electronic form. A depository functions as a bank- both are
common houses that hold assets of the participating members and provide services to clients.
Comparison of a Depository with a Bank
Depositories Banks
Hold securities in an account. Hold funds in an account.
Transfer securities between accounts on the Transfers funds between accounts on the
instruction of the account holder. instruction of the account holder.
Assist in transfer of ownership without having Assist in transfers without having to handle
to handle securities. money.
Facilitates safekeeping of shares. Facilitates safekeeping of money.

Benefits of Depository System / Depository Settlement:

(1) In the depository system, the ownership and transfer of securities takes place by means of electronic
book entries.
(2) Bad deliveries could be eliminated since shares are registered in the electronic form that cannot be
mutilated easily.
(3) Elimination of all risks associated with physical certificates.
(4) Dealing in physical securities has associated security risks of theft of stocks, mutilation of certificates,
and loss of certificates during movements through and from the registrars etc. Such problems do not arise in
the depository environment.
(5) No stamp duty for transfer of any kind of securities in the depository.
(6) This waiver extends to equity shares, debt instruments and units of mutual funds etc. in the depository.
Thus, cost can be reduced.
(7) Immediate transfer and registration of securities: In the
depository environment, once the securities are credited to the investors account on pay out, he becomes the
legal owner of the securities.
(8) Faster settlement cycle: The exclusive demat segments follow rolling settlement cycle of T+2 i.e. the
settlement of trades will be on the 5th working day from the trade day. This will enable faster turnover of
stock and more liquidity with the investor.
(9) Faster disbursement of non-cash corporate benefits: NSDL provides for direct credit of non-cash
corporate entitlements like rights, bonus etc. to an investor's account, thereby ensuring faster disbursement
and avoiding risk of loss of certificates in transit.
(10) Low brokerage for trading in dematerialised securities: Brokers provide this benefit to investors as
dealing in dematerialised securities reduces their back office cost of handling paper.
(11) Eliminates the risk of being the introducing broker:
Elimination of problems related to address Change, Transmission etc.
(12) In case of change of address or transmission of demat shares, investors are saved from undergoing the
entire change procedure with each company or registrar. Investors have to only inform their DP with all
relevant documents and the required changes are effected in the database of all the companies, where the
investor is a registered holder of securities.
(13) Elimination of problems related to selling securities on behalf of a minor. A natural guardian is not
required to take court approval for selling demat securities on behalf of a minor.
DEPOSITORIES IN INDIA
There are. 2 depositories in India :
1. The National Securities Depository Limited [NSDL]
2. Central Depository for Securities Limited [CDSL]
1. NATIONAL SECURITIES DEPOSITORY LIMITED (NSDL), the first depository in India. This
depository promoted by institutions of national stature responsible for economic development of the country
has since established a national infrastructure of international standards that handles most of the securities
held and settled in de-materialised form in the Indian capital market.
Using innovative and flexible technology systems, NSDL works to support the investors and brokers in the
capital market of the country. NSDL aims at ensuring the safety and soundness of Indian marketplaces by
developing settlement solutions that increase efficiency, minimise risk and reduce costs. NSDL plays a quiet
but central role in developing products and services that will continue to nurture the growing needs of the
financial services industry.

In the depository system, securities are held in depository accounts, which is more or less similar to holding
funds in bank accounts. Transfer of ownership of securities is done through simple account transfers. This
method does away with all the risks and hassles normally associated with paperwork. Consequently, the cost
of transacting in a depository environment is considerably lower as compared to transacting in certificates.
In August 2009, number of Demat accounts held with NSDL crossed one crore.
i) Promoters/Shareholders :
NSDL is promoted by Industrial Development Bank of India Limited (IDBI) - the largest development bank
of India, Unit Trust of India (UTI) - the largest mutual fund in India and National Stock Exchange of India
Limited (NSE) - the largest stock exchange in India. Some of the prominent banks in the country have taken
a stake in NSDL.
ii) NSDL Facts and figures As on June 30, 2014 : Number of certificates eliminated (Approx.) : 1,653 Crore
Investor's Accounts : 1, 31, 16, 821
Number of companies in which more than 75% shares are dematted : 12,531
Average number of accounts opened per day since November 1996 : 3,573
DP Service Centers : 14, 433
Presence of Demat account holders in the country : 86% of all pin codes in the country
2. CENTRAL DEPOSITORY FOR SECURITIES LIMITED [CDSL] was promoted by Bombay Stock
Exchange Limited (BSE) jointly with leading banks such as State Bank of India, Bank of India, Bank of
Baroda, HDFC Bank, Standard Chartered Bank, and Union Bank of India and Centurion Bank.
CDSL was set up with the objective of providing convenient, dependable and secure depository services at
affordable cost to all market participants. Some of the important milestones of CDSL system are :
a) CDSL received the certificate of commencement of business from SEBI in February, 1999.
b) Honourable Union Finance Minister, Shri Yashwant Sinha flagged off the operations of CDSL on July
15, 1999.
c) Settlement of trades in the demat mode through BOI Shareholding Limited, the clearing house of BSE,
started in July 1999.
d) All leading stock exchanges like the National Stock Exchange, Calcutta Stock Exchange, Delhi Stock
Exchange, The Stock Exchange, Ahmedabad, etc have established connectivity with CDSL.
e) As at the end of Dec 2007, over 5000 issuers have admitted their securities (equities, bonds,
debentures, commercial papers), units of mutual funds, certificate of deposits etc. into the CDSL system.
DEPOSITORY PARTICIPANT
A Depository Participant (DP) is described as an agent of the depository. They are the intermediaries
between the depository and the investors. The relationship between the DPs and the depository is governed
by an agreement made between the two under the Depositories Act.
The main characteristics of a depository participant are as under :
1. Acts as an agent to Depository.
2. Customer interface of Depository.
3. Functions like Securities Bank.
4. Account opening.
5. Facilitates dematerialisation.
6. Instant transfer of shares on pay-out of funds.
7. Credits to investors in IPO, rights, bonus.
8. Settles trades in electronic segment.

ONLINE SHARE TRADING

In today‟s world where everything from ordering a pizza to buying a house is happening online, share
trading cannot be left behind from being done online. All it takes to partake in online trading is some spare
cash, the desire to invest, and creating an online brokerage trading account. As compared to traditional
method of trading in physical securities which had many disadvantages like long settlement cycle
(settlement was done on fortnightly basis), bad deliveries, frauds and scams online trading system has many
advantages and some of them are listed below:
The advantages of online trading

1. You have the ability to manage your own stock portfolios
2. You will have more control and flexibility oVer the types of transaction you choose to conduct
3. The commission costs for trading are significantly less money than using the services of a professional
broker
4. You can get access to lower fee mutual fund investments
5. Online brokerage firms tend to offer their clients a slew of tools included real- time Level 2 stock
quotes, news, financial tools and graphs to help you do research
6. Some online brokerages will provide their clients to free access to high quality research reports created
by Standard and Poor and other predominate financial players
7. Online account investors have access to their accounts 24/7 - although market hours (trading hours)
are from 9:30am to 4pm
8. As long as you have access to a computer and the internet, you can take steps to manage your finances
wherever you may be.
The disadvantages of online trading:

1. First time investors may get sucked into all the technology and may temporarily forget that they are
actually using real money
2. There is no mentoring relationship between a professional broker and an online trading account holder,
leaving the investor out on his/her own to make choices
3. Novices not familiar with the ins and outs of the brokerage software can make costly mistakes
4. Like any financial strategy, committing yourself to online trading takes research and dedication to
make sure everything is up to par. By taking the time to do your research you will be able to overcome a
great learning curve and even possibly make some money from online trading.
MARKET CAPITALIZATION
Market Capitalization indicates how big the company is from the market's perspective. In other words, it
indicates how much money is required if you wish to buy all the shares of the company.
For example CIPLA's MC is Rs. 49,000 Crs. This is how much you need if you wish to buy all the shares of
Cipla. Similarly TCS MC Rs. 548,296 Crs.
Calculating a stock's capitalization
Market Capitalization = Market Price of the stock x The number of the stock's outstanding shares*
*Outstanding means the shares held by the public
For example, if Stock A has a Current Market Price of Rs. 20 per share, and there are 1,00,000 shares in the
hands of public investors, then Stock A has a capitalization of 20,00,000. The company's capitalization is an
effective parameter to group corporate stocks.
In the US, mid-cap shares are those stocks that have a market capitalization ranging from Rs. 9,000 crore to
Rs. 45,000 crore. In India, these shares would be classified as large-cap shares. Thus, classification of shares
into large-cap, mid-cap, small-cap is made on the basis of the relative size of the market in that particular

country. The total market capitalization of US markets is $15 trillion. In India, the market capitalization of
listed companies is around $600bn.
SMALL CAP STOCKS

The stocks of small companies that have the potential to grow rapidly are classified as small-cap stocks.
These stocks are the best option for an investor who wishes to generate significant gains in the long run; as
long he does not require current dividends and can withstand price volatility. Generally companies that have
a market Capitalization in the range of upto 250 crores are small cap stocks.
As many of these companies are relatively new, it is difficult to predict how they will perform in the market.
Being small enterprises, growth spurts dramatically affect their values and revenues, sending prices soaring.
On the other hand, the stocks of these companies tend to be volatile and may decline dramatically.
Most Initial Public Offerings are for small-cap companies, although these days large companies do tend to
source the capital markets for expansion plans. Aggressive mutual funds are also enthusiastic about adding
small-cap stocks in their portfolios. Because they have the advantage of being highly growth oriented,
small-cap stocks can forego paying dividends to investors, which enables the profits earned to be reinvested
for future growth.
MID-CAP STOCKS
Mid-cap stocks are typically stocks of medium-sized companies. These are stocks of well-known
companies, recognized as seasoned players in the market. They offer you the twin advantages of acquiring
stocks with good growth potential as well as the stability of a larger company. Generally companies that
have a market Capitalization in the range of 250-4000 crores are mid cap stocks
Mid-cap stocks also include baby blue chips; companies that show steady growth backed by a good track
record. They are like blue-chip stocks (which are large-cap stocks) but lack their size. These stocks tend to
grow well over the long term.
LARGE-CAP STOCKS
Stocks of the largest companies (many being blue chip firms) in the market such as Tata, Reliance, ICICI
are classified as large-cap stocks. Being established enterprises, they have at their disposal large reserves of
cash to exploit new business opportunities.
The sheer volume of large-cap stocks does not let them grow as rapidly as smaller capitalized companies
and the smaller stocks tend to outperfprm them over time. Investors, however gain the advantages of reaping
relatively higher dividends compared to small- and mid-cap stocks while also ensuring the long¬term
preservation of their capital.
PENNY STOCK
A penny stock is a stock that trades at a relatively low price and market capitalization, usually outside of the
major market exchanges. These types of stocks are generally considered to be highly speculative and high
risk because of their lack of liquidity, large bid-ask spreads, small capitalization and limited following and
disclosure. The term itself is a misnomer. because there is no generally accepted definition of a penny
stock. Some consider it to be any stock that trades for a very low price say Rs. 10/- or Rs. 20/- per share,
while others consider any stock trading off of the major market exchanges as a penny stock. However,
confusion can occur as there are some very large companies, based on market capitalization, that trade
below Rs. 20 per share, while there are many very small companies that trade for Rs.100 or more.
The typical penny stock is a very small company with highly illiquid and speculative shares. The company
will also generally be subject to limited listing requirements along with fewer filing and regulatory
standards.

4 RISK AND RETURNS
For selecting any investment avenue an investor will evaluate the investment from two angles,
(i) Returns Expected and
(ii) Risk associated with the expected returns.
RETURN
Return means the profit earned on the capital invested in the business. It is expressed as a percentage. The
return on an investment is the profit required to establish and maintain the investment. Returns from any
security depend on how well the security has done in the past and based on past performance we can
forecast the future performance of the company.
TYPES OF RETURN
1. PAST RETURNS/ REALISED RETURNS

Past returns are the returns that are already earned by the investor in the past, therefore they are also known
as „Realised returns‟. Past returns can be further classified into :
(i) Holding Period Returns and
(ii) Annualised Returns.
2. HOLDING PERIOD RETURNS

„Holding period returns‟ are the total returns earned by the investor during the time period for which the
investment is held.
Returns from a security are earned in two forms :
i) Revenue receipts (Interest, Dividends etc.) and
ii) Capital gains (i.e. change in the value of the security as compared to the price for which the security was
purchased).
These returns can be compared with the initial amount paid to purchase the security, and such returns can be
converted in percentage terms.
Let us take an example to understand the above concept, suppose you purchase share of X Ltd. today at a
price of Rs. 50 per share, during the year the company pays a dividend of Rs. 5 on the share and at the end
of the year you sold the share at Rs. 55.

From the example we can easily conclude that you earned Rs. 5 as dividend and Rs. 5 [i.e. Rs. 55 (Price at
the end of year) - Rs. 50 (purchasing price)] as capital gains (i.e. appreciation in the value of the share),
therefore your total earning is Rs.10 per share (Rs. 5 dividend + Rs. 5 capital gains).
Now, this Rs. 10 is earned by you by investing Rs. 50 at the beginning of the year. Therefore, if we want to
convert this return of Rs. 10 in terms of percentage we can easily do so as follows : 10/50 x 100 = 20%.
Therefore our holding period returns is Rs. 10 or 20%.
We can denote the above discussion in terms of formula as follows :
Where,
HPRt = Holding Period Returns for time „t‟
Dt = Dividend received during the time „t‟
Pt = Price of the security at the end of time „t‟
Pt -1 = Price of the security at the beginning of time „t‟
3. ANNUALISED RETURNS
Annualised returns means comparing returns on two different investments, the holding periods for the
investments which are of equal length.
Returns offered by any security can easily be converted into „Annualised Returns‟ [i.e. % p.a.] using the
following formula,
Where,
AR = Annualised Returns
HPRt = Holding period returns during the time t
Mt = No. of months during the holding period.
Above formula can be used in question where information about holding period is given in the question is in
months, if information about holding period is given in terms of weeks or days the formula can be modified
and instead of using the number 12 [i.e. no. of months], number 52 [i.e. no. of weeks in an year] or number
365 [i.e. no. of days in an year] can be used respectively for weeks and days information given in the
question.
4. EXPECTED RETURNS
„Expected Returns‟ are future returns and as mentioned earlier, future is generally based on past returns. In
the example given earlier „Mr. M‟ who consistently scored low marks would be expected to score low
marks, whereas Mr. N who consistently scored 90%+ would be expected to repeat his performance in any
upcoming exam. The point is that this principle of future being based on past is true for virtually everything
that exists, be it a person or a company.
Therefore, to calculate future/ expected returns, we can simply take an average of the past returns; this
average would be treated as returns expected to be earned from the security.
Averages are of two types, namely :
i) Simple average (i.e. without probabilities) and

ii) Weighted average (i.e. with probabilities)
5. EXPECTED RETURNS - WITHOUT PROBABILITIES (SIMPLE AVERAGE)

We already know the concept of „Simple average‟ from the subject of statistics that we have learned in the
earlier semesters. The formula for Expected Returns without probabilities is same as the formula for simple
average i.e.
Where,
Rx = Expected returns or average returns of the security.
Rx = Annual returns of the security for past years
n = number of years.
6. EXPECTED RETURNS - WITH PROBABILITIES (WEIGHTED AVERAGE)

Probability is defined as a chance of occurrence of an event. Higher the chance of occurrence of an event,
higher is the probability assigned to it, number assigned to an event varies between „0‟ and „1‟, „1‟ being the
highest number and „O‟ being the lowest.
Thus we can conclude the following:

i) Probabilities of all events taken together cannot be more than „1‟ (i.e. maximum probability that can be
assigned to an event is „l5)
ii) The sum total of all probabilities must be equal to „1‟
iii) A probability cannot be negative.
iv) If an outcome is certain to occur, it is assigned a probability of „1‟, while impossible outcomes are
assigned a probability of „O‟.
v) The possible outcomes are mutually exclusive
We know that Expected returns or Future returns are based on past, now if after studying the past if we see a
pattern in the returns of a security, we can use such pattern to assign probabilities to the possible returns the
security can earn in futureIn terms of formula
Where,
Rx = Expected Returns or Future Returns
i = number of possible events, lowest number of events possible being „1‟ (i.e.
at least on event will occur) and highest number being „n‟.
P = Probability of occurrence of events.
R = Returns earned under a particular event.

RISK
Risk can be defined as the chance that the actual outcome from an investment will differ from the expected
outcome. Risk is only associated with the expected return because they are to be realised in future, as
against this, there is no risk in past returns. This is because past returns have already occurred and therefore
cannot change and accordingly there is no chance of it being altered and as a result there is no risk
associated with past returns and that means that risk is only associated with Future return.
i) Risk is a situation where the possible outcome is uncertain.
ii) As past is certain, there is no risk associated with it.
iii) As future is uncertain, there is risk that what we think may or may not happen.
iv) But even future is based on past and therefore we can forecast the future, although not with 100%
certainty.
v) Even though we cannot be 100% sure about the future, we can study the past and help ourselves to take
such decisions that will reduce our risk to a considerably low level and at the same time maximise our
returns.
vi) Higher the fluctuation in the past returns, higher will be the risk associated with the future returns and
vice versa.
MEASURING RISK
Measuring risk means quantifying it in terms of number, this can be done by using various „Measures of
Risk:
1. Range,
2. Variance,
3. Standard Deviation and
4. Co-efficient of variation.
1. RANGE
Range refers to spread of the various possible future returns, in other words, Range refers to the difference
between the highest possible return and lowest possible return expected from the security. It is the
percentage between which the future returns are expected to fluctuate, higher the fluctuation higher is the
risk and therefore higher the range higher is the risk.
In terms of formula,
Range = highest possible return - lowest possible return.
Advantage(s) and Shortcoming of ‘Range’ as a measure of risk

Although „Range‟ as a measure of risk is very easy to calculate but it does not take into account the
probability of occurrence an event (in simple words, it gives equal importance to every possible return), and
therefore is not the most effective measure of risk.
2. VARIANCE
In case of Variance‟ we compare every possible return with the average or expected return of the security,
doing so we get how far are all the possible returns lying from the expected returns (i.e. level of variance of

all possible .returns from the average), after calculating the same for all the possible returns, the numbers so
calculated are squared to convert any negative numbers into positive numbers, the numbers so squared are
added to get Variance‟ in totality.
Higher the variance, higher will be the fluctuation of expected returns and accordingly higher will be the
risk.
In terms of formula,
Variance (without Probabilities)
Variance (with Probabilities)
Advantage(s) and Shortcoming of ‘variance’ as a measure of risk

Although variance takes into account probabilities, it is a squared number, and therefore its direct
comparison with expected return is not possible, therefore we take the square root of variance which is
Standard Deviation (a) to make direct comparison between risk (i.e. Standard Deviation) and returns
possible.
3. STANDARD DEVIATION
Standard deviation is nothing but square root of Variance. In terms of formula Standard Deviation is
denoted as follows :
Without Probabilities
With Probabilities
4. CO-EFFICIENT OF VARIATION
The coefficient of variation is a measure of risk per unit of return (i.e. risk taken to earn every „1%‟ of
return). This can be used to compare the risk and returns of alternative investments. A higher coefficient of
variation indicates that the investment is more risky because to earn every unit of return we are more and
more risk. It is calculated as the ratio of the standard deviation divided by returns on the investment. In
terms of formula,
THEORY OF DOMINANCE

A security is said to dominate the other security if :

1. It is giving higher returns at equal risk as compared to other security, or
2. It is giving equal returns at lower risk as compared to other security, or
3. It is giving higher returns at lower risk as compared to other security.
This theory is used when we have to select one or some securities from a group of many securities.
5. BETA
Beta is a measure of performance of a particular share or class of shares in relation to the general movement
of the market. If a share has a beta of 1, its rise and fall corresponds exactly with the market. With a beta of
2, its rise or fall is double i.e. when the market rises by 10 percent, it rises by 20 percent and when market
falls by 10 percent, it falls by 20 percent.
William F. Sharpe has developed a model for calculation of Beta of a security. It is given below:
Normally beta values for individual securities fall in range of 0.6 to 1.80. Beta can also take negative values.
However, such cases are very rare. A negative beta indicates that the two variables move in opposite
directions and the magnitude of the movement is indicated by the beta value. The value of beta may vary
depending on the period under consideration and the comparative variable. If any of these is changed the
value of beta may change. Though, theoretically the value of beta should not be a function of time frame, as
it demotes the company risk, the change in market fancy for the scrip may indeed change the beta. Thus,
beta is only an indicator of the expected relative movement. It is incapable of predicting the market by itself.
Therefore, investors, who use it for practical purpose, should be a good judge of how the market moves. If
the investors prediction of the market goes wrong using beta could cause more harm than good.
TYPES OF RISK

The various types of risks in investment may be classified as follows:

(1) Default risk:
It is the risk of issuer of investment going bankrupt. An investor who purchases shares or debentures will
have to face the possibility of default and bankruptcy of the company. In the case of fixed income securities
such as debenture or fixed deposits of companies, the investor may take the care to see that the credit rating
given to the company, so that the risk can be minimised.
(2) Business risk:

Business risk means the risk of a particular business failing and thereby your investment is lost. It is
identifiable as the variation in firm's earnings due to it's business or product line. The principal determinants
of a firm's business risk are the variability of sales and it's operating leverage. Operating leverage represents
the firm's ability to translate increased sales into increased profit. Business risk can be divided into two
broad categories, external and internal. External business risk is the result of operating conditions imposed
upon the firm by circumstances beyond its control. Internal business risk is associated with the efficiency
with which a firm conducts its operations.
(3) Financial risk:

The financial risk is a function of the company's capital structure or financial leverage. The company may
fall on financial grounds, if its capital structure tends to make earnings unstable. Financial leverage is the
percent change in net earnings for a given results from the use of debt financing in the capital structure. If a
company uses a large amount of debt, then it has contracted to pay a relatively large fixed amount for its
sources of capital. When the operating profits fall, the company will have to pay large interest payments and
the net profits will fall even more. This is an example of financial leverage. The likehood of a company
defaulting on its debt-servicing obligations is known as financial risk.
(4) Purchasing power risk:

The purchasing power risk of a security is the variation of real returns on the security caused by inflation.
Inflation reduces the purchasing power of money over time. As price rise, the purchasing power of a rupee
falls and the real return on an investment may fall even though the nominal return in current rupee rise. The
impact of inflation is felt greater in case of fixed income investments. On the other hand, in case of
fluctuating incomes like shares dividends, there is a possibility of the dividend rate being higher than the
inflation rate. Thus, unless the return on your investments are higher than the inflation rate, your
investments are not profitable. The returns on your investments after adjusting for inflation is known as real
rate of return.
(5) Interest rate risk:

The earnings of companies and the performance of their shares are sensitive to interest rates changes.
Therefore, potential variability of investment returns due to interest rate fluctuations is interest rate risk. The
prices of debt securities and all other securities with fixed payout are dependent upon the level of market
interest rates. When interest rates rise, bond values will generally fall. The returns on other types of
securities also depend upon interest rates. The degree of sensitivity to interest rate changes will naturally
differ from company to company. Recently, companies have started issuing 'floating rate bonds'. The rates
of interest on these bonds are linked to some floating rate such as 'prime rate' or the banks minimum lending
rate. When market interest rate rise, the bond rate rises and when it fall, the bond rate also falls. This is a
good way of circumventing the interest rate risk when interest rates are on the rise. But in a situation where
inflation is under control and interest rates are on the decline, it is bond to be disadvantageous to the
investors.
(6) Market risk:

The market risk means the variability in the rates of return caused by the market up swings or market down
swings. It is caused by investor reactions to tangible as well as intangible events in market. Most investors
are quick to note about the security markets that returns on securities tend to move together. That is, on a
good day, the fact that some stocks in the market are rising seems to fuel enthusiasm, and other stocks tend
to rise also. On the other hand, when some stocks begin to fall, others will also tend to fall as a mood of
pessimism pervades the market. This market psychology is the explanation of the existence of market risk,
which is the volatility of a security's return attributable to changes in the level of market returns. Some
securities are quite sensitive to changes in the market and have a high degree of market risk, while others
fluctuate very little as the market changes. When a relatively small increase in the market usually
accompanies a relatively larger increase in the price of stock, the stock has a high degree of market risk.
(7) Liquidity risk:

Liquidity risk arises from the inability to convert an investment quickly into cash. It refers to the ease with
which a stock may be sold. If a stock is highly liquid, it can be sold very quickly at a price which is more or
less equal to its previous market price. In a security market, liquidity risk is a function of the marketability
of the security.
When an investor wants to sell a stock he is concerned with its liquidity. On the other hand, when an
investor wants to buy a stock, he is interested in its availability. A stock may be deemed to be easily
available, if it can be purchased quickly at a price more or less equal to its previous price. A stock may be
regarded as not easily available, if the purchaser has to wait for quite sometime to buy it at a price which is
more or less equal to the previous price. Alternatively, the purchaser, may, have to offer a substantial
premium in order to buy the stock quickly. Thus, the lower marketability of stock gives a degree of liquidity
risk that makes the price of the stock a bit more uncertain.
(8) Systematic and Unsystematic risk:

The fluctuation in an investment's return attributable to changes in broad economic social or political factors
which influence the return on investment is a systematic risk. It is that portion of total risk of a security
which is caused by the influence of certain economic-wide factor like money supply, inflation, level of
government spending and monsoon which have a bearing on the fortune of every company. Systematic risk
is undiversifiable risk and investors cannot avoid the risk arising from the above factors.
Unsystematic risk is the variation in returns due to factors related to the individual firm or security. It is that
portion of total risk which arises from factors specific to a particular firm such as plant breakdown, labour
strikes, sources of materials etc. It is possible to reduce unsystematic risk by adding more securities to the
investors portfolio. All risky securities have some degree of unsystematic risk but combining securities into
diversified portfolios reduces unsystematic risk from the portfolio. Therefore, unsystematic risk is often
referred to as diversified risk. The sum of systematic and unsystematic risks is equal to the total risk of a
Security.
INVESTOR’S ATTITUDE TO RISK

i) Risk averse investors :
A rational investor would always like to maximise his returns at minimum possible risk. This category of
investor generally likes to avoid taking risk, he does not like to take extra risk if he is offered same level of
expected returns. He will take extra risk only if he is offered extra returns by investing in a risky security.
Normally all investors are risk averse because no one would like to incur extra risk for earning same level of
returns.
ii) Risk taking investors :

These are those investors like to take more risk, there main motive while investing money is not to earn
returns but to take risk. They like to take high risk with investing the funds available to them in risky
investments to satisfy there urge to take risk and in hope of earnings huge returns.
iii) Risk indifferent investors :
This category of investors are not concerned with the level of risk they take by investing money in a
particular investment avenue.
The empirical evidence shows that majority of investors are risk-averse,

i) A risk averter is likely to prefer
ii) A risk-seeker is likely to prefer
iii) A risk-neutral investor

He may invest in any of the above options.
INVESTOR’S ATTITUDE TOWARDS RISK AND ROLE OF INDIFFERENCE CURVE

The attitudes to risk are reflected in different relationships between utility and income. However, it does not
provide a direct measure of the riskiness of any particular course of action. The most common measure of
the riskiness of an action, or the risk associated with a particular financial asset is the standard deviation of
returns accruing to it.
When considering choices between alternative courses of action, decision makers may think of deciding on
different combinations of return on the one hand, measured by the expected value of the returns, and the risk
on the other, measured by standard deviation of those returns.
Indifference curves, which show trade off between risk and returns, can be used for judging investor‟s
attitude towards risk. Indifference curves show the risk-retum indifference for a hypothetical investor. All
the points lying on a given indifference curve offer the same level of satisfaction.
In this case, indifference curves can be drawn up, showing the different combinations of risk and return
which will leave an individual equally satisfied. If individuals are assumed to be risk-averse, which is
assumption generally made then the indifference curves will be as shown in Figure 9.3 rising from right to

left, with the more desirable combinations being as indicated by the arrow, having higher returns and lower
risk.
The extent of an individual's risk aversion will be reflected in the slopes of the indifference curves. An
individual who is very highly risk averse will be prepared to sacrifice a large amount of return in order to
secure a small reduction in risk and will therefore have relatively steep indifference curves. A risk neutral
individual will have horizontal indifference curves. Indifference curves are used by experts for selection of
securities in the portfolio. Portfolio manager seeks to increase investor‟s satisfaction by proper selection of
securities.
PORTFOLIO DIVERSIFICATION/REDUCTION OF RISK THROUGH DIVERSIFICATION:

Diversification is a technique of reducing the risk involved in a portfolio. It is also a process of conscious
selection of assets i.e. securities in a manner that the total risk is brought down. This helps to reduce the
unsystematic risk and promotes the optimisation of returns for a given level of risks in a portfolio.
There are two types of risks in a portfolio, systematic and unsystematic risk. Systematic risk is the
fluctuation in an investment's return attributable to changes in broad economic, social, political sectors
which influence the return on investment of the portfolio. Therefore, systematic risk is undiversifiable risk
because the investors cannot avoid or reduce the risk arising from the above factors.
On the other hand, unsystematic risk is the variation in returns on investment due to factors related to the
individual company or security. It is that portion of total risk which arises from factors specific to a
particular company such as breakdown, labour strikes, shortage of materials, etc. It is possible to reduce
unsystematic risk by diversification of a portfolio.
The diversification of portfolio risk can be made in the following manner:

(i) Changing the type of asset.
(ii) Changing the type of instrument.
(iii) Changing the industry line.
(iv) Changing the companies.
The principles involved in diversification of portfolio are:

(a) A single company investment is more risky than two companies.
(b) A single industry investment is more risky than two or more industries.
(c) Two companies or industries which are similar in nature of demand or make are more risky than two
in dissimilar companies or industries.

(d) The diversification is proper which involves two or more companies or industries whose fortunes
fluctuate independent of one another or in different directions.
Diversification involves not putting all eggs into one basket. Thus, it is good to have as many companies or
avenues as possible in one's portfolio. However, this is a misconception as economies of scale operate in the
reverse direction with the result that monitoring and review of the portfolio becomes difficult and costly.
Markowitz emphasised the need for a right number of securities and the securities which are negatively
correlated or not correlated at all. Many of such risks can be reduced by a proper choice of companies and
industries. Neither random selection nor adequate number of securities can guarantee the purpose. For an
individual investor a number of 10 to 15 companies can be sufficient to secure reduction of risk to an
optimum level, if they are properly selected.

PRACTICAL PROBLEMS
1. Calculate the return in the following example:
A Ltd. (Rs.) B Ltd. (Rs.)
Price as on 31-3-2005 20 10
Price as on 31-3-2006 15 15
Dividend for the year 1 1
2. Mr. Ashok purchased 10 shares of ACC Ltd. four years ago at Rs. 50 each. The company paid the
following dividends.
Year 1 Year 2 Year 3 Year 4
Dividend per Share (Rs.) 2 2 2.5 3
Dividend Amount (Rs.) 20 20 25 30
The current price of the share is Rs. 60. What rate of return has he earned on his investment if he sells the
shares now?
3. The probability distribution of annual returns on a security are given below:

Return on Security Probability
-0.35 0.04
-0.25 0.08
-0.15 0.14
-0.05 0.17
0.05 0.26
0.15 0.18
0.25 0.09
0.35 0.04
4. In January 2001, Mr. Bhandari purchased the following 5 scrips:

Co.‟s Name No. of Shares Purchase price
HDFC Ltd. 100 250
Coal India Ltd. 100 180
SAIL Ltd. 100 80
Flipkart Ltd. 100 240
Martuti Suzuki 100 260
He
Ltd.paid brokerage of Rs. 1,500
During the year 2001, Mr. Bhandari received the following.
Co‟s Name Dividend Bonus Shares
HDFC Ltd. 300 1:2
Coal India Ltd. 290
SAIL Ltd. 450
Flipkart Ltd. 500
Maruti Suzuki 600
In January
Ltd. 2002, Mr. Bhandari sold all his holdings at the following prices.
Co's Name Market Price
HDFC Ltd. 275

Coal India Ltd. 240

SAIL Ltd. 108
Flipkart Ltd. 200
Maruti Suzuki Ltd. 400
He paid brokerage of Rs. 1,865.
Calculate the holding period return.
5. Investor's assessment of return on a share of X Ltd. under three
Situation Chance (P) Return (%)
1 0.25 36
2 0.50 26
3 0.25 12
Calculate the expected rate of return.
6. Calculate the expected rate of return from the following

State of the Economy Probability of occurrence Rate of Return
Boom 0.30 40%

Normal 0.50 30%
Recession 0.20 20%
7. An investor would like to find the expected return on the share

State of the Economy Probability of Occurrence Rate of Return (%)
Boom 0.30 30
Normal 0.50 18
Recession 0.20 10
Calculate the expected return from the share.
8. Mr. Abraham has a portfolio of five stocks. The expected return and amount invested in each stock is
given below:
Stocks Expected Amount
A 0.14
return 10,000
invested
B 0.08 20,000
C 0.15 30,000
D 0.09 15,000
E 0.12 25,000
Portfolio value 1,00,000
Compute the expected return on Mr. Abraham's portfolio.
9. Dr. Shah purchased 400 shares of Sundar Ltd. @ Rs. 61 each on 15th October, 2004. He paid brokerage
of Rs. 600. The company paid the following dividends:
June, 2005 Rs. 800
June, 2006 Rs. 1,000

June, 2007 Rs. 1,200

He sold all his holding for Rs. 34,500 (net) on 15th October, 2007
(1) What is the holding period Return?
(2) What is the annualized Return?
(3) Is Mr. Shah a good investor?
10. Compute the expected return of an investment in the following security.

Economic Probability (P) Return on
Condition Investment (%)
Boom 0.275 +40%
Stagnation 0.450 +20%
Depression 0.275 -10%
11. Ashok purchased 100 shares of A Ltd. four years ago at Rs. 500 each. The rate of brokerage was 1%.
The Company paid the following dividends:
Year 1 Year 2 Year 3 Year 4
Dividend per share (Rs.) 2 2 2.50 3
Dividend amount 200 200 250 300
The current price of the share is Rs. 600. What is the profit has be earned on his investment if he sells the
shares now?
12. The probability distribution of annual returns on a security are

Return on Security Probability
-0.35 0.04
-0.25 0.08
-0.15 0.14
-0.05 0.17
0.05 0.26
0.15 0.18
0.25 0.09
0.35 0.04
Compute the expected return on the security.
13. Mr. Rajesh, a Fund Manager produced the following returns for the last five years. Rates of return on
Sensex are also given for comparison:
2003-04 2004-05 2005-06 2006-07 2007-08
Mr. Rajesh 6% 48% -15% 7% 11%
Sensex 12% 40% -6% 20% 3%
Calculate the average return and standard deviation of Mr. Rajesh's Mutual Fund. Did he do better or worse
than sensex by these measures?
14. Mr. Rajan wants to invest in company A or company B. The return on stock A and B and probabilities
are given below:

Company Company A Company B

Return % Probability Return % Probability
6 0.10 4 0.1
7 0.25 6 0.2
8 0.30 8 0.4
9 0.25 10 0.2
10 0.10 12 0.1
Calculate expected return and standard deviation of both the companies and advise Mr Rajan, whether he
should invest in company A or B.
15. Mr. A has invested equal amount in Security X and Security Y. The expected returns during the boom
and depression with equal probability of occurrence are as under:
Economic Expected Returns of
Conditions Security X Security Y
Boom 6 12
Depression 15 5
Calculate expected return and standard deviation of each security.
16. The rate of return on Stocks X and Y under different states of

the economy are given below:
Boom Norma Recession
Probability of occurrence 0.35 0.50
l 0.15
Rate of Return on stock X 20 30 40
Rate
(%) of Return on stock Y 40 30 20
Calculate
(%) the expected return and standard deviation of return on both the stocks.
(ii) If you could invest in either stocks X or stock Y, but not in both, which stock would you prefer?
(iii) What would be your decision if the probability changes to 30: 40: 30?
17. Shankar has been considering an investment in stock X or Y. He has estimated the following probability
distribution of return of stock X and Y.
Return on Stock X Return on Stock Probability
-10 05
Y 10
0 10 25
10 15 40
20 20 20
30 25 05
Calculate the expected return and standard deviation of Stock X and Y and state which stock is worth
investing.
18. The following is the information of stock A and Stock B under the possible states of nature:
State of nature Probability Return „A‟ Return „B‟
1 0.10 5% 0%
2 0.30 10% 8%
3 0.50 15% 18%
4 0.10 20% 26%

(1) Calculate the expected return on A and B.

(2) Calculate the standard deviation of stock A and B.
(3) If you want to invest in any one stock, which stock would you prefer?
19. Ramesh recently forecasted four economic situations which he believes are likely to occur with the
given probabilities. Based on these situations, an analyst made the following forecasts of the returns of stock
A, B and C.
Situation Probability (P) Conditional Returns %
A B C
High 0.20 -13 -4 -9
Low
growth 0.15 16 -2 8
Stagnation
growth 0.40 32 21 16
Recession 0.25 12 20 20
Calculate the mean return and standard deviation of stocks A, B and C and advise which stock is good for
investment.
20. Given below are the likely returns in case of shares of VCC Ltd. and LCC Ltd. in the various economic
conditions. Both the shares
Economic Probability Returns of Returns of
Conditions VCC Ltd. LCC Ltd.
High Growth 0.3 100 150
Low Growth 0.4 110 130
Stagnation 0.2 120 90
Recession 0.1 140 60
(1) Which of the two companies are risky investments?
(2) Mr. Suresh has three options for investing ? 1000.
(i) Only in shares of VCC Ltd.
(ii) Only in shares of LCC Ltd.
Which of the above options is the best? Why?
21. Following is the data relating to five securities.

Security A B C D E
Return (%) 8 8 12 4 9
Risk (S.D.) (%) 4 5 12 4 5
(i) Which of the securities should be selected for investment?
(ii) Assuming perfect correlation, analyse whether it is preferable to invest 75% in security A and 25% in
security C.
22. Mr. Anil purchased 2500 shares of JKL Ltd. @ Rs. 20 each (Face Value Rs. 5 per share) and paid
brokerage @ 2% on 01-01-2009. The company paid dividend @ 50% each year he sold all the shares at Rs.
25 each on 31-12-2010 and paid brokerage of Rs. 1,200.
The other investment alternative available to him was SBI fixed Deposit carrying interest @ 12%p.a.,
for year on compounded basis.

Was his decision to go for share investment right? Offer your comments with reasoning.
23. Mrs. Priya purchased 300 shares of ABC Ltd. @ Rs. 70 each on 9th Feb. 2009. She paid brokerage of
Rs. 500. She received dividend from the company as follows:
June 2009 Rs. 300
June 2010 Rs. 400
She sold all her holdings on 11th February 2011 for Rs. 27,000.
What is her holding period return?
(M.U. April 2012)
24. Ms. Snehal purchased 1000 shares of ABC Ltd. @ Rs. 100 each on 1st January, 2009. She paid a
brokerage of Rs. 500. During the year 2010 she received bonus shares of ABC Ltd. in the ratio of 3 : 5. She
also received dividends from the company as follows.
(M.U. Oct. 2012)
October 2009: Rs. 1500
October 2010: Rs. 750
She sold all her holdings in January 2011 @ Rs. 135 each. She had to pay a brokerage of Rs. 875. Calculate
the holding period return.
Following is the date relating to six securities select two securities for investment:
Security A B C D E F
Return (%) 8 8 12 4 9 ,8
Risk (S.D) (%) 4 5 12 4 5 6
Following is the date relating to six securities select two securities for investment:
Security M N O P Q R
Return (%) 10 10 12 15 11 10
Risk (S.D) (%) 6 4 12 15 7 3
Calculate Beta of Security X from the following information : SDx = 12% SDm = 9% and CORxm = +0.72
25. (Calculation of Beta from basic information without probabilities)

Find out beta of security X from the following information :
Period Return of Security X (%) Returns on Market Portfolio (%)
1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 -5 8
7 17 -6
8 19 5
9 -7 6
10 20 11
26. (Calculation of Beta from basic information (with probabilities) & Security Valuation using CAPM)

Calculate the beta factor of the following investment. Is acceptance of the investment worthwhile based
upon the level of risk? The risk free rate may be taken at 6%.
Probability Returns on (%)

Market (M) Investment (S)
1/3 9 6
1/3 12 30
1/3 18 18
27. (Calculation of Portfolio Beta)

Mr. X has invested in four securities A, B, C, & D, the following amounts :
A 10,000
B 20,000
C 16,000
D 14,000
The beta values of the securities are 0.80, 1.20, 1.40 & 1.75 respectively. Compute portfolio Beta.
28. The standard deviation of returns of security Y is 20% and of market portfolio is 15%. Calculate beta of
security Y if (a) CORYM ~ +0.70; (b) CORYM = +0.40; (c) CORYM = - 0.25.
29. Compute the beta factors and expected returns for K Ltd. and M Ltd. Return on government securities is
8%. Return in earlier years is-
Year K Ltd. M Ltd. Market Return
1 10% 16% 12%
2 12% 14% 14%
3 15% 18% 20%
4 18% 20% 21%
30. Calculate the beta factor of the following investment. Is acceptance of the investment worthwhile based
upon the level of risk? The risk free rate may be taken at 8%.
Probability Returns on (%)
Market (M) Investment (K)
20 % 12 10
60 % 18 22
20 % 23 27
31. Mr. M invested his funds in five securities in the ratio of 0.20 : 0.30 : 0.20 : 0.20 : 0.10, these securities
had beta of 0.70, 0.85, 1.75, 1.45 & 1.80 respectively. Calculate portfolio beta.
32. From the following information calculate Beta of a security:

Year Return on Security Return on Market Portfolio %
1 %
10 12
2 12 11
3 15 14
4 10 12

5 O8 11
33. From the following details calculate Beta of a security.

Year Return on Security Return on Market Portfolio (%)
1 (%)
10 12
2 12 10
3 13 10
4 10 12
5 8 15
6 11 14
7 16 20
8 12 15
9 18 20
10 20 22

5 PORTFOLIO MANAGEMENT
PORTFOLIO
1) Portfolio means combined holding of many kinds of financial securities i.e. shares, debentures,
government bonds, units and other financial assets.
2) It is also a combination of securities with different risk-return characteristics. A portfolio is built up out
of the wealth or income of the investor over a period of time with a view to manage the risk-return
preferences.
PORTFOLIO MANAGEMENT
1. Portfolio management means selection of securities and constant shifting of the portfolio in the light of
varying attractiveness of the constituents of the portfolio. It is a choice of selecting and revising spectrum of
securities to it in with the characteristics of an investor.
2. Management means utilisation of resources in the best possible manner. Portfolio management involves
maintaining a proper combination of securities which comprise the investor's portfolio in such a manner that
they give maximum return with minimum risk. This requires forming of a proper investment policy which is
a policy of formation of guidelines for allocation of available funds among the various types of securities.
3. A professional, who manages other people's or institution's investment portfolio with the object of
profitability, growth and risk minimization is known as a portfolio manager. He is expected to manage the
investor's assets prudently and choose particular investment avenues appropriate for particular times aiming
at maximization of profit. Portfolio management includes portfolio planning, selection and construction,
review and evaluation of securities. The skill in portfolio management lies in achieving a sound balance
between the objectives of safety, liquidity and profitability.
OBJECTIVES OF PORTFOLIO MANAGEMENT

The basic objective of portfolio management is to maximise yield and minimise risk. The other objectives
are as follows:
(a) Stability of Income:
An investor considers stability of income from his investment. He also considers the stability of purchasing
power of income.
(b) Capital Growth:

Capital appreciation has become an important investment principle. Investors seek growth stocks which
provides a very large capital appreciation by way of rights, bonus and appreciation in the market price of a
share.
(c) Liquidity:
An investment is a liquid asset. It can be converted into cash with the help of a stock exchange. Investment
should be liquid as well as marketable. The portfolio should contain a planned proportion of high-grade and
readily salable investment.
(d) Safety:

Safety means protection for investment against loss under reasonably variations. In order to provide safety,
a careful review of economic and industry trends is necessary. In other words, errors in portfolio are
unavoidable and it requires extensive diversification. Even investor wants that his basic amount of
investment should remain safe.
(e) Tax Incentives:

Investors try to minimise their tax liabilities from the investments. The portfolio manager has to keep a list
of such investment avenues along with the return risk, profile, tax implications, yields and other returns. An
investment programme without considering tax implications may be costly to the investor.
(f) Diversification:
In order to provide safety a careful review of economic and industry is necessary. In other words, errors in
portfolio are unavoidable and it requires extensive diversifivcation. Even investor wants that his basic
amount of investment is safe by investing in various types of securities over a wide range of options.
(g) Marketability:
It means the ease with the security can be bought and sold. It is essential for providing flexibility to
investment portfolio.
PORTFOLIO MANAGEMENT PROCESS

1. PLANNING :
This is the most important step; it is the foundation on which entire portfolio management process built. It
comprises of these tasks:
a) Identification of Objectives and Constraints :
This task involves assessing client‟s return expectations along with his risk appetite. Client needs to be
updated here the type of returns he can expect keeping in mind their risk taking ability. Here earning
required returns becomes objectives and risk taking ability becomes constraints.
b) Investment Policy Statement :

Once the objectives and constraints are identified, the next task is to draft an investment policy statement.
c) Capital Market Expectations :

Here we try to maximize returns at a given level of risk or minimize risk to earn a given level of returns.
d) Asset Allocation Strategy :

This is the last task in the planning stage.
i) Strategic Asset Allocation : A long term investment strategy is drawn keeping in mind Investment
policy statement and capital market expectation, such allocation is also refereed as strategic asset allocation.
ii) Tactical Asset Allocation : Any short-term change in the portfolio strategy as a result of the change
in circumstances of the investor or the market expectations is a tactical' asset allocation. If the changes
become permanent and the policy statement is updated to reflect the changes, there is a chance that the
temporary tactical allocation becomes the new strategic portfolio allocation.
2. EXECUTION :
After planning stage, execution of the plan is the next stage.
This consists of these decisions:
a) Portfolio Selection :

Here, specific assets are chosen for the client keeping in mind capital market expectations and asset
allocation strategy. Generally, the portfolio managers use the portfolio optimization technique
while deciding the portfolio composition.
b) Portfolio Implementation :
Once the composition of portfolio is finalized, the portfolio is executed. Here, transaction cost should be
kept in check as higher cost may lead to lower portfolio returns. Transaction costs include both explicit costs
like taxes, fees, commissions, etc. and implicit costs like opportunity costs, etc. Hence, the execution of the
portfolio needs to be appropriately timed and well-managed.
3. FEEDBACK :
Regular feedback of client should be taken to understand changing needs of client and to achiee long term
goals set in consolation with the client. Following two activities are undertaken with the help of regular
client feedback.
a) Monitoring and Rebalancing :
The portfolio manager needs to monitor j and evaluate risk exposures of the portfolio and compares it with
the strategic asset allocation. This is required to ensure that investment objectives and constraints are being
achieved. The manager monitors the investor‟s circumstances, economic fundamentals and market
conditions. Portfolio rebalancing should also consider taxes and transaction costs.
b) Performance Evaluation :
The investment performance of the portfolio must be evaluated regularly to measure the achievement of
objectives and the skill of the portfolio manager. Both absolute returns and relative returns can be used as a
measure of performance while analysing the performance of the portfolio.
APPROACHES TO CONSTRUCTION OF PORTFOLIO:

(A) INTERIOR DECORATING APPROACH:
Interior decorating approach is tailor-made to the investment objectives and constraints of each investor. In
case of exterior building or room structure, the furnishing and interior decoration to be carried out inside the
structure will depend upon the purpose for which it is to be used. Similarly, the portfolio will consist of
securities which will suit the individual's investment objectives and constraints. An individual investor has
to carefully develop his portfolio over a period of years to suit his needs and match his investment
objectives.
A serious minded investor will have to consider the following important categories of investment
opportunities.
(i) Protective investments:
These investments protect the investors against the uncertainties in life. The life insurance policy is a good
example of this type of investment opportunity.
(ii) Tax oriented investment:

Some investments provide tax incentives to the investors. For example. Public Provident Fund, National
Savings Certificates etc.
(iii) Fixed income investments:

These investment yield a fixed rate of return on the investments. For example, investment in preference
shares, debentures, bank deposits etc.
(iv) Emotional investments:

These investments are made for the purpose of emotional security and satisfaction. Investors get some
satisfaction from these investments. For example, investment made in house property, jewellery, household
appliances etc.
(v) Speculative investments:

These investments are made for the purpose of speculation. The motive behind it is to make quick gains out
of fluctuations in the market. For example, investment in real estates, shares, commodity trading etc.
(vi) Growth investments:

These investments are made for the purpose of earning capital gains. These are not made for getting regular
income. For example, investment in growth shares, real estates, land, gold etc.
With the help of these variety of investments, we can attempt to develop a matrix for matching the
individual characteristics of specific investments so that a suitable portfolio can be developed for each
investor.
(B) MARKOWITZ APPROACH:

Markowitz approach provides a systematic search for optimal portfolio. It enables the investors to locate
minimum variance portfolios i.e. portfolios with the least amount of risk for different levels of expected
return. It is the process of combining assets that are less than perfectly positively correlated in order to
reduce portfolio risk without sacrificing portfolio returns. It is more analytical than simple diversification
because it considers correlations between assets returns for lowering risk. There are computer based
packages available for determining the efficient portfolios. If we go through this process for different levels
of expected returns, we can locate minimum variance portfolio. Application of the above package will tell
us how much we can invest in each security to form an efficient portfolio for a given level of return.
Markowitz theory is based on following assumptions : .

• The return on an investment adequately summarises the outcome of the investment.
• The investors can visualise a probability distribution of rates of return.
• Investors base their investment decision on two criteria i.e., expected returns and variance of returns.
• All investors are risk averse, i.e. they seek highest returns at lowest possible risk.
PRINCIPLES OF PORTFOLIO CONSTRUCTION

The portfolio manager has to follow certain principles while constructing a portfolio. These principles are as
follows:
(1) Safety Principle:
The safety principle means that the portfolio must maintain its principal value in the event of forced
liquidation. Normally, the investor does not want to accept a loss of principal amount of investment. There
are two important considerations involved in determining the need for safety principal - tenure of ownership
and the effect of inflation. If the tenure of ownership is weak, the portfolio may be liquidated to meet some
contingencies. Another consideration is the effect of a rising price level on the principal invested initially in
the portfolio. For this purpose, many portfolio managers attempt to hedge against inflation by including at
least a portion of the portfolio in common stock.
(2) Need for Income:

In formulating the objective for a portfolio the starting point is usually to establish an amount of income the
portfolio must generate. This involves two stages. In the first stage, it is necessary to determine the amount
of income that the portfolio must provide based on current conditions. This involves determining a family
budget that is consistent with the standard of living desired and then determining whether there are other
sources of income in addition to the proposed portfolio of securities. The second stage is to determine how

much income must be provided by the portfolio of securities. As inflation is a fact of life, it is necessary to
estimate its impact and attempt to provide a stream of income from a securities portfolio that offsets it, as
well as possible.
(3) Taxation:
There may be strong incentive for many investors in the high tax brackets to invest in tax-exempt securities
rather than common stock. It offers investors to combine a high effective yield with relatively low risk.
Those investors who qualify tax-exempt securities may constitute a worthwhile investment.
(4) Temperament:
A higher return may be expected from a well- diversified portfolio of common stock than a portfolio of
bonds, some investors may not be willing to accept the greater risk associated with common stock. Thus,
temperament is the most important principle on the formulation of portfolio objectives. It indicates the
investor's willingness to accept risk. Some investors are able to accept risk. Common stock prices are
volatile. Investors who find these volatility disturbing, may not have the temperament for common stock
investment. Temperament may be the overriding constraint in arriving at an appropriate portfolio policy for
the investor.
FACTORS AFFECTING INVESTMENT DECISIONS IN PORTFOLIO MANAGEMENT

(a) Return:
Investors buy or sell financial instruments in order to earn return on them. The return on investment is the
reward to the investors. The return includes both current income and capital gains or losses, which arises by
the increase or decrease of the security price.
(b) Risk:
Risk is the chance of loss due to variability of returns on an investment. In case of every investment, there is
a chance of loss. It may be loss of interest, dividend or principal amount of investment. However, risk and
return are inseparable. Return is a precise statistical term and it is measurable. But the risk is not precise
statistical term. However, the risk can be quantified. The investment process should be considered in terms
of both risk and return.
(c) Time:
Time is an important factor in investment. It offers several different courses of action. Time period depends
on the attitude of the investor who follows a 'buy and hold' Policy. As time moves on, analysts believe that
conditions may change and investors may revaluate expected return and risk for each investment.
(d) Liquidity:
Liquidity is also important factor to be considered while making an investment. Liquidity refers to the
ability of an investment to be converted into cash as and when required. The investor wants his money back
any time. Therefore, the investment should provide liquidity to the investor.
(e) Tax Saving:

The investors should get the benefit of tax exemption from the investments. There are certain investments
which provide tax exemption to the investor. The tax saving investments increase the return on investment.
Therefore, the investors should also think of saving income tax and invest money in order to maximise the
return on investment.

PORTFOLIO STRATEGY MIX

Establishing an appropriate asset mix is a dynamic process, and it plays a key role in determining your
portfolio's overall risk and return. As such, your portfolio's asset mix should reflect your goals at any point
in time. Following are some different strategies of establishing asset allocations and examine their basic
management approaches.
(1) Strategic Asset Allocation:

This method establishes and adheres to a "base policy mix" - a proportional combination of assets based on
expected rates of return for each asset class. For example, if stocks have historically returned 10% per year
and bonds have returned 5% per year, a mix of 50% stocks and 50% bonds would be expected to return
7.5% per year.
(2) Constant-Weighting Asset Allocation:

Strategic asset allocation generally implies a buy-and-hold strategy, even as the shift in values of assets
causes a drift from the initially established policy mix. For this reason, you may choose to adopt a constant-
weighting approach to asset allocation. With this approach you continually rebalance your portfolio. For
example, if one asset is declining in value, you would purchase more of that asset; and if that asset value is
increasing, you would sell it.
There are no hard-and-fast rules for timing portfolio rebalancing under strategic or constant-weighting asset
allocation. However, a common rule of thumb is that the portfolio should be rebalanced to its original mix
when any given asset class moves more than 5% from its original value.
(3) Tactical Asset Allocation:

Over the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore, you may find it
necessary to occasionally engage in short-term, tactical deviations from the mix to capitalize on unusual or
exceptional investment opportunities. This flexibility adds a market timing component to the portfolio,
allowing you to participate in economic conditions more favorable for one asset class than for others.
Tactical asset allocation can be described as a moderately active strategy, since the overall strategic asset
mix is returned to when desired short-term profits are achieved. This strategy demands some discipline, as
you must first be able to recognize when short-term opportunities have run their course, and then rebalance
the portfolio to the long-term asset position.
(4) Dynamic Asset Allocation:

Another active asset allocation strategy is dynamic asset allocation, with which you constantly adjust the
mix of assets as markets rise and fall, and as the economy strengthens and weakens. With this strategy you
sell assets that are declining and purchase assets that are increasing, making dynamic asset allocation the
polar opposite of a constant-weighting strategy. For example, if the stock market is showing weakness, you
sell stocks in anticipation of further decreases; and if the market is strong, you purchase stocks in
anticipation of continued market gains.
(5) Insured Asset Allocation:

With an insured asset allocation strategy, you establish a base portfolio value under which the portfolio
should not be allowed to drop. As long as the portfolio achieves a return above its base, you exercise active
management to try to increase the portfolio value as much as possible. If, however, the portfolio should ever
drop to the base value, you invest in risk-free assetsso that the base value becomes fixed. At such time, you
would consult with your advisor on re-allocating assets, perhaps even changing your investment strategy
entirely.
Insured asset allocation may be suitable for risk- averse investors who desire a certain level of active
portfolio management but appreciate the security of establishing a guaranteed floor below which the

portfolio is not allowed to decline. For example, an investor who wishes to establish a minimum standard of
living during retirement might find an insured asset allocation strategy ideally suited to his or her
management goals.
(6) Integrated Asset Allocation:

With integrated asset allocation, you consider both your economic expectations and your risk in establishing
an asset mix. While all of the above-mentioned strategies take into account expectations for future market
returns, not all of the strategies account for investment risk aspects of all strategies, accounting not only for
expectations but also actual changes in capital markets and your risk tolerance. Integrated asset allocation is
a broader asset allocation strategy, albeit allowing only either dynamic or constant-weighting allocation.
Obviously, an. investor would not wish to implement two strategies that compete with one another.
Asset allocation can be an active process to varying degrees or strictly passive in nature. Whether an
investor chooses a precise asset allocation strategy or a combination of different strategies depends on that
investor's goals, age, market expectations and risk tolerance.

6 FUNDAMENTAL ANALYSIS
FUNDAMENTAL ANALYSIS
Fundamental analysis is a method of finding out the future price of a security which an investor wants to
buy. The objective of fundamental analysis is to appraise the 'intrinsic value' of a security.
There is an intrinsic value for each security and it can be determined by making an analysis of the
fundamental factors relating to the company, industry and economy. At any given point of time, the current
market price of a security can be different from its intrinsic value due to the temporary market conditions.
An investor can buy undervalued securities and sell overvalued securities. Thus, the intrinsic value of a
security should be determined for this purpose.
INTRINSIC VALUE
The intrinsic value of a security is that value which is justified by the facts such as assets, earnings,
dividends and prospects of the company. It is also measured as the present value of all future cash inflows
on the security i.e. dividends interest, capital gain, bonus, rights, etc. The fundamental analysis can
determine the intrinsic value of a security by discounting the prospective dividend using the rate of return
required by the investor as the discount rate. The prospective dividend or interest stream depends upon the
economic and industrial environment in the country.
1. MACRO-ECONOMIC ANALYSIS
It is very important to assess the state of the economy for the purpose of making investments. If a recession
is likely, or undergoing, the stock market is affected at certain times. On the other hand, if a strong
economic expansion is undergoing, the stock market is also affected at certain times. This status of an
economic activity has a major impact on overall stock market. Therefore, it is very important for the
investors to assess the state of the economy and its impact on the stock market.
Investment in debt as well as ownership securities is closely associated with the economic activity of the
country. An investment in the equity shares of a company is likely to be more profitable, if the economy is
strong and growing. The growth of a company depends basically on its ability to satisfy human wants
through production of goods or creation and supply of services. All the companies cannot grow at the same
rate and at the same time. If the national economy is declining, the investment in debt or equity will be
seriously considered. In this situation, greater attention should be given to fixed income obligations.
Some of the Macroeconomic variables are :
1. Monsoon & Agriculture
It is an important indicator, as adequate and timely rainfall normally results in enough food crops and raw
material for industries and also generation of hydro-electric power. This leads to stable prices and
profitability for the company and more funds in the hands of investors to invest in companies and eventually
more income for the company. On the other hand, drought/floods leads to shortage of food and raw material
in turn increased prices and lower profits for the company.

2. GDP
The Gross Domestic Product is the value of all the goods and services produced in an economy; it is
considered the most comprehensive single measure of aggregate economic performance of the economy as
it contains all economic activities during the reference period. The rate of growth of GDP is compared with
past growth rates to indicate the general direction of the economy. A higher GDP indicates positive growth
prospects.
3. Inflation
Inflation leads to increase in prices of commodities in the economy and hence less funds at the disposal of
investors to save and invest, this in turn leads to reduction in demand for various investments, this in turn
leads to reduction in share price of the company. On the other hand with high inflation the company also
faces increased manufacturing cost again leading to reduction in profits. Inflation can be judged by
analysing Wholesale Price Index (WPI), this index measures the price of goods at the wholesale level i.e.
how much produces are receiving from goods.
4. Fiscal Policy
Fiscal policy refers to government‟s spending and tax action and is part of demand-side management. It is
the most direct way to influence the economy. For example, when the government increases spending, it
creates more demand in the economy and similarly when the government reduces spending, it causes slow
down in the economy. It must be noted that government is a major buyer of several core sector products.
This also affects the company in form of change in its product demand.
5. Monetary Policy
Monetary policy, in the form of changing CRR and SLR is also demand side management of economy. The
RBI adjusts the money supply through variety of policies and thus influences the economy and cash at the
disposal of companies and banks to be used in business.
Some other variables are Government Policy, political stability, etc.
2. CURRENT STATE OF ECONOMY

The current state of national economy should be determined for the purpose of making investments. The
analyst can collect the data or required information from different sources.
1. Economic survey published by the Government before budget every year, will be very much useful in this
respect.
2. Investment climate can be studied from GNP and its components. GNP stands for Gross National
Product. It is the broadest measure of economic activity. It represents the aggregate amount of goods and
services produced in the economy for a period of time.
3. The analyst has also to study the Gross Domestic Product (GDP), Gross Domestic Savings and Gross
Domestic Capital formation. These factors must be favourable at the time of making investments. The
economic environment also includes credit policy, exim policy, foreign investment policy, policies to
encourage investment in infrastructure, investor protection and industrial policy of the country.

4. The investor has to make an analysis of the economy in order to determine his investment strategy. The
important thing is to identify the trends in the economy and adjust his investment portfolio accordingly. The
forecasts are also published in the newspapers, magazines and bulletins. They provide necessary perspective
to the investors.
5. An investor has to make his own economic forecasts. If the economy is expected to increase in real terms
next year, the stock market should be expected to improve accordingly. Inflation and price increase are also
important.
6. A real growth of GNP without inflation is desirable. A high rate of inflation will have adverse effect on
the stock market. A deficit in trade and balance of payments position of the country depreciate the currency
in foreign exchange markets and it will have negative impact on the economy and stock market.
7. An examination of interest rates, corporate profits, employment generation, housing, agriculture and other
economic variables will give an investor an easy reference in interpreting and assessing the direction of the
economy and stock market.
3. INDUSTRY ANALYSIS
1. Industry analysis is the study of industries which are on the upswing or growing. The ideal investment is
the investment in the growing industry. There are certain industries which have been growing in India. The
recent examples are of entertainment and computer softwares. The petrochemicals, bio-technology and
capital goods industries are also growing. Investment in these industries will definitely gain in future.
2. The investor should know the industry classification used in the economy. It is also necessary to know the
characteristics, problems and practices in different industries. There is also need to study the present and
future developments, operating features, seasonal variations and competitiveness in order to establish the
proper perspective.
3. A careful analysis of growth of industries will help to select few industries for investment. In recent times
growth of industries has been affected due to technological changes, competitive pressure, population, etc.
The competitive position of industries is also affected due to high labour costs, change in social habits,
Government regulations and automation.
4. An investor should select few industries that are in the expansion stage. Investment should not be made in
the industries which are in the pioneering stage. Similarly, industries that are in the stagnation stage or
declining in economic importance should be avoided. Investors should select such industries which have
developed a strong competitive position. It is difficult to identify a good industry for investment. However
an attempt to analyze all the above factors should be made by an investor.
4. COMPANY ANALYSIS

The industry analysis helps to select few industries for investment in securities. There are many companies
in an industry. For example, if an investor wants to invest in computer software industry, then he has to
select few companies from that industry. There are thousands of listed companies from computer software
industry. Therefore, an investor has to select few companies for investment.
A company analysis is a study of the variables which influence the future price of a company's share. It is an
assessment of company's competitive position, earning capacity and profitability. It is a method of finding
out the intrinsic value of a company's share.
This requires internal as well as external information of the company. Internal information consists of data
and events of the company which is available from its financial statements. External information consists of
demand, supply, competitors, pricing, market share, etc. which can be obtained from industry associations,
chambers of commerce, Government departments and stock exchange bulletins.
The basic financial statements which are used as tools of company analysis are the income statement, the
balance sheet and the statement of changes in financial position. While making company analysis, investors
should carefully judge that these statements are correct, complete, consistent and comparable. The accuracy
of the financial statements can be identified from the report of the auditors.
The most frequently used tools for company analysis are as follows:
(1) Ratio Analysis.
(2) Trend Analysis.
(3) Funds Flow Analysis.
(4) Common Size Statement Analysis.
(5) Technical Analysis.
5. FINANCIAL STATEMENT ANALYSIS

The massive amount of numbers in a company's financial statements can be bewildering and intimidating to
many investors. On the other hand, if you know how to analyze them, the financial statements are a gold
mine of information.
Financial statements are the medium by which a company discloses information concerning its financial
performance. Followers of fundamental analysis use the quantitative information gleaned from financial
statements to make investment decisions. The three most important financial statements are :
i) Balance Sheet,
ii) Income statement (i.e. Profit and Loss Account) and
iii) Cash flow statement
BALANCE SHEET
Investors often overlook the balance sheet. Assets and liabilities aren't nearly as attractive as revenue and
earnings. While earnings are important, they don't tell the whole story. The balance sheet highlights the
financial condition of a company and is an integral part of the financial statements.
The balance sheet, also known as the statement of financial condition, offers a snapshot of a company's
health. It tells you how much a company owns (its assets), and how much it owes (its liabilities). The
difference between what it owns and what it owes is its equity, also commonly called "net assets" or
"shareholders equity". The balance sheet tells investors a lot about a company's fundamentals : how much

debt the company has, how much it needs to collect from customers (and how fast it does so), how much
cash and equivalents it possesses and what kinds of funds the company has generated over time.
INCOME STATEMENT
The Income statement is a summary of the income and outgo of a business in terms of rupees over a
specified period of time with a residual showing of net income. It discloses the revenue realised from the
sale of goods and the costs incurred in the process of producing the scheme. It tells a story of progress or
decline over given period and why and how an indicated result was achieved. An analysis of income
statement is helpful in knowing profitability of the concern both with reference to sales as well as with
reference to capital invested.
CASH FLOW STATEMENTS

The cash flow statement shows how much cash comes in and goes out of the company over the quarter or
the year. At first glance, that sounds a lot like the income statement in that it records financial performance
over a specified period. But there is a big difference between the two.
What distinguishes the two is accrual accounting, which is found on the income statement. Accrual
accounting requires companies to record revenues and expenses when transactions occur, not when cash is
exchanged. At the same time, the income statement, on the other hand, often includes non-cash revenues or
expenses, which the statement of cash flows does not include. Just because the income statement shows net
income of Rs. 10,000 does not mean that cash on the balance sheet will increase by same amount. Whereas
when the bottom of the cash flow statement reads Rs. 10,000 net cash inflow, that‟s exactly what it means.
The company has Rs. 10,000 more in cash than at the end of the last financial period. It shows how the
company is able to pay for its operations and future growth. Indeed, one of the most important features
you should look for in a potential investment is the company's ability to produce cash. Just because a
company shows a profit on the income statement doesn't mean it cannot get into trouble later because
of insufficient cash flows. A close examination of the cash flow statement can give investors a better sense
of how the company will fare.
1. THREE SECTIONS OF THE CASH FLOW STATEMENT

Companies produce and consume cash in different ways, so the cash flow statement is divided into three
sections : cash flows from operations, financing and investing. Basically, the sections on operations and
financing show how the company gets its cash, while the investing section shows how the company spends
its cash
a) Cash Flows from Operating Activities
This section shows how much cash comes from sales of the company's goods and services, less the amount
of cash needed to make and sell those goods and services. Investors tend to prefer companies that produce a
net positive cash flow from operating activities. High growth companies, such as technology firms, tend to
show negative cash flow from operations in their formative years. At the same time, changes in cash flow
from operations typically offer a preview of changes in net future income. Normally it's a good sign when it
goes up. Watch out for a widening gap between a company's reported earnings and its cash flow from
operating activities. If net income is much higher than cash flow, the company may be speeding or slowing
its booking of income or costs.

b) Cash Flows from Investing Activities

This section largely reflects the amount of cash the company has spent on capital expenditures, such as new
equipment or anything else that needed to keep the business going. It also includes acquisitions of other
businesses and monetary investments such as money market funds. You want to see a company re-invest
capital in its business by at least the rate of depreciation expenses each year. If it doesn't re-invest, it might
show artificially high cash inflows in the current year which may not be sustainable.
c) Cash Flow from Financing Activities

This section describes the goings-on of cash associated with outside financing activities. Typical sources of
cash inflow would be cash raised by selling stock and bonds or by bank borrowings. Likewise, paying back
a bank loan would show up as a use of cash flow, as would dividend payments and common stock
repurchases.
2. CASH FLOW STATEMENT CONSIDERATIONS

Investors are attracted to companies that produce plenty of free cash flow (FCF). Free cash flow signals a
company's ability to pay debt, pay dividends, buy back stock and facilitate the growth of business. Free cash
flow, which is essentially the excess cash produced by the company, can be returned to shareholders or
invested in new growth opportunities without hurting the existing operations. The most common method of
calculating free cash flow is :
Net Income + Amortization/Depreciation
- Changes in Working Capital
- Capital Expenditures
Free Cash Flow
Ideally, investors would like to see that the company can pay for the investing figure out of operations
without having to rely on outside financing to do so. A company's ability to pay for its own operations and
growth signals to investors that it has very strong fundamentals.
RATIO ANALYSIS
Ratio analysis is the systematic process of determining and interpreting the numerical relationship of various
pairs of items derived from the financial statements of a business. Absolute figures of any aspect of business
may not convey any tangible meaning. Hence it is one of the most important tools of financial statement
analysis. It is the principal technique used in judging the condition disclosed by the financial statements. It
is a process of computing, determining, and presenting the relationship between items or groups in the
financial statements. It helps in appraisal of financial conditions, efficiency and profitability of a firm.
A ratio is simply one number expressed in terms of another. It is a statistical yardstick that provides a
measure of the relationship between figures. The relationship can be expressed as a percent or as a quotient.
An accounting ratio expresses the relationship between two figures or group of items in the financial
statements. Ratio analysis is a useful tool of financial appraisal at macro level as well as micro levels.
However, their use depends on the user and the purpose. There are no standard ratios applicable to all
purposes. Certain ratios are useful at micro level while others are useful at macro level. We are concerned
here more with the macro analysis.

TYPES OF FINANCIAL RATIOS:

Financial ratio analysis a study of relationship between various items or groups of items in financial
statements. These ratios can be classified in different ways. The ratios useful for financial analysis and
investment are as follows:
(1) Liquidity Ratios
(2) Profitability Ratios
(3) Solvency Ratios
(4) Leverage Ratios
(5) Efficiency Ratios
(6) Ratios Relevant for Equity shareholders.
(1) LIQUIDITY RATIOS

Liquidity refers to the ability of a firm to meet its obligations in the short run, usually a year. These ratios
measure the ability of a firm to meet its current obligations and indicates its short term financial stability.
The liquid ratio is designed to show the amount of cash available for meeting immediate payments.
Liquidity ratios are generally based on current assets and current liabilities. The important liquidity ratios
are:
(a) Current Ratio:
Current ratio is the relationship between current assets and current liabilities. This is defined as:
Current Ratio = Current Assets
Current Liabilities
It is normally expressed as a pure ratio. Current ratio measures the ability of a firm to meet its current
liabilities. This is concerned with working capital, hence it is also known as working capital ratio. Current
ratio is used to measure the solvency of a firm i.e., whether it is in a position to meet it's current obligations.
It is also used to test the adequacy of working capital, over-trading or under capitalisation. Normally, the
current ratio is considered as safe and sound if it is 2:1 or more. Therefore, the higher the current ratio, the
greater the short term solvency. However, in interpreting the current ratio the composition of current assets
should not be overlooked.
(b) Liquid Ratio:

The liquid ratio is the relationship between liquid assets and liquid liabilities. It is designed to show the
amount of cash available for meeting immediate payments. It is one of the strongest measure of liquidity of
a firm. It is also known as acid-test ratio.
The liquid ratio as defined as = Liquid Assets

Liquid Liabilities
All current assets except inventories and prepaid expenses are known as liquid assets. Similarly, all current
liabilities except bank overdraft are treated as liquid liabilities. Normally, liquid ratio of 1:1 is indicative of
a firm having a good short-term liquidity. Booth the current and liquid ratios must be considered together in
order to test the short-term financial strength and immediate solvency of a firm.

(2) PROFITABILITY RATIOS

Profitability is the final result of business operations. Every business organisation has to earn profit in order
to survive and grow. Therefore it is necessary to know whether it is earning adequate profits. The following
are the profitability ratios:
(a) Gross Profit Margin Ratio:
Gross profit is the difference between net sales and cost of goods sold. The gross profit margin shows the
proportion of sales after meeting the direct cost of goods sold i.e., direct material, direct labour and other
direct expenses. Gross profit margin is determined as follows:
Gross Profit Margin = Gross Profit x 100
Net Sales
The gross profit margin should be enough to cover operating, administrative and selling and distribution
expenses and to leave some profit to the proprietors. It measures the efficiency of production. This gross
profit ratio is compared with the past years in order to show the trend in the trading results and it will show
whether the business is progressing favourably. It can also be compared with other firms in order to give
idea as to the effectiveness of the management. The ratio of gross profit may be different types of industries
and it may even be different in the different units of the same industry depending upon various factors.
However, it is essential to know that the gross profit ratio is maintained steadily.
(b) Operating profit to sales ratio:

Operating profit to sales ratio
is the relationship between operating net profit and net sales. It is expressed as a percentage. Operating net
profit is equal to gross profit minus all operating expenses (manufacturing, administrative and distribution).
It measures the operating efficiency of the business. It is determined as:
Operating Profit Margin = Operating Profit x 100

Sales
Operating profit is the net profit before tax, and items of extra-ordinary incomes and expenses. The ratio of
operating profit margin is the final indication of the operational efficiency of the management. It measures
the profitability of various operations of the business such as buying, manufacturing and selling.
(c) Net Profit Ratio:

The net profit ratio is the relationship between the ultimate net profit and net sales. It is also expressed as a
percentage. It is determined as:
Net Profit Ratio = Net Profit (before tax) x 100

Net Sales
Net Profit, for this purpose, is equal to operating net profit plus non-operating income minus noon-operating
expenses. Net profit ratio measures the overall efficiency of production, administration, selling, financing
etc. It is also a measure on the net return on sales. It shows the earnings left for shareholders. This ratio is
the final measure of profitability because it takes into account the effect of non¬operating income and
expenses. Normally, high ratio of net profit to net sales is necessary for the success of the business.

(d) Return on Investment:

ROI is a measure of efficiency and it provides a starting point for analysing the influences and trends in a
firm's performance. It is defined as:
Return on Investment = Profit x 100
Capital Employed
Profit for this purpose, means net profit before interest, taxes, and abnormal and non-recurring gains and
losses.
Capital Employed for this purpose, can be determined as follows:
(i) Gross Capital Employed = Fixed Assets + Current Assets.
OR
(ii) Net Capital Employed = Fixed Assets + Current Assets - Current Liabilities.
OR
(iii) Proprietors Net Capital Employed = (Fixed Assets + Current Assets) - (Current Liabilities + Long
Term Borrowings)
OR
= Equity Capital + Preference Capital + Reserve & Surplus.
Return on investment is a measure of business performance. It examines the relationship 'between the size
of operating profits and capital employed. It provides a good indication of the profitability of the capital
employed in a firm. A higher ratio of ROI is an indication of better utilisation of funds by the firm. It also
indicates the high earning power of the firm.
(e) Return on Equity:

The return on equity is the measure of profitability of equity funds invested in a company. This indicates the
return on investment of the shareholders. It is determined as follows:
Net Profit after Tax
Return on Equity = Net Profit after tax x 100
Proprietor s Equity
Proprietor's Equity means equity capital + reserves. It is also known as net worth. The relationship between
the net profit and net worth is more meaningful to the shareholders. This ratio measures the productivity of
owners funds. A high ratio indicates that the owners funds have been better utilised. The shareholders and
prospective investors can compare the earning capacity of the company and then decide about their
investment.
(3) SOLVENCY RATIOS

Solvency of a firm is indicated by its ability to meet its immediate commitments. Whether the firm is
solvent or otherwise, is determined by adequacy of its quick assets as compared to its immediate liabilities.
The solvency ratios are subset of other financial ratios. The following ratios are used to judge the solvency
of a firm:
(a) Current ratio
(b) Liquid ratio
(c) Proprietory ratio

(d) Debt Equity ratio

(e) Interest coverage ratio.
These ratios measure the liquidity and indebtedness of the company. Current ratio and liquid ratio are used
to judge the short term financial solvency while other ratios are used to judge the long term financial
solvency of the firm. The current ratio and liquid ratio have already been discussed earlier.
(a) Proprietory Ratio
Proprietory ratio is the relation between the proprietor's funds and total assets. It is an important ratio used
for determining the long term solvency of a firm. It is used to measure the relationship between funds
invested by the owners themselves and the total funds invested in the business. It is determined as follows:
Proprietory Ratio = Net Worth
Total Assets
Net worth includes equity share capital, preference share capital, capital and revenue reserves and surplus
but the accumulated losses and miscellaneous expenditure are excluded. It is also called as Proprietors Fund,
or owners equity. Therefore this ratio is also known as Equity Ratio. The total assets include fixed assets as
well as current assets.
Proprietory ratio is the test of the capitalisation or capital structure of a company. The proprietory ratio
should not be too high or too low. Normally, 60% to 75% of the total assets can be financed by the
proprietor's funds. However, the optimum proprietory ratio depends upon the type of business. Thus, the
general principle is that the outside liabilities should be kept within such limits that the company can be in
confident position to face the adverse possibilities of the business depression without fear of insolvency. In
other words, the higher the share of proprietor's capital in the total capital of the company, the less is the
likelihood of insolvency in future.
(b) Debt-Equity Ratio
This ratio is the relation between fixed interest bearing capital raised by a company and its equity capital. It
is determined as follows:
Debt-Equity Ratio = Total Debt

Equity
The total debt includes preference shares, debentures and long term loans. The preference shares can be
considered under equity if it is redeemable after 12 years. Normally this ratio should be 2:1. A high debt-
equity ratio would indicate that the company prefers to go in for fixed charges capital rather than equity. In
such a situation, if profits are not sufficient to pay interest on such fixed charge liabilities, the results could
be adverse for equity holders. Therefore, lower the debt-equity ratio, the higher would be the degree of
protection enjoyed by the creditors. A higher debt-equity ratio can be allowed in the case of capital intensive
industries.
(c) Interest coverage ratio

Interest coverage ratio measures the margin of safety the firm enjoys with respect to its interest burden.
Long term creditors such as debenture holders, banks and financial institutions are primarily interested in
judging whether the company has the ability to pay regularly interest due to them and to repay the principal
at the date of maturity. The interest coverage ratio is determined as follows:
Interest Coverage Ratio = Profit before Interest and Taxes
Interest on Debt

It is calculated for each accounting period. If the interest coverage ratio is high, that means the firm can
easily meet its interest burden even if the profit before interest and faxes suffer a considerable decline. On
the other hand, a low interest coverage ratio may result in financial difficulties when profits before interest
and taxes decline.
(4) LEVERAGE RATIOS

Leverage is an ability of a company to use fixed cost assets or funds to magnify the return to its owners. The
leverage ratios are useful as an analytical tools for creditors, financial institutions and debenture holders.
They are a measure of the extent to which company finances its assets through debt and are the indicators of
the financial risk. Leverage is important because a company's rate of return on assets is in excess of interest
rate, the profits to equity investors are magnified in direct proportions to increase in leverage. We shall
consider the following leverage ratios:
(a) Interest coverage ratio
(b) Debt-equity ratio
(c) Shareholder's equity to total capital
(d) Funded debt to net working capital.
The first two ratios have already been discussed.
(a) Shareholder's equity to total capital:
This ratio is used to determine the long term solvency of a company. It is determined as follows:
Shareholders equity to total capital = Owned capital
Total capital
= Equity capital + Reserves
Fixed Assets + Working Capital
Given normally efficient management, the higher the share of owned capital in the total capital, the less is
the likelihood of insolvency in future. In general, if the equity ratio is lower, the earnings of the company
can be more stable. It will be considered acceptable and safe.
(b) Funded debt to net working capital:

This ratio is used to measure the company's ability to retire funded debt by using available relatively liquid
assets. It is calculated as under:
Funded debt to net working capital = Funded Debt
Net Working Capital
Funded debt is a debt with a maturity of more than one year which includes bonds, debentures, term loans
and mortgages. The net working capital is the difference between current assets and current liabilities. This
ratio helps in examining creditors contribution on the liquid assets of the company. If net working capital is
less than funded debt, difficulty in meeting financial obligation is likely to arise in the long run.
(5) EFFICIENCY RATIOS

Efficiency ratios are useful for measuring the company's managerial efforts in managing inventories,
production process, credit and assets and effectiveness of marketing and salesforce. These are very useful in
judging the performance of a company. These ratios indicate the managerial capabilities in effectively
utilizing the assets of the company. The following are the important efficiency ratios:

(a) Average collection period.

(b) Inventory turnover.
(c) Total assets turnover.
(d) Net worth turnover.
(e) Net working capital turnover.
(a) Average collection period:

The ratio is an indication of the company's credit policies and aggressiveness in collecting its receivables by
sales per day. Thus,
Average collection period = Receivables x 360
Net Sales
This is also known as Debtors Turnover ratio. The Receivables includes debtors and bills receivables. The
average collection period should be close to the sales terms granted by the company.
(b) Inventory Turnover:

This ratio is calculated by dividing the cost of goods sold by the average inventory. It is a measure
ofeffective inventory management policies. It gives the turnover of inventory. It also indicates how funds
invested in inventories are being turned over. Thus,
Inventory Turnover = Cost of Goods Sold
Average Stock
Cost of goods sold is the difference between net sales and operating profit. Average inventory is the average
of opening and closing inventory of a particular year. A high Inventory Turnover ratio indicates that the
smaller amount is blocked in inventory and which requires less amount of working capital.
A high inventory turnover ratio also indicates that the manufacturing activity is capable of being sustained
with the help of smaller inventory and consequently the chances of absolute stock are less.
(c) Total Assets Turnover:

It is a measure of the company's overall effectiveness in generating sales. It is determined as follows:
Total Assets Turnover = Net Sales
Total Assets
Total assets includes current assets, fixed assets and investments. This ratio should be higher than industry
ratio. If it is equal or more than the industry ratio, then it indicates that the company is effectively utilizing
its assets in generating sales.
(d) Net Worth Turnover:

This ratio is a measure of management's effectiveness in utilizing owners equity. It is determined as follows:
Net worth Turnover = Net Sales
Net Worth
Net worth includes equity shares and reserves and surplus. If this ratio is lower than industry average, it
indicates that the company has been using less efficient use of equity financing.
(e) Net working capital turnover:

The net working capital turnover is a direct measure of the company's productivity in generating sales. It is
calculated as follows:
Net working capital turnover = Net Sales

Net Working Capital
If the net working capital turnover ratio is lower than the industry average, it indicates that the company is
efficiently managed.
(6) RATIOS RELEVANT FOR EQUITY SHAREHOLDERS

These ratios are of primary interest to the company's shareholders. The equity ratios are as follows:
(a) Earning per share.
(b) Price to earnings ratio.
(c) Dividend payout ratio.
(d) Dividend yield ratio.
(e) Book value per share.
(a) Earnings Per Share (EPS):

EPS is the profit earned by each share. It is calculated on the basis of the number of shares outstanding in a
company. It helps to compare the different company's shares. This is the most important ratio to the
investors. The shareholder should know the earnings that he receives on his share. It is calculated as under:
EPS = Profit after Tax - Preference Dividend
Number of Equity Shares
Higher the EPS, the better is the chance of getting income on the investment as well as capital appreciation.
The investors can compare the EPS of different companies in the same industry and take the decision
regarding their investment.
(b) Price to Earning Ratio (P/E Ratio):

It is an overall measure of the desirability of a company. It is calculated as follows.
P/E Ratio = Market Price Per Equity share
Earnings per Share
P/E Ratio is a popular tool of valuation of equity investment. Price of equity shares depends on many factors
such as Govt, policy, economic outlook, quality of management, dividend distribution policy, past bonus
issues, shareholding pattern etc. P/E ratio is a unique mixture of past, present and future. Earnings is past,
price is present which in turn is based on future earnings. P/E is a ratio of present price to past earnings. It
denotes in how many years we can expect to recover our price.
P/E ratio of a company can be compared with Industry P/E Ratio. Normally, P/E ratio of a company should
be less than the industry average P/E ratio. According to some experts P/E ratio up to 20 is better for
investment into a share.
(c) Dividend payout ratio:

It is the ratio of dividends per share to earnings per share. It is also a ratio of total dividends to net income. It
is determined as:

Dividend payout = Dividends

Earnings
A proper dividend payout is dependent upon the company's ability to invest retained earnings.
(d) Dividend yield:

An investor gains from both capital appreciation and dividends. Dividend is a regular income. The investor
would like to know the yield or the relationship which the rate of dividend bears to the market price of the
share. His primary interest is the amount of return that he will get through dividends in relation to the price
that he paid for the share. Dividend yield is computed as:
Dividend yield = Dividend per Share x 100
Market Price per Share
When a company retains its earnings in the business for expansion its yield are low and company which
distributes a high percentage of its earnings has higher yields.
(e) Book value per share:

The book value per share is a measure of the historical cost value of a company's assets on a per share
basis,. It is determined as follows:
Book value per share = Equity Share Capital + Reserves Surplus
Number of Equity Shares
Book value is different from a face value of a share. Book value may be higher or lower than the face value.
If book value is higher than face value, it indicates that the company has made profits and has
accumulated reserves. A high book value denotes a high reserve and profits and good past performance of
the company. It also denotes that the company may consider bonus issue in future.
(f) Return on Net Worth (RONW):

Return on net worth is useful to the investors to determine if the company has made proper use of
shareholder's funds. It is derived as follows:
RONW = Net Profit x 100
Net Worth
Net profit is taken as after tax profits and net worth is equal to equity capital plus reserves. This is
significant because Indian accounting norms do not include the 'premium' amount in the share capital but it
is included in the reserves and surplus. If the investors want to invest in a company's share, its RONW
should be more than 15 percent.
(g) Capital Gearing Ratio:

This ratio brings out the relationship between the equity share capital and preference share capital plus long
term borrowings. It is calculated as follows:
Capital Gearing Ratio = Preference Capital + Debentures + Term Loans
Equity share Capital + Reserves
This is also known as capital structure ratio or financial leverage ratio. It is also the relationship between
capital entitled to fixed rate of interest or dividend and capital not so entitled. If the equity capital is higher
than the preference capital, debentures and term loans, the company is said to be low geared and vice versa.

This ratio also indicates the extent of 'trading on equity' which means taking advantage of equity capital to
borrowed capital on reasonable basis. It is the arrangement of using borrowed funds carrying a fixed rate of
interest in such a way so as to increase the rate of return on the equity shares. A company which is
highly geared has greater prospects of higher profits.
(h) Dividend Cover:

Dividend cover is the reciprocal of the pay-out ratio. It is calculated to find out the times the dividend is
protected in terms of earnings. The following formula is used to determine the dividend cover:
Dividend Cover = Earnings Per Share
Dividend Per share
Dividend Policy is significant in affecting price earnings ratio. With higher dividend ratio equity price goes
up and thus raises price earnings ratio. Dividend rates are raised to push in share prices up.
LIMITATIONS OF RATIO ANALYSIS:

1. Ratios are mere guides too action and not a substitute for reasoning and judgement. They do not indicate
the price changes.
2. The ratios are not reliable because in some cases they are influenced by 'window dressing' in the Balance
Sheet.
3. Ratios are just numerical expressions resulting from a quantitative analysis. Qualitative considerations are
also important.
4. Finally the ratios are often used as rough estimates and regarded as analysis of historical data.
Inconsistent accounting practices may render computations and analysis of ratios useless.
COMPARATIVE STATEMENT ANALYSIS

Ratios analyse is the comparison between two different financial variables, but it does not directly analyse
same financial variables for multiple years or multiple firms, this short coming can be overcome with the
help of Comparative Statement Analysis.
Comparative statements can be made for multiple firms (which is known as Inter-firm comparison) or for
multiple periods (which is known as Inter-Period comparison). With the help of comparative statements a
company can compare its own past performance (with inter period comparison) or can compare its
performance during a particular period with that of its competitors (with inter firm comparison).
Short comings of Comparative Statements

1. Inter period comparison is done in terms of absolute rupee and percentage terms, but while doing the
same inflation effect on the books of accounts is not taken into regard. Therefore, in inflatory economic
conditions comparative statements may not help an analyst to come to a right conclusion.
2. Instead of using Comparative statements an analyst can prepare Common size statements which converts
the financial data in the statements to common size using net sales & capital employed as base for income
statement and balance sheet respectively. „Common Size Statements‟ are discussed later on in the chapter.
3. Tread comparisons can also be used as an alternative to comparative
statements

4. In case of inter firm comparison comparative statements may not give accurate information due to
different accounting policies followed by different companies.
COMMON-SIZE STATEMENT
Common-size statement is a financial tool of studying key changes and trends in financial position of a
company. In common-size statement each item is broken down as a percentage of the total of which that
item is a part. Each percentage exhibits the relation of the individual item to its respective total [i.e. sales or
capital employed]. Therefore, the common-size percentage method repre¬sents a type of ratio analysis. This
is why this statement is also designated as "component percentage" or "100 percent statement".
Preparation of the common-size statement involves two steps :
i) State the total of the statement as 100 per cent;
ii) Compute the ratio of each statement item to the statement total.
There are two types of common-size statements, Common-size Balance Sheet and common-size Profits and
Loss Account.
COMMON-SIZE BALANCE SHEET

Common-size balance sheet is prepared by stating the capital employed as 100 and reducing individual
Source of Capital employed into percentages of the total. Likewise, individual application of capital
employed is expressed as percentage of the capital employed. Thus, the common-size balance sheet
percentages show the ratio of each source from which capital is accumulated as a source of capital
employed and its application for each type of asset.
The common-size balance sheet analysis can, of course, be carried further and extended to the study of what
portion of a subgroup, rather than the total, an item is. Thus, assessing the liquidity of current asset, it may
be of interest to know not only what proportion of total assets in inventories but also what proportion of
current assets is represented by this asset.
A study of common-size statement of the company with those of competitive company or the industry
would show whether or not the company is managing assets efficiently. An analysis of the pattern of
distribution of liability reveals debt-equity position of the company. Too large a percentage of liabilities in
relation to owner's equity shows debt pressure for the company and a relatively low margin of safety for
creditors.
While common-size statements do not focus light on the relative sizes of individual companies, which are
compared, the problem of actual comparability between them is a matter to be resolved by the analyst's
judgement.
COMMON-SIZE INCOME STATEMENT

The common-size income statement is designed to exhibit what proportion of the net sales has been
absorbed by the various costs and expenses incurred by the enterprise, and the percentage that remains as
net income. For preparing common-size income statement all items in the income statement are expressed in
percentage form in terms of the net sales. The common-size income statements for a number of years are
very helpful in pointing out efficiencies and inefficiencies in controlling specific expenses as compared to
net sales of the company.

TREND ANALYSIS
This method of analysis studies the percentage relationship that each item of the financial statement bears to
the same item in the base year. Through this analysis the analyst seeks to review changes that have taken
place in individual categories therein from year to year and over the years. Thus, trend analysis can take the
form of year-to-year comparisons, index number, trend series and trend ratio.
Under this method analysis trend in respect of certain financial items is studied by computing the year-to-
year change in absolute terms or in terms of percentages. In this method, the base year changes every year.
In order to calculate a series of index number a base year should be chosen. This base year will, for all items
have an index amount of? 100. In choosing the base year, the analyst should see that a normal year, in which
abnormal events have not taken place, is chosen. Index numbers of an item for different years are computed
by reference to the base year. If the value of the item in a year is less than that in the base year, the trend
percentage will be below 100 per cent if the amount is more than the base amount, the trend percentage will
be above 100 per cent.

PRACTICAL PROBLEMS
1. The Capital of ABC Ltd. consists of 9% Preference Shares of Rs.10 each, Rs. 3,00,000, Equity Shares of
Rs. 10 each, Rs. 8,00,000. The profit after tax is Rs. 2,70,000, Equity Dividend is 20% and market price of
Equity Shares Rs. 40. You are required to calculate following ratios and comment on them, (a) Dividend
Yield,
(b) Preference & Equity Dividend Cover, (c) Earnings Per Share and (d) Price-Eamings Ratio.
2. Following information is available relating to Beena Ltd. and Meena Ltd: (All Rs. in Lakhs)
Beena Ltd. Meena Ltd.
Equity share capital (Rs. 10) 200 250
12% preference shares 80 100
Profit after tax 50 70
Proposed dividend 35 40
Market price per share Rs. 25 Rs. 35
You are required to calculate:
(i) Earning per share, (ii) P/E Ratio, (lii) Dividend Payout Ratio, (iv) Return on Equity Shares.
As an analyst, advice the investor which of the two companies is worth investing.
3. M/s. Green a Blue Ltd. has presented its financial information for year 2006 as follows:
Balance Sheet on 31st March, 2006
Liabilities Amount (Rs.) Assets Amount (Rs.)
Share Capital 12,00,000 Fixed Assets 28,60,000
Reserves and Surplus Long 8,00,000 Stock in Hand 19,80,000
Term Debt 22,70,000 S. Debtors 16,50,000
Current Liabilities 23,50,000 Cash and Bank Balance 1,30,000
66,20,000 66,20,000
Total Total
Income Statement for the ended 31st March, 2006
Amount (Rs.)
Net Sales 1,02,00,000
Cost of Goods Sold 79,20,000
Selling and Administrative Expenses 79,20,000
Net Profit 15,45,6000
Tax Rate is 30%. Company's Capital is divided in 1,20,000 shares of Rs. 10 each
7,34,400
Company has declared dividend @ 25%
Market Price of the share is Rs. 50
You are required to evaluate investment in Company on
basis of:
(i) Dividend Yield. (ii) EPS. (iii) P/E ratio. (iv) ROCE.
4.
Particulars A Ltd. B Ltd.

(Rs. in Lakhs) (Rs. in Lakhs)

Equity Share Capital (Rs. 10) 200 250
10% Preference Share Capital 80 100
15% Debentures 20 60
Profit before interest and Taxes Proposed 60 80
Dividend 20 25
Provision for tax 17 21
Market Price per share Rs. 50 Rs. 60
You are required to calculate (i) EPS, (ii) P/E Ratio, (iii) Dividend Payout Ratio, (iv) Dividend yield and
advise which company's share is worth investing.
5. Veena Ltd. has presented its financial information for the year ended 31st March 2007.
Earnings before interest and taxes Rs. 8,00,000
1,0,000 Equity shares of Rs. 10 each Rs. 10,00,000
10% Debentures Rs. 15,00,000
Reserve and surplus (before adjustments) Rs. 5,00,000
Provision for taxation 30%
Proposed Dividend 20%
Market price per share Rs. 32
Calculate (i) EPS (ii) P/E Ratio (iii) Book Value per share and (iv) Dividend Yield and state whether
investment in Veena Ltd. Is advisable.
6. Triveni Industries Ltd. gives you the following information for the year ended 31st March 2008:
Profit before interest and taxes Rs. 16,50,000
Tax Rate 30%
Proposed Equity Dividend 25%
Capital Employed
10% Preference Share Capital Rs. 15,00,000
80000 Equity Shares of Rs. 10 each Rs. 8,00,000
15% Debentures of Rs. 100 each Rs. 7,00,000
Reserve and Surplus Rs. 12,00,000
Current Market Price per Equity Share Rs. 50
(i) Earning Per Share.
(ii) Price Earning Ratio.
(iii) Dividend Payout Ratio.
(iv) Dividend Yield.
(v) Book Value per Share and state whether it is worth investing in the Equity Shares of the Company.
7. The following information is available in respect of two listed companies namely Jay Ltd and Vijay Ltd.
Particulars Jay Ltd. Vi jay Ltd.
Equity share capital (? 10 each) Rs. 800 Lacs Rs. 1,000 Lacs

12% Pref. Shares Capital Rs. 100 Lacs Rs. 200 Lacs
Profit before Tax Rs. 400 Lacs Rs. 600 Lacs
Rate of Taxation 30% 30%
Dividend per Share Rs. 3 Rs. 2
Market Price Per Share Rs. 150 Rs. 120
(a) Earning Per share, (b) P/E Ratio.
(c) Dividend Payout Ratio, (d) Return on Total Capital.
Also advice as to which company should be preferred for investing in.
8. Following is the Balance Sheet of Satya Ltd. as on 31st March, 2011.

Balance sheet as on 31st March, 2011
Liabilities Rs. Assets Rs.
Share capital 10,00,000 Fixed Assets 15,00,000
Reserves and Surplus 6,00,000 Stock 4.30.000
Long Term Loans Sundry 5,00,000 Debtors 5,50,000
Creditors 4,00,000 Bank Balance 20,000
25,00,000 25,00,000
Following information is available from its Income statement: Income statement for the year ended 31st
March, 11
Net Sales 80,00,000
Cost of Goods sold 60,60,000
Selling and Administrative Expenses 6,40,000
Other Expenses 3,00,000
Net Profit before Interest and Tax 10,00,000
Other Information:
(1) Tax rate is 40%.
(2) The company's share capital is divided into 1,00,000 shares of Rs. 10 each
(3) The market price of the share is Rs. 60
(4) The company has declared divided @ 20%.
You are required to evaluate financial performance of the company with the help of following ratios:
(a) EPS (b)P/E ratio (c) Dividend yield (d) ROCE.
9. Following is the Balance Sheet of Tanmay Enterprises Ltd. as on 31st Balance sheet as on 31st March,
2011
8% Preference Share 56,000 Fixed Assets 3,38,000
Capital
Equity Share Capital 1,00,000 Investments 39,000
Reserves 1,04,000 Cash 13,000

Long Term Loans 1,82,000 Debtors 52,000

Creditors 44,200 Inventories 78,000
Provision for Tax 33,800
5,20,000 5,20,000
Its Income Statement for the year ended 31st March, 2011 is as follows:
Income statement for the year ended 31st March, 2011
Amount (Rs.)
Net Sales 3,90,000
Less: Cost of Goods sold 3,35,400
Gross Profit 54,600
Less: Operating Expenses 22,750
Operating Profit 31,850
Less: Interest 9,100
Net Profit before Tax 22,750
Additional Information:
(a) The Company is in the 30% tax bracket.
(b) Preference dividend is paid regularly.
(c) Equity Shares are of the Face Value of ? 10 each.
(d) The Company has declared dividend of 5% on its equity shares for the year ended 31st March 2011.
(e) The Market Price of Equity Share is ? 35 on 31st March 2011. Calculate the following ratios and state
whether investment in 1st March, 2011 these shares is recommended.
(i) Interest Coverage Ratio (v) EPS
(ii) Debt - Equity Ratio (vi) P/E Ratio
(iii) Inventory Turnover Ratio (vii)Pay out Ratio.
(iv) Gross Profit Ratio
10. The standard ratios of the industry and ratios of company A are given below:
Give your comments on the performance of the company:
Industry Company A
Standard
Net Profit Ratio 3.5% 2%
Current Ratio 2.5 3.00
Liquidity Ratio 1.5 2.4
Proprietory Ratio 0.70 0.97
Debtors Turnover Ratio 37 days 42 days
11. [Inter-Period Comparison]

Triangle Ltd. is carrying on a retail business. Its position on 31st March 2009 & 2010 is as follows :
The summarised Balance Sheet as on 31st March 2009 & 2010
Liabilities 2010 2009 Assets 2010 2009

Equity Share 1,81,500 1,50,000 Land & Building 87,000 75,000

Capital
Reserves & 33,750 28,500 Plant & Machinery 54,000 45,000
Surplus
Bank Loan 42,000 31,500 Furniture 16,500 11,250
Sundry 69,000 63,000 Investments 10,500 5,250
Creditors
Bills Payable 34,500 31,500 Stock in Trade 63,000 52,500
Bank O/D 12,000 10,500 Sundry Debtors 94,500 78,750
Loans & Advances 42,000 42,000
Cash & Bank 5,250 5,250
TOTAL 3,72,750 3,15,000 TOTAL 3,72,750 3,15,000
Summarised Income Statement
Particulars 2010 2009
Net Sales 1,32,000 1,25,550
Less: Cost of Goods Sold 94,500 89,250
Gross Margin 37,500 36,300
Less: Operating Expenses 21,000 20,400
Income Before Interest & Tax Less: Interest 16,500 15,900
6,000 5,400
Income Before Tax Less: Tax 10,500 10,500
5,250 5,250
Income After Tax 5,250 5,250
Prepare comparative statements & Comment on the same.
12. [Common Size statement]

Prepare common size financial statements from the following and comment on the same for More Ltd. :
Balance Sheet as on 31st March 2009 & 2010
Rs. Rs. Rs. Rs.
Equity Share Capital 2,00,000 2,00,000 Land 50,000 50,000
9% Pref. Sh. Cap 1,50,000 1,50,000 Building 1,50,000 1,35,000

Reserves 1,00,000 1,22,500 Plant & Machinery 1,50,000 1,35,000
17% Debentures 50,000 75,000 Furniture 50,000 70,000
Creditors 75,000 1,00,000 Stock 1,00,000 1,50,000
Bills Payable 25,000 37,500 Debtors 1,00,000 1,50,000
Tax Payable 50,000 75,000 Cash 50,000 70,000
6,50,000 7,60,000 6,50,000 7,60,000
Profit & Loss Account for the year ended 31st March 2009 & 2010
Particulars 2009 2010 Particulars 2009 2010
Rs. Rs. Rs. Rs.
To Cost of Goods Sold 300,000 375,000 By Sales 400,000 500,000
To Operating Expenses
Administrative 6,500 7,250
Selling 10,000 10,000

A Ltd. (Rs. B Ltd. (Rs.

lakhs) lakhs)
Cash 2 3
Debtors 3 7
Stock 12 10
Plant and Machinery 18 23
Total Assets 35 43
Sundry Creditors 9 10
12% Debentures 5 10
To Int on Debentures 8,500 12,750
To Net Profit 75,000 95,000
400,000 500,000 400,000 500,000
13. [Trend Analysis]

Calculate trend percentages from the following information taking 2008 as the base year :
Balance Sheet as on 31st March
Liabilitie 2010 2009 2008 Assets 2010 2009 2008
Eq.
s Share 1,50,000 1,50,000 1,50,000 Land & Bldg 1,25,000 1,10,000 87,500
Capital
Reserves 1,00,000 70,000 50,000 Plant & 50,000 45,000 37,500
Loans 1,10,000 1,20,000 95,000 Furniture
Mach. 25,000 25,000 15,000
Creditors 80,000 45,000 22,500 Stock 80,000 75,000 67,500
Debtors 1,00,000 80,000 70,000
Loans & Adv. 50,000 40,000 30,000
Cash & Bank 10,000 10,000 10,000
Bal.
Income Statement for the year ended 31st March
Particulars 2010 2009 2008
Rs. Rs. Rs.
Net Sales 20,00,000 18,00,000 15,00,000
Less: Cost of Sales 14,00,000 12,00,000 10,00,000
Gross Margin 6,00,000 6,00,000 5,00,000
Less: Operating Expenses (Excluding Interest) 3,90,500 3,88,000 3,39,000
Less: Interest 11,000 12,000 9,500

Income Before Tax 1,98,500 2,00,000 1,51,500
Less: Tax 79,400 80,000 60,600
Income After Tax 1,20,000 1,20,000 90,900
Less: Dividend 89,100 1,00,000 80,000
Retained Earnings 30,000 20,000 10,900
14. The following information is taken from the records of two companies in the same industry:

Equity capital 11 18
Reserves and surplus 10 5
Total Liabilities 35 43
Sales 60 85
Cost of goods sold 40 65
Other operating expenses 8 10
Interest expenses 0.60 1.20
Income tax 3.40 3.80
Dividend 1.00 2.00
Answer each of the following questions by making a comparison of one or more relevant ratios.
(a) Which company is using the shareholders money more profitably?
(b) Which company is better able to meet its current debt?
(c) If you want to purchase the debentures of one company which company's debentures would you buy?
(d) Which company collects its receivables faster assuming all sales are on credit basis?
(e) Which company retains the larger proportion of income in the business?
Solution:
(a) Return on shareholder‟s fund should be used to know the use of shareholder‟s money more profitably.
15. The capital of Spectra Co. Ltd. is as follows:

9% Preference (Rs. 10 each) 3,00,000
Equity Share (Rs. 10 each) 8,00,000
11,00,000
The accountant has ascertained the following information: Profit After Tax (10%) 2,70,000
Depreciation 60,000
Equity Dividend Paid 20%
Market Price of Equity Shares Rs. 40
You are required to work out the following ratios and show the necessary workings:
(i) Dividend Yield on Equity Shares.
(ii) Cover for the Preference and Equity Dividend.
(iii) The Earning Per Share.
(iv) The Price-Earning Ratio.
(v) The Net Cash Flow.
16. (a) Dukes Ltd has a debt equity ratio of 0.7.

State giving reasons whether the ratio will increase or decrease or remain unchanged in each of the
following cases:
(i) Sale of Land having book value of Rs. 7 lakhs for Rs. 9 lakhs.
(ii) Issue of Equity shares for Rs. 20 lakhs to vendors for purchase of plant.
(iii) Collection of trade debts amounting to Rs. 1 lakh.
(iv) Redemption of debentures of Rs. 25 lakhs at a premium of 1%, Out of the accumulated profits.
(v) Payment of Rs. 80,000 for bills payable on their maturity.
(b) You are required to calculate Return on Investment from the following details of Rahul Ltd. for the
year ended 31st March 2001.
Rs. in lakhs
Net Profit After Tax 65
Rate of Income Tax 50%
12.5 Convertible Debentures of Rs. 80
100
Fixed Assets at Cost 246

Depreciation upto date 46
Current Assets 150
Current Liabilities 70
(c) Fine Products Ltd presents the following Balance Sheet as on 31-3-2001:
Equity Share Capital 50 Fixed Assets 120
14% Debenture (Due on 31-3-2002) 20 Less: Depreciation 30
General Reserve 10 90
P & L Account 5 Stock 13
Sundry Creditors 35 Debtors 16
Cash at Bank 1
120 120
Comment upon the following ratios of Fine Products Ltd.:
(i) Current Ratio.
(ii) Quick Ratio.
(iii) Fixed Assets Net Worth Ratio.
(d) M/s. Jupiter Ltd intends to supply goods on credit to M/s. Pluto Ltd and Mars Ltd. The relevant details
for the year ending 31st March 2001 are as follows:
(Rs. in lakhs)
Pluto Ltd Mars Ltd
Trade Creditors 30 16
Trade Purchases 93 66
Cash Purchases 3 2
Advise with reasons as to which company he should prefer to deal with.
Solution:
(a) (i) Decrease the debt-equity ratio. Profit on sale of land will increase the reserve (equity).
(ii) Decrease the debt equity ratio. Equity will increase.
(iii) Debt equity ratio will remain unchanged. Current assets are exchanged.
(iv) Decrease in debt equity ratio. There will be reduction in debt.
(v) Debt equity ratio will remain unchanged. Only exchange of current liabilities.
17. Mr. A buys 100 equity shares of Beta Ltd. at Rs. 120 having face value of Rs. 10 per share on 15th
January 98. After a year he expects:
(i) Dividend of 20%
(ii) Market price of the share will be Rs. 140.
Calculate:
(1) Dividend Yield.
(2) Actual Rate of Return.

18. The Balance Sheet of Major Ltd as on 31st March 2005 is as under:
2,000 Equity shares of Rs. 100 2,00,000 Fixed Assets at Cost 5,00,000 3,40,000
each fully paid Less: Depreciation 1,60,000
7.5% Preference Shares 1,00,000 Current Assets:
General Reserve 60,000 Stock 60,000
12% Debentures 60,000 Debtors 80,000
Current Liabilities: Bank 20,000
Sundry Creditors 80,000
5,00,000 5,00,000
The Company wishes to forecast balance sheet as on 31st March 2006. The following additional particulars
are available:
(a) Fixed Assets costing Rs. 1,00,000 have been installed on 1st April 2005 but the payments will be
made on 31st March 2006.
(b) The fixed assets turnover ratio on the basis of the gross value of fixed assets would be 1.5.
(c) The stock turnover ratio would be 14.4 (calculated on the basis of the average stock)
(d) The break up of cost and the profit would be as follows:
Material 40%
Labour 25%
Manufacturing Expenses 10%
Office and Selling Expensesl0%
Depreciation Profit
The profit is subject to interest and tax at
(e) Debtors would be 1/9 of sales.
(f) Creditors would be 1/5 of materials consumed.
(g) In March 2006, a dividend @ 10% on equity capital would be paid.
(h) 12% Debentures for Rs. 25,000 have been issued on 1st April 2005.
Prepare the forecast balance sheet as on 31st March 2006 and show the following ratios: (i) Current Ratio,
(ii) Fixed Assets/Net Worth Ratio (iii) Debt Equity Ratio (iv) P/E Ratio if market price is Rs. 750 per share.
19. The following are the final accounts of Shansuddin International Ltd. for the year ended 31st March,
2006 and 2007.
Balance Sheet as on
Rs. Rs. Rs. Rs.
Equity Share of Rs. 10/- 2,32,570 2,39,150 Fixed Assets net 2,68,210 4,11,520
each fully Paid up block
8% Preference Shares of (-) 32,650 Stock at Cost 68,690 2,32,820
Rs. Each fully Paid up
General Reserve 1,61,560 2,13,430 Book of Debts 1,92,500 2,90,530
Profit and Loss A/c 62,280 82,050 Prepaid Expenses 4,150 6,640
8% Debentures of Rs. 100 92,500 3,20,000 Bank 1,04,360 1,18,430
each
Sundry Creditors 53,370 1,03,680
Other Current Liabilities 35,630 68,980
6,37,910 10,59,940 6,37,910 10,59,940

Revenue Statement
Rs. Rs. Rs. Rs.
Cost of Sales 6,07,760 12,84,340 Sales 9,19,540 19,32,130
Gross Profit 3,11,780 6,47,790
9,19,540 19,32,130 9,19,540 19,32,130
Administration Exp. 90,110 1.83.000 Gross Profit 3,11,780 6,47,790
Selling Expenses 90,000 179,000 Discount 2,730 9,560
Interest 7,400 25,600
Provision for Tax 69,340 1,47,120
Transfer to Reserve 40,000 50,000
Net Income 17,660 72,630
3,14,510 6,57,350 3,14,510 6,57,350

Assume that stock at cost on 1st April, 2007 was Rs. 68.690. Market Price of equity shares of the company
was Rs. 25 on 31st March, 2006 and Rs. 50 on 31st March, 2007.
You are required to calculate following ratios:
(a) Return on Capital Employed.
(b) Return on Proprietors Fund.
(c) Return on Equity Capital.
(d) Earning per share.
(e) Net Profit Ratio
(f) Stock Turnover Ratio.
(g) Debtors Turnover Ratio.
(h) Comment on Operating efficiency and profitability of the company.
The Capital of Bombay Oxygen and Co. is as follows:

Rs.
10% Preference Share Capital (Rs. 10) 12,00,00
12% Debentures 0
12,00,00
Equity Shares of Rs. 10 each 0
76,00,00
0
100,00,0
Profit before tax 00
30,00,00
Tax rate 40% Depreciation 0
1,20,000
Equity dividend proposed 10%
Market price per equity share Rs. 90
Calculate:
(a) Earning per share.
(b) Dividend payout ratio.
(c) Dividend yield ratio.
(d) Price earning ratio.
(e) Retention ratio.

7 TECHNICAL ANALYSIS
Technical analysis is a method of evaluating securities by analysing the statistical data generated by market
activity, such as past prices and volume of trading of a particular share. Technical analysts do not attempt to
measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can
suggest future activity.
The field of technical analysis is based on three assumptions :

(1) The market discounts everything,
(2) Price moves in trends,
(3) History tends to repeat itself.
1. The Market Discounts Everything

A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental
factors of the company. However, technical analysis assumes that, at any given time, a stock's price reflects
everything that has or could affect the company - including fundamental factors and therefore is not required
to be considered separately. This only leaves the analysis of price movement, which any individual knows is
a product of the supply and demand for a particular stock in the market.
2. Price Moves in Trends

In technical analysis, price movements are believed to follow trends. This means that the future price
movement is most likely to be in the same direction as the trend than to be against it after the same has been
established. Most strategies of technical analysis are based on this assumption.
3. History Tends to Repeat Itself

Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price
movement. The repetitive nature of price movements is attributed to market psychology; in other words,
market participants tend to provide a consistent reaction to similar market situation over time. Technical
analysis uses chart patterns to analyze market movements and understand trends. Although many of these
charts have been used from centuries, they are still believed to be relevant because they provide patterns of
price movements that are often repetitive.
CHARTING TECHNIQUES
There are four main types of charts that are used by investors and traders depending on the information that
they are seeking and their individual skill levels.
The chart types/ Charting Techniques are :
a) The line chart,
b) The bar chart,
c) The candlestick chart and

d) The point and figure chart.
A) LINE CHART
Line charts represents only the closing prices over a set period of time and are therefore the most simple of
the four charts. Line charts do not provide visual information of the trading range for the individual points
such as the high, low and opening prices. But, the closing price is often considered to be the most vital price
in stock data compared to the high and low for the day and this is why it is the only value used in line charts.
B) BAR CHART
The bar chart is an extension of line chart in a sense that it adds much more key information to each data
point. The chart is made up of a series of vertical lines that represent each data point. This vertical line
represents the high and low for the trading period, along with the closing price. The close and open are
represented on the vertical line by a horizontal dash. The opening price on a bar chart is denoted by the dash
that is located on the left side of the vertical bar. As against this, the close is represented by the dash on the
right. Generally, if the left dash (open) is lower than the right dash (close) then the bar will be shaded black,
representing an upward movement of the stock, which means it has gained value. When this is the case, the
dash on the right (close) is lower than the dash on the left (open).

C) CANDLE STICK CHARTS

The candlestick chart is similar to a bar chart, but it is visually constructed. Candlestick also has a thin
vertical line showing the period's trading range which is similar to the bar chart. But the difference lies in
the formation of a wide bar on the vertical line, which indicates the difference between the open and close.
And, like bar charts, candlesticks also rely heavily on the use of colours to explain the activities of share
price during the trading period. A major problem with the candlestick charts is the colour configuration,
therefore, it is important to understand the candlestick configuration used at the chart. There are two colour
constructs for days up and one for days that the price falls. When the price of the stock is up and closes
above the opening trade, the candlestick will usually be white or clear. If the stock has traded down for the
period, then the candlestick will usually be red or black. If the stock's price has closed above the previous
day‟s close but below the day's open, the candlestick will be black or filled with the colour that is used to
indicate an up day.
D) THE POINT AND FIGURE CHART

The point and figure chart is not well known or used by the average investor but it has had a long history of
use dating back to the first technical traders. This type of chart reflects price movements and is not as
concerned about time and volume in the formulation of the points. The point and figure chart removes the
noise, or insignificant price movements, in the stock, which can distort traders' views of the price trends.
These types of charts also try to neutralise the skewing effect that time has on chart analysis.

When first looking at a point and figure chart, you will notice a series of Xs and Os. The Xs represent
upward price trends and the Os represent downward price trends. There are also numbers and letters in the
chart; these represent months, and give investors an idea of the date. Each box on the chart represents the
price scale, which adjusts depending on the price of the stock: the higher the stock's price the more each box
represents.
TRENDS
Trend is one of the most important concepts in technical analysis. A trend is really nothing more than the
general direction in which a security or market is headed. Take a look at the chart below, anyone can
conclude that trend is up.
However, it's not always this easy to see a trend for example in the next figure, there is lot of opposite
movement i.e. ups and downs in this chart and there isn't a clear indication of which direction this security is
headed.

Regrettably, trends are not always easy to see. In simple words, defining a trend goes well beyond what is
normally visible to eyes. You will probably notice that in any given chart, prices do not tend to move in a
straight line in any particular direction, but rather it moves in a series of highs and lows. It is the movement
of these highs and lows that constitutes a trend in technical analysis. For example, a downtrend is one of
lower lows and lower highs while an uptrend is classified as a series of higher highs and higher lows.
TYPES OF TREND
There are three types of trend :
i) Up trends
ii) Downtrends
iii) Sideways/Horizontal Trends
As the names imply, when each successive peak and trough is higher, it's referred to as an upward trend. If
the peaks and troughs are getting lower, it's a downtrend. When there is little movement up or down in the
peaks and troughs, it's a sideways or horizontal trend. If you want to get really technical, you might even say
that a sideways trend is actually not a trend on its own, but a lack of a well-defined trend in either direction.
In any case, the market can really only trend in these three ways: up, down or nowhere.
Uptrend
TREND LENGTHS
An up trend, down trend or horizontal trend can continue for long time period, short time period or
intermediate time period, accordingly a trend of any direction can be classified as a long-term trend,
intermediate trend or a short term trend. In terms of the stock market, a major trend is generally categorized
as one lasting longer than 12 months. An intermediate trend is considered to last between one month to a
quarter of a year and a near-term trend is anything less than a month. A long-term trend is composed of
several intermediate trends, which often move against the direction of the major trend. If the major trend is
upward and there is a downward correction in price movement followed by a continuation of the uptrend,

the correction is considered to be an intermediate trend. The short-term trends are components of both major
and intermediate trends.
TRENDLINES
A trendline is a simple charting technique that adds a line to a chart to represent the trend in the market or a
stock. Drawing a trendline is as simple as drawing a straight line that follows a general trend. These lines
are used to clearly show the trend and are also used in the identification of trend reversals. An upward
trendline is drawn at the lows of an upward trend. This line represents the support the stock has every time it
moves from a high to a low. Similarly, a downward trendline is drawn at the highs of the downward trend.
This line represents the resistance level that a stock faces every time the price moves from a low to a high.
The diagram below shows an upward trendline.
CHANNELS
A channel, or channel lines, is the addition of two parallel trendlines that act as strong areas of support and
resistance. The upper trendline connects a series of highs, while the lower trendline connects a series of
lows. A channel can slope upward, downward or sideways but, regardless of the direction, the interpretation
remains the same. Traders will expect a given security to trade between the two levels of support and
resistance until it breaks beyond one of the levels, in which case traders can expect a sharp move in the
direction of the break. Along with clearly displaying the trend, channels are mainly used to illustrate
important areas of support and resistance.

The next diagram shows a descending channel on a stock chart; the upper trendline has been placed on the
highs and the lower trendline is on the lows. As long as the price does not fall below the lower line or move
beyond the upper resistance, the range-bound downtrend is expected to continue.
SUPPORT AND RESISTANCE

Support is the price level through which a stock or market rarely falls (denoted by the upward arrows).
Resistance, on the other hand, is the price level that a stock or market rarely exceeds (denoted by the
downward arrows).
These support and resistance levels are seen as important in terms of market sentiments and supply and
demand.
ROLE REVERSAL
Role reversal refers to a situation where the role of support or resistance level is reversed, this happens when
a resistance or support level is broken. If the price falls below a support level, that level will become
resistance. If the price rises above a resistance level, it will often become support. For a true reversal to
occur, it is important that the price make a strong move through either the support or resistance.
For example, as you can see in the next figure, the dotted line is shown as a level of resistance that has
prevented the price from heading higher on two previous occasions (Points 1 and 2). However, once the
resistance is broken, it becomes a level of support (shown by Points 3 and 4) by pushing up the price and
preventing it from heading lower again.

CHART PATTERNS AND ITS TYPES

A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future price
movements. Chartists use these patterns to identify current trends and trend reversals and to trigger buy and
sell signals.
The theory behind chart patters is based on the third assumption i.e. history repeats itself.
HEAD AND SHOULDERS

This is one of the most popular and reliable chart patterns in technical analysis. It is a reversal chart pattern
that when formed, signals that the security is likely to move against the previous trend. There are two
versions of the head and shoulders chart pattern. Head and shoulders top (shown on the left) is a chart
pattern that is formed at the high of an upward movement and signals that the upward trend is about to end
as against this Head and shoulders bottom which is also known as inverse head and shoulders (shown on the
right) is used to signal a reversal in a downtrend.
Both of these head and shoulders patterns are similar in that there are four main parts: two shoulders, a head
and a neckline. In addition to this, each individual head and shoulder is comprised of a high and a low. For
example, in the head and shoulders top image, the left shoulder is made up of a high followed by a low. In
this pattern, the neckline is a level of support or resistance. Remember that an upward trend is a period of
successive rising highs and rising lows. The head and shoulders chart pattern, therefore, indicates a
weakening in a trend by showing the deterioration in the successive movements of the highs and lows.
Head and shoulders top is shown on the left. Head and shoulders bottom, or inverse head and shoulders, is
on the right
CUP AND HANDLE

A cup and handle chart is a bullish (i.e. upward) continuation pattern in which the upward trend has not
stopped but has only paused for some time and will continue in an upward direction once the pattern is
confirmed.

As can be seen from Figure, this price pattern forms what looks like a cup, which is preceded by an upward
trend. The handle follows the cup formation and is formed by a generally downward/sideways movement in
the security's price. Once the price movement pushes above the resistance lines formed in the handle, the
upward trend can continue.
DOUBLE TOPS AND BOTTOMS

This chart pattern is another well-known pattern that signals a trend reversal - it is considered to be one of
the most reliable and is commonly used. These patterns are formed after a sustained trend and signal to
chartists that the trend is about to reverse. The pattern is created when a price movement tests support or
resistance levels twice and is unable to break through. This pattern is often used to signal intermediate and
long-term trend reversals.
Double top pattern is shown on the left, while a double bottom pattern is shown on the right.
In the case of the double top pattern in Figure, the price movement has twice tried to move above a certain
price level. After two unsuccessful attempts at pushing the price higher, the trend reverses and the price
heads lower. In the case of a double bottom (shown on the right), the price movement has tried to go lower
twice, but has found support each time. After the second bounce off of the support, the security enters a new
trend and heads upward.
TRIANGLES

Triangles are some of the most well-known chart patterns used in technical analysis. Symmetrical triangle,
ascending and descending triangle are the three types of triangles, which vary in the way they are
constructed and what they imply. These chart patterns are considered to last anywhere from a forth night to
several months.
The symmetrical triangle in Figure is a pattern in which two trendlines converge toward each other. This
pattern is neutral in that a breakout to the upside or downside is a confirmation of a trend in that direction. In
an ascending triangle, the upper trendline is flat, while the bottom trendline is upward sloping which
indicates that the stock has breached its support level more often in the past therefore shows an upward
trend, accordingly once it breaches its resistance level it indicates a trend reversal. This is generally thought
of as a bullish pattern in which chartists look for an upside breakout. The opposite of this happens in a
descending triangle, the lower trendline is flat and the upper trendline is descending. This is generally seen
as a bearish pattern where chartists look for a downside breakout.
FLAG AND PENNANT

When there is a sharp price movement followed by a generally sideways price movement these two short-
term chart patterns are the continuation patterns that are formed. This pattern is then completed upon
another sharp price movement in the same direction as the move that started the trend. The patterns are
generally thought to last from one to three weeks.

As can be seen from Figure, there is little difference between a pennant and a flag. The main difference
between these price movements can be seen in the middle section of the chart pattern. In a pennant, the
middle section is characterised by converging trendlines, much like what is seen in a symmetrical triangle.
The middle section on the flag pattern, on the other hand, shows a channel pattern, with no convergence
between the trendlines. In both cases, the trend is expected to continue when the price moves above the
upper trendline.
WEDGE
The wedge chart pattern can be either a continuation or reversal pattern. It is similar to a symmetrical
triangle except that the wedge pattern slants in an upward or downward direction, while the symmetrical
triangle generally shows a sideways movement. The other difference is that wedges tend to form over longer
periods, usually between three and six months.
At the most basic level, a falling wedge is bullish and a rising wedge is bearish. In Figure, we have a falling
wedge in which two trendlines are converging in a downward direction. If the price was to rise above the
upper trendline, it would form a continuation pattern, while a move below the lower trendline would signal
a reversal pattern.
TRIPLE TOPS AND BOTTOMS

Another type of reversal chart pattern in chart analysis triple tops and triple bottoms. These act in a similar
fashion as head and shoulders and double tops and bottoms but are not equally prevalent in charts. These
two chart patterns are formed when the price movement tests a level of support or resistance three times and
is unable to break through; this signals a reversal of the prior trend.

Triple tops and bottoms can lead to confusion during the formation of the pattern because they can look
similar to other chart patterns. After the first two support/resistance tests are formed in the price movement,
the pattern will look like a double top or bottom, which could lead a chartist to enter a reversal position too
soon.
ROUNDING BOTTOM
A rounding bottom, also referred to as a saucer bottom, is a long-term reversal pattern which signals a shift
from a downward trend to an upward trend. This pattern is traditionally thought to last anywhere from
several months to several years.
A rounding bottom chart pattern looks similar to a cup and handle pattern but without the handle. The long-
term nature of this pattern and the lack of a confirmation trigger, such as the handle in the cup and handle
make it a difficult pattern to trade.
TECHNICAL INDICATORS
There are numerous technical indicators that collectively add up to organized confusion. But when one
examines the technical indicators individually, it makes some sense. The following are some of the technical
indicators:
♦ The short interest ratio theory.
♦ Confidence Index.
♦ Spreads.

♦ Advance Decline Ratio.

♦ Market Breadth Index.
♦ Odd - Lot ratio.
♦ Insider Transaction.
♦ Moving Average.
The tools used by the mathematical trading methods are moving averages and oscillators. Oscillators are
trading tools that offer indications of when a currency is overbought or oversold. Though there are many
mathematical indicators, only the most important ones and commonly used are discussed below.
(1) Simple and Exponential Moving Average (SMA - EMA).
(2) Moving Average Convergence-Divergence (MACD).
(3) Bollinger Bands.
(4) The Parabolic System, Stop-and-Reverse (SAR).
(5) RSI (Relative Strength Index).
MOVING AVERAGE
A moving average is an average of a shifting body of prices calculated over a given number of days. A
moving average makes it easier to visualize market trends as it removes - or at least minimizes - daily
statistical noise. It is a common tool in technical analysis and is used either by itself or as an oscillator.
There are several types of moving averages, but discussed below are important and commonly used: the
simple moving average (SMA) and the exponential moving average (EMA).
(1) Simple Moving Average (SMA):

The simple moving average is an arithmetic mean of price data. It is calculated by summing up each
interval's price and dividing the sum by the number of intervals covered by the moving average. For
instance, adding the closing prices of an instrument for the most recent 25 days and then dividing it by 25
will get you the 25 day moving average.
Though the daily closing price is the most common price used to calculate simple moving averages, the
average may also be based on the midrange level or on a daily average of the high, low, and closing prices
Advantages:
Moving average is a smoothing tool that shows the basic trend of the market. It is one of the best ways to
gauge the strength a long-term trend and the likelihood that it will reverse. When a moving average is
heading upward and the price is above it, the security is in an uptrend. Conversely, a downward sloping
moving average with the price below can be used to signal a downtrend.
Drawbacks:
It is a follower rather than a leader. Its signals occur after the new movement, event, or trend has started, not
before. Therefore it could lead you to enter trade some late. It is criticized for giving equal weight to each
interval. Some analysts believe that a heavier weight should be given to the more recent price action.

2. Exponential Moving Average (EMA)

The exponential moving average (EMA) is a weighted average of a price data which put a higher weight on
recent data point. The weighting applied to the most recent price depends on the specified period of the
moving average. The shorter the EMA period, the more weight will be applied to the most recent price.
An EMA can be specified in two ways: as a percentage-based EMA, where the analyst determines the
percentage weight of the latest period's price, or a period-based EMA, where the analyst specifies the
duration of the EMA, and the weight of each period is calculated by formula. The latter is the more
commonly used.
Advantages:
Because it gives the most weight to the most recent observations, EMA enables technical traders to react
faster to recent price change. In comparison to Simple Moving Average, every previous price in the data set
is used in the calculation of EMA. While the impact of older data points diminishes over time, it never fully
disappears. This is true regardless of the EMA's specified period. The effects of older data diminish rapidly
for shorter EM As than for longer ones Because it gives the most weight to the most recent observations,
EMA enables technical traders to react faster to recent price change. In comparison to Simple Moving
Average, every previous price in the data set is used in the calculation of EMA. While the impact of older
data points diminishes over time, it never fully disappears. This is true regardless of the EMA's specified
period. The effects of older data diminish rapidly for shorter EM As than for longer ones but, again, they
never completely disappear.

3. MACD (Moving Average Convergence Divergence)

The moving average convergence-divergence indicator (MACD) is used to determine trends in momentum.
It is calculated by subtracting a longer exponential moving average (EMA) from a shorter exponential
moving average. The most common values used to calculate MACD are 12-day and 26-day exponential
moving average. Based on this differential, a moving average of 9 periods is calculated, which is named the
"signal line".
MACD = [12-day moving average - 26-day moving average] > Exponential Weighted Indicator
Signal Line = Moving Average (MACD) > Average Weighted Indicator
Due to exponential smoothing, the MACD Indicator will be quicker to track recent price changes than the
signal line. Therefore, when the MACD crossed the SIGNAL LINE: the faster moving average (12-day) is
higher than the.rate of change for the slower moving average (26-day). It is typically a bullish signal,
suggesting the price is likely to experience upward momentum i.e. buy signal. Conversely, when the MACD
is below the SIGNAL LINE: it is a bearish signal, possibly forecasting a pending reversal ie. sell signal.
4. Bollinger Bands
Bollinger Bands were developed by John Bollinger in the early 1980s. They are used to identify extreme
highs or lows in price. Bollinger recognized a need for dynamic adaptive trading bands, whose spacing

varies based on the volatility of the prices. During period of high volatility, Bollinger bands widen to
become more forgiving. During periods of low volatility, they narrow to contain prices.
Bollinger Bands consist of a set of three curves drawn in relation to prices:

(1) The middle band reflects an intermediate-term trend. The 20 day - simple moving average (SMA)
usually serves this purpose.
(2) The upper band is the same as the middle band, but it is shifted up by two standard deviations, a
formula that measures volatility, showing how the price can vary from its true value
(3) The lower band is the same as the middle band, but it is shifted down by two standard deviations to
adjust for market volatility.
Bollinger Bands establish a Bandwidth, a relative measure of the width of the bands, and a measure of
where the last price is in relation to the bands.
Lower Bollinger Band = SMA - 2 standard deviations
Upper Bollinger Band = SMA + 2 standard deviations.
Middle Bollinger Band = 20 day - simple moving average (SMA).
The probability of a sharp breakout in prices increases when the bandwidth narrows. When prices
continually touch the upper Bollinger band, the prices are thought to be overbought; triggering a sell signal.
Conversely, when they continually touch the lower band, prices are thought to be oversold, triggering a buy
signal.
(5) The Parabolic System, Stop-and-Reverse (SAR):

The parabolic SAR system is an effective investor's tool that was originally devised by J. Welles Wilder to
compensate for the failings of other trend-following systems. The Parabolic SAR is a trading system that
calculates trailing "stop-losses" in a trending market. The chart of these points follows the price movements
in the form of a dotted line, which tends to follow a parabolic path.
When the parabola follows along below the price, it is providing buy signals. When the parabola appears
above the price, it suggests selling or going short. The "stop-losses" dots are setting the levels for the
trailing stop-loss that is recommended for the position.
In a bullish trend, a long position should be established with a trailing stop that will move up every day until
activated by the price falling to the stop level. In a bearish trend, a short position can be established with a
trailing stop that will move down every day until activated by the price rising to the stop level.
The .parabolic system is considered to work best during trending periods. It helps traders catch new trends
relatively early. If the new trend fails, the parabola quickly switches from one side of the price to the other,
thus generating the stop and reverse signal, indicating when the trader should close his position or open an
opposing position when this switch occurs.

(6) Relative Strength Index (RSI):

The RSI was developed by J. Welles Wilder as a system for giving actual buy and sell signals in a changing
market. RSI is based on the difference between the average of the closing price on up days vs. the average
closing price on the down days, observed over a 14-day period. That information is then converted into a
value ranging from 0 to 100.
When the average gain is greater than the average loss, the RSI rises, and when the average loss is greater
than the average gain, the RSI declines. The RSI is usually used to confirm an existing trend. An uptrend is
confirmed when RSI is above 50 and a downtrend when it's below 50.
It also indicates situations where the market is overbought or oversold by monitoring the specific levels
(usually "30" and "70") that warn of coming reversals.
An overbought condition (RSI above 70) means that there are almost no buyers left in the market, and
therefore prices are more likely to decline as those who previously bought will now take their profit by
selling. An oversold condition (RSI below 30) is the exact opposite.

EVALUATION OF TECHNICAL ANALYSIS:

The technical analysis has the following limitations:
(1) All data used in technical analysis is past data. Therefore, these indices cannot take into account
unexpected events such as natural disasters and economic crisis. Charts, can only show activity by insiders
well before privileged information becomes public knowledge.
(2) A chart may show a sudden, deep decline which by strict interpretation is a signal to sell. But this may
be the result of one large trade of a lower than market price. The value of stock may bounce back quickly. If
the technician fails to wait for confirmation, the investment decisions may go wrong.
(3) With actively traded stocks, the prices may be the result of a battle of wits. Trading profits are realized
at the expense of others who are trying to achieve gains on their own terms. In such cases, the technicians
must be cleverer and luckier than their rivals.
FUNDAMENTAL V/S TECHNICAL ANALYSIS:
Sr. Basis of
Fundamental Analysis Technical Analysis
No. Comparison
Includes evaluating
It is a statistical method used to
company's stock to find its
find pattern and predict future
1 Meaning intrinsic value and analyse
movements based on past market
factors that may affect the
data.
price in the future.
It examines - financial data,
Industry Trends, Competitors It examines - price movements and
2 Methodology
performance and economic market psychology
outlook.
Time
3 Long-term approach Short term approach
Horizon
4 Function Investment Trading
Data gathered
5 Financial statements Charts
from
Concepts Return on Equity and Return
6 Dow Theory and Price Data
used on Assets
To find the right time to enter or
To find intrinsic value of
7 Goal exit based on the past and current
stock
trend
Looks backward as well as
8 Vision looks backward
forward
When price falls below When trader believes they can sell
9 Stock bought
intrinsic value it on for a higher price
10 Decision Risk Level will decide trades Market Volatility decides trades
11 Importance Value Price
12 Significance Investment Objectives Matter Profit/Loss Matters

8 TECHNICAL ANALYSIS THEORIES
TECHINCAL ANALYSIS THEORIES’

DOW THEORY
Dow Theory the grandfather of trend analysis is the Dow Theory, named after its creator, Charles Dow
(who established The Wall Street Journal). Many of today‟s more technically sophisticated methods are
essentially variants of Dow‟s approach.
It is based on the following tenets
1.The market has three movements
(1) The "main movement", primary movement or major trend may last from less than a year to several
years. It can be bullish or bearish. (2) The "medium swing", (3) The "short swing" or minor movement
varies with opinion from hours to a month or more. The three movements may be simultaneous.
2. Market trends have three phases

The accumulation phase (phase 1) is a period when investors "in the know" are actively buying (selling)
stock against the general opinion of the market. During this phase, the stock price does not change much
because these investors are in the minority demanding (absorbing) stock that the market at large is supplying
(releasing). Eventually, the market catches on to these astute investors and a rapid price change occurs
(phase 2). This occurs when trend followers and other technically oriented investors participate. This phase
continues until rampant speculation occurs. At this point, the astute investors begin to distribute their
holdings to the market (phase 3).
3.The stock market discounts all news

Stock prices quickly incorporate new information as soon as it becomes available. Once news is released,
stock prices will change to reflect this new information.
5.Trends are confirmed by volume

When price movements are accompanied by high volume, Dow believed this represented the "true" market
view.
The above represents these three components of stock price movements. In this figure, the primary trend is
upward, but intermediate trends result in short lived market declines lasting a few weeks. The intraday
minor trends have no long-run impact on price.

The Dow theory employs two of the Dow Jones averages, the industrial average and the transportation
average. If the Dow Jones industrial average is rising, then the transportation average should also be rising.
Such simultaneous price movements suggest a strong bull market. On the other hand, a decline in both the
averages are moving in opposite directions, the market is uncertain as to the direction of future prices.
If investors believe in Dow theory, they will try to liquidate when a sell signal becomes apparent which will
drive down prices. Buy signals have the opposite effect. However, there are several problems of Dow
theory. It is not a theory but an interpretation of known data. It does not explain why the two averages
should be able to forecast future stock prices. There may be a considerable lag between actual turning points
and those indicated by the forecast.
Again Dow theory can work only when a long, wide, upward or downward movement is registered in the
market. The theory does not attempt to explain a consistent pattern of the stock price movements.
ELLIOTT WAVE PRINCIPLE

Elliott wave principle was established by R.M. Elliott in 1930. It states that major moves take place in five
successive steps resembling tidal waves. In a major bull market, the first move is upward, the second
downward, the third upward the fourth downward and the fifth and final phase upward. The waves have a
reverse flow in a bear market. The Elliott wave principle, claimed to be a valuable tool for market prediction
is shown in the figure given oh the next page:
Elliot wave principle offers investor a basis for developing important market strategies. However, it has two
major limitations-first, it is difficult to identify the turning point of each stage and second, the investor
frequently cannot distinguish between a major and a minor five stage movement.
Basic Sequence
There are two types of waves: impulse and corrective. Impulse waves move in the direction of the larger
degree wave. When the larger degree wave is up, advancing waves are impulsive and declining waves are
corrective. When the larger degree wave is down, impulse waves are down and corrective waves are up.
Impulse waves, also called motive waves, move with the bigger trend or larger degree wave. Corrective
waves move against the larger degree wave.

The chart above shows a rising 5-wave sequence. The entire wave is up as it moves from the lower left to
the upper right of the chart. Waves 1,3 and 5 are impulse waves because they move with the trend. Waves 2
and 4 are corrective waves because they move against this bigger trend. A basic impulse advance forms a 5-
wave sequence.
A basic corrective wave forms with three waves, typically a, b and c. The chart below shows an abc
corrective sequence. Notice that waves a and c are impulse waves (green). This is because they are in the
direction of the larger degree wave. This entire move is clearly down, which represents the larger degree
wave. Waves a and c move with the larger degree wave and are therefore impulse waves. Wave b, on the
other hand, moves against the larger degree wave and is a corrective wave (red).
EFFICIENT MARKET THEORY

Efficiency of market implies that all known information is immediately discounted by all investors‟ and
reflected in share prices in the stock market. In an ideal efficient market, everyone knows all possible-to-
know information simultaneously, interprets it similarly and behaves rationally. In such a situation, the only
price changes that would occur are those which result from new information. In an efficient market, liquid

capital will channel quickly and accurately where it will do the community the most good. Efficient markets
will provide ready financing for worthwhile business ventures and drain capital away from corporations
which are poorly managed. It is essential that a country has efficient capital markets if it is to enjoy highest
possible level of wealth, welfare and education. One of the main reasons that some underdeveloped
countries do not advance is that they have insufficient capital markets. In inefficient capital markets prices
may be fixed or manipulated rather than determined by supply and demand. Capital may be controlled by a
few wealthy people and not be fluid and flow where it is needed.
.
In an efficient market, all the relevant information is reflected in the current stock price. Information cannot
be used to obtain excess return and the information has already been taken into account and absorbed in the
prices. Thus, all prices are correctly stated and there are no bargains in the stock market. Efficiency in the
security market means the ability of the capital markets to function so that prices of securities react rapidly
to new information. Such efficiency will produce prices that are appropriate in terms of current knowledge
and investors will be less likely to make unwise investments. The investors will also be less likely to
discover great bargains and thereby earn extraordinary high rates of return.
The following are the requirements of securities market to be efficient:

(1) Prices must be efficient so that new innovations and better products will cause a company's securities
prices rise and motivate investors to supply capital to the company.
(2) Information must be discussed freely and quickly across the nation so all investors can react to new
information.
(3) Transaction costs are ignored (i.e. brokerage or commission).
(4) Taxes are assumed to have no noticeable effect on investment - policy.
(5) Every investor is allowed to borrow or lend at the same rate.
(6) Investors must be rational and able to recognise efficient assets and invest money where it is needed
most.
Michael C. Jensen has defined an efficient market as, "A market is efficient with respect to a given
information set, if it is impossible to make profits by trading on the basis oftltat information set. By
economic profit is meant the risk-adjusted, returns net of all costs."
Eugene F. Fama has also defined an efficient market as,

"Market efficiency requires that in setting the prices of securities at any time t-1, the market correctly uses
all available information."
Thus, market efficiency means that all known information is immediately discounted by all investors and
reflected in the market price of stocks. This means that no one has an information edge. In an efficient
market, everyone knows all possible 'to know' information simultaneously. Every one interprets it similarly
and behaves rationally. The market is assumed to be efficient in many more senses. One cannot expect to
earn superior rates of return by analysing annual reports, announcements of dividend changes etc. The
strong form asserts that not even those with privileged information can make use of it to secure superior
investment results.
The Efficient Market Theory also popularly known as Random Walk Theory holds that the financial market
is in possession of all available information which may influence the price of a share or stock that as a result
there is perfect competition in the financial market. The theory assumes that share prices wander in a
random fashion because the investors, in a perfectly competitive market, take account of all the facts about a
share in determining its price.
This theory is supposed to take three forms, - weak form, semi - strong form and strong form.

(1) Weak form:

The weak form implies that the knowledge of the past patterns of stock prices does not aid investors to
attain improved performance. It is opposite of technical analysis which completely relies on charts and past
behaviour of stock prices. In this weak form of efficient market the past prices of stocks do not provide help
in giving any information about the future prices. Random Walk theory states that the stock prices move
randomly about a trend line which is based on anticipated earnings power. Therefore, analysing past data
does not permit the technician to forecast the movement of prices about the trend line and new information
affecting stock prices enters the market in random fashion. Thus, the weak form of efficient market theory is
a direct challenge to the chartist or technical analyst.
(2) Semi-strong form:

The semi-strong form of the efficient market theory concentrates on how rapidly and efficiently market
prices adjust to new publicly available information. The investor, in this form of market, will find it
impossible to earn a return on the portfolio which is based on the publicly available information in excess of
the return which may be said to be commensurate with the portfolio risk. Semi-strong form suggests the
fruitlessness of efforts to earn superior rates of return. It represents a direct challenge to traditional financial
analysis based on the evaluation of publicly available data. In the semi-strong market any new
announcement would bring a reaction immediately upon the announcement. This reaction could be even
prior to the announcement in the market. This reaction prior to or immediately after the announcement
would be caused by the additional information which is not anticipated by the stock market participants.
(3) Strong form:

The strong form is concerned with the possession of inside information. In the strong form of the market it
is stated that all information is represented in the security prices in such a way that there is no opportunity
for any person to make an extra-ordinary gain on the basis of any information. The stock prices reflect not
only what is generally known through public announcements but also what may not be generally known.
Certain groups have monopolistic access to information. This is the most extreme form of the efficient
market theory. If the strong form holds, then, any day is as good as other day to buy any stock. However,
most of research work, has indicated that the efficient market theory in the strongest form does not hold
good. There is no doubt that access to inside information, such as that available to corporate officials and
specialists, enables investors to beat the market. This is not surprising and explains why market efficiency is
usually restricted to the weak and semi-strong forms.
Efficient Market Theory suggests that the successive price changes are independent. It means that the prices
at any particular time usually reflect the intrinsic value of a security at an average. If the stock price moves
away from its intrinsic value, different investors will evaluate the information which is available differently
into the prospects of the firm and the professional investors will be able to make a short term gain on
random deviations from the intrinsic value but in the long run stocks will be forced back to its equilibrium
position.

9 CAPITAL ASSET PRICING MODEL
CAPM
Modern finance theory provides a theoretical representation of the way risky financial assets are priced in
the markets. Capital Asset Pricing Model (CAPM) is the theory developed and modified by the financial
economists through the sixties - W. Sharpe and J. Tobin. It can be applied to all capital assets such as shares,
debentures, bonds, etc.
ASSUMPTIONS OF CAPM:
The Capital Asset Pricing Model is based on the following assumptions:
(1) The investor's objective is to maximise the utility of terminal wealth.
(2) Investors make choices solely on the basis of risk and return.
(3) Investors have homogeneous expectations.
(4) Investors have identical one-period time horizons.
(5) Information is freely available.
(6) There is a risk-free asset and investors can borrow and lend any amount of money at the risk free rate.
(7) There are no taxes, transaction costs, or other market imperfections.
(8) Total assets quantity is fixed and all assets are marketable and divisible.
(9) Capital markets are in equilibrium.
CAPM EQUATION:
CAPM is that the expected return of an asset which will be related to a measure of risk for that asset known
as beta. CAPM specifies the manner in which expected return and beta are related. It provides the
intellectual basis for a number of the current practices in the investment industry.
According to CAPM, the relationship between Risk and Return is
Ki = Rf + B (Km - Rf)
Where Ki = Required or expected rate of return on security
Rf = Risk free rate of return
B = Beta coefficient of a security
Km = Expected rate of return on market portfolio
(a) Return: Return from an investment is the realisable cash flow earned by its owner during a given
period of time.
(b) Expected Rate of Return: It is the average return that ont expects to receive on an investment over the
long term.
(c) Market Portfolio: It is the portfolio comprising of all the risky securities that are traded in the market.
(d) Risk: Risk means chance of loss. It refers to the variability of possible returns associated with an
investment. The greater the dispersion of possible returns, the greater the risk and vice-versa. There are
different types of risk such as default risk, business risk, financial risk, purchasing power risk, interest rate
risk, liquidity risk, market risk. All these risks can be classified as systematic risk and unsystematic risks.

Systematic risk is external risk which cannot be diversified and investors cannot avoid the risk arising from
the above factors. However, unsystematic risk is internal -to the company and it can be diversified by
combining the securities in the portfolio.
Risk also refers to the dispersion of a probability distribution. How much do individual outcomes deviate
from the expected value? A simple measure of dispersion is the range of possible outcomes which is simply
the difference between the highest and lowest outcomes. A more sophisticated measure of risk, employed
commonly in finance, is the standard deviation. The standard deviation is calculated as follows:
(e) Beta: Beta is a measure of performance of a particular sha or class of shares in relation to the general
movement of tl market. Beta 1, rise or fall corresponds exactly with tl market and beta 2, rise or fall is
double. The systematic ( non-diversifiable risk of a security is generally measured 1 beta. This represents the
extent to which the return c security fluctuates in response to changes in the market ra of return. If a share has
consistently risen more than tl market as a whole it has a beta of more than 1. In future als this share can be
expected to rise at a rate higher than tl market as a whole. On the other hand, if the market falls, th share will
crash by greater than the market as a whole. Beta calculated statistically by dividing the co-variance between
particular security's return and the market rate of return b the variance of return on the market index as
follows:
CAPITAL MARKET LINE (CML)

The next step in deriving the asset pricing model is to define a set of criteria for identifying preferred
investments. Probably the most straight forward method is the mean-variance criteria. It utilizes only the
mean and variance of expected returns to identify the investments that dominate.
An investment 'A' dominates investment 'B' if investors always prefer A to B. The mean variance criteria
assumes that continuously compounded returns on investments are normally distributed. Expected value of
this distribution is the mean and the measure of dispersion of values around the mean is the standard
deviation. Using the mean as the measure of expected return and the standard deviation as the measure of
risk, we can represent any investment in risk-return space as a single point. An example of investment A
with expected return and standard deviation is shown in the diagram below:
By plotting the dominant investments in risk-return space, we can identify the set of investments that are not
dominated by any other investment. This is the mean-variance efficient set or efficient frontier of portfolios

of risky assets. The point of tangency between the efficient frontier and the highest possible indifference
curve of an investor will identify the investors preferred portfolio.
Introduction of risk-free asset with borrowing and lending at the risk free rate leads to the Capital Market
Line. The CML is a linear relationship between expected return and total risk. It, becomes the new efficient
frontier. The point of tangency between the CML and the old efficient frontier of risky assets identifies the
market portfolio. The market portfolio is a perfectly diversified mean-variance efficient portfolio containing
every investment in quantities proportional to their total market value. The tangency point between the
highest indifference curve and the CML reveals the investors preferred portfolio mix. This can be shown in
the diagram given below:
The preferred portfolio is L on the indifference curve U3. For this investor portfolio L would be the
investment alternative that maximises expected return within the investor's risk constraints and yields the
highest possible utility.
The empirical tests show that the CAPM is a fairly good representation on the market but there seem to be
significant deviations of empirical results from the theory and conclusions of many studies are often
conflicting. Therefore, several alternatives have been developed to this model.
The Capital Asset Pricing Model gives a relationship between a securities risk and return. The excess of
return earned on any other security is the risk premium or the reward for the excess risk pertaining to that
security. According to CAPM, the required rate of return on security is equal to Risk Free Rate + (Beta of
Security x Market Risk Premium). The Market Risk Premium is the difference between Average Rate of

Return on Market and Risk free Rate. The average rate of return on a market index like the BSE National
Index can be taken as Proxy for the average rate of return on the market.
SECURITY MARKET LINE (SML)

The graphical version of the CAPM is called Security Market Line. It shows the relationship between beta
and the required rate of return. The CAPM identifies security return net of the risk free rate as proportional
to the expected net market return, where beta serves as the constant proportionality. As a consequence of
this relationship, all securities in equilibrium plot along a straight line is called security market line (SML).
It is an alternative to CML which will use beta as the independent variable and will accommodate both
portfolios and individual assets.
In the figure, the required rate of return for three securities A, B and C is shown. Security 'A' is defensive
security with a beta of 0.5. It's required rate of return is 11%. Security 'B' is neutral security with a beta of 1.
It's required rate of return is equal to the rate of return on the market portfolio. Security 'C' is aggressive
security with a beta of 1.5. It's required rate of return is 17%.
The SML has a positive slope, indicating that the expected return increases with risk (beta). The expected
return of a security on the SML is determined by the riskless rate plus a systematic risk premium which is
proportional to its beta.
In market equilibrium the CAPM implies an expected return risk relationship for all individual securities.
The implications of the securities market line are enormous. If individual assets and portfolios are priced
correctly, then all currently priced assets and portfolios must lie on the SML because the beta value of a
security or a portfolio represents its contribution to the risk of the market portfolio.
Therefore, it follows that an asset lying above SML is undervalued because it offers a return higher than
what is consistent with the systematic risk it carries. Similarly, assets lying below the SML, are overvalued,
because they offer returns lower than what investors should expect from investing in those assets. Therefore,
the SML can become the comer stone for developing effective portfolio strategies.
INPUTS REQUIRED FOR APPLYING CAPM

The Capital Asset Pricing Model requires risk free rate of return, required rate of return, beta coefficient of a
security and return on securities and market portfolio. Risk free rate of return is determined on the basis of
security and market conditions. Corporates use the CAPM in three related ways:
(1) to determine hurdle rates for corporate investments,
(2) to estimate the required returns for divisions strategic business units or lines of business, and
(3) to evaluate the performance of these divisions or units.
Corporate managers often use the cost of capital as the required rate of return for new corporate capital
investments. To develop this overall cost of capital, the manager must have an estimate of the cost of equity
capital. To calculate a cost of equity, estimate of the firms beta and use the CAPM to determine the
companies required return on equity. Historical returns and beta are also used to evaluate the performance of
the asset or portfolio. Thus, there are various inputs used for applying CAPM.

PRACTICAL PROBLEMS
1. Calculate the beta value from the following information:
Year Return on Security Return on Market
1 10 Portfolio
12
2 12 10
3 13 10
4 10 12
5 8 15
6 11 14
7 16 20
8 12 15
9 18 20
10 20 22
2. There are two securities A and B. Security 'A' is less risky and has a beta of 0.89 and security 'B' is more
risky and has a beta of 1. The risk free return is 10% and the market rate of return is 12%. Calculate the
following:
(a) Risk Premium of the Market.
(b) Expected Return of Security 'A'.
(c) Expected Return of Security 'B'.
3. Returns on X Ltd. were 12%, 13%, 12% and 11% in the last four years. Returns on Y Ltd. were 12%,
13%, 9% and 10% in the last four years. While average market returns were 14%, 15%, 14%, 13% in the
last four years, return on Government Securities was 6.5%.
You are required to compute beta factors and expected returns for X Ltd. and Y Ltd. (using CAPM) and
offer your comments.
4. Solve:
Investment in Equity Initial Dividend/ Market Price (end of

Beta Risk Factor
Shares Price Interest the year)
ACC Limited 25 2 50 0.8
Tata Steel Limited 35 2 60 0.7
UB Limited 45 2 135 0.5
Indian Railway Bonds 1000 140 1005 0.99
Risk free return may be taken at 14%.

(1) Expected Rate of Return of portfolio in each using CAPM (Capital Asset Pricing Model).
(2) Average Return of Portfolio.

5. The expected returns and Beta of three securities are as follows:

Securities A B C
Expected Returns 18 11 15
(%)
Beta Factor 1.7 0.6 1.2
If risk free rate is 9% and market returns are 14%, which of the above securities are over, under or correctly
valued in the market? What should be your strategy?
6. Returns on Ram Ltd. were 11%, 13%, 12% and 10% in the past four years. Returns on Shyam Ltd. were
12%, 14%, 9% and 10% in the last four years. While average market returns were 12%, 14%, 14% and 13%
in the last four years. Return on Government securities is 8%. You are required to compute beta factors and
expected returns of Ram Ltd. and Shyam Ltd. using CAPM and offer comments.
7. The following information is available about two securities A and B.

Particulars A B
Expected return 10% 12%
Standard deviation of expected 15% 10%
return Correlation coefficient with 0.6 0.4
the market Beta 0.7 0.8
Which of the two securities is more risky? Why?
8. The risk free return is 8 percent and the return on market portfolio is 12 percent. If required return on a
stock is 15 percent, What is its beta?
(b) The risk-free return is 9 percent. The required return on a stock whose beta is 1.5 is 15 percent. What
is the return on the market portfolio?
9. Mr. Vipul has a portfolio of three securities. From the following details compute the portfolio returns and
rate of return on individual securities.
Price as on Price as on Yearly
Security
31.12.94 31.12.95 Dividend
A 20 30 2
B 30 40 3
C 50 60 5
10. a) What will be the expected return on a portfolio composed of the following securities?
Security Expected Proportion %
Return %
A 10 25
B 15 25
C 20 50
b)What will be the expected return if the proportion of each security in the portfolio is 20, 30 and 50
respectively?

10 PORTFOLIO EVALUATION
Portfolio helps investor to reduce or manage the risk involved in investing funds. It spreads the risk involved
in an investment from one security to a group of different types of securities.
MUTUAL FUNDS
a) A Mutual Fund is an intermediary that pools money from a number of investors and invests the same in a
variety of different financial instruments. The income earned through these investments and the capital
appreciation realized by the scheme is shared by the investors or Unit Holders, in proportion to the number
of units owned by them.
b) The organization that manages the investment is known as Asset Management Company [AMC].
c) In India, operations of AMC are supervised and regulated by the Securities and Exchange Board of India
(SEBI).
MUTUAL FUND COSTS

Efficiency of a Mutual Fund is also determined based on the expenses incurred by it and how the same are
kept under control. There are certain costs associated in operating mutual fund which are incurred by the
Asset Management Company [AMC]. These costs can be classified in two broad categories viz.
a) Operating expenses
b) Sales Charges
i) Front end loads/ Entry loads
ii) Back end loads/ Exit loads
a) Operating Expenses :
Costs incurred in operating mutual funds include advisory fees paid to investment managers, custodial fees,
audit fees, transfer agent fees, trustee fees, etc. The break-up of these expenses is required to be reported in
the scheme‟s offer document. The expenses ratio is arrived at by dividing operating expenses with average
net assets. Based on the type of the scheme and the net assets, operating expenses are determined within the
limits prescribed by SEBI regulations. Any expenses incurred beyond the specified limits are borne either
by the Asset Management Company or the Trustees or the sponsors. Operating expenses are calculated on
an annualised basis but are incurred on a daily basis, therefore, an investor is charged expenses on
proportionate basis depending on the time for which money is kept invested in the fund, b) Sales Charges :
These costs are also called by the name of sales loads, some examples of these expenses are payment of
agent‟s commission and expenses for distribution and marketing cost. These costs are charged directly to the
investors, this is because the fund may not want to put any burden of such cost on existing investors. As
these charges are charged from investors these expenses does not impact the performance of the fund. These
expenses are classified into :
i) Front end load :

This load is a one time fixed fee which is paid by an investor while he buys into a scheme. Printed load
determines the Public Offer Price (POP) which in turn determines how much of the initial investment gets
actually invested. This load is also known by the name of Entry Load. Public Offer Price with Front End
Load is calculated as follows:
Public Offer Price (i.e. the sale price) = NAV x (1 + Front end load)
If an investor invests say Rs. 50,000/- in a scheme that charges a 2% Front end load at an NAV per unit of
Rs. 10/-, the Public Offer Price (POP) will be calculated as follows:
POP = NAV x (1 + 0.02)
10 x 1.02 = 10.20 per unit
ii) Back End Load :

As there can be expenses incurred by the company while selling the units, company can also incur expenses
while repurchasing units from the investor such expenses can be liquidation expenses incurred to procure
funds for repurchasing units, etc. Back End Load will be a fixed fee at the time of redemption or repurchase
of units by the Asset Management Company. A redemption load exists permanently and is paid only at the
time of redeeming or selling units back to Asset Management Company. Back End load is also known by
the name of Exit Load.
The Repurchase price from the company‟s point of view is calculated as follows:
Repurchase Price or redemption price = NAV x (1 - Back End load)
Using the information given in (i) above, if the exit load is 1.75%, the repurchase price will be
= 10 x (1 - 0.0175)
= 10 x 0.9825 = Rs. 9.825
NAV
The Net Asset Value is the market value of the assets of the Mutual Fund Scheme minus its liabilities: The
net asset value of the mutual fund unit is computed as follows:
NAV = Market Value of fund + Receivables + Accrued Income - Liabilities & Expenses
Number of Units Outstanding
Thus, the factors affecting the NAV of a Mutual Fund are as follows:
(i) Sale and purchase of securities.
(ii) Sale and purchase of units.
(iii) Valuation of assets.
(iv) Accrued income and expenses.
The Rate of Return on a mutual fund is calculated as follows:
RATE OF RETURN = NAVe - NAVb + Dividend paid during the year x 100
NAVb
Where NAVe = Net Assets Value at the end of the period
NAVb = Net assets value at the beginning of the period.
MEASURES OF RETURN

(a) SHARPE'S MEASURE:

The Sharpe measure uses the standard deviation of returns as the measure of risk. It measures return relative
to total risk. In a well developed portfolio, total risk is predominantly from systematic risk factors. The
Sharpe measure can be used effectively with a portfolio.
The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result of
excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns
than its peers, it is only a good investment if those higher returns do not come with too much additional risk.
The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe
ratio indicates that a risk-less asset would perform better than the security being analyzed.
(b) TREYNOR'S MEASURE:

The Treynor's Index of measure provides a measure of return relative to beta, a measure of systematic risk.
It ignores any unsystematic risk that might be present. Finance theory indicates that expected return is a
function of necessary risk (systematic risk) only. Therefore, Treynor's measure can be an appropriate risk
measure for single securities as well as portfolio.
The Treynor ratio is calculated as:
(Average Return of the Portfolio - Average Return of the Risk-Free Rate)
Beta of the Portfolio
Whenever you notice that the Treynor Ratio is high it means that the investor has received high returns on
each market risk he has taken. Treynor‟s Ratio is important to a portfolio as it helps in understanding how
the funds of the business will perform not only on its own instability but also how it can bring about
unpredictability to the overall business.
Beta is an extensively used measure of market-related risks of stock and is known as the measurement of
market-related risk.
(c) JENSEN'S DIFFERENTIAL RETURN MEASURE:

Jensen's measure of portfolio performance is based on the capital asset pricing model. The CAPM expresses
the relationship between the risk of a security measured by its beta and expected rate of ret uni The basic
versions of the CAPM are expressed in the following equation:
Rp = Ki + βp(Rm - Ki)
Where Rp = expected return of a portfolio
Ki = risk-free rate of return
Bp = beta of a portfolio
Rm = expected return on a market index.

Jensen's measure of evaluating portfolio performance calculates the required return on a given portfolio and
then it is compared with the actual realized return of the portfolio. If the realised return is more than
calculated return the performance of the portfolio is better and vice-versa. For example, if there are two
mutual funds that both have a 12% return, a rational investor will want the fund that is less risky. Jensen's
measure is one of the ways to help determine if a portfolio is earning the proper return for its level of risk. If
the value is positive, then the portfolio is earning excess returns.
PRACTICE PROBLEMS
1. The details of three portfolios are given below. Compare these portfolios on performance using the
Sharpe, Treynor and Jensen's measures.
Portfolio Average Return Standard Beta
Deviation
1 15% 0.25 1.25
2 12% 0.30 0.75
3 10% 0.20 1.10
Market Index 12% 0.25 1.20
The risk-free rate of return is 9%.
2. The details about Mutual fund and Market Portfolio are as follows:
Mutual Fund Market
Average Rate of Return 22% 20%
Standard Deviation of Return 16% 14%
Beta 1.20 1.00
Risk free Return 12% 12%
Compare the portfolio performance of Mutual Fund as well as market using Sharpe and Treynor's Index.
3. Compare portfolio performance using Sharpe and Treynor measures for the following portfolios:
Average Return Standard Beta
(%) Deviation
Portfolio A 14% 0.25 1.25
Portfolio B 10% 0.15 1.10
4. Following information is given in respect of three Mutual Funds and Market:

Mutual Funds Average Return Std. Deviation Beta

A 12 18 1.1
B 10 15 0.9
C 13 20 1.2
Market 11 17 1.0
The mean risk free rate 6%. Calculate the Treynor's measure and Sharpe's measure and rank the portfolios.
5.
Portfolio Return Beta Risk free interest
rate
Birla 15% 1.2 9
Kotak 16% 1.5 9
Reliance 12% 0.8 9
Market Index 13% 1.0 9
You are required to rank these portfolios according to Jensen's Measure of Portfolio Return.
6. Three Mutual Funds have reported the following rates of return and risk over the last five years.
Growth fund Return Standard Beta
deviation
HDFC 15% 15% 1.10
ICICI 13% 16% 1.25
UTI 12% 10% 0.90
Evaluate the portfolio performance using Sharpe's and Treynor's Index. Which portfolio has performed
better?
7. Compare the following portfolios on performance using Sharpe, Treynor, and Jensen's measures and rank
them.
Portfolio Avg. returns Std. Deviation Beta
1 15% 0.20 1.25
2 12% 0.35 0.75
3 10% 0.15 1.20
Market Index 12% 0,25 1.00
Risk free return is 6%.
8. The details of three portfolios are given below:

You are required to rank these portfolios according to Sharpe's and Jensen's measures.
Portfolio Average Returns Standard Deviation Beta
A 12 0.25 1.30
B 15 0.30 0.80

C 10 0.20 1.20
Market 12 0.25 1.40
Index
9. You are asked to analyze the two portfolios having the following characteristics:
Portfolio Observed Return Beta Standard
Deviation
Alpha 0.18 1,2 0.04
Gama 0.15 15 0.02
The risk free rate of return is 0.09 and the return on Market Portfolio is 0.14 with Standard Deviation is
0.05. Compute the appropriate measure of performance of these portfolios and comment on their respective
performance. Use Sharepe's Index and Treynor's Index.
10. Based on the below mentioned data decide whether the portfolio has outperformed the market in terms
of Treynor and Sharpe.
Particulars Portfolio Market
Average Rate of Return 22% 20%
Standard Deviation 16% 14%
Beta 1.20 1.00
Riskfree Return 12% 12%
11. Following are the details of three portfolios:

Portfolio Average Return Standard Beta
Deviation
1 13% 0.25 1.25
2 12% 0.25 0.75
3 11% 0.20 1.00
The risk free rate of return is 8%. You are required to compare these portfolios on performance using the
Sharpe's, Treynor's and Jensen's measure and comment. (M.U. April 2012)
12. Based on the following data, decide whether the portfolio has outperformed the market in terms of
Treynor, Sharpe and Jensen benchmark evaluation measures:
(M.U. Oct. 2012)
Particulars Portfolio Market
Average Return 7% 10%
Beta 0.4 1.0
Standard Deviation 3 8
Risk-Free Rate 6% 6%

13. Evaluate performance of following portfolio and the market using the following data and comment on
the same:
Portfolio Standard Deviation Beta Expected Return
(%) β %
Dev Ltd. 20 1.25 35
Gandharva Ltd. 18 1.10 30
Asura Ltd. 19 1.15 32
Market 15 1.00 25
(Note: Risk-free interest rate is 8%)
(MU April 2013)

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TYBMS INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT SEM V

WE at EDUWIZ MANAGEMENT EDUCATION, believe in the philosophy -

And last but not the least,

THINK BMS…THINK EDUWIZ!!!

1|Page EDUWIZ MANAGEMENT EDUCATION

1 INTRODUCTION TO INVESTMENT ENVIRONMENT 4

3 CAPITAL MARKET IN INDIA 27

4 RISK AND RETURN 40

8 THEORIES OF TECHNICAL ANALYSIS 111

9 CAPITAL ASSET PRICING MODEL 134

10 PORTFOLIO EVALUATION 123

THINK BMS…THINK EDUWIZ!!!

2|Page EDUWIZ MANAGEMENT EDUCATION

UNIT II : RISK - RETURN RELATIONSHIP

UNIT III : PORTFOLIO MANAGEMENT AND SECURITY ANALYSIS

UNIT IV : THEORIES, CAPITAL ASSET PRICING MODEL AND PORTFOLIO PERFORMANCE

 Capital Asset Pricing Model:

 Portfolio Performance Measurement:

3|Page EDUWIZ MANAGEMENT EDUCATION

INTRODUCTION TO INVESTMENT ENVIRONMENT

There are two concepts of investment:

ELEMENTS OF INVESTMENTS/CRITERIA FOR SELECTING INVESTMENTS

4|Page EDUWIZ MANAGEMENT EDUCATION

(e) Tax Saving

ii) Determination Of investment objectives and constrains :

5|Page EDUWIZ MANAGEMENT EDUCATION

iii) Investment Analysis :

iv) Portfolio Construction :

v) Portfolio Performance Evaluation :

vi) Portfolio Revision :

i) Risk averse investors:

ii) Risk taking investors:

6|Page EDUWIZ MANAGEMENT EDUCATION

iii) Risk indifferent investors :

ii) A risk-seeker is likely to prefer

iii) A risk-neutral investor

INVESTMENT V/S SPECULATION V/S GAMBLING

7|Page EDUWIZ MANAGEMENT EDUCATION

8|Page EDUWIZ MANAGEMENT EDUCATION

A] NON MARKETABLE FINANCIAL ASSETS

1. POST OFFICE SAVINGS SCHEMES

9|Page EDUWIZ MANAGEMENT EDUCATION

10 | P a g e EDUWIZ MANAGEMENT EDUCATION

Min : Rs. 100.

2. PUBLIC PROVIDENT FUND (PPF)

11 | P a g e EDUWIZ MANAGEMENT EDUCATION

12 | P a g e EDUWIZ MANAGEMENT EDUCATION

(ii) Savings Account

4. COMPANY FIXED DEPOSITS IN INDIA

13 | P a g e EDUWIZ MANAGEMENT EDUCATION

5. UNIT LINKED INSURANCE PLANS [ULIPS]

14 | P a g e EDUWIZ MANAGEMENT EDUCATION

• Balanced ULIPs (invest about 40% - 60% in equities)

15 | P a g e EDUWIZ MANAGEMENT EDUCATION

INSTRUMENTS OF MONEY MARKET

5. READY FORWARD CONTRACTS

16 | P a g e EDUWIZ MANAGEMENT EDUCATION

7. PASS THROUGH CERTIFICATES

8. DATED GOVERNMENT SECURITIES

10. MONEY MARKET MUTUAL FUNDS [MMMFS]

C] DEBENTURES AND BONDS/DEBT INSTRUMENTS

17 | P a g e EDUWIZ MANAGEMENT EDUCATION