MGTF 01 - SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

UNIT -1
Introduction to investments - Nature and scope of investment decision - investment planning, investment
process – Investment alternatives - Govt. Securities - Money market instruments - equity bonds- mutual
funds-- mutual fund types - performance evaluation of mutual fund- derivative instruments - futures - options -
commodity futures, index futures - stock futures - hedge funds. Impact of fiscal and monetary policy on
investments, comparison of investment products.

UNIT - II
Institutional arrangement- Indian stock market and Bond markets, new issue market – functions – trading-
types of orders– settlement - Depository services - Book building process - listing - secondary market - online
trading- Risk and return- systemic risk types-unsystematic risk -minimizing risk-risk management -
measurement of risks and return-beta.

UNIT III
Security Analysis - Fundamental Analysis - Economic Analysis - Industry analysis - company analysis-
measuring earnings, forecasting earnings, Valuation of fixed income securities-common stock valuation- one
year holding-multiple year holding-constant growth model –multiple growth model-Bond valuation and yields
- Bonds duration and yield analysis –YTM,YTC-bond risk- bondduration - Term structure theories - and
valuation of options, Technical analysis-theories –Dow flow theory, Chart analysis- efficient market
hypothesis.

UNIT IV
Portfolio management-steps- Markowitz portfolio theory-risk and return of Portfolio- portfolio construction-
portfolio selection- CAPM, APT efficient frontier- constructing the optimum portfolio- portfolio
revision-formula plans -portfolio performance evaluation-Need for Evaluation – Measuring Portfolio Return –
Risk Adjusted Returns- Sharpe Ratio, Treynor Ratio, Jensen’s performance Index

UNIT V
Mechanics of investing- stock trading platforms-market terms-M trading-application based trading- Trading
Procedure-broker-Demat Account- Dematerialization-Specified and Non-specified Securities- online
transaction –bonds-shares- mutual fund units

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Unit -1
Introduction to investments:

INVESTMENT DECISIONS

Investment decisions are crucial decisions for every organization as it determines its
profitability. It should be ensured that a proper study is done regarding the risk and return
before committing any capital into available investment avenues. Investment decisions are of
two types: Long term and short term investment decisions.

Long term investment decisions are concerned with the investment of funds in long term
assets and are termed as Capital budgeting. Whereas, short term decisions relate to
investment in short term assets which is also called working capital management.

Nature of Investment Visions

1. Require Huge Funds: Investment decisions requires a large amount of funds to be

deployed by firm for earning profits. These decisions are very imperative and requires
due attentions as firms have limited funds but the demand for the funds is excessive.
Every firm should necessarily plan its investment programmes and control its
expenditures.
2. High Degree of Risk: These decisions involve a high amount of risk as they are taken
on the basis of estimated return. Large funds are invested for earning income in future
which is totally uncertain. These return fluctuates with the changes in fashion, taste,
research and technological advancement thereby leading to a greater risk.

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3. Long Term Effect: Investment decisions have a long lasting effects on future
profitability and growth of firm. These decisions decide the position of a firm in
future. Any wrong decision may have very adverse effects on return of an
organization and may even endanger its survival. Whereas, right decision taken brings
good returns for firm leading to better growth.
4. Irreversibility: Decisions related to investment are mostly irreversible in nature. It is
quite difficult to revert back from decisions once taken related to the acquisition of
permanent assets. Disposing off these high value assets will cause heavy losses to
firm.
5. Impacts Cost Structure: Investment decisions widely impacts the cost structure of
an organization. Firms by taking these decisions commit themselves to various fixed
cost such as interest, rent, insurance, supervision etc. for the sake of earning profits. If
these investments do not provide the anticipated return, then firm overall cost will
raise thereby causing losses.
6. Long term Commitment of Funds: Funds are deployed for a longer term by
organisations through these decisions. Firm deployed high amount of capital for long
period on permanent basis. Financial risk in investment decisions increases due to
long term commitment of funds. A firm should properly plan and monitor all of its
capital expenditures.
7. Complexity: Investment decisions are most complex decisions as they are based on
future events which are totally uncertain. Future cash flows of an investment cannot
be estimated accurately as they are influenced by changes in economic, social,
political and technological factors. Therefore, uncertainty of future conditions makes
it difficult to accurately predict the future returns.

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1.Selection of Right Assets: Investment decisions help in choosing the right type of
investment plan for deploying the funds. Each of the available opportunities is properly
analyzed by management while making investment decisions. This way every aspect of asset
available for investment is taken into consideration which leads to building up a strong
portfolio.
2.Identify Degree of Risk: These decisions help in identifying the level of risk associated
with an investment opportunity. Decisions are taken on the basis of expected return and risk
required for earning such return. Managers properly evaluate assets using various tools for
finding out the risk while taking investment decisions.
3.Determines firm Profitability: Decisions regarding investment plans determine the future
profit earning potential of a firm. A right decision may bring a large amount of funds to an
organization leading to better growth. Whereas, any wrong decision regarding deployment of
funds may cause heavy losses and even adversely affect the continuity of the firm.
4.Enhance Financial Understanding: Investment decisions impart a large amount of
beneficial financial knowledge to individuals taking these decisions. Investors while
choosing the asset use a variety of tools and techniques for analyzing its profitability. It
provides a lot of information which enhances the overall financial knowledge and enables
investors in making rational decisions regarding investment.
5.National Importance: These decisions are of national importance for a nation as it leads to
overall development and growth. Investment decisions taken determine the level of
employment, economic growth and economic activities in a country. More investment creates
a better supply of funds in an economy which increases the pace of overall economic
development.

Investment planning PROCESS

Investment planning is the process of identifying financial goals and converting them
through building a plan. Investment planning is the main component of financial planning.
The investment planning begins with identification of goals and objectives
Investment planning helps you choose the right investments as per your financial goals and
objectives. Nowadays, there are various types of investment planning in the form of cash,
bonds, securities, and properties. So according to the funds available, we can invest in these
plans to obtain our desired goals and objectives.

The process
Step 1 - Establishing Investment Goals and Objectives
Investment Objectives: During our initial discussion we will spend time discussing your
short and long-term financial goals and objectives. Understanding the role that your
investments play in your current and future cash flow, and where you are in the

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'accumulation-income generation-preservation-distribution' cycle is essential to matching
your investment goals to your investment portfolio.
Step 2 - Determining Risk Tolerance and Appropriate Asset Allocation
Risk Profile. Using a model risk analysis profile questionnaire we will have a discussion
regarding risk-reward, time horizon for investments and return expectations.
Asset Allocation. The results of the risk analysis model will provide information that I will
use to develop a suitable investment portfolio. A portfolio comprising investment asset
categories that will provide you with an investment portfolio designed to help you achieve
your investment goals and objectives.
Step 3 - Creating the Investment Portfolio
Portfolio Design. Whether your portfolio is being designed for long term capital appreciation
or the generation of income, selecting the investments to build your portfolio is an important
step in developing a suitable investment strategy. There are a number of alternatives that will
be discussed and explored as a part of this process, and I will help you to determine which is
suitable for your needs. Mutual Funds, Managed Accounts, Wrap Accounts, Individual
Securities, Bank Products, Annuities, Insurance Products may all have a place in your
portfolio. It is at this step in the process that we focus on which is suitable for your specific
needs.
Step 4 - Monitoring and Reporting
Portfolio Review and Reporting. Performance of the investment portfolio relative to your
stated objectives and the investment marketplace and the broad economy helps you to keep
your investment portfolio and decisions in perspective. We establish a timeframe to meet and
discuss whether you are on track and making strides to achieve your investment objectives.

Objectives of Investment Planning

The three most important objectives of investment planning are the growth of the invested
amount, the safety of money, and income generation. Besides, other objectives include tax
minimization and liquidity of the investment.

Importance of Investment Planning

1. Income Managed through Planning
Investment Planning helps us plan effectively your monthly expenditures, bill payments,
taxes, etc. You are aware of how much you earn from salary, interest, dividends, and whether
it is enough for fulfilling your financial objectives. This way, income is better managed
through planning
2. Increase in Savings
Recording incomes and expenses in a financial plan make you aware of your savings. Hence,
you can make a budget whether you are within budget or overspending. This will makes you

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aware of how much you need to save to reach your goals. Also, a sudden requirement of
money can put you off track. Hence, it is important to invest in the money with high
liquidity. This can be taken out easily when needed for educational purposes, serious illness
or other important matters
3. Financial Security
Investment planning is not only important for individual security but can provide a financial
security net to the family as well. Financial Security of the family is an important part of
investment planning. Having family covered under security net gives an individual peace of
mind
4. Maintaining the Standard of Living
Investment creates savings that bring an individual under a financial security net. This can be
useful in difficult times. For example, the death of a working member of a family affects the
standard of living.

Investment Objectives: During our initial discussion we will spend time discussing your
short and long-term financial goals and objectives. Understanding the role that your
investments play in your current and future cash flow, and where you are in the
'accumulation-income generation-preservation-distribution' cycle is essential to matching
your investment goals to your investment portfolio.

Risk Profile. Using a model risk analysis profile questionnaire we will have a discussion
regarding risk-reward, time horizon for investments and return expectations.
Asset Allocation. The results of the risk analysis model will provide information that I will
use to develop a suitable investment portfolio. A portfolio comprised of investment asset
categories that will provide you with an investment portfolio designed to help you achieve
your investment goals and objectives

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Portfolio Design. Whether your portfolio is being designed for long term capital
appreciation or the generation of income, selecting the investments to build your portfolio is
an important step in developing a suitable investment strategy. There are a number of
alternatives that will be discussed and explored as a part of this process, and I will help you
to determine which is suitable for your needs. Mutual Funds, Managed Accounts, Wrap
Accounts, Individual Securities, Bank Products, Annuities, Insurance Products may all have
a place in your portfolio. It is at this step in the process that we focus on which is suitable for
your specific needs.

Portfolio Review and Reporting. Performance of the investment portfolio relative to your
stated objectives and the investment marketplace and the broad economy helps you to keep
your investment portfolio and decisions in perspective. We establish a timeframe to meet and
discuss whether you are on track and making strides to achieve your investment objectives

Investment alternatives

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Mutual fund types

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 ➢ Based on Asset Class
1. Equity Funds
Equity funds primarily invest in stocks, and hence go by the name of stock funds as well.
They invest the money pooled in from various investors from diverse backgrounds into
shares/stocks of different companies. The gains and losses associated with these funds
depend solely on how the invested shares perform (price-hikes or price-drops) in the stock
market. Also, equity funds have the potential to generate significant returns over a period.
Hence, the risk associated with these funds also tends to be comparatively higher

2. Debt Funds
Debt funds invest primarily in fixed-income securities such as bonds, securities and treasury
bills. They invest in various fixed income instruments such as Fixed Maturity Plans (FMPs),
Gilt Funds, Liquid Funds, Short-Term Plans, Long-Term Bonds and Monthly Income Plans,
among others. Since the investments come with a fixed interest rate and maturity date, it can
be a great option for passive investors looking for regular income (interest and capital
appreciation) with minimal risks

3. Money Market Funds

Investors trade stocks in the stock market. In the same way, investors also invest in the
money market, also known as capital market or cash market. The government runs it in
association with banks, financial institutions and other corporations by issuing money market
securities like bonds, T-bills, dated securities and certificates of deposits, among others. The
fund manager invests your money and disburses regular dividends in return. Opting for a
short-term plan (not more than 13 months) can lower the risk of investment considerably on
such funds.

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 4. Hybrid Funds
As the name suggests, hybrid funds (Balanced Funds) is an optimum mix of bonds and
stocks, thereby bridging the gap between equity funds and debt funds. The ratio can either be
variable or fixed. In short, it takes the best of two mutual funds by distributing, say, 60% of
assets in stocks and the rest in bonds or vice versa. Hybrid funds are suitable for investors
looking to take more risks for ‘debt plus returns’ benefit rather than sticking to lower but
steady income schemes.

➢ Based on Investment Goals

1. Growth Funds
Growth funds usually allocate a considerable portion in shares and growth sectors, suitable
for investors (mostly Millennials) who have a surplus of idle money to be distributed in
riskier plans (albeit with possibly high returns) or are positive about the scheme.

2. Income Funds
Income funds belong to the family of debt mutual funds that distribute their money in a mix
of bonds, certificates of deposits and securities among others. Helmed by skilled fund
managers who keep the portfolio in tandem with the rate fluctuations without compromising
on the portfolio’s creditworthiness, income funds have historically earned investors better
returns than deposits. They are best suited for risk-averse investors with a 2-3 years
perspective.

3. Liquid Funds
Like income funds, liquid funds also belong to the debt fund category as they invest in debt
instruments and money market with a tenure of up to 91 days. The maximum sum allowed to
invest is Rs 10 lakh. A highlighting feature that differentiates liquid funds from other debt
funds is the way the Net Asset Value is calculated. The NAV of liquid funds is calculated for
365 days (including Sundays) while for others, only business days are considered.

4. Tax-Saving Funds
ELSS or Equity Linked Saving Scheme, over the years, have climbed up the ranks among all
categories of investors. Not only do they offer the benefit of wealth maximisation while
allowing you to save on taxes, but they also come with the lowest lock-in period of only
three years. Investing predominantly in equity (and related products), they are known to
generate non-taxed returns in the range 14-16%. These funds are best-suited for salaried
investors with a long-term investment horizon.

5. Aggressive Growth Funds

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Slightly on the riskier side when choosing where to invest in, the Aggressive Growth Fund is
designed to make steep monetary gains. Though susceptible to market volatility, one can
decide on the fund as per the beta (the tool to gauge the fund’s movement in comparison with
the market). Example, if the market shows a beta of 1, an aggressive growth fund will reflect
a higher beta, say, 1.10 or above.

6. Capital Protection Funds

If protecting the principal is the priority, Capital Protection Funds serves the purpose while
earning relatively smaller returns (12% at best). The fund manager invests a portion of the
money in bonds or Certificates of Deposits and the rest towards equities. Though the
probability of incurring any loss is quite low, it is advised to stay invested for at least three
years (closed-ended) to safeguard your money, and also the returns are taxable.

7. Fixed Maturity Funds

Many investors choose to invest towards the of the FY ends to take advantage of triple
indexation, thereby bringing down tax burden. If uncomfortable with the debt market trends
and related risks, Fixed Maturity Plans (FMP) – which invest in bonds, securities, money
market etc. – present a great opportunity. As a close-ended plan, FMP functions on a fixed
maturity period, which could range from one month to five years (like FDs). The fund
manager ensures that the money is allocated to an investment with the same tenure, to reap
accrual interest at the time of FMP maturity.

8. Pension Funds
Putting away a portion of your income in a chosen pension fund to accrue over a long period
to secure you and your family’s financial future after retiring from regular employment can
take care of most contingencies (like a medical emergency or children’s wedding). Relying
solely on savings to get through your golden years is not recommended as savings (no matter
how big) get used up. EPF is an example, but there are many lucrative schemes offered by
banks, insurance firms etc.

9. Based on Structure
Mutual funds are also categorised based on different attributes (like risk profile, asset class,
etc.). The structural classification – open-ended funds, close-ended funds, and interval funds
– is quite broad, and the differentiation primarily depends on the flexibility to purchase and
sell the individual mutual fund units.

10. Open-Ended Funds

Open-ended funds do not have any particular constraint such as a specific period or the
number of units which can be traded. These funds allow investors to trade funds at their

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convenience and exit when required at the prevailing NAV (Net Asset Value). This is the sole
reason why the unit capital continually changes with new entries and exits. An open-ended
fund can also decide to stop taking in new investors if they do not want to (or cannot manage
significant funds)

11. Closed-Ended Funds

In closed-ended funds, the unit capital to invest is pre-defined. Meaning the fund company
cannot sell more than the pre-agreed number of units. Some funds also come with a New
Fund Offer (NFO) period; wherein there is a deadline to buy units. NFOs comes with a
pre-defined maturity tenure with fund managers open to any fund size. Hence, SEBI has
mandated that investors be given the option to either repurchase option or list the funds on
stock exchanges to exit the schemes.

12. Interval Funds

Interval funds have traits of both open-ended and closed-ended funds. These funds are open
for purchase or redemption only during specific intervals (decided by the fund house) and
closed the rest of the time. Also, no transactions will be permitted for at least two years.
These funds are suitable for investors looking to save a lump sum amount for a short-term
financial goal, say, in 3-12 months.

➢ Based on Risk
1. Very Low-Risk Funds
Liquid funds and ultra-short-term funds (one month to one year) are known for its low risk,
and understandably their returns are also low (6% at best). Investors choose this to fulfil their
short-term financial goals and to keep their money safe through these funds.

2. Low-Risk Funds
In the event of rupee depreciation or unexpected national crisis, investors are unsure about
investing in riskier funds. In such cases, fund managers recommend putting money in either
one or a combination of liquid, ultra short-term or arbitrage funds. Returns could be 6-8%,
but the investors are free to switch when valuations become more stable.

3. Medium-risk Funds
Here, the risk factor is of medium level as the fund manager invests a portion in debt and the
rest in equity funds. The NAV is not that volatile, and the average returns could be 9-12%.

4. High-Risk Funds
Suitable for investors with no risk aversion and aiming for huge returns in the form of
interest and dividends, high-risk mutual funds need active fund management. Regular

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performance reviews are mandatory as they are susceptible to market volatility. You can
expect 15% returns, though most high-risk funds generally provide up to 20% returns.

Performance evaluation of mutual fund:

1. Returns - Capital Gains

● Unrealized Gains are funds paper profits. As market price of securities rises, the NAV
per share also increases.
● Any unrealized losses are also reflected on funds NAV.
● Therefore, total return from a mutual fund for a given year is determined by the
dividend distributions, net capital gains distributions, and ?NAV due to unrealized
capital gains.
2. Investment Style and Risk
● What is Investment Style?
● On what basis does the manger choose the securities
● How does the fund manager analyze the securities.
● Three primary types of investment style

1. Value 2. Growth, 3. Momentum

❖ Investment Style - Value

● Value Investing
● Invest in companies whose current market value appears to be below the companys
real worth
● stock is below the value of comparable companies in the same business

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 ● Manger utilize fundamental analysis to assess value valuation techniques of the
flowing type is often used
● Price/ Earnings approach
● Price/ Book Value approach
● Dividend Growth approach
❖ Investment Style - Growth
● Growth Investing
● Portfolio manager selects company based on expectation of strong growth
● underlying belief is that if a companys earnings growth meets or exceeds analysts
expectations, the stock price will appreciate.
● Earnings announcements and price volatility
● Stock price volatility is high during the period leading up to quarterly earnings
announcements
● This volatility reflects the price movement of a growth fund can be a Manger utilize
fundamental analysis to assess value

4.Turnover and Taxes

● Turnover measures how often the total holding is

changed.
● 100 turnover - holding is changed once a year
● 300 turnover - holding is changed three times a
year
● Low turnover is characteristic of a Buy-hold
policy
● Large Cap, Value investing, Bond fund etc.,
● High turnover indicative of active trading
strategy
● Aggressive growth, Capital appreciation, momentum
trading
● High turnover creates higher transaction cost.
Return must reflect this added cost.

4. Turnover and Taxes

● High turnover is not always bad. Turnover should be judged against the objective of
the fund.
● Investors may equate high turnover with market savvy and intelligence of the fund
manager.

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 ● When the market performs well, investors ignore turnover and other costs associated
with it. When market is flat or performing poorly, this cost stands out.
(Or)
How to Evaluate Mutual Fund Performance
Define the Investment Goals

What is the purpose of my investment? Answer to this should be the foundation of your
mutual fund choices. For instance, if you want a regular income with capital protection, you
can choose to invest in a debt fund. However, if you have a higher risk appetite and an aim to
build your wealth, equities will suit your purpose. So it is crucial to define your financial
goal first and then decide your investment. This also has a pivotal role in fund evaluation.

Shortlist a few peer Funds to compare

It is difficult to assess a mutual fund in isolation. So, you should always make a small list of
comparable funds and continuously compare them. There are many FinTech firms and third
party websites that offer free mutual fund screener tools.

Check the historical Performance Data

Now every mutual fund handbook comes with a disclaimer stating that past performance is
no indicator of future performance. However, this data can help you check how the fund has
fared across different market cycles. Consistency can also shed light on the skill of the fund
manager. In short, it will be easier for you to find a fund with lower risks but higher returns.

Fee Structure of the Fund

A mutual fund company charges you for its services and expertise. Some funds require deft
management and quick decisions on whether to buy, sell or hold on to an asset. Please
remember that a fund with a higher fee is automatically better. Do check out other parameters
too before choosing.

Risk-Adjusted Returns
Every fund expects certain risks related to the market and the industry. When fund strategies
in such a way that they make more returns against anticipated risks, we call them
risk-adjusted returns.

Performance against Index

Indexes like Nifty, BSE Sensex and BSE 200 set benchmarks, and all fund performances are
evaluated on this basis. Comparing different timelines against the benchmark as well as
peers, can be insightful. A well-managed fund won’t fall too hard during a market low

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Derivative instruments
A derivative is an instrument whose value is derived from the value of one or more
underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks
indices, etc. Four most common examples of derivative instruments are Forwards, Futures,
Options and Swap

Examples of Derivative Instruments

Examples of derivatives include the following:

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Commodity futures, index futures - stock futures:
A derivative is a contract involving a promise to buy or sell an underlying asset which it
‘derives’ value from, at some particular point in future (which in India is the last Thursday of
every month.)
Futures contracts are contracts made for an underlying asset; which can be a commodity,
stock, currency, metals, bonds, and any other security you can find on an exchange.
This contract has a fixed price at which the buyer of the contract intends to buy the asset, and
the seller of the contract sells the asset. Which means the buyer is in long position, and the
seller of the contract is in short position with regards to the underlying asset.

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Hedge funds are the pooled sum gathered from the accredited investors to be invested
strategically and managed aggressively to earn high returns and mitigate chances of loss.
These are not regulated by any securities market regulators and therefore hold high risk and
are more volatile.

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 ● Accredited Investors: An ordinary investor cannot invest in hedge funds. Only
qualified or accredited investors like banks, insurance companies and even high
net worth individuals are allowed to invest in such funds.
● Wide Investment Latitude: The hedge funds cover almost all kinds of asset
classes, including stocks, bonds, real estate, currencies, equities, derivatives,
etc.
● Uses Leverage: The funds which are invested as hedge funds are usually the
borrowed sum in the hands of the fund manager.
● Risk Factor: Some of the hedge funds are exposed to a high risk which may
lead to huge losses. The lock-in period is comparatively very high regarding
other investment options.
● Fee Structure: The fees of hedge fund managers are ‘Two and Twenty’, i.e. 2%
is the fixed fees, whereas the manager takes 20% on the profit earned. This fee
structure is quite high as compared to other investment options.
● Tax Obligation: The hedge fund is not exempted from tax and is taxable on the
grounds of the level of investment. This tax will not be borne by the
unitholders.
● No Regulation: These funds are not registered and do not lie under the
regulation of the securities market regulators.

Impact of fiscal and monetary policy on investments

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Monetary policy refers to the strategies employed by a nation’s central bank with regard to
the amount of money circulating in the economy, and what that money is worth. While the
ultimate objective of monetary policy is to achieve long-term economic growth,
Investors should have a basic understanding of monetary policy, as it can have a significant
impact on investment portfolios and net worth.
● Central banks enact monetary policy to keep inflation, unemployment, and economic
growth stable and positive.
● When the economy overheats central banks raise interest rates and take other
contractionary measures to slow things down - this can discourage investment and
depress asset prices.
● During a recession, on the other hand, the central bank lowers rates and adds money
and liquidity to the economy - stimulating investment and consumption, having a
generally positive impact on asset prices.
● Understanding how monetary policy can influence various asset class prices can
position investors to take advantage of changes in rates or other measures taken by
central banks.

Impact on Investments
Monetary policy can be restrictive (tight, contractionary), accommodative (loose,
expansionary) or neutral (somewhere in between). When the economy is growing too fast
and inflation is moving significantly higher, the central bank may take steps to cool the
economy by raising short-term interest rates, which constitutes restrictive or tight monetary
policy. Conversely, when the economy is sluggish, the central bank will adopt an

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accommodative policy by lowering short-term interest rates to stimulate growth and get the
economy back on track

● Monetary policy affects the primary asset classes across the board – equities, bonds,
cash, real estate, commodities and currencies. The effect of monetary policy changes
is summarized below (it should be noted that the impact of such changes is variable
and may not follow the same pattern every time
● Both fiscal policy and monetary policy can impact aggregate demand because
they can influence the factors used to calculate it: consumer spending on goods
and services, investment spending on business capital goods, government
spending on public goods and services, exports, and imports. It is often the cause
of multiple trilemmas.

comparison of investment products.

1.. STOCKS
. Stocks are one of riskier types of investments, but they can result in high returns if you sell
your shares at the right time. As an asset and portfolio manager, you may choose a
combination of stocks for your clients and advise on their performance.

2.2. BONDS
Bonds are essentially a type of loan in which you lend money to a bond issuer (the
government, a municipality, a corporation, etc.) in exchange for interest payments plus the
repayment of the principal balance once the bond reaches its maturity date. One of the
advantages of bonds is that they can provide a reliable stream of income for clients—because
they earn interest payments over time.

3. MUTUAL FUNDS :
A mutual fund is a professionally managed portfolio that pools money from investors, using
that money to invest in various assets such as stocks, bonds, and short-term investments.
When someone invests in a mutual fund, they don’t need to make any decisions about where
their money goes; you do this for them as their investment portfolio manager.

.4. EXCHANGE-TRADED FUNDS (ETFS

exchange-traded funds (ETFs) are a collection of different assets such as stocks and bonds.
They typically track a market index and are designed to replicate the same return value as the
index they track. ETFs are usually passively managed, meaning they don’t have a fund
manager who actively picks the investments included in the fund. The main difference
between ETFs and other types of funds is how they are bought and sold. While you buy

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mutual fund shares directly through a fund company, ETFs are traded on thestock exchange.
As such, they can be bought and sold more flexibly and their price can fluctuate throughout
the day.

5. ANNUITIES
Annuities are a contract between an individual and an insurance company in which the
company makes routine payments to the individual over a specified period of time in
exchange for an initial payment. Types of annuities vary widely, with some promising a fixed
payment amount and others offering a variable amount based on the value of the investment
assets you chooseThe duration of payments also depends on what type of annuity you buy.

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UNIT -2

Institutional arrangement

Institutional arrangements are generally understood as a set of agreements on the division

of the respective responsibilities of agencies involved in the collection, compilation and
dissemination of data pertaining to a given statistical domain.

Indian stock market and Bond markets, new issue market:

● A stock market is a platform where investors come to trade in financial instruments

like shares, bonds, and derivatives. The stock exchange works as a facilitator of this
transaction and enables the buying and selling of shares.
● Most of the trading in the Indian stock market takes place on its two stock exchanges:
the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). The
BSE has been in existence since 1875.3 The NSE, on the other hand, was founded in
1992 and started trading in 1994.

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 ●

Introduction to the Indian Stock Market

Stock markets are among the largest avenues for investments. There are primarily two stock
exchanges in India, the Bombay Stock Exchange (BSE) and the National Stock Exchange
(NSE). Companies list their shares for the first time on a stock exchange through an IPO.
Investors may then trade in these shares through the secondary market.
The two stock exchanges in India have on some occasions witnessed stocks worth INR
6,00,000 crores being traded. The uninitiated in India often consider investing in stocks
markets gambling, but a basic understanding of the share market can change that perception.

Regulation of the Indian Stock Markets

The regulation and supervision of the stock markets in India rest with the Securities and
Exchange Board of India. SEBI was formed as an independent identity under the SEBI Act
of 1992 and has the power to conduct inspections of the stock exchanges. The inspections
review the operations of the market and the organizational structure along with aspects of
administrative control. The main role of SEBI includes:
● Ensuring a fair and equitable market for investors to grow in
● Compliance of the exchange organization, the system its practices in accordance with
the rules framed under the Securities Contracts (Regulation) Act (SC(R) Act), 1956
● Ensure implementation of the guidelines and directions issued by the SEBI
● Check if the exchange has complied with all the conditions and has renewed the
grants, if needed, under Section 4 of the SC(R) Act of 1956.

Types of Share Markets

27
There are two kinds of share markets namely the Primary and Secondary Markets.

Primary Share Market

It is in the primary market that companies register themselves to issue their shares and raise
money. This process is also known as listing on the stock exchange. The purpose of entering
into the primary market is to raise money and if the company is selling their shares for the
very first time it is referred to as the Initial Public Offering (IPO). Through this process, the
company becomes a public entity.

Secondary Market
The shares of a company are traded in the secondary market once the new securities are sold
in the primary market. This way investors can exit by selling their shares. These transactions
that take place in the secondary market are called trades. It involves the activity of investors
buying from each other and selling amongst themselves at an agreed-upon price. A broker is
an intermediary that facilitates these transactions.

How do the Share Markets work

1. Understanding the Stock Exchange Platform
A stock exchange is precisely a platform that conducts the trading of financial instruments
like stocks and derivatives. The activities on this platform are regulated by the Securities and
Exchange Board of India. The participants have to register with SEBI and the stock exchange
in order to conduct trades. Trading activities include brokering, issuing of shares by
companies, etc.
2. Listing of the Company in the Secondary Market
The shares of a company are listed on the secondary market for the first time through an
Initial Public Offer or IPO. The allotment of stocks takes place before listing and investors
who bid for the stocks get their share depending on the number of investors.
3. Trading in the Secondary Market
Once the company has been listed, stocks can be traded in the secondary market by the
investors. This is the marketplace for the buyers and sellers to transact and make profits or in
some cases, losses.
4. Stock Brokers

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Because of the magnitude of investors who number in the thousands, it is difficult to have
them assemble at one location. Therefore, to conduct trade, stockbrokers and brokerage firms
come into the picture.
These are entities that are registered with the Stock Exchange and serve as intermediaries
between the investors and the exchange itself. When you place an order to buy any share at a
given rate, the broker processes it at the exchange where there are multiple parties involved.

5. Passing of your order

Your buy order is passed on to the exchange by the broker, where it is matched for a sell
order for the same. The exchange takes place when the seller and the buyer agree upon a
price and finalize it; the order is then confirmed.

6. Settlement
Once you finalize a price, the exchange confirms the details to ensure that there is no default
in the transaction. The exchange then facilitates the transfer of ownership of the shares which
is known as Settlement. You receive a message once this takes place. The communication of
this message involves multiple parties like the brokerage order department, the exchange
floor traders, etc.
The settlement time earlier took weeks to materialize which now happens in T+2 days. This
means that if you trade today, the shares are reflected in your Demat account in two working
days time. Investing in the share market is subject to market risks. It is recommended you
seek expert guidance before investing

Bond markets.

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New issue market
A new issue is a stock or bond which is being offered for the first occasion to investors. This
new issue may be a corporation’s Initial Public Offering (IPO) or a new issue floated by an
entity that has previously floated several similar issues.
Where this issue will come is known as the new issue market. The new issue market is
compared to the secondary market, which interacts with existing shares and bonds.
Important Points
● New issues, whether stocks or bonds, are a way for a business to raise money.
● An initial public offering (IPO) is a form of stock offering that allows investors to
purchase a formerly private organization’s stock for the first time.
● Bonds, preferreds, and convertible securities may all be issued as new issues to help a
company collect debt money.
● Bonds are classified debt financing when they are issued as new issues, while stocks
and IPOs are regarded as equity financing when they are issued as new issues.
● Investors should be mindful of the “hype” that surrounds a new problem such as an
IPO, as it can swing either way.
● A secondary offering allows businesses that are already publicly traded to create a
new issue.

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New Issue Market Functions
Here are the major functions of New Issue Market:
1. A new issue is a method of obtaining capital for a business. Companies can
choose between issuing debt (i.e. borrowing) or issuing equity (i.e. stock) (i.e.,
selling a portion of the organization).
2. Irrespective of the path they follow, when those securities are presented for sale
they will be issuing a new issue. To collect funds for government activities,
governments will issue new sovereign debt issues in the shape of Treasury
securities.
3. The new issue would be scrutinized using the debt route (i.e., issuing bonds)
depending on the issuer’s creditworthiness to repay its commitments and entire
economic capacity. Issuing bonds could be a choice that is not easily accessible
if the company is a startup with no sales.

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Trading
There are four main types of forex trading strategies: scalping, day trading, swing trading and
position trading. Different trading styles depend on the timeframe and length of period the
trade is open for.

32
 1. Scalping
Scalping is the most short-term form of trading. Scalp traders only hold positions open for
seconds or minutes at most. These short-lived trades target small intraday price movements.
The purpose is to make lots of quick trades with smaller profit gains, but let profits
accumulate throughout the day due to the sheer number of trades being executed in each
trading session.
2. Day trading
For those that are not comfortable with the intensity of scalp trading, but still don't wish to
hold positions overnight, day trading may suit.
Day traders enter and exit their positions on the same day (unlike swing and position traders),
removing the risk of any large overnight moves. At the end of the day, they close their
position with either a profit or a loss. Trades are usually held for a period of minutes or
hours, and as a result, require sufficient time to analyse the markets and frequently monitor
positions throughout the day. Just like scalp traders, day traders rely on frequent small gains
to build profits.
3. Swing trading
Unlike day traders who hold positions for less than one day, swing traders typically hold
positions for several days, although sometimes as long as a few weeks. Because positions are
held over a period of time, to capture short-term market moves, traders do not need to sit
constantly monitoring the charts and their trades throughout the day.
4. Position trading
Position traders are focused on long-term price movement, looking for maximum potential
profits to be gained from major shifts in prices. As a result, trades generally span over a
period of weeks, months or even years. Position traders tend to use weekly and monthly price
charts to analyse and evaluate the markets, using a combination of technical indicators and
fundamental analysis to identify potential entry and exit levels.

Types of orders

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ORDER is an instruction given by the investor to purchase or sell the stocks on a trading
platform or the broker platform. There are several types of orders in the stock market.

Types of orders in stock market:

1. Market order: it is an order given by the investor to buy securities at the current
market price. This type of order gets executed immediately. The price at which the
order gets executed can’t be guaranteed as the stock prices change within a fraction of
seconds and the last traded price (LTP) changes by the time the order gets executed.
However, the price is nearer to the bid price. In a chart, the body of the candlesticks
represent the market orders.
2. Limit Order: it is an order given by the investor to buy or sell securities at a specific
predetermined price. In other words, the buy limit order gets executed only when the
spot price is less than or equal to the limit price (i.e., spot price <= limit price) and the
sell limit orders get executed only when the spot price is greater than or equal to the
limit price (i.e., spot price >= limit price). Since there is no guarantee that this type of
orders get executed at a later time, they are also known as pending orders. Whenever
limit orders get executed, price rejections are seen.
3. Stop Order: Stop orders are opposite of limit orders,i.e., if an investor wants to
purchase a stock above market price,a buy stop order is initiated at a stop price greater
than the market price. Similarly, if an investor wants to sell a stock below market
price, a sell stop order is initiated at a stop price below the current market price.
4. Stop Loss Order: this type of orders are used by investors when they don’t want to
monitor the stock price continuously. Unlike limit orders which get executed when
they enter a price range, stop loss orders remain inactive until a certain price is passed
and then they are converted to market orders. As soon as it is converted to market
order, the order gets executed at the best price, thereby reducing the loss incurred
5. Stop-limit Order: generally, stop orders get converted to market orders at stop price
and in stop order example, there is a chance of the buy stop order getting executed at
a price of Rs. 110, if there is aggressiveness in the market. But if the investor wants to
buy the stock at Rs. 105 only, then he can initiate a stop-limit order which converts
the stop order to a limit order at Rs.105 and it gets executed only when the price is
less than or equal to the limit price.
● MIS (Margin Intraday Squareup) Orders: this type of orders are used by
intraday traders as MIS orders are intraday orders and they need to be squared off
during the same day. If the trader does not squareoff this type of orders within the
day, they are automatically squared off a few minutes before the close of the
market and it is generally 30 minutes earlier in the case of the commodity and
derivatives market.

34
 ● CNC (Cash N Carry) Orders: this type of orders are positional orders and the
trader will not get any margin, nor will they be automatically squared off. Using
CNC to buy and sell shares on the same day is considered as intraday trade only.
● Bracket Order: it is a type of order in which the investor enters the market with a
buy/sell order along with a target and a stop loss order. When the main order is
executed, the system will initiate the two other orders, i.e., target and stop loss
order and when either of them executes, the other order is canceled. Bracket
orders are only for intraday traders and they will be automatically squared off a
few minutes before the close of the market.
● Cover Order: it is a buy/sell market order along with a compulsory stop loss
order in a specific range, which cannot be canceled. The cover orders are
automatically squared off a few minutes before the market closes and are useful
only for intraday investors. Since the stop loss is compulsory, the leverage/margin
is high.

Settlement
Settlement can be defined as the process of transferring of funds through a central agency,
from payer to payee, through participation of their respective banks or custodians of funds.
The two key elements for payment processing are payment order or message requesting the
transfer of funds to the payee and the actual transfer of funds between the payer's bank and
the payee's bank.
Settlement systems can be classified based on
(i) time - designated-time (or deferred) settlement systems and real-time (or continuous)
settlement systems and
(ii) amount - gross settlement and net settlement.
India has multiple payments and settlement systems, for both gross and net settlement
systems.

Gross Settlement
A gross settlement system is one in which the settlement or funds transfer occurs individually
as and when each payment transaction is processed in the system. Each transaction is settled
on a one-to-one basis without bundling or netting with any other transaction. In some
countries, there are systems in which the final settlement of transfers occurs at the end of the
processing day without netting the credit and debit positions on a transaction-by-transaction
basis. Such systems are called end-of-day gross settlement systems

Net Settlement
In a net settlement system, many transactions are accumulated and offset against each other,
with only the net differential being transferred between members. A participating member's

35
net settlement position, debit or credit, as the case may be, is calculated, on either a bilateral
or a multilateral basis, as the sum of the value of all the transfers it has received up to a
particular point in time minus the sum of the value of all the transfers it has sent. Multilateral
net settlement makes it easier for members to manage their liquidity.

Deferred Settlement
In NEFT, the beneficiary customer receives the funds only after final settlement takes place
between members. However, in a few systems like UPI and IMPS, while funds are credited
to the beneficiary customer immediately, the inter-bank settlement is done later according to
a pre-defined settlement cycle which at present takes place four times a day. This is called
Deferred Settlement and in the case of IMPS and UPI, the settlement.

Unwinding
In a scenario where supervisory action undertaken on a participating member bank by
imposing restrictions on a member bank indicates that a fraudulent / erroneous transaction
was undertaken that needs to be reversed, the member positions or specific transaction may
need to be removed from the settlement file of the payment system by unwinding the
position in the system. This unwinding of payment transactions from the settlement file is
essential for risk mitigation to eliminate settlement risk.

Depository services
Depository services are services in which the securities of investors are kept in an electronic
form just as a bank keeps all your cash in its account and provides all services related to the
transaction of cash,similarly we help you out in performing the service through a demat
account.
Depository services allow investors to hold and transfer securities such as shares, bonds,
equities, and mutual funds in electronic form. It is similar to a bank safekeeping all your cash
in an account and facilitating transactions. The two main depositories in India include:

● National Securities Depository Ltd. (NSDL)

● Central Depository Services Ltd. (CDSL)

National Securities Depository Ltd (NSDL)

NSDL is the oldest and largest depository in India. It commenced operations in 1996 in
Mumbai. It was the first depository to provide trading services in electronic format.
According to data from SEBI, NSDL has around 2.4 crore active investors, with more than
36,123 depository participant service centers across 2,000 cities.
NSDL is entrusted with the safekeeping of the following financial securities in the electronic
format:

36
 ● Stocks
● Bonds
● Debentures
● Commercial papers
● Mutual Fund

Central Depository Services Ltd (CDSL)

CDSL started operations in Mumbai in 1999 and is the second-largest depository in the
country after NSDL.
Like NSDL, it provides all services, like holding financial securities in the electronic format
and facilitating trade and settlement of orders. All forms of stocks and securities - just like
NSDL - are held at this central depository.
According to data from SEBI, it has more than 5.2 crore active customer accounts with
around 21,434 depository participant service centers.

Difference Between NSDL and CDSL

The only difference between both the depositories is their operating markets. While NSDL
has National Stock Exchange (NSE) as the primary operating market, CDSL’s primary
market is the Bombay Stock Exchange (BSE)

Book building process

Book building is a process of price discovery. It is a mechanism where, during the period for
which the IPO is open, bids are collected from investors at various prices, which are above or
equal to the floor price. The offer price is determined after the bid closing date.
Book building is a process by which the issuer company before filing of the prospectus,
builds-up and ascertains the demand for the securities being issued and assesses the price at
which such securities may be issued and ultimately determines the quantum of securities to
be issued.
Under the book building process, the issuing company is required to tie up the issue amount
by way of private placement. The issue price is not priced in advance. It is determined by the
offer of potential investors about the price which they may be willing to pay for the issue. To
tie-up the issue amount, the company organizes road shows and various advertisement
campaigns
During the book building process, the issuer company ties up with a selected group of
individuals and agencies for private placement. The entire exercise is done on a wholesale
basis.
The price of the instrument is the weighted average at which the majority of investors are
willing to buy the instrument. The price is investor driven and based on market forces of

37
demand and supply. Book building refers to the collection of bids from investors, which is
based on an indicative price range, the offer price being fixed after the bid closing date.
Benefits of Book Building:
Book building helps in evaluating the intrinsic worth of the instrument being offered and the
company’s credibility in the eyes of the public. The entire exercise is done on a wholesale
basis
● Price of instrument is determined in a more realistic way on the commitments made
by the prospective investors to the issue
● The prime objective of book building process is to determine the highest market price
for shares and securities and demand level from highest quality investors in order to
adjust pricing and allocation decision.
● Book building is a process of fixing price for an issue on feedback from potential
investors on how they are willing to bid to pick up issues and instruments.
● The process of book building is advantageous to the issuer company as the pricing of
issue would be more realistic as the final price is decided about 11 to 12 days before
the opening of the issue. Book building also offers access to capital more quickly than
the public issue.
● As the issue is pre-sold, there would be no uncertainties relating to the fate of the
issue involved.
● The Issuer company saves advertising and brokerage commissions.
● Issuers can choose investors by quality.
● Optimal demand based pricing is possible.
● Efficient capital raising with improved issue procedures, leading to a reduction in
issue costs, paperwork and lead times.
● Flexibility to increase/decrease price and/or size of offering the issues is possible.
● m) Transparency of allocations is made.
● Upgraded information flow of issues, lead managers, syndicate members and
investors is made possible.
● Book-building process inspires investors' confidence leading to a larger investor
universe.
● Book-building process creates a liquid and buoyant aftermarket.
● Immediate allotment and listing of placement portion of securities.

Limitations of Book Building:

1. Book building is appropriate for mega issues only. In the case of small issues, the
companies can adjust the attributes of the offer according to the preferences of the potential
investors. It may not be possible in big issues, since the risk-return preference of the
investors cannot be estimated easily.

38
2. The issuer company should be fundamentally strong and well known to the investors.
3. The book building system works very efficiently in matured market conditions. In such
circumstances, the investors are aware of various parameters affecting the market price of the
securities. But, such conditions are not commonly found in practice.
4. There is a possibility of price rigging on listing as promoters may try to bailout syndicate
members.

Listing
Listing of Securities
Listing means admission of the securities for trading on the stock exchange through a formal
agreement between the stock exchange and the company. Securities are bought and sold in
the recognized through members who are known as brokers. The price at which the securities
are buy and sales are known as official Quotation

Types of Listing of Securities

1. Initial listing: Here, the shares of the company are listed for the first time on a stock
exchange.
2. Listing for public Issue: When a company which has listed its shares on a stock exchange
comes out with a public issue.
3. Listing for Rights Issue: When the company which has already listed its shares.in the
stock exchange issues securities to the existing shareholders on rights basis.
4. Listing of Bonus shares: When a listed company in a stock exchange is capitalizing its
profit by issuing bonus shares to the existing shareholders.
5. Listing for merger or amalgamation: When the amalgamated company issues new
shares to the shareholders of amalgamated company, such shares are listed.

Advantage of listing
➔ To The Company:
● The company enjoys concessions under direct tax laws.
● The company goodwill increases at the international & national Level.
● Term loan facilities/extend by the financial institution / bankers the form of Rupee
currency and the foreign currency.
● Avoiding the fear of easy takeovers of the organization by others because of wide
distribution.

➔ To the investors
● Maintain liquidity and safety in securities.
● Listed securities are preferred by the bankers for extending term facility. Rule of the
stock exchange protect the interest of the investor.

39
 ● Official quotation of the securities on the stock exchange corroborate the valuation
taken by the investor for the purpose of tax assessments under income tax act , wealth
tax act secondary market

Secondary Market
The secondary market is where investors buy and sell securities they already own. It is what
most people typically think of as the "stock market," though stocks are also sold on the
primary market when they are first issued.
Transactions that occur on the secondary market are termed secondary simply because they
are one step removed from the transaction that originally created the securities in question.
For example, a financial institution writes a mortgage for a consumer, creating the mortgage
security. The bank can then sell it to Fannie Mae on the secondary market in a secondary
transaction.

Some of the Important Functions of Stock Exchange/Secondary Market are listed

below:
1. Economic Barometer:
A stock exchange is a reliable barometer to measure the economic condition of a country.
Every major change in country and economy is reflected in the prices of shares. The rise or
fall in the share prices indicates the boom or recession cycle of the economy. Stock exchange
is also known as a pulse of economy or economic mirror which reflects the economic
conditions of a country.

2. Pricing of Securities:
The stock market helps to value the securities on the basis of demand and supply factors. The
securities of profitable and growth oriented companies are valued higher as there is more
demand for such securities. The valuation of securities is useful for investors, government
and creditors. The investors can know the value of their investment, the creditors can value
the creditworthiness and the government can impose taxes on the value of securities.

3. Safety of Transactions:
In the stock market only the listed securities are traded and stock exchange authorities
include the companies names in the trade list only after verifying the soundness of the
company. The companies which are listed also have to operate within the strict rules and
regulations. This ensures safety of dealing through the stock exchange.

4. Contributes to Economic Growth:

40
In the stock exchange securities of various companies are bought and sold. This process of
disinvestment and reinvestment helps to invest in the most productive investment proposal
and this leads to capital formation and economic growth.

5. Spreading of Equity Cult:

Stock exchange encourages people to invest in ownership securities by regulating new issues,
better trading practices and by educating the public about investment.

6. Providing Scope for Speculation:

To ensure liquidity and demand of supply of securities the stock exchange permits healthy
speculation of securities.

7. Liquidity:
The main function of the stock market is to provide a ready market for sale and purchase of
securities. The presence of the stock exchange market gives assurance to investors that their
investment can be converted into cash whenever they want. The investors can invest in long
term investment projects without any hesitation, as because of stock exchange they can
convert long term investment into short term and medium term.

8. Promotes the Habits of Savings and Investment:

The stock market offers attractive opportunities of investment in various securities. These
attractive opportunities encourage people to save more and invest in securities of corporate
sector rather than investing in unproductive assets such as gold, silver, etc

Online trading
Online trading is a fairly popular method of transacting in financial products online. Brokers
have gone online, with their platforms providing all kinds of financial instruments like
stocks, commodities, bonds, ETFS, and futures.
Online share trading involves buying and selling stocks through an online platform. Using
the online share trading account, you can easily buy or sell share stocks, mutual funds, bonds,
and other securities without the need for an intermediate broker or agent.

Benefits of online trading:

1. It eliminates the middleman:You can buy and sell without even speaking to your
broker. This makes online trading alluring for someone who does not have the
finances to work with full-service brokers.
2. It’s cheaper and faster: When a broker executes your trades, it costs you more
money. On the other hand, when you trade online, a brokerage charge is levied but it

41
 is always less than what a traditional broker who has to place a trade physically,
would charge you. Online trading is almost instantaneous.
3. It offers greater investor control: One of the most important advantages of online
trading is that it gives you greater control over your investments. You can trade
whenever you want with online trading during the trading hours and you can also take
your own decision without any interference from the broker.
4. You can monitor your investments in real time: Your online trading platform has a
lot of advanced tools and interfaces to monitor your investing performance and to do
your own research. You can see real time gains or losses whenever you login from
your phone or computer.

Some Online Trading Platforms

1. Desktop trading software - This is a type of trading software, which has to be
installed on your PC or laptop. You require an active internet connection to operate
the software. It simulates terminal-based trading once installed. This software has
many features to help you make informed decisions about share trading.
2. Browser/Web-based platform - This platform helps trade directly on the
stockbroker’s website, with minimum internet and no downloads. You can get access
the financial services from web-based platforms. These include purchasing Initial
Public Offerings (IPOs), investing in Mutual Funds or bonds, and trading in
derivatives. The key highlight of this platform is the instant execution of orders
along with quick settlements.
3. Mobile-based trading app - Mobile-based apps for both Android and Apple
smartphones are available. The advantage of these apps is that they allow you to trade
on the go. You can do share trading from anywhere, and at any time.

Difference between Online trading and Offline trading

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Risk and return

❖ Concept of Risk
A person making an investment expects to get some returns from the investment in the
future. However, as the future is uncertain, the future expected returns too are uncertain. It is
the uncertainty associated with the returns from an investment that introduces a risk into a
project. The expected return is the uncertain future return that a firm expects to get from its

43
project. The realized return, on the contrary, is the certain return that a firm has actually
earned.
The realized return from the project may not correspond to the expected return. This
possibility of variation of the actual return from the expected return is termed as risk. Risk is
the variability in the expected return from a project. In other words, it is the degree of
deviation from expected return. Risk is associated with the possibility that realized returns
will be less than the returns that were expected. So, when realizations correspond to
expectations exactly, there would be no risk

Types of Risk
Systemic risk
Business organizations are part of society that is dynamic. Various changes occur in a society
like economic, political and social systems that have influence on the performance of
companies and thereby on their expected returns. These changes affect all organizations to
varying degrees. Hence the impact of these changes is system-wide and the portion of total
variability in returns caused by such across the board factors is referred to as systematic risk.
These risks are further subdivided into interest rate risk, market risk, and purchasing power
risk.

Types
1. Market Risk:
market prices of investments, particularly equity shares may fluctuate widely within a short
span of time even though the earnings of the company are not changing. The reasons for this
change in prices may be varied. Due to one factor or the other, investors’ attitude may change
towards equities resulting in the change in market price. Change in market price causes the
return from investment to very. This is known as market risk. The market risk refers to
variability in return due to change in market price of investment
In bull phases, market prices of all shares tend to increase while in bear phases, the prices
tend to decline. In such situations, the market prices are pushed far out of line with the
fundamental value.
2. Interest-rate Risk:
interest rates on risk free securities and general interest rate level are related to each other. If
the risk free rate of interest rises or falls, the rate of interest on the other bond securities also
rises or falls. The interest rate risk refers to the variability in return caused by the change in
level of interest rates
When the interest rate rises, the prices of existing securities fall and vice-versa.
3. Purchasing power or Inflation Risk:
The inflation risk refers to the uncertainty of purchasing power of cash flows to be received
out of investment. It shows the impact of inflation or deflation on the investment. The

44
inflation risk is related to interest rate risk because as inflation increases, the interest rates
also tend to increase. The reason being that the investor wants an additional premium for
inflation risk (resulting from decrease in purchasing power). Thus, there is an increase in
interest rate.
If an investor makes an investment, he forgoes the opportunity to buy some goods or services
during the investment period. If, during this period, the prices of goods and services go up,
the investor losses in terms of purchasing power

Unsystematic risk
The returns of a company may vary due to certain factors that affect only that company.
Examples of such factors are raw material scarcity, labour strike, management inefficiency,
etc. When the variability in returns occurs due to such firm-specific factors it is known as
unsystematic risk. This risk is unique or peculiar to a specific organization and affects it in
addition to the systematic risk. These risks are subdivided into business risk and financial
risk.

Types
1. Business Risk:
Business risk refers to the variability in incomes of the firms and expected dividend there
from, resulting from the operating condition in which the firms have to operate.
2. Financial Risk:
It refers to the degree of leverage or degree of debt financing used by a firm in the capital
structure. Higher the degree of debt financing, the greater is the degree of financial risk. The
presence of interest payment brings more variability in the earnings available for equity
shares. This is also known as financial leverage. A firm having lesser or no risk financing has
lesser or no financial risk.

Minimizing Risk

8 Strategies to Reduce Investment Risks:

1. Understand your Risk Tolerance:
Risk Tolerance refers to the ability of an investor to endure the risk of losing their capital i.e.
invested. Risk tolerance mainly depends on the investor’s age and current financial
obligations. For example, if you are in your mid-20s, unmarried and have fewer financial
responsibilities then you are more risk-tolerant compared to the other investors who are in
their late 50s and are married with college-going children. So as the general rule, younger
investors are more risk-tolerant than older investors.
2. Keep Sufficient Liquidity in your Portfolio:

45
Beware! A financial emergency can come anytime! So, we need to redeem our investments
anytime even when the markets are down. This risk can be reduced if we maintain adequate
liquidity. If we have liquid assets in our portfolio, then our existing investments can deliver
optimal long-term returns and we will be able to benefit from any periodic market
corrections
3. The Asset Allocation Strategy:
Asset Allocation refers to investing in more than one asset class for reducing the investment
risks and this strategy also provides us with optimal returns. We can invest in a perfect mix
of key asset classes like Equity, Debt, Mutual Funds, Real Estate, Gold etc.
4. Diversify, Diversify and Diversify:
After we have found our perfect mix of asset classes for our portfolio, we can further reduce
the overall investment risk by diversifying our investment in the same asset class. This
means that if we are investing in Equity Mutual funds, then we should diversify in this asset
class by investing in large, middle or small-cap equity mutual funds.
5. Instead of Timing the Market, Focus on Time in the Market:
Rather than making a quick buy by timing the market, we should focus on staying for a
longer time in the market. Only then can we take the benefit of compounding. If we are
invested for a longer time in the stock market, then the smaller corrections won’t affect our
portfolio and will reduce the overall investment risk.
6. Do your Due Diligence:
Always do your due diligence, before investing in any type of investment tool as you are
responsible for your finances. For example, if you are buying a stock for long term
investment purposes then you must check how the management is performing and certain
key ratios suck Debt-Equity ratio, PE, etc. By doing fundamental analysis we will get an idea
of how the company will perform in the upcoming years
7. Invest in Blue-Chip Stocks:
To avoid liquidity risk, it is always better to stay invested in a blue-chip stock or fund.
Investors should check the credit rating of debt securities to avoid default risk.
Remember that all types of investment products have some other risks. As we have discussed
earlier one should consider their risk appetite before deciding on any investment. One should
be careful that investment decisions should not affect their lifestyle.
8. Monitor Regularly:
After considering all the factors above, one should monitor their portfolio regularly. If you
are a long-term investor, that doesn’t mean that you invest and forget about your portfolio.
You need to regularly keep a watch on your portfolio’s performance and do periodic reviews.

Portfolio review should be done once in six months, that’s because some asset classes like
equities are prone to short-term volatility, as a long-term investor you should overlook

46
short-term volatility and only change when your investments show poor performance over an
extended period.

Risk management
Risk management is the process of identifying, assessing and controlling threats to an
organization's capital and earnings. These risks stem from a variety of sources including
financial uncertainties, legal liabilities, technology issues, strategic management errors,
accidents and natural disasters.
A successful risk management program helps an organization consider the full range of risks
it faces. Risk management also examines the relationship between risks and the cascading
impact they could have on an organization's strategic goals.

5 Basic Methods for Risk Management

Avoidance
Avoidance is a method for mitigating risk by not participating in activities that may incur
injury, sickness, or death. Smoking cigarettes is an example of one such activity because
avoiding it may lessen both health and financial risks.

Retention
Retention is the acknowledgment and acceptance of a risk as a given. Usually, this accepted
risk is a cost to help offset larger risks down the road, such as opting to select a lower
premium health insurance plan that carries a higher deductible rate. The initial risk is the cost
of having to pay more out-of-pocket medical expenses if health issues arise. If the issue
becomes more serious or life-threatening, then the health insurance benefits are available to
cover most of the costs beyond the deductible. If the individual has no serious health issues
warranting any additional medical expenses for the year, then they avoid the out-of-pocket
payments, mitigating the larger risk altogether.

Sharing
Sharing risk is often implemented through employer-based benefits that allow the company
to pay a portion of insurance premiums with the employee. In essence, this shares the risk
with the company and all employees participating in the insurance benefits. The
understanding is that with more participants sharing the risks, the costs of premiums should
shrink proportionately. Individuals may find it in their best interest to participate in sharing
the risk by choosing employer health care and life insurance plans when possible.

Transferring

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The use of health insurance is an example of transferring risk because the financial risks
associated with health care are transferred from the individual to the insurer. Insurance
companies assume the financial risk in exchange for a fee known as a premium and a
documented contract between the insurer and individual. The contract states all the
stipulations and conditions that must be met and maintained for the insurer to take on the
financial responsibility of covering the risk.

Loss Prevention and Reduction

This method of risk management attempts to minimize the loss, rather than completely
eliminate it. While accepting the risk, it stays focused on keeping the loss contained and
preventing it from spreading. An example of this in health insurance is preventative care.

❖ Concept of Return
Return can be defined as the actual income from a project as well as appreciation in the value
of capital. Thus there are two components in return—the basic component or the periodic
cash flows from the investment, either in the form of interest or dividends; and the change in
the price of the asset, commonly called as the capital gain or loss.
In connection with return we use two terms—realized return and expected or predicted
return. Realized return is the return that was earned by the firm, so it is historic. Expected or
predicted return is the return the firm anticipates to earn from an asset over some future
period.

Measurement of risks and return

★ Measurement of Risk:
Quantification of risk is known as measurement of risk.
Two approaches are followed in measurement of risk:
(i) Mean-variance approach, and
(ii) Correlation or regression approach.
Mean-variance approach is used to measure the total risk, i.e. sum of systematic and
unsystematic risks. Under this approach the variance and standard deviation measure the
extent of variability of possible returns from the expected return and is calculated as:

Where,
Xi = Possible return,

48
 P = Probability of return,
and n = Number of possible returns.

Correlation or regression method is used to measure the systematic risk. Systematic risk is
expressed by β and is calculated by the following formula:

Where,
rim = Correlation coefficient between the returns of stock i and the return of the market
index, σ
m = Standard deviation of returns of the market index, and
σi = Standard deviation of returns of stock i.

Using regression method we may measure the systematic risk

The form of the regression equation is as follows:

Where,
n = Number of items,
Y = Mean value of the company’s return,
X = Mean value of return of the market index,
α = Estimated return of the security when the market is stationary, and
β = Change in the return of the individual security in response to unit change in the return of
the market index.

★ Measurement of Return

𝑛
Return 𝑥 = ∑ 𝑥𝑖 × 𝑝(𝑥𝑖)
𝑡=1
Where,

49
𝑥 = Expected return
xi= Possible return
p(xi)= probability of getting possible return

Beta (β)
Beta shows the relationship between the market risk (systematic risk) and security return. It
is denoted by the Greek letter beta β

UNIT III
SECURITY ANALYSIS

Security Analysis

Security analysis is the analysis of tradable financial instruments called securities. It deals
with finding the proper value of individual securities (i.e., stocks and bonds). These are
usually classified into debt securities, equities, or some hybrid of the two. Tradeable credit
derivatives are also securities. Commodities or futures contracts are not securities. They are
distinguished from securities by the fact that their performance is not dependent on the
management or activities of an outside or third party. Options on these contracts are however
considered securities, since performance is now dependent on the activities of a third party.

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Types of analysis

● Fundamental analysis
● Technical analysis
● Quantitative analysis

Fundamental analysis
Fundamental analysis is the process of evaluating a security to make forecasts about its
future price. For a stock, fundamental analysis typically includes reviewing many elements
related to stock prices, including: Performance of the overall industry the company
participates in. Domestic political conditions.

Technical analysis
Technical analysis is a form of security analysis that uses price data and volume data,
typically displayed graphically in charts. The charts are analyzed using various indicators in
order to make investment recommendations.

Quantitative analysis
Quantitative analysis is applied to the measurement, performance evaluation, valuation of a
financial instrument, and predicting real-world events such as changes in a country's gross
domestic product (GDP).

Fundamental Analysis
fundamental analysis is a method of assessing the intrinsic value of a security by analyzing
various macroeconomic and microeconomic factors. The ultimate goal of fundamental

51
analysis is to quantify the intrinsic value of a security. The security’s intrinsic value can then
be compared to its current market price to help with investment decisions.

Components of financial analysis

Fundamental analysis consist of three parts

1. Economic analysis
2. Industry analysis
3. Company analysis

Economic Analysis
Economic Analysis relates to the analysis of the economy.This is related to study about the
economy in details and analysis whether economic conditions are favorable for the
companies to prosper or not.Analysts always try to find out whether the economic
development is conducive for the growth of the company.

● Performance of economy
● Economic forecasting
● anticipatory surveys
● barometric approach
● Econometric model building
● Opportunistic model building
Factors of economic analysis

Major Tools of economic analysis

● Gross Domestic Product

● Fiscal Policy
● Monetary Policy
● Saving Rate
● Trade Deficit
● Exchange Rate

Industry analysis

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Industry analysis is a market assessment tool used by businesses and analysts to understand
the competitive dynamics of an industry. It helps them get a sense of what is happening in an
industry, e.g., demand-supply statistics, degree of competition within the industry, state of
competition of the industry with other emerging industries, future prospects of the industry
taking into account technological changes, credit system within
the industry, and the influence of external factors on the
industry.

Types of industry analysis

There are commonly three methods

1. Competitive forces model( porters 5 forces model)

2. PESTLE analysis
3. SWOT Analysis

Company analysis
Company analysis is a process carried out by investors to evaluate securities, collecting info
related to the company’s profile, products and services as well as profitability. It is also
referred to as ‘fundamental analysis.’ A company analysis incorporates basic info about the
company, like the mission statement and apparition and the goals and values. During the
process of company analysis, an investor also considers the company’s history, focusing on
events which have contributed in shaping the company.

● Analysis of financial statements

● Financial performance
● Financial ratios –comparative analysis
● Assessment of risk Estimation of future returns

Measuring earnings,
A company's earnings are its after-tax net income. This is the company's bottom line or its
profits. Earnings are perhaps the single most important and most closely studied number in a
company's financial statements.

Forecasting earnings,
To predict earnings, most analysts build financial models that estimate prospective revenues
and costs. Many analysts will incorporate top-down factors such as economic growth rates,
currencies and other macroeconomic factors that influence corporate growth.

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Valuation of fixed income securities
A fixed-income security is an investment that provides a return in the form of fixed periodic
interest payments and the eventual return of principal at maturity. Unlike variable-income
securities, where payments change based on some underlying measure—such as short-term
interest rates—the payments of a fixed-income security are known in advance.

Examples of Fixed Income Securities

● Treasury Bills (T-Bills)
● Treasury Notes (T-Notes)
● Treasury Bonds (T-Bonds)
● Corporate Bonds.
● Municipal Bonds.
● Certificates of Deposit (CDs)
A fixed-income bond can be valued using a market discount rate, a series of spot rates, or a
series of forward rates.
A bond yield-to-maturity can be separated into a benchmark and a spread.

Common stock valuation Stock valuation is the process of determining the intrinsic value
of a share of common stock of a company. There are two approaches 0to value a share of
common stock: (a) absolute valuation i.e. the discounted cashflow method and (b) relative
valuation (also called the comparables approach).

Share Valuation Models

The market model says that the return on a security depends on the return on the market
portfolio and the extent of the security's responsiveness as measured by beta. The return also
depends on conditions that are unique to the firm.

1. One year holding

So = D + S / (1+r)²

2. multiple year holding

So= D1/(1+r)¹ + D2 /(1+r)² + D3/(1+r)³+.........+ Sn/(1+r)³

Constant growth model ( Gordon Growth )

The Constant Growth Model is a way of share evaluation. Also known as Gordon Growth
Model, it assumes that the dividends paid by the company will continue to go up at a

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constant growth rate indefinitely. It helps investors determine the fair price to pay for a stock
today based on future dividend payments.
The constant growth model, or Gordon Growth Model, is a way of valuing stock. It assumes
that a company's dividends are going to continue to rise at a constant growth rate indefinitely.
You can use that assumption to figure out what a fair price is to pay for the stock today based
on those future dividend payments.

Multiple growth model

The multistage dividend discount model is an equity valuation model that builds on the
Gordon growth model by applying varying growth rates to the calculation. Under the
multistage model, changing growth rates are applied to different time periods.
Multi-stage models describe how systems can fail through one or more possible routes. They
are sometimes described as “multi-step” or “multi-hit” models , because each route typically
requires failure of one or more sequential or non-sequential steps

Bond valuation and yields

A bond is a fixed income instrument that represents a loan made by an investor to a

borrower (typically corporate or governmental). A bond could be thought of as an I.O.U
[“I Owe You”] between the lender and borrower that includes the details of the loan and
its payments. Bonds are used by companies, municipalities, states, and sovereign
governments to finance projects and operations. Owners of bonds are debt holders, or
creditors, of the issuer. Bond details include the end date when the principal of the loan is
due to be paid to the bond owner and usually includes the terms for variable or fixed
interest payments made by the borrower.

• Bonds are units of corporate debt issued by companies and securitized as tradable
assets.
• A bond is referred to as a fixed income instrument since bonds traditionally pay a
fixed interest rate (coupon) to debt holders. Variable or floating interest rates are
also now quite common.
• Bond prices are inversely correlated with interest rates: when rates go up, bond
prices fall and vice-versa.
• Bonds have maturity dates at which point the principal amount must be paid back
in full or risk default.

Governments (at all levels) and corporations commonly use bonds in order to borrow
money. Governments need to fund roads, schools, dams or other infrastructure. The
sudden expense of war may also demand the need to raise funds.

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 Similarly, corporations will often borrow to grow their business, to buy property and
equipment, to undertake profitable projects, for research and development or to hire
employees. The problem that large organizations run into is that they typically need far
more money than the average bank can provide. Bonds provide a solution by allowing
many individual investors to assume the role of the lender. Indeed, public debt markets let
thousands of investors each.
lend a portion of the capital needed. Moreover, markets allow lenders to sell their bonds to
other investors or to buy bonds from other individuals—long after the original issuing
organization raised capital.

Yield is a general term that relates to the return on the capital the investor invests
in a bond.
There are several definitions that are important to understand when talking about yield as it
relates to bonds: coupon yield, current yield, yield-to-maturity, yield-to-call and
yield-to-worst

Bonds duration and yield analysis

The basic yield concepts are:

● Coupon yield is the annual interest rate established when the bond is issued. It’s the
same as the coupon rate and is the amount of income you collect on a bond,
expressed as a percentage of your original investment. If an investor buys a bond for
$1,000 and receives $45 in annual interest payments, the coupon yield is 4.5 percent.
This amount is figured as a percentage of the bond’s par value and will not change
during the lifespan of the bond
● Current yield is the bond’s coupon yield divided by its market price

Yield to maturity (YTM) is the overall interest rate earned by an investor who buys a bond
at the market price and holds it until maturity. Mathematically, it is the discount rate at
which the sum of all future cash flows (from coupons and principal repayment) equals the
price of the bond. YTM is often quoted in terms of an annual rate and may differ from the
bond’s coupon rate. It assumes that coupon and principal payments are made on time. It
does not require dividends to be reinvested, but computations of YTM generally make that
assumption. Further, it does not consider taxes paid by the investor or brokerage costs
associated with the purchase.

Yield to call (YTC) is figured the same way as YTM, except instead of plugging in the
number of months until a bond matures; you use a call date and the bond’s call price. This

56
calculation takes into account the impact on a bond’s yield if it is called prior to maturity
and should be performed using the first date on which the issuer could call the bond.

Yield to worst (YTW) is whichever of a bond’s YTM and YTC is lower. If you want to
know the most conservative potential return a bond can give you—and you should know it
for every callable security—then perform this comparison.

Yield reflecting broker compensation is the yield adjusted by the amount of the mark-up
or commission (when purchased) or mark-down or commission (when sold) and other fees
or charges that are charged by the broker for its services.

Interest rates regularly fluctuate, making each reinvestment at the same rate virtually
impossible. Thus, YTM and YTC are estimates only, and should be treated as such. While
helpful, it’s important to realize that YTM and YTC may not be the same as a bond’s total
return. Such a figure is only accurately computed when a bond is sold or when it matures.

Bond Risk

Generally stocks are considered to be risky but bonds are not. This is not absolutely correct .
Bonds do carry risks, but the nature and types of risks may be different . The risks are related
to the interest rate, default, marketability, and callability.

● Interest rate risk

Variability in the return from the debt instruments to investors is caused by the
changes in the market interest rate. This is known as the interest rate risk. Changes in
interest rates affect bonds more directly than they affect equity. There is a relationship
between the coupon rate and market interest rate. If the market interest rate moves up
, the price of the bond declines and vice versa.

● Default risk

The failure to pay the agreed value of the debt instrument by the issuer in full , on
time , or both is known as default risk. Treasury bills and bonds issued by the central
government are devoid of this risk. The same cannot be assured of bonds/debentures
issued by corporate bodies. One of the steps taken to avoid default risk is to have
rating agencies rate the capacity of a company to serve the debt. Regulators such as
RBI and SEBI use credit rating to determine the eligibility of the fixed income
instruments.

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 ● Marketability risk

Variations in return caused by difficulties in selling the bonds quickly without having to
make a substantial price concession is known as marketability risk .This risk is different from
the market risk that affects all securities in the market in that it is a specific risk. The
marketability or liquidity of a particular bond depends on the corporate entity that issues it.

● Callability risk

The uncertainty created for the investor’s return by the issuer’s ability to call the bond
at any time is known as callability risk. Debt instruments used to carry a call option.
The call option provides the issuer the right to call back the instruments by redeeming
them. This facility provides a way out for the issuer if the market interest rate declines
.Since the bond or debenture can be called at any time , there is uncertainty regarding
the maturity period. This feature of the bond may depress the price of the bond and
the uncertainty element attached to callable bonds makes the investors ask for higher
yields.

Bond duration
Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a
change in interest rates. A bond's duration is easily confused with its term or time to maturity
because certain types of duration measurements are also calculated in years.
Bond duration is a way of measuring how much bond prices are likely to change if and when
interest rates move. In more technical terms, bond duration is measurement of interest rate
risk. Understanding bond duration can help investors determine how bonds fit into a broader
investment portfolio.

Term structure theories and valuation of options,

The bond portfolio manager is often concerned with two aspects of interest rates the interest
rate level and
the term structure of interest rates. The relationship between the yield and time or years to
maturity is called the term structure. The term structure is also known as yield curve. In
analysing the effect of maturity on yield and all other influences are held constant. Usually,
pure discount instruments are selected to eliminate the effect of coupon payments. The
selected bonds should not have early redemption features. The maturity dates are different,
but the risks, tax liabilities, and redemption possibilities are similar.

58
The general perception is that the curve will be upward moving up to a point and then
become flat. This is shown in Figure

Theories of Term Structure of Interest Rates:

There are at least three competing theories that attempt to explain the term structure of
interest
1. The Expectations Theory:
This theory was developed by J R Hicks (1939), F Lutz (1940), and B Malkiel (1966).
According to the expectation theory, the shape of the curve can be explained by the
expectations of investors about future interest rates. If the short-term rates are expected to be
relatively low in the future, then the long-term rate will be below the short-term rate. There
are three reasons for investors to anticipate a fall in the interest rate.
1. Anticipation of the fall in the inflation rate and reduction in the inflation premium
2. Anticipation of a balanced budget or cut in the fiscal deficit
3. Anticipation of recession in the economy, and a fall in the demand for funds by
private companies
The long-term rates will exceed the current short-term rates, if there is an expectation that the
market rates will be higher in the future. Thus, the yield curve depends upon the expectations
of the investors. This is illustrated in Figure

Its Assumptions:
1. All investors have definite expectations with respect to future short-term interest rates, and
these expectations are held with complete confidence.

59
2. The objective of investors is to maximize expected profits, and they are prepared to
transfer funds freely from one maturity to another in order to achieve this objective.
3. There are no costs associated with investment and disinvestment in securities. It means
that there are no transaction costs.
4. The short-term and long-term interest rates are adjusted for any differences due to risk and
liquidity.
5. ‘Safe’ securities of various maturities are perfect substitutes in the portfolios of investors.
6. Investors are profit maximisers who hold such financial assets in their portfolios which
maximize return over a period they are held.
7. All investors hold with certainty the same expectations of how future rates are going to
behave.

A rising yield curve (a) indicates investors' expectations of a continuous rise in interest rates.
A flat yield curve (b) means that investors expect the interest rate to remain constant. A
declining yield curve (c) shows that investors expect the interest rate to decline.

2. Liquidity preference theory:

Keynes liquidity preference theory as advocated by J R Hicks (1939) accepts that
expectations influence the shape of the yield curve. In a world of uncertainty, it would be
more desirable for investors to invest in short-term bonds than in long-term ones because of
their greater liquidity. If no premium exists for holding long-term instruments, investors
would prefer to hold short-term bonds to minimize the possible variation in the nominal
value of their portfolio.

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The exponents of the liquidity preference theory believe that investors prefer the short term
rather than the long term. Hence, they have to be motivated to buy the long-term bonds or
lengthen the investment horizon. The bond issuing corporation or contributor pays a
premium to motivate the investors to buy. This liquidity premium theory asserts that over
time the forward rates are actually higher than the projected interest rate.

3. The Segmented Markets Theory:

Critics of the expectations theory, such as J Culbertson (1957), and F V Modigliani and R.
Sutch (1966) pointed out that liquidity preferences cannot be the main consideration for all
classes of investors. In their view, insurance companies, pension funds, and even retired
persons prefer long-term rather than short-term securities to avoid possible fluctuations in the
interest rate. This can be explained in detail.
Life insurance companies offer insurance policies that do not require any payment for a long
time. For example, an insurance policy issued to a 25-year-old may involve another 20 or
more years before the company has to make a payment. Premium payments are fixed by the
expected future rate of interest. If the insurance company invests the funds in a long-term
bond, the interest the bond would earn is certain and if the earned interest rate is higher than
the promised interest rate, the company stands to gain, and its risk is also reduced. If it
invests in one-year bonds, the risk of reinvestment is there and if there is a fall in the market
interest rate, the insurance company stands to lose, and it would be difficult for the company
to meet its obligation. This leads insurance companies to prefer long-term bonds to
short-term ones.
On the other hand, commercial banks and corporates may prefer liquidity to meet their
short-term requirements and therefore, they prefer short-term issues. The supply of and
demand for funds are segmented in sub-markets because of the preferred habits of
individuals. Thus, the yield is determined by the demand for and supply of funds.
Its Assumptions:
1. Assets of different maturities are imperfect substitutes with each other.
2. Markets for assets of different maturities are divided into separate markets.
3. Interest rates for one type of asset in every market are determined by their demand and
supply which, in turn, affect the yield to maturity.
4. There is uncertainty about the behavior of interest rates in future.

Technical analysis
Technical analysis is a trading discipline employed to evaluate investments and identify
trading opportunities in price trends and patterns seen on charts. Technical analysts believe
past trading activity and price changes of a security can be valuable indicators of the
security's future price movements.

61
Technical analysis tools are used to scrutinize the ways supply and demand for a security will
affect changes in price, volume, and implied volatility. It operates from the assumption that
past trading activity and price changes of a security can be valuable indicators of the
security's future price movements when paired with appropriate investing or trading rules.

Theories –Dow flow theory, Chart analysis

Dow Theory
The Dow Theory is a financial theory that says the market is in an upward trend if one of
its averages (i.e. industrials or transportation) advances above a previous important high
and is accompanied or followed by a similar advance in the other average.
The Dow Theory is a technical framework that predicts the market is in an upward trend if
one of its averages advances above a previous important high, accompanied or followed by
a similar advance in the other average.

The theory is predicated on the notion that the market discounts everything in a way
consistent with the efficient markets hypothesis.
• In such a paradigm, different market indices must confirm each other in terms of
price action and volume patterns until trends reverse.

The Dow Theory is an approach to trading developed by Charles H. Dow who, with
Edward Jones and Charles Bergstresser, founded Dow Jones & Company, Inc. and
developed the Dow Jones Industrial Average in 1896. Dow fleshed out the theory in a
series of editorials in the Wall Street Journal, which
he co-founded. Dow believed that the stock market as a whole was a reliable measure of
overall business conditions within the economy and that by analyzing the overall
market; one could accurately gauge those conditions and identify the direction of major
market trends and the likely direction of individual stocks.

There are six main components to the Dow Theory:

1.The Market Discounts Everything

The Dow Theory operates on the efficient markets hypothesis (EMH), which states that
asset prices incorporate all available information. In other words, this approach is the
antithesis of behavioral economics.
Earnings potential, competitive advantage, management competence—all of these factors
and more are priced into the market, even if not every individual knows all or any of these
details.

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2.There Are Three Primary Kinds of Market Trends
Markets experience primary trends which last a year or more, such as a bull or bear
market. Within these broader trends, they experience secondary trends, often working
against the primary trend, such as a pullback within a bull market or a rally within a bear
market; these secondary trends last from three weeks to three months. Finally, there are
minor trends lasting less than three weeks, which are largely noise.

3.Primary Trends Have Three Phases

A primary trend will pass through three phases, according to the Dow Theory. In a bull
market, these are the accumulation phase, the public participation (or big move) phase,
and the excess phase. In a bear market, they are called the distribution phase, the public
participation phase, and the panic (or despair) phase.

4.Indices Must Confirm Each Other

In order for a trend to be established, Dow postulated indices or market averages must
confirm each other. This means that the signals that occur on one index must match or
correspond with the signals on the other. If one index, such as the Dow Jones Industrial
Average, is confirming a new primary uptrend, but another index remains in a primary
downward trend, traders should not assume that a new trend has begun.

5.Volume Must Confirm the Trend

Volume should increase if the price is moving in the direction of the primary trend and
decrease if it is moving against it. Low volume signals a weakness in the trend. For
example, in a bull market, the volume should increase as the price is rising, and fall during
secondary pullbacks. If in this example the volume picks up during a pullback, it could be a
sign that the trend is reversing as more market participants turn bearish.

6. Trends Persist Until a Clear Reversal Occurs

Reversals in primary trends can be confused with secondary trends. It is difficult to
determine whether an upswing in a bear market is a reversal or a short-lived rally to be
followed by still lower lows, and the Dow Theory advocates caution, insisting that a
possible reversal be confirmed.

Chart Analysis
Charts are graphical presentations of price information of securities over time. Charts plot
historical data based on a combination of price, volume as well as time intervals.

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The use of charts is so prevalent, that technical analyst is often referred to as chartists.
Originally, charts were drawn manually, but a majority of charts nowadays are drawn by
computer.

Types of Chart
The main chart types used by technical analysts are the line chart, bar chart, candlestick
chart, Renko Chart, Point-and-Figure charts, etc. Charts can also be presented on an
arithmetic or logarithmic scale. The types of charts and the scale used depend upon what
information the technical analyst considers to be most important, and which charts and
which scale ideally shows that information.\

1. Line Charts: Line charts are the most basic form of charts, They are composed of a
single line from left to right that links the closing prices. Generally, only the closing
price is graphed, presented by a single point.This is a popular type of chart used in
presentations and reports to give a very general view of the historical and current
direction.

2. Bar Chart: One of the basic tools of technical analysis is the bar chart. Bar charts are
also referred to as open-high-low-close (OHLC) charts. They are comprised of a
series of vertical lines that indicate the price range during that Time Frame.
If the opening price is lower than the closing price, the line is often colored black (or
green) to represent a rising period. The opposite is true for a falling period, which is
represented by a red color.

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 3. Candlestick Chart: Another kind of chart used in the technical analysis is the
candlestick chart, so-called because the main component of the chart which represents
prices looks like a candlestick, with a thick ‘body’ and usually, a line extending above
and below it, called the upper shadow and lower shadow, respectively.

The top of the upper shadow represents the high price, while the bottom of the lower
shadow shows the low price. Patterns are formed both by the real body and the
shadows. Candlestick patterns are most useful over short periods of time, and mostly
have significance at the top of an uptrend or the bottom of a downtrend, when the
patterns most often indicate a reversal of the trend.
4. Renko Chart: Unlike the other Charts, the Renko Chart is a noise-less charting
technique that concentrates merely on price movements, completely disregarding time
and the usage of volumes.
This Chart consists of white/green and black/red bricks. These are placed depending
on whether the price rose or not compared with the previous brick. If it did by enough
value, established by the brick size, a new one is placed. White/Green bricks are used
when the price of the security goes up and black/red bricks when they go down.

Efficient market hypothesis.

The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is
a hypothesis that states that share prices reflect all information and consistent alpha
generation is impossible.
The efficient market hypothesis (EMH) or theory states that share prices reflect all
information. The EMH hypothesizes that stocks trade at their fair market value on exchanges.

65
Proponents of EMH posit that investors benefit from investing in a low-cost, passive
portfolio.

Types of EMH
There are three forms of EMH: weak, semi-strong, and strong.1 Here's what each says about
the market.
Weak Form EMH: Weak form EMH suggests that all past information is priced into
securities. Fundamental analysis of securities can provide you with information to produce
returns above market averages in the short term. But no "patterns" exist. Therefore,
fundamental analysis does not provide a long-term advantage, and technical analysis will not
work.
Semi-Strong Form EMH: Semi-strong form EMH implies that neither fundamental analysis
nor technical analysis can provide you with an advantage. It also suggests that new
information is instantly priced into securities.
Strong Form EMH: Strong form EMH says that all information, both public and private, is
priced into stocks; therefore, no investor can gain advantage over the market as a whole.
Strong form EMH does not say it's impossible to get an abnormally high return. That's
because there are always outliers included in the averages.

UNIT IV
PORTFOLIO MANAGEMENT

Portfolio management
Portfolio management is the selection, prioritization and control of an organization’s
programmes and projects, in line with its strategic objectives and capacity to deliver.

The goal is to balance the implementation of change initiatives and the maintenance of
business-­as­-usual, while optimizing return on investment.
A portfolio is a collection of projects and/or programmes used to structure and manage
investments at an organizational or functional level to optimize strategic benefits or
operational efficiency. They can be managed at an organizational or functional level.
Where projects and programmes are focused on deployment of outputs, and outcomes and
benefits, respectively, portfolios exist as coordinating structures to support deployment by
ensuring the optimal prioritization of resources to align with strategic intent and achieve best
value

Steps involved in Portfolio management process

Portfolio management involves a complex process with the following steps to be followed
carefully.

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 1. Identification of objectives and constraints.
2. Selection of the asset mix.
3. Formulation of portfolio strategy
4. Security analysis
5. Portfolio execution
6. Portfolio revision
7. Portfolio evaluation.

1. Identification of objectives and constraints

The primary step in the portfolio management process is to identify the limitations and
objectives. The portfolio management should focus on the objectives and constraints of an
investor in the first place. The objective of an Investor may be income with minimum
amount of risk, capital appreciation or for future provisions. The relative importance of these
objectives should be clearly defined.

2. Selection of the asset mix

The next major step in the portfolio management process is identifying different assets that
can be included in the portfolio in order to spread risk and minimize loss.

In this step, the relationship between securities has to be clearly specified. Portfolios may
contain the mix of Preference shares, equity shares, bonds etc. The percentage of the mix
depends upon the risk tolerance and investment limit of the investor.

3. Formulation of portfolio strategy

After a certain asset mix is chosen, the next step in the portfolio management process is
formulation of an appropriate portfolio strategy. There are two choices for the formulation of
portfolio strategy, namely
● an active portfolio strategy; and
● a passive portfolio strategy.
An active portfolio strategy attempts to earn a superior risk adjusted return by adopting
market timing, switching from one sector to another sector according to market condition,
security selection or a combination of all of these.

4. Security analysis
In this step, an investor actively involves himself in selecting securities.
Security analysis requires the sources of information on the basis of which analysis is made.
Securities for the portfolio are analyzed taking into account of their price, possible return,
risks associated with it etc

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5. Portfolio execution
When selection of securities for investment is complete the execution of the portfolio plan
takes the next stage in a portfolio management process. Portfolio execution is related to
buying and selling of specified securities in given amounts. As portfolio execution has a
bearing on investment results, it is considered one of the important step in portfolio
management.

6. Portfolio revision
Portfolio revision is one of the most important steps in portfolio management. A portfolio
manager has to constantly monitor and review scripts according to the market condition.
Revision of portfolio includes adding or removing scripts, shifting from one stock to another
or from stocks to bonds and vice versa.

7. Performance evaluation
Evaluating the performance of a portfolio is another important step in portfolio management.
Portfolio manager has to assess the performance of the portfolio over a selected period of
time. Performance evaluation includes assessing the relative merits and demerits of the
portfolio, risk and return criteria, adherence of the portfolio management to publicly stated
investment objectives or some combination of these factors.’
Performance evaluation gives useful feedback to improve the quality of the portfolio
management process on a continuing basis.

Markowitz portfolio theory or Modern Portfolio Theory (MPT)

Markowitz model is a set of efficient frontier. Efficient portfolio means maximum expected
return for a given level of risk or it offers minimum risk for a given level of expected return
● The modern portfolio theory (MPT) is a method that can be used by risk-averse
investors to construct diversified portfolios that maximize their returns without
unacceptable levels of risk.
● The modern portfolio theory can be useful to investors trying to construct efficient
and diversified portfolios using ETFs.
● Investors who are more concerned with downside risk might prefer the post-modern
portfolio theory (PMPT) to MPT.

Modern portfolio theory argues that any given investment's risk and return characteristics
should not be viewed alone but should be evaluated by how it affects the overall portfolio's
risk and return. That is, an investor can construct a portfolio of multiple assets that will result
in greater returns without a higher level of risk.

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Benefits of the MPT
The MPT is a useful tool for investors who are trying to build diversified portfolios. In fact,
the growth of exchange-traded funds (ETFs) made the MPT more relevant by giving
investors easier access to a broader range of asset classes.
● MPT is a useful tool for investors trying to build diversified portfolios. In fact, the
growth of exchange traded funds (ETFs) made MPT more relevant by giving
investors easier access to different asset classes. Stock investors can use MPT to
reduce risk by putting a small portion of their portfolios in government bond ETFs.
The variance of the portfolio will be significantly lower because government bonds
have a negative correlation with stocks. Adding a small investment in Treasuries to a
stock portfolio will not have a large impact on expected returns because of this loss
reducing effect.3
● Similarly, MPT can be used to reduce the volatility of a U.S. Treasury portfolio by
putting 10% in a small-cap value index fund or ETF. Although small-cap value
stocks are far riskier than Treasuries on their own, they often do well during periods
of high inflation when bonds do poorly. As a result, the portfolio's overall volatility is
lower than one consisting entirely of government bonds. Furthermore, the expected
returns are higher.3
● Modern portfolio theory allows investors to construct more efficient portfolios. Every
possible combination of assets that exists can be plotted on a graph, with the
portfolio's risk on the X-axis and the expected return on the Y-axis. This plot reveals
the most desirable portfolios. For example, suppose Portfolio A has an expected
return of 8.5% and a standard deviation of 8%. Further, assume that Portfolio B has
an expected return of 8.5% and a standard deviation of 9.5%. Portfolio A would be
deemed more efficient because it has the same expected return but lower risk.3
● It is possible to draw an upward sloping curve to connect all of the most efficient
portfolios. This curve is called the efficient frontier. Investing in a portfolio
underneath the curve is not desirable because it does not maximize returns for a given
level of risk

Criticism of the MPT

Perhaps the most serious criticism of the MPT is that it evaluates portfolios based on
variance rather than downside risk.
That is, two portfolios that have the same level of variance and returns are considered equally
desirable under modern portfolio theory. One portfolio may have that variance because of
frequent small losses. Another could have that variance because of rare but spectacular
declines. Most investors would prefer frequent small losses, which would be easier to endure.

Risk and return of Portfolio

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The risk of a two-asset portfolio is dependent on the proportions of each asset, their standard
deviations and the correlation (or covariance) between the assets’ returns. As the number of
assets in a portfolio increases, the correlation among asset risks becomes a more important
determinant of portfolio risk.
i. Portfolio Return:
The expected return of a portfolio represents the weighted average of the expected returns on
the securities comprising that portfolio with weights being the proportion of total funds
invested in each security (the total of weights must be 100).
ii. Portfolio Risk:
Unlike the expected return on a portfolio which is simply the weighted average of the
expected returns on the individual assets in the portfolio, the portfolio risk, σp is not the
simple, weighted average of the standard deviations of the individual assets in the portfolios.

Portfolio construction
Portfolio construction is a process of selecting securities optimally by taking minimum risk
to achieve maximum returns. The portfolio consists of various securities such as bonds,
stocks, and money market instruments.
To plan for the portfolio investment, you must take an in-depth look at all current assets,
investments, and debts if any. Now, you can define your financial goals for the short and long
terms. To establish a risk-return profile, you have to decide on the extent of risk and volatility
you're willing to take, and what returns you want to generate. Now, the benchmarks can be
set in place to track portfolio performance.
With a risk-return profile in place, the next step is to create an asset allocation strategy that is
diversified and structured for maximum returns. Now, adjust the plan to consider significant
life changes, like buying a home or retiring. The investor has to choose whether to opt for
active management, which might include professionally-managed mutual funds, or passive
management, which might consist of ETFs that track specific indexes.
Once a portfolio is in place, it's crucial to monitor the investment and ideally reevaluate goals
annually, making changes as needed

Portfolio selection
A portfolio is a collection of financial investments like stocks, bonds, commodities, cash,
and cash equivalents, including closed-end funds and exchange traded funds (ETFs). People
generally believe that stocks, bonds, and cash comprise the core of a portfolio.
Portfolio selection aims to assess a combination of securities from a large quantity of
available alternatives. It aims to maximize the investment returns of investors. Investors can
maximize the return for a considered risk level, or they can focus on risk minimization for a
predetermined level of return. This selection process is defined by the investor objective
variables. The output of this stage is the securities set and the vector of money invested in

70
each selected security. This sequence is called a portfolio selection algorithm and specifies
how the investor must reinvest its wealth from period to period.
The process of portfolio selection may be briefly described as the selection of a securities set
from an available universe, driven by the decision maker objectives and according to the
portfolio selection process knowledge and beliefs that the investor has about the market
behavior. The aim behind this selection is to invest a limited amount of money during a
temporary period, on securities that bring to the investor the best expected values over its
decision variables. In an economic sense, the aim is to maximize the investor's wealth. The
process is driven by the following information categories:

1. Quantitative: indices, technical indicators, securities prices (time series).

2. Qualitative: beliefs, news, speculation, fundamentals.

In a general expression, the portfolio selection problem may be defined like a multi
objective optimization one. The directive for the process is the investor profile, and this one
is defined by multiple objective variables and constraints.
The investor profile is defined by the following aspects:

✔Position: geographical position, job, sociological and economic conditions.

✔Preferences: risk attitude, time conditions, expected return.
✔Predictions: trading rules, beliefs, stock trends, and so on. I
In this way, the portfolio selection process has two stages:

Stage 1: The first one consists in generating beliefs about securities performance in the
horizon planning (the time period over which the investor is going to take portfolio
decisions). In order to generate this belief, the investor must observe the environment
behavior and use its experience and its domain application knowledge. The output of this
stage is the rules set that describe subjectively the securities performance (the predicted
behavior). The rules set or beliefs are generally probability distributions for the securities,
association rules, temporal patterns, trading rules, and so on.

Stage 2: The second stage consists in using the beliefs about the securities to design a
portfolio. This selection process is defined by the investor objective variables. The output of
this stage is the securities set and the vector of money invested in each selected security.
This output is called a portfolio and is applied to an investment period; when the investor is
working with multiple periods must build a sequence of portfolios (one for each period).
This sequence is called a portfolio selection algorithm and specifies how the investor must
reinvest its wealth from period to period.

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CAPM, APT efficient frontier

Capital Assets Pricing Model The total risk of security consists of two types (1systematic
risk (2) unsystematic Risk. Systematic risk is also known non diversifiable or market risk, is
the portion of the security that cannot be eliminated through diversification. Unsystematic
risk, also called diversifiable and the business risk. , is the portion of security which we can
eliminate by diversification .The capital assets pricing model shows the relationship to the
expected return on a security or its systematic risk.
CAPM is developed by Willam F Sharpe. It provides the relationship between the Return and
non diversifiable risk. The basic theme of CAPM is that expected return is increased linearly
with the systematic risk measured by the beta. The excess return over the and above the risk
free return is called risk premium. It is the reward to take more risks . Mathematical
representation

ri= P1 - P0 + D / P0 *100
Where;
P0= Current market price
P1 = Estimated Market price after 1 year
D = Dividend

Security Market line

A graphical representation of the CAPM model is known as Security Market Line. SML
shows what rate of return is required to compensate for a given level of risk.
Assumptions
● Market is perfect
● Risk Free rate
● Homogeneous expectation
● Time period
● Rational Investors
● Divisible
● Diversification

Benefits of CAPM
● Risk Adjusted return
● No dividend Company
● Undervalued overvalued shares
● Analysis of risk of project
● Minimization of risk.

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APT (Arbitrage pricing theory)
Apt is developed by Stephen Ross, it is an alternative model of asset pricing. It explains the
nature of equilibrium in asset pricing in a less complicated manner with fewer assumptions
compared to CAPM. APT generates riskless profit in the security market; it is selling
security at higher prices and purchasing the security at the lower prices.

The APT Model Assumption

● Investor has homogeneous expectation
● Investors are risk averse and utility maximizes
● No transaction cost
● Security returns are generated according to factor model
● Risk returns are not the basis.
There are various factors considered when we calculate the APT. these are
a. Change in the level of industry production
b. Change in the shape of yield curve
c. Change in the inflation rate
d. Change in the real interest rate
e. The level of the consumption
f. The level of the money supply

Constructing the optimum portfolio

An optimal portfolio is one designed with a perfect balance of risk and return. The
optimal portfolio looks to balance securities that offer the greatest possible returns with
acceptable risk or the securities with the lowest risk given a certain return.
To create an Optimal Portfolio one of the main aspects is Risk Diversification. It can be
achieved by using some technical ideologies.
Optimal portfolio is a term used to refer to Efficient Frontier with the highest return-to-risk
combination given the specific investor’s tolerance for risk.

Portfolio revision
Portfolio revision involves changing the existing securities. This may be effected either by
changing the securities currently included in the portfolio or by altering the proportion of
funds invested in the securities. New securities may be added to the portfolio or some of the
existing securities may be removed from the portfolio. Portfolio revision thus leads to
purchases and sales of securities. The objective of portfolio revision is the same as the
objective of portfolio selection like maximizing the return for a given level of risk or
minimizing the risk for a given level of return.
The ultimate aim of portfolio revision is the maximization of returns and minimization of
risk.

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Objectives of Portfolio Revision
The objective of portfolio revision is the same as the objective of portfolio selection like
maximizing the return for a given level of risk or minimizing the risk for a given level of
return.
The ultimate aim of portfolio revision is:
• To maximize the returns and
• To minimize the risk.

Need for Portfolio Revision

The primary factor necessitating portfolio revision is changes in the financial markets since
the creation of the portfolio.
The need for portfolio revisions may arise because of some investor related factors also.
These factors may be listed as:
i. Availability of additional funds for investment.
ii. Change in risk tolerance.
iii. Change in investment goals.
iv. Need to liquidate a part of the portfolio to provide funds for some alternative use.

The portfolio needs to be revised to accommodate the changes in the investor’s position.
Thus, the need for portfolio revision may arise from changes in the financial market or
changes in the investors’ position, namely his financial status and preferences.

Constraints in Portfolio Revision

Portfolio revision or adjustment necessitates purchases and sale of securities.
The practice of portfolio adjustment involving purchase and sale of securities gives rise to
certain problems that act as constraints in portfolio revision. Some of these are as follows:

1. Transaction Cost
Buying and selling securities involve transaction costs such as commission and brokerage.
Frequent buying and selling of securities for portfolio revision may push up transaction costs
thereby reducing the gains from portfolio revision. Hence, the transaction costs involved in
portfolio revision may act as a constraint to the timely revision of the portfolio.

2 . Taxes
Tax is payable on the capital gains arising from sales of securities.
Usually, long term capital gains are taxed at a lower rate than short term capital gains. To
qualify as long term capital gain, a security must be held by an investor for a period of not
less than 12 months before the sale.

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Frequent sale of securities in the course of periodic portfolio revision or adjustments will
result in short term capital gains which would be taxed at a higher rate compared to long
term capital gains. The higher tax on short term capital gains may act as a constraint to
frequent portfolio revisions.

3. Statutory Stipulations
The largest portfolios in every country are managed by investment companies and funds.
These institutional investors are normally governed by certain statutory stipulations
regarding their investment activity. These stipulations often act as constraints in timely
portfolio revision.

4. Intrinsic Difficulty
Portfolio revision is a difficult and time-consuming exercise. The Methodology to be
followed for portfolio revision is also not clearly established. Different approaches may be
adopted for the purpose. The difficulty of carrying out revision itself may act as a constraint
to portfolio revision.

Portfolio Revision Strategies

Two different strategies may be adopted for portfolio revisions which are as follows:

1. Active Revision Strategy

Active revision strategy involves frequent and sometimes substantial adjustments to the
portfolio. Active portfolio revision is essentially carrying out portfolio analysis and portfolio
selection all over again. It is based on an analysis of the fundamental factors affecting the
economy, industry, and company has also the technical factors like demand and supply.
Consequently, the time, skill, and resources required for implementing an active revision
strategy will be much higher. The frequency of trading is likely to be much higher under
active revision strategy resulting in higher transaction costs.

2. Passive Revision Strategy

A passive revision strategy, in contrast, involves only minor and frequent adjustments to the
portfolio over time. The practitioners of passive revision strategy believe in market
efficiency and homogeneity of expectation among investors. They find a little incentive for
actively trading and revising portfolios periodically. Under passive revision strategy,
adjustment to the portfolio is carried out according to certain predetermined rules and
procedures designed as formula plans. These formula plans help the investor to adjust his
portfolio according to changes in the securities market.

Formula plans

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Formula plans consist of the basic rules and regulations for purchasing and selling
investments. Formula plans enable the investors to estimate the total amount that he has to
spend on purchase of securities. Investors may become emotional and they may not act
rationally while making investments. Investors can earn superior profit by using formula
plans.
The formula plan gives a path or course of action within the framework of the investment
objectives of the investor. The investor can easily act according to the formula given to him
without experiencing the problem of forecasting fluctuations in the future stock prices. The
investor is safeguarded against any possible loss resulting from portfolio construction

Advantages of the formula plan

Formula plans offer the following advantages to the investors:

1. The investor obtains basic rules and regulations for purchase and sale of securities.
2. The rules and regulations laid down by the formula plans are rigid and they enable the
investors to overcome emotions and make rational decisions.
3. The investors can earn higher income from their portfolio by adopting formula plans.
4.. A course of action is determined in the light of the objectives of the investors.
5. The investor is able to control buying and selling of securities.
6. Formula plans are helpful in making decisions on the timing of investment.

Disadvantages of formula plans

1. The formula plans do not help in the selection of security. The selection of security is
based on fundamental or technical analysis.
2. Formula plans are highly rigid.
3. The formula plans can be applied for long periods, otherwise the transaction cost will be
high.
4. Formula plans do not help the investors make forecasts of market movements. Without
such forecasts best stocks cannot be identified.

Implementation of formula plan

The formula plans are formulated only when the investor has a pool of funds which he wants
to invest in securities. The investor should hold two portfolios namely,

● aggressive portfolio; and

● conservative portfolio.
The aggressive portfolio will have a large number of fluctuations whereas the conservative
portfolio which is composed of bonds will be defensive in nature. The conservative portfolio
is intended to complement the aggressive portfolio.

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If the stock prices remain constant, profits will not be available. Only when stock prices
fluctuate frequently, investors can make profit out of such price fluctuations. The investor
before implementing formula plans should equip himself with the historical movement of
prices.

Portfolio performance evaluation

The portfolio performance evaluation primarily refers to the determination of how a
particular investment portfolio has performed relative to some comparison benchmark. The
evaluation can indicate the extent to which the portfolio has outperformed or
under-performed, or whether it has performed at par with the benchmark. The evaluation of
portfolio performance is important for several reasons. First, the investor, whose funds have
been invested in the portfolio, needs to know the relative performance of the portfolio. The
performance review must generate and provide information that will help the investor to
assess any need for rebalancing of his investments. Second, the management of the portfolio
needs this information to evaluate the performance of the manager of the portfolio and to
determine the manager’s compensation, if that is tied to the portfolio performance. The
performance evaluation methods generally fall into two categories, namely conventional and
risk-adjusted methods.

Need for Evaluation

The evaluation of portfolio performance is important for several reasons. First, the investor,
whose funds have been invested in the portfolio, needs to know the relative performance of
the portfolio. The performance review must generate and provide information that will help
the investor to assess any need for rebalancing of his investments. Second, the management
of the portfolio needs this information to evaluate the performance of the manager of the
portfolio and to determine the manager’s compensation, if that is tied to the portfolio
performance. The performance evaluation methods generally fall into two categories, namely
conventional and risk-adjusted methods.

Risk Adjusted Returns

The risk-adjusted methods make adjustments to returns in order to take account of the
differences in risk levels between the managed portfolio and the benchmark portfolio. While
there are many such methods, the most notables are the Sharpe ratio (S), Treynor ratio (T)
and Jensen’s alpha (a).These measures, along with their applications, are discussed below.
Sharpe Ratio, Treynor Ratio, Jensen’s performance Index

Sharpe Ratio (Reward to Variability Ratio)

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The Sharpe ratio (Sharpe, 1966) computes the risk premium of the investment portfolio per
unit of total risk of the portfolio. The risk premium, also known as excess return, is the
return of the portfolio less the risk-free rate of interest as measured by the yield of a
Treasury security. The total risk is the standard deviation of returns of the portfolio. The
numerator captures the reward for investing in a risky portfolio of assets in excess of the
risk-free rate of interest while the denominator is the variability of returns of the portfolio. In
this sense, the Sharpe measure is also called the ‘‘reward to-variability’’ ratio. The Sharpe
ratio for an investment portfolio can be compared with the same for a benchmark portfolio
such as the overall market portfolio.

SR= 𝑟𝑝 − 𝑟𝑓/σ𝑝
Where,
rp= Realized return from portfolio
rf= Risk free return
σ𝑝 = SD of portfolio

Treynor Ratio
The Treynor ratio (Treynor, 1965) computes the risk premium per unit of systematic risk.
The risk premium is defined as in the Sharpe measure. The difference in this method is in
that it uses the systematic risk of the portfolio as the risk parameter. The systematic risk is
that part of the total risk of an asset which cannot be eliminated through diversification. It is
measured by the parameter known as ‘beta’ that represents the slope of the regression of the
returns of the managed portfolio on the returns to the market portfolio.

Tp = 𝑟𝑝 − 𝑟𝑓/ β𝑝
Where
β𝑝= Beta of portfolio

Jensen’s Alpha
Jensen’s alpha (Jensen, 1968) is based on the Capital Asset Pricing Model (CAPM) of
Sharpe (1964), Lintner (1965), and Mossin (1966). The alpha represents the amount by
which the average return of the portfolio deviates from the expected return given by the
CAPM. The CAPM specifies the expected return in terms of the risk-free rate, systematic
risk, and the market risk premium. The alpha can be greater than, less than, or equal to zero.
An alpha greater than zero suggests that the portfolio earned a rate of return in excess of the
expected return of the portfolio.

α𝑝 = 𝑅𝑝 − 𝐸(𝑅𝑝)

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E(Rp) = Rf + β𝑝 (𝑟𝑚 − 𝑅𝑓)
Where;
α𝑝 = 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡𝑖𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛
Rp = actual return
E(Rp) = Expected return

In short, the portfolio has a positive alpha, suggesting superior performance. When the
portfolio is well diversified all three methods –Sharpe, Treynor, and Jensen – will give the
same ranking of performance. In the example, the managed portfolio outperformed the
market on the basis of all three ratios. When the portfolio is not well diversified or when it
represents the total wealth of the investor, the appropriate measure of risk is the standard
deviation of returns of the portfolio, and hence the Sharpe ratio is the most suitable. When
the portfolio is well diversified, however, a part of the total risk has been diversified away
and systematic risk is the most appropriate risk metric. Both Treynor ratio and Jensen’s
alpha can be used to assess the performance of well-diversified portfolios of securities.
These two ratios are also appropriate when the portfolio represents a sub-portfolio or only a
part of the client’s portfolio

UNIT V
Mechanics of investing
Mechanical investing is any one of a number of ways of buying and selling stocks
automatically or according to pre-set criteria or triggers. The primary purpose of this
approach is to remove as much human emotional behavior as possible. Emotions will often
negatively impact or cloud rational investment decisions.

Stock trading platforms

The technology used for trading is known as a trading platform, such as opening, closing,
and controlling market positions through an intermediary, say, an online broker. Brokers also
offer online trading platforms either for free or at a discount rate in exchange for keeping a
sponsored account and/or making a specified number of trades per month. The best trading
sites provide a combination of robust features and low fees
A trading platform is a programme that allows investors and traders to position trades
through financial intermediaries and to track accounts. Trading platforms also come bundled
with other services, such as quotes in real-time, charting software, news feeds, and even
premium analysis. Additionally, services can be tailored specifically to specific markets such
as stocks, currencies, options, or futures markets.

List of Best Trading Platforms in India :-

1. Zerodha Kite

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 2. Upstox Pro
3. FYERS ONE
4. Sharekhan Trade Tiger
5. Angel Broking Speed Pro
6. Trade Station
7. Trade Eye
8. Trade Racer
9. Trader Terminal (TT)
10. NSE Now

Market terms

M trading
MTrading is an online broker that allows trading currency pairs, precious metals, stocks,
indices and fossil fuels. We are committed to offering the latest and state-of-the-art trading
platforms to ensure that you get the best trading experience in every type of financial market.

Trading Procedure
Before selling the securities through the stock exchange, the companies have to get their
securities listed in the stock exchange. The name of the company is included in listed
securities only when stock exchange authorities are satisfied with the financial soundness and
other aspects of the company.
Previously the buying and selling of securities was done in trading floor of stock exchange;
today it is executed through computer and it involves the following steps:

Trading Procedure on a Stock Exchange:

The Trading procedure involves the following steps:
1. Selection of a broker:
The buying and selling of securities can only be done through SEBI registered brokers who
are members of the Stock Exchange. The broker can be an individual, partnership firms or
corporate bodies. So the first step is to select a broker who will buy/sell securities on behalf
of the investor or speculator.

2. Opening Demat Account with Depository:

Demat (Dematerialized) account refer to an account which an Indian citizen must open with
the depository participant (banks or stock brokers) to trade in listed securities in electronic
form. Second step in trading procedure is to open a Demat account.
Depository participant will maintain securities account balances of investor and intimate
investor about the status of their holdings from time to time.

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 3. Placing the Order:
After opening the Demat Account, the investor can place the order. The order can be placed
to the broker either (DP) personally or through phone, email, etc.

4. Executing the Order:

As per the Instructions of the investor, the broker executes the order i.e. he buys or sells the
securities. Broker prepares a contract note for the order executed. The contract note contains
the name and the price of securities, name of parties and brokerage (commission) charged by
him. Contract note is signed by the broker.

5. Settlement:
This means actual transfer of securities. This is the last stage in the trading of securities done
by the broker on behalf of their clients. There can be two types of settlement.

(a) On the spot settlement: It means settlement is done immediately and on spot settlement
follows. T + 2 rolling settlement. This means any trade taking place on Monday gets settled
by Wednesday.
(b) Forward settlement: It means settlement will take place on some future date. It can be T
+ 5 or T + 7, etc. All trading in stock exchanges takes place between 9.55 am and 3.30 pm.
Monday to Friday.

Broker
In general terms, a broker is someone who buys and sells things on behalf of others. They are
the middlemen between two parties. In stock market jargon, a broker is an individual or a
firm that executes ‘buy’ and ‘sell’ orders for an investor for a fee or commission. Besides
executive client orders, some brokers also provide additional services such as research,
intelligence, investment plans, margin funding and such other value-added services.
Brokers earn money by charging a fee or commission from their clients for every order they
execute. Unlike in the past, many trades are now executed via electronic systems without any
human intervention. Although a number of investors still prefer using a human stockbroker
for professional insight that comes with it.
Brokers know their market best, they have expertise not only on trading processes but also on
market behavior. They know who to talk to, what to do, and above all, how to do it well.
TYPES OF BROKERS
Based on the types of clients they cater to, stock brokers are usually classified into two
distinct categories:
● Institutional Stock Brokers

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Institutional Stock brokers have large institutions and companies as their clients and trade in
securities on behalf of them. They offer services such as investment banking, securities
services (IPO or secondary offerings), advisory services, and brokerage services to
institutional investors.
● Personal Stockbrokers
Personal stockbrokers offer investment banking, advisory services and brokerage services to
small businesses and individual investors.

Services provided by Best Stock Broker in India

Let’s take a quick tour of the services provided by stockbrokers to their clients in a broader
way.

➔ Top Stock brokers are the ones who give accurate advice on the stocks i.e which
stocks to buy or not. This is because they have valuable knowledge about stocks and
other financial securities. They do proper research on the stocks and the volatility of
the stock market before making any recommendations.
➔ Top stock brokers in India have the right to buy and sell shares on behalf of their
clients and handle their related work. They also hold and maintain all the records of
all transactions, statements and more.
➔ Stockbrokers also answer client’s queries regarding investment. Also, top stock
brokers in India actively manage the client’s portfolio and do proper diversification
regarding stocks.
➔ Stockbrokers are highly updated with the stock market news, and hence they inform
their client if any new update or opportunity comes in the stock market.
➔ Stockbrokers also help a client to make changes in investment strategies depending on
the market conditions.

Dematerialization (DEMAT Account)

A demat account (short for "dematerialized account") is an account to hold financial
securities (equity or debt) in electronic form. In India, demat accounts are maintained by two
depository organizations, National Securities Depository Limited and Central Depository
Services Limited.
Dematerialization (DEMAT) is the move from physical certificates to electronic
bookkeeping. Actual stock certificates are then removed and retired from circulation in
exchange for electronic recording.
Dematerialization was designed to offer more security, as well as increased speed, to
financial trades. It has become the norm in bookkeeping for financial institutions.

Why was dematerialization needed?

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Handling of paperwork related to shares in the physical format often led to errors and
unforeseen mishaps in the past
Tracking records and share documents with respect to transfer and upkeep transactions was
difficult
The authorities in charge of updating these documents could not keep up with the increasing
volume of share papers, which, if left unchecked, could cripple the financial base of the
Indian share market and associated businesses

Benefits of dematerialization
There is a wide range of benefits of dematerialisation of securities. Some of them are as
follows:

1. You can conveniently manage your shares and transactions from anywhere
2. Stamp duty is not levied on your electronic securities
3. Holding charges levied are nominal
4. Risks involved with physical securities such as theft, loss, forgery or damage are
eliminated
5. You can buy securities in odd lots and buy a single security
6. Due to the elimination of paperwork, the time required for completing a
7. transaction gets reduced

Specified and Non-specified Securities

Specified Securities means ‘equity shares’ and ‘convertible securities’ as defined under
clause (zj) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of
India (Issue of Capital and Disclosure Requirements) Regulations, 2009.

Specified Securities means, with respect to any Person,

(a) all preferred Capital Stock issued by such Person and required by the terms thereof to be
redeemed or for which mandatory sinking fund payments are due,
(b) all securities issued by such Person that contain two distinct components, typically
medium-term debt and a forward contract for the issuance of common stock prior to the debt
maturity, including such securities commonly referred to by their tradenames as “FELINE
PRIDES”, “PEPS”, “HITS”, “SPACES” and “DECS” and generally referred to as “equity
units” and
(c) all other securities issued by such Person that are similar to those described in the
forgoing clauses (a) and (b).

Non-securities

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A non-security is an alternative investment that is not traded on a public exchange as stocks
and bonds are. Assets such as art, rare coins, life insurance, gold, and diamonds all are
non-securities.
Non-securities by definition are not liquid assets. That is, they cannot be easily bought or
sold on demand as no exchange exists for trading them.Non-securities also are known as real
assets.

Online transaction
Online transaction is a payment method in which the transfer of fund or money happens
online over electronic fund transfer. Online transaction process (OLTP) is secure and
password protected. Three steps involved in the online transaction are Registration, Placing
an order, and, Payment.
Online transaction processing (OLTP) is information systems that facilitate and manage
transaction-oriented applications, typically for data entry and retrieval transaction processing.
So online transaction is done with the help of the internet. It can’t take place without a proper
internet connection.

Stages of Online Transaction

There are three stages of Online Transactions
Pre-purchase/Sale: In this stage, the product or service is advertised online with some
details for the customers.
Purchase/Sale: When a customer likes a particular product or service, he/she buys it and
makes the payment online
Delivery Stage: This is the final stage where the goods bought are delivered to the
consumer.

Steps Involved in Online Transaction

The following are the steps involved in Online Transaction:

1] Registration
The consumer has to register online on the particular website to buy a particular good or
service. The customer’s email id, name, address, and other details are saved and are safe with
the website. For security reasons, the buyer’s ‘Account’ and his ‘Shopping Cart’ is password
protected.
2] Placing an Order
When a customer likes a product or a service, he/she puts the product in the ‘shopping cart’.
The shopping cart gives a record of all the items selected by the buyer to be purchased, the
number of units or quantity desired to be bought per item selected and the price for each
item.

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The buyer then proceeds to the payment option after selecting all the products.
3] Payment
The buyer then has to select the payment option, he/she has various payment options. These
payment pages are secured with very high-level encryptions so that the personal financial
information that you enter (bank/card details) stay completely secure. Some ways in which
you can make this payment are:

★ Cash On Delivery: The Cash on Delivery option lets the buyer pay when he/she
receives the product. Here, the payment is made at the doorstep. The customer can
pay in cash, or by debit or credit card.
★ Cheque: In this type of payment, the buyer sends a cheque to the seller and the seller
sends the product after the realization of the cheque.
★ Net Banking Transfer: Here, the payment is transferred from the buyer’s account to
the seller’s account electronically i.e. through the internet. After the payment is
received by the seller, the seller dispatches the goods to the buyer.
★ Credit or Debit Card: The buyer has to send his debit card or credit card details to
the seller, and a particular amount will be deducted from his/her account.
★ Digital Cash: Digital Cash is a form of electronic currency that exists only in
cyberspace and has no real physical properties. Here the money in buyer’s bank
account is converted into a code that is saved on a microchip, a smart card or on the
hard drive of his computer. When he makes a purchase, he needs to mention that
particular code to the website and thereafter the transaction is duly processed.

Bonds
A bond is a debt security, similar to an IOU. Borrowers issue bonds to raise money from
investors willing to lend them money for a certain amount of time.

When you buy a bond, you are lending to the issuer, which may be a government,
municipality, or corporation. In return, the issuer promises to pay you a specified rate of
interest during the life of the bond and to repay the principal, also known as face value or par
value of the bond, when it "matures," or comes due after a set period of time.

Investors buy bonds because:

1. They provide a predictable income stream. Typically, bonds pay interest twice a year.
2. If the bonds are held to maturity, bondholders get back the entire principal, so bonds
are a way to preserve capital while investing.
3. Bonds can help offset exposure to more volatile stock holdings

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Types of Bonds

There are three main types of bonds:

● Corporate bonds are debt securities issued by private and public corporations.
● Investment-grade. These bonds have a higher credit rating, implying less credit risk,
than high-yield corporate bonds.
● High-yield. These bonds have a lower credit rating, implying higher credit risk, than
investment-grade bonds and, therefore, offer higher interest rates in return for the
increased risk.
● Municipal bonds, called “munis,” are debt securities issued by states, cities, counties
and other government entities. Types of “munis” include:
○ General obligation bonds. These bonds are not secured by any assets;
instead, they are backed by the “full faith and credit” of the issuer, which has
the power to tax residents to pay bondholders.
○ Revenue bonds. Instead of taxes, these bonds are backed by revenues from a
specific project or source, such as highway tolls or lease fees. Some revenue
bonds are “non-recourse,” meaning that if the revenue stream dries up, the
bondholders do not have a claim on the underlying revenue source.
● U.S. Treasuries are issued by the U.S. Department of the Treasury on behalf of the
federal government. They carry the full faith and credit of the U.S. government,
making them a safe and popular investment. Types of U.S. Treasury debt include:
○ Treasury Bills. Short-term securities maturing in a few days to 52 weeks
○ Notes. Longer-term securities maturing within ten years
○ Bonds. Long-term securities that typically mature in 30 years and pay interest
every six months
○ TIPS. Treasury Inflation-Protected Securities are notes and bonds whose
principal is adjusted based on changes in the Consumer Price Index. TIPS pay
interest every six months and are issued with maturities of five, ten, and 30
years.

Shares
Shares are units of equity ownership in a corporation. For some companies, shares exist as a
financial asset providing for an equal distribution of any residual profits, if any are declared,
in the form of dividends. Shareholders of a stock that pays no dividends do not participate in
a distribution of profits. Instead, they anticipate participating in the growth of the stock price
as company profits increase.

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TYPES OF SHARES
1. PREFERENCE SHARES
As the name suggests, this type of share gives certain preferential rights as compared to other
types of share. The main benefits that preference shareholders have are:
● They get first preference when it comes to the payout of dividend, i. e. a share of the
profit earned by the company
● When the company winds up, preference shareholders have the first right in terms of
getting repaid

Further, there are three sub- types in preference shares:

1. Cumulative preference shares:
Cumulative shareholders have the right to receive arrears on dividend before any dividend is
paid to equity shareholders. For example, if the dividends on preference shares for the year
2017 and 2018 have not been paid due to market downturns, preferential shareholders are
entitled to receive dividend for all preceding years in addition to the current one.
2. Non-cumulative preference shares:
Non-cumulative shareholders cannot claim any outstanding dividend. These shareholders
only earn a dividend when the company earns profits. No dividends are paid for the prior
years.
3. Convertible preference shares:
As the name suggests, these shares are convertible. Convertible shareholders can convert
their preference shares into equity shares at a specific period of time. However, the
conversion of shares will need to be authorized by the Articles of Association (AoA) of the
company.

2. EQUITY SHARES
Equity shares are also known as ordinary shares. The majority of shares issued by the
company are equity shares. This type of share is traded actively in the secondary or stock
market. These shareholders have voting rights in the company meetings. They are also
entitled to get dividends declared by the board of directors. However, the dividend on these
shares is not fixed and it may vary year to year depending on the company’s profit. Equity
shareholders receive dividends after preference shareholders.

Mutual fund units

Units represent your holding in a mutual fund scheme and are the smallest portion of its
ownership. Sometimes, they are also referred to as shares. Mutual fund units are issued by
fund companies according to the amount of money invested by investors.

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Types of mutual funds

● Money market funds have relatively low risks. By law, they can invest only in
certain high-quality, short-term investments issued by U.S. corporations, and federal,
state and local governments.
● Bond funds have higher risks than money market funds because they typically aim to
produce higher returns. Because there are many different types of bonds, the risks and
rewards of bond funds can vary dramatically.
● Stock funds invest in corporate stocks. Not all stock funds are the same. Some
examples are:
○ Growth funds focus on stocks that may not pay a regular dividend but have
potential for above-average financial gains.
○ Income funds invest in stocks that pay regular dividends.
○ Index funds track a particular market index such as the Standard & Poor’s 500
Index.
○ Sector funds specialize in a particular industry segment.
● Target date funds hold a mix of stocks, bonds, and other investments. Over time, the
mix gradually shifts according to the fund’s strategy. Target date funds, sometimes
known as lifecycle funds, are designed for individuals with particular retirement dates
in mind.

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