INVESTMENT MANAGEMENT Mod.

TABLE OF CONTENTS
CONTENTS PAGE
CHAPTER ONE: Introduction to Investment Management ..........................................1

1.1. Investments: Meaning, Types and Characteristics.....................................................1
1.2. The Investment Management Process........................................................................2
1.3. Investment Alternatives .............................................................................................6
1.4. Indirect Investment ....................................................................................................8
1.5. Return and Risks ........................................................................................................17
1.6. Capital Asset Pricing Model (CAPM) .......................................................................17
1.7. Capital Asset Pricing Model (CAPM)...................................................................................25
1.8. Summary ...............................................................................................................................27
CHAPTER TWO: Securities Market and Trading..........................................................30
2.1. Introduction.................................................................................................................30
2.2. Types of Financial Markets ........................................................................................35
2.3. Foreign Exchange Markets .........................................................................................44
2.4. Stock Market Indicators and indexes ..........................................................................48
2.5. Institutional Versus Private investments.....................................................................51
2.6. Summary .................................................................................................................................56
CHAPTER THREE: Security Analysis .............................................................................58
3.1. Introduction.................................................................................................................58
3.2. Fundamental Analysis.................................................................................................59
3.2.1 Market/Economic Analysis .................................................................................60
3.2.2. Industry Analysis................................................................................................67
3.2.3. Company Analysis .............................................................................................74
3.2.4. Technical Analysis.............................................................................................88
CHAPTER FOUR: Bond and Bond Valuation.................................................................103
4.1. Introduction...................................................................................................................103
4.2. Features of Debt Securities ...........................................................................................104
4.3. Valuation of Bonds .......................................................................................................110
4.4. Global Bond Market .....................................................................................................120
4.5. Summary...................................................................................................................................121
CHAPTER FIVE: Introduction to derivative market .....................................................123
5.1. Introductions to Derivatives.........................................................................................123
5.2. Hedging Against Risk ..................................................................................................123
5.3. Description of Derivatives Markets .............................................................................124
5.4. Forward and Futures Contracts....................................................................................125
5.5. Options.........................................................................................................................131
5.6. Swaps ...........................................................................................................................137
5.7. Caps and floors ............................................................................................................138
5.8. Summary.................................................................................................................................139
Reference ......................................................................................... .142
i
CHAPTER ONE
INTRODUCTION TO INVESTMENT MANAGEMENT
1 .0 . AIM AND OBJECTIVES

Upon on completing this unit, you should be able to:
 explain the meaning, types characteristics and objectives of investment
 specify the investment management process
 explain the fundamental investment alternatives
 distinguish between direct and indirect investment
 Explain the investment risk and return.
 List and discuss different investment alternatives
 understand what is capital asset pricing model
1.1. Introduction
What is investment?
Investment or investing is a term with several closely-related meanings in business
management, finance and economics, related to saving or deferring consumption. Investing is
the active redirecting resources from being consumed today so that they may create benefits
in the future; the use of assets to earn income or profit.
An investment is the choice by the individual, after thorough analysis, to place or lend money
in a vehicle (e.g. property, stock securities, and bonds) that has sufficiently low risk and
provides the possibility of generating returns over a period of time. Placing or lending money
in a vehicle that risks the loss of the principal sum or that has not been thoroughly analyzed
is, by definition speculation, not investment.
In the case of investment, rather than store the good produced or its money equivalent, the
investor chooses to use that good either to create a durable consumer or producer good, or to
lend the original saved good to another in exchange for either interest or a share of the
profits.
In the first case, the individual creates durable consumer goods, hoping the services from the
good will make his life better. In the second, the individual becomes an entrepreneur using
the resource to produce goods and services for others in the hope of a profitable sale. The
third case describes a lender, and the fourth describes an investor in a share of the business.
In each case, the consumer obtains a durable asset or investment, and accounts for that asset
by recording an equivalent liability. As time passes, and both prices and interest rates change,
the value of the asset and liability also change.
An asset is usually purchased, or equivalently a deposit is made in a bank, in hopes of getting
a future return or interest from it. The word originates in the Latin "vestis", meaning garment,
and refers to the act of putting things (money or other claims to resources) into others'
Copyright@ Rift Valley University Center for Distance Education 1

Investment management (MGMT-301)
pockets. The basic meaning of the term being an asset held to have some recurring or capital
gains. It is an asset that is expected to give returns without any work on the asset per se.
1.2 Investments: Meaning, Types and Characteristics

1.2.1 Meaning of Investment
The word "investment" can be defined in many ways according to different theories and
principles. It is a term that can be used in a number of contexts. However, the different
meanings of "investment" are more alike than dissimilar. Generally, investment is the
application of money for earning more money. Investment also means savings or savings
made through delayed consumption. According to economics, investment is the utilization
of resources in order to increase income or production output in the future.
An amount deposited into a bank or machinery that is purchased in anticipation of earning
income in the long run is both examples of investments. Although there is a general broad
definition to the term investment, it carries slightly different meanings to different industrial
sectors.
According to economists, investment refers to any physical or tangible asset, for example, a
building or machinery and equipment. On the other hand, finance professionals define an
investment as money utilized for buying financial assets, for example stocks, bonds,
bullion, real properties, and precious items.
According to finance, the practice of investment refers to the buying of a financial product
or any valued item with anticipation that positive returns will be received in the future. The
most important feature of financial investments is that they carry high market liquidity. The
method used for evaluating the value of a financial investment is known as valuation.
According to business theories, investment is that activity in which a manufacturer buys a
physical asset, for example, stock or production equipment, in expectation that this will
help the business to prosper in the long run.
1.2.2 Types of investments

Investments may be classified as financial investments or economic investments. In
Finance investment is putting money into something with the expectation of gain that upon
thorough analysis has a high degree of security for the principal amount, as well as security
of return, within an expected period of time. In contrast putting money into something with
an expectation of gain without thorough analysis, without security of principal, and without
security of return is speculation or gambling. Investment is related to saving or deferring
consumption. Investment is involved in many areas of the economy, such as business
management and finance whether for households, firms, or governments.
Economic investments are undertaken with an expectation of increasing the current
economy’s capital stock that consists of goods and services. Capital stock is used in the
production of other goods and services desired by the society. Investment in this sense
implies the expectation of formation of new and productive capital in the form of new

constructions, plant and machinery, inventories, and so on. Such investments generate
physical assets and also industrial activity. These activities are undertaken by corporate
entities that participate in the capital market.
Financial investments and economic investments are, however, related and dependent. The
money invested in financial investments is ultimately converted into physical assets. Thus,
all investments result in the acquisition of some asset, either financial or physical. In this
sense, markets are also closely related to each other. Hence, the perfect financial market
should reflect the progress pattern of the real market since, in reality, financial markets exist
only as a support to the real market.
1.2.3 Characteristics of Investment

The features of economic and financial investments can be summarized as return, risk,
safety, and liquidity.
1. Return
 All investments are characterized by the expectation of a return. In fact, investments
are made with the primary objective of deriving a return.
 The return may be received in the form of yield plus capital appreciation.
 The difference between the sale price and the purchase price is capital appreciation.
 The dividend or interest received from the investment is the yield.
 The return from an investment depends upon the nature of the investment, the
maturity period and a host of other factors.
 Return = Capital Gain + Yield (interest, dividend etc.)
2. Risk
Risk refers to the loss of principal amount of an investment. It is one of the major
characteristics of an investment.
The risk depends on the following factors:
 The investment maturity period is longer; in this case, investor will take larger
risk.
 Government or Semi Government bodies are issuing securities which have less
risk.
 In the case of the debt instrument or fixed deposit, the risk of above investment is
less due to their secured and fixed interest payable on them. For instance
debentures.
 In the case of ownership instrument like equity or preference shares, the risk is
more due to their unsecured nature and variability of their return and ownership
character.
 The risk of degree of variability of returns is more in the case of ownership capital
compare to debt capital.
 The tax provisions would influence the return of risk.

3. Safety:
Safety refers to the protection of investor principal amount and expected rate of return.
Safety is also one of the essential and crucial elements of investment. Investor prefers safety
about his capital. Capital is the certainty of return without loss of money or it will take time
to retain it. If investor prefers less risk securities, he chooses Government bonds. In the case,
investor prefers high rate of return investor will choose private Securities and Safety of these
securities is low.
4. Liquidity:
Liquidity refers to an investment ready to convert into cash position. In other words, it is
available immediately in cash form. Liquidity means that investment is easily realizable,
saleable or marketable. When the liquidity is high, then the return may be low. An
investor generally prefers liquidity for his investments, safety of funds through a
minimum risk and maximization of return from an investment.
1.2.4 Objectives of Investment

In broad terms, four main investment objectives cover how you accomplish most financial
goals. These investment objectives are important because certain products and strategies
work for one objective, but may produce poor results for another objective. It is quite
likely you will use several of these investment objectives simultaneously to accomplish
different objectives without any conflict. Let’s examine these objectives and see how they
differ.
a. Capital Appreciation
Capital appreciation is concerned with long-term growth. This strategy is most familiar in
retirement plans where investments work for many years inside a qualified plan. However,
investing for capital appreciation is not limited to qualified retirement accounts. If this is
your objective, you are planning to hold the stocks for many years. You are content to let
them grow within your portfolio, reinvesting dividends to purchase more shares. A typical
strategy employs making regular purchases. You are not very concerned with day-to-day
fluctuations, but keep a close eye on the fundamentals of the company for changes that
could affect long-term growth.
b. Current Income
If your objective is current income, you are most likely interested in stocks that pay a
consistent and high dividend. You may also include some top-quality real estate investment
trusts (REITs) and highly-rated bonds. All of these products produce current income on a
regular basis. Many people who pursue a strategy of current income are retired and use the
income for living expenses. Other people take advantage of a lump sum of capital to create
an income stream that never touches the principal, yet provides cash for certain current
needs (college, for example).

c. Capital Preservation
Capital preservation is a strategy you often associate with elderly people who want to make
sure they don’t outlive their money. Retired on nearly retired people often use this strategy
to hold on the detention has. For this investor, safety is extremely important – even to the
extent of giving up return for security. The logic for this safety is clear. If they lose their
money through foolish investment and are retired, it is unlike they will get a chance to
replace it. Investors who use capital preservation tend to invest in bank CDs, U.S. Treasury
issues and savings accounts.
d. Speculation
The speculator is not a true investor, but a trader who enjoys jumping into and out of stocks
as if they were bad shoes. Speculators or traders are interested in quick profits and used
advanced trading techniques like shorting stocks, trading on the margin, options and other
special equipment. They have no love for the companies they trade and, in fact may not
know much about them at all other than the stock is volatile and ripe for a quick profit.
Speculators keep their eyes open for a quick profit situation and hope to trade in and out
without much thought about the underlying companies. Many people try speculating in the
stock market with the misguided goal of getting rich. It doesn’t work that way. If you want
to try your hand, make sure you are using money you can afford to lose. It’s easy to get
addicted, so make sure you understand the real possibilities of losing your investment.
The secondary objectives are tax minimization and Marketability or liquidity.
e. Tax Minimization:
An investor may pursue certain investments in order to adopt tax minimization as part of
his or her investment strategy. A highly-paid executive, for example, may want to seek
investments with favorable tax treatment in order to lessen his or her overall income tax
burden. Making contributions to an IRA or other tax-sheltered retirement plan can be an
effective tax minimization strategy.
f. Marketability/Liquidity:
Many of the investments we have discussed are reasonably illiquid, which means they
cannot be immediately sold and easily converted into cash. Achieving a degree of liquidity,
however, requires the sacrifice of a certain level of income or potential for capital gains.
Common stock is often considered the most liquid of investments, since it can usually be
sold within a day or two of the decision to sell. Bonds can also be fairly marketable, but
some bonds are highly illiquid, or non-tradable, possessing a fixed term. Similarly, money
market instruments may only be redeemable at the precise date at which the fixed term
ends. If an investor seeks liquidity, money market assets and non-tradable bonds aren't
likely to be held in his or her portfolio.

1.3 The Investment Management Process
The starting point would be an understanding of the investment management process.
a. Setting the Investment Objective

The first step for the investor is to set the investment objective. Which would vary for
individuals, pension and mutual funds, banks, financial institutions, insurance companies,
etc?
For instance the objective for a pension or mutual fund or insurance company maybe to have
a cash flow specification to satisfy liabilities at different dates in the future. These liabilities
would include redemption, dividends or claim settlement payouts.
For a bank it maybe to lock in a minimum interest spread over their cost of funds.
For the individual investor the objective maybe to maximize return on investment - A more
appropriate word would be ‘optimize’. As the individual would achieve optimum return at
optimum risk. To maximize return would imply the maximization of risk, which would not
be practical or sustainable.
b. Establishing Investment Policy
Setting policy begins with asset allocation amongst the major asset classes available in the
capital market. Which range from equities, debt, fixed income securities, real estate, foreign
securities to currencies.
While setting the investment policy the constraints of the environment and that of the
investor have to be kept in perspective.
The environment would include: government rules and regulations (or restrictions); another
would be the operating system of the market place. Individual constraints would include
financial capability, availability of time to undertake the exercise, risk profile and the level of
understanding the investor has of the investment environment.
c. Selecting the Portfolio Strategy

The portfolio strategy selected would have to be in conformity with both the objectives and
policy guidelines. Any contradiction here would result in a systems break down and losses.
Let’s consider a person with a job that keeps him busy for 10-12 hours a day, five days of the
week. On Saturday he helps the family with household chores. On Sunday he takes the day
off and enjoys himself. Now with such a busy life, we cannot expect him to obtain optimal
returns from investments in the equity market. Where is the time for thought, analysis and
action? He would at best be playing a game of Russian roulette.
For a person with such a busy life schedule it would be best to invest in fixed income
securities. These would include RBI bonds, Bank deposits, insurance, etc. The portfolio
strategy selected would have to be in conformity with both the objectives and policy
guidelines. Any contradiction here would result in a systems break down and losses.
Let’s consider a person with a job that keeps him busy for 10-12 hours a day, five days of the
week. On Saturday he helps the family with household chores. On Sunday he takes the day

off and enjoys himself. Now with such a busy life, we cannot expect him to obtain optimal
returns from investments in the equity market. Where is the time for thought, analysis and
action? He would at best be playing a game of Russian roulette.
For a person with such a busy life schedule it would be best to invest in fixed income
securities. These would include RBI bonds, Bank deposits, insurance, etc. Where there is a
lower but assured return. However, if this average, hard working and successful person still
wants to invest in the equity market for a relatively higher rate of return. Then he would have
to create the time for the thought, analysis and action required for success in this endeavor.
Portfolio strategies are mainly of two types: Active strategies and Passive strategies. Active
strategies have a higher expectation about the factors that are expected to influence the
performance of the asset class. While Passive strategies involve a minimum expectation
input. The latter would include indexing which would require the investor to replicate the
performance of a particular index. Between these two extremes we have a range of other
strategies which have elements of both active and passive strategies. In the fixed income
segment, structured portfolio strategies have become popular. Here the aim would be to
achieve a predetermined performance in relation to a benchmark. These are frequently used
to fund liabilities.
d. Selecting the Assets
It is of importance for the investor to select specific assets to be included in the portfolio. It is
here that the investor or manager attempts to construct an optimal or efficient portfolio. This
would give the expected return for a given level of risk, or the lowest risk for a given
expected return.
The asset classes he can choose from are:
 Equity
 Fixed income securities (which would include RBI bonds and bank deposits)
 Debt instruments
 Real estate
 Art objects
 Rare stamps
 Currencies
The investor would ideally have all the above in his investment portfolio. This would then
require the investor to rebalance the various components of his overall portfolio from time to
time, depending on his objectives with respect to this portfolio. These objectives may be time
based or asset price based or a combination of both.
e. Measuring and Evaluating Performance
This step would involve the measuring and evaluating of portfolio performance relative to a
realistic benchmark. We would measure portfolio performance in both absolute and relative
terms, against a predetermined, realistic and achievable benchmark. Further, we would

evaluate the portfolio performance relative to the objective and other predetermined
performance parameters.
The investor or manager would consider two main aspects; namely risk and return. He would
measure and evaluate, whether the returns were worth the risk, or whether the risk was worth
the return. The issue here is, whether the portfolio has achieved commensurate returns, given
the risk exposure of the portfolio
1.4 Investment Alternatives
Now-a-days a wide range of investment opportunities are available to the investor.
These are primarily bank deposits, corporate deposits, bonds, units of mutual funds,
instruments under National Savings Schemes, pension plans, insurance policies, equity
shares etc. All these instruments compete with each other for the attraction of investors.
Each instrument has its own return, risk, liquidity and safety profile. The profiles of
households differ depending upon the income-saving ratio, age of the household’s head,
number of dependents etc. The investors tend to match their needs with the features of the
instrument available for investment. They do have varying degrees of preferences for
savings vehicles.
Every investor tends to keep some cash balance and maintain a certain amount in the form
of bank deposit to meet his/her transaction and precautionary needs. In the case of salaried
people, contributions to Employees Provident Fund become compulsory. Life Insurance is
widely preferred to meet situations arising out of untimely deaths of the bread earner.
Besides these needs, the surplus income (savings) awaits investment in alternative financial
assets. Investors have to take decisions relating to their investment in competing assets/
avenues. An investor has a wide array of investment avenues, which may be classified as
shown in the Exhibit 1.1.
Investment Avenues
1.4.1 Equity shares

A share is a single unit of ownership in a corporation, mutual fund, or other organization.
A joint stock divides its capital into shares, which are offered for sale to raise capital,
termed as issuing shares. Thus, a share is an indivisible unit of capital, expressing the

proprietary relationship between the company and the shareholder. The denominated value
of a share is its face value: the total capital of a company is divided into number of shares.
In financial markets, a share is a unit of account for various financial instruments including
stocks (ordinary or preferential), and investments in limited partnerships, and real estate
investment trusts. The common feature of all these is equity participation (limited in the
case of preference shares).The income received from shares is known as a dividend. A
shareholder, also known as a stockholder, is a person who owns shares of a certain
company or organization, and is thus a part-owner of the company. The process of
purchasing and selling shares often involves going through a stockbroker as a middle man.
A firm's total assets minus its total liabilities. Equivalently, it is share capital plus retained
earnings minus treasury shares. Shareholders' equity represents the amount by which a
company is financed through common and preferred shares.
Shareholder' Equity = Total Assets - Total Liabilities
OR
Shareholders' Equity = Share Capital + Retained Earnings - Treasury Shares
Also known as "share capital", "net worth" or "stockholders' equity". Shareholders' equity
comes from two main sources. The first and original source is the money that was
originally invested in the company, along with any additional investments made thereafter.
The second comes from retained earnings which the company is able to accumulate over
time through its operations. In most cases, the retained earnings portion is the largest
component. EQUITY SHARE is a. a share or class of shares whether or not the share
carries voting rights, b. any warrants, options or rights entitling their holders to purchase or
acquire the shares referred to under (a), or c. other prescribed securities. An equity share is
a perpetual liability because it signifies an owner legal demand upon the assets of the entity
in which the equity share if held.
Stock typically takes the form of shares of either common stock or preferred stock. As a
unit of ownership, common stock typically carries voting rights that can be exercised in
corporate decisions. Preferred stock differs from common stock in that it typically does not
carry voting rights but is legally entitled to receive a certain level of dividend payments
before any dividends can be issued to other shareholders. Convertible preferred stock is
preferred stock that includes an option for the holder to convert the preferred shares into a
fixed number of common shares, usually anytime after a predetermined date. Shares of such
stock are called "convertible preferred shares" (or "convertible preference shares" in the
UK).
Although there is a great deal of commonality between the stocks of different companies,
each new equity issue can have legal clauses attached to it that make it dynamically
different from the more general cases. Some shares of common stock may be issued
without the typical voting rights being included, for instance, or some shares may have

special rights unique to them and issued only to certain parties. Note that not all equity
shares are the same.
Preferred stock may hybrid by having the qualities of bonds of fix return and common stock
having voting right. They also have preference in the payment of dividend over prefer stock
and also have given the preference at the time of liquidation over common stock. They have
other features of accumulation in dividend.
The investor, however, has to bear in mind that the shares of a blue chip comany, though
issued at a premium, could have a far greater demand in the market for various reasons.
When there is an over subscription on the issue, many small investors might not get an
allotment of the shares. Hence, demand for the shares goes up immediately when the shares
are traded in the secondary market.
1.4.2 Preference shares:
Capital stock which provides a specific dividend that is paid before any dividends are paid
to common stock holders, and which takes precedence over common stock in the event of
liquidation. Like common stock, preference shares represent partial ownership in a
company, although preferred stock shareholders do not enjoy any of the voting rights of
common stock holders. Also unlike common stock, preference shares pay a fixed dividend
that does not fluctuate, although the company does not have to pay this dividend if it lacks
the financial ability to do so. The main benefit to owning preference shares are that the
investor has a greater claim on the company assets than common stockholders. Preferred
shareholders always receive their dividends first and, in the event the company goes
bankrupt, preferred shareholders are paid off before common stockholders.
1.4.3 Debentures and Bond:
A type of debt instrument that is not secured by physical asset or collateral. Debentures are
backed only by the general creditworthiness and reputation of the issuer. Both corporations
and governments frequently issue this type of bond in order to secure capital. Like other
types of bonds, debentures are documented in an indenture. Debentures have no collateral.
Bond buyers generally purchase debentures based on the belief that the bond issuer is
unlikely to default on the repayment. An example of a government debenture would be any
government-issued Treasury bond (T-bond) or Treasury bill (T-bill). T-bonds and T-bills
are generally considered risk free because governments, at worst, can print off more money
or raise taxes to pay these type of debts Bonds and debentures are fixed income instruments
which are taken by investors looking for regular, fixed income through payment of interest
on the principal purchase. Bonds and debentures are debt instruments with different types
of exposure. In general terms bondholders are secured by access to the underlying asset in
case of default by the issuer. Debentures, on the other hand, are unsecured, and debenture
holders do not have recourse to assets in the case of default by the debenture issuer.
a. Convertible debentures:

A type of loan issued by a company that can be converted into stock by the holder and,
under certain circumstances, the issuer of the bond. By adding the convertibility option the
issuer pays a lower interest rate on the loan compared to if there was no option to convert.
These instruments are used by companies to obtain the capital they need to grow or
maintain the business. Convertible debentures are different from convertible bonds because
debentures are unsecured; in the event of bankruptcy the debentures would be paid after
other fixed income holders. The convertible feature is factored into the calculation of the
diluted per-share metrics as if the debentures had been converted. Therefore, a higher share
count reduces metrics such as earnings per share, which is referred to as dilution.
b. Government securities:
A government bond is a bond issued by a national government, generally promising to pay
a certain amount (the face value) on a certain date, as well as periodic interest payments.
Bonds are debt investments whereby an investor loans a certain amount of money, for a
certain amount of time, with a certain interest rate, to a company or country. Government
bonds are usually denominated in the country's own currency. Bonds issued by national
governments in foreign currencies are normally referred to as sovereign bonds, although
the term "sovereign bond" may also refer to bonds issued in a country's own currency. The
first ever government bond was issued by the English government in 1693 to raise money
to fund a war against France. It was in the form of a tontine. Later, governments in Europe
started issuing perpetual bonds (bonds with no maturity date) to fund wars and other
government spending. The use of perpetual bonds ceased in the 20th century, and currently
governments issue bonds of limited duration.
Government bonds are usually referred to as risk-free bonds, because the government can
raise taxes or create additional currency in order to redeem the bond at maturity. Some
counter examples do exist where a government has defaulted on its domestic currency debt,
such as Russia in 1998 though this is very rare. Another example is Greece in 2011. Its
bonds were considered very risky, in part because Greece did not have its own currency.
c. Public sector undertakings bonds:
Public Sector Undertakings (PSUs) issue debentures that are referred to as PSU bonds.
Minimum maturity of PSU bonds is generally 5 years for taxable bonds and 7 years for tax-
free bonds. The maturity of some bonds is also 10 years. The typical maturity of a corporate
debenture is between 3-12 years. Debentures with lower maturity are normally issued as
debenture convertible partly or fully into equity. The interest income from bonds and
debentures is classified under the heading “income from business or profession”. The
difference between face value and issue price in the case of Deep Discount Bonds can be
classified as interest to be accrued on field basis every year. The incidence of TDS on
bonds and debentures depend on the terms and structure thereof. The interest on taxable
bonds is exempt only up to a certain limit as per section 80L of the Income-Tax Act,
whereas the interest on tax-free bonds is fully exempt. While PSUs are free to set the

interest rates on taxable bonds, they cannot offer more than a certain interest rate on tax-
free bonds, which is fixed by the Ministry of Finance. More important, a PSU can issue tax-
free bonds only with the prior approval of Ministry of Finance.
In general, PSU bonds have the following investor-friendly features-
a. There is no deduction of tax at source on the interest paid on these bonds;
b. They are transferable by mere endorsement and delivery;
c. There is no stamp duty applicable on transfer; and
d. They are traded on the stock exchanges.
In addition, some institutions are ready to buy and sell these bonds with a small price
difference.
1.4.4 Money market instruments
The major purpose of financial markets is to transfer funds from lenders to borrowers.
Financial market participants commonly distinguish between the capital market and the
Money market. The money market refers to borrowing and lending for periods of a year or
less.
a. Treasury bills
Treasury bills are short-term securities issued by the U.S. Treasury. The Treasury sells bills
at regularly scheduled auctions to refinance Eagle Traders issues. It also helps to finance
current federal deficits. They further sell bills on an irregular basis to smooth out the
uneven flow of revenues from corporate and individual tax receipts.
A certificate of deposit is a document evidencing a time deposit placed with a depository
institution. The following information appears on the certificate:
 the amount of the deposit
 the date on which it matures
 the interest rate; and
 The method under which the interest is calculated.
Large negotiable CDs are generally issued in denominations of $1 million or more.
b. Commercial Paper
Commercial Paper is a short-term unsecured promissory note issued by corporations and
foreign governments. It is a low-cost alternative to bank loans, for much large, credit
worthy issuers. Issuers are able to efficiently raise large amounts of funds quickly and
without expensive Securities and Exchange Commission (SEC) registration. They sell
paper, either directly or through independent dealers.
c. Deposits
Among non-corporate investments, the most popular are deposits with banks such as
savings accounts and fixed deposits. In fact, deposits are similar to fixed income securities
as they earn a fixed return. However, unlike fixed income securities, deposits are not
represented by negotiable instruments. The important types of deposits in India include-

bank deposits, company deposits, post office time deposits, post office recurring deposits,
and monthly income scheme of post office.
A bank deposit, which is a safe, liquid and convenient option, can be made by opening a
bank account and depositing money in it. There are various kinds of bank accounts: current
account, savings account, and fixed deposit account. While a deposit in current account
does not earn any interest, deposits in other kinds of bank accounts earn interest. Deposits
in scheduled banks are very safe because of the regulations of RBI and the guarantee
provided by the Deposit Insurance Corporation. While saving bank account gives an
interest of 3.5 per cent per annum, bank fixed deposits give interest from 5 to 11 per cent
depending on duration from 30 days to 5 years and above. The interest rates on bank
deposits are generally slightly higher than those on post office time deposits. No
withdrawal is permitted before six months from post office time deposits (POTD)... The
tenure of recurring deposits is 5 years and can be extended for another five years.
d. Monthly Income Scheme of the Post Office (MISPO)-
This scheme appeals to conservative investors with traditional values, and for good reason.
This scheme offers monthly income and is a safe, guaranteed-by-the-government option.
For retirees, widows and others looking for a steady income, it can be ideal. The Post
Office Monthly Income Scheme, or PO MIS, is offered by Indian Post Offices. A lump sum
amount is deposited with the post office and monthly interest earned each month is paid out
to you. As the scheme is offered by post offices, it is backed by the government. Thus, the
PO MIS is one of the safest investments available.
e. Tax sheltered saving schemes
Tax-sheltered saving schemes provide significant tax benefits to those who participate in
them. The most important tax-sheltered saving schemes in India are-
 Employees Provident Fund
 Public Provident Fund Scheme
f. Employees Provident Fund Scheme (EPF):
Employees' Provident Fund Scheme takes care of following needs of the members:
i. Retirement
ii. Medical Care
iii. Housing
iv. Family obligation
v. Education of Children
vi. Financing of Insurance Polices
g. Public Provident Fund Scheme (PPF): Public Provident Fund F (PPF) is a savings-
cum-tax-saving instrument in India. It also serves as a retirement-planning tool for
many of those who do not have any structured pension plan covering them.
Individuals and Hindu Undivided Families can open the PPF account. Even in the

name of a minor account can be opened. A person can have only one account in his
name.
h. Life insurance policies
Till recently, life insurance in India was provided primarily by the Life Insurance
Corporation of India (LIC), which was established by an Act of Parliament in 1956.
However, the insurance sector has now been opened for private players also. Some of the
life insurance policies are briefly described as follows:
i. Endowment assurance policy-
Insures the life of the policy-holder as well as provides him a lump-sum amount at the time
of maturity. Amount assured is payable at the end of endowment period or at the time of
death, if it occurs earlier. Money back policy, the second most popular scheme, is of special
interest to persons who feel the need for lump-sum benefits at periodic intervals. Unlike the
ordinary endowment assurance policy where the full sum assured in the event of survival is
payable only at the end of the endowment period, under this scheme part payments are
made periodically. Under the whole life policy, the assured is required to pay insurance
premiums throughout his life and, on his death, the assured amount is payable to his
beneficiaries.
j. Unit Linked Insurance Plans (ULIPs)-
A type of insurance vehicle in which the policyholder purchases units at their net asset
values and also makes contributions toward another investment vehicle. Unit linked
insurance plans allow for the coverage of an insurance policy, and provide the option to
invest in any number of qualified investments, such as stock, bonds or mutual funds. A unit
linked insurance plan acts just like a savings vehicle, but also has the benefits of an
insurance contract. When an investor purchases units in a ULIP, he or she is purchasing
units along with a larger number of investors, just like an investor would purchase units in a
mutual fund. Different ULIPs offer different qualified investments. Be sure to read the
plan's prospectus before purchasing any ULIP.
The most widely held policy in India is the ‘Money-back policy’ followed by a traditional
endowment policy. Endowment policies are the ideal vehicle for retirement savings
because, in addition to the sum assured, they provide a fat bonus at the time of retirement.
Moreover, the insured does not have to track his investments and has to merely pay his
installments in time.
Innovative Products- With the entry of new players, the insurance market has been flooded
with many new innovative products. While sales of traditional life insurance products like
individual, whole life and term assurance will remain popular, sales of new products like
single premium, investment-linked retirement products, variable life and annuity products
are also on the rise. In fact, these products already have a significant share in the portfolios
of companies that have introduced them.
1.4.5 Financial Derivatives

Financial derivatives have crept into the nation's popular economic vocabulary on a wave of
recent publicity about serious financial losses suffered by municipal governments, well-
known corporations, banks and mutual funds that had invested in these products. Congress
has held hearings on derivatives and financial commentators have spoken at length on the
topic. Derivatives however remain a type of financial instrument that few of us understand
and fewer still fully appreciate, although many of us have invested indirectly in derivatives
by purchasing mutual funds or participating in a pension plan whose underlying assets
include derivative products. In a way, derivatives are like electricity. Properly used, they
can provide great benefit. If they are mishandled or misunderstood, the results can be
catastrophic. Derivatives are not inherently "bad." When there is full understanding of these
instruments and responsible management of the risks, financial derivatives can be useful
tools in pursuing an investment strategy. This brochure attempts to familiarize the reader
with financial derivatives, their use and the need to appreciate and manage risk. It is not a
substitute, however, for seeking competent professional advice before becoming involved
in a financial derivative product.
The introduction of derivative products has to a derivative contract should be able to
identify all the risks that are being assumed (interest rate, currency exchange, stock index,
long or short-term bond rates, etc.) before entering into a derivative contract. Part of the
risk identification process is a determination of the monetary exposure of the parties under
the terms of the derivative instrument. As money usually is not due until the specified date
of performance of the parties' obligations, the lack of an up-front commitment of cash may
obscure the eventual monetary significance of the parties' obligations. Credit and
investment risk of issuers of debt securities. Lately, some commercial firms have begun
issuing ratings on a company's securities which reflect an evaluation of that company's
exposure to derivative financial instruments to which it is a party. , the creditworthiness of
each party to a derivative instrument must be evaluated independently by each counter
party. In a derivative situation, performance of the other party's obligations is highly
dependent on the strength of its balance sheet. Therefore, a complete financial investigation
of a proposed counterparty to a derivative instrument is imperative. Some derivative
products are traded on national exchanges. Regulation of national futures exchanges is the
responsibility of the U.S. Commodities Futures Trading Commission. National securities
exchanges are regulated by the U.S. Securities and Exchange Commission (SEC). Certain
financial derivative products, like options traded on a national securities exchange, have
been standardized and are issued by a separate clearing corporation to sophisticated
investors pursuant to an explanatory offering circular. Performance of the parties under
these standardized options is guaranteed by the issuing clearing corporation. Both the
exchange and the clearing corporation are subject to SEC oversight.
Other derivative products are traded over-the-counter (OTC) and represent agreements that
are individually negotiated between parties. If you are considering becoming a party to an

OTC derivative, it is very important to investigate first the creditworthiness of the parties
obligated under the instrument so you have sufficient assurance that the parties are
financially responsible.
Stock futures are traded in the market regularly and, in terms of turnover, have succeeded
that of other derivative instruments.
1.4.6 Real estate
Buying property is an equally strenuous investment decision. Real estate investment
generally offers easy entry and good hedge against inflation. But, during deflationary and
recessionary periods, the value of such investments may decline. Real estate investments
are classified as direct or indirect. In a direct investment, the investor holds legal little to the
property. Direct real estate investments include single-family dwellings, duplexes,
apartments, land and commercial property. In case of indirect investment, investors appoint
a trustee to hold legal title on behalf of all the investors in the group. The more affluent
investors are likely to be interested in the following types of real estate: agricultural land,
semi-urban land, and time-share in a holiday resort. The most important asset for individual
investors generally is a residential house or flat because the capital appreciation of
residential property is, in general, high. Moreover, loans are available from various quarters
for buying/constructing a residential property. Interest on loans taken for
buying/constructing a residential house is tax-deductible within certain limits. Besides,
ownership of a residential property provides psychological satisfaction.
However, real estate may have the disadvantages of illiquidity, declining values, lack of
diversification, lack of tax shelter, a long depreciation period and management problems.
Reasons for investing in real estate are given below:
 High capital appreciation compared to gold or silver particularly in the urban area.
 Availability of loans for the construction of houses.
 The possession of a house gives an investor a psychologically secure feeling and a
standing among his friends and relatives.
1.4.7 Precious Objects
If one believes investing in real estate is too risky or too complicated, one might want to
consider other-tangible investments, such as gold and other precious metals, gems and
collectibles. Such investments may entail both risk and reward. Precious objects are items
that are generally small in size but highly valuable in monetary terms. The two most widely
held precious metals that appeal to almost all kinds of investors are gold and silver.
Historically, they have been good hedges against inflation. Also, they are highly liquid with
very low trading commissions. Investment in gold and silver, however, has no tax
advantage associated with them. When the economy picks up, some investors predict
higher inflation and therefore, may think precious metals such as gold and silver will regain
some of their glitter. Precious stones include diamonds, sapphires, rubies and emeralds.

Precious stones appeal to investors because of their small size, ease of concealment, great
durability and potential as a hedge against inflation. Collectibles include rare coins, works
of art, antiques, Chinese ceramics, paintings and other items that appeal to collectors and
investors. Each of these items offers the knowledgeable collector/ investor both pleasure
and the opportunity for profit. It does not provide current income, and may be difficult to
sell quickly.
1.5 Indirect Investments
Indirect investing can be undertaken by purchasing the shares of an investment company. An
investment company sells shares in itself to raise funds to purchase a portfolio of securities.
The motivation for doing this is that the pooling of funds allows advantage to be taken of
diversification and of savings in transaction costs. Many investment companies operate in
line with a stated policy objective, for example on the types of securities that will be
purchased and the nature of the fund management.
a. Unit Trusts
A unit trust is a registered trust in which investors purchase units. A portfolio of assets is
chosen, often fixed-income securities, and passively managed by a professional manager.
The size is determined by inflow of funds. Unit trusts are designed to be held for long periods
with the retention of capital value a major objective.
b. Investment Trusts
The closed-end investment trust issue a certain fixed sum of stock to raise capital.
After the initial offering no additional shares are sold. This fixed capital is then managed by
the trust. The initial investors purchase shares, which are then traded on the stock market.
An open-end investment company (or mutual fund) continues to sell shares after the initial
public offering. As investors enter and leave the company, its capitalization will continually
change. Money-market funds hold money-market instrument while stock and bond and
income funds hold longer-maturity assets.
c. Hedge Funds
A hedge fund is an aggressively managed portfolio which takes positions on both safe and
speculative opportunities. Most hedge funds are limited to a maximum of 100 investors with
deposits usually in excess of $100,000. They trade in all financial markets, including the
derivatives market.
1.6 Return and Risks

1.6.1 Introduction
Return expresses the amount which an investor actually earned on an investment during a
certain period. Return includes the interest, dividend and capital gains; while risk represents
the uncertainty associated with a particular task. In financial terms, risk is the chance or
probability that a certain investment may or may not deliver the actual/expected returns.
The risk and return trade off says that the potential return rises with an increase in risk. It is

important for an investor to decide on a balance between the desire for the lowest possible
risk and highest possible return.
Risk Analysis
Risk in investment exists because of the inability to make perfect or accurate forecasts. Risk
in investment is defined as the variability that is likely to occur in future cash flows from an
investment. The greater variability of these cash flows indicates greater risk. Variance or
standard deviation measures the deviation about expected cash flows of each of the possible
cash flows and is known as the absolute measure of risk; while co-efficient of variation is a
relative measure of risk.
For carrying out risk analysis, following methods are used-
 Payback [How long will it take to recover the investment]
 Certainty equivalent [The amount that will certainly come to you]
 Risk adjusted discount rate [Present value i.e. PV of future inflows with discount
rate]
However in practice, sensitivity analysis and conservative forecast techniques being simpler
and easier to handle, are used for risk analysis. Sensitivity analysis [a variation of break
even analysis] allows estimating the impact of change in the behavior of critical variables
on the investment cash flows. Conservative forecasts include using short payback or higher
discount rates for discounting cash flows.
1.6.2 Returns on financial assets
People want to maximize expected returns subject to their tolerance for risk. Return is the
principal reward in the investment process, and it provides the basis to investors in
comparing alternative investments. Measuring historical returns allows investors to assess
how well they have done, and it plays a part in the estimation of future, unknown returns.
We often use two terms regarding return from investments, realized return and expected
return. Realized return is after the fact return that was earned. Realized return is history.
Expected return is the return from an asset that investors anticipate they will earn over some
future period. It is a predicted return, and it may or may not occur.
Components of return
Stock returns consist of both a capital gain and a dividend yield component, and we show
that predictability of stock returns by lagged dividend-price ratios mainly reflects
predictability of future dividend yields, which make up a significant component of average
returns. We propose a novel log linear approximation of stock returns into a capital gain
and a dividend yield component and derive testable restrictions of non predictability of
capital gains.
We often use the term yield to express return. Yield refers to the income component in
relation to some price for a security. For our purposes, the price that is relevant is the
purchase price of the security. The yield on a Rs. 1,000 par value, 6 per cent coupon bond
purchased for Rs. 950 is 6.31 per cent (Rs. 1,000 par value, 6 percent coupon bond

purchased for Rs. 950 is 6.31 percent (Rs. 60/Rs. 950). However, we need to remember that
yield is not, for most purposes, the proper measure of return from a security. The capital
gain or loss must also be considered. Equation 1.1 is a conceptual statement for total return.
Total return = Income + Price change (+/-) … (1.1)
Note that either component of return can be zero for a given security over any given time
period. A bond purchased for Rs. 800 and held to maturity provides both type of income:
interest payments and a price change. The purchase of a non-dividend-paying stock that is
sold four months later produces either a capital gain or a capital loss, but no income.
Thus, a measure of return must consider both dividend/interest income and price change.
Returns over time or from different securities can be measured and compared using the
total return concept. The total return for a given holding period relates all the cash flows
received by an investor during any designated time period to the amount of money invested
in the asset. Total return is defined as
Cash payments received + Price change over the period
Total return = --------------------------------------------------------- X 100
Purchase price of the asset
(P(t-1) – P(t-1) ) + D
r= -----------------------
P(t)
Where, r = total return, P(t) = price of an asset at time (t), P(t–1) = price of an asset at time
(t-1), D = dividend or interest income in simple terms.
Example: Jindal Steels share’s price on June 10, 2004 is Rs. 900 (Pt–1) and the price on
June 9, 2005 (Pt), is Rs. 950. Dividend received is Rs. 76 (D). Determine the rate of return.
Solution:
(P(t-1) – P(t-1) ) + D
r= ----------------------- X 100
P(t)
(950 – 900) + 76
= ------------------- X 100
900
= 126/900 X 100
= 14%
Calculation of average returns
The total return is an acceptable measure of return for a specified period of time. But we
also need statistics to describe a series of returns. For example, investing in a particular
stock for ten years or a different stock in each of ten years could result in 10 total returns,
which must be described mathematically. There are two generally used methods of
calculating the average return, namely, the arithmetic average and geometric average. The
statistics familiar to most people is the arithmetic average. The arithmetic average,

customarily designated by the symbol X = ΣX /n, or the sum of each of the values being
considered divided by the total number of values.
Example: The return of stock A for four quarters is as follows: Quarter-I = 10%; Quarter-
II= 8%; Quarter-III= -4%; and Quarter IV= 20%. The average return is
X = 10 + 8 + (-4) + 20 /4 = 8.5%
The arithmetic average return is appropriate as a measure of the central tendency of a
number of returns calculated for a particular time, such as a year. However, when
percentage changes in value over time are involved, the arithmetic mean of these changes
can be misleading. The geometric average return measures compound, cumulative returns
over time. It is used in investments to reflect the realized change in wealth over multiple
periods. The geometric average is defined as the nth root of the product resulting from
multiplying a series of returns together, as in Equation 1.2.
G = [(1 + r1) (1 + r2) … (1 + r n)] 1/n – 1 … (1.2)
Where, r = total return, n = number of periods.
Return relative: On adding 1.0 to each return (r), we shall get a return relative. If the return
for a period is 10 percent (.10), then the return relative is 1.10. The investor has received
Rs. 1.10 relative to each Rs. 1 invested. If the return for a period is –15 percent (-.15) then
the return relative is .85 (1-.15). Return relatives are used in calculating geometric average
returns because negative total returns cannot be used in the math. Here, we also need to
note that the geometric average rate of return would be lower than the arithmetic average
rate of return because it reflects compounding rather than simple averaging.
1.6.3 Risk in holding securities
Risk is generally associated with the possibility that realized returns of securities will be
less than the returns that were expected. The source of such risk is the failure of dividends
(interest) and/or the security’s price to materialize as expected.
There are numerous forces that contribute to variations in return— price or dividend
(interest). These forces are termed as elements of risk. Some factors are external to the firm
and cannot be controlled. These factors affect large numbers of securities. In investments,
those forces that are uncontrollable, external, and broad in their effect are called sources of
systematic risk. Other forces are internal to the firm and are controllable to a large degree.
The controllable, internal factors Somewhat peculiar to industries and/or firms are referred
to as sources of unsystematic risk.
That portion of total variability in return caused by factors affecting the prices of all
securities is known as systematic risk. Economic, political, and sociological changes are
sources of systematic risk. Their effect is to cause prices of nearly all individual common
stocks and/or all individual bonds to move together in the same manner. Conversely, the
portion of total risk that is unique to a firm or industry is called unsystematic risk. Factors
such as management capability, consumer preferences, and labour strikes cause
unsystematic variability of returns in a firm. Unsystematic factors are largely independent

of factors affecting securities markets in general. Because these factors affect one firm, they
must be examined for each firm.
Sources of systematic risk
As discussed, the main constituents of systematic risk include- market risk, interest rate risk
and purchasing power risk.
a. Market risk:
Market risk is the risk that the value of a portfolio, either an investment portfolio or a
trading portfolio, will decrease due to the change in value of the market risk factors. The
four standard market risk factors are stock prices, interest rates, foreign exchange rates, and
commodity prices. The price of a stock may fluctuate widely within a short span of time
even though earnings remain unchanged. The causes of this phenomenon are varied, but it
is mainly due to a change in investors’ attitudes towards equities in general, or toward
certain types or groups of securities in particular. Variability in return on most common
stocks that is due to basic sweeping changes in investor expectations is referred to as
market risk. The reaction of investors to tangible as well as intangible events causes market
risk.
Expectations of lower corporate profits in general may cause the larger body of common
stocks to fall in price. Investors are expressing their judgement that too much is being paid
for earnings in the light of anticipated events. The basis for the reaction is a set of real,
tangible events– political, social, or economic.
b. Interest-rate risk:
Interest rates are constantly moving. When interest rates go up, the market value of bonds
issued in the past with lower interest rates, will go down. (As their price goes down, the
yield will rise, making them competitive with interest rates being offered on new bonds). If
you need to sell a bond before its maturity date, you will lose money if interest rates are
higher when you sell the bond, than they were when you bought it. This is what is known as
interest rate risk. Interest rates and bond prices carry an inverse relationship; as interest
rates fall, the price of bonds trading in the marketplace generally rises. Conversely, when
interest rates rise, the price of bonds tends fall. This happens because when interest rates are
on the decline, investors try to capture or lock in the highest rates they can for as long as
they can. To do this, they will scoop up existing bonds that pay a higher rate of interest than
the prevailing market rate. This increase in demand translates into an increase in bond price.
On the flip side, if the prevailing interest rate were on the rise, investors would naturally
jettison bonds that pay lower rates of interest. This would force bond prices down.
c. Purchasing-power risk:
The risk that unexpected changes in consumer prices will penalize an investor's real return
from holding an investment. Because investments from gold to bonds and stock are priced
to include expected inflation rates, it is the unexpected changes that produce this risk. Fixed
income securities, such as bonds and preferred stock, subject investors to the greatest

amount of purchasing power risk since their payments are set at the time of issue and
remain unchanged regardless of the inflation rate. When an investor buys a bond, he or she
essentially commits to receiving a rate of return, either fixed or variable, for the duration of
the bond or at least as long as it is held.
But what happens if the cost of living and inflation increase dramatically, and at a faster
rate than income investment? When that happens, investors will see their purchasing power
erode and may actually achieve a negative rate of return (again factoring in inflation).
Put another way, suppose that an investor earns a rate of return of 3% on a bond. If inflation
grows to 4% after the purchase of the bond, the investor's true rate of return (because of the
decrease in purchasing power) is -1%.
d. Unsystematic risk
Market, purchasing-power, and interest-rate risks are the principal sources of systematic
risk in securities; but we should also consider another important category of security
risks— unsystematic risks. The portion of total risk that is unique or peculiar to a firm or an
industry, above and beyond those affecting securities markets in general is called
unsystematic risk. Factors such as management capability, consumer preferences, and
labour strikes can cause Unsystematic variability of returns for a company’s stock.
Examples of unsystematic risks:
 Business risk: Business risks are of a diverse nature and arise due to innumerable
factors. These risks may be broadly classified into two types, depending upon their
place of origin.
 Internal Risks are those risks which arise from the events taking place within the
business enterprise. Such risks arise during the ordinary course of a business. These
risks can be forecasted and the probability of their occurrence can be determined.
Hence, they can be controlled by the entrepreneur to an appreciable extent External
risks are those risks which arise due to the events occurring outside the business
organization. Such events are generally beyond the control of an entrepreneur. Hence,
the resulting risks cannot be forecasted and the probability of their occurrence cannot
be determined with accuracy.
e. Financial Risk:
While there is almost always a ready market for government bonds, corporate bonds are
sometimes entirely different animals. There is a risk that an investor might not be able to
sell his or her corporate bonds quickly due to a thin market with few buyers and sellers for
the bond.
Low interest in a particular bond issue can lead to substantial price volatility and possibly
have an adverse impact on a bondholder's total return (upon sale). Much like stocks that
trade in a thin market, you may be forced to take a much lower price than expected to sell
your position in the bond.
f. Default or insolvency risk:

When an investor purchases a bond, he or she is actually purchasing a certificate of debt.
Simply put, this is borrowed money that must be repaid by the company over time with
interest. Many investors don't realize that corporate bonds aren't guaranteed by the full faith
and credit of the U.S government but are dependent on the corporation's ability to repay
that debt. Investors must consider the possibility of default and factor this risk into their
investment decision. As one means of analyzing the possibility of default, some analysts
and investors will determine a company's coverage ratio before initiating an investment.
They will analyze the corporation's income statement and cash flow statement, determine
its operating income and cash flow, and then weigh that against its debt service expense.
The theory is the greater the coverage (or operating income and cash flow) in proportion to
the debt service expenses, the safer the investment.
g. Other Risks
Besides the above described risks, there are many more risks, which can be listed, but in
actual practice, they may vary in form, size and effect. Some of such identifiable risks are
the Political Risks, Management Risks and Liquidity Risks etc. Political risk may occur due
to the changes in the government, or its policy shown in fiscal or budgetary aspects,
changes in tax rates, imposition of controls or administrative regulations etc. Management
risks arise due to errors or inefficiencies of management, causing losses to the company.
Marketability liquidity risks involve loss of liquidity or loss of value in conversions from
one asset to another say, from stocks to bonds, or vice versa. Such risks may arise due to
some features of securities, such as call ability; or lack of sinking fund or Debenture
Redemption Reserve fund, for repayment of principal or due to conversion terms, attached
to the security, which may go adverse to the investor.
1.6.4 Risk measurement
Understanding the nature and types of risk is not adequate unless the investor or analyst is
capable of measuring it in some quantitative terms. The quantitative expression of the risk
of a stock would make it comparable with other stocks. However, the risk measurements
cannot be considered fully accurate as it is caused by multiplicity of factors such as social,
political, economic and managerial aspects.
Risk is measured by the variability of returns. The statistical tool often used to measure risk
is the standard deviation. We know, standard deviation is a measure of the values of the
variables around its mean or it is the square root of the sum of the squared deviations from
the mean divided by the number of observations. This can be illustrated with an example.
Example: The following information is given about two companies Rani Limited and
Raja Limited. Compute standard deviation of the returns of their shares

We may note from the above information the expected returns (means) are same in case of
both the companies. The return of the Rani Ltd. ranges between 5 percent and 13 percent
while that of Raja Ltd. ranges between 5 percent and 11 percent. The standard deviation
and variance may be calculated as follows:
The expected returns for both the companies under consideration are same (i.e. 9.3%). But
the variations in expected returns are different. The returns of Raja Ltd. are more stable
than that of Rani Ltd. Hence, the share of the former is safer than the latter company. The
standard deviation is an absolute measure, which can be applied when the mean is the
same. But the coefficient of variation is the relative measure of the degree of uncertainty.

Example: Torrent and company estimates the probability and the expected returns as
returns for the five observations as follows:
(a) What are the expected values of return and standard deviation?
Ans. Expected return equation is R = nΣ i=1 RPi i
= .10 × 0.1 + 0.05 × 0.2 +0.2 × 0.4 + 0.35 × 0.2 + 0.5 × 0.1
= 0.01 + 0.01 + 0.08 + 0.07 + 0.05
= 22%
σ = NΣ i=1 P(R – ) i R 2Pi
= 22 from the above
= [(.10 - .22)2 × 0.1 + (0.05 - .22)2 × 0.2 + (.20 - .22)2 × 0.4
+ (.35 - .22)2 × 0.2 + (.50 - .22)2 × 0.1
= .00144 + .00578 + .00016 + .00338 + .00784 = .01860
σ = 0.0186 = 0.1364 = 13.64%
The concepts of variance, standard deviation, covariance and beta coefficients etc., are
also used to explain the measure of risk. In the context of portfolio of assets, or
investment in any assets risk is inherent in all such dealings. This risk primarily arises first
out of parting of your funds or loss of liquidity. Money lent or parted is always having an
element of risk. This element is the same as the concept of total risk.
1.7 Capital Asset Pricing Model (CAPM)

William Sharpe published the capital asset pricing model (CAPM). Parallel work was also
performed by Treynor and Lintner. CAPM extended harry Markowitz’s portfolio theory
to introduce the notions of systematic and specific risk. For his work on CAPM, Sharpe
shared the 1990 Nobel Prize in Economics with Harry Markowitz and Merton Miller.
CAPM considers a simplified world where:
 There are no taxes or transaction costs.
 All investors have identical investment horizons.
 All investors have identical opinions about expected returns, volatilities and correlations
of available investments.
CAPM decomposes a portfolio's risk into systematic and specific risk. Systematic risk is the
risk of holding the market portfolio. As the market moves, each individual asset is more or
less affected. To the extent that any asset participates in such general market moves, that
asset entails systematic risk. Specific risk is the risk which is unique to an individual asset.
It represents the component of an asset's return which is uncorrelated with general market
moves. According to CAPM, the marketplace compensates investors for taking systematic
risk but not for taking specific risk. This is because specific risk can be diversified away.

When an investor holds the market portfolio, each individual asset in that portfolio entails
specific risk, but through diversification, the investor's net exposure is just the systematic
risk of the market portfolio. Systematic risk can be measured using beta. According to
CAPM, the expected return of a stock equals the risk-free rate plus the portfolio's beta
multiplied by the expected excess return of the market portfolio. Specifically, let z s and zm
be random variables for the simple returns of the stock and the market over some specified
period. Let zf be the known risk-free rate, also expressed as a simple return, and let ßbe the
stock's beta. Then
E(Zs)=Zf+ß[E(Zm)-Zf]-----------[1]
Where E denotes an expectation.
Stated another way, the stock's excess expected return over the risk-free rate equals its beta
times the market's expected excess return over the risk free rate.
For example, suppose a stock has a beta of 0.8. The market has an expected annual return
of 0.12 (that is 12%) and the risk-free rate is .02 (2%). Then the stock has an expected one-
year return of
E(Zs)=.02+8[.12-.02]=0.10----------[2]
Because 1 is linear, it generalizes to portfolios. Let Zp be a portfolio's simple return, and let
ßnow denote the portfolio's beta. We obtain
E(Zp)=Zf+ß[E(Zm)-Zf]--------------[3]
Formula 1 is the essential conclusion of CAPM. It states that a stocks (or portfolio's) excess
expected return depends on its beta and not its volatility. Stated another way, excess return
depends upon systematic risk and not on total risk.
We call CAPM a "capital asset pricing model" because, given a beta and an expected return
for an asset, investors will bid its current price up or down, and adjusting that expected
return so that it satisfies formula 1. Accordingly, the CAPM predicts the equilibrium price
of an asset. This works because the model assumes that all investors agree on the beta and
expected return of any asset. In practice, this assumption is unreasonable, so the CAPM is
largely of theoretical value. It is the most famous example of an equilibrium pricing model.
Security Market Line (SML)
The SML essentially graphs the results from the capital asset pricing model (CAPM)
formula. The x-axis represents the risk (beta), and the y-axis represents the expected return.
The market risk premium is determined from the slope of the SML.
The relationship between β and required return is plotted on the securities market line
(SML) which shows expected return as a function of β. The intercept is the nominal risk-
free rate available for the market, while the slope is the market premium, E(Rm)− Rf. The
securities market line can be regarded as representing a single-factor model of the asset
price, where Beta is exposure to changes in value of the Market. The equation of the SML
is thus:

SML: E (Ri) = Rf + ßi(E(Rm) - Rf
It is a useful tool in determining if an asset being considered for a portfolio offers a
reasonable expected return for risk. Individual securities are plotted on the SML graph. If
the security's expected return versus risk is plotted above the SML, it is undervalued since
the investor can expect a greater return for the inherent risk. And a security plotted below
the SML is overvalued since the investor would be accepting less return for the amount of
risk assumed.
Thus, CAPM and SML help the investor in evaluating risk for a return, in making any
investment decision. The principle of the higher the risk, the higher is the return is
embodied in this Model.
Concept of portfolio Models
Risks in relation to portfolios are also to be understood in the present discussion.

Therefore, the concept of Risk in two Major Models used in valuation is related to
systematic, unsystematic and total risk. The two models are those of Markowitz and
Sharpe which go by the name of Modern Portfolio Theory. These models are described in
a Financial Management course.
1.8 Summary
Investments are the sacrifice of current liquidity or current birrs for future liquidity. Hence,
this chapter has introduced investment analysis and defined the concept of a security. It has
looked at the securities that are traded and where they are traded. In addition, it has begun the
development of the concepts of risk and return that characterize securities. The fact that these
are related - an investor cannot have more of one without more of another - has been stressed.
This theme will recur throughout the module. The module has also emphasized the role of
uncertainty in investment analysis. This, too, is a continuing theme.
The lesson has also briefly described the different avenues of financial investment both
traditional and modem. They are broadly grouped in to fixed income type and varying

income type. Fixed income group avenues are generally preferred by Risk-averse investors.
Varied income types are called as derivatives. There are different types of derivatives namely
options, futures, warrants, rights, and convertible etc. are available. These avenues help the
investors to choose the particular avenues so as to cater his motives or preference
It is hoped that this discussion has provided a convincing argument for the study of
investment analysis. Very few subjects combine the practical value of investment analysis
with its intellectual and analytical content. It can provide a gateway to a rewarding career and
to personal financial success.
REVEW QUESTIONS
1. The two layers required by the institutional investors for active security selection are
_____ and _____
A. security analysis; tax obligations
B. security analysis; risk tolerance
C. security analysis; portfolio choice
D. security analysis; risk-return trade-off
2. Which of the following statements is correct about investors' risk aversion?
A. Personal trust managers typically display greater risk aversion than do individual
investors.
B. Individual investors' risk aversion tends to decrease over time because investors'
wealth tends to increase over time.
C. A risk adverse investor would not be likely to invest in U.S. equities or in non-U.S.
securities because risk adverse investors seek to minimize risk.
D. In middle age, risk aversion level diminishes.
3. In an investment management process, forming capital market expectations is one of the
steps in
A. Execution
B. Feedback
C. Implementation
D. Planning
4. Major asset classes include all of the following except:
A. real estate
B. certificates of deposit
C. precious metals
D. fixed-income securities
5. Some important regulatory constraints affecting institutional investors are prudent
investor laws, which affect primarily ____________, and ERISA, which affects
_____________.
A. endowment funds; mutual funds
B. personal trusts; pension funds

C. mutual funds; pension funds
D. endowment funds; personal trusts
6. In an investment management process, the steps involved in the feedback phase are:
A. strategic asset allocation, capital market expectations
B. asset allocation and portfolio optimization, security selection, implementation
C. monitoring, rebalancing, performance evaluation
D. Identify constraints and objectives, formulating IPS.
7. A passive approach to portfolio management is based on the concept that
A. asset allocation should be applied only to fixed-income investments
B. investors can consistently identify undervalued securities
C. security prices are generally close to fair levels
D. investment management involves asset allocation and security selection
8. In order for an investor to specify her investment objectives, the investor should identify
her ____________.
A. constraints and return requirement
B. constraints and asset allocation
C. return requirement and risk tolerance
D. asset allocation and risk tolerance
9. Primary market refers to the market
A. that attempts to identify mispriced securities and arbitrage opportunities
B. In which investors’ trade already issued securities.
C. Where new issues of securities are offered.
D. In which securities with custom-tailored characteristics are designed.
10. Which term refers to the valuation of securities included in a portfolio
A. Unbundling
B. Security analysis
C. Security allocation
D. Security selection

CHAPTER TWO
SECURITIES MARKET AND TRADING
2.0 Aim and Objectives
Upon on completing this unit, you should be able to:
 Understand the basic definitions, functions and structure of security
market
 Distinguish between primary, secondary and thirdly financial market
 Explain the Foreign exchange markets
 Discriminate between institutional and private
investments.
 Recognize stock market indicators
2.1 Introduction
Charged with many different functions, the financial system fulfils its various roles mainly
through markets where financial claims and financial services are traded (though in some
lesser-developed economies government dictation and even barter are used). These markets
may be viewed as channels through which moves a vast flow of loan able funds that it
continually being drawn upon by demanders of funds and continually being replenished by
suppliers of funds.
Depending on the characteristics of financial claims being traded and the needs of different
investors, the flow of funds through markets around the world may be divided into different
segments. Comprehensive descriptions of these concepts are given below.
2.1.1: Definition of Security Market
A security market is a market in which financial assets are traded. In addition to enabling
exchange of previously issued financial assets, financial markets facilitate borrowing and
lending by facilitating the sale by newly issued financial assets. Examples of financial
markets include the New York Stock Exchange (resale of previously issued stock shares), the
U.S. government bond market (resale of previously issued bonds), and the U.S. Treasury bills
auction (sales of newly issued T-bills). A financial institution is an institution whose primary
source of profits is through financial asset transactions. Examples of such financial
institutions include discount brokers (e.g., Charles Schwab and Associates), banks, insurance
companies, and complex multi-function financial institutions such as Merrill Lynch.
2.1.2: The Basic Functions of Security Market

Financial markets serve six basic functions. These functions are briefly listed below:
 Borrowing and Lending: Financial markets permit the transfer of funds (purchasing
power) from one agent to another for either investment or consumption purposes.
 Price Determination: Financial markets provide vehicles by which prices are set both
for newly issued financial assets and for the existing stock of financial assets.

 Information Aggregation and Coordination: Financial markets act as collectors and
aggregators of information about financial asset values and the flow of funds from
lenders to borrowers.
 Risk Sharing: Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
 Liquidity: Financial markets provide the holders of financial assets with a chance to
resell or liquidate these assets.
 Efficiency: Financial markets reduce transaction costs and information costs.
 In attempting to characterize the way financial markets operate, one must consider
both the various types of financial institutions that participate in such markets and the
various ways in which these markets are structured.
2.1.3: The Major Players in Financial Markets

By definition, financial institutions are institutions that participate in financial markets, i.e.,
in the creation and/or exchange of financial assets. At present in the United States, financial
institutions can be roughly classified into the following four categories: "brokers;" "dealers;"
"investment bankers;" and "financial intermediaries."
a. Brokers:
A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a
seller (or buyer) to complete the desired transaction. A broker does not take a position in the
assets he or she trades -- that is, the broker does not maintain inventories in these assets. The
profits of brokers are determined by the commissions they charge to the users of their
services (either the buyers, the sellers, or both). Examples of brokers include real estate
brokers and stock brokers.
Diagrammatic Illustration of a Stock Broker:
Payment ----------------- Payment

------------>| |------------->
Stock | | Stock
Buyer | Stock Broker | Seller
<-------------|<----------------|<-------------
Stock | (Passed Thru) | Stock
Shares ----------------- Shares
b. Dealers:
Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not
engage in asset transformation. Unlike brokers, however, a dealer can and does "take
positions" (i.e., maintain inventories) in the assets he or she trades that permit the dealer to
sell out of inventory rather than always having to locate sellers to match every offer to buy.
Also, unlike brokers, dealers do not receive sales commissions. Rather, dealers make profits
by buying assets at relatively low prices and reselling them at relatively high prices (buy low

- sell high). The price at which a dealer offers to sell an asset (the "asked price") minus the
price at which a dealer offers to buy an asset (the "bid price") is called the bid-ask spread and
represents the dealer's profit margin on the asset exchange. Real-world examples of dealers
include car dealers, dealers in U.S. government bonds, and Nasdaq stock dealers.
Diagrammatic Illustration of a Bond Dealer:
Payment ----------------- Payment
------------>| |------------->
Bond | Dealer | Bond
Buyer | | Seller
<-------------| Bond Inventory |<-------------
Bonds | | Bonds
-----------------
c. Investment Banks:
An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs = Initial
Public Offerings) by engaging in a number of different activities:
 Advice: Advising corporations on whether they should issue bonds or stock, and, for
bond issues, on the particular types of payment schedules these securities should
offer;
 Underwriting: Guaranteeing corporations a price on the securities they offer, either
individually or by having several different investment banks form a syndicate to
underwrite the issue jointly;
 Sales Assistance: Assisting in the sale of these securities to the public.
 Some of the best-known U.S. investments banking firms are Morgan Stanley, Merrill
Lynch, Salomon Brothers, First Boston Corporation, and Goldman Sachs.
d. Financial Intermediaries:
Unlike brokers, dealers, and investment banks, financial intermediaries are financial
institutions that engage in financial asset transformation. That is, financial intermediaries
purchase one kind of financial asset from borrowers -- generally some kind of long-term loan
contract whose terms are adapted to the specific circumstances of the borrower (e.g., a
mortgage) -- and sell a different kind of financial asset to savers, generally some kind of
relatively liquid claim against the financial intermediary (e.g., a deposit account). In addition,
unlike brokers and dealers, financial intermediaries typically hold financial assets as part of
an investment portfolio rather than as an inventory for resale. In addition to making profits on
their investment portfolios, financial intermediaries make profits by charging relatively high
interest rates to borrowers and paying relatively low interest rates to savers.
Types of financial intermediaries include: Depository Institutions (commercial banks,
savings and loan associations, mutual savings banks, credit unions); Contractual Savings
Institutions (life insurance companies, fire and casualty insurance companies, pension funds,

government retirement funds); and Investment Intermediaries (finance companies, stock and
bond mutual funds, money market mutual funds).
Diagrammatic Example of a Financial Intermediary: A Commercial Bank

Lending by B Borrowing by B
Deposited
------- Funds ------- funds -------
| |<............. | | <............. | |
| F |.............> | B | ..............> | H |
------- Loan ------- deposit -------
Contracts accounts
Loan contracts Deposit accounts
Issued by F to B issued by B to H
Are liabilities of F are liabilities of B
and assets of B and assets of H
NOTE: F=Firms, B=Commercial Bank, and H=Households
Important Caution: These four types of financial institutions are simplified idealized
classifications, and many actual financial institutions in the fast-changing financial landscape
today engage in activities that overlap two or more of these classifications, or even to some
extent fall outside these classifications. A prime example is Merrill Lynch, which
simultaneously acts as a broker, a dealer (taking positions in certain stocks and bonds it
sells), a financial intermediary (e.g., through its provision of mutual funds and CMA
checkable deposit accounts), and an investment banker.
2.1.4: Structures of Financial Market
The costs of collecting and aggregating information determine, to a large extent, the types of
financial market structures that emerge. These structures take four basic forms:
 Auction markets conducted through brokers;
 Over-the-counter (OTC) markets conducted through dealers;
 Organized Exchanges, such as the New York Stock Exchange, which combine
auction and OTC market features. Specifically, organized exchanges permit
buyers and sellers to trade with each other in a centralized location, like an
auction. However, securities are traded on the floor of the exchange with the
help of specialist traders who combine broker and dealer functions. The
specialists broker trades but also stand ready to buy and sell stocks from
personal inventories if buy and sell orders do not match up.
 Intermediation financial markets conducted through financial intermediaries;
Financial markets taking the first three forms are generally referred to as securities markets.
Some financial markets combine features from more than one of these categories, so the
categories constitute only rough guidelines.

a. Auction Markets:
An auction market is some form of centralized facility (or clearing house) by which buyers
and sellers, through their commissioned agents (brokers), execute trades in an open and
competitive bidding process. The "centralized facility" is not necessarily a place where
buyers and sellers physically meet. Rather, it is any institution that provides buyers and
sellers with a centralized access to the bidding process. All of the needed information about
offers to buy (bid prices) and offers to sell (asked prices) is centralized in one location which
is readily accessible to all would-be buyers and sellers, e.g., through a computer network. No
private exchanges between individual buyers and sellers are made outside of the centralized
facility.
An auction market is typically a public market in the sense that it open to all agents who wish
to participate. Auction markets can either be call markets -- such as art auctions -- for which
bid and asked prices are all posted at one time, or continuous markets -- such as stock
exchanges and real estate markets -- for which bid and asked prices can be posted at any time
the market is open and exchanges take place on a continual basis. Experimental economists
have devoted a tremendous amount of attention in recent years to auction markets.
Many auction markets trade in relatively homogeneous assets (e.g., Treasury bills notes, and
bonds) to cut down on information costs. Alternatively, some auction markets (e.g., in
second-hand jewelry, furniture, paintings etc.) allow would-be buyers to inspect the goods to
be sold prior to the opening of the actual bidding process. This inspection can take the form
of a warehouse tour, a catalog issued with pictures and descriptions of items to be sold, or (in
televised auctions) a time during which assets are simply displayed one by one to viewers
prior to bidding.
Auction markets depend on participation for any one type of asset not being too "thin." The
costs of collecting information about any one type of asset are sunk costs independent of the
volume of trading in that asset. Consequently, auction markets depend on volume to spread
these costs over a wide number of participants.
b. Over-the-Counter Markets:
An over-the-counter market has no centralized mechanism or facility for trading. Instead, the
market is a public market consisting of a number of dealers spread across a region, a country,
or indeed the world, who make the market in some type of asset. That is, the dealers
themselves post bid and asked prices for this asset and then stand ready to buy or sell units of
this asset with anyone who chooses to trade at these posted prices. The dealers provide
customers more flexibility in trading than brokers, because dealers can offset imbalances in
the demand and supply of assets by trading out of their own accounts. Many well-known
common stocks are traded over-the-counter in the United States through NASDAQ (National
Association of Scurries Dealers' Automated Quotation System).

c. Intermediation Financial Markets:
An intermediation financial market is a financial market in which financial intermediaries
help transfer funds from savers to borrowers by issuing certain types of financial assets to
savers and receiving other types of financial assets from borrowers. The financial assets
issued to savers are claims against the financial intermediaries, hence liabilities of the
financial intermediaries, whereas the financial assets received from borrowers are claims
against the borrowers, hence assets of the financial intermediaries. (See the diagrammatic
illustration of a financial intermediary presented earlier in these notes.)
2.2 Types of Financial Markets
Charged with many different functions, the financial system fulfils its various roles mainly
through markets where financial claims and financial services are traded (though in some
lesser-developed economies government dictation and even barter are used). These markets
may be viewed as channels through which moves a vast flow of loan able funds that it
continually being drawn upon by demanders of funds and continually being replenished by
suppliers of funds.
Depending on the characteristics of financial claims being traded and the needs of different
investors, the flow of funds through markets around the world may be divided into different
segments. These include:
2.2.1 Primary versus Secondary Markets
The global financial markets may be divided into primary markets and secondary markets.
When equity shares are initially issued, they are said to be sold in the primary market.
Equity can be issued either privately (unquoted shares) or publicly via shares that are listed
on a stock exchange (quoted shares).
Public market offering of new issues typically involves the use of an investment bank in a
process, which is referred to as the underwriting of securities.
Private placement market includes securities which are sold directly to investors and are
not registered with the securities exchange commission. There are different regulatory
requirements for such securities.
In the private equity market, venture capital is often provided by investors as ‘start-up’
money to finance new, high-risk companies in return for obtaining equity in the company.
In general private placement market is viewed as illiquid. Such a lack of liquidity means that
buyers of shares may demand a premium to compensate for this unappealing feature of a
security.
a) Primary public market
Initial public offering (IPO) means issuing public equity, i.e. when a company is engaged
in offering of shares and is included in a listing on a stock exchange for the first time. It
allows the company to raise funds from the public.
If a company is already listed and issues additional shares, it is called seasoned equity
offering (SEO) or secondary public offering (SPO). When a firm issues equity at a stock

exchange, it may decide to change existing unquoted shares for quoted ones. In this case the
proceeds from sale of shares are received by initial investors. However, when a company
issues newly created shares, the raised funds are received by the company.
Process of going public. The issuing company has to develop a prospectus with detailed
information about the company operations, investments, financing, financial statements and
notes, discussion on the risks involved. This information is provided to potential investors for
making decision in buying large blocks of shares. The prospectus is registered within and
approved by the securities exchange commission. Afterwards the prospectus is sent to
institutional investors, meetings and road shows are organized in order to present the
company.
Share issues are often underwritten by banks. A bank, which is underwriting a share issue
agrees, for a fee, to buy any shares not acquired by investors. This guarantees that the issuing
company receives the funding that it expects. In the case of rights issues, firms sometimes
avoid paying a fee to underwriters by using the deep discount route. In a rights issue, failure
to sell the new shares would result from the share price (prior to the issue) falling below the
sale price of the new shares.
The deep discount method prices the new shares at such a low level that the market price is
extremely unlikely to fall so far.
The share offer price is determined by the lead underwriter, which takes into account the
prevailing market and industry conditions. During the road show the lead underwriter is
engaged in book building, i.e. a process of collecting indications of demanded number of
shares by investors at various possible offer prices.
IPO factors. Public equity markets play a limited role as a source of new funds for listed
corporations. Because of information asymmetry, companies prefer internal financing (i.e.,
retained earnings) to external financing. Myers and Majluf (1984) have introduced the
pecking-order theory, which states that companies adopt a hierarchy of financial preferences.
If external financing is needed, firstly, companies prefer debt funding. Equity is issued only
as a last resort. Statistics on company sources of financing support this view.
On the other hand, during equity markets growth and share price increase periods IPO market
tend to increase dramatically, while the drop in share prices is followed by decrease in net
issuance of public equity. A large number of the issues in the late 1990s were ‘new economy’
offerings, like the technology, media, and telecommunications sector.
Among other factors the economic cycle is considered to play a significant role in a
company’s decision to issue public equity. Equity is often used to finance long-term
investments, which fluctuate over the business cycle. Shiller (2003) has related the timing of
equity issuance with investor sentiment. Developments in investor optimism over time may
have an impact on the cost of equity, thus influencing the amount of equity issued.
E.g., excessive increases in risk aversion resulting in falling stock market prices could raise
the cost of equity, preventing companies from new equity issues. Companies also issue

equity in order to finance the acquisition of other companies, either by using the cash
proceeds of public offerings or by issuing shares, which are subsequently exchanged for the
shares of a target company. Therefore merger and acquisition (M&A) cycles can also be
expected to correlate with equity issuance activity.
There are important advantages and disadvantages of initial public offerings (IPOs).
Advantages of IPOs:
 Possibility to obtain funds to finance investment.
 The price of a company’s shares acts as a measure of the company’s value.
 Increases of company financial independence (e.g. from banks) due to listing of
Company’s shares on a stock exchange.
 Possibility to diversify investments of current company owners by selling stakes
in the company in a liquid market.
 Increased recognition of the company name.
 Improved company transparency.
 A disciplining mechanism for managers.
Disadvantages of IPOs:
 High issuance costs due to underwriters’ commission, legal fees, and other
charges.
 High costs due to disclosure requirements.
 Risk of wider dispersed ownership.
 Separation of ownership and control which causes ‘agency problems’.
 Divergence of managers’ and outside investors’ interests.
 Information asymmetry problems between old and new shareholders.
 Risk of new shareholders focusing on short-term results.
IPO market has received negative publicity due to several problems:
Spinning. Spinning occurs, when investment bank allocates shares from an IPO to corporate
executives. Bankers’ expectations are to get future contracts from the same company.
Laddering. When there is a substantial demand for an IPO, brokers encourage investors to
place the first day bids for the shares that are above the offer price. This helps to build the
price upwards. Some investors are willing to participate to ensure that the brokers will
reserve some shares of the next hot IPO for them.
Excessive commissions. These are charged by some brokers when the demand for an IPO is
high. Investors are willing to pay the commissions if they can recover the costs from the
return on the very first day, especially when the offer price of the share is set significantly
below the market value.
The literature contains strong evidence that IPOs on average perform poorly over a period of
a year or more. Thus from a long term perspective many IPOs are overpriced. Since
introduction of Sarbanes-Oxley Act in US, which aimed at improving company reporting
processes and transparency, initially returns from IPOs in general have been lower.

b) Secondary Equity Market
Equity instruments are traded among investors in a secondary market, in which no new
capital is raised and the issuer of the security does not benefit directly from the sale.
Secondary markets are also classified into organized stock exchanges and over-the counter
(OTC) markets.
Apart from legal structure, numerous historical differences are found in the operations of
national stock markets. The most important differences are in the trading procedures.
The trading on secondary markets takes place among investors, however most often through
specialized intermediaries - stock brokers (dealers), who buy or sell securities for their
clients.
Securities’ trading in the secondary market form the means by which stocks or bonds bought
in the primary market can be converted into cash. The knowledge that assets purchased in the
primary market can easily and cheaply be resold in the secondary market makes investors
more prepared to provide borrowers with funds by buying in the primary market. Effective
secondary market is an important basis of successful primary market.
If transaction costs are high in the secondary market the proceeds from the sale of securities
will be reduced, and the incentive to buy in the primary market would be lower.
Also high transaction costs in the secondary market might tend to reduce the volume of
trading and thereby reduce the ease with which secondary market sales can be executed.
Therefore high transaction costs in the secondary market could reduce primary market asset
liquidity. In consequence there can be adverse effects on the level of activity in the primary
market and hence on the total level of investment in the economy.
c) Organized exchanges
Stock exchanges are central trading locations, in which securities of corporations are traded.
These securities may include not only equity, but also debt instruments as well as derivatives.
Equity instruments can be traded if they are listed by the organized exchange, i.e. included in
a stock exchange trading list. The list is formed of instruments that satisfy the requirements
set by the exchange, including minimum earnings requirements, net tangible assets, market
capitalization, and number and distribution of shares publicly held. Each stock exchange
specifies the set of requirements.
Advantages of listing on the stock exchange to the corporation and its shareholders are:
 The ability to sell shares on the stock exchange makes people more willing to
invest in the company.
 Investors may accept a lower return on the shares and the company can raise
capital more cheaply.
 Stock exchange provides a market price for the shares, and forms basis for
valuation of a company.
 The information aids corporate governance, allows monitoring the management of
the company.

 Listing makes takeover bids easier, since the predator company is able to buy
shares on the stock market.
 The increased transparency may reduce the cost of capital.
 However there are several disadvantages of listing, which include:
 Listing on the stock exchange is costly for the company.
 It requires a substantial amount of documentation to be prepared, e.g. audited and
prepared according to IFRS financial statements.
 It increases transparency, which may cause problems in terms of market
competition and in takeover cases.
Stock market dealers and brokers fulfill specific functions at the equity market. Dealers
make market in securities, maintain securities inventories and risk their own funds. In
contrast to dealers, who risk their own funds, brokers do not own securities, but execute
matching of buyers and sellers for a specific fee.
! Dealer – an agent who buys and sells securities as a principal on its own account, rather
than as a broker for his clients. Dealer may function as a broker, or as market maker.
Dealers stand ready to buy at the bid price and to sell at the ask price, and making profit from
the average spread. However, when the stock prices are going down, dealers experience loss
of value of stock inventory. This forms the primary risk for the dealer.
! Broker – an agent who executes orders to buy and sell securities on behalf of his clients in
exchange for a commission fee.
In order to profit from different price movements directions dealers make positioning.
 If the dealer expects the stock prices to increase, it buys the stock and takes a long
position. Profit is earned, if the stock is sold at a higher price.
 If a dealer expects the stock price to decline, he tries to benefit from a short position.
In a short sale the security is borrowed and sold in the expectation of buying this
security back later at a lower price. The investor tries to sell high and buy low,
profiting from the difference. Proceeds from a short sale cannot be used by the short
seller, and must be deposited at the broker. The short seller must pay any cash
dividends to the lender of the security. This rule is related to the amount of drop in
stock prices by approximately the after-tax amount of a cash dividend after the
dividend payment date. Stock exchanges apply down stick restrictions on short sales
in order to prevent from panic selling and driving stock prices sharply down.
If the dealer’s forecast is wrong, the dealer must close the position at unfavorable price and
absorb the loss. This creates the risk of dealer bankruptcy, and forces stock exchanges as well
as securities exchange commission’s to impose the specific regulations in order to prevent
this type of price manipulations.
! Short sale – the sale of the security, which is not owned by the seller at the time of trade.
Security dealers are heavily levered. Typically the dealer’s equity forms a small percentage
of the market value of his inventory. Most dealers financing is in the form of debt (e.g. bank

loan). Majority of dealer debt financing is in the form of repurchase agreements (REPO, see
chapter on Money markets).
There are several types of stock exchange members:
 Commission brokers – who execute buy and sell orders for the public for the fee.
This is the largest group of market participants, acting as agents of lenders or
buyers of financial securities. They may find the best price for someone who
wishes to buy or sell securities.
 Odd-lot brokers – a group of brokers, who execute transactions of fewer than
100 shares. These brokers break round lots (a multiple of 100 shares) into odd-lots
and vise versa for a fee.
 Registered trader – who owns a seat on a stock exchange and trades on his own
 account. Large volume of trades, along with the possibility of speedy execution of
orders, allow the traders to cover their large investments into the seat of a stock
exchange.
 Specialists – who are market makers for individual securities listed on an
organized stock exchange. Their purpose is to reduce variability of the securities
prices. When there are too many sell orders, the specialists have to perfume a role
of buyers to keep the prices from falling for a period. When there are too many
buy orders, the specialists have to perfume a role of sellers to prevent the
temporary rise in prices.
 Issuing intermediary - who undertakes to issue new securities on behalf of a
borrower. An issuing house acts as an agent for the borrower in financial markets.
This task is usually carried out by investment banks
 Market-maker is an intermediary who holds stock of securities and quotes a
price at which each of the securities may be bought and sold. Market-making is
usually performed by the securities divisions of the major banks
 Arbitrageur - who buys and sells financial assets in order to make a profit from
pricing anomalies. Anomalies occur when the same asset is priced differently in
two markets at the same time. Since financial markets are well informed and
highly competitive, usually these anomalies are very small and do not last long.
Anomalies are usually known, thus there is no risk of arbitrage, which makes it
different from speculation.
 Hedger - who buys or sells a financial asset to avoid risk of devaluation of
currency, change of interest rates or prices of the securities in the market.
! Arbitrage – is the simultaneous purchase of an undervalued asset or portfolio and sale
of an overvalued but equivalent asset or portfolio, in order to obtain a riskless profit on
the price differential. It takes advantage of market inefficiencies in a risk-free manner.
Stock exchanges set quite high commissions for all member firms. The competition from
other types of markets, e.g. OTC or third market (direct trading transactions), force stock

exchanges to move to negotiated commission schedule, where lower fees can be applied to
larger transactions.
Majority of transactions at the stock exchanges are fully automated. Small buy and sell
orders are matched by computers.
d) Over-the-counter (OTC) market
Over-the-counter (OTC) market is the marketplace for trading financial instruments, which
are generally unlisted financial instruments. These markets are networks of dealers, who
make markets in individual securities. Common equity shares that are traded on it can be
listed and unlisted shares.
! Over-the-counter (OTC) market – a market for securities made up of dealers. It is
not an organized exchange, and trading usually takes place by electronic means. Two
large segments of OTC markets can be distinguished:
 Unorganized OTC markets with unregulated trading taking place between individuals.
Typically these markets do not restrict possibilities to buy and sell outside of organized
exchanges.
 Highly organized and sophisticated OTC markets, often specializing in trading
specific company shares. Examples of organized over-the-counter markets are the
NASDAQ and upstairs markets in the United States. Trading takes place via a computer
network. Market makers display the prices at which they are prepared to buy and sell,
while investors trade with the market makers, usually through brokers. The upstairs
market is mainly used by institutional investors and handles large buy and sell orders
(block trades). Institutions place orders through brokers, who an attempt to find a
transaction counterparty. In the absence of such a counterparty, the broker attempts to
execute the order with market makers.
e) Electronic Stock Markets
Since the middle of 1990s a number of electronic stock markets were created for disclosing
and executing stock transactions electronically. While publicly displaying buy and sell orders
of stock, they are adapted mainly to serve execution of orders institutional investors mainly.
Registered and regulated electronic stock exchanges developed from electronic
communication networks (ECN). Some electronic communication networks (ECNs) exist
along with official exchanges.
! Electronic communication networks – order-driven trading systems, in which the
book of limit orders plays a central role.
The popularity of ECNs stems from the possibility to execute security trade orders
efficiently. They may allow complete access to orders placed on other organized or electronic
exchanges, and thus eliminate the practice of providing more favourable quotes exclusively
to most important clients. As a result quote spreads between the bid and ask prices are
reduced.

Since ECNs can execute orders of stocks listed and traded on organized or other electronic
exchanges, they form the increasing competition among the stock exchanges. Examples of
well known electronic trading systems include Instinet (acquired by NASDAQ), Archipelago
(merged into NYSE), and SETS (London Stock Exchange’s premier electronic trading
system).
As an alternative to organized stock exchanges the so called alternative trading systems
(ATS) have developed, based on the idea there is no necessity to use an intermediary in order
to conduct a transaction between two parties. In fact the services of a broker or a dealer are
not required to execute a trade. The direct trading of stocks between two customers without
the use of a broker or an exchange is called an ATS.
There are two types of alternative trading systems (ATS):
 crossing networks;
 Dark pools.
Electronic crossing networks do not display quotes but match large buy and sell orders of a
pool of clients (dealers, brokers, institutional investors) anonymously. These networks are
batch processors that aggregate orders for execution. Market orders are crossed once or a few
times per day at prices, which are determined in the primary market for a security.
The trade price is formed as a midpoint between bid and ask prices, observed in the primary
market at a certain time. There is a variety of ECNs, depending upon the type of order
information that can be entered by the subscriber and the amount of pretrade transparency
that is available to participants. An example of an electronic crossing network is POSIT.
! Electronic crossing networks – order-driven trading systems, in which market
orders are anonymously matched at specified time, determined in the primary market
for the system.
Electronic crossing networks provide low transaction costs and anonymity, which are
important advantages for large orders of institutional investors. They are specifically
designed to minimize market impact trading costs.
However, there is no trading immediacy, since the traders have to wait until the crossing
session time to execute the orders and an offsetting order entered by other market participant.
Thus their execution rates tend to be low. Besides, if they draw too much order flow away
from the main market, they can reduce the quality of the prices on which they are basing their
trades.
Dark pools are private crossing networks, which perform the traditional role of a stock
exchange and provide for a neutral gathering place at the same time. Their participants
submit orders to cross trades at prices, which are determined externally. Thus they provide
anonymous (“dark”) source of liquidity.
Dark pools are electronic execution systems that do not display quotes but execute
transactions at externally provided prices. Buyers and sellers must submit a willingness to
transact at this externally provided price in order to complete a trade.

The key advantage of dark pools systems is that they are designed to prevent information
leakage and offer access to undisclosed liquidity.
A separate form of computerized trading is program trading, which is defined as
simultaneous buying and selling of a large portfolio of high rated stocks with a significant
aggregate value. Another understanding of programme trading refers to the use of computer
system (Designated order turnaround (DOT)), which allows traders to send orders to many
trading posts at the exchange. Program trading is used to reduce the susceptibility of stock
portfolio to stock market movements, e.g. by selling a number of stocks which become
overpriced, or by purchasing of stocks which become underpriced.
The critics of program trading state that it is one of the major reasons for decline or rise in
the stock market and increases market volatility. Due to these concerns, stock exchanges
implement collars, which restrict program trading when a wide stock index changes (e.g. by
2 percent) from the closing index on the previous trading day. When the collars are imposed,
program trading for the sell orders becomes allowed when the last movement in the stock
price was up (or “uptick”). Conversely, when program trading is for the buy orders, it
becomes allowed when the last movement in the stock price was down (or “downtick”). Such
restrictions are supposed to half stabilizing effect on the market.
f) Secondary Equity Market Structure
Secondary markets are characterized based on the trading procedures.
1. Cash vs. forward markets
Cash markets are markets where stocks are traded on a cash basis and transactions have to
be settled within a specified few days period. Typical period is three days after the
transaction.
In order to increase the number of trades most cash markets allow margin trading.
Margin trading allows the investor to borrow money or shares from a broker to finance the
transaction.
Forward markets are markets in which in order to simplify the clearing operations, all
transactions are settled at a predetermined day, e.g. at the end of a period (month). This is a
periodic settlement system, in which a price is fixed at the time of the transaction and
remains at this value in spite of market price changes by the settlement time. In order to
guarantee a position, a deposit is required. Such a system does not prevent short-term
speculation. Some cash markets provide institutionalized procedures to allow investors to
trade forward, if they desire.
2. Continuous markets and auction markets
Continuous markets are markets where transactions take place all day and market makers
are ensuring market liquidity at moment.
Dealer market is the market in which dealers publicly post bid and ask prices
simultaneously, and these become firm commitments to make transaction at the prices for a

specific transaction volume. Investors are addressing the dealers offering the best price
(quote).
Auction market is a market in which the supply and demand of securities are matched
directly and the price is formed as an equilibrium price. An open outcry system allows
brokers to negotiate loudly until price, which is an equilibrium of buy and sell orders, is
determined.
In a call auction market all orders are put into an order book until an auction and are
executed at a single price. Liquidity requires that such trades take place one or several times
during a day. Such trading procedures are aimed at defining the auction price that maximizes
the trading volume.
! Call auction – a method of determining the market price of a security by finding the
price, which balances buyers and sellers. Such price fixing takes place periodically
each day at defined time.
2.3. Foreign Exchange Markets
What Does Foreign Exchange Mean? -------------------------------------------------
It is the exchange of one currency for another or the conversion of one currency into another
currency. Foreign exchange also refers to the global market where currencies are traded
virtually around-the-clock. The term foreign exchange is usually abbreviated as "forex" and
occasionally as "FX."
Foreign exchange transactions encompass everything from the conversion of currencies by a
traveler at an airport kiosk to billion-dollar payments made by corporate giants and
governments for goods and services purchased overseas. Increasing globalization has led to a
massive increase in the number of foreign exchange transactions in recent decades. The
global foreign exchange market is by far the largest financial market, with average daily
volumes in the trillions of dollars.
The foreign exchange market (forex, FX, or currency market) is a global, worldwide
decentralized over-the-counter financial market for trading currencies. Financial centers
around the world function as anchors of trading between a wide range of different types of
buyers and sellers around the clock, with the exception of weekends. The foreign exchange
market determines the relative values of different currencies.
The primary purpose of the foreign exchange is to assist international trade and investment,
by allowing businesses to convert one currency to another currency. For example, it permits a
US business to import British goods and pay Pound Sterling, even though the business's
income is in US dollars. It also supports speculation, and facilitates the carry trade, in which
investors borrow low-profit currencies and lend (invest in) high-profit currencies, and which
(it has been claimed) may lead to loss of competitiveness in some countries.
a. Foreign Exchange Rate
In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX
rate) between two currencies specify how much one currency is worth in terms of the other.

It is the value of a foreign nation’s currency in terms of the home nation’s currency. [1] For
example an exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, $)
means that JPY 91 is worth the same as USD 1. The foreign exchange market is one of the
largest markets in the world. By some estimates, about 3.2 trillion USD worth of currency
changes hands every day.
The spot exchange rate refers to the current exchange rate. The forward exchange rate refers
to an exchange rate that is quoted and traded today but for delivery and payment on a specific
future date.
b. Foreign Exchange Reserve
Foreign exchange reserves (also called Forex reserves or FX reserves) in a strict sense are
only the foreign currency deposits and bonds held by central banks and monetary authorities.
However, the term in popular usage commonly includes foreign exchange and gold, SDRs
and IMF reserve positions. This broader figure is more readily available, but it is more
accurately termed official international reserves or international reserves. These are assets of
the central bank held in different reserve currencies, mostly the US dollar, and to a lesser
extent the euro, the UK pound, and the Japanese yen, and used to back its liabilities, e.g. the
local currency issued, and the various bank reserves deposited with the central bank, by the
government or financial institutions.
c. Currency Risk
Currency risk is a form of risk that arises from the change in price of one currency against
another. Whenever investors or companies have assets or business operations across national
borders, they face currency risk if their positions are not hedged.
 Transaction risk is the risk that exchange rates will change unfavorably over time. It
can be hedged against using forward currency contracts;
 Translation risk is an accounting risk, proportional to the amount of assets held in
foreign currencies. Changes in the exchange rate over time will render a report
inaccurate, and so assets are usually balanced by borrowings in that currency.
When a firm conducts transactions in different currencies, it exposes itself to risk. The risk
arises because currencies may move in relation to each other. If a firm is buying and selling
in different currencies, then revenue and costs can move upwards or downwards as exchange
rates between currencies change. If a firm has borrowed funds in a different currency, the
repayments on the debt could change or, if the firm has invested overseas, the returns on
investment may alter with exchange rate movements — this is usually known as foreign
currency exposure.
Currency risk exists regardless of whether you are investing domestically or abroad. If you
invest in your home country, and your home currency devalues, you have lost money. Any
and all stock market investments are subject to currency risk, regardless of the nationality of
the investor or the investment, and whether they are the same or different. The only way to

avoid currency risk is to invest in commodities, which hold value independent of any
monetary system.
Currency risk has been shown to be particularly significant and particularly damaging for
very large, one-off investment projects, so-called megaprojects. This is because such projects
are typically financed by very large debts nominated in currencies different from the
currency of the home country of the owner of the debt. Megaprojects have been shown to be
prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost
overruns, schedule delays, unforeseen foreign currency and interest rate increases, etc. – the
costs of servicing debt becomes larger than the revenues available to do so. Financial
restructuring is typically the consequence and is common for megaprojects.
Note: The above paragraph means that most currency risk is seen where there is huge money
involved. Mostly big projects involve loans and that too borrowed in other currencies. Now,
if the local currency loses its value, then the cost gets greater than the revenues and thus, the
business gets in debt trap, meaning unable to pay off your loans.
d. Changes in reserves
The quantity of foreign exchange reserves can change as a central bank implements monetary
policy. A central bank that implements a fixed exchange rate policy may face a situation
where supply and demand would tend to push the value of the currency lower or higher (an
increase in demand for the currency would tend to push its value higher, and a decrease
lower). In a flexible exchange rate regime, these operations occur automatically, with the
central bank clearing any excess demand or supply by purchasing or selling the foreign
currency. Mixed exchange rate regimes ('dirty floats', target bands or similar variations) may
require the use of foreign exchange operations (sterilized or unsterilized to maintain the
targeted exchange rate within the prescribed limits.
e. Excess reserves
Foreign exchange reserves are important indicators of ability to repay foreign debt and for
currency defense, and are used to determine credit ratings of nations, however, other
government funds that are counted as liquid assets that can be applied to liabilities in times of
crisis include stabilization funds, otherwise known as sovereign wealth funds. If those were
included, Norway, Singapore and Persian Gulf States would rank higher on these lists, and
UAE's $1.3 trillion Abu Dhabi Investment Authority would be second after China. Apart
from high foreign exchange reserves, Singapore also has significant government and
sovereign wealth funds including Temasek Holdings, valued in excess of $145 billion and
GIC valued in excess of $330 billion. India is also planning to create its own investment firm
from its foreign exchange reserves.
Note: The above paragraph means when the countries have extra foreign currency, they are
able to pay the loans off. They are able to invest in other countries and so, maintain the local
currency position in the international economy.

Functions of Foreign Exchange Markets
1. The foreign exchange market serves two functions: converting currencies and
reducing risk. There are four major reasons firms need to convert currencies.
2. First, the payments firms receive from exports, foreign investments, foreign profits,
or licensing agreements may all be in a foreign currency. In order to use these funds
in its home country, an international firm has to convert funds from foreign to
domestic currencies.
3. Second, a firm may purchase supplies from firms in foreign countries, and pay these
suppliers in their domestic currency.
4. Third, a firm may want to invest in a different country from that in which it currently
holds underused funds.
5. Fourth, a firm may want to speculate on exchange rate movements, and earn profits
on the changes it expects. If it expects a foreign currency to appreciate relative to its
domestic currency, it will convert its domestic funds into the foreign currency.
Alternately stated, it expects its domestic currency to depreciate relative to the foreign
currency. An example similar to the one in the book can help illustrate how money
can be made on exchange rate speculation. The management focus on George Soros
shows how one fund has benefited from currency speculation.
6. Exchange rates change on a daily basis. The price at any given time is called the spot
rate, and is the rate for currency exchanges at that particular time. One can obtain the
current exchange rates from a newspaper or online.
7. The fact that exchange rates can change on a daily basis depending upon the relative
supply and demand for different currencies increases the risks for firms entering into
contracts where they must be paid or pay in a foreign currency at some time in the
future.
8. Forward exchange rates allow a firm to lock in a future exchange rate for the time
when it needs to convert currencies. Forward exchange occurs when two parties agree
to exchange currency and execute a deal at some specific date in the future. The book
presents an example of a laptop computer purchase where using the forward market
helps assure the firm that will not lose money on what it feels is a good deal. It can be
good to point out that from a firm's perspective, while it can set prices and agree to
pay certain costs, and can reasonably plan to earn a profit; it has virtually no control
over the exchange rate. When spot exchange rate changes entirely wipe out the profits
on what appear to be profitable deals, the firm has no recourse.
9. When a currency is worth less with the forward rate than it is with the spot rate, it is
selling at forward discount. Likewise, when a currency is worth more in the future
than it is on the spot market, it is said to be selling at a forward premium, and is hence
expected to appreciate. These points can be illustrated with several of the currencies.
10. A currency swap is the simultaneous purchase and sale of a given amount of currency
at two different dates and values.

2.4. Stock Market Indicators and indexes
2.4.1: Stock Market Indicators
Trading of stocks in the secondary market is related to stock price changes. Investors monitor
stock price quotations, provided in financial websites and press. Though format is different,
most of terms provide similar information.
Stock exchanges provide information on market capitalization, which is the market’s
valuation of the firm and is found by multiplying the number of shares by their market price.
Earnings per share are net profits attributable to common shareholders divided by the
number of common shares outstanding.
Annual dividend is a net profit portion distributed to the shareholders over the last year on a
per share basis.
Dividend yield is the annual dividend per share as a percentage of the stock’s actual price.
The price/earnings ratio (P/E ratio) is the reciprocal of the earnings yield. It conveys the
same information but avoids the use of percentages.
! Price / earnings ratio (P/E ratio) – the ratio of the stock market price to the
earnings per share. Sometimes called earnings multiplier
If a firm has a high P/E ratio, the indication is that the market values it highly for some
reason other than current earnings. The usual presumption is that future earnings are likely to
grow rapidly and the price increased in its anticipation. Shares of another company in the
same sector might be judged ‘cheap’ if their P/E ratio were low by comparison (for no
obvious reason).
Stock quotations also include volume of shares traded the previous day. Stock price
quotations show the “last” or closing price on the previous session.
2.4.2. Stock Market Indexes
Stock market indexes are measures of the price performance of stock portfolios, which are
formed to represent a stock market as a whole or a specific segment of the market, or sub
indexes.
The well- known indices include the Dow Jones Industrial Average, the Standard & Poor’s
500 in the United States; the FTSE 100 in the United Kingdom; the Nikkei 225 in Japan; the
DAX in Germany; the CAC 40 in France; and the Hang Seng in Hong Kong.
National stock markets have at least one index, and some countries with well developed
stock markets (in particular the United States) have numerous indexes.
Indices can be categorized by the way:
 the number of stocks included;
 the method of weighting the stock prices;
 The method of averaging.
The number of stocks can vary from a small number of largest most liquid company stocks
to a wide portfolio of all stocks traded on a particular market. The indexes based on a small

number of stocks have the advantage of easy calculation; however they can hardly represent
stock market as a whole.
Weighting of the stock prices is diverse. Contribution of individual stock prices to an index
may be
 Un weighted (as in the case of the Financial Times Ordinary Share Index),
 value weighted (for example the Financial Times Stock Exchange (FTSE) 100),
 Price weighted (such as the Dow Jones Industrial Average).
In the case of un weighted indexes all stocks equal influence irrespective of the sizes of the
companies. Average of daily rates of share price change is calculated each day and gives
stock price change average on one day. The product of such changes starting from a base
date provides the index. The calculation involves two stages: 1) averaging stock price
changes on a single day; 2) compounding the daily averages over time.
Example
An average of 10% rise of share prices on one day is followed by an average 20% raises of
share prices the next. This gives a rise of 32% over the two days: 1.1 x1.2 =1.32. Thus un
weighted index is equal to 1, 32.
Indexes have a number of uses:
 to measure and monitor market movements;
 To provide a means of ascertaining changes in aggregate wealth over time.
 To perform a role as barometers of the economy; in particular stock market
movements tend to be leading indicators which means that they provide indications of
likely future changes in the level of activity in the economy as a whole. Fourth, they
provide a means of evaluating the performance of fund managers by providing
benchmarks against which portfolio managers can be compared.
 To provide the basis for derivative instruments such as futures and options;
 To provide the framework for the creation of tracker funds, which is to reflect the
performance of a stock market.
 To be used by capital market models, in particular the capital asset pricing model (for
discount rates for capital projects, estimating required rates of return on shares,
deriving fair rates of return for utilities).
Value weighted and arithmetically averaged indexes a key ones. In order to measure stock
market values, an index has to reflect accurately the total market capitalization. An
arithmetically averaged value-weighted index accurately measures the aggregate value of the
stocks covered by its index. A reliable measure of the total value of the market is also
required for measuring changes in aggregate wealth over time and as a basis for derivative
instruments.
Example
Suppose index is based on just three stocks whose prices and numbers of shares issued are
the following.

Stock A Price 50Euro, total 10 million shares
Stock B Price 100Euro, total 10 million shares
Stock C Price 200Euro, total 5 million shares
The changes relate to just one day (so no compounding over time is involved).
Supposed (a) that stock A rises in price by 15% during the day while the other two prices
remain unchanged, and
(b) That stock C undergoes a 15% price rise while the other two prices remain constant
during the day.
Before the price rise, the index equals 100.
In the event of a 15% rise in the price of A, the new index will be (using arithmetic means):
(New value / Old value) x 100 =
= (1, 15 + 1 + 1) / (1 +1 +1) x 100 = 1,05 x 100 =105
If the price of C rises by 15%, the new index will be:
(New value / Old value) x 100 =
= (1 + 1 + 1,15) / (1 +1 +1) x 100 = 1,05 x 100 =105
It can be seen that a 15% rise in either stock price has the same effect on the index despite the
fact that C has a higher stock price and is issued by a larger company.
Arithmetically averaged value-weighted stock indices are the only indices that are macro
consistent, i.e. it is possible for all investors to hold the index portfolio simultaneously. An
index portfolio is a portfolio of shares that matches a stock index in terms of its constituent
shares and their relative proportions.
The larger number of stocks is covered by an index, the more effective it is.
Indices that provide a very broad coverage, and hence reliably reflect the whole market, are
referred to as broad capitalization indices. A good broad capitalization index is
characterized by completeness and invests ability. This should make it possible for fund
managers to buy all the shares in the index. Invest ability is particularly important for the
managers of index tracker funds, but may require some sacrifice of completeness in order to
eliminate illiquid stocks.
The calculation of value-weighted indices has moved towards a free-float basis and away
from a total capitalization basis. Free float includes only those shares that are available for
purchase, rather than all shares. The free float basis excludes shares held by governments,
founding families, and non-financial companies.
The stock-index weighting is thus based on the total value of a company’s shares available
for purchase, and not on the full market capitalization of the company.
Weighting for multi-country stock indices is subject to discussion. One view is to weight
each country by its contribution to global market capitalization. However the ratio of stock
market capitalization to national income (GDP) varies considerably between countries.

Another view is to use national income (GDP) rather than market capitalization for
weighting. .This approach would provide a more stable weighting since relative GDP is less
volatile than relative market capitalization.
Two types of emerging-market stock index are available. There are indices based on total
market capitalization and indices based on the shares available for foreign investors. The
performances of the two different types of index can be significantly different.
Stock indexes are used by institutional investors as benchmarks for performance
measurement. Index tracker funds aim to replicate the performance of an index.
Although most stock indexes are based on arithmetic averages, there are some that use
geometric averaging. However geometric averaging has particular problems. The geometric
mean overestimates the effects of rises in the prices of smaller company stocks and
underestimates the effects of changes in the stock prices of larger companies. Since large
corporations are large because of rapid growth in the past, it follows that the use of geometric
means gives too little weight to the stock prices of rapidly growing companies and too much
weight to the stock prices of slow growth companies. So the use of geometric means under
weights stocks, whose prices rise rapidly, and over weights stocks, whose prices increase
slowly. In consequence, over time, indices based on geometric means tend to understate the
true rate of increase in stock prices. The cumulative effect of such understatement over time
can substantially distort the calculated market rise.
2.5. Institutional versus Private investments
The importance of investment is a fact, which is acknowledged in no less a book than the
spiritual books as the above quotation portrays. Investment may be simply defined as putting
money into a venture in order to gain profit or interest. There is no doubt that there is more
value in putting ones money or savings to work than in keeping it idle. The importance of
investment derives from the basic principle of finance regarding the time value of money.
Simply put, this means that the value of money depreciates with time, especially because of
the possible income foregone if the money were put in a savings account, shares or any other
productive activity.
Investment can be defined as the commitment of funds to one or more assets that will be
held over some future time period for return that is commensurate with risk. The field of
investments, therefore, involves the study of the investment process. Investment is concerned
with the management of an investor’s wealth, which is the sum of current income and the
present value of all future income.
The two main forms of investments are direct investment and indirect investment. Direct
Investment involves an investor investing directly in financial assets in return for dividends
and / or interest and capital gains. In this case the financial assets are owned directly by the
investor. Indirect Investment involves buying and selling financial assets through an
investment company. Investors who purchase shares of a particular portfolio managed by an
investment company are purchasing an ownership interest in that portfolio of securities and

are entitled to a pro rata share of the dividends, interest, and capital gains generated.
Shareholders also pay a pro rata share of the company’s expenses and its management fee,
which are deducted from the portfolio’s earnings as it flows back to the shareholders.
It is a common phenomenon nowadays to find investors looking beyond the traditional
investments such as deposits with banks and other financial institutions for opportunities that
provide them with higher return on their capital. The basic aim therefore, of any investor is to
obtain a better than “average market” return from that investment, be it by way of income or
capital growth, or a mixture of both at a reasonable risk to their investment. Most
investments are generally made with a speculative objective –That of achieving returns
which are higher than returns that may be obtained from traditional investments. (E.g. bank
deposits, fixed interest debentures, government securities). Both direct and indirect
investments essentially accomplish the same thing. The essential difference is that the
investment company stands between the investors and the portfolio of securities in the case
of indirect investment.
Investments to collective investment schemes generally are, and should ideally be, medium
to long-term commitments to certain assets which are expected to provide some income or
capital appreciation or a mixture of both. Short-term investments are more speculative in
nature and are made with the hope of making abnormal gains within a short period or when
funds cannot be committed for long or medium-term periods. Collective investment schemes
or companies are bodies that pool the resources of a group of people to invest in order to
achieve economies of scale. By pooling the funds of thousands of investors, a widely
diversified portfolio of financial assets can be purchased and the investment company can
offer its owners or shareholders a variety of services
Types of Investment Companies
The main types of investment companies are Unit Investment Trusts, Closed-end Investment
Companies and Open-end Investment Companies.
Unit investment Trust is an unmanaged fixed-income security portfolio put together by a
sponsor and handled by an independent trustee. It offers investors diversification and
minimum operating cost. HFC for instance operates a unit trust that deals in bonds.
Closed-end investment companies are managed companies who usually sell no additional
shares of its own stock after the initial public offering. Their capitalizations are fixed unless a
new public offering is made.
Open-end investment companies, the most familiar type of managed company, are popularly
referred to as mutual fund and continue to sell shares to investors after the initial sale of
shares that starts the fund. Examples in Ghana are EPACK Investment Fund, NTHC Horizon
Fund, SAS Fortune Fund, Gold Fund and Databank M-Fund. Both open-end and close-end
schemes have professional fund managers who buy and sell securities periodically in order to
achieve their objectives. The major distinction between close-end and open-end investment
companies (mutual funds) is the way in which mutual funds raise their money or redeem

shares. Mutual funds raise money continuously without limit to neither the number of
investors nor the number of shares issued. The name “open-end” perhaps derives from the
continuous offering of shares without limit. Through this continuous offering the fund
obtains new capital to invest. Additionally, on each trading day, the mutual fund stands ready
to buy back shares from an investor who wants to sell. This affords it more liquidity.
This module focuses on portfolio investment with particular emphasis on open-ended
investment schemes or mutual funds.
Investments may be made by an individual in assets of his own choice and this had been the
traditional investment pattern until collective investment schemes / mutual funds were
introduced. Mutual funds are investment vehicles which allow the pooling of resources of
various, often small, investors who are not necessarily, known to each other for investment in
certain assets. An individual may personally have very limited resources for investment
which in turn limits his possibilities of having a diversified portfolio. In Ghana for instance,
one would need about ¢700,010 to invest in the shares of Standard Chartered Bank (shares
selling in lots of 10). The combined limited resources of several individuals into a common
pool or fund, however, enables them to overcome the problems of both the diversification of
funds and the minimum investment threshold that may be applicable in certain types of
assets. With collective investment schemes (mutual funds), an investor who can afford
¢50,000 every month can conveniently enjoy all the benefits of large scale and diversified
investments.
Investment funds are in practice, managed by professionals with adequate knowledge and
information on the sector where investments are proposed to be made. This enables them to
properly plan the timing for acquisition and subsequent disposal of these investments. The
common objective of funds managers is to invest in companies when they feel the shares are
‘underpriced’ and to dispose of those shares when they feel those shares have reached their
peak. But in addition to the benefit of being managed by professionals, funds are regulated
and closely supervised by authorities with a view to protecting the interest of the public at
large and to prevent the offering/marketing of schemes with abusive clauses or which are set
up with a view to dupe investors. Supervision by regulatory authorities however does not,
and should not be taken, to imply that the capital amount invested in funds is secure.
The performance of a fund is generally determined by reference to its Net Asset Value. The
Net Asset Value is obtained by dividing the total net assets (total assets less total liabilities)
of the fund as at a particular date by the total number of participating fund units (i.e. the
number of units/shares standing in the Register) on that date.
Different Type of Funds
It is important to understand that each mutual fund has different risks and rewards. In
general, the higher the potential return, the higher the risk of loss. Although some funds are
less risky than others, all funds have some level of risk--it's never possible to diversify away
all risk. This is a fact for all investments. Each fund has a predetermined investment

objective that tailors the fund's assets, regions of investments, and investment strategies. At
the fundamental level, there are three varieties of mutual funds:
1) Equity funds (stocks)
2) Fixed-income funds (bonds)
3) Money market funds
All mutual funds are variations of these three asset classes. For example, while equity funds
that invest in fast-growing companies are known as growth funds, equity funds that invest
only in companies of the same sector or region are known as specialty funds.
Benefits of Mutual Funds
Most collective investment schemes/funds offer the following advantages to investors:
 Professional Management
The primary advantage of funds is the professional management of investors’ money.
Investors purchase funds because they do not have the time or the expertise to manage their
own portfolio. A mutual fund is a relatively inexpensive way for a small investor to get a
full-time manager to make and monitor investments. These managers closely monitor each
investment made with a view to making rational and timely decisions so as to enhance the
performance of each fund under their management.
 Diversification
By owning shares in a mutual fund instead of owning individual stocks or bonds, an
investor’s risk is spread out. The idea behind diversification is to invest in a large number of
assets so that a loss in any particular investment is minimized by gains in others. In other
words, the more stocks and bonds you own, the less any one of them can hurt you. Large
mutual funds typically own hundreds of different stocks in many different industries. It
wouldn't be possible for an investor to build this kind of a portfolio with a small amount of
money. To achieve a truly diversified portfolio, you may have to buy stocks with different
capitalizations from different industries and bonds having varying maturities from different
issuers. For the individual investor this can be quite costly.
By purchasing mutual funds, you are provided with the immediate benefit of instant
diversification and asset allocation without the large amounts of cash needed to create
individual portfolios. One caveat (beware), however, is that simply purchasing one mutual
fund might not give you adequate diversification - check to see if the fund is sector or
industry specific. For example, investing in an oil and energy mutual fund might spread your
money over fifty companies, but if energy prices fall, your portfolio will likely suffer.
 Economies of Scale
The easiest way to understand economies of scale is by thinking about volume discounts: in
many stores the more of one product you buy, the cheaper that product becomes. For
example, when you buy a dozen donuts, the price per donut is usually cheaper than buying a
single one. This occurs also in the purchase and sale of securities. If you buy only one
security at a time, the transaction fees will be relatively large.

Mutual funds are able to take advantage of their buying and selling size and thereby reduce
transaction costs for investors. When you buy a mutual fund, you are able to diversify
without the numerous commission charges. Imagine if you had to buy the 10-20 stocks
needed for diversification. The commission charges alone would eat up a good chunk of your
savings. Add to this the fact that you would have to pay more transaction fees every time you
wanted to modify your portfolio - as you can see the costs begin to add up. Mutual funds are
able to make transactions on a much larger scale (and cheaper).
 Divisibility
Many investors don’t have the exact sums of money to buy round lots of securities. ¢50,000
is usually not enough to buy a round lot of a stock, especially after deducting commissions.
Investors can purchase mutual funds in smaller denominations, ranging from ¢50,000 to
¢500,000 minimums. So, rather than having to wait until you have enough money to buy
higher-cost investments, you can get in right away with mutual funds. This leads us to the
next advantage.
 Liquidity
One of the difficulties of emerging stock markets such as the Ghana Stock Exchange is the
relative length of time it takes for an investor on the capital market to sell his shares for cash.
This problem which relates to liquidity is overcome by investing in mutual fund in view of
the instant liquidity it offers. Liquidity speaks to the ease with which one can sell and buy
shares at a competitive price. An investor can also sell mutual funds at any time. Both the
liquidity and smaller denominations of mutual funds provide mutual fund investors the
ability to make periodic investments through monthly purchase plans. The following
however could be some of the disadvantages of collective investment scheme/mutual
fund:
 Costs
Mutual funds don't exist solely to make your life easier--all funds are in it for a profit. The
mutual fund industry is masterful at burying costs under layers of jargon. These costs are
complicated.
 Dilution
It's possible to have too much diversification. Because funds have small holdings in so many
different companies, high returns from a few investments often don't make much difference
on the overall return. Dilution is also the result of a successful fund getting too big. When
money pours into funds that have had strong success, the manager often has trouble finding a
good investment for all the new money.
 Taxes
When making decisions about your money, fund managers don't consider the investor’s
personal tax situation. For example, when a fund manager sells a security, a capital-gain tax
is triggered, which affects how profitable the individual is from the sale. It might have been
more advantageous for the individual to defer the capital gains liability.

2.6. Summary
This chapter explains how financial markets function and surveys different types of financial
instruments and institutions involved in those markets. It also discusses the roles of financial
intermediaries and the implications of automated financial trading for both domestic and
world financial markets.
Financial markets channel funds from those who save to those who wish to make capital
investments. Financial markets can be divided into primary and secondary markets. The
former deal with newly issued financial instruments, whereas the latter deal with transactions
of previously issued financial instruments.
Financial markets can also be divided into money and capital markets. Financial instruments
in money markets have maturities less than one year. Examples of money market
instruments are U.S. Treasury bills, commercial paper, bank certificates of deposit,
Eurodollar deposits, and federal funds loans. Financial instruments in capital markets have
maturities equal to or greater than one year. Examples of capital market instruments are
business equities, corporate bonds, U.S. Treasury notes and bonds, mortgage loans, and
consumer and commercial loans.
Cyber trading of financial instruments using Internet brokers and other automated trading
systems has speeded up financial exchanges both within and across national markets.
Development in cross-border financial exchange using automated trading systems has raised
regulatory concerns from different nations.
Financial intermediaries serve to reduce problems associated with asymmetric information in
financial transactions. Asymmetric information can lead to potential problems stemming
from adverse selection and moral hazard. Financial intermediaries may also allow savers to
benefit from economies of scale as a result of lower average costs of fund management.
The majority of financial institutions are depository institutions, which include commercial
banks, savings banks and savings and loan associations, and credit unions. Non-depository
financial institutions include insurance companies, pension funds, mutual funds, finance
companies, brokers, investment banks, and government-sponsored institutions such as the
Federal Financing Bank and mortgage-financing institutions.
Equity markets also exist to facilitate the transfer of funds from savers of funds to investors,
which need to raise money. Organized stock exchanges as well as over the counter markets
ensure that a secondary market provides a means for existing investors to sell their equity
securities.
Newly issued shares are sold in the primary market by public offer, tender, placement, or
through a rights issue. In addition to common (ordinary) shares there are various types of
preferred shares.
Stock exchanges may be order-driven, quote-driven, or a hybrid of these two systems. In all
stock market trading systems share prices are determined by the demand and supply.

The key types of orders are market orders, which accept the existing share price, and limit
orders which specify upper limits to buying prices or lower limits to selling prices.
Most individual investors buy equity instruments indirectly through institutional investors
such as pension funds, insurance companies, and investment funds. Therefore most of the
trading on stock exchanges is done through institutional investors. Some types of institutional
investment, like investment funds or exchange-traded funds (ETFs), trade their own shares
on a stock exchange directly.
Stock markets operate most efficiently if they have sufficient depth and breadth. A deep
market has a large number of traders, who ensure that small price movements raise many
new buy or sell orders. This helps to avoid excessive share price volatility, since price falls
are met by new purchase orders, and price rises are met by new sell orders. A broad market
contains traders with differing opinions such that some will be forecasting price rises whilst
others expect falls.
The diversity of views helps to prevent large price swings. When stock markets are
characterized by uniformity of opinion, extreme share price movements can result. If the
overwhelming majority of investors expect a rise, there would be many buyers and few sellers. Sharp
price rises (a bubble) would result. If the majority expects a price fall, sales would dominate
purchases and share prices could fall dramatically (and a stock market crash can occur).
PPost Test Questions
1. Callable bonds give the issuing company the option to _______________.
A. pay no coupon on the bonds until maturity
B. cancel the company's obligation to pay bond interest
C. convert the bonds to common stock
D. Repurchase the bonds
2. Over- the-counter market is be an example for _______________.
A. auction market
B. dealer market
C. brokered market
D. direct search market
3. Which of the following statements is true about initial public offering?
A. An IPO is a secondary market transaction in the stock of a company that was
formerly privately owned.
B. Explicit costs of an IPO tend to be roughly 2% of the funds raised.
C. IPOs have been shown to be poor long-term investments.
D. Almost all IPOs turn out to be underpriced.
4. Which of the following observations concerning private placements is true?
A. They are made available to the general public.
B. They generally will be more suited for very large offerings.
C. They are characterized by high post-issue liquidity.
D. They do not trade in secondary markets like stock exchanges.
Answers to questions
1. D 3. C
2. B 4. D

CHAPTER THREE
SECURITY ANALYSIS
3.0 AIMS AND OBJECTIVES
Upon completing this unit, you should be able to:
 Explain the nature of security analysis
 Describe the types and purposes of fundamental analysis
 discuss the market, industry and company analysis
 Explain meaning and several tools of technical analysis
3.1 INTRODUCTION
Security analysis is about valuing the assets, debt, warrants, and equity of companies
from the perspective of outside investors using publicly available information.
The methods used to analyze securities and make investment decisions fall into two very
broad categories: fundamental analysis and technical analysis. Fundamental analysis
involves analyzing the characteristics of a company in order to estimate its value. Technical
analysis takes a completely different approach; it doesn't care one bit about the "value" of a
company or a commodity. Technicians (sometimes called chartists) are only interested in
the price movements in the market.
Despite all the fancy and exotic tools it employs, technical analysis really just studies and
demand in a market in an attempt to determine what direction, or trend , will continue in the
future. In other words, technical analysis attempts to understand the emotions in the market
by studying the market itself, as opposed to its components. If you understand the benefits
and limitations of technical analysis, it can give you a new set of tools or skills that will
enable you to be a better trader or investor.
The technical approach is the oldest approach to equity investment dating back to the late
19th century. It continues to flourish in modern times as well. As an investor, we often
encounter technical analysis because newspapers cover it; television programmers routinely
call technical experts for their comments and investment advisory services circulate
technical reports. As an approach to investment analysis, technical analysis is radically
different from fundamental analysis. These terms refer to two different stock-picking
methodologies used for researching and forecasting the future growth trends of stocks. Like
any investment strategy or philosophy, both have their advocates and adversaries. Here are
the defining principles of each of these methods of stock analysis:
Fundamental analysis is a method of evaluating securities by attempting to measure the
intrinsic value of a stock. Fundamental analysts study everything from the overall economy
and industry conditions to the financial condition and management of companies.
Technical analysis is the evaluation of securities by means of studying statistics generated by
market activity, such as past prices and volume. Technical analysts do not attempt to measure

a security's intrinsic value but instead use stock charts to identify patterns and trends that may
suggest what a stock will do in the future.
In the world of stock analysis, fundamental and technical analysis is on completely opposite
sides of the spectrum. Earnings, expenses, assets and liabilities are all important
characteristics to fundamental analysts, whereas technical analysts could not care less about
these numbers. Which strategy works best is always debated, and many volumes of
textbooks have been written on both of these methods. So, do some reading and decide for
yourself which strategy works best with your investment philosophy. Detailed descriptions
of this analysis are given below.
3.2 FUNDAMENTAL ANALYSIS
Fundamental analysis of a business involves analyzing its financial statements and
health, its management and competitive advantages, and its competitors and markets. When
applied to futures and forex, it focuses on the overall state of the economy, interest rates,
production, earnings, and management. When analyzing a stock, futures contract, or
currency using fundamental analysis there are two basic approaches one can use; bottom up
analysis and top down analysis. The term is used to distinguish such analysis from other
types of investment analysis, such as quantitative analysis and technical analysis.
Fundamental analysis is performed on historical and present data, but with the goal of
making financial forecasts. There are several possible objectives:
1. to conduct a company stock valuation and predict its probable price evolution,
2. to make a projection on its business performance,
3. to evaluate its management and make internal business decisions,
4. To calculate its credit risk.
When the objective of the analysis is to determine what stock to buy and at what price,
there are two basic methodologies
1. Fundamental analysis maintains that markets may misprice a security in the short run
but that the "correct" price will eventually be reached. Profits can be made by trading
the mispriced security and then waiting for the market to recognize its "mistake" and
reprice the security.
2. Technical analysis maintains that all information is reflected already in the stock
price. Trends 'are your friend' and sentiment changes predate and predict trend
changes. Investors' emotional responses to price movements lead to recognizable
price chart patterns. Technical analysis does not care what the 'value' of a stock is.
Their price predictions are only extrapolations from historical price patterns.
Investors can use any or all of these different but somewhat complementary methods for
stock picking. For example many fundamental investors use technical’s for deciding entry
and exit points. Many technical investors use fundamentals to limit their universe of
possible stock to 'good' companies.

The choice of stock analysis is determined by the investor's belief in the different
paradigms for "how the stock market works". Fundamental analysis includes:
1. Market/Economic analysis
2. Industry analysis
3. Company analysis
On the basis of these three analyses the intrinsic value of the shares are determined. This
is considered as the true value of the share. If the intrinsic value is higher than the market
price it is recommended to buy the share. If it is equal to market price hold the share and
if it is less than the market price sell the shares.
3.2.1 MARKET/ECONOMIC ANALYSIS
The economy is studied to determine if overall conditions are good for the stock market.
Is inflation a concern? Are interest rates likely to rise or fall? Are consumers spending? Is
the trade balance favorable? Is the money supply expanding or contracting? These are just
some of the questions that the fundamental analyst would ask to determine if economic
conditions are right for the stock market for studying the Economic Analysis, the Macro
Economic Factors and the forecasting Techniques are studied in following paragraphs.
a) Macro Economic Factors
The macro economy is the study of all the firms operates in economic environment. The
key variables to describe the state of economy are explained as below:
1. Growth rate of Gross Domestic Product (GDP):
An economy's overall economic activity is summarized by a measure of aggregate
output. As the production or output of goods and services generates income, any
aggregate output measure is closely associated with an aggregate income measure.
The United States now uses an aggregate output concept known as the gross
domestic product or GDP. The GDP is a measure of all currently produced goods
and services valued at market prices. One should notice several features of the
GDP measure. First, only currently produced goods (produced during the relevant
year) are included. This implies that if you buy a 150-year old classic Tudor
house, it does not count towards the GDP; but the service rendered by your real
estate agent in the process of buying the house does. Secondly, only final goods
and services are counted. In order to avoid double counting, intermediate goods—
goods used in the production of other goods and services—do not enter the GDP.
For example, steel used in the production of automobiles is not valued separately.
Finally, all goods and services included in the GDP are evaluated at market prices.
Thus, these prices reflect the prices consumers pay at the retail level, including
indirect taxes such as local sales taxes.
A measure similar to GDP is the gross national product (GNP). Until recently, the
government used the GNP as the main measure of the nation's economic activity.
The difference between GNP and GDP is rather small. The GDP excludes income

earned abroad by U.S. firms and residents and includes the earnings of foreign
firms and residents in the United States. Several other measures of output and
income are derived from the GNP. These include the net national product (NNP),
which subtracts from the GNP an allowance for wear and tear on plants and
equipment, known as depreciation; the national income, which mainly subtracts
indirect taxes from the NNP; the personal income, which measures income
received by persons from all sources and is arrived at by subtracting from the
national income items such as corporate profit tax payments and social security
contributions that individuals do not receive, and adding items such as transfer
payments that they do receive but are not part of the national income; and the
personal disposable income, which subtracts personal tax payments such as
income taxes from the personal income measure. While all these measures move
up and down in a generally similar fashion, it is the personal disposable income
that is intimately tied to consumer demand for goods and services—the most
dominant component of the aggregate demand—and the total demand for goods
and services in the economy from all sources.
It should be noted that the aggregate income/output measures discussed above are
usually quoted both in current prices (in "nominal" terms) and in constant dollars
(in "real" terms). The latter quotes are adjusted for inflation and are thus most
widely used since they are not subject to distortions introduced by changes in
prices.
2. Savings and investment:
Growth of an economy requires proper amount of investments which in turn is
dependent upon amount of domestic savings. The amount of savings is favorably
related to investment in a country. The level of investment in the economy and the
proportion of investment in capital market is major area of concern for investment
analysts. The level of investment in the economy is equal to: Domestic savings +
inflow of foreign capital - investment made abroad. Stock market is an important
channel to mobilize savings, from the individuals who have excess of it, to the
individual or corporate, who have deficit of it. Savings are distributed over various
assets like equity shares, bonds, small savings schemes, bank deposits, mutual
fund units, real estates, bullion etc. The demand for corporate securities has an
important bearing on stock prices movements. Greater the allocation of equity in
investment, favorable impact it have on stock prices.

3. Industry Growth rate:
The GDP growth rate represents the average of the growth rate of agricultural
sector, industrial sector and the service sector. The current contribution of industry
sector in GDP in the year 2004-05 is 6.75 percent approximately. Publicly listed
company play a major role in the industrial sector. The stock market analysts focus
on the overall growth of different industries contributing in economic
development. The higher the growth rate of the industrial sector, other things
being equal, the more favorable it is for the stock market.
4. Price level and Inflation:
The inflation rate is defined as the rate of change in the price level. Most
economies face positive rates of inflation year after year. The price level, in turn,
is measured by a price index, which measures the level of prices of goods and
services at given time. The numbers of items included in a price index vary
depending on the objective of the index. Usually three kinds of price indexes,
having particular advantages and uses are periodically reported by government
sources. The first index is called the consumer price index (CPI), which measures
the average retail prices paid by consumers for goods and services bought by
them. A couple of thousand items, typically bought by an average household, are
included in this index.
A second price index used to measure the inflation rate is called the producer price
index (PPI). It is a much broader measure than the consumer price index. The
producer price index measures the wholesale prices of approximately 3,000 items.
The items included in this index are those that are typically used by producers
(manufacturers and businesses) and thus it contains many raw materials and semi-
finished goods. The third and broadest measure of inflation is the called the
implicit GDP price deflator. This index measures the prices of all goods and
services included in the calculation of the current output of goods and services in
the economy, the GDP.
The three measures of the inflation rate are most likely to move in the same
direction, even though not to the same extent. Differences can arise due to the
differing number of goods and services included for the purpose of compiling the
three indexes. In general, if one hears about the inflation rate number in the
popular media, it is most likely to be the number based on the CPI.
5. Agriculture and monsoons:
Agriculture is directly and indirectly linked with the industries. Hence increase or
decrease in agricultural production has a significant impact on the industrial
production and corporate performance. Companies using agricultural raw
materials as inputs or supplying inputs to agriculture are directly affected by
change in agriculture production. For example- Sugar, Cotton, Textile and Food

processing industries depend upon agriculture for raw material. Fertilizer and
insecticides industries are supplying inputs to agriculture. A good monsoon leads
to higher demand for inputs and results in bumper crops. This would lead to
buoyancy in stock market. If the monsoon is bad, agriculture production suffers
and cast a shadow on the share market.
6. Interest Rate:
The concept of interest rates used by economists is the same as the one widely
used by ordinary people. The interest rate is invariably quoted in nominal terms—
that is, it is not adjusted for inflation. Thus, the commonly followed interest rate is
actually the nominal interest rate. Nevertheless, there are literally hundreds of
nominal interest rates. Examples include: savings account rate, six-month
certificate of deposit rate, 15-year mortgage rate, variable mortgage rate, 30-year
Treasury bond rate, 10-year General Motors bond rate, and commercial bank
prime lending rate. One can see from these examples that the nominal interest rate
has two key attributes—the duration of lending/borrowing involved and the
identity of the borrower.
Fortunately, while the hundreds of interest rates that one encounters may appear
baffling, they are closely linked to each other. Two characteristics that account for
this linkage are the risk worthiness of the borrower and the maturity of the loan involved.
So, for example, the interest rate on a 6-month Treasury bill is related to that on a 30-year
Treasury bond, as bonds/loans of different maturity levels command different rates. Also,
a 30-year General Motors bond will carry a higher interest rate than a 30-year Treasury
bond, since a General Motors (GM) bond is riskier than a Treasury bond.
Finally, one should note that the nominal interest rate does not represent the real cost of
borrowing or the real return on lending. To understand the real cost or return, one
must consider the inflation-adjusted nominal rate, called the real interest rate. Tax
and other considerations also influence the real cost or return. Nevertheless, the
real interest rate is a very important concept in understanding the main incentives
behind borrowing or lending.
7. Government budget and deficit:
Government plays an important role in the growth of any economy. The
government prepares a central budget which provides complete information on
revenue, expenditure and deficit of the government for a given period.
Government revenue come from various direct and indirect taxes and government
made expenditure on various developmental activities. The excess of expenditure
over revenue leads to budget deficit. For financing the deficit the government goes
for external and internal borrowings. Thus, the deficit budget may lead to high rate
of inflation and adversely affects the cost of production and surplus budget may
results in deflation. Hence, balanced budget is highly favorable to the stock
market.

8. The tax structure:
The business community eagerly awaits the government announcements regarding
the tax policy in March every year. The type of tax exemption has impact on the
profitability of the industries. Concession and incentives given to certain industry
encourages investment in that industry and have favorable impact on stock market.
9. Balance of payment, forex reserves and exchange rate:
Balance of payment is the record of all the receipts and payment of a country with
the rest of the world. This difference in receipt and payment may be surplus or
deficit. Balance of payment is a measure of strength of rupee on external account.
The surplus balance of payment augments forex reserves of the country and has a
favorable impact on the exchange rates; on the other hand if deficit increases, the forex
reserve depletes and has an adverse impact on the exchange rates. The industries involved
in export and import are considerably affected by changes in foreign exchange rates. The
volatility in foreign exchange rates affects the investment of foreign institutional investors
in Indian Stock Market. Thus, favorable balance of payment renders favorable
impact on stock market.
10. Infrastructural facilities and arrangements:
Infrastructure facilities and arrangements play an important role in growth of
industry and agriculture sector. A wide network of communication system, regular
supply or power, a well developed transportation system (railways, transportation,
road network, inland waterways, port facilities, air links and telecommunication
system) boost the industrial production and improves the growth of the economy.
Banking and financial sector should be sound enough to provide adequate support
to industry and agriculture. The government has liberalized its policy regarding the
communication, transport and power sector for foreign investment. Thus, good
infrastructure facilities affect the stock market favorable.
11. Demographic factors:
The demographic data details about the population by age, occupation, literacy and
geographic location. These factors are studied to forecast the demand for the
consumer goods. The data related to population indicates the availability of work
force. The cheap labor force in India has encouraged many multinationals to start
their ventures. Population, by providing labor and demand for products, affects the
industry and stock market.
12. Sentiments:
The sentiments of consumers and business can have an important bearing on
economic performance. Higher consumer confidence leads to higher expenditure
and higher business confidence leads to greater business investments. All this
ultimately leads to economic growth. Thus, sentiments influence consumption and
investment decisions and have a bearing on the aggregate demand for goods and
services.

b) Economic Forecasting Techniques
Forecasting for an individual firm obviously begins with a forecast for the industry or
industries in which it is involved. Beyond this, the analyst must determine the degree to
which the company’s share of each market may vary during the forecast period. Such
variations can result from the introduction of a new product, the improvement of an
existing product, the opening, closing, or expansion of plants, the activities of domestic or
foreign competitors, a change in sales effort, or a variety of other factors. Information
required to make such assessments may come in part from the company’s own investment
and marketing plans. Information on the activity and sales prospects of competitors is
frequently collected from the firm’s own salesmen. An increasing number of companies
now employ sophisticated market research techniques to determine the probable reaction
of their customers to new products.
1. Anticipatory Surveys:
Some elements of the future are known with reasonable accuracy. Government
spending is reflected in existing budgets. These budgets indicate how much will be
spent and how much money will be extracted from the stream of private spending
by taxation. Similar information is available on some parts of the private economy.
Periodic surveys conducted both by government and by private organizations
measure business plans to invest in new plants and equipment. Increasingly,
attempts are made to probe the mood and intentions of consumers concerning the
possible purchase of automobiles, houses, appliances, and other durable goods.
Regular surveys are also made to determine the general mood of the public—
whether people are optimistic or pessimistic about their own economic future and
thus whether their spending is apt to be relatively strong or relatively weak. In
general, such information obtained from the various surveys of investment plans,
spending plans, and attitudes has been highly useful to economic forecasters. Such
information helps to limit the range of possibility. But plans and attitudes change,
sometimes quite abruptly, and although the surveys are useful tools they are not
clear and reliable guides to the future.
2. Barometric or Indicator approach:
Some elements of the future are known with reasonable accuracy. Government
spending is reflected in existing budgets. These budgets indicate how much will be
spent and how much money will be extracted from the stream of private spending
by taxation. Similar information is available on some parts of the private economy.
Periodic surveys conducted both by government and by private organizations
measure business plans to invest in new plants and equipment. Increasingly,
attempts are made to probe the mood and intentions of consumers concerning the
possible purchase of automobiles, houses, appliances, and other durable goods.
Regular surveys are also made to determine the general mood of the public—

whether people are optimistic or pessimistic about their own economic future and
thus whether their spending is apt to be relatively strong or relatively weak. In
general, such information obtained from the various surveys of investment plans,
spending plans, and attitudes has been highly useful to economic forecasters. Such
information helps to limit the range of possibility. But plans and attitudes change,
sometimes quite abruptly, and although the surveys are useful tools they are not
clear and reliable guides to the future.
3. Diffusion Indexes:
Some economists also use sets of statistics called diffusion indexes to calculate
economic turning points. A diffusion index is a method of summarizing the
common tendency of a group of statistical series. If a greater number of the series
are rising than are declining, the index will be above 50; if fewer are rising than
declining, it will be below 50. In effect, a diffusion index measures the degree to
which either strength or weakness pervades the economy. If, for example, most of
a group of industries are increasing their production rates, the economy as a whole
is probably expanding; if the proportion of industries that are growing begins to
decline and falls significantly below 50 percent for a period of time, the economy
is probably in a recession, or at least moving in that direction.
4. Money and Stock Prices:
Monetary theory in its simplest form states that fluctuations in the rate of growth
of money supply are of utmost importance in determining GNP, corporate profits,
interest rates, stock prices etc. Monetarists contend that changes in growth rate of
money supply set off a complicated series of events that ultimately affects share
prices. In addition, these monetary changes lead stock price changes. Thus, while
making forecasts, changes in growth rate of money supply should be given due
importance. Some thinkers states that stock market leads changes in money
supply. However, sound monetary policy is a necessary ingredient for steady
growth and stable prices.
5. Econometric Model Building:
Economists frequently use mathematical equations to express the normal relations
between various economic factors. As a simple example, a given increase in
consumer income will ordinarily produce a certain increase in sales, saving, and
tax revenue, and these developments can be expressed mathematically. With a
sufficient number of equations, all the important interactions within the economy
can be simulated in a mathematical model. With the advent of computers able to
make millions of calculations in a few moments, economists began to construct
more and more complex sets of equations, called econometric models. These
models, some of which include hundreds of equations, can be used to forecast
overall economic activity (macroeconomic forecasting) or developments in

particular parts of the economy (microeconomic forecasting). The success of
econometric forecasting has so far been limited because the exact nature of
economic relations is not fully known, and also because of the inadequacies of
existing statistics. Nevertheless, the improvement of these techniques represents
the greatest hope for more accurate economic forecasting in the future
6. Opportunistic Model Building:
Opportunistic model building or GNP model building or sectoral analysis is
widely used forecasting method. Initially, the forecaster must hypothesize total
demand and thus total income during the forecast period. Obviously, this will
necessitate assuming certain environmental decisions, such as war or peace,
political relationships among the level of interest rates. After, this work has been
done, the forecaster begins building a forecast of the GNP figure by estimating the
levels of the various component of GNP like the number of consumption
expenditures, gross private domestic investment, government purchases of goods
and services and net exports. After adding the four major categories the forecaster
comes up with a GNP forecast. Now he tests this total for consistency with an
independently arrived at a priori forecast of GNP.
3.2.2 INDUSTRY ANALYSIS
Industry analysis is a type of investment research that begins by focusing on the status of
an industry or an industrial sector. A form of fundamental analysis involving the process
of making investment decisions based on the different stages an industry is at during a
given point in time. The type of position taken will depend on firm specific
characteristics, as well as where the industry is at in its life cycle.
a) Industry Life Cycle Analysis
Many industrial economists believe that the development of almost every industry may be
analyzed in terms of following stages (Figure-):
1. Pioneering stage: New technologies like personal computers or wireless
communication portray the initial stages of an industry. At this stage, it is very
difficult to anticipate which firms will succeed; some firms will be a total success
while some might fail completely. Hence, the risk involved in selecting any specific
firm in the industry is quite high at this stage. However, at this stage, since the new
product has not yet flooded its market, there will be a rapid growth in sales and
earnings at industry level. Like, for example, in 1980’s, personal computers were a
part of very few houses, while on the other hand, products like fans or even
refrigerators were part of almost every household. So naturally, the growth rate of
products like refrigerators will be much less.
2. Rapid growth stage: Once the product has proved itself in the market, several leaders
in the industry start surfacing. The start-up stage survivors become more stable and
market share can be easily envisaged. Thus, the performance of the industry in

general will be more minutely tracked by the performance of the firms that have
survived. As the product breaks through the market place and is used commonly, the
growth rate of the industry is still faster than the rest of economy.
3. Maturity and stabilization stage: The product has attained the full aptitude to be
consumed at this stage by the users. So, any growth from this point just tracks the
growth of the economy in general. At this stage, as the product gets more and more
standardized, it compels the producers to compete heavily on price basis. As a result,
the profit margins are lowered and add to the pressure on profits. Most often, firms at
this stage are referred to as cash cows as their cash flows are quite consistent but offer
very little opportunity for growth of profit. Instead of reinvesting the cash flows in the
company, they are best milked from.
4. Decline stage: In this stage following features are identified.
Costs become counter-optimal
Sales volume decline or stabilize
Prices, profitability diminish
Profit becomes more a challenge of production/distribution efficiency than
increased sales
b) Classification of Industry
Industry means a group of productive or profit making enterprises organizations that have
a similar technically substitute goods, services or source of income. Besides Standard
Industry Classification (SIC), industries can be classified on the basis of products and
business cycle i.e. classified according to their reactions to the different phases of the
business cycle. These are classified as follows:
1. Growth Industries: A sector of the economy experiencing a higher-than-average
growth rate. Growth industries are often associated with new or pioneer industries
that did not exist in the past and their growth is related to consumer demand for the
new products or services offered by the firms within the industry. If companies across
and industry exhibit solid earnings and revenue figures, that industry may be showing
signs that it is in its growth stage. Growth industries tend to be composed of relatively
volatile and risky stocks. Often investors must be willing to accept increased risk in
order to take part in the potentially large gains offered by stocks within a particular
growth industry.
2. Cyclical Industries: A type of an industry that is sensitive to the business cycle, such
that revenues are generally higher in periods of economic prosperity and expansion,
and lower in periods of economic downturn and contraction. Companies in cyclical
industries can deal with this type of volatility by implementing cuts to compensations
and layoffs during bad times, and paying bonuses and hiring en masse in good times.
Cyclical industries include those that produce durable goods such as raw materials
and heavy equipment For example, the airline industry is a fairly cyclical industry; in

good economic times, people have more disposable income and, therefore, they are
more willing to take vacations and make use of air travel. Conversely, during bad
economic times, people are much more cautious about spending. As a result, they
tend to take more conservative vacations closer to home (if they go at all) and avoid
expensive air travel.
3. Defensive Industries: Defensive industries are those, such as the food processing
industry, which hurt least in the period of economic downswing. For example- the
industries selling necessities of consumers withstands recession and depression. The
stock of defensive industries can be held by the investor for income earning purpose.
Consumer nondurable and services, which in large part are the items necessary for
existence, such as food and shelter, are products of defensive industry.
4. Cyclical-growth Industries: These possess characteristics of both a cyclical industry
and a growth industry. For example, the automobile industry experiences period of
stagnation, decline but they grow tremendously. The change in technology and
introduction of new models help the automobile industry to resume their growing
path.
c) Characteristics Of An Industry Analysis

In an industry analysis, the following key characteristics should be considered by the
analyst. These are explained as below:
1. Post sales and Earnings performance: The historical performance of sales and
earnings should be given due consideration, to know how the industry have reacted in
the past. With the knowledge and understanding of the reasons of the past behavior,
the investor can assess the relative magnitude of performance in future. The cost
structure of an industry is also an important factor to look into. The higher the cost
component, the higher the sales volume necessary to achieve the firm’s break-even
point, and vice-versa.
2. Nature of Competition: The top firms in the industry must be analyzed. The demand
of particular product, its profitability and price of concerned company scrip’s also
determine the nature of competition. The investor should analyze the scrip and should
compare it with other companies. If too many firms are present in the industry, this
will lead to a decline in price of the product.
3. Raw Material and Inputs: We need to have a look on industries which are dependent
on raw material. An industry which has limited supply of raw material will have a
less growth. Labor in also an input and problems with labor will also lead to growth
difficulties.
4. Attitude of Government towards Industry: The government policy with regard to
granting of clearance, installed capacity and reservation of the products for small
industry etc. are also factors to be considered for industry analysis.

5. Management: An industry with many problems may be well managed, if the
promoters and the management are efficient. The management has to be assessed in
terms of their capabilities, popularity, honesty and integrity. A good management also
ensures that the future expansion plans are put on sound basis.
6. Labor Conditions and Other Industrial Problems: The industries which depend on
labor, the possibility of strike looms as an important factor to be reckoned with.
Certain industries with problems of marketing like high storage costs, high transport
costs etc leads to poor growth potential and investors have to careful in investing in
such companies.
7. Nature of Product Line: The position of industry in the different stages of the life
cycle is to be noted. And the importance attached by planning commission on these
industries assessment is to be studied.
8. Capacity Installed and Utilized: If the demand is rising as expected and market is
good for the products, the utilization of capacity will be higher, leading to bright
prospects and higher profitability. If the quality of the product is poor, competition is
high and there are other constraints to the availability of inputs and there are labor
problems, then the capacity utilization will be low and profitability will be poor.
9. Industry Share Price Relative to Industry Earnings: While making investment the
current price of securities in the industry, their risk and returns they promise is
considered. If the price is very high relative to future earnings growth, the investment
in these securities is not wise. Conversely, if future prospects are dim but prices are
low relative to fairly level future patterns of earnings, the stocks in this industry might
be an attractive investment.
10. Research and Development: The proper research and development activities help in
increasing economy of an industry and so while investing in an industry, the
expenditure should also be considered.
11. Pollution Standards: These are very high and restricted in the industrial sector. These
differ from industry to industry, for example, in leather, chemical and pharmaceutical
industries the industrial effluents are more.
d) Profit Potential of Industries: Porter Model
Michael Porter (Harvard Business School Management Researcher) designed various vital
frameworks for developing an organization’s strategy. One of the most renowned among
managers making strategic decisions is the five competitive forces model that determines
industry structure. According to Porter, the nature of competition in any industry is
personified in the following five forces:
 Threat of new potential entrants
 Threat of substitute product/services
 Bargaining power of suppliers
 Bargaining power of buyers
 Rivalry among current competitors

The five forces mentioned above are very significant from point of view of strategy
formulation. The potential of these forces differs from industry to industry. These forces
jointly determine the profitability of industry because they shape the prices which can be
charged, the costs which can be borne, and the investment required to compete in the
industry. Before making strategic decisions, the managers should use the five forces
framework to determine the competitive structure of industry.
Forces driving industry competition
Let’s discuss the five factors of Porter’s model in detail:

Risk of entry by potential competitors: Potential competitors refer to the firms which
are not currently competing in the industry but have the potential to do so if given a
choice. Entry of new players increases the industry capacity, begins a competition for
market share and lowers the current costs. The threat of entry by potential competitors is
partially a function of extent of barriers to entry. The various barriers to entry are-
 Economies of scale
 Brand loyalty
 Government Regulation
 Customer Switching Costs
 Absolute Cost Advantage
 Ease in distribution
 Strong Capital base

Rivalry among current competitors: Rivalry refers to the competitive struggle for
market share between firms in an industry. Extreme rivalry among established firms poses
a strong threat to profitability. The strength of rivalry among established firms within an
industry is a function of following factors:
Extent of exit barriers
Amount of fixed cost
Competitive structure of industry
Presence of global customers
Absence of switching costs
Growth Rate of industry
Demand conditions
Bargaining Power of Buyers: Buyers refer to the customers who finally consume the
product or the firms who distribute the industry’s product to the final consumers.
Bargaining power of buyers refer to the potential of buyers to bargain down the prices
charged by the firms in the industry or to increase the firms cost in the industry by
demanding better quality and service of product. Strong buyers can extract profits out of
an industry by lowering the prices and increasing the costs. They purchase in large
quantities. They have full information about the product and the market. They emphasize
upon quality products. They pose credible threat of backward integration. In this way,
they are regarded as a threat.
Bargaining Power of Suppliers: Suppliers refer to the firms that provide inputs to the
industry. Bargaining power of the suppliers refer to the potential of the suppliers to
increase the prices of inputs( labor, raw materials, services, etc) or the costs of industry in
other ways. Strong suppliers can extract profits out of an industry by increasing costs of
firms in the industry. Supplier’s products have a few substitutes. Strong suppliers’
products are unique. They have high switching cost. Their product is an important input to
buyer’s product. They pose credible threat of forward integration. Buyers are not
significant to strong suppliers. In this way, they are regarded as a threat.
Threat of Substitute products: Substitute products refer to the products having ability of
satisfying customer’s needs effectively. Substitutes pose a ceiling (upper limit) on the
potential returns of an industry by putting a setting a limit on the price that firms can
charge for their product in an industry. Lesser the number of close substitutes a product
has, greater is the opportunity for the firms in industry to raise their product prices and
earn greater profits (other things being equal).
The power of Porter’s five forces varies from industry to industry. Whatever be the
industry, these five forces influence the profitability as they affect the prices, the costs,
and the capital investment essential for survival and competition in industry. This five
forces model also help in making strategic decisions as it is used by the managers to
determine industry’s competitive structure.

Porter ignored, however, a sixth significant factor- complementary. This term refers to the
reliance that develops between the companies whose products work is in combination
with each other. Strong complementary might have a strong positive effect on the
industry. Also, the five forces model overlooks the role of innovation as well as the
significance of individual firm differences. It presents a stagnant view of competition.
e) Techniques for Evaluating Relevant Industry Factors
The techniques (long term and short term) for evaluating industry factors are explained in
the following sections. These are:
1. End-Use and Regression Analysis: End-use analysis for product demand analysis
refers to a process whereby the analyst attempts to diagnose the factors that determine
the demand for output of the industry. In a single product firm, units demanded
multiplied by price will equal sales revenue. The analyst frequently forecast the
factors like disposable income, per capita consumption, price elasticity of demand etc.
that influence the demand of the product. For studying the relationship between
various variables simple linear regression analysis and correlation analysis is used.
Industry sales against time, industry sales against macro economic variables like
gross national product, personal income disposable income and industry earnings
over time may be regressed. When two or more independent variables are better able
to explain variability in the dependent variables, the multiple regression analysis is
used.
2. Input-Output Analysis: Input-output analysis is an economics term that refers to the
study of the effects that different sectors have on the economy as a whole, for a
particular nation or region. This type of economic analysis was originally developed
by Wassily Leontief (1905 – 1999), who later won the Nobel Memorial Prize in
Economic Sciences for his work on this model. Input-output analysis allows the
various relationships within an economic system to be analyzed as a whole, rather
than individual components. Input-output analysis seeks to explain how one industry
sector affects others in the same nation or region. The analysis illustrates that the
output of one sector can in turn become an input for another sector, which results in
an interlinked economic system. The analysis is represented as a matrix, where
different rows and columns are filled with values representing the inputs and outputs
of various sectors.
3. Growth Rate: The growth rate of different industry should be forecasted by
considering historical data. Once the growth rate is estimated, future values of
earnings or sales may be forecast. Since the growth rate is such an important factor in
determining the stock prices, not only its size but its duration must be estimated.
Sometimes, patents expire, competition within an industry becomes more aggressive
because foreign firms begin to compete, economically depressed periods occur or
other factors cause growth rate to drop.

3.2.3 COMPANY ANALYSIS
Fundamental analysis is the method of analyzing companies based on factors that affect
their intrinsic value. There are two sides to this method: the quantitative and the
qualitative. The quantitative side involves looking at factors that can be measured
numerically, such as the company’s assets, liabilities, cash flow, revenue and price to-
earnings ratio. The limitation of quantitative analysis, however, is that it does not capture
the company’s aspects or risks immeasurable by a number - things like the value of an
executive or the risks a company faces with legal issues. The analysis of these things is
the other side of fundamental analysis: the qualitative side or non number side. Although
relatively more difficult to analyze, the qualitative factors are an important part of a
company. Since they are not measured by a number, they more represent an either
negative or positive force affecting the company.
Fundamental analysis is not as simple as looking at numbers and computing ratios; it is
also important to look at influences and qualities that do not have a number value. The
present and future values are affected by the following factors:
1. Competitive Edge: Another business consideration for investors is competitive
advantage. A company's long-term success is driven largely by its ability to maintain
a competitive advantage - and keep it. Powerful competitive advantages, such as Coca
Cola's brand name and Microsoft's domination of the personal computer operating
system, create a moat around a business allowing it to keep competitors at bay and
enjoy growth and profits. When a company can achieve competitive advantage, its
shareholders can be well rewarded for decades.
a. Market share: The market share of the company helps to determine a
company’s relative position within the industry. If the market share is high,
the company would be able to meet the competition successfully. The size of
the company should also be considered while analyzing the market share,
because the smaller companies may find it difficult to survive in the future.
b. Growth of annual sales: Investor generally prefers to study the growth in sales
because the larger size companies may be able to withstand the business cycle
rather than the company of smaller size. The rapid growth keeps the investor
in better position as growth in sales is followed by growth in profit. The
growth in sales of the company is analyzed both in rupee terms and in
physical terms.
c. Stability of annual sales: If a firm has stable sales revenue, other things being
remaining constant, will have more stable earnings. Wide variation in sales
leads to variation in capacity utilization, financial planning and dividends.
This affects the Company’s position and investor’s decision to invest.
2. Earnings: The earning of the company should also be analyzed along with the sales
level. The income of the company is generated through the operating (in service

industry like banks- interest on loans and investment) and non-operating income (ant
company, rentals from lease, dividends from securities). The investor should analyze
the sources of income properly. The investor should be well aware with the fact that
the earnings of the company may vary due to following reasons:
 Change in sales.
 Change in costs.
 Depreciation method adopted.
 Inventory accounting method.
 Wages, salaries and fringe benefits.
 Income tax and other taxes.
3. Capital Structure: Capital structure is combination of owned capital and debt capital
which enables to maximize the value of the firm. Under this, we determine the
proportion in which the capital should be raised from the different securities. The
capital structure decisions are related with the mutual proportion of the long term
sources of capital. The owned capital includes share capital
a. Preference shares: Preference shares are those shares which have preferential rights
regarding the payment of dividend and repayment of capital over the equity
shareholders. At present many companies resort preference shares.
b. Debt: It is an important source of finance as it has the specific benefit of low cost of
capital because interest is tax deductible. The leverage effect of debt is highly
advantageous to the equity shareholders. The limits of debt depend upon the firm’s
earning capacity and its fixed assets.
c. Management: Just as an army needs a general to lead it to victory, a company
relies upon management to steer it towards financial success. Some believe that

management is the most important aspect for investing in a company. It makes
sense - even the best business model is doomed if the leaders of the company fail to
properly execute the plan.
So how does an average investor go about evaluating the management of a company?
This is one of the areas in which individuals are truly at a disadvantage compared to
professional investors. You can't set up a meeting with management if you want to invest
a few thousand dollars. On the other hand, if you are a fund manager interested in
investing millions of dollars, there is a good chance you can schedule a face-to-face
meeting with the upper brass of the firm.
Every public company has a corporate information section on its website. Usually there
will be a quick biography on each executive with their employment history, educational
background and any applicable achievements. Don't expect to find anything useful here.
Let's be honest: We're looking for dirt, and no company is going to put negative
information on its corporate website.
Instead, here are a few ways for you to get a feel for management:
1. Conference Calls
The chief executive officer (CEO) and chief financial officer (CFO) host quarterly
conference calls. (Sometimes you'll get other executives as well.) The first portion
of the call is management basically reading off the financial results. What is really
interesting is the question-and-answer portion of the call. This is when the line is
open for analysts to call in and ask management direct questions. Answers here
can be revealing about the company, but more importantly, listen for candor. Do
they avoid questions, like politicians, or do they provide forthright answers?
2. Management Discussion and Analysis (MD&A)
The management discussion and analysis is found at the beginning of the annual
report (discussed in more detail later in this tutorial). In theory, the MD&A is
supposed to be frank commentary on the management's outlook. Sometimes the
content is worthwhile, other times its boilerplate. One tip is to compare what
management said in past years with what they are saying now. Is it the same
material rehashed? Have strategies actually been implemented? If possible, sit
down and read the last five years of MD&A’s; it can be illuminating.
3. Ownership and Insider Sales
Just about any large company will compensate executives with a combination of
cash, restricted stock and options. While there are problems with stock options, it
is a positive sign that members of management are also shareholders. The ideal
situation is when the founder of the company is still in charge. Examples include
Bill Gates (in the '80s and '90s), Michael Dell and Warren Buffett. When you
know that a majority of management's wealth is in the stock, you can have
confidence that they will do the right thing. As well, it's worth checking out if

management has been selling its stock. This has to be filed with the Securities and
Exchange Commission (SEC), so it's publicly available information. Talk is cheap
- think twice if you see management unloading all of its shares while saying
something else in the media.
4. Past Performance
Another good way to get a feel for management capability is to check and see how
executives have done at other companies in the past. You can normally find
biographies of top executives on company web sites. Identify the companies they
worked at in the past and do a search on those companies and their performance.
5. Operating Efficiency:
Corporate governance describes the policies in place within an organization
denoting the relationships and responsibilities between management, directors and
stakeholders. These policies are defined and determined in the company charter
and its bylaws, along with corporate laws and regulations. The purpose of
corporate governance policies is to ensure that proper checks and balances are in
place, making it more difficult for anyone to conduct unethical and illegal
activities.
Good corporate governance is a situation in which a company complies with all of
its governance policies and applicable government regulations in order to look out
for the interests of the company's investors and other stakeholders.
Although, there are companies and organizations that attempt to quantitatively
assess companies on how well their corporate governance policies serve
stakeholders, most of these reports are quite expensive for the average investor to
purchase.
Fortunately, corporate governance policies typically cover a few general areas:
structure of the board of directors, stakeholder rights and financial and information
transparency. With a little research and the right questions in mind, investors can
get a good idea about a company's corporate governance.
Financial and Information Transparency
This aspect of governance relates to the quality and timeliness of a company's
financial disclosures and operational happenings. Sufficient transparency implies
that a company's financial releases are written in a manner that stakeholders can
follow what management is doing and therefore have a clear understanding of the
company's current financial situation.
Stakeholder Rights
This aspect of corporate governance examines the extent that a company's policies
are benefiting stakeholder interests, notably shareholder interests. Ultimately, as
owners of the company, shareholders should have some access to the board of
directors if they have concerns or want something addressed. Therefore companies

with good governance give shareholders a certain amount of ownership voting
rights to call meetings to discuss pressing issues with the board.
Another relevant area for good governance, in terms of ownership rights, is
whether or not a company possesses large amounts of takeover defenses (such as
the Macaroni Defense or the Poison Pill) or other measures that make it difficult
for changes in management, directors and ownership to occur. (To read more on
takeover strategies, see The Wacky World of M&As.)
Structure of the Board of Directors
The board of directors is composed of representatives from the company and
representatives from outside of the company. The combination of inside and
outside directors attempts to provide an independent assessment of management's
performance, making sure that the interests of shareholders are represented.
The key word when looking at the board of directors is independence. The board
of directors is responsible for protecting shareholder interests and ensuring that the
upper management of the company is doing the same. The board possesses the
right to hire and fire members of the board on behalf of the shareholders. A board
filled with insiders will often not serve as objective critics of management and will
defend their actions as good and beneficial, regardless of the circumstances.
Information on the board of directors of a publicly traded company (such as
biographies of individual board members and compensation-related info) can be
found in the DEF 14A proxy statement.
We've now gone over the business model, management and corporate governance.
These three areas are all important to consider when analyzing any company. We
will now move on to looking at qualitative factors in the environment in which the
company operates.
6. Financial Performance:
a. Balance Sheet: The level, trends, and stability of earnings are powerful forces in the
determination of security prices. Balance sheet shows the assets, liabilities and
owner’s equity in a company. It is the analyst’s primary source of information on the
financial strength of a company. Accounting principles dictate the basis for assigning
values to assets. Liability values are set by contracts. When assets are reduced by
liabilities, the book value of share holder’s equity can be ascertained. The book value
differs from current value in the market place, since market value is dependent upon
the earnings power of assets and not their cost of values in the accounts.
b. Profit and Loss account: It is also called as income statement. It expresses the results
of financial operations during an accounting year i.e. with the help of this statement
we can find out how much profit or loss has taken place from the operation of the
business during a period of time. It also helps to ascertain how the changes in the
owner’s interest in a given period have taken place due to business operations. Last of

all, for analyzing the financial position of any company following factors need to be
considered for evaluating present situation and prospects of company.
a) Company Analysis: The Study of Financial Statements
The massive amount of numbers in a company's financial statements can be bewildering
and intimidating to many investors. On the other hand, if you know how to analyze them,
the financial statements are a gold mine of information.
Financial statements are the medium by which a company discloses information
concerning its financial performance.
Followers of fundamental analysis use the quantitative information gleaned from financial
statements to make investment decisions. Before we jump into the specifics of the three
most important financial statements – income statements, balance sheets and cash flow
statements - we will briefly introduce each financial statement's specific function, along
with where they can be found.
The main techniques of financial analysis are:
1. Comparative Financial Statements
2. Trend Analysis
3. Common Size Statement
4. Fund Flow Statement
5. Cash Flow Statement
6. Ratio Analysis
1. Comparative Financial Statements: Financial statements of two or more firms may
be compared for drawing inferences. This is known as inter-firm comparison.
Similarly, there may be inter-period comparison, i.e., comparison of the financial
statements of the same firm over a period of years known as trend analysis. This is
also known as horizontal analysis, since each accounting variable for two or more
years is analyzed horizontally. Inter-firm or inter-period comparisons are very much
facilitated by the preparation of comparative statements. In preparing these
statements, the items are placed in the rows and the firms of years are shown in the
columns. Such arrangement facilitates highlighting the difference and brings out the
significance of such differences. The statement also provides for columns to indicate
the change form one year to another in absolute terms and also in percentage form. In
calculating percentages, there is one difficulty, namely, if the figure is negative,
percentages cannot be calculated. Likewise, if the change is from or to a zero balance
in account, it is not possible to calculate the percentage.
Advantages
 These statements indicate trends in sales, cost of production, profits, etc.,
helping the analyst to evaluate the performance, efficiency and financial
condition of the undertaking. For example, if the sales are increasing coupled
with the same or better profit margins, it indicates healthy growth.

 Comparative statements can also be used to compare the position of the firm
with the average performance of the industry or with other firms. Such a
comparison facilitates the identification or weaknesses and remedying the
situation.
Disadvantages
1. Inter-firm comparison may be misleading if the firms are not of the same age and size,
follow different accounting policies in relation to depreciation, valuation of stock, etc.,
and do not cater to the same market. Inter-period comparison will also be misleading if
the period has witnessed frequent changes in accounting policies.
2. Trend Analysis: For analyzing the trend of data shown in the financial statements it is
necessary to have statements for a number of years. This method involves the
calculation of percentage relationship that each statement item bears to the same item in
the “bas year”. Trend percentages disclose changes in the financial and operating data
between specific periods and make possible for the analyst to form an opinion as to
whether favorable or unfavorable tendencies are reflected by the data.
3. Common Size Statement:
Financial statements when read with absolute figures are not easily understandable,
sometimes they are even misleading. It is, therefore, necessary that figures reported in
these statements, should be converted into percentage to some common base. In profit
and loss account sales figure is assumed to be equal to 100 and all other figures are
expressed as percentage of sales.
Similarly, in balance sheet the total of assets or liabilities is taken as 100 and all the
figures are expressed as percentage of the total. This type of analysis is called vertical
analysis. This is a static relationship because it is a study of relationship existing at a
particular date. The statements so prepared are called common-size statements
4. Fund Flow Statement: Income Statement or Profit or Loss Account helps in
ascertainment of profit or loss for a fixed period. Balance Sheet shows the financial
position of business on a particular date at the close of year. Income statement does not
fully explain funds from operations of business because various non-fund items are
shown in Profit or Loss Account. Balance Sheet shows only static financial position of
business and financial changes occurred during a year can’t be known from the
financial statement of a particular date. Thus, Fund Flow Statement is prepared to find
out financial changes between two dates. It is a technique of analyzing financial
statements. With the help of this statement, the amount of change in the funds of a
business between two dates and reasons thereof can be ascertained. The investor could
see clearly the amount of funds generated or lost in operations. These reveal the real
picture of the financial position of the company.
5. Cash Flow Statement: The cash flow statement shows how much cash comes in and
goes out of the company over the quarter or the year. At first glance, that sounds a lot

like the income statement in that it records financial performance over a specified
period. But there is a big difference between the two.
What distinguishes the two is accrual accounting, which is found on the
income statement. Accrual accounting requires companies to record
revenues and expenses when transactions occur, not when cash is
exchanged. At the same time, the income statement, on the other hand,
often includes non-cash revenues or expenses, which the statement of cash
flows does not include.
Just because the income statement shows net income of $10 does not
means that cash on the balance sheet will increase by $10. Whereas when
the bottom of the cash flow statement reads $10 net cash inflow, that's
exactly what it means. The company has $10 more in cash than at the end
of the last financial period. You may want to think of net cash from
operations as the company's "true" cash profit. Because it shows how much
actual cash a company has generated, the statement of cash flows is critical
to understanding a company's fundamentals. It shows how the company is
able to pay for its operations and future growth.
Indeed, one of the most important features you should look for in a
potential investment is the company's ability to produce cash. Just because
a company shows a profit on the income statement doesn't mean it cannot
get into trouble later because of insufficient cash flows. A close
examination of the cash flow statement can give investors a better sense of
how the company will fare.
6. Ratio Analysis: Ratio is a relationship between two figures expressed mathematically. It
is quantitative relationship between two items for the purpose of comparison. Ratio
analysis is a technique of analyzing financial statements. It helps in estimating financial
soundness or weakness. Ratios present the relationships between items presented in
profit and loss account and balance sheet. It summaries the data for easy understanding,
comparison and interpretation. The ratios are divided in the following group:
Liquidity Ratios
Liquidity ratios provide information about a firm's ability to meet its short-term
financial obligations. They are of particular interest to those extending short-term
credit to the firm. Two frequently-used liquidity ratios are the current ratio (or
working capital ratio) and the quick ratio.
The current ratio is the ratio of current assets to current liabilities:
Current Assets
Current Ratio = --------------------
Current Libilities

Short-term creditors prefer a high current ratio since it reduces their risk.
Shareholders may prefer a lower current ratio so that more of the firm's assets are
working to grow the business. Typical values for the current ratio vary by firm and
industry. For example, firms in cyclical industries may maintain a higher current
ratio in order to remain solvent during downturns.
One drawback of the current ratio is that inventory may include many items that
are difficult to liquidate quickly and that have uncertain liquidation values. The
quick ratio is an alternative measure of liquidity that does not include inventory in
the current assets. The quick ratio is defined as follows:
Current Assets - Inventory
Quick Ratio = ----------------------------
Current Liabiliites
The current assets used in the quick ratio are cash, accounts receivable, and notes
receivable. These assets essentially are current assets less inventory. The quick
ratio often is referred to as the acid test. Finally, the cash ratio is the most
conservative liquidity ratio. It excludes all current assets except the most liquid:
cash and cash equivalents. The cash ratio is defined as follows:
Cash + Marketable Securites
Cash Ratio = -----------------------------
Current Libilities
The cash ratio is an indication of the firm's ability to pay off its current liabilities if
for some reason immediate payment were demanded.
2. Asset Turnover Ratios: Asset turnover ratios indicate of how efficiently the firm
utilizes its assets. They sometimes are referred to as efficiency ratios, asset utilization
ratios, or asset management ratios. Two commonly used asset turnover ratios are
receivables turnover and inventory turnover.
Receivables turnover is an indication of how quickly the firm collects its accounts
receivables and is defined as follows:
Annual Credit Sales
Receivables Turnover = ---------------------
Accounts Receivable
The receivables turnover often is reported in terms of the number of days that credit sales
remain in accounts receivable before they are collected. This number is known as the
collection period. It is the accounts receivable balance divided by the average daily credit
sales, calculated as follows:
Accounts Receivable
Average Collection Period = ----------------------
Annual Credit Sale /365
The collection period also can be written as:

365
Average Collection Period = -------------------
Receivable Turnover
Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a
time period divided by the average inventory level during that period:
Cost of Goods Sold
Inventory Turnover = -------------------
Average Inventory
The inventory turnover often is reported as the inventory period, which is the number of
days worth of inventory on hand, calculated by dividing the inventory by the average
daily cost of goods sold:
Average Inventory
Inventory Period = -------------------------
Annual Cost Goods Sold/365
The inventory period also can be written as:
365
Inventory Period = -----------------
Inventory Turnover
Other asset turnover ratios include fixed asset turnover and total asset turnover.
Profitability ratios
Profitability ratios offer several different measures of the success of the firm at generating
profits.
The gross profit margin is a measure of the gross profit earned on sales. The gross profit
margin considers the firm's cost of goods sold, but does not include other costs. It is
defined as follows:
Sales - Cost of Goods Sold
Gross Profit Margin = -----------------------------
Sales
Return on assets is a measure of how effectively the firm's assets are being used to
generate profits. It is defined as:
Net Income
Return on Assets = ------------
Total Assets
Return on equity is the bottom line measure for the shareholders, measuring the profits
earned for each dollar invested in the firm's stock. Return on equity is defined as follows:
Net Income
Return on Equity = -----------------
Shareholder Equity

FORECASTING EARNINGS
There is strong evidence that earnings have a direct and powerful effect upon dividends
and share prices. So the importance of forecasting earnings cannot be overstated. These
ratios are generally known as ‘Return on Investment Ratios’. These ratio help in
evaluating whether the business is earning adequate return on the capital invested or not.
With the help of the following ratios the performance of the business can be measured.
The earnings forecasting ratios are:
 Return on Total Assets: A ratio that measures a company's earnings before interest
and taxes (EBIT) against its total net assets. The ratio is considered an indicator of
how effectively a company is using its assets to generate earnings before contractual
obligations must be paid.
To calculate ROTA:
EBIT
= ------------
Total Net Assets
Where EBIT = Net Income + Interest Expense + taxes
 The greater a company's earnings in proportion to its assets (and the greater the
coefficient from this calculation), the more effectively that company is said to be
using its assets.
To calculate ROTA, you must obtain the net income figure from a company's
income statement, and then add back interest and/or taxes that were paid during the
year. The resulting number will reveal the company's EBIT. The EBIT number
should then be divided by the company's total net assets
 Return on Equity: The amount of net income returned as a percentage of
shareholders equity. Return on equity measures a corporation's profitability by
revealing how much profit a company generates with the money shareholders have
invested.
ROE is expressed as a percentage and calculated as:
Return on Equity = Net Income/Shareholder's Equity
Net income is for the full fiscal year (before dividends paid to common stock holders but
after dividends to preferred stock.) Shareholder's equity does not include preferred shares.
Also known as "return on net worth" (RONW). The ROE is useful for comparing the
profitability of a company to that of other firms in the same industry.
There are several variations on the formula that investors may use:
1. Investors wishing to see the return on common equity may modify the formula above
by subtracting preferred dividends from net income and subtracting preferred equity
from shareholders' equity, giving the following: return on common equity (ROCE) =
net income - preferred dividends / common equity.

2. Return on equity may also be calculated by dividing net income by average
shareholders' equity. Average shareholders' equity is calculated by adding the
shareholders' equity at the beginning of a period to the shareholders' equity at period's
end and dividing the result by two.
3. Investors may also calculate the change in ROE for a period by first using the
shareholders' equity figure from the beginning of a period as a denominator to
determine the beginning ROE. Then, the end-of-period shareholders' equity can be
used as the denominator to determine the ending ROE. Calculating both beginning
and ending ROEs allows an investor to determine the change in profitability over the
period.
Earnings and Role of Financing
Borrowing of money at a fixed cost and the use of these funds to earn return on assets is
known as employing leverage. If one can earn more on borrowed money than you have to
pay for it, the leverage is to firm’s advantage. However, leverage should be used within
reasonable limits because excessive use of debt relative to equity increases borrowing
costs and also the cost of equity funds. The volatility of share holders returns increases
with the expansion of the degree of financial leverage. The greater volatility of earnings
owing to increased leverage can, at certain levels of debt financing, cause the market to
pay less per rupee of earnings. Further with the use of more debts it may become
progressively difficult to maintain (or improve) the rate of return on assets. One of the
best ways of measuring the proportions of debt and equity financing is:
a. Debt to asset ratio = Total Debt / Total Assets
b. Debt to equity ratio = Total Debt / Net Worth
c. Long term debt to equity = Long Term Debt/ Net Worth
VALUATION RATIOS: EARNINGS AND DIVIDEND LEVEL
 Book value per share:
A measure used by owners of common shares in a firm to determine the level of safety
associated with each individual share after all debts are paid accordingly.
Total Shareholder Equity - Preferred Equity
Book Value Share = --------------------------------------------
Total out Standing Shares
Earnings per share (EPS):
The portion of a company's profit allocated to each outstanding share of common stock.
Earnings per share serve as an indicator of a company's profitability.
Calculated as:
Net Income - Dividends on preferred Stock
= -------------------------------------------
Average Outstanding Shares

When calculating, it is more accurate to use a weighted average number of shares
outstanding over the reporting term, because the number of shares outstanding can change
over time. However, data sources sometimes simplify the calculation by using the number
of shares outstanding at the end of the period.
Diluted EPS expands on basic EPS by including the shares of convertibles or warrants
outstanding in the outstanding shares number
Dividend per Share (DPS):
The sum of declared dividends for every ordinary share issued. Dividend per share (DPS)
is the total dividends paid out over an entire year (including interim dividends but not
including special dividends) divided by the number of outstanding ordinary shares issued.
DPS can be calculated by using the following formula:
D-SD
DPS = ----
S
D - Sum of dividends over a period (usually 1 year)
SD - Special, one time dividends
S - Shares outstanding for the period
Dividend Payout Ratio (D/P ratio):
The percentage of earnings paid to shareholders in dividends.
Calculated as:
Yearly Dividend per Share
= --------------------------
Earnings per Share
or equivalently:
Dividends
= ------------
Net Incomes
Dividend and Earnings Yield:
These ratios are used to evaluate the profitability from the stand point of ordinary
shareholders. Earnings per share (EPS) and Dividend per Share (DPS) are calculated on
the basis of book value of share but yield is always calculated on the basis of market value
of shares. This ratio is called as Earnings Price ratio.
Dividend Yield = Dividend per share/ Market value per share
Earnings Yield = Earnings per share/ Market value per share
Price to Earnings Ratio:
A valuation ratio of a company's current share price compared to its per-share earnings.
Calculated as:
Market Value per Share
-------------------------
Earnings per Share (EPS)

Practical Example
Competitive Benchmarking Reports Research Competitive Benchmarking Report
provides information that enables A Company to analyze and compare its financial
performance, business segments, geographical presence, products and services and
business strategies vis-à-vis its competitors.
 GOLD Analysis The Gold Profiles provide very comprehensive information
about the company. These reports include price history and charting, an
extended business summary, the five year financial history and information
on management, insiders and institutions. The Gold Profiles also successfully
outline the strategic position of the company within the market and provide
detailed information on the functioning of the company under various
constraints.
 Silver Analysis The Silver Profiles are a scaled down version of the Gold
Profiles that provide detailed information about the company. These include
information on performance of the company, its strategy, joint ventures, key
executives, new products, M&A etc. Timely, precise and up-to-date
information presented in these reports allows decision makers to make
successful strategic decisions.
 Porter Analysis In the globalised market scenario, companies need to
understand and challenge the competitive markets they operate in. RocSearch
analysts use Porter’s Five Forces Framework developed by marketing guru
Michael Porter to analyze various industries and enable companies to identify
and develop appropriate strategies.
 PEST Analysis PEST refers to all Political, Economic, Social and
Technological factors affecting any industry. RocSearch’s acclaimed team of
industry analysts religiously follow industry trends and monitor any changes
that occur in the business scenario. All reported information including insider
tit bits is examined and analyzed to produce an original document that
effectively mirrors the external business environment.
 SWOT Analysis Our industry analysts put into perspective all political,
economic, social and technological factors affecting any industry to identify
the emerging opportunities for any company operating in that industry.
Strengths and weaknesses of the company are analyzed to establish whether
it can take advantage of the emergent opportunities. Various threats that can
hamper its progress are also examined and listed. The findings can be used to
take advantage of opportunities and to make contingency plans for threats.

3.2.4. TECHNICAL ANALYSIS
a) Meaning of Technical Analysis
Technical analysis is a method of evaluating securities by analyzing the statistics
generated by market activity, such as past prices and volume. Technical analysts do not
attempt to measure a security's intrinsic value, but instead use charts and other tools to
identify patterns that can suggest future activity.
Just as there are many investment styles on the fundamental side, there are also many
different types of technical traders. Some rely on chart patterns; others use technical
indicators and oscillators, and most use some combination of the two. In any case,
technical analysts' exclusive use of historical price and volume data is what separates
them from their fundamental counterparts. Unlike fundamental analysts, technical analysts
don't care whether a stock is undervalued - the only thing that matters is a security's past
trading data and what information this data can provide about where the security might
move in the future.
Before embarking on a journey to technical trading, we are best served to understand the
five main assumptions of this approach. These are:
1. Art over science – Many investment approaches require us to perform a great deal of
math to generate an answer. Technical analysis does not. Looking at the same chart,
many investors will derive different answers. Therefore, reading charts evolves into
an art form where each analyst can provide a unique insight.
2. No need to know – As more information becomes available, people become obsessed
with knowing why events occur. In the markets, we often never know. Instead of
searching for the next piece of data that magically unlocks the puzzles, technicians
focus on the past and interpolate how it will affect the future.
3. History repeats – A study of history shows that set patterns repeat themselves over
long periods. By relying on the past to predict the future, we can take advantage of
these patterns.
4. Self-fulfilling prophecy – Enough people seeing the same pattern will take actions
that force the prediction to occur. While this is positive if you are on the right side of
the trade, it presents a major weakness when everyone attempts to exit at the same
time.
5. Momentum reverses – When a trade becomes very crowded with everyone
assuming the same position, unexpected surprises can drive prices. If the exit
becomes crowded, what first looked promising quickly becomes a nightmare.
In many markets, technical analysis serves as a solid series of guiding posts. By
examining trends, we increase the likelihood that markets remain in our favor and trades
remain profitable.

b) Tools of Technical Analysis
Generally used technical tools to analyze the market data are as follows:
Dow Theory
Any attempt to trace the origins of technical analysis would inevitably lead to Dow
Theory. While more than 100 years old, Dow Theory remains the foundation of much of
what we know today as technical analysis.
Dow Theory was formulated from a series of Wall Street Journal editorials authored by
Charles H. Dow from 1900 until the time of his death in 1902. These editorials reflected
Dow’s beliefs on how the stock market behaved and how the market could be used to
measure the health of the business environment.
Due to his death, Dow never published his complete Theory on the markets, but several
followers and associates have published works that have expanded on the editorials. Some
of the most important contributions to Dow Theory were William P. Hamilton's "The
Stock Market Barometer" (1922), Robert Rhea's "The Dow Theory" (1932), E. George
Schaefer's "How I Helped More Than 10,000 Investors to Profit in Stocks" (1960) and
Richard Russell's "The Dow Theory Today" (1961). 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.
Dow first used his Theory to create the Dow Jones Industrial Index and the Dow Jones
Rail Index (now Transportation Index), which were originally compiled by Dow for The
Wall Street Journal.
Dow created these indexes because he felt they were an accurate reflection of the business
conditions within the economy because they covered two major economic segments:
industrial and rail (transportation). While these indexes have changed over the last 100
years, the Theory still applies to current market indexes.
Explanation of Theory:
An important part of Dow Theory is distinguishing the overall direction of the market. To
do this, the Theory uses trend analysis.
Before we can get into the specifics of Dow Theory trend analysis, we need to understand
trends. First, it's important to note that while the market tends to move in a general
direction, or trend, it doesn't do so in a straight line. The market will rally up to a high (
peak ) and then sell off to a low ( trough ), but will generally move in one direction.
n upward trend is broken up into several rallies , where each rally has a high and a low.
For a market to be considered in an uptrend, each peak in the rally must reach a higher
level than the previous rally's peak, and each low in the rally must be higher than the
previous rally's low.
A downward trend is broken up into several sell-offs , in which each sell-off also has a
high and a low. To be considered a downtrend in Dow terms, each new low in the sell-off

must be lower than the previous sell-offs low and the peak in the sell-off must be lower
than the peak in the previous sell-off.
Now that we understand how Dow Theory defines a trend, we can look at the finer points
of trend analysis.
Dow Theory identifies three trends within the market: primary, secondary and minor. A
primary trend is the largest trend lasting for more than a year, while a secondary trend is
an intermediate trend that lasts three weeks to three months and is often associated with a
movement against the primary trend. Finally, the minor trend often lasts less than three
weeks and is associated with the movements in the intermediate trend.
Let us now take a look at each trend.
Primary Trend
In Dow Theory, the primary trend is the major trend of the market, which makes it the
most important one to determine. This is because the overriding trend is the one that
affects the movements in stock prices. The primary trend will also impact the secondary
and minor trends within the market. Dow determined that a primary trend will generally
last between one and three years but could vary in some instances. Regardless of trend
length, the primary trend remains in effect until there is a

For example, if in an uptrend the price closes below the low of a previously established
trough, it could be a sign that the market is headed lower, and not higher.
When reviewing trends, one of the most difficult things to determine is how long the price
movement within a primary trend will last before it reverses. The most important aspect is
to identify the direction of this trend and to trade with it, and not against it, until the
weight of evidence suggests that the primary trend has reversed.
Secondary, or Intermediate, Trend

In Dow Theory, a primary trend is the main direction in which the market is moving.
Conversely, a secondary trend moves in the opposite direction of the primary trend, or as
a correction to the primary trend.
For example, an upward primary trend will be composed of secondary downward trends.
This is the movement from a consecutively higher high to a consecutively lower high. In a
primary downward trend the secondary trend will be an upward move, or a rally. This is
the movement from a consecutively lower low to a consecutively higher low.
Below is an illustration of a secondary trend within a primary uptrend. Notice how the
short-term highs (shown by the horizontal lines) fail to create successively higher peaks,
suggesting that a short-term downtrend is present. Since the retracement does not fall
below the October low, traders would use this to confirm the validity of the correction
within a primary uptrend.
In general, a secondary, or intermediate, trend typically lasts between three weeks and
three months, while the retracement of the secondary trend generally ranges between one-
third to two-thirds of the primary trend's movement. For example, if the primary upward
trend moved the DJIA from 10,000 to 12,500 (2,500 points), the secondary trend would
be expected to send the DJIA down at least 833 points (one-third of 2,500).
Another important characteristic of a secondary trend is that its moves are often more
volatile than those of the primary move.

Minor Trend
The last of the three trend types in Dow Theory is the minor trend, which is defined as a
market movement lasting less than three weeks. The minor trend is generally the
corrective moves within a secondary move, or those moves that go against the direction of
the secondary trend. Due to its short-term nature and the longer-term focus of Dow
Theory, the minor trend is not of major concern to Dow Theory followers. But this doesn't
mean it is completely irrelevant; the minor trend is watched with the large picture in mind,
as these short-term price movements are a part of both the primary and secondary trends.
Most proponents of Dow Theory focus their attention on the primary and secondary
trends, as minor trends tend to include a considerable amount of noise. If too much focus
is placed on minor trends, it can to lead to irrational trading, as traders get distracted by
short-term volatility and lose sight of the bigger picture.
Support and Resistance Level
The concepts of support and resistance are undoubtedly two of the most highly discussed
attributes of technical analysis and they are often regarded as a subject that is complex by
those who are just learning to trade. This article will attempt to clarify the complexity
surrounding these concepts by focusing on the basics of what traders need to know. You'll
learn that these terms are used by traders to refer to price levels on charts that tend to act
as barriers from preventing the price of an asset from getting pushed in a certain direction.
At first the explanation and idea behind identifying these levels seems easy, but as you'll
find out, support and resistance can come in various forms and it is much more difficult to
master than it first appears.
The Basics
Most experienced traders will be able to tell many stories about how certain price levels
tend to prevent traders from pushing the price of an underlying asset in a certain direction.
For example, assume that Jim was holding a position in Amazon.com (AMZN) stock
between March and November 2006 and that he was expecting the value of the shares to
increase. Let's imagine that Jim notices that the price fails to get above $39 several times
over the past several months, even though it has gotten very close to moving above it. In

this case, traders would call the price level near $39 a level of resistance. As you can see
from the chart below, resistance levels are also regarded as a ceiling because these price
levels prevent the market from moving prices upward.
On the other side of the coin, we have price levels that are known as support. This
terminology refers to prices on a chart that tend to act as a floor by preventing the price of
an asset from being pushed downward. As you can see from the chart below, the ability to
identify a level of support can also coincide with a good buying opportunity because this
is generally the area where market participants see good value and start to push prices
higher again.
Volume of Trade
Dow gave special emphasis to volume. Technical analysts use volume as an excellent
method of confirming the trend. Therefore, the analyst looks for a price increase on heavy
volume relative to the stock’s normal trading volume as an indication of bullish activity.
Conversely, a price decline with heavy volume is bearish. A generally bullish pattern
would be when price increase are accompanied by heavy volume and the small price
increase reversals occur with the light trading volume, indicating limited interest in selling
and taking profits and vice-versa.
Breadth of the market
The breadth of the market is the term often used to study the advances and declines that
have occurred in the stock market. Advances mean the number of shares whose prices
have increased from the previous day’s trading. Decline indicates the number of shares
whose prices have fallen from the previous day’s trading. This is easy to plot and watch
indicator because data are available in all business dailies. The net difference between the
number of stocks advanced and declined during the same period is the breadth of market.
A cumulative index of net differences measures the net breadth. An illustrative calculation
of the breadth of the market is shown in Table below:

Breadth of the Market
To analyze the breadth of the market, it is compared with one or two market indices.
Ordinarily, the breadth of the market is expected to move in tandem with market indices.
However, if there is a divergence between the two, the technical analysts believe that it
signals something. It means, if the market index is moving upwards whereas the breadth
of the market is moving downwards, it indicates that the market is likely to turn bearish.
Likewise, if the market index is moving downwards but the breadth of the market is
moving upwards, then it signals that the market may turn bullish.
Short Selling
The selling of a security that the seller does not own, or any sale that is completed by the
delivery of a security borrowed by the seller. Short sellers assume that they will be able to
buy the stock at a lower amount than the price at which they sold short.
Selling short is the opposite of going long. That is, short sellers make money if the stock
goes down in price.
This is an advanced trading strategy with many unique risks and pitfalls. Novice investors
are advised to avoid short sales.
Odd Lot Trading
An order amount for a security that is less than the normal unit of trading for that
particular asset. Odd lots are considered to be anything less than the standard 100 shares
for stocks. Trading commissions for odd lots are generally higher on a percentage basis
than those for standard lots, since most brokerage firms have a fixed minimum
commission level for undertaking such transactions.
Odd lots may inadvertently arise in an investor's portfolio through reverse splits or
dividend reinvestment plans. For example, a 1-for-8 reverse split of a security, of which
the investor holds 200 shares, will result in a post-split amount of 25 shares.

While trading commissions for odd lots may still be higher than for standard lots on a
percentage basis, the popularity of online trading platforms and the consequent plunge in
brokerage commissions means that it is no longer as difficult or expensive for investors to
dispose of odd lots as it used to be in the past.
Moving Average
Most technical traders incorporate the power of various technical indicators, such as
moving averages, to aid in predicting future short-term momentum, but these traders
never fully realize the ability these tools have for identifying levels of support and
resistance. As you can see from the chart below, a moving average is a constantly
changing line that smoothes out past price data while also allowing the trader to identify
support and resistance. Notice how the price of the asset finds support at the moving
average when the trend is up, and how it acts as resistance when the trend is down. Most
traders will experiment with different time periods in their moving averages so that they
can find the one that works best for this specific task A five-day moving average of daily
closing prices is calculated as follows:
The moving averages are used to study the movement of the market as well as the
individual security prices. These moving averages are used along with the price of a stock.

The stock prices may intersect the moving average at a particular point and give the buy
and sell signal.
The moving average analysis recommends buying a stock when
1. Stock prices line rises through the moving average line when graph of the moving
average line is flattening out.
2. Stock price line falls below the moving average line, which is rising.
3. Stock price line, which is above the moving average line, falls but begins to rise again
before reaching the moving average line.
Moving average analysis recommends selling a stock when
1. Stock price lines falls through the moving average line when graph of the moving
average line is flattening out.
2. Stock prices line rise above the moving average line, which is falling.
3. Stock price line, which is below the moving average line, rises but begins to fall again
before reaching the moving average line.
The buy and sell signals initiated by a moving average trading system vary with the length
of time over which the moving average is calculated.
Relative Strength Analysis
Relative Strength is a technical analysis strategy to help investors sort through all of the
various recommendations.
Identify individual stock trends! - When the upward trends of stocks are identified early
enough, the stocks may be purchased and a profit may be realized by a continuance of the
trend. Although past performance is not necessarily a determining factor in the future
performance of a stock, using Relative Strength Analysis for stock selection has proven to
be a profitable strategy over time.
This selection, which is used to compare all of the stocks that are being followed (both
Daily and Weekly History), will sort them by their strength rating of the previous week
placing a rank on them and then sorting them by the current week's strength rating. The
reason this report requires at least 45 Weeks of historical data is that we are looking for a
sustained growth in price so that we can catch part of the growth of the issue in our own
portfolio.
This report is one of the most valuable tools of this system. The report will show you
which stocks are stronger and how much they are stronger than the previous. It provides
you with a means of analyzing hundreds of issues without having to look at each of the
individual charts to make comparisons. This tool has provided superior returns in testing
and in actual practice. The idea is to buy stocks that are experiencing strong upward
momentum with the expectations that the stocks will continue to be strong. These can be
found within the top 10 or 20 issues. Look at the charts of the stocks from this group that
meets your investment criteria.

Use this report in conjunction with the busy signals generated by the Daily and Weekly
stock market barometers and you will have a winning combination that will help you
make your money work harder.
One special note here is that the price of some stocks will spike upward due to some event
such as an announced buyout offer. This spike will cause this stock to appear high in the
relative strength listing. This is why we recommend that you look at the charts, so that
you don't buy into an issue that has experienced a onetime spike in price. It is important to
look for issues that are experiencing a steady upward momentum.
For example, consider the data for ABC corp. a hypothetical growth firm in the electronic
industry shown in the table below.
Relative Strength Data for ABC Corp.
From 2001 to 2002, ABC did slightly well than most of the firms in the industry as its
price grew relatively more than the industry average (from 1.78 to 2). Moreover, from
2001to 2002, the electronic industry showed weakness relative to all industrial stock as the ratio
declined from .081 to .072. From 2001 to 2002, ABC showed no increased strength relative to its
market average as the ratio is constant at .144. But from 2002 to 2003, ABC showed considerable
strength relative both to its industry and the market. Therefore, the technical analyst would select
certain industries and firms, which demonstrated relative strength to be the most promising
investment opportunities.
Charts
Charts are the valuable and easiest tools in the technical analysis. The graphic
presentation of the data helps the investor to find out the trend of the price without any
difficulty. A large number of charts are used to analyze the trend of the market.
The bar and line chart is the simplest and most commonly used tool of a technical analyst.
Bar charts contain measures on both axis: price on the vertical axis and time on the
horizontal axis. On bar charts, the analysts plot a vertical line to represent the range of
prices of the stock during the period that may be a day, week or month etc. thus the top of
the vertical line would represent the highest price of the stock during the day and the
bottom of the line would represent the low price of the stock during the same day. A small
horizontal line is drawn across the bar to denote the closing price at the end of the time
period.
Line chartists have found key patterns to determine the most probable action of a stock.

Five Standard Chart Patterns
a) Stocks with downside potential:
b) Stocks that appear to have reached possible lows but need consolidation:
c) Stocks that have declined and experienced consolidation and could do well in a
favorable market:

d) Stocks that have performed relatively well but are currently in neutral trends:
e) Stocks in established up trends and/or with possible upside potential:
Mutual Fund Liquidity

A ratio published monthly by the Investment Company Institute that compares the amount
of cash relative to total assets held by a mutual fund. Equity investors use the mutual fund
liquidity ratio to gauge the demand for shares and the bullishness or bearishness of
portfolio managers For example, if a mutual fund is sitting on a large amount of cash, the
Theory is that it is doing so because it is hard pressed to find quality investment
opportunities; therefore, it has a bearish sentiment toward the market. Conversely, if a
mutual fund is highly invested and has a very small amount of cash on hand, the Theory is
that it has found some excellent investing opportunities and is taking advantage of these
opportunities by being nearly fully invested - that is to say, it is bullish.
Put/Call Ratio
A ratio of the trading volume of put options to call options. The put-call ratio has long
been viewed as an indicator of investor sentiment in the markets. Times where the number

of traded call options outpaces the number of traded put options would signal a bullish
sentiment, and vice versa.
Technical traders have used the put call ratio for years as an indicator of the market. Most
importantly, changes or swings in the ratio are seen as instances of great importance as
this is commonly viewed as a change in the tide of overall market sentiment. By being
able to get ahead of the tide, traders may be able to reap the rewards of taking positions at
prices below future projections.
Evaluation of Technical Analysis
Technical analysis appears to be a highly controversial approach to security analysis. It
has its ardent votaries; it has its severe critics. The advocates of technical analysis offer
the following interrelated arguments in support of their position.
1. Under the influence of crowd psychology, trends persist for quite some time. Tools of
technical analysis that help in identifying these trends early are helpful aids in
investment decision making.
2. Shifts in demand and supply are gradual rather than instantaneous. Technical analysis
helps in detecting these shifts rather early and hence provides clues to future price
movements.
3. Fundamental information about a company is absorbed and assimilated by the market
over a period of time. Hence, the price movement tends to continue in more or less
the same direction till the information is fully assimilated in the stock price.
4. Charts provide a picture of what has happened in the past and hence give a sense of
volatility that can be expected from the stock. Further, the information on trading
volume which is ordinarily provided at the bottom of a bar chart gives a fair idea of
the extent of public interest in the stock.
The detractors of technical analysis believe that technical analysis is a useless exercise.
Their arguments run as follows:
1. Most technical analysts are not able to offer convincing explanations for the tools
employed by them.
2. Empirical evidence in support of the random walk hypothesis cast its shadow over the
usefulness of technical analysis.
3. By the time an uptrend or downtrend may have been signaled by technical analysis, it
may already have taken place.
4. Ultimately, technical analysis must be a self defeating proposition. As more and more
people employ it, the value of such analysis tends to decline.
5. The numerous claims that have been made for different chart patterns are simply
untested assertions.
6. There is a great deal of ambiguity in the identification of configurations as well as
trend lines and channels on the charts. The same can be interpreted differently. As an
example, here is an extract from a commentary of a technical analyst:

Despite these limitations, technical analysis is very popular. It is only in the rational,
efficient and well ordered market where technical analysis has no use. But given the
imperfections, inefficiencies and irrationalities that characterize real markets, technical
analysis can be helpful. Hence, it can be concluded that technical analysis may be used,
albeit to a limited extent, in conjunction with fundamental analysis to guide investment
decision-making, as it is supplementary to fundamental analysis rather than substitute for
it.
P
Post Test Questions
1. All of the following changes relate to supply shock, except:
A. changes in the price of imported oil
B. changes in the tax rates and money supply
C. Changes in the educational level of an economy's workforce.
D. Changes in the wage rates at which the labor force is willing to work.
2. An example of a defensive industry is ______________.
A. food producers and processors
B. auto manufacturers
C. durable goods producers
D. capital goods producers
3. Which of the following affects the sensitivity of a firm's earnings to the business cycle?
A. Financial leverage
B. Dividend policy
C. Tax liabilities
D. Instrument leverage
4. Which of the following is a characteristic of the consolidation stage of the industry life
cycle?
A. New technology
B. Many competitors
C. Slow growth
D. Emergence of industry leaders
5. At what stage the industry might grow at less than the rate of the overall economy, or it might
even shrink?
A. Maturity stage
B. Consolidation stage
C. Relative decline
D. Start-up stage
6. A transition from the end of an expansion to the start of a contraction is termed as:
A. Trough.
B. Peak.
C. Business cycle.
D. Cyclical industry.

7. What is the first step of a top-down analysis of a company's prospects?
A. Analysis of the global economy
B. Analysis of the domestic economy
C. Analysis of the company's industry
D. Analysis of the company's fundamentals
8. The behavioral tendency of investors to hold on to losing investments is termed as:
A. disposition effect
B. money effect
C. market effect
D. P/E effect
9. One of the limits on investors' ability to exploit the mistakes of behavioral investors is
fundamental risk, which is ______________.
A. the possibility that mispricing will worsen
B. the forecast error made by fundamental analysts
C. the difference between stock prices forecast by fundamental analysts and prices
forecast by technical analysts
D. the possibility that a stock which appears under-valued or over-valued is actually
priced correctly
10. When stock price falls below a support level, technical analysts interpret this as a(n):
A. Bullish signal.
B. bearish signal
C. Hold recommendation.
D. Uncertain signal requiring further confirmation.
1. B
2. A
3. A
4. D
5. C
6. B
7. A
8. A
9. A
10. B

CHAPTER FOUR
BOND AND BOND VALUATION
4.0 AIMS AND OBJECTIVES
After studying this unit, you should be able to:
- explain the meaning and features of debt securities
- explicate the sense and valuations of bond
- Describe the meaning and nature of global bond markets.
4.1. INTRODUCTION
Companies issue various types of long -term securities to help meet their needs for funds.
These include long-term debt (bonds), preferred stock, and common stock. Long-term debt
and preferred stock are sometimes referred to as fixed -income securities. Holders of these
types of securities receive relatively constant distributions of interest or dividend payments
over time and have a fixed claim on the assets of the firm in the event of bankruptcy. For
example, Ford Motor Company sold $250 million of bonds in 1992, at which time it agreed
to pay its lenders an interest rate of 87⁄8 percent or $88.75 per year until 2022 for each
$1,000 of debt outstanding.
Since then, the company has continued to pay this interest rate, even though market interest
rates have fluctuated. Similarly, DuPont issued $70 million of preferred stock in 1947.
Investors paid $102 per share, and the company agreed to pay an annual dividend of $3.50
per share. Since then DuPont has continued to pay this amount, even though common stock
dividends have been increased numerous times. Common stock, on the other hand, is a
variable income security. Common stockholders are said to participate in a firm’s earnings
because they may receive a larger dividend if earnings increase in the future, r their
dividend may be cut if earnings drop. For example, in 1998 Ford Motor paid an annual
dividend per share of $1.72. After a number of disappointing years of earnings, the annual
dividend rate was reduced to $0.40 per share in 2004.
Investors in common stock have a residual claim on the earnings (and assets) of the firm
since they receive dividends only after the claims of bondholders and other creditors, as
well as preferred stockholders, have been met.
Fixed-income securities —long -term debt and preferred stock —differ from each other in
several ways. For example, the interest paid to bondholders is a tax -deductible expense for
the borrowing company, whereas dividends paid to preferred stockholders are not. Legally,
long term debt holders are considered creditors, whereas preferred stockholders are
considered owners. Thus, a firm is not legally required to pay dividends to its preferred
stockholders, and the failure to do so have less serious consequences than the failure to
meet interest payment and principal repayment obligations on long-term debt. In addition,
long-term debt normally has a specific maturity, whereas preferred stock is often perpetual.

Knowledge of the characteristics of the various types of long -term securities is necessary
in developing valuation models for these securities. The valuation of long -term securities is
important to a firm’s financial managers, as well as to current owners, prospective
investors, and security analysts. For example, financial managers should understand how
the price or value of the firm’s securities (particularly common stock) is affected by its
investment, financing, and dividend decisions. Similarly, both current owners and
prospective investors should be able to compare their own valuations of the firm’s
securities with actual market prices to make rational security purchase and sale decisions.
Likewise, security analysts use valuation techniques in evaluating long-term corporate
securities when making investment recommendations.
This chapter focuses on the characteristics and valuation of fixed -income securities,
namely, long-term debt.
4.2: FEATURES OF DEBT SECURITIES
4.2.1: Definition of Debt Securities
Debt securities are a type of financial platform in which an issuer, also known as a creditor,
provides assets to a borrower with the intention of receiving a repayment of the funds.
Basically, it is some form of contract that represents money owed to another party. Examples
of this include different types of bonds, documents such as debentures, or even paper money
issued by a bank or government. These debt securities are usually backed by some sort of
legal standing; however, some countries do not regulate the practice and allow creditors to
issue statements privately.
The concept of a debt security is important to the continued function of most of the
worldwide economy. Those institutions with capital provide individuals and companies in
need of funding with the ability to purchase goods and services on credit. The creditor then
issues some sort of binding document designed to symbolize the debt accrued. These
documents are considered to be worth a certain value, requiring the individual or group to
repay the debt according to the terms of the agreement.
Debt securities can be traded much like goods, allowing them to represent potential economic
value. In this way, a bank or private entity can issue some sort of credit, create a debt security
document, and then sell it to another source for the right to collect the repayment value. Debt
securities therefore essentially equate to the exchange of money.
Within the debt securities market, a number of different types of credit-based documents can
be issued. Private debt securities are issued to a private entity by some sort of organization
with the purpose of eventually being paid off with the addition of interest, such as a credit
card account. Corporate debt securities are those which are issued to a company and
represent a certain portion of that company's assets. Governments of all levels, from
municipal to federal, issue debt securities in the form of bonds. These are essentially
promissory notes, which guarantee a repayment with interest to individuals after a certain
period of time.

4.2.2. Features of Long -Term Debt
Long -term debt has a number of unique features. Several of these are discussed in the
following paragraphs.
Indenture An indenture is a contract between a firm that issues long-term debt securities
and the lenders. In general, an indenture does the following:
 It thoroughly details the nature of the debt issue.
 It carefully specifies the manner in which the principal must be repaid.
 It lists any restrictions placed on the firm by the lenders. These restrictions are called
covenants, and the firm must satisfy them to keep from defaulting on its obligations.
Typical restrictive covenants include the following:
1. A minimum coverage, or times interest earned, ratio the firm must maintain
2. A minimum level of working capital6 the firm must maintain
3. A maximum amount of dividends the firm can pay on its preferred and common stock
4. other restrictions that effectively limit how much leasing and issuing of additional
debt the firm may do
Debt covenants are used to resolve agency problems among debt holders, stockholders,
and managers. Restrictive covenants, such as those listed, can be used to protect debt
holders by prohibiting certain actions by shareholders or managers that might be
detrimental to the market value of the debt securities and the ability of the firm to repay
the debt at maturity. Debt covenants can also be used to alter the terms of a debt issue if a
future significant corporate event should lower the market value of the debt issue.
One such example of “event risk language” is a “poison put” covenant, which allows
bondholders to sell their debt back to the company at par value in the event of a leveraged
buyout (LBO) transaction and a downgrade in the credit rating of the debt issue to below
investment grade. International Paper’s 1992 issue of 75⁄8 percent notes, due 2007,
contains an option allowing holders to redeem the bonds at par (plus accrued interest) in
the event of a ratings decline to less than investment grade.
Strong debt covenants can reduce managerial flexibility and thus impose opportunity costs
on the firm. At the same time, strong covenants can result in higher credit ratings and
lower borrowing costs to the firm by limiting transfers of wealth from bondholders to
stockholders and placing limits on the bargaining power of management in any future debt
renegotiations. The optimal package of covenants minimizes the sum of these costs.
Trustee Because the holders of a large firm’s long -term debt issue are likely to be widely
scattered geographically, the Trust Indenture Act of 1939 requires that a trustee represent
the debt holders in dealings with the issuing company. A trustee is usually a commercial
bank or trust company that is responsible for ensuring that all the terms and covenants set
forth in the indenture agreement are adhered to by the issuing company. The issuing
company must pay the trustee’s expenses.

Call Feature and Bond Refunding A call feature is an optional retirement provision
that permits the issuing company to redeem, or call, a debt issue prior to its maturity date
at a specified price termed the redemption, or call, price. Many firms use the call feature
because it provides them with the potential flexibility to retire debt prior to maturity if, for
example, interest rates decline.
The call price is greater than the par value of the debt, and the difference between the two
is the call premium. During the early years of an issue, the call premium is usually equal
to about one year’s interest. Some debt issues specify fixed call premiums, whereas others
specify declining call premiums. For example, consider the Ford Motor Company $250
million of 87⁄8 percent, 30-year sinking fund debentures discussed earlier. Beginning on
November 15, 2002, the company could retire all or part of this issue at 104.153 percent
of par value, and the following year the redemption price was scheduled to drop to
103.737 percent of par.
Similar reductions in the redemption price are scheduled for each year up to the year
2012. Thereafter, the bonds can be redeemed by the company at 100 percent of par value.
Many bonds are not callable at all for several years after the initial date. For example, the
Ford debentures were not callable until 2002—10 years after the issue date. This situation
is referred to as a deferred call.
Details of the call feature are worked out in the negotiations between the underwriters and
the issuing company before the debt is sold. Because a call feature gives the company
significant flexibility in its financing plans, while at the same time potentially depriving
the lenders of the advantages they would gain from holding the debt until maturity, the
issuing company has to offer the investors compensation in the form of the call premium
in exchange for the call privilege.
In addition, the interest rate on a callable debt issue is usually slightly higher than the
interest rate on a similar non callable issue. Because of the interest savings that can be
achieved, a firm is most likely to call a debt issue when prevailing interest rates are
appreciably lower than those that existed at the time of the original issue. When a
company calls a relatively high interest rate issue and replaces it with a lower interest rate
issue, the procedure is called bond refunding.
Sinking Fund Lenders often require that a borrowing company gradually reduce the
outstanding balance of a debt issue over its life instead of having the entire principal
amount come due on a particular date 20 or 30 years into the future. The usual method of
providing for a gradual retirement is a sinking fund, so called because a certain amount of
money is put aside annually, or “sunk,” into a sinking fund account. For example, with the
Ingersoll-Rand 7.20 percent 30-year debentures issued in 1995, the company is required
to redeem $7.5 million of the bonds annually between 2006 and 2025, thus retiring 95
percent of the debt issue prior to maturity.

In practice, however, a company can satisfy its sinking fund requirements either by
purchasing a portion of the debt each year in the open market or, if the debt is callable, by
using a lottery technique to determine which actual numbered certificates will be called
and retired within a given year. The alternative chosen depends on the current market
price of the debt issue. In general, if current interest rates are above the issue’s coupon
rate, the current market price of the debt will be less than $1,000, and the company should
meet its sinking fund obligation by purchasing the debt in the open market. If, on the other
hand, market interest rates are lower than the issue’s coupon rate, and if the market price
of the debt is above the call price, the company should use the call procedure.
Equity -Linked Debt Some debt issues (and some preferred stock issues) are linked to
the equity (common stock) of the firm through a conversion feature that allows the holder
to exchange the security for the company’s common stock at the option of the holder.
Interest costs of a convertible debt issue are usually less than a similar debt issue without
the conversion option, because investors are willing to accept the value of the conversion
privilege as part of their overall return. Another form of equity -linked debt is the issuance
of warrants with debt securities. A warrant is an option to purchase shares of a
company’s common stock at a specified price during a given time period.
Typical Sizes of Debt Issues Debt issues sold to the public through underwriters are
usually in the 25 million to several hundred million -dollar range. During the past several
years, some very large companies, such as Ford and AT&T, have sold multibillion-dollar
bond issues to investors. Because the use of an underwriting group in a public offering
involves considerable expense, it is usually uneconomical for a company to make a public
offering of this nature for debt issues less than about $25 million. Private placements,
however, frequently involve lesser amounts of money —for example, $5 to $10 million —
because the entire debt issue is purchased by a single investor, such as an insurance
company.
Coupon Rates The coupon rates on new bonds are normally fixed and set equal to market
interest rates on bonds of comparable quality and maturity so that the bonds sell at or near
par value. However, during the inflationary period of the early 1980s, when interest rates
reached record levels and bond prices were quite volatile, highly rated companies began
issuing bonds with floating coupon rates.
At the end of December 2003, Duke Energy had $2.7 billion of floating rate debt
outstanding with an average interest rate of 1.8 percent. The interest rate on this debt is
based on commercial paper rates and a spread relative to the U.S. dollar London Interbank
Offer Rate (LIBOR). Such a floating rate debt protects investors against a rise in interest
rates because the market price of the debt does not fluctuate as much as for fixed interest
rate debt. Original issue deep discount (OID) bonds have coupon rates below prevailing
market interest rates at the time of issue and hence sell at a discount from par value.

Some OID bond issues pay no interest and are known as zero coupon bonds. The Time
Warner zero coupon discounted debenture issue of November 30, 1995, maturing on
January 15, 2036, is one such example. One of the advantages to the issuing firm of these
types of bonds is the reduction in (or elimination of) interest payments (a cash outflow)
during the life of the bonds. Another advantage is the slightly lower cost (yield to
maturity) of these issues compared with bonds that are issued at or near par value. The
primary disadvantage of these types of bonds is the large cash outflow required by the
firm at maturity. OID bonds have decreased in popularity due to changes in the tax laws,
which eliminated the tax advantages to companies of these issues over debt issued at par,
and the issuance by several brokerage firms of lower-risk substitutes.
One such substitute is Merrill Lynch’s TIGRs —Treasury Investment Growth Receipts —
which are backed by U.S. Treasury bonds. The U.S. Treasury has also issued its own zero
coupon bonds. These securities, which pay no interest, are purchased at a discount from
face value and can then be redeemed for the full face value at maturity.
Maturity The typical maturity on long -term debt is about 20 to 30 years. Occasionally,
companies borrow money for as long as 40 years. (In 1993,Walt Disney and Coca-Cola
sold 100- year bonds, the first such bond issues since 1954.) On the other end of the scale,
companies in need of financing are often willing to borrow for as few as 10 years,
especially if they feel that interest rates are temporarily high, as was true in the
environment of the early 1980s—an environment characterized by high rates of inflation
and historically high interest rates.
But during the late 1990s and early 2000s, a period of generally low inflation and
moderate interest rates, many large companies were issuing fixed-rate debt securities with
25- and 30-year maturities. Like the floating rate bonds described earlier, which protect
investors against interest rate risk, firms have also been issuing bonds that are redeemable
at par at the option of the holder. These are known as extendable notes or put bonds. If
interest rates rise and the market price of the bond falls, the holder can redeem them at par
and reinvest the proceeds in higher-yielding securities.
An example of a put bond is Ingersoll -Rand’s 6.443 percent debenture issue of 1997 that
matures in 2027. The debentures are redeemable for the full principal amount plus interest
at the option of the holder on November 15, 2007, and each November 15 thereafter.
When performing bond valuation and yield -to-maturity calculations, bond investors
should keep in mind that the realized maturity of a debt issue may differ from its stated
maturity. This can occur for a variety of reasons. The bond indenture may include early
repayment provisions through the exercise of a call option, required sinking fund
payments, open market purchases, or tender offers. Also, maturity extensions or
contractions may occur as the result of reorganization, merger, and leveraged buyout
(LBO), default, or liquidation.

4.2.3. DEFINITION OF BONDS
Dear learner; Have you ever borrowed money? Of course you have! Whether we hit our
parents up for a few bucks to buy candy as children or asked the bank for a mortgage most of
us have borrowed money at some point in our lives. Just as people need money, so do
companies and governments. A company needs funds to expand into new markets, while
governments need money for everything from infrastructure to social programs. The problem
large organizations run into is that they typically need far more money than the average bank
can provide. The solution is to raise money by issuing bonds (or other debt instruments) to a
public market. Thousands of investors then each lend a portion of the capital needed. Really,
a bond is nothing more than a loan for which you are the lender. The organization that sells a
bond is known as the issuer. You can think of a bond as an IOU given by a borrower (the
issuer) to a lender (the investor).
Of course, nobody would loan his or her hard-earned money for nothing. The issuer of a
bond must pay the investor something extra for the privilege of using his or her money. This
"extra" comes in the form of interest payments, which are made at a predetermined rate and
schedule. The interest rate is often referred to as the coupon. The date on which the issuer has
to repay the amount borrowed (known as face value) is called the maturity date. Bonds are
known as fixed-income securities because you know the exact amount of cash you'll get back
if you hold the security until maturity.
For example, say you buy a bond with a face value of $1,000, a coupon of 8%, and a
maturity of 10 years. This means you'll receive a total of $80 ($1,000*8%) of interest per
year for the next 10 years. Actually, because most bonds pay interest semi-annually, you'll
receive two payments of $40 a year for 10 years. When the bond matures after a decade,
you'll get your $1,000 back.
Debt versus Equity
Bonds are debt, whereas stocks are equity. This is the important distinction between the two
securities. By purchasing equity (stock) an investor becomes an owner in a corporation.
Ownership comes with voting rights and the right to share in any future profits. By
purchasing debt (bonds) an investor becomes a creditor to the corporation (or government).
The primary advantage of being a creditor is that you have a higher claim on assets than
shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a
shareholder. However, the bondholder does not share in the profits if a company does well -
he or she is entitled only to the principal plus interest.
To sum up, there is generally less risk in owning bonds than in owning stocks, but this comes
at the cost of a lower return.

4.3 VALUATION OF BONDS
4.3.1 Bond valuation-Terminology
Bond valuation is a technique for determining the fair value of a particular bond. Bond
valuation includes calculating the present value of the bond's future interest payments, also
known as its cash flow, and the bond's value upon maturity, also known as its face value or
par value. Because a bond's par value and interest payments are fixed, an investor uses bond
valuation to determine what rate of return is required for an investment in a particular bond
to be worthwhile.
Bond valuation is only one of the factors investors consider in determining whether to
invest in a particular bond. Other important considerations are: the issuing company's
creditworthiness, which determines whether a bond is investment-grade or junk; the bond's
price appreciation potential, as determined by the issuing company's growth prospects; and
prevailing market interest rates and whether they are projected to go up or down in the
future
Debt instruments Type and typical features

In order to understand the valuation of bonds, we need to be familiar with certain bond-
related terms.
Par Value- It is the value stated on the face of the bond. It represents the amount the firm
borrows and promises to repay at the time of maturity. Usually the par or face value of
bonds issued by business firms is Rs. 100. Sometimes it can be Rs. 1000.
Coupon Rate and Interest- A bond carries a specific interest rate which is called the
coupon rate. The interest payable to the bond holder is simply par value of the bond ×
coupon rate. Most bonds pay interest semi-annually. For example, a GOI security which
has a par value of Rs. 1000 and a coupon rate of 11 per cent pays an interest of Rs. 55
every six months.
Maturity Period- Typically, bonds have a maturity period of 1-10 years; sometimes they
have a longer maturity. At the time of maturity the par (face) value plus perhaps a nominal
premium is payable to the bondholder.
The time value concept
Time Value of Money (TVM) is an important concept in financial management. It can be
used to compare investment alternatives and to solve problems involving loans,
mortgages, leases, savings, and annuities.
TVM is based on the concept that a dollar that you have today is worth more than the
promise or expectation that you will receive a dollar in the future. Money that you hold
today is worth more because you can invest it and earn interest. After all, you should
receive some compensation for foregoing spending. For instance, you can invest your
dollar for one year at a 6% annual interest rate and accumulate $1.06 at the end of the
year. You can say that the future value of the dollar is $1.06 given a 6% interest rate
and a one-year period. It follows that the present value of the $1.06 you expect to
receive in one year is only $1.
A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced
payments or receipts promised in the future can be converted to an equivalent value today.
Conversely, you can determine the value to which a single sum or a series of future
payments will grow to at some future date.
Future Value is the amount of money that an investment with a fixed, compounded
interest rate will grow to by some future date. The investment can be a single sum
deposited at the beginning of the first period, a series of equally-spaced payments (an
annuity), or both. Since money has time value, we naturally expect the future value to be
greater than the present value. The difference between the two depends on the number of
compounding periods involved and the going interest rate Future Value = present value (1 +
interest rate).
If the deposited money is allowed to cumulate for more than one time, the period exponent is
added to the previous equation.
Future value = (Present Value) (1 + interest rate) t
t- The number of time periods the deposited money accumulates as interest.

The present value
The present value of money can be found simply by reversing the earlier equation.
Present value × (1 + interest rate) = Future value
Present value = Future value/ 1 + interest rate
The multiple period of present value equation takes into account of the multiple periods.
Present value = Future value/ (1 + interest rate)t
4.3.2. Valuation Model
The value of a bond- or any asset, real or financial- is equal to the present value of the cash
flows expected from it. Hence, determining the value of a bond requires:
 An estimate of expected cash flows
 An estimate of the required return. To simplify the analysis of bond valuation we will
make the following assumptions:
 The coupon interest rate is fixed for the term of the bond.
 The coupon payments are made every year and the next coupon payment is receivable
exactly a year from now.
 The bond will be redeemed at par on maturity.
Given these assumptions, the cash flow for a non-callable bond comprises an annuity of a
fixed coupon interest payable annually and the principal amount payable at maturity.
Hence the value of a bond is:
P =nΣ (t=1) C/ (1 + r)t + M/(1 + r)n (4.1)
Where P = value (in rupees)
n = number of years
C = annual coupon payment (in rupees)
r = periodic required return
M = maturity value
t = time period when the payment is received.
Since the stream of semi-annual coupon payments is an ordinary annuity, we can apply the
formula for the present value of an ordinary annuity. Hence the bond value is given by the
formula:
P = C × PVIFAr, n + M × PVIFr, n (4.1 a)
To illustrate how to compute the value of a bond, consider a 10-year, 12 per cent coupon
bond with a par value of Rs. 1000. Let us assume that the required yield on this bond is 13
per cent. The cash flows for this bond are as follows:
 10 annual coupon payments of Rs. 120.
 Rs. 1000 principal repayment 10 years from now.
The value of the bond is:
P = 120×PVIFA13%, 10 yr + 1,000×PVIF13%, 10yr
= 120 × 5.426 + 1000 × 0.295
= 651.1 + 295 = Rs. 946.1

Bond values with semi-annual interest
Most bonds pay interest semi-annually. To value such bonds, we have to work with a unit
period of six months, and not one year. This means that the bond valuation equation has to
be modified along the following lines:
 The annual interest payment, C, must be divided by 2 to obtain the semi-annual
interest payment.
 The number of years to maturity must be multiplied by two to get the number of half-
yearly periods.
 The discount rate has to be divided by two to get the discount rate applicable to half-
yearly periods.
 With the above modifications, the basic bond valuation becomes:
P =nΣ (t=1) C/2/ (1 + r/2)t + M/ (1 + r/2)2n
= C/2 (PVIFAr/2, 2n) + M (PVIFr/2, 2n) (10.2)
Where P = value of the bond
C/2 = semi-annual interest payment
R/2 = discount rate applicable to a half-year period
M = maturity value
2n = maturity period expressed in terms of half-yearly periods. Illustration
Example 4.1: Consider a 8-year, 12 per cent coupon bond with a par value of Rs. 100 on
which interest is payable semi-annually. The required return on this bond is 14 per cent.
Solution: Applying Eq. 10.2, the value of the bond is:
P =16 Σ (t=1) 6/(1.07)t + 100/ (1.07)+ 16
= 6 (PVIFA7%, 16 yr) + 100 (PVIF7%, 16 yr)
= Rs. 6 (9.447) + Rs. 100 (0.388) = Rs. 95.5.
Example4.2: At an annual rate of compounding of 9 per cent, how long does it take for a
given sum to become double and triple its original value?
Solution: Pt = P0 (1 + r)n
When the n value is not given it can be solved by using log ln
n ln (1 + r) = ln Pt
n ln (1 + 0.09) = ln 2
n. ln 0.0862 = ln 0.6931
n = 8.04 years
To triple
n ln (1 + 09) = ln 3
n. ln 0.0862 = ln 1.0986
= 12.74 years
Example4.3: Of the following which amount is worth more at 16 per cent; Rs. 1000 today
or Rs. 2100 after five years?
Solution: The present worth of Rs. 2100 = 2100 (1 + r) n = 2100 (1 + 0.16)5
= 2100 × 0.476 = 999.60

The present worth of Rs. 2100 is Rs. 999.60 which is less than Rs. 1,000. Hence Rs. 2100
after five years is not worth full.
Example4.4: Determine the price of Rs. 1,000 zero coupon bond with yield to maturity of
18 per cent and 10 years to maturity. What is YTM of this bond if its price is Rs. 220?
Solution:
a. Price = Face value/ (1 + YTM)n
=1,000/ (1 + 0.18)10
= 1,000/5.2338
= Rs. 191.07
b. Face value /Bond value)1 /T – 1 = YTM
(Rs. 1000/ Rs. 200)1/w – 1 = YTM
(4.55) 0.1 – 1 = YTM
1.163 – 1 = 0.163
YTM = 16.3
Example 4.5: Arvind considers Rs. 1000 par value bond bearing a coupon rate of 11%
that matures after 5 years. He wants a minimum yield to maturity of 15%. The bond is
currently sold at Rs. 870. Should he buy the bond?
Solution:
P0 =Coupon / (1+ Y) + … + Coupon + Face value/ (1+ Y)5 (Or)
P0 = (Coupon) (PVIFA, n) + (Principal amount) (PVIF/k,n)
P0 = 110 (PVIFA 15%, 5 years) + 1000 (PVIF/15%, 5 yrs)
= 110 (3.352) + 1000 (0.497)
= 368.7 + 497 = 865.7.
At Arvind’s anticipated minimum yield of 15% the price should be Rs. 865.70 but the
market price is higher. Hence, he should not buy.
Example4.6: Anand owns Rs. 1,000 face value bond with five years to maturity. The
bond has an annual coupon of Rs. 75. The bond is currently priced at Rs. 970. Given an
appropriate discount rate of 10%, should Anand hold or sell the bond?
Solution:
P0 = Coupon (PVIFA k, n) + Principal amount (PVIF k, n)
= 75 (PVIFA 10%, 5 yrs) + 1000 (PVIF 10%, 5 yrs)
= 75 × 3.7908 + 1000 (0.6209)
= Rs. 284.31 + 620.9
= Rs. 905.21.
The market price Rs. 970 is higher than the estimated price Rs. 905.2. It is better for
Anand to sell the bond.

4.2.3 Bond Return
The total return received from holding an asset or portfolio of assets. Holding period
return/yield is calculated as the sum of all income and capital growth divided by the value
at the beginning of the period being measured.
Holding period return = Income + (End of Period Value - Initial Value)
---------------------------------------------
Initial Value
To calculate holding period return/yield over multiple years we calculate tha annualized
period return:
Holding period return is a very basic way to measure how much return you have obtained
on a particular investment. This calculation is on a per-dollar-invested basis, rather than a
time basis, which makes it difficult to compare returns on different investments with
different time frames. When making comparisons such as this, the annualized calculation
shown above should be used
Example 4.7:
a. An investor ‘A’ purchased a bond at a price of Rs. 900 with Rs. 100 as coupon
payment and sold it at Rs. 1000. What is his holding period return?
b. If the bond is sold for Rs. 750 after receiving Rs. 100 as coupon payment, then what
is the holding period return?
Solution:
a. Holding period return = Price gain + Coupon payment/ Purchase price
=100 + 100/900
=200/900
= 0.2222
Holding period return = 22.22%
b. Holding period return = Gain or loss + Coupon payment/ Purchase price
= –150 + 100/900
=–50/ 900
= 0.0555
Holding period return = 5.5%
The current yield- The current yield is the coupon payment as a percentage of current
market prices Current yield = Annual coupon payment/ Current market price With this
measure the investors can find out the rate of cash flow from their investments every year.
The current yield differs from the coupon rate, since the market price differs from the face
value of the bond. When the bond’s face value and market price are same, the coupon rate
and the current yield would be the same. For example, when the coupon payment is 8%
for Rs. 100 bond with the same market price, the current yield is 8%. If the current market
price is Rs. 80 then the current yield would be 10%.

a. Yield to maturity
The rate of return anticipated on a bond if it is held until the maturity date. YTM is
considered a long-term bond yield expressed as an annual rate. The calculation of YTM
takes into account the current market price, par value, coupon interest rate and time to
maturity. It is also assumed that all coupons are reinvested at the same rate. Sometimes
this is simply referred to as "yield" for short An approximate YTM can be found by using
a bond yield table. However, because calculating a bond's YTM is complex and involves
trial and error, it is usually done by using a programmable business calculator.
The current yield calculation we learned above shows us the return the annual coupon
payment gives the investor, but this percentage does not take into account the time value
of money or, more specifically, the present value of the coupon payments the investor will
receive in the future. For this reason, when investors and analysts refer to yield, they are
most often referring to the yield to maturity (YTM), which is the interest rate by which the
present values of all the future cash flows are equal to the bond's price.
An easy way to think of YTM is to consider it the resulting interest rate the investor
receives if he or she invests all of his or her cash flows (coupons payments) at a constant
interest rate until the bond matures. YTM is the return the investor will receive from his or
her entire investment. It is the return that an investor gains by receiving the present values
of the coupon payments, the par value and capital gains in relation to the price that is paid.
The yield to maturity, however, is an interest rate that must be calculated through trial and
error. Such a method of valuation is complicated and can be time consuming, so investors
(whether professional or private) will typically use a financial calculator or program that
is quickly able to run through the process of trial and error. If you don't have such a
program, you can use an approximation method that does not require any serious
mathematics.
To demonstrate this method, we first need to review the relationship between a bond's
price and its yield. In general, as a bond's price increases, yield decreases. This
relationship is measured using the price value of a basis point (PVBP). By taking into
account factors such as the bond's coupon rate and credit rating, the PVBP measures the
degree to which a bond's price will change when there is a 0.01% change in interest rates
To find out the yield to maturity the present value technique is adopted. The formula is,
c(1 +r)-1 + c(1 + r)-2 + . . . + c(1

+ r)-Y + B(1 + r)-Y =P
Where
c = annual coupon payment (in dollars, not a
percent)
Y = number of years to maturity
B = par value
P = purchase price

Illustration 10.8: A four-year bond with the 7% coupon rate and maturity value of Rs.
1000 is currently selling at Rs. 905. What is its yield to maturity?
Solution: Since all the three values are known out of the four values, it can be found out
by using trial and error procedure.
Let us try ten per cent.
----------------------------------------------------------------------------------------
Cash flow PV for 10% PV of CF
----------------------------------------------------------------------------------------
70 0.9091 63.64
70 0.8264 57.85
70 0.7513 52.59
1070 0.6830 730.82
Rs. 904.90
The yield to maturity is 10 per cent. The approximate yield to maturity can be found out
by using the following formula too. Y = C + (P or D/years to maturity) / (P + F) / 2 O
Y = Yield to maturity
C = Coupon interest
P or D = Premium or discount
PO = Present value
F = Face value
In the case of previous sum = 70 + (95/4) / (905 + 1000)/2
=93.75/ 952.5
= 0.098
Y = 9.8%
Yield to maturity is 9.8%.
b. Price-yield relationship
Up to this point, we've talked about bonds as if every investor holds them to maturity. It's
true that if you do this you're guaranteed to get your principal back; however, a bond does
not have to be held to maturity. At any time, a bond can be sold in the open market, where
the price can fluctuate - sometimes dramatically. We'll get to how price changes in a bit.
First, we need to introduce the concept of yield. The relationship of yield to price can be
summarized as follows: when price goes up, yield goes down and vice versa. Technically,
you'd say the bond's price and its yield are inversely related.
Here's a commonly asked question: How can high yields and high prices both be good
when they can't happen at the same time? The answer depends on your point of view. If
you are a bond buyer, you want high yields. A buyer wants to pay $800 for the $1,000
bond, which gives the bond a high yield of 12.5%. On the other hand, if you already own
a bond, you've locked in your interest rate, so you hope the price of the bond goes up.
This way you can cash out by selling your bond in the future.

For any given bond, a graph of the relationship between price and yield is convex. This
means that the graph forms a curve rather than a straight-line (linear). The degree to
which the graph is curved shows how much a bond's yield changes in response to a
change in price. In this section we take a look at what affects convexity and how investors
can use it to compare bonds
Price-yield relationship
Relationship between bond price and time

The price of a bond is only valid at a single point in time, even if the required yield does
not change. Why? The maturity date gets closer (remaining number of compounding
period’s decreases):
1. The number of remaining coupon payments is less
2. The present value of the par value changes
Even within the span of a single day, the price that must be paid to purchase a given bond
changes, since the bond has accrued interest that has not yet been paid out by the coupon.
If this were not the case, then arbitrageurs could purchase bonds the day before their
coupon payment and sell them the day after. Because arbitrageurs do exactly that, the
market remains efficient and sellers of bonds are compensated for accrued interest. Note
that accrued interest is often listed separately from the price of a bond.
When the required yield (marketplace interest rate) does not change:
1. The price of a discount bond always increases towards par value over time.
2. The price of a premium bond always decreases towards par value over time.
3. If the required yield is equal to the coupon rate (marketplace interest equals bond
interest), the price is always the par value.
The path of a bond over time (required yield does not change) is one of three fundamental
factors that influence price.
Only when the current price is equal to par value-in such a case the bond is said to be a
par bond-there is no change in price as time passes, assuming that the required yield does
not change between now and the maturity date. This is shown by the dashed line in
Exhibit 10.2.

Price changes with time
Relationship between coupon rate, required yield, and price

At the time of issuance, a bond's coupon rate is set to the (approximate) prevailing yield in
the market. The price of the bond is then (approximately) equal to the par value. This
leads to:
 When the investor's desired interest rate (required yield, 9%) is the same as the bond's
interest rate (coupon rate, 9%), the investor will pay the par value ($1,000) and vice
versa.
 Suppose the marketplace yields rise. The bond's coupon rate is now below the
prevailing rates and is no longer competitive. Consequently, the bond's price is forced
to drop below par value. This price drop represents a form of interest income to the
investor as compensation for the bond's coupon rate being lower than the marketplace
(required yield). A bond selling below its par value is called selling at a discount.
This leads to:
 If the marketplace yield increases above the coupon rate (interest rate goes above
9%), the bond price will drop below par value (below $1,000) and sell at a discount.
 Alternatively, the marketplace yields drop below the coupon rate. The bond's interest
rate is now higher than the market place (required yield), which makes this bond a
very attractive investment. The bond's price increases as investors bid for the higher
yields. A bond selling above its par value is called selling at a premium. This leads to:
 If the bond's coupon rate is higher than prevailing marketplace yields (interest rate
goes below 9%), the price will rise above par value (above $1,000) and sell at a
premium.
 Purchasing a bond at a discount or a premium can have important implications to the
tax treatment of the bond's future cash flows, even in the case of tax-exempt bonds.
c. Realized yield to maturity
The YTM calculation assumes that the cash flows received through the life of a bond are
reinvested at a rate equal to the yield to maturity. This assumption may not be valid as
reinvestment rate/s applicable to future cash flows may be different. It is necessary to

define the future reinvestment rates and figure out the realized yield to maturity. How this
is done may be illustrated by an example.
Consider a Rs. 1000 par value bond, carrying an interest rate of 15 per cent (payable
annually) and maturing after 5 years. The present market price of this bond is Rs. 850.
The reinvestment rate applicable to the future cash flows of this bond is 16 per cent. The
future value of the benefits receivable from this bond, calculated in Exhibit 10.3 works
out to Rs. 2032. The realised yield to maturity is the value of r* in the following equation.
Present market price (1 + r*) 5 = Future value
850 (1 + r*) 5 = 2032
(1 + r*) 5 = 2032/850 = 2.391
1 + r = (2.391)1/5
r* = 0.19 or 19%.
Future value of benefits
4.4. Global Bond Market

The environment in which the issuance and trading of debt securities occurs. The bond
market primarily includes government-issued securities and corporate debt securities, and
facilitates the transfer of capital from savers to the issuers or organizations requiring capital
for government projects, business expansions and ongoing operations Most trading in the
bond market occurs over-the-counter, through organized electronic trading networks, and is
composed of the primary market (through which debt securities are issued and sold by
borrowers to lenders) and the secondary market (through which investors buy and sell
previously issued debt securities amongst themselves). Although the stock market often
commands more media attention, the bond market is actually many times bigger and is vital
to the ongoing operation of the public and private sector.

In addition to raising capital in the U.S. financial markets, many U.S. firms go to other
countries to raise capital. International bonds are sold initially to investors outside the home
country of the borrower. There are two major types of long -term instruments in the
international bond market —Eurobonds and foreign bonds. Eurobonds are bonds issued by
a U.S. corporation, for example, denominated in U.S. dollars but sold to investors outside
the United States, such as in Europe and Japan. The bond offering is often underwritten by
an international syndicate of investment bankers. For example, IBM could sell dollar -
denominated bonds to investors in Europe or Japan.
The Eurobond market has been used because there is less regulatory interference than in the
issuing country and, in some cases, less stringent disclosure requirements. Eurobonds are
also bearer bonds (the name and country of the bond owner is not on the bond), providing
the bondholder with tax anonymity and an opportunity, perhaps, to avoid the payment of
taxes. For these reasons, the cost of Eurobond financing may be below that of domestic
financing. Foreign bonds, in contrast, are underwritten by an investment banking syndicate
from a single country. Foreign bonds are normally denominated in the currency of the
country of sale. The bond issuer, however, is from a country other than the country in
which the bonds are being issued.
For example, Crown Cork & Seal Company, Inc., with 65 plants outside the United States,
might enter the foreign bond market to raise capital for a new plant to be built in France.
These bonds could be sold in France and be denominated in Euros, or they could be sold in
another country and denominated in that country’s currency.
The international bond market has grown rapidly, and it continues to provide firms with
additional alternative sources of funds that are, in some cases, lower in cost than purely
domestic financing.
4.5. Summary
The chapter has considered methods for comparing bonds with different structures of
payments and different maturities.
Bonds are debts of the governments, companies, and organizations that issue them. One of
the ways in which bonds differ from shares is in the relative certainty of future cash flows.
In the absence of default by the issuer, the future cash flows from a bond are typically known
with certainty. This is in contrast to shares since shares typically have dividend payments,
which are variable and uncertain. The relative certainty of bond cash flows influences the
pricing and analysis of bonds. The fair price of a bond is estimated using a discount model.
The relative certainty of bond cash flows means that other characteristics, such as duration
and convexity, can also be reliably estimated. Other important bond characteristics are future
bond yields and of bond price volatility (risk).
The debt markets are used by both firms and governments to raise funds for long-term
purposes, though most investment by firms is financed by retained profits. Firms and
governments can issue corporate bonds of various types of shares. Bonds usually pay a fixed

rate of interest at pre-determined intervals. Bonds are traded on a stock exchange and their price
fluctuates in response to supply and demand. In the short run the supply of both is fixed and price
fluctuations are therefore the result of changes in demand.
P
Post Test Questions
Multiple Choice Questions
1. Which of the following is a source of bias that leads to investor errors in information
processing?
A. Framing
B. Regret avoidance
C. Conservatism
D. Prospect theory
2. Callable bonds give the issuing company the option to _______________.
A. pay no coupon on the bonds until maturity
B. cancel the company's obligation to pay bond interest
C. convert the bonds to common stock
D. repurchase the bonds
3. A 10-year maturity bond has a 7% coupon rate, paid annually, and a yield to maturity of 6%.
The current price of the bond is $1,073.60. A portfolio manager with a two-year horizon
forecasts that, two years from today, 8-year bonds will sell at a yield to maturity of 7%, and
that coupon payments can be reinvested in short-term securities over the coming two years
at 5%. What is the two-year return for this bond?
A. 3.3%
B. 3.2%
C. 6%
D. 6.5%
4. The two sources of potential value in active bond management are ______________ and
______________.
A. identifying relative mispricing within fixed-income market; immunization
B. inflation targeting; immunization
C. identifying relative mispricing within fixed-income market; interest rate
forecasting
D. cash flow matching; interest rate forecasting
5. An insurance company issues a guaranteed investment contract (GIC) with a ten-year
maturity. The insurance company elects to fund this obligation with a coupon bond that also
has a ten-year maturity. Therefore, the insurance company is subject to ____________ in the
event that market interest rates increase and to ____________ in the event that market
interest rates decrease
a. losses resulting from duration risk; losses resulting from price risk
b. losses resulting from convexity risk; losses resulting from reinvestment rate
risk
c. losses resulting from reinvestment rate risk; losses resulting from price
risk
d. losses resulting from price risk; losses resulting from reinvestment rate
risk
Answers to 4. c
questions 1. c 5. d
2. d
3. d

CHAPTER FIVE
INTRODUCTION TO DERIVATIVE MARKET
5.0. Aim and Objectives
After studying this unit, you should be able to:
- Define the terms derivatives, hedging, forward, future, options, swaps, etc.
- Describe what a Derivative market is and compare it to other financial markets.
- Identify different types of derivative instruments.
- explain the basic features of forward and future contracts, options, swaps and Caps
and floors
5.1 Introduction to Derivatives

Derivative is a product whose value is derived from the value of one or more basic variables,
called bases (underlying asset, index, or reference rate), in a contractual manner. The
underlying asset can be equity, forex, commodity or any other asset. For example, wheat
farmers may wish to sell their harvest at a future date to eliminate the risk of a change in
prices by that date. Such a transaction is an example of a derivative. The price of this
derivative is driven by the spot price of wheat which is the “underlying”.
5.2. Hedging against risk
Investments based on some underlying assets are known as derivatives. The capital invested
is less than the price of the underlying asset. This creates financial leverage and allows
investors to multiply the rate of return on the underlying asset. Because of this leverage,
derivatives have several uses,
 Speculative or taking an advantage over specific profit opportunity,
 Hedging a portfolio against a specific risk.
Participants in derivative markets own portfolios of financial securities, which must be taken
into consideration when understanding impact of any particular derivatives transaction.
Any derivatives transaction involves cash flows, which are more or less opposite to the cash
flows generated by the other securities in the portfolio. When the two sets of cash flows
moves in the opposite direction, it is a hedge. When the two sets of cash flows moves in the
same direction, it is a speculative position. This is why speculative trades increase risk
exposure, while hedging reduces risk exposure.
Hedging ensures counterbalancing cash flows, which reduce dispersion of possible outcomes
and therefore reduces the risk. Conversely, by adding more cash flows, which move in the
same direction, speculating increases profit when outcomes are favorable, but increases
losses when outcomes are unfavorable. Thus the risk is increased.
The underlying cash position is the twin transaction that is undertaken simultaneously with
the derivatives trade. The underlying cash position motivates the hedge transaction. If the
underlying cash position consists of only one financial security, then it is called micro hedge.

If the underlying cash position consists of a portfolio of financial securities, then it is called
macro hedge.
Macro hedging is prevalent in financial institutions than in non-financial companies, which
may be hedging only a single financial security on their balance sheets. The hedge is always
tailored to the hedger’s underlying cash position. The hedger’s cash flows as well as his goals
will determine the configuration of the derivatives transaction.
5.3. Description of Derivatives Markets
The establishment and growth of financial derivatives markets has been major development
trend in financial markets over the past thirty-five years. Financial innovation and increased
market demand led to a rapid growth of derivatives trading. Development of financial
derivatives was speeded up by the globalization of business, the increased volatility of
foreign exchange rates, and increasing and fluctuating rates of inflation.
! Derivatives - securities .bearing a contractual relation to some underlying asset or rate.
In general derivatives contracts promise to deliver underlying products at some time in the
future or give the right to buy or sell them in the future. They can be based on different types
of assets (such as equities or commodities), prices (such as interest rates or exchange rates),
or indexes (such as a stock-market index).
The derivative contract can then be traded in a different market from that in which the
underlying product (equity, bonds, and currency) is itself traded. Markets in which
underlying products are traded (such as the forex market) are often referred to as cash
markets to distinguish them from derivatives markets. Although cash and derivatives markets
are separate, the derivatives markets are linked to cash markets through the possibility that a
delivery of the underlying product might be required.
There is a close relationship between the prices of derivatives contracts and the prices of the
underlying assets they represent, and that the value of a derivative, and hence its price, varies
as the price in the cash market fluctuates. However, in practice, derivatives seldom lead to
the exchange of the underlying product. Instead, contracts are closed out or allowed to lapse
before the delivery date arrives.
For portfolio managers change of the risk profile through derivative transactions takes a very
low cost. Without derivatives, portfolio managers have to conduct transactions in the
underlying cash markets (i.e., money, bond, or equity markets) at a higher cost, including the
costly transfer of securities. Thus the dynamic growth of hedge funds can be explained by the
rise of low-cost derivatives markets. Hedge funds typically exploit small price differences of
similar financial products. Only when the transaction cost is smaller than the price
differential, then hedge fund takes a position.
The types of derivatives include:
 Options,
 Forwards,
 Futures,
 Swap contracts
 Various forms of bonds.

A forward contract gives the holder the obligation to buy or sell a certain underlying
instrument (like a bond) at a certain date in the future (i.e., the delivery or final settlement
date), at a specified price (i.e., the settlement price). Forward contracts consist of futures and
swaps. Futures contracts are forward contracts traded on organised exchanges. Swaps are
forward contracts in which counterparties agree to exchange streams of cash flows according
to predetermined rules. For example, an interest-rate swap is a derivative in which one party
exchanges a stream of interest payments for another party’s stream of cash flows. The most
important difference with options is that options give the holder the right (but not the
obligation) to buy or sell a certain underlying instrument at a certain date in the future at a
specified price.
Derivatives are traded on organized exchanges or over-the-counter (OTC) market.
Derivatives contracts traded and privately negotiated directly between two parties belong to
the OTC market, generally interest-rate linked derivatives, like swaps and forward-rate
agreements. All contract terms, such as delivery quality, quantity, location, date, and price,
are negotiable in it. The total value of derivative contracts outstanding in global OTC
markets is substantially higher than the exchanges-traded amount. A trend is a provision of
standard contracts, which makes it easier for more participants to access the OTC markets.
Besides, OTC trades are increasingly being cleared through clearinghouses in much the same
way as exchange-based contracts.
Derivative contracts like futures and options, which are traded in organized exchanges, are
generally standardized, based on electronic trading. The traditional distinction between
exchange-based and OTC derivatives is becoming less clear.
5.4. Forward and futures contracts
5.4.1. Principles of forward and futures contracts
A futures contract is a legally binding commitment to buy or sell a standard quantity of a
something at a price determined in the present (the futures price) on a specified future date.
The buyer is called the long, and the seller is called the short. Futures contracts are “zero
sum games”.
! Futures contracts - a customized contract to buy (sell) an asset at a specified date
and a specified price (futures price). The contract is traded on an organized
exchange, and the potential gain/ loss is realized each day (marking to market).
The forward contract is a private agreement between the two parties and nothing happens
between the contracting date and the date of delivery.
! Forward contract - a customized contract to buy (sell) and asset at a specified date
and a specified price (forward price. No payment takes place until maturity.
Forwards and futures contracts markets include diverse instruments on:
 Currencies;
 Commodities;

 Interest rate futures;
 Short-term deposits;
 Bonds;
 Stock futures;
 Stock index futures;
 Single stock futures (contract for difference).
There is no money exchanged when the contract is signed. To ensure that each party fulfills
its commitments, a margin deposit is required. The exchanges set a minimum margin for
each contract and revise it periodically. Margin is determined depending upon the risk of the
individual contract
Futures prices fluctuate every day. Therefore all contract positions are marked to market at
the end of every day. If net price movements result in gain on a position of the previous day,
the customer immediately receives cash in the amount of the gain. And vise versa, if there is
a loss, the customer must cover the loss. As soon as a customer’s account falls below the
maintenance margin, the customer receives a margin call to fill up the initial margin. If this is
not done immediately, then the broker closes down the position on the market. In effect
future contracts are canceled every day and replaced by new contracts with a delivery price
equal to the new futures price, i.e. the settlement price at the end of the day.
It is rare for a futures contract to be used for the exchange or physical delivery of the
underlying instruments. Many contracts have no facility for the exchange of the financial
instrument. Thus financial futures markets are independent of the underlying cash markets,
and are operating in parallel to those markets. Most future contracts are closed out by an
offsetting position before the delivery occurs. A long offsets by going short and the short
offsets by going long at any time before the delivery date.
Offsetting does not involve incremental brokerage fees because the fee to establish initial
short position includes the commission to take the offsetting long position, i.e. the round
trip commission.
The total number of outstanding contracts is called open interest. For every outstanding
contract one person is short (has taken a short position) and one is long (has taken a long
position. If a particular transaction involves a new long and a new short, the open interest
increases by one contract. If a transaction involves offsetting by an existing long and
offsetting by an existing short, the open interest decreases by one contract. However, if a
transaction is made by offsetting an existing short or long, and if the other side of transaction
is a new investor, the open interest remains unchanged. Each futures exchange has a clearing
house to keep track of the short and long positions.
! Open interest or a financial instrument at some specified future date.
The main economic function of futures is to provide a means of hedging. A hedger seeks to
reduce an already existing risk. This risk reduction could be achieved by taking a futures

position that would provide profit in the event of a loss on the underlying position (and a loss
in the case of a profit on the underlying position).
! Long hedge – a long anticipatory hedge generally involving buying futures
contracts in anticipation of spot purchase.
! Short hedge – a short hedge involves selling futures contracts to cover the risk on a
position in the spot market. This is the most common use of hedging in investment
management.
The most common products underlying futures contracts are foreign currencies (exchange
rates), interest rates on notional amounts of capital, and stock exchange indices. The futures
contracts are themselves tradable – that is, they can be bought and sold in futures markets. To
increase their tradability, futures contracts are standardized in terms of both time period and
amount. They specify the quantity and quality of the underlying product, the agreed price and
the date of delivery.
The procedure of marking to market of futures contract, which implies that all potential
profits and losses are immediately realized, is the basis for the key difference between the
forward and future contracts.
A forward contract may or may not be marked to market. Where the counterparties are two
high-credit-quality entities, the two parties may agree not to mark positions to market.
However, if one or both of the parties are concerned with the counterparty risk of the other,
then positions may be marked to market. When a forward contract is not marked to market,
then there are no interim cash flows.
Because there is no clearinghouse that guarantees the performance of a counterparty in a
forward contract, the parties to a forward contract are exposed to counterparty risk, the risk
that the other party to the transaction will fail to perform.
When hedging the specified source of risk two questions have to be answered:
 Which contract should be used?
 What amount should be hedged?
The answer to the first question depends upon the source of risk, which will dictate the use of
some specific stock market index, interest rate or currency contract.
The answer to the second question depends upon optimal hedge ratio to be used.
The hedge ratio is the ratio of the size of the (short) position to be taken in futures contract to
the size of the exposure (the value of the portfolio to be hedged).
Hedge ratio = (Number of contracts x Size x Spot price) / V; where V – is the market value
of the underlying asset position.
The number of contracts to be sold if hedge ratio, that is to be implemented, is known can be
derived from this equation:
N = Hedge ratio x V / (Size x Spot price)

Example
Assume the manager of a futures fund has 1000000 Euro. The fund manager buys FTSE 100
futures relating to 1000000 of shares when the FTSE 100 stands at 5000.The futures mature
in one year.
Let’s determine the key characteristic of the contract
The number of futures contracts bought will be equal: 1,000,000/ (5000 x 10) = 20 contracts
Does any of the 1000000Euro need to be used in the purchase of the futures? Yes, the initial
margin must be provided
The approximate capital gain on the fund over a year, if the
FTSE 100 rises by 7%, will be equal to 7% (minus the net
Cost of carry).
In order to find the total return on the fund, interest on the money on deposit plus interest on
maintenance margin (i.e. interest on approximately 1,000,000) should be added to the capital
gain.
5.4.2. Forward and futures valuation
Valuations of all derivative models are based on arbitrage arguments. This involves
developing a strategy or a trade wherein a package consisting of a position in the underlying
(that is, the underlying asset or instrument for the derivative contract) and borrowing or
lending so as to generate the same cash flow as the derivative. The value of the package is
then equal to the theoretical price of the derivative. If the market price of the derivative
deviates from the theoretical price, then the actions of arbitrageurs will drive the market price
of the derivative toward its theoretical price until the arbitrage opportunity is eliminated.
The pricing of futures and forward contracts is similar. If the underlying asset for both
contracts is the same, the difference in pricing is due to differences in features of the contract
that must be dealt with by the pricing model.
A futures price equals the spot (cash market) price at delivery, though not during the life of
the contract. The difference between the two prices is called the basis:
Basis = Futures price – Spot price = F – S
The basis is often expressed as a percentage of the spot price (discount or premium) =
Percentage basis = ( F – S ) / S
Futures valuation models determine the theoretical value of the basis. This value is constraint
by the existence of profitable riskless arbitrage between the futures and spot markets for the
asset.
In a well-functioning market, when arbitrageurs implement their strategy by selling the
futures and buying underlying asset, this would force the futures price down so that at some
price for the futures contract, the arbitrage profit is eliminated. This strategy that results in
the capturing of the arbitrage profit is referred to as a cash-and-carry trade. The reason for
this name is that implementation of the strategy involves borrowing cash to purchase the

underlying asset and “carrying” that underlying asset to the settlement date of the futures
contract.
In general, the formula for determining the theoretical price of the contract, assuming that
lending and borrowing rates are both the same and equal to financing cost, and that there is
no margin, becomes:
Theoretical futures price = Spot price + (Spot price) x (Financing cost - Cash yield) where
financing cost - is the interest rate to borrow funds, cash yield - is the payment received from
investing in the asset (e.g. dividend) as a percentage of the cash price.
Example
Assume that the underlying asset price is 100 Euro, financing cost is 1% and cash yield is
2%. Then the theoretical futures price is: 100 Euro + [100 Euro × (1% − 2%)] = 99 Euro
The future price can be above or below the spot (cash) price depending on the difference
between the financing cost and cash yield. The difference between these rates is called the
cost of carry and determines the net financing cost.
Positive carry means that the cash yield exceeds the financing cost, while the difference
between the financing cost and the cash yield is a negative value.
Negative carry means that the financing cost exceeds the cash yield.
Zero futures happen when the futures price is equal to the spot (cash) price.
At the settlement date of the futures contract, the futures price must equal the spot (cash
market) price. The reason is that a futures contract with no time left until delivery is
equivalent to a spot (cash market) transaction. Therefore, as the delivery date approaches, the
futures price is converging to the spot (cash market) price. This happens as financing cost
and the yield that can be earned by holding the underlying asset, and finally the cost of carry,
approaches zero, when the delivery date approaches.
However, the borrowing rate is usually higher than the lending rate. The impact of this
difference is important when defining theoretical futures price.
In the cash-and-carry trade, the theoretical futures price based on borrowing rate becomes
Theoretical futures price = Spot price + (Spot price) × (Borrowing rate -Cash yield)
In the reverse cash-and-carry trade, the theoretical futures price based on lending rate
becomes:
Theoretical futures price = Spot price + (Spot price) ×(Lending rate - Cash yield)
Both equations together provide a band between which the actual futures price can exist
without allowing for an arbitrage profit. The first equation establishes the upper value for the
band while the second equation provides the lower value for the band.
The reverse cash-and-strategy trade requires the short selling of the underlying. It is assumed
in this strategy that the proceeds from the short sale are received and reinvested.
In practice, for individual investors, the proceeds are not received, and, in fact, the individual
investor is required to deposit margin (securities margin and not futures margin) to short sell.
For institutional investors, the underlying may be borrowed, but there is a cost to borrowing.

This cost of borrowing can be incorporated into the model by reducing the cash yield on the
underlying.
For strategies applied to stock index futures, a short sale of the components stocks in the
index means that all stocks in the index must be sold simultaneously. This may be difficult to
do and therefore would widen the band for the theoretical future price.
For valuation of stock index futures the fair value premium is used.
The excess of the fair futures price over the spot (i.e. actual) stock index is called the fair
value premium. The formula for the fair value premium is:
FP = I x [{(r - y)/100} x{d/365}] where FP is the fair value premium, I is the spot FTSE 100
Index, r is the interest rate, y is the expected percentage dividend yield on the index portfolio,
and d is the number of days to maturity of the futures contract.
Short cash and carry involves selling the borrowed stock and buying futures. In this case the
excess of interest over dividends is a net inflow and this gain should be matched by having a
guaranteed future purchase price that exceeds the spot sale price by the amount of this net
inflow. The money from the stock sale is put on deposit. In the case of short selling, the
borrower of the stock must pay sums equivalent to the dividends to the lender of the stock.
The excess of interest over dividends is a net inflow that should be matched by a capital loss
guaranteed by the futures price.
5.4.3. Use of forwards and futures
Going long or short in futures market without any offsetting position is described as taking
A. Speculative position.
In a futures hedge an investor offsets a position in the cash (spot) market with a nearly
opposite position in the futures market. The objective is to reduce the overall risk position.
The hedged position has lower expected return than an un hedged position.
In a long hedge the investor takes a long position in futures. In a short hedge the investor
takes a short position in futures. A very important type of hedge occurs when an investor
with the long position in the spot market simultaneously take a short position in the futures
contracts.
In short hedging the hedger may be able to find a futures contract for a virtually identical
item as hedger’s cash (spot) position. Then the gains (losses) in the spot market are offset by
the gains (losses) in the futures market. This offset is shown in the figure bellow.
Figure5.1. Profit profile for perfect hedge
Short future Long spot
profit -----------------------------------------------------------------------------Hedge
0 p
loss
Figure 5.1. Profit profile for perfect hedge

The Figure5.1 provides profit profiles. Assume, the investor goes long in the spot market at
50 Euro. As the spot price increases (decreases) the investor gains (losses) exactly the same
amount. The profit profile for a spot position is offset exactly by the short futures position.
Profit profile for the net position is a horizontal line, indicating no change in the value of the
net position as the spot price changes. Flat profile represents a perfect hedge.
However most often identical or similar future contracts do not exist. In this situation, the
hedger must utilize a short position in a similar, but different asset. This is called a cross
hedge. The relationship between a spot position and a futures contract in a cross hedge is not
a perfect straight line. It is shown as a dotted line in the figure below. Here it is assumed that
the investor takes a long position in the spot market in grade A investment assets, and offsets
by taking short position in the futures market in grade B investment assets. Grade B asset
prices are assumed to move half as fast as grade A asset prices. The
Figure 5.2 shows profit profile for long spot grade A investment assets, short futures grade B
investment assets and the net position. The gains and losses on the spot position are cut in
half for grade an investment asset by the short hedge.
Long Grade
Short future Grade B Hedge

Profit p
0
Loss
Figure 5.2. Profit profile for a cross hedge

The hedger can estimate the slope of the line (β) by using regression analysis in order to find
the best-fitting relationship. For every unit of the spot asset (cash market), the hedger shorts β
units of the futures. β is called the optimal hedge ratio.
The optimal hedge ratio is not a perfect hedge, because the link between the spot and futures
is not perfect. The optimal hedge ratio is the best in the sense that the expected change in the
hedged position is zero.
5.5. Options
5.5.1. Options Definition
Stock markets by their very nature are fickle. While fortunes can be made in a jiffy, more
often than not the scenario is the reverse. Investing in stocks has two sides to it:
 Unlimited profit potential from any upside; or
 A downside which could make you a pauper.
Derivative products are structured precisely for this reason; that is to curtail the risk exposure
of an investor. Index futures and stock options are instruments that enable the investor to

hedge his portfolio or open positions in the market. Options contracts allow you to run your
profits while restricting your downside risk.
Most people remain puzzled by Options. The truth is that most people have been using
options for some time now, as options are built into everything from mortgage to insurance.
In the stock markets, an option is a contract, which gives the buyer the right, but not the
obligation to buy or sell shares of the underlying security at a specific price on or before a
specific date. "Option", as the word suggests, is a choice given to the investor to either honor
the contract; or if he chooses not to, walk away from the contract.
To begin with there are two kinds of options; namely, the "Call" option and the "Put" option,
which we shall explain presently.
A "Call Option", is an option to buy a stock at a specific price on or before a certain date. In
this way, call options are like security deposits. If for example, you want to rent a certain
property and left a security deposit for it. The money would be used to insure that you could
in fact rent the property at the price agreed upon when you returned. However, if you never
returned, you would give up your security deposit, but you would have no other liability. Call
options usually increase in value as the value of the underlying instrument rises.
When you buy a Call option, the price you pay for it called the option premium, secures your
right to buy that certain underlying stock at a specified price called the strike price on or
before a specified date. If you decide not to use the option to buy the stock and you are not
obliged to, your only cost is the option premium.
A "Put Option", is an option to sell a stock at a specific price on or before a certain date. In
this way, put options are like insurance policies.
Let's say you buy a car, and then buy auto insurance for the car. You pay a premium to the
insurance company, and are hence protected if the asset is damaged in an accident. If this
accident were to happen, you can use your insurance policy to regain the insured value of the
car. If all goes well and the insurance is not needed, the insurance company keeps your
premium amount in return for taking on the risk of damage or loss. In similar fashion, the Put
option gains in value as the value of the underlying instrument decreases. With the Put
option, the investor can "insure" a stock by fixing a selling price. If adverse market action
causes the stock price to fall, thereby causing damage to the asset. Then, the investor can
exercise the put option and sell it at its "insured" price level. Thereby causing the underlying
asset to regain its value. If on the other hand the price of your stock goes up due to
favourable market action, then there is no damage to the asset. Then you the investor do not
need to use the insurance. And once again, your only cost is the option premium paid by you.
Thus, the primary function of listed options is to allow investors ways and means to manage
market risk.
Technically, an option is a contract between two parties. The buyer receives a privilege for
which he pays a premium. And the seller accepts an obligation for which he receives a fees.

5.5.2. Types of Options
An option is a contract between two parties giving the taker (or buyer) the right, but not the
obligation, to buy or sell a parcel of stocks (or shares) at a predetermined price; possibly on
or before a predetermined date. To acquire this right the buyer pays a premium to the writer
(or seller) of the contract. There are two types of options; namely:
 Call options
 Put options
We shall discuss both these types of options. You are advised to follow the thought, to
understand the concept. The names and the prices in the illustrations below are not in real
time and have only been used to help explain these options.
Call Options
The call options give the taker (or buyer) the right, but not the obligation, to buy the
underlying stocks (or shares) at a predetermined price, on or before a determined date.
Let's say Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call at a Premium of 8.
This contract allows Raj to buy 100 shares of SATCOM at BIRR 150.00 per share at any
time between the current date and the end of August. For this privilege, Raj pays a fee of
BIRR 800.00; that is BIRR 8.00 a share for 100 shares.
The buyer of a "call" has purchased the right to buy and for that he pays a premium. Now, let
us see how one can profit from buying an option.
Raj purchases a December Call option at BIRR 40.00 for a premium of BIRR 15.00. That is
he has purchased the right to buy that underlying share for BIRR 40.00 by the end of
December. If the price of the underlying stock rises above BIRR 55.00 (that is BIRR 40.00 +
BIRR 15.00) he will break even and start making a profit. However, to book this profit he
would have to exercise this option on or before the expiry date. Now, suppose the price of the
underlying stock does not rise but falls. Then Raj would choose not to exercise the option
and forgo the premium of BIRR 15.00 and thus limit his loss to this amount only.
If the Premium = BIRR 15.00 and the Strike price of the Call Option = BIRR 40.00, then the
Breakeven point = BIRR 15.00 + BIRR 40.00 = BIRR 55.00. That is to say that the price of
the underlying stock would have to rise to BIRR 55.00 before Raj would break even in his
transaction.
A trader is of the view that the index or Nifty would go up to 1400 in January, but does not
want the risk of prices going down. Therefore, he buys 10 Options of January contracts at
1345. He pays a premium for buying these Call Options (that is the right to buy these
contract) for BIRR 500.00 X 10 = BIRR 5,000.00.
In January, the Nifty index goes up to 1365. He sells the Call Options or exercises the option
and takes the difference between the Nifty Spot and the Strike price of his Call Option
contracts (that is BIRR 1365.00 - BIRR 1345 = BIRR 20.00). Now the market lot of the
Nifty contract is 200. So, the trader books a profit of BIRR 20.00 X 200 = BIRR 4,000.00 per

contract. Now, as he had bought 10 Call Options contracts his total profit would be BIRR
4,000.00 X 10 = BIRR 40,000.00.
He had paid BIRR 5,000.00 towards the premium for buying these Call Options. So he would
have earned BIRR 40,000.00 less BIRR 5,000.00 which is BIRR 35,000.00 when he
exercised these Call Option contracts.
If, on the other had the Nifty had fallen below 1345, then the trader will not exercise his right
and would opt to forego the premium of BIRR 5,000.00 he had paid initially. So, in case the
Nifty falls further below the 1345 level the traders loss is limited to the premium he paid up
front, but the profit potential is unlimited.
Call Options: Long and Short Positions:
 When you expect prices to rise, then you take a long position by buying the Call
Option. You are bullish on the underlying security.
 When you expect prices to fall, then you take a short position by selling the Call
Option. You are bearish on the underlying security.
Put Options
A Put Option gives the holder the right to sell a specified number of shares of an underlying
security at a fixed price for a period of time.
Let's say Raj purchases 1 Infosys Technology Aug 3500 Put - Premium 200. This contract
allows Raj to sell 100 shares of Infosys Technology at BIRR 3,500.00 per share at any time
between the current date and the end of August. To have this privilege, Raj pays a premium
of BIRR 20,000.00 (that is BIRR 200.00 per share for 100 shares). The buyer of a put has
purchased a right to sell.
To explain this further, let's say Raj is of the view that a stock is overpriced and its price
would fall in the future, but he does not want to take the risk in the event of the price rising.
So, he purchases a Put option at BIRR 70.00 on Stock 'X'. By purchasing the put option Raj
has the right to sell the stock at BIRR 70.00, but he has to pay a premium of BIRR 15.00 for
this contract.
So Raj would breakeven only after the stock falls below BIRR 55.00 (that is BIRR 70.00 less
BIRR 15.00) and would start making a profit on this contract when the stock price falls
below BIRR 55.00.
Let us illustrate this further. A trader on 15 December is of the view that Wipro is overpriced
and would fall in the future, but does not want to take the risk in the event the price rises. So,
he purchases a Put option on Wipro. The quotes are as under:
 Spot BIRR 1,040.00
 Jan Put 1050 BIRR 10.00
 Jan Put 1070 BIRR 30.00
The trader purchases 1000 Wipro Put at Strike price 1070 at Put price of BIRR 30.00. He
pays a Put premium of BIRR 30,000.00. His position in the following price point’s situations
is discussed below:

 Jan Spot price of Wipro = 1020
 Jan Spot price of Wipro = 1080
In the first situation, the trader has the right to sell 1000 Wipro shares at BIRR 1,070.00 , the
Spot price of which is BIRR 1,020.00. By exercising the Put option he earns BIRR (1070 -
1020) = BIRR 50.00 per put, which totals BIRR 50,000.00. His net income is BIRR
50,000.00 less BIRR 30,000.00 (that is the premium paid upfront) = BIRR 20,000.00.
In the second price situation, the price is higher in the Spot market, so the trader would not
sell at a lower price. In this case he would have to let his Put option expire unexercised. His
loss here would be initial premium paid for the Put option contracts that is BIRR 30,000.00.
Put Options: Long and Short Positions:
 When you expect price to fall, then you take a long position by buying Puts. You are
bearish.
 When you expect prices to rise, then you take a short position by selling Puts. You are
bullish
Option Concepts
The investor would find it useful to know certain important terms used with regard to
transactions in options. These terms are listed below:
 Strike price,
 In-the-money,
 Out-of-the-money,
 At-the-money,
 Covered Call, and
 Covered Put
At this stage, we would like to reiterate, that the visitors who have not dealt in stocks and
share, or investors who have dealt in stocks and shares but have not indulged in the leverage
provided by options as a speculative instrument would be well advised to meet a qualified
investment advisor to understand the nuances of this instrument.
It is always better to be on the side of caution and have a healthy margin of safety available
to us at all times in our financial transactions.
Strike price
The strike price denotes the price at which the buyer of the option has a right to purchase or
sell the underlying. Five different strike prices will be available at any point of time. The
strike price interval would be of 20. Let's say that the index is currently at 1410, then the
strike prices available would be 1370, 1390, 1410, 1430 and 1450. The strike price is also
called the exercise price. This strike price is fixed for the entire duration of the option, the
profit or loss from the contract would depend on the price movement of the underlying stock
or index in the Cash market.

In-the-money
A Call option is said to be "in-the-money", if the strike price is les than the market price of
the underlying (whether stock or index). A Put option is "in-the-money", when the strike
price is greater than the market price of the underlying.
Let's say Raj purchases 1 SATCOM AUG 190 Call at a premium of BIRR 10.00. Here, the
option is "in-the-money" till the market price of SATCOM is ruling above the strike price of
BIRR 190.00. This is the price at which Raj would like to buy 100 shares of SATCOM
anytime before the end of August.
Similarly, if Raj has purchased a Put option at the same strike price; then the option would be
"in-the-money" if the market price of SATCOM was lower than BIRR 190.00 per share.
Out-of-the-money
A Call option is said to be "out-of-the-money" if the strike price of the contract is greater
than the market price of the underlying stock. Similarly, a Put option is "out-of-the-money" if
the strike price is less than the market price of the underlying stock.
To explain this further, let's say Raj purchases 1 INFTEC AUG 3500 Call at a premium of
BIRR 150.00. The option is "out-of-the-money", if the market price of INFTEC is ruling
below the strike price of BIRR 3,500.00. This is the same price at which Raj would like to
buy 100 shares of INFTEC anytime before the end of August.
Similarly, if Raj has purchased a Put option at the same strike price; then the option would be
"out-of-the-money", if the market price of INFTEC was above BIRR 3,500.00 per share.
At-the-money
The option with a strike price equal to that of the market price of the underlying stock is
considered to be "at-the-money" or near-the-money.
Let's say Raj purchases 1 ACC AUG 150 Call or Put at a premium of BIRR 10.00. In this
case, if the market price of ACC is ruling at BIRR 150.00, which is equal to the strike price,
then the option is said to be "at-the-money".
To explain this further, let's say the Index is at 1410, and then the strike prices available
would be 1370, 1390, 1410, 1430 and 1450. The strike price for a Call option that are greater
than the underlying Index are said to be "out-of-the-money" for strike prices 1430 and 1450
considering that the underlying in the cash market is at 1410. Similarly, "in-the-money"
strike prices would be 1370 and 1390 which are lower than the underlying of 1410. And of
course, the strike price 1410 would be "at-the-money".
At these prices an investor can take a positive or negative view on the market; that is both
Call and Put options would be available. Therefore, for a single series 10 options (that is 5
Calls and 5 Puts) would be available; and considering that there are 3 series, a total of 30
options would be available to take a position.
Covered Call options
Covered option helps the writer to minimize his loss. In a covered call option, the writer of
the call option takes a corresponding long position in the stock in the cash market; this would

cover his loss in the options position, in case there is a sharp increase in the price of the
stock. Further, he is able to reduce his average cost of acquisition in the cash market (which
would be the cost of acquisition less the option premium received).
To illustrate this, let's say Raj believes that HUL has hit rock bottom at a price level of BIRR
182.00 and that it would move up in a narrow range. He can take a long position in HUL
shares and at the same time write a Call option with a strike price of BIRR 185.00 and collect
a premium of BIRR 5.00 per share. This would bring down the effective cost of HUL shares
to him to BIRR 177.00 (that is BIRR 182.00 less BIRR 5.00). If the price stays below BIRR
185.00 till expiry, then the Call option would not be exercised and Raj the writer of the Call
option would keep the BIRR 5.00 per share he had collected as premium. If on the other hand
the price goes above BIRR 185.00 and the option is exercised, then Raj would deliver the
shares acquired in the cash market.
Covered Put options
Similarly, the writer of a Put option can create a covered position by selling the underlying
security (that is, if it is already owned). The effective selling price will increase by the
premium amount (if the option is not exercised at maturity). Here again, the investor is not in
a position to take advantage of any sharp increase in the price of the stock, as the underlying
asset has already been sold. However, if the there is a sharp decline in the price of the
underlying asset, the option would be exercised and the investor would be left only with the
premium amount. The loss in the option exercised would be equal to the gain in the short
position of the underlying asset
5.6. SWAPS
A swap is an agreement whereby two parties (called counterparties) agree to exchange
periodic payments. The cash amount of the payments exchanged is based on some
predetermined principal amount, which is called the notional principal amount or simply
notional amount. The cash amount each counterparty pays to the other is the agreed-upon
periodic rate times the notional amount. The only cash that is exchanged between the parties
are the agreed-upon payments, not the notional amount.
A swap is an over-the-counter (OTC) contract. Hence, the counterparties to a swap are
exposed to counter party risk.
Swap can be decomposed into a package of derivative instruments, e.g. a package of forward
contracts. However, its maturity can be longer than that of typical forward and futures
contracts, it is negotiated separately, can have quite high liquidity (larger than many forward
contracts, particularly long-dated (i.e., long-term) forward contracts).
The types of swaps typically used by non-finance corporations are:
 Interest rate swaps,
 currency swaps,
 commodity swaps, and
 Credit default swaps.

Interest rate swap is a contract in which the counterparties swap payments in the same
currency based on an interest rate. For example, one of the counterparties can pay a fixed
interest rate and the other party a floating interest rate. The floating interest rate is commonly
referred to as the reference rate.
Currency swap is a contract, in which two parties agree to swap payments based on
different currencies.
Commodity swap is a contract, according to which the exchange of payments by the
counterparties is based on the value of a particular physical commodity. Physical
commodities include precious metals, base metals, natural gas, crude oil, food.
A credit default swap (CDS) is an OTC derivative that permits the buying and selling of
credit protection against particular types of events that can adversely affect the credit quality
of a bond such as the default of the borrower.
Although it is referred to as a “swap,” it does not have the general characteristics of a typical
swap. There are two parties in the CDS contract: the credit protection buyer and credit
protection seller. Over the life of the CDS, the protection buyer agrees to pay the protection
seller a payment at specified dates to insure against the impairment of the debt of a reference
entity due to a credit-related event. The reference entity is a specific issuer.
The specific credit-related events are identified in the contract that will trigger a payment by
the credit protection seller to the credit protection buyer are referred to as credit events.
If a credit event does occur, the credit protection buyer only makes a payment up to the credit
event date and makes no further payment. At this time, the protection buyer is obligated to
fulfill its obligation. The contract will call for the protection seller to compensate for the loss
in the value of the debt obligation
5.7. CAPS AND FLOORS
Caps and floors are agreements between two parties, whereby one party for an upfront fee
agrees to compensate the other if a designated interest rate (called the reference rate) is
different from a predetermined level. The party that benefits, if the reference rate differs
from a predetermined level, is called the buyer, and the party that must potentially make
payments is called the seller. The predetermined interest rate level is called the strike rate.
An interest rate cap specifies that the seller agrees to pay the buyer if the reference rate
exceeds the strike rate. An interest rate floor specifies that the seller agrees to pay the buyer
if the reference rate is below the strike rate.
The terms of an interest rate agreement include: (1) the reference rate; (2) the strike rate that
sets the cap or floor; (3) the length of the agreement; (4) the frequency of reset; and (5) the
notional amount (which determines the size of the payments). If a cap or a floor is in the
money on the reset date, the payment by the seller is typically made in arrears.

5.8 SUMMARY
The need for sophisticated risk management in the face of highly volatile exchange rates
provides one of the principal reasons for the growth of derivatives markets. These allow
firms to hedge risk by taking out contracts in derivatives markets, which carry the opposite
risk to that which they face in the underlying markets. The principal types of derivatives are
futures, forwards, swaps and options. Futures promise the delivery of an underlying asset of a
specified kind on a given date, although delivery is seldom made.
Options give the right to buy and/or sell an underlying asset, although that right need not be
taken up. In order to increase tradability, futures and options are highly standardized.
Both offer the possibility of very high rates of profit. Futures do this through the system of
margin payments. In the case of options, this occurs because buyers of options pay only the
premium for the right to trade at the specified price.
Derivative contracts are offered in relation to exchange rates, short-term and long-term
interest rates and stock exchange indices. They are widely used for speculation as well as for
risk management. In recent years, options have become extremely complicated, with new
forms of options contracts appearing regularly.
Forward and futures contracts are likely to provide cheaper protection against loss than
options, but remove the profit opportunity if prices move in favor of the firm. Thus, options
are generally preferable if the hedger is uncertain about the direction the price of the
underlying asset is likely to move. A hedger who is confident about the direction in which
the price will move is more likely to choose forward or futures contracts or remain in an open
position and accept the risk of a price change.
A trader who is confident that the price will fall may (a) sell the product before the price
falls; (b) take an offsetting short position by selling futures contracts; or (c) sell the currency
forwards. This eliminates entirely her exposure to the price fall.
A trader who is uncertain in which direction the price will move may choose options. Even
then, if she thinks that the price is more likely to fall than to rise, financial futures are
preferable to options because they are likely to offer her cheaper protection. Options are
preferable if the trader has no view or thinks that the price is more likely to rise than fall.
Derivatives markets have been controversial in recent years. Many companies have
experienced losses badly in these markets, and fears about causing serious problems for the
international financial system continue to be widespread
P Post Test Questions
Part I: State whether each of the following statements is True (T) or False (F)
1. Derivatives are securities similar to shares and debentures.
2. Underlying assets of a derivative must be a physical asset.
3. Standardized forward contracts may be called futures.
4. Forward contracts are traded only at computerized stock exchanges.
5. All futures contract must be settled by delivery of the asset.

6. In case of futures, the counterparty guarantee provided by the exchange.
7. Futures contracts do have a theoretical price.
8. Seller of a futures contract incurs a loss when the future price increases.
9. Option premium is the price for getting a right against other party.
10. In options, the option writer has a right against the option holder.
11. Options contract is only an extended version of a futures contract.
12. Call options and put options are inverse of each other.
13. American options can be exercised only on the strike date.
14. There is no fixed strike date in European options.
15. Option premium is one time non-refundable amount.
16. Expiry date of an option contract is mutually decided by the parties.
17. Loss of the call options holder is always limited.
18. Loss of the put option holder is always limited.
19. Excess of call option market price over the strike price is called intrinsic value.
20. Intrinsic value of an option is non-negative.
21. Swap deals with the delivery of a physical asset.
22. Swap arrangements are always standardized.
Part II: Multiple Choice Questions
1. A Futures contract is standardized version of a
(a)Put option, (b)Call option,(c)Call + Put,(d)Forward contract
2. Margins are imposed on options sellers to safeguard the interest of
(a)Exchange,(b)Brokers, (c)Buyers,(d) d) All of the above
3. In Futures trading, the margin in payable to the broker by
(a)Buyer of Futures,(b)Sellers of Futures,(c)None of (a) and (b),(d)Both of (a) and (b)
4. A contract which gives the holder a right to buy a particular asset at a particular rate
on or before a specified date is known as
(a) European Option, (b) Straddle,(c) American Option, (d) Strangle
5. In India, derivatives in interest rates are regulated by
(a) Securities and Exchange Board of India,(b) Forward Market Commission,(c)
Reserve Bank of India,(d) Ministry of Finance
6. The maximum loss of a call option holder is equal to
a. Strike-Spot Price,(b) Spot Price,(c) Premium,(d)So + Premium
7. The maximum loss of a put option writer is equal to
(a)Strike Price – Premium,(b)Strike Price,(c)Spot Price,(d)Strike Price plus premium
8. Intrinsic Value of a 'out of money' call option is equal to
(a)Premium,(b)Zero,(c)Spot Price,(d)Strike Price
9. Holder of an American call option can
(a)Buy the asset only on expiration,(b)Sell the asset on or before expiration,(c)Buy
the asset on or before expiration, (d)Sell the asset only on expiration

10. How the increase in volatility in asset price, will affect the value of the option?
(a)Increase the value,(b)Decrease the value,(c)May not affect,(d)Any of the above
11. Holder of European put option can
a. Sell the asset on or before expiry,(b)Sell the asset on or after expiry,(c)Sell the
asset on expiry only (d) Sell the asset before expiry only
12. Maximum gain of a put option holder is restricted to
(a)Strike Price,(b)Spot Price,(c)Spot Price – Premium,(d)Strike Price - Premium
13. Break-even of a call option occurs when spot price is equal to
(a)Strike Price + Premium,(b)Strike Price – Premium,(c)Premium, (d)None of the
above
14. Break-even of a Put option occurs when spot price is equal to
(a)Strike price + Premium,(b)Strike Price – Premium, (c)Premium,(d)None of the
above
15. Before expiry date, the time value of a call option is
(a)Strike Price - Spot Price,(b)Spot Price - Strike Price,(c)Market Premium - Intrinsic
Value,(d) Intrinsic Value
16. Out of 4 factors i.e.,(i) Dividend Yield, (ii) Market Interest, Rates, (iii) Time to
Expiry, and (iv) Price volatility, which affect the premium of an option?
(a) (i), (ii), and (iv),(b), (ii),(iii)and (iv),(c) (ii) and (iv),(d) (i), (iii) and (iv)
17. In Futures, the terms and conditions are standards with reference to
(a)Rate and Date only, (b)Quantity only,(c)Place of delivery only,(d)All of the above
18. In call options, which of the following has an m relation with its value?
(a)Volatility,(b)Time to Expiry,(c)Strike Price, (d)Spot Price
19. If Strike price is more than the spot price of the asset, the call option is known as
(a)American Option,(b)European Option,(c)Out of Money Option,(d)In the Money
Option
Part -1
(1) F, (2) F, (3) T, (4) F, (5) F, (6) T, (7) T, (8) T, (9) T, (10) F, (11) F, (12) F, (13) F, (14)
F, (15) T, (16) F, (17) T, (18) T, (19) T, (20) T, (21) F, (22) F,
Part -II
l.(d), 2. (d), 3. (d), 4. (c), 5. (c), 6. (c), 7(a), 8(b), 9. (c), 10. (a), 11. (c), 12. (d), 13. (a), 14.
(b), 15 (c), 16(d), 17. (d), 18. (c), 19. (c)]


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TABLE OF CONTENTS

CHAPTER ONE: Introduction to Investment Management ..........................................1

Reference ......................................................................................... .142

1 .0 . AIM AND OBJECTIVES

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1.2 Investments: Meaning, Types and Characteristics

1.2.2 Types of investments

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1.2.3 Characteristics of Investment

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1.2.4 Objectives of Investment

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a. Setting the Investment Objective

c. Selecting the Portfolio Strategy

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1.4.1 Equity shares

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1.6 Return and Risks

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f. Default or insolvency risk:

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1.7 Capital Asset Pricing Model (CAPM)

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Risks in relation to portfolios are also to be understood in the present discussion.

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2.1.2: The Basic Functions of Security Market

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2.1.3: The Major Players in Financial Markets

Payment ----------------- Payment

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Diagrammatic Example of a Financial Intermediary: A Commercial Bank

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